Introduction to Financial Planning

available for buying or construction of the property. Generally referred to as home equity in the US, such loans are not that popular in India. This is because a house is considered sacrosanct and the ultimate security in India. However, the Indian version of the loan, an overdraft facility against the security of house property has been discussed. 4. Personal loan - Personal loans are available to salaried individuals and self employed professionals. Some banks require that the salaried individual should at least be a graduate working with a reputed company with a minimum age of 21 years. These conditions differ from bank to bank. In addition, personal loans are disbursed based on a minimum salary criterion. The individual should be permanently employed with the company. For self-employed individuals like doctors, chartered accountants, architects, engineers and MBAs from reputed institutes, a loan is available based upon the previous income tax return filed. The number of years of professional experience is also used as a criterion to sanction the loan. The typical documentation required includes proof of date of birth and residence, past bank statements, income tax returns, salary statements or profit and loss account and balance sheet attested by a chartered accountant. 5. Auto loans - Some of the popular types of auto loans are as follows: Margin money scheme - under this scheme a margin money of at least 10% needs to be paid up- front along with one Equated Monthly Instalment (EMI). Postdated cheques have to be issued for the balance EMIs. Advance equated monthly instalment scheme - five to nine EMIs need to be paid in advance under this scheme. It is a 100% loan scheme. The balance EMIs need to be paid through post-dated cheques. Security deposit scheme - under this scheme a specified sum needs to be deposited as a security deposit. Interest is received on this deposit, though at a lower rate of interest than that payable on the loan. Theoretically, this is also a 100% loan scheme. Lease finance scheme - a lease is an agreement between the owner of an asset (lessor) and its user (lessee). The ownership remains with the lessor who gives the asset for use to the lessee in return for periodic rental payments to the lessor. Typical documentation required includes proof of identity, proof of residence, proof of income, banking his-tory and signature verification from the bank. 6. Leasing - Another alternative loan mechanism Lease financing enables the renting or leasing of assets rather than buying the assets. For example, cars or consumer durables computers or a house may be leased. It is a contract, whereby the owner of the asset (the lessor) grants to another party (the lessee), the right to use the asset, usually for an agreed period of time, in return for the payment of rent. In India, only the lessor is allowed to charge depreciation on the assets and claim tax deduction. In the case of cars, consumer durables and such other things, at the end of the lease period the owner usually transfers the asset to the lessee at a notional amount. 151

Buy Vs. Lease The buy versus lease decision is an important one. There are three basic steps used to calculate whether an asset should be bought or leased out: 1. Compute the net present value (NPV) of the buy alternative, 2. Compute the incremental NPV of the lease alternative, 3. Take the alternative that leads to the higher net positive NPV. If neither alternative leads to a positive NPV, do not lease or buy the assets. Let us take an example to explain the steps. ABC Co. Ltd. is thinking of acquiring some plant and machinery. The annual revenue from the machinery 5,000. It has an expected useful life of five years. The tax rate is 50%. If the asset is bought If the asset is leased Purchase price = Rs. 10,000 Annual lease payment is Rs. 3,000 to be paid at the end of the year for 5 years Estimated salvage value is Rs.0 Annual operating cost is Rs. 2,000 Straight line depreciation is charged The required rate of return is 10% Annual operating cost = Rs. 2,000 Let us first consider the buy alternative. Calculate the after tax cash flows and calculate their net present value by discounting at an appropriate required rate of return. Year Cash flow Depreciation Taxable Tax Cash flow PV Factor Discounted before tax Income after tax 10% cash flow (1) (2) (3) (4) (5) (6) (7) (8) 0 -10,000 2,000 3,000 1,500 -10,000 1 -10,000 1 5,000 2,000 3,000 1,500 3,500 0.909 3.181.5 2 5,000 2,000 3,000 1,500 3,500 0.826 2.891.0 3 5,000 2,000 3,000 1,500 3,500 0.751 2.629.5 4 5,000 2,000 3,000 1,500 3,500 0.683 2.390.5 5 5,000 2,000 3,000 1,500 3,500 0.621 2.173.5 3.266.0 NPV = Now let us consider the lease alternative. The lessee does not have to pay the purchase prise of the asset. However, the lessee loses the depreciation tax shield and does not have the benefit of salvage value of the asset. Year Initial Dep. Tax Lease rental Tax Net total PV factor Present investmen shield lost benefit lease outflow at 5% value on lease outflow (3)+(6) t saved rental (1) (2) (3) (4) (5) (6) (7) (8) (9) 0 10,000 152 10,000 -2,500 1.0 10,000

1 -1,000 3,000 1,500 -1,500 -2,500 0.952 -2,380.0 2 -1,000 3,000 1,500 -1,500 -2,500 0.957 -2,267.5 3 -1,000 3,000 1,500 -1,500 -2,500 0.864 -2,160.5 4 -1,000 3,000 1,500 -1,500 -2,500 0.823 -2,057.5 5 -1,000 3,000 1,500 -1,500 -2,500 0.784 -1,960.0 NPV = -825.5 We use the after tax cost of debt i.e. 0.1 X (1-0.5) = 0.05 or 5% as the discounting factor to take care of an indirect effect of leasing. It reduces the borrowing capacity of the firm as debt and leasing are near substitutes. The lease rental can be considered to be a sum of principal repayment and interest cost. Decision Making NPV of incremental Decision lease effects NPV of buy alternative Positive Lease Negative Buy Positive Negative Do not use the asset Positive Positive If the some of two NPVs is Negative positive, lease otherwise don’t use the Negative asset Therefore in our example we should but the asset. Hire-Purchase - Hire-purchase Finance Hire-purchase had its origin in the UK in the middle of the 19th century when sewing machines were sold under a formal agreement to hire with an option to purchase. After some time, the system of instalment sale became popular for all types of articles like furniture, pianos and other consumer goods. Later even railway wagons were sold to collieries under hire-purchase schemes. In India, pioneering efforts in hire-purchase financing were made by the Auto Supply Company Ltd., which commenced operations in 1920. The business picked up in the post-war years and the bulk of advances were made in the road transport industry. Hire-purchase credit is defined as a system under which-term loans for purchases of goods and services are advanced to be fractionally liquidated through a contractual obligation. The goods whose purchases are thus financed may be consumer goods or producer goods or they may simply be services such as air travel. Hire- purchase credit is available in India for a wide range of products and services. Products like automobiles, sewing machines, refrigerators, TV sets, machinery and equipment, other capital goods, industrial sheds; and services like educational fees and medical fees, are now financed with the help of such credit. India has a long list of private and public sector hire-purchase companies. While most of these are funded by deposits from the public, they also borrow from banks and other institutions. Retail and wholesale traders, commercial banks, IDBI, the Industrial Credit and Investment Corporation of India (ICICI), the National Small Indus-tries Corporation (NSIC), the State Financial Corporations (SFCs), the State Industrial Development Corporations (SIDCs) too provide hire-purchase credit. In the recent past, banks have also increased their business in the field of instalment credit and consumer loans. The IDBI indirectly participates in financing hire-purchase business by way of rediscounting usance bills/promissory notes arising out of sales of indigenous machinery on deferred payment basis. 153

A hire-purchase agreement between the hirer and the hiree involves the following three conditions: 1. The owner of the asset (the hiree or the manufacturer) gives the possession of the asset to the hirer, who will pay instalments (rentals) over a specified period of time. 2. The ownership of the asset will transfer to the hirer on the payment of all instalments. 3. The hirer will have the option of terminating the agreement at any time before the transfer of ownership of the assets. Differences between Leasing and Hire-Purchase Financing Hire-purchase financing Depreciation - Hirer Lease financing 1 is entitled to claim depreciation on the assets 1 Depreciation - Lessee is not entitled to claim hired. depreciation on the assets leased Taxation - Only the interest portion of the 2 Taxation - The entire lease rental is deductible as 2 hire-purchase instalment is deductible as expense for tax purposes expense for tax purposes 3 Once all the instalments are paid, the hirer 3 Lessee does not automatically become owner of becomes owner and can claim salvage value the asset and can therefore not claim its salvage value. Difference with Instalment Sale: Instead of hire-purchase, if an asset is acquired on sale by instalments, the buyer immediately becomes the owner of the asset. As owner of the asset, the buyer can claim depreciation and interest expenses as tax deductible expenses. In other words, except for timing of the ownership of the assets, hire-purchase and instalment sale are similar. 8. Consumer Loans Consumers credit is not new to India. Consumers have been availing of credit from local sources for purchasing and meeting household needs. This credit is available from varied sources like the local grocer to specialist finance companies. Some of the Sources are : b) Banks - Banks are required to take the permission of the RBI before undertaking any consumer credit/ retail financing activities. Banks provide both leasing and hire-purchase facilities to consumers. Banks have set up subsidiaries to transact both leasing and hire-purchase business. With a shakeout in the financing industry, many banks may also like to take up such business in their own books by merging their subsidiaries. c) Non-Banking Finance Companies - These companies popularly known as NBFCs are regulated by the RBI. The RBI has a special cell devoted to the governance of their activities and lays down stringent rules and regulations regarding their supervision and control. 154

d) Nidhis or Mutual Benefit Societies - Such entities find recognition and are registered under the Companies Act, 1956. They are subject to rules and regulations as may be imposed by the central government or the RBI from time to time. e) Money Lending Firms - Such entities are governed by the respective state governments through legislation enacted in this regard under the Constitution of India. A licence is required to carry out the money lending activities and the state governments regulate the maximum interest rate to be charged, proper accounts need to be maintained and returns have to be filed to stipulated authorities. Documentation normally required includes financing agreement, guarantee from a suitable guarantor, hypothecation or pledge agreement, promissory note, postdated cheques, age, income and residence proof. 9. Credit cards - A credit card is known as ‘plastic money’. It is useful as it allows you to displace cash in your pocket. Carrying a lot of cash is cumbersome and sometimes you may not have the cash to pay for necessary expenses. Most banks allow for an interest free credit period of about 45 days. Further, you may pay only 5% of your expenses outstanding at the end of the month and avail of credit for the rest. The interest charges for this are, however, high at around 2.5% - 3% per month. You may also withdraw cash from designated ATMs or branches but the cost of this may be as high as 3% per transaction. The easier availability of loans, changing lifestyles, and increased consumerism has made managing debt of a client one of the most important tasks of a financial planner. There is a necessity to warn the client about excessive use of credit and to make provisions to avert any default. Loans also have attendant costs like application fees, credit-check fees, and other costs. Credit cards have additional costs like annual fees, trans- action fees and late fees that push up the already high cost of credit. Refinancing Here we provide a short introduction to re -financing, a term often heard in the context of loans. Refinancing is the process of obtaining finance for on lending by various financing institutions. The Reserve Bank of India (RBI) is the lender of last resort for a number of financial institutions, for example the scheduled banks, co- operative banks, state financial corporations, the Export Import Bank of India (EXIM Bank), National Bank for Agricultural and Rural Development (NABARD). Refinancing is usually provided at the bank rate. The bank rate is specified from time to time by the RBI. For the priority sectors like exports, agriculture, small scale industries and housing etc., refinance may be provided at a concessional rate. These institutions, in turn, refinance other lending institutions. For example NABARD refinances banks, co-operative banks and regional rural banks for loans disbursed to the rural sector. Similarly, the Industrial Development Bank of India (IDBI) refinances state financial corporations, National Housing Bank refinances housing finance companies, and Small Industries Development Bank of India (SIDBI) refinances banks for their loans to small scale industries. For personal loans, refinancing refers to repayment of high-cost loans by availing of low interest cost loans in a falling interest rate scenario. An individual should carefully study the prepayment clause in a personal loan. Normally, banks levy a penalty for prepayment which may be as high as 2-4% of the loan outstanding. 155

