Chapter 1 - Basics of Investment

Chapter 1 - Basics of Investment	1.0 Introduction
	1.1 What Is Investment?
	1.2 Investment Environment
	1.3 Nature Of Investments
	1.4 Why Investment?
	1.5 Risk & Return
	1.6 Understanding Terms
	1.7 Income , Expenses, Borrowing And Investments
	1.8 Investment ,Speculation And Gambling
	1.9 Methods Of Investing
	1.10 Investment Alternatives
	1.11 Long-term Financial Instruments
	1.12 Short Term Financial Instruments
	1.13 Financial Assets Vs Real Assets
	1.14 Factors Influencing Investment Decisions
	1.15 Investment Process
	Chapter (1) end quiz

Chapter- 1.15 Investment Process

1.15 Investment Process

Process of Investment

The process of making an investment is an activity that calls for planning. It is possible with some effort to learn this and make well-informed investment decisions. This requires that the investor is able to:

Key Factors You Need To Consider Before An Investment:

There are several constraints that an individual has to take into account before making an investment. These include:

Liquidity:

This is one of the parameters used to measure the efficiency of an investment alternative or instrument. Liquidity is the ability to convert an investment into money. Higher the liquidity for an investment, higher would be its demand and vice versa. At the same time, marketability is the measure of demand for an investment instrument. The higher the demand, the easier it is to find a buyer. Liquidity of an investment provides security to the investor that the money would be available when needed. By way of example, Mrs Rupiah may sell the shares invested in a company any time because they have yielded high returns to pay off a house loan

Age:

The ability of an individual to take risk is linked with his/her age. Typically, the higher the age of an individual, the low is the risk appetite or tolerance.

Taxes

The government declares tax benefits for citizens through rebates, exemptions etc and these should be considered while making any investment. For example, under Sec 80CCC an investor gets tax benefit for his investments in ELSS(Equity Linked Savings Schemes). Investors need to take a call between the tax benefit and returns these schemes offer. Other options may not have a tax benefit but may be more lucrative in terms of returns.

Need For Regular Income:

Investors may have a need to obtain periodical or regular returns and this will influence their decision to invest in such instruments

Time Horizon:

As explained before, the time horizon will vary from short term (as short as one day) to long term which could be a few months to several years

Risk Tolerance :

Investment decisions are always a trade off between the risk appetites of the investor versus the returns expected. This relation has already been explained.

Lack of time:

Some investment instruments like equity (shares), mutual funds, real estate, and insurance products need a fair amount of analysis to ensure that the return profile is understood. Sometimes investors, typically professionals like doctors or lawyers who are interested in these investments, may not be able to spare the required time for performing the analysis. They may then seek the help of an intermediary or an advisor. The advisor’s investment objectives may or may not match with those of the investor and this in itself constitutes a risk. Therefore, there is no excuse to blindly relying on someone’s advice without possessing reasonable knowledge of the investment

Price Discovery:

Several assets such as shares are very active market instruments and may be volatile. This creates uncertainty in the minds of the buyer as to the direction the price will move towards if they buy. Will it come down leading to a loss or go up resulting in profit?

Chapter- 1.14 Factors Influencing Investment Decisions

1.14 Factors Influencing Investment Decisions

Attempt: 1

How are investment decisions made?

The important considerations for any individual investor before making an investment decision or after making the investments are as follows:

• Rate of return expected.
• Risk appetite or tolerance.
• Tax benefit (deduction in the taxable income by virtue of making the investment).
• Marketability (ability to find a buyer when we want to sell the asset or the demand for the asset).
• Liquidity (ability to sell the asset and raise money).

Example:

To make an investment decision in the stock market you have to be really aware of the factors affecting the stock market, which we would cover in this course. Apart from this, your age, earnings, savings and risk-bearing capacity will influence your investment decisions. Another important factor is the time horizon or period of time you can invest. All these affect your investment decisions.

Chapter- 1.13 Financial Assets Vs Real Assets

1.13 Financial Assets Vs Real Assets

WANT TO KNOW THE DIFFRENCE BETWEEN FINANCIAL ASSETS & REAL ASSETS?

At this point it is important to note that there are differences between financial assets and real assets. For example, purchase of a real asset such as a residential flat which may cost several lakhs of rupees and an investment in the share of a company (financial asset) is different. However, this comparison gives a measure of return each asset class offers. Sometimes comparison between investment in gold, shares and mutual fund are made to show the risk return profile of each class of investment.

