Investment planning

Sub-Section 2.1 Types of Investment Risks Risk Risk is usually understood as ―exposure to a danger or hazard‖. In investment decisions, risk is defined as the possibility that what is actually earned as return could be different from what is expected to be earned. For example, consider an investor who buys property after reading about the huge returns made by property investors. He expects to earn at least 50% return in 3 years. But if property prices fall during that period, the investor could end up with a negative return of 30%. This deviation between actual and expected returns is the risk in his investment. If the return from an investment remains unchanged over time, there would be no risk. But there is no investment of that kind in the real world. Even returns on government saving products change. For example, consider the Public Provident Fund (PPF), which is a 15-year deposit in which investors have to put in money at least once every year. This investment is considered to be government- guaranteed and its returns are viewed as being very safe. The rate of return on PPF was 9% in the year 2003. Consider the changes ever since: • Reduced to 8% in March 2003 • Increased to 8.6% in December 20011 • Increased to 8.8% in April 20012 • Reduced to 8.1% in April 2016 • Reduced to 7.6% in January 2018 • Increased to 8% in April 2019 An investor, who began to invest in 2003, hoping to earn 9% return, would have found that by March 2003, the rate had come down to 8%. With effect from April 1, 2012, the rate of interest is 8.8% (compounded annually). The unexpected change to investment return that impacts the investor‘s financial plans is the risk investors have to deal with. Deviations from expected outcomes can be positive or negative: both are considered to be risky. However, it is human nature to focus on negative deviations- or situations when actual returns fall below the expected level. The causes of risk depend on the uses to which the investment proceeds are put, and the factors that influence them. For example, returns earned from investment in the equity shares of a cement company depend on the performance of the company, which in turn is a function of factors such as demand for cement, employee costs, prices of inputs, government duties, competition from imports. The risk associated with investing in such a company would be affected by all these factors that can cause returns to deviate from expected levels. All investments are subject to risk, but the type and extent of risk are different. Thus it is important to understand the common types of risk and evaluate investments with respect to them. 2.1.1. Market Risk - Systematic and Unsystematic Total risk consists of two parts. The part of risk that affects the entire system is known as systematic risk, and the part that can be diversified away is known as unsystematic risk. Systematic risk or market risk refers to those risks that are applicable to the entire financial market or a wide range of investments. These risks are also known as undiversifiable risks, 91

because they cannot be eliminated through diversification. Systematic risk is caused due to factors that may affect the economy/markets as a whole, such as changes in government policy, external factors, wars or natural calamities. Here are some examples. • The 2008 financial crisis affected economic growth and led to depressed equity prices across all stocks. • The RBI increased interest rates sharply during 2010-11 in order to control inflation. This led to a fall in the prices of all bonds during that period. Unsystematic risk is the risk specific to individual securities or a small class of investments. Hence it can be diversified away by including other assets in the portfolio. Unsystematic risk is also known as diversifiable risk. Inflation risk, exchange rate risk, interest rate risk and reinvestment risk are systematic risks. Inflation risk affects all investments, though its highest impact is on fixed rate instruments. All overseas investments are subject to exchange rate risk. Interest rate and reinvestment risk impact all debt investments. Credit risk, business risk, and liquidity risks are unsystematic risks. The following examples illustrate how an investment can be subject to both systematic and unsystematic risk. (i) Ajay invests in equity shares of an infrastructure company. He believes that the company will do well because of the growing demand for infrastructure, and the company‘s strong technical and managerial capabilities. Ajay‘s investment is subject to two main risks- business risk and market risk. Ajay can reduce his business risk by investing in other companies operating in different sectors. But an economic slowdown would reduce the profitability of all companies. This is the market risk in equity investment that cannot be diversified. (ii) Ashima is keen to invest in bonds issues. Her investment is subject to credit risk and interest rate risk. She can reduce credit risk by increasing the proportion of highly-rated bonds in her portfolio. However, if interest rates fall, then prices of all the bonds held by her will decline. This is the interest rate risk which is common to all debt investments. 2.1.2. Inflation Risk Inflation risk represents the risk that the money received on an investment may be worth less when adjusted for inflation. Inflation risk is also known as purchasing power risk. It is a risk that arises from the decline in value of security‘s cash flows due to the falling purchasing power of money. Consider a simple example. Asha has invested a lump sum in bank fixed deposits that yield her about ₹5000 per month. This is adequate to cover the cost of her household provisions. Suppose that inflation rises to 10%, meaning that there is a general rise in prices of goods by about 10%. Then ₹5000 will no longer be enough to cover Asha‘s monthly provisions costs, she would need 10% more, or ₹5500. The purchasing power of her cash flows has declined. Asha would have to manage her budget at a lower level, or reallocate her investments to earn higher cash flows. Her investment, though in a reliable bank deposit, has been exposed to inflation risk. 92

Inflation risk is highest in fixed return instruments, such as bonds, deposits and debentures, where investors are paid a fixed periodic interest and returned the principal amount at maturity. Both interest payments and principal repayments are amounts fixed in absolute terms. Suppose a bond pays a coupon of 8% while the inflation rate is 7%, then the real rate of return is just 1%. If inflation goes up to 9%, the bond may return a negative real rate of return. Thus even while the investor is holding the bond, its real value has been eroded because of changing inflation. Inflation risk has a particularly adverse impact on retired persons, whose income flows tend to be fixed in absolute terms. Consider an investor who is planning for his retirement years. He plans to invest in debt instruments that earn about 6% -8% p.a. to meet his monthly expenses. Suppose average inflation for the next 5 years is expected at least 9%. Clearly, the retiree is likely to earn only -3% to -1% in real terms, so his investment will not earn enough to cover his expenses. 2.1.3. Interest Rate Risk Interest rate risk refers to the risk that bond prices will fall in response to rising interest rates, and rise in response to declining interest rates. Bond prices and interest rates have an inverse relationship. This can be explained with an example. An investor invests in a 5-year bond that is issued at ₹100 face value, and pays an annual interest rate of 8%. Suppose that after one year, interest rates in the markets start declining. New 5-year bonds are issued by companies with a similar credit rating at a lower rate of 7.5%. Investors in the old bonds have an advantage over investors in the new bonds, since they are getting an additional 0.5% interest rate. Since investors want to earn the maximum return for a given level of risk, there will be a rush of investors trying to buy up the old bonds. As a result the market price of the old bond will go up. The price will rise up to a level at which the IRR of the cash flows from the old bond is about 7.5%. This will take place for all bonds until their yields are aligned with the prevailing market rate. Suppose, instead, that interest rates have increased. New issuers of 5-year debt will be forced to offer higher interest rates of, say, 9%. Now investors in the new bonds will earn more than investors in the old bonds. The holders of the old bonds (which pay only 8% interest) will sell off their holdings and try to buy the new bonds. This market reaction will push down the prices of the old bonds up to the level at which the IRR of its cash flows exactly matches the market rate. The relationship between rates and bond prices can be summed up as: • If interest rates fall, or are expected to fall, bond prices go up. • If interest rates rise, or are expected to rise, bond prices decline. Bond investments are subject to volatility due to interest rate fluctuations. This risk also extends to debt funds, which primarily hold debt assets. 2.1.4. Purchasing Power Risk The risk that unexpected changes in consumer prices will penalize an investor's real return from holding an investment. Purchasing power risk is the chance that the value of an asset or income will be eroded as inflation shrinks the value of a country's currency. Put another 93

way, it is the risk that future inflation will cause the purchasing power of cash flow from an investment to decline. The best way to fight this type of risk is through appreciable investments, such as stocks or convertible bonds, which have a growth component that stays ahead of inflation over the long term. Inflation risk is also known as purchasing power risk. For details refer to the Inflation risk explained above. 2.1.5. Liquidity Risk Liquidity or marketability refers to the ease with which an investment can be bought or sold in the market. Liquidity risk refers to an absence of liquidity in an investment. Thus liquidity risk implies that the investor may not be able to sell his investment when desired, or it has to be sold below its intrinsic value, or there are high costs to carrying out transactions. For example, the market for corporate bonds in India is not liquid, especially for retail investors. Investors who want to sell a bond may not find a ready buyer. Even if there were a buyer, the price may be lower due to the lack of liquidity. Investments in property and art are also subject to liquidity risk. 2.1.6. Reinvestment Risk Re-investment risk arises from the probability that income flows received from an investment may not be able to earn the same interest as the original interest rate. The risk is that intermediate cash flows may be reinvested at a lower return as compared to the original investment. For example, consider an investment in a bond with a maturity of 5 years and interest income at 12% per year. Each year ₹12 is received for every ₹100 invested. These cash flows have to be reinvested at the rates that are prevalent at the time they are received, so they may not earn 12%. The reinvestment rates can be high or low, depending on the situation at that time. This is the reinvestment risk. • If Interest rate rises, reinvestment risk reduces, or is eliminated • If Interest rate falls, reinvestment risk increases 2.1.7. Exchange Rate Risk Exchange rate risk is incurred due to changes in the exchange rate of domestic currency relative to a foreign currency. When a domestic investor invests in foreign assets, or a foreign investor invests in domestic assets, the investment is subject to exchange rate risk. It must be noted that • If domestic currency depreciates (falls in value) against foreign currency, the value of foreign asset goes up in terms of domestic currency. 94

• If domestic currency appreciates (increase in value) against foreign currency, the value of foreign asset goes down in terms of domestic currency. Example: An NRI based in the US invests $1000 in a bank deposit in India @10% for 1 year when the exchange rate is ₹45 per US$. After one year, the rupee depreciates and the exchange rate is ₹50 per US$. What is the risk to his investment if he decides to repatriate the money back? The value of his investment has increased in rupee terms and declined in dollar terms as the rupee has depreciated against the dollar. Initial Invested amount = US$1000 @45 ₹per US$ = ₹45000 Interest earned = 10% x 45,000 = ₹4500 Investment value after one year = 45000+4500 = ₹49,500 Investment value in dollar terms @50 ₹per US$ = 49500/50 = $990 Loss in investment value = 1,000 - 990 = $10 Although the deposit paid a nominal return of 10%, there was a loss in investment value, because the exchange rate depreciated by more than 10%. 2.1.8. Regulatory Risk Regulatory risk is the risk of a change in regulations and law that might affect an industry or a business. The risk that a change in laws and regulations will materially impact a security, business, sector or market. A change in laws or regulations made by the government or a regulatory body can increase the costs of operating a business, reduce the attractiveness of investment and/or change the competitive landscape. Such changes in regulations can make significant changes in the framework of an industry, changes in cost- structure, etc. 2.1.9. Investment Manager (Alpha) Risk The Beta of the market, by definition is 1. An index scheme mirrors the index. Therefore, the index scheme too would have a Beta of 1, and it ought to earn the same return as the market. The difference between an index fund‘s return and the market return, as seen earlier, is the tracking error. Non-index schemes too would have a level of return, which is in line with its higher or lower beta as compared to the market. Let us call this the optimal return. The difference between a scheme‘s actual return and its optimal return is its Alpha – a measure of the fund manager‘s performance. Positive alpha is indicative of outperformance by the fund manager; negative alpha might indicate under-performance. Since the concept of Beta is more relevant for diversified equity schemes, Alpha should ideally be evaluated only for such schemes. 95

These quantitative measures are based on historical performance, which may or may not be replicated. Such quantitative measures are useful pointers. However, blind belief in these measures, without an understanding of the underlying factors, is dangerous. While the calculations are arithmetic – they can be done by a novice; scheme evaluation is an art - the job of an expert. The return of a portfolio is dependent on the fund manager‘s skills to take correct decisions and in turn translate the portfolio return in capital gain over the period. Alpha is a measure of excess return over a benchmark and is positive when portfolio outperforms a benchmark and negative when portfolio underperforms the benchmark. Since the portfolio can underperform the benchmark, investor is exposed to risk and is known as investment manager risk or alpha risk. 2.1.10. Business Risk Business risk is the risk inherent in the operations of a company. It is also known as operating risk, because this risk is caused by factors that affect the operations of the company. Common sources of business risk include cost of raw materials, employee costs, introduction and position of competing products, marketing and distribution costs. For example, consider a company that manufactures jute bags. Suppose the cost of jute, which is the key raw material, goes up. The company has to face higher operating costs, which it may or may not be able to pass on to its customers through higher selling prices. This is a risk specific to businesses that use jute as an input. 96

