Case Study On

Investment Avenues In The Present Financial Year

By

Investment Avenues In The Present Financial Year

Executive Summary

India created millionaires at the fastest pace in the world in 2007 according to an annual

Merrill Lynch Capgemini report. The combined investment of the Indian millionaires reaches

as high as $600 billion. Thus as our society becomes increasingly affluent, a growing number

of high net-worth individuals and families are looking for ways to optimize investment

management. Given the complexity that goes along with investment and the sheer number of

financial options to consider, adopting a casual approach to managing their finances and

investments can lead to distortion in their investment and can severely affect their financial

health. Not only that, it can come in the way of achieving their financial goals in life. Thus a

need for an investment manager is rising exponentially in recent times, which can facilitate all

of their investing, borrowing, and trust needs while helping them accumulate, preserve, and

transfer investment.

Large banks and brokerage houses create separate sales forces, provide premium services and

other 'benefits' to retain or attract HNIs (High Net worth Individuals). The primary reason for

the preferred banking and premium services is the higher profitability and economies of scale.

These investment management outfits manage the investment of these HNIs and their social

group’s investment across various asset classes ranging from equities, debt, private equity, real

estate investments, art, mutual fund, structured products and commodities.

Each asset class has a unique risk/return profile associated with it; the notion of risk of return

goes hand in hand. Even at a certain given point of time, a particular investment might

experience a growth in its value while another investment might face a decline or downfall.

Thus, no single asset tends to outperform others consistently, therefore it is critical to diversify

and adapt the portfolio to the dynamic investment climate. Therefore planning for investment

requires understanding of the asset allocation process. The present report elicit an in-depth

coverage of major investments avenues and their performance over the past couple of years in

a bid to arrive at optimum asset allocation for the investor keeping in mind risk appetite,

investment goals and duration marching of the cash flows of the asset.

Table Of Contents

Introduction

"The Poor Make Money by Working for it; While the Rich Make Money by having their assets works for Them"

The above is a simple message by Robert T Kiyosaki from his book "Rich Day Poor Dad", to

motivate Kids (new to investment) start investing, so that your assets work for U.

Many individuals find investments to be fascinating because they can participate in the

decision making process and see the results of their choices. Not all investments will be

profitable, as investor wills not always make the correct investment decisions over the period

of years; however, you should earn a positive return on a diversified portfolio. In

addition, there is a thrill from the major success, along with the agony associated with the

stock that dramatically rose after you sold or did not buy. Both the big fish you catch and the

fish that get away can make wonderful stories.

“An investment is a voyage with a purpose” which succeeds only if it has been planned in

advance .In other words it is a process that never succeeds if it has not been calculated and

planned in advance. But, nowadays, as market conditions change and new financial products

appear and disappear, making decisions about investments and portfolios is no easy task.

Individuals are bombarded with a dizzying array of investment options. Information abounds,

advice comes from all quarters, recommendations often contradict one another, and new

products and asset classes are invented at breakneck speed.

Given the complexity that goes along with investment and the sheer number of financial

options to consider, investors today face bewildering choice about - what they should do with

their money? How should investors make sense of the chaos of information and innuendo that

exists about investment management? How should they create a portfolio of investments that

will meet their needs and help them achieve their goals? While these questions may seem

daunting, they are necessary. Investing is not a game but a serious subject that can have a

major impact on investor's future well being.

Virtually everyone makes investments. Even if the individual does not select specific assets

such as stock, investments are still made through participation in pension plan, and employee

saving program me or through purchase of life insurance or a home. Each of this investment

has common characteristics such as potential return and the risk you must bear. The future is

uncertain, and you must determine how much risk you are willing to bear since higher

return is associated with accepting more risk. In 1986, Microsoft Corporation first offered its

stock to the public. Nine years later, the stock's value had increased over 5,000 percent- a $

10,000 investment was worth over $ 5,00,and 000 in the same year, worlds of wonder also

offered its stocks to the public. Nine years later the company was defunct- a $ 10,000 was

worth nothing. These are two examples of emerging firms that could do exceedingly well or

fail. Would invest in large, well establish firms generate more consistent returns?

Over the years some investments have generated extraordinary gains, while others have

produced only mediocre returns, and still others have resulted in substantial losses. The

individual should start by specifying investment goals. Once these goals are established, the

individual should be aware of the mechanics of investing and the environment in which I

investment decisions are made. These include the process by which securities are issued and

subsequently bought and sold, the regulations and tax laws that have been enacted by

various levels of government, and the sources of information concerning investment that are

available to the individual. An understanding if this financial background leads to three

important general financial concepts that apply to investing.

Various assets classes and products classifications

Source: Author

Today the field of investment is even more dynamic than it was only a decade ago. World

event rapidly-events that alter the values of specific assets the individual has so many assets to

choose from, and the amount of information available to the investors is staggering and

continually growing. Furthermore, inflation has served to increased awareness of the

importance of financial planning and wise investing. In this project I will first talk about

economy, inflation, equity markets and debt markets to understand investments behavior. The

Scope of the project is restricted to the case study on Investment Avenues In The Present

Financial Year at Welingkar Institute of Management Development and Research,Mumbai.

And the report also includes a various types of risk and asset allocation strategies. Let’s

understand these investment avenues one by one.

Objective of the study

Limitations of the study

Methodology used

Expert opinions are collected from the investment advising and financial planning community

during the stint of the project

Also opinion of clients and prospects are collected by way of filling up of a questionnaire to

analyze their risk profile and their style of investment.

Extensive study of research reports and journals published by top notch investment advisory

firms , and then their analysis and interpretation.

Reading of various research reports, latest news and articles related to topic on

websites,magazines, references, etc.

Inflation

Inflation is a situation where there is ' too much money chasing too few goods'. In such times

buyers bid up prices of scarce products/services The scarcity could be caused by supply

issues or a faster than expected rise in demand. Irrespective of what causes inflation, the

impact is the same. The value of the currency you are holding declines.

Let's explain this with the help of an example. Suppose the Indian Rupee was freely

exchangeable with only one commodity- crude oil. Let's assume the conversion rate is Re 1=

1 barrel of crude (wish it were true!). Now there is tension in the Gulf region resulting in

reduced supply. Due to the subsequent rise in price of crude oil in international markets, we

would now have to pay more Rupees for every barrel of oil. Suppose crude prices rise by

10%. The new exchange rate will be Rs. 1.1 = 1 barrel of declined from 1 barrel of crude per

Rupee to only 0.91 barrel of crude per Rupee this is the erosion in the value of the currency

that we are talking about. Also note that while the Indian Rupee may be appreciating vis-à-vis

other currencies, in the ' real sense' there is erosion in value.

Another important fallout one can expect due to rising inflation is higher interest rates. The

central banks aim to reduce demand in the economy by rising the cost of money.

When making fresh investments or evaluating your existing holdings in potentially

inflationary times you need to keep two things in mind:

1. The possibility of higher interest rates

2. The erosion in the value of the currency

Classification of investors as per their risk profile:

Risk tolerance is a vital consideration in determining an appropriate investment mix for the client. Based on the

responses to the questions asked in the risk profiling questionnaire, a client falls in one of the risk categories

given below:

Risk Category Description

Secure As a secure investor, the best

investment for him/her would be low

risk instruments such as cash and fixed

income securities. This approach offers

a high degree of stability, liquidity and

is aimed towards capital preservation.

Conservative As a conservative investor, the best

investment for him/her would be

primarily low risk instruments such as

cash and fixed income securities with

small exposure to equity instruments.