Financial Assets	Real Assets
• Available through active markets like stock exchanges	• Available in traditional markets
• Off er high liquidity	• Offer low to moderate liquidity
• Easy to possess	• Difficult process to possess
• Does not require physical holding	• Requires physical holding
• Divisible to smallest unit, as for example, one share	• Unit of division is large, as for example, one flat or one bungalow

The decision to choose between the procurement of financial or real assets is made based on your need, objectives, time horizon, and risk appetite of an investor. Also sometimes you may have to go for financial assets to acquire a real asset. For example, if you plan to buy a flat after three years you can invest your money in financial assets and later acquire the real asset.

But the choice could be based on:

• Availability of funds.
• Need for liquidity (ability to sell the asset and generate cash).
• Time period of investment.
• Required rate of return
• Tax benefits

Matrix Of Investments And Their Relative Comparison

Features/Investment	Return	Risk	TDS	Tax Benefit	Market ability	Liquidity
Real Estate	High	Low	No	No	Low	Low
Bullion	Medium	Low	No	No	High	High
Antiques	Medium	Low	No	No	Low	Low
Bank Deposits	Low	Low	Yes	No*	No	High
P O Deposits	Low	No	Yes	Yes	No	Medium**
Government Bonds***	Low	No	Yes	Yes	Medium	Medium
Mutual funds – Debt	Low	Low	No	No	High	High
Mutual funds – Equity	High	High	No	Yes	High	High
Mutual funds Money Market	Very Low	Low	No	No	High	High
Equity Shares	High	High	No	No*	High	High
* Bank deposit with lock-in period of five years and ELSS in mutual fund gives tax benefit ** Some of the post office deposits like NSC have a lock-in period till maturity showing poor liquidity *** These bonds include bonds issued by the government or the government- sponsored and associated bodies like the RBI.

Following are the descriptions of the attributes in the table above:
Return	:	Rate of interest / dividend / capital appreciation.
Risk	:	Volatility or variation in annual or other periodic returns.
TDS	:	Tax deduction at source
Tax Benefit	:	Under Sec 80C, 80CCC and 80D.
Marketability	:	Ability of the investment instrument to find the buyer.
Liquidity	:	Ability of the investment instrument to convert itself into cash.

Chapter- 1.12 Short Term Financial Instruments

1.12 Short Term Financial Instruments

Various Financial Instruments

Short-Term Financial Instruments

Money Market Instruments

These are specialised forms of mutual funds that invest in extremely short-term fixed income instruments and thereby provide easy liquidity. Unlike most mutual funds, money market funds are primarily oriented towards protecting your capital and then aim to maximize returns. Money market funds usually yield better returns than savings accounts, but lower than bank fixed deposits. For example, treasury bills, commercial papers, certificate of deposits, bills discounting (see reference for more details).

Equity Trading

Another most popular high-risk and high-return investment option available to investors is by way of investing in shares of companies. Equity investment has the potential to yield high returns but also has equivalent risks. However, it is a time-tested theory that investing judiciously for a long-term in well-known companies always provides better returns and lowers the risk element.

Derivatives Trading

Derivatives are financial contracts or financial instruments whose values are derived from the value of something else (known as the underlying). The underlying on which a derivative is based can be an asset, as for example, commodities, equities (stocks) etc. The main types of derivatives are forwards, which if traded on an exchange are known as futures, options and swaps. We shall cover these in a separate chapter in detail. Each of the above non-traditional or innovative and short-term financial instruments are discussed individually in a detailed manner in the later chapters.

chapter- 1.11 Long-term Financial Instruments

1.11 Long-term Financial Instruments

Various Financial Instruments

Traditional Financial Investments

Term Deposits

A time deposit, also known as a term deposit, is money deposited with a banking institution that cannot be withdrawn for a certain ‘term’ or period of time. When the term is over it can be withdrawn or it can be reinvested for another term. The avenues for such investments include:

• Commercial Banks
• Post Office
• Non-Banking Financial Companies ( NBFCs )

Recurring Deposits

The objective of the scheme is to enable the depositor to make a financial position for his future needs by paying monthly installments for an agreed period. It will be known as a recurring deposit amount. The avenues for such investment are the same as above.

Chit Fund (Recognised / Unrecognised)

This is peculiar to India and operates by enrolment of members. The members’ pool money once in a month and the pooled amount is given to one of the members usually by draw of lots or using a chit. Hence the name chit fund. However, if members opt go for auction, their amount of profit could be more.

For example, let us suppose that you join a chit fund with 20 people, each promising to contribute Rs 2,000 per month for 20 months. At the end of your term you would get Rs 40,000. However, if in the first month somebody takes the amount by auction, say at 50 per cent loss, s/he would get in the first month 50 per cent of the whole amount i.e. Rs 20,000. Therefore the balance 50 per cent would be shared by all the other members i.e. in the next month every member needs to pay only Rs 1,000 instead of Rs 2,000.

