Investments: A Detailed Understanding

An investment is an asset or item that is purchased with the hope that it will generate income or appreciate in value, in the future. 

In layman's language, the savings when associated with a certain risk in order to earn returns are the basic form of investing. 

This lesson aims to talk about the basics of investment  the various factors affecting investment decisions, how investing is different from speculating, investment attributes, investment avenues, time value of money, real rate of return, the profile of the Indian investor and regulation (Protection of investors rights).

by Siddharth Jogani
11 months ago
1

An investment is an asset or item that is purchased with the hope that it will generate income or appreciate in value, in the future. 

In an economic sense, an investment is the purchase of goods that are not consumed today but are used in the future to create wealth. 

In finance, an investment is a monetary asset purchased with the idea that will generate income in the future or appreciate and be sold at a higher price.

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Investments are different from speculation (See heading, Investment v/s Speculation)

In this lesson, we are concerned mainly about the various forms of investments, the factors that affect investment decision. (Explained in detail later)

The basic theory driving investment as acceptable is that an individual believes that the
pleasure derived from future consumption will be more than the pleasure forgone today. It is commitment of funds to one or more assets that will be held over a certain time period. Investment creates wealth and wealth is the driver of consumption. The future consumption is the main motivation of an investment made today. More wealth = More consumption , Less wealth = less consumption. As a result Investment, wealth and consumption are interrelated. This is an investment consumption cycle.

Investment >> Creates Wealth >> Leads to consumption
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Investment is an activity that results from savings of an individual. Savings depend on
positive surplus cash flow of an individual. Investments are made from savings or it can be said that people invest their savings. However, not all savers are investors. Savings are put into bank accounts, fixed deposits or can also be held in the form of ideal cash. Investment is the saving with a desire to earn a better return (above average) with some risk.  

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Individuals invest to improve their lifestyle in future. Investible fund comes from holding
assets, borrowed money, and from savings or foregone consumption. By foregoing 
today's consumption and investing the same, one expects to enhance the future consumption possibilities. Anticipated future consumption may be for other family members, such as education funds for children or retirement fund to meet the expenses when an individual stops working. Regardless of many reason for an individual to invest, important is to manage the wealth effectively, obtaining the most from it. This includes protecting the assets from inflation, taxes and other related factors.

Objectives of Investment

Every person has an objective to invest their savings that is left after spending on current needs. Savings in cash doesn't earn anything instead incurs loss on purchasing power because of inflation. Thus, every investment is considered after evaluating the five characteristics that have been discussed here in above with the following objective:

1.     To maximize the return

2.     To protect the purchasing power of the savings

3.     To minimize the risk

The Financial Planner addresses viewer queries on the show
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If an individual is making an investment decision today that will directly affect his/her future wealth, it would make sense to make a plan to guide their decisions. Majority of people do not have in place any type of formalized investment plan. However, taking some time to put together a financial plan can reap tremendous benefits. Financial planning provides a direction and meaning to one's financial decisions. It allows one to understand how each decision makes an affect on other areas of their finances.


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1. Return 

Investments are made to earn returns. The return expectation can be
the amount received as interest, dividend received on stocks, capital
appreciation on assets and many more. Different investments have different
returns. Returns from an investment depend on its rating,liquidity and time
horizon of the investment. It is measured as Holding Period Return.

HPR = [ Annual Income +(Price at end - Price at beginning)] / Price at beginning

2. Risk 

Savings becomes investment because of the risk factor. Risk is an inherent part of any investment activity. Some of the risk associated with an investment can be –

A. Loss of capital

B. Delay in repayment of capital

C. Non payment of Interest

D. Variability of returns

Different investment products have different risk. Government securities, bank deposits have higher safety and negligible risk. Equity shares have higher risk on the other end. It can give hige profit and at the same time has the potential to erode the capital. Risk and return are directly related. Higher the risk taken, higher can be the return, similarly low return comes with low risk. Basic risk measurement terms are :      

Variance: It is the mean of squares of deviations of individual returns around their average value.       

Standard deviation: It is the square root of variance, the deviation of actual returns from expected returns.·       

Beta: This measures the volatility of return of an investment in relation to the market return.

3. Safety

An investment is considered to be safe, if there is a certainty of return of capital without any loss of the same. The safety on probable return is generally illustrated by the ratings of the investment vehicles. A (AAA) bond signifies highest possibility of return of capital with accrued benefits to the bond holder. This is a prime characteristic of investments, as every investor invests to get back his/her capital together with profit.