This approach aims to protect clients‘

capital and at the same time generate

better returns than a secure portfolio.

Moderate As a moderate investor, the best

investment for him/her would be a

judicious combination of cash, fixed

income securities and equities. This

approach aims to balance between

capital preservation and growth but is

likely to involve at least some short

term volatility.

Growth As a growth investor, the best

investment for him/her would be

primarily in equity instruments. This

approach concentrates on achieving a

good overall return on investment

while avoiding the most speculative

areas of the capital market. Significant

short term fluctuation in value can be

expected but with high potential for

upside in the long run.

Aggressive As an aggressive investor, the best

investments for clients falling in this

category will be in equities and will

include exposure to more speculative

areas of the markets. The aim is to

maximize the appreciation of assets in

the long term while accepting the

possibility of large short term

fluctuation in value. Due to the

exposure to higher risk instruments the

possibility of a return greater than what

is expected from a growth portfolio is a

characteristic of this portfolio.

Strategy for Robust Investment and Financial Planning

Start early

Investing is easy once you know how. That’s why starting early gives you an extra edge, to

learn from mistakes and experiment with various investment techniques and asset classes. As

you grow older, you can take limited risks with equities and would prefer to invest in debt too.

Also, every year that you postpone investing towards retirement, the annual savings you need

to make to reach your financial goal will keep on rising. For instance, to get Rs 10 lakh at the

end of 20 years, if you start now you will need to invest Rs 13,879 annually but if you start 10

years later, the annual investment will shoot up to Rs 56,984.

Know yourself

Invest in shares or mutual funds based on your needs and after doing proper homework. Don't

buy something because your neighbor believes he has a winner on hand, or your broker is

issuing a big buy report on a stock.

Carefully choose securities that fit your profile. It is important to relate the risk perceived in a

given security not only to returns, but also to your attitude towards risk. It is important to

understand your emotions towards money and comfort levels with risk. For instance, what

would be your reaction if your stock investments plummet by 35 per cent in a month? ow

would that affect your medium term or long term plans?

The risk/return trade-off

There is no harm in assuming a big risk in the quest for higher long term returns, and your

profile does not preclude taking of such risks. Equities promise higher long term returns but

the period taken to realize these returns too can be uncertain. As far as debt mutual funds are

concerned, they are more stable tenure but returns are much lower. As an investor, you should

be able to judge whether the perceived risk is worth taking in order to get the expected return

and whether a higher return is possible for the same level of risk (or a lower risk is possible for

the same level of return). Smart investing will involve choices, compromises and trade-offs.

And you have to decide the combination of factors that suit you best.

Don't overpay for growth

Seek out shares that are capable of delivering sustainable earnings growth but don’t fall into

the trap of overpaying for growth. Even the best growth stock may not deliver dream returns

if your purchase price was too high to begin with. Warren Buffet, one of the most successful

investors in the world, said back in 1983: "For the investor, a too high purchase price for the

stock of an excellent company can undo the effects of a subsequent decade of favourable

business developments." So growth riding on the back of a reasonable purchase price may be a

good motto to stick with.

The reinvestment risk

If it suits your plan, choose a fund that reinvests your dividends or interest. That won't leave

you exposed to the risk of reinvesting the amount at equivalent or higher returns for the same

level of risk. Such alternatives are more than often not easily available. The reinvestment risk

is implicitly defined for a debt instrument. Yield-to-maturity, which is the actual yield on a

bond if held to maturity, may be a familiar term to those who invest in fixed income. But few

know that this YTM assumes that each interest cheque received by the investor is reinvested at

the coupon rate. In reality, however, most investors are probably spending this interest on full

filing current needs. So even if investors are getting a coupon of 18 per cent on a semi-annual

debt instrument, their YTM is much lower.

Evaluate your future

A lot of investing is about how you see your future, financially speaking. We all make certain

assumptions while estimating our future needs, and how we intend to meet those needs. But

circumstances can change. Hence it is important that you review your portfolio at least once a

year. Also try to evaluate the performance of your investments against the level of risk you are

assuming for achieving the returns you want. And when necessary re-balance your portfolio to

stay on track with your long term financial goals.

Beware of the law of averages

The average, or mean, acts like a powerful magnet that pulls stock prices down sharply, often

causing returns to deteriorate after they exceed historical norms by substantial margins. Stocks

display runaway tendencies by appreciating sharply. Subsequently, prices may plateau causing

disappointment. In such a situation, investors may profit from selling out earlier than originally

planned. And if the fundamental story is still intact, you could even buy back your shares at a

lower price. So stay tuned to any short-term movements in the stock market that affect your

stocks. However, if your goals are long term, don't get into the trading mode, where you

compromise on the big picture for short-term gains. It is important that you still think long

term. As Benjamin Graham, author of the investment classic The Intelligent Investor wrote:

"In the short term, the stock market is a voting machine-reflecting a voter registration test that

requires only money, not intelligence or emotional stability-but in the long run the market is a

weighing machine.

A trend may not be your best friend

The psychology of the stock market is not only based on how investors judge future events,

but also on how they react to the immediate past. There is a tendency among common

investors to buy shares of those companies or sectors that have performed well very recently. It

is critical that you assess where you are in the cycle during any bull run. That's because what

may seem to be an everlasting phenomenon eventually turns out to be illusory. It will be

replaced by another, equally compelling one. And as an investor, you are left with shares

bought at the peak of a cycle. Like Burton Malkiel, the author of A Random Walk Down Wall

Street has to say: "It is not hard, really, to make money in the market… What is hard to avoid

is the alluring temptation to throw your money away on short, get-rich-quick speculative

binges."

Time marches on

Time can dramatically enhance the value of your starting capital through the magic of

compounding. At 10 per cent annually, the annual incremental capital accumulation on a Rs

10,000 investment is Rs 1,000 in the first year, is over Rs 2,300 by the 10th year, and just

under Rs 10,000 by the 25th year. After 25 years, the total value of the initial Rs 10,000 is Rs

108,000, a ten-fold increase in value. Give your investment all the benefit of time that you can

afford. Choosing an investment plan that automatically reinvests your dividends and interest is

also a way to benefit from the power of compounding.

Age plays a key role in determining your investment profile. Hence, constructing a portfolio

that suits your age is essential. By mapping your age and your background, you can establish a

portfolio that comprises of different asset classes, in differing proportion. For example, if you

are five years away from retirement, with no major savings for a post-retirement life, then you

would build a portfolio comprising fixed income instruments. Similarly, a 24-year old would

focus on parking investments in riskier investments like equities, since time is on his side. We

have constructed profiles based on your age and some assumptions. Then we have constructed

a break-up of investments that can be used as a guide. You may wish to fine-tune this to meet

your own requirements. While reading through these profiles, please note that these are typical

attributes and are not absolute. Again, your risk profile changes depending on how you

perceive yourself too. A senior citizen with no dependents, but with lots of savings, may find it

perfectly okay to take on more risk. Similarly, a young person but with many dependents and

lots of financial liabilities may be more conservative than other people his age. We have

assumed that tax liabilities have been provided for, and the suggested investment break-up is

for the net funds available. Broadly, you can classify investments in to cash and bullion, fixed

income instruments, equities and mutual funds. Cash and bullion are taken as one, as both are

equally liquid and widely used as a means of savings. Savings would also include funds in

your bank savings accounts Apart from pure equities and fixed income instruments, mutual

funds are popular investment vehicles. We have classified mutual funds separately since the

risk of investing in funds is relatively lower. Moreover, balanced funds juggle between debt

and equity making an all-inclusive classification difficult.