SUMMARY  Risk is usually understood as ―exposure to a danger or hazard‖. In investment decisions, risk is defined as the possibility that what is actually earned as return could be different from what is expected to be earned.  Total risk consists of two parts. The part of risk that affects the entire system is known as systematic risk, and the part that can be diversified away is known as unsystematic risk.  Systematic risk or market risk refers to those risks that are applicable to the entire financial market or a wide range of investments. These risks are also known as undiversifiable risks, because they cannot be eliminated through diversification.  Unsystematic risk is the risk specific to individual securities or a small class of investments. Hence it can be diversified away by including other assets in the portfolio. Unsystematic risk is also known as diversifiable risk.  Inflation risk represents the risk that the money received on an investment may be worth less when adjusted for inflation. Inflation risk is also known as purchasing power risk. It is a risk that arises from the decline in value of security‘s cash flows due to the falling purchasing power of money.  Interest rate risk refers to the risk that bond prices will fall in response to rising interest rates, and rise in response to declining interest rates.  Purchasing power risk is the chance that the value of an asset or income will be eroded as inflation shrinks the value of a country's currency.  Liquidity risk implies that the investor may not be able to sell his investment when desired, or it has to be sold below its intrinsic value, or there are high costs to carrying out transactions.  Re-investment risk arises from the probability that income flows received from an investment may not be able to earn the same interest as the original interest rate.  Exchange rate risk is incurred due to changes in the exchange rate of domestic currency relative to a foreign currency. When a domestic investor invests in foreign assets, or a foreign investor invests in domestic assets, the investment is subject to exchange rate risk.  Regulatory risk is the risk of a change in regulations and law that might affect an industry or a business.  The return of a portfolio is dependent on the fund manager‘s skills to take correct decisions and in turn translate the portfolio return in capital gain over the period. Alpha is a measure of excess return over a benchmark and is positive when portfolio outperforms a benchmark and negative when portfolio underperforms the benchmark. Since the portfolio can underperform the benchmark, investor is exposed to risk and is known as investment manager risk or alpha risk.  Business risk is the risk inherent in the operations of a company. It is also known as operating risk, because this risk is caused by factors that affect the operations of the company. 97

Sub-Section 2.2 Product Profiling in Terms of Inherent Risk and Tenure When contemplating an investment, the financial planner must first understand the client‘s financial goals, their time horizons and the client‘s risk appetite. The client may have long-term goals like retirement or may have something near-term in mind, like buying a new car. To create a portfolio based on time, it is important to understand that volatility is a bigger risk in short term than long term. If you have 30 years to reach a goal, such as retirement, market volatility that causes the value of your investment to plunge may not be an immediate danger given that you have decades to recover. Experiencing the same volatility a year before you retire can derail your plans. Based on the return and risk attributes, investment options can be broadly classified into the following asset classes: • Equity • Debt • Cash Equity as an asset class represents a growth-oriented asset. The major source of income to the investor is growth in value of the investment over time. Debt as an asset class represents an income- oriented asset. The major source of return from a debt instrument is regular income. Cash and its equivalents are for parking funds for a short period of time and earning a nominal return. Let‘s look at what type of equity, debt and cash products are available and how they can fit into the client‘s portfolio to achieve financial goals. 2.2.1. Short-term Products – Low Returns with Capital Protection As a general rule, short-term goals are those less than three five years in the future. With a short-term horizon, if a drop in the market occurs, the date on which the money will be needed will be too close for the portfolio to have enough time to recover from the market drop. To reduce the risk of loss, holding the investment in cash or cash-like vehicles is likely the most appropriate strategy. Short-term debt funds, Money market funds and cash- equivalent investments are popular conservative investments, as are savings accounts Near term goals could be buying a car or make the down payment for a house in a year or two. For near term goals stay away from equity. Such goals can be met through debt funds, which invest purely in fixed-income instruments. Income funds may be used to ensure that your money grows at a steady pace. Investors with short-term money/goals have two primary objectives:  Safety of capital  Return on capital The typical investment tenure for such investments is less than 12 months. 98

Money Market Funds / Liquid Schemes Money Market or Liquid Funds are very short term maturity. They invest in debt securities with less than 91 days to maturity. However, there is no mark to market for securities less than 60 days to maturity. The primary source of return is interest income. Liquid fund is a very short-term fund and seeks to provide safety of principal and superior liquidity. It does this by keeping interest rate and credit risk low by investing in very liquid, short maturity fixed income securities of highest credit quality. There are ultra short-term plans which are also known as treasury management funds, or cash management funds. They invest in money market and other short term securities of maturity up to 365 days. The objective is to generate a steady return, mostly coming from accrual of interest income, with minimal NAV volatility. These funds are slightly riskier than Liquid Funds. Because they primarily invest in short-term debt securities maturing from 90 days to 1.5 Yrs. For debt funds, maturity period of the underlying securities is a point to be checked along with a credit rating. Longer the maturity period means higher the interest rate risk. At the same time, lower the credit rating means higher the risk of default. An investor seeking the lowest risk ought to go for a liquid scheme. However, the returns in such instruments are lower. The comparable for a liquid scheme in the case of retail investors is a savings bank account. Switching some of the savings bank deposits into liquid schemes can improve the returns for in any case do him. Businesses, which not earn a return on their current account, can transfer some of the surpluses to liquid schemes. Money market funds provide investors with current income and seek to preserve your principal. Because of their stability, money market funds are often used for emergency cash reserves or for a very short-term financial goal. Cash-equivalent investments and money market funds are the least volatile of the investment types and are therefore ideal for people with extremely low risk tolerance. However, the income from this type of investment is only slightly higher than interest rates offered by banks on savings accounts making them poor choices to combat the damage inflation inflicts on your purchasing power. Short Term Debt Funds Short Term Plan combines short term debt securities with a small allocation to longer term debt securities. Short term plans earn interest from short term securities and interest and capital gains from long term securities. The volatility in returns will depend upon the extent of long-term debt securities in the portfolio. Short term funds may provide a higher level of return than liquid funds and ultra short term funds, but will be exposed to higher mark to market risks. Consider this example. XYZ and PQR short term plans are holding 20% and 30% respectively in long term bonds. Interest rates in the market have unexpectedly fallen sharply. Which one will show a better return? The answer to this will be PQR short term plan, because it holds a higher proportion of long term securities. This is beneficial in a falling interest rate environment. 99

Debt instruments are FDs, Bonds, debt based Mutual Fund Scheme such as Short Term Funds, Gilt Funds, Liquid Funds, floater etc. Depending upon the liquidity needs and taxation, the product should be taken debt category. Fixed Maturity Plans (FMPs) FMPs are closed-end schemes that invest in a portfolio of debt securities which mature on or before the maturity of the scheme. The bonds are held to maturity and intervening changes in price does not affect the yield at maturity. This limits the interest rate risk in the fund. The yield from the fund will depend on tenor and credit quality of the securities held in the portfolio. Investors who hold the investment to maturity earn this yield. FMPs come with tenors ranging from 90 days to 3 years and some even longer. To benefit from the interest risk mitigating structure of FMPs, the investment horizon of the investor must match the tenor of the scheme. Bank Deposits Perhaps the simplest of investment avenues, by opening a bank account and depositing money in it one can make a bank deposit. There are various kinds of bank accounts: current account, savings account, and fixed deposit account. While a deposit in a current account does not earn any interest, deposits in other kinds of bank accounts earn interest. Banks offer deposits of varying time frames beginning with a minimum of 7 days. So an investor looking to park money for even a week can choose a fixed deposit with a matching tenure. The interest on the deposit is added to income and taxed at the marginal rate of taxation. The important features of bank deposits are as follows:  Deposits in scheduled banks are very safe because of the regulations of the Reserve Bank of India and the guarantee provided by the Deposit Insurance Corporation  The interest rate on fixed deposits varies with the term of the deposit. Interest is generally paid quarterly.  Bank deposits enjoy exceptionally high liquidity. Banks now offer customers the facility of premature withdrawals of a portion or whole of fixed deposits. Such withdrawals would earn interest rates corresponding to the periods for which they are deposited, at times with some penalty.  A tax savings fixed deposit is a bank term deposit which has a tenure of 5 years or more and which enjoys tax benefit under section 80 C of the IT Act. Post Office Time Deposits (POTDs) The Post Office Term Deposit (POTD) is similar to a bank fixed deposit, where you save money for a definite time period earning a guaranteed return through the tenure of the deposit. At the end of the deposit‘s tenure; the maturity is made up of the capital deposited and the interest it earns. Arbitrage Funds These are considered as equity mutual funds. Hence, they are more tax efficient if your holding period is more than a year. While arbitrage funds have favourable tax treatment, returns are more stable for short-term debt funds Recurring Deposits (RDs) This is one more type of secured investment. This product is ideally suitable to those who not able to invest a lump sum and looking for monthly investment. Either you can use Bank RDs or Postal 100

RD. Ideally bank offers RD of minimum tenure with 6 months to a maximum of 10 Yrs. Interest received on RD is taxable as per your tax slab. 5-Yrs National Savings Certificate (NSC) You can invest in Postal NSC of 5 years, only if you are sure that goal is exactly at 5 years from today. You can claim deduction under Sec.80C. However, the interest on NSC will be taxable. 2.2.2. Medium-term Products – Inflation Beating with Reasonable Capital Appreciation Intermediate-term goals are those five to 10 years in the future. At this range, some exposure to stocks and bonds will help grow the initial investment's value, and the amount of time until the money must be spent is far enough in the future to permit a degree of volatility. Balanced mutual funds, which include a mix of stocks and bonds, are popular investments for intermediate-term goals. However, choosing the right products on the investor—risk tolerance level, financial health, financial goals, age, and some other factors. Debt-Oriented Hybrid Funds (Monthly Income Plans) Debt-oriented hybrids invest minimum of 70% to 95% in a debt portfolio. The debt component is conservatively managed with the focus on generating regular income, which is generally paid out in the form of periodic dividend. The credit risk and interest rate risk are taken care of by investing into liquid, high credit rated and short term debt securities. The allocation to equity is kept low and primarily in large cap stocks, to enable a small increase in return, without the high risk of fluctuation in NAV. These portfolio features largely contribute accrual income in order to provide regular dividend for monthly income plans (MIPs). Debt-oriented hybrids are designed to be a low risk product for an investor. These products are suitable for traditional debt investors, who are looking for an opportunity to participate in equity markets on a conservative basis with limited equity exposure. Monthly income plan is a debt-oriented hybrid. Capital Protection funds are closed-end hybrid funds that seek to provide principal protection by investing in a combination of debt instruments and equity derivatives. The portion invested in debt securities mature over the tenor of the fund to the principal amount. The remaining funds are invested in equity derivatives to earn higher returns. Mutual Fund Monthly Income Plans can be a better option for a conservative investor who is looking for better returns by taking limited exposure to stock market. Balanced Mutual Funds Balanced mutual funds can be Equity oriented or Debt oriented hybrid plans. If the average equity exposure of a balanced fund is more than 60% and the remaining 40% is in debt products then it is treated as a Balanced Fund – Equity oriented. If the average debt exposure is around 60% and equity is 40% then these funds are treated as Balanced funds – 101

