NISM SERIES V-A: MUTUAL FUND DISTRIBUTORS BY- CA NITIN GURU

Chapter 1: Investment Landscape

Financial Goals:
Financial goals are the personal, big-picture objectives ou set for how ou ll save and spend
money.
When we assign amounts and timelines to these objectives, we convert these into financial
goals.
Examples:
Funding a child s education cost of the marriage of one s son or daughter funding the lifest le
in retirement bu ing a vehicle bu ing or renovating one s house etc

Goal Setting and its Steps:

Goal setting is a very important exercise, while planning for investments.
The first step in goal setting is to identify the events in life. Some of the events are desirable
and planned, or undesirable- that spring up as surprises.
After identifying the events, one needs to assign priorities which of these are more important
than the others.
After that, one needs to assign a timeline as well as amount of funding required at the time
of such events.

Financial Goals, Time Horizon for their achievement and Inflation:

One needs to assign amount to the financial goals.
In the process of planning, this is an important question: How much would it cost? Well, this
question must be answered in terms of amount needed, and when it is needed.
The costs are quite likely to move up. Such a rise in the cost of the goals is called inflation.
Inflation adjustment for the goal values is critical, without which the entire planning can go
haywire.

Savings & Investments:

The word saving originates from the same root as safe The safet of mone is of critical
importance here.
Whereas, when one invests money, the primary objective typically is to earn profits.
The important point to note here is that there is a trade-off between risk and return.
Saving and investing are not to be considered as two completely different things, but two
steps of the same process in order to invest money, one needs to save first. Thus, saving
precedes investing.

Factors to evaluate investments:

Safety: safety of capital invested/ surety of income from investment.
Liquidity: how easily can one liquidate the investment and convert it to cash?
Returns: returns may be in the form of regular (or periodic) income, also known as current
income; and capital appreciation, or capital gains.

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Convenience: convenience with respect to investing, taking the money out fully or partially,
as well as the investor s abilit to convenientl check the value of the investment as well as
to receive the income.
Ticket size: What is the minimum amount required for investment?
Taxability of earnings: What one retains after taxes is what matters, and hence, taxation of
the earnings is another important factor that one must consider.
Tax deduction: tax deduction may be available in case of certain products, which increases the
return on investment, since the same is calculated after factoring the net amount invested.
However, the product may have a lock-in period of certain years in that case, and this is a
trade-off between liquidity and tax deduction.

Different Asset Classes:

Various investment avenues can be grouped in various categories, called asset classes.
There are four broad asset categories or asset classes- Real estate, Commodities, Equity and Fixed
income.

1. Real Estate:
Real estate is considered as the most important and popular among all the asset
classes.
Real estate could be further classified into various categories, viz., residential real
estate, land, commercial real estate, etc.
Some of the traits of Real estate are as follows:
o Location
o Illiquid
o Not a divisible asset
o One can invest in physical/financial form
o Current income in form of rent, and capital appreciation
o High transaction costs (brokerage, registration charges, etc.)
o High cost of maintenance of the property

Commodities:
We consume a lot of commodities on a regular basis. However, it is not possible to invest in
most of these, as many of these are either perishable and hence cannot be stored for long, or
storage of the same could take a lot of space, creating different kind of difficulties.
There are commodities derivatives available on many commodities, but it may not be wise to
call these investments for two reasons
(1) These are leveraged contracts, i.e. one can take large exposure with a small of money
making it highly risky, and
These are normall short term contracts whereas the investors needs ma be for longer
periods.
There are two commodities that many investors are quite familiar with as investment
avenues, i.e., gold and silver.
Some of the characteristics of gold and silver as investments, are as follows:
o prices are in sync across the world, thus, globally accepted assets

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o used as investments or storage of value for long

o only capital appreciation, no current income
o come in varying degrees of purity

Fixed Income:
When someone borrows money, one has to return the principal borrowed to the lender in the
future. There could also be some interest payable on the amount borrowed.
There are various forms of borrowing, some of which are through marketable instruments like
bonds and debentures.
There are many issuers of such papers, e.g. Companies, Union Government, State
Governments, Municipal Corporations, banks, financial institutions, public sector enterprises,
etc.
Bonds are generally considered to be safer than equity. However, these are not totally free
from risks.
Bonds can be classified into subcategories on the basis of issuer type i.e. issued by the
government or corporates or on the basis of the maturity date: short term bonds (ideal for
liquidity needs), medium term bonds, and long term bonds (income generation needs).