Age : 22-30 years

Profile : You are single or are married but with no kids. Dependents are not an issue at this

stage and your focus is on creating a sizable corpus of investments for the future. Incomes

typically grow at a fast rate annually. The ability to take risk is high and losses in the short

term are acceptable. You can invest in equities with a time frame of about 5-6 years which

protects you from short-term fluctuations.

Category %

Cash and bullion 10Fixed income instruments 30Equity shares 40Mutual funds-equity growth 20

Age : 31-45 years

Profile : You are now married and your family size has expanded, with two kids. Your parents

are now dependent on you for emotional and some financial support. The focus is on

consolidating your investments, making them more secure. The ability to take risk is there but

to a limited extent. Limiting losses is a priority. Building on a corpus of funds for children’s

education becomes a priority now.

Category %

Cash and bullion 10Fixed income instruments 40Equity shares 30Mutual funds-equity growth 20

Age : 45-60 years

Profile : This is the age when retirement blues set in. Children's college and higher education

make demands on your funds. You must also ensure that your retirement plans are in place, if

you have not done it already. Hence, risk taking ability as a whole diminishes considerably.

Category %

Cash and bullion 10Fixed income instruments 50Equity shares 20Mutual funds-equity growth 20

Age : Beyond 60

Profile :

You are taking life easy, some introspection, spending time with the family and maybe doing

some part time work. Or like some workhorses, you are still engaged as a full time consultant

with your ex-employer. The ability to take shocks is extremely limited and you should lower

your exposure to equities. Your prime criterion should be to have a higher proportion of fixed

income investments and stay liquid to meet any medical emergencies.

Category %

Cash and bullion 10Fixed income instruments 70Equity shares 10Mutual funds-equity growth 10 Cash for canvas: The new guidelines for investment in art

Equity

Parking our money in the shares or stocks of companies implies an equity investment. This can

be done either by directly investing into the stock market or by way of an equity-based mutual

fund. Since these shares are traded on stock exchange, the market indices and movements

dictate the daily prices of these scripts. Since the capital markets are highly volatile, investing

in shares brings about a tremendous degree of risk. Equity as an asset class is considered to be

the most “high risk-high-return” investment and in order to enjoy superior returns; one must

keep them invested over a long time horizon. When we buy shares of a company, we become

an owner in that company and are given certain rights. Moreover, when the company achieves

growth and witnesses a spurt in its share price over a period of time, we benefit in the form of

capital appreciation. Also, fundamentally strong companies can tide over a changing inflation

and interest rate scenario and emerge strong over the long run. Equity as an asset class, surpass

all other investments when it comes to returns. However, in order to make the most of this

investment option, it is important to stay invested for good amount of time. During the short

term, sentiments take the better of a company‘s fundamentals and even good companies ‗bear‘

the brunt. For instance, the ongoing stock market crisis has ensured that even sound companies

have lost more than 50% of their value. However, by being invested in such stocks definitely

pays off over the long term, that is, at least 5-7 years. Also, we will notice that by staying

invested in a stock for the long term, it does not really matter at what prices we bought it at.

This is because a good company will continue to grow over time, make good profits and

reward its investors with good return. This way the original buying prices become insignificant

as we would have grown our investment multi-fold in the long run. The fact that we can make

returns as much as 20% or even more per annum if we stay invested for a good 10 years or

more, can be reaffirmed when we look at the returns given by the benchmark index – the

SENSEX – over different time periods

SENSEX returns over various time horizons

Source: BSE India and author’s calculations

The table below depicts the chances of making a loss depending upon the period for which we

stay invested in equities. Thus we can see that, if we had invested in the Sensex for a year

during the period 1979 to 2008, then in 10 out of 29 years, we would have faced a loss.

However, if the investment term was longer, that is, 10 years or more, than the probability of a

loss is zero.

Average returns of Sen sex with probability of loss

Particulars 1 YR 3 YR 5 YR 7 YR 10 YR 15 YR 20 YR

Probability of loss 0.38 0.22 0.12 0.13 0.05 0.00 0.00

Average Return (%) 25.21 19.46 18.76 19.14 17.12 16.78 16.84

Source: BSE India and author’s calculations

Debt

Just as people need money, so do companies and governments. A company needs funds to

expand into new markets, while governments need money for everything from infrastructure to

social programs. The problem large organizations run into is that they typically need far more

money than the average bank can provide. The solution is to raise money by issuing bonds (or

other debt instruments) to a public market. Thousands of investors then each lend a portion of

the capital needed. A bond is nothing more than a loan for which you are the lender. The

organization that sells a bond is known as the issuer. You can think of a bond as an IOU given

by a borrower (the issuer) to a lender (the investor).

For example, say an investor buys a bond with a face value of Rs 1,000, a coupon of 8%, and a

maturity of 10 years. This means the investor receives a total of Rs 80 (Rs 1,000 * 8%) of

interest per year for the next 10 years. Actually, because most bonds pay interest semi-

annually, the investor receives two payments of Rs 40 a year for 10 years. When the bond

matures after a decade, the investor gets your Rs 1,000 back.

The different types of bonds include government securities, corporate bonds, commercial

paper, treasury bills, strips etc. These bonds are either fixed interest bonds or floating rate

bonds. In fixed interest bonds, the interest component remains the same throughout the tenure

of the security. Say a 10-year bond issed today bears 8% interest. Even if 5 years hence, the

interest rate in the economy goes down to 5%, this 8% bond will continue to earn the investor

8% interest. In a floating rate bond, the interest rate varies depending on the interst rate of a

security that the bond chooses to benchmark it's interest rate to.

The process of debt instruments alongside other asset classes like equity is important in order

to keep a fair balance between risks and returns. Debt investments also score over on two main

parameters of assured returns and liquidity. In spite of many investors favoring the equity

segment due to its high return potential, the stability and minimal risk that the debt component

in a portfolio provides cannot be sidelined. The key debt instruments in India are company

bonds, fixed deposits, debt mutual funds and government schemes. They are popular due to the

following reasons:

Low risk tolerance Since most of these securities are either government backed or by a bank

etc, there is a minimal or at times, a zero default risk attached to it. The safety that these

instruments provide offers the most attraction towards these investments since they assist in

mitigating the risk element in the overall portfolio. So they are ideally suited for investors with

a low risk appetite. Besides, fixed income instruments offer a stable and a fixed rate of return.

Need for returns in the short–term Since one can avail fixed income instruments for a

shorter duration as well, it satisfies your liquidity requirements to a great extent. For investors

who do not have a long term horizon in mind as regards investing their investment, this is the

most ideally suited investment option. The liquidity that these securities carry can be

particularly useful for a person in the higher age category such as 40-50 years and for people in

their retirement years as in this age liquidity and investment preservation are important factors

to consider.

Predictable versus Uncertain Returns As the name suggests, these ‗fixed income‘

instruments provide a fixed amount of return at the maturity of the investment. During the term

of security, price fluctuations in the security price are likely. However, if the security is held

till its entire tenor, the interest earned/return gained on the investment is fixed and this

effective yield from the instrument is known to the investor during the purchase itself. Hence,

there is a certain fixed income that is gained on such securities.

Source: RBI and NSE India

As so many options are available for the investors to invest in debt, one must be careful while

investing. The various parameters to be considered before investing are:

Risk i.e. the credit risk attached with the instrument,

Returns which can be made over a period of time after taxes, and

Liquidity: as debt instruments are not very liquid, particularly long term investments.