Debt oriented. (These proportions can vary among different balanced funds). Balanced funds are less risky compared to pure Equity funds. Equity portion will provide the capital appreciation through stock prices appreciation and dividend income. Whereas, Debt portion can provide stability through interest income and appreciation in Bond prices. These funds can be a better bet for first-time equity investors. These are also suitable for the investors who want to protect the downside during market downturns and want to benefit during market upswings. Remember that balanced funds may not out-perform the Equity funds during market upswings (Bull run). Balanced funds can be a useful investment option to meet critical Financial Goals like Retirement Planning, Kid‘s Higher Education etc., Equity Mutual Funds If one has an investment horizon of more than 5 years, one can consider investing in Large Cap or Diversified Equity Mutual Funds. Equity Linked Saving Schemes (ELSS) which come with a lock-in period of 3 years, are a great tool to save tax in the year of investment as well as to create tax-free wealth in the long run. Primary purpose of every ELSS investment should be to achieve a future financial goal or to create long-term wealth for distant goals like retirement planning etc. and tax saving in the year of investment should be an incidental benefit or a secondary objective. Investments in ELSS must be made every year in different ELSS schemes and each year investment can be linked to one or more of the following common financial goals Gold Investment in Gold can be made through physical gold or gold funds. Gold funds invest in gold and gold-related securities. Gold Exchange Traded Fund (Gold ETF) is like an open-end index fund that invests in gold. The NAV of such funds moves in line with gold prices in the market, though some tracking error is possible. Investors need a demat account for buying units of Gold ETF. Post-NFO, retail investors can transact in ETF units only in the stock exchange. Gold Index Funds (also called Gold Savings Funds) invest in Gold ETF units. They are costlier than the Gold ETF. Unlike Gold ETF, Gold index funds make it possible for investors to transact in the units, directly with the scheme, even post-NFO. Further, since SIP is possible, and the investor does not need a demat account, Gold Index Funds are quite popular among retail investors. Gold Sector Funds invest in shares of companies engaged in gold mining and processing. Though gold prices influence these shares, the prices of these shares are more closely linked to the profitability and gold reserves of the companies. Therefore, NAV of these funds do not closely mirror gold prices. 102

Government Securities Government securities are issued by the RBI on behalf of the government. RBI is the nodal regulatory authority for primary and secondary markets in government securities. Government borrowings can be for the short term (maturity less than 1 year) or for the long term (maturity greater than 1 year). Short-term borrowings are through the issue of Treasury Bills with maturities of 91 days, 182 days or 364 days. Cash Management Bills for maturities less than 91 days may be issued occasionally to tide over very short-term fund shortages. Dated Government Securities, commonly known as G-Secs, refer to securities with maturities from 1 to 30 years. T-bills and cash management bills are zero coupon securities, issued at a discount and redeemed at par. Other G-Secs are usually issued as interest paying coupon bonds, with a fixed rate of interest paid semi-annually. Some G-Secs are issued as zero coupon bonds with no interest payments. Since 2002, there have been issues with floating rate bonds as well, though such bonds are not many, as they are not very liquid. Inflation Indexed Bonds Inflation Indexed Bonds (IIB) are a category of government securities issued by the RBI which provides inflation protected returns to the investors. These bonds have a fixed real coupon rate which is applied to the inflation adjusted principal on each interest payment date. On maturity, the higher of the face value and inflation adjusted principal is paid out to the investor. Thus, the coupon income as well as the principal is adjusted for inflation. The inflation adjustment to the principal is done by multiplying it with the index ratio. The index ratio is calculated by dividing the reference index on the settlement date by the reference index on the date of issue of the security. The Wholesale Price Index (WPI) is the inflation measure that is considered for the calculation of the index ratio for these bonds. The IIBs are issued through an auction, like other G-secs. Currently, bonds with a tenor of 10 years are being issued. The coupon is paid on a half-yearly basis. These bonds do not offer any tax benefits to the investors and are interest income and maturity value are taxed like other fixed income instruments. Non-Convertible Debenture (NCDs) Non - Convertible debentures are fixed income products that offer comparatively higher returns. NCDs have some inherent risk associated which an investor has to take into consideration before making any investment decision. Exchange Traded Funds Exchange-traded funds (ETFs), which offer flexibility of a stock and protection of a fund invest in stocks comprising an index, trade on exchanges. One of the main advantages of investing in an index ETF is that you can sell and buy at real-time prices rather than waiting for the closing of the day to determine the price. 103

2.2.3. Long-term Products – Managed Risk for Wealth Creation in the Long-Term Equity Oriented Mutual Funds A scheme might have an investment objective to invest largely in equity shares and equity related investments like convertible debentures. Such schemes are called equity schemes. Diversified equity fund is a category of equity funds that invest in a diverse mix of equities that cut across sectors (such as banking, pharma, etc.). They may be managed actively or passively. The RGESS tax benefit discussed in Chapter 1 is available only for diversified equity schemes that invest in companies, which fulfil specified criteria. Sector funds invest in only a specific sector. For example, a banking sector fund will invest in only shares of banking companies. Gold sector fund will invest in only shares of gold- related companies. Thematic funds invest in line with an investment theme. For example, an infrastructure thematic fund might invest in shares of companies that are into infrastructure construction, infrastructure toll-collection, cement, steel, telecom, power etc. The investment is thus more broad-based than a sector fund; but narrower than a diversified equity fund. Equity Linked Savings Schemes (ELSS), offer income tax benefits to investors. However, the investor cannot sell the Units for at least 3 years. ELSS schemes invest in a range of sectors. Equity Income / Dividend Yield Schemes invest in multiple sectors. They select shares that fluctuate less, and therefore, dividend represents a larger proportion of the returns earned by the scheme from those shares. The NAV of such equity schemes are expected to fluctuate lesser than other categories of equity schemes. Real Estate Investment Trusts (REITs) REITs is an investment trust that owns and manages a pool of commercial properties and mortgages and other real estate assets; shares can be bought and sold in the stock market. In other words, REITs is a security that sells like a stock on the major exchanges and invests in real estate directly, either through properties or mortgages. REITs typically offer investors high yields, as well as a highly liquid method of investing in real estate. REITs are essentially a pooling vehicle which allow investors to participate in small amounts into a securitized real estate-linked investment. On the one hand, these securities help to make investing in real estate more accessible, long term and income-oriented. On the other hand, they also help to build an efficient secondary market for developers to exit projects. REITs usually will invest in commercial properties and use rental income to distribute as dividend to unit holders. The advantage of REITs is that it is regulated and managed under a trust umbrella. This means that there is accountability and audit around the use of investor funds. Real estate is often considered as an unorganized sector and there can be ambiguity linked to transaction value. In case of REITs the transactions are monitored and there is a specified method for valuations of properties, hence the ambiguity is reduced. 104

REITs will help investors channelise their investments into India's realty sector through a regulated mechanism. As the investment in REITs is asset-backed, it is helpful for investors to invest in real estate without the hassle of going through the checks on property titles and the plethora of regulatory formalities. Thus, REITs are an investment vehicle for retail investors to invest in real estate and diversify their investment portfolio. Further, REITs provide an exit option to developers and investors in commercial/retail assets and also addresses the liquidity concerns for an illiquid asset. With listing of REITs, disclosures and transparency improve in addition to providing a professional management structure. Further, with 90% of profits to be distributed annually as dividend, regular dividend income with annual appreciation acts as a hedge against rising inflation. Portfolio Management Services PMS is an investment facility offered by financial intermediaries to larger investors. The PMS provider keeps receiving money from investors. Unlike mutual funds, which maintain their investment portfolio at the scheme level, the PMS provider maintains a separate portfolio for each investor. The cost structure for PMS, which is left to the PMS provider, can be quite high. Besides a percentage on the assets under management, the investor may also have to share a part of the gains on the PMS portfolio; the losses are however borne entirely by the investor. PMS have an unconstrained range of investments to choose from. The limits, if any, would be as mentioned in the PMS agreement executed between the provider and the client. Variants of PMS structure exist. In some cases the PMS provider has the discretion to decide on investments. In other cases, approval of the client has to be taken for each investment. Some PMS providers operate on ‗advice only‘ basis PMS are regulated by SEBI, under the SEBI (Portfolio Managers) Regulations, 1993. However, since this investment avenue is meant only for the larger investors, the mutual fund type of rigorous standards of disclosure and transparency are not applicable. The protective structures of board of trustees, custodian etc. is also not available. Investors therefore have to take up a major share of the responsibility to protect their interests. Private Equity Private equity consists of investors and funds that make investments directly into private companies or conduct buyouts of public companies that result in a delisting of public equity. While the company is relatively stable, it requires long term capital to scale up and grow in size. Private equity investment managers screen such companies with significant growth potential and provide them capital. Each private equity investment is backed by a strong investment thesis which plays out over a 3 to 5 year time horizon. Each investment is preceded by extensive business, legal and financial due-diligence and post investment the investment managers exert significant influence on the company through shareholder rights and board positions. 105

The subscription offer for investment into the fund is exclusively opened for a short period to a select group of investors, including HNIs, body corporates, trusts, partnership firms, as the threshold investment amount (ticket size) is typically high. Investment can be done into a venture capital fund (SEBI Approved) or a PE structure. Investments could be made into equity or debentures of unlisted entities. A share of the profits of the fund's investments, called carried interest, is paid to the PE fund's management company as a performance incentive, typically up to 20%. The remaining 80% of the profits are paid to the fund's investors. A minimum rate of return (e.g., 8–12%) is fixed, which must be achieved before the fund manager can receive any carried interest payments. Venture Capital Venture Capital Funds largely invest in unlisted companies. Venture capital funds invest at an earlier stage in the investee companies‘ life than the private equity funds. Thus, they take a higher level of project risk and have a longer investment horizon (3 – 5 years). Such investments are risky as they are illiquid, but are capable of giving impressive returns if invested in the right venture. The returns to the venture capitalists depend upon the growth of the company. Venture capitalists have the power to influence major decisions of the companies they are investing in as it is their money at stake. Structured Products Structured Products are pass-through debt or hybrid products outside the mutual fund structure. Structured products or notes are hybrid products with a large component of debt and then some derivatives. The derivative exposure could be linked to any risk asset, such as equity, commodities and currencies. In India, structured notes with debt securities and equity derivative exposure are popular. These are also available in the mutual fund format as hybrid fixed term funds. Essentially, structured products seek to give potential returns that are higher than the underlying derivative-linked asset in times of a rally and limit the downside when markets fall. Many notes come with a capital protection theme, seeking to limit losses and return at least the capital. Structured products come with limited maturity and investors have to stay put for a specified period. In the Indian capital market, most structured products are modeled around equity markets and the maturity ranges from 12-36 months. There are generally two types of structures—conservative and aggressive. The conservative notes come with capital protection as the main attraction and the upside participation in the risk asset returns is lower than for the aggressive products. For example, an 18-month structured product could offer 150% participation in upside returns of equity markets from now till maturity, and if the market falls below the initial index level, you get your capital back. A 150% upside participation means, if the equity market returns for the specified period stands at 10%, you will get 15% return on the portion invested in equity derivatives. Some products have a more aggressive pay off. These offer a higher participation in upside returns but don‘t protect capital. For example, 250% upside participation, but if the market falls in the defined period, by, say, more than 15% (or any other defined threshold), you also face the downside. Hence, there is a chance making a loss, but gains, too, can be much higher. 106

Public Provident Fund (PPF) Scheme The Public Provident Fund is savings-cum-tax-saving instrument in India. The scheme is fully guaranteed by the Central Government. One of the most safest investment avenues available in India which has a maturity of 15 years. Not deposit more than ₹1.50 lac per annum as the excess amount will neither earn any interest nor will be eligible for rebate under Income Tax Act. The amount can be deposited in lump sum or in a maximum of 12 installments per year. The government of India decides the rate of interest for PPF account. The current interest rate effective from 1 April 2019 is 8.00% Per Annum (compounded annually). Interest will be paid on 31 March every year. Interest is calculated on the lowest balance between the close of the fifth day and the last day of every month. The following table summarizes risk-return features of various asset classes with indicative time horizon: Asset Class Return Risk Primary Objective Time Period Short term debt Low Low Capital protection Moderate Low Income Short Medium term debt Moderate Moderate Medium Long term debt High Income or growth Long at fixed rates Long Large cap High Higher Longer equity Growth with low Higher Higher income Mid and small Moderate cap equity Uncertain Growth High Moderate Private equity Growth Uncertain Long Property Growth with rental income Cyclical Gold Moderate Growth 107

