Securities and asset allocation — the whole menu, explained simply

Two ways to give a business your money

Imagine your neighbour Ramesh runs a small samosa stall and wants ₹1 lakh to buy a bigger fryer. He can get that money from you in exactly two ways.

Way one — you lend it. "Give me ₹1 lakh. I will pay you ₹1,000 every month as interest, and return your ₹1 lakh after three years." You are a lender. You know exactly what you get and when. You do not care whether he sells 100 samosas a day or 1,000 — your ₹1,000 is fixed.

Way two — you become a part-owner. "Give me ₹1 lakh and you own 30% of the stall." Now there is no fixed payment. If the stall booms you take 30% of a big profit. If it flops you may get nothing back at all.

Way one is debt. Way two is equity. Every security in the entire securities market is a variation of one of these two, or a mixture of both.

The workbook states the differences directly:

Why equity earns more (and can earn nothing)

Here is the exact example the workbook uses, and it is worth understanding rather than memorising.

A business borrows at 12%. It puts that money into assets that earn 14%.

• The lender gets his 12%. Not a rupee more, however well things go.
• The extra 2% belongs to the equity investor.

Now flip it. Suppose the assets earn only 9%. The lender still must be paid 12% — that is a legal obligation. The shortfall comes out of the owner's pocket. The equity investor may not earn anything at all.

That is the whole risk–return trade-off in one line: all residual benefits go to the equity investor, so his return is likely to be higher than the debt investor's — and so is his risk.

The process of splitting your money between these two choices is called asset allocation. It depends on your expected return, your investing time period, your risk appetite and your needs.

What else is on the menu

Beyond plain equity and debt, the workbook lists these:

• Hybrid securities — have features of both debt and equity.
• Commodities — real assets like gold, silver, copper, agricultural produce. Can be physical, but usually held as commodity mutual funds, ETFs and commodity derivatives. ETFs and mutual funds are suitable for retail investors.
• Derivatives — contracts to buy or sell an underlying asset on preset terms. Most heavily traded products of the past twenty years, but ideally suited to sophisticated investors.
• Mutual funds — pool money from many investors and invest per a mandate. Best suited for retail investors.
• Structured products — a traditional product (a bond, a currency) with a derivative embedded inside. Complex, highly customised, illiquid — so generally suitable for high net worth investors with a high risk appetite.
• Distressed securities — securities of a company near or in bankruptcy, or whose credit rating has crashed. Banks, mutual funds and insurers must exit such names because of regulatory limits on holding low-rated companies, so these securities trade at a steep discount to face value. Attractive to hedge funds, who are not bound by the same rules. For sophisticated investors.
• Electronic Gold Receipts (EGRs) — gold in electronic form, with trading, clearing and settlement. Traded on a Gold Exchange. Governed alongside the SEBI (Vault Managers) Regulations, 2022.
• Zero Coupon Zero Principal (ZCZP) instruments — issued by a Not for Profit Organization for social projects. They pay no financial return at all; they promise a social return. Listed on the Social Stock Exchange (SSE) segment of a recognised exchange.

Notice which products the workbook flags for which investor. This gets tested.

Why a company picks debt or equity

Governments, note, issue only debt — never equity. A company has a choice, and weighs four things:

1. Ability to pay periodic interest. Steady profits → debt is affordable. Unsteady profits → prefer equity.
2. Willingness to dilute ownership. New equity means the existing owners' slice shrinks. Do not want that? Borrow instead.
3. Ability to give collateral. Lenders like security. A services business with few assets may have nothing to pledge, so equity is preferred.
4. Time period the capital is needed for. Short-term needs → debt (bank borrowing, commercial paper). Long-term needs that lenders will not touch → equity.

Short-term needs — paying suppliers, salaries, giving customers credit — are called working capital needs and are met with short-term debt. Long-term needs — a factory, a road, a port — need long-term capital.

Equity, feature by feature

Denomination. Equity capital is divided into equity shares, each with a face value. In India face value is typically Re.1, ₹2, ₹5 or ₹10. Companies funded by equity are called joint stock companies because the shareholders jointly own them.

