Investments — the ground floor

Why people invest at all

Nobody earns and spends in perfect balance. In some phases of life you earn more than you spend. In others you spend more than you earn. The workbook shows this as a life-cycle pattern of savings: the two lines rarely match.

So people with surplus money have two choices. Keep it until they need it. Or pass it to someone who needs it now — on the condition that it comes back with some increment.

That is the core trade-off. You postpone consumption today in exchange for an expected higher amount to consume later. The difference between the two is called return.

Saving is not investment

People use the two words interchangeably. The workbook does not.

• Saving is simply money earned minus money spent.
• Investment is the current commitment of savings with an expectation of getting back a higher amount. It involves a specific time period. It is the process of making savings work.

Three further differences:

Remember the last line in exactly that direction: every investor is a saver, but not vice versa.

Financial assets and real assets

Financial assets — shares, debentures, bank deposits, PPF, mutual fund units. Physical (tangible) 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 maintenance. They are mainly income generating, though equity-oriented ones are held for long-term capital appreciation. They also allow small and frequent investments.

Investment versus speculation

These overlap so much that they are hard to separate. The workbook tries two criteria: time horizon and the decision-making process.

Be careful with the first one. The workbook says there is a tendency to call short-term activity speculative and long-term holding investment — and it says that tendency is not appropriate. Transactions happen on every time scale, from micro-seconds to perpetual holding.

The sharper test is the process:

• An investor does the work to determine an asset's value, then buys what is worth more than its market price.
• A speculator takes on risk not commensurate with the return, hoping for higher gains, with minimum research and analysis of true value.

The dictionary meaning helps: speculation is "the forming of a theory or conjecture without firm evidence".

Investment objectives — risk first, then return

Investment objectives are investors' goals expressed in terms of risk, return and liquidity preferences.

Some investors state goals only as returns — "I want my money to double this year." The workbook says such an investor must be told this means excessive risk. Goals stated only in return terms lead to inappropriate asset allocation and risky strategies.

The workbook's phrase to remember: "risk leads return", not the other way round. So a detailed look at the investor's willingness and ability to take risk should come before any talk of desired return.

The four return objectives:

Building up the required rate of return

An investor commits money for a period to earn three things:

1. Pure time value of money — the reward for postponing consumption
2. Compensation for expected inflation
3. Risk premium — for uncertainty about future payments

These stack up in layers:

• Real risk-free rate = pure time value of money. No inflation, no uncertainty.
• Nominal risk-free rate = real risk-free rate adjusted for expected inflation.
• Required rate of return = nominal risk-free rate plus risk premium.

The workbook's first example: give up ₹1,000 today for a guaranteed ₹1,020 later. The pure rate of interest is 2%.

What the required rate of return is not. It is the minimum return investors expect. It is not a guaranteed or assured return. It is not the expected or forecast return. And it is not the realised return.

Time value of money

A rupee today is worth more than a rupee tomorrow, because today's rupee can be invested. Invest ₹100 at a risk-free 5% and it becomes ₹105 in a year — that is its future value. Turn it round: a certain ₹105 a year away has a present value of 105 ÷ 1.05 = ₹100.

The certainty makes it risk-free, and that 5% is the risk-free rate — also called the nominal rate of return. It ignores changes in purchasing power. The workbook's footnote gives the example of a risk-free investment: a treasury (government) bond.

The real risk-free rate depends on subjective factors (the desire to consume now) and objective factors (investment opportunities available, and the real growth rate of the economy).

Adding inflation — multiply, don't add

Keep the real rate at 2%. Now prices rise 6%. To stay whole the investor needs 8.12%, not 8%:

Fail to add this and you lose money in real terms.

Risk premium

The nominal risk-free rate is certain in both amount and timing. Government securities fit this pattern, "with some caveats". Most investments do not. The extra compensation above the nominal risk-free rate is the risk premium. Higher perceived risk, higher premium.

What risk actually is

The workbook corrects two common ideas.

Risk is not "exposure to danger". It is the variability in impact when exposed. In investing, risk is the possibility that actual earnings differ from expected. Technically: dispersion around the average expected return.

Risk is not uncertainty. When you have no knowledge of future variability or its causes, that is uncertainty. When there is theoretical or empirical knowledge of the causes, it is risk. In one line: risk is known uncertainty.

The seven risks in this chapter

Risk and return

The relationship is positive: greater risk, higher required return. As expected volatility rises, the risk premium goes up. The slope of the line is the required return per unit of risk.

Two caveats the workbook adds. In reality the relationship is non-linear — return does not rise in proportion. And the line differs between individuals, because risk appetite differs.

Types of investments

Two broad buckets: financial and non-financial (real estate, gold, commodities — also called real investments).

Financial instruments are claims on future cash flows, and come in two generic types: debt and equity. They can also be split by transferability: security form (shares, bonds, notes — easily traded) versus non-security form (fixed deposits, insurance — no secondary market).