Mutual Funds: Expected return, risk level and indicative investment horizon Mutual Brief/ Set of assets they invest in Expected Risk Indicative Fund type return High Investment Invest predominantly in large-cap High Equity: stocks High High horizon Large-cap Invest in stocks across market High High More than Equity: capitalization and sectors High 5 years Diversified Invest predominantly in small and High High More than Equity: Small mid cap stocks Moderate 5 years and mid- High Very low More than caps Diversified equity funds that have Moderate 5 years Equity: ELSS a 3 year lock-in period and Low Low (tax provide income tax exemption Moderate More than planning) under section 80 C upto ₹1.50 lakh Moderate 5 years Invest into companies in the same Moderate Moderate Equity: Index proportion as that index (Sensex More than funds of Nifty) Moderate Moderate 5 years Invest at least 65% of the corpus Moderate Balanced into equity and the remainder into Moderate Moderate 5 years funds debt securities Moderate Invest into short-term corporate Moderate Less than Liquid funds debt papers, certificate of deposit 90 days (CDs) and money market Income instruments, with a maturity of up 1 to 3 years funds – short to 91 days term Invest into short-term debt papers 3 to 5 years Income whose maturities are up to 3 years funds – long 5 to 10 to term Funds that invest in long-term 20 years debt papers whose maturities Gilt funds range between few months and 30 days to 5 can go even beyond 25 years years Fixed Invest in government securities maturity whose maturities range between 3 years plans (FMPs) few months and can go even Monthly beyond 20 years 5 years income plans Invest in debt papers whose (MIPs) maturity or tenure coincides with Gold ETFs that of the scheme Hybrid funds that invest a small portion (up to 30%) in equity and rest into debt Invest in physical gold and are traded on an exchange. 108

Sub-Section 2.3 Risk Profiling of Investors The funds allocated to various goals are invested in different investment avenues. Different investment products have various levels of inherent risk. Similarly, there are differences between investors with respect to the levels of risk they are comfortable with (risk appetite). At times there are also differences between the level of risk the investors think they are comfortable with, and the level of risk they ought to be comfortable with. Risk profiling is an approach to understand the risk appetite of investors. This is an essential pre- requisite to advise investors on their investments. 2.3.1. Understanding Investor’s Investment Psychology and Investment Behavior Much economic theory is based on the belief that individuals behave in a rational manner and that all existing information is embedded in the investment process. This assumption is the crux of the efficient market hypothesis. But, researchers questioning this assumption have uncovered evidence that rational behavior is not always as prevalent as we might believe. Behavioral finance attempts to understand and explain how human emotions influence investors in their decision-making process. Behavioral finance studies the psychology of financial decision-making. Most people know that emotions affect investment decisions. People in the industry commonly talk about the role greed and fear play in driving stock markets. Behavioral finance extends this analysis to the role of biases in decision making, such as the use of simple rules of thumb for making complex investment decisions. In other words, behavioral finance takes the insights of psychological research and applies them to financial decision making Over the past fifty years established finance theory has assumed that investors have little difficulty making financial decisions and are well-informed, careful and consistent. The traditional theory holds that investors are not confused by how information is presented to them and not swayed by their emotions. But clearly reality does not match these assumptions. Behavioral finance has been growing over the last twenty years specifically because of the observation that investors rarely behave according to the assumptions made in traditional finance theory. Behavioral researchers have taken the view that finance theory should take account of observed human behaviour. They use research from psychology to develop an understanding of financial decision making and create the discipline of behavioral finance. How behavioral biases affect investment Behaviour Research in psychology has documented a range of decision-making behaviours called biases. These biases can affect all types of decision-making, but have particular implications in relation to money and investing. The biases relate to how we process information to reach decisions and the preferences we have. The biases tend to sit deep within our psyche and may serve us well in certain circumstances. However, in investment they may lead us to unhelpful or even hurtful 109

decisions. As a fundamental part of human nature, these biases affect all types of investors, both professional and private. However, if we understand them and their effects, we may be able to reduce their influence and learn to work around them. A variety of documented biases arise in particular circumstances, some of which contradict others. The following sections discuss the key biases and their implications for investors and advisers. Optimism or Confidence Bias: Investors cultivate a belief that they have the ability to outperform the market based on some investing successes. Such winners are more often than not short-term in nature and may be the outcome of chance rather than skill. If investors do not recognize the bias, they will continue to make their decisions based on what they feel is right than on objective information. Familiarity Bias: This bias leads investors to choose what they are comfortable with. This may be asset classes they are familiar with, stocks or sectors that they have greater information about and so on. Investors holding an only real estate portfolio or a stock portfolio concentrated in shares of a particular company or sector are demonstrating this bias. It leads to concentrated portfolios that may be unsuitable for the investor‘s requirements and feature higher risk of exposure to the preferred investment. Since other opportunities are avoided, the portfolio is likely to be underperforming. Anchoring: Investors hold on to some information that may no longer be relevant, and make their decisions based on that. New information is labelled as incorrect or irrelevant and ignored in the decision making process. Investors who wait for the ‗right price‘ to sell even when new information indicate that the expected price is no longer appropriate, are exhibiting this bias. For example, they may be holding on to losing stocks in expectation of the price regaining levels that are no longer viable given current information, and this impacts the overall portfolio returns. Loss Aversion: The fear of losses leads to inaction. Studies show that the pain of loss is twice as strong as the pleasure they felt at a gain of a similar magnitude. Investors prefer to do nothing despite information and analysis favouring a particular action that in the mind of the investor may lead to a loss. Holding on to losing stocks, avoiding riskier asset classes like equity when there is a lot of information and discussion going around on market volatility are manifestations of this bias. In such situations investors tend to frequently evaluate their portfolio‘s performance, and any short-term loss seen in the portfolio makes inaction the preferred strategy. Herd Mentality: This bias is an outcome of uncertainty and a belief that others may have better information, which leads investors to follow the investment choices that others make. Such choices may seem right and even be justified by short-term performance, but often lead to bubbles and crashes. Small investors keep watching other participants for confirmation and then end up entering when the markets are over heated and poised for correction. Similarly a bull market make people allocate more than what is advised to risky assets. The recent experience overrides analysis in decision making. 110

Choice Paralysis: The availability of too many options for investment can lead to a situation of not wanting to evaluate and make the decision. Too much of information also leads to a similar outcome on taking action. 2.3.2. Risk Based on Investor’s Life Stage One of the approaches to understand the differences in the risk and return preferences of individuals is to use the life cycle stage of an investor. It has been observed that most individuals follow predictable life cycle stages in their patterns of earning, spending, saving and willingness to take on risk in investment. Consider these standardisations used commonly in financial planning:  Young investors are capable of taking higher risk. There are likely to be lower claims on their income and able to save more. They may have long investing horizons and high preference for growth assets.  Investors with young dependent families are usually less able to take risks. Their ability to save may be low because of higher expenses on setting up home and family. They may have uncertain investing horizons, high liquidity needs and a combination of growth and income assets might help them.  Investors at a stage where income levels are high and expenses have stabilized are considered to have higher risk-taking ability. Savings are likely to be high at this stage. They may seek long-term growth assets to accumulate wealth.  Investors close to retirement see their risk tolerance coming down. They are closer to the distribution stage in their life and seek a reduction in holding period, and a switch to income from growth.  Retired investors seek regular income, shorter investing horizons and low-risk portfolios. They are keen to distribute their wealth and like protection of their wealth from capital erosion. The life cycle of the investor has to be seen in conjunction with the individual situation to get the correct risk profile. 2.3.3. Risk Based on Investor’s Earnings, Income Generation and Assets One of the most important factors that influences the risk appetite of an investor is the regularity and sustainability of income. People earning regular income can take more risk than those with unpredictable income streams. Some of the other factors that influence the risk appetite of an investor are discussed below: Factor Influence on Risk Appetite Family Information Earning Members Risk appetite increases as the number of earning members increases Dependent Members Risk appetite decreases as the number of 111

Life expectancy dependent members increases Risk appetite is higher when life expectancy is Personal Information Longer Age Employability Lower the age, higher the risk that can be taken Well qualified and multi-skilled professionals Nature of Job can afford to take more risk Knowledge about Those with steady jobs are better positioned to take risk markets A person who is better informed about markets is in a better position to take market risks, than someone who is Psyche ignorant about them. Daring and adventurous people are better Financial Information positioned mentally, to accept the downsides Capital base that come with risk Regularity of Income Higher the capital base, better the ability to financially take the downsides that come with risk People earning regular income can take more risk than those with unpredictable income streams More such factors can be added. The financial planner needs to judge the investor‘s ability to take risk based on such factors, rather than just ask a question ―How much risk are you prepared to take?‖ Further, the adviser has to consider the investment horizon. If the investor‘s goals are mostly short-term, then risk investments may not be suitable. The investor‘s willingness to take risk may be in variance to the ability to take risk and earn better returns. Investors who refuse to consider the better returns from growth investments such as equity even for their very long term goals such as retirement, is a case to point. The willingness to take risks depends upon their knowledge and comfort with investments and their recent experiences. Some risk profiling tools are available in websites. These typically revolve around investors answering a few questions, based on which the risk appetite score gets generated. Some of these risk profile surveys suffer from the investor trying to ―guess‖ the right answer, when in fact there is no right answer. Risk profiling is a tool that can help the investor; it loses meaning if the investor is not truthful in his answers. Some advanced risk profilers are built on the responses to different scenarios that are presented before the investor. Service providers can assess risk profile based on actual transaction record of their regular clients. 112

While such tools are useful pointers, it is important to understand the robustness of such tools before using them in the practical world. Some of the tools featured in websites have their limitations. The investment advisor needs to use them judiciously. 2.3.4. Risk Tolerance - Risk Capacity and Risk Appetite Risk Tolerance is the degree of variability in investment returns that an individual is willing to withstand. Risk tolerance is an important component in investing. An individual should have a realistic understanding of his or her ability and willingness to stomach large swings in the value of his or her investments. Investors who take on too much risk may panic and sell at the wrong time. Investors can assess their degree of risk tolerance by taking one of a number of different risk tolerance questionnaires. In addition, it can be useful to review worst-case returns for different asset classes historically in order to get an idea of how much money one would feel comfortable losing if his or her investments have a bad year or bad series of years. Other factors affecting risk tolerance are the time horizon that one has to invest, future earning capacity, and the presence of other assets such as a home, pension, social security or inheritance. In general, one can take greater risk with investable assets when there are other, more stable sources of funds available. Financial risk tolerance can be split into two parts: Risk Capacity: the ability to take risk This relates to their financial circumstances and their investment goals. Generally speaking, a client with a higher level of wealth and income (relative to any liabilities they have) and a longer investment term will be able to take more risk, giving them a higher risk capacity. Risk Attitude: the willingness to take risk Risk attitude has more to do with the individual's psychology than with their financial circumstances. Some clients will find the prospect of volatility in their investments and the chance of losses distressing to think about. Others will be more relaxed about those issues. Risk tolerance is typically measured using questionnaires that estimate the ability and willingness to take risks. The responses of investors are converted into a score that may classify them under categories that characterize their risk preferences. Risk profiling is an exercise that determines the level of risk that an investor can take. It is an assessment of an investor‘s risk tolerance. Financial risk tolerance depends upon risk capacity and risk attitude. Risk attitude is a preference of the investor towards risk. Some investors may be unwilling to accept loss in invested amounts; some may be unwilling to risk a dynamic redemption value; some may dislike varying pay outs; some may not like products that do not offer liquidity. Risk attitude is a psychometric attribute. Each investor may have a different response to a risky situation, and may choose to avoid, mitigate, directly deal with or actively manage risks. 113