Mutual Funds

A mutual fund is a professionally managed type of collective investment scheme that pools

money from many investors and pools it in stocks, bonds, short term money market

instruments and other securities. Mutual funds have a fund manager who invests the money on

behalf of the investors by buying/selling stocks, bonds, etc. India has around 1,000 mutual

fund schemes but this number has grown exponentially in the last few years. The total Assets

under Management (AUM) in India of all Mutual funds put together touched a peak of Rs. 5,

44,535 cores at the end of August 2008.

There are many reasons why investors prefer mutual funds. Buying shares from the market is

one way of investing. But this requires spending time to find out the performance of the

company whose share is being purchased, understanding the future business prospects of the

company, etc. However many investors find it cumbersome and time consuming to pour over

so much of information before investing their money. Investors therefore prefer the mutual

fund route. They invest in a mutual fund scheme which in turn takes the responsibility of

investing in stocks after conducting due analysis and research. The investor need not bother

with researching hundreds of stocks. He leaves it to the mutual fund and its professional fund

management team.

Another reason why investors prefer mutual funds is because mutual funds offer

diversification. An investors‘ money is invested by the mutual fund in a variety of shares,

bonds and other securities thus diversifying the investor‘s portfolio across different companies

and sectors. Mutual funds can be broadly divided into three categories:

Various classifications of Mutual Funds

Source: AMFI

Equity Funds – These are by far the most widely known category of funds and they account for

broadly 40% of the industry‘s assets. Equity funds essentially invest the investor‘s money in

equity shares of companies. Fund managers try and indentify companies with good future

prospects and invest in the shares of such companies. These funds are generally considered to

have the highest risk, and hence, they also offer the probability of maximum returns.

Debt Funds – These funds invest money in debt instruments such as short and long term

bonds, Government securities, t-bills, corporate paper, commercial paper, call money, etc. The

main objective of debt fund is to preserve the capital and generate income from the client. Debt

schemes are considered to be safer and less volatile and have thus managed to attract investors.

Debt markets in India are wholesale in nature and hence retail investors generally find it

difficult to directly participate in the debt markets. Not many investors understand the

relationship between interest rates and bond prices or the difference between coupon and yield

but they can however participate in the debt markets through debt mutual funds.

Liquid Funds – These funds are by far the biggest contributors to the mutual fund industry,

liquid funds attract a lot of institutional and HNI money. They account for approximately 40%

of industry AUM. Less risky and better returns than a bank current account are the two

advantages of Liquid Funds. Money market instruments have maturities not exceeding 1 year.

Hence Liquid Funds (also known as money market mutual funds) have portfolios having

average maturities of less than or equal to 1 year. Thus such schemes normally do not carry

any interest rate risk.

Insurance

Insurance is designed to offer financial protection for you and your family during the times of uncertainties. One

can choose from a range of traditional insurance, unit linked and general insurance plans designed to help you

with your savings, retirement, investment, protection needs and also save taxes.

Income Tax

SectionGross Annual Salary How Much Tax Can You Save? Most Suited Life Insurance Plan

Sec. 80C Across All income Slabs. Upto Rs. 33,990 saved on investment of Rs. 1,00,000 All the life insurance plans

Sec. 80CCC Across All income Slabs Upto Rs. 33,990 saved on investment of Rs. 1,00,000 All the pension plans

Sec. 80D* Across All income SlabsUpto Rs. 10,197 saved on Investment of Rs. 30,000.

(Inclusive of Rs. 15,000 towards health insurance of

parents).

All the health insurance plans/health riders

available with the conventional plans

Total Savings

Possible**

44187

Rs. 33,990 under Sec. 80C and under Sec. 80 CCC, Rs. 10,197 under Sec. 80D, calculated for a male with gross annual income

exceeding Rs. 10,00,000

Sec. 10 (10)D Under Sec. 10(10D), the benefits you received are completely tax-free, subject to the conditions laid down therein

* Applicable to premiums paid for Critical illness Benefit, Accelerated Sum Assured and

Waiver of Premium Benefit.

** These calculations are illustrative and based on our understanding of current tax

legislations, which are subject to change. Please contact your tax consultant for exact

calculations of your tax liabilities.

Insurance, in law and economics, is a form of risk management primarily used to hedge against

the risk of a contingent loss. Insurance is defined as the equitable transfer of the risk of a loss,

from one entity to another, in exchange for a premium. Insurer is the company that sells the

insurance. Insurance rate is a factor used to determine the amount, called the premium, to be

charged for a certain amount of insurance coverage. Risk management, the practice of

appraising and controlling risk, has evolved as a discrete field of study and practice.

There are several types of insurances in India for example, health, disability, casualty, life

insurance, property, credit insurance, etc. Insurance as an investment Insurance may not be the

best place to invest ones hard-earned money, but there are sufficient reasons for one to believe

that it can be a highly lucrative avenue to facilitate savings. People often talk about yield on

investment and tend to compare their values with those available on various insurance

schemes. This is particularly typical within the Indian sub-continent where one conveniently

forgets the element of risk covered by life insurance It is extremely unfair to compare the

performance of insurance against other investments without considering the core features of

insurance.

The very essence of insurance is to protect ones family from the uncertainty of his life. Hence

it proves very logical to evaluate the costs involved towards this feature. When a person pay

insurance premium for his car, does he get anything if fortunately no mishap happens? This

means that he spent the amount to secure a valuable property. Hence one must accept that out

of the total amount paid by him for his life insurance, a certain amount is used for providing

the risk cover and only the balance can be utilized as savings. In other words, the total

premium one pay minus the amount evaluated as the cost of insurance must be considered as

the amount invested to get the maturity amount. If one calculates the yield from returns, he will

be in for a surprise.

Secondly, we tend to think very unrealistically about our life. We often compare the results

after say 10 years from an investment scheme, for instance PPF. And then we try to convince

ourselves that PPF is providing a better yield than an insurance policy. For instance, if one

invest Rs.10,000/- in PPF after 1 year his money will grow to Rs.11100/- accruing a return of

11 percent. But what if his death occurs in the first year itself? The Rs.10,000/- can give him

an insurance cover up to an approximate sum of Rs.12 lakhs (depending upon the plan, age,

etc) and this amount shall become available to the nominee of the policyholder as against the

mere paltry Rs.11,100/- that PPF shall pay.

Art

The spectrum of the Art market in India is widening. It is now emerging as an investment

avenue as well. For a matter of fact, a painting of the eminent Tyeb Mehta recently earned him

whopping Rs. 6.9 cores, which is record in itself! Until now, appreciating and buying works of

art was restricted to the ‗page 3‘socialites. This might be partially true, but the profile of art

buyers is now getting more diverse. A lot of young professionals and entrepreneurs are taking

interest in art and buying it with an investment perspective.

Why Invest in Art? When we buy an art piece, we are investing in that artist‘s work. And since

all works of art are unique, a good piece has a lot of value attached to it. In the past couple of

years, select art creations have given much higher returns than what one could earn in the

blazing Indian stock markets. Yes, it is quite possible that excess liquidity might have found its

way to art assets, thus inflating their prices. But even otherwise, Indian Art creations, of late,

have found preference in foreign shores as well for their aesthetic quality.

Art as an asset class has low co-relation with other financial assets. So, if other financial assets

are going through a phase of correction, the art market might not necessarily be hit with the

same intensity. If we could spot talent early and are sure about taking a call on a young artist‘s

work, then the rewards can be phenomenal in the long term. Performance of an Indian Art as

an asset class over last few years In 2005, when shares gave a return of 46.7% and gold of

24.6%, art gave no less than 154.8%. But that of course has been one side of the story. These

returns reflect the work of certain top artists.