Part ownership. A company issues 10,000 shares of face value ₹10 → equity capital of ₹1,00,000. Same 10,000 shares at face value ₹2 → ₹20,000. Own 5,100 of those 10,000 shares and you have a 51% stake — a majority stake. Some companies give employees a slice through ESOPs (employee stock option programs).

Two kinds of shareholder. Inside shareholders are the promoters who start the company with their own money and skills — venture capitalists coming in early also count as insiders. Outside shareholders are members of the public who invest later.

Variable return and residual claim. Equity capital is raised for perpetuity and is not returned during the life of the business. Dividend is not pre-determined — it depends on profits left over after every cost, including interest and tax. And if the business fails, shareholders are ranked last: liquidation proceeds go first to government, lenders and employees, then to preference shareholders, and only whatever is left — the residual — reaches equity shareholders.

Net worth and reserves. A company need not pay dividend every year. Profit that is kept back is called retained profits and becomes part of the company's reserves. Here is the point students miss: reserves belong to the equity shareholders, even though the money sits inside the company. Reserves raise the net worth and the value of the shares.

Risk capital. Equity is also called risk capital — these investors accept that the business may succeed or fail, with no fixed return promised.

Management and control. Promoters run the company at first. As it grows and takes public money, ownership and management separate. Thousands of small shareholders cannot run a company, so a board of directors does, with professional independent directors representing small shareholders. Every share carries one vote, exercised in a general meeting, by postal ballot, or through e-voting.

Three kinds of equity capital

Ordinary shares — full voting rights, variable dividend.

Differential voting rights (DVR) shares — separate the right to profits from the right to vote. Investors usually get a higher dividend but proportionately lower voting rights. Why would a company issue these? So promoters can raise risk capital without diluting their control.

Preference shares — a special kind of equity that pays a pre-defined rate of dividend. They sit between debt and equity:

Preference shares get their dividend before ordinary shareholders and get capital back before them in a winding-up — that is the "preference". But they carry no voting rights and no right over the company's assets. If profits are short, unpaid dividend can be carried forward to later years when the terms allow — those are cumulative preference shares. They are usually not listed, and there is little scope for capital appreciation, because they do not participate in the company's profits: the company over-performing or under-performing does not change their value.

Returns and risks from equity

You earn from equity in two ways: dividend that may be paid periodically, and an increase in the value of the investment in the secondary market.

Both depend on the company's future residual cash flows — the profits left after every other claim is paid. The risk is that these future benefits are not assured or guaranteed; they can only be estimated.

Equity prices are described as noisy. Many players act at once on new information and re-align. A stock with stable and consistent growth appreciates; one whose performance is deteriorating depreciates. Prices rise when buyers will pay more and more; they fall when sellers accept less and less. So stock prices are a barometer of how a company, a sector or the whole economy is doing.

Debt, feature by feature

A debt security is a contract between the issuer and the lender. Three features define it:

• Principal — the amount borrowed. The face value is the principal due on each security.
• Coupon — the rate of interest, stated as a percentage of face value. It depends on the issuer's default risk, the lender's credit policy, the maturity and market conditions. The periodicity (quarterly, half-yearly, annual) is agreed in the contract.
• Maturity — the date the principal must be repaid. Once repaid, the bond is extinguished and ceases to exist.

Why issue securities instead of taking a bank loan? Say a company needs ₹100 crore. One bank loan = one lender. Or it issues 1 crore securities of ₹100 face value each — now thousands of investors participate, and someone putting in ₹1,000 gets 10 securities. Each investor's exposure is limited to what he invested.

Other features of debt:

• Floating rate of interest — the coupon is not fixed but linked to a benchmark such as MIBOR (Mumbai Interbank Offer Rate), re-set at an agreed frequency, say every six months.
• Credit rating — because lenders are outsiders and cannot see inside the business, the company appoints a credit rating agency to assess its ability to meet interest and principal obligations.
• Priority — interest is paid before taxes and before anything goes to equity investors. Missing it is a default, which damages the credit rating. On failure of the business, lenders are settled before employees and equity investors.
• Security — many borrowings are secured by a mortgage on the company's assets, so lenders can force a sale to recover dues.
• Control — lenders do not manage the company, but may restrict the Board: no unrelated diversification, no further borrowing, no second charge on assets, or a demand for more equity as a cushion.
• Conversion — lenders may convert debt into equity through convertible debentures. Interest is paid up to the conversion date; afterwards the holding is equity, with all shareholder rights and no more lender rights.

