CHAPTER 1: INVESTMENT LANDSCAPE – 8 Marks

1.1 Investors and their Financial Goals

“Please suggest some good investments.” “Which mutual fund schemes should one buy this
year?” “Which is the best mutual fund scheme?” “Which is the best investment?” “Should I
invest in stocks or real estate?” “What is your view of the stock market?” “Are my investments
proper? Or should I make some changes?”

One hears these and many similar questions very regularly. There is an issue with these
questions. These are about the investments and not the investor. The investor’s needs are
not even discussed, and probably not even considered important.

As leadership guru and bestselling author Simon Sinek says, “Start with Why”. The discussion
of investments must start with “why” – the purpose of investment. “Why is one investing?”

1.1.1 Financial Goals

The above are some examples of common situations we see regularly in our own life or the
lives of people around us. Though there is no explicit mention of money in these examples,
we intuitively know that money would be involved in each of these situations, whether Shalini
has to be educated well, or Surinder Singh has to buy a house, or Mrs. D’Souza or Rabindra
have to fund their lives in retirement. In the investment world, the requirements of these four
are known as financial objectives. When we assign amounts and timelines to these objectives,
we convert these into financial goals.

There are numerous examples of such financial goals. Among the most common are funding
a child’s education, the cost of the marriage of one’s son or daughter, funding the lifestyle in
retirement, buying a vehicle, buying or renovating one’s house, taking a big vacation. At the
same time, there could be some not-so-common ones like starting one’s own business or
taking a sabbatical from work and fund one’s higher education.

The first step in goal setting is to identify these events in life

After identifying the events, one needs to assign priorities–which of these are more important
than the others. Retirement or children’s education fall into the responsibility’s category,
whereas a grand vacation may be a good-to-have goal. Having said that, it is only the individual
and the family that can decide which is which. A financial advisor or a mutual fund distributor
may only guide and help one take an appropriate decision. At the same time, the role of such
an intermediary would be very important.
After that, one needs to assign a timeline as well as the amount of funding required at the time of
such events Factors to evaluate investments

The three most important factors to evaluate investments are safety, liquidity, and returns.
In addition to these, there are few more parameters such as convenience, ticket size (or the
minimum investment required), taxability of earnings, tax deduction, etc.

1.2 Different Asset Classes

Various investment avenues can be grouped in various categories, called asset classes. An
asset class is a grouping of investments that exhibit similar characteristics. There are four
broad asset categories or asset classes, and then there are various subcategories, within each
of these. The four broad categories—Real estate, Commodities, Equity and Fixed income.

1.2.1 Real Estate

Real estate is considered as the most important and popular among all the asset classes.

As an asset category, real estate exhibits certain traits, some of which are listed as under:

• Location is the most important factor impacting the performance of an investment in

real estate
• Real estate is illiquid
• It is not a divisible asset
• One can invest in physical real estate, as well as in the financial form
• Apart from capital appreciation, it can also generate current income in form of rents
• In case of real estate, the transaction costs, e.g., brokerage charges, registration charges,
etc. are quite high. This would bring down the return on investment.
• The cost of maintenance of the property, as well as any taxes payable must be adjusted
before calculating the return on investment, something that many individual investors
do not. These expenses are also quite high, and cannot be ignored.
• The investments acquired or sold shall be accounted at transaction price excluding all
transaction costs such as brokerage, stamp charges and any charge customarily included
in the broker’s contract note that are attributable to acquisition/sale of investments.
1.2.2 Commodities

This is another asset category that people at large are familiar with in various ways. On a
regular basis, people consume many commodities, e.g., agricultural commodities like spices;
petroleum products such as petrol and diesel; or metals like gold and silver.
Gold and silver come in varying degrees of purity. Each one can be bought at different prices
from the market. However, for a large majority of investors, it is almost impossible to make
out the level of purity. If we opt for a purity certificate, the cost goes up and without one, the
risk of getting lower quality metal is high.

1.2.3 Fixed Income

When someone borrows money, one has to return the principal borrowed to the lender in
the future. There could also be some interest payable on the amount borrowed. There are
various forms of borrowing, some of which are through marketable instruments like bonds
and debentures2.
There are many issuers of such papers, e.g., Companies, Union Government, State
Governments, Municipal Corporations, banks, financial institutions, public sector enterprises,
etc.

Bonds are generally considered to be safer than equity. However, these are not totally free
from risks. These risks will be discussed in detail later in the chapter.