4. Liquidity

It is an important feature of any investment. The yield on any investment is to an extent a function of liquidity. It can be defined as the property of an investment, wherein it can be converted in cash on demand, without loss in value. Liquidity in marketable assets are provided by the market, while non marketable assets like fixed deposits cannot be liquidated in market but can be offered for premature repayment to bank.

5. Tax efficiency

Some investments offer tax benefits, while others don't. An ideal
investment is that which offers tax efficient return commensurate to risk with safety and liquidity. Tax benefits available to an investment can be any one of the following:

A. Investments can offer tax benefit on initial deposits

E.g. A Public Provident Fund (PPF) which offers Section 80C benefit for deposits, (Max. Exemption is 1,00,000)

B. Investments can offer tax benefit on returns generated

E.g.  Dividends on equity, which are tax free.
C. Investments which when redeemed are tax exemptedE.g. Maturity
proceeds of an insurance policy.
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Speculation is an activity, quite contrary to its literal meaning , in which a person
assumes high risks, often with out regard for the safety of his invested principal, to achieve large capital gains.

Investment and speculation both are an activity of purchasing assets with an expectation of return. The difference between the two is basically the risk taking capacity. A speculator differs from an investor in taking risk.

Risk: Risk in an investment is low compared to the risk in speculation or gambling

Leverage: No component of leverage is seen I.e. Mostly investment is carried with ones own fund, whereas speculative activity is usually on borrowed capital

Time period: Investments are usually for a longer term, speculation is for a short term.

Basis: Investments are based on. Fundamental analysis and on the strength of the investment instrument, however speculation are mostly based on the idea of making gains on tips and technical analysis.

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Investment alternative refer to those options/instruments that help investor save and
invest. These are issued by various banks, financial institutions, stock brokerages, insurance providers, credit card agencies and government sponsored entities. These instruments are categorized in terms of their volatility, risk, liquidity and return.

The various investment options available to an investor are -

1. Shares 

These represent ownership of a company. While shares are initially issued by corporations to finance their business needs, they are subsequently bought and sold by individuals in the share market. They are associated with high risk and high returns. Returns on shares can be in the form of dividend payouts by the company or profits on the sale of shares on the stock market (capital appreciation), Shares, stocks, equities and securities are words that are generally used interchangeably.

There are two types of shares - Equity and preference shares. Preference are those shares which have first preference for payment of dividend and refund of capital in case of winding up. Equity shares are those shares which are not preference shares. Preference shares aren't popular in india. These shares may be cumulative, participating and convertible.

Shares of known and financially sound companies are called Blue chip shares and such companies are blue chip companies because of their market reputation and goodwill that they carry. Investors usually prefer investing in blue chip companies due to the safety and attractive returns.

2. Debentures and Government Bonds 

These are issued by companies to finance their business operations and by governments to fund expenses like infrastructure and social programs. A debenture is a document issued by a company as an evidence of debt. Bonds are issued by the government and debentures are issued by the private sector companies. Bonds have a fixed interest rate, making the risk associated with them lower than shares. The face value of bonds is recovered at the time of maturity. Debentures may be convertible or non-convertible. If a debenture is convertible into shares at maturity, it is called convertible. Convertible Debentures may be partly or fully convertible.

However the method of raising long term funds through debentures is not very popular in India.

3. Treasury Bills

These are instruments issued by the government for financing short term needs. They are issues at a discount and redeemed at face value. The profit earned is the difference between face value and the price at which the T-bill was issued. It is highly liquid because of the repayment guaranteed by the Government. There are two types of t-bills i.e. regular and ad-hoc (ad- hoc are issued in favour of RBI only). 
T-bills have maturity period of 91 days or 182 days or 364 days. State Governments do not issue T-bills.

4. Bank Deposits  

These are low risk and low-medium return investments. In India, people trust the banking system more than the stock markets with their money. There are various types of deposits: Savings , Recurring , Current and Fixed.  Savings a/c’s give a return from 3-6% pre-tax. Current a/c’s are for businessmen and generate no returns. Fixed deposits generate a return from 7-12% pre-tax.

5. Mutual Fund 

These are professionally managed financial instruments that involve the diversification of investment into a number of financial products such as shares, bonds and government securities. This helps to reduce an investor’s risk exposure, while increasing the profit potential. There are open-ended and close- ended funds. 

