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Investment Planning

(Professional Development Program)

IMS Learning Resources Pvt Ltd.

E-Block, 6th Floor,
NCL Bandra Premises,
Bandra Kurla Complex,
Bandra (E). Mumbai 400 051
Tel No: +91 22 66680005
Fax No: +91 22 66680006

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Investment Planning is all about achieving desired rate of returns from investible surplus and existing
assets, matching one’s time frame of goals, age and risk profile. Hence this forms the heart of
comprehensive financial planning process. Investment planning begins with designing a suitable strategy
identifying and selecting various asset classes to grow existing assets and future investible surplus.

Sound investment strategy is based on comprehensive knowledge about various classes of assets,
their unique characteristics and understanding of expected returns and associated risks with each

class of asset. It is important to bear in mind that investment strategy will always be linked to one’s risk

This program will guide you systematically in understanding the concepts required for preparing a

sound investment plan.

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Table of Contents

Chapter - 1 Fundamentals of Investment Planning .................................................................... 8

Chapter - 2 Understanding Investment Risk ............................................................................ 16

Chapter - 3 Measurement of Risk ........................................................................................... 27

Chapter - 4 Managing Risk in Investments .............................................................................. 40

Chapter - 5 Measuring Investment Returns ............................................................................. 54

Chapter - 6 Building an Investment Portfolio ........................................................................... 71

Chapter - 7 Small Saving Schemes ........................................................................................ 94

Chapter - 8 Fixed Income Instruments .................................................................................. 107

Chapter - 9 Life Insurance Products ...................................................................................... 116

Chapter - 10 Mutual Funds ..................................................................................................... 126

Chapter - 11 Stock market investments .................................................................................. 144

Chapter - 12 Derivatives ......................................................................................................... 160

Chapter - 13 Real Estate ........................................................................................................ 188

Chapter - 14 Investment strategies ......................................................................................... 197

Chapter - 15 Asset Allocation .................................................................................................. 205

Chapter - 16 Structuring Portfolio for Investors ....................................................................... 212

Chapter - 17 Regulation of Financial Planners ........................................................................ 219

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Chapter 1

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Fundamentals of Investment Planning

What is Investing?

I nvestment refers to a commitment of funds to one or more assets that will be held over some future
time period. It is important to understand the difference between Savings and Investments. Anything not
consumed today and saved for future use can be considered as savings. Almost all of us save money. In
fact we are a nation of savers where the domestic savings is a high percentage of Gross Domestic Product
– sometimes as high as 26-27%. It is important to channel these savings into productive investment avenues.
Almost all individuals have wealth of some kind, ranging from the value of their services in the workplace to
tangible assets to monetary assets.. For our purposes, investment will mean a measurable asset retained
in order to increase one’s personal wealth. A financial asset is one that generates income and contributes to
accumulation and growth of wealth over a period of time. The two elements in investments are generation
of income on a periodic basis and/or growth in value over a period of time.

Investment scenario in India

A pick-up in investment, reflecting the high business optimism, not only strengthened industrial
performance but also reinforced the growth outlook itself. The rally in gross domestic capital formation
(GDCF) that had commenced in 2002-03 continued and as a proportion of GDP it reached a high of 30.1
per cent in 2004-05.1
The increasing trend in gross domestic savings, which provided most of the resources for investment,
as a proportion of GDP observed since 2001-02 continued with the savings ratio rising from 26.5 per
cent in 2002-03 to 28.9 per cent in 2003-04 and further to 29.1 per cent in 2004-05.2
India is a nation of savers and the domestic savings is a very high percentage of GDP. That is extremely
good. It is shocking to note that more than 45% of domestic savings is invested in bank deposits and
only about 2/3% in equity and equity related investments. This clearly shows that while as a nation we
are very good savers we are very poor investors because it is equally important for the savers to invest
in avenues that fetch decent returns after considering factors like inflation, taxation, etc. Bank deposits
not only offer lower returns but they are hardly tax efficient and thus do not serve the cause of earning
high post tax & net of inflation returns. In developed countries the proportion of savings being diverted to
equity and equity related instruments is in the region of 20-25% of GDP while around 20% of savings are
parked in bank deposits.
Some investors have failed to recognize the less obvious, but potentially more damaging, risk of diminished
income from staying completely invested in low yielding fixed income securities or bank deposits.
The financial planner should ensure that investors take a hard look at the fixed income components of their
portfolios and rethink this strategy in the context of more comprehensive, long-term objectives. Understanding
where the clients are coming from, the priorities in their life and the challenges they face in a rapidly changing
investment horizon. Succeeding in career, planning children’s education, marriages and having more than
enough for an enjoyable retirement are some of the objectives most people aim at.

Economic Survey 2005-2006 2
Economic Survey 2005-2006

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The financial planner in India hence, has a very important role to play. The planner’s job in India is more
challenging because of Indian mind set and the aversion to risk. It will be part of his job to educate his
clients on concepts of risks and returns and their relationship.

Why Invest?
We all work for money. It is equally important to ensure that money works for us. We should inculcate
the habit of reliance on a secondary source of income. We invest to improve our future welfare. Funds
to be invested come from assets already owned, borrowed money, and savings or foregone consumption.
By foregoing consumption today and investing the savings, we expect to enhance our future consumption
possibilities. Anticipated future consumption may be by other family members, such as education funds
for children or by ourselves, possibly in retirement when we are less able to work and produce for our
daily needs. Regardless of why we invest we should all seek to manage our wealth effectively, obtaining
the most from it. This includes protecting our assets from inflation, taxes and other factors.

Investment fundamentals
Some of the fundamental rules of investments are:
The following table will demonstrate the difference, very graphically:
It is assumed that an investor invests Rs 1,000/- p.m., at the end of each month, systematically, in
different invest plans which yield 5%, 8%, 12% and 15% p.a. returns.
Look at the big difference in the maturity values as the term gets longer and longer and as the
returns are higher.

Indian investors have always preferred fixed income securities where the returns are assured and have
compromised on the returns. In general investors are risk averse and more so Indian investors. It is the
job of the financial planner to advise the investors on the concept of focusing on higher returns for better
stability and higher capital building over a longer period of time. The above table very clearly illustrates
how a higher rate of return over longer period of time can make a world of difference to the capital at the
end of the term.

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Mr. Sunil Joshi, a very conservative investor, has been religiously investing Rs. 5,000/- p.m. in a provident
fund account which gives him interest at the rate of 8% p.a. compounded annually. Mr. Ashwin Shah, on
the advise of his planner, has been investing Rs. 5,000/- p.m. in equity linked investments which
have given him around 15% p.a. return. Both start at the same age of 25 years and keep investing
for 30 years. Mr. Sunil Joshi will have a capital amount of Rs. 74.50 lacs in his provident fund
account while Mr. Ashwin Shah will have accumulated Rs. 3.46 crores which is about 5 times the
retirement capital of Mr. Sunil Joshi. These dramatic results have been possible because of the
focus on the rate of return. Mr. Sunil Joshi has done well by starting early and investing regularly
but he has not focused on the rate of returns on his investments. While assured returns are important
it is also important to focus on expected returns on investment, even at a risk.

How Do We Invest?
If we are making investment decisions today that will directly affect our future wealth, it would make
sense that we utilize a plan to help guide our decisions. Surprisingly, the majority of people do not have
in place any type of formalized investment plan. Taking some time to put together a financial plan can
reap tremendous benefits. First, let’s define financial planning.
Financial planning is the process of meeting one’s life goals through the proper management of your
finances. Life goals can include buying a home, saving for child’s education or planning for retirement.
Financial planning provides direction and meaning to one’s financial decisions. It allows one to understand
how each financial decision affects other areas of finances. For example, buying a particular investment
product might help you pay off your mortgage faster or it might delay your retirement significantly. By
viewing each financial decision as part of a whole, one can consider its short and long-term effects on
life goals. One can also adapt more easily to life changes and feel more secure that goals are on track.

Common Mistakes in the planning process

It may be helpful to be aware of some common mistakes people make when approaching investments:

1. Don’t set measurable financial goals.

2. Make a financial decision without understanding its effect on other financial issues.
3. Confuse financial planning with investing.
4. Neglect to re-evaluate their financial plan periodically.
5. Think that financial planning is only for the wealthy.
6. Think that financial planning is for when they get older.
7. Think that financial planning is the same as retirement planning.
8. Wait until a money crisis to begin financial planning.
9. Expect unrealistic returns on investments.
10. Think that using a financial planner means losing control.
11. Believe that financial planning is primarily tax planning.
These are some of the most common misconceptions about financial planning and it the perhaps one of
the first jobs of the financial planner to clear these areas with the prospective client. The financial planner
should explain the process of planning; the various steps involved and the ultimate objective of the
exercise before hand and make the investor comfortable about disclosing his personal information.

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What Process Do We Use to Invest?
Nobody plans to fail but many fail to plan. It is important for the investor to realize that planning is very
important. The financial planner has to spend time in educating the investors about the common mistakes
and how to come over them. He has to take the client through the systematic process of financial
planning outlined below.
The financial planning process consists of six steps that help the investor/client take a “big picture” look
at where he is financially. Using these six steps, the investor can work out where he is now, what he may
need in the future and what he must do to reach his goals. These six steps are:

1. Establishing and defining the client-planner relationship.

The financial planner should clearly explain or document the services to be provided to you and define
both his and the client’s responsibilities. The planner should explain fully how he will be paid and by
whom. The client and the planner should agree on how long the professional relationship should last
and on how decisions will be made.

2. Gathering client data, including goals.

The financial planner should ask for information about the client’s financial situation. The client and the
planner should mutually define the personal and financial goals, understand the client’s time frame for
results and discuss, if relevant, how he feels about risk. The financial planner should gather all the
necessary documents before giving the client the advice he needs.

3. Analyzing and evaluating your financial status.

The financial planner should analyze the client’s information to assess his current situation and determine
what he must do to meet his goals. Depending on what services you have asked for, this could include
analyzing your assets, liabilities and cash flow, current insurance coverage, investments or tax strategies.

4. Developing and presenting financial planning recommendations and/or alternatives.

The financial planner should offer financial planning recommendations that address client’s goals, based
on the information collected. The planner should go over the recommendations with the client to help
him understand them and help the client make informed decisions. The planner should also listen to the
client’s concerns and revise the recommendations as appropriate.

5. Implementing the financial planning recommendations.

The client and the planner should agree on how the recommendations will be carried out. The planner
may carry out the recommendations or serve as the “coach,” coordinating the whole process with the
client and other professionals such as attorneys or stockbrokers.

6. Monitoring the financial planning recommendations.

The client and the planner should agree on who will monitor the progress towards achieving the goals.
If the planner is in charge of the process, he should report to the client periodically to review the situation
and adjust the recommendations, if needed, along with life changes.

Product selling Vs. Financial planning

Financial planning is the process through which the planner helps his client to achieve his financial
goals. The financial planner may also be an insurance advisor and/or a mutual fund distributor. The
planner may have a product bias because of the commissions and brokerages and he may try to push

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these products rather than act in the best interest of his client. This is not only unethical and immoral but
is also not a proper strategy for long term business success for the planner. It is a well established fact
that success in marketing any product or service is more dependant on motivating a client to buy the
product/service rather than resorting to aggressive selling tactics. The client would be better motivated
to opt for your service as a planner if you take care of his long term interest rather than your short term
interest of brokerage/commissions. It is easier for you to achieve your goals if you help a large number
of people achieve their goals.
The financial planner plays a very important role in designing an investment plan that would best suit his
client’s needs. He tries to understand thoroughly the financial goals of his clients; he discusses the
various investment options available and finally suggests to his client a financial plan that will serve the
purpose of achieving the client’s goals. This is a very comprehensive process which requires a thorough
understanding of the financial products; markets; economy and also an analysis of the client’s risk
profile; needs; goals, etc. Thus financial planning is much superior to selling financial products/services;
more comprehensive and more rewarding for the client and the planner in the long term.
In India many investors have a low level of understanding of the concept of financial risk and hence have
conventionally preferred fixed income instruments to market related instruments with uncertain income
flows. Thus our investors have a very low risk tolerance. It is one of the most important tasks of the
planner to educate his client on the concept of investment risk ; prepare the client mentally to accept
volatility in the markets in the short term and explain how patience will be rewarded in the long term.
Product selling does not involve these steps of educating and increasing the risk tolerance of the investor.
Hence a planner will enjoy a long term advantage and better relationship with his client compared to a
product seller.

Self-Help or Professional Help?

Some investors may feel that they understand financial products better and can do the financial planning
themselves rather than entrust the same to a professional financial planner. Investors may prefer some
personal finance software packages, magazines or self-help books that can help them do their own
financial planning. However, they may decide to seek help from a professional financial planner if:

n They need expertise that they don’t possess in certain areas of finances. For example, a planner
can help you evaluate the level of risk in your investment portfolio or adjust your retirement plan
due to changing family circumstances.
n They may want to get a professional opinion about the financial plan they have developed for
n They may not have the time to spare to do their own financial planning.
n Certain changes take place in the family or an immediate need or unexpected life event such as a
birth, inheritance or major illness.
n An investor may feel that a professional adviser could help him improve on how he is currently
managing his finances.
n An investor may feel that he should improve his financial position but does not know where to start
and how to go about it.
Some of the common problems which are brought before the financial planner are listed below. The list
is inclusive and there can a number of other areas as well.

n How should I create and preserve personal wealth?

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n How can I achieve a specific lifetime financial objective?
n How should I provide for my children’s education?
n I am receiving a distribution from my employer. What do I do?
n Do I have enough to retire?
n I just received a lump-sum inheritance. What do I Do?
n When should I execute my stock options?
n How should I best leave wealth to my heirs?
Expectations from a financial planner
1. He should believe that a sound financial plan is fundamental to achieving his client’s goals and
enhancing the quality of life.
2. He should also believe that money is not everything but having control and confidence about
managing it can allow the client to concentrate on other things like family, career and future.
3. He should recognize that the issues that brought the client to him are unique and he should try to
take result oriented approach to solving the client’s concerns.
4. He should adopt a personal, confidential and patient approach to help his client reach decisions on
complex choices and alternatives in investments.

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Review Questions
1. Financial Planning is:
a. Investing assets to receive the highest rate of return possible
b. Keeping taxes as low as possible
c. Planning to retire with the maximum income possible
d. A process of solving financial problems and reaching financial goals
2. The main reason people fail to plan is:
a. They keep on postponing
b. They are too old to plan
c. They are too young to plan
d. They lack the expertise to plan
3. Successful investing can be directly related to
I. Starting early
II. Investing regularly
III. Taking unduly high risks
IV. Focusing on risk and return in different investment vehicles
a. I & II only
b. III only
c. I, II and IV only
d. All four

1. d
2. a
3. c

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Chapter 2

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Understanding Investment Risk

Definitions and Concepts

Understanding Risk

I n the context of investments “risk” refers not only to the chance that a person may lose his capital but
more importantly to the chance that the investor may not get the desired return on an investment
vehicle. We invest in various investment products which generally comprise: 1. Fixed Income Instruments
and 2. Growth oriented investments. In the case of Fixed Income Instruments with a definite coupon rate
there is virtually no “risk” of not being able to get the desired returns but in the case of other instruments
an investor goes with an expectation of a certain amount of return and the term “risk” in this context
refers to the probability of the investor not getting the desired/expected returns
The notion of risk is an integral and primary concept in the understanding of investments. Risk can be
defined as the uncertainty of an outcome from an investment decision. In making an investment decision,
an investor forms an exception regarding that decision’s outcome. Any departure form that expected
outcome can be considered the risk of that decision. Thus, another way to consider risk is to consider
the possibilities of unexpected outcomes. The outcome form an investment decision may unexpectedly
increase or decrease the principal amount invested. While most people consider the decrease in value
as the investment risk, we will observe that in measuring risk, both positive and negative unexpected
outcomes must be considered. Before considering the issues regarding the measurement of risk let us
begin by enumerating the different types of risk that may exist for an investment.
The issue of risk being incorporated in both positive and negative surprises can be explained with a
simple example. Assume you are explaining the possible outcomes of an investment decision to a client
where the client may receive a return of either 8% (poor outcome) or a 16% (good outcome). You also
explain that the client may expect to receive a simple average of the two returns, or 12%, from the
investment decision. Your client now states that she is averse to the 8% outcome and wants to know if
the investment can yield 12% or better. That is, the client wishes to remove the poor outcome altogether.
Notice that if this were possible, then the simple average of the new investment decision, or the expected
outcome would now be 14% ((16%+12%)/2) and the new poor outcome would now be 12%. In other
words, risk, or the unexpected outcomes, cannot go away. It is only meaningful in the context of an
expected outcome and both positive and negative unexpected outcomes. There are many different
ways in which the principal invested can be unexpectedly changed. We will now consider each of these
types of risk.

Risk Avoidance
Investment planning is almost impossible without a thorough understanding of risk. There is a risk/return
trade-off. That is, the greater risk accepted, the greater must be the potential return as reward for
committing one’s funds to an uncertain outcome. Generally, as the level of risk rises, the rate of return
should also rise, and vice versa.
Before we discuss risk in detail, we should first explain that risk can be perceived, defined and handled
in a multitude of ways. One way to handle risk is to avoid it. Risk avoidance occurs when one chooses

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to completely avoid the activity the risk is associated with. An example would be the risk of being injured
while driving an automobile. By choosing not to drive, a person could avoid that risk altogether. Obviously,
life presents some risks that cannot be avoided. One may view a risk in eating food that might be toxic.
Complete avoidance, by refusing to eat at all, would create the inevitable outcome of death, so in this
case, avoidance is not a viable choice. In the investment world, avoidance of some risk is deemed to be
possible through the act of investing in “risk-free” investments. Short-term maturity Government bonds
are usually equated with a “risk-free” rate of return. In the Indian market place “risk free” returns are the
returns available on Treasury Bills of a certain tenor; necessarily less than one year and about 90days
or 180 days. Stock market risk, for example, can be completely avoided by choosing not to invest
equities and equity related instruments.

Risk Transfer
Another way to handle risk is to transfer the risk. An easy to understand example of risk transfer is the
concept of insurance. If one has the risk of becoming severely ill (and unfortunately we all do), then health
insurance is advisable. An insurance company will allow you to transfer the risk of large medical bills to them
in exchange for a fee called an insurance premium. The company knows that statistically, if they collect
enough premiums and have a large enough pool of insured persons, they can pay the costs of the minority
who will require extensive medical treatment and have enough left over to record a profit. Risk transfer can
also occur in investing. One may purchase a put option on a stock or on the market index which allows that
person to “put to” or sell to someone their stock or the index at a set price, regardless of how much lower the
stock or the index may drop. There are many examples of risk transfer in the area of investing.

The Risk Averse Investor

Do investors dislike risk? In economics in general, and investments in particular, the standard assumption
is that investors are rational. Rational investors prefer certainty to uncertainty. It is easy to say that
investors dislike risk, but more precisely, we should say that investors are risk averse. A risk-averse
investor is one who will not assume risk simply for its own sake and will not incur any given level of risk
unless there is an expectation of adequate compensation for having done so. Note carefully that it is not
irrational to assume risk, even very large risk, as long as we expect to be compensated for it. In fact,
investors cannot reasonably expect to earn larger returns without assuming larger risks.
Investors deal with risk by choosing (implicitly or explicitly) the amount of risk they are willing to incur.
Some investors choose to incur high levels of risk with the expectation of high levels of return. Other
investors are unwilling to assume much risk, and they should not expect to earn large returns.
We have said that investors would like to maximize their returns. Can we also say that investors, in
general, will choose to minimize their risks? No! The reason is that there are costs to minimizing the risk,
specifically a lower expected return. “Lower the risk, lower the return”. Taken to its logical conclusion,
the minimization of risk would result in everyone holding risk-free assets such as savings accounts and
Treasury bills. Thus, we need to think in terms of the expected return/risk trade-off that results from the
direct relationship between the risk and the expected return of an investment.

Influence of Time on Risk

Investors need to think about the time period involved in their investment plans. The objectives being
pursued may require a policy statement that speaks to specific planning horizons. In the case of an
individual investor this could be a year or two in anticipation of a down payment on a home purchase or
a lifetime, if planning for retirement. Generally speaking, the longer the time horizon the more risk can
be incorporated into the financial planning.

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Globally as well as in India it is well established on the basis of track record of performance that equities
as a class of asset has outperformed other asset classes and delivered superior returns over longer
periods of time. With these statistics available why wouldn’t everyone at all times be 100 percent invested
in stocks? The answer is, of course, that while over the long term stocks have outperformed, there have
been many short term periods in which they have underperformed, and in fact, have had negative
returns. Exactly when short term periods of underperformance will occur is unknown and thus there is
more risk in owning stocks if one has a short term horizon than if there exists a long term horizon. A
financial planner has to take into account the time horizon while structuring investment portfolios and
the general rule is that the younger a person is, the longer can be his time horizon and hence more
exposure to equities – this follows the rule that risk and returns go up with time.
Time has a different effect when analyzing the risk of owning fixed income securities, such as bonds.
There is more risk associated with holding a bond long term than short term because of the uncertainty
of future inflation and interest rate levels. If one were to “lock in” a rate of 8 percent for a bond that
matured in one year, an upward move in inflation or interest rates would have a less adverse effect on
the price of that bond than a 8 percent bond that matured in thirty years. That is because the bond could
be redeemed in one year and reinvested in a bond with a presumably higher interest rate. The thirty year
bond, however, will continue to pay only 8 percent for the rest of its thirty year life.

Types of Investment Risk

Systematic versus Unsystematic Risk

Modern investment analysis categorizes the traditional sources of risk causing variability in returns into
two general types: those that are pervasive in nature, such as market risk or interest rate risk, and those
that are specific to a particular security issue, such as business or financial risk. Therefore, we must
consider these two categories of total risk.
The following discussion introduces these terms.
Total risk can be divided into its two components, a general (market) component and a specific (issuer)
component. Then we have systematic risk and nonsystematic risk, which are additive:
Total risk = General risk + Specific risk
= Market risk + Issuer risk
= Systematic risk + Unsystematic risk

Systematic Risk
An investor can construct a diversified portfolio and eliminate part of the total risk, the diversifiable or
non market part. What is left is the non diversifiable portion or the market risk. Variability in a security’s
total returns that is directly associated with overall movements in the general market or economy is
called systematic (market) risk.
Virtually all securities have some systematic risk, whether bonds or stocks, because systematic risk
directly encompasses interest rate, market and inflation risks. The investor cannot escape this part of
the risk because no matter how well he or she diversifies, the risk of the overall market cannot be
avoided. If the stock market declines sharply, most stocks will be adversely affected; if it rises strongly,
most stocks will appreciate in value. These movements occur regardless of what any single investor
does. Clearly, market risk is critical to all investors.

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Unsystematic Risk
The variability in a security’s total returns not related to overall market variability is called the unsystematic
(non market) risk. This risk is unique to a particular security and is associated with such factors as
business and financial risk as well as liquidity risk. Although all securities tend to have some nonsystematic
risk, it is generally connected with common stocks.
Remember the difference: Systematic (Market) Risk is attributable to broad macro factors affecting all
securities. Nonsystematic (Non-Market) Risk is attributable to factors unique to a security.

Market Risk
A market is a place where goods and services are traded. Events occur within a market that similarly
affect all the goods traded in that market. For example, when the Reserve Bank of India unexpectedly
changes interest rates, most financial securities are affected similarly. Other examples of events that
affect all securities are the possibilities of war, severe natural catastrophes, recessions, structural changes
in the economy, tax law changes, even changes in consumer preferences etc. When the unexpected
change in values is systematic to the whole market, that risk is termed as market or systematic risk.

Reinvestment Risk
In the context of bonds investors look at the current yield as well as Yield To Maturity (YTM) – the return
one would get if the security were held till the maturity and redeemed with the issuing institution.
It is important to understand that YTM is a promised yield, because investors earn the indicated yield
only if the bond is held to maturity and the coupons (the periodic interest payments) are reinvested at the
calculated YTM (yield to maturity). It is important to reinvest the periodic payments, at the same rate as
the YTM, to obtain the YTM yield on the security. In the context of long term bonds during the tenor of
which the interest rates may fluctuate in any economy it is virtually difficult for the investor to invest
periodic coupon payments at YTM and hence the risk of not being able to get the desired return (YTM)
and this risk is referred to as reinvestment risk.
Obviously, no trading can be done for a particular bond if the YTM is to be earned. The investor simply
buys and holds. What is not so obvious to many investors, however, is the reinvestment implications of
the YTM measure. Because of the importance of the reinvestment rate, we consider it in more detail by
analyzing the reinvestment risk.
The YTM calculation assumes that the investor reinvests all coupons received from a bond at a rate equal
to the computed YTM on that bond, thereby earning interest on interest over the life of the bond at the
computed YTM rate. In effect, this calculation assumes that the reinvestment rate is the yield to maturity.
If the investor spends the coupons, or reinvests them at a rate different from the assumed reinvestment
rate of 10 percent, the realized yield that will actually be earned at the termination of the investment in
the bond will differ from the promised YTM. And, in fact, coupons almost always will be reinvested at
rates higher or lower than the computed YTM, resulting in a realized yield that differs from the promised
yield. This gives rise to reinvestment rate risk.
This interest-on-interest concept significantly affects the potential total dollar return. The exact impact is
a function of coupon and time to maturity, with reinvestment becoming more important as either coupon
or time to maturity, or both, rises. Specifically:

a. Holding everything else constant, the longer the maturity of a bond, the greater the reinvestment risk.
b. Holding everything else constant, the higher the coupon rate, the greater the dependence of the
total return from the bond on the reinvestment of the coupon payments.

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The notion of reinvestment rate risk is particularly easy to see in the retirement planning process. In
assisting a client with a retirement plan, an assumed rate of return is built into the retirement forecast as
to estimate the annual contributions the client will be required to make to the retirement plan. It is
assumed that the funds will build at that rate of return until the client retires. What we see in reality is
varying rates of return throughout the life of the portfolio. Some realized rates of return may be better
than the forecast and some may be worse than the forecast. Either way, as the retirement plan grows,
we will not see the steady, forecasted rate of return on the retirement portfolio. If the rates of return are
consistently lower than the original forecast, the clients will not have enough funds at retirement to meet
their need. In this case, the reinvestment risk is the cause of the problem.

Interest Rate Risk

The variability in a security’s return resulting from changes in the level of interest rates is referred to as
interest rate risk. Such changes generally affect securities inversely; that is, other things being equal,
security prices move inversely to interest rates. The reason for this movement is tied up with the valuation
of securities. Interest rate risk affects bonds more directly than common stocks and is a major risk faced
by all bondholders. As interest rates change, bond prices change in the opposite direction.
As a financial planner, while considering investments in various fixed income securities it is desirable to
explain the concepts of interest rate risk as well as reinvestment risk and build the same while structuring
client portfolios. If the current scenario is such that the interest rates may rise in the near future and may
keep rising for some time to come, then may be more of short term debt instruments would find place in
the portfolio and in a scenario where the interest rates have reached historic peaks and may fall in the
future, then it would make sense to commit funds for long term and hence investors should be advised
to get into long term bonds/annuities of insurance companies, etc. to protect from these two risks that
we have discussed.
The values of all financial and real assets are in some part dependent on the general levels of interest
rates in an economy. Therefore, any unexpected change in the general level of interest rates will also
unexpectedly affect the values of all such assets. Financial assets such as bonds are especially affected
by such changes. As we shall see later, the values of bonds and all other fixed income securities are
inversely related to interest rates, i.e. when interest rates increase, these values decrease and vice
versa. Values of stocks are also affected by changes in interest rates, though understanding the impact
of interest rate changes on stock values is less straightforward than for bonds. Real assets such as real
estate are also tremendously impacted by changes in interest rates. When changes in interest rates are
unexpected, the uncertain changes in asset values are said to arise form interest rate risk. The reader
can appreciate why participants in the financial markets so engrossed in pending activities of the Reserve
Bank of India which through its policy making decisions, has a considerable influence on interest rates.

Purchasing Power Risk

Inflation risk is also known as purchasing power risk because the ability to purchase different quantities
of goods and services is dependent upon the changing levels of prices of all items in an economy. For
example, assume a client wishes to invest a sum ofRs. 2,90,000 which is expected to result in a certain
outcome of Rs. 3,00,000. Now also consider that the client wishes to purchase a car, either today or one
year from now and which is valued today also at Rs. 2,90,000. Suppose the price of this car increases
to Rs. 3,10,000 over the year. In this case, the investor would have been better off if she had bought the
car instead of investing the amount. Thus the investor has a choice in how the money may be used. If
the money is invested then the client will need an additional Rs. 10,000 to purchase the car. In other
words, the inflation in the car’s price has eroded the purchasing power of the invested sum. If we

20 Investment Planning PDP

consider that the increase in the price of the car was unexpected, then we can consider the effect of the
outcome as arising out of inflation risk. Inflation risk is especially important to investment decisions
where the financial securities being utilized are interest rate sensitive. Such as bonds.
A factor affecting all securities is the purchasing power risk also known as inflation risk. This is the
chance that the purchasing power of invested money may decline. With uncertain inflation, the real
(inflation-adjusted) return involves risk even if the nominal return is safe (e.g., a Treasury bond). This
risk is related to interest rate risk, since interest rates generally rise as inflation increases, because
lenders demand additional inflation premiums to compensate for the loss of purchasing power.

Liquidity Risk
“Liquidity’ in the context of investment in securities is related to being able to sell and realize cash with
the least possible loss in terms of time and money. Liquidity risk is the risk associated with the particular
secondary market in which a security trades. An investment that can be bought or sold quickly and
without significant price concession is considered liquid. The more the uncertainty about the time element
and the price concession, the greater the liquidity risk. A Treasury bill has little or no liquidity risk,
whereas a small cap stock listed in a regional stock exchange may have substantial liquidity risk.
Liquidity is concerned with the ability to convert the value of an asset into cash. Any event or condition
that affects this ability is termed as liquidity risk. For example, an investor may wish to sell her holding in
a stock. If the investor cannot find a buyer for the stock, then her position in that stock cannot be
liquidated. Hence, in this example, she faces liquidity risk. Assets differ from each other by liquidity risk.
Securities offered by the government (such as Treasury bills) are very liquid because there are many
participants seeking to trade in these securities. Treasury bills can be sold almost instantaneously, and
hence are considered to be highly liquid. At the other end of the spectrum, stocks of very small and little
known companies are considered to contain high liquidity risk because they are thinly traded. When
investors make purchase decisions that may require to be quickly converted to cash, they will always
seek securities which have low liquidity risk. For example, firms that temporarily place excess cash in
financial (marketable) securities in order to enhance yields will seek highly liquid securities that do not
increase the firm’s liquidity risk exposure.

Regulation Risk
Some investments can be relatively attractive to other investments because of certain regulations or tax
laws that give them an advantage of some kind. Interest earned on Public Provident Fund accounts are
totally tax free (exclusion from income u/s 10 of the Indian Income Tax Act). As a result of that special
tax exemption on the interest as well as the invested amount qualify for deduction from income u/s 80C
the yield on PPF account is much higher than its current interest rate of 8%. The risk of a regulatory
change that could adversely affect the stature of an investment is a real danger. A special committee
has advised the Government of India to do away with various sections of The Income Tax Act which
allow exclusions and deductions. If its recommendations are accepted by the Government then the
attractiveness of this investment avenue will drop dramatically. Dividends on shares and equity mutual
funds are tax free in the hands of investors. These avenues become attractive because of the tax
concessions (which are matters of legislation) and these can change. That is one risk associated with
investments which cannot be avoided. The best solution lies in periodic review of investment plans.

Business Risk
The risk of doing business in a particular industry or environment is called business risk. For example,
some commodities like fertilizers and oil are highly price sensitive in the Indian context and the Government

PDP Investment Planning 21

policies of subsidies substantially affect the profitability of the companies engaged in manufacturing/
marketing these products.
The risk associated with the changes in a firm’s abilities to measure up to expectations is known as
business risk or unsystematic risk. Business risk can be further segregated into operating risk and
financial risk. The risk that a business may not be able to meet its fixed operating costs, such as rent,
management salaries, etc., is known as operating risk. The risk that the firm may not be able to meet its
fixed financial obligations, such as paying interest on its debt or lease payments, is known as financial
risk. Financial risk is also known as credit risk since lenders or creditors of funds seek to assess the
ability of the firm to meet its debt services obligations.

International Risk
International Risk can include both Country risk and Exchange Rate risk.

Exchange Rate Risk

All investors who invest internationally in today’s increasingly global investment arena face the prospect
of uncertainty in the returns after they convert the foreign gains back to their own currency. Unlike the
past when most Indian investors ignored international investing alternatives, investors today must
recognize and understand exchange rate risk, which can be defined as the variability in returns on
securities caused by currency fluctuations. Exchange rate risk is sometimes called currency risk.
The market for potential assets in which to invest spans the entire globe. Investors are not
constrained to invest only in their home countries. However, when an investor purchases a security
in a foreign country, it must be paid for in a foreign currency. At the time of the purchase, the value
of the foreign security is derived form the current, or spot, exchange rate. The exchange rate that
will prevail when the investor sells the security in the future cannot be predicted with any certainty,
and hence, the conversion value becomes uncertain. This uncertainty can be considered as
exchange rate risk. We illustrate this risk by a simple example.
For example, a U.S. investor who buys an Indian stock denominated in Indian Rupees must ultimately
convert the returns from this stock back to dollars. If the exchange rate has moved against the investor,
losses from these exchange rate movements can partially or totally negate the original return earned. A
stable rather than a depreciating foreign currency (in this case Indian Rupee) is what the investor would
be looking for while deciding to invest in that country. The returns to an international investor is always
the market returns + or – the foreign currency appreciation or depreciation in the intervening period.
Obviously, the investors who invest only in domestic markets do not face this risk, but in today’s global
environment where investors increasingly consider alternatives from other countries, this factor has
become important. Currency risk affects international mutual funds, global mutual funds, closed-end
single country funds, American Depository Receipts, foreign stocks, and foreign bonds.

Country Risk
Country risk, also referred to as political risk, is an important risk for investors today. With more investors
investing internationally, both directly and indirectly, the political, and therefore economic, stability and
viability of a country’s economy need to be considered. More and more international investors are
investing in the Indian market because of the political and economic stability of India in the last few years
and the belief of continued stability on these fronts. Transparent economic policies and political stability
are key factors for attracting more foreign investments in India.
Many firms operate in foreign political climates that are more volatile than those in the United States.

22 Investment Planning PDP

Firms can face the danger of the foreign operations being nationalized by the local government or can
experience imposed restriction of capital flows from the foreign subsidiary to the parent. Danger from a
violent overthrow of the political party in power can also have an effect on the rate of return investors
receive on foreign investments. Many countries have also been unable to meet their foreign debt
obligations to banks and other foreign institutions which contain important political and economic
The informed investor must have some feel for the political/economic climate of the foreign country in
which he or she invests. Political risk represents a potential deterrent to foreign investment. The best
solution for the investor is to be sufficiently diversified around the world so that a political or economic
development in one foreign country does not have a major impact on his or her portfolio.

Am I Willing to Accept Higher Risk?

Every investor needs to find his or her comfort level with risk and construct an investment strategy, with
the help of a financial planner, around that level. A portfolio that carries a significant degree of risk may
have the potential for outstanding returns, but it also may fail dramatically.
An investor’s comfort level with risk should pass the “good night’s sleep” test, which means the investor
should not worry about the amount of risk in his portfolio so much as to lose sleep over it.
There is no “right or wrong” amount of risk – it is a very personal decision for each investor. However,
young investors can afford higher risk than older investors can because young investors have more time
to recover if disaster strikes. If an investor is five years away from retirement, he probably would not
want to be taking extraordinary risks with his nest egg, because he will have little time left to recover
from a significant loss.
Of course, a too conservative approach may mean the investor will not achieve his financial goals.

Investors can control some of the risk in their portfolio through the proper mix of stocks and bonds. Most
experts consider a portfolio more heavily weighted toward stocks riskier than a portfolio that favours bonds.

PDP Investment Planning 23

Review Questions :
1. Which of the following statements concerning investment risk is (are) correct)
I. It is the uncertainty that actual return will differ from the expected return.
II. It is composed of two parts: systematic risk and unsystematic risk.
a. I only
b. II only
c. Both I and II
d. Neither I nor II
2. Systematic risk has all the following components EXCEPT:
a. Market risk
b. Business risk
c. Interest rate risk
d. Purchasing power risk
3. All the following statements concerning unsystematic risk are correct EXCEPT:
a. It can not be reduced by diversification
b. It is that portion of total risk that is unique to the particular firm
c. It may be affected by changes in consumer preferences and the competence of the firm’s
d. Such risk may be independent of factors affecting other industries
4. Unsystematic risk is composed of which of the following:
I. Business risk
II. Market risk
III. Financial risk
a. I only
b. I & II only
c. I & III only
d. I, II and III
5. All the following statements concerning systematic risk are correct EXCEPT:
a. It is typically influenced by the same factors affecting the market prices of many other comparable
b. It is typically affected by economic, political and sociological factors
c. It is typically found to some extent in nearly all listed securities
d. It can usually be substantially reduced by a carefully executed program of diversification
6. If Indian Rupee was Rs. 48 to a US$ in 2004 and Rs. 46.50 to a US$ in 2005, which of the
following statements is true:
a. Foreign Institutional Investors would not attribute any significance to this change in values
b. FII’s will perceive the currency risk to be very high
c. FII’s will perceive the currency risk to be low
d. FII’s will shy away from Indian markets

24 Investment Planning PDP

7. Inflation is on the rise; interest rates may move up in the near future. An investor seeks your
advice which of the two products would be good for him at this point in time. Government of India
taxable bonds offering 8% p.a. return for 6 years with no premature repayment option or AAA
rated corporate Fixed Deposit for one year offering 8% p.a. interest.
What would be your advice?
a. Better let the investor decide because both are safe.
b. He should prefer the 1 year FD
c. He should prefer the 6 year GOI Bond
d. He can choose either of them – there is no difference as the interest rate is the same

1. c
2. b
3. a
4. c
5. d
6. c
7. b

PDP Investment Planning 25

Chapter 3

26 Investment Planning PDP

Measurement of Risk

W e invest in various investment vehicles expecting some amount of return from these avenues.
The investment risk refers to the probability of actually not earning the desired or expected return
and may be a lower or negative return. A particular investment is considered riskier if the chances of
lower than expected returns or negative returns are higher.

n Standard deviation (si) measures total, or stand-alone, risk.

n The larger the si, the lower the probability that actual returns will be close to the expected return.

Standard Deviation
When an investor goes in for an investment option, he may do so expecting to get a return of say 15%
in one year. This is only a one-point estimate of the entire range of possibilities. Given that an investor
must deal with the uncertain future, a number of possible returns can and will occur.
In the case of a Treasury bill, of say 90 days, paying a fixed rate of interest, the interest payment will be
made with 100 per cent certainty barring a financial collapse of the economy. The probability of occurrence
is 1.0, because no other outcome is possible.
With the possibility of two or more outcomes, which is the norm for stock market investment, each
possible likely outcome must be considered and a probability of its occurrence assessed. The result of
considering these outcomes and their probabilities together is a probability distribution consisting of the
specification of the likely returns that may occur and the probabilities associated with these likely returns.
Probabilities represent the likelihood of various outcomes and are typically expressed as a decimal
(sometimes fractions are used.) The sum of the probabilities of all possible outcomes must be 1.0,
because they must completely describe all the (perceived) likely occurrences.
How are these probabilities and associated outcomes obtained? The probabilities are obtained on the
basis of past occurrences with suitable modifications for any changes expected in the future. In the final
analysis, investing for some future period involves uncertainty and, therefore, subjective estimates.
Investors and analysts should be at least somewhat familiar with the study of probability distributions.
Since the return which an investor earns from investing is not known, it must be estimated. An investor
may expect the TR (total return) on a particular security to be 10 per cent for the coming year, but in
truth, this is only a “point estimate.”
Probability distributions can be either discrete or continuous. With a discrete probability distribution, a
probability is assigned to each possible outcome. With a continuous probability distribution an infinite
number of possible outcomes exist. The most familiar continuous distribution is the normal distribution
depicted by the well-known bell-shaped curve often used in statistics. It is a two-parameter distribution
in which the mean and the variance fully describe it.
To describe the single most likely outcome from a particular probability distribution, it is necessary to
calculate its expected value. The expected value is the average of all possible return outcomes, where
each outcome is weighted by its respective probability of occurrence. For investors, this can be described

PDP Investment Planning 27

as the expected return.

