Chapter 1: Need for Investment and Different Investment Avenues

1.1 What is investment?

Investment is an activity where you set aside some money now, in anticipation of receiving a higher amount in the future.

For example, depositing Rs. 10,000 in a fixed deposit (FD) for a three-year period today may give you Rs. 11,910 after the specified duration. (Assuming the FD pays an interest of 6% p.a.)

Similarly, investors of equity stocks, mutual funds, and even insurance plans, expect their invested money to grow over time.

We can summarize financial investment with the following formula:

Invested Money + Time = Invested Money + Returns

This equation sum up the simple activity of investment where, if you set aside a sum for a certain period, you may receive an additional sum in the form of interest, along with your invested amount after the period.

The need to invest – Why invest?

There are two primary reasons everyone should invest:

To counter inflation

To meet financial goals

Countering inflation with investment

 Inflation is the general rise in price of commodities. If we look at it from the perspective of money, it is a depreciation in the value of money.

For example, if the price of 1 kg of tomatoes is now Rs. 11 compared to Rs. 10 last year, it indicates a price rise (or inflation) of 10% over the period of a year.

So, if you had Rs. 100 last year, you could’ve bought 10 kgs of tomatoes.

But assuming you kept Rs. 100 unspent for a year, and now inflation has caused the price to go up to Rs. 11, your ability to buy (or purchasing power) has gone down to about 9 kgs of tomatoes with the same amount of money.

However, if you had invested your Rs. 100 at 10% p.a., you will still be able to buy the same quantity of tomatoes, like the year before.

Thus, investing can help you retain and even grow the purchasing power of your wealth.

Meeting financial goals

Our lives are made up of various goals:

  • Education
  • Employment
  • Accumulating Wealth
  • Family
  • Kids’ Education
  • Retirement

We need to achieve these goals as we progress, and almost all our goals need some financial support.

A few financial goals, like household expenses, clothing and entertainment costs, etc. can be met with your regular income. However, goals like buying a house, paying for higher education of kids, and retirement, etc. need a large financial pool.

Developing the ability to meet your financial goals is the second important reason to invest.

Example:

If you are currently salaried, you may be earning Rs. 1 lakh per month. However, to fulfil a goal, such as buying a house, you will need much more than just Rs. 1 lakh.

Assume that the house you want to buy is priced at Rs. 50 lakhs. You can easily opt for a bank loan if you can pay at least 20% of this price i.e.  Rs. 10 lakhs. Since your income is Rs. 1 lakh per month, you will need about 10 months (or more) to collect this amount.

Assume that you aim to buy this house after two years, and you can invest your savings at 10% p.a.

You only need to invest about Rs. 37,800 per month from your salary, for two years, to accumulate Rs. 10 lakhs.

That means:

You can invest only a little above Rs. 9 lakh and still meet your goal of buying the house.

 

1.2 When to invest?

The sooner the better. By investing in the market right away, you allow your investments more time to grow.  The concept of compounding interest multiplies your income by accumulating your earnings and dividends. Considering the unpredictability of markets, these are three golden rules that all investors must follow:

1. Invest early

2. Invest regularly

3. Invest for long-term and not short-term

Compounding is growth via reinvestment of returns earned on savings. Compounding has a snowballing effect because you earn income not only on the original investment but also on the reinvestment of dividend/interest accumulated over the years. The power of compounding is one of the most compelling reasons for investing as soon as possible. The earlier you start investing and continue to do so consistently, the more money you will make. The longer you let your money remain invested and the higher the returns, the faster your money will grow. That's why stocks are the best investment option for the long-term. The general upward momentum of the economy mitigates stock market volatility and the risk of losses. That’s the reasoning behind investing for the long-term rather than short-term.

How much money do I need to invest?

There is no statutory amount that investors need to invest in order to generate adequate returns from their savings. The amount that you invest will eventually depend on factors such as:

  • Savings made
  • Your time horizon
  • Your risk profile

 

1.3 Available avenues of investment

 Investment options available to choose from are plenty. Pick the right investment tool based on your risk appetite, financial goals and investment time horizon, etc. If you feel that you can live with market volatility, then buy stocks. If you do not want to risk the volatility and simply desire some income, then you should consider fixed income securities. However, remember that risk and returns are directly proportional to each other. Higher the risk, higher the returns.