6. Certificate of Deposit

Certificates of deposit (CDs) are issued by banks, thrift institutions and credit unions. They usually have a fixed term and fixed interest rate.

7. Annuities 

These are contracts between investors and insurance companies, wherein the latter makes periodic payments in exchange for financial protection in the event of an unfortunate incident.

8. Derivatives

This includes futures, options, swaps, etc.  It is a contract or agreement between two entities to buy or sell the underlying asset at a future date, at today's pre-agreed price.

Futures

A futures contract is an agreement between two parties to buy or sell the underlying asset at a future date at today's future price. Futures contracts differ from forward contracts in the sense that they are standardised and exchange traded. They are
exchange-traded. They are standardised. The parties have to deposit certain initial margin (small percentage of the trade amount). They are highly regulated and are liquid. As a result, eliminate the counter-party risk.

Options

An option gives the holder of the option the right to do something. The holder does not have to exercise this right. However for this right the holder pays a price, known as the option premium. The writer of the option receives this premium. There are two types of options - Call and Put.

9. Real Estate

Investment in real estate include properties like buildings, lands, farm houses, flats or houses. Such properties attract the attention of affluent investors. As the demand increases but the supply of land is limited, the prices tend to increase. Therefore, it is an attractive form of investment but is the most illiquid asset. It is a long term investment, requires payment of stamp duty and a lot of legal formalities along with registration. SEBI has recently come out with guidelines for introduction and functioning of Real Estate Investment Trust (REIT) in the Indian real estate market. Once introduced these REITs will benefit retail investors the most. REIT is a trust which issues real estate in the form of units as a result even a small investors can benefit from capital appreciation, these are liquid and exchange traded.

10. Insurance

When talking about insurance, Life insurance is a kind of investment because it provides family protection to the investor as well as return on investment in he form of yearly bonus on the policy. The return is as low as 6% because of the risk coverage and tax incentives. The amount of premium paid on a life insurance policy is exempt u/s 80C of Income-Tax Act. There are different policies such as whole life policy, endowment policy, money back policy, etc.

11. Gold and silver 

They are also called as precious metals or objects. Everybody likes gold and hence requires gold or silver. These two precious metals are used for making ornaments and they hold an emotional value in India. In India, investment in gold is more psychological than calculated, many individuals think that gold is an investment which can never give negative returns. They act as a store of wealth. Gold bars are highly liquid and can be easily sold anytime. The pricing depends on the purity of the objects. The risk faced is of theft and fraud. India is the largest consumers of gold in the world followed by china at the second position. India accounts for about 20 percent of global demand. Recently in India, Gold Exchange Traded Funds (ETF’s) were launched which made it easier for individuals to own gold in electronic format. It is less costly, high liquidity and guarantees purity to the investors.

12. Alternative investments

They include investments made in arts, antiques, etc. These investments are not in the form of traditional investments i.e. not availed by the masses. They were availed only by the High Net Worth clients in the past are now availed by retail investors. They are in the form of paintings or their equivalent holding some historic value or just as a hobby.  They may fetch good returns if one finds a buyer who is either a huge fan of the artists’ work, or is an archaeologist. These works are usually kept in museums or halls.

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Power of compounding is an important concept when it comes to investing. It deals with the present value and future value of money. Money has time value. A rupee today is more valuable than a rupee a year hence. Individuals, in general prefer current consumption to future consumption. In an inflationary period, a rupee today represents greater real purchasing power than a rupee a year hence.

The process of investing money as well as reinvesting  the interest earned thereon is called compounding. 

The future value or compounded value of an investment after n years when the interest rate is r percent is : FV = PV(1+r)n

In this equation (1+r)n is called the future value interest factor or simply the future value factor. 

Compound interest concept is different from the simple interest concept as in the former interest is re-invested (Interest is earned on interest) however in the latter it isn’t.

Investors should always start investing at an early age, as the power of compounding can change the figures by huge margins. E.g. If Mr. A invests Rs. 10,00,000 @ 12 % 
for 20 years, then at the end of the term , he gets Rs. 96,46,293 as per the formula above. If the term is reduced to 10 years, then Mr. A will get Rs. 31,05,848. The difference in the final amount shows the power of compounding as the money.