Insurance Premiums

Life insurance in India is known to public or investors through LIC for many decades. The Life Insurance Corporation of India and other companies sell their products through a sales network called life insurance agents. There are several new players in the new millennium as insurance may now be offered by private companies as well. That means there are wide options open to customers which ensure life as well as give you a good return after maturity. In case the person availing the policy survives the period for which his/her risk of death is covered, s/he will receive a payment called a ‘survival benefit’ which is seen by many as protection plus investment. There are multiple insurance schemes and will be discussed later.

Provident Fund Schemes

These investments are available only to employees of a firm. The employees contribute to this fund through their monthly deduction in their salary. They are attractive because they also offer income tax benefits.

Pension Fund Schemes

The employee may access these funds usually after a period or 15 to 20 years or after retirement. Insurance, provident fund and pension funds have attracted investors as they offer certain income tax benefits. In India, investors traditionally invest the surplus money available to them in banks (public and private sector) despite low to modest interest rates because they consider them ‘safe’. Post offices also offer deposit schemes. They usually offer better rates of interest than commercial banks. Post offices are seen by many urban people as lacking in service (customer care) and are typically used in non-urban areas and by investors who are able to invest only small sums of money. However, the well-informed are willing to take the risk for better returns.

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Non-Traditional Financial Investments

Equity Instruments

These are documents which serve as legally enforceable evidence of the right of ownership in a firm, such as a share certificate/stock certificate. (We shall cover it in detail later).

Debt Instruments

These are documents or electronic obligations that enable the issuing party to raise funds by promising to repay a lender in accordance with the terms of a contract. It can be in the form of following (see the reference for more details).

• Corporate Securities
• Company Deposits
• Bonds
• Debentures

Bonds

It is a fixed income (debt) instrument issued for a period of more than one year with the purpose of raising capital. The central or state government, corporations and similar institutions sell these bonds. A bond is generally a promise to repay the principal along with a fixed rate of interest on a specified date, called the maturity date.

Hybrid Instruments

Generally hybrid instruments are used to refer to financial instruments that blend characteristics of debt and equity markets. For example, convertible debentures, warrants etc.

Mutual Funds

Mutual funds are investment companies that pool money from investors at large and offer to sell and buy back its shares on a continuous basis and use the capital thus raised to invest in securities of different companies. (We shall cover this extensively in the following sections).

Unit-Linked Insurance Plans (ULIPs)

A ULIP is a life insurance policy which provides a combination of risk cover and investment. The dynamics of the capital market have a direct bearing on the performance of the ULIPs.

chapter- 1.10 Investment Alternatives

1.10 Investment Alternatives

Attempt: 1

What are the Investment Alternatives available for an Investor?

There are several investment options:

Real assets

are assets that are intrinsically valuable because of their utility. They include real estate, gold, equipment, patents, etc. They are directly opposite to financial assets. Real assets can be tangible or intangible.

Tangible Assets:

Investment to procure assets like a car, television, washing machine and any other household articles which are physical and have a long life are considered as tangible investments as they result in the creation of tangible assets. Procuring these assets may be viewed as either an expense or an investment based on the reasons for buying the same. For example, buying a car for personal use is considered as expenditure. If a car is purchased with a view to generate income by operating a taxi service, the purchase would be considered as an investment as it can potentially result in the generation of periodic income.

Intangible Assets:

The procurement of knowledge such as this course for which you have paid with the intention of becoming a smart investor may be considered as an investment in an intangible asset. The asset that is being acquired by you - knowledge related to investments - is an intangible asset.

An individual may make a decision to procure an asset with either a short or long-term horizon in mind. This decision is based on the individual’s need at that point in time. Some examples of investment in assets that are tangible include:

Real Estate:

It could be an apartment, either residential or commercial. It could be the purchase of vacant land for the construction of residential or commercial buildings or individual houses or bungalows.

Bullion: One can invest in precious metals like gold, silver etc.

Precious Stones:

Investments in precious stones like diamonds and gems etc are also bound to fetch good returns.

Business:

Fixed assets such as land and building, plant and machinery or intangible assets such as patents, royalty etc.

Others:

Antiques, paintings etc.

Individual investors are normally attracted to tangible assets and procure them to meet their financial needs that may cater to the short-term or long-term needs. The following section provides example of financial instruments classified on a time horizon. Financial instruments are cash, evidence of an ownership interest in an entity or a contractual right to receive or deliver cash or another financial instrument.

Financial Instruments

Are cash, evidence of an ownership interest in an entity or a contractual right to receive or deliver cash or another financial instrument.