Risk attitude, or the willingness to assume risk, is a subjective factor which is difficult to assess. It is defined not by the investor‘s financial situation but by psychological factors. An individual‘s attitude to risk is influenced by his level of knowledge and experience with investment matters. It can also be shaped by immediate experiences. For example, when equity markets are going up, the levels of optimism amongst investors is high too and they are willing to take higher risks. Risk capacity is the ability to take risk, which relates to an individual‘s financial circumstances and investment knowledge. This can be objectively measured by financial parameters such as total wealth, income, savings ratio and net worth. An investor with high net worth, adequate insurance or adequate emergency funds enjoys a relatively strong financial position, which in turn implies a higher capacity to take risk. On the other hand, if the investor has high liquidity requirements, such as the need to withdraw for an emergency, then the capacity to take risks will be low. The ability to save has an impact on the capacity to take risk. Investors with low savings and investments tend to avoid high risk investments. Risk capacity is based on verifiable facts and is therefore the more dependable portion of the risk profiling exercise. Risk attitudes are typically measured using psychometric testing tools. The use of a questionnaire to assess risk tolerance is the most commonly used approach. The questions attempt to get a view on investing, making loss in investments, volatility in returns, need for capital protection and willingness to take greater risk for better returns. Various models are used to analyse the information and arrive at the risk score based on which asset allocation and investment choices are tuned for the investor. Allocation based on the risk profiling exercise may be unsuitable to the investor if due consideration is not given to both ability (capacity) and willingness (attitude) to take risk. Many risk profiling exercises focus excessively on the emotional aspects of risk tolerance. However, an investor‘s attitude to risk may be derived from recent experiences or based on inadequate information. When there is uncertainty in financial markets, the responses may indicate an unwillingness to take risk. Or, the respondents may not have enough knowledge or understanding of investments and therefore choose to be safe. If such responses are used to allocate assets, then the investor may end up with a lower risk portfolio despite having a good ability to take risk. If an investor seeks modification in the asset allocation each time an investment under-performs, it suggests a greater willingness to take risk. The risk profile of an investor tends to change over time. The risk tolerance of an investor is not static but changes with changes in factors that affect attitude and ability to take risk. Life changing events such as marriage, children, and retirement affect the risk tolerance. Other factors such as changes in level of income, debt, or changes in the investment horizon also impact the risk profile of the individual. Any changes in risk taking ability have to be monitored so that the portfolio is aligned to the new preferences. 114

2.3.5. Classifying Investors as Per their Risk Profile Investors can be classified into three broad categories based on their risk profile: (i) Conservative Investors  Do not like to take risk with their investments. Typically new to risky instruments.  Prefer to keep their money in the bank or in safe income yielding instruments.  May be willing to invest a small portion in risky assets if it is likely to be better for the longer term. (ii) Moderate Investors  May have some experience of investment, including investing in risky assets such as equities.  Understand that they have to take investment risk in order to meet their long- term goals.  Are likely to be willing to take risk with a part of their available assets. (iii) Aggressive Investors  Are experienced investors, who have used a range of investment products in the past, and who may take an active approach to managing their investments  Willing to take on investment risk and understand that this is crucial to generating long term return.  Willing to take risk with a significant portion of their assets. The risk preferences of the investor are taken into account while constructing an investment portfolio. 2.3.6. Matching Products to Investor’s Profile and Tenure of Goals A financial planner should choose the financial products considering the client‘s risk profile, time horizon and financial goals. Indicative portfolios for various types of investors – conservative, moderate and aggressive may be constructed as follows: Asset Classes Conservative Moderate Aggressive Short-Term Bills 20% 10% 5% Long –Term Debt 60% 40% 10% Gold 10% 10% 5% Commodities 0% 0% 10% Large Cap Equity 10% 30% 30% Mid- Cap Equity 0% 10% 20% Real Estate 0% 0% 20% 115

Financial advisors may use a range of tools to construct a portfolio, from simple intuitive models to sophisticated mathematical models. A conservative investor likes income and therefore, holds more of income-oriented asset classes; an aggressive investor prefers growth and therefore, holds more of growth-oriented asset classes. The three portfolios as above will have different levels of risk and return. They will also have to be managed for risk, in terms of an appropriate investing horizon. An investor, who likes income and needs it in the short term, should not choose an aggressive asset allocation. This would expose the capital invested to short term risk and may not generate the income as needed. An investor wary of any risk to capital may have to choose a conservative allocation and settle for a lower level of return as well. The process of dividing the portfolio among different assets so that the overall portfolio‘s return is protected from the effect of a fall in one or few assets is called asset allocation The asset allocation that is suitable for a person will depend upon their specific situation. For example, a person close to retirement will have a higher allocation to safer investments such as debt and lower allocation to equity. On the other hand, an individual in the high income period whose goals are far away will prefer to earn higher returns with assets such as equity rather than lower risk assets with lower returns. The suitable asset allocation is a function of the investment period available to the investor and their ability to take risk. The nature of the goal will also determine the type of investment to some extent. For instance, if saving for a foreign holiday and margin requirement for a home loan with the same time frame, it is better to be conservative and invest in fixed income products for the loan, since it is a more important goal. On the other hand, you can look at investing in equities to save for the foreign holidays, since it can even be called off if required. Indicative portfolios for the various investors‘ profiles – conservative, moderate and aggressive may be constructed describing return, risk and time horizon attributes. Consider this illustrative example: Asset Classes Conservative Moderate Aggressive Cash and Debt 80% 45% 20% Equity 10% 45% 70% Alternative 10% 10% 10% Total 100% 100% 100% Return Expectations 8%-9% 10%-12% >15% Time Horizon 2-3 years 3-5 years Atleast 5 years Proportions to be invested in various asset classes may be determined based on the above descriptions, and offered to investors as a standard solution. 116

Sub-Section 2.4 Asset Allocation - Financial Assets 2.4.1. Asset Allocation - Base of Investment Planning Asset Allocation — dividing an investment portfolio into different asset classes — is the cornerstone of investment planning. A portfolio is made up of several investment options across asset classes. The construction of the portfolio involves allocating money to various asset classes. This process is called asset allocation. In simple terms, asset allocation is the process of deciding how to distribute the investor‘s wealth among the various asset classes for investment purposes. It is this decision which determines how much of the assets need to be distributed over the following asset classes with different characteristics. Asset allocation also provides for a direction to the future income, cash flows of the investor in terms of where he should invest to achieve his financial goals. It is very difficult to determine in a year which particular asset class would be the best performing one. Investing in only one class of asset could prove to be risky. A fundamental justification for asset allocation is the notion that different asset classes offer returns that are not perfectly correlated. Hence, diversification reduces the overall risk in terms of the variability of returns for a given level of expected return. Therefore, having a mixture of asset classes is more likely to meet the investor's expectations in terms of amount of risk and possible returns. 2.4.2. Asset Classes - Equity, Debt, Cash, Precious Metals Every investment option can be described in terms of its risk and return characteristics. For example, the returns on the equity shares of a company would depend upon the profits the company makes and the business risks that the company faces. This translates into the possibility of a higher long term return, but a good amount of short term volatility in returns. The returns from bonds of a company would depend on the ability to generate enough cash to pay interest, even if the company would make losses or a minimal profit. This translates into steady periodic return, with limited possibility for capital appreciation. Example: Debt vs. Equity A company that makes garments for export finds that a large order has been cancelled and its profits may decline. Let us discuss what effect this event will have on the lenders and owners of the company. The return to owners of a company depends upon the profitability of the company which is expected to decline with the cancellation of the export order. Their returns will therefore, come down. But the lenders will earn the fixed interest irrespective of the decline in profits. Investment options with conceptually similar risk-return features can be clubbed together into asset classes. 117

Owners of the company invest in equity; their returns immediately respond to profitability of the company. Lenders to the company invest in debt; their returns are not immediately affected, but any permanent drop in profits will impact them in the future. Therefore, equity is one asset class; debt is another. Based on the return and risk attributes, investment options can be broadly classified into the following asset classes: • Equity • Debt • Cash Equity as an asset class represents a growth-oriented asset. The major source of income to the investor is growth in value of the investment over time. Debt as an asset class represents an income-oriented asset. The major source of return from a debt instrument is regular income. Cash and its equivalents are for parking funds for a short period of time and earning a nominal return. However, as investment options have extended beyond capital market products, these basic categories have also expanded to include commodities, real estate and currency. The risk and return features of each asset class are distinctive. Therefore, the performance for each asset class may vary from time to time. For example, commodities as an asset class perform well during inflationary times. Equity on the other hand, is impacted by inflation and tends to correct down. Following is the list of generally used asset classes and their risk-return attributes: Cash • Generally required for meeting day to day and Bonds emergency requirements. Stocks • Cash held holds negligible value in terms of returns and hence, there is minimal risk. • Bonds provide fixed return in the form of coupon/interest income. • Bonds have the scope for capital appreciation when interest rates fall, but may be subject to interest rate risk when interest rates rise. • Corporate bonds are subject to credit risk of the issuer. • Government securities are considered to be risk-free as it is believed that a Government will not default on its obligations towards its own citizens. • Risk and return characteristics of bond are relatively lower than equity and hence, suitable for an investor seeking regular income flows with minimal risk. • A stock represents ownership in a company. • Empirical study suggests that this asset class provides higher returns if invested for long run. • Volatility is higher in this asset class than cash and bonds 118

as an asset class. Real estate • Real estate Involves investment in land or building (commercial as well as residential), or Real Estate • Investment Trust (REIT). Precious metals • Real estate as an asset class presents a number of such as gold • management issues including tenancy management, property maintenance, legal clearances, illiquidity etc. Other alternative • • Physical gold is preferred by Indian families as a secure assets and stable investment and is also highly liquid. (Investment in • Gold also provides as an option of asset class for Art/ Collectibles) diversification within a portfolio of assets, being directly/ indirectly correlated with other asset classes. • Gold is generally used as a hedge against inflation. • Investment in art/collectibles is being made for reasons which are personal and emotional, generally deriving pleasure. Art/collectibles have a very low correlation with other asset classes and hence, have diversification benefits. Fine art and other collectibles have a very subjective value. Hence, there may be no exact measure for determination of the same. This asset class comes with very low level of liquidity. 2.4.3. Expected Rate of Return The amount one would anticipate receiving on an investment that has various known or expected rates of return. For example, if one invested in a stock that had a 50% chance of producing a 10% profit and a 50% chance of producing a 5% loss, the expected return would be 2.5% (0.5 * 0.1 + 0.5 * -0.05). It is important to note, however, that the expected return is usually based on historical data and is not guaranteed. For the most part, the expected return is a tool used to determine whether or not an investment has a positive or negative average net outcome - it is not a hard and fast figure of profit or loss. In the example above, for instance, the 2.5% expected return cannot, in fact, be realized - it is merely an average. In addition to expected return, wise investors should also consider the probability of return in order to properly assess risk. After all, one can find instances in which certain lotteries offer a positive expected return, despite the very low probability of realizing that return. 119