2.3 Personal Financial Statement Analysis Cash Flow Management and Budgeting Strategies Learning Outcomes At the completion of this section, you should be able to:  explain the purpose of budgeting;  outline methods for managing salary income for both, clients in the workforce and clients who have retired. In this section we will examine the importance of cash flow planning for clients at all stages in their lives. Cash flow simply refers to income and expenditure and how its management, or lack thereof, greatly impacts on a client’s capacity to achieve financial objectives. Sound cash flow management is based on the capacity of the client to budget or control their income and expenditure. All clients will have finite levels of income. For wages and salary earners, there is the limitation of the level of actual salary/wages being paid by the employer. For business owners, be they owners of a limited company, wherein they are employees, or self-employed as a partner in a partnership or sole trader, income limitations are governed, ultimately, by the level of income/revenue generated by the business. The major objective of cash flow planning is to generate surplus income which, in the case of a business, is otherwise known as profit. Surplus income or profit is the income that remains after allowing for all costs including taxation. Motives for Holding Cash 1. Transaction motive: This is the motive of day to day routine transactions to meet daily requirements. 2. Precautionary motive: This is to take precaution against unforeseen events like natural calamities, riots, strikes etc. 3. Speculative motive: This is to take part in investment needs like investing in securities – shares, bonds, debentures etc. 4. Compensation motive: A minimum balance is needed to avail of bank accounts, credit cards, ATM cards, personal loans etc. Salary and Wages: Cash Flow Planning For the wage and salary earner, income tax is deducted via the tax deducted at source (TDS) taxation system. This then means that the individual has to ‘budget’ for personal retirement fund/pension contributions if they are not already deducted before receiving net salary and wages. On this point, financial planners often recommend that personal retirement fund/pension contributions be deducted by the payroll office prior to paying net after tax-after retirement fund income. Deducting retirement fund contributions before being paid allows the individual to then budget for living costs with a view to identifying surplus income that can be accumulated for short and long term goals. In order to be able to identify surplus income, the client must be able to identify all costs that are incurred in their normal lifestyle. Such costs include food and groceries, rent or loan repayments, electricity and 156

telephone, insurances, motor vehicle/two wheeler registration and running costs — including petrol. The importance of this type of calculation cannot be overstated as it is vital that the client is able to tell the planner what it costs for him/ her to ‘live’ each year. These costs are otherwise known as annual living costs (ALC). The Working Client The client who is working either as an employee or as a self-employed person must carefully budget their income and expenditure. Not only does this client have to meet ALC but, in addition, the client must budget for short and long term savings. Such savings can be categorised as retirement savings and pre-retirement savings. Pre-retirement savings include numerous different savings goals. Saving for retirement is based upon an objective to accumulate sufficient capital that, in retirement, can generate an income to provide the client with a similar lifestyle that they enjoyed prior to retirement. Naturally, retirement savings capacity varies from client to client and is largely influenced by the level of income earned pre-retirement and the level of expenditure pre-retirement. As you progress further in your financial planning career, you will discover that it is sometimes the case that the more an individual earns through his/her working life, the more the individual will spend. Sometimes, high-income earners have very little capacity to accumulate surplus income simply because their expenditure level is too high. For such a client, consulting with a financial planner may be the most rewarding decision made, as the financial planner is able to develop a budget for the client with a view to identifying and accumulating surplus income. It is sometimes the case that a high-income earner will also have high levels of liabilities which impede the ability to save. In such a situation, the financial planner ’s initial task is to help the client implement a debt management programme to reduce the liabilities as soon as possible. Following this, or sometimes simultaneously, the financial planner will be helping the client to start a savings programme. As you will also discover in your career, at times comparatively low-income earners have a greater capacity to save when compared to higher-income earners. You will also see apparent anomalies where a low wage earner has, through discipline and application, accumulated a higher level of assets and savings than some high-income earners. This is simply a reflection of the individual’s approach to the task of saving. One simple method of budgeting and managing salary income is to establish a programme where all salary/ wages is initially directed to a main account in a bank (this should usually be a 2-in-1 account). From this account an automatic direct debit is made to credit another account with the amount of money the client requires for weekly, fortnightly or monthly living costs. On this living costs account, the client should have access via automatic teller machines (ATMs) and via a cheque book. The residual salary that remains in the initial account is used to fund the payment of such regular costs as: Loan/rent, Personal loan, Retirement fund contributions, Insurance premiums Importantly, if the client is likely to lack the discipline to refrain from using this initial bill account for day -to- day costs, the financial planner may diplomatically suggest to the client that he/she should not have ATM or cheque book access to the main account. 157

A flow chart of how this system of budgeting works appears below. Regular Salary/Wages Bill Account Day to day account For direct debiting of loan, rent, for food petrol, personal loan, retirement fund entertainment etc insurances, long term non- retirement fund savings etc. No ATM or cheque book access The amount of salary/wages to remain in the bill account is determined by completing the annual cost of living worksheet. The worksheet will, with an acceptable level of accuracy (subject to the client’s honesty), identify the total costs for a year. If the costs total, say, Rs. 120,000 per year, of which the client needs Rs. 60,000 to cover such items as weekly food, petrol and clothing, with an additional Rs. 60,000 of costs that occur either on an annual, quarterly or monthly basis, then clearly this client needs to ensure that an amount of Rs. 5,000 per month (Rs 60,000 per year) accumulates in the bill account. Similarly, the client should ensure that, in total, Rs. 5,000 per month is automatically transferred to the day-to-day account through an automatic debit on the day after being paid. The success of such a system is very much reliant upon the client’s capacity to ‘live’ within the day-to-day account balances and to refrain from making impulsive withdrawals from the bill account. If, to take this example further, our client earned Rs. 136,000 net (after TDS), then clearly we have identified a potential surplus (profit) that can be directed to other financial goals and objectives. The use of this surplus cash needs to be directed to longer- term goals such as retirement planning (retirement fund) and pre- retirement goals such as, saving for overseas holidays. Indeed, the financial planner may also encourage the client to accumulate retirement savings that are not within the retirement fund/pension system so as to provide a hedge against future legislation changes. The initial accumulation of the surplus/profit should take place in the bill account. From here it can be directed on, say, a monthly basis to longer- term savings such as term deposits or mutual funds. If the client has set short- term financial goals such as saving for a house or perhaps saving for a holiday, then, depending upon the duration of the savings, it may be appropriate to accumulate this component of the client’s savings in the bill account. If the bill account should grow to, say, Rs. 10,000 or more, then it may be appropriate for the financial planner to suggest that, for this aspect of their planning, the client uses term deposits. The reason for investing in a term deposit is that it is likely to pay a higher rate of interest. The flow chart of salary and its use, under this system, is as follows. Managing salary income – savings capacity 158

Regular Salary/Wages Day to day account ATM & cheque book Bill account No ATM or cheque access book access Retirement Fund Loan Insurance premiums Car, holiday It is important to remember that throughout your career you may well meet clients who have their own perfectly effective cash flow management and budgeting systems. In such a situation, it may be a case of not altering their system but rather, adding value to their position through skilful recommendations for the purpose of retirement fund and non-retirement fund savings. There are numerous systems of cash flow/budget management that are used and recommended by financial planners throughout the world. However, central to all such systems is an objective to ensure that the client’s costs are met and accumulation of capital is possible through identifying, and then investing surplus income. The financial planner consulting with a client who is unable to control costs and/or identify surplus income has the role of diplomatically recommending alterations to the client’s spending patterns. For such a client, the above flow chart of income and expenditure may be the ideal solution to establishing an enhanced system of cash flow management. The Retired Client The process of cash flow management is equally important for the retired client as well as the salary and wage earner, for the retired client has a finite amount of capital from which to generate income. The retired client rarely has the opportunity, if at all, to return to the workforce/business to generate additional capital. As such, retired clients need to know their ALC as a means of determining the rate, in terms of time and amount, at which they can spend income. A strategy sometimes used by financial planners to assist with cash flow planning for a retired client is to have all investment income directed to a main account. From the main account, on a regular basis, an automatic debit is applied with a subsequent direct credit to the client’s local bank account as follows. Managing non-salary income – retiree Pension Retirement fund Provident fund Other Investment Main Account (Cheque Book) Local Bank Account 159

As a result of investments paying income distributions at various times throughout the year, the process of having a standard direct debit on the main account to the local bank account helps to smooth out the highs and lows of a client’s cash flow. For example, using the above model, if the retired client required Rs. 48,000 per year of after- tax income to meet the ALC, quite simply a monthly Rs. 4,000 direct debit on the main account will see the required income arrive in the client’s local bank account. This does not necessarily mean that the client can regularly spend Rs. 4,000 per month as some other costs occur on a less regular basis such as car insurance and registration once a year. As such, the client must then manage or budget the income sitting in the local bank account to ensure the required funds are available to pay the once-per-year costs. As an alternative, and using the above Rs. 48,000 ALC, if the client needed, say, Rs. 36,000 per year of regular costs that occur each month and Rs. 12,000 per year of once-per-year costs, the above automatic monthly debit from the main account could be reduced to Rs. 3,000 per month. The balance of the Rs. 48,000 per year costs of Rs. 12,000 (Rs. 48,000 – Rs.36,000) could then be accumulated in the main account. The client could then use a cheque from the main account to pay the once per year costs as they arise throughout the year. This strategy still requires that the client maintain the discipline of not spending the accumulating Rs. 12,000 of once-per-year costs. The use of the main account is important not only from a budgeting perspective, but also because such accounts generally pay a higher rate of interest than the client’s normal bank account (main account will most likely be a 2- in-1 account). Financial planners who recommend term deposits or 2-in-1 accounts for the management of their retired clients’ investment capital, they will often establish a similar system of income management. Under the term deposit or a 2- in-1 account system, the financial planner is able to establish for the retired client a regular monthly income payment to the client’s local bank account. In situations where the client has insufficient capital to generate the required level of income, the term deposit or 2-in-1 facilities will likely provide the opportunity to include a measure of capital to boost the client’s overall cash flow. However, care should be taken by the financial planner, as the inclusion of capital may see the client’s overall capital decline over time. Whether or not this is acceptable will depend upon the client’s life expectancy and the actual level of investment capital held. The following few topics are also closely related to cash flow planning and budgeting and need to be kept in mind before a cash flow planning and budgeting strategy for a client is formulated: 1. Emergency fund planning 2. Debt management 3. Liquidity 4. Monitoring, evaluation and compliance of budgets 5. Forecasting 160

Emergency Fund Planning An emergency fund may be required for a variety of reasons. Some of them are as follows: a) Natural disasters like typhoons, floods (or drought conditions) and earthquakes can cause harm to both life and property. In such a case, to get back to a semblance of normalcy, an emergency fund may be required till such time regular income commences and for asset reconstruction or medical expenses. b) In today’s situation, man-made disasters like riots and civil disturbances can also disrupt life and funding may be required for the victims of such events. c) Though, medical science has made rapid strides, medical emergencies like operations or major diseases require funding at short notice. d) Similarly, nobody can predict death, funeral expenses and social obligations may require sizeable funds from the surviving members of the family. e) Marriage of children may require liquid funds at short notice even though such events are anticipated and savings may have been made for them. f) Similarly, when children are dependant and studying, emergency funding may be required for additional courses like tuitions or computer skills. g) When a house is being constructed, emergency funding may be required for unplanned additions or cost overruns. h) A client may like to keep a small fund aside for lucrative investments that may come his/her way. i) Involvement in litigation may require emergency funding during the course of the litigation and then at the time of settlement, if any. How does one keep an emergency fund? Though there is no benchmark figure available, around Rs. 20,000 to Rs. 50,000 (or around two months of total family income) should be kept in liquid assets. Examples of some measures that could be taken are as follows: a) Traditionally, gold and silver have been used for storing wealth. This wealth can then be realised in the case of extreme emergencies. b) Savings accounts have been specially designed for liquidity. The money in a savings bank account, though earning only around 4% interest, is readily available on demand during banking hours. c) Even fixed deposits in banks are liquid to the extent that premature withdrawals can be made at a discount to the negotiated rate of interest at the discretion of the bank manager. d) Similarly, life insurance policies have a cash or surrender value which can be utilised in case of emergencies. e) Shares which are actively traded on the stock exchanges are also liquid, specially with the dematerialisation of major shares. f) While liquid fund schemes of mutual funds are realisable within a day, open ended schemes can be redeemed in a week or so. g) Withdrawals/loans are permitted from the Public Provident Fund account of an individual after five years three years respectively. 161

h) Loans against shares schemes of mainly foreign banks are another source of liquidity for individuals. There is a stiff margin imposed by these banks against specific shares and the interest rate is quite high. i) Loan is also available against specified insurance policies of LIC. j) Foreign banks provide unsecured loans against documents like income tax returns and salary slips. The verification and loan documentation process may however take some time. k) With the advent of credit cards, advances are available albeit at a stiff interest rate, going up to 36% p.a. The money can be withdrawn from ATM counters at all times and from bank counters during banking hours. Liquidity By liquidity we mean the ease with which assets can be realised to give cash. Different types of assets have differing liquidity profiles. For example, while a savings bank account is highly liquid (near cash), property is the other end of the spectrum being difficult to dispose off and requiring lengthy paperwork. The different advantages of adequate liquidity are: a) Adequate liquidity is required to ensure the smooth running of day to day life. b) Payments made by cash usually attract a cash discount on purchases. b) While making large purchases like that of a car or a consumer durable, liquidity provides better bargaining power. c) Adequate liquidity is a source of mental satisfaction and peace. d) In case of distress sales of assets (for example when a family is moving abroad), adequate liquidity has the potential to provide good bargains to prospective buyers. e) Liquidity is important both in the short term and long term as needs have to be matched with resources at all times. Monitoring, evaluation and compliance of budgets The task of budgeting does not end with the preparation of budget as such. Every budget needs to be evaluated and monitored. Any variances, from the budgeted amounts whether income or expenses will have to be noted and relevant action taken. A statement of variances may need to be prepared, which apart from showing the variance from budgeted figures, will also include reasons thereof and specific measures taken to address the same. A statement of variances may be checked from the following angles: a) Whether there had been an error in budgeting the figures concerned. b) Housing: - Make sure that you do not spend ostentatiously on constructing and maintaining the house as it will just attract additional house tax. - If expenditure on cleaning, ironing and other housework is high, these tasks could be done by you or your family members. - Save on house electricity by installing power saving devices, specially if using high-energy consumption appliances like air-conditioners, heaters and suchlike. - Make sure that the rent you are paying is in line with the locality in which the house is situated. 162

