|
STOCKS
BONDS
MUTUAL FUNDS
MONEY MARKET OR FOREX
SAVINGS AND INTERESTS
OTHER INVESTMENTS
USING A FINANCIAL ADVISOR
INVESTMENT PRINCIPLES
Top
Stock is a small part of the ownership of a company. It
is also called SHARE or EQUITY. You become the part owner by buying the stock.
Being an owner you carry the complete risk. If the company becomes very profitable
you gain. If the company sinks you lose your investment. The gain can be the
increase in the value of the stock, which you can sell. It can be the income
every year in the form of dividends distributed from the profits of the
company. Being a small owner you have no control over the affairs of the
company. You have only the right to be informed about the major decisions. You
are invited to attend the general meetings of the shareholders. The majority at
these meetings approves decisions. Your individual vote may be of little
consequence. Many countries have regulations to protect small investors from
being cheated. An individual shareholder can sue the management in case of
fraud or mismanagement. In most countries the shares are issued in the electronic
or dematerialized form. You do not have to keep any certificates. The
depository keeps the shares in a safe custody. You enjoy all the rights. Over a
period of time, the shares or stock yield the highest returns compared to other
forms of investments. From Jan. 1926 to Dec. 1990, 1$ grew to 415 $ on an
average in the USA. In case of the best companies 1$ invested gave the returns
of 6,356 $ over the same period. What you get will depend on many factors. Even
the best companies can have difficulties. Ford had one of the largest annual
losses ($3,300 million in three years) during the early 80s. IBM nearly went
bankrupt in 1914. Most recently Swiss Air had no money to fly, and could not
even refund the customers for the tickets purchased.
Ideally you should invest in
stock the amount you do not need, or which you are prepared to lose. The value
of the stock will go up or down. This may not even have any relationship with
the performance of the company. A stockholder has no guarantee or security for
his investment. In case of liquidation of a company, all the employees, taxes,
creditors and other dues have to be paid off first. The stockholder will
generally get almost nothing. You cannot hold anyone responsible.
There are tax concessions in many
countries in respect of income from dividends and gains from selling the stock
at a higher price. The stock market is quite fascinating.
The stock can be bought in the
primary or secondary market. When the company issues the stock for the first
time ?also called PUBLIC ISSUE ?any one can subscribe to this issue. There
may be some restrictions regarding the number, the mode of payment and place
where the applications can be submitted. The company issues a PROSPECTUS- a
detailed document giving complete information regarding the company including
the time frame for the project, utilization of the funds, future prospects,
risks perceived by the management etc. The prospective applicants are advised
to study this document carefully. The public issue is kept open for a few days
for enabling the persons to apply. After receiving all the applications the
shares are issued within the stipulated time. The company may also invite
applications in case of substantial expansion. But such public issues are few
and far between. The other market is the secondary market. Huge transactions
take place in this market every working day. Here the existing shareholders
sell their shares to buyers. To purchase or sell shares in this market a person
has to register himself with a broker or a broker house authorized to operate
in this market The shares are quoted in a stock exchange and this information
is widely available. The intimation to purchase or sell (quantity and price)
has to be confirmed to the broker. Some brokerage has to be paid. After the
necessary formalities, which may take at best a few days, the transaction is
completed.
The shares are kept in a
depository and the details are given to the account holder periodically. The
advantage of the secondary market is that the past performance of the company
is available for study. While investing in stocks it is necessary to remember
that liquidity is low. Only funds not likely to be needed urgently should be
invested. It is absolutely essential to study the background and the past
performance of the company. The performance should be compared with the
performance of the competitors. To minimize the risks, it is advisable to have
diversified stocks.. You must devote time to study the trends and the market
movement of stocks. Stock markets these days follow a global trend. Watch not
only NYSE & NASDAQ but also FTSE, NIKKEI, HANG SENG as well as DAX and CAC.
Stock market is the place to make tons of money. Even of you do not, you will
never forget the experience.
It used to be believed that the
best time to invest in a company is when it goes public. i.e. issues stock for
the first time called initial public offer or I.P.O. The value is analyzed, the
information is totally presented and there is a basis for the issue price. But
there is only one snag. The performance of the unit, the skills of the
management and the acceptability of the product in the market is totally
unknown. Many technology stocks have slipped well below the issue price in a
relatively short time. On the other hand the statistics and performance figures
for the stocks quoted on the market are available. The most important being P/E
i.e.. Profits divided by earnings. The best time to invest in stocks from the
open market or secondary market should be when the stock is available at the
lowest price, but again only future can decide whether the market was in fact
the lowest. You can become wiser only after buying. It is also a fact that
though the market i.e.. Dow Jones, Hang Sang or FTSE may go up or down, it will
be very rare if all stocks go up or down together. You need to identify only
the ones which are low priced today and likely (?) to go up in future. Sudden increase
or decrease in price of stocks is called volatility. The longer that you invest
in stocks the less will the volatility matter. The risks are that over a short
period of usually two or three years and rarely more than five, the losses on
holding shares can be substantial. The rewards are in the long-term, say 10 to
20 years. Hence looking at it from another angle,. the best time to invest is
when you are not likely to need the funds that you are investing. For a proper
investment decision you will need not only intellectual ability, technical
skills (understanding balance sheets) but in addition right mental approach.
Since future is always uncertain, many a time things will happen which are not
anticipated. A balanced person will not panic, he will take the rough with the
smooth and keep the long term approach. Therefore the first prerequisite before
investing would be to assess your future needs and take a well reasoned
decision regarding the amount you can afford to invest in stocks for a reasonably
long period. An army of investment analysts and experts make constant efforts
to sift every piece of investment information. This is available to almost
everyone and this increases the market efficiency. So an investment into stocks
can be made anytime. What would differ is which stocks to invest in. Very few
investors have been able to achieve consistently a performance, which is better
than market. This number is no more than the laws of chance would allow.
The stocks in the market are
divided into certain categories. This is more for the purpose of analyzing the
performance of a group of stocks. The categories may be technology shares, fast
moving consumer goods, Automobiles, Steel, Aluminum, cosmetics, Drugs & pharmaceuticals,
Hospitality, Air lines, Hospitals, Banking, Housing etc. These classifications
can change over a period of time. In a dynamic world it can be assumed that
different stocks can face different risks. If you have an investment in only
one kind of stock or a number of stocks in the same market say airline the risk
you face is much bigger when the air line industry faces problems after the
attack on the WTC. On the other hand if you have some stocks in the pharma
group it may not face any risks at all. In fact due to the possibility of
biological warfare, it may do better. So if you invest in a diversified market
your risks would be certainly less. But you must understand the meaning of
RISK, The definition of risk is ?chance or possibility of a danger, loss or
injury? We can reword this for investment purpose as ?chance that the actual
outcome from an investment will differ from the expected outcome? Hence an
investment in terms of risk can turn out to be bad or very good too! So when
you buy stocks in several markets you reduce the risk. But you also sacrifice
the chance of getting higher returns. Hence the decision to buy stocks in
several different markets ?also called diversification - will naturally depend
on your ability to take risks. If you are young, have good income and less
liability you can afford to buy stock in only a few markets. If you are lucky
you can win a lot of money. You can lose a lot too! But if you are retired and
dependent on the income from the stock for your livelihood you cannot take the
risk, You must invest in several markets. This will call for judgement. When
the economy of a country is affected, all markets will be affected but not
equally badly. In times of recession the first industry affected is capital
goods industry. The last probably is drugs & pharmaceuticals. So depending
on the guess of the future and your limited ability to take risks you must
choose a judicial mix of stock in different markets. If you were to buy all the
stock in the market in the right proportion the returns will match the market
index. In such a situation you will perform as well or as badly as the market.