Doubling Period 

Investors are usually interested in knowing in how much time duration their investment value will double. There are two basic rules that are followed in order to determine the time taken for the investment value to double.Rule of 72 and Rule of 69

Rule of 72: According to this thumb rule, the doubling period is obtained by dividing 72 by the interest rate. If interest rate is 8% then, the doubling period is 8 years(72/8).

Rule of 69: It is more accurate than the rule of 72, according to this the doubling period is equal to 0.35+ (69/Interest rate). E.g. If interest rate is 10%, then doubling period will be 7.25 (0.35+(69/10))

Real Rate of Return

This deals with the inflation rate i.e. a lot of times the returns one receives are negative, they do not beat the inflation levels. The real rate of return is the rate after adjusting inflation factor. The formula for real rate of return is given below -

Real Rate of return = (Nominal rate – Inflation rate)/ (1+inflation rate)
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Indian Investor Profile = Low Risk + High Returns

An investor profile is a reflection of an investor’s goals and objectives. It defines the risk someone is willing to take in order to earn certain return. Based on the profile, an investor along with its financial advisor can take necessary steps and allocate funds accordingly.  For an average investor, no one trust others with their funds, they think no one can plan better than them, as a result the financial planners aren’t getting a lot of business compared to the opportunities here. However, this is because of a series of events where investor’s were duped. The Harshad Mehta Crash in the 90’s, the vanishing companies of the nineties and the Satyam scam to name a few.

In the nineties, the stock market saw a roller coaster where the sensex crashed and people committed suicide as they lost all their savings and a lot of them played on borrowed capital. It was clear then that this was not a way to make a living. As your hard earned money was probably safer in nationalised banks, post offices or fixed deposits. But the mistake here was that investors would invest only during the bull run ( when prices are rising, market is booming or at its peak) as a result the next bear run would take their savings with the crash.

However. this is changing and now there’s a new breed of Indian investor – younger, more informed, more confident and well paid. There are more and more women who are
educated and invest online. The financial reforms and appointment of SEBI and other such regulatory bodies have helped protecting the rights of investors. Let’s have a look at the regulatory bodies in more detail.

Where To Invest in 2013 is an interesting panel discussion on alternate investment avenues for ...
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There are four main legislations governing the securities market and protecting the
interests of investors:

  1. SEBI Act, 1992 establishes SEBI to protect investors and develop and regulate the securities market.
  2. The Companies Act, 1956 sets out the code of conduct for the companies in relation to the issue, allotment m and transfer of securities and disclosures to be made in public issues. This ensures that there is transparency in the dealings of securities market and thus leads to investor protection.
  3. The Securities Contract (Regulation) Act, 1956 provides for regulation of transactions in securities through control over stock exchanges.
  4. The Depositories Act, 1996 provides for electronic maintenance and transfer of ownership of demat securities.

In India, the responsibility of protecting rights of investors and regulating the securities market is shared by:

  1. DCA (the Department of Company Affairs): Now called the Ministry of Company Affairs is under the ministry of finance. It exercises supervision over three professional bodies – ICAI, ICSI and ICWAI
  2. DEA (the Department of Economic Affairs)
  3. RBI (Reserve Bank of India) and 
  4. SEBI (Securities Exchange Board of India): Plays an important role in protecting the interests of investors.  SEBI strongly believes that investors are the backbone of securities market. 
On 17th January 2003, the then Prime minister Shri Atal Bihari Vajpayee launched the Securities Market Awareness Campaign (SMAC) This by far has been the largest campaign by SEBI. The motto of SMAC was ‘An Educated Investor is a Protected Investor’  It spread the message of  Invest with knowledge”.

The Multi- Pronged approach by SMAC :

  1. Workshops: More than 2000 workshops have been conducted in across India.
  2. Advertisements: More than 700 advertisements in 10 regional languages.
  3. Website dedicated to Investor education: http://investor.sebi.gov.in
  4. Radio: SEBI tied up with All India radio and later 93.5 RED FM for investor protection.
  5. Educative Material
  6. Messages on Television
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11
Sections
1083
Views
1. Definition
2. Concept
3. Savings v/s Investment
4. Why People Invest?
5. How people Invest?
6. Factors Affecting Investment Decisions
7. Investment v/s Speculation
8. Investment Alternatives / Options Available to an Indian Investor
9. Time Value Of Money : Magic of Compounding
10. Profile of the Indian Investor
11. Regulations
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