- House contents and the home should be insured to take care of fire, theft, natural disasters and riots. - House telephone expenses should be minimised by calling long-distance at a cheap rate time and using e- mail. Internet telephony is now available and could be utilised. c) Food: - Make sure that you have good relationships with the local grocer and general merchant to avail bulk discounts and other bargains. - Supermarkets and value stores are coming up quickly and provide good bargains. d) Living expenses - Transport costs can be rationalized by using public transport and car pools. - Some items like presents and gifts, though social obligations are discretionary in nature. - Tax consultancy and accounting fees may be considered to make savings, which are possible through tax planning. - Depending on the social status even club memberships and donations may be discretionary in nature. - Though entertainment is necessary, cable television has provided a cheap alternative to other means of entertainment. e) Personal expenses - Personal expenses on clothing, cosmetics, personal care products are largely non- discretionary in nature. - Spending on hobbies may be curtailed if the budget is exceeding limits. - It is essential to take medical insurance, specially for older people. 2.4 Forms of Business Ownership/ Entity Relationships There are a number of structures for a business or investor to use. The simplest is the sole trader, where the individual runs and manages the business and retains all profits or losses. He or she can employ people if required. Importantly, liability is borne by the individual for all debts incurred. The second form is the partnership where two or more join to operate the business and share the benefits equally. Similarly, liability can be apportioned between the partners. The third structure is the company. Effectively, the business is split into a number of equal parts called shares. The shareholders’ entitlement to any benefit and a say on how the company operates is generally determined by the number of shares held. There are many reasons for establishing a company to operate the business. In many cases they are used to offer protection to the business owners from creditors if things go wrong. Furthermore, a company provides perpetuity as a company can continue to operate beyond the life of those individuals who may have started the business. Lastly, a company also provides a means for an investor to participate in a business by purchasing a stake in the business through shares, to which we now turn. 163

For a comparison of different forms of business ownership, refer the Figure 4.3 on next page. In addition, a few other ownership structures are as follows: Trusts A trust is an entity created to hold assets for the benefit of certain persons or entities, with a trustee managing the trust (and often holding the title on behalf of the trust). Most trusts are founded by the persons (called trustors, settlers and/or donors) who execute a written declaration of trust, which establishes the trust and spells out the terms and conditions upon which it will be conducted. The declaration also names the original trustee or trustees, successor trustees or means to choose future trustees. The assets of the trust are usually given to the trust by the creators, although assets may be added by others. During the life of the trust, profits and, sometimes, a portion of the principal (called ‘corpus’) may be distributed by the beneficiaries, and at some time in the future (such as the death of the last trustor or settlor) the remaining assets will be distributed to beneficiaries. A trust may take the place and avoid probate (management of an estate with court supervision) by providing for distribution of all assets origi- nally owned by the trustors or settlers upon their death. There are numerous types of trusts, including ‘revocable trusts’ created to handle the trustors’ assets (with the trustor acting as initial trustee), often called a ‘living trust’ or ‘inter vivos trust’ which only becomes irrevocable on the death of the first trustor; ‘irrevocable trust’ which cannot be changed at any time; ‘charitable remainder unitrust’ which provides for eventual guaranteed distribution of the corpus (assets) to charity, thus gaining a substantial tax benefit. There are also court decreed ‘constructive’ and ‘resulting’ trusts over property held by someone for its owner. A ‘testamentary trust’ can be created by a will to manage assets given to beneficiaries. If there is more than one trustee, the trust document specifies their role and whether they are required to act jointly or singly. In India, trusts are governed by the Indian Trusts Act, 1882. A trust is defined as ‘an obligation annexed to the ownership of property and arising out of a confidence reposed in and accepted by the owner or declared and accepted by him, for the benefit of another, or the owner’. The trustee is the person in whom the trust is reposed, the beneficiary is the person for whose benefit the trust is reposed and the author of the trust is the person who reposes the confidence. Foundations/Exempt Organisations In the year 1860, the Societies Registration Act was enacted. In order to describe the reasons for which the Act was being enacted, it was written as follows in the preamble to the Act: ‘Whereas it is expedient that provision should be made for improving the legal condition of societies established for the promotion of literature, science, or the fine arts or for the diffusion of useful knowledge, the diffusion of political, educational or for charitable purposes, it is enacted as follows: Any seven or more persons associated for any literary, scientific, or charitable purpose, or for any such purpose as is described in Section 20 of the Act, may, by subscribing their names to a memorandum of association, and filing the same with the registrar of Joint Stock Companies, form themselves into a society under the Act. The Memorandum of the Society Shall Contain: 164

The name of the society, the objects of the society, the names, addresses, and occupations of the governors, council, directors, committee or other governing body to whom, according to the rules o the society, the management of its affairs is entrusted. The property, moveable and immoveable, belonging to a society registered under this Act, if not vested in trustees, shall be deemed to be vested, for the time being, in the governing body of such society, and in all proceedings, civil and criminal, may be described as the property of the governing body of such society by their proper title. The following societies may be registered under this Act: Charitable Societies, the military orphan funds or societies established at the several presidencies of India, societies established for the promotion of science, literature and fine arts, for instruction, the diffusion of useful knowledge, the diffusion of political education, the foundation of or maintenance of libraries or reading rooms for general use among the members or open to the public, or public museums and galleries of paintings and other works of art, collections of natural history, mechanical and philosophical inventions, instruments or designs.’ Exempt Organizations The income of the following organisations/entities shall be exempt from tax: 1. Income of a local authority 2. Income of housing authority 3. Income of an approved scientific research association 4. Income of specified news agency 5. Income of sports association 6. Income of professional institutions 7. Income of armed forces fund 8. Income of fund established for welfare of employees and their dependants 9. Income of a fund set up by LIC under a pension scheme 10. Income of a society or trust existing for development of Khadi or village industries 11. Income of an authority known as Khadi and Village Industries Board. 12. Income of anybody or authority established under any act for administration of charity, endowment. 13. Income of European Economic Community 14. Income of SAARC fund 15. Income of IRDA 16. Income of certain funds of national importance 17. Income of educational institution not set up for the purpose of profit 18. Income of a hospital set up for philanthropic purposes and not for the purpose of profit 19. Income of notified mutual funds 20. Income of notified Exchange Risk Administration Fund 21. Income of Investor Protection Fund set up by recognised stock exchanges 22. Any income of the Credit Guarantee Fund Trust for small scale industries 23. Any income by way of dividends or long term capital gains of a venture capital fund or venture capital company 24. Income of an infrastructure capital fund or Infrastructure Capital Company 25. Income of trade union 26. Income of trustees of provident fund, gratuity fund, superannuation fund. 165

27. Income of employees’ state insurance fund 28. Income of corporation of government or anybody wholly financed by government or anybody wholly financed by government for promoting interest of scheduled caste or tribe or backward classes 29. Income of a corporation for promoting the interest of a minority community 30. Income of co-operative societies for scheduled castes or tribes 31. Income of any authority under the law for marketing of commodities 32. Income of certain boards/authorities 33. Income of newly established industrial undertakings in Free Trade Zones 34. Income of certain industrial undertakings in north-eastern region Professional Associations/Corporations Professional associations are formed to protect and preserve the common interests of the professionals they represent. Since the problems faced by them may be similar, the approach of solving them may also be similar in nature. Now, virtually every trade or profession has an association which represents the interests of its members. Examples are the Indian Medical Association, the Bar Council, the Financial Planning Standards Board, India. Most of the professional associations are registered under the Societies Registration Act, 1860. They may also be registered as public trusts depending on the law applicable in that state. The memorandum of the society will define the objects of the trust. Usually some registration and membership fee is prescribed for members. Section 25 of the Companies Act has a provision which allows the registration of limited companies without the word ‘Limited’ coming into the name. Some other associations like the Bar Council are formed under an Act of Parliament or legislature of the respective state. Rules are framed by each professional association, governing its members, election of members to the managing committee and other office bearers and how to carry out its objectives. For example, one of the objectives may be to resolve disputes between members (arbitration) without resorting to the courts of law. Another objective may be self-regulation of its members as regards ethical standards. Examples of such associations are that of chartered accountants, company secretaries, chartered engineers, chartered architects. The disciplinary action may extend to the extent of expulsion of members or debarring practice. Sources of revenues for the professional associations are registration fees and annual membership fees. They may also organise regular seminars and continuing education programmes for their members which are usually charged. Though the association may be working on a no-profit, no -loss basis, the accounts need to be maintained and audited. Usually, the associations present the accounts to the members at the general meetings organised annually. Corporations Generally, corporations refer to statutory corporations formed under an act of Parliament or State Legislature. Examples include State Bank of India, Industrial Development Bank of India and Unit Trust of India. They are governed by their respective acts and statutes and are responsible to parliament through their respective minis-tries. Any major change including change in ownership, change in shareholding pattern, pattern of funding, extent of government holding require the approval of the parliament. The government holds a majority share in these corporations and their accounts are subject to the audit of the 166

Controller and Auditor General of India (CAG). However, the government is now aiming for corporatisation of these entities so that they can be brought into the mainstream and compete freely in the market. In other words, the government is seeking to remove the special status accorded to these institutions. Other Forms of Organisation A trade association is another form of an organisation. A trade association is defined as ‘an association of individuals or companies in a specific business or industry organized to promote common interests’. In business, a particular sector or class of business may be influenced by similar forces, they may face similar situations and problems. In order to seek solutions to these problems they may come together as an industry or trade association. For example the most important industry associations in India are the Confederation of Indian Industries (CII), Federation of Indian Chambers of Commerce and Industry (FICCI) and Associated Chamber of Commerce & Industry (ASSOCHAM). While all the three above are national bodies, associations may also be organised on a regional basis. Further, certain trades or businesses may form separate organisations for their own trade. For example the Association of Mutual Funds of India (AMFI) is one such organisation. Like a professional association, a trade association may be organised as a society or a public trust or even a limited company. It may have its own constitution and governing committee/board. The accounts will also in all likelihood be subject to regular audit. The sources of income are membership and registration fees. 2.5 Concepts in Behavioral Finance According to conventional financial theory, the world and its participants are, for the most part, rational “wealth maximizers”. However, there are many instances where emotion and psychology influence our decisions, causing us to behave in unpredictable or irrational ways. Behavioral finance is a relatively new field that seeks to combine behavioral and cognitive psychological theory with conventional economics and finance to provide explanations for why people make irrational financial decisions. Why is behavioral finance necessary? When using the labels “conventional” or “modern” to describe finance, we are talking about the type of finance that is based on rational and logical theories, such as the capital asset pricing model (CAPM) and the efficient market hypothesis (EMH). These theories assume that people, for the most part, behave rationally and predictably. For a while, theoretical and empirical evidence suggested that CAPM, EMH and other rational financial theories 167

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did a respectable job of predicting and explaining certain events. However, as time went on, academics in both finance and economics started to find anomalies and behaviors that couldn’t be explained by theories available at the time. While these theories could explain certain “idealized” events, the real world proved to be a very messy place in which market participants often behaved very unpredictably. One of the most rudimentary assumptions that conventional economics and finance makes is that people are rational “wealth maximizers” who seek to increase their own well-being. According to conventional economics, emotions and other extraneous factors do not influence people when it comes to making economic choices. In most cases, however, this assumption doesn’t reflect how people behave in the real world. The fact is people frequently behave irrationally. Consider how many people purchase lottery tickets in the hope of hitting the big jackpot. From a purely logical standpoint, it does not make sense to buy a lottery ticket when the odds of winning are overwhelming against the ticket holder. Despite this, millions of people spend countless money on this activity. These anomalies prompted academics to look to cognitive psychology to account for the irrational and illogical behaviors that modern finance had failed to explain. Behavioral finance seeks to explain our actions, whereas modern finance seeks to explain the actions of the “economic man” Prospect Theory Traditionally, it is believed the net effect of the gains and losses involved with each choice are combined to present an overall evaluation of whether a choice is desirable. Academics tend to use “utility” to describe enjoyment and contend that we prefer instances that maximize our utility. However, research has found that we don’t actually process information in such a rational way. In 1979, Kahneman and Tversky presented an idea called prospect theory, which contends that people value gains and losses differently, and, as such, will base decisions on perceived gains rather than perceived losses. Thus, if a person were given two equal choices, one expressed in terms of possible gains and the other in possible losses, people would choose the former - even when they achieve the same economic end result. According to prospect theory, losses have more emotional impact than an equivalent amount of gains. For example, in a traditional way of thinking, the amount of utility gained from receiving Rs.50 should be equal to a situation in which you gained Rs.100 and then lost Rs.50. In both situations, the end result is a net gain of Rs50. However, despite the fact that you still end up with a Rs.50 gain in either case, most people view a single gain of .Rs50 more favorably than gaining Rs.100 and then losing Rs.50. Series of tests were conducted in which subjects answered questions that involved making judgments between two monetary decisions that involved prospective losses and gains. For example, the following questions were used in their study: 1.You have Rs.1,000 and you must pick one of the following choices: 169