Question 1 Calculate the expected return from the given data:- POSSIBLE RETURNS (Xi ) PROBABILITY p (Xi) 30 0.10 40 0.30 50 0.40 60 0.10 70 0.10 Ans :-POSSIBLE RETURNS PROBABILITY p (Xi) Xi *p(Xi) 0.10 3 POSSIBLE RETURNS (Xi ) 0.30 12 30 0.40 20 40 0.10 6 50 0.10 7 60 = ∑ Xi *p(Xi) = 48 70 Hence, Expected return is 48% Question 2 You are thinking of some shares of ABC Ltd . The rate of return expectations are as follows:- POSSIBLE RETURNS (Xi ) PROBABILITY p (Xi) 0.05 0.20 0.10 0.40 0.08 0.10 0.11 0.30 Compute the expected Return E (R ) on the investments . Answer :- Expected Return E(R) = (0.20) (0.05) + (0.4)(0.1)+ ( 0.10) (0.08) + (0.3)(0.11) E(R) = 0.091 = 9.1% Estimated Rate of Return from Equity and Debt As a general rule, the higher the risk, the higher is the expected return. So, equity is expected to yield more than fixed-income securities and bank fixed deposits. While making a financial plan, it is important to keep in mind that an asset's performance over the last four-five years cannot be expected to continue for a longer period of, say, 10-15 years. It's best to go by the asset's long-term performance. Equity: The National Stock Exchange Nifty has given an average annual return of 12.5% in the past 15 years. This is tax-free and five percentage points more than the average inflation 120

of 7% during the period. If we consider the 10-year return on every trading day since December 2007, the Nifty has risen 16% a year. This shows that though there have been periods when equity has returned 20% or more, you should expect just 12-15% a year over long periods. Fixed income options: Government and corporate bonds have given good returns over the last couple of years with 10-year government bond yields touching 8.5-9%. Debt mutual funds, especially income funds, have been generating 9-11% a year. Banks have been offering 9-10% on fixed deposits while corporate fixed deposits and non-convertible debentures have been giving as much as 12.5% a year. On an average an investment in equities in India has a return of 15-25%. The average rate of return on bonds and securities in India has been around 8%- 12% p.a. 2.4.4. Goal Specific Asset Allocation When a need can be expressed in terms of the sum of money required and the time frame in which it would be needed, we call it a financial goal. When a financial goal is set, its monetary value and the future date on which the money will be required is first defined. This goal definition indicates the amount of investment value that needs to be generated on a future date. It is normal to include assumptions for expected inflation rate while defining a future goal. Then the return that the portfolio should generate to achieve the targeted sum can be ascertained, after understanding how much the investor can save for the goal. Example: Arjun is 35 years old and intends to start saving for retirement. To begin with, he needs to ascertain the amount or corpus required by estimating the amount he would require to meet his post-retirement expenses. Hence, he may estimate the household expenses, travel expenses and medical expenses, along with annual inflation rate over the next 25 years. By taking all these into account, he would be able to ascertain the future value of the total amount he would require post-retirement. Thus, he would be able to ascertain the value of his retirement corpus, as his financial goal. Asset allocation linked to financial goals is the most appropriate form of asset allocation strategy, as it links the asset allocation to the investor‘s financial goals. The investment horizon is a function of the investor‘s financial goals, depending on when the money would be required to fund some of life‘s major events. Consider the example above. Arjun‘s portfolio would need to be long-term oriented, with scope for capital appreciation over an investment horizon of 25 years. Hence, his asset allocation would be over-weight equity, as an asset class. In case of other long-term goals, such as saving for a young child‘s education or for buying a house, equity will be suitable as the predominant asset class. The invested amount requires growth and capital appreciation and the investment horizon is long enough to mitigate short term volatility in equity. 121

In case, an investor is saving for a short term goal, such as saving for buying a car, for a holiday and for an older child‘s higher education, the portfolio would need to have debt as a predominant asset class in order to enable a small but stable growth in the invested amount. Further, a retired investor looking for a certain amount of regular monthly cash flow in the form of a pension, will invest his retirement corpus in debt, as he cannot afford any capital erosion. Again, an individual who has kept some funds aside as emergency funds would consider cash and money market securities, as they are highly liquid and capital is preserved. While implementing an asset allocation linked to the investor‘s financial goals, an advisor may consider the following steps:  Assessment of the investor‘s risk profile based on ability and willingness to take risks  Many advisors use various risk profiling tools to find out the risk profile of their clients.  Assessment of the needs  The investor‘s needs are essentially about answering the questions: how much money would be required and when?  Along with this, the advisor also assesses the available resources and matches the same with the needs.  Arriving at recommendations based on the above two steps.  Most advisors arrive at an investment plan based on the above two steps. Often, both the steps offer two different solutions. The advisor is then required to counsel the investor and help arrive at a mutually agreed investment plan. 2.4.5. Asset Allocation Changes when Approaching Goals Change in goals can alter the asset allocation. For example, when one nears a goal, it is better to move to safer assets like debt. Time-horizon investing is all about planning. You need to think about your goals. Once you have done that, investment selection is based on the amount of time you have until the goal must be funded. As the funding date approaches, assets are shifted to move conservative investments to reduce the risk of market-related losses derailing your strategy. However, associated fees need to be considered when choosing the mix of investments. The term to the goal changes every day and a long term financial goal becomes a short term goal as the time to the goal comes closer. Investments made for the goal have to be monitored and switched from growth assets to liquid assets so that the funds can be accessed when required. For XYZ, the financial goal of supporting the son‘s business in 5 years is long term today. However, closer to the end of 5 years, it will become a liquidity need, calling for a switch to liquid investments. It is good to plan ahead for the switch and do it over a period of time so that there is some protection from the volatility seen in the value of growth assets. For example, if the investments are being held in equity shares, then they can be sold in tranches over six months to a year and the funds moved to a short-term investment. 122

Redeeming the investment fully at one point runs the risk of prices being low at that point, and therefore a lower corpus value. Doing it over a period of time will protect the investment from this risk, since low prices for some tranches will be offset by higher prices for others. 2.4.6. Selection of Asset Mix According to Client’s Goals Asset classes differ in their risk-return features.  Equity is a growth-oriented, long-term investment. The major source of return from equity is capital appreciation over time.  Debt is an income-oriented investment, which provides regular income to the investor. The scope for capital appreciation is limited in debt.  Equity offers higher long-term returns as compared to debt, but in the short term its returns tend to be volatile.  Cash and its equivalents are used to invest short-term surpluses and offer capital protection, but a low level of return. Before making a choice of the asset mix according to client‘s financial goal, the financial planning should also consider the time horizon and the risk profile of the client. For a long term goals like retirement, which is 25 years away, if the client is aggressive, percent of your portfolio can be allocated to equity instruments. For contingency planning, funds should be maintained in cash equivalent instruments and liquid funds It's important to know the \"when\" of your financial goals, because investing for short-term goals differs from investing for long-term goals: Your investment strategy will vary depending on how long you can keep your money invested. Most goals fit into one of the three categories below—short-term, medium-term and long-term.  Short-Term Goals, (less than three years). The closer you get to your goal, the less risk you generally want to take with the money you've already accumulated to pay for it. Because you plan to spend the money you set aside for short-term goals relatively quickly, you'll want to focus on safety and liquidity rather than growth in your short- term portfolio. This means you'll be more inclined to put your money into federally insured bank or credit union accounts or cash equivalent investments, which aren't likely to lose much value in six months or a year. Liquid investments are those you can sell easily with little or no loss of value, such as Treasury bills, money market accounts and funds, and other low-risk investments that pay interest. If those investments have maturity dates, the terms are very short. For example, T-bills have maturity dates of 13 or 26 weeks. You may also want to consider alternatives that don't impose potential penalties or fees for accessing your money before a maturity date. For example, a five-year CD might be safe, but the early withdrawal penalty is likely to cut into the money you are 123

counting on for a short-term goal such as a down payment on a home you want to buy next year or a tuition payment that's due next January. Cash investments typically pay lower interest rates than longer-term bonds— sometimes not enough to outpace inflation over the long term. But since you plan to use the money relatively quickly, inflation shouldn't have much of an impact on your purchasing power. And keep in mind that some cash investments offer the added security of government insurance, such as bank money market accounts and CDs, which are both insured by the Federal Deposit Insurance Corporation.  Mid-Term Goals (three to ten years).Choosing the right investments for mid-term goals can be more complex than choosing them for short- or long-term goals. That's because you need to strike an effective balance between protecting the assets you've worked hard to accumulate while achieving the growth that can help you build your assets and offset inflation. Mid-term goals are typically those for which you need time to accumulate the money. Or they may be things you're not yet ready for but are looking forward to. The more time you have, or the more flexible the timing, the more risk you can probably afford to take with your money. For example, you might want to invest some of your assets in stocks, either directly or through mutual funds or exchange-traded funds, because of the potential for a higher return that would allow you to reach your goals sooner. As the time frame for those goals gets shorter, you can gradually move some of those assets into more price-stable investments. Here are possible strategies for managing a portfolio of investments for goals that are three to ten years in the future:  Balance your mid-term portfolio with a mix of high-quality fixed-income investments—such as a mid-term government bond fund or high-yield CD— with modest growth investments, such as a diversified large-company stock fund. Then monitor the stock investments closely and be prepared to sell to limit your losses if there's a major market downturn.  Establish limits for gains and losses in your mid-term stock portfolio. For instance, you may decide ahead of time that you'll sell an investment if it increases in value 20 percent or decreases 15 percent—or whatever percentage you're comfortable with. As your goal approaches, you can reinvest your assets in less volatile investments.  Balanced funds, which usually invest in a mix of about 60 percent stock to 40 percent bonds, growth and income funds, or equity income funds that invest in well-established companies that pay high dividends, might be appropriate choices for a mid-term portfolio. Ultimately, the key to achieving modest growth while minimizing risk is to keep a close eye on performance and gradually shift to more stable, income-producing investments as the date of your goal approaches.  Long-Term Goals (more than ten years). For many people, the number one long-term goal is a financially secure retirement. But it's also a goal with a long time horizon. When your goal is paying for college, for example, you think in terms of paying costs 124

for four years—or perhaps a few more for a post-graduate or professional degree. But when you think about retirement, you have to think in terms of managing expenses for 15, 20, 30, or maybe even 40 years that you'll be living after retirement. Since you'll need income for that entire period, it is important to make your money work for you, and this means earning a rate of return that outpaces inflation and allows your principal investment to grow over time. The general rule is that the more time you have to reach a financial goal, the more investment risk you can afford to take. For many investors, that can mean allocating most of the principal you set aside for long-term goals to growth investments, such as individual stock, stock mutual funds, and stock exchange traded funds (ETFs). Over time, you can gradually shift a greater percentage of your accumulated account value into income-producing investments such as bonds. 125

Sub-Section 2.5 Types of Asset Allocation Strategies Introduction ‗Don‘t put all your eggs in one basket‘ is an old proverb. It equally applies to investments. The risk and return in various asset classes (equity, debt, gold, real estate and others) are driven by different factors. This implies that return from asset classes at any point in time will not be the same in direction or magnitude but will vary depending upon the impact of the prevalent economic conditions on their performance. For example, during the recessionary situation in 2007-09, equity markets in many countries fared poorly, but gold prices went up. Thus, an investor who had invested in both gold and equity earned better returns than an investor who invested in only equities. The distribution of an investor‘s portfolio between different asset classes is called asset allocation. An efficient asset allocation is one which includes asset classes that have low or negative correlation so that the returns from the investments do not rise and fall together. Being invested in multiple asset classes allows the portfolio to benefit from the higher returns of the asset class which finds the prevalent economic conditions favourable to their performance, and reduce the risk of the being invested only in an asset class that has performed poorly. Some international researches suggest that asset allocation and investment policy can better explain portfolio performance, as compared to selection of securities within an asset class (stock selection). Three types of asset allocation viz. Strategic, Tactical and Life Stage based Asset Allocation are discussed below. 2.5.1. Strategic Asset Allocation Strategic Asset Allocation is allocation aligned to the financial goals of the individual. In other words, asset allocation that builds purely on the needs and preferences of the individual over the long-term is called Strategic Asset Allocation (SAA). SAA is a long-term strategy where the choice of asset classes that will be part of the investment portfolio is usually based on the short-term and long-term financial goals set in place by the investor. The goal is to generate the targeted return while keeping the level of risk to the investor low. The proportional allocation to each asset class is driven by investor objectives and constraints and is rebalanced to the asset allocation that was determined to meet the desired goal. 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. Profiling the investor with regard to their ability to take risks, need for growth, income or capital protection, and investment horizon is done using questionaires and other tools to determine the optimal allocation between growth-oriented and income-oriented assets. Strategic asset allocation may involve periodic rebalancing to restore the original proportions to various asset classes. Strategic asset allocation is a long term plan that is reviewed periodically for continued relevance to the individual‘s goals or situation. A change in these fundamentals may alone trigger a change in the allocation. The allocation to 126

an asset class will not be increased on the basis of expected performance of the asset class. This implies that while the portfolio is protected from errors in asset performance forecast, at the same time the portfolio will not benefit from a higher exposure to an asset class that is performing well. The portfolio will be rebalanced periodically so that the allocations to various asset classes that may have changed over time due to their performance, is brought back to what was originally envisaged. Example: Strategic Asset Allocation A portfolio is strategically allocated 60% to debt and 40% to equity. Equity market has significantly risen in that year and when the portfolio was reviewed at the end of the year, it was found that the debt now represents 50% of the total portfolio value and equity represents 50% of the portfolio value. How will the portfolio be rebalanced? The portfolio will be rebalanced by selling equity to bring down the equity allocation to 40% and using the funds to buy debt and increasing the debt allocation to 60%. Strategic asset allocation may also entail a revision of the proportions, based on changes to the investor‘s situation. For example, an investor may decide to have 80% in equity and 20% in debt when the plan to save for retirement was begun in early years. As the investor nears retirement the desire would be to change the ratio in favour of debt over equity. Strategic asset allocation has its disadvantages. There is no change in the allocations to assets based on market movements and therefore there is no active call about which asset class is likely to out-perform or under-perform. Strategic portfolios can under-perform during bull runs in certain assets, when it would systematically take out of a winning asset class and invest the proceeds into a losing asset class to maintain a fixed ratio between the two asset classes. Example To give an example, following is the allocation of capital to different asset classes given the risk tolerance, time horizon and financial goals. Asset % of allocation Amount Stocks 60% 60,000 Bonds 35% 35,000 Cash 5% 5,000 Total 100% 1,00,000 At the end of one year period, a portfolio of stocks has given a return of 12% and that of bonds is 8%. The portfolio, at the end of the year, before rebalancing look like this: 127