But the purpose of the investment in stocks of your choice is to earn a better
return than the market. Secondly it will not be possible for anyone to buy all
the stock in the right proportion all the time. Hence with the limited funds
and limited information available regarding the future movement of price of
various stock you will take a decision to buy stock in different markets to match
the degree of risk you can afford to take.
The returns generated by stocks
in most countries are not exceptional. The picture is similar around the world.
The US common stocks on an average rose 4.2 times during 1989-99. In the U.K.
the rise ending the 25 year period during 1999 was 36 fold. In Japan share
values, ended 1999, are languishing over 50% below the peak in 1989. But they
are still 5 times higher than what they were in 1974. A study conducted by an
investment bank has shown that the average return on gilt edged security
(Bonds) for 1974-94 (after adjusting for inflation and assuming no tax) was
5.7%.?In contrast, the corresponding
figure for equities (stock) was 13.5%.?
Equities represent the risk capital that is invested in projects to
produce the best returns. Such capital can be, and is, reinvested elsewhere
when there are better opportunities. This mobility may not be free. But risk
capital will always be limited and the demand for it will always carry it to
where returns are better.
But there are certain limitations
when you invest in stocks. Apart from risks there is also the issue of
liquidity. If you want the funds badly can you sell the stock easily, safely
and without loss? This problem of liquidity is the issue. Since the stock
market is volatile, the price could be very low at the precise time that you
need the money. You have little option but to sell at a loss to get the money
that you want. Such volatility may not exist in securities and Bond market
because the interest payable is fixed and time period is also fixed. So it is
said that the liquidity is good.
Some persons get a lot of thrill
and excitement by the decisions to invest in stocks, watching the movement of
prices, making money by selling stock when the gains are handsome and feeling a
sense of achievement now and then. But along with investment in stocks goes a
responsibility. It becomes necessary to watch not only movements of prices on
national stock exchange but important exchanges world over. The stock markets
these days are global, it becomes also imperative to watch the economy and
performance of industries. Fortunately data are available but these must be
analyzed understood and acted upon. The performance of individual management is
important as even when an industry faces problems, some unit can show
superlative performance and outstanding results. You may not become Warren
Buffett or George Soros, but you can certainly become a much wiser person.
Top
BONDS
A bond is defined as a long-term
promissory note with stipulated interest supported by a consideration or under
seal secured by a mortgage. A bond has the promise of stipulated interest on a
long-term basis. There is a guarantee for the performance. Bonds issued by the
Governments are also termed as securities. The issuing Government or
Federal/Central Government in case of issue by State Government or Local
Authority guarantees the payment. Companies issue DEBENTURES. These may be
secured by a charge on specific assets of the company. To ensure proper
compliance of the regulations and proper upkeep & maintenance of the
assets, a trust is formed or trusties are appointed. Even debt instruments
issued by companies are covered under the broad term BOND for the purpose of
investments. It is compulsory for such companies to get a ‘rating ?from the
recognized Rating Agencies. This helps in estimating the repaying capacity of
the company. Triple an i.e. AAA is the highest rating. The interest on a bond
can be fixed for the entire period, or it can be floating. The floating rate
will be linked to either the bank rate or some other independently determined
rate such as LIBOR. In general, the safety of the investment and the regular
income from the interest are assured. The market price of the bonds does not
fluctuate widely on the market. This ensures liquidity. A bond- holder is a
secured creditor. He has legal rights to sue the company in case of default.
Bonds maintain a balance of safety, yield and liquidity. The returns in
investments from bonds over a period of time are likely to be less than returns
from stock market.
Basically bonds are debt instruments.
They are stable forms of investments. The period of issue is generally 10 to 15
years. In some countries there are restrictions on investments in Government
Securities by individuals. Sometimes minimum amounts to be invested are
prescribed. In many countries individuals can invest in Government Securities
in the same manner as stocks. These are quoted on the stock exchange and can be
purchased in the same manner as stocks through brokers.
The investment in bonds can be
through the primary market when they are first issued. The application has to
be submitted as per the terms stipulated by the issuing authority. In case of
companies debentures are now in the same category as stocks. The depositories
keep the individual accounts.
In many countries the prime
lending rates, or bank rates are being reduced over a period of time. This is a
big opportunity for the bond market. The fluctuations in the bond market depend
on these interest rates. Hence the volume of transactions on the bond market
are very small compared to the stock market.
Transactions through the broker
are possible on the PC. There are e-brokerage facilities available. You need to
have a specified bank account and a specific depository account. The facility provider
registers these. The transactions then can be carried out on your PC. The
instructions are given on your PC to purchase or sell. The facility provider
verifies your bank balance as well as your depository stock balance. As soon as
the transaction is completed, your bank balance is debited in case of purchase
or credited in case of sale. Simultaneously your depository balance is credited
in case of purchase or debited in case of sale. This is not only quick but also
safe.
Primarily you are buying bonds/debentures
to balance your portfolio. At least part of your investment is safe. Bonds may
have some special tax benefits as decided by Government. You can certainly
sleep better with investments in Bonds.
Bond market in general is not volatile. It is a liquid
investment, which means that you can buy and sell bonds without appreciable
loss. You can invest in bonds whenever you have the necessary funds available.
Bonds pay a fixed and unchanging income with the expectation that their price
will not be subject to wide fluctuation. The interesting point to note is that
historically the interest rates moved from 4.5% in 1960 to near 10% in late
1980s. But the trend in the first few years of the twenty first century has
been for the interest rates to fall. In US it is only 2%(Nov. 2001). This
raises several interesting issues. If the expectation (today? is that the
interest rates will go down in the next say 10 to 15 years, Bonds which give
the guaranteed (today’s) interest for the next 10 to 15 years (depending on the
maturity period) is a very good investment indeed. You are assured the higher
rate of (today’s interest) over the next 10 to 15 years when the interest rates
may go down. . This will increase the value of the Bond over the period
depending on the fall in interest rate. But one can argue that these low rates
can continue only for a limited period and as soon as the economy revives, the
interest rates may be revised up wards. Under such a situation, the long term
Bond may result in some losses. So even in case of Bonds the future course of
events is important.
Investors have a fascination with potential rewards associated
with investing in stocks or equities. There is
Consequently, a lack of interest in understanding Bonds,
which are, fixed income securities. But several factors now contribute towards
a renewed enthusiasm. First is the downward trend in interest rates. Second has
been the slide in price of information technology stocks. Third is the effect
of disasters such as terrorist attacks in the US. This has shifted the relative
odds in the stock and bond market.