Choice A: You have a 50% chance of gaining Rs.1,000, and a 50% chance of gaining Rs.0. Choice B: You have a 100% chance of gaining Rs.500. 2.You have Rs.2,000 and you must pick one of the following choices: Choice A: You have a 50% chance of losing Rs.1,000, and 50% of losing Rs.0. Choice B: You have a 100% chance of losing Rs.500. If the subjects had answered logically, they would pick either “A” or “B” in both situations. (People choosing “B” would be more risk averse than those choosing “A”). However, the results of this study showed that an overwhelming majority of people chose “B” for question 1 and “A” for question 2. The implication is that people are willing to settle for a reasonable level of gains (even if they have a reasonable chance of earning more), but are willing to engage in risk-seeking behaviors where they can limit their losses. In other words, losses are weighted more heavily than an equivalent amount of gains. Herd Behavior One of the most infamous financial events in recent memory would be the bursting of the internet bubble. However, this wasn’t the first time that events like this have happened in the markets. How could something so catastrophic be allowed to happen over and over again? The answer to this question can be found in what some people believe to be a hardwired human attribute: herd behavior, which is the tendency for individuals to mimic the actions (rational or irrational) of a larger group. Individually, however, most people would not necessarily make the same choice. There are a couple of reasons why herd behavior happens. The first is the social pressure of conformity. You probably know from experience that this can be a powerful force. This is because most people are very sociable and have a natural desire to be accepted by a group, rather than be branded as an outcast. Therefore, following the group is an ideal way of becoming a member. The second reason is the common rationale that it’s unlikely that such a large group could be wrong. After all, even if you are convinced that a particular idea or course or action is irrational or incorrect, you might still follow the herd, believing they know something that you don’t. This is especially prevalent in situations in which an individual has very little experience. Herd behavior was exhibited in the late 1990s as venture capitalists and private investors were frantically investing huge amounts of money into internet-related companies, even though most of these dotcoms did not (at the time) have financially sound business models. The driving force that seemed to compel these investors to sink their money into such an uncertain venture was the reassurance they got from seeing so many others do the same thing. A strong herd mentality can even affect financial professionals. The ultimate goal of a money manager is to follow an investment strategy to maximize a client’s invested wealth. For example, if a herd investor hears that internet stocks are the best investments right now, he will free up his investment capital and then dump it on internet stocks. If biotech stocks are all the rage six months later, he’ll probably move his money again, perhaps before he has even experienced significant appreciation in his internet investments. 170

Keep in mind that all this frequent buying and selling incurs a substantial amount of transaction costs, which can eat away at available profits. Furthermore, it’s extremely difficult to time trades correctly to ensure that you are entering your position right when the trend is starting. By the time a herd investor knows about the newest trend, most other investors have already taken advantage of this news, and the strategy’s wealth- maximizing potential has probably already peaked. This means that many herd-following investors will probably be entering into the game too late and are likely to lose money as those at the front of the pack move on to other strategies. While it’s tempting to follow the newest investment trends, an investor is generally better off steering clear of the herd. Just because everyone is jumping on a certain investment “bandwagon” doesn’t necessarily mean the strategy is correct. Therefore, the soundest advice is to always do your homework before following any trend. Just remember that particular investments favored by the herd can easily become overvalued because the investment’s high values are usually based on optimism and not on the underlying fundamentals. Anchoring and Contrarian Investing Rational analysis is essential to making smart investment decisions. Unfortunately, our first reaction to a complicated situation, usually instinctive, often does not serve our best interests. The field of behavioral finance studies how and why we make economic decisions. Researchers have identified dozens of mental shortcuts. One heuristic that the brain uses to solve complex evaluations is to make an initial guess and then adjust from that point as we receive additional information to find a better answer. This mental process is called “anchoring.” Anchoring is one of the root psychological flaws that pushes otherwise brilliant people to make financial mistakes. It’s critical to admit this heuristic is hardwired in your brain or you will continue to succumb to it. To avoid making serious financial mistakes, you must become a vigilant contrarian. In the mental process of anchoring, we begin with some tentative solution to our problem and then we seek a better or more accurate solution. For example, we walk onto a car lot and note the sticker price, and we use that number as our starting point for negotiations. We know we can buy the car for that amount, and we start the process of seeking to get a better price. Studies have shown that the higher the first price we are given, the higher will be the final price we end up paying for the exact same item. Stores sometimes bump their prices 30% higher before a 30% off sale because they understand this principle. We use mental anchoring more when we are unfamiliar with what the right answer is supposed to be. Conversely, the antidote to anchoring is to have done your homework and be able to evaluate the anchors you are given. Doing your research online before setting foot on the car lot helps you step into the process with the ability to analyze the reasonableness of that sticker price. Although nearly all of us seem to say we are long-term investors, our tendency is to be swayed emotionally by the most recent short-term movements in the markets. We want to invest more in sectors that have 171

recently been doing well, and we want to avoid, eliminate or reduce sectors that have recently dropped in value. One study found that because of moving in and out of mutual funds at exactly the wrong moments, investors in mutual funds experience returns that underperform the very funds they were invested in, by 2.2 percentage points annually. Investors tend to fixate on relative past performance. If their portfolios have gone straight from 100,000 to 120,000 over the past year, they are happy. If their portfolios rose to 150,000 before dropping back to 120,000, however, they are upset and depressed. People anchor to the high-water mark of their portfolios and are only satisfied when they hit an all-time high. Avoiding the mistakes that stem from anchoring requires adopting an investment philosophy that does not depend on historical prices and past performance. Adopt an investment philosophy that dampens rather than amplifies trends. If your philosophy is to panic and sell at corrections and then wait to get back into the markets after they are appreciating again, your emotions amplify any losses. Learn to be a contrarian and rebalance your portfolio regularly. Set buy and sell targets. Monitor an objective stock evaluation. Pretend you don’t already own it and you have to buy it at the current price. Make half a mistake, sell some and take some profit off the table. One of the first principles of investing is humility. Knowing that your first instinct is probably wrong, doing nothing is often better than doing something quickly. Hence minimizing trading, being patient and investing in the markets going up is an excellent way to tune out the noise of short-term movements. Second, if your instincts are often wrong and the markets are inherently volatile, plan on some of your investments losing money. Therefore avoid leverage or options that could amplify a mistake to a loss that might jeopardize your financial goals. Finally, practice setting an asset allocation that provides diversification. Regular rebalancing to a target allocation gives you the best chance of meeting your goals and an objective standard to practice contrarian investing by selling what has gone up and buying what has gone down. Contrarian Investment Strategies: Investing does not have to be hard. You will achieve better results by thinking outside the box and applying alternative ideas and concepts to investing. Investing requires hard work. It takes time, consistency, and patience. The way to make money is to lead the crowd. All that is required is an open mind and some common sense. Contrarian investing is an investing approach that often runs counter to conventional wisdom. To do well you must adopt a strategy that is different from that of the mainstream. You cannot just get into the market, do what everyone else is doing and expect to make a lot of money. To do better than average you must do something different than that of the average investor. 172

Legendary investor and contrarian Warren Buffett says “Most people get interested in stocks when everyone else is. The time to get interested is when no one else is. You can’t buy what is popular and do well.” Many of the most successful investors on Wall Street such as Warren Buffett, Marc Faber, Jim Rogers, and John Templeton are contrarian investors. Contrarians look for crowd behavior among investors that lead to exploitable mispricing of equities. Crowd behavior in the market leads to mispricing of equities both on the upside and the down side. Widespread pessimism can lead the market to understate a company’s real value and widespread optimism results in excessive prices and bubbles. The contrarian investing approach seek to take advantage of mispriced assets caused by the over optimism and over pessimism. We humans are prone to stumble into metal pitfalls and according to legendary Ben Graham, the father of value investing; we are our own worst enemy in investing. It is easy to find an investment that looks attractive at first glance. Once we have an investment we like it is not difficult to find conforming evidence to our initial judgment. Our mind is programmed to look for evidence supporting our original hypothesis. We have a behavioral deficit and a self-serving tendency of turning any information into supporting facts. Here are a few common examples… We are far more likely to seek out information that confirms our views. We choose what we read and what we watch on television. We also choose our friends and we are more likely to get along with people that share our views. Most people are not confrontational by nature and it makes us more comfortable to be around people that agree with us. And even if our friend does not agree with us they may just go along with our conclusion rather than to be confrontational. So to find unbiased views we must talk to people with different opinions. Warren Buffett appropriately said “Never ask a barber if you need a haircut”. We are subject to many behavioral pitfalls and it is easy to get caught up in counterproductive behavior. When we are asked in the cold light of day how we will behave in the future, we turn out to be bad at imagining how we will actually act in the heat of the moment. To reduce the risk of falling prey to our emotional behavior we can prepare by pre-commit to a strategy. That means that we need to do our investment research when we are in a rational state of mind when there is little happening in the market. By pre -committing to a strategy we are less likely to fall prey to our own emotional behavior and we are more likely to follow through on our plan when the market is irrational. It may be difficult to keep a clear head during a physiologically challenging event like a sharp market selloff but that is why we commit to our plan of action beforehand. Warren Buffett provides a good example of his strategy “We simply attempt to be fearful when others are greedy and to be greedy only when others are fearful.” By strictly following our plan we can remove a lot of the emotions and invest with a cold and rational mind. Using this strategy we can decide at what price to buy and sell beforehand and avoid suffering from mental pitfalls such as loss aversion and over optimism. Mental Accounting: Mental accounting is the set of cognitive operations used by the investors to organize, evaluate and keep track of investment activities. Three components of mental accounting receive the most attention. This first captures how outcomes are perceived and experienced, and how decisions are made and 173

subsequently evaluated. A second component of mental accounting involves the assignment of activities to specific accounts. Both the sources and uses of funds are labeled in real as well as in mental accounting systems. Gamblers Fallacy: It arises when the investors inappropriately predict that tend will reverse. It May result in anticipation of good or poor end. CLASSIFICATION OF COGNITIVE ILLUSION COGNITIVE ILLUSIONS HEURISTICS PROSPECTTHEORY Repersentativeness Loss Aversion Regret Aversion Over Confidence Anchoring Mental Accounting Self-Control Gamblers Fallacy Availability Bias Conclusions Though the above examples of illusions are widely observed, behavioral finance dose not claim that all the investors will suffer from the same illusion simultaneously. The susceptibility of an investor to a particular illusion is likely to be a function of several variables. For example, there is suggestive evidence that the experience of the investor has an explanatory role in his regard with less experienced investors being prone to extrapolation (representativeness) while more experienced investors commit gambler fallacy 14 . Similarly, behavioural factors play a vital role in the decision making process of the investors. Hence the investors has to take necessary steps to minimize or avoid illusions for influencing in their decision making process, investment decisions in particular. 2.6 Behavioral Finance - Investor Psychology Smart and successful way of investing calls for a thorough understanding of behavioral finance not just market sentiments, crowd behavior or company performance. 174

Evidence reveals repeated patterns of irrationality, inconsistency and incompetence in the ways human beings arrive at decisions and choices when faced with uncertainty. Behavioral finance attempts to explain how and why emotions and cognitive errors influence investors and create stock market anomalies such as bubbles and crashes. Why is Behavior Finance important? “Investing is not a game where the guy with the 160 IQ beats the guy with the 130 IQ….Once you have ordinary intelligence, what you need is the temperament to control the urges that get other people into trouble in investing.” –Warren Buffett Common Mental Mistakes (Errors) 1. Overconfidence 2. Projecting the immediate past into the distant future 3. Herd Like behavior (Social proof), driven by a desire to be part of the crowd or an assumption tha the crowd is omniscient 4. Misunderstanding randomness, seeing patterns that does not exist 5. Commitment and consistency bias 6. Fear of changes, resulting in a strong bias for the status quo 7. “Anchoring “ on irrelevant data 8. Excessive aversion to loss 9. Using mental accounting to treat some money (such as climbing, winning or unexpected bonus) differently than other money 10. Allowing emotional connections to over-ride reason 11. Fear of uncertainty 12. Embracing certainty (however irrelevant) 13. Overestimating the likelihood of certain events based on every memorable data or experience (vividness bias) 14. Becoming paralyzed by information overload 15. Failing to act due to an evidence of attractive options 16. Fear of making an incorrect decision and feeling stupid (regret aversion) 17. Ignoring important data points and focusing exclusively on less important ones, drawing conclusions from a limited sample size 18. Reluctance to admit mistakes 19. After finding out whether or not an event occurred, overestimating the degree to which one would have predicted to correct outcome (hindsight bias) 20. Believing that once investment success is due to wisdom rather than rising market, but failures are not one’s fault 21. Failing to accurately assess one’s investment time horizon 22. A tendency to seek only information that confirms one’s options or decisions 23. Failing to organize the large cumulative impact of small amount over time 24. Forgetting the powerful tendency of regression to the mean 25. Confusing familiarity with knowledge 175

