Basics of investments - Financial concepts

The world of investing can be a cold, chaotic, and confusing place. In this tutorial, we'll go through some of the theories that investors have developed in an effort to explain the behaviour of the market. We will discuss concepts, like risk return trade-off, rupee cost averaging and diversification, that are especially useful for individual investors.

Here are some of the fundamental concepts of finance and investment.


The Risk Return trade-off

Deciding what amount of risk you can take while remaining comfortable with your investments is very important.

In the investing world, the dictionary definition of risk is the chance that an investment's actual return will be different than expected. Technically, this is measured in statistics by standard deviation. Practically, risk means you have the possibility of losing some or even all of your original investment.

Low risks are associated with low potential returns. High risks are associated with high potential returns. The risk return trade-off is an effort to achieve a balance between the desire for the lowest possible risk and the highest possible return. The risk return trade-off theory is aptly demonstrated graphically in the chart below. A higher standard deviation means a higher risk and therefore a higher possible return.


A common misconception is that higher risk equals greater return. The risk return trade-off tells us that the higher risk gives us the possibility of higher returns. There are no guarantees. Just as risk means higher potential returns, it also means higher potential losses.

On the lower end of the risk scale is a measure called the risk-free rate of return. It is represented by the return on 10 year Government of India Securities because their chance of default (i.e. not being able to repay principal and interest) is next to nothing. This risk free rate is used as a reference for equity markets whereas the overnight repo rate is used as a reference for debt markets. If the risk-free rate is currently 6 per cent, this means, with virtually no risk, we can earn 6 per cent per year on our money.

The common question arises: who wants 6 per cent when index funds average 13 per cent per year over the long run (last five years)? The answer to this is that even the entire market (represented by the index fund) carries risk. The return on index funds is not 13 per cent every year, but rather -5 per cent one year, 25 per cent the next year, and so on. An investor still faces substantially greater risk and volatility to get an overall return that is higher than a predictable government security. We call this additional return, the risk premium, which in this case is 7 per cent (13 per cent - 6 per cent).

How do you know what risk level is most appropriate for you? This isn't an easy question to answer. Risk tolerance differs from person to person. It depends on goals, income, personal situation, etc. Hence, an individual investor needs to arrive at his own individual risk return trade-off based on his investment objectives, his life-stage and his risk appetite.


Diversification

Diversification is a risk-management technique that mixes a wide variety of investments within a portfolio in order to minimize the impact that any one security will have on the overall performance of the portfolio.

Diversification essentially lowers the risk of your portfolio. There are three main practices that can help you ensure the best diversification:

  • Spread your portfolio among multiple investment vehicles such as cash, stocks, bonds, mutual funds, and perhaps even some real estate. Alternately you could invest only in mutual funds but of varied types. For example you could invest 30 per cent in equity schemes, 40 per cent in debt/income schemes and 30 per cent in money market schemes. You could also invest in commodity funds although as and when permitted by SEBI

  • Vary the risk in your securities. If you are investing in equity funds, then consider large cap as well as small cap funds. And if you are investing in debt, you could consider both long term and short term debt. It would be wise to pick investments with varied risk levels; this will ensure that large losses are offset by other areas

  • Vary your securities by industry. This will minimize the impact of specific risks of certain industries

Diversification is the most important component in helping you reach your long-range financial goals while minimizing your risk. At the same time, diversification is not an ironclad guarantee against loss. No matter how much diversification you employ, investing involves taking on some sort of risk.


Rupee cost averaging

If you ask any professional investor what their hardest task is, he or she will tell you that it is timing the market. Trying to time the market is a very tricky strategy. Buying at the absolute low and selling at the peak is nearly impossible in practice. This is why investment professionals preach rupee cost averaging (RCA).

RCA is the process of buying fixed amounts into a security/stock/mutual fund at fixed points in time regardless of the prevailing price. This means you buy more units of the security at lower prices, and fewer units at higher prices. The cost per unit/share over time therefore averages out. This reduces the risk of investing a large amount in a single security/mutual fund at the wrong time.

This principle is very powerful and works best over long periods of time. The Systematic Investment Plans (SIPs) launched by mutual funds work on this principle and are therefore a highly recommended investment option.


Asset allocation

Asset allocation is an investment portfolio technique that aims to balance risk and create diversification by dividing assets among major categories such as bonds, stocks, real estate, and cash. Each asset class has different levels of return and risk, so each will behave differently over time. At the same time that one asset is increasing in value, another may be decreasing or not increasing as much.

The underlying principle of asset allocation is that the older a person gets, the less risk he or she should face. After you retire you may have to depend on your savings as your only source of income. It follows that you should invest more conservatively at this time since asset preservation is crucial.

Determining the proper mix of investments in your portfolio is extremely important. Deciding what percentage of your portfolio you should put into stocks, mutual funds, and low risk instruments like bonds and treasuries isn't simple, particularly for those reaching retirement age. Imagine saving for 30 or more years in the stock market only to see the stock market decline in the years just before your retirement! Therefore one must change asset allocation over time to move more towards safer asset classes (bonds, treasuries) as one gets older. To determine your asset allocation plan, we suggest you speak to an investment advisor who can customize a plan that is right for you.