Governments, corporations and individuals issue debt
instruments. They call for fixed periodic payments called interest and eventual
repayment of the amount borrowed, called the principal. Bonds issued by
federal, state and local governments differ in quality, yield and maturity.
These are among the safest and most liquid securities available. Short-term
government securities have maturity of one year or less. Treasury bills are
offered weekly at a discount, with maturity of 10 to 30 years. Corporations
engaged in industry or business offer private debt instruments. They range from
high quality to defaulted securities. The subclasses mainly
represent.modifications of the two basic promises interest and repayment of
principal. Convertible bonds provide the holder with an option to exchange the
bond for a predetermined number of stock at any time prior to maturity. Secured
or mortgage bonds are secured by a specific lien against assets. During
liquidation the creditors receive proceeds from the sale of those assets up to
a limit of debt.
It is also obligatory in many countries for the debt
instruments to be rated by a rating agency. The rating agency, after study of
the finances of the company, gives a rating, which signifies the ability of the
corporation to repay. These ratings are also revised from time to time
depending on the change in the finances of the corporation.
The types and variations of bonds are substantial. You have
to study the bond contract, which spells out all the details behind the issue.
In general yield from the safest bonds i.e. Govt. bonds will be less than yield
from private bonds. It is necessary to strike a proper balance depending on
your specific needs.
Diversification is said to reduce risk. Govt. bonds- gilts
in UK and treasury bonds in the United States are definitive risk free assets
because the likelihood that the government will default on its obligations are
effectively zero. Bonds or debentures and other securities in this category all
have some assurance from the issuer to repay the capital and interest. Some
assets may be specifically be mortgaged for the security. Independent rating
agencies may have given a rating for the bond/debentures after fully analyzing
the financial position of the issuer. Bonds have a long term and well-defined
terms of interest payment and repayment of capital. This makes bonds less
volatile. There is very little risk and good liquidity. Bonds can be traded in
the market at relatively stable prices. This means that you can get the money
by selling bonds whenever you need some money. You do not have to sell at a
distress. Unlike stock, a legal liability has been created in your favor at the
time of issuing the bonds. You have a legal remedy in case of default.
The consideration, therefore, for investment in bonds is
liquidity. It is necessary for you to study your future needs in terms of cash.
When you are likely to need? How much you are likely to need? What are the
different ways in which you can get the amount?
Each case is different, the needs are different and the
resultant mix of investments will also be different. Investors can spread the
risks by not putting all their eggs in one basket. They can invest in different
categories of investment including bonds to reduce losses due to future
uncertainties. The future is going to be always unpredictable and different.
Bonds help in containing these risks.
MUTUAL FUNDS
An individual investor who
desires to invest in stock has limited money. On the other hand the different
stocks being traded in the stock market are quite large. When an opportunity
arises to purchase some stock, he may not have the liquid cash. He may not be
able to study the trends in stock market. He may not be able to analyze the
movement of prices in the stock market. It may be difficult for him to
visualize the future prospects of different categories of industries, He may
not be able to analyze the performance of individual companies and the changes
in their management. In short very few persons can have the time, knowledge and
skills to take the best advantage of opportunities that arise in the stock
market. Mutual funds are basically investment companies, which continuously
sell and buy stock. Any one can participate in its activities by investing in
the mutual fund. The total capital available to a mutual fund is managed by the
investment company usually a trust. All the stock owned, by this company valued
at the market price is the net asset value or NAV. This amount divided by the
shares will be the NAV per share. The Mutual Fund Company continuously sells
the shares and redeems its shares. The Mutual Fund Company will buy the shares
from the investor at his option at any time at the NAV. For managing the fund,
the company will charge some commission called “load? This can be charged
either at the time of selling or at the time of purchase. It can be seen that
by investing in mutual fund one can get the advantage of large market and the
expertise of the professional management. The company is watching the stock
market all the time and trying to get the best yield for the investors.
Mutual funds state specific
investment objectives in their prospectus. The main type or objectives are
growth, balanced income, and industry specific funds. Growth funds possess
diversified portfolios of common stocks in the hope of achieving large capital
gain for the investors. The balanced funds generally hold a portfolio of
stocks, and bonds. This achieves both capital gains and dividend along with
interest income. Income funds concentrate heavily on high interest and high
dividend yielding securities.
Industry specific funds invest in
portfolios of selected industries. This appeals to investors who are extremely
optimistic about the prospects for these few industries. One should be willing
to assume the risks associated with such a concentration of investment. As it
happened in information technology a bad performance can virtually result in
huge losses. Sometimes the same company may have a family of mutual funds. The
investor may be allowed to shift from a fund with one objective to a fund with
a different objective for a fee.
II). How do you begin investing into the Mutual Fund Market?
There are a number of mutual fund
companies. Each company has a family of mutual funds with different objectives
such as growth, income, industry specific etc. One is tempted to invest in a
mutual fund because of the professional services and expertise associated with
the management of a mutual fund. To begin investing you can approach any of the
mutual fund and by a very simple application, purchase the shares at the NAV.
The NAV is available on a daily basis. The mutual fund will let you know the
“load? i.e.?additional amount you have
to pay when you buy and when you sell. In case of entire commission added to
NAV at the time of purchase by the investor the process is called front-end
loading. In case of entire commission being charged at the time of sale by the
investor the process is called backend loading.
The mutual fund keeps on selling
and purchasing stock in the market. Depending on the price of the stock the NAV
will be changing. This will be quoted on a daily basis so that the investor can
decide whether to buy more share or sell the total or some part of it. The
mutual fund will also declare and pay dividend from time to time depending on
the dividend income. The dividends declared on the stocks owned by the mutual
fund will be the income of the mutual fund. The mutual fund will declare
dividend and pay the same to the investors depending on its income.
There are a large number of
mutual funds. Each will have a family of mutual funds with different
objectives. Before investing, the prospectus of the mutual fund that specifies
the condition should be studied. The past performance of the mutual fund can be
examined. The comparison can be made with the stock market index. Over a period
of time the mutual fund should do better than the index. (The index gives a
measure of how the overall stocks have moved either up or down.) Such a study
should include dividends declared by the mutual fund over a period of time.
After investing the, performance of the mutual fund will be communicated to the
investor. A comparison with performance of other mutual funds with the same
objectives will help in understanding the subject.
There is no secondary market in
the shares of a mutual fund. Investment in mutual fund is by buying new shares
in the fund. Mutual funds pay no taxes on the income they receive. In order to
qualify for the tax exempt status, funds must distribute most of the income
they get (90% in U.S. and 100% after costs in U.K.) They must hold a
diversified portfolio. In U.S. no more than 25% can be in a single investment.
For half of the portfolio no more than 5% can be securities of a single issuer.
These aspects severely limit the flexibility.