Skewness of Asset Allocation Due to Cultural Bias Behavioral finance can help people make better asset allocation and savings decisions, but it has had less impact in the actual management of investment portfolios. This is because its lessons have not been fully learned. Investors seem to prefer stocks with a low probability of a very high return. But stocks with high volatility and high return Skewness show low future returns. To improve stock selection, behavioral tools should be used. Various articles claim that behaviorally managed portfolios have not achieved higher returns than those managed in traditional styles, such as growth and value. But lack of success is mostly due to the incorrect application of behavioral finance to the management of portfolios and that behavioral tools can help investors meet and exceed investment objectives. Among the more puzzling phenomena in finance is the apparent negative empirical relationship between standard measures of risk and reward in equities. Established financial theory dictates that investors expect to be compensated for taking risk, yet the negative relationship between volatility and future stock returns is well documented (Fama and French, 1992, and Frazzini and Pedersen, 2010), standing as an empirical critique of the Capital Asset Pricing Model (CAPM). Recent market volatility and the growing interest in minimum volatility strategies have increased scrutiny on this puzzling phenomenon. Research by Barberis and Huang (1999) proposes a behavioral rationale for the apparent volatility anomaly. Based on Kahneman and Tversky’s cumulative prospect theory, they postulate that investors have an explicit preference for stocks with lottery-like payoffs, or a low probability of a very high return. Stocks with a history of infrequent extreme positive returns without a commensurate frequency of similarly strong below-average returns are said to demonstrate positive “Skewness.” A behavioral preference for stocks with lottery-like payoffs leads positively skewed stocks to be “overpriced” under the mean-variance assumptions of CAPM, leading to subsequent negative average excess returns. Recent research has demonstrated that the volatility anomaly may be explained by the negative relationship between Skewness and future returns. Investors with a behavioral bias for stocks with lottery-like payoffs appear willing to pay a premium for stocks with high Skewness. For portfolios where Skewness is low, expected returns increase with higher levels of risk consistent with CAPM. This relationship is reversed for high levels of Skewness where the assumption of normally distributed returns does not hold. On average, Skewness increases with higher levels of volatility. As a result, stocks with both high levels of volatility and high historical return Skewness exhibit extremely low future returns. Basic Investment Style and its Drawback Stock selection can be improved by the use of behavioral tools. Empirical academic research has highlighted two types of pervasive investor behavior which impact share prices, causing them to diverge from those predicted by the Efficient Markets Hypothesis (EMH); under reaction of stock prices to news and overreaction or anchoring to a stream of good or bad news. 176

As an example, consider a company that has just reported a positive earnings surprise due to some fundamental improvement in its business. If EMH held, then the stock price should immediately change to the new equilibrium price where all the new information would be reflected. However, in practice, analysts and investors will take a series of steps to fully reflect the new available information and, therefore, an investor who buys on the announcement of the news can generate a positive excess return. When a company’s fortunes change from negative to positive and vice versa, investors tend to overreact and anchor on the past. As a result, it takes time for the change to be reflected in the share price. Similar to underreaction, an investor can generate excess returns by focusing on those companies where investors anchor. Once again, timely sales could enhance portfolio returns. Other potential behaviors include risk aversion, the tendency to sell young winners well before they have contributed their full alpha to the portfolio; avoidance of pain, a manager’s tendency to sell stocks as they are experiencing a substantial drop in price; and loss aversion, the reluctance to sell losers in hope of their possible recovery. Behavioral finance has been shown to positively impact investors’ financial decision-making. By applying the behavioral toolbox to strategy, design, stock selection and portfolio evaluation, we can use these same tools to better meet and exceed our clients’ expectations. 2.7 Economic Environment Analysis Economic Research Clearly, changes in the economic environment will have an impact on the plans you prepare for clients, as well as the plans already in place and subject to review. Monitoring the economic environment is predicted upon a fundamental understanding of the workings of the Indian economy, and so, much of this section is dedicated to giving you that background. The study of economics takes in two levels of interest: Micro economics refers to the study of economics at a personal level or at consumer choice level. It refers to the laws of supply and demand and how prices affect demand by the consumer and the production of goods and services by a supplier. These issues are the ones that affect the client from day to day. In financial planning terms this could mean aspects like the price of a share holding in their portfolio, or the term deposit rate currently available from banking institutions. Macro economics is the study of economics where all of the individual laws of supply and demand are effectively ‘grouped’ and examined in the context of our place in the world at large. The performance of the Indian economy as a whole is thus a macro economic issue. Indicators of economic health include the rates of economic growth (as measured by GDP), inflation, interest rates, exchange rates, and the level of unemployment. These matters are often known to clients, but many do not see them as having a direct impact on their lives. Most clients will want their financial planner to have a reasonable working knowledge of the forces at work in the Indian economy, and whilst they will not expect you to influence those forces, they will expect you to understand and explain them. 177

India’s Economy The Indian economy is what is termed a mixed economy — that is, one in which economic decisions and inputs are shared between the private sector and the public sector. In comparison, a capitalist economy is one in which the economic decisions and inputs are made by the free-trading market while a socialist economy is one in which the decisions and inputs are made by the government through economic planning. India produces sizeable export surpluses in tea, oil meal, marine products, coffee and rice. Of these, India is the world ’s top producer of tea and also records its highest consumption. India is also recognised as one of the top producers of coal and mica. However, the country has to import a large part of its petrol consumption. Among manufactured goods, India exports engineering goods, leather and leather manufactures, textiles, gems and jewellery, handicrafts and carpets. Most of these are traditional products and are produced in the small-scale sector, village and gramudyog industries. It is widely regarded that these commodities form the backbone of the Indian export economy. Destination wise, India exports to the Asian countries, Organisation of Petroleum Exporting Countries (OPEC) countries, Western Europe, Eastern Europe and North America. Of these, exports to USA and Western Europe are the highest. The agriculture and manufacturing sectors in India, have declined in importance as contributors to the GDP. Services or the tertiary sector account for a major 54% of GDP composition. Despite the lower share of manufacturing in GDP, in recent years, manufactured exports have been increasing, outstripping the rate of growth of agriculture exports. In the services sector, the two most notable developments in recent years have been growth in the information technology and finance industries, the latter growth largely due to extensive deregulation of the Indian financial system. The role of the services sector in the economy has steadily increased in terms of output and employment over the last fifty years. It is also the fastest growing sector in the economy. Figure illustrates this. Note: Services sector comprises trade, transport, communication, banking, insurance, real estate, public administration and other services. Gross Domestic Product GDP at factor cost at constant (1993 -94) prices in the year 2004-05 is now estimated at Rs.15,29,408 crore (as against Rs. 15,29,366 crore estimated earlier), showing a growth rate of 6.9 per cent over the Quick Estimates of GDP for the year 2003-04 of 14,30,548 crore, released on 31st January 2005. 178

The sectors which showed growth rates of 5 per cent or more, are ‘manufacturing’ (9.2 per cent as compared to 6.9 per cent earlier), ‘electricity, gas and water supply’ (5.5 per cent as compared to 3.7 per cent earlier), ‘construction’ (5.2 per cent as compared to 7.0 per cent earlier), ‘trade, hotels, transport and communication’ (11.4 per cent as compared to 11.8 per cent earlier), ‘financing, insurance, real estate and business services’ (7.1 per cent as compared to 7.1 per cent earlier), and ‘community, social and personal services’ (5.9 per cent as compared to 5.8 per cent earlier). National Income The net national product (NNP) at factor cost, also known as national income, at 1993-94 prices is now estimated at Rs. 13,54,599 crore (as compared to Rs. 13,54,385 crore estimated earlier), during 2004-05, as against the previous year’s Quick Estimate of Rs. 12,66,005 crore. In terms of growth rates, the national income is estimated to rise by 7.0 per cent during 2004-05 in comparison to the growth rate of 9.0 per cent in 2003-04. Per Capita Income The per capita income in real terms (at 1993-94 prices) during 2004-05 is estimated to attain a level of Rs. 12416 (as against Rs. 12,414 estimated earlier), as compared to the Quick Estimates for the year 2003-04 of Rs. 11799. The growth rate in per capita income is estimated at 5.2 per cent during 2004-05, as against the previous year’s estimate of 7.1 per cent. Largely through deregulation, tariff reduction and the partial floating of the Indian rupee, the Indian economy has become increasingly integrated with overseas economies. Our markets are increasingly exposed to world-wide trends. This has created both threats and opportunities for Indian firms. With all the above in mind, the financial planner needs to be aware of the push and pull influences impacting on the various market sectors. Aspects like companies moving off- shore to take advantage of cheap labour and/or other reduced costs need to be considered. These influences make investment choice a dynamic part of the financial planning process. Attention and research into the shifts and balances in the economy are an integral part of the financial planner ’s work. Growth in the Indian Economy Economic growth takes place when there is an expansion in the production of output of goods and services to meet consumption demands. Officially, India ’s economic growth is measured by estimating changes in the GDP at constant prices over a year. The GDP is a measure of the total value of final goods and services produced in the domestic economy each year (‘final’ meaning not used as inputs in the production of other goods and services).The following relationship or model is often used: GDP =C + I + G + (X – M) Where C = Personal consumption spending on goods and services I = Private sector fixed capital expenditure. G = Government expenditure X = Export receipts M= Import expenditure The relationship highlights expenditure, that is the actual rupee expenditure for goods and services produced in the economy, as one means of measuring GDP. Note also that the GDP relationship incorporates 179

the three key players in the economy — consumers/households, business (the private sector), and government. You can also see from the above model that high imports can result in a lower GDP figure. For living standards to rise in India, GDP must grow at a faster rate than the population. This way, there is greater quantity of goods and services per person. Furthermore, if unemployment is high, the pursuit of higher levels of economic growth will normally mean that the higher levels of production involved will require the taking up of more labour, thereby reducing unemployment. In essence, GDP becomes a measure of India’s economic health. If GDP is too low, it can mean unused resources in the Indian economy such as increased unemployment (unused labour resource). High unemployment can see consumer spending slow down, not only by virtue of those unemployed having less to spend, but by concerns of job security for those in the workforce. If GDP is too high, demand exceeds the production capabilities of India and we need to import goods from over-seas. Our indebtedness to the rest of the world increases, effectively lowering the value of our economy. This results in a lower Indian rupee which fuels inflation (i.e., increases in average prices) as those overseas goods cost more. These variations in the health of the economy can translate into reduced or increased profits for business. These issues interrelate to affect the returns your clients will see in their investments. Given the importance of GDP as a barometer of economic health and robustness, GDP projections are a consideration in formulating recommendations. The Business Cycle For many years there has been a strong tendency for capitalist or free enterprise economies to experience periods of increased production and sales, higher employment and possibly price rises. Such boom periods were invariably followed by a downturn in the levels of production, employment and, to a lesser extent, prices. These recurrent periods of economic growth and recession have become known as business cycles, because they represent a pattern of business expansion and contraction over a number of years. Although there is no clearly determined length of a business cycle, length has typically fluctuated around four years from one boom period to the next. There are some notable exceptions, however. For example, before its economy turned down in the fourth quarter of 1990 (and notwithstanding the share market crash in October 1987), the United States of America had completed eight successive years of steady economic growth, the longest peacetime recovery period. With increasing globalisation and liberalisation and as India integrates with the world economy, the business cycle becomes important in India too. Stages of the Business Cycle It is widely accepted that the business cycle consists of four distinct phases: 1. recovery (expansion or upswing); 2. boom (or peak); 180

3. contraction (or downswing); and 4. recession (trough or depression). Each stage, or phase, of the business cycle is characterised by a particular combination of economic variables, among them GDP, prices of goods and services and the unemployment rate. Recovery is marked by the following economic characteristics:  Increasing investment spending;  Increasing consumer spending;  Increasing price levels;  Increasing company profits;  Increasing money wages;  Rising employment; and  Increasing national income. Boom is marked by:  Economic indicators reaching a maximum level before declining;  High level of employment;  Faltering of business optimism;  Slackening in the rate of investment activity;  Higher costs for business firms; and  The occurrence or indication of unfavourable trends in international trade. While a boom may coincide with a period of inflation, it is possible for a peak in economic activity to occur without inflation being experienced. Contraction is marked by:  A decline in the level of national income;  A decrease in aggregate spending;  A decrease in company profits;  Decreasing price levels; and  Decreasing wages levels. Recession is marked by:  Low levels of private or public investment;  Reduced output levels in secondary industry, although outputs in primary industry may increase.  Existence of excess capacity in the majority of industries;  A high level of liquidity preference;  The lack of investment opportunities because profit expectations are low or non-existent;  Low level of foreign investments due to low confidence in the economy; and  A high level of unemployment 181