1.2.4 Equity

This is the owner’s capital in a business. Someone who buys shares in a company becomes a
part-owner in the business. In that sense, this is risk capital, since the owner’s earnings from
the business are linked to the fortunes, and hence the risks, of the business. When one buys
the shares of a company through the secondary market, the share price could be high or low
in comparison to the fair price.

Historically, equity investing has generated returns in excess of inflation, which means the
purchasing power of one’s money has increased over the years. It has also delivered higher
returns than other investment avenues, most of the time, if one considers long investment
periods. Since the base year of 1979, Sensex has grown from a level of 100 to around 66000
i.e., July 2023. This is an appreciation of around 16 percent p.a., compounded annually.3

Apart from long term capital appreciation, equity share owners may also receive dividends
from the company. Such dividends are shared out of the profit that the company has
generated from its business operations. If the company does really well, the dividends tend
to grow over the years.

There are similarities and differences between the various asset categories.

Investments in equity and bonds can be done only in financial form, whereas one can buy the
other two assets, viz., real estate and commodities either in financial or in physical form. It is
this physical form that gives a feeling of safety to many. Anything that is tangible is perceived
to be safer than something intangible.

Real estate and commodities differ from equity and bonds in another way, too. These could
be bought as an investment or for consumption purposes. For example, one may invest in
residential property and give it on rent to generate income. This is an investment. At the same
time, one may also buy a flat to live in–for residential purposes. Such a self-occupied house
may not be an investment. A similar logic may be applied to gold and silver by checking
whether one has invested in the metal or bought the same for personal use.

When someone invests in equity shares, part of the profits made by the company may be
shared with the investor. With a careful analysis of various equity shares, it is possible to
receive a periodic income (though without any guarantee about how much would one
receive, and whether one receives anything at all). Similarly, real estate could be given on rent
to generate intermittent cash flow. Bonds pay interest income. It is the commodities where
such intermittent cash flow is not [Link] investment avenues can be categorized
into different asset category as can be seen from the illustration in Table 1.1:

Table 1.1 Investment avenues classified under different asset categories

Equity Fixed Income

• Blue-chip Companies • Fixed deposit with a bank
• Mid-sized companies • Recurring deposit with a bank
• Small-sized companies • Endowment Policies
• Unlisted Companies • Money back Policies
• Foreign Stocks • Public Provident Fund
• Equity Mutual Funds • Sukanya Samruddhi Yojana (SSY)
• Exchange Traded Funds • Senior Citizens’ Savings Scheme (SCSS)
• Index Funds • Post office Monthly Income Scheme
• Recurring deposit with a post office
• Company fixed deposit
• Debentures/bonds
• Debt Mutual Funds
Real Estate/Infrastructure Commodities
Physical Asset • Gold
• Residential/ Commercial • Silver
Financial Asset • Gold Funds
• Real Estate Mutual Funds (REMF) • Commodity ETFs
• Real Estate Investment Trusts (ReIT)
• Infrastructure Investment Trust (InvIT)
Hybrid asset classes Others
• Hybrid Mutual funds or Multi-Asset Fund • Rare coins
• Art
• Rare stamps

1.3 Investment Risks

To obtain a better understanding of the investment avenues, it is essential to understand the
different types of risks involved.

1.3.1 Inflation Risk

Inflation or price inflation is the general rise in the prices of various commodities, products,
and services that we consume. Inflation erodes the purchasing power of money. The following
table explains what inflation can do to the purchasing power of our money.

How much money would you need to buy the goods you can If inflation is assumed
buy with Rs. 10,000 today at 8% p.a.4
After 5 years Rs. 14,693

4 The numbers are arrived at by using the future value equation, i.e., A = P * (1 + r) ^ n, where A is the future value (the values
in the right-side column); P is the present value (Rs. 10,000 in the example); r is the rate of inflation (8% p.a. in the example);
n is the number of years (the periods in the first column in this table).
 After 10 years Rs. 21,589
After 20 years Rs. 46,610
After 30 years Rs. 1,00,627
1.3.2 Liquidity Risk

Investments in fixed income assets are usually considered less risky than equity. Even within
that, government securities are considered the safest. In order to avail the full benefits of the
investments, or to earn the promised returns, there is a condition attached. The investment
must be held till maturity. In case if one needs liquidity, there could be some charges or such
an option may not be available at all.