Expected Return
In the case of a fixed income security like a Government of India Bond or a bank fixed deposit, normally
the expected return is the same as the coupon rate or rate of interest. Hence there, are no uncertainties
about being able to get the expected return.
In the case of investments where the returns are market dependant, for example a stock, one will have
to estimate the possible returns and the probability of getting the same, as given here below:

In this case, the expected return is calculated as under:

Expected return = Sum (returns*probability)

= (0.04*0.1+0.08*0.2+0.12*0.4+0.16*0.2+0.2*0.1)
= .004+.016+.048+.032+.02
= 0.12 or 12%

It is a normal distribution curve as pictorially depicted below:

28 Investment Planning PDP

Standard Deviation
We have mentioned that it’s important for investors to be able to quantify and measure risk. To calculate the
total risk associated with the expected return, the variance or standard deviation is used. This is a measure
of the spread or dispersion in the probability distribution; that is, a measurement of the dispersion of a
random variable around its mean. Without going into further details, just be aware that the larger this
dispersion, the larger the variance or standard deviation. Since variance, volatility and risk can in this context
be used synonymously, remember that the larger the standard deviation, the more uncertain the outcome.

Calculating Standard Deviation

Let’s use the same table that we did for calculating the expected returns and find out the standard
deviation of the same:

Standard deviation is square root of variance.

Variance = Sum of {Probabilities*(actual return – expected return)2}

Variance = Probability * (actual return – expected return)2

So, based on the figures in the table we can work out the variance as under;
Expected return already calculated to be 12%

Variance = sum of last column = (6.4+3.2+0+3.2+6.4) = 19.2

Standard deviation = Square root of variance = 4.3817
Let’s quickly work out another example to understand how to arrive at expected returns and calculate
standard deviation.

PDP Investment Planning 29

Expected return = [-6*.15+0*.2+6*.3+12*.2+18*15)
= [-0.9+0+1.8+2.4+2.7] = 6%
Standard deviation can be worked out as follows:

Variance = (21.6+7.2+0+7.2+21.6) = 57.6

Standard deviation = 7.5895
Calculating a standard deviation using probability distributions involves making subjective estimates of
the probabilities and the likely returns. However, we cannot avoid such estimates because future returns
are uncertain. The prices of securities are based on investors’ expectations about the future. The relevant
standard deviation in this situation is the ex ante (estimated before the event) standard deviation and
not the ex post (calculated after the events/historic) based on realized returns.
Although standard deviations based on realized returns are often used as proxies for projecting standard
deviations, investors should be careful to remember that the past cannot always be extrapolated into the
future without modifications. Historic (ex post) standard deviations may be convenient, but they are
subject to errors. One important point about the estimation of standard deviation is the distinction between
individual securities and portfolios. Standard deviations for well- diversified portfolios are reasonably
steady across time, and therefore historical calculations may be fairly reliable in projecting the future.
Moving from well- diversified portfolios to individual securities, however, makes historical calculations
less reliable. Fortunately, the number one rule of portfolio management is to diversify and hold a portfolio
of securities, and the standard deviations of well-diversified portfolios may be more stable.
Something very important to remember about standard deviation is that it is a measure of the total risk of
an asset or a portfolio, including both systematic and unsystematic risk. It captures the total variability in
the assets or portfolios return, whatever the sources of that variability. In summary, the standard deviation
of return measures the total risk of one security or the total risk of a portfolio of securities. The

30 Investment Planning PDP

historical standard deviation can be calculated for individual securities or portfolios of securities using total
returns for some specified period of time. This ex post value is useful in evaluating the total risk for a
particular historical period and in estimating the total risk that is expected to prevail over some future period.
The standard deviation, combined with the normal distribution, can provide some useful information
about the dispersion or variation in returns. In a normal distribution, the probability that a particular
outcome will be above (or below) a specified value can be determined. With one standard deviation on
either side of the arithmetic mean of the distribution, 68.3 percent of the outcomes will be encompassed;
that is, there is a 68.3 percent probability that the actual outcome will be within one (plus or minus)
standard deviation of the arithmetic mean. The probabilities are 95 and 99 percent that the actual outcome
will be within two or three standard deviations, respectively, of the arithmetic mean.

In a bell shaped normal distribution the probabilities for values lying within certain bands are as follows:
± 1 S.D. 68.3%
± 2 S.D. 95.4%
± 3 S.D. 99.7%

What Standard Deviation Means

Say a fund has a standard deviation of 4% and an average return of 10% per year. Most of the time (or,
more precisely, 68% of the time), the fund’s future returns will range between 6% and 14% (or its 10%
average plus or minus its 4% standard deviation). Almost all of the time (95% of the time), its returns will
fall between 2% and 18%, or within two standard deviations i.e. [10-(2*4) or 10 + (2*4)]

Limitations of Standard Deviation

Using standard deviation as a measure of risk can have its drawbacks. For starters, it’s possible to own
a fund with a low standard deviation and still lose money. In reality, that’s rare. Funds with modest
standard deviations tend to lose less money over short time frames than those with high standard

PDP Investment Planning 31

The bigger flaw with standard deviation is that it isn’t intuitive. Certainly, a standard deviation of 7% is
higher than a standard deviation of 5%, but these are absolute figures and one can not reach a conclusion
as to whether these are high or low figures. Because a fund’s standard deviation is not a relative
measure, which means it’s not compared to other funds or to a benchmark, it is not very useful to the
investor without some context.

Let us consider two stocks: stock X and stock Y whose returns and probability are given as follow:

Stock X

Expected return on stock X is sum of the last column which is 12%

Stock Y

Expected return on stock Y is the sum of the last column which is 12%.
In this example, we find that the expected returns of both stocks are the same.
If the expected returns on two stocks are the same, obviously one should prefer that stock where the
risk is less. In other words, we shall go ahead and measure the standard deviation of both the stocks to
find out which stock is more likely to give us the expected returns of 12%.

32 Investment Planning PDP

Variance which is the sum of the last column = 2.1
Standard deviation for stock X = 1.449
Let’s work out for stock Y

Variance of stock Y which is the sum of last column = 0.6

Standard deviation of stock Y = 0.77
Thus, after the calculation of total risk (standard deviation), it is obvious that stock Y is more likely to
deliver the expected returns of 12% compared to stock X. This case has been discussed basically to
understand that while deciding on which stock to invest in, it is important to consider the expected return
as well as the total risk of not getting the desired return stock wise and reach decision accordingly. All
the same, it may be pertinent to point out here that standard deviation is more seriously considered and
is useful in portfolio of stocks rather than individual stocks. We shall consider the portfolio scenario in the
subsequent topics.

Beta is a measure of the systematic risk of a security that cannot be avoided through diversification.
Beta measures non-diversifiable risk. Beta shows the price of an individual stock which performs with
changes in the market. In effect, the more responsive the price of a stock to the changes in the market,
the higher is its Beta.
Beta is a relative measure of risk – the risk of an individual stock relative to the market portfolio of all
stocks. If the security’s returns move more (or less) than the market’s returns as the latter changes, the
security’s returns have more (or less) volatility (fluctuations in price) than those of the market. It is
important to note that beta measures a security’s volatility, or fluctuations in price, relative to a benchmark,
the market portfolio of all stocks.

PDP Investment Planning 33

Securities with different slopes have different sensitivities to the returns of the market index. If the slope
of this relationship for a particular security is a 45-degree angle, the beta is one (1). This means that for
every one percent change in the market’s return, on average, this security’s returns change one (1) per
cent. The market portfolio has a beta of one (1). A security with a beta of 1.5 indicates that, on average,
security returns are 1.5 times as volatile as market returns, both up and down. This would be considered
an aggressive security because when the overall market return rises or falls 10 per cent, this security,
on average, would rise or fall 15 per cent. Stocks having a beta of less than 1.0 would be considered a
more conservative investment than the overall market.
Betas can be negative or positive. But generally, betas have been found to be positive which means that
the direction of the movement of individual stock generally tends to be in line with the market: falling
when the market is falling and rising when the market is rising.
Beta is useful for comparing the relative systematic risk of different stocks and, in practice, is used by
investors to judge a stock’s risk. Stocks can be ranked by their betas. Because the variance of the
market is a constant across all securities for a particular period, ranking stocks by beta is the same as
ranking them by their absolute systematic risk. Stocks with high betas are said to be high-risk securities.
Given below are different scenario showing how the portfolio return moves relative to market for Beta
equal to 1, 0.5, and 2.

34 Investment Planning PDP

The beta of a security is a historical measure and it is arrived at by plotting the actual returns on the
security over long periods of time with market returns as shown in the earlier charts. A line is drawn
which depicts beta of the security.
To determine the beta of any security, you’ll need to know the returns of the security and those of the
benchmark index you are using for the same period. Using a graph, plot market returns on the X-axis
and the returns for the stock over the same period on the Y-axis.
Upon plotting all of the monthly returns for the selected time period (usually one year), we draw a best-
fit line that comes the closest to all of the points. This line is called the regression line.
Beta is the slope of this regression line. The steeper the slope, the more the systematic risk, the shallower
the slope, the less exposed the company is to the market factor. In fact, the coefficient (Beta) quantifies

PDP Investment Planning 35

the expected return for the stock, depending upon the actual return of the market.

Calculating Beta
Rs = a + BsRm
Rs = estimated return on the stock
a = estimated return when the market return is zero
Bs = measure of the stock’s sensitivity to the market index
Rm = return on the market index
Allowing for random errors, some times beta is calculated as under:
Rs = a + BsRm+ e
“e” is the random error term embodying all of the factors that together make up the unsystematic return.
If we want to compare the return on the security related to the risk free avenues, then the formula is:
Rs = Rf + Bs (Rm - Rf)
Where the concept of Rf is the risk free return – return that can be obtained by investing in risk free
securities like treasury bills.

For example, suppose you are considering a private equity investment in a company with a new job
work. The process is inherently risky, i.e. the standard deviation of the project is 75% per year. The beta
of the project is 0.5. The Rf = 5% and the E[Rm] = 14.5%. What is the required rate of return on the
Theory tells us that the answer does not depend upon the volatility associated with the returns. Instead
we use the beta of the project.
E[Rjob] = 5% + (.5)(14.5% - 5%) = 9.5%
This is the required rate of return on the project. The answer would not change if the range of outcome
next year broadened or narrowed. ß (beta) is the only relevant piece of information — now all that
remains is to estimate it!

36 Investment Planning PDP

Review Questions:
1. Mr. Joshi has analysed a stock for a one-year holding period. The stock is currently quoting at
Rs 100 and is paying no dividends. There is a 50-50 chance that the stock may quote Rs 100 or
Rs 120 by year-end. What is the expected return on the stock?
a. 12%
b. 10%
c. 15%
d. 20%
2. A stock is quoting at Rs. 100 and is paying no dividends. The possible year end price and the
probabilities are given below:
Year end price Probabiltiy
110 0.1
115 0.2
120 0.3
125 0.2
130 0.1
What is the expected return on the stock?
a. 10%
b. 15%
c. 8%
d. 20%
3. What is the standard deviation of the stock based on the figures in question 2?
a. 14.45
b. 5.79
c. 16.30
d. 33.60
4. Stocks A and B are not paying any dividends. Stock A is quoting at Rs. 100 while B is quoting at
Rs 50. There is a 50-50 chance that stock A will quote at Rs 120 and Rs 140 while there is a 50-
50 chance that the stock B will quote at Rs 60 and Rs 70 at the end of the year. Which stock will
you buy considering the return and the risk?
a. I shall buy B because it is cheaper
b. I will buy Stock B because the risk is less
c. I will buy Stock A because the risk is less
d. The risk and the return in both are same; I shall buy any one
5. Compute the expected return for the stock when the risk free return is 8% and the expected return
from the market is 12% for a stock with Beta of 1.2.
a. 15.6%
b. 12.8%
c. 16.4%
d. 22.2%

PDP Investment Planning 37

6. Beta of stock A is 1.5 while that of stock B is 1. If the market is expected to rise then an aggressive
investor would buy:
a. Either A or B; because in a rising market all stocks will rise
b. Stock A because it may deliver superior returns compared to B
c. Stock B because the risk will be less compared to A while the returns would be the same
d. Stock B because it may deliver superior returns compared to A

1. b
2. c
3. b
4. d - (while deciding you calculate the risk also besides the returns)
5. b - use the formula Rs = Rf + Bs (Rf -Rm)
6. b - higher beta means higher risk and also higher returns compared to market.

38 Investment Planning PDP

Chapter 4

PDP Investment Planning 39

Managing Risk in Investments

R isk is an integral part of investments. Risk in the context of investments not only refers to the
chance of losing one’s capital, but mainly to the chance/probability of getting less than expected
returns from an investment vehicle. Thus, risk in investments can not be avoided but it can be managed
to suit one’s risk profile and investment objectives.
“Risk” in investments is categorized as “systematic” and “unsystematic” risk; which are also called non
diversifiable and diversifiable risk. Unsystematic risk can be reduced through diversification while
systematic risk is a market risk which can not be reduced through diversification.
Investors can resort to different strategies to manage risk in investments. Let’s look at some strategies
that investors can adopt to manage risk.

It is well established in investments that in order to be able to obtain required returns, it is essential to
reduce the risk and this can be achieved through diversification. Diversification reduces the risk and can
be achieved through diversifying investments:

n Across different asset classes – equity; debt; commodities; precious metals; real estate and so on.
n Across different countries (geographies) – India; USA; UK; Japan; Singapore; Australia; Middle
East and so on.
n Across different securities and so on – Different stocks; bonds, etc.
n Across maturities – short term; long term; for life; etc.

Diversification across different asset classes

n As financial planners, we should ensure that the investments are diversified across different asset
classes and that proper allocation among different assets is made as decided in the Asset Allocation
n It is important to decide the quantum of investments in risky asset classes like equity, real estate,
etc. based on the age, risk appetite, etc. of the investor. Over dependence on a particular asset
class can also be quite risky. For example, if an investor is highly risk averse and has little or no
exposure to equities, then he will find the going tough if the interest rates in the economy were to
fall. He will continue to earn less over a period of time and may even suffer loss on existing investing
because of fall in bond prices. Hence, exposure to equity should be considered in such cases.
n Similarly, a very high exposure to equity can prove very tricky because the stock market over a
long period of time may turn bearish and the investor may get very little return and capital appreciation
in this period. The chances of capital loss are also quite high in such cases. Equity is a long term
asset class and should be accordingly planned while deciding the Asset Allocation Plan.
Portfolio of Securities
While investing in stocks, it is essential to invest in a number of stocks and not just a few to reduce the

40 Investment Planning PDP

risk. But the purpose of diversification will be achieved only if the stocks belong to different sectors and
that some of the sectors are not related to each other. Let us look at the following example to understand
the co-relationship between two securities in a portfolio:
Suppose you live on an island where the entire economy consists of only two companies: one sells
umbrellas while the other sells sunscreen lotion. If you invest your entire portfolio in the company that
sells umbrellas, you’ll have strong performance during the rainy season, but poor performance when it’s
sunny outside. The reverse occurs with the sunscreen company, the alternative investment: your portfolio
will be high performance when the sun is out, but it will tank when the clouds roll in. Chances are you’d
rather have constant, steady returns. The solution is to invest 50% in one company and 50% in the
other. Since you have diversified your portfolio, you will get decent performance year round instead of,
depending on the season, having either excellent or terrible performance.
It is a well established fact as borne out by the following diagram that diversification across securities
reduces the risk:

Studies and mathematical models have shown that maintaining a well-diversified portfolio of 25 to 30
stocks will yield the most cost-effective amount of risk reduction. Investing in more securities will still
yield further diversification benefits, albeit at a drastically smaller rate.
So, it is only sensible to hold a certain number of securities and monitor the same periodically rather
than holding too many securities in a portfolio which will serve the purpose of diversification in a very
limited way.
Further, diversification benefits can be gained by investing in foreign securities because they tend to be less
closely correlated to domestic investments. For example, an economic downturn in the Indian economy
may not affect Japan’s economy in the same way. Therefore, having Japanese investments would allow an
investor to have a small cushion of protection against losses due to an Indian economic downturn.
The following important conclusions can be drawn regarding diversification across securities:

1. The number of securities should be limited to say 20 to 30 and not more.

2. The securities should ideally belong to different industrial sectors, and if possible, even different
geographical regions.

PDP Investment Planning 41

3. The co-relation of market movements may be built in selecting stocks in a portfolio (oil marketing
companies and automobiles; export oriented and import dependant companies; lending companies
and borrowing companies, etc.).
Returns on the portfolio
In a portfolio containing a number of securities, the returns on the same will depend upon the return on
individual securities as well as weightage of each of the security in the total portfolio. While deciding on
the securities to be invested in the weightage of each security, the portfolio is also decided at the point
of investment. The weightage may change over a period of time with change in prices of underlying
securities as well the portfolio value. The weights are calculated on the basis of initial investment value.
We can express the same in the following formula for return on the portfolio:

E (RP) is the expected return on the portfolio,
Wi is the weight of security i in the portfolio and,
E(ri) is the expected return on security i

Let us consider a portfolio with two securities A and B with a weight of 60% assigned to A and 40% to
security B. If the following are the probabilities of return for individual securities A and B let us try and
find out the probable return on the portfolio:

Expected return on security A = [ (0.15*25)+(0.2*15)+(0.3*0)+(0.2*-5)+(0.15*-10) ]

= 3.75+3+0-1-1.5
= 4.25%
Expected return on security B = [(0.15*30)+(0.2*20)+(0.3*5)+(0.2*0)+(0.15*-10)
= 4.5+4+1.5+0-1.5
= 8.5%

42 Investment Planning PDP

Return on the portfolio = RAB = WA*RA+WB*RB
= 0.6*4.25+0.4*8.5
= 2.55+3.40
= 5.95%
Where, WA is the weight of A in the portfolio while WB is the weight of B in the portfolio..

Risk of the Portfolio - Measurement

Risk on a portfolio is calculated by considering the standard deviation of individual securities included in
the portfolio as well as interactive risk among securities, measured by covariance.

Variance of Portfolio
Given a portfolio consisting of n securities, the variance of the portfolio can be written as:

Portfolio Risk =Sum of individual securities’ risks + Sum of interaction among securities
sP2 is the variance of the portfolio.
ri, j is the covariance between securities i and j.
sI is the standard deviation of security i.

is the formula for calculating the standard deviation of a portfolio of two securities x and y where sXY is
the standard deviation of the portfolio, w represents the weight of securities x and y in the portfolio while
COVxy is the covariance between securities x and y.

Let us consider a portfolio with two securities X and Y with a weight of 60% assigned to X and 40% to
security Y. If the following are the probabilities of return for individual securities X and Y, let us try and
find out the standard deviation of the portfolio:

PDP Investment Planning 43

The same can be done in 3 steps: firstly find out the standard deviation of individual securities; secondly
calculate the covariance between the two securities and thirdly the risk on the portfolio.

Standard deviation of Securities X and Y

Expected return on security X is = {0.1*30+0.2*20+0.5*10+0.2*(-10)+0.1*(-20)}
= 8%
Expected return on security Y is = {0.1*20+0.2*15+0.5*10+0.2*0+0.1*(-10)}
= 9%
sX2 = Variance of security x = {[.1*(30-8)2]+[0.2*(20-8)2] + [0.5*(10-8)2]+[0.2*(-10-8)2]+[0.1*(-20-8)2]}
= 0.1*484 + 0.2*144 + 0.5*4 + 0.2*324 + 0.1*784
= 48.4+28.8+2+64.8+78.4
= 222.4
Hence, standard deviation of security x is = square root of 222.4 = 14.91%
Similarly, the variance of security y can be calculated as under:
= {[0.1*(20-9)2] + [0.2*(15-9)2] + [0.5*(10-9)2] + [0.2*(0-9)2] + [0.1*(-10-9)2}
= 0.1*121+0.2*36+0.5*1+0.2*81+0.1*361
= 12.1+7.2+0.5+16.2+36.1
= 72.1
Standard deviation of security y is square root of 72.1 = 8.49%

Covariance between securities X and Y

The use of formula is illustrated by actually taking out the figures in the probability of returns on securities
x and y
COVxy = 0.1*(30-8)(20-9)+ 0.2*(20-8)(15-9) + 0.5*(10-8)(10-9) +
0.2*(-10-8)(0-9) + 0.1 (-20-8)(-10-9)
= 24.2+14.4+1+32.4+53.2
= 125.2

44 Investment Planning PDP

Portfolio Risk

s2XY = (0.6)2*(14.91)2 + (0.4)2*(8.49)2 + (2*0.6*0.4*125.2)

= (0.36*222.31) + (0.16*72.08) + (60.1)
= 80.03+11.53+60.1
= 151.66
sXY = square root of 151.66
= 12.31%

Expected return on the portfolio

Portfolio Risk and return in a two security scenario

The calculations may look complicated but in many cases the correlation between the securities is given
and hence, it is easier to work out the portfolio risk and the portfolio return. Let us look at the following
example to understand things better:
Example 2 security case

= 30% ´ 0.15 + 70% ´ 0.20 = 0.185 or 18.5%

sP2 = wA2sA2 + wB2sB2 + 2 wAwBrA,B´sA´B
= (0.3)2´0.05 + (0.7)2´0.06 +2 ´0.3´0.7´0.5´0.224´0.245
= 0.0454248
sP = Square root of 0.0145248 = 0.213 or 21.3%
Thus the portfolio risk is 21.3% while the expected return of the portfolio is 18.5%

Covariance and Correlation Coefficient

The covariance and correlation coefficient measure the extent to which securities move together in the

PDP Investment Planning 45

market. For instance, suppose you own Stock A and B and both are high-tech stocks selling computer
chips. Suppose that news breaks about Company A revealing a quality assurance issue with their
computer chips and the announcement of a major recall. Stock A’s price will probably decrease if the
market had not expected such an announcement. Because Stock B is also in the computer chip industry,
its stock may very well decrease as well since investors will respond adversely to the overall market for
computer chips. The measure of Stock B’s sensitivity to Stock A’s stock price could be measured over
time to see the extent to which they move together. We could use both the covariance and the correlation
coefficient to track the movements.
Stock B could be measured relative to an overall stock market index as well in order to see how sensitive it
is to that market’s general movements. The relationship between the movements of two securities or between
a single security and general market movements are critical observations. As we shall see in a later chapter,
these observations and measures of co-movements provide the underpinning in constructing efficient
portfolios that contain many securities that move together in the same direction to each other (positive
correlation) tend to do very well in good times and very poorly in bad times. The opposite is true too in that
securities which are negatively correlated balance each other out in good time and in bad times as well.
Covariance and correlation coefficients are simple to calculate for two securities but become more complicated
as the number of securities increases. That is why it is necessary to use computer programs to conduct
such analysis.

1. Actually, rather than use the standard deviation, we can also use its squared value, termed the
variance to describe risk. That is, we may use a2 (the standard deviation squared) to describe the
risk in an individual security.

Any two securities whose prices react to information similarly are said to have a positive covariance.
Securities with a negative covariance have returns that vary inversely, or that their prices move in
opposite directions as reactions to the same information event.
The covariance between two securities is calculated as follows:
As you can see, the covariance of these two securities is 0.14. This means that these two securities
tend to move in opposite directions. Without calculating the correlation coefficient, it is difficult to determine
the extent to which they move together. Since the covariance is calculated similar to the standard
deviation, we know that this is an absolute number. That is why it is necessary to use the covariance to
calculate the correlation coefficient.

Correlation Coefficient
The correlation coefficient measures the strength of the relationship between two securities and the
coefficient is always a value between – 1 and + 1. If the value is –1, it can be said that the returns of the
securities are perfectly negatively correlated, meaning that the prices change equally but in opposite
directions, where direction implies increase and decrease. If they value is + 1, the two securities are
perfectly positively correlated and that the security prices change equally and in the same direction as
well. If the correlation coefficient equals zero, it means that the two securities do not move together in
any meaningful way.

46 Investment Planning PDP

The calculation for correlation coefficient is as follows:

Thus we can see that if correlation coefficient is –0.70, it means that these two securities exhibit a strong
negative movement in opposite directions. In this case, barring other issues, these two securities may
be suitable to put in a portfolio in order to project it from general stock market cycles.

FIGURE 5:1 Correlation Analysis

Figure 5:1 demonstrates the concept of correlation. In Panel A, assets i and j are perfectly correlated,
with r ij equal to + 1. As i increases in value, so does j in exact proportion to i. Panel B, assets i and j
exhibit a perfect negative correlation, with r if equal to – 1. As i increases, j decreases in exact proportion
to i. Panel C demonstrates assets i and j having no correlation at all, with r ij equal to 0.

Portfolio Effect
An investor who is holding only investment i may consider adding investment j in the portfolio. If equal
amounts are invested in each stock, the new portfolio’s Expected Return will be Kp. We define Kp as the
Expected Return of the portfolio:
Kp = XiKi+XjKj
The X values represent the weights assigned by the investor to each component in the portfolio and are
50 percent for both investments in this example. The i and j values were determined to be 10 percent.
Thus we have:
Kp = 0.5(10%) + 0.5(10%) = 5% + 5% = 10%
What about the standard deviation (ó p ) for the total portfolio? Assume standard deviation of i = 3.9%

PDP Investment Planning 47

and j = 5.1%. If a weighted average were taken of the two investments, the new standard deviation
would be 4.5 percent:
s¡ Xi + s¡ Xj
0.5 (3.9%) + 0.5 (5.1%) = 1.95% + 2.55% = 4.5%
The interesting element is that the investor appears to be worse off from the combined investment. His
Expected Return remains at 10 percent, but his standard deviation has increased from 3.9 to 4.5 percent.
It appears that he is adding risk rather than reducing it by expanding his portfolio and without any
change in return.
There is one fallacy in the analysis. The standard deviation of a portfolio is not based on the simple
weighted average of the individual standard deviation (as the Expected Return is) rather, it considers
significant interaction between the investments. If one investment does well during a given economic
condition while the other does poorly and vice versa, there may be significant risk reduction from combining
the two, and the standard deviation for the portfolio may be less than the standard deviation for either
investment (this is the reason we do not simply take the weighted average of the two).

FIGURE 5:2 Investment Outcomes under Different Conditions

Note : In Figure 5:2 risk-reduction potential from combining the two investments under study. Investment
i alone may produce outcomes anywhere from 5 to 15 percent, and investment j, from 6 to 20 percent.
By combining the two, we narrow the range for investment (i, j) from 7.5 to 12.5 percent. Thus, we have
reduced the risk while keeping the Expected Return constant at 10 percent.

Coefficient of Determination
As we just saw, correlation and covariance are statistical measures that gauge the nature of the relationship
between two random variables. Sometimes, the relationships between such variables may be one of
dependence or causality. For example, when our income increases (decreases), our consumption of goods
and services generally also increases (decreases). In this case, we can say that changes in consumption
are caused (is dependent upon), to some extent, on changes in income. In this example, we can then
classify consumption as the dependent variable and income as the independent variable. A common

48 Investment Planning PDP

procedure to measure the extent of such a dependent relationship between two variables is known as
simple regression analysis. Regression analysis provides us with many statistical gauges of the relationship
which help us better understand the scope and nature of the relationship. One such measure in a statistic
known as the coefficient of determination, also known as R². This widely used statistical measure (R²),
represents the proportion of variation in the dependent variable that has been explained or accounted for by
the independent variable. In the above example of income and consumption, the R² statistic form a simple
regression analysis would tell us how many changes in consumption, are explained by changes in income.
What is interesting to note is that the coefficient of determination, when observed as a result of simple
regression analysis, is also the square of the correlation coefficient, which was discussed previously.
Since the correlation coefficient is commonly denoted by the symbol ‘r’, hence the R² for the determination
coefficient. Also note that since correlation has a value between – l and + l, its squared value must also
necessarily be a value between o and l. Continuing further, we consider the correlation value of – l to
represent a perfect negative relationship (each change in a variable being matched by an equal but
directionally opposite change in the other) between two variables and a correlation value of + l to represent
a perfect positive relationship (each change in a variable being matched by an equal, in both magnitude
and direction, change in the other) between two variables. Thus, the squared values in both these
cases, or their R², would equal l. We can say then that the value of R² being equal to l implies that the
independent variable fully explains all changes in the dependent variable. When the value of R² is equal
to zero, we can similarly say that there is absolutely no dependent relationship between the two variables.
In the case where multiple regression analysis is being used, i. e. relationships between and among
more than two variables, the R² measure similarly interprets the depth of the relationship but is no more
simply the squared correlation value.

Risk Reduction through Product Diversification

It is important to have a dynamic asset allocation plan diversified among different asset classes. Financial
investment products comprise direct equity; indirect equity through the mutual fund route; balanced
fund which focuses on both debt and equity; debt – corporate and government; fixed income instruments
like small saving schemes; government bonds, fixed deposits – bank and corporate, etc. Risk on the
total portfolio is reduced through investments among different products, in a pre-determined proportion,
depending upon the risk profile of the investor and managed through periodic review of the proportion.

Risk Reduction through Time Diversification

When it comes to equity investments, it is a well established fact, especially in respect of retail investors that
they cannot time the market. It is the time one stays invested that would determine the returns on equity
investments over a period of time and not market timing. Many investors tend to take higher exposure to
equity at market highs and tend to reduce their exposure during market lows due to emotional swings.
These investors invariably end up losing money. The best and time tested solution lies in systematic investment
and sticking to asset allocation plans. The quantum of funds allocated to equities can be invested over a
period of time through systematic investment plans. Almost all mutual funds offer SIP’s where the people
can invest in these funds on a monthly basis at predetermined dates and fixed amounts per month. Auto
debit and ECS make it very convenient for investors to invest on a systematic basis. Another very important
strategy could be parking the available funds in Floating Rate Debt funds and transferring fixed quantum of
funds on a monthly basis through a Systematic Transfer Plan out of floaters through SIP’s into equity funds.
In this strategy, the funds may earn decent returns in floating rate funds with less interest-rate risk while the
equity market timing-risk is reduced through SIP’s.

PDP Investment Planning 49

Diversification reduces unsystematic risk in a portfolio. Unsystematic refers to a specific individual
corporate or country financial risk event. Therefore, as the number of securities increase in a portfolio,
the portfolio’s unsystematic risk decreases. The remaining risk is called systematic or market risk.
Systematic risk cannot be diversified out of a portfolio; however, systematic risk can be hedged.
Consider a portfolio consisting of an indexation of the BSE Sensex. By holding positions in these 30
companies, a portfolio has reduced the unsystematic risk. Now the dependence and exposure on the
fortune or failure of each company is an approximation of a 1 in 30 chance. The portfolio’s remaining risk
is viewed as systematic or market risk. This means that the portfolio value will swing with the benchmark
market. A manager can reduce this systematic risk by hedging.
To offset the systematic risk, a fund manager would establish a hedge. This hedge would offset the
value changes in the underlying portfolio position. Typically, this offset is accomplished with the futures,
options, or other derivative markets.

If the actual portfolio had a market value of Rs. 12 lacs and the NSE Nifty was trading at 3,000, then four
future contracts would be sold to effectively offset the market risk. This is so because each futures contract
represents the index level times a multiplier of Rs. 3,00,000 per contract at the Nifty level of 3000 (Each Nifty
contract size is 100). By selling four (4) contracts; i.e. 400 Nifties, the market value of Rs. 12,00,000/- of the
portfolio is protected against a fall in Nifty. When the market falls by 5%, the portfolio will fall by 5% resulting
in a loss of Rs. 60,000/- while the Nifty futures contract will earn Rs. 60,000/- on 4 contracts because Nifty
would have fallen from 3000 to 2850. This is an example of fully hedging the portfolio through selling the
index futures.
The same effect can be achieved by buying Index puts as well. The “put” option starts gaining when the
market starts falling and in case the market rises, the loss on puts will be to the extent of premium paid
only. In other words, puts can be used to limit the loss in case of a market rise with potential to earn
unlimited profits in case of a market fall. The use of futures and options as tools of hedging as well as
leveraging portfolios has been explained in a separate topic.

50 Investment Planning PDP

Review Questions:
1. Given the following information, what is the expected return on the portfolio of two securities
where both are held in equal weights?

a. 15%
b. 19%
c. 16%
d. 17%
2. What would be the standard deviation of the portfolio comprising of the two securities as per
details given below?

a. 4.14%
b. 3.82%
c. 14.13%
3. Diversification among different asset classes will reduce all risks. Is this statement true?
a. Yes
b. No; diversification does not serve the purpose of risk reduction
c. No; diversification reduces non systematic risk only
d. No; diversification reduces systematic risk only
4. Hedging is a strategy adopted to reduce all risks. Is this true?
a. Yes
b. No; hedging does not serve the purpose of risk reduction
c. No; hedging reduces non systematic risk only
d. No; hedging reduces systematic risk only
5. Hedging, against market loss, in a diversified stock portfolio can be achieved through which one
of the following strategies?
a. By selling index futures
b. By selling index puts
c. By buying specific stock futures
d. By buying index futures

PDP Investment Planning 51

6. Mr. Ashok Kulkarni, age 40 years, is a salaried person. He wants to invest Rs. 1,00,000/- in
equities and seeks your advice about whether this is the right time to invest in equities and how to
go about it. What would be your advice to him?
a. Stay away from stock market because it is a risky place.
b. This is not the right time to invest in stocks because the market is likely to fall.
c. Invest the funds in a floating rate debt fund and adopt SIP route to invest in mutual funds
systematically on a monthly basis as retail investor cannot time the market.
d. Buy shares of Infosys Technologies as the company is doing very well and has declared a
bonus also.
7. Mr. A. G. Doshi has investments in stocks of 50 companies. He wants to invest some more
money in direct equities and requests you to advice him on how many more companies he should
invest in so that he shall have a well diversified equity portfolio. What will be your advice to him?
a. He should have at least another 50 more companies to be adequately diversified.
b. He already has too many companies. He should reduce the number to about 20/25 companies
belonging to diverse industrial sectors. Any additional investment he wants to make, he should
make in these companies.
c. Diversification cannot be achieved through increasing the number of companies in one’s
d. He can continue to hold on to all and add more companies as per funds availability.
8. A small investor wants to participate in the equity market but does not have the expertise or the
funds to have a well diversified equity portfolio. What will be your advice to him?
a. Equity is not the place for small investors as the risks are very high. He should stay away.
b. Since funds available are limited, he can buy just one or two stocks of large companies and
participate in the equity boom.
c. He should prefer a diversified equity mutual fund as this is where diversification can be achieved
even on a small capital.
d. He should first get the expertise by undergoing training programs and then only venture into
stock market.

1. c
2. a
3. c
4. d
5. a
6. c
7. b
8. c

52 Investment Planning PDP

Chapter 5

PDP Investment Planning 53

Measuring Investment Returns

W e all make investments to get returns/rewards from the investment vehicles. There are two types
of returns viz. realized return and expected return.
Realized return is what the term implies; it is ex post (after the fact) return, or return that was or could have
been earned. Realized return has occurred and can be measured with the proper data. Expected return, on
the other hand, is the estimated return from an asset that investors anticipate (expect) they will earn over
some future period. As an estimated return, it is subject to uncertainty and may or may not occur.
The objective of investors is to maximize expected returns, although they are subject to constraints,
primarily risk. Return is the motivating force in the investment process. It is the reward for undertaking
the investment.
An assessment of return is the only rational way (after allowing for risk) for investors to compare alternative
investments that differ in what they promise. The measurement of realized (historical) returns is necessary
for investors to assess how well they have done or how well investment managers have done on their
behalf. Furthermore, the historical return plays a large part in estimating future, unknown returns.
Return on a typical investment consists of two components:

1. Yield: The basic component that usually comes to mind when discussing investing returns is the
periodic cash flows (or income) on the investment, either interest or dividends. The distinguishing
feature of these payments is that the issuer makes the payments in cash to the holder of the asset
on a periodic basis. Yield measures relate these cash flows to a price for the security, such as the
purchase price or the current market price.
2. Capital gain (loss): The second component is also important, particularly for stocks but also for
long-term bonds and other fixed-income securities. This component is the appreciation (or
depreciation) in the price of the asset, commonly called the capital gain (loss). It is the difference
between the purchase price and the price at which the asset can be, or is, sold.

Total return
Given the two components of a security’s return, we need to add them together (algebraically) to form
the total return, which for any security is defined as:
Total return = Yield + Price change where:
the yield component can be nil or positive.
the price change component can be nil, positive or negative.

Measurement of Total return

Total return = {Cash payments received + Price change over the period}/purchase price of the asset
The price change over the period = end price – open price (can be negative)

54 Investment Planning PDP

The shares of Alpha were bought on Jan 1 for Rs. 50/-. During the year, Alpha paid a dividend of Rs. 2/- per
share. At the end of the year, Alpha was sold for Rs. 52/- What is the total return on Alpha?
Returns = Dividend + price change = 2 + (52-50) = 2+2 = 4
Total returns = returns/purchase price = 4/50 =0.08 = 8%
This is a conceptual statement for the total return for any security. The important point here is that a
security’s total return consists of the sum of two components, yield and price change. Investors’ returns
from assets can come only from these two components - an income component (the yield) and/or a
price change component, regardless of the asset.

Current Yield
It is a very simple measure of returns on any security and it is obtained by the following formula:
Annual Interest/price of the security

Yield to Maturity (YTM)

The rate of return on bonds most often quoted for investors is the yield to maturity (YTM), which is
defined as the promised compounded rate of return an investor will receive from a bond purchased at
the current market price and held to maturity. It captures the coupon income to be received on the bond
as well as any capital gains and losses realized by purchasing the bond for a price different from face
value and holding to maturity. Similar to the Internal Rate of Return (IRR), in financial management, the
yield to maturity is the periodic interest rate that equates the present value of the expected future cash
flows (both coupons and maturity value) to be received on the bond to the initial investment in the bond,
which is its current price.
An investor would use the bond’s coupon rate, price, par value, and term to maturity to determine the
yield to maturity, or internal rate of return. For a bond selling at Rs. 1,000 and expected to be redeemed
by the issuer at Rs. 1,000, the current yield and the yield to maturity are identical. However, the yield to
maturity will differ from the current yield if the bond sells at a discount or a premium.

Computation of YTM

P = Price of the security
C = annual interest payments received
r = rate of interest
M = Maturity value (amount receivable on maturity)
n = number of years left for the security to mature
The computation of YTM requires a trial and error procedure. The interest payments are payments of
annuity over a period of time while the maturity value is the future value of the present price of the bond
and “r” the YTM has to be worked out substituting different values for r.