Equity:
This is the owner s capital in a business. Someone who buys shares in a company becomes a
part-owner in the business.
Historically, equity investing has generated returns in excess of inflation, which means the
purchasing power of one s mone has increased over the ears
It has also delivered higher returns than other investment avenues, most of the times, if one
considers long investment periods.
Apart from long term capital appreciation, equity share owners also receive dividends from
the company.
Equity share prices generally fluctuate a lot, often without regard to the business
fundamentals. However, over long periods of time, the share prices follow the fortunes of the
firm. If the profits of the company continue to grow over the years, the share price follows.

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Investment avenues classified under different asset categories

INVESTMENT RISKS

Inflation Risk:
Inflation, or price inflation is the general rise in the prices of various commodities, products,
and services that we consume. Inflation erodes the purchasing power of the money.
The following table explains what inflation can do to the purchasing power of our money:

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The returns on investment without factoring inflation is known as nominal rate However
when this number is adjusted for inflation one gets real rate of return
If the investment returns are higher than inflation, the investor is earning positive real rate,
and vice versa.

Liquidity Risk:
Investments in fixed income asset are usually considered less risky than equity. Even within
that, government securities are considered the safest.
In order to avail the full benefits of the investments, or to earn the promised returns, there is
a condition attached.
The investment must be held till maturity. In case if one needs liquidity, there could be some
charges or such an option may not be available at all.
Some investment options offer instant access to funds, but the value of the investment may
be subject to fluctuations. Equity shares, listed on stock exchanges are an example of this.
While it is easy to sell shares to get cash in case of a large number of listed shares, the equity
prices go up and down periodically. Such investments are not appropriate for funding short
term liquidity needs.

Credit Risk:
When someone lends money to a borrower, the borrower commits to repay the principal as
well as pay the interest as per the agreed schedule.
There are three possibilities in such cases:
(1) The issuer honours all commitments in time,
(2) The issuer pays the dues, but with some delay, and
(3) The issuer does not pay principal and the interest at all.
While the first is the desirable situation, the latter two are not. Credit risk is all about the
possibility that the second or the third situation may arise.

Market Risk and Price Risk:

When securities are traded in an open market, people can buy or sell the same based on their
opinions.
Since the opinions may change very fast, the prices may fluctuate more in comparison to the
change in facts related to the security. Such fluctuations are also referred to as volatility.
There are two types of risks to a security market risk and price risk:

o Market risk:
Let s take an example When there is a possibilit of a countr getting into a warlike
situation, there is a widespread fear that this may impact the economy, and the
companies within it. Due to such a fear, it is quite possible that the prices of all stocks
(or at least a large number of stocks) in the market may witness a fall. This is a market
wide fall.

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o Price Risk:
On the other hand, when the sales of a compan s products fall due to technological
changes or arrival of a better product the compan s share price falls During such
times, there could be many other companies, whose share prices may rise. This is an
example of a company specific risk.

Interest Rate Risk:

It is the risk that an investment's value will change as a result of a change in interest rates.
This risk affects the value of bonds/debt instruments more directly than stocks. Any reduction
in interest rates will increase the value of the instrument and vice versa
The relationship between interest rates and bond prices is inverse. If the interest rates rise,
the price bonds decreases, and vice versa; and, if the interest rates remain unchanged, so does
the bond price.
The interest rate risk varies for bonds with different maturities. Those with longer maturity
would witness higher price fluctuations in comparison to those with shorter maturities. Such
movements in bond prices on account of changes in interest are referred as interest rate
risk . This is a market-wide factor affecting the prices of all bonds.

Risk Measures and Management Strategies

In order to manage the investment risks, one may consider the following strategies:

Avoid:
One may totally avoid certain investment products, if one does not want to take the respective
risk.