Mutual funds are a means to
invest in a portfolio of stocks. Such an investment in different stocks may not
be possible for an individual investor. Hence the best time to invest is when
the NAV of the mutual fund is at the lowest. Lowest not only in relation to the
past but also future. Actually it is only the future that is important. If one
were confident or sure of future of any individual stock then it would be best
to invest in that stock. The risk would be there but so would be the
possibility of rewards. But many a time the future is not clear. The economic
situation does not indicate any clear picture regarding the future. At such a
juncture it would be advisable to invest in mutual fund. Mutual fund reduces
risk because the investment is in a number of different stocks. Secondly it is
also possible to select a mutual fund with an objective suited to your needs.
Choosing a mutual fund is the
most crucial aspect of investment in a mutual fund. In case of a stock it is
easy to look at the past performance such as sales, profits, price on the stock
market, dividends record etc. It is also possible to compare the performance
with the other competitors. In case of mutual fund, firstly there are different
families of Mutual Funds being managed by different companies. Secondly there
are mutual funds with different objectives. Thirdly the past performance of a
mutual fund may not be a good guide to future performance. One has to be very
careful in evaluation. First aspect has to be trust. Is the management of the
fund trustworthy??Are there any adverse
or doubtful reports in the market? This is important because many a time a good
performance could be a matter of chance. Secondly mutual funds are with
different objectives. It is necessary to decide which objective is important
for you. If one can take risks, growth objective may give better returns over a
period of time. One should have the patience to wait for the long term, which
may be necessary. Income funds may not give appreciation in capital but may
assure income. If the need is regular income, then one has to invest in income
fund. On the other hand there will a number of industry specific funds.
Information technology, pharma sector, hotel & hospitality industry,
processed food, fast moving, consumer goods, capital goods, automobiles, white
goods, etc…etc.. All the industries cannot do better at the same time. The
future of an industry will depend on many factors. An expert who can analyze
these factors and make a good guess can certainly get good rewards.
There are many methods of
evaluating the performance of the selected mutual fund. The purpose is to find
if the management of a fund has done better through its selective buying and
selling. One way is to compare the yield of a mutual fund with the market or a
random portfolio. Even if the mutual fund has done better, the cost should be
also taken into account/. It should be ensured that the excess return is
sufficient to cover the added expenses incurred for the purchase of mutual
fund. Lastly even after choosing a fund and investing, the performance must be
watched.
Frequently, investors feel
insecure in managing their own investment. They consider themselves inadequate
to perform this task successfully. The investor feels that he lacks the
education, background, time, foresight, resources and temperament to handle the
portfolio. In such a case the choice is mutual fund. Managers trained in the
ways of security analysis devote full time to the objective of the fund. This
permits a constant monitoring. Secondly the mutual fund has large amounts of
money entrusted to it. This makes it possible to diversify investments. The
diversification will be as per the objectives. An average investor cannot
achieve this. The mutual fund being a large institution, it may be able to
obtain lower brokerage commission. Mutual funds pay no taxes on the income they
receive. They do not pay taxes on the capital gains they realize. Investment in
mutual fund mode is very simple. There is no secondary market in the shares of
a mutual fund. Investment is by buying new shares in the fund. Investors can
sell shares back to the fund. These transactions take place at the per share
value of the fund. This is feasible because mutual funds mostly hold marketable
securities. These trade on the recognized stock exchange. This gives mutual
fund an important edge. The success of mutual funds in attracting capital to
manage has been notable.
It should be remembered that
historically there is very little statistical evidence to show that mutual funds
have performed better. An analysis done in U.K. has found that very few funds
have been able to beat the all share index or FTSE. The Securities and Exchange
Commission in U.S. found some evidence that mutual funds outperformed the
market by very small amounts. The same study found that there was no
consistency with respect to which funds provided the investor with superior
performance. What has to be remembered is that would an individual investor be
able to do better. The confidence of investors in mutual funds and its growth
seems to indicate otherwise. So if you think along the lines of the majority,
you can choose mutual fund.
Top
MONEY MARKET OR FOREX
Each country has its own currency.
Whenever one currency is exchanged with another it is a foreign exchange or
forex transaction. The foreign exchange market has experienced many changes
since its inception. For many years the United States and its allies
participated in a system under the Bretton woods Agreement. The foreign
exchange rates were tied to the amount of gold reserves belonging to the
nation. However in the summer of 1971, President Nixon took the United States
off the gold standard. After this many countries followed and there was no
relation between the gold reserves and the exchange rates. Floating exchange
rates materialized. Today supply and demand for a particular currency or its
relative value, is the driving factor in determining exchange rates. The fall
of communism and the dramatic growth of the Asian and Latin American economies
have decreased obstacles and increased opportunities for investors in foreign
exchange. Increasing trade and foreign investment have made the economies of
all nations more and more interrelated. Economic figures are regularly reported
around the world. Inflation, unemployment levels, unexpected news, such as
natural disasters or political instability, alters the desirability of holding
a particular currency. This influences the international supply and demand for
that currency. The U.S. dollar, therefore, fluctuates constantly against
currencies of the rest of the world.
Forex investments are investments
in a currency other than that of your own country. If you have U.S. dollars
your investment is in dollars. If you have British Pounds your investment is in
Pounds. You desire to visit a foreign country. You know the approximate amount
of money you will spend. You have the option of either taking your own currency
to that country and exchanging the same when you visit that country . You also
have the option of exchanging the currency in your own country and keeping the
currency of the foreign country with you well before you visit that country.
e.g. You are to visit Japan but you are at present in New York. You can change
the U.S. dollars into Japanese Yen before you leave. This is a foreign exchange
investment. You would do it if you think the Yen is going to become stronger.
i.e. In future you will get less yen for dollars.
Forex investments are trading in
future by options. An option gives you the right, but not an obligation, to buy
or sell a specific amount or foreign exchange at a specified price within a
specified period. Options are either call or put.?Calls give the holder the right to buy the foreign currency or
Forex at a specified price. Puts give the right to sell Forex at a specified
price. Depending on the actual market price when you exercise the option you
will gain/lose the difference between the specified price and the market price.
Trading in the Forex market is
through the brokerage houses that deal in foreign exchange. You can trade by
options in Forex market.?The Forex market
may be expected to go up or go down. If you expect the Forex market to go up
you will go in for calls. e.g. The value of 1 us dollar today is 48 Indian
Rupees. You are expecting that the Forex market will result in 1 us dollar
equal to 55 Indian Rupees after say four months. You can go in for call option
agreeing to buy 10 U.S. dollar at the rate of 50 Indian Rupees/dollar at any
time during the next six months. Whenever the actual market price is above 50
you can exercise the option. If the actual market price is 54 Indian rupees you
can exercise the call option. You can actually buy 10 U.S. dollar by paying
only 50 Rs. per dollar i.e. by paying only 500 Rs. But the actual value being
540 Rs. The gain to you is Rs. 40. Similarly if you think the market is going
to be 40 Rs./dollar you can go in for put option. Here you will be able to sell
the dollars in Forex market at the agreed price ie. Rs. 48 Rs./dollar though
the actual market price is less i.e. Only 40 Rs/dollar. The gain you make will
depend on the actual difference in the market price and the options price.