Like in the stock markets, where mid-caps can outperform large-caps, in the art market, the

work of junior artists could fetch higher returns as they may be bought for a cheaper price. If

one wants to take a safe bet while buying art, one should stick to renowned artists. It is more

certain than not that one would earn a decent short-term return. For an artist‘s work to

command exceptional prices in the market, it is important that he be consistent with good work

over a prolonged period of time. If he is unable to deliver quality on a consistent basis, then the

prices of his previous work done also stagnates. Some of the popular names are:

Artist Returns*

Tyeb Mehta 75.70%

VS Gaitonde 72.80%

FN Souza 66.60%

SH Raza 42%

MF Hussain 39%

*Returns are over the period from 1998-2006

Source: Financial Times

Various Methods to Invest in Art One can invest in Art either by buying a work of art or

investing through an Art fund. Buying Art works directly: Investing directly in art is pretty

expensive. One has to pay a 15-20% commission when he buys a piece of work. And when he

wants to sell, again he pays another 15-20% commission. And also the short term and long

term capital gains tax. If he sells within a 3-year period, he will have to pay 33.8% short term

capital gains. If he sells after 3 years, he would have to pay 20% long term capital gains tax.

That means he has to make 65-70% before he make his first one percent.

Investing in Art through a Fund

If one does not understand Art like the popular majority, and still wants to take an exposure in

art, then he has an option of art fund which is on the lines of a mutual fund. There are several

active art funds in India. They, however, seem to be out of reach of retail investors as most of

them require a minimum investment of Rs. 10 lakh and above. Also, a fund will charge him a

management fee of just 3% every year and an annual fee of 8%. Osian‘s is among the reputed

names among the various funds that have been launched. Among other popular names are

Crayon Capital Art Fund and Synergy Yatra Art Fund.

Foreign Remittances

Recently, Indians are taking more money outside the country, legally that is. According to

figures put out by the Reserve Bank of India, outward remittances by Indians climbed

manifold from a mere $10 million in 2004-05 to $441 million in 2007-0812. A significant

portion of outward remittance (another third) is spent on investment in equity and debt. The

balance goes towards gifts, donations, deposits and purchase of immovable property. It is the

geographical diversification of these clients that is probably accounting for the rise in real

estate as well as equity investments overseas. Of course, tourism and education are also

contributing their share.

In the eight months of 2008/09 fiscal, that number has once again been eclipsed and is already

at $530 million. RBI figures show that the money that is taken out is spent mainly (about a

third) on travel, tours and education. There are about 8 million outbound tourists from India

and the travel industry expects this to double to over 16 million in the next three to four years.

About 1.3 lakh students go abroad for higher studies.

The liberalization process was speed ed up during 2006-2007 as inflows of forex began

peaking. It was felt that there was sufficient cushion to allow a higher amount to be taken out

(to balance the unstoppable inflows of that period) — either for expenses or investment.

Therefore the Government has been steadily liberalizing the amount that can be taken out

under its Liberalized Remittance Scheme (LRS). Starting with about $25,000 that an Indian

could remit outside in a year, the amount has been gradually increased to about $2 lakh a year.

Why Remittances?

Long term investment Creation

● Creating investment outside India in one of the stable economies.

● Creating investment outside India to be used by the second generation of the client e.g.

Education of kids outside India, buying real estate aboard.

Geographical Diversification

Currently most of the HNI clients have maximum exposure to Indian Economy therefore from

the asset allocation point of view; clients need to diversify to mitigate geographic risk

Geopolitical Risk

Recent events in India have increased the geopolitical risk in India which might have negative

implication the Indian currency.

Opportunistic

LRS gives a tremendous platform to the HNI clients to get exposure to opportunistic trades in

the global markets

Product Choices

Under LRS clients can invest in wide range of products like warrants, structures, on

crude, gold, commodity long short, etc. across the globe.

Under LRS clients have option to put money in various currency deposits.

Structured Products

While there is no common single definition, broadly any financial instrument which

implements a pre-defined strategy with a pre-defined objective on a single/multiple underlying

securities/asset classes can be called a structured product. It is generally a pre-packaged

investment strategy which is based on derivatives, such as a single security, a basket of

securities, options, indices, commodities, debt issuances and/or foreign currencies, and to a

lesser extent, swaps. The variety of products just described is demonstrative of the fact that

there is no single, uniform definition of the structured product.

A feature of some structured products is a ―principal guarantee‖ function which offers

protection of principal if held to maturity. For example, an investor invests Rs. 100; the issuer

simply invests in a risk free bond which has sufficient interest to grow to 100 after the 5 year

period. The bond might cost Rs. 80 today and after 5 years it will grow to Rs. 100. With the

leftover funds the issuer purchases the options and swaps needed to perform whatever the

investment strategy is. Theoretically an investor can just do these themselves, but the cost and

transaction volume requirements of many options and swaps are beyond many investors.

As such, structured products were created to meet specific needs that cannot be met from the

standardized financial instruments available in the markets. Structured products can be used as

an alternative to a direct investment, as part of the asset allocation process to reduce risk

exposure of a portfolio, or to utilize the current market trend. Structured products are usually

issued by investment banks or affiliates thereof. They have a fixed maturity, and have two

components: a note and a derivative. The derivative component is often an option.

The note provides for periodic interest payments to the investor at a predetermined rate, and

the derivative component provides for the payment at maturity. Some products use the

derivative component as a put option written by the investor that gives the buyer of the put

option the right to sell to the investor the security or securities at a predetermined price.

Other products use the derivative component to provide for a call option written by the

investor that gives the buyer of the cal option the right to buy the security or securities from the

investor at a predetermined price.

Risks associated with structured products

The risks associated with many structured products, especially those products that present risks

of loss of principal due to market movements, are similar to those risks involved with the

options and the potential for serious risks involved with options trading are well-established.

Even in the case of a ―principal protected‖ product, they are only insured by the issuer, and

thus they have the potential for loss of principal in the case of a liquidity crisis, or other

solvency problems with the issuing company. The benefits of structured products can include:

Principal protection

Tax-efficient access to fully taxable investments

Enhanced returns within an investment

Reduced volatility (or risk) within an investment

Structured products are by nature not homogeneous – as large number of derivatives and

underlying can be used – but can however be classified under the following categories:

Interest rate-linked Notes & Deposits

Equity-linked Notes & Deposits

FX and commodity-linked Notes & Deposits

Hybrid-linked Notes & Deposits

Credit Linked Notes & Deposits

Market Linked Notes & Deposits

Combinations of derivatives and financial instruments create structures that have significant

risk/return and/or cost savings profiles that may not be otherwise achievable in the

marketplace. Structured products are designed to provide investors with highly targeted

investments tied to their specific risk profiles, return requirements and market expectations.

Commodities

Commodity investment has become increasingly popular over the past few years, as the

associated benefits have become more widely known. We know that global volumes on

commodity exchanges are several times the volume on equity exchanges. As global growth has

continued unabated, led by the new economic powerhouse of China, commodities have been

consumed at an unprecedented rate. With the rise in demand and problems of tight supply,

prices have risen across most of the commodity spectrum.

Commodity investors, both passive and active, have enjoyed an above-trend performance.

However, unlike in previous bull markets, commodities are no longer just the preserve of

institutional portfolios, and there are now many products available for the retail investor.

Moreover, with strong returns, significant news flow and several available investment vehicles,

investment money has poured into commodity markets. Diversification Commodities offer

many different characteristics to other asset classes and are, therefore, an excellent portfolio

diversifier, no matter how large or small a portfolio.