Asset % of allocation Amount Stocks 61% 67200 Bonds 34.5% 37800 Cash 5.5% 5000 Total 100% 110000 Now, rebalance the portfolio to the proper mix of stock, bonds and cash as per your long term strategy. After rebalancing, the portfolio will look like this- Asset % of allocation Amount Stocks 60% 66000 Bonds 35.0% 38500 Cash 5.0% 5500 Total 100% 110000 2.5.2. Tactical Asset Allocation Tactical Asset Allocation is the decision that comes out of calls on the likely behaviour of the market. An investor who decides to go overweight on equities i.e. take higher exposure to equities, because of expectations of buoyancy in industry and share markets, is taking a tactical asset allocation call. Tactical asset allocation is suitable only for seasoned investors operating with large investible surpluses. Even such investors might like to set a limit to the size of the portfolio on which they would take frequent tactical asset allocation calls. The major portion of the portfolio would be aligned to a strategic asset allocation. If strategic asset allocation is need-based, tactical allocation is view-based. It brings in the element of market timing to the asset allocation decision. We have seen that different asset classes perform well at different times. If the portfolio is rebalanced based on a view about the relative performance of asset classes, it may actively manage the risk and return, with the objective of outperforming the asset class indices. This strategy is called tactical asset allocation (TAA). Tactical asset allocation involves active portfolio management with the aim of adding value through short term adjustments in asset allocation based on the view for relative asset class performance. If the expected returns for each asset classes are equal to their long-run expected returns, then the portfolio‘s strategic asset allocation will be stable. However, from time to time 128

returns will deviate from the long-run returns and create opportunities for value to be added by tactical shifts in asset allocation. TAA involves tactically increasing a portfolio‘s exposure to those assets that are relatively attractive and reducing a portfolio‘s exposure to overvalued assets. TAA is a favored strategy among advisors and managers as it enables them to outperform underlying benchmarks that are closely aligned to strategic allocations. TAA involves rebalancing the portfolio based on the market view and may be done at three levels. The investors may themselves take a call on the market performance and make changes in the portfolio. The role of the advisor would be limited to executing the changes. In a more involved advisory mode, the advisors may express their views on the market and recommend over-weighting asset classes which they expect to perform well; under- weighting where they expect under performance; and neutral-weighting where they expect no significant change in performance. At the third level, the product provider, such as a mutual fund may make the tactical shifts in the portfolio without recourse to the investor or advisor. Example: Tactical Asset Allocation Consider a portfolio that has a strategic allocation of 60% in debt and 40% in equity. In response to expected continued good performance in equity markets the fund manager increases the allocation to equity to 70% and decreases the allocation in debt to 30%. What is the value add? Assume equity markets gave a return of 18% and debt markets gave a return of 9%. The returns from the tactically rebalanced portfolio would be: 30% x 9% + 70% x 18% = 15. 3% The returns from the original portfolio would have been: 60% x 9% + 40% x 18% = 12. 6% The difference of 2.7% is the value added from tactical asset allocation. Dynamic Asset Allocation Tactical rebalancing made by a manager can add or reduce value to the portfolio, depending on whether the call on the asset class performance was right or wrong. There is no formula to market timing and asset class performance can vary dynamically and not always be amenable to precise tactical calls. When markets crash unexpectedly, tactical asset allocation comes under stress. In such situations, mechanical trigger-based on which changes to asset allocation can be made, become popular. Dynamic asset allocation (DAA) works on the basis of a pre-specified model which does a mechanical rebalancing between asset classes. The allocation to each asset class is not a fixed percentage, but varies depending on the performance of chosen asset class variables. Several mathematical models have been proposed and used in DAA. The main objective of these models is creating a mechanical system that triggers asset allocation and rebalancing. Rebalancing may be done periodically 129

on the happening of an event such as the proportion of an asset class or level of a market going beyond specified limits. 2.5.3. Life Stage Based Asset Allocation The life cycle of any individual can be typically sub-divided into following stages: • Childhood Stage • Young Investor • Young Couple in Mid 30‘s • Mature Couple with grown up children • Retired Couple The age at which each stage of the life cycle starts may vary from one individual to another, but in our society most people would fall into a standard cycle. Childhood Stage Childhood Stage is a period of dependency that usually lasts until children finish their full- time education. In this stage, the financial needs are met by parents or guardians. Most general financial needs for the parents would be to plan for their Education. The most ideal way to give their children more privileged opportunities is to start investing money for this purpose when their children are still young. The allocation for this purpose would be to start early with aggressive portfolio allocation which would have equity allocation of around 80% and debt allocation of around 20%. The allocation needs to be transferred to more conservative i.e. from equity to debt when the goal is near approaching. Young Investor In this stage, the client is young, a single professional with long term focus of wealth creation and investment horizon. Capital Growth is paramount. He seeks to accumulate as much wealth over the next 30 years to retirement as possible and is happy to tolerate a high degree of portfolio volatility. The primary objective of this client is to maximize their opportunity for capital growth over a 10-year plus timeframe. The portfolio would typically comprise aggressive into equity and very small portion into fixed income asset class. Young Couple with Kids In this stage, the client is married, has children and is in his mid-30s. He has long term focus and capital growth is of paramount importance. They seek to accumulate as much wealth over the next 20-25 years prior to retirement as possible, and would be ready to tolerate the portfolio volatility, long term capital preservation for estate planning purpose is also important in this stage. The primary objective of this client is to generate long term capital growth with average emphasis on current income and capital preservation. The investment time horizon would be seven to ten years. In this stage also the equity would dominate the portfolio with some active management of equity and fixed income assets to provide some degree of balance. 130

Mature Couple with Grown Up Children In this stage, the clients are a couple with an age of around 45-50, who are looking to work for another 10-15 years and then retire. They have responsibilities towards higher education of one or two of their children. They seek to accumulate as much wealth for retirement as possible but without taking excessive risk. The primary objective of such a client is to invest in a portfolio that is evenly split between interest bearing securities and growth oriented investments, an exposure to a range of investment sectors including cash, fixed interest and shares ensures the portfolio is truly balanced. Retired Couple In this stage, clients are retired couple; both aged 60 and above with independent children, married and settled down comfortably. In their investment portfolio they are looking for income as well as some capital growth. Capital preservation is important to them. They don‘t mind a relatively small holding in growth assets. A high level of stable income is sought by investing in fixed income securities with exposures to government bonds and securities and other fixed income asset class. The client is also concerned about the underlying liquidity in the portfolio and being able to access some or the entire money invested if required. In conclusion, we can say that it is very important for a financial planner to identify the client life cycle and accordingly he should advise on the asset allocation based on his risk profile. The life cycle of the investor has to be seen in conjunction with the individual situation to get the correct risk profile. Another approach to understanding risk preferences is to classify investors broadly into categories based on their risk and return profiles.  An investor with a short to medium term investing horizon, who is unwilling to take risks on capital and likes regular income may be said to fit a conservative profile.  An investor with a longer term investment horizon, but with the need for both income and growth and a moderate level of risk tolerance may be in a moderate profile.  A risk-seeking investor with longer term investing horizon, focus on growth and tolerance for short term losses may fit an aggressive profile. Indicative model portfolios for these profiles may be constructed describing return, risk and time horizon attributes. Consider this illustrative example: Asset Classes Conservative Moderate Aggressive Short term bills 20% 10% 5% Long term debt 60% 40% 10% Gold 10% 10% 5% Commodities 0% 0% 10% Large cap equity 10% 30% 30% Mid cap equity 0% 10% 20% 131

Real Estate 0% 0% 20% Total 100% 100% 100% Financial planners may use a range of tools to construct a portfolio, from simple intuitive models to sophisticated mathematical models. A conservative investor likes income and therefore, holds more of income-oriented asset classes; an aggressive investor prefers growth and therefore, holds more of growth-oriented asset classes. The three portfolios as above will have different levels of risk and return. They will also have to be managed for risk, in terms of an appropriate investing horizon. An investor, who likes income and needs it in the short term, should not choose an aggressive asset allocation. This would expose the capital invested to short term risk and may not generate the income as needed. An investor wary of any risk to capital may have to choose a conservative allocation and settle for a lower level of return as well. Portfolio Rebalancing Rebalancing is the process of buying and selling portions of your portfolio in order to set the weight of each asset class back to its original state. In addition, if an investor's investment strategy or tolerance for risk has changed, he or she can use rebalancing to readjust the weightings of each security or asset class in the portfolio to fulfill a newly devised asset allocation. The asset mix originally created by an investor inevitably changes as a result of differing returns among various securities and asset classes. As a result, the percentage that you've allocated to different asset classes will change. This change may increase or decrease the risk of your portfolio, so let's compare a rebalanced portfolio to one in which changes were ignored, and then we'll look at the potential consequences of neglected allocations in a portfolio. There are basically three different ways you can rebalance your portfolio:  You can sell off investments from over-weighted asset categories and use the proceeds to purchase investments for under-weighted asset categories.  You can purchase new investments for under-weighted asset categories.  If you are making continuous contributions to the portfolio, you can alter your contributions so that more investments go to under-weighted asset categories until your portfolio is back into balance. Investment with a Portfolio and Rebalancing Assume a requirement of 1500000 after 10 years. Investment is made in equity and debt in a ratio of 75:25. Investment is made at the beginning of the period. Find amount to be invested in equity and debt each. Rate of return on equity 11% and debt 8%. Step-1: Assume investment amount of 1000. Hence 750 will be invested in equity and 250 will be invested in debt. 132

Step-2: As both equity and debt grow at their own rate, find FV of both in isolation Equity: PMT(bgn)=750 N=10 i/y=11 FV:13921 Debt: PMT(bgn)=250 N=10 i/y=8 FV:3911 Total value of the portfolio: 17832 If investment of 1000 accumulates 17832, how much to invest for 1500000? Cross multiplication: 1500000*1000/17832 = 84120 (approx) Equity investment=63090 Debt investment=21030 Assume in the above case if proportion is changed to 50:50, assuming the amount of ₹15,00,000 is required after 5 years, the amount of investment in each component will be Step-1: Assume investment amount of 1000. Hence 750 will be invested in equity and 250 will be invested in debt. Step-2: As both equity and debt grow at their own rate, find FV of both in isolation Equity: PMT(bgn)=750 N=5 i/y=11 FV:5185 Debt: PMT(bgn)=250 N=5 i/y=8 FV:1584 Total value of the portfolio after 5 years: 6769 Now the portfolio will be divided in 50:50 Step-3: Equity: PV=3385 PMT(bgn)=500 N=5 i/y=11 FV:9160 Debt: PV=3385 PMT(bgn)=500 N=5 i/y=8 FV:8141 Hence the total value of portfolio = 17301 Cross multiplication: 1500000*1000/17301 =86700 (annual investment) Example 2: Raman, aged 30 years, wants to retire at age 60. Raman's monthly household expenses are ₹20,000. He wants to provide for household living expenses in his post retirement period @85% of pre-retirement household expenses. You have suggested him to invest an equal amount every month from now in Equity Mutual Fund scheme and Debt Mutual Fund scheme and rebalance the combined portfolio after every ten years in such a way that the individual portfolios have equal amount of funds. After his proposed retirement he would invest the combined accumulated corpus in Debt investment only to generate inflation linked monthly annuity in the beginning of every month. What equal monthly amount should he invest in each of Equity and Debt schemes starting from today? Considering - Inflation: 7.00% p.a.; Equity Returns: 11.00% p.a.; Debt Returns: 8.00% p.a a) 7800 b) 7390 c) 5820 d) 7450 133