There would be some fee/commission required to be paid. This would be the cost
of transaction and result in reduction of the gain to some extent. The foreign
exchange market is the largest financial market in the world, Traditionally the
foreign exchange market has only been available to banks, money managers, and
large financial institutions. Over the years, these institutions, including the
U.S. Federal Reserve Bank, have realized large gains via currency trading. This
growing market is now linked to a worldwide network of currency dealers,
including banks, central banks, brokers, and customers such as importers and
exporters. Today the foreign exchange market offers opportunities for profit
not only to banks and institutions, but to individual investors as well.
?/span>Holding currencies is no longer a practical proposition. Currency
does not have an intrinsic value. It is just a paper, which is no longer linked
to gold standard. Mostly you will enter into a contract which will give you an
option to buy the foreign exchange (i.e. Foreign currency) at a rate which is
agreed now. For example you know that you are likely to need a certain amount
of foreign exchange at a future date. It may be to pay for imports or paying of
commission or costs proposed to be incurred in foreign country.
If you expect the price of that
currency to go up you can enter into a future contract to purchase the foreign
exchange at the rate available for future trading. In some case even if you do
not expect any change in foreign exchange rate you enter into a contract to
save you from incurring higher costs in case the price goes up in future. So
you can enter into foreign exchange contracts if you anticipate high volatility
in the foreign exchange rates. Here you are only hoping to gain from such
contracts, The time to enter into such contracts would be as soon as you become
aware of any such future possibility of change in foreign exchange rate. An
intelligent investor employs both fundamental and technical analysis prior to
entering any trade. Fundamentals include watching the world news, and
particularly studying variables that may cause the market price of a currency
to fluctuate. Monetary and fiscal policy, political conditions, trade patterns,
economic indicators, interest rates, inflation and unemployment figures are to
be observed. Faith in a government’s ability to stand behind its currency also
impacts currency price.
In today’s world there are a
large number of currency markets. Trading in one currency vs. another is a
market. Since there are many currencies, there are a large number of possible
markets. But only some of these markets are active. i.e. There are large
volumes of trading and the frequency of the trades is also high. These are the
active markets. Most investors prefer a volatile market. Profits depend on
changes in the market. Higher the changes, higher are the chances of large
profits. In an actively traded market a large number of investors are
operating. When you desire to trade, you need another trader who will buy when
you sell and who will sell when you buy. This is easily possible in an actively
traded market.
The Forex market is cash inter
bank or inter dealer market. Forex market is not a market in a traditional
sense. There is no centralized location for trading activity. Trading occurs
over the telephone and through computer terminals at thousands of locations
worldwide. The most often traded currencies, the major currencies are those of
countries with stable governments and respected banks that target low
inflation. Currencies that often trade with the U.S. dollar include Japanese
Yen, British Pound, the Swiss franc and now the new European currency ?Euro.
These are the most liquid. Countries suffering political instability or
economic turmoil have currencies which are often tightly regulated and simply
too illiquid. Forex is a continuous global market, providing participants with
24-hour market access. The only breaks in trading occur during a brief period
over the weekend. The major dealer centers are that of Sydney, Tokyo, London
and New York. Even though a 24-hour market the time of the day can have a
direct impact on the liquidity available for trading a particular currency. The
time zones therefore become important.
Technical analysis has grown
dramatically in popularity in the foreign exchange market since the 1980s.
Buying and selling opportunities are identified and tracked by computer
charting, using trend lines, support and resistance levels, reversals and
numerous patterns and analysis to study the behavior patterns of market crowds.
Over long historical periods, currencies have displayed identifiable trends and
patterns, which provide investors with profitable opportunities.
People invest in forex markets
because of the large opportunities they offer. They are very large markets
involving trading of 1,500 billion $ every day. An individual investor can
realize huge profit potential by buying or selling a particular currency
against the U.S. dollar or any other major currency. Investor can generate
profits whether a currency is rising or falling. Buying one currency (which is
expected to rise) against another currency can do this. Or you may sell one
currency (which is expected to fall) against another currency. Taking a long
position means buying a currency at one price and aiming to sell it later at a
higher price. A short position is one in which the investor sells a currency
that he hopes will fall and aims to buy it back later at a lower price. Buying
or selling currencies can also be in response to the economic or political
events, which occur. These are called reactive responses. Buying or selling
currencies on anticipation of rise or fall is a speculative response. Market
participants anticipating the direction of currency prices generate the bulk of
currency activity. In general, the value of currency vs. other currency (i.e.
Exchange rate or foreign exchange rate) is a reflection of the condition of
that country’s economy with respect to the other major economies. George Soros
took a massive position against British Pound in 1992 and virtually forced the
U.K. government out of the semi fixed exchange rate mechanism with its EU
partners. He made a fortune out of this transaction. You can lose money also.
The quantum fund set up by George Soros produced remarkable annual compound
returns of 30% between 1969 and 1987. Depending on the risks that an investor
is prepared to take the gains can be quite high. The style of George Soros was
to take big, often interlinked speculative position using lots of leverage. It
was possible to produce a 10% gain in the net worth of the fund that he was
managing by means of only 1% favorable move in the YEN.
Top
SAVINGS AND INTERESTS
The idea of savings is somewhat similar
to “Piggybank? A child does not know when and how much it can save.?Each saving amounts to almost no value. A
nickel or a dime cannot buy anything. But nickels & dimes saved now and
then over a period of long time can accumulate to dollars, which have some
value. Typically a householder or a salaried person does not know how much he
can save regularly. The demands can be quite irregular in terns of sickness,
education or special obligations. But if the small amounts saved are kept in
the form of cash, you may spend them. Secondly it cannot earn any interest.
Rich people in any society or countries are limited. But there are a large
number of middle income and even larger number of lower income groups. The idea
of savings account was to have an account where small sums of money saved from
time to time are deposited. Whenever needed you can withdraw the amounts also.
But you will earn a small interest on the balance in your account. A large
number of such accounts enable the bank to get funds at its disposal which it
can lend. Normally at any one time only a few savings account holders will want
to withdraw any money. This amount the bank keeps in terms of cash to meet will
such demand. The bank knows such demand from its experience. So though each savings
account may have small balance, a large number of such accounts are able to
provide funds to the bank. Savings account provide the facility of security of
the money. Some interest though small is paid. Whenever you have some amount
you find extra the same can be deposited in the savings account. Thus savings
account is an investment because you are able to get returns in the form of
interest. There can be several types of savings accounts. e.g. Joint accounts
in the name of husband & wife or a savings account in the name of a minor
child who can deposit but not withdraw,?
special savings account with certain facilities etc. It can be easily
understood that savings account induces a person to save small amounts of money
when possible. The investment generated as a result of such savings is
available in times of need. But savings are investments only if the currency is
stable and inflation is within limits. If the inflation is very high savings
depreciate very rapidly. The purchasing power reduces and hence the savings do
not remain good investments.