PDP Investment Planning 55

Approximate Computation of YTM
Instead of following the trial and error basis, one can find out the approximate value of YTM by using the

YTM is the yield to maturity
C = annual interest payment
M = Maturity value of the bond
P = Present price of the bond
n = number of years to maturity

Arithmetic average returns

A stock not paying dividends, quotes at Rs. 100 at the beginning of the year. It quotes at Rs. 120; Rs. 132;
Rs. 118.80 at the end of year 1, 2, and 3 respectively. Let’s find out how the arithmetic average return is
calculated over this period:
Opening price Rs. 100
Year 1 : 20/100 = 20%
Year 2 : (132-120)/120 = 10%
Year 3 : (118.8-132)/132 = -10%
Total returns over 3 years = 20%
Arithmetic average return = 20/3 = 6.66% p.a.
Using the same method, let us calculate the arithmetic average returns based on the following figures:
Opening price Rs. 100;
Year 1 end price Rs. 200;
Year 2 end price Rs. 100
What is the arithmetic average return for this stock?
Year 1 returns 100%
Year 2 returns -50% [(-100/200)*100]
Total returns over 2 years 50%
Arithmetic average returns 50/2 = 25%
This example brings out the limitations of Arithmetic Average Returns because it is obvious that the
returns on the stock can not be 25% when the opening price and price at the end of the second year are
the same at Rs. 100/-.

56 Investment Planning PDP

Therefore, this measure of Arithmetic Average Returns is used for measuring future period returns
rather than past returns.

Geometric Average Returns

The formula for measuring Geometric Average Returns is:

G = [(1+R1)(1+R2)(1+R3) …(1+Rn)]1/n -1
G is the Geometric Average Returns
R1…..Rn is the return over different periods from 1 to n
Let’s try to work out the geometric average return in the following example:
Opening price Rs. 100;
Year 1 end price Rs. 200;
Year 2 end price Rs. 100
R1 = 100% or 1
R2 = -50% or –0.5
G = square root of [(1+1)(1-.5) – 1]
= square root of [(2*0.5) – 1] = 0

Types of Returns
Investors use various methods by which they measure investment returns. We will discuss several type
of returns; the nominal rate of return, the real rate of return, the real after tax rate of return, total return
and risk adjusted return. We will briefly discuss each of these concepts.

Nominal Rate of Return

The nominal rate of return is simply the return that one can earn on an investment. If for instance, you
invest your money in a Certificate of Deposit that promises to pay 7 percent per year, a Rs. 100
investment will yield Rs 107, one year later. In this example, the nominal rate of return is 7 percent, the
rate you can earn before considering the effects of inflation or taxes on your investments.

Required Rate of Return

The required rate or return is a key concept in investment planning. However, it is also a difficulty and
complex concept to understand for reasons that require further discussion. Thus, it is worthwhile for us
to spend some time on this issue.
When an investor assesses an investment opportunity, they may conduct much research and analysis
to gauge the attractiveness of the investment. Ultimately, the investor will boil down the research and
analysis to two factors; the risk of the investment opportunity and the return the investor expects to earn
on this investment. The rate of return that an investor expects to earn on a risk-free security (e.g. A
Treasury Bill) is the return that an investor expects to earn on a security that is free of default risk. All
other securities contain the possibility of defaulting on their obligations. Hence, an investor will require
returns in addition to the risk free rate as compensation for assuming the higher risk. We can think of this
compensatory additional return as the security’s risk premium. Thus we may express the required rate
of return as follows:

PDP Investment Planning 57

Required rate of return = risk-free return + risk premium
What the planner needs to comprehend is that in arriving at a required rate of return, the primary
assessment is the nature and extent of risk of an investment opportunity. The greater our understanding
of the riskiness of a security, the more accurate our understanding of the risk premium we must receive,
as compensation, in order to be induced to invest in that particular security. For example, suppose an
investor, or planner, is considering an investment in two securities – a small cap stock and a highly rated
bond. The planner will understand that the bond contains lower default risk than the small Cap stock and
will provide a greater assurance of an income stream and a redemption value at maturity. On the other
hand, the small cap stock’s price will most likely fluctuate greatly and a higher probability will exist that
the firm may well go bankrupt. Thus, from the planner’s or investor’s perspective, the bond will be
considered a much safer investment and the risk premium that the investor will require to invest in the
bond will be much lower than what will be assessed for the stock. When these risk premiums are added
to the risk free rate, the rate or return that the investor will require for the small cap stock will be much
higher than the bond. In summary, the required rate of return may be considered as the gauge of the
security’s riskiness.
There are two other related return concepts that are also worth discussing briefly. Under various economic
conditions, the performance of securities with varying characteristics will differ. For example, when the
economy is in a recessionary stage, we expect most stocks to perform poorly, in terms of the returns
they generate during this period. In this example, this rate would be the stock’s expected rate. If the
investor’s required rate for this stock was higher than the expected rate, then the investor would not
consider this investment, since the expected rate would not compensate the bearing of the risk of this
particular security, as determined by the required rate. Similarly, in an economic growth cycle, the
expected rate may equal or exceed the required rate and the investment would be made. Thus, we
observe that both the required rate and the expected rate are assessed and compared and which lead
to the eventual trading decision. Finally, note that the assessment of both the required rate and the
expected rate begin before the investment decision and they continue to exist during the tenure of that
decision, i.e. As long as the security is held. Once the investor sells the security, then the rate that was
actually earned, or the realized rate, can be calculated. The realized rate may well be, and usually is,
different form both the expected rate and the required rate.

The Real Rate of Return

The decision to invest is, in a sense, decision not to consume. Alternately, an investment decision is a
decision that implies a postponement of current consumption. To understand this further, consider this
example; suppose you made a return of 12 percent in one year and 15 percent the following year, did
you truly do better in the second year? The answer to this question depends on what your earnings
could buy at the end of each of those years, or the purchasing power of your earnings. If the general
level of prices, or inflation was very mild in the first year and severe in the second, your earnings would
stretch further (purchase more) in the first year than in the second and hence you would have actually
done better in the first year. Thus, the investment decision is related to the purchasing power of your
earnings. This relationship, in turn, allows us to describe the concept of the real rate of return.
Consider another simple example. Suppose you have Rs. 100 that you are seeking to manage for one year
and that you have two choices of how to use this money. The first choice is to invest the money in a savings
account where you will earn a nominal rate of return of 3 percent/year. Thus, in this choice, if you decided to
invest, you would have Rs 103 at the end of the year. The second choice is to buy a watch, which you have
always wanted, and which too costs Rs. 100, today. Had you decided to invest the money, then you would
buy the watch one year from today. However, due to the general increase in the level of prices, or inflation,

58 Investment Planning PDP

you may find that at the end of the year, the price of the watch has increased to Rs. 104. In this case, you
cannot buy the watch. Further, not having bought the watch before, you have also given up the enjoyment
of possessing the watch for the entire year. Thus, at the beginning, if you feel that the price of the watch will
increase to a level that is higher than what you would earn from your investment, you would be prone to not
invest and buy the watch. The only way you would be inclined to invest instead would be if you were being
provided with a nominal rate that was greater than what you would expect the price to be in a year’s time. In
the above example, you would invest only if the nominal rate was just greater than 4%. Note that you would
not be willing to invest if the nominal rate was just enough (equal to 4% in this example) to offset the cost
increase. If that were so, you would rather buy the watch and get to enjoy it for the year.
There are two important observations that we can make form this example. First, the decision to invest
is always in competition with the decision to consume. That is, the decision to invest can be considered
as a decision to postpone consumption. Second, we will invest only when we expect not only to consume
a similar product in the future but that we are also rewarded by a higher earning rate for postponing our
consumption. If we are not offered this reward, we will always tend to consume and not invest.
In the above example, the rate we earn on the investment is the nominal rate, the rate at which the price of
the product will rise is the inflation rate and the rate of the reward is the real rate of return. Thus in the above
example, if the savings (nominal) rate was 6 percent and the inflation rate was 4 percent, the real rate of
return would approximately be 2 percent. This approximate relationship can be expressed as follows:
Nominal rate = real rate + inflation rate
The exact relationship is given by the following equation:
(1 + Nominal rate) = (1 + real rate) x (1 + inflation rate)
The real rate = [ (1 + Nominal rate)/ (1 + inflation rate) ] –1

Real After Tax Rate of Return

Many of the returns that investors earn are not tax-free. Short-term capital gains are taxed at the investor’s
marginal tax rate. Recall that short-term capital gains are those gains that are held for less than one
year in case of financial assets like equities, Debt etc. and three years in case of real assets like real
estate, work of arts etc. Long-term capital gains are gains from increases in security prices where the
security was held (owned) for one year, three years or longer. Such gains are currently taxed at 20
percent with indexation or 10% flat without indexation for most individuals. In advising a client to sell a
financial instrument, the real after tax rate of return must be taken into consideration in order to relay a
true picture of return to the client. Taxes are relevant to all of us, but those clients in high income tax
brackets are particularly affected by after tax returns.
The formula for the real after tax rate or return is:
r = ( R) (1-t) – I
where r is the real after tax rate or return, R, is the nominal rate of interest, and t is the tax rate at which
the investment will be taxed and I is the inflation rate for the period.
In this formula, we took the rate of inflation into consideration because it reduces the purchasing power
of our returns. If the nominal rate of interest on a security is yielding 9 percent, the individual ‘s tax rate
is 30 percent and the inflation rate is an equal to 4 percent, the real after tax rate of return is:
R = (0.0 0.09) (1- 0.30) – 0. 0.04 = 2.3 %

PDP Investment Planning 59

Total Return
The notion of total return centers on the total return that an investment yields. For example, when talking
about stocks, the total return is equal to any dividends that the stock pays plus the capital gains or
losses that the investor realizes on the sale of the stock. The same notion is true for mutual funds
whereby the fund earns dividends and/or interest as well as capital gains or losses. Total returns are
expressed in whole currency terms. For example, suppose an investor purchased Stock A for Rs. 100
per share. Over the next four years, Stock A paid annual dividends of Rs. 20.00 each year. At the end of
the fourth year the investor decided to sell his stock at market for a price of Rs. 120.00 per share. Thus
the gains are as follows:

Year 1 Rs. 20.00

Year 2 Rs. 20.00
Year 3 Rs. 20.00
Year 4 Rs. 20.00
Total Income Rs. 80.00
Capital Gain: Rs. 20
Total Gain : Rs. 100

Thus, total return over the four years is Rs. 100 / Rs. 100 = 100%

Risk Adjusted Return

Risk premium is a percentage return that an investment must expect to earn in order for an investor to
assume a given level of risk. The risk premium will be different for each investment once all investment
have different risk profiles and different expected returns. For example, for a deposit at a bank or RBI
Treasury bill, the risk premium approaches zero. For common stock, the investor’s required return may
carry a 9 -10 percent risk premium in addition to the risk-free rate of return. If the risk-free rate were 8%
percent, the investor might have an overall required return of 17 to 18% percent on common stock.

n Real rate 5%
n Anticipated inflation 5%
n Risk – free rate 8%
n Risk premium 9 – 10%
n Required rate of return 19 – 20%
Corporate bonds fall somewhere between short-term government obligations (generally no risk) and
common stock in terms of risk. Thus, for bonds, the risk premium may be 3 to 4% percent. Like the real
of return and the inflation rate, the risk premium is not stagnant but changes from time to time; for
instance, if the issuing company’s risk profile changes or if the macroeconomic outlook becomes more
uncertain, then the risk premium will change. If investors are very fearful about the economic outlook,
the risk premium may be 12- 14% percent

Measuring Investment Returns

In order to begin to understand the various types of investment returns and their uses, we begin by
considering a simple investment return for one time period. Recall, that when we discussed stocks, the

60 Investment Planning PDP

total return was equal to any dividends that the stock paid plus the capital gains or losses that the
investor realized on the sale of the stock. The same notion is true for mutual funds whereby the fund
earns dividends and/or interest as well as capital gains or losses.
Suppose you purchase stock X, at a price of Rs. 125. During the year, the stock pays a dividend of Rs
3. At the end of the year, you also sell the stock for Rs150 as it has increased in market value. Recall
our formula for the Holding Period Return which is:

HPR = P1 –P0 + Dividends/P0

The return on this investment is: (150-125+3) = = 22 .4 %

Time Weighted Returns versus Dollar Weighted Returns

In reality we may want to consider investments over a period of time whereby we may have added to
our investment positions or reduced our investment positions. If this is the case, measuring investment
returns is a bit more difficult. With the basic concept of the holding period return, however, we measure
investment returns where there are series of cash inflows and outflows.
Keeping with the example above, suppose that instead of selling the share of stock at the end of the year,
we decide to purchase one more share of stock at the current market value of Rs 150. At the end of the
year, we collect our second Rs 3 dividend, and subsequently sell both shares of our stock for Rs160 each.
The cash outflows for the purchase of stock are as follows.

To - Rs. 125 to purchase first share of stock, where To is our initial cash outflow at
Time zero

Ti - Rs. 150 to purchase second share of stock

The cash inflows for the receipt of dividends are as follows:

T1 - Rs. 3 dividend
T2 - Rs. 3 dividend plus Rs320 for selling each share of stock at Rs. 160.
Using the discounted cash flow approach, we calculate the average return (r) over two years as follows:

Solving for r, we get

R= 12.95%
This value is known as the internal rate of return on the investment and is also known as the compounded
annual growth rate of return on the investment.
The time weighted rate of return (Simple Airithmatic Rate of Return) is a formula which uses the holding
period returns of an investment and averages them in order to yield an average rate of return. It is
unlike the CAGR of return in that it ignores the number of shares held in each period. It does not take
cash inflows/outflows into consideration during any period. Using the numbers from our previous
examples, we find that the holding period return from at the end of period 1 was 20 percent. The return
on the second share of stock was 28-27+3/27 or 14.81 percent.
To calculate the average time weighted rate of return:
Time Weighted Rate of Return = (20% + 14.81%)/2
= 17.41%

PDP Investment Planning 61

In this particular example, the dollar weighted return yielded less return than the time weighted rate of
return. Depending upon the individual investment results either measurement could yield a result greater
than the other. In general the results from these two measures will be different however.
Time weighted returns are generally used in order to measure results of money managers in their
management of particular funds. Because money managers cannot control the timing or the amount of
money coming into their funds, time weighted returns are used in order to measure results.
Since investors are particularly interested in the total amount of return that a portfolio or security yields
over a period of time, the dollar weighted rate of return is generally considered to be the superior
measure of return for this reason. This measure would thus be used by those wishing to know how
investment returns fared within a particular portfolio or portfolios.

Arithmetic versus Geometric Averages

A separate set of measures arises from averaging returns on investments. The arithmetic and geometric
weighted averages are examples of such returns. The time weighted return discussed in the previous
section is also an example of arithmetic average rate of return. The geometric rate of return considers
cash flows generated during the security’s holding period to be reinvested at the security’s required rate
of return. Thus, this method includes the effect of compounding into consideration when calculating the
return. The equation for the geometric is as follows:

Rg = [(1 + HPR year1) X (1 + HPR year2) X (1+HPR year)]¹/n – 1

Where Rg is the geometric rate of return and n, stands for the nth period of investment.
The arithmetic rate of return is a simple average of annual returns. Using the same numbers from the
previous example of calculating the time weighted rate of return, we calculate the geometric rate as follows:

Rg = [(1 + 0.2) X (1 + 0.1481)]½ – 1

= 17.38%
Notice that the geometric average return is 17.38% whereas the arithmetic rate of return is 17.41%. It
will always be true that the geometric rate of return will yield a smaller number than the arithmetic rate of
return. In general, the lower the returns, the greater is the disparity between the two averages.

This chapter began with a description of the different kinds of risk that accompany investments. It is
useful to understand the nature and various types of risk since investors implicitly or explicitly price this
risk in arriving at required returns investments. Therefore, the description of different types of risk is
followed by explanations of how risk may be Measured. Once we can identify the types of risk in an
investment and understand how to measure such risk, we can then proceed to identify what kinds of
returns we may require from investing in different kinds of investment products.
“How much was the return on your investment?” Before having read this chapter, such a question may
have been interpreted as a simple question. Not any more. In this chapter, we studied the many different
forms that investment returns may take. Returns may be classified by inflation, as in the real rate return,
or by the investment risk, as in the risk-free rate. Other return measures may incorporate taxes, the
effect of time or the means of averaging. Even though the simplicity of the term is no more, the astute
student should recognize that the various return definitions exist because they are all meaningful to
investors under different investment circumstances and scenarios. These differing applications were
explained in the context of defining each of the terms of returns. Armed with such knowledge, a financial
planner cannot only explain investment outcomes to clients more clearly but also help clients identify the

62 Investment Planning PDP

misuse and abuse of these in the description of investment products.

Mr. Ketan bought a share on Jan 1, 2003 for Rs. 45/-. The company did not pay any dividends. The year
end prices were as follows:

2003 = 50
2004 = 55
2005= 48
If he sold the share on end 2005 for Rs. 48, what returns did he get on this investment?

R1 = (5/45)*100 = 11.11% = 0.111
R2 = (5/50)*100 = 10% = 0.1
R3 = (-7/55)*100 = -12.72% = -0.127
Arithmetic Average returns = [11.11+10-12.72]/3 = 2.79665
Geometric Average returns = {cube root of [(0.111+1)*(.01+1)*(-0.127+1)]} -1

= {cube root of 1.0669} - 1

= 1.023-1 = .023 or 2.3%
Yield to Call
Most corporate bonds, as well as some government bonds, are callable by the issuers, typically after
some deferred call period. For bonds likely to be called, the yield-to-maturity calculation is unrealistic. A
better calculation is the promised yield to call. The end of the deferred call period when a bond can first
be called, is often used for the yield-to-call calculation. This is particularly appropriate for bonds selling
at a premium (i.e., high-coupon bonds with market prices above par value).
Bond prices are calculated on the basis of the lowest yield measure. Therefore, for premium bonds
selling above a certain level, yield to call replaces yield to maturity, because it produces the lowest
measure of yield.

Compounding vs. Discounting

The concept of compounding, that is interest on interest, is an important concept, as is its complement,
discounting. Compounding involves future value resulting from compound interest. Present value (discounting)
is the value today of the Rupee to be received in the future. Such Rupees are not comparable because of
the time value of money. In order to be comparable, they must be discounted back to the present. Tables
exist for both compounding and discounting, and calculators and computers make these calculations simple.

Post Tax Returns (Tax Adjusted Returns)

As an investor, you learn very quickly that taxes can take a big bite out of your investment returns. After
all, it’s not what you make, but what you keep that really counts. If an investment is made in a taxable
vehicle within a taxable account, one should really look at the net after tax return.

Mr. Mukherjee has an investment with an 8% taxable yield. Mr. Mukherjee pays tax at the rate of 30% on
his income. What is Mr. Mukherjee’s post tax return on this investment?

PDP Investment Planning 63

Return = 1
Tax = 0.3
Post tax return = 1-0.3 = 0.7
Taxable yield = 8%
Post tax yield = 8*0.7 = 5.6%
Conversely, let us assume that Mr. Mukherjee gets 8% tax free returns and he is paying tax at 30%.
What is his taxable yield on this investment?
Tax free return = 0.7 = 8%
Taxable return = 1 = 8/0.7 = 11.4285%
The formula can be given as:
Taxable return = Tax free return / (1-t)
Where “t” is the marginal rate at which the investor pays tax.

Let us try and find out what would be the yield to Mr. Mukherjee on his 10% tax free bonds if he is paying
tax at 20%.

Tax free return = 10%

10 %
Taxable return = 10 % /(1 - t ) = = 12 .5 %
0 .8

Alternatively: Tax free return / (1-t) = 10/(1-0.2) = 10/0.8 = 12.5%

Mr. Arun Joshi makes it a point to invest Rs. 70,000/- every year in his Public Provident Fund account.
He enjoys tax deduction u/s 80C on the amount deposited and he earns 8% p.a. tax free interest,
credited annually to his PPF account. He pays income tax at the rate of 30%. What is the tax adjusted
yield on PPF deposits to Mr. Arun Joshi?
Tax adjusted yield is = Tax free return / (1-t)
For deduction u/s 80C, the return will be 8/(1-0.3) = 8/0.7 = 11.4285%
But this return is also tax free u/s 10
Hence, additional yield calculation will follow
Yield on PPF to Mr Arun Joshi = 11.4285/0.7 = 16.3265%
Since PPF investment qualifies for tax deduction, the tax adjusted yield in the year of investment is
11.4285% as calculated above and since the return is not taxable, the yield works out to 16.3265% as
calculated subsequently.
The three important aspects of tax adjusted yields are:

1. Deduction on amount invested and subsequent saving of income tax.

2. The returns on the investment being taxable or tax free.
3. The capital gain or loss, if any, on maturity/withdrawal and whether the same is taxable or not.

64 Investment Planning PDP

In the case of PPF deposits, there are no capital gain/loss issues and hence maturity value taxability is
not an issue while calculating the yield.

Annualized Return
An annualized return is a rate of return over a full calendar year on an investment that is held for less
than a full calendar year. For example, if an investment produced a return of 5% in 182 days, the
annualized yield would be approximately 10%. It is important to note that this return measurement
assumes the return could be duplicated over the full year, which may or may not actually be achievable.

Mr. Patel bought a share for Rs. 110 on 10th Jan 2006 and sold it after 45 days at Rs. 120/-. Calculate his
annualized returns.

Absolute returns Rs. 10/110 over 45 days
Annualized returns = (10*365)/(110*45) = 0.7373 or 73.73%

Real (Inflation-Adjusted) Return

All of the returns discussed earlier are nominal returns, or money returns. They measure Rupee amounts
or changes but say nothing about the purchasing power of these Rupees. To capture this dimension, we
need to consider real returns, or inflation-adjusted returns.
To calculate inflation-adjusted returns, we divide 1 + nominal total return by 1 + the inflation rate as
shown in the following equation. This calculation is sometimes simplified by subtracting rather than
dividing, producing a close approximation.
Real return = {(1 + Nominal return)/(1+ Inflation rate)} – 1

The rate of return on a stock in a particular year was 19.5 %. The rate of inflation during that year was
5.5%. What is the real return on the stock?
Real return = {(1+0.195)/(1+0.055)} – 1
= 1.1327-1 = .1327 = 13.27%
Merely by subtracting inflation rate from the return on the stock, we will get a less accurate return i.e.
19.5-5.5 = 14%

Holding Period Return

A holding period return is the total return actually realized or expected from holding a specific asset for
a specified period of time (not necessarily one year). The return is measured the same as total return,
that is, adding dividends and capital gains and dividing the resulting figure by the purchase price.

Mr. Patel bought a share for Rs. 110 on 10th Jan 2006 and sold it after 45 days at Rs. 120/-. No dividend
was received by him in this period. Calculate his holding period returns.
Holding period returns = (120-110)/110 = .0909 = 9.09%

PDP Investment Planning 65

Portfolio of Securities - Measures of Return

Portfolio Performance Measurement

We have been discussing returns on individual securities. Now let us measure portfolio returns.

Benchmark Portfolios
Evaluation of portfolio performance, the bottom line of the investing process, is an important aspect of
interest to all investors and money managers. The framework for evaluating portfolio performance consists
of measuring both the realized return and the differential risk of the portfolio used to compare a portfolio’s
performance, and recognize any constraints that the portfolio manager may face. A 12% return, by
itself, is a fairly meaningless figure. It must be viewed in comparison to the performance, over the same
timeframe, of alternative investments bearing a similar level of risk.
Remember, one can only measure return in relation to the risk taken. Investing is always a two-dimensional
process based on return and risk. These two factors are opposite sides of the same coin, and both must
be evaluated if intelligent decisions are to be made. Therefore, if we know nothing about the risk of an
investment, there is little we can say about its performance. Although all investors prefer higher returns,
they are also risk averse. To evaluate portfolio performance properly, we must determine whether the
returns are large enough given the risk involved. If we are to assess performance carefully, we must
evaluate performance on a risk-adjusted basis.
We must make relative comparisons in performance measurement, and an important related issue is
the benchmark to be used in evaluating the performance of a portfolio. The essence of performance
evaluation in investments is to compare the returns obtained on some portfolio with the returns that
could have been obtained from a comparable alternative. The measurement process must involve relevant
and obtainable alternatives; that is, the benchmark portfolio must be a legitimate alternative that
accurately reflects the objectives of the portfolio owners.
An equity portfolio consisting of BSE Sensex stocks should be evaluated relative to the BSE Sensex or
other equity portfolios that could be constructed from the Index, after adjusting for the risk involved. On
the other hand, a portfolio of small capitalization stocks should not be judged against that same benchmark.
If a bond portfolio manager’s objective is to invest in bonds rated A or higher, it would be inappropriate
to compare his or her performance with that of a junk bond manager.
Even more difficult to evaluate are equity funds that hold some midcap and small stocks while holding
many BSE Sensex stocks. Comparisons for such a widely diversified group can be quite difficult.
Many observers now agree that multiple benchmarks can be more appropriate to use when evaluating
portfolio returns. All investors should understand that even in today’s investment world of computers
and databases, exact, precise, universally agreed upon methods of portfolio evaluation remain an elusive
goal. An evaluation is imperative, though it is unfortunate that some studies have indicated that most
investors don’t have a good idea how well their portfolios are actually performing.

Risk-adjusted Returns
Recognizing the necessity to incorporate both return and risk into the analysis of portfolio return, three
researchers - William Sharpe, Jack Treynor, and Michael Jensen developed measures of portfolio
performance in the 1960s. These measures are often referred to as the composite (risk-adjusted)
measures of portfolio performance, meaning that they incorporate both realized return and risk into the
evaluation. These measures are still used by mutual funds and money managers.

66 Investment Planning PDP

Sharpe Ratio
William Sharpe introduced a risk-adjusted measure of portfo lio performance c alled the
reward-to-variability ratio (RVAR). This measure uses a benchmark based on the ex post capital market
line. Sharpe used RVAR to:

n Measure the excess return per unit of total risk (as measured by standard deviation).
n Rank portfolios by RVAR (the higher the RAVR, the better the portfolio performance).

RP - Rf

Rp = Return of the portfolio

Rf = Risk free return
SD = Standard Deviation of Portfolio (total risk)

Treynor Measure
Jack Treynor presented a similar measure called the reward-to volatility ratio (RVOL). Like Sharpe,
Treynor sought to relate the return on a portfolio to its risk. Treynor, however, distinguished between
total risk and systematic risk, implicitly assuming that portfolios are well diversified; that is, he ignores
any diversifiable risk. He used as a benchmark the ex post security market line.

RP - Rf


Beta is the measure of market risk of the portfolio.

Jensen’s Index
Michael Jensen’s measure of portfolio performance was differential return measure (Alpha). It calculated
the difference between what the portfolio actually earned and what it was expected to earn given its
level of systematic risk. Basically, it attempts to measure the constant return that the portfolio manager
earned above, or below, the return of an unmanaged portfolio with the same market risk.
The Sharpe and Treynor measures can be used to rank portfolio performance and indicate the relative
positions of the portfolios being evaluated. Jensen’s measure is an absolute measure of performance.
Jensen’s index = Rp – [Rf + (Rm- Rf)*B]
Rp= return on the portfolio
Rf = risk free return
Rm = Market return (Index return)
B = Beta of the portfolio (Beta is the measure of market risk of the portfolio)

PDP Investment Planning 67

Review Questions:
1. What is the arithmetic average returns on stock A if the stock was bought for Rs. 75/- and the year
end prices for the last 3 years were Rs. 85, Rs. 95, and Rs. 100/-?
a. 10.11%
b. 12. 24%
c. 13.4%
d. 11.11%
2. What is geometric average returns for stock A given the details above?
a. 11.24%
b. 10.01%
c. 11.46%
d. 13.62%
3. What is the current yield of a bond bearing a coupon rate of 8% payable annually and currently
priced at Rs. 950 with a face value of Rs. 1000/-?
a. 8%
b. 9%
c. 13.40%
d. 9.12%
4. What is the YTM of the above bond (by using the method of computing the YTM approximately),
if the bond will mature after 2 years?
a. 11.24%
b. 8%
c. 10.82%
d. 8.42%
5. Mr. A bought a stock X for Rs. 102/- and sold it after a year for Rs. 115/-. He also received a
dividend of Rs. 2/- per share in the interim. What is the total return on stock X?
a. 11.30%
b. 12.74%
c. 14.70%
d. 15.0 %
6. Mr. A bought stock X for Rs. 102 and sold it for Rs. 115/- after 120 days. He did not get any
dividend on the stock. What is the holding period return on stock X to Mr. A?
a. 12.74%
b. 38.76%
c. 44.73%
d. 25.48%

68 Investment Planning PDP

7. Mr. A bought stock X for Rs. 102 and sold it for Rs. 115/- after 120 days. He did not get any
dividend on the stock. What is the annualized return earned by Mr. A?
a. 12.74%
b. 38.76%
c. 44.73%
d. 25.48%
8. Mr. Vasudeo Mumbaikar invested Rs. 10,000/- in his PPF account and saved income tax of Rs.
3,000/-. He will get 8% p.a. interest which is tax free on his PPF deposit. What is the tax adjusted
yield on PPF deposit of Rs. 10,000/- enjoyed by Mr. Vasudeo Mumbaikar?
a. 8%
b. 11.43%
c. 16.32%
d. 10%
9. Mr. Winston Jones purchased National Saving Certificate for Rs. 10,000/- and saved income tax
of Rs. 2,000/-. He will get Rs. 16,010/- on maturity after 6 years which works out to a return of 8%
p.a. What is the tax adjusted yield on NSC purchased by Mr. W Jones?
a. 8%
b. 11.43%
c. 16.32%
d. 10%
10. Given the following information about the returns on a portfolio, find out the Sharpe Index:
Return on the portfolio was 15% while risk free return was 8% and the standard deviation of the
portfolio was 4%.
a. 3.75
b. 2.25
c. 1.75
d. 5.75

1. a
2. b
3. c
4. c
5. c
6. a
7. b
8. c
9. d
10. c

PDP Investment Planning 69

Chapter 6

70 Investment Planning PDP

Building an Investment Portfolio

W e now consider how investors go about selecting stocks to be held in portfolios. Individual investors
often consider the investment decision as consisting of two steps:

n Asset allocation
n Security selection
The asset allocation decision refers to the allocation of portfolio assets to broad asset markets; in other
words, how much of the portfolio’s funds are to be invested in stocks, how much in bonds, money
market assets, and so forth. Each weight can range from zero percent to 100 percent. If it is possible to
make investments globally, then we have to ask the following questions:

1. What percentage of portfolio funds is to be invested in each of the countries for which financial
markets are available to investors?
2. Within each country, what percentage of portfolio funds is to be invested in stocks, bonds, bills, and
other assets?
3. Within each of the major asset classes, what percentage of portfolio funds goes to various types of
bonds, exchange-listed stocks versus over-the-counter stocks, and so forth?
Many knowledgeable market observers agree that the asset allocation decision may be the most important
decision made by an investor. According to some studies, for example, the asset allocation decision
accounts for more than 90 per cent of the variance in quarterly returns for a typical large pension fund.
The rationale behind this approach is that different asset classes offer various potential returns and
various levels of risk, and the correlation coefficients may be quite low.
Correlation determines the extent to which a variable moves in the same direction as other variable,
such as inflation. It is statistically determined and labeled as the correlation coefficient. Correlation can
help in making decisions concerning diversification among mutual fund categories.
The asset allocation decision involves deciding the percentage of investible funds to be placed in stocks,
bonds, and cash equivalents. It is the most important investment decision made by investors because it
is the basic determinant of the return and risk taken. This is a result of holding a well-diversified portfolio,
which we know is the primary lesson of portfolio management.
The returns of a well-diversified portfolio within a given asset class are highly correlated with the returns
of the asset class itself. Within an asset class, diversified portfolios will tend to produce similar returns
over time. However, different asset classes are likely to produce results that are quite dissimilar. Therefore,
differences in asset allocation will be the key factor over time causing differences in portfolio performance.
Factors to consider in making the asset allocation decision include the investor’s return requirements
(current income versus future income), the investor’s risk tolerance, and the time horizon. This is
done in conjunction with the investment manager’s expectations about the capital markets and
about individual assets.
According to some analyses, asset allocation is closely related to the age of an investor. This
involves the so-called life-cycle theory of asset allocation. This makes intuitive sense because the

PDP Investment Planning 71

needs and financial positions of workers in their 50s would differ, on average, from those who are
starting out in their 20s. According to the life-cycle theory, for example, as individuals approach
retirement, they become more risk averse.
Stated at its simplest, portfolio construction involves the selection of securities to be included in the
portfolio and the determination of portfolio funds (the weights) to be placed in each security. The Markowitz
model provides the basis for a scientific portfolio construction that results in efficient portfolios. An efficient
portfolio is one with the highest level of expected return for a given level of risk, or the lowest risk for a
given level of expected return.

Asset Classes
Portfolio construction listing out the asset classes, where money can be invested are:

n Cash (or cash equivalents such as money market funds)

n Stocks
n Bonds
n Real Estate (including Real Estate Investment Trusts)
n Foreign Securities
Each investor must determine which of these major categories of investments is suitable for him/her, in
consultation with the financial planner. The next step, as discussed in the preceding section on asset
allocation, is to determine which percentage of total investable assets should be allocated to each category
deemed appropriate. Only then should individual securities be considered within each asset class.

Diversification is the key to the management of portfolio risk because it allows investors to minimize risk
without adversely affecting return.
Random diversification refers to the act of randomly diversifying without regard to relevant investment
characteristics such as expected return and industry classification. An investor simply selects a relatively
large number of securities randomly.
For randomly selected portfolios, average portfolio risk can be reduced to approximately 19 per cent. As
we add securities to the portfolio, the total risk associated with the portfolio of stocks declines rapidly.
The first few stocks cause a large decrease in portfolio risk. Based on these actual data, 51 per cent of
portfolio standard deviation is eliminated as we go from 1 to 10 securities.
Unfortunately, the benefits of random diversification do not continue as we add more securities. As
subsequent stocks are added, the marginal risk reduction is small. Nevertheless, adding one more
stock to the portfolio will continue to reduce the risk, although the amount of the reduction becomes
smaller and smaller.
It is also established in the US through studies that by adding foreign securities to the portfolio, the risk
is reduced dramatically – to the extent of 33%.

Risk Reduction in the Stock Portion of a Portfolio

1. Law of Large Numbers

One simple way of going about risk reduction is through increasing the number of securities held. As we
add securities to this portfolio, the exposure to any particular source of risk becomes small. According to
the Law of Large Numbers, the larger the sample size, the more likely it is that the sample mean will be

72 Investment Planning PDP

close to the population expected value. Risk reduction in the case of independent risk sources can be
thought of as the insurance principle, named for the idea that an insurance company reduces its risk by
writing many policies against many independent sources of risk.
We are assuming here that rates of return on individual securities are statistically independent such that
any one security’s rate of return is unaffected by another’s rate of return.
Unfortunately, the assumption of statistically independent returns on stocks is unrealistic in the real
world. We find that most stocks are positively correlated with each other; that is, the movements in their
returns are related. Most stocks have a significant level of co-movement with the overall market of
stocks, as measured by such indexes as the BSE Sensex or NSE Nifty. Risk cannot be eliminated
because common sources of risk affect all firms.

Modern Portfolio Theory

In the 1950’s, Harry Markowitz, considered the father of modern portfolio theory, originated the basic
portfolio model that underlies modern portfolio theory. Before Markowitz, investors dealt loosely with the
concepts of return and risk. Investors have known intuitively for many years that it is smart to diversify,
that is, not to “put all of your eggs in one basket.” Markowitz, however, was the first to develop the
concept of portfolio diversification in a formal way. He showed quantitatively why, and how, portfolio
diversification works to reduce the risk of a portfolio to an investor.
Markowitz sought to organize the existing thoughts and practices into a more formal framework and to
answer a basic question: Is the risk of a portfolio equal to the sum of the risks of the individual securities
comprising it? Markowitz was the first to develop a specific measure of portfolio risk and to derive the
expected return and risk for a portfolio based on covariance relationships.
Markowitz developed an equation that calculates the risk of a portfolio as measured by the variance or
standard deviation. His equation accounts for two factors:

1. Weighted individual security risks (i.e., the variance of each individual security, weighted by the
percentage of investible funds placed in each individual security).
2. Weighted co-movements between securities’ returns (i.e., the covariance between the securities’
returns, again weighted by the percentage of investible funds placed in each security).
2. Combination of securities
It is assumed that combination of two securities results in risk reduction. Is it possible to reduce the risk
of a portfolio by adding into it a security whose risk is higher than that of any of the investments held
already? Let us consider the following example:

Obviously, the stock Y is riskier because the standard deviation is higher but the expected return is also
higher. We will have to analyze and find out whether it would be sensible for an investor who is already

PDP Investment Planning 73

holding Stock X to buy a riskier stock Y; add it in his portfolio to reduce the risk. Whether buying stock Y
and adding to one’s portfolio will amount to diversification?
Let us find out by assuming that we shall build a portfolio of 2 securities with weightage of 60% for stock
X and weightage of 40% for stock Y.
The expected return on the portfolio Rp would be 0.6*10+0.4*14 = 11.60%
If we assume that stock Y gives good returns when stock X performs badly, then we will have returns of
0.6*9+0.4*16 = 11.80%
If it is the other way round, that is, stock X performs well while stock Y does not perform well, we will have
a situation when the return will be 0.6*11+0.4*12 = 11.40%. In either case, we have got returns very close
to the expected return with risk virtually being nil. We have assumed a negative correlation between stock
X and Stock Y. In other words, when we have two or more securities in a portfolio, the returns will depend
upon the interactive risk between / among those securities. If we can find two securities that are perfectly
negatively correlated, then we can have a portfolio of two securities without any risk at all.

Covariance or interactive risk

Where the probabilities are equal the formula can be expressed as:
COVxy is arrived out by using the formula given below:

If it assumed that stock X gives a return of 9% while stock Y gives a return of 16% and stock X gives a
return of 11% when stock Y gives a return of 12%, using the example given above the covariance can
be worked out as under:
½ [(9-10)(16-14)+(11-10)(12-14)]
= ½ [-2-2]
= -2
We have taken two corresponding observations at the same time, determined the variation of each from
its expected value, and multiplied the two deviations together and taken the average of such deviations.
The coefficient of correlation is another measure that would indicate the similarity or dissimilarity in the
behaviour of the two variables.
Rxy = COVxy / (sx * sy)
= -2/(2*4) = -2/8 = -0.25
The stocks X and Y are negatively correlated, which means one stock will perform while the other may
not and vice versa. A perfect correlation will be when Rxy = 1 and a perfect negative correlation will be
when Rxy = -1.

74 Investment Planning PDP

Rxy lies between -1 and +1.
When Rxy = 0, these two stocks are absolutely not co- related at all and the returns will be independent
of each other.
Thus, we can conclude that in order to achieve diversification we should choose stocks with negative or
low covariance. The purpose of diversification will not be served if we add securities that have positive
co-relation or no co-relation at all.

Portfolio effect in a 2 security case

We have seen that diversification reduces the risk. While achieving risk reduction, one should not
compromise on the returns. In general, the lower the correlation of securities in a portfolio, the less risky
the portfolio will be. True diversification is about choosing correct securities that are negatively correlated
rather than mere increase in number of securities.

sxy is the portfolio standard deviation
wx = percentage of stock x in the total portfolio value
wy = percentage of stock y in the total portfolio value
s2x = variance of stock x
sy2 = variance of stock y
COVxy = covariance of stock x and stock y
In the case which we have been discussing, we have already calculated:
COVxy = -2
Weights for stock x and stock y are 0.6 and 0.4 respectively.
Variance for stocks x and y have been given as 4 and 16.
So portfolio variance will be:
1.44+2.56-0.0096 = 3.99
Portfolio risk will be square root of variance which is less than 2.
Thus, by adding a security y with a higher risk to security x and constructing a portfolio, we have achieved
risk reduction without compromising on the returns.

When does Diversification pay?

n Combining securities with perfect positive correlation with each other provides no reduction in
portfolio risk. The risk of the resulting portfolio is simply a weighted average of the individual risks
of the securities. As more securities are added under the condition of perfect positive correlation,
portfolio risk remains a weighted average. There is no risk reduction.