There are many types of investments available in the market. But all investment instruments are broadly based on the following four basic investment areas or assets classes:
 • Equity Markets
 • Debt Markets
 • Real Estate, &
 • Gold
 

1.3.1 Equity

Equity investments include direct investment in shares, equity mutual funds, etc. Stocks can be bought/sold from exchanges (secondary market) or via IPOs – Initial Public Offerings (primary market). Stocks are among the best long-term investment options wherein market volatility and the resultant risk of losses, if given enough time, are mitigated by the general upward momentum of the economy.

On an average, an investment in equities outperforms in terms of returns against all other asset classes in the long-term.

If you had invested Rs. 1 lakh in the Nifty 50 Index of NSE in January 2001, you would have approximately Rs. 1 crore by the beginning of 2018.

That is a compounded annual growth rate (CAGR) of about 14%, unparalleled by any other investment asset.

What is equity?

Owners of a firm or a business usually invest in it to fund its activities. Equity represents their respective ownership interests in that business. Business houses can sell equity, or ownership interests in the business in exchange for capital investments from other investors.

Investors buying the ownership interest (or equity) of a business, enjoy the gains and losses of the business activity.

Example:

Sudheer Energy Ltd. is a company looking for equity investors, and is offering 12% ownership stake for Rs. 100 crores.

An investor (or multiple investors) interested in buying the stake will invest Rs. 100 crores in the company and own 12% of the equity shares of the company.

These investors will share up to 12% of the net gain or loss in the business activity.

Gain and loss in equity

Gains on equities can be in the following two forms:

  • Capital appreciation: Rise in financial value of equity stocks
  • Dividend: Business gains distributed by the business to equity holders

Business loss usually results in depreciation in capital value of the equity.

For Example, Sheetal bought 100 equity shares of Fable Motors in 2001. She paid Rs. 50 per share at the time of buying. The current price of the stock is Rs. 500 per share. This is capital appreciation - the stock price increased from Rs. 50 to Rs. 500.

Every year, the firm also declared a dividend at 10% of the face value of the share (Rs. 10 at the time of buying). Thus, Sheetal has received Rs. 100 (100x10x10%) every year from the firm as dividend. This will be called her dividend income.

Equity markets

Equity market is the place where businesses looking for equity capital can meet investors with money and engage in a transaction where investors buy equity in exchange for money. Apart from businesses, investors too can trade equity among themselves.

Thus, in short, the equity market facilitates transfer of equity between businesses and investors.

The health and performance of equity markets are good indicators of the development and health of the country’s economy.

Usually, national stock indexes add a numerical value to this indicator. You can analyze the trend in the movement of this number to judge the state of the economy and make a decision about buying or selling equity stocks.

Types of equity capital (or equity shares in the market)

There are two types of equity stocks available in the market, based on their placement:

  • Publicly Traded Shares
  • Privately Placed Shares (Private Equity)

Publicly traded equity shares

Although any business can issue equity shares to its investors, not every business can raise funds from the public.

Only companies with a proven record of performance and a minimum capital size can opt for public listing and raise capital from retail investors through stock exchanges.

Thus, all companies that you find listed on stock exchanges are those with a long history of stable business performance. The markets are heavily regulated by Securities & Exchange Board of India (SEBI), which works to make markets transparent and reliable for investors.

Note: In equity markets, larger firms are considered safer than smaller firms. Though these firms may offer lower growth than their smaller counterparts, they offer steady growth. These are also called blue chip stocks.

Private equity

Private equity denotes those shares that you may hold by investing, for instance, in your friend’s business or start-up. This market is less regulated, and all the business risk is borne by investors.

These companies cannot raise equity funds from the public or trade their equity shares on stock exchanges, until they satisfy the criteria for raising capital investment from the public.

Indian stock exchanges

There are five approved stock exchanges in India, out of which two are national stock exchanges:

  • The Bombay Stock Exchange Ltd. (BSE Ltd.)
  • National Stock Exchange Ltd. (NSE Ltd.)

Indexes BSE Sensex and Nifty 50 are considered two national stock indexes, indicating the overall health of the nation’s economy.

BSE Sensex consists of the 30 largest publicly traded companies from major economic sectors. Nifty 50 is an index of the 50 largest companies’ stocks from major economic sectors.

How to invest in equity markets?

There are two common ways through which you can invest in the Indian equity markets:

Directly through a demat-cum-trading account

Indirectly, through professionally managed funds like mutual funds

 

1.3.2 Debt

Debt investment includes investment in bonds, debentures, debt mutual funds, etc. It is a fixed income (debt) instrument issued for a certain period with the purpose of raising capital.  Central or state governments, corporations and similar institutions sell bonds. A bond is generally a promise to repay the principal along with a fixed rate of interest on a specified date called as the maturity date.