Correlation of commodities with equities and bonds over the past decade has been very little.

The reason for this is fundamental. Unlike bonds, commodities are real assets and tend to hold

their value in the face of inflation. Similarly, they are physically scarce and, as such,

experience positive price shocks at times when other asset classes, such as equities, sell off.

The war premium applied to the oil price is a pertinent example of how commodities can

actually be an effective portfolio hedge in uncertain times. Therefore, their inclusion in a

balanced portfolio can help generate strong absolute returns with less risk.

Many investors, however, have been surprised that recent returns from their commodity

investments have not matched the rises in underlying prices. Since the early 90s, the primary

avenue available for investing in commodities has been traditional indices. These indices

performed well for a period, but over the past few years it has become increasingly clear that

their performance has been different to that of the commodity spot (cash) price.

Why invest in commodities?

Price Discovery:

Exchange based trading act as a vehicle for "price discovery”, with the price level accurately

reflecting the underlying conditions in the market.

Price Transparency:

All the participants' in the market can have equal access toa neutral and authoritative price

level.

Risk Transfer:

By locking in the price for future delivery, they can "hedge" against unfavorable price

movements that may occur before the delivery date.

Portfolio Diversification:

Commodities provides a good avenue for investors to diverse their portfolio from equity and

bonds

Inflation Hedge:

Commodities like gold are natural protection against inflation. Furthermore, the commodities

have actual physical worth not the notional like equities.

Commodities are very powerful tool for asset allocation and portfolio diversification. The

bullish trend in commodities last very long and secular in nature since it takes a long time

before supply and demand adjusted itself to market condition. Commodities offer a wonderful

opportunity to diversify ones portfolio, while benefiting from the long-term scarcity, and

therefore performance, of the asset class. Commodities, however, are not, and never will be, as

efficiently traded as other asset classes.

The peculiarities of supply and demand and the presence of non-price sensitive players imply

that there will always be persistent alpha opportunities. The passive investor will not only miss

out on these opportunities, but quite often supplies the opportunity to the active investor by

blindly following an index and distorting the market. The vast majority of participants in

commodities are these passive investors or hedgers.

These non-price sensitive participants have inadvertently created opportunities for active

investors and, as such, this asset class is ripe with opportunities to outperform the passive

participants. Commodities should always be considered as part of a balanced portfolio, but

given the complexities and opportunities, selecting the right vehicle is very important in

determining the end benefit. Therefore, looking beyond the traditional indices is often

worthwhile.

Among commodities the GOLD is considered to be a best hedge against the inflation risk in

general. In India, people relay on Gold holdings has a hedge against the unforeseen

circumstances as it has a real physical value. Gold is the only asset class which offers dual

benefits; it is tangible as well as liquid, unlike real estate which is tangible but not liquid, or

company shares which are liquid but not tangible. An old adage preaches, ―Gold shines when

everything else falls apart. Gold is considered as a ‗must-have in the investor‘s portfolio and

experts recommend an exposure of anything between 5 to 15 percent of one‘s total assets in

gold.

GOLD v/s SENSEX returns over various time horizons

Source: COMEX, BSE India and Author calculations

The table above tells us how gold can mitigate the risk of loss. One look at the year 2008 will

tell you that during that year, while gold grew at 29.18%, the SENSEX fell by 54.75%. Now if

one had invested all his money in the sensex that year, he would have lost 54.75% of it. But if

he had invested 5% in gold and rest in equities, his total loss would have been reduced to

50.55%.

Gold in this case, will reduce the impact of loss. Higher the allocation towards gold, better the

risk mitigation. For instance, in the year 2008 itself, if instead of 5%, had he invested 25% in

gold, his total loss would have been just 33.77%. But the reverse would also hold true. In a

year when the equities are booming, gold might actually weigh down on his total returns as

happened in the year 2007. But that must not discourage an investor from putting some money

in gold. Gold is an option not as volatile as equities. While in the last 10 years, equities have

fallen as well as gained by 50%, the maximum fall and gain on gold has been just around 25%.

Investments in gold can be made either directly through the ownership of physical gold in the

form of bars, coins, jewellery etc. one can also invest indirectly by way of trading in gold. In

India, traditionally, majority of the gold has been purchased in the form of jewellery. However,

with the advent of gold trading through Exchange Traded Funds (ETFs) and buying Gold

Futures, investor‘s perceptions have undergone a change.

Real Estate

Looking for attractive avenues to park the funds? If the recent statistics are anything to go by,

real estate is emerging as one of the hot investment destinations. The multiple benefits of

investing in real estate today are:

1. Higher, risk-adjusted returns as compared to various asset classes over a period of time.

2. Assured, regular income

3. Capital appreciation

4. Inflation hedge

5. Portfolio Diversification

According to the report from Knight Frank India research ‗India Property Investment Review

Quarter 4 2005‘; on an average, the return from rental income on an investment in commercial

property in the metros is around 10.5%, the highest in the world. Compare this with other

investment opportunities like bank deposits and bonds that offer returns ranging between 5.5 to

6.5%.

Rejuvenated demand since early 2004 has led to the firming up of real estate markets across

the three sectors – commercial, residential and retail. The supply just about matches the

demand in almost all metros around the county. There has been an upward pressure on the

Real estate values. From a technical perspective, robust demand and upward prices are helping

revive investment and speculative interest in real estate and this is being further aided by

excess money supply, stock market gains and policy changes in favour of the real estate sector.

In recent years, increasing demand from the IT/ITES and BPO sector has led to approximately

20-40% increase in capital values for office space in the last 12-15 months across major metros

in India. The net yield from Grade-A office property have come down from 12-14% in 2003

and currently average around 10.5-11% p.a. the fall in yields has resulted from decreasing

interest rates and increasing appetite from investors. This has in turn resulted from abundant

liquidity options available coupled with the acceptability of Real estate as a conventional asset

class. Lower interest rates, easy availability of housing finance, escalating salaries and job

prospects have been lending buoyancy to the residential sector.

The net yields (after accounting al outgoings) on residential properties are currently at 4-6%

p.a. However, these investments have benefited from the improving residential capital values.

As such, investors can count on potential capital gains to improve their overall returns. Capital

values in the residential sector have risen by about 25-40%p.a. in the last 15-18 months.

The retail market in India has been growing due to increasing demand from retailers, higher

disposable incomes and dearth of quality space as on date. However, the risks associated with

this sector are higher as retailers are prone to cyclical changes typical of a business cycle.

Changing consumer psycho graphics combined with increasing disposable incomes will ensure

further growth of the retail sector in India.

Understanding of Risk in investment

The fact is that one cannot get rich without taking risks. Risks and rewards go hand in hand;

and, typically, higher the risk one takes, higher the returns he can expect. In fact, the first

major Zurich Axiom on risk says: "Worry is not a sickness but a sign of health. If you are not

worried, you are not risking enough". Then the minor axiom says: "Always play for meaningful

stakes". The secret, in other words, is to take calculated risks, not reckless risks. In financial

terms, among other things, it implies the possibility of receiving lower than expected return, or

not receiving any return at all, or even not getting your principal amount back.

Risk/return Matrix

Source: ICFAI textbook Portfolio Management

Every investment opportunity carries some risks or the other. In some investments, a certain

type of risk may be predominant, and others not so significant. A full understanding of the

various important risks is essential for taking calculated risks and making sensible investment

decisions. There are seven major risks present in varying degrees in different types of

investments

Default risk

This is the most frightening of all investment risks. The risk of non-payment refers to both the

principal and the interest. For all unsecured loans, e.g. loans based on promissory notes,

company deposits, etc., this risk is very high. Since there is no security attached, one can do

nothing except, of course, go to a court when there is a default in refund of capital or payment

of accrued interest. So, one must look at the CRISIL / ICRA credit ratings for the company

before he invests in company deposits or debentures.