PDP Investment Planning 75

n Combining two securities with zero correlation (statistical independence) with each other reduces the
risk of the portfolio. If more securities with uncorrelated returns are added to the portfolio, significant
risk reduction can be achieved. However, portfolio risk cannot be eliminated in this case.
n Combining two securities with perfect negative correlation with each other could eliminate risk
altogether. This is the principle behind hedging strategies.
n Finally, we must understand that in the real world, these extreme correlations are rare. Rather,
securities typically have some positive correlation with each other. Thus, although risk can be
reduced, it usually cannot be eliminated. Other things being equal, investors wish to find securities
with the least positive correlation possible. Ideally, they would like securities with negative correlation
or low positive correlation, but they generally will be faced with positively correlated security returns.
Markowitz’s theory shows us that the risk for a portfolio encompasses not only the individual security
risk but also the co-variance between the securities, and that three factors determine portfolio risk:

n The variance of each security.

n The co-variances between securities.
n The portfolio weights for each security.
The standard deviation of the portfolio will be directly affected by the correlation between the two stocks.
Portfolio risk will be reduced as the correlation coefficient moves from +1.0 downward.
One of Markowitz’s real contributions to portfolio theory is his insight about the relative importance of the
variances and co-variances. As the number of securities held in a portfolio increases, the importance of
each individual security’s risk (variance) decreases, while the importance of the covariance relationships
increases. In a portfolio of 500 securities, for example, the contribution of each security’s own risk to the
total portfolio risk will be extremely small; portfolio risk will consist almost entirely of the covariance risk
between securities.
Markowitz’s approach to portfolio selection is that an investor should evaluate portfolios on the basis of
their expected returns and risk as measured by the standard deviation. He was the first to derive the
concept of an efficient portfolio, defined as one that has the smallest portfolio risk for a given level of
expected return or the largest expected return for a given level of risk.
Investors can identify efficient portfolios by specifying an expected portfolio return and minimizing the
portfolio risk at this level of return. Alternatively, they can specify a portfolio risk level they are willing to
assume and maximize the expected return on the portfolio for this level of risk. Rational investors will
seek efficient portfolios because these portfolios are optimized on the two dimensions which are of most
importance to investors: expected return and risk.

3. Rupee Cost Averaging

The systematic investment plans in mutual funds, along with consistent periodic new purchases of
shares, creates risk reduction by creating a lower cost per share owned over time. This is known as
rupee cost averaging. This strategy allows one to take away the guesswork of trying to time the market.
You invest a fixed amount of money at regular intervals, regardless of whether the market is high or low.
By doing so, you end up buying fewer shares when the prices are high and more shares when the prices
are low. Because rupee cost averaging involves regular investments during periods of fluctuating prices,
you should consider your financial ability to continue investing when price levels are low. However, this

76 Investment Planning PDP

approach reduces the effects of market fluctuation on the average price you pay for your shares.
Additionally, it helps you maintain a regular investment plan.
In order to reduce risk associated with investments for getting a desired level of returns:

n It is essential to be diversified across different asset classes.

n It is pertinent to have more securities in a particular asset class, say equities.
n Co-relation among different securities chosen is more important than mere number of securities in
one’s portfolio to achieve diversification.
n It is a fact that risk in investments can be reduced but can not be totally removed through
n Systematic investment – investments in selected securities at regular pre determined intervals will
serve the purpose of “Rupee Cost Averaging” and take away the risk of investing at the wrong time.
These are time-tested investment philosophies that should go into building investment portfolios.
Modern portfolio theory begins by combinations of securities, or portfolios, which are superior to other
combinations either from better returns and / of lower risk These superior or “efficient” combinations are
then plotted to determine a “frontier” of all such efficient combinations. Next, each investor’ s personal
risk-return considerations or “utility” is introduced into the construction. Finally, the efficient combinations
are superimposed on the investor’s desired utilities, or benefits, to arrive at one efficient combination, an
“optimal portfolio” for the stated investor.
We have seen how the combination of two investments has allowed us to maintain our return of 10
percent but reduce the portfolio standard deviation to 1.8 percent. We also saw in the preceding table
that different coefficient correlations produce many different possibilities for portfolio standard deviations.
A shrewd portfolio manager may wish to consider a large number of portfolios, each with a different
expected value and standard deviation, based on the expected values and standard deviations of the
individual securities and more importantly, on the correlations between the individual securities. Though
we have been discussing a two-asset portfolio case, our example may be expanded to cover 5.,10.,or
even 100-asset portfolios. The major tenets of portfolio theory that we are currently examining were
developed by professor Harry Markowitz in the 1950s, and so we refer to them as Markowitz portfolio
theory. In 1990 Markowitz won the Nobel Prize in economics for this work.
Assume we have identified the following risk-return possibilities for eight different portfolios (there may
also be many more, but we will restrict ourselves to this set for now).
In diagramming our various risk-return points in the table on page 78, we show the values in Figure 6:1.
Although we have only diagrammed eight possibilities, we see an efficient set of portfolios would lie
along the ACFH line in Figure 6:1. This line is efficient because the portfolios on this line dominate all
other attainable portfolios. This line is called the efficient frontier because the portfolios on the efficient
frontier provide the best risk return trade-off.
The incremental benefit from reduction of the portfolio standard deviation through adding securities appears
to diminish fairly sharply with a portfolio of 10 securities and is quite small with a portfolio as large as 20. A
portfolio of 12 to 14 securities is generally thought to be of sufficient size to enjoy the majority of desirable
portfolio effects. See W H. Wagner and S.C. Lau, “the Effect of Diversification on Risk.”

PDP Investment Planning 77

FIGURE 6:1 Diagram of Risk-Return Trade-Offs

That is along this efficient frontier we can receive a maximum return for a given level of risk or a minimum
risk for a given level of return. Portfolios do not exist above the efficient frontier, and portfolios below this
line do not offer acceptable alternatives to points along the line. As an example of maximum return for a
given level of risk, consider point E. Along the efficient frontier, we are receiving a 14 percent return for
a 5 percent risk level, whereas directly below point F, portfolio E provides a 13 percent return for the
same 5 percent standard deviation.
To also demonstrate that we are getting minimum risk for a given return level, we can examine point A
in which we receive a 10 percent return for a 2.8 percent risk level, whereas to the right of point A, we get

78 Investment Planning PDP

the same 10 percent return from B, but a less desirable 3.1 percent risk level. One portfolio can consist
of various proportions of two assets or two portfolios. For example, we can connect the points between
A and C by generating portfolios that combine different percentages of portfolio A and portfolio C and so
on between portfolios C and F and portfolios F and H. Although we have shown but eight points (portfolios),
a fully developed efficient frontier may be based on a virtually unlimited number of observations as is
presented in Figure 6:1.

A first question to be posed to a professional money manager is: Have you followed the basic objectives
that were established? These objectives might call for maximum capital gains, a combination of growth
plus income, or simply income (with many variations in between). The objectives should be set with an
eye toward the capabilities of the money managers and the financial needs of the investors. The best
way to measure adherence to these objectives is to evaluate the risk exposure the fund manager has
accepted . Anyone who aspires to maximize capital gains must, by nature, absorb more risk. An income-
oriented fund should have a minimum risk exposure.
A classic study by john McDonald published in the journal of Financial and Quantitative Analysis indicates
that mutual fund managers generally follow the objectives they initially set. He measured the betas and
standard deviations for 12.3 mutual funds and compared these with the funds’ stated objectives. For
example, funds with an objective of maximum capital gains had an average beta of 1.22. Those with a
growth objective had an average beta of 1.01, and so on all the way down to an average beta of 0.55 for
Using betas and portfolio standard deviations, we see that the risk absorption was carefully tailored to the
fund’s stated objectives. Funds with aggressive capital gains and growth objectives had high betas and
portfolio standard deviations., while the opposite was true of balanced and income-oriented funds. Other
studies have continually reaffirmed the position established in this seminal study by McDonald.
Adherence to objectives as measured by risk exposure is important in evaluating a fund manager because
risk is one of the variables a money manager can directly control. While short-run return performance
can be greatly influenced by unpredictable changes in the economy, the fund manager has almost total
control in setting the risk level. He can be held accountable for doing what was specified or promised in
regard to risk. Most lawsuits brought against money managers are not for inferior profit performance but
for failure to adhere to stated risk objectives. Although it may be appropriate to shift the risk level in
anticipation of changing market conditions (lower the beta at a perceived peak in the market), long-run
adherence to risk objectives is advisable.

Measurement of Return in Relation to Risk

In examining the performance of fund managers, the return measure commonly used is excess returns.
Though the term excess returns has many definitions the one most commonly used is total return on a
portfolio (capital appreciation plus dividends) minus the risk-free rate:
Excess returns = Total portfolio return – Risk-free rate
Thus, excess returns represent returns over and above what could be earned on a riskless asset. The
rate on RBI Treasury bills is often used to represent the risk-free rate of return in the financial markets
(though other definitions are possible). Thus, a fund that earns 12 percent when the Treasury bill rate is
6 percent has excess returns of 6 percent.
Once computed, excess returns are then compared with risk. We look at three different approaches to
comparing excess returns to risk: the Sharpe approach, the Treynor approach, and the Jensen approach.

PDP Investment Planning 79

Sharpe Approach
In the Sharpe approach, the excess returns on a portfolio are compared with the portfolio standard deviation

Total portfolio return – Risk-free rate

Sharpe measure =
Portfolio standard deviation

The portfolio manager is thus able to view excess returns per unit of risk If a portfolio has a return of 10
percent, the risk-free rate is 6 percent, and the portfolio standard deviation is 18 percent the Sharpe
measure is 0.22:

10% - 6% 4%
Sharpe measure = = = 0.22
18% 18%

This measure can be compared with other portfolios or with the market in general to assess performance.
If the market return per unit of risk is greater than 0.22, then the portfolio manager has turned in an
inferior performance. Assume there is a 9 percent total market return, a 6 percent risk-free rate, and a
market standard deviation of 12 percent. Then the Sharpe measure for the overall market is 0.25 or:

9% - 6% 3%
= = 0.25
12% 12%

The portfolio measure of 0.22 is less than the market measure of 0.25 and represents an inferior
performance. Of course, a portfolio measure above 0.25 would represent a superior performance.

Treynor Approach
The formula for the second approach for comparing excess returns with risk (developed by Treynor) is:

Total portfolio return – Risk-free rate

Treynor measure =
Portfolio beta

The only difference between the Sharpe and Treynor approaches is in the denominator. While Sharpe
uses the portfolio standard deviation, Treynor uses the portfolio beta. Thus, one can say that Sharpe
uses total risk, while Treynor uses only the systematic risk, or beta Implicit in the Treynor approach is
the assumption that portfolio managers can diversify away unsystematic risk, and only systematic risk
If a portfolio has a total return of 10 percent, the risk-free rate is 6 percent, and the portfolio beta is 0.9,
the Treynor measure would be 0.044.

10% - 6% 4% 0.04
= = = 0.044
0.9 0.9 0.9

80 Investment Planning PDP

This measure can be compared with other portfolios or with the market in general to determine whether
there is a superior performance in terms of return per unit of risk. Assume the total market return is 9
percent, the risk-free rate is 6 percent, and the market beta (by definition) is 1; then the Treynor measure
as applied to the market is 0.03:

9% - 6% 3% 0.03
= = = 0.030
1.0 1.0 1.0

This would imply the portfolio has turned in a superior return to the market (0.044 versus 0.030) Not only
is the portfolio return higher than the market return (10percent versus 9 percent), but the beta is less
(0.9 versus 1.0) Clearly, there is more return per unit of risk.

Jensen Approach
In the third approach, Jensen emphasizes using certain aspects of the capital asset pricing model to
evaluate portfolio managers. He compares their actual excess returns (total portfolio return – risk-free
rate) with what should be required in the market, based on their portfolio beta.
The required rate of excess returns in the market for a given beta is shown in Figure 6:2 given below, as
the market line. If the beta is 0, the investor should expect to earn no more than the risk-free rate of
return because there is no systematic risk. If the portfolio manager earns only the risk-free rate of return,
the excess returns will be 0. Thus, with a beta of 0, the expected excess returns on the market line are
0. With a portfolio beta of 1, the portfolio has a excess returns as shown in the following diagram.

FIGURE 6:2 Risk-Adjusted Portfolio Returns

The expected portfolio excess returns should be equal to market excess returns. If the market return
(KM) is 9 percent and the risk-free rate (RF) is 6 percent, the market excess returns are 3 percent. A
portfolio with a beta of 1 should expect to the market rate of excess returns (KM-RF), equal to 3 percent.

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Other excess returns expectations are shown for betas ranging from 0 to 1.5.For example, a portfolio
with a beta of 1.5 should provide excess returns of 4.5.

Adequacy of Performance
Using the Jensen approach, the adequacy of a portfolio manager’s performance can be edged against
the market line. Did he or she fall above or below the line?
The vertical difference from a fund’s performance point to the market line can be viewed as a measure
of performance. This value, termed alpha or average differential return, indicates the difference
between the return on the fund and a point on the market line that corresponds to a beta equal to the
fund. In the case of fund, the beta of 1.5 indicated an excess return of 4.5 percent along the market, and
if the actual excess return was only 3.9 percent, we thus have a negative alpha of 0.6 percent (3.9% to
4.5%). Clearly, a positive alpha indicates a superior performance, while a negative alpha leads to the
opposite conclusion.
Key questions for portfolio managers in general include the following: Can they consistently perform at
positive alpha levels? That is, can they generate returns better than those available along the market
line, which are theoretically available to anyone?

FIGURE 6:3 Empirical Study of Risk- Adjusted Portfolio Returns- Systematic Risk and Return

The upward-sloping line is the market line, or anticipated level of performance based on risk. The small dots
represent performance of the funds. About as many funds under-performed (negative alpha below the line)
as over performed (positive alpha above the line). Although a few high-beta funds had an unusually strong
performance on a risk adjusted basis, there is no consistent pattern of superior performance.

Indexing-Buy and Hold

Indexing-buy and hold is a concept which is, in most sense, opposite to the concept of market timing.
In other words, planners who advocate indexing believe that future price changes or duration of changes
cannot be predicted with any consistency. Hence, such planners consider market timing as an exercise
in futility and instead, advise their clients to buy securities and funds which track broad market indexes.
The basic concept of indexing rests with the assumption that planners cannot outperform the performance
of market indexes such as the S&P 500 Index, the BSE Sensex 30, NSE 50 etc., on a consistent (i.e.
year in, year out) basis. Indexers also believe that over the long run the market will generally outperform
at least 50% of all fund advisors. Further, the advisors who will outperform the market in any given year

82 Investment Planning PDP

or two will in turn perform worse than the index in subsequent years. Moreover, the fund advisors who
may outperform the market indexes over a future time period of time cannot be identified today with
any certainty or reliability. Given these observations, such planners consider the alternative of investing
in securities or funds that closely track the performance of underlying market indexes as desirable. Such
planners also consider holding their investment positions for a longer time period, and hence, they will
“buy and hold “their positions. The length of time over which a position is held depends primarily on the
client particulars such as investment objective, investment time-horizon and risk preferences
and the macroeconomic conditions as reflected through the business cycle.
Mutual funds are most popular as securities that track the movement of market or securities indexes. Most
large mutual fund companies, offer index mutual funds for investors. These funds provide the appropriate
vehicles for both investors and financial planners to buy and hold a basket of securities, in the form of a
single mutual fund, that track financial market indexes. Since indexers may choose to track a wide variety of
indexes such as large and small cap indexes, broad and narrow marker indexes, stock and bond market
indexes, domestic and foreign market indexes, the fund companies offer numerous index funds that cover
generally most indexing needs. The new type of fund has appeared in the markets that also tracks indexes,
known as “Exchange Traded Funds”or ETFs, have become very popular tracking tools in this decade,
and the number of ETFs being offered in the market are increasing almost daily. The companies that offer
ETFs claim that ETFs are much easier to trade since they are structured like common stocks, provide
benefits in shielding against capital gains taxes and are generally cheaper than index mutual funds.
Indexes which follow a passive buy-and-hold strategy claim a number of benefits in their approach over
active approach to investments. First, and as mentioned earlier, market indexes are generally expected
to outperform most actively managed funds over longer time periods. This is because indexers believe
the markets to be efficient and consistently picking winners near impossible. Second, passively investing
through index tracking securities is considerably cheaper because the costs of researching to find winning
investments are not expended. Further, since the compositions of indexes do not change very frequently,
very little trading and transaction costs are incurred in managing index tracking funds.
On the other hand, funds that are actively managed charge high fees. These fees are paid because
these funds managers consider their skills at investments to be superior and hence, require higher fees.
Moreover, “active” managers continuously produce information about various securities that either
indicates buying, selling or holding various investment positions. Since such an approach requires frequent
alterations in portfolio structure, the costs involved in an active style also increase due to the much
higher costs of transactions.

Money Manager Selection and Monitoring

To begin with, the search process uses the same objectives used in the investment decision process
itself. The first three questions to address, as in the investment decision process, are as follows:

1. What is the primary objective of the investment decision for which you need a money manager?
2. What are the risk/return preferences of the clients?
3. What is the investment time horizon?
Understanding the answers to these three questions thoroughly will considerably ease the burden of
planners in selecting suitable money managers. We will return to the description of how the selection is
made easy, but first let us evaluate each of these three questions in some detail.
There are many reasons to invest. Examples of reasons include savings and investments for retirement, for
children’s college education, to buy a house or car, to build wealth, etc. Along with each of these reasons is
an associated objective. For example, in saving for retirement, an appropriate objective may be to maintain

PDP Investment Planning 83

and/or increase the standard of living that pre-existed before retirement. Similarly, in providing for children’s
college education, provisions may be for public or private colleges and may include the financing of an auto
for a child as well. The point being made here is that the need and the objectives help us determine certain
aspects of the investments decision which in turn help us evaluate managers.
Consider the example of a parent who can afford to save a limited sum of money towards a child’s
education. Given this limitation (or budget constraint) the parent next has to consider the type of college
(public or private) to fund for. Obviously, private colleges cost more and hence the future funding required
for a private college education would require a higher rate of growth than the rate required for funding
public college education. Thus, the choice of managers in this case would be determined by the style of
the managers. A growth style manager would be desirable to grow money faster whereas a balanced
fund manager may be considered for that same investment, if the objective were to fund the education
at a public college. Being able to tie the objective (private or public education, in this example) allows us
to narrow the manager selection criterion to only managers who practice/affirm a certain style of
management. This inclusion reduces the universe of potential managers significantly. Similarly, for the
need to fund for retirement, the objective may differ from maintaining living standard to improving them.
Continue with the example of funding for children’s education. Assume that the limited funds that a parent
can save towards this objective will require the fund to grow at a 12% rate in order to be sufficient to meet
the funding need. This required rate of return of 12% would imply that most of the savings be invested in
equity or other high-yielding instruments. An associated feature of such an investment would be a fairly
significant amount of investment risk that the parent would be exposed to and which in turn would also imply
that there would be a higher probability of accumulating insufficient funds. In this case, the risk preference
of the client would become another input in the process of manager selection. The risk preference of the
client would determine what styles of funds are chosen. The styles that were affirmed when the investment
objective was considered may either be reinforced or rejected by including the risk preferences of clients.
There is another important aspect of including the risk preferences of clients in selecting the fund manager.
One of the important variables that enters the process of manager selection is the risk perspective of the
manager himself. It is a good idea to evaluate and match the risk preferences of the manager to those of the
client. Once the manager is selected and the investment process begins, the level of comfort, or discomfort,
will be considerably influenced by the style of the chosen manager. In this case, matching the manager’s
risk preference with that of client can considerably help the planner in managing the client relationships.
Finally, the time horizon of the investment decisions must also be included in the selection process. In
the college funding example, given some limited amount of funds and given a certain risk preference
profile, the shorter the time available to accumulate the funds, the greater will be the need to find
managers who pursue growth and aggressive growth styles, and vice versa. Another way to consider
this is that if the planner can persuade a client to invest early, whatever the investment need be, then the
planner can have more flexibility in choosing managers. The right choice of managers will ultimately
lead to client satisfaction and retention.
The reader should note that the application of the basics of the investment process serves as screens in the
manager selection process. They help us eliminate many managers from the selection process and isolate
others. They help us narrow down the universe of managers to a level where the selection process is more
manageable and where it is feasible to apply other subjective and objective criteria to further narrow the
selection process. Finally, and most importantly, the inclusion of the client’s basic inputs in the selection
process should generally lead to a much greater level of client satisfaction. In the following sections, other
selection criteria that need to be used on a smaller subset of managers are discussed.
Many planners tend to jump first on assessing the past performances of money managers in selecting a

84 Investment Planning PDP

manager. The relationship between past performance and manager selection has been widely studied.
Results of these studies generally support the notion that using past performance as the main criterion
in the selection process is, at best, a very poor indicator of future performance potential. In a sense,
manager performance should be the last screen in the selection process, the step that affirms a manager’s
choice. It is much more prudent to consider other facets of managers that reinforce the investment
objectives, risk preferences and timing horizon decisions.
There are several subjective and objective criteria that may be applied to further narrow the selection
process. Once the general fund style has been identified, managers within that style can be scrutinized
further. The main objective at this stage is to identify inconsistencies and incongruencies between the
stated style of the managers and the styles that they have actually implemented in their practices. The
following are examples of questions that need to be assessed in determining the selection.

n Has the manager consistently selected securities that are compatible with the stated style?
n If not, how often have they strayed from their paths?
n Does the manager use risk management techniques that are consistent with the fund’s stated
n How often have the fund’s operating expenses exceeded both those stated and those that were
n How often has the fund’s risk exceeded the stated or expected risk?
n How long has a manager served for a fund?
n Is the manager known to have managed funds of many different styles or have there been transitions
within similar styles?
n If the manager affirms a passive style, how often has he strayed from that style, and vice versa?
n How consistently does the manager apply security selection techniques, whether qualitative or
quantitative or both?
n Has the manager ever violated or has not been in compliance with laws and regulations?
n Does the manager engage in “window dressing” types of activities that are harmful to clients?
n What are the answers to the above question for the investment team members that the manager
n How research oriented is the manager?
As the reader can observe, there are many questions that require to be evaluated in selecting a manager.
However, it may be useful to categorize these questions along some common themes. Happily, such a
categorization is possible. In using the above criteria, the selector is trying to assess two basic traits of
a manager.
Perhaps the most important summation of these criteria is to understand how consistent a manager is
and has been. The more consistent a manager has been towards her/his style, trading activity, security
selection techniques, fund expense levels, etc. the better. Alternately, managers who change their
operating activities often are much more likely to under perform against their expectations. Another way
to consider the issue of consistency is that the manager’s activities are as stable as the investment
decision inputs of the clients. The client’s retirement objectives or their risk tolerances for those investment
do not change on a weekly or monthly basis. The basic idea here is that neither should the manager’s
attitudes and perceptions change on those scales. In a sense, there is a direct relationship between
consistency and competency.

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The other important theme to assess is the ethical make-up of the manager. Managers (and funds)
whose styles, trading, expenses, selection techniques, etc, change often are also much more likely to
engage in activities that are undesirable or even in violation of investment rules and regulations. It is
important to note that the manager’s ethics is as important as his/her competency. Neither can be
sacrificed at the expense of the other. Managers who rank high on both the scales are appropriate for
further consideration in the selection process.
Finally, after the universe of managers has been whittled down to a few, the past performance of managers
should be assessed. As has been noted before, past performance is not a reliable indicator of future
performance. As it turns out, given the considerations of consistency (competency) and ethics, the issue of
past performance in predicting future performance, is actually not that daunting a task. In assessing past
performance, two observations need to be, those that were expected and how different were they from their
peers? Second, how widely did the past returns vary and in comparison to their peers? In other words, if a
fund is expected to produce about 12 percent (e.g. growth fund) per year, how many times in the last 5 (or
10) years has the fund’s returns been close to 12 percent? Further, if the average return over the past
returns has indeed been around 12 percent, have the individual (annual) returns been widely divergent from
the expected 12 percent, even though they average around 12 percent. As the reader can see, the main
point being made here is that the consistency and stability of performance and in accord with expectations
is a far more powerful tool in manager selection criteria than trying to find the superstars of yesterday.
It should be fairly clear to the reader that the selection criteria for a manager also define the monitoring
criteria. Monitoring the performance of the manager is akin to ensuring that the manager does not
change any facet of his behavior once he has been selected. Similarly, the planner must note that the
very act of selecting a manager is also a reward for the past consistency, competency and the ethics of
a manager. In the same vein, a planner should not seek to replace a manager whose performance in a
certain year has not been up to par, especially if the manager has strayed from the stated and expected
objectives and behavior. The planner should note that in a longer framework of time, it is the consistent
managers whose performances are most likely to satisfy the needs and objectives of their clients.
Modern portfolio theory is a method by which assets are selected to be included in a portfolio such that
the expected portfolio outcome optimizes the individual’s utility. The most powerful concept in this
optimization process is the benefits of diversification across different asset classes. This benefit shows
up primarily as both a reduction in risk and or an increase in return. This in turn leads to the optimal
solution. The portfolio outcomes in terms of risk and return are used to assess the performance of
portfolios both by comparisons with benchmarks and comparisons with peer group performances. The
performance of portfolios and their managers is one of the criteria used in selecting money managers.
Various money manager selection and monitoring criteria were examined and a set of guidelines were
established for this very important task.

Asset Allocation and Diversification

This chapter presents two key investment concepts: Investment Policy Statements (IPS) and Asset
Allocation. The former concept is an essential part of any investment plan in that an IPS lays the framework
and objectives of how an investment plan will be managed, why such a path is chosen and how it will
serve the client. The asset allocation decision is the most notable decision managers have to make in
managing client portfolios. Each of these two concepts are explained in detail, in this chapter. Managerial
implications of these two concepts are also discussed in the latter sections of the chapter.

Investment Policy Statement

An Investment Policy Statement (IPS) serves as a plan that guides the investor and the planner in long-

86 Investment Planning PDP

term financial and investment decisions. While investors may differ in type or form, each requires a clear
investment policy statement in order to achieve long-term goals and investments objectives.
Investors may be categorized as being either institutional investors or individual investors. Though financial
planners will most often interact with individual investors, there will be occasions when an institutional
investor may require the planner’s service and advice. Hence, it is important for the planner to be able to
understand the needs of both types of clients and articulate IPS’s for both types. Of course, the obvious
client for most financial advisors is the individual investor.
Generally, institutional investors differ from individuals in the amount and size of the portfolios under
management. Within the institutional category of investors, there are subcategories, each of which differ
in their investment needs. Examples of such sub-categories of institutional investors include mutual
funds, pension funds, endowment funds, insurance companies, etc.
To understand how these institutions differ in their investment need, consider the example between the
needs of a defined benefit pension plan and an endowment fund. The primary goal of pension plan
mangers is to ensure the availability of cash that requires to be distributed to plan beneficiaries every
year. Thus, pension plan management and policy is integrally involved in investments that match cash
outflows with inflows. In a pension plan, the amounts of distribution to be made are generally known in
advance; this in turn, determines to a large extent the choice of investment vehicles required to meet
those distribution needs. Thus, IPS’s for pension funds are much more guided by regulatory and
compliance needs, which in turn protect the interests of the plan beneficiaries.
Consider now the issues surrounding the management of investment assets for an endowment fund. An
endowment fund is an accumulation of donations that is provided to a non-profit organization by its donors.
Generally the investment objectives of endowment funds are much more attuned to the needs of the non-
profit organization, Sometimes, the donors may impose managerial clauses themselves. Typically,
endowment funds seek to produce a small stream of income to augment the operating budget of the
organization and to grow the rest of the corpus at a very moderate rate, such that the income may take the
form of a perpetual stream. Thus, the IPS of an endowment fund is generally very different from that of a
pension fund.
Banks and insurance companies are other examples of institutional entities that need investment policies.
Both these institutions are similar to pension funds in that their investment needs are dictated by those
who lend them the investment funds. Insurance companies invest in order to ensure sufficient availabilities
of future funds required to be distributed as payouts to policy holders. Banks invest in order to meet
short and long term obligations that it promise to pay depositors on specific savings deposits. All types
of investors, their needs and the appropriate investment policies, are discussed in the following sections.

Investment Policies For Individual Investors

Life – Cycle Indentification

Investment goals of the individual client naturally emerge from the financial planning process. It is important
to note that the goals of an individual will change over time as the client progresses through various
stages of his/her life. Thus, the investment objectives will also change over time as the client ages and
succeeds at achieving previously set goals.
The investment goals that are generally associated with various stages of a client’s life are known as the
client’s life-cycle needs. Generally, the needs of various individuals at certain stages of life tend to be
similar. For example, early career individuals want to accumulate wealth, whereas in the late career stage
individuals seek to protect wealth more. Thus, we can classify these typical investment needs at various life

PDP Investment Planning 87

cycles. These classifications provide us with a tool to apply in the investment planning process.
The first stage of an individual’s earning and career is considered as the accumulation phase. This
phase begins when an individual first becomes gainfully employed and continues until the client is about
40 to 50 years of age. During this time period, investors are generally much more open to assuming
greater investment risk to attain higher returns. Typically, such investors can shrug off losses on the
assumption that they have sufficient time to earn and recoup their losses. Further, if the losses are in
securities, they can understand that their investment time horizon permits them to wait out any temporary
downturn in the economy and business cycle since they are expected to be followed by growth cycles
that will eventually increase their wealth. Further, individuals progressing through their careers also
observe increased incomes and savings; these savings augment the growth of their wealth. Essentially,
individuals in this phase are the beneficiaries of the power of compounding in the value of their wealth.
Common investment goals during this phase are the purchase of a house, saving for children’s education
and accumulating funds for retirement.
The next stage of the client life cycle is the conservation/protection phase. This stage begins seamlessly
with the trailing off of the accumulating phase and remains as the dominant phase until the first few
years of retired life. During this stage, the client seeks to consolidate the assets that have been
accumulated. Individual earnings reach their peaks at this stage as does their savings. The aging of
clients is reflected through their investments as they tend to lean toward a reduction in undertaking risk
and are content to receive lesser returns. Unlike the accumulation phase, investors recognize the
devastation that can be caused by significant losses of wealth to their well being. Further, they understand
that the time they have left before retirement may not be sufficient to undo losses that result from
excessive risk taking. Thus, at this stage, loss aversion becomes the dominating trait of the investment
life cycle. Common investment goals during this time period are children’s education, savings for retirement
and the beginnings of the need to gift to their beneficiaries, charities and well wishers.
The last stage is known as the preservation and gifting stage. This stage tends to begin soon after
retirement and continues through life expectancy. During this stage, the investor is primarily concerned
with preserving capital rather than enhancing returns. The loss of earning power and the fixed expenses
of retirement loom large during the early parts of this stage. Thus the investments in this stage of life
tend to be more conservative relative to the other life-cycle stages. This is also the phase in which the
client will most likely seek the planner’s assistance in gifting income and property to desired beneficiaries.
The ages mentioned in the above life-cycle discussion are only benchmarks. Similarly, particular goals
will vary by client, life-cycle stage, and age. For instance, over the last 100 years, the age at which
individuals start families has considerably increased. This implies that the investment goal of saving for
children’s education has shifted along the entire life cycle. Thus, the educational savings requirements
can be part of the life-cycle phase where the client is primarily interested in conservation and protection
as compared to the traditional notion that this objective is mostly encountered in the accumulation
phase. Similarly, emerging healthcare technologies are changing the needs of individuals in the latter
stages. The growth of long-term care policies is a reflection of the impact of biotechnology on the longevity
of life. The concept of life cycles is important for planners to understand but care must be taken not to
compartmentalize clients by age in order to impose life stage needs without considering the impact of
the clients’s idiosyncratic or subjective attributes. Rather, careful discussion and analysis based upon
client goals will yield a more accurate measure in which stage or stages the client resides.
Life-cycle planning is thus relevant in the investment processes because it allows the planner to identify
with the client through the various time horizons for each goal within the financial plan. Without time
horizons, an investment policy would not be whole. The client could be subject to too much risk and / or

88 Investment Planning PDP

insufficient funds for current consumption (too much savings), etc. The policy then, would not accurately
articulate the goals within the plan and thus would subject the achievement of goals to imminent failure.

Investment Objectives
Once the goals, life cycle, and time horizons for the goals have been identified, the investment objectives
become easier to identify. Investment objectives identify the goals of the portfolio in relation to the
reasons for the individual’s financial needs. Investment objectives can be further classified into four
types current income, capital growth, total return, and preservation of capital.
Current income is a strategy whereby the main objective of the portfolio is to generate an immediate and
ongoing flow of cash to the client. That is, the investor requires income generation from the principal
balance of the portfolio via interest or dividend payments. An investor who relies on the portfolio for
income in this way needs the cash for living purposes. Thus the investments tend to be conservative in
nature. Common investment securities are corporate bonds, government bonds, government mortgage
backed securities preferred stocks and perhaps stable Blue Chip stocks that pay regular dividends.
Capital growth is a strategy whereby the portfolio funds are invested over the long term with the objective
of capital appreciation in mind. Because the objective is growth over the long term, the riskiness of the
portfolio tends to be higher. The most common securities for this type of approach are equities, particularly
those in high growth companies or sectors. However, it is always a good idea to diversify the portfolio
holdings among various sectors and industries. Further, stocks of very large companies that lead their
industries (blue chip) in this case, can help to diversify the portfolio while achieving some of the same
growth objectives. Mutual funds, which invest in various sectors or industries can also help to diversity
a portfolio at a reasonable cost.
The total return approach is a strategy that blends the current income and capital growth approaches. Thus,
the investor wants the portfolio to grow over time, but wishes to have income generated from it right away as
well. Obviously having two objectives from the same portfolio can be challenging to manage, but it can be
done if applied correctly. Thus, this strategy would use a blend of methods of the two strategies above.
Those investors interested in presentation of capital are most interested in ensuring that the amount of
money invested in the portfolio does not decrease. Therefore, the investment choices are safe vehicles.
Large returns are not important for these clients and types of investments are typically government
bonds, certificates of deposit money markets (funds), and fixed annuities.

Risk for Individual Investors

Although we may have determined the goals and the investment objectives of our client, we cannot
seriously discuss the minute details of an investment policy without first assessing the risk tolerance of
the client. Without a meaningful assessment of client risk attitudes, the investment policy will be useless.
Finance professionals often think of risk in terms of the standard deviation of returns and stock betas. In
some cases, individual investors may understand these concepts but more often than not, most investors
do not fully understand these concepts. After all, that is why they seek out investment advisors for such
expertise. Since the client may not understand the intricacies of integrating investor risk preferences in
financial applications, it is even more important for the advisor to determine the client’s risk preference
before structuring appropriate portfolios.
Many clients describe risk in terms of losing money so it may be a good starting point upon which to discuss
the notion of risk. This notion of loss can be seen from several perspectives, so it can be helpful if the client
can articulate risk to the planner in one of these ways. Loss to some individuals occurs when the original
value of the portfolio has decreased in either absolute terms or relative return percentages. For instance,

PDP Investment Planning 89

suppose a client started with an initial investment of Rs. 2,50,000 and experienced a Rs. 50,000 decrease
in value due to a general downturn in the market. Some investors feel that they have lost Rs. 50,000 and
consider it a total loss. Similarly, they might say that they lost 20 percent of their portfolio.
Other investors who are investing for the long term may not be concerned if the value of the portfolio
decreases for some period of time if they feel that the losses sustained are short tem in nature. These
types of investors often perceive a loss only when they sell assets from the portfolio and therefore have
a realized loss.
Risk to clients may also appears in the form of the types of securities that they know of. Therefore suggesting
new types of securities to these clients may appear to the client as a type of risk that they do not wish to
engage in. It is a challenge to the advisor to help the client understand why these types of investments are
better for the client. In the end, the advisor may or may not be successful in persuading the client.
Conversely, clients may have a notion of risk in areas where they have had previous investment losses.
For instance, those who lost money in stock market crashes trend to be averse to investing in stocks in
the future. It is up to the advisor to help clients understand why their investments failed in the first
instance and the measures that the planner can put into place to minimize those types of losses in the
future. Some investors may mimic the popular or in vogue. Such practices can result in undesirable
outcomes and result in large losses. Thus when an advisor advocates some technique or security as
appropriate for the client, the client may consider this to be risky and very poor advice.
Risk is extremely difficult to define. The planner must initially spend a lot of time with the client to
ascertain what risk means to that client. This can be accomplished through discussion with the client
and is often done with questionnaires, which are used as complements to client/planner conversations,
Since each investor is subjectively and idiosyncratically different, risk will have a different meaning to
each investor. When implementing an investment policy, it is valuable to incorporate the risk characteristics
into the plan. This should be done in such a way so that the investor and the planner can quantify the
risk. Thus if certain events occur, such as a portfolio losing 10 percent of its value, the planner and
investor will have identified, in advance, appropriate actions for that particular event. With such pre-
planned and agreed upon actions, further risk to the portfolio value may be minimized.

Other Topical Considerations for Individual Investment Policies

Tax Considerations
Incorporating the notion of before and after-tax investment returns in a portfolio is an important concept
in portfolio planning. The after-tax considerations must effectively integrate with other portions of the
financial plan so that taxes are minimized in years with high expected income. Recall that taxes can be
deferred (paid at a later date when assets are sold at a profit), can be avoided or can be taxed at capital
gains rates (investments held greater than one year) rather than at ordinary rates. It is useful to spell out
the tax consequences in the investments policy. However, the advisor must discuss and incorporate
into the plan the potentiality for changes in the tax law. Because laws change, tax planning relative to
portfolio management can be a very challenging aspect to the planner. When the client has a negative
bias toward taxes or has complicated transactions the sale and purchase of assets to and from the
portfolio. Tax considerations and goals should be spelled out in the investment policy to assist the
planner and the client in quantifying tax consequences of decisions.

Measurement of Returns and Successes of the Planner

The client and the planner should decide upon a method that measures the success of the advisor in
picking investments. The time weighted rate of return (or the holding period return) is a method used

90 Investment Planning PDP

for fund manager evaluation. This is so because a typical fund manager cannot control the amount of
funds he or she has under management (in which case a geometric rate of return could be used). No
matter what method is used, it should be spelled out in the investment policy so that both the planner
and the investor have appropriate expectations regarding what performance measures are going to be
used to judge the advisor.

Macroeconomic Factors
A good planner is always aware of macroeconomic factors that can ultimately affect investments. These
factors should be integrated into the plan. For instance, historical inflation rises, which affect the real
rate of return on assets, should be discussed in any plan in order to sustain the purchasing power of the
client to the greatest extent possible. Other factors that should be taken into consideration are interest
rates, economic growth or decline as a whole or in specific industries, unemployment, political stability,
and the legal environment. While this list is not exhaustive, it is meant to give the advisor an appreciation
of the areas that can affect the investment policy. As the planner gets to know the client, he or she can
integrate those areas within the macroeconomic environment into the client’s plan.

PDP Investment Planning 91

Review Questions:
1. Which of the following statements concerning diversification is (are) correct?
I. Studies suggest portfolios of 100 or more different common stocks are needed to substantially
reduce unsystematic risk.
II. The key to effective risk reduction through diversification is combining assets whose returns
show negative, low or no correlation over time.
a. I only
b. Both statements are correct
c. II only
d. None of the two statements is correct
2. Which of the following statements concerning correlation coefficients is (are) correct?
I. A correlation coefficient of -1 for the returns of two securities would indicate that both of them
should be carefully considered for inclusion in a portfolio since maximum risk reduction could
be achieved by including both.
II. The returns of security B would increase 8% if the returns of security A increased 8% and the
correlation coefficient for the returns of the two securities was +1.
a. I only
b. II only
c. Both the statements are correct
d. None of the statement is correct
3. Is it possible to reduce the risk by adding a security with a higher risk to a security with a lower risk
that is already held?
a. No, the total risk after the addition will be higher
b. The new security will have no impact in reducing the risk
c. Yes, provided both the securities are negatively correlated
d. Yes, provided both the securities are positively correlated to each other
4. What is the portfolio standard deviation in the following case of two (2) securities which are held
in equal weights?
Covariance of two securities = -8; Standard deviation of stock x = 2 and Standard deviation of
stock y = 4
a. 1
b. 2
c. 4
d. 0
5. Which of the following statements is (are) correct?
I. “Rupee cost averaging” can be achieved through Systematic Investment Plan
II. “Rupee cost averaging” helps in reducing risk
a. I only
b. Both
c. II only
d. None

1. b 2. c 3. c 4. a 5. b

92 Investment Planning PDP

Chapter 7

PDP Investment Planning 93

Small Saving Schemes

T hese are ideal investment vehicles for the small investor – the retail resident Indian investors. Non
resident Indians are not allowed to invest in these schemes. Let us look at the salient features of
these schemes.

