Know All About Investments22 November, 2016
The word investment invokes fear in many people. Many associate investments with risk, high stakes and rich people and prefer to hold all their assets in liquid form. A typical Indian household holds almost 50% of all its savings in the form of cash or in bank deposits. But investments are not rocket science and with a little bit of education and understanding, the common man should be able to make their investments offer them higher returns. Investments include everything from the money in fixed deposit to gold to real estate as well as money invested in stocks and bonds. While some investments require a large amount of money to invest, most investments do not require a huge amount and can be even as low as Rs. 100/month. The only form of asset that cannot be really called an investment is cash that is hidden away in your closet, more so in the wake of the recent demonetization.Why is Investing Important?
Money that you earn/save today will be worth less in the future because of inflation. The purchasing power of your money will be less in the future than it is today. Just think back to 10 years ago and what Rs 100 got you then versus what it can get you today and you will see that the real value of Rs 100 has diminished in these 10 years. This is inflation and the only way to beat it is to invest your earnings/savings in some investment avenues that will yield a higher return than inflation and taxes combined.
So, instead of allowing your money to sit idle in cash deposits or in low yield savings accounts, investing them wisely can fetch handsome returns.
Returns from investments are of two types: Capital Appreciation and Income. Income is what you earn on a periodic basis through the investment like interest on a deposit, dividend from stocks or rent from a real estate property. Capital Appreciation is the increase in the value of the investment at the time of selling versus the value at which you bought in.
Some kinds of investments also offer you deductions in your tax returns and aid in reducing your tax burden.
Investments make your money work for you that will help you in meeting future financial needs like higher education or wedding expenses.
Putting away money in liquid investments also helps you in times of financial emergencies like a sudden medical expense.
Choosing an investment is based on your risk appetite and your financial goals. Balancing these two requires some understanding of the types of investments and planning.Types of Investments
We can classify investments into two broad categories namely Direct and Managed Investments. Direct investments are managed by the investors themselves. Managed Investments are funds that are managed by a financial organization or an individual on behalf of the investor. Following are some of the investment avenues listed in the order of increasing risk:Direct Investments
Fixed Deposits: Fixed Deposit is the safest kind of investment. You deposit an amount with a bank or financial institution for a specific numbers of days/months in return for a fixed interest income. The risk in this is very low since your return is not affected by the vagaries of the economy unless the financial institution itself goes bankrupt or defaults, which is a very rare occurrence. Of course, the returns are commensurate with the low level of risk. The returns for this investment type barely covers for inflation and if the fixed term is more than a couple of years of high inflation, it may not even beat inflation.
Recurring Deposits: This is very similar to Fixed Deposits but instead of setting aside a lump sum amount at one time, you are allowed to contribute a fixed amount every month/quarter/year. The benefit of this investment is that you can save a small amount every month and add to your investment.
Small Savings Schemes: The Government of India offers a variety of investment schemes for the benefit of a large part of its population that cannot afford to set aside a large amount of money. These investments are aimed at protecting capital and come with the financial guarantee of the Government of India. Any citizen of the country can invest in these schemes. Some of the popular ones are Employee Provident Fund (EPF), National Pension Scheme (NPS), Sukanya Samriddhi Scheme etc. Investments in these schemes are eligible for tax exemption under Section 80C of the Income Tax Act.
Real Estate: Investing in property has always been considered the most secure and with increasing urbanization and exploding property rates, returns have also been quite high in the recent years. Real Estate investments may also offer regular income on your investment by leasing/renting your property. Since the investment in real estate requires a substantial amount of capital to be laid out, bank loans are availed by many in the hope that the returns from the investment beats the interest expenditure on the loan.
The pitfalls of this investment is that it is not very liquid and it may not be easy to get out of a property quickly. Buying and selling also invites various taxes and fee that need to be taken into consideration before making the decision. Value of a property is also largely influenced by macro-economic factors and sometimes by nature. For example, floods/tsunami in a city might decrease prices of ground level properties.
Gold (and other precious metals): This has, traditionally, been the most favored investment by Indians. Indian households hold a good amount of capital as gold ornaments. Precious Metal prices rarely offer negative returns and are also highly liquid since buying and selling requires minimum effort. The negative of holding a large investment in Gold is the threat of theft and the cost of storing it safely. Until recently, trading in these were highly unregulated but with recent efforts by the Government of India to bring in transparency in high value transactions, Gold might lose some of its glitter as an investment option.