Business risk

The market value of the investment in equity shares depends upon the performance of the

company one has invested in. If a company's business suffers and the company does not

perform well, the market value of that share can go down sharply. This invariably happens in

the case of shares of companies which hit the IPO market with issues at high premiums when

the economy is in a good condition and the stock markets are bullish. Then if these companies

could not deliver upon their promises, their share prices fall drastically. When one invests

money in commercial, industrial and business enterprises, there is always the possibility of

failure of that business; and he may then get nothing, or very little, on a pro-rata basis in case

of the firm's bankruptcy. A recent example of a banking company where investors were

exposed to business risk was of Global Trust Bank. Global Trust Bank, promoted by Ramesh

Gelli, slipped into serious problems towards the end of 2003 due to NPA-related issues.

However, the Reserve Bank of India's decision to merge it with Oriental Bank of Commerce

was timely. While this protected the interests of stakeholders such as depositors, employees,

creditors and borrowers was protected, interests of investors, especially small investors were

ignored and they lost their money. The greatest risk of buying shares in many budding

enterprises is the promoter himself, who by over stretching or swindling may ruin the business.

Purchasing power risk or inflation risk

When prices shoot up, the purchasing power of the money goes down. Some economists

consider inflation to be a disguised tax. Given the present rates of inflation, it may sound

surprising but among developing countries, India is often given good marks for effective

management of inflation. The average rate of inflation in India has been less than 8% p.a.

during the last two decades. In India's case, inflation, in terms of the wholesale prices, which

remained benign during the last few years, began firming up from June 2006 onwards and

topped double digits in the third week of June 2008. The skyrocketing prices of crude oil in

international markets as well as food items are now the two major concerns facing the global

economy, including India. Ironically, relatively "safe" fixed income investments, such as bank

deposits and small savings instruments, etc., are more prone to ravages of inflation risk

because rising prices erode the purchasing power of the capital. "Riskier" investments such as

equity shares are more likely to preserve the value of one‘s capital over the medium term.

Liquidity risk

Money has only a limited value if it is not readily available as and when one need it. In

financial jargon, the ready availability of money is called liquidity. An investment should not

only be safe and profitable, but also reasonably liquid. An asset or investment is said to be

liquid if it can be converted into cash quickly, and with little loss in value. Liquidity risk refers

to the possibility of the investor not being able to realize its value when required. This may

happen either because the security cannot be sold in the market or prematurely terminated, or

because the resultant loss in value may be unrealistically high. Current and savings accounts in

a bank, National Savings Certificates, actively traded equity shares and debentures, etc. are

fairly liquid investments. In the case of a bank fixed deposit, one can raise loans up to 75% to

90% of the value of the deposit; and to that extent, it is a liquid investment. Some banks offer

attractive loan schemes against security of approved investments, like selected company

shares, debentures, National Savings Certificates, Units, etc. Such options add to the liquidity

of investments.

But one should, however, be under the impression that all listed shares and debentures are

equally liquid assets. Out of the 8,000-plus listed stocks, active trading is limited to only

around 1,000 stocks. A-group shares are more liquid than B-group shares. The secondary

market for debentures is not very liquid in India. Several mutual funds are stuck with PSU

stocks and PSU bonds due to lack of liquidity

Interest rate risk

In this highly volatile market situation, interest rate fluctuation is a common phenomenon with

its consequent impact on investment values and yields. Interest rate risk affects fixed income

securities and refers to the risk of a change in the value of one‘s investment as a result of

movement in interest rates. Suppose a person has invested in a security yielding 8 per cent p.a.

for 3 years. If the interest rates move up to 9 per cent one year down the line, a similar security

can then be issued only at 9 per cent. Due to the lower yield, the value of his security gets

reduced.

Political risk

The government has extraordinary powers to affect the economy; it may introduce legislation

affecting some industries or companies in which one has invested, or it may introduce

legislation granting debt-relief to certain sections of society, fixing ceilings of property, etc.

One government may go and another come with a totally different set of political and

economic ideologies. In the process, the fortunes of many industries and companies undergo a

drastic change. Change in government policies is one reason for political risk. Whenever there

is a threat of war, financial markets become panicky. Nervous selling begins. Security prices

plummet. In case a war actually breaks out, it often leads to sheer pandemonium in the

financial markets. Similarly, markets become hesitant whenever elections are round the corner.

The market prefers to wait and watch, rather than gamble on poll predictions. International

political developments also have an impact on the domestic scene, what with markets

becoming globalized. This was amply demonstrated by the aftermath of 9/11 events in the

USA and in the countdown to the Iraq war early in 2003. Through increased world trade, India

is likely to become much more prone to political events in its trading partner-countries.

Market risk

Market risk is the risk of movement in security prices due to factors that affect the market as a

whole. Natural disasters can be one such factor. The most important of these factors is the

phase (bearish or bullish) the markets are going through. Stock markets and bond markets are

affected by rising and falling prices due to alternating bullish and bearish periods: Thus

Bearish stock markets usually precede economic recessions.

Bearish bond markets result generally from high market interest rates, which, in turn,

are pushed by high rates of inflation.

Bullish stock markets are witnessed during economic recovery and boom periods.

Bullish bond markets result from low interest rates and low rates of inflation

How to allocate across various asset classes?

The best-performing asset varies from year to year and is not easily predictable. Table below17

shows that from year 2000-08, not even a single asset class could retain its last year‘s ranking.

This means that if investor‘s portfolio is concentrated to one particular asset class, or, if he

―jumps‖ from one asset to the next, he may easily end up with worse results than any

consistent plan. Such a person can be quite successful at transferring value away from himself

rather than creating wealth. Thus here comes the role of asset allocation which refers to the

strategy of dividing investor‘s total investment portfolio among various asset classes, such as

stocks, bonds, money market securities, real estate, structured products, etc. Essentially, asset

allocation is an organized and effective method of diversification.

A fundamental justification for asset allocation is the notion that different asset classes offers

returns that aren't perfectly correlated; hence diversification reduces the overall risk in terms of

the variability of returns for a given level of expected return. For e.g. if in the year 2007-08

someone has taken exposure in only equities, then his portfolio would have been down by

approximately (–55%), but in same period if he would have invested in equities and gold

equally his portfolio would be down by just (-12%), as equities were down by 55% and gold

was up by 30% at the same time. Thus we see that lot of asset classes have negative correlation

with each other, and as no one can predict the markets accurately, so just by diversifying the

portfolio across various asset classes one can generate good returns with lesser amount of risk.

Performance of various asset classes during 2000-2008

Source: AMFI, Money control, BSE India, COMEX and Author calculations

The different assets have varying risks and experience different market fluctuations; proper

asset allocation insulates the entire portfolio from the ups and downs of one single class of

securities. So, while part of portfolio may contain more volatile securities - which have been

chosen for their potential of higher returns - the other part of the portfolio devoted to other

assets remains stable. Because of the protection it offers, asset allocation is the key to

maximizing returns while minimizing risk.