1. Public Provident Fund

2. Post Office Monthly Income Scheme
3. Post Office Time Deposit
4. National Saving Certificate
5. Kisan Vikas Patra
6. Government of India Taxable Savings Bond
7. Senior Citizen Saving Scheme

1. Public Provident Fund (PPF)

Who can invest?

n An adult individual in his own name
n An adult on behalf of a minor for whom he is the guardian.
n HUF’s can not open new accounts now; with effect from 13.5.2005. Existing PPF accounts opened
in the name of HUF shall continue till maturity and deposits can be made in the account as per
n A PPF account is in addition to Employee Provident Fund and GPF for government employees. n
other words who contribute to EPF and GPF can also open PPF account.
Where can one open a PPF account?
One can open a PPF account in -

n Head Post-Office,
n G.P.O.,
n Any Selection Grade Post Office,
n Any branch of the State Bank of India and
n Selected branches of Nationalised Banks.
How much can one invest?
n Minimum investment Rs. 500 in a financial year
n Maximum of Rs. 70,000/- in a financial year
n Can be invested in a lump sum or in convenient instalments.
n Total number of credits per year is restricted to 12
n Minimum investment each time is Rs. 5/-.

94 Investment Planning PDP

n The ceiling of Rs. 70,000/- per annum is for each account.
n If an individual has his own account and accounts in the name of minors (where he is the guardian) the
total investment in a financial year can not exceed Rs 70,000/- in all the accounts taken together.
n A HUF account where he is the karta is considered separate for this purpose.
n 8% p.a. credited to the account, once a year, as on 31st March of each year.
n Deposits made on or before the 5th of the calendar month are eligible for interest for the month. It is
the date of deposit and not date of realization that is considered for this purpose.
n Interest is calculated on monthly product basis and credited to the account as on 31st March.
n The interest rate can be changed by the Government of India at any time and the new rate will
affect the balance lying in the account from that date.
n Past interest rates were as under:
Upto 14.1.2000 12%
15.1.2000 to 28.2.2001 – 11%
1.3.2001 to 28.2.2002 – 9.5%
1.3.2002 to 28.2.2003 – 9%
1.3.2003 onwards – 8%
n PPF is a 15 year account.
n The term of the account can be extended by 5 years at a time by making an application in a
specified form to the deposit office; within one year.
n An account can be extended any number of times.
n The entire balance can be withdrawn in full after the expiry of 15 years from the close of the
financial year in which the account was opened.
n The depositor can take a loan in the third financial year from the financial year in which the account
was opened.
n Loan can be taken upto 25% of the amount standing at the end of the second preceding financial year.
n The loan shall be repayable in 36 instalments and shall bear interest at the rate of 1%. No loan can
be obtained after the end of 5th year.
n A depositor is permitted to make one withdrawal every financial year.
n Withdrawal is permitted from the 7th financial year
n Amount of withdrawal can not exceed 50% of the balance to his credit at the end of the fourth year
immediately preceding the year of withdrawal or at the end of the preceding year, whichever is less.
Tax benefits
n The interest earned on PPF account (including interest during the extension period) is excluded
from income tax under section 10(11).

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n The entire deposit in the account is exempt from Wealth Tax
n The annual contribution to the account is eligible for deduction u/s 80C
n A PPF account with one deposit office can be transferred to another deposit office.
n In other words an account can be transferred from Post Office to any bank branch or from any bank
branch to any other branch of any other bank or to post office.
n PPF account is necessarily opened in a single name. Nomination facility is available.
n A depositor can nominate more than one person and stipulate the percentage of sharing among
the nominees.

2. Post Office Monthly Income Scheme:

Who can Invest?

n An adult individual in his own (single account)
n An adult on behalf of a minor for whom he is the guardian
n An adult individual jointly with other adult individuals (joint account) – the total number of account
holders restricted to 3
Where can one invest?
n In all GPO’s
n In all selection grade Post Offices
n In select sub post offices

How much can one invest?

n Minimum Rs. 1,000/-
n Maximum Rs. 3,00,000/- in single account (including all the deposits made earlier)
n Maximum Rs. 6,00,000/- in joint account (including all the deposits made earlier)
n The maximum limit of Rs. 3,00,000/- is applicable per individual and deposits in joint accounts are
considered as having been made equally by all the depositors for the purpose of determining the
n 8% per annum payable monthly
n In select post offices ECS facility is available where the interest is credited every month directly to
the saving bank account of the depositor automatically through the Electronic Clearing Service.
n A depositor may open a SB account with the same Post Office where he has deposited his POMIS
amount and give standing instructions for crediting the interest amount directly to this SB account
on a monthly basis.

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n Past interest rates were as under:
For deposit accounts opened up to
14.1.2000 – 12%
From 15.1.2000 to 28.2.2001 – 11%
From 1.3.2001 to 28.2.2002 – 9.5%
From 1.3.2002 to 28.2.2003 – 9%
n 6 years
n The interest rate as above remains unchanged for the entire term of 6 years
n No premature repayment is permitted within 1 year of deposit
n After 1 year but before completion of 3 years premature withdrawal of entire balance is permitted
n If withdrawn, prematurely, before 3 years a penalty of 2% of deposit amount is levied – no deduction
from interest already paid; Example: If a depositor withdraws Rs. 1,00,000/- prematurely after 2
years of deposit, he will be paid Rs. 98,000/-, over and above the interest at the rate of 8% p.a.
which he has already received for the period for which the deposit was held by Post Office.
n If withdrawn prematurely after 3 years the penalty is restricted to 1% of the deposit amount – no
deduction from interest already paid.
n Part withdrawals are not permitted – if required the depositor will have to withdraw the entire
deposit amount.
Bonus on maturity
n A bonus of 10% of deposit amount is payable on maturity (at the end of 6 years)
n This bonus has been discontinued from 13th February 2006
n No bonus is payable for deposit accounts opened after 13th February 2006
n As per the latest circular 5% Bonus will be payable on new deposit accounts made on or after 8th
December 2007.
Tax benefits
n No tax benefit; the interest is taxable
n Tax is not deducted at source from the interest, presently

n A deposit account can be transferred from one post office to any other post office at any time on the
request of the depositor(s).
n Nomination facility is available

3. Post office Time Deposit

Who can Invest?

n An adult individual in his own (single account)

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n An adult on behalf of a minor for whom he is the guardian
n An adult individual jointly with other adult individuals (joint account) – the total number of account
holders restricted to 3
n Provident funds, charitable trusts, institutions, co-operative societies and Government bodies are
not permitted to invest in this scheme after 13th May 2005.
How much can one invest?
n Minimum Rs 200/- and thereafter in multiples of Rs. 200/-
n No Maximum Limit - Any amount can be invested

n Interest is payable once a year

n Interest is compounded on a quarterly basis and hence the effective yield is slightly more than the
interest rate indicated above

Tax benefit
n As per the latest circular tax benefit is available u/s 80C of Income Tax Act from April 1, 2007 on
deposits made for period of 5 years or more.
n Tax is not deducted at source from the interest, presently.

n No premature repayment before completion of 6 months.
n No interest is payable if withdrawn after 6 months but before 12 months.
n In respect of deposits for 2 years to 5 years the interest payable shall be 2% less than the rate
applicable for the period for which the deposit has been held.

4. National Saving Certificates (NSC) VIII Issue

Who can purchase?

n An adult individual in his own name.
n An adult individual jointly with another – on “Jointly or survivor” basis ( A type).
n An adult individual jointly with another – on “Either or survivor” basis ( B type).
n Parents and guardians on behalf of a minor.
n HUF’s are not allowed to purchase NSC’s from 13th May 2005.

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Where can one invest?
n Can be purchased from all post offices which are allowed to open Savings account.
n National saving certificates are available in denominations of Rs. 100, Rs. 500, Rs. 1,000, Rs. 5,000
and Rs. 10,000
n Can be purchased for any amount without any ceiling
n Can be purchased for amounts in multiples of Rs 100
Maturity Value
n Rs. 100 becomes Rs 160.10 after the full term of 6 years
Premature repayment
n Not allowed during the full term of 6 years
n In case of death of the investor premature payment is allowed to nominee at lower rates as per
Tax benefit
n Amount invested qualifies for deduction from income u/s 80C within the over all ceiling of Rs. 1,00,000
along with other specified investments/expenditure
n Accrued interest also qualifies for deduction u/s 80C -every year from the second year onwards till
the year before the year of maturity

5. Kisan Vikas Patra

Who can purchase?

n An adult individual in his own name
n An adult individual jointly with another – on “Jointly or survivor” basis (A type)
n An adult individual jointly with another – on “Either or survivor” basis (B type)
n Parents and guardians on behalf of a minor
n HUF’s, Trusts are not allowed to purchase KVP’s from 13th May 2005

Where can one purchase Kisan Vikas Patra?

n It can be purchased from all post offices which are allowed to open Savings account.

n Kisan Vikas Patras are available in denominations of Rs. 100, Rs. 500, Rs. 1,000, Rs. 5,000,
Rs 10,000 and Rs. 50,000
n Can be purchased for any amount with out any ceiling
n Can be purchased for amounts in multiples of Rs 100
Maturity Value
n Rs. 100 becomes Rs. 200/- after the full term of 8 years & 7 months
Premature repayment
n Not allowed within 2 ½ years of purchase in normal circumstances

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n In case of death of the investor premature payment is allowed to nominee at lower rates as per
n After 2 ½ years premature encashment is freely allowed and the amounts payable for a certificate
of Rs 1,000/- denomination are as follows

Tax benefit
n Tax is not deducted at source on maturity or otherwise – No TDS as of now.
n Interest on KVP is taxable on accrual basis.

6. Government of India 8% Taxable Savings Bonds

Who can purchase?

n An adult individual in his own name
n An adult individual jointly with another – on “Jointly or survivor” basis
n An adult individual jointly with another – on “Either or survivor” basis type)
n Parents and guardians on behalf of a minor
n Hindu Undivided Family
n Charitable Institutions or a University {approved u/s 80G or 35(1)(ii)/(iii) of Income Tax Act
From where can one purchase these bonds?
n Bonds can be purchased from designated branches of State Bank of India; its subsidiaries and
Nationalised Banks; ICICI Bank; IDBI Bank; UTI Bank; HDFC Bank and Stock Holding Corporation
of India Ltd. (SHCIL)
n The bonds can be purchased for any amount in multiples of Rs. 1,000/- without any upper limit

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The full term of the bond is 6 years

n The bonds carry interest at the rate of 8% p.a. payable half yearly i.e. 31st January and 31st July
every year
n ECS facility is available – banks credit interest directly to bond holder’s account every 6 months
through ECS
n Cumulative option is also available – in which case Rs. 1,000/- becomes Rs. 1601/- at the end of
the term of 6 years
n Premature encashment is not allowed
n These bonds are not transferable and hence loans can not be availed against security of these
Tax Benefit
n Interest is taxable
n No Tax is deducted at source(TDS) presently

7. Senior Citizen Savings Scheme, 2004

Who can invest?

n An individual who has attained the age of 60 years or above
n An adult individual who is above 55 years or more and who has retired – voluntarily or otherwise
(within one month from the date of receipt of retirement benefit and an amount not exceeding the
retirement benefit within the overall ceiling of the account)
n The account can be opened singly or jointly with spouse (the spouse may be below 60 years of age)
n Joint account holder can not be anybody other than spouse
n HUF’s and Non Residents are not allowed to invest

Where can one open this account?

n The account can be opened in Select Post Offices and branches of banks which accept PPF deposits
n Any number of accounts can be opened with each deposit in multiples of Rs. 1,000/-
n Maximum permissible investment Rs. 15,00,000/-
n Only one deposit account permitted in one calendar month for each depositor
n If both husband and wife are eligible to invest then each of them can invest up to Rs. 15,00,000/-
taking the total to Rs. 30 lacs.

PDP Investment Planning 101

n Joint photographs (both husband and wife in one photo)
n PAN Card or declaration in Form 60
n Age proof for the first holder
n Retirement Proof along with proof of retirement benefits received for depositors above 55 years
but not above 60 years
n Photograph of nominee(s)
n The full term of the account is 5 years which can be extended by 3 years on maturity Interest:
n 9% p.a. payable quarterly on 31st March/30th June/30th September and 31st December
n Only non cumulative option is available
n ECS facility has been made available in many deposit branches and hence interest can be credited
directly to the depositor’s bank account
n Nomination facility is available
n Joint nomination with percentage allocation is permitted
n Photograph and signature of the nominee(s) are also obtained and kept on the record of the deposit

Premature closure
n Permitted only after one year from the date of deposit – in case of extreme emergencies premature
closure within one year may be permitted on application to Ministry of Finance, Government of
n In case of closure before 2 years but after 1 year an amount equivalent to 1.5% of the deposit
amount is deducted as penalty – no deduction from interest already paid
n In case of closure after 2 years but before 5 years an amount equivalent to 15% of the deposit
amount is deducted – no deduction from interest already paid
n In case of death of depositor full amount is paid without any deduction

n A deposit account may be transferred from one deposit office/bank to another in case of change of
residence, by making an application in specified form along with the pass book
Tax benefit
n Interest is taxable – no tax benefit
n Tax is deducted at source from the interest payable– senior citizens who are not assessed to
Income tax can submit 15 H (if depositor is above 65 years of age) and form 15G (if not above 65
years of age) to avoid tax deduction at source from the interest
n Principal Amount can be considered towards the deductions u/s 80C

102 Investment Planning PDP

Review Questions:
1. In respect of a Public Provident Fund account and a Hindu Undivided Family which of these
statements is true?
a. New account can not be opened
b. Yes new account can be opened
c. No deposits are allowed in the old PPF accounts of HUF
d. The amount that can be deposited in a PPF account of a HUF and that of the karta together
can not exceed Rs. 70,000/- in a year
2. In respect of a PPF account and a Minor which of these statements is true?
a. New PPF account can not be opened in the name of a minor
b. No new deposits are allowed to be made in the PPF accounts already held in the name of minors
c. The amounts that can be deposited in a PPF account of a minor and that of the guardian
together can not exceed Rs. 70,000/- in a financial year
d. An individual can deposit amount not exceeding Rs. 70,000/- in a financial year in his account
as well as the account in the name of the minor where he is the guardian
3. Interest on PPF account is payable for the month subject to the following condition getting fulfilled:
a. Deposit should have been made on or before the 10th of the month and the cheque should
have been realized by that date
b. Date of deposit should be on or before 10th of the month; date of realization can be later
c. Date of deposit should be on or before 5th day of the month; date of realization can be later
d. Deposit should have been made on or before 5th day of the month and the cheque should
have been realized by that date
4. How many times a PPF account, on the expiry of the full term of 15 years, can be extended for 5
years, on an application being made by the depositor?
a. Only once
b. Only twice
c. Only thrice
d. Any number of times
5. Interest rate on a PPF account is 8% p.a. Which of the following statements regarding interest
is true?
a. The interest is taxable
b. The interest is taxable but not subjected to TDS
c. The rate of interest can change at any time
d. The rate of interest will remain unchanged for the entire term of 15 years but at the time of
extension, changed rate, if any, will become applicable
6. A bonus of 10% of deposit amount is payable on Post Office Monthly Income Scheme account,
on maturity, provided:
a. The deposit account was opened before 11th February 2006
b. The deposit account is held in joint names
c. The deposit amount does not exceed the prescribed maximum limits in the scheme
d. It is payable on all accounts irrespective of number of depositors as well as when the deposit
was made

PDP Investment Planning 103

7. Interest on Post Office Monthly Income Scheme is
a. Tax free
b. Taxable and subject to TDS
c. Taxable but not subject to TDS
d. None of the above
8. In Post Office Time Deposit the maximum limit on investment is:
a. Rs. 1,00,00/- per person
b. No maximum limit
c. Rs. 3,00,000/- in single account and Rs. 6,00,000/- in joint accounts
d. Rs. 5,00,000/- per person
9. Accrued interest on National Savings Certificates, purchased in the previous years
a. Need not be shown as Income from other sources
b. Should be shown as Income from other sources but the same is deductible u/s 80L of the
Income Tax Act in all years except the year of maturity
c. Should be shown as Income from other sources but can be claimed as deduction from income
u/s 80C of the Income Tax Act, in all years except the year of maturity
d. It can be treated as capital gains and accounted for as such in the year of maturity
10. Which of the following statements, in respect of Senior Citizen Saving Scheme, is true?
a. The account can be held jointly with son or daughter
b. The account can be held jointly but both the joint holders should above 60 years of age
c. An individual below 60 years can not invest in this scheme at all
d. An individual above 55 years can invest within one month of receipt of retirement benefits
11. If husband and wife both are above 60 years of age the maximum amount they can invest in
Senior Citizen Savings Scheme is:
a. Rs. 15 lacs, totally, between the two of them
b. Rs. 30 lacs, totally; each person not exceeding Rs. 15 lacs
c. No ceiling on the amount of investment in this scheme
d. Only one of them can invest and the total can not exceed Rs. 15 lacs
12. Which of the following statements is true regarding interest on Senior Citizen Savings Scheme?
a. Taxable and subject to TDS
b. Taxable but not subject to TDS
c. Tax free
d. Rate of interest can change at any time during the 5 year term
13. Which of the following statements is true in respect of nomination in Senior Citizen Savings
a. Only one person can be nominated
b. Nomination is permitted only in case of single account
c. Joint nomination is permitted on successive nomination basis
d. Joint nomination is permitted on proportional nomination basis

104 Investment Planning PDP

14. Cumulative interest option is available in Senior Citizen Savings Scheme.
a. Not true; only non cumulative option is available
b. True; but the depositors have to specifically apply for the same
c. Available at the option of all the depositors jointly
d. Available only for depositors in the age group of 55 to 60
15. The maximum amount that an individual can deposit in 8% GOI taxable Savings Bond is;
a. Not exceeding Rs. 2 lacs in a financial year
b. Not exceeding Rs. 2 lacs
c. No ceiling at all; any amount can be deposited
d. Rs 6,00,000/- if held jointly
16. Which out of the following persons are not allowed to invest in 8% GOI Taxable Savings Bonds?
a. Charitable Institution approved u/s. 80G of the Income Tax Act
b. Universities
c. Non Resident Indians
d. All the above

1. a
2. c
3. c
4. d
5. c
6. a
7. c
8. b
9. c
10. d
11. b
12. a
13. d
14. a
15. c
16. c

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Chapter 8

106 Investment Planning PDP

Fixed Income Instruments

Short Term Instruments – Money Market Instruments

T he following are the short term instruments of less than 1 year maturity. These instruments are
essentially institutional plays and retail investors don’t get to participate in this directly.

1. Call Money Market

This is basically an inter-bank market where the day-to-day surplus funds are made available/lent to
banks that have a short fall. The loans have a maturity of 1 day to about 14 days and are repayable on
demand at the option of either the lender or the borrower. In terms of liquidity this is slightly lower than
cash – in other words the liquidity is very high

2. Repos
Repos or repurchase agreements (ready forward) are transactions in which one party sells security to
another party simultaneously agreeing to purchase it in future at a specified date and time for a
predetermined price. The difference in the prices is the cost of borrowing to one party and income to the
party lending the money. These transactions are secured and hence the counter party risk is highly
reduced. Therefore, the interest rate is also lower compared to call money rates. In repos the purchaser
acquires the title to securities and he can enter into further transactions on these securities.
Repos are generally for a period of about 14 days or less though there is no such restriction on the
maximum period for which a repo can be done.
Government Securities, Treasury bills and PSU bonds are the instruments used as collateral security
for repo transactions.

3. Treasury Bills
Treasury Bills are borrowings of Government of India for periods of less than 1 year and the normal
tenors are 91 days, 182 days and 364 days. The main holders of Treasury Bills are banks and primary
dealers, which are required to hold government securities as part of their liquidity requirements (SLR –
The statutory liquidity ratio – banks are required to keep a certain percentage of their total demand and
time liabilities invested in government securities – Investments in Treasury banks serve the purpose of
meeting SLR requirements – currently SLR is 25%) On 91 days Treasury Bills, currently, the yield is
around 5.9% to 6.40% p.a. while the yield on 364 days Treasury bill hovers around 6.9% to about 7.1%
p.a. Banks subscribe to Treasury Bills through an auction process and Reserve Bank of India acts on
behalf of Government of India in this regard. Government of India also makes longer term borrowings to
which banks subscribe. The securities where the term is 1 year or more are called Dated Securities.

4. Commercial Paper (CP)

CP’s are short term, unsecured, usance promissory notes issued by large corporations. The rate of
interest will depend on over all short term money market rates as well as credit standing of the issuer
company. Individual investors can invest in Commercial Paper. These are issued at discounts to the
face value and the extent of discount will determine the yield on the paper. Banks are not permitted to

PDP Investment Planning 107

co-accept or underwrite CP’s issued by companies. The CP’s are regulated by Reserve Bank of India
and companies can issue CP’s to meet their short term requirement of funds, subject to norms laid by
RBI from time to time. A company is eligible to issue CP only if its tangible net worth is more than Rs. 4
crores and if it has a sanctioned working capital limit from a bank or a financial institution. The minimum
credit rating required for CP’s is P-2 of CRISIL or its equivalent of other credit rating agencies. The
period is 15 days to less than a year and the denomination is Rs 5 lacs and its multiples.

5. Certificates of Deposit (CD)

Instruments very similar to CP’s but issued by banks are called Certificates of Deposit. These are
negotiable short term bearer deposits issued by banks. These are interest bearing, maturity dated
obligations forming part of the time deposits of banks. In the past when interest rates on bank deposits
were regulated CD’s became handy for banks to raise short term deposits even at rates lower than the
regular fixed deposit interest rates.

6. Forward Rate Agreements (FRA)

A Forward Rate Agreement(FRA) is a forward contract in which one party pays a fixed interest rate, and
receives a floating interest rate equal to a reference rate (the underlying rate). The payments are calculated
over a notional amount over a certain period of time and netted i.e only the differential is paid. It is paid
on the termination date. The reference rate is fixed one or two days before the termination date, dependent
on the market convention for the particular currency. FRA’s are over-the-counter derivatives. A swap is
a combination of FRA’s.
The payer of the fixed interest rate is also known as the borrower or the buyer whilst the receiver of the
fixed interest rate is the lender or the seller.

7. Interest rate swaps (IRS)

An Interest Rate Swap is the exchange of one set of cash flows for another. A pre-set index, notional
amount and set of dates of exchange determine each set of cash flows. The most common type of
interest rate swap is the exchange of fixed rate flows for floating rate flows. A counter-party’s
creditworthiness is an assessment of their ability to repay money lent to them over time. If a company
has a good credit rating, they are more likely to be able to pay back a loan over time than a company
with a poor credit rating. This effect is magnified with time. By making it easier for less creditworthy
agents to borrow in the short term than in the long term, lenders make sure that they are less exposed
to this risk.
Therefore, we would expect that in fixed-floating interest rate swaps, the entity paying fixed and receiving
floating is usually the less creditworthy of the two counterparties.
The interest rate swap gives the less creditworthy entity a way of borrowing fixed rate funds for a longer
term at a cheaper rate than they could raise such funds in the capital markets by taking advantage of the
entity’s relative advantage in raising funds in the shorter maturity buckets.

Fixed Income Instruments – Long Term

This segment deals with securities and deposits that have maturity periods one year or longer and
where coupon/interest is paid periodically, as opposed to discounted prices in case of short term
instruments, discussed earlier. These vehicles are attractive for investors who seek regular income with
relative safety. Some of the most popular avenues of fixed income instruments are as under:

108 Investment Planning PDP

GOI dated securities – Government Bonds

GILT edged securities

Government of India borrows for long term through these securities. Banks, financial institutions, insurance
companies and mutual funds subscribe to these bonds through the auction process initiated by Reserve
Bank of India. These bonds are plain vanilla bonds of face value Rs 1000/- where on the coupon/interest
is paid to the holders on half yearly basis. These bonds are quoted as “8% GOI bonds 2014” which
indicate the coupon rate and maturity of these bonds. The prices of these bonds fluctuate based on the
prevailing interest rates, the nearness to payment of coupon and of course, market factors of liquidity/
demand/supply, etc. These bonds are generally issued for periods ranging from 3 years to 20 years.
Because of the longer term, bigger size and illiquidity of these bonds these have not been attractive for
retail investors. However, investors can participate in the government securities, indirectly, through the
mutual fund route. Some mutual funds have launched GILT funds which invest only in Government
securities while Income Funds of mutual funds predominantly invest in fixed income securities including
Government securities.
The Government of India issues securities in order to borrow money from the market. One way in which
the securities are offered to investors is through auctions. The government notifies the date on which it
will borrow a notified amount through an auction. The investors bid either in terms of the rate of interest
(coupon) for a new security or the price for an existing security being reissued. Since the process of
bidding is somewhat technical, only the large and informed investors, such as, banks, primary dealers,
financial institutions, mutual funds, insurance companies, etc generally participate in the auctions.

PSU Bonds
Public Sector Undertaking, Public Sector Enterprises and local authorities, but supported by State/
Central Government issue securities similar to Central Government Securities. Normally the respective
Government offers guarantee for payment of interest and repayment of principal amount of these PSU
borrowings. These bonds, as they carry sovereign guarantee, are considered less risky compared to
corporate bonds/debentures but more risky compared to Government securities. Many State Government
corporations have floated bonds in the past and have raised moneys for infrastructure projects and the
Indian retail investors have participated in the issues in a big way. The investors have received excellent
returns while the corporations could raise much needed capital funds for major projects. It is also expected
that Government of India will allow Municipal Corporations to raise funds from the market, for
developmental projects, through issue of tax free bonds at attractive rates of interest.

Corporate Bonds/Debentures
Companies can borrow directly from the market through issue of securities, subject to capital market
regulations for meeting their capital requirements. These are typically “debentures” which are borrowings
of the companies and these may be secured against a charge on the assets of the company or these
may be unsecured. The term of the debentures will depend upon the need of the company. Companies
can issue Non Convertible Debentures which are pure fixed income instruments and also partly convertible
or fully convertible debentures. The convertible debentures normally bear interest till the date of conversion
and/or on the non-convertible portion till redemption. Where the tenor of the debentures is 18 months or
more credit rating for the debentures is mandatory. The non convertible debentures and the non-
convertible portion of partly convertible debentures are redeemed on maturity at par or with a premium.
The rate of interest will depend on market conditions as well as creditworthiness of the company and the
credit rating for the debentures. Companies in the past found it convenient to tap the capital market and

PDP Investment Planning 109

raise funds through issue of NCD’s and PCD’s and they preferred this route to long term borrowing from
banks. The investors also preferred NCD’s because the debentures were secured and the interest rates
were quite high. Now that the rates of interest have come down the debentures don’t continue to enjoy
the same patronage from the retail investor. To the investor interest on debentures is taxable and also
subject to TDS. Companies have tapped the market with Zero Coupon Bonds as well Optional Fully
Convertible Debentures. These special instruments serve some purpose for the investors as well as the
companies from the point of taxation as well as postponing interest liabilities, etc.

Corporate Deposits
Companies are allowed to borrow from the public through public deposits for meeting their medium term
capital requirements. The acceptance of deposits by Indian companies is subject to the provisions of
Section 58A and 58AA of the Companies Act, 1956 and Companies (Acceptance of Deposits) Rules,
1975 (as amended).

Manufacturing Companies:
n The public deposit mobilized by a company should not exceed 25% of Tangible Net worth of the
company (capital + free reserves) – this fixes the maximum amount a company can borrow from
the public through fixed deposits route.
n A company can borrow from its share holders also and this amount should not exceed 10% of its
net worth taking the total borrowings through public deposits to 35% of the company’s net worth. In
respect of Government companies the limit is 35% of the company’s net worth.
n The maximum term of deposit cannot exceed a term of 3 years while the minimum term is 6 months
n The company is free to fix the rate of interest payable on its fixed deposits within the overall limits
laid down under the Companies (Acceptance of Deposits) Rules, 1975 and notifications made
there under from time to time
n The interest received by the depositor is taxable
n A company is liable to deduct tax at source where the interest per annum per depositor is likely to
exceed Rs. 2,500/-. This limit may change as per provisions of Income Tax Act.
n Credit rating of fixed deposits is not mandatory
n Fixed deposits are unsecured borrowings of the company

Non Banking Finance Companies:

n Only NBFC’s which are registered with RBI can accept fixed deposits
n Credit rating of Fixed Deposits is mandatory
n An NBFC can accept fixed deposits only if credit rating is above Minimum rating fixed by RBI from
time to time
n These companies are allowed to raise much higher amounts by way of fixed deposits in relation to
their net worth
n To the investor Fixed Deposits with NBFC’s offer a higher risk higher return investment option
n The interest is taxable and subject to TDS
n Housing Finance Companies also accept fixed deposits and TDS is made only when the interest
on deposits is likely to exceed Rs. 5,000/- p,a, per depositor whereas in respect of other companies
the limit is Rs. 2,500/-

110 Investment Planning PDP

Bank deposits
n Banks accept fixed deposits for short term as well long term offering specific fixed rate of interest.
n This is the most popular investment vehicle for the retail investors in India because investors find
banks very convenient to deal with.
n These deposits are perceived to be highly safe and liquid
n Interest rates tend to be lower compared to other fixed income avenues of comparable maturities
n Interest is taxable
n Interest is subject to TDS – where interest on term deposit is likely to exceed Rs 5,000/- per annum
per depositor per branch the bank is required to deduct tax at source
n Bank deposits are highly flexible in their features and banks accept term deposits with extremely
investor friendly features
n Investment in a Bank Fixed Deposit with a 5 year lock-in period qualifies for deduction from income
under sec 80C of Income Tax Act.
n Bank deposits can be insured against risk of default, by bank, with Deposit Insurance and Credit
Guarantee Corporation of India Ltd. to the maximum limit of Rs. 1,00,000/- per depositor per bank.
Investors in relatively smaller banks and co-operative banks find this an important protection.

Features of fixed income securities

n The return or the yield which comprises of regular flow through coupon/interest and capital
appreciation or loss, if any, on maturity.
n The liquidity. Investors some times prefer securities of shorter term as well as vehicles where the
exit is easier. The fixed income options like Money Market Mutual Funds and call deposits are
found ideal by investors who want to park their money for short term.
n Risk: This is a major factor. The risk of default is a factor which determines where the investor
would like to invest his savings. Unsecured company fixed deposits, especially the ones which are
not rated, can be considered quite risky. The better the credit rating of an instrument the lower
could be the return on the same.
n Taxability and tax deduction at source are also important factors that determine flow of money to
a particular avenue. 8% GOI taxable savings bonds and small saving schemes like Post Office
Monthly Income Schemes have managed to attract huge funds flow because the interest on these,
though taxable, is not subjected to tax deduction at source while Public Provident Fund, though a
longer term option, attracts substantial investor interest because of tax benefits.
n Convenience of handling is a parameter on which bank deposits score over many other avenues.
A large net work of branches and ATM’s make banks very easy to handle.

Valuation of fixed income securities:

Money market securities
The valuation of these securities is normally a function of the current interest rate prevailing in the
market on short term debt instruments.
If a 90day treasury bill of R.s 1,00,000/- is available for say 98,186 then the yield on the same would be
worked as follows:
Income earned is 1,00,000 – 98,186 = 1,814
Tenor 90 days

PDP Investment Planning 111

The yield therefore is (1814*365)/(98,186*90) = 7.49%
The yield is worked out for a year of 365 days from the discounting at which the treasury bill is available.
The formula for calculating the yield is PV = FV/ [1+ (i*n/365)
PV = present value or the price of the bill/security
FV = face value or the value receivable on maturity
n = number of days to maturity
i = yield per annum
In respect of fixed income securities which have less than 1 year left to maturity when all factors viz. PV,
FV and n are known and yield “i” can be calculated using the above formula.

Longer term securities

In respect of longer term securities the time between receipts of interest income becomes a significant
factor in its valuation. In market instruments there are no interest payments and the same is built in the
price. In respect of dated securities and bonds interest payments are made at specified intervals. The
amount of interest and the timing of these payments will affect the price of a longer term security.
There are two types of yields which come into play here. The current yield which is nothing but the periodic
payments received on the amount invested or in other words: the coupon divided by purchase price.
The other type of yield is YTM which is calculated as follows:

P = Price of the security
C = annual interest payments received
r = rate of interest
M = Maturity value – amount receivable on maturity
n = number of years left for the security to mature
The computation of YTM required a trial and error procedure. The interest payments are payments of
annuity over a period of time while the maturity value is the future value of the present Price of the bond
and “r” the YTM has to be worked out substituting different values for r.

It may be pertinent to add here that small investors have little or no exposure to government securities
and the money market instruments directly. Some investors have been participating in these avenues
through the mutual fund route. However investors have found company fixed deposits as well as non
convertible and convertible debentures easier to invest and have been investing in these vehicles.
Public Sector bonds floated by many Government and Semi Government corporations have also received
good response from the retail investors. Besides the avenues discussed above fixed income instruments
include Small savings schemes like Post Office Monthly Income Scheme, Public Provident Fund, National
Saving Scheme, Kisan Vikas Patra and direct borrowing by Government of India through 8% GOI Taxable
Savings Bonds and Senior Citizen Savings Scheme. These schemes and their features have been
discussed in detail under the topic “Small Saving Schemes”.

112 Investment Planning PDP

Review Questions:
1. If the yield on 90 days Treasury Bills is currently 6.9% what should be the price of the Treasury Bill
of Rs 1,00,000/- in the market?
a. Rs. 93,100
b. Rs. 98,327
c. Rs. 1,06,900
d. Rs. 96,549
2. Bank deposits, at the option of the bank, can be insured with DICGC and the maximum cover
available per depositor is;
a. No insurance cover is available on bank deposits
b. Rs. 2,00,000/- per branch of the bank
c. Rs. 1,00,000/- per branch of the bank
d. Rs. 1,00,000/- per bank
3. Interest on bank deposits is
a. Tax free u/s 10
b. Deduction is available u/s 80L for individual investors
c. Taxable and subject to TDS where the interest is likely to exceed Rs. 5,000/- p.a. per depositor
per branch
d. Taxable and subject to TDS where the interest is likely to exceed Rs. 5.000/- p.a. per depositor
per bank
4. A Manufacturing company can accept fixed deposits subject to the following conditions:
a. Not exceeding 20 times the net worth of the company
b. Not exceeding 25% of its net worth from the public and not exceeding 10% of net worth from
its share holders
c. No such restrictions – the company may decide the quantum
d. Not exceeding 5 times the net worth of the company.
5. If the market price of the bond, bearing coupon of 8%, is Rs. 985, face value of the bond is Rs. 1,000
and if there are two years to maturity then YTM would be:
a. Equal to 8%
b. Less than 8%
c. Cant say
d. More than 8%
6. If the interest rate in the economy rises then the prices of existing bonds will
a. Rise
b. Fall
c. Remain steady
d. The fall or rise will depend upon the coupon rate and the maturity date of the bond

PDP Investment Planning 113

7. Commercial Papers (CP) are:
a. Long term instruments issued by banks
b. Long term instruments issued by companies
c. Short term instruments issued by eligible companies
d. Short term instrument which can be issued by any company
8. Interest on short term money market instruments:
a. Is paid periodically by the issuer
b. It is discounted in the price
c. It is paid by the issuer, as agreed between the issuer and the investor, but subject to Tax
Deduction at source
d. Is paid on a quarterly basis
9. How frequently is interest on Government securities (Dated Securities) paid?
a. Once a year
b. Half yearly
c. Quarterly
d. On maturity
10. It is expected that interest rates may rise in the near future. Which of the following instruments
would you choose?
a. One year bank FD offering 8% p.a.
b. 5 year Bank FD offering 8.5%
c. 6 year GOI bonds offering 8% p.a.
d. Keep money locked in long term securities

1. b
2. d
3. c
4. b
5. d
6. b
7. c
8. b
9. b
10. a

114 Investment Planning PDP

Chapter 9

PDP Investment Planning 115

Life Insurance Products

L ife insurance is a misunderstood concept in India. Basically Life Insurance Plans should provide
insurance cover to protect the dependants of the Life Assured. But conventionally Life Insurance
policies have been sold as investment products where the Life Assured gets a lump sum at the end of a
fixed term or periodic returns on a regular basis during the term. The emphasis has been more on the
investment aspects than on life cover. The private players in Life Insurance sector in India they have
brought in newer concepts like adding riders to life insurance policies but they also continue to sell
insurance plans with more emphasis on the investment features.
Let us look at some of the standard policies offered by Life Insurance Companies.

Endowment Policy
n An endowment policy covers risk for a specified period, at the end of which the sum assured is paid
back to the policyholder, along with the bonus accumulated during the term of the policy.
n The method of bonus payment is called reversionary bonus. The quantum of bonus is not assured
and it is based on the investment out come of Life insurance companies.
n It is insurance-cum-investment product where the emphasis is more on investment because life
cover for a given premium is less compared to a whole life policy with more focus on maturity
benefit compared to death benefit.
n Endowment life insurance pays the sum assured in the policy either at the insured’s death or at a
certain age or after a number of years of premium payment.
n Ideally this policy is used by investors who would like to have a certain amount of capital at the end
of a fixed term and protect the end capital through life insurance of the saver.
n This has been the most popular life insurance plan of LIC of India before the private players entered
life insurance sector and popularized Unit Linked Insurance Plans

Whole Life Insurance Policy

n A whole life policy runs as long as the policyholder is alive.
n As risk is covered for the entire life of the policyholder, therefore, such policies are known as whole
life policies.
n A simple whole life policy requires the insurer to pay regular premiums throughout the life.
n Whole Life plans with limited payment options are also available where the insured is required to
pay premium for a specific term after which premium payment will stop but life cover will continue
n In a whole life policy, the insured amount and the bonus is payable only to the nominee of the
beneficiary upon the death of the policyholder.
n There is no survival benefit as the policyholder is not entitled to any money during his / her own

116 Investment Planning PDP

Term Life Insurance Policy
n Term life insurance policy covers risk only during the selected term period.
n The sum assured becomes payable only on death of the policy holder and not on end of the term
as in an endowment plan
n The term life insurance policy offers maximum life insurance cover for a given premium payment
as this is pure life insurance without any investment built in
n Term life policies are primarily designed to meet the needs of those people who are initially unable
to pay the larger premium required for a whole life or an endowment assurance policy.
n No surrender, loan or paid-up values are granted under term life policies because reserves are not
n If the premium is not paid within the grace period, the policy lapses without acquiring any paid-up

Money Back Policy

n Money back policy provides for periodic payments of partial survival benefits during the term of the
policy, as long as the policyholder is alive.
n They differ from endowment policy in the sense that in endowment policy survival benefits are
payable only at the end of the endowment period.
n An important feature of money back policies is that in the event of death at any time within the
policy term, the death claim comprises full sum assured without deducting any of the survival
benefit amounts, which may have already been paid as money-back components. The bonus is
also calculated on the full sum assured
n This is an insurance plan with emphasis on investments and periodic return.
n A segment of investor population finds the periodic receipts from Life Insurance Company attractive
and hence prefers this plan.