Figure Implications for Financial Planning The behaviour of an individual company during the successive stages of a business cycle is expected to influence investors’ perceptions of its profit performance and hence of its dividend policy and, in turn, its share price. The share market cycle is clearly heavily influenced by the general business climate. When business is booming and company profits are up, share prices tend to increase, as do their returns. Conversely, when the business cycle is in a contraction stage, company profits are squeezed and shares tend to reduce in value and returns decline. However, share markets do not necessarily move in concert with the business cycle. Share market prices and hence cycles are regarded by many economists as one (but not the only, or even the major) leading indicator of the business or economic cycle. (These indicators are considered later in this topic.) The business cycle should have an important influence on the timing of investments, that is when investments are made (in the trough), how long they are held (during the upswing), and when they are liquidated (at the peak). This is often called timing the market; however note our warnings about this strategy. It is very difficult, rather impossible to time the market. Interest rates tend to be high at the peak of the business cycle. This is an appropriate time to invest in fixed interest securities such as bonds, which will provide an above-average return as interest rates fall in the downswing of the cycle. However, high interest rates lower bond prices, and so the peak is an inappropriate time to consider selling bonds in a client’s portfolio. In essence, the business cycle is reflected in several economic indicators that you must be aware of when advising or developing plans for your clients (see later below). Inflation Inflation is essentially a situation of rising prices. The most popular measure of inflation in India is the change in the wholesale price index (WPI) over a period of time. The WPI is essentially an index measure of the wholesale prices of a selected ‘basket’ of goods and services in the economy. The actual regimen (or 182

composition) of the basket of goods in the WPI is varied periodically to reflect changing consumer preferences. The WPI is expressed as a percentage with reference to some base year, according to a formula: WPI = (WPI of end of year – WPI of beginning of year)/WPI of beginning of year x 100 For example, WPI on Jan 1st 2018 is 106.09 and WPI of Jan 1st 2019 is 109.72 then inflation rate for the year 1981 is, (109.72 – 106.09)/106.09 x 100 = 3.42% and we say the inflation rate for the year 1981 is 3.42%. The rate of inflation is the difference in the price index between two years expressed as a percentage of the first year. An alternative measure of inflation is the consumer price index (CPI). As the name suggests, this is concerned with the consumer market for goods. In general, there is considerable co-movement between the WPI and CPI in India with the CPI tending to follow the WPI with a lag. In India, inflation is more of a cost-push phenomenon, i.e., it is affected by increases/decreases in administered prices like petroleum products, interest rates and so on, as opposed to demand pull inflation which results from increases in money supply, i.e., more money chasing a limited production of goods. Current and expected rates of inflation are of enormous relevance. For example: Long term interest rates are normally related to expected rates of inflation over the term of the investment. According to one theory, the long term interest rate is roughly equal to the real rate of interest plus the expected average inflation rate. Long term interest rates, in turn, represent a benchmark against which returns from higher risk investments may be compared. In the financial planning process, it is desirable to compose a mix of investments which will result in the purchasing power of the invested capital being at least maintained. In other words, investments should be sought which will preferably provide both income and capital growth. The income should be adequate for the investor ’s needs and the rate of capital growth should at least equal the rate of inflation. In practice, this is not always achieved because the investor may only have a limited amount of investment money available (thereby restricting the income component) and each investor’s needs may vary, which require some compromises to be made to the income/capital growth ratio. A benchmark of 3% to 4% can be selected as a long term rate of inflation for cash flow projections from investment portfolios. The maintenance of stable economic conditions in India has proven to be a challenging task over the years, because of excessive inflation, high interest rates and external current account pressures. Policy action by government to address these pressures has frequently contributed to a short term economic downturn and, inevitably, constrained the sustainable pace of economic growth. The resultant sudden changes in the economic outlook affect the confidence of businesses and consumers. In addition, uncertainty about inflation prospects can lead to higher real interest rates, discouraging investment and distorting investment patterns. However, in recent years, the problem of inflation has been addressed. Inflation has remained low into the new millennium over the last few years. 183

Deflation A sustained downward trend in prices is termed deflation. It is just the opposite of inflation. At first glance, deflation appears to be a favourable phenomenon. A rupee earned during deflation would buy more goods and services. However, the negative aspects are far reaching. In an environment where declining prices are more common than price hikes, corporate profits suffer. A deflationary world is one of single-digit earnings growth and meager stock market returns. Debt assumes gigantic proportions and both, individuals as well as corporates find it difficult to service it. Corporates would pressure governments to block competition from more efficient producers in other countries. The most common example of deflation is in the US after the stock market crash of 1929. The crash forced a sharp contraction in the nation’s money supply, and with one blow its credit worthiness collapsed. The depression was characterised by relentlessly falling prices for everything, and which we today describe as deflation. New investment is discouraged, spending is completely put off, and saving becomes an appreciated habit. Once this arrives, monetary policy is useless to extricate the economy. The Japanese are facing a similar phenomenon. There has not been deflation on a broad scale in the USA since the Great Depression of the 1930s. The causes of deflation are two-fold. One is cyclical and occurs normally when an economy enters a weak phase. Companies are forced to eliminate jobs and, in turn, the demand for goods and services falls. Consumer prices then fall because of the lower demand. Pockets of this kind of deflation are to be found in all developed economies, but there are usually sufficient inflationary pressures — such as rising commodity prices — so that the problem does not last. Asher says in Japan, deflation has become more serious because of what he calls ‘structural problems’. For years, he says, prices in Japan have been too high — among the highest in the world. But as Japanese companies have increasingly farmed out labor to low-wage Asian countries, production prices — and the prices of finished goods — have dropped. The lower prices are initially good for consumers, but ultimately the reduced prices translate into lower corporate profit margins, and the downward spiral begins. Economic Indicators A wide range of regularly published economic statistics exists which provides indications of the state of various segments of the economy or of its overall well- being. These statistics are known as economic indicators, and they are particularly useful for monitoring business cycles and the other macro economic variables we have discussed so far in this topic. You will recall in Topic 4 that we referred to two such indicators in our discussion of the share market — the BSE Sensex and the NSE Nifty. Where economic indicators point to the current state of the economy, they are known as coincident indicators. However, not all published economic indicators refer to the current state of the economy. Some may be more indicative of events long past, that is, of events which preceded the indicator. These are known as lagging indicators. 184

Again, other indicators have been found to consistently precede economic activity by a period of several months. These are known as leading economic indicators and are arguably the most valuable. Examples in the Indian context include the DSE-ECRI Indian Leading Index, designed to anticipate recessions and recoveries. The Indian Coincident Index, on the other hand, moves in tandem with the economy. For more information on these indices, you can e-mail [email protected]. The trends in these economic indicators regularly appear in The Economic Times. Examples of Leading, Lagging and Coincident Indicators Leading Indicators 1. Inventory levels in the economy 2. Order book position for the manufacturing sector specially sales of commercial vehicles 3. Money supply 4. Share price movement 5. Interest rate spreads Lagging Indicators 1. Commercial and industrial loans outstanding i.e. non-food credit 2. Changes in the consumer price index Coincident Indicators 1. Index of industrial production Indicators are usually published as a number and any movement in that number represents a proportional change in the indicator involved. Government Economic Policy The background work undertaken by a financial planner must take into account the stance taken by the central government both in its present legislative programme as well as in the overall thrust of its policy. To be constantly aware of this stance forms an integral part of the general awareness necessary to carry out your role effectively. The role of government in a mixed economy such as India’s is constantly changing. It is often adhoc and uncoordinated, stemming as much from political issues as from economic fundamentals. Sometimes your clients will seek explanations of the effects of proposed or new government economic policies on their own situation, and you need to be sure you know these effects at a personal or micro level. The well-researched planner is in the best position to address these issues. Often, the government will provide ‘real world’ examples through various publications to help you understand the impacts of government policy on families and individuals. The Internet is a great resource for information of this type. You should look at the following sites for information on economic policy: http://www.finmin.nic.in However, the government generally endeavours to manage the economy to provide a setting conducive for positive economic growth, low unemployment and low inflation. Externally, the government must manage the affairs of the nation to enhance India’s trading position as evidenced by our exchange rate with the rest of the world’s currencies. 185

Often,’ it is the arms ’ of government that are independent of political influence which are responsible for the management of various aspects of the economy. For example, the Reserve Bank of India (RBI) has as one of its major objectives the control of inflation within a defined target range, which it pursues by regulating the official interest rate. Such activities have a direct effect on investors. To achieve its overall economic objectives, the government has at its disposal two main policy ‘levers’: Monetary policy, which controls, through regulation of interest rates, the money supply (and hence inflation) in the domestic economy; and Fiscal policy, which controls the level of government spending (e.g. through the budget) and revenue raising through taxation. Let’s now look at these two aspects of government policy and how they can influence financial planning decision making. Monetary Policy and Interest Rates Government policy concerning the money supply and the control of inflation is termed monetary policy, and is implemented through the RBI, which acts independently. Like fiscal policy, monetary policy aims to stabilise the economy, but through regulation of the money supply. Basically, monetary policy acts upon interest rates and these in turn affect the level of investment undertaken in the economy. The purchase of capital equipment such as machinery and buildings will often be financed by borrowed funds, and hence an increase in the level of interest to be paid will discourage the purchase of capital equipment and investment spending. In addition, a rise in interest rates may influence the level of investment spending by altering the relative attractiveness of capital equipment purchases and other financial investments such as debentures and bonds. Conversely, a fall in the level of interest will encourage investment spending and economic activity. Interest rates can also directly affect consumer confidence in the economy, and thus the level of demand for goods and services. Low rates encourage personal consumption as people feel confident in being able to service any credit debt. Conversely, high rates discourage borrowing. Monetary policy can be implemented reasonably quickly. The RBI reviews regularly the official (base) interest rate, and can effect immediate change. Any change in the official interest rate quickly flows through to the retail rates for lenders and borrowers. Interest rates are clearly of major significance to the planner, as they impact on the projections they make for interest-bearing investments and other investment decisions. In comparison with fiscal policy, changes in monetary policy can be implemented reasonably quickly. Monetary policy is thus a more subtle and politically acceptable method of influencing the economy. Factors which Affect Interest Rates The simplest explanation for movements in interest rates derives from the concept that money is a commodity, and the price of the commodity (money) is the rate of interest. As in other commodity markets, 186

the price of money in the money market responds to supply and demand factors. (Lenders supply cash and demand interest-bearing securities while borrowers demand cash and supply securities.) Balance is obtained at the interest rate that equates the supply of money with the demand for money. If there are many borrowers in the market competing for a limited supply of cash, then, other things being equal, interest rates will move up, in the same way that the price of wool will move up if there are more buyers than sellers in the market. If, on the other hand, there are investors wanting to lend but few borrowers in the market, then interest rates will drop. While supply and demand influences are basic to movements in the price of money, a range of factors also affect the level of interest rates. Quite often, short- term interest rates (for terms to maturity of six months or less) are influenced by different factors from those which determine the pattern of long term rates (for terms of up to ten years or longer). Long-Term Interest Rates In general, long term interest rates are influenced by inflationary expectations as well as the underlying real rate of interest required. For example (and simplistically), if investors were to seek a 6% real rate of return over the life of the investment, and inflation over the period was predicted to be 5%, then a rate approaching 11% would be sought. In normal times, it can be expected that the longer the term to maturity of the security, the higher will be the interest rate. This is because greater risk is associated with long- term than with short term investments (the major risk being inflation), and the investor requires a greater reward or risk premium to compensate for tying money up over a longer period. An additional explanation is that long term rates can be regarded as the weighted average of expected future short-term rates over the duration of the investment, and if rates are expected to rise over the long term, this will be reflected in the coupon rate of the security. Interest rates are also affected by the characteristics of the borrower. For example, the rate on sound debentures to businesses may be about 9%, indicating modest risk, while the rate of unsecured loans to individuals would be around 16%, reflecting greater risk. Short-Term Rates Short- term interest rates, on the other hand, are influenced by a list of short term macro economic influences. In the Indian context, the key official bank rate is set by the RBI. The bank rate is the rate at which banks can borrow from the RBI. Short term interest rate, like the bank deposit rates are influenced by the bank rate along with the cash reserve ratio (CRR) and the statutory liquidity ratio (SLR). The CRR is the cash reserve which banks are required to keep with the RBI while the SLR is the proportion of funds to be kept in government securities by banks. The CRR is currently 5% while the SLR is 24%. The RBI has a broad set of objectives that includes the stability of the currency and the promotion of employment, as well as the economic well- being of the people. It will therefore act for a variety of reasons while setting rates in the economy. Understandably, controlling the economy through monetary policy is no precise science and the RBI may be accused of making the wrong call on interest rates in hindsight. Sometimes, solving one problem creates another. For example, it may take measures to stimulate economic growth by lowering interest rates to encourage spending and investment in building and equipment. This increased demand could spill over to 187

increased imports, thereby seeing more imports than exports. This can lower demand for the Indian rupee, thereby lowering our exchange rate and driving up the price of imported goods, hence fuelling inflation. Part of the problem lies in the ambiguity of much economic data that the RBI must rely on, and hence the uncertainty of just where the economy is in the economic cycle. Furthermore, the RBI must judge whether its past decisions on interest rates have had the intended effects. From this, predicting just what the RBI will do, and hence forecasting with some confidence interest rates, is problematic. Money market analysts utilise a number of predictive theories or models. Suffice it to say, no one model has proven superior in its predictive capacity, and we will just have to live with the market dynamics. The importance of long term and short- term interest rates varies with the nature of the financial planning activity. In general, however, the financial planning task is better accomplished by acting on the basis of anticipated interest rates (in conjunction with current rates) than on the basis of current rates alone. An understanding of the implications of such monetary policies is important because of implementation of a recommendation can be affected by changes in monetary policy. For example, if a client has accepted a recommendation that provides exposure to a sector affected negatively by a policy shift, there may be implications in product price or performance for the client. Anticipation or response to such events can crystallise a portfolio review to take care of any downward possibilities for the client. Components of Money Supply There are various measures of money supply in the economy (M1 – M4). Of these, M3 is the most widely used. The definitions are as follows: M1 – Currency with public + Demand deposits with banks + Demand component of savings bank deposits + Other deposits with RBI. M2 – M1 + Post office savings deposits M3 – M1 + Time deposits with banks M4 – M3 + All post office deposits excluding NSC. M1 is also known as narrow money as it excludes time deposits with banks while M3 is known as broad money as it is a broader definition and includes time deposits with banks. Another definition of money is high powered money which is defined as the sum of : 1. Currency with public 2. Cash with banks 3. Bankers deposits with RBI 4. Other deposits with RBI Fiscal Policy Fiscal or budgetary policy, that is policies about spending, borrowing and taxes, has a major influence on debt raisings and on interest rates, as well as a direct effect on most clients’ financial plans. Fiscal policy is based on revenue and outlays. Revenue comes from taxation, sale of government assets, and borrowings, and outlays mostly result from the public debt interests, welfare and health payments, and other government expenditure. 188