What is debt?

Debt is one of the two ways of investing in a commercial activity, the other being equity investments. Debt is known for a lower, but safer and steady stream of income for investors.

Bonds or debt securities are also called fixed income securities because of the fixed rate of interest they offer.

Examples:

Simple examples of debt securities for individual investors would be fixed deposits, government bonds, municipal bonds, corporate bonds, etc.

Debt investors are lenders, not owners

An investment offering an interest rate of 8% on the invested money will be a debt investment if the payment of interest is not conditional to business performance.

Thus, unlike equity investors, debt investors do not hold an ownership interest in the business and do not share in the gains or losses of the business.

This precedence and detachment of interest payments from business performance makes debt investment a safer investment option over equity shares.

Indian debt markets

Indian debt markets facilitate the trading of debt or fixed income securities between borrowers and investors. The Indian debt market relies on the following three components to function:

Issuers of Securities

Large corporations, financial institutions (banks etc.) or Government bodies

 

Credit Rating Agencies

These agencies indicate the investment risk of the debt security. AAA to BBB are investment grade ratings

 

Financial Institutions

Banks, Mutual Funds, Life Insurance Companies and Pension Funds invest in debt securities on behalf of their investors

Type of debt securities

You can invest in the following four different types of fixed income securities or debt investments in India:

Government Bonds (G-Sec or Gilt Securities)

Corporate bonds

Certificates of Deposit

Bank or Post Office deposits

Can retail investors buy government securities/ Gilts?

Yes, retail investors can now invest in government bonds online. If you are investing in an individual capacity or as a Hindu Undivided Family (HUF), you can invest in selected government bonds online through ICICIdirect.

How to invest in debt markets?

  • Indirect route

Mutual funds and life insurance plans offer to invest your money in a portfolio of debt securities. These portfolios are professionally managed.

Investors usually do not have a say in the investment decisions of the fund. However, you can select funds based on the type of debt securities they invest in.

  • Direct route

You can buy selected government and corporate bonds in secondary markets or apply for them whenever a new issue comes up. In both cases, a demat account will help you invest, trade and hold the bonds safely in electronic form.

How does debt investment work?

You may find that a bank fixed deposit works with a set of standard conditions which are declared at the time of setting up the deposit. These can be:

  • The term of the deposit
  • The rate of interest on the deposit
  • Mode of interest payment – in the account every month, or only at maturity

Similarly, every fixed income security will have certain terms defined at the time of issue. An example of a bond investment would be:

Face Value (Maturity Value): Rs. 10,000

Coupon (Rate of Interest): 8%

Maturity date (defines time from the date of issue): 15 December, 2025

 The price of the bond depends on market conditions and prevalent market interest rates.

Factors that affect bond prices

The price at which bonds may be available in the market may vary because of the following factors:

  • Prevalent market rate of interest
  • Credit rating or risk level of the issuer

(bonds from high risk companies could be available at a higher discount, or may offer higher coupon/interest rate)

  • Demand and supply factors, to some extent

The average rate of return on bonds and securities in India has been around 6- 8% p.a.

1.3.3 Real estate

Real estate investment could be in residential or commercial properties.

Real estate is among the traditional investment assets for individuals. The Indian real estate market has seen great progress in terms of financing and investment opportunities in the sector.

Real estate has also been one of the booming sectors in India. With rising population and economic growth, cities have been looking at increasing demand in residential and commercial real estate markets.

Metro cities have also been witnessing a huge surplus of residential real estate inventories. However, with the introduction of RERA (Real Estate Regulation and Development Act), the demand-supply imbalance is likely to disappear soon.

How to invest in Real Estate?

Like all other investment assets, real estate too has two modes of investment:

  1. Direct investment
  2. Indirect or through Real Estate Funds

How do you earn from Real Estate investment?

There are two ways you can earn from your real estate investments:

  1. Rental Income
  2. Capital Appreciation

You receive rental income when you hold the asset and let it to others for use while capital appreciation is the rise in the value of the property. Both incomes may depend on numerous external factors such as development of infrastructure, connectivity, security, etc.

Direct investment

The simplest way to invest in real estate is to buy a piece of land, or commercial assets like shops, apartments and houses directly.