Bond or debenture? In India, a debt instrument of a government or public sector organisation is called a bond; one from the private corporate sector is called a debenture. Some argue debentures are secured and bonds unsecured. The workbook is clear: these differences have vanished over time and the terms are now used interchangeably.

Some debt is listed on the NSE or BSE and can be traded. Unlisted securities have to be held until maturity.

Bond shapes beyond plain vanilla

A plain vanilla bond pays a fixed rate periodically and returns the principal at maturity — issued at face value, say ₹100, and redeemed at par, the same ₹100.

Varying the coupon:

• Zero coupon bond — pays no coupon at all. Issued at a discount to face value, redeemed at face value; the interest you earn is the difference. A long-maturity zero coupon bond is issued at a very big discount and is called a deep discount bond. The workbook's example: ABC Communications Holdings raised ₹4,280 crore, maturity value ₹100, issue price ₹85.80 for Series 1 and ₹82.55 for Series 2. A variant is issued at face value and redeemed at a premium — the defining feature is simply no intermediate coupon payments.
• Floating rate bond — coupon re-set against a benchmark. Example: a 5-year bond re-set semi-annually at 50 basis points above the 1-year government security yield. Also called variable rate or adjustable rate bonds — those names are used when resets are a year apart or longer. Common in the housing loan market.
• Deferred interest bonds — the borrower can defer coupons in the initial 1 to 3 years.
• Step-up bonds — the coupon is stepped up periodically, so the interest burden is low early and rises over time.

Varying the exit:

• Callable bond — the issuer can redeem early. If interest rates fall, the issuer calls the bond and re-issues cheaper. The investor loses the chance to stay in a high-coupon bond. Workbook example: XYZ Bank, ₹10,000 face value, 9.75% coupon, 10-year tenor, rated Care AAA, with the option to redeem after 5 years and one day from allotment.
• Puttable bond — the investor can demand early redemption. If rates have risen, the investor exits a low-coupon bond and re-invests higher.
• Amortizing bond — the principal is repaid over the life of the bond, not at the end. Every instalment carries both interest and principal. Auto loans, consumer loans and home loans work this way. Its stated "maturity" is only the last payment in the schedule.

Keep the call/put direction straight, because it is a favourite: call = issuer's right; put = investor's right.

How debt is classified

Two ways:

• By type of borrower — government, or non-government (banks, corporations).
• By tenor — up to one year is the money market; longer maturities are the capital market.

These are not separate worlds. The government issues treasury bills in the money market and long-term bonds in the capital market. Companies issue commercial paper in the money market and bonds in the capital market.

Central government securities are considered free of credit or default risk — the government can raise taxes, borrow easily, or in the extreme print notes to repay.

Money market securities run from one day up to one year: repos/reverse repos, certificates of deposit, treasury bills and commercial papers. All of them are issued at a discount and redeemed at par — zero coupon in structure. (Inter-bank call money, term money and inter-corporate deposits are money market transactions too, but do not create a security, so they are not counted here.)

• Repo — borrowing money at a pre-set rate against collateral of an eligible security. A reverse repo is the same transaction seen from the lender's side. Eligible collateral: central and state government securities and select corporate bonds.
• Tri-party repo — done on the electronic platform of the Clearing Corporation of India (CCIL) or the exchanges, and cleared through a Central Counterparty that gives a settlement guarantee and collects margins. Ordinary repos settle bilaterally. Exchanges offer a basket repo contract of 1 to 7 days against a basket of securities chosen by the Clearing Corporation.
• Certificates of Deposit (CDs) — short-term tradable deposits issued by banks. Unlike a regular bank deposit, a CD is a security, so it is transferable before maturity — though in practice trading is extremely limited and most holders keep them to maturity.
• Treasury bills (T-bills) — central government short-term borrowing, issued for 91 days, 182 days and 364 days, through an auction managed by the RBI, and listed soon after issue.
• Commercial paper (CP) — short-term company borrowing. Must be credit rated, but is an unsecured corporate loan with a limited secondary market. Maturities up to 364 days; the 90-day CP is the most popular.