Joint Life Insurance Policy

n These plans are ideal for a married couple especially when both are bread winners or business partners.
n Joint life insurance policies are similar to endowment policies offering maturity benefits as well as
death benefits.
n In case of death of one of the persons the sum assured becomes payable.
n The sum assured is paid again on death of the surviving policy holder or on policy maturity.
n The premiums payable cease on the first death or on the expiry of the selected term, whichever is
n If one or both the lives survive to the maturity date, the sum assured as well as the vested bonuses
are payable on the maturity date.

Group Insurance
n Group insurance offers life insurance protection under group policies to various groups such as
employers-employees, professionals, co-operatives, weaker sections of society, etc.
n It also provides insurance coverage for people in certain approved occupations at the lowest possible
premium cost.

PDP Investment Planning 117

n Group insurance plans have low premiums. Such plans are particularly beneficial to those for
whom other regular policies are a costlier proposition.
n Companies with a large workforce have preferred to provide life insurance to their less sophisticated
employees/workers through Group Insurance Plans.
n Group insurance plans extend cover to large segments of the population including those who
cannot afford individual insurance.
n A number of group insurance schemes have been designed for various groups.

Loan Cover Term Assurance Policy

n Loan cover term assurance policy is an insurance policy, which covers a home loan.
n In the event of unfortunate death of the policy holder, before the full repayment of the housing loan,
the amount outstanding in the housing loan is paid in full.
n The cover on such a policy keeps reducing with the passage of time as individuals keep paying
their EMIs (equated monthly instalments) regularly, which reduces the loan amount.
n This plan provides a lump sum in case of death of the life assured during the term of the plan. The
lump sum will be a decreasing percentage of the initial sum assured as per the policy schedule.
n Since this is a non-participating (without profits) pure risk cover plan, no benefits are payable on
survival to the end of the term of the policy.

Term Assurance Plans

n Under this plan, in case of death of the policy holder during the policy term, the sum assured will be
paid to the beneficiary.
n There are no maturity benefits. Hence on survival, the policy will terminate.
n The life insured will need to pay the regular annual premium for the term chosen.
n These are typically low cost bare insurance plans with no investment frills
n For a little additional cost some companies offer Term assurance plans with return of premium and
here on survival till maturity all the premiums paid will be returned
n Some term assurance plans provide extended life cover rider where after the end of term, insurance
up to certain percentage of sum assured, continues for a specified term , say 5 years, without
payment of any premium
n Insurance companies tend to place a number of restrictions on term plans like:
1. Maximum life cover; say Rs 50 lacs
2. Maximum term – say 25 years
3. Maximum age at maturity – say 55 years and so on ...

Unit Linked Insurance Plans

n ULIPs are market-linked insurance plans with a life cover thrown in.
n The said insurance cover is lower than most plain-vanilla plans (like endowment plans) as a sizable
portion of the premium goes towards investments in market-linked instruments like stocks, corporate
bonds and government securities.
n On death sum assured together with market related returns on the investments is paid – in other
words the death benefit could be more than sum assured

118 Investment Planning PDP

n Generally, the choice of extent of life cover is left to the insured/policy holder
n The choice of investment plans is also left to the policy holder with an option to switch between
different investment plans, a number of times, during the entire term of the plan. For example an
investor may choose the aggressive or equity plan at his young age and later on switch to
conservative or protective or debt plan at a later age.
n ULIP provides multiple benefits to the consumer. The benefits besides life protection include:
1. Investment and Savings
2. Flexibility
3. Adjustable Life Cover
4. Investment Options
5. Transparency
6. Options to take additional cover against
n Death due to accident
n Disability
n Critical Illness
n Surgeries
n ULIPs have managed to outsell plain vanilla plans by quite a margin. For some private insurance
companies, they account for up to 70% of new business generated.
n ULIPs by their very nature are long term investment vehicles because of costs involved as well as
the nature of underlying investments especially equities.
n Investors while choosing ULIPs should very carefully study the loads charged by Life Insurance
Companies because past performance shown by these companies is essentially on the net
investment portion of the premium paid by the policy holder. So if the charges are high naturally
the lump sum receivable at the end of the term will also be affected substantially.
n The policy holders should pay premium continuously for a minimum period of 3 years. The insurance
cover will continue even if the policy holder fails to pay the annual premium after a minimum period
of at least 3 years. The policy becomes paid up after 3 years and upon surrender the market value
becomes payable.
How Unit Linked Insurance Plans work?
Let’s assume that Mr. Vikas Joshi, aged 30 years, is prepared to pay life insurance premium of Rs
20,000/- per annum. In a ULIP he can choose the extent of life cover he wants and where he wants his
fund to be invested. Let us also assume that Mr. Joshi presently opts for the Aggressive plan where his
entire amount will be invested in equities and he chooses life cover of Rs. 2,00,000/-.
From the premium paid by Mr. Joshi expenses under the following heads will be deducted.

n Sales and marketing expenses

n Administration expenses
n Underwriting expense
n Mortality charges
n Fund management expenes
The quantum of mortality charges will depend upon extent of life cover opted while the fund management

PDP Investment Planning 119

expenses will also depend upon the investment option exercised – the cost could be low for a debt fund
and higher for an equity fund.
In some cases out of Rs. 20,000/- paid by Mr. Joshi expenses will account for nearly Rs. 5,000/- in the
first year or first two years and only the balance amount of Rs. 15,000/- will be invested as per his option.
The quantum of administration, selling and marketing expenses go down dramatically from the third
year onwards but in the initial 2 years they tend to be quite high and this can alter the returns on the
ULIP substantially. It is very important for Mr. Joshi to study the fine print regarding expenses thoroughly
before choosing a specific Plan.
Mr. Joshi should also realize that he will get better returns only if he invests for a long period for the
following important reasons:

n Expenses, as a percentage of premium, tend to go down dramatically over longer period time
n Equity as an asset class will perform better over longer period of time
n In the short term equity may perform erratically and may not deliver superior returns
Where ULIPs invest?
Each investment fund is composed of units. All the units in a fund are identical. You can choose from the
following funds:

Liquid fund
The Liquid fund invests 100% in bank deposits and high quality short-term money market instruments.
The fund is designed to be cash secure and has a very low level of risk; however unit prices may
occasionally go down due to the use of short-term money market instruments. The returns on the funds
also tend to be lower.

Secure Managed /Protector Fund

The Secure Managed fund invests 100% in Government Securities and Bonds issued by companies or
other bodies with a high credit standing, however a small amount of working capital may be invested in
cash to facilitate the day-to-day running of the fund. This fund has a low level of risk but unit prices may
still go up or down. The risk that this fund may face is the interest rate risk. If after investment the interest
rates rise that may lead to a fall in unit prices temporarily.

Hybrid Fund / Moderate fund / Defensive Managed

15% to 30% of the Defensive Managed fund will be invested in high quality Indian equities. The remainder
will be invested in Government Securities and Bonds issued by companies or other bodies with a high
credit standing. In addition, a small amount of working capital may be invested in cash to facilitate the
day-to-day running of the fund. The fund has a moderate level of risk with the opportunity to earn higher
returns in the long term from some equity investment. Unit prices may go up or down.

Balanced Fund
30% to 60% of the Balanced Managed fund will be invested in high quality Indian equities. The remainder
will be invested in Government Securities and Bonds issued by companies or other bodies with a high
credit standing. In addition a small amount of working capital may be invested in cash to facilitate the
day-to-day running of the fund. The fund has a higher level of risk with the opportunity to earn higher
returns in the long term from the higher proportion it invests in equities.

120 Investment Planning PDP

Growth fund / Aggressive Fund
The Growth fund invests 80% to 100% in high quality Indian equities. In addition a small amount of
working capital may be invested in cash to facilitate the day-to-day running of the fund. The fund
has a higher level of risk with the opportunity to earn higher returns in the long term from the
investment in equities.

n The past performance of any of the funds is not necessarily an indication of future performance.
n There are no investment guarantees on the returns of unit linked funds.
Who can opt for ULIPs?
n Individuals who are already adequately insured
n Individuals who are well informed regarding the market and are in a position to take a call on the
performance of equity and or debt markets over a period of time
n Investors who are prepared to take more risk for better returns compared to pure endowment plans

Insurance plans for child’s future

Life insurance plans help in servicing various needs in an individual’s financial planning exercise. One
such need happens to be planning for his children’s future. Children’s insurance plans help in addressing
many of these needs.
While individuals might have a financial plan for themselves in place, it is equally important that they secure
the financial future of their children. For example, suppose an individual wants to plan for his son’s education.
A child plan will serve in achieving this goal. An illustration will help understand this better.

n A parent saves regularly every year or every month for a fixed term
n The plan offers to pay lump sum amounts every year which could be spent on child’s education on
the child reaching a certain age
n There are plans that pay a single lump sum on the child attaining a certain age – typically planned
to provide for marriage expenses
n The most important insurance feature in a child care plan is that in the event of unfortunate death
of premium paying parent further premium payments are waived (at the option of the policy holder
while entering the plan) and the lump sums are paid as planned so that the child’s education
expenses are met
n Some plans also offer a rider called Accidental Disability Guardian Benefit rider where the future
premiums are waived in case the parent is disabled because of an accident
n It is the life insurance of the parent that is important and not that of the child because the child
should not face financial problems on death of the parent - many people tend to insure the child to
secure the child’s feature.
n The returns on some products are market linked and not assured and therefore it is important to
understand cost factors, track record of performance and other features before choosing a plan

Pension Plans
n A pension plan is a retirement plan
n An investor can start planning for retirement from an early age or look at the options close to retirement
n Ideally, investments should start from an early age through regular instalments on yearly basis

PDP Investment Planning 121

n Lump sum single premium payment is also allowed for investors, past a particular minimum age
limit – minimum age limit for starting of pension – in many cases it happens to be 40 years
n The pension payments can start immediately or after a time lag – Immediate annuity or deferred
n In case of deferred annuities, at the end of the term of deferment the pensioner can exercise an
option of getting some lump sum and pension on the balance amount or pension on the full amount
– part payment of capital is allowed
n The pension payments are at guaranteed rates for entire life of the pensioner or for a fixed term of
say 10/15/20 years
n Some pension plans provide for paying increased rates of pension over a period of time – ideal
hedge against inflation
n The pension payments can be monthly, quarterly, half yearly or yearly – at the option of the pensioner.
n The pension payments can continue to spouse on the death of the pensioner, at the same rates or
reduced rates, as prescribed by Life Insurance companies – this option can be exercised by pensioner
n The capital sum may be returned to the nominee on the death of the pensioner (return of purchase
price) or forfeited – the rate of return on annuity plans will depend on which option the pensioner
exercises – the rate of returns are lower when the pensioner wants return of purchase price
n In case of immediate pension – the quantum of pension depends on the age, at entry, of the
pensioner – the higher the age at entry the higher the amount of pension
n Pension plans typically offer no life insurance cover but some plans do have term assurance rider
for deferred pension plans, at an additional cost
n The most important factor that should be considered while choosing a pension plan is that it
provides protection from interest rate risk – insurance companies guarantee a specific return for
the entire life of the pensioner where as in other avenues like fixed deposits/small savings, etc.
the interest rates may go down disrupting the budget of the pensioner – these plans “cover the
risk of living too long”

122 Investment Planning PDP

Review Questions:
1. In a Whole life plan with limited payments, the sum assured becomes payable:
a. At the end of premium paying term
b. Only on death of the policy holder
c. At the end of the premium term or on death of the policy holder which ever is earlier
d. The sum assured is not payable at all if the policy holder survives the premium paying term
2. In an Endowment Assurance Plan the sum assured becomes payable:
a. Only at the end of the term of the policy
b. On death of the policy holder or at the end of the term of the policy which ever is earlier
c. Only on death of the policy holder
d. No sum is payable if policy holder survives the full term
3. In a Term Assurance Plan the sum assured becomes payable:
a. Only at the end of the term of the policy
b. On death of the policy holder or at the end of the term of the policy which ever is earlier
c. Only if the policy holder dies after the end of the term
d. Only if the policy holder dies before the end of the term for which he has been insured
4. The best way to take care of a child’s future through insurance plans is to
a. Insure the life of the child for maximum possible amount
b. Life insurance plans can not protect the child’s future at all
c. Invest in a child care plan with premium waiver benefit, where upon death of the parent further
premium need not be paid but the child will get all benefits of the policy
d. Invest in a child care plan but not opt for premium waiver rider because that involves additional
5. Unit Linked Insurance Plans are most suited under which of the following conditions?
a. Ideal for under insured persons
b. Suitable for persons who are adequately insured and are prepared to take some risks for
better returns
c. Suitable for investors with short term objective
d. Suitable for people looking for maximizing insurance cover on minimum premium payments
6. Unit Linked Insurance Plans are basically:
a. Short term and Low cost insurance plans
b. Low cost investment plans with no risk
c. Market related plans with emphasis on investments
d. Market related plans with emphasis on insurance
7. In respect of Unit Linked Insurance Plans which of the following statements is true?
a. The returns are assured
b. No risk investment plans
c. The return shown by way of past performance is on the entire amount of premium paid by the
policy holder
d. Only a certain percentage of premium is invested in securities and a good amount, is deducted
for various expenses, especially in the first few years

PDP Investment Planning 123

8. A young and aggressive investor, who is already adequately insured, should choose which of the
following options in a ULIP plan?
a. Aggressive/Growth plan which predominantly invests in equities
b. A conservative or protector plan which predominantly invests in bonds and government
c. The choice is immaterial as all funds tend to perform equally well over longer periods of time
d. A higher insurance cover with lower risk investment option ; say liquid fund/bond fund
9. An investor who wants to invest in immediate pension plan seeks your advice on what option to
choose. He is 50 years of age and he expects to live for another 30 years at least. Which one of
the following options is suitable to him?
a. Guaranteed pension for 5 years - offering 7% p.a.
b. Guaranteed pension for 20 years - offering 6.5% p.a.
c. Guaranteed pension for life and there after to his spouse -offering 7% p.a.
d. He should be advised to invest in a mutual fund rather than pension plan of a life insurance

1. b
2. b
3. d
4. c
5. b
6. c
7. d
8. a
9. c

124 Investment Planning PDP

Chapter 10

PDP Investment Planning 125

Mutual Funds

A Mutual fund is a collective investment vehicle where the resources of a number of unit holders are
pooled and invested as per objectives disclosed in the offer document. A mutual fund is set up as
a trust which supervises the function of An Asset Management Company (AMC) which manages the
investments collected in the mutual fund schemes.

A mutual fund investor enjoys the following advantages

1. Professional management
The funds are invested by professional fund management team that analyses the performance and
prospects of companies and selects suitable investments in line with the objectives of the schemes.

2. Diversification
It is impossible for a small investor to diversify across different investment vehicles as well as over a
large number of companies. He invariably runs the risk of non diversification on his investments because
of low capital. The mutual fund provides him the best option where on a small capital invested the unit
holder gets a diversified portfolio.

3. Regulated operation
The mutual fund administration and fund management are subject to stringent regulations by Self
Regulatory Organisation voluntarily set up mutual funds – viz. Association of Mutual Funds of India
(AMFI) and also by Securities and Exchange Board of India (SEBI). Thus the interest of the investors is
kept protected.

4. Higher returns
As these funds are well managed and well diversified they tend to perform better than the market over
a longer period of time; there is potential for the unit holders to get better returns compared to fixed
income avenues over a longer period of time.

5. Transparency
The NAV’s of open ended funds are disclosed on a daily basis while the portfolio is disclosed on a
monthly basis ensuring transparency to the investors.

6. Liquidity
Open ended funds can be redeemed at any time; there is no lock-in period; provides excellent liquidity;
the redemptions are also very fast and investors in equity funds tend to get money back

7. Tax Benefits
Mutual funds enjoy tax benefits on the incomes received by them as well as on capital gains. The unit
holders also enjoy certain tax benefits on the income earned; the capital gains made and on amount
invested in certain types of funds.

126 Investment Planning PDP

8. Flexibility
Mutual funds offer a lot of flexibility where the investments can be lump sum investments or Systematic
investment Plans on a monthly/quarterly basis with very small amounts of investments. Withdrawal can
be also full or part or on a systematic basis.

What is the history of Mutual Funds in India and role of SEBI in mutual funds industry?
Unit Trust of India was the first mutual fund set up in India in the year 1963. In early 1990s, Government
allowed public sector banks and institutions to set up mutual funds.
In the year 1992, Securities and exchange Board of India (SEBI) Act was passed. The objectives of
SEBI are – to protect the interest of investors in securities and to promote the development of and
regulation of the securities market.
As far as mutual funds are concerned, SEBI formulates policies and regulates the mutual funds to
protect the interest of the investors. SEBI notified regulations for the mutual funds in 1993. Thereafter,
mutual funds sponsored by private sector entities were allowed to enter the capital market. The regulations
were fully revised in 1996 and have been amended thereafter from time to time. SEBI has also issued
guidelines to the mutual funds from time to time to protect the interests of investors.
All mutual funds whether promoted by public sector or private sector entities including those promoted
by foreign entities are governed by the same set of Regulations. There is no distinction in regulatory
requirements for these mutual funds and all are subject to monitoring and inspections by SEBI. The
risks associated with the schemes launched by the mutual funds sponsored by these entities are of
similar type.

How is a mutual fund set up?

A mutual fund is set up in the form of a trust, which has sponsor, trustees, an asset management
company (AMC) and a custodian. The trust is established by a sponsor or more than one sponsor who
is like promoter of a company. The trustees of the mutual fund hold its property for the benefit of the unit
holders. Asset Management Company (AMC) approved by SEBI manages the funds by making
investments in various types of securities. Custodian, who is registered with SEBI, holds the securities
of various schemes of the fund in its custody. The trustees are vested with the general power of
superintendence and direction over AMC. They monitor the performance and compliance of SEBI
Regulations by the mutual fund.
SEBI Regulations require that at least two thirds of the directors of trustee company or board of trustees
must be independent i.e. they should not be associated with the sponsors. Also, 50% of the directors of
AMC must be independent. All mutual funds are required to be registered with SEBI before they launch
any scheme.

What is Net Asset Value (NAV) of a scheme?

The performance of a particular scheme of a mutual fund is denoted by Net Asset Value (NAV). Mutual
funds invest the money collected from the investors in securities markets. In simple words, Net Asset Value
is the market value of the securities held by the scheme. Since market value of securities changes every
day, NAV of a scheme also varies on day to day basis. The NAV per unit is the market value of securities of
a scheme divided by the total number of units of the scheme on any particular date. For example, if the
market value of securities of a mutual fund scheme is Rs 300 lakhs and the mutual fund has issued 10 lakhs
units of Rs. 10 each to the investors, then the NAV per unit of the fund is Rs.30. NAV is required to be
disclosed by the mutual funds on a regular basis - daily or weekly - depending on the type of scheme.

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Different types of mutual fund schemes

Schemes according to Maturity Period

A mutual fund scheme can be classified into open-ended scheme or close-ended scheme depending on
its maturity period.

Open-ended Fund/ Scheme

An open-ended fund or scheme is one that is available for subscription and repurchase on a continuous
basis. These schemes do not have a fixed maturity period. Investors can conveniently buy and sell units
at Net Asset Value (NAV) related prices which are declared on a daily basis. The key feature of open-
end schemes is liquidity.

Close-ended Fund/ Scheme

A close-ended fund or scheme has a stipulated maturity period e.g. 3- 5 years. The fund is open for
subscription only during a specified period at the time of launch of the scheme. Investors can invest in
the scheme at the time of the initial public issue and thereafter they can buy or sell the units of the
scheme on the stock exchanges where the units are listed. In order to provide an exit route to the
investors, some close-ended funds give an option of selling back the units to the mutual fund through
periodic repurchase at NAV related prices. SEBI Regulations stipulate that at least one of the two exit
routes is provided to the investor i.e. either repurchase facility or through listing on stock exchanges.
These mutual funds schemes disclose NAV generally on weekly basis. The market prices in respect of
listed close ended funds tend to be at a discount to NAV. Similarly when mutual funds offer limited
repurchase on a periodic basis at intervals they charge a hefty exit load especially in the first few years
since inception – the loads tend to get smaller as more time elapses. Thus the liquidity in close ended
fund comes with a cost higher than open ended funds.

Schemes according to expenses

Load funds and no load funds: Funds which collect charges at the time of entry or exit or both from the
investors are known as load funds. Funds which do not collect any of these charges at all are called “No
load funds” - Issue expenses; distribution and marketing expenses are borne by AMC’s or sponsors.
However AMC’s are allowed to charge higher management fees in respect of no load funds compared
to load funds. Load charged at the time of purchase is called entry load while load charged at the time
of redemption is called exit load. Mutual funds want investors to invest for longer terms with them.
Hence some times they charge a Contingent Deferred Sales Charge (CDSC) which will be charged only
if the investor exits the fund before a certain period of time – say 6 months; this motivates the investors
to stay invested in the fund for at least that period of time.
SEBI has stipulated the maximum load that can be charged by mutual funds and how the same can be
levied. Initial expenses should not exceed 6% of initial resources raised/funds mobilized under the scheme.
In respect of a New Fund Offer (NFO) – launch of a new mutual fund scheme – the offer document
which is also called KIM (Key information memorandum) should contain all details regarding expenses.
If the fund charges entry load of say 2.25% then the initial investors in the fund will be sold units of Face
Value Rs 10.00 at a price of Rs 10.225 and in respect of existing fund the load will be charged at
specified rates on closing NAV for the day.

Schemes according to Investment Objective

A scheme can also be classified as growth scheme, income scheme, or balanced scheme considering
its investment objective. Such schemes may be open-ended or close-ended schemes as described

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earlier. Such schemes may be classified mainly as follows:

Growth / Equity Oriented Scheme

The aim of growth funds is to provide capital appreciation over the medium to long- term. Such schemes
normally invest a major part of their corpus in equities. Such funds have comparatively high risks.
Growth schemes are good for investors having a long-term outlook seeking appreciation over a period
of time.

Income / Debt Oriented Scheme

The aim of income funds is to provide regular and steady income to investors. Such schemes generally
invest in fixed income securities such as bonds, corporate debentures, Government securities and
money market instruments. Such funds are less risky compared to equity schemes. These funds are not
affected because of fluctuations in equity markets. However, opportunities of capital appreciation are
also limited in such funds. The NAVs of such funds are affected because of change in interest rates in
the country. If the interest rates fall, NAVs of such funds are likely to increase in the short run and vice
versa. However, long term investors may not bother about these fluctuations.

Balanced Fund
The aim of balanced funds is to provide both growth and regular income as such schemes invest both in
equities and fixed income securities in the proportion indicated in their offer documents. These are
appropriate for investors looking for moderate growth. They generally invest 40-60% in equity and debt
instruments. These funds are also affected because of fluctuations in share prices in the stock markets.
However, NAVs of such funds are likely to be less volatile compared to pure equity funds.

Money Market or Liquid Fund

These funds are also income funds and their aim is to provide easy liquidity, preservation of capital and
moderate income. These schemes invest exclusively in safer short-term instruments such as treasury
bills, certificates of deposit, commercial paper and inter-bank call money, government securities, etc.
Returns on these schemes fluctuate much less compared to other funds. These funds are appropriate
for corporate and individual investors as a means to park their surplus funds for short periods.

Gilt Fund
These funds invest exclusively in government securities. Government securities have no default risk.
NAVs of these schemes also fluctuate due to change in interest rates and other economic factors as is
the case with income or debt oriented schemes.

Index Funds
Index Funds are equity funds and they replicate the portfolio of a particular index such as the BSE Sensex,
S&P NSE 50 index (Nifty), etc These schemes invest in the securities in the same weightage comprising an
index. NAVs of such schemes would rise or fall in accordance with the rise or fall in the index, though not
exactly by the same percentage due to some factors known as “tracking error” in technical terms. These
funds are also called “passive funds” as not much fund management skills are involved and these funds are
expected to perform in line with the market. The expenses of fund management tend to be lower in index
funds and these funds are suitable to investors who are happy with market returns.

Exchange Traded Funds (ETF)

ETF’s are traded like stocks and thus offer more flexibility than conventional mutual funds. Investors
can purchase or sell ETF’s at real time prices as against day end NAV’s in case of open ended mutual

PDP Investment Planning 129

funds. ETF’s provide investors an opportunity to take advantage of intra day swings in the market and
can be used to hedge their long positions in the equity market. ETf’s are cheaper than even Index funds
but in the Indian market place this concept has not picked up. NIFTY Bees and UTI SUNDER are two
listed ETF’s. These are traded on very low volumes with a high spread between bid and offer prices –
higher spread increases the cost and decreases the attractiveness of the ETF.

Sectoral Funds
A mutual fund house may feel that a particular industrial sector may perform better than other sectors and
that this sector offers tremendous growth opportunities over a period of time compared to other sectors.
They may launch a sector specific fund and the funds mobilized in this scheme would be invested in equities
of companies of that sector. For example a Pharma fund will invest in equities of pharmaceutical companies
only and not in other industrial sectors. These are high risk funds and the returns can also be higher.

Thematic Funds
A fund house may feel that some sectors as a theme may outperform other securities because of
government policies, consumer preferences, over all market conditions, etc. The fund house may launch
a thematic fund and invest the funds collected only in companies which are connected with the specific
theme. For example An infrastructure fund is not a sectoral fund as it will not fund only in one sector but
invest in companies which are involved in infrastructure – cement, steel; engineering; construction,
telecommunication, etc. These are slightly less risky compared to sectoral funds but more risk in
comparison with diversified equity funds. Funds classified on the lines of market caps like Small Cap
Fund; Mid Cap Fund or Large Cap funds can also be considered as thematic where the theme is
“market capitalization”.

Offshore funds
Indian mutual funds have been permitted to invest overseas. Some mutual fund houses have already
launched schemes which seek to invest a certain percentage of their corpus in foreign companies which
are listed and traded outside India. These funds are unique in that they offer diversification across
geographies, for the first time, to Indian investors.

Commodity Funds
These funds make investments in different commodities directly or through commodities futures contracts
and also invest shares of companies dealing in commodities. Typically they must invest in one commodity
or a diversified set of commodities – A gold fund invests only in gold whereas a metal fund may invest in
precious metals and base metals like gold, silver, platinum, copper, nickel, zinc, etc. These funds serve
the purpose of diversification across asset classes as direct investments by retail investors in commodities
is virtually impossible due to various physical constraints.

Real Estate Funds

These funds invest in properties directly or indirectly by lending to real estate developers or buying
shares of real estate and/or housing finance companies which are expected to benefit from real estate
boom. Mutual funds in India are all set real estate funds as the norms have been cleared recently by
SEBI. Retail investors can take advantage of real estate boom through this indirect investment in real
estate even on a lower capital.

Tax Saving Funds

Equity linked Saving Schemes of mutual funds with a lock in period of 3 years come with a tax benefit
also. Investments in these schemes qualify for deduction u/s 80C of the Income Tax Act within the

130 Investment Planning PDP

overall ceiling of Rs. 1,00,000/-. Many fund houses have launched ELSS and these funds have rewarded
the investors handsomely. These schemes tend to get open ended after the initial lock in period of 3
years for the investors.
Approved pension plans of mutual funds also enjoy tax benefit u/s 80C of the Income Tax Act. Pension
funds designed by UTI mutual fund called “Retirement benefit plan” and that of Templeton Investments
called ‘Templeton India Pension Plan” are basically balanced funds where the investors tend to save income
tax at the time of investment – these plans are suitable to long term investors who would like to take
moderate risk as against high risk in ELSS tax saving plans. The lock in period is 3 years but mutual funds
have fixed age limits for entry as well for getting pension – as these plans are retirement plans in nature.

Expenses charged by mutual funds

Mutual fund investors in India tend to assess a fund’s performance based only on the NAV basis. The first
and last question on their minds is ‘what returns has the fund given?’ Rarely, if ever, do they ask questions
like ‘how much is the fund charging me? What goes into the expenses? Is it possible for the fund house to
lower the expenses?’ The returns to the investor can sometimes change substantially through lower expenses
charged by the AMCs especially in debt funds or under-performing equity markets.
Mutual funds charge 3 kinds of expenses to the funds:

1. Initial issue expenses

2. Investment management and advisory fees charged by AMC
3. Recurring expenses marketing and selling expenses, audit fees, custodial charges, Trustee fees, etc.
Initial issue expenses were allowed to the extent of 6% of funds mobilized and these expenses were
allowed to be charged to the fund over a period of 5 years. These expenses were being charged over
a period of time and are typically borne by investors who stay invested and not by some initial investors
who might have redeemed and exited the fund in a short span of time. This provision had the effect of
penalizing long term investors and was proving beneficial to short term investors. It has been recently
amended by SEBI – now open ended funds can not charge issue expenses to the fund separately over
a period of time and the initial expenses will be part of the recurring expenses permitted to be incurred
by them as well as entry load, if any. However close ended funds can charge initial issue expenses as
per prescribed maximum limit of 6% and amortize the same over the term of the plan and charge the
same to the investors exiting the funds as entry load before the end of the term for which the fund will
remain close ended.

Investment management charges

Fund management expenses for equity funds

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Fund management expenses for “No Load’ equity funds

The percentage is computed on weekly average net assets managed by the AMC.
Total expenses that can be charged to the funds are subject to the following ceilings:
Total expenses permitted on equity funds
Average weekly Net Assets

Valuation of mutual funds

Mutual funds are required to declare their NAV’s on daily/weekly basis. The reported NAV is a function
of valuation of underlying securities and therefore it is relevant to know how a mutual fund should value
their securities. SEBI has issued guidelines regarding valuations of assets held.
Valuation of traded securities: The closing price on the stock exchange where it is mainly traded is taken
for valuation purpose. If it is not traded on a given date the value of the previous day is used.
Valuation of non-traded securities: Where a security is not traded on any stock exchange for 60 days or
more prior to valuation date, it is treated as “Non Traded security”. Such a security will be valued “in
good faith” on the basis of appropriate valuation method, which shall be periodically evaluated by the
trustees and reported by Auditors as fair and reasonable.
Debt instruments and Government securities are valued on a Yield to maturity basis with adequate
discounts for illiquidity, if any, in respect of a given security.
Many Money market instruments are valued at cost plus accrual basis and some instruments, of medium
term, at current yield basis.

Taxation of mutual funds

Income earned by mutual funds is tax free u/s 10 (23D) of the Income Tax Act.

Taxation of investors

Equity Oriented funds

Equity oriented funds are growth funds, equity funds; derivative funds, etc. where 65% or more of the
total corpus has been invested in equities. Previously this limit was 50%.

132 Investment Planning PDP

Dividends distributed by these funds are tax free in the hands of the investor u/s 10 (35) of the Income
Tax Act. The mutual fund is also not required to pay any Dividend Distribution Tax.
Taxation on equity oriented funds of different entities:

STCG indicates Short Term Capital gains made on selling the equity-oriented fund within one year of
LTCG – Long Term Capital Gains made on selling the equity oriented fund after having held it for one
year or more from the date of purchase. This is applicable to all equity oriented funds including close
ended funds
DDT – Dividend Distribution Tax payable by the mutual fund

Other than equity oriented funds

Where STCG – indicates short term capital gain wherein the mutual fund has been sold within one year
of purchase.
LTCG* – Long Term Capital Gain, where the mutual fund has been sold after a holding period of 1 year
or more – 10% tax is payable without indexation or 20% with indexation.
DDT – dividend distribution tax is payable on the amount of dividend to be distributed – the rate of
taxation depends on the identity of the investor and class of assets held under fund management.
Dividends of Non equity funds are also tax free in the hands of investor but dividend distribution tax is
payable by the mutual funds. It may be noted that DDT impacts the return to the investor indirectly
because DDT is paid out of the funds thereby affecting NAV of the fund.

Double Indexation Benefit

Double indexation benefit in respect of debt funds and fixed maturity plans: Investors who are risk
averse prefer debt funds. But these funds also face interest rate risk especially at a time when the

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interest rates are not stable and showing signs of moving up. Hence investors prefer to lock in their
funds in debt funds which are fixed maturity plans where the mutual funds invest the corpus in debts that
shall mature at a fixed time in future, say 18 months or 24 months or 36 months. The yield on these
bonds/government securities are typically Held to Maturity (HTM) yields and hence there is no risk of
capital loss on account of interest rate fluctuations. The investors are sure of the return that can be
expected from these FMP’s. Further indexation benefits are also available on these plans and hence the
rate of taxation is also lower.

n An investor invests in a 15 month FMP in March 2005 maturing in May 2006. If he invests Rs.
10,000/- and if the return expected FMP is about 8% p.a. he will get Rs. 11,000/- after 15 months.
n If the investor is in the 30% tax bracket even when he earns 8% p.a. on fixed income instruments
his tax adjusted yield will be only 5.6%.
n However in an FMP Rs. 1,000/- earned by him will be treated as Short Term Capital Gain and the
tax payable is 20% of the taxable capital gains after applying inflation index.
n The Inflation index for FY 2004 -2005 is applicable for purchase; which we shall assume to be 1.
Assuming inflation rate of 5% p.a. the inflation index for FY 2006-2007 will be 1.1025.
n In the given example Rs. 10,000/- has given capital appreciation of Rs. 1,000/-. The indexed cost
of acquisition works out to 10000*1.1025/1 = Rs 11,025/-
n The maturity value is Rs. 11,000/-
n Thus the taxable short term capital gains is 11000-11025 = -25 resulting in a nominal loss.
n Hence tax payable on this investment is NIL.
n The investor in this FMP has earned 8% virtually tax free because of indexation benefits.

Short term loss on Dividend Stripping

Investors used to resort to tax planning through dividend stripping in equity funds. They invested in
funds that declared a very high percentage of dividends. They used to purchase these units cum dividend
and sell them at ex dividend NAV’s almost immediately with very little market risk involvement. Thus,
these investors received tax free dividends from mutual funds and suffered notional short term capital
loss because ex dividend NAV’s used to be substantially lower compared to cum dividend NAV’s at
which the units were purchased. But now with amendment in the Income Tax act in respect of allowing
capital loss on mutual funds these planning methods have become virtually impossible. Short term
capital loss will be allowed only if the investor had bought the units at least 3 months before record date
for dividend or sold the units at least 9 months after the record date for dividend purpose. If transactions
of purchase and sale of mutual funds have been done within the period specified above resulting in
capital loss then the same will be treated as dividend stripping and actual loss, if any, in excess of
dividend amount only will be allowed as short term capital loss.

Mr. Devesh Patel buys 1000 units of a fund for Rs. 12.50 cum dividend on 10th March 2006; he receives
dividend of Rs. 2.00 per unit on 14th March 2006 and he sells the units on 15th March 2006 at a price of
Rs. 10.20. What is the short term capital loss incurred by Mr Patel for income tax purpose?
Mr. Patel has not bought 3 months prior to record date for dividend nor has he sold 9 months after the record

134 Investment Planning PDP

date for dividend. Hence short term capital loss will be limited to actual loss as per calculations given below;

Sale Value Rs. 10200

Purchase value Rs. 12500
Loss Rs. 2300
Dividend received Rs. 2000
Permitted short term Rs. 300 and not Rs. 2300
capital loss
Short term loss on bonus stripping
If a person acquires units of UTI or any mutual fund, within a period of 3 months prior to the record date
for distribution of bonus units and sells or transfers any of the originally acquired units within a period of
nine months after such record date, while retaining all or any of the bonus units, then loss, if any, arising
from such transactions shall be ignored and the amount of such loss shall be deemed to be the cost of
acquisition of the bonus units.
Wealth Tax: Ownership of units of mutual funds is not wealth as per definitions of Wealth Tax Act and
hence mutual funds are not chargeable to wealth tax.

Service standards of mutual funds

Matters of dispatch of statement of accounts, redemption cheques, etc. are promptly attended to by
Registrars who are appointed by Mutual funds for providing these services. Forms for fresh investments
are collected through the collection centres and designated banks and sent to centralized processing
offices of the Registrars.
Telephonic access: Almost all mutual funds have provided toll free numbers or customer help desk telephone
numbers in major cities to help the investors with their queries relating to their mutual fund investments.
Internet access: Mutual funds provide investors with PIN (Personal identification Number) and enable
them to watch their investments, online, through the internet. They can contact mutual funds through e
mail for various investment related services.
Transparency: SEBI has made many mandatory provisions that shall ensure that the interest of the
small investors in mutual fund is protected. Disclosure of daily NAV’s in open ended funds; weekly
NAV’s of close ended funds; Monthly fact sheets; detailed annual account statements; etc. are some
examples of transparency efforts.
Redemptions: Liquidity is a very great attraction in mutual funds. An investor in an open ended fund can
redeem his holdings partly or fully at any time without giving any notice to the mutual fund and the redemptions
in most equity funds take place on T+2 basis while in respect of debt funds it is even better at T+1 basis in
most cases. T is the day when redemption request is received before fixed hours. The additional number of
working days for actual payment of redemption is just 2 in many cases, which is extremely good from a
liquidity point of view. In respect of liquid funds; money market funds, etc. the redemptions received before
a stipulated time are made in a matter of hours – here the time is the essence.
In general, the service standards set by the mutual fund industry in India are quite high and the investors
have little to complain about.

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Types of Investment plans
Automatic Reinvestment Plans (ARP): Mutual funds generally offer Growth Plans and Dividend Plans
in their schemes. Under Dividend Plan an investor may opt for Dividend Pay Out or Dividend
Reinvestment. In growth plan no dividend distribution is made and the NAV keeps on growing. In Dividend
plan the fund may choose to declare a dividend after the NAV has appreciated substantially. Under
ARP these dividends are automatically invested in units at ex dividend NAV’s and here the number of
units keeps on increasing. Under Dividend Pay out option the investor gets cash payment of dividend.
The financial planner would be in the best position to advise the investor on which option to choose.
Systematic Investment Plan (SIP): Mutual fund investments, especially equity funds, are essentially
long term in nature. In the short term the equity funds may yield negative returns as well. Investors who
might have made lump sum investments at market peaks may feel let down by the mutual funds – It is
also our experience that mutual fund collections in equity funds are the highest around market peaks.
The retail investors cannot time the market. Further most investors receive their incomes on a monthly
basis and would be more comfortable investing on a monthly basis rather than lump sums at intervals.
To meet all these needs mutual funds offer SIP’s where the investors can invest in select funds on
systematic basis (monthly or quarterly) on pre determined dates for a pre determined period say 6
months; 1 year; 5 years and so on. Thus SIP’s serve the purpose of “Rupee Cost Averaging’ strategy in
investments and investors get much better returns without the heart burn of falling markets, in the short
term. In order to encourage SIP’s funds were not charging any loads when investors opted for this route
but now most funds treat SIP’s on par with lump sum investments regarding expenses, etc.
Systematic Withdrawal Plans (SWP): Many investors need periodic income; say on a monthly basis on
their investments. These people tend to invest in a lump sum, mainly in income funds or floating rate funds,
etc. and opt for SWP. In SWP they specify the amount and the periodicity of payments – part of the unit
holdings are redeemed automatically at prevailing NAV’s and paid to the investor as systematic withdrawal
– subject to a minimum balance to be maintained by the investor. These are convenient for retired persons.
Systematic Transfer Plans (STP): These plans are suitable for investors who would like to invest large
sums in equity funds but who do not want to time the markets. These investors prefer to park the lump
sum amounts in a debt fund/floating rate funds and opt for STP where on a periodic basis, a fixed
amount is transferred, on a specified date from Debt fund to a chosen equity fund. This serves the
advantage of SIP while the lump sum enjoys market related returns.
Mutual funds offer a variety of products to suit almost every conceivable need of the investor. The
options are so many in number that they tend to confuse the retail investor. A financial planner has a
very important role in helping the investor select the funds, plans, strategies, etc. most suitable to him,
from the point of risk profile, taxation, meeting the investment objectives, achieving financial goals, etc.