Bonds: Bonds are Fixed Income instruments of investment. These are IOUs issued by the borrower to the lender for a fixed period and a fixed interest rate. Bonds are issued by both public and private sector enterprises to raise a large amount of capital from the public. Investors are paid a guaranteed interest that does not change in value irrespective of the fortunes of the company. However, as in any debt instrument, risk of default is the largest risk component in Bonds. Based on the default risk posed by the borrower, the interest rates vary to offer a commensurate return for the risk undertaken by the lender.
Bonds are also traded on exchanges and thereby offer liquidity to the investors. The price at which a Bond security is traded on the exchange depends on the changing risk profile of the borrower and the changes in the interest rate in an economy. For example, in an environment of falling interest rates, Bond prices increase to equalize for the higher returns offered. But the fluctuations in Bond prices are not as volatile as it maybe with stocks and are seen as stable investments.
Stocks: Shares of a company are sold to the public in order to raise a large amount of capital. The investor who buys a share of a company becomes a shareholder and has voting rights in the company affairs. Shares are traded on exchanges and their prices are subject to the vagaries of the market as well as factors that influence the wellbeing of the company and the industry it operates in. Share prices are highly volatile but their returns are also quite high to make up for the risk element involved. Shares offer income in the form of dividends, declared periodically by the issuing company, as well as capital appreciation in prices as traded on the exchange.Managed Funds
For an individual investor with neither the time nor expertise to manage their investments, managed funds come in handy. Direct investments sometimes require a large amount of capital to be invested and may require active management to mitigate risks. Funds take care of both these problems. Funds are managed by professional financial services companies or individual managers, who collect funds from the market and proceed to invest the corpus in various assets. They manage the portfolio based on the risk-return profile of the investor and offer diversification benefits as well. Some of the popular forms of Funds are listed below:
Mutual Funds: This is the most popular form of Fund investments. A fund manager will raise a corpus of funds from the market and then invest this in equities or bonds or a combination of both. The purpose of the fund determines the portfolio combination and the prospectus for the fund at the time of raising capital will state the purpose and risk profile of the fund. For example, a Growth Fund might invest largely in equities while an Income Fund will invest heavily in Bonds. A Balanced Fund will have equal stakes in equities and debt. The fund managers actively manage the portfolio by buying and selling regularly to maintain the returns promised to the investors. It is possible to get the diversification benefits of investing in a wide variety of industries by investing in a Mutual Fund. The fund manager charges a fee for their time and effort. The Net Asset Value (NAV) of a fund is based on the value of the portfolio on any given day. The NAV of the fund is reported on a daily basis and investors can choose to buy into a fund or exit the fund based on the movement of the NAV.
Exchange Traded Funds (ETF): ETFs are financial instruments that are traded through an Exchange and their prices are based on the price movements of an underlying asset. There are Gold ETFs, Equity ETFs and various other ETFs. For example, the value of the Sensex ETF rises with the value of the Sensex and the value of the Gold ETF rises with the price of Gold and vice versa. Gold ETFs are also highly liquid and also protect the investor from having to worry about theft and storage. ETFs are issued by fund management companies and they hold the underlying assets in question.New Age Investments
With increasing sophistication of investors and the rise of online banking and trading, new financial instruments are being derived every day to offer more diversity to investors. Here are some of the new investment avenues that have become popular recently:
Hedge Funds: A hedge fund is a private investment fund, charging a performance fee and is open to only a limited number of investors. Since these are closed funds, they are not strictly governed by the rules of the SEC and can employ many trading practices that are aimed at return maximization. But these funds are meant only for high net worth individuals and require a very high initial investment.
Venture Capital Funds: Startup companies require a high amount of capital and Venture Capital Funds aim at providing that. The funds are deployed in promising startups with an aim at exiting via an IPO. The returns are long-term capital gains only and there is a high level of risk that the startups might not grow into their potential. Investing in a Venture Capital Fund requires a large capital investment, patience and time to get involved in the startups getting funded.
Peer to Peer (P2P) Lending: This is a rising star in the Indian investment scene where borrowers and lenders are matched through an online platform. Borrowers who need to raise money for various reasons, come to the P2P platforms seeking a loan. The platform rates the borrowers based on their credit score, credit history and personal profile and determines a lending rate commensurate with the risk posed by lending to the particular borrower. Investors can choose to diversify their portfolio by lending to various borrowers on the platform, spreading their risk and earning a handsome return. Typically, the interest rates are higher than those offered by corporate bonds and other debt securities. For the investor, P2P lending provides all the advantages of investing in fixed income – non-volatile, assured income while also overcoming the disadvantage of low yields in bonds. This is still at a nascent stage in India and as more and more lenders and borrowers participate, P2P lending has the potential to be a prominent part of an investor’s portfolio.