Government securities (G-secs), also called treasury bonds, are issued mainly to fund the fiscal deficit, through an electronic auction managed by the RBI. The RBI publishes a half-yearly issuance calendar. Tenors run from one year to 40 years. The commonest form is the fixed coupon bond, or dated security — fixed coupon, semi-annual interest, redeemed at par. Other forms: treasury bills, floating rate bonds, zero coupon bonds and inflation-indexed bonds.

G-secs matter for everyone, not just the government: the G-sec rate is the benchmark. Every other borrower pays a spread over it. If the 10-year G-sec is at 8.4%, a company issuing 10-year bonds pays more — the premium reflects its credit risk. G-secs are mandated to be listed as soon as they are issued, and are the most liquid part of the long-term debt market: over 90% of trading activity. But trading concentrates in a few benchmark securities — the 1, 5, 10, 15 and 30-year.

Corporate bonds come from two segments: public sector units (PSUs) including public financial institutions, and the private corporate sector.

• Tax-free bonds — mainly issued by infrastructure PSUs when the government authorises them. Interest is not taxable for the investor.
• Capital gains bonds — issued by NHAI, NABARD, National Housing Bank and other notified entities. They let investors save tax on long-term capital gains under Section 54 EC of the Income Tax Act.
• PSU and institutional bonds dominate overall issuance. By sector, finance is about 70% of total bond issuance and manufacturing about 30%.
• The gap between a corporate bond's yield and the G-sec yield is the credit spread. It depends on the credit rating, expected default probability, industry, and the overall credit and liquidity situation. Higher rating → lower spread → cheaper borrowing.
• Masala bonds — issued outside India by Indian companies but denominated in Indian rupees. Coupon and principal are paid in rupees, so the foreign investor, not the Indian issuer, bears the currency risk. The first masala bond was issued by the International Finance Corporation (IFC) and listed on the London Stock Exchange.
• Green debt securities — raise funds for sustainable projects: renewable energy, clean transportation, climate change adaptation, green buildings, biodiversity conservation. Part of ESG investing. Sovereign Green Bonds were announced in the Union Budget FY 2022-2023 speech.
• Bharat Bond ETF — tracks the Nifty Bharat Bond Index of AAA-rated PSU bonds. Has a defined tenure — one series of 5 years, another of 11 years — a very low expense ratio, a high degree of safety, and is taxed like an ordinary debt fund.

Also note: company fixed deposits. Companies raise these from retail investors for a fixed term at a pre-defined rate. They are credit rated but unsecured, and because a deposit is not a security, there is no liquidity — investors hold to maturity.

What debt gives you, and what it costs you

Benefits: fixed income promised under a legal contract, which makes debt less risky than variable-return securities and ideal for retired persons; and a fixed tenor, so capital is tied up only for a limited period.

Risks — five of them:

1. Inflation / purchasing power risk. A bond promising 8% over five years is a good investment only if inflation stays below 8%. Above that, the real return is negative. Debt is especially vulnerable because, unlike equity, coupons are fixed and cannot rise with inflation.
2. Default / credit risk. Government securities are free of it; all other debt is exposed. Credit rating is a good indicator. The higher coupons of lower-rated debt are tempting, but those bonds are riskier. Secured debt has lower default risk because there is recourse to assets — which is exactly why unsecured debt such as corporate fixed deposits pays higher rates than secured bonds.
3. Reinvestment risk. Take the interest out and you must find somewhere to put it at the same or a higher rate. Choose the cumulative option and you implicitly reinvest at the security's own rate. Investors tend to prefer payouts even when they do not need the cash — and that preference exposes them to reinvestment risk.
4. Call risk. The issuer calls the bond early, usually when rates decline, to retire high-cost debt. You are forced to reinvest at lower rates.
5. Liquidity risk. Secondary markets are thin and dominated by institutions, so smaller investors usually end up holding to maturity. That means: if rates fall you cannot sell and book the price gain; if rates rise you cannot switch into higher coupons; and any drop in credit quality during the bond's life leaves you stuck with more credit risk.