1. (B) 7,390 Current age of Raman = 30 years Retirement age = 60 Life expectancy = 80 Current monthly expenses = 20000 Monthly expenses required in post retirement life = 20000*1.07^30 * 0.85 = 129408 Inflation = 7% p.a. Debt return = 8% p.a. Inflation adjusted rate of return = (8-7)/1.07 = 0.9345…% p.a. Corpus required at the time of retirement to receive inflation adjusted monthly annuity ( ₹129408 ) in the beginning of every month Use CMPD Set = begin N = 20*12 I = 0.9345 Pmt = 129408 p/y = 12 c/y = 1 pv = solve = 28350915 To accumulate 28350915, Raman wants to invest monthly from now equally in equity mutual fund and debt fund and rebalance after every 10 years. To calculate the monthly investment we use following method Let he saves he saves ₹50 in equity and ₹50 in debt every month. Equity return = 11% p.a. Debt return = 8% p.a. First calculate the future value after 10 years In equity scheme ( first 10 years ) Set = begin N = 10*12 I = 11 Pmt = -50 p/y = 12 fv = solve = 10621 = FV1 In debt scheme ( first 10 years ) Set = begin N = 10*12 134

I=8 Pmt = -50 p/y = 12 fv = solve = 9064 = FV2 After 10 years portfolio has to be rebalance in equity: debt = 50:50 In equity scheme ( 10-20 years) Set = begin N = 10*12 I = 11 Pv = -( FV1+FV2)/2 = - (10621+9064)/2 Pmt = -50 p/y = 12 fv = solve = 38568 In debt Scheme (10-20 years ) Set = begin N = 10*12 I=8 Pv =-( FV1+FV2)/2 = - (10621+9064)/2 Pmt = -50 Fv = solve = 30313 The same method we will follow for next 10 years. We will get total accumulate amount from equity scheme (108413) and debt scheme (83419) = 191832 Using unitary method 191832 amount will be accumulated if saving monthly = ₹100 28350915 amount will be accumulated if saving monthly = 100*28350915/191832 = ₹14779 Therefore we can say, Monthly investment in equity scheme = 14779/2=₹7389.50 Monthly investment in debt scheme = 14779/2=₹7389.50 Example 3 Your client Mr A. has his Rs. 50 lakh portfolio in three asset classes as on 1st April 2009 comprised of Equity and Debt each in 35 % allocation with the rest of the portfolio invested in Gold ETF. Over the period upto 1st January 2013, Gold has given a total return of 90 % in the portfolio whereas equity and debt have returned 11% and 15%, respectively. You rebalance the portfolio today and 135

change its allocation to 60% in equity with the other two classes equally sharing the balance. What should be the transfer of money amongst asset classes. (a)Shift from Equity to Debt Rs. 1,52,962 and shift from Gold ETF to Equity Rs. 6,66,762 (b) Shift from Debt to Equity Rs. 2,10,000 and shift from Debt to Gold ETF Rs. 1,05,000. (c) Shift from Debt to Equity Rs. 6,51,500 and shift from Gold ETF to Equity Rs. 14,89,99 (d) Shift from Debt to Equity Rs. 9,01,176 and shift from Gold ETF to Equity Rs. 15,69,288 ANSWER :- OPTION –(C) Shift from Debt to Equity Rs. 6,51,500 and shift from Gold ETF to Equity Rs. 14,89,99 SOLUTION:- STEP -1 Size of the portfolio as on 1-Apr-2009 5,000,000 Rs Equity : 35% of portfolio 1,750,000 Rs ( 5000000*35%) Debt : 35% of portfolio 1,750,000 Rs. (5000000*35% ) Gold ETF: 30% of portfolio 1,500,000 Rs. (5000000*30%) STEP-2 As on 1-Jan-2013 Value of Equity = 1,942,500 Rs. 1750000*(1+11%) Value of Debt= 2,012,500 Rs. 1750000*(1+15%) Value of Gold ETF = 2,850,000 Rs. 1500000*(1+90%) Total portfolio size = 6,805,000 Rs. 1942500+2012500+2850000 STEP-3 Revised allocation 1-Jan-2013 Equity : 60% of the portfolio = 4,083,000 Rs. 6805000*60% Debt : 20% of the portfolio = 1,361,000 Rs. 6805000*20% Gold ETF: 20% of the portfolio = 1,361,000 Rs. 6805000*20% 136

STEP-4 Shift from Debt to Equity = 651,500 Rs. (2012500-1361000) Shift from Gold ETF to Equity = 1,489,000 Rs (2850000-1361000) Example 4 Mr. A is of 35 yrs with spouse and a kid of an age 5 yrs. His strategic asset allocation is 50:35:15 in equity, debt and liquid. He is able to invest rs 1.5lakh pa immediately to work various life goal. At age 40 the allocation would change to 40:50:10 in equity, debt and liquid asset with annual investment going up to 2.5 lakh for 5 more years. At age 45, for next 10 year he adapts the conservative wealth protection allocation 25:70:5 in eq, debt & liquid asset with 3 lakh pa investments. The per annum return expected in this stage are; from equity : 12%.11% & 10%, from debt : 9%,8% & 7%, from liquid asset : 6,5%,5.5% & 4.5%.What amount could he accumulate by his age 55 years? a. 113.9 lakhs b. 97.21 lakhs c. 66.65 lakhs d. 117.91 lakhs ANS- For the first 5 years we would invest Equity: Debt: Liquid ratio of 50:35:15. Value of equity portfolio after 5 years would be ₹ 533639 (Set: Begin, N = 5, I% = 12, PV = NA, PMT = -150000*0.5, FV = (?) = Solve). Value of the debt portfolio after 5 years would be ₹ 342475(Set: Begin, N = 5, I% = 9, PV = NA, PMT = -150000*0.35, FV = (?) = Solve). Value of the liquid portfolio after 5 years would be ₹ 136434(Set: Begin, N = 5, I% = 6.5, PV = NA, PMT = -150000*0.15, FV = (?) = Solve). The value of equity, debt and liquid portfolio after 5 years would be ₹ 1012548. For the next 5 years we would invest Equity: Debt: Liquid ratio of 40:50:10. Value of equity portfolio after next 5 years would be ₹ 1373767 (Set: Begin, N = 5, I% = 11, PV = -1012548*0.4, PMT = -250000*0.4, FV = (?) = Solve). Value of the debt portfolio after next 5 years would be ₹ 1535874(Set: Begin, N = 5, I% = 8, PV = - 1012548*0.5, PMT = -250000*0.5, FV = (?) = Solve). Value of the liquid portfolio after next 5 years would be ₹ 279537(Set: Begin, N = 5, I% = 5.5, PV = - 1012548*0.1, PMT = -250000*0.1, FV = (?) = Solve). The value of equity, debt and liquid portfolio after next 5 years would be ₹ 3189178. For the last 10 years we would invest Equity: Debt: Liquid ratio of 25:70:05. Value of equity portfolio after last 10 years would be ₹ 3382814 (Set: Begin, N = 10, I% = 10, PV = -3189178*0.25, PMT = - 300000*0.25, FV = (?) = Solve). Value of the debt portfolio after last 10 years would be ₹ 7496073 (Set: Begin, N = 10, I% = 7, PV = -3189178*0.70, PMT = -300000*0.70, FV = (?) = Solve). Value of the liquid portfolio after last 10 years would be ₹ 440252 (Set: Begin, N = 10, I% = 28 4.5, PV = - 3189178*0.05, PMT = -300000*0.05, FV = (?) = Solve). The value of equity, debt and liquid portfolio after last 10 years at the age of 55 would be ₹ 1,13,19,139.59. Option (a) is the closest option. 137

SUMMARY  SAA is a long-term strategy where the choice of asset classes that will be part of the investment portfolio is usually based on the short-term and long-term financial goals set in place by the investor.  Tactical Asset Allocation is the decision that comes out of calls on the likely behaviour of the market.  Tactical asset allocation is suitable only for seasoned investors operating with large investible surpluses.  If strategic asset allocation is need-based, tactical allocation is view-based. It brings in the element of market timing to the asset allocation decision  Dynamic asset allocation (DAA) works on the basis of a pre-specified model which does a mechanical rebalancing between asset classes.  The life cycle of any individual can be typically sub-divided into following stages:  Childhood Stage -  Young Investor  Young Couple in Mid 30‘s  Mature Couple with grown up children  Retired Couple  The life cycle of the investor has to be seen in conjunction with the individual situation to get the correct risk profile  An investor with a short to medium term investing horizon, who is unwilling to take risks on capital and likes regular income may be said to fit a conservative profile.  An investor with a longer term investment horizon, but with the need for both income and growth and a moderate level of risk tolerance may be in a moderate profile.  A risk-seeking investor with longer term investing horizon, focus on growth and tolerance for short term losses may fit an aggressive profile. 138

SECTION II- SELF ASSESSMENT QUESTIONS 1. A mutual fund that invests in Indian Equities, foreign equities, Indian Corporate Bonds, Indian Government Gilts is subject to the following risks? 1. Business Risk, 2. Default Risk, 3. Systematic Risk, 4. Interest Rate Risk. a) 1 & 3 only b) 1,3 & 4 only c) 3 & 4 only d) 1, 2, 3 & 4 2. Risk appetite of investors is assessed through _______. a) Risk Appetizers b) Asset Allocators c) Risk Profilers d) Financial Plan 3. Choose the instrument from the following which does not have reinvestment risk: a) Short term bonds b) Corporate Bonds with Call option c) Zero coupon bonds d) Government securities 4. A businessman wants to achieve the goal of marriage of his daughter after 10 years. The funds required would be ₹25 lakh at then costs. He wants to invest monthly for the goal. You suggest an asset allocation strategy where he should invest monthly in equity and debt in ratio 65:35 for 9 years, and shift the entire accumulated amount in these funds to liquid fund in the last year. If the returns expected from equity, debt and liquid funds in this period are 12% p.a., 9% p.a. and 5% p.a., respectively, what approximate amount per month is required to be allocated to equity and debt schemes? a) ₹12,679 & ₹8,453 b) ₹9,485 & ₹6,323 c) ₹8,601 & ₹4,631 d) ₹12,075 & ₹8,050 5. An investor who seeks a high level of return and is willing to bear the risks of such investments is likely to be recommended a) Aggressive portfolio b) Conservative portfolio c) Moderate portfolio 139

6. Which of the following depends on the market? a) Strategic asset allocation b) Tactical asset allocation c) Investor risk profile d) None of the above Read the following caselet and answer the questions that follow: Mr. C is a 45 year single earning member of his family with a good income. He is saving for different financial goals, some of which are due for funding now. He has a home loan and car loan that he is servicing. 7. How would you best categorize Mr. C‘s risk profile? a) Conservative b) Moderate c) Liquidity seeker d) Aggressive 8. What are the assets that will be most suitable for Mr. C given his situation? a) Primarily growth with some income-oriented assets b) Primarily liquid assets c) Primarily growth assets d) Combination of liquid and income-oriented assets 9. Mr C. has to park the funds from fixed deposits that have matured for a short period till it will be used for his daughter‘s education. What will you suggest as a suitable investment option? a) Large-cap equity, to capture growth but with lower risk b) Current account, to enable liquidity c) Alternative investments, to increase the corpus d) Short-term fixed deposit, to ensure liquidity and some returns 10. An investor holds a large portfolio of shares from different companies and industries. Her portfolio is likely to be protected from a) Credit risk b) Inflation risk c) Liquidity risk d) Unsystematic risk 140