Performance of mutual funds

Investors are very keen on fund performance and the alert ones keep watching the fund performance
very frequently – even on a daily basis. Each fund is evaluated and compared with the performance of
the market and other funds in the market. The performance of a fund manager is generally evaluated on
two counts:

1. The ability to out perform the market and deliver superior returns
2. The ability to eliminate unsystematic risk through diversification.

136 Investment Planning PDP

Change in NAV is the most common performance measure used by investors. However the limitation
here is that this formula does not take into considerations the dividends distributed during the period.
Hence NAV’s of growth plans are considered for the purpose of measuring performance. Sometimes
dividend distribution is added to the difference in NAV’s to measure the performance.

Let us assume that Mr. Bose had invested Rs. 10,000/- in a new fund offer at a unit price of Rs. 10/- with
a load of 2.5%. After one year he finds that the NAV has gone up to Rs 15/-. The total returns earned by
Mr. Bose will be calculated as follows:
Unit price paid by Mr. Bose will be Rs. 10+0.25 (entry load) = Rs. 10.25
No of units allotted to him in NFO will be Rs. 10,000/10.25 = 975.61
If he sells after one year he will get 975.61*15 = 14634.15
Gains made by Mr Bose = 14634.15 – 10,000 = 4,634.15 assuming no exit load and no dividend pay out
during the one year period
Even though the NAV has gained 50% in one year the actual returns to Mr. Bose works out to 46.34%
due to the entry load.
Please remember that when funds announce on a periodic basis the returns earned over one year; two
years; three years; since inception etc. it is assumed that units have been bought at Rs. 10/- and loads
have been ignored in this calculation of performance.

Risk adjusted performance measurement

Many magazines and internet sites rank funds on the basis of performance over a given period of time.
These performances are absolute performances and the risks taken by fund managers are not taken
into consideration in this evaluation and comparison. Two funds may show same returns but their risk
characteristics could be dramatically different and these funds may perform very differently when the
market goes up or down. A useful comparison can be achieved only when risk adjusted returns are
calculated. We have dealt with measuring risk adjusted returns in earlier topics. It may be worthwhile to
recall some very important performance measures here.

Sharpe Index

RP - Rf


Rp – Return of the portfolio

Rf – Risk free return
SD – Standard Deviation of Portfolio (total risk)

Treynor Index

RP - Rf


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Beta is the measure of market risk of the portfolio
Jensen’s index = Rp –[Rf + (Rm- Rf)*B]
Rp – return on the portfolio
Rf – risk free return
Rm – Market return (Index return)
B – Beta of the portfolio

Let us try to compare two funds with the following information on returns and the risk; given that risk free
return is 8%.

Sharpe Index
Fund A = (14-8)/10 = 0.6
Fund B = (18-8)/18 = 10/18 = 0.555
Market = (12-8)/8 = 4/8 = 0.5

Treynor Index
Fund A = (14-8)/1 = 6
Fund B = (18-8)/1.5 = 6.66
Market = (12-8)/1 = 4
Jensen’s index
Fund A = 14% - [8%+(12-8)*1] = 2%
Fund B = 18% -[8%+ (12-8)*1.5] = 4%
Other performance measures
Expense ratio: The expense ratio is an indicator of the fund’s cost effectiveness and efficiency. It is
the ratio of total expenses to average net assets of the fund. Expense ratio must be evaluated from the
point of fund size, average account size and portfolio composition – equity or debt. Funds with small
corpus will have a higher expense ratio compared to a fund with a large corpus. Naturally higher
expense ratio will affect fund performance adversely. It is important to note that brokerage and
commissions on the fund’s transactions are not included in the expenses figure of the fund while
computing the expense ratio.
Income Ratio: Income ratio is defined as fund’s net investment income divided by net assets for the
period. This ratio is a useful measure for evaluating income oriented funds, particularly debt funds. This
ratio is used in conjunction with ratios like total return and expense ratios.

138 Investment Planning PDP

Benchmarking relative to market
Index Funds: An investor expects an index fund to perform in line with the market and he does not
expect the fund to out perform the bench mark index. Any difference between fund returns and the
market returns is tracking error. The lower the tracking error, the better the performance of the fund in
replicating the underlying market index.
Sectoral funds: A sector specific fund is expected to perform in line with sector index. For example a
Pharma fund should perform in line with Pharmaceutical Index. It is easier to evaluate performance
because many sector indices are available facilitating easy comparison.
Active Equity Funds: Most equity funds are actively managed. The offer document generally spells
out the relevant market index they will be bench marking their performance to. While disclosing
performance on a periodic basis fund houses give out the fund performance as well as that of the
relevant bench mark index and this facilitates easy comparison. It becomes easier for the investor to
find out the extent of under performance or out performance of the specific fund in relation to bench
mark index.
Debt Funds: Generally investors have used interest rates on term deposits with banks as bench mark
for assessing the returns on debt funds for a matching maturity. However the debt funds comprise of
corporate debt securities and/or government securities. Ideal bench marking would depend up on the
composition of debt instruments in the debt – for example A GSec Fund of GILT fund should be
benchmarked to returns on Government Securities rather than bank fixed deposits.
Money Market Funds: These funds have invested in short term instruments. Hence, performance of
money market funds is usually bench marked against the treasury bill of matching period.

Benchmarking relative to other similar mutual funds

While choosing investors have preferred to invest funds that have performed better in relation to other
funds in the same category. There is a tendency to rank funds on the basis of their past performance
over a given period of time; say 1 year; 2 years ; 3 years or 5 years and invest in top performing funds in
that category. It is important to keep track of the nature of underlying investments; investment objectives
of the funds and risk profile also while comparing different funds.

Choosing the right mutual fund

There are a large number of mutual funds. Their number is increasing day by day. The financial planner
should have clear idea of relative merits of various funds in terms of risk, returns, track record of
performance, etc.
He should have a good idea of the investment objectives of his client taking into consideration factors
like time horizon, risk appetite, return expectations, etc
Then he should arrive at an optimal mix of asset classes that would best meet the investment objectives.
Based on these factors and his evaluation of performance of funds he should suggest a portfolio of
funds that will add value, over time, through strategic asset allocation.
The real skill of a financial planner is in first arriving at a good mix of investment options and then
selecting the best funds that would deliver the desired results.

Latest changes in mutual fund industry

Only close-ended schemes will be allowed to charge initial issue expenses from investors. Even here,
when a close-ended scheme is amortizing such expenses over a period, if an investor somehow exits

PDP Investment Planning 139

the scheme before such amortization is complete, the remaining part of the expenses attributable to him
must be recovered from him; which is done through gradually reducing exit loads.
This is a positive move and will prevent the likelihood of shifting the burden of expenses from one
investor to another. Till now, open-ended schemes were also allowed to amortize the expenses and if a
significant part of the investors of an NFO redeemed their units, this had the potential to increase the
burden of the initial issue expenses upon the remaining investors tremendously. But with the new
regulation, that will no longer be the case and the expenses will be rightfully borne by the person who is
supposed to pay them.
In another amendment, SEBI has standardized the process of declaring and distributing dividends.
Among other guidelines related to the communication of dividend distribution, SEBI has stated that the
notice of dividend should be issued by the AMC within one day of the decision by the trustees to
distribute the dividend. Further, the record date for such dividend should be 5 days from the issuance
of the notice. Before the issuance of notice, no communication indicating the probable date of the
dividend declaration should be made.
It has been observed over years that New fund offers manage to collect substantial subscription during
the NFO period while existing funds with very good track record do not manage to collect additional
investments at the same rate, Hence fund houses have developed tendencies to come out with NFO’s
to boost the Assets Under Management (AUM). SEBI has stipulated that a mutual fund may come out
with NFO’s only if the new fund has something new to offer to the investors and the investment objectives
are unique and different from the funds already managed by the fund house. SEBI has placed the
responsibilities on Trustees of mutual fund that they should declare that the NFO is new in terms of its
investment objective and does not in any way replicate the existing funds of the mutual fund.
Mutual fund industry has recorded tremendous growth over the last few years. It is expected to maintain
the growth rate in future. A look at the following figures will prove the popularity of mutual funds in India.

Investors seem to prefer mutual funds compared to other investment vehicles – that is obvious from the
fact that total assets under management of mutual funds have gone up by a whopping 225% over a
period 3 ¼ years. Investors are willing to take more risk for the sake of higher returns as evidenced from
the fact that equity funds account for 31% of total AUM of mutual funds as on 31st July 2006 compared
to just 11.21% in April 2003.

140 Investment Planning PDP

Review Questions:
1. How many units will be allotted to Mr. Chaturvedi if he invests Rs. 1 lakh in a New Fund offer of an
equity fund, which charges entry load of 2.25%?
a. 10,000 units
b. 9779.951 units
c. 9756.098 units
d. 9779 units
2. The risk measure used for calculating Treynor Index is:
a. Alpha
b. Variance
c. Beta
d. Standard Deviation
3. Which of the following is a self regulatory organization in mutual fund industry?
c. RBI
d. Company Law Board
4. Which one among following funds can be considered riskier than the others?
a. Debt Funds
b. Index Fund
c. Diversified equity fund
d. Sector specific equity fund
5. Which one of the following statements is not true about mutual funds?
a. Mutual fund can lend securities
b. Mutual fund can trade in derivatives
c. Mutual fund can invest in foreign equities
d. Mutual fund can lend money to unit holders
6. While seeking SEBI approval for new funds which of the following is required to give a declaration
that the new fund is unique in its investment objectives?
a. Directors of Asset Management Company
b. Directors of Sponsor Company
c. Registrars
d. Trustees
7. Initial issue expenses, not exceeding 6% of funds collected, can be amortized in the subsequent
years, in the following cases only:
a. Close ended funds
b. Open ended equity funds
c. Open ended debt funds
d. Exchange Traded Funds.

PDP Investment Planning 141

8. In respect of index funds the difference between fund performance and the market performance
is called:
a. Under performance of the fund
b. Out performance of the fund
c. Tracking error
d. Superior returns over market returns
9. Which of the following is the best measure of a fund performance?
a. NAV related performance over the period
b. Risk adjusted performance
c. Absolute returns in comparison with bank deposits
d. Absolute returns in comparison with risk free returns
10. In respect of a “No load fund” which one of the statements is not true?
a. Asset management, custodial, registrar and administrative and selling expenses are not charged
to the fund
b. Asset management and other recurring expenses are charged to the fund
c. “No load” funds are permitted to charge higher fund management expenses compared to
“Load funds”
d. No load refers to the entry load at the time of NFO – the units are allotted at par to the NFO unit

1. b
2. c
3. b
4. d
5. d
6. d
7. a
8. c
9. b
10. a

142 Investment Planning PDP

Chapter 11

PDP Investment Planning 143

Stock market investments

O ne of the most important asset classes is equity shares. In a client’s portfolio the equity investments
– direct and indirect form an essential component. We have discussed indirect equity investments
through the mutual fund route. We shall now deal with direct investments in shares. An investor has the
choice between primary and secondary markets to invest in stocks.

Primary market
Certain eligible companies may tap the capital market for their capital requirements. Eligibility criteria
have been laid down by SEBI – the capital market regulator, and discussed in this chapter elsewhere.
The eligible companies who need funds approach SEBI registered Merchant Bankers for tapping the
capital market. The merchant bankers advise the company on matters of regulation, compliance with
statues, marketing, pricing, timing and other issues which are of vital importance. Where the issue size
is large companies prefer to appoint more than one merchant banker for this purpose – with specific
functions. As per the advice of the merchant banker a company may choose to issue shares with fixed
price or a price band where the price will be discovered in a book building process. The company may
be entering the capital market for the first time where upon its shares are to be listed on the stock
exchanges – such an issue is called Initial Public Offering (IPO). An existing listed company may come
out with a subsequent issue to raise capital and such an issue is called “Follow on Public Offering (FPO)
Fixed price issues: These are issues where a company enters the capital market and invites subscription
from the public to its issue of equity capital at a fixed price – at par or at a premium. Fixed price issues
was the norm until some years ago, especially before the book building concept was introduced in India
but now we find more and more companies adopting the book building route to raise capital.
Book building issues: Here the companies announce a price band for the issue and the investors can
exercise their options in the application and bid for the same at whatever price they are prepared to pay
for the issue – but within the price band. The price band essentially consist of two prices the floor price
and the cap price. The difference between the two cannot be more than 20%. In case of an FPO the
listed company can announce the price band just a day before the issue opens for subscription while in
the case of IPO’s the price bands are mentioned in the application form itself.
The bid lots are also decided by the issuer. Essentially a person applying for a book building offer of
shares shall bid in multiples of prescribed lot sizes and within the price band. The bidder can make three
bids in the prescribed application form and can also revise or withdraw his bid before the close of the
offer. Here the investor has the freedom to decide the price at which he shall be interested, of course
within a band. Individuals in single or joint names, HUF’s, Body Corporate, Banks and Financial Institutions,
Mutual funds, Non Resident Indians, Insurance Companies, Venture capital funds and others can apply
for the issues. In order to present a level playing field for the small investors SEBI has stipulated that a
certain minimum percentage of the issued shares should be reserved for allotment to “Retail Individual
Investors” in case of over subscription of the issue. The reservation for retail individual investors is 35%
of the net public offer and in the event of the issue getting oversubscribed it should be ensured that at
least 35% of the shares are allotted to retail individual investors. ‘Retail individual investor’ means an

144 Investment Planning PDP

investor who applies or bids for securities of or for a value of not more than Rs.1,00,000 The allocation
for non institutional investors, who are not retail investors, the reservation is 15% and the reservation for
qualified institutional bidders (QIB) the reservation is 50%.
Subscription list for public issues shall be kept open for at least 3 working days and not more than 10
working days. In case of Book built issues, the minimum and maximum period for which bidding will be
open is 3–7 working days extendable by 3 days in case of a revision in the price band. The public issue
made by an infrastructure company may be kept open for a maximum period of 21 working days. Rights
issues shall be kept open for at least 30 days and not more than 60 days – “rights” issues are issues of
companies to raise further capital but only existing share holders of the company are entitled to apply for
the same; the rights can be renounced by an existing share holder, in which case the renouncee gets
the right to apply for the shares. The retail investor can tender his bids at the specified centres where his
bids will be accepted and registered in the book. Many broking houses have provided facilities for
applying to an IPO/FPO through the internet; applications can be made online also.
One of the important advantages is, book building is a transparent process and while the book is open
it is easy for the potential investor to know the details of bids already received; the prices at which the
bids have been made; extent of subscription in relation to the issue size (over subscription or under
subscription levels) etc. Many times the extent of subscription already received and the quantum of
institutional participation influence investor decisions. After the book is closed the price of the issue is
discovered. If the issue is over subscribed, at the cap price, then it is up to the company (in consultation
with the Book Running Lead Manager) to decide the price at which shares would be allotted. Many
times it is done at the cap price but some times it is even done at prices lower than the cap price. The
shares can be allotted at discounts in relation to the discovered price for the retail individual investors –
some public sector companies which came out with issues offered shares to retail individual investors at
discount to the discovered price. Even if a person has bid at prices higher than discovered price the
person will be allotted at discovered price only and not at the highest bid price.
In case of fixed price issues, the investor is intimated about the allotment/refund within 30 days of the
closure of the issue. In case of book built issues, the basis of allotment is finalized by the Book Running
lead Managers within 2 weeks from the date of closure of the issue. The registrar then ensures that the
demat credit or refund as applicable is completed within 15 days of the closure of the issue. The listing
on the stock exchanges is done within 7 days from the finalization of the issue. Banks offer to lend to the
investor in select IPO’s in which case the investor pays only the margin money, of about 40%, while the
bank pays the balance and puts in the application – thus leveraging is possible while applying to IPO/
FPO’s with attendant risks and costs.
Some investors traditionally have preferred to invest in stocks through the IPO/FPO route only. These
investors believe that this process is less risky. It is a well established fact that IPO’s are more risky
because the availability of information to the investing public compared to existing listed companies is
much lower in IPO’s. Decisions based purely on information provided in the offer document (the
prospectus) can prove to be tricky when the pricing is free. It is less risky to invest in an existing listed
company because price history and performance history can be studied, in detail, whereas that does not
happen to be the case in IPO’s. It is also true that issuers price the issue in such a way that they “leave
something on the table” for the IPO investors. But it is not the case all the time. Hence investors should
study the offer documents carefully; understand the pricing and the future potential of the company very
well before deciding to apply in a public issue of shares.

PDP Investment Planning 145

Secondary market

Client registration
An investor can invest in shares through the secondary market. He can invest in a stock which is already
listed in one of the stock exchanges. In India there are 23 stock exchanges but only two of them are
most important viz. National Stock Exchange (NSE) and The Stock Exchange, Mumbai (BSE). Investors
who would like to buy or sell shares directly from the market will have to register themselves as clients
with brokers or sub brokers. Brokers are members of stock exchanges while sub brokers work under a
specific broker – both should be SEBI registered Stock market intermediaries.
It is mandatory for the market participant to get the full details of the client in a format prescribed by SEBI
called KYC – Know Your Client. Personal information of the client is obtained in this specified format and
proof of the supplied information like residence proof, personal identity proof, Income Tax PAN details,
demat account and bank account details, etc. are taken along with duly filled KYC form. Then the client
and broker enter into an agreement – in the format prescribed by SEBI for this purpose. Thereafter the
client is registered with the market participant and allotted a unique client ID. Now the client can trade on
the stock exchange through the broker/sub broker.

There are basically two trading mechanisms adopted by stock exchanges the world over to provide
liquidity to investors. The two mechanisms are:

n Quote Driven Mechanism of Trading &

n Order Driven Mechanism of Trading
Quote Driven Mechanism is adopted by less liquid and emerging stock exchanges where trading requires
some stock brokers to provide two-way quotes. These liquidity providers, who trade on their own account,
are called market makers or specialists or jobbers (in India). This is a less efficient mechanism because
the price spread between bid and offer tends to be high thanks to lower liquidity and less competition.
This mechanism is generally adopted in stock exchanges where trading is done on the floor of the
exchange on a face to face basis. In India this was the mechanism adopted by BSE for more than a
century before moving over to the more efficient Order Driven Mechanism of trading in line with newer
National Stock Exchange. In India, now on both NSE and BSE we follow the Order Driven Mechanism
of trading where the trader places his order through his broker’s trading terminal. The trader is also
allowed to trade on the internet and he can place his orders on a particular stock exchange through the
internet by special trading facilities provided by the stock broker.
The order placed by the registered client is accepted first by the broker - the acceptance is subject to the
order meeting certain requirements in terms of trading limits set for the client (based on the margin lying
with the broker), etc. Then the order goes into the trading system of the stock exchange and gets
stacked on a time price priority basis. It is mandatory that the order entered in the system is clearly
identifiable to the specific client through the usage of unique client ID. The order will get executed if the
price condition, if any, specified by the trader, is met.

Types of orders
Market order – the trader decides to buy or sell a particular scrip at the current market price; he can
place a market price order; such orders get executed instantly at prices close to the last traded price –
but it is difficult to estimate the price at which the order will be executed, as the price keeps changing
very fast with time.

146 Investment Planning PDP

Limit Order – The trader would place a buy order at a price lower than the last traded price or a sale
order at a price higher than the last traded price for a particular stock.
Stop Loss Order – This type of order enables the trader to limit his loss or protect his profits. This order
enters the system on a trade being executed at a particular price, called trigger price. The trigger price
should be higher than current market price for buying orders and lower than market price for selling
orders. Technical traders and day traders use Stop Loss Order facility more frequently.
Disclosed Quantity – There is a facility in the trading system that while placing an order for sale or
purchase the quantity disclosed in the trading system could be lower than the actual size of the order –
the maximum possible reduction in this type of stipulation is 90% - In other words, if somebody wants to
buy 1000 shares of a scrip he can use DQ facility and specify that quantity that should be shown in the
system – but the specified quantity in this case should be 100 shares or more - which is 10% or more of
the actual order size.
All the orders placed in the system are day orders – valid for the day and all pending orders get
automatically cancelled at the end of the day.
An order once placed in the system can be modified or cancelled any time before execution. Modification
in factors like quantity, price, etc. are permitted but client code modifications are not allowed – an order
with a wrong client code will have to be cancelled.

Risk management
Brokers are required to have Base Minimum Capital (BMC) with the respective stock exchanges. Brokers
also bring in additional capital over and above the BMC in the form of cash, bank fixed deposits and/or
securities. The brokers are set intra day trading limits, called Gross Exposure (GE) based on the total
margin money lying with the stock exchanges. The extent of trading a broker can do is a function of his
capital – thus restricting over trading and over exposures – as the first containment measure. Similarly,
the net exposure of any broker, at any point in time is also limited to a certain times his capital. The
brokers also take margin money from active clients along the same principles of restricting exposures
beyond certain times the margin thus controlling the speculation and reducing the risk. SEBI has laid
down mandatory rules for brokers to collect margins from clients who trade in volumes beyond some
minimum limits – currently collection of client margins is compulsory if a client at any point in time has
net outstanding positions in excess of Rs 5 lacs (unless the same is to result in delivery) and the margin
should be at least 10% of net outstanding position. Stock exchanges also collect VaR and M2M margins
on the outstanding positions – VaR – value at risk and M2M – mark to market margins. The extent of
margins may vary and generally tends to increase as the market gets more and more volatile.

Pay in and pay out, settlements, etc.

Both NSE and BSE follow rolling settlement system as against fixed period settlements which were
followed earlier. Each day’s obligations are settled independently and not clubbed with any other day’s
positions to arrive at settlement’s net obligations for each broker.
It is a matter of compliance of SEBI regulation that a broker issues confirmation of day’s trades to a
client in a specified format. This contract note should carry the trade details like Order Number, Trade
Number, Trade Time, Scrip Name, whether bought or sold, the quantity, Market rate, brokerage, net
rate along with all details of the client, his code number, address, PAN number, settlements details, etc.
It is also mandatory that the broker should issue contract note to the client within 24 hours of the end of
day of trade and should obtain client’s confirmation on the duplicate copy. Brokers may send contracts
by post or through courier but should maintain proof that the same were dispatched within the stipulated

PDP Investment Planning 147

time. Electronic mailing of contracts shall also serve the purpose but the same also should be done
within the time limit of 24 hours.
Brokers collect the payments from clients who might have bought shares (pay in obligations) and credit
the same in Brokers’ account exclusive marked for client transactions. Brokers use the funds in the
clients accounts to meet Pay in obligations to the stock exchange through another account called Clearing
Account. The funds pay in is done before specified hours on T+2 basis – that is within two working days,
before stipulated hours, after trading day (T).
Similarly securities pay in for shares sold by clients is also required to be made before a specified time
on T+2 basis – through the pool account of the broker maintained for meeting clearing obligations. Thus
funds pay in and securities pay in take place on T+2 basis but in the early part of the day.
Pay out of funds and securities are made on T+2 basis and the funds and securities are credited to
brokers’ accounts at the later half of 2nd working day after the trade day.
It may be worthwhile to know that a broker is required to make payments to a client who might have sold
shares within 48 hours of pay out day – in other words the trade takes place on trade day (T), broker
receives payments/deliveries 2 days later (T+2) and client should receive payments/deliveries within 48
hours of T+2.
It is important for a stock market investor to know his duties to the brokers like placing order specifically,
keeping cash margins with brokers while trading beyond certain limits, making payments/delivering
securities with in the prescribed time limit and also his rights to receive contracts, payments/securities
within the SEBI stipulated time frame. We may add here that each stock exchange has provided means
by which a client can verify the trade on the same day from the web site of the stock exchange concerned. and
A broker can not charge brokerage in excess of 2.5% of the market price of stock bought or sold. A
broker may charge all other charges over and above the brokerage. These charges include Service Tax
on brokerage which is currently 12.36% (including education cess of 3%), Regulatory charges, Stamp
duty & Securities Transaction Tax. STT is currently 0.125% of turn over on delivery based trades;
0.025% of turn over of all non delivery trades in the cash segment and 0.017% of turn over of all non
delivery trades in the derivatives segment.

Corporate benefits
Companies declare book closure or record dates for determining eligibility for corporate benefits like
dividend, bonus, rights entitlements, stock splits, etc. On the stock exchanges the stocks remain cum
dividend, cum bonus or cum rights up to a certain date and all investors who buy the particular stock on
or before this specific date will be entitled to that corporate benefit. The next day onwards the stock
starts quoting ex dividend, ex bonus or ex rights – meaning investors who buy after these dates will not
get the respective corporate benefit; alternatively if a share holder of the company sells the stock cum
benefit he won’t be entitled to it but if sells ex benefit he shall get the benefit. The stock for some time on
the exchanges may trade on “no delivery” basis – all trades entered during the no delivery period are
clubbed and settled, on a particular day, after the end of no delivery period. In other words, the pay in
and pay out of funds and securities in respect of this particular stock which is trading on a no delivery
basis is delayed to the extent of no delivery period and settled together, at a later date.

Types of securities
Equity shares – the most common form of securities ; (the conventional stock or common stock or

148 Investment Planning PDP

ordinary share) is the equity share issued by a company and the investors in equity shares are owners
of the company to the extent of their share holding. These share holders are entitled to dividend and
other benefits declared by the company and are also entitled to vote. Companies may issue shares
without voting rights also. Normally the shares traded are fully paid up but in certain cases partly paid
shares are also listed and traded on the stock exchanges.
Convertible debentures: A company may choose to issue debentures which could be converted partly
or fully into equity shares at a later date. These securities are also listed and traded on the stock exchanges.
Warrants are essentially issued to share holders and the holder of the warrant will be able to exercise
his right to purchase shares of the company at a future date. Till the prescribed date for exercising the
rights to additional shares these warrants are also traded on the stock exchanges.
Preference shares can also be issued by a company. This is a not a popular instrument with the stock
market investors because this is essentially a fixed income instrument with no scope for capital
Bonus Shares: Companies reward the share holder by issuing bonus shares. Bonus shares are free
shares distributed by the company to its share holders, as on a given date, in a proportion which is
decided by the board and approved by the share holders and subject to certain limits, as prescribed by
SEBI in this regard. A 1:1 bonus implies that a share holder having 100 shares will get another 100
shares free of cost ; similarly a 2:3 bonus implies that a share holder having 3 shares will get 2 bonus
shares. As a point of valuation a bonus per se does not add value to share holders because the price of
the stock adjusts for the bonus shares after the same are issued. However, a bonus declaration is a
signal, to the market, from the company management that they are very confident about their future
performance and that they will be able to service the expanded capital. In the market place it is common
to find that companies that reward the share holders with frequent bonuses get better valuations compared
to similar but conservative companies.
Rights Shares – Issue of additional shares to existing share holders to raise capital is called Rights Issue.
The difference is that compared to bonus shares which are issued free here the share holder has to pay a
price for getting additional shares – the price could be market related and may be at a discount to the market
price of the stock. If the company issues rights shares to raise money for expansion/modernization/new
acquisitions, etc then that is considered quite positive. It may be worth while to understand how the market
price gets adjusted for rights issues when trading on cum right and ex right basis.

Let’s assume the cum rights price to be Rs. 200
Rights in the ratio of 1:2 at a price of Rs. 110
The ex rights price will be calculated as under:
1:2 means one share will be offered on two shares already held
Two shares cum rights will cost 2*200 = 400 ; no of cum right shares 2
One rights share will cost = 110 ; no of right shares 1
Total cost =510; no of ex right shares 3
The price per share ex rights = 510/3 = 170/-
Thus the stock will start quoting at an ex right price of Rs 170 if it closed at cum right price of Rs. 200/-
on the above terms.

PDP Investment Planning 149

Stock splits: Normally the nominal value or the face value of a share is Rs. 10/- but a company may
choose to have the face value as Rs. 5 or Rs. 4 or Rs. 2 or even Re 1. Companies with low floating stock
and/or companies whose shares are highly priced and not traded in huge volumes on the stock exchange
may consider reducing the face value and increasing the number of shares. The stock splits does not
necessarily result in value addition to the investor but all the same it improves the liquidity and invariably
leads to better prices on the market place.
If a share holder is holding 100 shares of a company – FV Rs 10/- and the company announces a stock
split of 5:1; then the number of stocks held by the investor will rise 5 fold to 500 while the face value will
come down to Rs. 2/- and the market price will come down ex split to one fifth of cum split price. This is
considered an investor friendly move and such companies command better valuations on the market.

Valuation of shares
It is very important to understand how the shares are valued on the stock exchanges. Investors would
like to buy “under-valued” stocks and sell ‘over-valued’ stocks held by them. It is easier said than done.
To label a stock at a price as under-valued or over-valued requires an understanding of valuation of
shares. Many methods are followed for valuing shares. Let us look at a few of them.

Dividend discount model

One of the widely followed valuation models is the dividend discount model. According to this model the
present value of the share will be equal to the present value of the dividend and the expected sale price
of the stock.
Let us begin with the case where the investor expects to hold the equity share for one year. The price of
the equity share will be;

P0 = current price of the equity share
D1 = dividend expected a year hence
P1 = price of the share expected a year hence
r = rate of the return required on the equity share
the underlying assumptions are the dividend of D1 will be paid at the end of the year and the share can
be sold after one year at a price P1

If an investor expects to receive a dividend of 2.50 per share and year end price to be Rs. 150 and
needs a return of 15% p.a. on his share investment at what price should he buy this share?

here D1 = 2.5; P1 is 150 and r = 0.15

then P0 = [2.5(1+0.15)]+ [150(1+0.15)] = (1.5/1.15) + (150/1.15)
= 2.173 +130.43 = 132.60

150 Investment Planning PDP

We have considered for a single period of one year; we can extend the same to multi periods where the
present value of each year’s dividend will be discounted at the required rate of return and so will be the
sale price at the end of the period.
Stock prices and dividends have a tendency to grow over a period of time; we can factor in these growth
rates in our calculation of share value:
If the current price, P0, becomes P0 (1+g) a year hence, for g the rate of growth, we get:

Simplifying the above equation we get:

The steps in simplification are:

The dividend paid out by a company has been growing at the rate of 10% p.a. over the last few years.
The next year’s dividend is expected to be Rs. 2/- per share. The expected return is 16%. At what price
should we buy the stock?

We may add here that D1 is the expected dividend for the next year; given the current year’s dividend one
can work out the next year’s expected dividend by applying the rate of growth of dividends as follows:
D1 = D0*(1+g)

If a company has been currently paying dividend at the rate of Rs. 2/- per share and if the growth rate is

PDP Investment Planning 151

10% and expected return is 15% what should be present price of the share?
D1 = D0*g = 2*(1.10) = 2.20

However, this constant growth model is rarely used in the market place for valuing the stocks mainly
because it is very difficult to estimate the growth rate and that too in perpetuity.

Earnings Multiplier Approach

Another and more popular approach to stock valuation is the earnings multiplier approach. Price to
earnings ratio is calculated as follows:
P/E ratio = Market Price /EPS
Where EPS is = Profit After Tax/No. of shares
Market Price/PE ratio is the P/E multiple for the stock.
P0 = E1 * (P0/E1)
P0 is the estimated price
E1 is the estimated EPS &
P0/E1 is the reasonable P/E ratio
The P/E ratio can be worked out as follows on the basis of dividend discounting model:

where b is the plough back ratio or the proportion of retained profits out of total profits, r the required rate
of return and g the growth rate, (1-b) is the dividend pay out ratio.
Thus the P/E multiple of a stock price is directly proportional to the dividends distributed by the company.
Another factor that influences the P/E ratio is the interest rate. The required rate of return on securities
including stock as the interest rates rise. When the interest rate rises security prices will fall. The relation
between interest rates and P/E ratios is inverse.
Riskier stocks have lower P/E multiples. Riskier a stock the higher the returns expectations and hence
lower the P/E ratio. This is typically true in the market place of mid cap and small cap stocks; these are
high risk stocks and tend to trade at lower P/E multiples compared to large cap stocks because the
return expectations from mid cap and small cap stocks are higher.
P/E multiplier is a very common tool used for value purposes and we can summarise how the price
projections are done for stock valuations, as follows:

1. Estimate the EPS for the current financial year based on company’s past track record, statements
regarding future out look, orders on hand, market price trends for the product, reported profits for
the completed quarters, etc. This is a very highly skilled job and many researchers keep on estimating
and revising, on a periodic basis because of the numerous elements involved.

152 Investment Planning PDP

2. Find out the growth rate of earnings – based on track record and other factors listed above
3. Find out the average P/E ratio of other comparable companies in the industry
4. Find out the historic P/E ratio at which this stock has been quoting
5. Arrive at a reasonable multiple for this stock based on the industry average and this stock’s own
P/E in the past; one of the thumb rules for a reasonable P/E ratio is the growth rate of EPS,
worked out in step 2 above – if the EPS grows at 20% p.a. a P/E ratio of 20 is reasonable
6. Multiply the P/E multiple arrived in step 5 by earnings estimated in step 1 to arrive at the projected
price for the stock at the end of the year.
n An investor can reach his decision on buying/holding/selling the stock based on the following
n Current market price
n Required return
n Estimated market price at the year end, as worked out above
If the estimated market price is greater than or equal to (Current market price*required return) then it is
worth buying the stock ; but if it is estimated to be less then buying can be avoided.
The valuations are much more complex than as listed above because the crucial factors of earnings
projections and the multiples are influenced by various events some of which could be emotional rather
than rational.

Other Valuation Techniques

Investors use other valuation techniques, based on fundamental analysis concepts. Three that are fairly
often referred to are price to book value, price/sales ratio and economic value added. Price to book
value is calculated as the ratio of price to stockholders’ equity as measured on the balance sheet. It is
sometimes used to value companies, particularly financial companies. Banks have often been evaluated
using this ratio because the assets of banks have book values and market values that are similar. If the
value of this ratio is 1.0, the market price is equal to the accounting (book) value. It is also used in
merger and acquisition analysis.
The price/sales ratio is a valuation technique that has received increased attention recently. This ratio is
calculated as a company’s total market value (price times number of shares) divided by it sales, In
effect, it indicates what the market is willing to pay for a firm’s revenues.
The newest technique for evaluating stocks is to calculate the economic value added, or EVA. In effect,
EVA is the difference between operating profits and a company’s true cost of capital for both debt and
equity and reflects an emphasis on return on capital. If this difference is positive, the company has
added value. Some studies have shown that stock price is more responsive to changes to EVA than to
changes in earnings, the traditional variable of importance; some mutual funds are now using EVA
analysis as the primary tool for selecting stocks for the fund to hold. One recommendation for investors
interested in this approach is to search for companies with a return of capital in excess of twenty percent
because this will in all likelihood exceed the cost of capital, and, therefore, the company is adding value.

Fundamental Analysis
Fundamental analysis is based on the premise that any security (and the market as a whole) has an
intrinsic value, or the true value as estimated by an investor. This value is a function of the firm’s underlying
variables, which combine to produce an expected return and an accompanying risk. By assessing these
fundamental determinants of the value of a security, an estimate of its intrinsic value can be determined.

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This estimated intrinsic value can then be compared to the current market price of the security. Similar
to the decision rules used for bonds, decision rules are employed for common stocks when fundamental
analysis is used to calculate intrinsic value.
In equilibrium, the current market price of a security reflects the average of the intrinsic value estimates
made by investors. An investor whose intrinsic value estimate differs from the market price is, in effect,
differing with the market consensus as to the estimate of either expected return or risk, or both. Investors
who can perform good fundamental analysis and spot discrepancies should be able to profit by acting,
before the market consensus reflects the correct information.
Fundamental analysis is based on the premise that any security (and the market as a whole) has an
intrinsic value, or the true value as estimated by an investor. This value is a function of the firm’s underlying
variables, which combine to produce an expected return and an accompanying risk. By assessing these
fundamental determinants of the value of a security, an estimate of its intrinsic value can be determined.
This estimated intrinsic value can then be compared to the current market price of the security. Similar
to the decision rules used for bonds, decision rules are employed for common stocks when fundamental
analysis is used to calculate intrinsic value.
In equilibrium, the current market price of a security reflects the average of the intrinsic value estimates
made by investors. An investor whose intrinsic value estimate differs from the market price is, in effect,
differing with the market consensus as to the estimate of either expected return or risk, or both. Investors
who can perform good fundamental analysis and spot discrepancies should be able to profit by acting,
before the market consensus reflects the correct information.
Under either of the two fundamental approaches, an investor will have to work with individual company
data. Does this mean that the investor should plunge into a study of company data first and then consider
other factors such as the industry within which a particular company operates or the state of the economy,
or should the reverse procedure be followed? In fact, each of these approaches is used by investors and
security analysts when doing fundamental analysis. These approaches are referred to as the “top-
down” approach and the “bottom-up” approach.
With the “bottom-up” approach, investors focus directly on a company’s basics, or fundamentals.
Analysis of such information as the company’s products, its competitive position, and its financial status
leads to an estimate of the company’s earnings potential, and, ultimately, its value in the market.
Considerable time and effort are required to produce the type of detailed financial analysis needed to
understand even relatively small companies. The emphasis in this approach is on finding companies
with good long-term growth prospects, and making accurate earnings estimates. To organize this effort,
bottom-up fundamental research is often broken into two categories, growth investing and value investing.
Growth stocks carry investor expectations of above-average future growth in earnings and above-
average valuations as a result of high price/ earnings ratios. Investors expect these stocks to perform
well in the future, and they are willing to pay high multiples for this expected growth.
Value stocks, on the other hand, feature cheap assets and strong balance sheets. Value investing can
be traced back to the value-investing principles laid out by the well-known Benjamin Graham, who wrote
a famous book on security analysis that has been the foundation for many subsequent security analysts.
Growth stocks and value stocks tend to be in vogue over different periods, and the advocates of each
camp prosper and suffer accordingly.
In many cases bottom-up investing does not attempt to make a clear distinction between growth and
value. Many companies feature strong earnings prospects and a strong financial base or asset value,

154 Investment Planning PDP

and therefore have characteristics associated with both categories.
The top-down approach is the opposite to the bottom-up approach. Investors begin with the economy and
the overall market, considering such important factors as interest rates and inflation. They next consider
likely industry prospects, or sectors of the economy that are likely to do particularly well (or particularly
poorly). Finally, having decided that macro factors are favourable to investing, and having determined
which parts of the overall economy are likely to perform well, individual companies are analyzed.
There is no “right” answer to which of these two approaches to follow. However, fundamental analysis
can be overwhelming in its detail, and an investor should decide which approach seems more reasonable
and try to develop a consistent method of action.

Technical analysis
Technical analysis can be defined as the use of specific market-generated data for the analysis of both
aggregate stock prices (market indices or industry averages) and individual stocks.
The technical approach to investing is essentially a reflection of the idea that prices move in trends
which are determined by the changing attitudes of investors toward a variety of economic, monetary,
political and psychological forces. The art of technical analysis - for it is an art - is to identify trend
changes at an early stage and to maintain an investment posture until the weight of the evidence indicates
that the trend is reversed.
Technical analysis is sometimes called market or internal analysis, because it utilizes the record of the
market itself to attempt to assess the demand for, and supply of, shares of a stock or the entire market.
Thus, technical analysts believe that the market itself is its own best source of data.
Technicians believe that the process by which prices adjust to new information is one of a gradual
adjustment toward a new (equilibrium) price. As the stock adjusts from its old equilibrium level to its new
level, the price tends to move in a trend. The central concern is not why the change is taking place, but
rather the very fact that it is taking place at all. Technical analysts believe that stock prices show identifiable
trends that can be exploited by investors. They seek to identify changes in the direction of a stock and
take a position in the stock to take advantage of the trend.
The following points summarize technical analysis:
Technical analysis is based on published market data and focuses on internal factors by analyzing
movements in the aggregate market, industry average, or stock. In contrast, fundamental analysis focuses
on economic and political factors, which are external to the market itself.
The focus of technical analysis is identifying changes in the direction of stock prices which tend to move
in trends as the stock price adjusts to a new equilibrium level. These trends can be analyzed, and
changes in trends detected, by studying the action of price movements and trading volume across time.
The emphasis is on likely price changes.
Technicians attempt to assess the overall situation concerning stocks by analyzing breadth indicators,
market sentiment, and momentum. Technical analysis includes the use of graphs (charts) and technical
trading rules and indicators.
Price and volume are the primary tools of the pure technical analyst, and the chart is the most important
mechanism for displaying this information. Technicians believe that the forces of supply and demand
result in particular patterns of price behavior, the most important of which is the trend or overall direction
in price. Using a chart, the technician hopes to identify trends and patterns in stock prices that provide
trading signals.