Direct Impact of the Budget Changes in the revenue gathered by adjusting taxes and charges, and changes in expenditure clearly have a direct effect on the economy in a number of ways: Increases in business taxes and charges will reduce liquidity and hence the amount of funds available for investment; conversely a reduction can stimulate investment. Increases in personal taxation or reduction in government benefits can squeeze people’s incomes and reduce consumption. Tax ‘relief’ can stimulate consumer spending. Finally, there is the overall ‘psychological’ effect of the budget on business and consumer confidence, and hence on investment and consumption in the economy. Government Debt and Interest Rates If the government budgets for a deficit, then it must meet the shortfall, usually by borrowing. Where this alternative is followed, the higher the deficit, the larger the public sector borrowing requirement becomes, which, if met through the sale of government securities (rather than by monetary expansion), may require higher interest rates to encourage the public to buy the bonds. Additionally, a high borrowing requirement may ‘crowd out’ borrowings by the private sector. The funds to cover government debt come from bank deposits, and this means that the banks have less money to lend to other credit seekers. Credit tightens, and if demand exceeds supply, its cost (i.e. interest rates) rises. A further important point is that budget restraint is not separate from the external debt issue, because the public sector component of foreign debt must be serviced through the annual budget. The servicing of the public debt is linked to the value of the Indian rupee. If India’s current account deficit worsens (that is, the value of imports continues to exceed the value of exports), this will place downward pressure on the value of the Indian rupee and will create further inflationary pressures. Furthermore, if the Indian rupee weakens against major foreign currencies, it will become more difficult to service the foreign debt (which will be in those currencies) and will place more strain on the budget. In order to prevent the Indian rupee from falling, it may be necessary for the government to induce a rise in interest rates in order to attract an inflow of investment funds. As you can see then, fiscal policy interacts with monetary policy. Direct Impact on Clients Similarly, fiscal policies affect the financial plans of all Indians. Consider, for example, changes in taxation of perquisites or emphasis on investments to a particular sector. Consequently, any change by the financial planner in its policy needs to be factored into the financial planner’s work. On an ongoing basis, the financial planner needs to be constantly up to date with such policies to ensure that all advice is given in the light of the current situation. At the same time, any significant changes to government fiscal policy could trigger the necessity for reviews of existing clients’ portfolios. Exchange Rate Policy 189

While the value of the Indian rupee is no longer directly regulated by the government, government policy, particularly that exercised through the RBI can influence the exchange rate; i.e., the value of the currency vis-a-vis overseas currencies. A combination of domestic and international economic activities and Indian monetary policy determines the exchange rate. The RBI can regulate the money supply to the economy in order to stabilise interest and inflation rates and, hence, is able to affect the exchange rate of Indian currency. For example, higher interest rates in India generally (but not always) encourage appreciation of the rupee. In addition, the RBI may intervene directly by buying or selling the currency on overseas money markets. For example, the RBI may attempt to ‘shore up’ a falling Indian rupee by releasing dollars, particularly if the rupee is considered undervalued. A subsequent rise in the rupee value may see the RBI buy dollars. India thus has a managed floating exchange rate policy, where the market is by and large allowed to set the exchange rate, but with the RBI intervening to smooth out the potentially more extreme fluctuations. The general depreciation of the currency over the last decade has meant that India’s real purchasing power overseas has declined; that is it has to export more in order to purchase the same quantity of imports. To achieve this, of course, it needs to increase the competitiveness of its export industries vis-a-vis those of its major trading competitors. This is an ongoing challenge for Indian exporters. A lower real exchange rate will tend to moderate the effects of reductions in protection on import-competing industries and provide a relative stimulus for export industries. With lower rates, our goods become more competitive on overseas markets. In India, while manufacturing’s share of overall production has continued to decline as in many other countries, the share of some manufacturing activities has expanded, and some manufactured exports have increased considerably. Lower exchange rates also make overseas goods relatively more expensive and so dampen the level of imports. Given these two effects on exports and imports, a lower exchange rate can increase GDP. (Check the formula for GDP to see why.) Implications for Financial Planners The variation in exchange rate can alter the share market prices and profitability of companies that are in- volved in international trade. When the rupee appreciates against the importing country’s currency, then the demand for those goods may decline. This can eventually result in lower share prices of those companies that mainly rely on export of goods. The exchange rate influences the level of overseas investor confidence in the Indian economy. Confidence is boosted by a rise in the exchange rate, which can lead to increased investment in local industries, and a more positive share market outlook. Financial Institutions and Regulator y Bodies The Reserve Bank of India (RBI) The RBI is the central bank of the country and has for long been the centre of the Indian financial and monetary system. As the apex institution overseeing the Indian monetary system, it has been guiding, monitoring, regulating, controlling and promoting the Indian financial system since its inception. As compared to the Bank of England, Riksbank of Sweden amongst others. which are central banks of these countries, it is quite young. However, it is perhaps the oldest among the central banks in developing countries. The RBI started functioning from April 1, 1935 under the Reserve Bank of India Act, 1934. It was a 190

private shareholders’ institution till January, 1949 after which it became a state owned institution under the Reserve Bank (Transfer to Public Ownership) of India Act, 1948. This Act empowers the central government, in consultation with the Governor of the bank, to issue such directions to it as they might consider necessary in the public interest. The RBI has largely an independent character and that is how it should be, even though it is the banker to the government. The Governor of the bank and all the Deputy Governors are appointed by the central government. Its roles and functions include being the note issuing author-ity, the government’s and bankers’ bank, supervising and exchange control authority, promoter of the financial system and regulator of money and credit. The Securities and Exchange Board of India After the Capital Issues Control Act was repealed and the office of the Controller of Capital Issues (CCI) abolished in 1992, SEBI was set up on February 21, 1992 through an ordinance. SEBI was created to reduce the confusion amongst market participants arising out of multiple regulatory authorities. In a multiple regulatory structure, there is also an overlap of functions of different regulatory bodies. Now, every aspect of security market regulation is entrusted to SEBI - a single highly visible and independent organisation. SEBI is backed by a statute and is accountable to parliament. It is modeled on the all-powerful Securities and Exchange Commission (SEC) of the US and other regulatory bodies in developed countries. The scope of operations of SEBI is very wide, it can frame or issue rules, regulations, directives, guidelines, norms in respect of both primary and secondary markets (for equity shares and bond/debenture issues), intermediaries operating in these markets, and certain financial institutions, specially mutual funds. Even the monolith, the Unit Trust of India (UTI) is sought to be brought under the control of SEBI. However, even now SEBI’s operations are confined to listed companies on the bourses, the unlisted companies coming under the purview of the Department of Company Affairs (DCA) . The question of providing more teeth to the SEBI is always in the air, though care needs to be taken that it does not overlap with the functions of other regulatory bodies. SEBI has been able to achieve a number of reforms to its credit which include dematerialisation of shares, rolling settlements, self-regulation of merchant bankers, rules regarding take- over of companies, regulation of credit rating agencies and so on. The demutualisation of stock exchanges is currently being envisaged. Commercial Banks The Indian banks include 27 public sector banks, 196 regional rural banks and 34 private sector banks. The first group includes the State bank of India (SBI), its seven associate banks and 19 other nationalized banks. The 27 nationalised banks accounted for 70% of bank offices in 1996, and 82 to 92% of bank deposits/credit during 1970 to 1996. The New Economic Policy of 1991 liberalised the entry of foreign banks and private sector Indian banks. Out of the total number of private sector banks, nine banks were newly set up after 1991. Among the Indian banks, the SBI (along with its associate banks) accounted for 14 (21)% per cent of the total bank offices, 21 (27)% of deposits, 20 to 24 (28 to 30)% of credit and 24 (32)% of investments during 1986 to 1997. The new private sector banks have had a mixed experience in the Indian economy, some doing rather well and providing path breaking services to consumers, while others are still struggling. The banking sector has also seen consolidation with many significant mergers and acquisitions. Recently, the RBI also issued guidelines on conversion of financial institutions and finance companies into universal banks. The first to do 191

this are Industrial Credit and Investment Corporation of India (ICICI) and ICICI Bank. After a long time, the RBI has also issued three new licences for new private sector banks. Co-operative Banks The co -operative banking structure has three -tier linkages between state, district and village level institutions. At the state level, there are state co-operative banks and the state land development banks; at the district level, the central co-operative banks or the district central co-operative banks and the central land development banks; then at the village level, the primary agricultural credit societies, the primary land development banks and the branches of state land development banks. Besides, there are the urban co - operative banks or the primary co-operative banks which are outside the above structure. The apex institutions from the point of view of promotion, supply of re- sources, supervision and control are the government, RBI, National Bank for Agriculture and Rural Development (NABARD), and National Co- operative Bank of India. The co -operative banks have assumed significant roles as regional banks, though some have even progressed beyond into new regions on an all- India basis. However, due to lower supervision and control as compared to scheduled commercial banks, a number of them have been recently mired in controversies, specially relating to the capital markets. Industrial Development Bank of India (IDBI) IIDBI provides financial assistance for the establishment of new projects as well as for expansion, diversification, modernisation and technology upgradation of existing industrial entities (companies). IDBI is vested with the responsibility of coordinating the working of institutions engaged in financing, promoting and developing industries. It is an apex development financial institution for this purpose. It has evolved an appropriate mechanism for this purpose. IDBI also undertakes/supports wide-ranging promotional activities including entrepreneurship development programmes for new entrepreneurs, provision of consultancy services for small and medium enterprises, upgradation of technology and programmes for economic upliftment of the underprivileged. IDBI’s role as a catalyst to industrial development encompasses a wide spectrum of activities. IDBI can finance all types of industrial concerns covered under the provisions of The IDBI Act. With over three decades of service to the Indian industry, IDBI has grown substantially in terms of size of operations and portfolio. However, in the new liberalised environment, all financial institutions including IDBI, are finding it difficult to survive. They had been traditionally relying on SLR bonds for resources. When these resources dried up, they approached the retail markets to raise funds at high cost. Margins declined and in some cases even became negative. On the other side, with the slowdown in industrial activity, there was minimal demand for term loans. Moreover, as the boundaries between commercial banks and financial institutions were removed, banks gave tough competition in the project loans market. As a result, even IDBI, like ICICI, has been contemplating conversion into a universal bank. Life Insurance Corporation of India (LIC) In India, life insurance business has been conduced since 1818. There were a large number of companies (245 on the eve of nationalization) that conducted life insurance business. In 1956, the life insurance business of all companies was nationalized and a single, monopoly institution - the LIC was set up. Since 192

then, LIC has diversified its activities in the recent past by establishing i) LIC Housing Finance Ltd. ii) LIC Mutual Fund and some other entities in the financial sector. General Insurance Corporation (GIC) In the early days, a number of Indian and many foreign companies did general insurance business in India and abroad. Even LIC, some mutual companies and co-operative societies conducted general insurance business. On the eve of nationalisation, 68 Indian insurers and 45 non-Indian insurers did business in this field. In November, 1972, the business of these organisations was nationalised and vested in the hands of GIC and its four subsidiaries which are National Insurance Co. Ltd., New India Assurance Co. Ltd., Oriental Fire and General Insurance Co. Ltd. and United India Insurance Co. Ltd. The GIC was given charge of the overall control, superintendence and policy making for smooth operation of general insurance business. Presently, the direct general insurance business is done mostly by the subsidiaries of the GIC. GIC is responsible mainly for the re-insurance business. Liberalisation of the Insurance Sector In January, 1994, the R. N. Malhotra Committee report on insurance sector reforms was released. The Malhotra committee advocated the opening up of the sector while assuring adequate safety to the funds of the assured. It also made recommendations such that the existing public sector companies were not left to dealing with individual customers in non-lucrative markets. To create an entry barrier, the minimum networth of insurance companies was kept at Rs. 1000 million. A 26% cap was kept on foreign shareholding in the case of joint ventures. To ensure a level playing field, the private sector players are required to write a certain percentage of their business in rural areas. The Insurance Regulatory and Development Authority (IRDA) was established as the apex regulatory body for the insurance sector. Since the opening up, IRDA has licensed a number of private sector insurance companies and they have been established. Most of them are joint ventures with foreign insurance companies. Though, still unable to make a dent in the insurance business of the public sector giants, a number of them, specially in the life insurance sector have started on a very positive note. The general insurers are waiting for more remunerative tariffs before going all out to garner business. Unit Trust of India and mutual fund industry In India, the mutual fund industry started with the setting up of the Unit Trust of India (UTI) in 1964. It was promoted by a host of financial institutions and is governed by a special Act of Parliament. It grew out of an idea of the late Finance Minister T.T. Krishnamachary to promote an institution that would channel the savings of small investors to the industry and the capital markets. In 1986, two public sector banks, State Bank of India (SBI) and Canara Bank entered the market with their own mutual fund schemes. However, it was in 1999 that the industry matured. This was largely due to benefits made available in the budget. As a result, the mutual fund corpus increased manifold. The industry too responded by adopting self-regulation to win back the faith of the investors that had been eroded by assured return schemes that did not keep their promises. The Association of Mutual Funds of India (AMFI) came into being and began its work to set standards for the market. The wheel has turned a full circle and it is the UTI which is now facing liquidity problems as regards its flagship scheme US 64 and other assured return schemes. It appears that the government is ready to bail out the institution before it is fully brought under the supervision of SEBI. 193