Choosing debt or equity as an investor

Four questions:

• Income or growth? Debt is income-oriented, equity is growth-oriented. Retired investors needing steady cash prefer debt.
• Time horizon? Debt is issued for 7 days to 30 years, most commonly 90 days to 7 years. Short horizon → debt. Long horizon → equity, whose short-term value swings frequently.
• Risk appetite? Debt is more stable and structured to return principal, though default is possible. In equity, dividend amount and frequency are unknown, may be zero, and there is no assurance of return of principal — the amount invested may be completely lost.
• How often will you review? Active reviewers prefer equity, which is listed and lets them sell laggards. Debt investors, even in listed bonds, mostly buy and hold to maturity.

Hybrids — the in-between instruments

Convertible debentures. Debt that can turn into equity shares later. It pays coupon like any bond; at redemption the investor takes shares instead of principal. The issuer fixes, at issue time: the conversion date, the conversion ratio (shares per debenture), the conversion price (usually at a discount to market price), and the proportion that converts.

• Fully convertible debentures (FCD) — the entire face value converts.
• Partly convertible debentures (PCD) — part converts; the rest stays a debenture, keeps earning interest and is repaid at redemption.
• Optionally convertible debentures (OCD) — conversion is at the debenture holder's discretion.

The issuer likes convertibles because they carry a lower coupon than pure debt (the investor is also being paid in the hope of capital appreciation) and because the debt need not be repaid — shares are issued instead. The downside for the issuer: existing shareholders get diluted.

Depository receipts (DRs). A DR represents shares of a local company but is listed and traded on a stock exchange outside the country, and is issued in foreign currency, usually dollars. Shares are lodged with a custodian bank, which authorises the DR issue.

• Listed on a US exchange such as the NYSE → American Depository Receipt (ADR).
• Listed on an exchange outside the USA → Global Depository Receipt (GDR).
• Issued in India, listed here, with foreign shares underlying → Indian Depository Receipt (IDR).

If existing shares are offered up for conversion, it is a sponsored issue; the company may instead issue fresh shares, with funds raised abroad repatriated to India within a specified period. Holders of DRs get dividends and capital appreciation but NOT voting rights. DRs may have two-way fungibility — shares can be bought locally and converted into DRs, and DRs converted back into underlying shares. SEBI's IDR guidelines cover the money limit, a lock-in on conversion, and the rule that IDRs are available only to resident Indian investors and not to FPIs.

Foreign Currency Convertible Bonds (FCCBs). Foreign-currency (usually dollar) debt raised abroad by Indian companies, convertible into the company's equity before maturity. Interest and principal are paid in foreign currency, and the conversion price is usually set at a premium to the current market price. They let companies raise debt at lower rates abroad, often faster than pure foreign debt. Rules to know:

• A company not eligible to raise equity in the domestic market is not eligible to issue FCCBs either.
• Unlisted companies that raise FCCBs must list the shares domestically within a stipulated time.
• Regulated by RBI notifications under FEMA; guidelines from the 1993 scheme on FCCBs and Ordinary Shares (Through Depository Receipt Mechanism).
• Maturity shall be not less than five years.
• Expenses limited to 4% of issue size for a public issue and 2% for a private placement.

Warrants. A warrant gives the holder the right but not the obligation to subscribe to a specific number of the company's equity shares at a predetermined price, on or after a predetermined date. Warrants are like stock options with two differences: stock options are issued by the stock exchange and live 1 to 3 months; warrants are issued by the company and live longer.

Under SEBI rules the investor pays 25% of the consideration upfront. Exercise the warrant and you pay the balance and receive shares. Decide against it and you forfeit the 25% already paid.

The workbook's example: ABC Ltd shares trade at ₹180. The company issues 400,000 warrants at ₹220 to institutional investors, exercisable a year later. Upfront payment = 25% × (400,000 × 220) = ₹2.20 crore.

Why would a company do this? If it issues shares today it only gets today's ₹180 valuation. If prospects are improving, issuing warrants at ₹220 lets the company capture the future price appreciation. And the investor locks in a price by paying only 25% today.

Commodities

Equity and debt are financial assets. Commodities are real assets — things consumed or used in manufacturing. That is why they react to a changing macroeconomic environment more directly than equity and debt.

Four categories: soft commodities (agricultural — sugar, tea, coffee, cocoa, corn, wheat, soya-bean), bullion (gold and silver), base metals (copper, zinc, aluminium, nickel), and energy (crude oil and natural gas).