Factors contributing in investment decision

Source: Author

In the above diagram, it‘s clearly shown that security selection, market timing and some other

factors might affect the performance of the portfolio, but major contribution in the overall

performance, which is close to 91%, is the correct asset allocation. The important task of

appropriately allocating one‘s available investment funds among different assets classes can

seem daunting, with so many securities to choose from. But before selecting the asset classes

and the amount of exposure to be taken in each of them, an investor needs to know the risk-

return characteristics of the various asset classes. Figure below compares the risk and potential

return of some of the most popular ones:

Source: Author

Alternate assets have the highest potential return, but also the highest risk. On the other hand,

Liquid funds have the lowest risk since they are backed by the government, but they also

provide the lowest potential return.

Above figure also demonstrates that when one chooses investments with higher risk, his

expected returns also increase proportionately. But this is simply the result of the risk-return

trade-off. They will often have high volatility and are therefore suited for investors who have a

high risk tolerance, and who have a longer time horizon because of the risk-return trade-off

which says one can seek high returns only if he is willing to take losses - that diversification

through asset allocation is important. As each asset class has varying levels of return for a

certain risk, investor‘s risk tolerance, investment objectives, time horizon and available capital

will provide the basis for the asset composition of his portfolio.

Asset Allocation Strategies

Allocation of investment in various assets can be done by using different asset allocation

strategies18. Till now we‘ve seen the importance of asset allocation, but more important is the

type of strategy used. Asset allocation can be an active process in varying degrees or strictly

passive in nature. Whether an investor chooses a precise asset allocation strategy or a

combination of different strategies; depends on that investor's goals, age, market expectations

and risk tolerance. All the asset allocation strategies are discussed below:

Strategic asset allocation (SAA)

It refers to the neutral asset allocation that aims to achieve the investor‘s long-term investment

objectives. It is based on the longer-term risk and return outlook for the asset classes. It is a

method that establishes and adheres to what is a 'base policy mix'. This is a proportional

combination of assets based on expected rates of return for each asset class. For example, if

stocks have historically returned 10% per year and bonds have returned 5% per year, a mix of

50% stocks and 50% bonds would be expected to return 7.5% per year

Tactical asset allocation (TAA)

Over the long run, a strategic asset allocation strategy may seem relatively rigid. Therefore,

one may find it necessary to occasionally engage in short-term, tactical deviations from the

mix in order to capitalize on unusual or exceptional investment opportunities. This flexibility

adds a component of market timing to the portfolio, allowing him to participate in economic

conditions that are more favorable for one asset class than for others. Tactical asset allocation

can be described as a moderately active strategy, since the overall strategic asset mix is

returned to when desired short-term profits are achieved. This strategy demands some

discipline, as one must first be able to recognize when short-term opportunities have run their

course, and then re balance the portfolio to the long-term asset position. The deviation from the

SAA is done with the aim to enhance returns in the shorter term may differ from investor to

investor.

Dynamic Asset Allocation

Another active asset allocation strategy is dynamic asset allocation, with which you constantly

adjust the mix of assets as markets rise and fall and the economy strengthens and weakens.

With this strategy you sell assets that are declining and purchase assets that are increasing,

making dynamic asset allocation the polar opposite of a constant-weighting strategy. For

example, if the stock market is showing weakness, you sell stocks in anticipation of further

decreases, and if the market is strong, you purchase stocks in anticipation of continued market

gains

Constant-Weighting Asset Allocation

Strategic asset allocation generally implies a buy-and-hold strategy, even as the shift in the

values of assets cause a drift from the initially established policy mix. For this reason, you may

choose to adopt a constant-weighting approach to asset allocation. With this approach, you

continually rebalance your portfolio. For example, if one asset were declining in value, you

would purchase more of that asset, and if that asset value should increase, you would sell it.

There are no hard-and-fast rules for the timing of portfolio rebalancing under strategic or

constant-weighting asset allocation. However, a common rule of thumb is that the portfolio

should be rebalanced to its original mix when any given asset class moves more than 5% from

its original value.

Insured Asset Allocation

With an insured asset allocation strategy, you establish a base portfolio value under which the

portfolio should not be allowed to drop. As long as the portfolio achieves a return above its

base, you exercise active management to try to increase the portfolio value as much as

possible. If, however, the portfolio should ever drop to the base value, you invest in risk-free

assets so that the base value becomes fixed. At such time, you would consult with your advisor

on re-allocating assets, perhaps even changing your investment strategy entirely. You can

implement an insured asset allocation strategy with a formula approach or a portfolio insurance

approach.

The formula approach is a graduated strategy: as the portfolio value decreases, you purchase

more and more risk-free assets so that when the portfolio reaches its base level, you are

entirely invested in risk-free assets. With the portfolio insurance approach you would use put

options and/or futures contracts to preserve the base capital. Both approaches are considered

active management strategies, but when the base amount is reached, you are adopting a passive

approach. Insured asset allocation may be suitable for risk-averse investors who desire a

certain level of active portfolio management but appreciate the security of establishing a

guaranteed floor below which the portfolio is not allowed to decline. For example, an investor

who wishes to establish a minimum standard of living during retirement might find an insured

asset allocation strategy ideally suited to his or her management goals.

For example, let‘s assume a portfolio of $100, a floor value of $75 and a multiplier of 2. As

the initial cushion is $25 (100-75), the initial investment in stocks is $50 (25x2). Thus, the

initial mix is 50/50 shares/cash. Suppose the share market falls 10%, hence the investor‘s

shares will fall from $50 to $45. The total portfolio value is now $95, and the cushion is $20

(95-75). According to the CPPI rule, the new stock position is $40 (20x2). This requires the

sale of $5 of shares and investment of the proceeds in cash. If shares fall further, more will be

sold. If they increase in value, shares will be bought, and so on.

Integrated Asset Allocation

With integrated asset allocation you consider both your economic expectations and your risk in

establishing an asset mix. While all of the above-mentioned strategies take into account

expectations for future market returns, not all of the strategies account for investment risk

tolerance. Integrated asset allocation, on the other hand, includes aspects of all strategies,

accounting not only for expectations but also actual changes in capital markets and your risk

tolerance. Integrated asset allocation is a broader asset allocation strategy, albeit allowing only

either dynamic or constant-weighting allocation - obviously, an investor would not wish to

implement two strategies that are competing with one another.

Conclusion:

Year 2008 was an exceptional year for all the economies across globe. It started with euphoria.

The economies were booming. Beginning of the year saw the Indian stock market at a life time

high of 21K levels. Everything looked rosy. But by the end of the year we were at the other

side of the spectrum. Almost all economies are slowing down and some have even gone in

recession. Reputed investment banks & insurance companies in the US have perished. World‘s

largest housing mortgage companies have been bailed out. The leading automobile companies

across globe are close to bankruptcy. Unemployment is at peak levels. There are no takers of

the real estate. Stock market has crashed. But at the same time bond markets outperformed the

benchmark because of rising interest rates which in turn was the result of high inflation. Most

of the private equity funds, art funds are at all time low, but at the same time some of the

commodities & gold gave decent return on investments. This proves that most of the asset

classes are not correlated with each other, rather some of them have negative correlation. Thus

diversification is the key to success.

Millionaires in India are rising with the fastest pace in the world, thus need for a wealth

manager is rising exponentially. India has a high potential market for the wealth management

firms, and this is one of the most important reasons, why all major foreign players are setting

up or planning to set up their outfit here. The importance of this HNI segment has been

realized globally and as a result all large banks and brokerage houses have a huge pressure to

attract and retain these customers who are typically more profitable than retail banking,

brokerage and insurance customers. The wealth management industry has grown far more

competitive, with financial institutions, professional services firms, independents and other

advisors and service providers actively fighting for HNI clients. At this stage it becomes very

important for an investor to evaluate the firms on various parameters.