Post restructuring, UTI is expected to be divided into three parts: the sponsor, AMC and trustee. Major financial institutions are to be roped in to be its sponsors. Housing Development Finance Corporation (HDFC) HDFC was set up in 1977 by ICICI. The primary objective at that time was to channel funds from household savings and the capital markets to the need for housing finance. It has since developed as the primary lending institution in the housing finance sector. It raises its resources through public deposits, loans from commercial banks and financial institutions, through capital markets and through lending from multilateral funding agencies like the World bank and United States Agency for International Development (USAID). HDFC has emerged as one of the best managed financial institutions in the country. Many banks and financial institutions have subsequently set up housing finance subsidiaries. Some of them are performing well in the market. In fact, in recent times, a rate war has been sparked off with SBI reducing interest on its housing loan portfolio. Even the government has been prompt in extending sops to this sector through various measures. Non-Banking Finance Companies (NBFCs) NBFCs, as the name suggests, are non- bank financial intermediaries in the financial markets. They provide a wide range of services including leasing, hire purchase, consumer finance, merchant banking and share market investments. They have been able to carve out a niche for themselves in the Indian financial system. As compared to banks, they are quicker and leaner, have streamlined decision making processes and are not subject to the stringent controls for scheduled commercial banks. They raise their resources through bank loans, bonds/ debentures, share capital and fixed deposits from the public. Rating from an accredited credit rating institution is compulsory for fixed deposits raised from the public. Till some time back, they had a poor name in the market because of the activities of a few players like CRB Capital Markets Ltd. There has been a shake-out and consolidation in the sector and most of the fly-by-night operators have now disappeared. They are under the direct supervision and control of the RBI. Credit Rating Agencies There are four major credit rating agencies operating in the Indian market, namely Credit Rating and Information Services of India Ltd. (CRISIL), Investment Information and Credit Rating Agency Ltd. (ICRA), Credit Analysis and Research Ltd. (CARE) and Fitch Ratings, India. While the first three are promoted primarily by ICICI, IFCI and IDBI respectively, the latter is the wholly owned subsidiary of its US counterpart. Apart from Fitch -IBCA, the other two major rating agencies in the US market (Moody’s and Standard & Poor ’s ) are represented by tie-ups and equity participation in ICRA and CRISIL respectively. CRISIL enjoys a dominant position in the Indian market for credit rating. Rating fees are low and most of these companies have diversified into providing value added advisory and information services for corporate clients. Credit Ratings Credit rating is the process of assigning easily understandable and standard scores to debt instruments which claim to give an idea of the credit quality of the instrument. It is an indication of the issuer’s capability in meeting the debt obligations on the instrument in time. Credit rating is communicated through symbols and there are separate symbols for long- term (bonds and debentures), medium term (fixed deposits), short term (commercial paper). The symbols for long term 194

instruments, for example are AAA, AA+, AA, AA-, A+, A, A-, BBB+, BBB, BBB-, BB+, BB, BB- , B+, B, B-, C and D. Usually, instruments rated upto BBB- are considered investment grade while those rated lower are speculative grade. Symbols for medium term instruments are similar. For short term instruments, the symbols used are P1, P2, P3, P4 and P5 (+ and – signs are used to indicate differences in the credit quality within a particular grade). Issuance of commercial paper requires a minimum credit rating of P1. Credit ratings are awarded based on an elaborate process whereby both quantitative factors (financial ratios) and qualitative factors (economic environment, industry prospects, industry standing and management) are considered before arriving at the final score. Structured Obligations Sometimes a debt instrument may not be able to get a good investment grade standalone rating. In such cases, it may be possible to structure the rating through credit enhancements like third party guarantees, cash collateral, cherry picking etc. In such cases, it may be possible to get a higher rating and a symbol (SO) is put after the credit rating to denote a structured obligation. The Economic Outlook In developing a financial plan for a client, it is necessary to formulate a view on the economic outlook for the medium to long term. This is because investment performance is not just the result of product selection or business risk but is also strongly influenced by macro economic factors or economic risk. The economic outlook postulates a view on trends in inflation, economic growth, interest rates, exchange rates and other macro economic factors. These factors will affect the financial planning industry and the effective rates of return available from local and overseas securities, gold prices and general commodity prices. Moreover, the prevailing state of the economy will give rise to certain policy measures to correct any imbalances, and these policy measures must be considered when evaluating the likely performance of investment products. For example, if the balance on current account is worsening, short term interest rates are likely to rise in order to attract foreign capital inflow and thereby place a floor under the exchange rate. Again, if inflation is rising, the government is likely to take anti-inflationary measures, such as tightening fiscal and/or wages and/or monetary policy. The implications of these policy measures for an investment plan must be carefully considered. Demographic Research The economy and economic indicators are of significance only in relation to the population of the country. Economic indicators make sense when considered in relation to population growth and composition. Financial planners need to keep in touch with population trends for a variety of reasons. For example, life expectancy figures are of immediate significance to planners in the life insurance field. The figures are used in calculating sums insured for both term life and disability policies. For example, a dependant may need supporting for the remainder of their lives should the insured die, and that period needs estimating. Economic outlooks and forecasts are published by economists on a regular basis and should form part of the basic research you undertake in the formulation of recommendations on behalf of your clients. As the Indian and world economies are ever changing, your role as a financial planner is to keep abreast of these changes and assist your clients in any review process to understand the impact of these changes on their strategies. 195

However, economic research is a part of the overall research you should undertake. You need to keep abreast of legislative changes, particularly as it relates to social security, taxation and superannuation. And, of course, there is research into particular products and types of products, both as they emerge on the market and are modified thereafter. Research needs to be undertaken on an ongoing basis, in some cases as part of the general awareness work which an interested planner must do and otherwise in a particular fashion directed towards finding out specialised information. There are important reasons for carrying out research for the professionalism of the planner as well as the benefit of the client. The preparation of strategic options for a client begins only after taking into account all of the areas of influence covered in this topic. Summary : In Topic 2, we understood:  Basics of Primary and Secondary Markets  Derivative Market & Foreign Exchange Market  Basic concepts of Insurance  Debt Management  Personal Financial Statement, and Cash Flow and Budgets  Concepts in Behavirol Finance  Cycles of economy  Financial Institutions and Regulations 196

Reading 1 Assessing Investment Opportunities in the “New” Economy Lovaii Navlakhi, CFPCM Investing in India There are several good reasons for investing in India: Demographics and Location: One of the largest economies in the world. A large and rapidly growing consumer market up to 300 million people, constitute the market for branded consumer goods - estimated to be growing at 8% per annum. Demand for several consumer products is growing at over 12% per annum. Skilled man-power and professional managers are available at competitive cost. One of the largest pools of scientists, engineers, technicians and managers in the world. Strategic location - access to the vast domestic and South Asian market. English is widely spoken and understood. Political and Financial:  One of the largest manufacturing sectors in the world, spanning almost all areas of manufacturing activities.  Rich base of mineral and agricultural resources.  Long history of market economy infrastructure  Foreign investment is welcome; approval is required but is automatic in sixty categories of Industries.  Sophisticated financial sector.  Vibrant capital market with over 9,000 listed companies and market capitalisation of US$ 154 billion (March,1996)  Well-developed R&D infrastructure and technical and marketing services.  Policy environment that provides freedom of entry, investment, location, choice of technology, production, import and export. Well balanced package of fiscal incentives.  A sophisticated legal and accounting system.  Rupee is convertible on Current Account at market determined rate.  Free and full repatriation of capital, technical fee, royalty and dividends.  Foreign brand names are freely used. No income tax on profits derived from export of goods.  Complete exemption from Customs Duty on industrial inputs and Corporate Tax Holiday for five years for 100 per cent Export Oriented units and units in Export Processing Zones.  Corporate Tax applicable to the foreign companies of a country, with which agreement for avoidance of Double Taxation exists, can be one which is lower between the rates prevailing in any one of the two countries and the treaty rate.  A long history of stable parliamentary democracy. 197

With the vast technical and managerial skills available in India, Indian and American SMEs can join hands both as complementary and supplementary partners, to cater to not only the vast Indian market but also the untapped markets in Asia and Africa. Today, India is one of the most exciting emerging markets in the world. Skilled managerial and technical man-power that match the best available in the world and a middle class whose size exceeds the population of the USA or the European Union, provide India with a distinct cutting edge in global competition. Some of the easiest and most rewarding means of investing in India would be by investing in Equities. This can be done in 2 ways: 1. Direct Equity Investment 2. Mutual Funds Equity Investing Introduction Equity essentially is owners’ capital of company and has a right to profits of the company. The stock markets collectively take an overall view of the company’s future profits and put a price to it. Thus, apart from its own profits and prospects, the share price of a company is also impacted by the mood swings of the stock markets and its investors. A retail investor must plan a systematic, long term and a disciplined investment. Timing the market often lands when at a rough end. The aim of equity investments is not to generate high short term gains but to generate reasonably high long term benefits. Time Horizon-3 years+ Benefits of Direct Equity The ultimate goal of making an investment is maximization of wealth. To achieve this, it is important that the investor gets a rate of return on his investment that exceeds the rate of inflation. Otherwise the real value of the investment would have actually declined. It also allows an investor to participate in the profits and growth of companies. As companies make financial and management decisions that increase the value of their firms, equity investors benefit from that growth by seeing the stock price rise. Investors also have the freedom to sell their stock in the market. Investing in Direct Equity If an individual wants to invest in direct equity, he has to register with a broker with the 2 main stock exchanges in India- NSE, BSE where shares are bought and sold. He can either invest through a broker in the secondary market or invest in the IPO(Initial Public Offer) of a company. Taxation To encourage investment in equities, the taxes on them have been changed drastically from the FY05-06. Short term gains are now taxed at 10% (As against their applicable slabs last year)-For a period less than a year. Long term gains are exempt from tax. 198

Securities Transaction Tax at 0.02% is also charged on transactions. Fundamentals while looking at investment in equities: Company’s Management: The management of the Company is what ultimately takes decision on the business and is largely responsible for the performance of the business. Hence a look at the people behind the business (Their background) would give us a picture of the prospects of the company. The style of business of the management should also be taken into consideration to determine if the company will take risky decisions to achieve its objectives or would rather be conservative in their approach. Business/Sector: The prospects of the business in general, how the sector that the company is in is performing. How much competition it is facing and how much threat does the competition pose? This determines whether the Company is too prone to competitor’s performance or is it a Monopoly and can proceed in its plans without fear of anybody else overtaking them. Previous results and growth prospects: This is the most important aspect while investing. We need to understand the business of the company and also take into consideration its performance in the past. The important ratios worth considering investment are: 1. P/E: Price Earning Ratio: This ratio is calculated by dividing Market Price/ EPS. A low PE ratio shows that the share is undervalued/ is cheap compared to its peers and is a good buy if the other factors (Like Management and Prospects of business) also indicate that it is a good buy. We cannot compare the PEs of stocks across sectors, only within the sector.(For eg: we cannot compare the PE of Infosys with the PE of ONGC, because both are in different sectors). 2. EPS: Earning Per share: It is calculated by Net Profit/ Total no. of shares. This indicates the gains that the company makes for the investor and is an input for the PE ratio- It show how much a person is paying to earn a Rupee on his investment. 3. Beta: This is indicators which show how volatile a company’s price movement is via-a-vis the sensex. A Beta of more than 1 indicates that it is more volatile than the sensex; a beta of less than 1 indicates that it is less volatile than the sensex. For eg: If a company has a Beta of 1.2, it means that if the sensex moves by 10%. It would move by 12% 4. Market Value to Book value: It is also called Price to Book Value(P/B Ratio). It is calculated by Market Value/ Book Value. This ratio reflects the contribution of a firm to the wealth of the society. It means if the Ratio is 3, the company has generated 2 rupees for every rupee invested in it. Technical Analysis: Technical Analysis involves a study of market generated data like prices and volumes to determine the future direction of price movement. How to Invest: To start investing in equities, you need to have a demat account with a Depository Participant and a trading account with a broker. You could then start trading shares where the shares would be in your demat account, if you want to sell your shares, you would have to deliver them from your account by way of 199

Delivery instructions. If you have shares in physical form, you need to get these dematted and only then can be sold. NRIs need to get necessary approvals from RBI before investing and the funds are repatriable. Investing in Mutual Funds Investing in mutual funds is very easy and convenient mode of investing in the equity market. An NRI/PIO can invest in mutual funds from an NRE account. The funds are repatriable and the same rules apply as Direct Equity investments. The things to look at while investing in MFs are: 1. Track record of the fund house 2. Past performance of the scheme 3. Fund Manager 4. Type of scheme and time horizon to stay invested 5. Portfolio How to Invest: To invest you need to sign an application form and give a cheque for the scheme. You also need to mention your PAN and Bank details and give proof of the same. The returns in the past have been spectacular for the options mentioned above, but since corporate profits have risen sharply in the recent past and due to higher base, the results might not be as spectacular as the last few years. But this option still looks as the most attractive avenue for investment in the long run. Mr. Lovaii Navlakhi, Certified Financial Planner, is a Practicing Financial Planner and Managing Director - International Money Matters Pvt. Ltd., Bangalore. 200