Given the various choices in investing your money, it is important to clearly understand the various criteria that differentiate the investment avenues.
Initial Investment Requirements: Some investments like deposits, small savings allow investors to start with a very small amount of money while real estate demands a huge outlay. Stocks, Bonds and Mutual Funds allow investments in small amounts.
Systematic Investment: A systematic investment captures the ups and downs of the market and is recommended as the ideal way to invest. But only some types of investments allow such investing. For example, one cannot buy a little bit of a property every month whereas it is quite possible in financial assets.
Inflation Protection: Any investment ought to at least guarantee that your purchasing power remains the same and offer a return that is equal to or greater than the inflation rate in the economy.
Income Potential: Deposits and Bonds offer periodic interest income while equities do not carry any assured dividend income. For investors who depend on their investments as a source of income, debt securities would be the preferred investment vehicle.
Diversification: Diversification is the effort to spread risk so as to not be affected by the vagaries of the market or shocks to the economy. Some investments like Mutual Funds and P2P lending inherently offer this while bonds and real estate do not.
Volatility: Stock prices go up and down on an everyday basis and this rapid movement in prices is termed as volatility. Some investors do not mind volatility as long as the long-term returns are safe. For short-term investments, volatility is a risk factor.
Maintenance Costs: Does your investment require any maintenance? Gold has to be stored safely in a locker and real estate comes with many maintenance requirements. Financial investments do not require maintenance.
Ease of Exit: When an investor wants to exit an investment in order to meet some financial need, does the investment offer liquidity to allow a quick and easy exit? Stocks, bonds, deposits, gold and MFs are all fairly liquid and the entire investment could be recovered fairly quickly. Real estate market is not so liquid and it may be difficult to find a buyer, in a hurry, for a property at the market rate.
Part Exit: If the investor needs only a portion of the investment to be recovered, does the investment allow that? Real Estate does not while equities and other fixed income investments do.
Transaction Costs: Buying in and selling of investments normally entail some transaction costs. Ornamental gold comes with making charges and this portion is completely lost while selling the gold. Real estate involves registration fee, brokerage commission and a whole lot of other charges. Bonds, equities and MFs also have brokerage fee and service charges although they are all only a small percentage of the transaction value.
Tax Implications: All investments are not treated the same by the taxman. Small savings deposits in government schemes actually allow you to deduct the whole or part of the invested amount as an expense while profits from equities sales do not attract any tax if the holding period had been over a year. Interest income is fully taxed and it is important to take the tax component into account while comparing returns from the different investment types.Here is a table for a quick glance:
Risk Vs Return
The most important factor to consider before making an investment is the risk-return profile of the asset class.
Historically, equities have performed better with 10-year returns peaking at 17% in India. However, they have also been the most volatile. The chart above, depicts the movement of returns for the different investment types over the last 20 years:
Investments that have traditionally been seen as stable and secure like gold and real estate do not really hold up their reputation when real returns are analyzed over a long period of time. These investments are certainly more stable with not much of fluctuation in returns but their long-term returns are only slightly better than inflation. Investments in Fixed Deposits offer no protection against inflation.Diversification
A good investment portfolio must consist of all asset classes to offer stability during turbulent time and growth during an economic boom. What percentage of a person’s total investment ought to be in each investment type is best decided by the individual, based on his/her growth needs and risk appetite.
In any case, it is widely suggested by Financial Advisors to hold only 5% of one’s assets as cash. A growth oriented portfolio could have 40 – 50% invested in equities while a more conservative portfolio that demands steady income should vest majority in Bonds and Fixed Income securities.
With Demat accounts it is now possible for individual investors to get into action by themselves. Buying and Selling of equities, bonds, ETFs are all now possible with the click of a button. For investors with inertia, fund managers and financial advisors can help with decisions on asset allocation as well as the actual investment.
Hedge Funds and other alternative investment options are ideally suited for the wealthy and aggressive investors.Emerging Trends
With India going digital, more and more growth will come with investments in Financial Assets rather than Physical Assets like Cash, Gold or Property. With the recent demonetization and the thrust towards a cashless economy by the Government of India, the graph is certainly skewed towards Financial Assets.
The demonetization of old Rs 500/1000 in India has seen banks collecting deposits worth thousands of crores which could mean fall in interest rates in the near future. Investors who seek income over growth might be affected by lowered interest rates. Investing through a P2P lending platform might be the better option for such investors.