It is also possible that persons
in the middle income group can have large balances in the savings accounts. The
banks can then shift part of these investments to higher interest bearing
deposits. Alternatively if the person having savings account does not have
enough balance in his account but wishes to withdraw money for his use, the
bank can allow this. The bank merely transfers the funds from higher interest
investment to the savings account. Many facilities have become possible and
simple with the computers and inter connection. Withdrawing money from savings
bank account through ATMs have become very convenient. These ATMs are open for
24-hours. It is also possible to withdraw money from a different city to the
one in which you have the account. The savings bank account has therefore
provided not only the means of savings but also the security of money deposited
as well as availability of the same at any time in any city. Sometimes these
deposits up to a certain value are also insured against any eventuality
including collapse of the bank.
Saving bank accounts generally
pay smaller interest. But you can get the amount back at any time without any
advance notice or loss of interest.?
Secondly other higher yielding investments require higher quantum of
money. Hence when the amounts are small and you do not know how many times and
how much you will save, it is best to put the money in the savings bank
account. Many other investments carry the cost of commission, documentation or
fee. In case of savings account the process is very simple. Similarly when you
cannot anticipate when you will need the funds, savings account is a good
option. The supposition is that the total amounts are small and you may need
this in a hurry. Investment in savings bank account has two risks. One is the
reliability of the bank. It has happened in quite a few countries. The banks
have collapsed. Even in such a case the small investor is protected by some
kind of insurance. You must make sure that the insurance cover is adequate for
your balance. The other is inflation level in the country. If the inflation
level is in twenties or thirties it is eating away into the value of your savings.
Hence you have to think of other alternatives.
Term?deposit accounts are essentially investment of your savings for a
specified period. The term deposit is like investment in a bond. The bank
agrees to give you a fixed rate of interest (or a floating rate which is very
rare) on the term deposit for an agreed period of years. This rate is generally
higher than the rate of interest in case of savings account. It is also higher
for a longer period. The bank will pay higher interest if your term of deposit
is 5 years instead of 2 years. The reason for this is that the banks can safely
lend this money to a businessman for this long period. Theoretically you cannot
ask for the return of this money before the term. In actual practice subject to
some penalty, you can withdraw the term deposit before maturity in many cases.
Hence if the amounts are large and you are fairly sure of not needing this for
a long period, it makes sense to invest in term deposits. The term should be
chosen with care so that you get the highest rate of interest possible and get
the amount when you are likely to need it. So if you can spare the amount for a
longer period it makes sense to invest the money in term deposits.
Savings bank accounts were quite
simple. You could deposit the money any number of times. Depending on the rules
the interest was paid on the minimum balance in the account. The interest was
credited once in a year. But of late there is competition in the banking sector
too. Secondly computerization in banking has made accounting faster. It is also
now possible to give standing instructions to the bank regarding the operation
of the savings account. This can help you in making some regular payments.
Similarly ATMs have made withdrawal of money quite simple and possible at
anytime.?So when choosing a savings
account and the bank, you can look at the facilities being provided. A bank
having total computerization can permit you to withdraw money from any city in
the country. It is also helpful if the bank has branches in more cities and
readily accessible from where you reside or work. The rate of interest will be
generally the same but this should be verified. Some savings accounts may have
the facility of automatic transfer of funds to a higher interest bearing term
deposits, if the balance increases beyond a certain limit. In another case the
funds in the higher interest bearing term deposits can be transferred to the
savings bank, if you have issued cheques exceeding the balance. Some banks will
accept instructions for regular payments for insurance, telephones, electricity
bills etc. from the savings bank account. Similarly many banks will credit the
dividends, annuity and such other payments directly to the savings account
electronically. Hence to choose the right savings account the different
facilities being offered by the banks and the convenience it will offer to you
should be studied. In some cases even facilities proposed in near future should
be taken into account while choosing the right savings account.
Top
OTHER INVESTMENTS
PRIVATE VENTURES :
A). Private Companies :
Private companies have stocks, which are?not widely held. Basically these companies
are?having stock, which is held either
by a few individuals or their?friends,
relations or individuals who are known to the promoters. Public companies have
to invite subscription to stock by means of the issue of a prospectus. It has
to give complete information in respect of their prospective activities, risks,
anticipated sales, expected profits etc. The stock is permitted to be quoted on
stock exchange.?Since the stock is
quoted on the stock exchange, the management is required to make available
all-important information which may affect the price of the stock on the
market. They are required to publish the quarterly results in the newspapers.
The basic idea is that since public at large is investing in public companies,
no one should be able to take advantage of any inside information which is not
available to the public. The information should be available to all. The
private companies are not subject to such discipline . They cannot invite
subscription from general public. This severely limits availability of large
funds from public. Hence generally only those who know the management of the
company or their promoters and can put their faith in them will want to invest
in such companies. Stock in a private company cannot be sold in the stock
exchange through a broker. The prices are not quoted. There may be conditions
attached to the sale. The present promoters or management may have the
first?right to buy the share. If they
do not buy the same can be sold to someone else. But this is possible only if
the present management agrees. They are thus investments with high risk.
Secondly they may not be readily available. They are not traded. Hence it may
be quite difficult to know the value of the stock. The liquidity is also
limited. You may not be able to sell if you do not find a buyer who agrees to
the conditions of the management. The person who invests in private companies
must be able to know what is happening in the company by his own diligence. The
management of a private company has a lot of freedom since they are not subject
to the discipline of a public company. This may help then in achieving better
results. The rewards will be shared by the investor. Over a period of time the
present promoters may want to buy out the stock held by small investors.?They may be willing to pay quite a high
price for this. Not many companies are now private and those who have stock in
such successful companies may not want to sell. Hence the opportunity for
investing in a private company are not always available. The trustworthiness
and track record of the management, requires proper?scrutiny.
b). Private Funds :
Venture
capital industry is a relatively small but growing sector of the investable
capital market. Basically venture capital has emerged by wealthy persons who
can pool their resources and create a large amount of private capital. Venture
capital investments possess unique characteristics. First of all here the
philosophy is long term investment. In case of a start up company i.e. a
company, which is just starting, the investor must have the patience to wait
till the seed become a mature fruit. It does take time to build and develop a
new company. The investor must also realize that where a company will finally end
up may turn out to be quite different from the end proposed. Companies
frequently need to change products or at least modify the prototype if the
product does not meet with the expectations,?
The selection of the venture has to be proper. The idea should be right
and outside conditions suitable. All the homework must be done thoroughly
including time frame for each stage from concept to sales. The team, which will
implement the project, should be cohesive and committed to the project. It
should not depend on one individual. There should be enough cushions in the
financial calculations so that a slight change does not sink the project.
In
spite of all the precautions, all projects will not succeed. But a few that
will succeed will do so well that the venture capital industry will still make
above average returns. This is the force that is driving the venture capital
industry.