1.3.3 Credit Risk

When someone lends money to a borrower, the borrower commits to repay the principal as
well as pay the interest as per the agreed schedule. The same applies in the case of a
debenture or a bond or a fixed deposit. In the case of these instruments, the issuer of the
instruments is the borrower, whereas the investor is the lender. The issuer agrees to pay the
interest and repay the principal as per an agreed schedule. There are three possibilities in
such arrangements:

(1) the issuer honours all commitments in time, (2) the issuer pays the dues, but with some
delay, and (3) the issuer does not pay principal and the interest at all. While the first is the
desirable situation, the latter two are not. Credit risk is all about the possibility that the second
or the third situation may arise.

1.3.4 Market Risk and Price Risk

When securities are traded in an open market, people can buy or sell the same based on their
opinions. It does not matter whether these opinions are based on facts, or otherwise. Since
the opinions may change very fast, the prices may fluctuate more in comparison to the change
in facts related to security. Such fluctuations are also referred to as volatility.

There are two types of risks to a security—market risk and price risk.

The risk specific to the security can be reduced through diversification across unrelated
securities, but the one that is market-wide cannot be reduced through diversification.

1.3.5 Interest Rate Risk

Interest rate risk is the risk that an investment's value will change as a result of a change in
interest rates. This risk affects the value of bonds/debt instruments more directly than stocks.
Any reduction in interest rates will increase the value of the instrument and vice versa.
When the interest rates in the economy increase, the prices of existing bonds decrease, since
they continue to offer the old interest rates.

Risk Measures and Management Strategies

• Diversify
For a lay investor a prudent approach would be to diversify across various investment options.
This spreads the risk of loss and thus the probability of losing everything can be significantly
reduced through diversification.

1.4 Behavioural Biases in Investment Decision Making

Before discussing asset allocation, it is important to take a detour and discuss behavioural
biases in investment decision making. This is also one of the risks the investors must
understand. However, this risk is not related to the investments, but the role of emotions in
decision making, or in other words the irrational behaviour of investors towards management
of money.

Investors are driven by emotions and biases. The most dominant emotions are fear, greed
and hope. Some important biases are discussed below:

• Availability Heuristic
Most people rely on examples or experiences that come to mind immediately while analyzing
any data, information, or options to choose from. In the investing world, this means that
enough research is not undertaken for evaluating investment options. This leads to missing
out on critical information, especially pertaining to various investment risks.

• Confirmation Bias
Investors also suffer from confirmation bias. This is the tendency to look for additional
information that confirms their already held beliefs or views. It also means interpreting new
information to confirm the views. In other words, investors decide first and then look for data
to support their views. The downside is very similar to the previous one – investors tend to
miss out on many risks.

• Familiarity Bias
An individual tends to prefer the familiar over the novel, as the popular proverb goes, “A
known devil is better than an unknown angel.” This leads an investor to concentrate the
investments in what is familiar, which at times prevents one from exploring better
opportunities, as well as from a meaningful diversification.

• Herd Mentality
“Man is a social animal” – Human beings love to be part of a group. While this behaviour has
helped our ancestors survive in hostile situations and against powerful animals, this often
works against investors interests in the financial markets. There are numerous examples,
where simply being against the herd has been the most profitable strategy.

• Loss Aversion
Loss aversion explains people's tendency to prefer avoiding losses to acquiring equivalent
gains: it is better not to lose Rs. 5,000 than to gain Rs. 5,000. Such behaviour often leads
people to stay away from profitable opportunities, due to the perception of high risks, even
when the risk could be very low. This was first identified by Psychologists Daniel Kahneman
and Amos Tversky. Kahneman went on to win Nobel Prize in Economics, later on.

• Overconfidence
This bias refers to a person’s overconfidence in one’s abilities or judgment. This leads one to
believe that one is far better than others at something, whereas the reality may be quite
different. Under the spell of such a bias, one tends to lower the guards and take on risks
without proper assessment.

• Recency bias
The impact of recent events on decision making can be very strong. This applies equally to
positive and negative experiences. Investors tend to extrapolate the event into the future and
expect a repeat.

• Behaviour patterns
There are different types of people and the factors that influence their lives also impact the
manner in which they save or invest. The drive to save more or be regular in investing often
come from these personal factors. Behavioural tests are very useful in determining and
knowing the kind of personality a person has and this would include whether they are
spenders or savers or investors. Knowing this can help in making the right efforts to get the
individual to perform the desired ac-on.

1.5 Risk Profiling

The risk profilers try to ascertain the risk appetite of the investor so that one does not sell
mutual fund schemes that carry a higher risk than what the investor can handle.

1.6 Understanding Asset Allocation

The basic meaning of asset allocation is to allocate an investor’s money across asset
categories in order to achieve some objective. In reality, most investors’ portfolios would
have the money allocated across various asset categories. However, in many such cases, the
same may be done without any process or rationale behind it.