Depending on your profession and price and type of property you are investing in, you may need to pay at least 10 to 25% of the total price out of your pocket. The rest of the investment can be via bank loans.

Bank finance plays a very important role in real estate investing.

Indirect or Real Estate Funds

Real estate funds are a better option if you are looking to invest small sums. You can invest in the following two types of real estate funds:

  • Real Estate Mutual Funds (REMFs)
  • Real Estate Investment Trusts (REIT)

The difference between both funds is that REITs generally own real estate assets, while REMFs invest in a portfolio of REITs, or real estate firms through lending or equity.

REITs are better if you are looking for regular income, while REMFs may offer better capital appreciation.

Development of REITs in Indian markets

Compared to other financial instruments and even mutual funds, REITs are a recent development in India. REITs officially started in 2014, when SEBI, for the first time, put in place regulations for setting up of REITs in India.

There is still a long way to go for smooth functioning and availability of REITs to smaller retail investors in India. Introduction of RERA (Real Estate Regulatory Authority) Act should help REITs gain more interest with both financial institutions and investors.

Embassy Office Parks, the country’s very first REIT listing, had been reported in September 2018, to be listed by the end of the year.

 

1.3.4 Gold

Gold investment could be in

  1. Gold ETF (Exchange traded funds)
  2. Sovereign Gold Bonds. (SGBs)

Gold ETFs

Gold ETFs are professionally managed funds which invest in physical gold. When you invest in these funds, you are allotted units, just like any other mutual fund. Over time, the price of these units may appreciate, or you may receive dividend income from the fund.

Gold ETFs are a close alternative to owning physical gold. They are traded on stock exchanges, and you can buy them through your stock broker. The units are credited to your demat account like stocks.

Sovereign Gold Bonds (SGBs)

SGB is a scheme by the Government of India to allow investors an alternative and safer route of benefitting from investments in gold.

You can buy the bonds through your stock broker, banks or post office in 1-gram denominations.

SGBs are safer than holding physical gold and investing in Gold ETFs, as you receive 2.5% interest on your total investment for the holding period.

 

1.4 Risk reward matrix for investments

While all of us want to grow our wealth and continuously look for avenues to do it faster, we should pay attention to investment risks along the way.

In the investment world, “Higher investment risk indicates an opportunity for higher returns on investment.”

Asset returns over time

Investments in different assets will give you different growth rates. Historically, assets falling in different risk categories have shown the following rate of returns:

Asset Class

Return p.a.

Equity 1

12.50%

Debt/Bonds 2

8.26%

Real Estate 3

6.92%

Gold 4  

4.50%

 

  1. Sensex return for the period between 2000 -2019, Source: bseindia.com
  2. Long duration, debt fund category returns for 10 years as on August 22,2019, Source: Morningstar.in
  3. NHB RESIDEX return for the period of Jun 2013 – June 2018 with base year as 2017-18 Source BIS: Real Residential Property Price Index (ending July 2018)
  4. Precious metals category returns for last 5 years as on August 22, 2019 , Source morningstar.in

 

1.5 How to self-evaluate your investment risk profile?

Every person is different and so are their goals and needs in life. Your financial goals coupled with your current financial health decide if you can be an aggressive investor or a conservative investor.

A simple way to imagine your ‘investment risk profile’ is to evaluate your current investment profile with the financial needs pyramid:

 

Financial Needs Pyramid

When you start earning, your investments should start at the bottom of the pyramid. Your Investment Risk Profile becomes more aggressive as you climb the pyramid.

Additionally, you can also invest aggressively in your financial goals if they are too far off on the timeline.

For example, when you start investing in your newborn’s higher education goal, buying some stocks won’t hurt. This is because your investment has ample time to grow.

Further, you can manage your risk in highly volatile investments.

How to manage investment risk?

There are two ways you can manage investment risks:

Invest for long-term

Invest small sums regularly

You can use both ways to minimize risk in high-risk investments like equity stocks, gold funds etc.

If you have a large sum to invest in a high-risk investment, you should park the funds in a low-risk investment tool like a debt fund and then transfer the money from that fund to the high-risk investment instrument over time.

For example, if you want to invest Rs. 10 lakhs into equity stocks or fund, you can invest Rs. 1 lakh in the first month and keep the rest in a short-term bond fund.

Then, you can transfer the remaining amount in small chunks over the next few months.

In this way, you can control the volatility in your investment’s value due to sudden market movements.