Whether you are a new or experienced investor, investing in a modest or sizable portfolio, understanding certain key investment concepts is important. Principal Mutual Fund brings to you a primer to help understand concepts such as - diversification, time value of money, rupee cost averaging and others - as a foundation to form a sound investment strategy.
Inflation
Inflation refers to a continuous rise in general price level, which shrinks the value of money or purchasing power over a certain length of time. It is calculated in terms of per cent change in the value of price index consisting of a range of goods or services. An inflation rate of 8% means that the general level of prices of goods and services has increased by 8% over the previous period.
In other words, purchasing the same amount of goods and services will cost you 8% more than what it would have cost you in the previous period. Thus, Inflation can also be explained as a decline in the real value of money - a loss of purchasing power in the means of exchange, which is also the monetary unit of account.
There are several inflation measures available in India – the most commonly used are based on Consumer Price Index (CPI) and Wholesale Price Index (WPI). Within these, there are several sub-indices (e.g. CPI for Industrial Workers, CPI for Urban Non Manual Labourers, etc.) as well. These sub-indices are designed to see how price increases affect different set of people. Since WPI is available on a weekly basis, inflation based on that is the most commonly referred inflation measure in India.
Risk & Return
Risk is defined as the uncertainty or deviation in the return expected from an asset class. This risk could be measured in terms of standard deviation of an asset class. Risk can be classified as below:
Systematic Risk
Systematic risk is defined as a risk that takes place in all the risky assets because of macro-economic factors like earthquakes, floods, war, etc. However, it cannot be eliminated through diversification.
Unsystematic Risk
Unsystematic risk is defined as a risk that is unique to a particular asset class and can be eliminated or reduced by diversifying a portfolio.
A security's return is calculated by its holding-period return: the change in price plus any income received, expressed as a percentage of the original price. An improved measure would be to take into consideration the timing of dividends or other payments, and the rates at which they are reinvested. The total return on an investment has two components: the expected return and the unexpected return. The unexpected return comes about because of unanticipated events. The risk from investing stems from the possibility of an unexpected event.
Relationship between risk and return
A simple relationship exists between risk and return – the higher the potential return, the higher the level of risk involved. Whilst everyone would like to maximize return and minimize risk and would prefer to have a return every year of approximately 15-20% with no opportunity of investments falling in value, the reality is that these investments do not exist. As a common rule, the bigger the potential investment return, the higher the investment risk and the longer the investment time horizon.
Asset Classes
An asset class is a specific category of investment such as stocks, bonds, real estate or cash. Investing is a trade-off between risk and expected return. Depending on the risk appetite of an individual, he can choose to invest in a combination of asset classes that would optimize his returns. Some of the most common asset classes are as follows:
Cash
Cash assets comprise of near currency assets viz., T-Bills, commercial paper, money market instruments, and short-term government bonds that are liquid (i.e. they can be easily converted to hard currency at short notice).
Equity
Equity (also known as a stock or share) is a portion of the ownership of a company. A share in a corporation gives the owner of the stock a stake in the company and its profits. As the individual buys more stocks, he increases his ownership stake in the company. Stocks are generally more risky; along with providing an opportunity to earn significant returns, they also carry the risk of part or complete loss of the invested amount.
Bonds
A bond is a formal contract that obligates the borrower to repay the borrowed money with interest to the issuer of the bond. In India, the corporate bond market mainly consists of issuers of three different categories – government-owned financial institutions (FIs), government-owned public sector undertakings (PSUs) and private corporate entities.
Real Estate
Recently, investing in real estate has become increasingly popular making it a common investment vehicle. Although the real estate market has plenty of opportunities for making significant amounts of money, real estate as an asset class is not readily accessible to the retail investor. However, with the introduction of real estate mutual funds (REMF), investors across various sections of the society will be able to take advantage of the growth in this sector.
Gold
Of all precious metals, gold is the most popular as an investment. It is renowned as a hedge against inflation and has limited downside risk.
Diversification
Diversification indicates building/ creating an investment portfolio that includes securities from different asset classes. It spreads risks across various financial investments, reducing the impact that poor returns from any one investment are likely to have on the overall portfolio. The prices of shares, bonds, listed property and other investments often do not rise and fall in tandem. When one type of investment is on the rise, another may be on the decline. The result is that your portfolio's overall performance is likely to be less volatile. The objective of diversification is to reduce the risk involved in building a portfolio. Diversification reduces the risk for an investor because all investments may not move in the same direction in the same proportion at the same time.
A diversified portfolio should be constructed to reflect your personal goals and individual risk tolerance. There are many ways to diversify across several asset classes. Asset allocation is a method of strategically dividing your investment portfolio among stock, bond and cash investments to help protect your portfolio from the rise and fall in any one investment.
Diversification will help to:
- Ease potential risk to overall portfolio
- Improve chances for attaining consistent returns
- Avoid the downside that can come from regularly readjusting your portfolio to follow current market developments
Power of Compounding
Compounding refers to the reinvestment of earnings at the same rate of return to constantly grow the principal amount, year after year. It is a technique of making your money work harder for you and is perhaps the most powerful tool that an average investor can use to plan for many of life’s financial goals, including retirement.