Two features make commodities awkward: storage and insurance costs, which can be very high and put physical commodities out of an ordinary investor's reach; and the need for specialised knowledge — not just macroeconomics and geopolitics but weather, rainfall, snowfall, inventory levels and consumer preferences.

Two roles make them valuable:

• Protection against inflation — commodity prices are usually higher when inflation is rising, so they act as a hedge.
• Low correlation to equity and debt — precisely because equity and debt suffer during inflation while commodities do not. That makes commodities an efficient means of diversification.

One warning the exam likes. Buying shares of a steel company is not a pure play on steel. You get the upside of rising steel prices, but also the company's own risks — high debt-equity exposure, foreign competition, import policy changes — which can push the share price down even while global steel prices rise. For direct exposure, use commodity ETFs, commodity mutual funds or commodity derivatives.

Derivatives, in one page

A derivative's value is derived from some other, more basic underlying variable. Traded both OTC and on exchanges. The exchange-traded derivatives in India are futures and options.

• Futures — an agreement between buyer and seller to buy or sell the underlying at a predetermined price and quantity on a predetermined date.
• Options — give the holder the right but not the obligation to buy or sell. A call option is the right to buy; a put option is the right to sell. The preset price is the exercise or strike price. Both futures and options settle on a preset expiry date.

Because everything expires, derivatives have a short shelf life and are primarily for investors with a short investment horizon.

Features to remember:

• Contracts are designed by the Exchanges and the specifications are approved by the regulator. Specifications include contract size, quotation unit, tick size, contract grade, trading hours, trading cycle, expiration date, delivery terms and daily price limits.
• Derivatives are under-funded — you only deposit an upfront margin, a small percentage of the underlying's value.
• Derivatives are leveraged. The workbook's example: ABC Ltd trades at ₹100, margin is 10%. A margin deposit of ₹100 gives exposure to 10 shares, which would have cost ₹1,000 outright — a leverage of 10 times.
• Derivatives markets are often more liquid than the cash market, and traded volumes are often several times cash volumes.
• Derivatives are risky precisely because of that leverage: a small margin tempts investors into positions beyond their risk-bearing capacity, and leverage magnifies losses as much as gains.

Three roles: they aid price discovery (being more liquid, they are better at establishing a fair price); they transfer risk from those who want to avoid it to those willing to bear it for a price, making them hedging tools; and they let retail investors diversify into currencies and commodities.

Segment specifics worth a line each:

• Equity derivatives — futures and options on stock indices (Nifty, Bank Nifty) and specified individual stocks, with SEBI's strict eligibility criteria. Index F&O are settled in cash; individual stock F&O are settled by physical delivery of the stock. Clearing, settlement and risk management are done by the Clearing Corporation.
• Currency derivatives — INR pairs (USDINR, EURINR, GBPINR, JPYINR) and cross-currency pairs (EURUSD, GBPUSD, USDJPY). All of them, INR and cross-currency alike, are cash-settled in Indian rupees.
• Commodity derivatives — on gold, industrial metals, crude oil and agri-commodities. Commodity options are options on futures, not on the spot commodity — because SEBI regulates the commodity futures market while State governments regulate commodity spot markets. On expiry the option devolves into a futures position.
• Interest rate derivatives — Interest rate futures (IRF) on specified government securities, treasury bills and MIBOR; interest rate options (IRO) on government securities. Settled in cash.

Asset allocation and diversification

Different goals need different things from your money, and no single investment can provide growth, liquidity, regular income, capital protection and adequate return all at once.

The workbook gives five people who each got this wrong by concentrating everything in one place:

• Jayesh owns only real estate. He needs money urgently and cannot sell or borrow quickly enough.
• Kamal leaves everything in a savings account earning very low interest and cannot accumulate enough.
• Latika is entirely in equities. Her value keeps fluctuating and she is unsure the funds will be there when needed.
• Harmeet holds mostly gold jewellery and cannot generate income for monthly expenses.
• Gayatri holds bank fixed deposits. Her interest is fixed but her expenses keep rising.

The common disease is concentration. Spread across assets and a fall in one is cushioned by a rise in another, because not all asset values move together. That splitting is asset allocation.

The right allocation depends on the person: someone close to retirement holds more debt and less equity; someone earning well with distant goals leans to equity. Suitable asset allocation is a function of the investment period available and the ability to take risk.