The
venture capitalists can either manage the fund themselves or more often hire
professions who can manage the fund and day to day decisions. Only the venture
capitalists or private fund owners will decide the policies. Either way success
will depend on their ability to analyze economic trends for potential market
opportunities. Careful screening and selection of teams who are capable of
exploiting new opportunities is vital. . The exit strategy represents a plan
for recouping the investment. Generally there are two main avenues. One is
merely selling the company or selling the investment to other investors when
the company is very successful. The other alternative is to go public i.e. make
an IPO (initial public offer) and sell the shares in the company to a wide
range of investors. Efficient financial markets, which seek out and fund
important new technologies are necessary today. Without this, innovations and
products would not have emerged with a speed, which could not have been
imagined a few decades ago. The progress of a country may well depend on the
availability of venture capital and its efficient use. Diversifying into a member
of different companies and regional diversification can minimize risk. Another
important diversification is investment in firms at various stages of
development.
C). Incorporating?:
Any one
who has money to invest can go into the business himself. There are many
success stories of individuals going into the business and coming out to be
highly successful. Bill Gates and Sam Walton may be good examples. What is not
obvious is that for every one successful example there could be several
examples of failures. Investment in stock is investment in business run by
someone else. You have no control over what he does. But what he does affects
your investment. Going in to the business for one’s self is risky. But every
investment is risky. Being in control you should be if anything, able to do
better. What does ensure business success? Today the business is highly
competitive. Many persons are awed by the complex operations and decisions
required to be made. Basically success in business requires a few key ingredients.
You have to visualize the opportunity. You must have confidence in yourself.
You should have a lot of patience to try and try again, if you do not succeed
in the first attempt. Understanding the customer needs and satisfying them
better at lower cost is also important. Ability to work with others and getting
the best out of your employees are also skills worth having. You may not have
all the qualities to start with but you must go on learning, acquiring new
skills and developing qualities that you find are necessary. As you go along
there will be difficult periods, trying times, adversity etc. But you must
continue your efforts. If you lose heart, all others in the venture will be
totally frustrated. Ups & downs will be there in every business. You have
to be a source of encouragement for others. Even if you lose your investment,
the skills that you develop and experience that you gain will be invaluable.
Another
important factor in success is the ability to listen to others. Many successful
businessmen are so confident that they stop listening to others. This is sure
road to disaster. It is equally important to realize when mistake is made. The
thing to do is admit the mistake and take corrective steps as soon as possible.
It is true that when you are in business, all your eggs are in one basket and
risks are quite large. But so can be the rewards. The decision would many a
time depend on the mental attitude of the person rather than the risk reward
equation.
An
annuity is a fixed sum paid in perpetuity. It can be linked to an index but
generally it is a fixed sum. When you are in employment, either you or your
employer or both can invest in an annuity. A small amount is paid to the
annuity provider till the age of retirement.. This amount, accumulated over the
years, enables the annuity provider to pay a fixed sum (monthly, quarterly or
yearly as agreed) to you till you live. This is a good retirement benefit.
Annuity can also be purchased at any time by a single payment also. Depending on
the single payment and terms of the annuity, the annuity provider will continue
to pay the annuity till you live. In a way it is like pension.. The annuity
payments are calculated taking into account the interest rates, life cycles,
inflation etc.
Interest
rates during the later part of 2001 are going down all over the world. But in
most countries inflation is very much under control. Under such a situation a
retired person with limited?liability
desires to have a fixed income till be lives.?
He can then manage his affairs well. In other forms of investment there
is some uncertainty as to how much income he can get. Even in case of 15 years
bonds, the interest that he will get after the 15-year period is over cannot be
known in advance. If after 15 years the bank rate is low, he may get lower
interest in new investment in bonds. In case of stock market the uncertainty is
considerably more. In case of annuity, once he has made his purchase of
annuity, his annuity payments will ensure the fixed income contracted for till
he lives. He can live for another 5 years or another 30 years he will continue
to get the payments. So for certain category of persons annuity payments are
good investments.
Some
employees are allowed to invest some portion of the salary (agreed by him) in a
portfolio. Here the annuity payments after retirement will depend on the
success of the portfolio.?These are
also therefore called variable annuity. There are certain tax benefits to the
employees in such schemes.
Real estate
has received attention in recent years as a compliment to stocks and bonds.
Real estate is either land and/or building and is fixed in location. Each piece
of real estate is unique because of the location. No two real estates are
identical, The value of real estate also depends on how nearby properties are
and the way they are utilized. The value also depends on local and economic
conditions. A real estate cannot be moved. Hence location in an area of demand
becomes very important. Real estates are durable goods having long economic
life. Use of the property in?future has
to be thought of. Properties usually involve large funds and are not divisible.
Due to this the market for real estate is less efficient. For many large
properties there are only a few buyers. Since the trading is not very often,
the market price is difficult to establish. Information on price is not readily
available as in case of stocks and bonds. It takes a long time to conclude a
deal in real estate. Ownership of a real estate requires management of the
property. Institutional investors would normally prefer a local partner to
ensure expertise familiar with the local market. Real estate ownership also
involves complicated legal procedures. Hence transaction costs are quite high, compared
to other investments.
One of
the most important reasons for investing in real estate is hedge against
inflation. Real estate is a very good investment in an inflationary climate. Including
real estate in a portfolio imports diversification. It enhances the risk return
characteristics. Investment in real estate results in tax benefits. The cost of
real estate (less land) can be depreciated for tax purposes at a rate, higher
than the actual decline in value of property. Taxable investors can use this to
shelter other income.
There
are many ways in which you can invest in real estate. Major types sought by
investors are office buildings, industrial buildings, shopping centers, apartment
buildings, hotels, motels and some specialty real estate such as restaurants.
With direct investment the investor can obtain all or part of the real estate
asset. The investor can manage the asset himself or delegate this to others for
a fee. Indirectly the investment can be through an intermediary. They include
REITs ( Real Estate Investment Trusts), public limited companies or syndicates.
There are also debt investments in real estate. You can provide a part of debt
capital in return for a claim on a part of income from the property. Such a
claim would be secured by a lien on the property known as mortgage. This is the
security for the investment.
It can
be seen that there are many ways in which you can make investment in real
estate. You have to analyze your own requirements and needs and take an
appropriate decision.
Investors
know that there is a trade off between risk and return. When you seek a big
reward, you have to be prepared for an eventuality when you may lose a
substantial amount. You also know that one way of managing the risk is to
diversity. This means you will buy a number of stocks. When the value of some
stocks go down, some may go up.?Hence
less risk. Recent years have been wonderful for investors. A consequence of
this is that a whole generation of investors has grown up not knowing the
effects of a collapse of the stock market. A bear market (when stock values are
falling) gripped the Wall Street between 1937 and 1941. The market fell four
years out of five. It lost 38% of its value. In UK in 1973 and 1974 shares fell
31% and 55% respectively. The Wall Street crash from 1929 to 1933 resulted in
share values falling persistently for 3 years. When market bottomed out it was
87% below the peak of September 1929. Such knowledge can help in keeping a
balance in times of adversity.
Some
person may feel that you can safely invest in mutual funds because they have
trained managers devoting full time for this activity. They have large amounts
of money for diversification across industry and security types. A study
conducted by Wharton school of finance and commerce in USA for Securities and
Exchange Commission “found no relationship between the performance of mutual
funds studied and the fees and charges that these funds levied? Michael C.