Take a position to benefit from some event / development

An investor can also take an investment position in anticipation of some development in the
market.
Let us take an example, a bond investor expects the interest rates to go down. In that case,
one may sell the short maturity bonds and invest in long maturity bonds. If the interest rates
move down the investor s judgment would be rewarded handsomely, but if the judgment is
wrong, there could be losses, too. This is an example of managing the interest rate risk.

Diversify
While the previous strategy is possible when one has superior knowledge, not everyone would
possess the same. Those who do not know everything about everything, a prudent approach
would be to diversify across various investment options. This spreads the risk of loss and thus
the probability of losing everything can be significantly reduced through diversification.

Behavioural Biases in Investment Decision Making

Investors are driven by emotions and biases. The most dominant emotions are fear, greed and hope.
Some important biases are discussed below:

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Availability Heuristic
Most people rely on examples or experiences that come to mind immediately, which means
that enough research is not undertaken for evaluating investment options. This leads to
missing out on critical information.

Confirmation Bias
It is the tendency to look for additional information that confirms to their already held beliefs
or views. It also means interpreting new information to confirm the views.

Familiarity Bias
An individual tends to prefer the familiar over the novel, as the popular proverb goes, 'A
known devil is better than an unknown angel.' This leads an investor to concentrate the
investments in what is familiar, which at times prevents one from exploring better
opportunities.

Herd Mentality
'Man is a social animal' - Human beings love to be part of a group.

Loss Aversion
Loss aversion explains people's tendency to prefer avoiding losses to acquiring equivalent
gains: it is better not to lose Rs. 5,000 than to gain Rs. 5,000. Such a behavior often leads
people to stay away from profitable opportunities, due to perception of high risks, even when
the risk could be very low.

Overconfidence
This bias refers to a person s overconfidence in one s abilities or judgment This leads one to
believe that one is far better than others at something, whereas the reality may be quite
different.

Recency Bias
The impact of recent events on decision making can be very strong. A bear market or a
financial crisis lead people to prefer safe assets. Similarly, a bull market makes people allocate
more than what is advised for risky assets. The recent experience overrides analysis in decision
making.

Risk profiling:
The risk profilers try to ascertain the risk appetite of the investor so that one does not sell mutual fund
schemes that carry higher risk than what the investor can handle. In order to ascertain the risk
appetite, the following must be evaluated:

The need to take risks

The ability to take risks, and
The willingness to take risks

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Understanding Asset Allocation

Asset Allocation is a process of allocating money across various asset categories in line with a stated
objective. There are two popular approaches to asset allocation:

Strategic Asset Allocation

It is allocation aligned to the financial goals of the individual. It considers the returns required
from the portfolio to achieve the goals, given the time horizon available for the corpus to be
created and the risk profile of the individual.

Tactical Asset Allocation

It dynamically changes the allocation between the asset categories. The purpose of such an
approach may be to take advantage of the opportunities presented by various markets at
different points of time, but the primary reason for doing so is to improve the risk-adjusted
return of the portfolio.

Rebalancing
An investor may select any of the asset allocation approach, however there may be a need to
make modifications in the asset allocations.
Many practitioners advocate that the portfolio should be rebalanced to restore the target
asset allocation. Their argument is that the asset allocation was decided by an analysis of the
needs and risk appetite of the investor. We need to reduce the allocation to the risky asset if
that has gone up. On the other hand, if the allocation has gone down in the asset that has the
potential to generate higher returns, we need to correct that as well.
Such a rebalancing offers a huge benefit it makes the investor buy low and sell high.
The rebalancing approach can work very well over the years, when the various asset
categories go through many market cycles of ups and downs.
On the other hand, one may also need to do a rebalancing of the asset allocation, when the
investor s situation changes and thus the needs or the risk appetite might have changed
Rebalancing in required in case of strategic asset allocation as well as tactical asset allocation.

Do-it-yourself versus Taking Professional Help

One option is to manage the investments oneself. That would involve finding the right
investments and carrying out the related research and administration work.
The other option is to outsource the entire job to a professional or a company engaged in such
a business.
Mutual fund is that second option it is managed by a team of professionals, known as the
asset management company.
So the next logical question is which of the two choices is better investing oneself or taking
professional help to manage m investments
This question should be broken down into three components:
1. Can one do the job oneself?
2. Does one want to do it?
3. Can one afford to outsource?