Investments — the ground floor

Why this chapter comes first

A PMS distributor sells a product meant for wealthy, fairly sophisticated clients. But the exam starts at the very bottom: what investment is, what return is made of, and what can go wrong. Get these ideas clean and every later chapter becomes easier.

Life does not match income to spending

People pass through phases. In some phases they earn more than they spend. In others they earn less than they spend. The workbook's point is simple: income and spending rarely match.

So people with a shortfall borrow, and people with a surplus lend. The borrower must be willing to repay more than they received. The lender postpones consumption today in exchange for a larger amount later.

Saving is not investing

The exam wants these two words kept apart.

• Saving is just the difference between money earned and money spent.
• Investment is the current commitment of savings with an expectation of receiving a higher amount later. It involves a specific time period. It is making savings work to generate return.

The workbook draws three contrasts:

And the line to memorise: "every investor is a saver but not vice versa."

Financial assets and real assets

Financial assets — shares, debentures, bank deposits, public provident fund, mutual fund investments. Physical (real) assets — gold, diamonds, other precious metals, real estate.

The workbook lists the advantages of financial assets: greater liquidity, flexibility, convenience of investing and ease of maintaining the investment. They are primarily income generating, though equity-oriented ones are held for long-term capital appreciation. They also allow small and frequent investments.

Investment versus speculation

These two are "so intermingled" that separating them is very difficult. The workbook offers two ways to try — time horizon and the process of decision making — and then knocks down the first one.

Time horizon. Transactions happen on a continuum from micro-seconds to perpetual holdings. There is a tendency to call short-term activity speculation and long-term ownership investment. The workbook says this is not appropriate.

Decision process. This is the useful test. The dictionary meaning of speculation is "the forming of a theory or conjecture without firm evidence".

• An investor carries out a process to find the value of an asset, and buys when the intrinsic value is higher than the current market price.
• A speculator pays no cognizance to the value of the asset. Profit making is the sole purpose, without much consideration of the risk involved.

So holding period does not decide it. Whether you valued the asset decides it.

Investment objectives

The workbook defines investment objectives as goals expressed in terms of risk, return and liquidity preferences.

Many investors state goals only as return — "I want my money to double this year." That is dangerous. Stating goals only in return terms can lead to inappropriate asset allocation and risky strategies. The investor must understand that "risk leads return" and not the other way around. So a detailed look at risk appetite — her willingness and ability to take risk — should come before any discussion of desired return.

The return objective comes in four flavours:

What a required return is made of

When you commit a rupee for a period, you want paying for three things:

1. Pure time value of money — because you postponed consumption.
2. Compensation for expected inflation — because prices will change.
3. A risk premium — because future payments are uncertain.

Build it up in layers:

• The real risk-free rate is what you demand with no inflation and no uncertainty. It is the compensation for postponing consumption. Give up ₹1,000 today for a guaranteed ₹1,020 later and the pure rate is 2%.
• Add expected inflation and you get the nominal risk-free rate.
• Add a risk premium and you get the required rate of return.

In simple terms, for small values:

Nominal risk-free rate = Real risk-free rate + Inflation Required rate of return = Nominal risk-free rate + Risk premium

The workbook is careful about what the required rate is not. It is the minimum return investors expect. It is not a guaranteed or assured return. It is different from expected or forecasted return. It is different from realised return.

Time value of money

Money today is worth more than the same money tomorrow, because today's money can be invested and earn a return. Invest ₹100 at a risk-free 5% and after a year it is ₹105 — that is its future value. Going the other way, ₹105 due in a year is worth ₹105 ÷ 1.05 = ₹100 today — its present value.

What sets the real risk-free rate? An interaction between a subjective factor — the desire for current consumption — and objective factors — the investment opportunities available and the real growth rate of the economy.

Risk premium and the risk–return line

A government security (with some caveats) gives a return you are certain of — both the amount and the timing. When cash flows or their timing are uncertain, investors demand extra. That extra is the risk premium. Higher the risk, higher the risk premium.

The relationship between risk and return is positive — but the workbook adds two details examiners like:

• In reality it is nonlinear. There is no proportionate increase in return for each extra unit of risk.
• The line is different for different individuals, depending on their risk appetite or risk aversion.

What "risk" means

In investments, risk is the possibility that actual earnings differ from expected earnings. Mathematically it is the dispersion around the average expected return, measured by standard deviation.

Note what that implies: a surprise on the upside is also risk in this sense.

The seven risks

The currency direction is a classic trap. For an investor holding foreign assets, home currency depreciation increases returns and appreciation reduces them.

Mitigation, per the workbook: political risk — diversify globally, invest in stable economies, monitor policy. Geopolitical risk — diversify globally, hold safe-haven assets (gold, bonds), stay informed. Regulatory risk — diversify across industries and geographies, monitor policy, prefer companies with strong compliance.

Types of investment

Financial investments (equity, bonds) are claims on future cash flows. Non-financial investments (real estate, gold, commodities) are also called real investments. The word securities generally means equity, bonds, derivatives and the like, and they are transferable.

Equity. Ownership stake; returns from capital appreciation and dividends. Empirically, higher long-run returns than other asset classes, with greater volatility. Analysed through fundamental analysis. Continuously reviewing and adjusting a portfolio to match market conditions and risk tolerance is called rebalancing.

Fixed income. Regular interest (coupons) plus return of principal at maturity — government, corporate and municipal bonds, treasury bills. Typically less volatile than equity. Held to maturity, they generally return principal and coupons provided the issuer does not default. Government bonds are low-risk thanks to sovereign guarantees; corporate bonds pay higher yields for higher credit risk. Still exposed to interest rate risk (prices fall when rates rise), credit risk and inflation risk.

Commodities.

And the key fact: commodities generate no current income. The investor counts only on capital appreciation.

Real estate. Residential, commercial, industrial, and special segments such as healthcare facilities and student housing. Offers both rental income and capital appreciation, and acts as an inflation hedge. Risks: market fluctuations, interest-rate-driven financing costs, liquidity risk, management time and unforeseen expenses, high upfront costs, local regulation.

Structured products. Traditional investments (bonds or equities) combined with derivatives to create customised risk–return profiles. They can offer capital protection and tailored exposure. But they are complex, often lack transparency, may be hard to trade before maturity, and carry credit risk of the issuer. Best suited to sophisticated investors — HNIs, institutions.

Non-traditional. Art, paintings, horses (prize earnings, stud fees, resale), distressed assets bought at a discount. Challenges: illiquidity, complex valuation, high transaction costs, niche market risks.

Channels: direct or managed

Direct investment — buying securities issued by companies and government bodies, or gold and silver from dealers. For financial securities, intermediaries help:

• Distributors — connect AMCs with investors; earn commissions or fees based on products sold.
• Brokers — buy and sell on exchanges; earn brokerage. Full-service (advice, portfolio management) or discount (low-cost platforms, minimal advice).
• Registered Investment Advisers — tailored advice. Some earn commission, some charge fees — but advisers are prohibited from earning both commission and fees from the same investor. SEBI-registered RIAs follow fiduciary standards.

Indirect investment through managed portfolios — professionally managed for fees, profit-sharing or both:

PMS decisions may be discretionary or non-discretionary. AIF categories, as the workbook lists them: Category I — start-ups, VC funds, social ventures. Category II — private equity, debt funds. Category III — hedge funds, long-short funds.