Jensen after a study found that “the funds earned (net of expenses) about 1.1%
less per year (compounded continuously) than they should have earned given
their level of systematic risk?
On the
other hand it may be quite difficult for an individual investor to find the
time to study and analyze stock movements on the exchange, let alone study the
performance of management of different companies. It is in this context that an
investor can use professional investment counsel to advise him on investment
policy. The investor can ask questions and discuss his objectives with the
counsel. Such discussion can be quite invaluable in guiding the investor.
Alternatively the entire management of the portfolio can be entrusted to such a
professional. Many banks, financial institutions and brokerage houses are
offering such services. This in effect creates a small mutual fund exclusively
for the investor to meet with his individual needs. The range of services can
vary considerably under this type of arrangement. Naturally the costs will also
vary. The cost benefit analysis has to be attempted. The costs are likely to be
high for a small investor. When the funds are sizable, the costs could be
reasonable. Hiring the services of a professional to take complete control of
your portfolio would rob you of the excitement and a sense of achievement. As
is rightly said you cannot have the cake and eat it too!
INVESTMENT PRINCIPLES
The dictionary
defines risk as the “chance or possibility of a danger, loss or injury? For
investment purposes, this can be translated as “the chance that the actual
outcome from an investment will differ from the expected outcome? Here
different can be different positively or different negatively. Even if an
outcome of investment turns out to be better than your expectation, it is still
different. Hence, it is risky. The price of an investment will always go up and
down. The movement in the price of an investment is the risk. A large movement
is high risk. A little movement is little risk. Now it is easy to understand
the risk reward relationship. A stock whose prices can go up or down by a large
margin can go up by a large amount or go down by a large amount. You are
holding this stock. If the prices go up by a large amount you have reaped a
high reward. You can sell the stock and gain the value of difference. But if
the price of the stock goes down, it may go down by a large amount because this
stock is subject to high fluctuations. Now even if you do not sell the stock
the value has already gone down by a large amount. You have lost the amount of
difference. On the other hand if you hold a stock which hardly ever goes up or
down, you have no risk. But there is not going to be any reward either. So
either you have to take high risk with a possibility of big reward (and equally
good possibility of losing a substantial amount) or be satisfied with no risk
no reward at the other extreme. So it is easy to understand the risk reward
relationship. Your purpose of investing is two fold.. To get some regular
income and also if possible increase the value of your investment. It has been
seen that over a long period -say more than 10 to 15 years- there has always
been good returns from the stock. As the investment horizon lengthens even
unlucky investors are able to move into profit zone. Secondly the gap between
the best possible and worst possible returns narrows and stabilizes.
Satisfactory investment returns are available for all equity investors who are
prepared to wait. In most cases these returns are substantially better than
those produced by other investments such as bonds. An investment bank has shown
that the average rate of return on U.K. govt. bonds for 1974 to 1994 (after
adjusting for inflation) was 5.7% per year. The corresponding figure for
equities was 13.5%. This is likely to be in future also. Equities represent the
risk capital that is invested in projects to produce the best return. Such
capital can be, and is, reinvested elsewhere when better opportunities open up.
Risk capital is always limited. The demand for it will always ensure that it
finds its use where the returns are higher. It is therefore reasonable to argue
that there is no reason to fear investment in equities in a diversified
portfolio. It is only necessary to follow sound investment principles.
?/span>Diversification is one way to reduce risk.
The investor desires to get rewards but he also wants that under no
circumstances should he lose substantially. Many different ways are possible.
One traditional approach is to have a large number of securities in the
portfolio. But it should be kept in mind that mere number might be less
important than the kind of securities. The stock market consists of stocks
which have high fluctuation called volatile and those which move in a narrow
range called stable. Logically it may make sense to have a balance of both.
This would be diversification. But even here those who want high rewards and can
take higher risk may keep more of the volatile stocks. Those who want to take
less risk may keep more of stable stocks. Again there are many industry types.
All industries may not do badly (or do very well) at the same time. It may have
interdependence. Some may be related in such a way that when one does well the
other will not do well. Better health and well being may be good for travel
& hotel industry. But may be less welcome to the pharma industry. If you
have stocks of both, one may compensate for the other in case of violent
fluctuations. Similarly the movements in stocks of small companies may differ
from the movement of stocks in large companies. A small individual investor
cannot just invest in a large number of stocks for the purpose of diversification.
He must therefore select the few varieties of stocks carefully so that all of
them will not go up or down together and all of them will not have volatile
movements at the same time. The risks can never be reduced to zero in portfolio
of any size. Diversification also means investments in other assets. The most
important for diversification are bonds. Bonds give an assured income over a
long period. There is a security for the payment of interest and capital. In
case of Govt. bonds there is no risk at all. Some investment in bonds would
also reduce the risk for a part of the investment. Diversification can also be
achieved by investing in real estate. This can give a good hedge against
inflation. You could also invest in mutual fund. Mutual funds are available
with various objectives. Mutual funds could be diversified stock portfolios,
income funds or even balanced funds that invest in both stocks & bonds. So
it is possible to select a mutual fund which can match with your desired kind
of diversification.
?You have some money and you want to invest.
The basic purpose of investing is to see if you could earn more from this
amount and turn it into a substantial amount by taking some risks. Some persons
may invest only for the thrill of the experience. The stimulus provided by
pitting your brains can be quite exciting in a battle on the stock market. The
investors are all competing in the stock market. The score card is the index.
Winners are there for everyone to notice. Such investors do not need the income
or the appreciation of capital. They are looking for the fun, the excitement
and the joy of getting noticed. They can do what they like and need not go into
the asset allocation question.
For a
large numbers of investors the reason for investing is more practical. They
need certain income from the investment regularly. They would like to build a
reserve of capital for the future needs. This resolve of capital can be turned
into cash when needed in future for various needs. These needs may not be known
precisely today but some estimates can be worked out. The first step therefore
is to work out the present and future needs. How much regular income do you
need today? Will this requirement increase or decrease in future and by how
much? How much capital may be needed in future-may be to buy a house, expansion
of business, sickness, etc. For working out these figures you will have to
remember that a dollar today is not worth a dollar after five years. If you can
buy something for a dollar today, you may or may not be able to buy the same
thing for a dollar after say 5 years. This is due to inflation. Inflation
erodes the value of money. So you have to take into account the rate of
inflation. The higher the rate of inflation, the bigger the amount of money
that you have to provide in future for the same need. Many of these questions
may not have exact answers. You will have to assume the future rate of
inflation. You will have to estimate broadly your needs. Once these are identified,
you can progress to the next step. How can I plan my investment to meet these
needs. Surely it is easier to work out such an exercise if the approximate
requirements are known. Such targets are easier to achieve if the returns
expected are lower and the time required for?
achieving them is longer. If the time frame is short the person has to
remember that he has to be very cautious. He cannot afford the shocks that the
stock market may deal. On the other hand if the time horizon over which you are
expected to achieve the results is long you can afford to be more risk
inclined. This is because even if there are adverse situations, you have plenty
of time for the period when fortune is sure to smile.
| 