Equity shares

Ownership. A share in profits and the right to vote. Shareholders are residual owners — paid after all contractual claims — and have ultimate control. Rewards come two ways: dividend and capital appreciation.

Equity enjoys time diversification: return fluctuations tend to cancel out over time, so equities offer better risk-adjusted returns over long holding periods.

Listed vs unlisted. Listed securities trade on an exchange — the public market — with continuous pricing and better liquidity, but prices are more prone to sentiment. Unlisted ones trade over the counter in the private market, priced at intervals, less liquid, and investors may demand an illiquidity risk premium.

Fixed income

A promise to pay a stream of cash flows over the contract term. Can be transferable or non-transferable. Issued by companies, municipalities, states and sovereigns. Government securities form the largest component of the debt market in India and the world.

G-Secs are issued by the Central or State Governments:

• Treasury bills — short term, original maturity less than one year
• Dated securities / bonds — original maturity one year or more
• Central Government issues both. State Governments issue only dated securities, called State Development Loans (SDLs).

G-Secs carry practically no default risk, hence risk-free gilt-edged instruments.

Corporate bonds pay more because of default risk. The gap in yield between a corporate bond and a G-Sec of the same maturity is the credit spread — effectively a risk premium.

Credit ratings (CRISIL scale)

BBB and above = investment grade. Below BBB = high yield or junk. Many institutional investors are prohibited from junk bonds.

Money market vs capital market

Money market: maturity of one year or less — T-bills, Commercial Papers, Certificates of Deposit up to one year. Capital market: more than one year — stocks and bonds. The longer horizon raises uncertainty, so investors demand a term premium.

Commodities

Soft (corn, wheat, soybean, soybean oil, sugar) are perishable, highly volatile, subject to business-cycle risk, weather-sensitive, and historically show low correlation with stocks and bonds. Exposure is usually through forwards or futures.

Hard (gold, silver, oil, copper, aluminium) are priced by global demand and supply. Gold is a "safe haven" in uncertainty and geopolitical crisis. Commodities generate no current income — only capital appreciation.

Real estate

The largest asset class in the world. Good diversifier, historically a good inflation hedge, offers both appreciation and rent. Usually long term, large commitments. Split into commercial and residential, and by tier I, II and III cities. REITs and real estate funds allow exposure with smaller outlay.

Structured products

Customised, sophisticated, heavy use of derivatives, often linked to indices, baskets, currencies, rates or commodities. Larger denominations. Capital protection may be anywhere from 0% to 100%. They must not be taken as guaranteed capital protection or assured return.

Distressed securities

Securities of companies in financial distress or near bankruptcy. Available at huge discounts but need higher valuation skill. The workbook says they are also referred to as "fallen angels". Many funds are prohibited from holding them. Popular with hedge fund managers.

Art, paintings, collectibles

Moderate long-term returns, low correlation with equities and bonds, big-ticket, each piece unique, unregulated market, no income, relatively illiquid, heavy information asymmetry. Exposure is also possible through art funds.

Channels for investing

1. Direct. Buy securities, gold or silver yourself, using fee-based intermediaries such as brokers, depositories and advisers.

2. Registered Investment Advisers. Under SEBI's RIA regulation of 2013, only qualified professionals licensed by SEBI as RIAs can act as "advisers". They are paid fees by investors. Distributors — MF distributors, share brokers, insurance agents — can no longer claim the title. RIAs follow a strict code of conduct, act in investors' best interests, and disclose conflicts of interest.

3. Managed portfolios. Professionally managed pooled vehicles — Mutual Funds, Alternative Investment Funds, Portfolio Managers, Collective Investment Schemes.

Mutual funds

A trust that pools savings of investors with a common financial goal. Income and gains are shared in proportion to units held — a true pass-through intermediary. Benefits: professional management, diversification, convenience, account administration, lower transaction costs, regulatory protection, product variety. Not "get rich quick", not risk-free. Regulated by SEBI under the Mutual Fund Regulations, 1996.

Alternative Investment Funds

A privately pooled vehicle collecting funds from sophisticated investors — institutions and HNIs, not the public. Minimum investment ₹1 crore.

Portfolio Management Services

A portfolio manager is a body corporate that advises, directs or undertakes management of a portfolio of securities for investors.

• Discretionary — manages each investor's funds individually and independently.
• Non-discretionary — manages funds in accordance with the investor's directions.

Key rules: a written agreement setting out mutual rights and obligations. No fee scale is prescribed — fees are as per the agreement, fixed, return-based, or a combination. Minimum ₹50 lakh in funds or securities to open an account. A portfolio manager cannot borrow on behalf of clients.

MF vs AIF vs PMS

All three are managed portfolios and all are regulated by SEBI. Mutual funds are the most stringently regulated because they serve retail investors. AIFs (₹1 crore) and PMS (₹50 lakh) serve institutional and HNI investors, who are expected to understand complex strategies, so their investment restrictions are relatively less.