Diversification is what asset allocation produces — a combination of investments such that a fall in one or a few is made up by others doing well. The catch: the benefit only exists if the investments do not rise and fall together. Allocating across asset classes (equity, debt, gold, real estate) is the first level. Choosing shares across different industries within equity is the next level.

Six practical things a good portfolio needs

1. Managing return and risk requirements — decide where to invest so goals are met, and manage risk through diversification. Mutual funds are an easy way to diversify even with a small amount.
2. Aligning investment horizon to product — equity returns are far more volatile over the short term but can be expected to outperform debt over a reasonably long horizon. Guided by the investor's age and liquidity needs: younger investors with no immediate liquidity needs should hold more equity, because they can sit tight through volatile periods.
3. Aligning portfolio features to needs — a retirement portfolio focuses on growth while accumulating and shifts to income after retirement. Rebalancing must be easy.
4. Ease of investment and exit — you save periodically, so investing must be convenient; and you must be able to liquidate easily when a plan matures or an emergency hits.
5. Flexibility — for example a low-risk investor may pick a debt-oriented Monthly Income Plan, using the growth option so income accrues without periodic payouts.
6. Information and updates — securities are issued under regulations that require adequate information to be given to investors, so performance and suitability can be assessed.

Price versus value in equity

Here is the idea that separates investing from gambling. Stock prices are anchored in intrinsic value, and prices cannot mindlessly deviate from fair value for long periods.

• Intrinsic value — the estimated value per share based on the future earning potential of the company; formally, the discounted value of its future benefits.
• Market price — the price the share actually trades at, reflecting many investors' differing estimates of intrinsic value.

Markets gather everyone's estimates into an equilibrium price, and in this price discovery process estimates are tested, rewarded and penalised by demand and supply.

But equity markets are not perfectly efficient — prices reflect information through a chaotic process, with episodes of inefficiency. So:

• Intrinsic value more than market price → the share is undervalued.
• Intrinsic value less than market price → the share is overvalued.

The goal is to buy undervalued and sell overvalued. Doing it correctly and consistently is hard, because what is being priced is the unknown future. Equity investing is not amenable to mathematical formulation.

The equity investing process

• Security selection — understanding the business, its prospects, profit forecasts and expansion plans.
• Market timing — not all shares are attractive at all times. Firms move through economic cycles; in a slowing economy steel and construction slow more than FMCG, because items of regular consumption are still bought. Businesses also pass through growth phases — an early-stage firm may grow fast from a near-monopoly position, then attract competition and settle into stable, lower growth.
• Sector and segment weighting — large or small, new or established, growth-oriented or dividend-paying. This choice drives the portfolio's risk and return.

Four ratios every equity investor meets

Price-Earnings (PE) multiple = Market price per share ÷ Earnings per share. It shows how much the market values per rupee of earnings. EPS = profit after taxes ÷ number of shares outstanding. A stock "trading at 12x" trades at twelve times its earnings. If earnings are expected to grow, the market pays a higher multiple — so the focus is on the prospective PE, not the historical one. Used on the index, a market PE of 22x or above is widely considered an overvalued zone and 12x or lower an undervalued zone. A stable, large, well-known company usually trades at a higher PE than a smaller, less known, riskier company in the same sector.

Price to Book Value (PBV) = Market price per share ÷ Book value per share. Book value is the accounting value per share — net worth, that is capital plus reserves, per share. Its big limitation: most assets sit on the books at cost less depreciation and are not inflation adjusted, so the realisable value is not reflected. PBV below one may indicate an undervalued stock. In a bull market PBV moves up, indicating rich valuation.

Dividend yield = Dividend per share ÷ Market price per share. Note the trap built into this: dividend is declared as a percentage of face value, not of market price. A 40% dividend on a ₹10 face value share is ₹4 per share. If the share trades at ₹200, the dividend yield is 4/200 = 2%. Dividend yield is inversely related to price: price up, yield down. PSUs, especially PSU banks, tend to have higher dividend yields. As a market indicator: a bull market shows falling dividend yields; a bear market shows higher and rising ones.