Sameer and Sanjay are friends, just started their career at 20 and plan to retire at 65. Sameer starts saving 
5,000 every year from age 20 and continues to do so until he is 35 years old, after which he stops making any further investment. Sanjay, on the other hand, starts saving 12,000 every year from the age of 35 and continues to do so until he retires at the age of 65. If both earn, say, 12% per annum on their investments, which of them would be wealthier when they retire at 65? Sameer! Surprising, isn't it? At 65, Sameer would have accumulated 36.43 lakh whereas Sanjay's wealth would have been lower at 32.44 lakh.
The result would be the same even if one considers a one-time investment. For example, assume that Sameer invests 10,000 at the age of 20 in an instrument that fetches 15% per annum. Sanjay, on the other hand, invests 100,000 at the age of 40 in the same instrument. When both turns 60, Sameer's 10,000 investment would have grown to 26.78 lakh, while Sanjay's 1 lakh would have grown to only 16.37 lakh.
Thus, the longer you stay invested the more money you will make. The best way to take benefit of compounding is to start saving and investing wisely as early as possible. The earlier you start investing, the greater will be the power of compounding.
Power of Triggers
Trigger facility is an additional, optional feature provided in mutual fund schemes, which enables investors to book profit automatically at a pre-defined time or value. In another words, the fund declares a dividend, redeems and/or switches the units automatically on behalf of the investor on the date of the event.
Principal Mutual Fund has introduced the option of Triggers in its funds. You can specify a specific event, which may be related to time or value, in advance and when this event takes place the trigger is activated. Thus, this facility enables you to keep track of your investments without having to put in time and effort to track portfolio movements on a regular basis. It also helps you maintain a disciplined investment approach that ensures that you meet your investment goals. Triggers are of three types –time-based, value-based and event-based.
Time-based triggers
Time-based triggers are activated on a particular date that you have specified. For example, if you wish to gift some units to your mother on her birthday, a trigger can be set for that date.
Value based triggers
These triggers are based on the change in value of your investments. For example, you need 7.5 lakh for meeting the expenses of son's higher education after 5 years and you have invested 5 lakh in an equity scheme for this. If you set a trigger for change in investment value by at least 50%, the money is shifted to a low risk scheme as soon the value reaches that figure. In this way, the dream of your son's higher education will not go sour even if the market turns bearish.
Event-based triggers
You can also set triggers based on the occurrence of a particular external event that affects the value. For example, you want to set the Sensex value of 20,000 as a trigger. If the Sensex is less than 20,000 on the date of allotment, the trigger would be activated when the Sensex closes above 20,000. However, if the Sensex is more than 20,000 on the date of allotment, the trigger would be activated when the Sensex closes below 20,000.
Duration
Duration measures a bond's sensitivity to changes in interest rates. It is a measurement of how long, in years, it takes for the price of a bond to be pay off by its internal cash flows. The longer the bond has until maturity, the greater will be its duration. The longer a bond's duration, the more responsive it is to changes in interest rates. Duration constantly adjusts as coupon payments are made over the life of a bond.
If an investor expects interest rate to fall during the course of time the bond is held, a bond with longer duration will be preferred as the bond’s price would increase more than comparable bonds with shorter durations. On the other hand, an investor, who is concerned about wide fluctuations in the principal value of bond holdings should consider a bond with short duration. Investors who are comfortable with fluctuation and are confident that interest rates will fall should look for a longer duration bond. Yield Curve
Yield curve is a chart consisting of the yields of bonds of the same quality but different maturities. This is used as a measure to assess the future of interest rates. Here, the time value is plotted on the X-axis and yields on the Y-axis. The curve graphically demonstrates the rate at which market participants are willing to transact debt capital for the short term, medium term and long term. The yield curve is positive when long-term rates are higher than short-term rates; however, the yield curve is sometimes negative or inverted.Normal Yield Curve
When long-term interest rates are higher compared to short-term interest rates, the shape of the yield curve is upward sloping. Steep Yield Curve
This curve is normally observed at the beginning of an economic expansion or just at the end of a recession. The slope of the yield curve increases as the difference between long-term yields and short-term yields become wider. The inherent assumption behind such a curve could be that while short-term economic conditions warrant lower rates, factors like inflation, etc. could rise in the medium / long-term justifying much higher long-term rates. Flat Yield Curve
When there is no change in market outlook on interest rates, we get flat yield curve. This is because yields are almost same across tenors. Inverted Yield Curve
When short-term interest rates are higher than long-term interest rates the shape of yield curve takes downward sloping. This happens when markets expect high volatility in the near future however long term story remains same.
Time Value of Money
One of the most fundamental concepts in finance is that money has a “time value.” That is to say, money in hand today is worth more than money that is likely to be received in the future. For example, if you are offered the choice between having 10,000 today and having 10,000 at a future date, you would prefer to have 10,000 now. By accepting 10,000 early, you can put the money in bank and earn some interest. Thus, the time gap allowed helps us to make money. This incremental gain is time value of money. Rupee Cost Averaging
Rupee cost averaging is an approach in which you invest a fixed amount of money at regular intervals. This in turn ensures that you buy more shares of an investment when prices are low and less when they are high. By investing on a fixed schedule, you avoid the complex or even impossible duty of trying to figure out the exact best time to invest. The rupee cost averaging effect - averages out the costs of your units and hence lessens the results of short-term market fluctuation on your investments.Getting started on a rupee cost averaging strategy
- Decide on the amount you can invest on a regular and long-term basis
- Select an investment you want to hold for the long-term
- Invest at regular intervals (weekly, monthly or quarterly)
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