Asset Allocation is a process of allocating money across various asset categories in line with a
stated objective. The underlined words are very important. First, it is a “process”, which
 always involves several steps, and those steps should not be ignored or skipped. Second, the
whole idea behind asset allocation is to achieve some objective. Whichever approach one
selects, one must go through the steps of the process in order to achieve the objective.
There are two popular approaches to asset allocation5.

Strategic asset allocation

Strategic Asset Allocation is allocation aligned to the financial goals of the individual. It
considers the returns required from the portfolio to achieve the goals, given the time horizon
available for the corpus to be created and the risk profile of the individual.

Tactical asset allocation

As opposed to the strategic asset allocation, one may choose to dynamically change the
allocation between the asset categories. The purpose of such an approach may be to take
advantage of the opportunities presented by various markets at different points in time, but
the primary reason for doing so is to improve the risk-adjusted return of the portfolio

As an illustration, if the appropriate allocation to equity and debt in a portfolio is say 60:40
and equity valuations are attractive, it may be increased to say 65:35 or 70:30. If equity
valuation is stretched, it may be reduced somewhat.

Rebalancing

An investor may select any of the asset allocation approaches, however, there may be a need
to make modifications in the asset allocations.

The rebalancing approach can work very well over the years when the various asset categories
go through many market cycles of ups and downs.

On the other hand, one may also need to do a rebalancing of the asset allocation, when the
investor’s situation changes and thus the needs or the risk appetite might have changed.
Rebalancing is required in the case of strategic asset allocation as well as tactical asset
allocation.

1.7 Do-it-yourself versus Taking Professional Help

One option is to manage the investments oneself. That would involve finding the right
investments and carrying out the related research and administration work. The other option
is to outsource the entire job to a professional or a company engaged in such a business.

A mutual fund is that second option – it is managed by a team of professionals, known as the
 asset management company. This is what really needs to be understood. By choosing to
invest through mutual funds, one is not investing in alternative investment options, but only
changing the way of investing money. The entire job of investing is outsourced to a
professional firm.

So, the next logical question is: “Which of the two choices is better – investing oneself or
taking professional help to manage my investments?”

This question should be broken down into three components:

1. Can one do the job oneself?

2. Does one want to do it?
3. Can one afford to outsource?

Can one do the job oneself?

This is the question about ability. In order to do a good job, there are a few requirements,
viz., ability to do the job and the availability of time required for the same. There are tasks
where one may not have the skills and knowledge, e.g., a history teacher may not be able to
help her daughter to study Mathematics in the higher classes. At the same time, one may not
have enough time required for the job.

In either case, one is unable to do manage money oneself and should consider outsourcing it.

Does one want to do it?

Even when one has the required skills and knowledge to manage one’s money, it is very likely
that one may not enjoy money management–either the research and analysis or
administration or accounting. At the same time, one may want to spend time on one’s main
profession or on certain other activities, e.g., spending time with family and friends, pursuing
hobbies, etc. That also means that one needs help in managing investments.

Can one afford to outsource?

There is some cost associated with mutual funds since the agencies involved need to be paid
their professional fees. While we will cover the costs associated with managing mutual funds
in a later chapter, it is important to mention here that SEBI (the securities markets regulator)
has issued guidelines on the maximum amount that can be charged to the fund.

Most people make the mistake of comparing these fees with zero cost of managing one’s own
money oneself. By this comparison, the cost of a mutual fund always looks higher between
the two options.

What is missed out in this comparison is the hidden costs of doing the investment
management job on one’s own. This hidden cost comes in the form of one’s time and
the
Potential mistakes that an individual investor is likely to make.

Chapter 1: Sample Questions

1. Which among the following investment avenues does not offer income on a regular
basis?

a. Real estate
b. Physical Gold
c. Stocks
d. Debentures

2. Which amongst the following asset categories can also be purchased for
consumption purposes apart from an investment?

a. Real estate
b. Stocks
c. Bonds
d. Debentures

3. The purchasing power of currency changes on account of which of the following?

a. Asset allocation
b. Compound interest
c. Inflation
d. Diversification

4. What is the real rate of return?

a. Return that the investor gets after payment of all expenses

b. Return that the investor gets after taxes
c. Return that the investor gets after adjusting the risks
d. Return that the investor gets after adjusting inflation

5. When the interest rate in the economy increases, the price of existing bonds .

a. Increases
b. Fluctuate
c. Decreases