Who does the research

• Buy-side research is done by institutional investors managing portfolios, aiming for returns above benchmarks. Buy-side analysts tend to be generalists, covering more sectors and stocks, focused on questioning the model and understanding downside risks.
• Sell-side research is done by broking houses employing specialists who track sectors and stocks, build earnings models, interact with management, peers, suppliers and customers, and arrange meetings for buy-side clients.

Two ways to analyse, two ways to value

Fundamental analysis studies financial statements and information about a stock to estimate future potential. Technical analysis studies price and volume patterns — charts, support and resistance, trends — treating price as an aggregate indicator of all information about a stock.

Fundamental analysis follows the economy–industry–company (EIC) framework, done in two directions:

• Top-down — begins at macro factors, then identifies sectors and stocks.
• Bottom-up — begins at stock selection on business potential, then ratifies it against industry and macro indicators.

Information comes from audited financial statements; analyst meetings, plant visits and management interactions; industry reports and presentations; and government and regulatory publications.

Valuation has two broad approaches:

• Discounted cash flow (DCF) models — rigorous, based on the business itself: earnings, growth and dividends. They need clearly specified assumptions about cash flow estimates and about the discounting rate (the proxy for risk) — and because analysts differ on both, DCF valuations differ significantly.
• Relative valuation models — find the pricing of something similar, using peer group and sector averages. They identify both undervalued and overvalued stocks because they include the market price. Easier to understand and tweak — but that is also the limitation: they can import the valuation errors already in market prices, and assumptions about comparables and peer groups may be generalised and prone to error.

Time value of money, and why a bond has a price

A rupee today is worth more than a rupee in future. Put ₹1,000 in a 2-year deposit at 8% simple interest and it becomes ₹1,160 (₹1,000 principal + ₹160 interest). So today's ₹1,000 beats a future ₹1,000.

The rule: today's money should be compounded before comparing with a future amount; future money should be discounted before comparing with today's.

For a bond, the future cash flows are discounted at a rate called the yield — the current fair rate for that tenor and credit quality — and added up. That sum is the present value, the bond's theoretical fair value.

Two rules follow:

• The further ahead the cash flow, the lower its present value. ₹10 arriving in year 1 is worth more today than ₹10 arriving in year 10, at the same discount rate.
• The higher the discount rate (yield), the lower the present value. Discount at 12% instead of 10% and the bond is worth much less; discount at 8% and it is worth more.

Which gives the most important sentence in the debt half of this chapter: there is an inverse relationship between yield and price. As price falls, yield rises; as yield rises, price falls.

Yield versus coupon. In bond markets it is the price that is quoted and known. Coupon and redemption are also known, so the yield can be computed. The yield is the actual measure of return at a point in time; the coupon merely tells you the cash flows. They differ because you can buy or sell at a price different from face value:

Current yield = Coupon rate ÷ Market price. A bond paying a 12% annual coupon trading at ₹109.50 has a current yield of (12 ÷ 109.5) × 100 = 10.95%.

Yield to Maturity (YTM) is the rate that equates the present value of all future cash flows with the current price. It changes as the price changes. It is the discount rate implied in the bond value at a point in time, and yield quotations in the debt market usually refer to YTM.

The debt investing process

Same three steps as equity, but macroeconomic knowledge matters more.

• Security selection depends on risk appetite and liquidity needs. Retail investors prefer bank fixed deposits, postal savings certificates, money market mutual funds and short-term debt mutual funds — liquid and safe. Institutions can also take government securities and corporate bonds; money market instruments and G-secs give liquidity, corporate bonds give higher returns.
• Market timing needs an interest rate outlook and a credit outlook, which turn on oil prices, the fiscal deficit and government policy. Because price and yield move inversely, it makes sense to buy long-dated government securities when the interest rate cycle has peaked, locking in high yields. On credit: corporate yields are always above government yields of the same maturity — the credit spread. The spread is narrow when the economy is booming and widens during a recession, when corporate revenues suffer and risk perception rises. That widening is also when highly rated companies' bonds become available at attractive yields.
• Determining weights — how much in each product. For example roughly 20% of the debt allocation in liquid funds; more in gilt funds if the rate cycle has peaked (G-sec prices have bottomed and can be expected to rise); credit risk funds kept lowest during recessionary phases. Investors who lack the expertise to read interest rate movements should simply use dynamic bond funds.