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Volume data are used to gauge the general condition in the market and to help assess its trend. The
evidence seems to suggest that rising (falling,) stock prices are usually associated with rising, (falling)
volume. If stock prices rose but volume activity did not keep pace, technicians would be skeptical about the
upward trend. An upward surge on contracting volume would be particularly suspect. A downside movement
from some pattern or holding point, accompanied by heavy volume, would be taken as a bearish sign.

Income derived from equity shares comprises dividends and capital appreciation. Dividends of Indian
companies are tax free in the hands of share holders. The companies declaring dividends are required
to pay Dividend Distribution Tax at rates prescribed from time to time; currently 12.5% + Surcharge of
5%. DDT is an indirect tax on the dividend income of the share holders.
Capital gains on shares can be classified as Short Term Capital Gains and Long Term Capital Gains. In
respect of securities listed and traded on the stock exchanges the holding period is 12 months for
determining whether the security is a long term capital asset or otherwise.
Day trading: A trader may buy and sell the shares on the same day without receiving or giving delivery
of shares. These transactions are considered speculative in nature. The income earned is taxed at the
rate applicable – say 30% if the annual income is in excess of Rs. 2,50,000/-
STCG: If a stock has been sold within 12 months of purchase the difference between selling and buying
prices will be short term capital gain. STCG is taxed at the rate of 10% & @ 15% w.e.f. from financial
year 2008-09 in respect of securities which are traded on the exchanges and where Securities Transaction
Tax has been levied on the transactions.
LTCG : Long term capital gains are tax exempt u/s 10(38), where the asset sold is a long term capital
asset, held for more than 12 months, and sold on a stock exchange where STT has been levied on the

156 Investment Planning PDP

Review Questions:
1. A company paid dividend of Rs 2.50 per share which is expected to grow at the rate of 8% p.a. If
the expected rate of return is 12% what should be current price of the stock according to the
dividend discounting model?
a. 67.50
b. 62.50
c. 70.25
d. 65.00
2. A “Stop loss order” is generally used for
a. protecting profits
b. limiting losses
c. technical reasons of support and/or resistance
d. all the three above
3. While trading on screen based trading systems which one of the following statements about
“orders” is not true?
a. Orders pending at the end of the trading day are automatically cancelled
b. Orders once placed in the system can not be modified or cancelled
c. Once an order is placed it is not possible to modify the client code
d. The quantity that would be disclosed in the system can be shown to be less than the true
quantity of the order
4. The present mechanism of trading used in NSE and BSE is
a. Quote driven mechanism of trading
b. Order driven mechanism of trading
c. Institution oriented mechanism of trading
d. Jobber oriented mechanism of trading
5. A stock is quoting at Rs 100/- cum rights. What will be the price ex rights if the company offers
rights shares in the ratio 1:2 at a price of Rs 70/ (assuming the market price is steady)?
a. 100
b. 90
c. 80
d. 70
6. A company fixes record date for bonus and stock split simultaneously. If the bonus is in the ratio
of 1:2 and the stocks to be split from FV of Rs 10 to Rs 2 and if the cum bonus and cum split price
was Rs 900 what should be the ex bonus and ex stock split price?
b. 110
c. 120
d. 300

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7. An investor received 10 bonus shares of an infotech company on 10th March 2005. The cost of
acquisition is NIL being bonus shares. He sold the bonus shares through a member of NSE, on
10th May 2006, for a price of Rs. 3200 each. What will be capital gains tax payable by the investor
on the sale?
a. Rs. 3200 + education cess
b. Rs. 6400 + education cess
c. The rate of taxation will depend upon the tax slab at which the investor is being taxed on his
total income
d. NIL – this is LTCG and hence no tax is payable
8. A company is growing at an average rate of 20% on the top and bottom lines. The current market
price is Rs. 225 while the EPS for the last year was Rs. 12. Is it advisable to buy the stock if the
required return is 18%?
a. The stock may quote at Rs. 240 after one year and hence do no buy
b. The stock may quote at Rs. 288 at a P/E of 20 on the next year’s EPS – given that the growth
rate is 20% – hence buy
c. It can not be predicted – the risks seem to be high – do not buy
d. There is no certainty that the growth rate will be maintained – the required return is very high
– do not buy
9. Interest rate has the following effect on share valuation:
a. As the interest rises the stock prices will rise
b. Interest rate rise or fall has no impact on stock prices
c. Stock market has nothing to do with interest rates
d. As the interest rate rises the stock prices tend to fall
10. Which one of the following statements regarding market capitalization and P/E multiples is true?
a. As Mid cap stocks are riskier the P/E multiple tends to be higher as compared to large cap stocks
b. As mid cap stocks are riskier the P/E multiple tends to be lower as compared to large cap stocks
c. As mid cap stocks are less risky their P/E multiples tend to be lower as compared to large cap
d. As mid cap stocks are less risky their P/E multiples tend to be higher as compared to large
cap stocks
11. The spread between floor price and cap price in respect of book built IPO’s should not exceed
a. 20%
b. 15%
c. 10%
d. No such limit

1. a 2. d 3. b 4. b 5. b 6. c
7. d 8. b 9. d 10. b 11. a

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Chapter 12

PDP Investment Planning 159


D erivatives have become very important in the field of investments. They are very important financial
instruments for risk management as they allow risks to be separated and traded. Derivatives are
used to shift risk and act as a form of insurance. This shift of risk means that each party involved in the
contract should be able to identify all the risks involved before the contract is agreed. It is also important
to remember that derivatives are derived from an underlying asset. This means that risks in trading
derivatives may change depending on what happens to the underlying asset.
A derivative is a product whose value is derived from the value of an underlying asset, index or reference
rate. The underlying asset can be equity, forex, commodity or any other asset. For example, if the
settlement price of a derivative is based on the stock price of a stock for e.g. Tata Steel which frequently
changes on a daily basis, then the derivative risks are also changing on a daily basis. This means that
derivative risks and positions must be monitored constantly.
We will try and understand

n What are derivatives?

n Why have derivatives at all?
n How are derivatives traded and used?
A derivative security can be defined as a security whose value depends on the values of other underlying
variables. Very often, the variables underlying the derivative securities are the prices of traded securities.
Let us take an example of a simple derivative contract:

n Mr. Kulkarni buys a futures contract, of 100 shares lot size

n He will make a profit of Rs. 1000 if the price of Tata Steel rises by Rs. 10
n If the price is unchanged Mr. Kulkarni will receive nothing.
n If the stock price of Tata Steel falls by Rs. 9 he will lose Rs. 900.
As we can see, the above contract depends upon the price of the Tata Steel scrip in the cash market –
referred to, in market parlance, as the spot price – the price of the security in the futures segment could
be different from cash market but it moves in line with the cash market price. Similarly, futures trading is
done on Sensex futures and Nifty futures. The underlying securities in this case are the BSE Sensex
and NSE Nifty.
Derivatives and futures are basically of 3 types:

n Forwards and Futures

n Options
n Swaps

160 Investment Planning PDP

Forward contract
A forward contract is the simplest mode of a derivative transaction. It is an agreement to buy or sell an
asset (of a specified quantity) at a certain future time for a certain price. No cash is exchanged when the
contract is entered into.

Mr. Kulkarni wants to buy a car, which costs Rs. 2,00,000 but he has no cash to buy it outright. He can only
buy it 3 months hence. He, however, fears that prices of cars will rise 3 months from now. So in order to
protect himself from the rise in prices Mr. Kulkarni enters into a contract with the car dealer that 3 months
from now he will buy the car for Rs. 2,00,000. What Mr. Kulkarni is doing is that he is locking the current
price of a car for a forward contract. The forward contract is settled at maturity. The dealer will deliver the car
to Mr. Kulkarni at the end of three months and Mr. Kulkarni in turn will pay Rs. 2,00,000/- to the car dealer
on delivery.

Mr Patel is an importer who has to make a payment for his consignment in six months time. In order to
meet his payment obligation he has to buy dollars six months from today. However, he is not sure what
the Re/$ rate will be then. In order to be sure of his expenditure he will enter into a contract with a bank
to buy dollars six months from now at a decided rate. As he is entering into a contract on a future date it
is a forward contract and the underlying security is the foreign currency.
The difference between a share and derivative is that shares/securities is an asset while derivative
instrument is a contract.
To understand the use and functioning of the index derivatives markets, it is necessary to understand
the underlying index. A stock index represents the change in value of a set of stocks, which constitute
the index. A market index is very important for the market players as it acts as a barometer for market
behavior and as an underlying in derivative instruments such as index futures.

The Sensex and Nifty

In India the most popular indices have been the BSE Sensex and S&P CNX Nifty. The BSE Sensex has
30 stocks comprising the index which are selected based on market capitalization, industry representation,
trading frequency etc. It represents 30 large well-established and financially sound companies. The
Sensex represents a broad spectrum of companies in a variety of industries. It represents 14 major
industry groups. Then there is a BSE national index and BSE 200. However, trading in index futures has
only commenced on the BSE Sensex.
While the BSE Sensex was the first stock market index in the country, Nifty was launched by the National
Stock Exchange in April 1996 taking the base of November 3, 1995. The Nifty index consists of shares
of 50 companies with each having a market capitalization of more than Rs 500 crore.

Futures and stock indices

For understanding of stock index futures a thorough knowledge of the composition of indexes is essential.
Choosing the right index is important in choosing the right contract for speculation or hedging. Since for
speculation, the volatility of the index is important whereas for hedging the choice of index depends
upon the relationship between the stocks being hedged and the characteristics of the index.
Choosing and understanding the right index is important as the movement of stock index futures is quite
similar to that of the underlying stock index. Volatility of the futures indexes is generally greater than
spot stock indexes.

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Every time an investor takes a long or short position on a stock, he also has an hidden exposure to the
Nifty or Sensex. As most often stock values fall in tune with the entire market sentiment and rise when
the market as a whole is rising.
Retail investors will find the index derivatives useful due to the high correlation of the index with their
portfolio/stock and low cost associated with using index futures for hedging.

Understanding index futures

A futures contract is an agreement between two parties to buy or sell an asset at a certain time in the
future at a certain price. Index futures are all futures contracts where the underlying is the stock index
(Nifty or Sensex) and helps a trader to take a view on the market as a whole.
Index futures permits speculation and if a trader anticipates a major rally in the market he can simply buy
a futures contract and hope for a price rise on the futures contract when the rally occurs.
We have index futures contracts based on S&P CNX Nifty and the BSE Sensex and near 3 months
duration contracts are available at all times. Each contract expires on the last Thursday of the expiry
month and simultaneously from the next day onwards a new contract is introduced for trading.

Futures contracts in Nifty in August 2006

The settlement day is the last Thursday of the month or the previous working day if last Thursday
happens to be a holiday.
The permitted lot size is 100 or multiples thereof for the Nifty. That is if you buy one Nifty contract, the
total deal value will be 100*3400 (Nifty futures price) = Rs. 3,40,000

We have seen how one can take a view on the market with the help of index futures. The other benefit
of trading in index futures is to hedge your portfolio against the risk of trading. In order to understand
how one can protect his portfolio from value erosion let us take an example.
Stocks carry two types of risk – company specific and market risk. Company specific risk can be reduced
through diversification while market risk is reduced through hedging.
Beta is the measure of market risk. Beta measures the relationship between movement of the index to
the movement of the stock. The beta measures the percentage impact on the stock prices for 1%
change in the index. Therefore, for a portfolio whose value goes down by 11% when the index goes
down by 10%, the beta would be 1.1. When the index increases by 10%, the value of the portfolio
increases 11%. The strategy of hedging is resorted to with the objective of reducing portfolio beta to
zero and reducing the market risk.
Hedging involves protecting an existing equity portfolio from future adverse price movements in the
stock market. In order to hedge the portfolio, a market player needs to take an equal and opposite

162 Investment Planning PDP

position in the futures market to the one held in the cash market. Every portfolio has a hidden exposure
to the index, which is denoted by the beta. Assuming you have a portfolio of Rs. 20 lacs, which has a
beta of 1.2, you can factor a complete hedge by selling Rs. 24 lacs of S&P CNX Nifty futures.

Steps in hedging
1. Determine the beta of the portfolio. If the beta of any stock is not known, it is safe to assume that
it is 1.
2. Short sell the index in such a quantum that the gain on a unit decrease in the index would offset the
losses on the rest of his portfolio. This is achieved by multiplying the relative volatility of the portfolio
by the market value of his holdings.
Therefore in the above scenario we have to short sell 1.2 * 20 lacs = 24 lacs worth of Nifty.
Now let us study the impact on the overall gain/loss that accrues:

As we see, that portfolio is completely insulated from any losses arising out of a fall in market sentiment.
But as a cost, one has to forego any gains that arise out of improvement in the overall sentiment. Then
why does one invest in equities if all the gains will be offset by losses in futures market. The idea is that
everyone expects his portfolio to outperform the market. Irrespective of whether the market goes up or
not, his portfolio value would increase.
The same methodology can be applied to a single stock by deriving the beta of the scrip and taking a
reverse position in the futures market.
Thus, we have seen how one can use hedging in the futures market to offset losses in the cash market.

Speculators are those who do not have any position on which they enter in futures and options market.
They only have a particular view on the market, stock, commodity etc. In short, speculators put their
money at risk in the hope of profiting from an anticipated price change. They consider various factors
such as demand supply, market positions, open interests, economic fundamentals and other data to
take their positions.

Kirit is a trader but has no time to track and analyze stocks. However, he fancies his chances in predicting
the market trend. So instead of buying different stocks he buys Nifty Futures.
On Sept 1, 2006 he buys 100 Nifty futures @ 3400 on expectations that the index will rise in future. On
Sept 16,2006 Nifty rises to 3460 and at that time he sells Nifty futures and squares his position.
Selling Price : 3460*100 = Rs. 3,46,000
Less: Purchase Cost: 3400*100 = Rs. 3,40,000

Net Gain Rs. 6,000

PDP Investment Planning 163

Kirit has made a profit of Rs. 6,000 by taking a call on the future value of the Nifty. However, if Nifty had
fallen he would have made a loss.
Similarly, if Kirit had a bearish view on the market he could have sold Nifty futures and bought the same
back after the expected market fall and made a profit from a falling market.

An arbitrageur is basically risk averse. He enters into those contracts were he can earn riskless profits.
When markets are imperfect, buying in one market and simultaneously selling in other market gives
riskless profit. Arbitrageurs are always in the look out for such imperfections.
In the futures market one can take advantages of arbitrage opportunities by buying from lower priced
market and selling at the higher priced market. In index futures arbitrage is possible between the spot
market and the futures market (NSE has provided a special software for buying all 50 Nifty stocks in the
spot market)

n Take the case of the NSE Nifty.

n Assume that Nifty is at 3400 and 3 month’s Nifty futures is at 3500.
n The futures price of Nifty futures can be worked out by taking the interest cost of 3 months into
n If there is a difference then arbitrage opportunity exists.
If we assume 8% interest rate then Nifty three months futures should be quoting at Rs. 3468 but is
actually quoting at Rs. 3500; which is higher than the correct price thus providing an arbitrageur an
opportunity – he will sell 3 months futures at 3500 and buy spot at 3400 and should make Rs 32 per Nifty
because of the difference between the actual price and the “correct price:.
These kind of imperfections continue to exist in the markets but one has to be alert to the opportunities
as they tend to get exhausted very fast.

Pricing of Index Futures

The index futures are the most popular futures contracts as they can be used in a variety of ways by
various participants in the market.

The cost of carry model

The cost-of-carry model where the price of the contract is defined as:
F Futures price
S Spot price
C Holding costs or carry costs
If F < S+C or F > S+C, arbitrage opportunities would exist i.e. whenever the futures price moves away
from the fair value, there would be chances for arbitrage.
If Nifty is quoting at Rs. 3400 and the 3 months futures of Nifty is Rs 3500 then one can purchase
Nifty at Rs. 3400 in spot by borrowing @ 8% annum for 3 months and sell Nifty futures for 3 months
at Rs. 3500.

164 Investment Planning PDP

Here F=3400+68=3468 and is less than prevailing futures price and hence there are chances of arbitrage.

Sale = 3500

Cost =3400 + 68 = 3468

Arbitrage profit = 32

However, one has to remember that the components of holding cost vary with contracts on different

Futures pricing in case of dividend yield

We have seen how we have to consider the cost of finance to arrive at the futures index value. However,
the cost of finance has to be adjusted for benefits of dividends and interest income. In the case of equity
futures, the holding cost is the cost of financing minus the dividend returns.

Suppose a stock portfolio has a value of Rs. 100 and has an annual dividend yield of 3% which is
earned throughout the year and finance rate =12% the fair value of the stock index portfolio after one
year will be
F= Rs. 100 + Rs. 100 * (0.12 – 0.03)
Futures price = Rs. 109
If the actual futures price of one-year contract is Rs. 112. An arbitrageur can buy the stock at Rs. 100,
borrowing the fund at the rate of 12% and simultaneously sell futures at Rs. 112. At the end of the year,
the arbitrageur would collect Rs. 3 for dividends, deliver the stock portfolio at Rs 112 and repay the loan
of Rs. 100 and interest of Rs. 12.
The net profit would be Rs. 112 + Rs. 3 - Rs. 100 - Rs. 12 = Rs. 3
Thus, we can arrive at the fair value in the case of dividend yield.

Trading strategies

We have seen earlier that trading in index futures helps in taking a view of the market, hedging, speculation
and arbitrage. In this module we will see one can trade in index futures and use forward contracts in
each of these instances.

Taking a view of the market

If you are bullish on the market buy index futures
If you are bearish on the market sell index futures

On August 13, 2006, ‘X’ feels that the market will rise so he buys 100 Nifties with an expiry date of
August 31 at an index price of 3350 costing Rs. 3,33,500 (100*3350).
On August 21 the Nifty futures have risen to 3362 so he squares off his position at 3362

PDP Investment Planning 165

‘X’ makes a profit of Rs. 1200 (100*12)

On August 13, 2006, ‘X’ feels that the market will fall so he sells 100 Nifties with an expiry date of August
31 at an index price of 3350 costing Rs. 3,33,500 (100*3350).
On August 21 the Nifty futures have fallen to 3312 so he squares off his position at 3312.
X makes a profit of Rs. (100*38) = Rs. 3,800/-
In the above cases ‘X’ has profited from speculation i.e. he has wagered in the hope of profiting from an
anticipated price change.

The margining system is based on the JR Verma Committee recommendations. The actual margining
happens on a daily basis while online position monitoring is done on an intra-day basis.
Daily margining is of two types:

1. Initial margins
2. Mark-to-market profit/loss
The computation of initial margin on the futures market is done using the concept of Value-at-Risk
(VaR). The initial margin amount is large enough to cover a one-day loss that can be encountered on
99% of the days. VaR methodology seeks to measure the amount of value that a portfolio may stand to
lose within a certain horizon time period (one day for the clearing corporation) due to potential changes
in the underlying asset market price. Initial margin amount computed using VaR is collected up-front.
The daily settlement process called “mark-to-market” provides for collection of losses that have already
occurred (historic losses) whereas initial margin seeks to safeguard against potential losses on outstanding
positions. The mark-to-market settlement is done in cash.
Let us take a hypothetical trading activity of a client of a NSE futures division to demonstrate the margins
payments that would occur.

n A client purchases 100 units of FUTIDX NIFTY 31 Aug 2006 at Rs. 3400.
n The initial margin payable as calculated by VaR is 15%.
Total long position = Rs. 3,40,000 (100*3400)
Initial margin (15%) = Rs. 51,000
Assuming that the contract will close on Day + 3 the mark-to-market position will look as follows:
Nifty closed on Day 1 at 3450
Nifty closed on Day 2 at 3350
Nifty was sold on Day 3 at 3425

Position on Day 1
Close Price 3450*100 = 3,45,000
Market to market profit = 50*100 = 5,000
Day end margin on open position = 345000*.15 = 51750
Additional margin = 51750 -51000 = 750

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Receivable by client = 5000 – 750 = 4250

New position on Day 2

Value of new position = 3350*100= 3,35,000
Margin = 50,250
Margin at end of day1 = 51750
Mark to market loss = 345000 – 335000 = 10,000
Amount payable by client = 10000-1500 {less margin payable [51750-50250]} = 8500
Net position on Day 3
Profit on sale 342500 – 335000 = 7500
Release of margin = 50,250
Amount receivable by client = 7500+50250 = 57,750
Net profit on the whole deal:
Initial margin out go = -51,000
End of day 1 = 4,250
End of day 2 = -8,500
End of day3 = 57,750
Net profit = (-51000+4250-8500+57750) = 2,500
Which is 100*(3425-3400) = the lot size*(difference between sale and purchase price of the index)

All trades in the futures market are cash settled on a T+1 basis and all positions (buy/sell) which are not
closed out will be marked-to-market. The closing price of the index futures will be the daily settlement
price and the position will be carried to the next day at the settlement price.
The most common way of liquidating an open position is to execute an offsetting futures transaction by
which the initial transaction is squared up. The initial buyer liquidates his long position by selling identical
futures contract.
In index futures the other way of settlement is cash settled at the final settlement. At the end of the
contract period the difference between the contract value and closing index value is paid.

The markets are volatile and huge amount of money can be made or lost in very little time. Derivative
products are structured precisely for this reason — to curtail the risk exposure of an investor. Index
futures and stock options are instruments that enable an investor to hedge his portfolio or open positions
in the market. Option contracts allow an investor to run his profits while restricting his downside risk.
Apart from risk containment, options can be used for speculation and investors can create a wide range
of potential profit scenarios.

What are options?

Some people remain puzzled by options. The truth is that most people have been using options for
some time, because options are built into everything from mortgages to insurance.

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An option is a contract, which gives the buyer the right, but not the obligation to buy or sell shares of the
underlying security at a specific price on or before a specific date.
‘Option’, as the word suggests, is a choice given to the investor to either honour the contract; or if he so
chooses to walk away from the contract.
To begin, there are two kinds of options: Call Options and Put Options.
A Call Option is an option to buy a stock at a specific price on or before a certain date. In this way, Call
options are like security deposits. If, for example, you wanted to rent a certain property, and left a security
deposit for it, the money would be used to insure that you could, in fact, rent that property at the price agreed
upon when you returned. If you never returned, you would give up your security deposit, but you would have
no other liability. Call options usually increase in value as the value of the underlying instrument rises.
When you buy a Call option, the price you pay for it, called the option premium, secures your right to buy
that certain stock at a specified price called the strike price. If you decide not to use the option to buy the
stock, and you are not obligated to, your only cost is the option premium.
Put Options are options to sell a stock at a specific price on or before a certain date. In this way, Put
options are like insurance policies
If you buy a new car, and then buy auto insurance on the car, you pay a premium and are, hence,
protected if the car is damaged in an accident. If this happens, you can use your policy to regain the
insured value of the car. In this way, the put option gains in value as the value of the underlying instrument
decreases. If all goes well and the insurance is not needed, the insurance company keeps your premium
in return for taking on the risk.
With a Put Option, you can “insure” a stock by fixing a selling price. If something happens which causes
the stock price to fall, and thus, “damages” your asset, you can exercise your option and sell it at its
“insured” price level. If the price of your stock goes up, and there is no “damage,” then you do not need
to use the insurance, and, once again, your only cost is the premium. This is the primary function of
listed options, to allow investors ways to manage risk.
Technically, an option is a contract between two parties. The buyer receives a privilege for which he
pays a premium. The seller accepts an obligation for which he receives a fee.

Now let us see how one can profit from buying an option. Mr. Shah feels that the market will go up. He
is bullish on Nifty but he does not want to lose money if he is turned wrong and if the market goes down.

n He buys an Options Contract September 2006 Nifty for a strike price of 3450 paying a premium of
Rs. 50.
n In about 15 days time Nifty goes up and therefore he sells the option for Rs. 75 making a profit of
Rs. 25 per Nifty.
n The contract size being 100 he will make a profit of Rs. 25*100 = Rs. 2,500/-.
n If he had not sold and if the Nifty had gone up further he would have made even more profits.
n If the Nifty were to fall his maximum loss would have been restricted to Rs. 50*100 = Rs. 5,000/-
the premium paid by him for having bought the call option.
n Thus, you can see that the profit potential in a call option is unlimited while the loss is limited to the
actual premium paid.

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Call Options-Long & Short Positions
When you expect prices to rise, then you take a long position by buying calls. You are bullish.
When you expect prices to fall, then you take a short position by selling calls. You are bearish.

Put Options
A Put Option gives the holder of the right to sell a specific number of shares of an agreed security at a
fixed price for a period of time.
Example: Mr. Dutt purchases one contract of Infoysys Technologies Sep 2006 1800 Put —Premium
Rs. 50 (contract size 100 shares)
This contract allows Sam to sell 100 shares Infosys Technologies at Rs. 1800 per share at any time
between the current date and the expiry of Sep 2006 series. To have this privilege, Sam pays a premium
of Rs. 5,000 (Rs. 50 a share for 100 shares).
He will make a profit if the share price of Infosys Technologies falls during this period. He has the
potential to make high profits as there is a potential for the stock price to fall by any amount but in case
the price of the share goes up; he will suffer a loss but the loss will be limited to Rs. 5,000/- premium paid
by him for purchasing the right to sell (buy a put option)
The buyer of a put has purchased a right to sell. The owner of a put option has the right to sell.

Put Options-Long & Short Positions

When you expect prices to fall, then you take a long position by buying Puts. You are bearish.
When you expect prices to rise, then you take a short position by selling Puts. You are bullish.
The following table will summarise the actions to be taken depending upon your view on the stock price:


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Option styles
Settlement of options is based on the expiry date. However, there are three basic styles of options you
will encounter which affect settlement. The styles have geographical names, which have nothing to do
with the location where a contract is agreed! The styles are:
European: These options give the holder the right, but not the obligation, to buy or sell the underlying
instrument only on the expiry date. This means that the option cannot be exercised early. Settlement
is based on a particular strike price at expiration. Currently, in India only index options are European in
Example: Mr. Dutt purchases 1 NIFTY SEP 2006 3450 Call — Premium 20. The exchange will settle
the contract on the last Thursday of August. Since there are no shares for the underlying, the contract is
cash settled.
American: These options give the holder the right, but not the obligation, to buy or sell the underlying
instrument on or before the expiry date. This means that the option can be exercised early. Settlement
is based on a particular strike price at expiration.
Options in stocks that have been recently launched in the Indian market are “American Options” while
the options on the Index are “European Options”.
Example: Mr Patel purchases 1 TATA STEEL SEP 06 - 520 Call —Premium 20
Here Mr. Patel can close the contract any time from the current date till the expiration date, which is the
last Thursday of September.
American style options tend to be more expensive than European style because they offer greater
flexibility to the buyer.

Option Class & Series

Generally, for each underlying, there are a number of options available: For this reason, we have the
terms “class” and “series”.
An option “class” refers to all options of the same type (call or put) and style (American or European) that
also have the same underlying.
Example: All Nifty call options are referred to as one class.
An option series refers to all options that are identical: they are the same type, have the same underlying,
the same expiration date and the same exercise price.
Example: ACC SEP 2006 900 refers to one series and trades take place at different premiums


Important Terms
Strike price: The Strike Price denotes the price at which the buyer of the option has a right to purchase
or sell the underlying. Five different strike prices will be available at any point of time. The strike price
interval will be of 20. If the index is currently at 3,410, the strike prices available will be 3,370; 3,390;
3,410; 3,430; 3,450. The strike price is also called Exercise Price. This price is fixed by the exchange
for the entire duration of the option depending on the movement of the underlying stock or index in the
cash market.
In-the-money: A Call Option is said to be “In-the-Money” if the strike price is less than the market price of

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the underlying stock. A Put Option is In-The-Money when the strike price is greater than the market price.
Example: Ram purchases 1 ACC SEP 900 Call —Premium 50
In the above example, the option is “in-the-money”, till the market price of ACC is ruling above the strike
price of Rs. 900, which is the price at which Ram would like to buy 100 shares anytime before the expiry
of Sep 2006 series.
Similary, if Ram had purchased a Put at the same strike price, the option would have been “in-the-
money”, if the market price of ACC was lower than Rs. 900 per share.
Out-of-the-Money: A Call Option is said to be “Out-of-the-Money” if the strike price is greater than the
market price of the stock. A Put option is Out-Of-Money if the strike price is less than the market price.
At-the-Money: The option with strike price equal to that of the market price of the stock is considered as
being “At-the-Money” or Near-the-Money.
If the index is currently at 3,410, the strike prices available will be 3,370; 3,390; 3,410; 3,430; 3,450. The
strike prices for a call option that are greater than the underlying (Nifty or Sensex) are said to be out-of-
the-money in this case 3430 and 3450 considering that the underlying is at 3410. Similarly in-the-money
strike prices will be 3,370 and 3,390, which are lower than the underlying of 3,410 while the strike price
of 3410 is ‘at the money’.
At these prices one can take either a positive or negative view on the markets i.e. both call and put options
will be available. Therefore, for a single series 10 options (5 calls and 5 puts) will be available and considering
that there are three series a total number of 30 options will be available to take positions in.

Covered Call Option

Covered option helps the writer to minimize his loss. In a covered call option, the writer of the call
option takes a corresponding long position in the stock in the cash market; this will cover his loss in his
option position if there is a sharp increase in price of the stock. Further, he is able to bring down his
average cost of acquisition in the cash market (which will be the cost of acquisition less the option
premium collected).
Example: Mr. Rajan believes that HLL has hit rock bottom at the level of Rs. 232 and it will move in a
narrow range. He can take a long position in HLL shares and at the same time write a call option with a
strike price of 235 and collect a premium of Rs. 5 per share. This will bring down the effective cost of
HLL shares to 227 (232-5). If the price stays below 235 till expiry, the call option will not be exercised
and the writer will keep the Rs.5 he collected as premium. If the price goes above 235 and the Option is
exercised, the writer can deliver the shares acquired in the cash market.

Covered Put Option

Similarly, a writer of a Put Option can create a covered position by selling the underlying security (if it is
already owned). The effective selling price will increase by the premium amount (if the option is not
exercised at maturity). Here again, the investor is not in a position to take advantage of any sharp
increase in the price of the asset as the underlying asset has already been sold. If there is a sharp
decline in the price of the underlying asset, the option will be exercised and the investor will be left only
with the premium amount. The loss in the option exercised will be equal to the gain in the short position
of the asset.

Pricing of options
Options are used as risk management tools and the valuation or pricing of the instruments is a careful

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balance of market factors.
There are four major factors affecting the Option premium:

n Price of Underlying
n Time to Expiry
n Exercise Price Time to Maturity
n Volatility of the Underlying
And two less important factors:

n Short-Term Interest Rates

n Dividends
The Intrinsic Value of an Option
The intrinsic value of an option is defined as the amount by which an option is in-the-money, or the
immediate exercise value of the option when the underlying position is marked-to-market.
For a call option: Intrinsic Value = Spot Price - Strike Price
For a put option: Intrinsic Value = Strike Price - Spot Price
The intrinsic value of an option must be positive or zero. It cannot be negative. For a call option, the strike
price must be less than the price of the underlying asset for the call to have an intrinsic value greater than 0.
For a put option, the strike price must be greater than the underlying asset price for it to have intrinsic value.

Price of underlying
The premium is affected by the price movements in the underlying instrument. For Call options (the right
to buy the underlying at a fixed strike price) as the underlying price rises so does its premium. As the
underlying price falls so does the premium.
For Put options as the underlying price rises, the premium falls; as the underlying price falls the
premium rises.
The following chart summarises the above for Calls and Puts.

The Time Value of an Option

Generally, the longer the time remaining until an option’s expiration, the higher its premium will be. This
is because the longer an option’s lifetime, greater is the possibility that the underlying share price might
move so as to make the option in-the-money. All other factors affecting an option’s price remaining the

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same, the time value portion of an option’s premium will decrease (or decay) with the passage of time.
Note: This time decay increases rapidly in the last several weeks of an option’s life. When an option
expires in-the-money, it is generally worth only its intrinsic value.

Volatility is the tendency of the underlying security’s market price to fluctuate either up or down. It
reflects a price change’s magnitude; it does not imply a bias toward price movement in one direction or
the other. Thus, it is a major factor in determining an option’s premium. The higher the volatility of the
underlying stock, the higher the premium because there is a greater possibility that the option will move
in-the-money. Generally, as the volatility of an under-lying stock increases, the premiums of both calls
and puts overlying that stock increase, and vice versa.
Higher volatility = Higher premium
Lower volatility = Lower premium

Interest rates
In general interest rates have the least influence on options and equate approximately to the cost of
carry of a futures contract. If the size of the options contract is very large, then this factor may become
important. All other factors being equal as interest rates rise, premium costs fall and vice versa. The
relationship can be thought of as an opportunity cost. In order to buy an option, the buyer must either
borrow funds or use funds on deposit. Either way the buyer incurs an interest rate cost. If interest rates
are rising, then the opportunity cost of buying options increases and to compensate the buyer premium
costs fall. Why should the buyer be compensated? Because the option writer receiving the premium can
place the funds on deposit and receive more interest than was previously anticipated. The situation is
reversed when interest rates fall – premiums rise. This time it is the writer who needs to be compensated.

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The options premium is determined by the three factors mentioned earlier – intrinsic value, time value
and volatility. But there are more sophisticated tools used to measure the potential variations of options
premiums. They are as follows:

n Delta
n Gamma
n Vega
n Rho

Delta is the measure of an option’s sensitivity to changes in the price of the underlying asset. Therefore,
it is the degree to which an option price will move given a change in the underlying stock or index price,
all else being equal.

Change in option premium

Delta = —————————————
Change in underlying price
For example, an option with a delta of 0.5 will move Rs 5 for every change of Rs 10 in the underlying
stock or index.

A trader is considering buying a Call option on a futures contract, which has a price of Rs. 20. The
premium for the Call option with a strike price of Rs. 19 is 0.80. The delta for this option is +0.5. This
means that if the price of the underlying futures contract rises to Rs. 21 – a rise of Re 1 – then the
premium will increase by 0.5 x 1.00 = 0.50. The new option premium will be 0.80 + 0.50 = Rs. 1.30.
Far out-of-the-money calls will have a delta very close to zero, as the change in underlying price is not
likely to make them valuable or cheap. An at-the-money call would have a delta of 0.5 and a deeply in-
the-money call would have a delta close to 1.
While Call deltas are positive, Put deltas are negative, reflecting the fact that the put option price and the
underlying stock price are inversely related. This is because if you buy a put your view is bearish and
expect the stock price to go down. However, if the stock price moves up it is contrary to your view
therefore, the value of the option decreases. The put delta equals the call delta minus 1.
It may be noted that if delta of your position is positive, you desire the underlying asset to rise in price.
On the contrary, if delta is negative, you want the underlying asset’s price to fall.

174 Investment Planning PDP

Uses: The knowledge of delta is of vital importance for option traders because this parameter is heavily
used in margining and risk management strategies. The delta is often called the hedge ratio. e.g. if you
have a portfolio of ‘n’ shares of a stock then ‘n’ divided by the delta gives you the number of calls you
would need to be short (i.e. need to write) to create a riskless hedge – i.e. a portfolio which would be
worth the same whether the stock price rose by a very small amount or fell by a very small amount.
In such a “delta neutral” portfolio any gain in the value of the shares held due to a rise in the share price
would be exactly offset by a loss on the value of the calls written, and vice versa.
Note that as the delta changes with the stock price and time to expiration, the number of shares would
need to be continually adjusted to maintain the hedge.

This is the rate at which the delta value of an option increases or decreases as a result of a move in the
price of the underlying instrument.

Change in option delta

Gamma = —————————————
Change in underlying price
For example, if a Call option has a delta of 0.50 and a gamma of 0.05, then a rise of ±1 in the underlying
means the delta will move to 0.55 for a price rise and 0.45 for a price fall. Gamma is rather like the rate
of change in the speed of a car – its acceleration – in moving from a standstill, up to its cruising speed,
and braking back to a standstill. Gamma is greatest for an ATM (at-the-money) option (cruising) and
falls to zero as an option moves deeply ITM (in-the-money ) and OTM (out-of-the-money) (standstill).

It is a measure of an option’s sensitivity to time decay. Theta is the change in option price given a one-
day decrease in time to expiration. It is a measure of time decay (or time shrunk). Theta is generally
used to gain an idea of how time decay is affecting your portfolio.

Change in an option premium

Theta = ———————————————

Change in time to expiry

Theta is usually negative for an option as with a decrease in time, the option value decreases. This is
due to the fact that the uncertainty element in the price decreases.
Assume an option has a premium of 3 and a theta of 0.06. After one day it will decline to 2.94, the second
day to 2.88 and so on. Naturally other factors, such as changes in value of the underlying stock will alter the
premium. Theta is only concerned with the time value. Unfortunately, we cannot predict with accuracy the
change’s in stock market’s value, but we can measure exactly the time remaining until expiration.

This is a measure of the sensitivity of an option price to changes in market volatility. It is the change of
an option premium for a given change – typically 1% – in the underlying volatility.

Change in an option premium

Vega = ——————————————
Change in volatility

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Example: If stock X has a volatility factor of 30% and the current premium is 3, a vega of .08 would
indicate that the premium would increase to 3.08 if the volatility factor increased by 1% to 31%. As the
stock becomes more volatile the changes in premium will increase in the same proportion. Vega measures
the sensitivity of the premium to these changes in volatility.
What practical use is the vega to a trader? If a trader maintains a delta neutral position, then it is
possible to trade options purely in terms of volatility – the trader is not exposed to changes in underlying

The change in option price given a one percentage point change in the risk-free interest rate. Rho
measures the change in an option’s price per unit increase –typically 1% – in the cost of funding the

Change in an option premium

Rho = ———————————————————
Change in cost of funding underlying

Options Pricing Models

There are various option pricing models which traders use to arrive at the right value of the option. Some
of the most popular models have been enumerated below.

The Binomial Pricing Model

The binomial model is an options pricing model which was developed by William Sharpe in 1978. Today,
one finds a large variety of pricing models which differ according to their hypotheses or the underlying
instruments upon which they are based (stock options, currency options, options on interest rates).
The binomial model breaks down the time to expiration into potentially a very large number of time
intervals, or steps. A tree of stock prices is initially produced working forward from the present to expiration.
At each step it is assumed that the stock price will move up or down by an amount calculated using
volatility and time to expiration. This produces a binomial distribution, or recombining tree, of underlying
stock prices. The tree represents all the possible paths that the stock price could take during the life of
the option.
At the end of the tree – i.e. at expiration of the option — all the terminal option prices for each of the final
possible stock prices are known as they simply equal their intrinsic values.
Next the option prices at each step of the tree are calculated working back from expiration to the present.
The option prices at each step are used to derive the option prices at the next step of the tree using risk
neutral valuation based on the probabilities of the stock prices moving up or down, the risk free rate and
the time interval of each step. Any adjustments to stock prices (at an ex-dividend date) or option prices
(as a result of early exercise of American options) are worked into the calculations at the required point
in time. At the top of the tree you are left with one option price.
Advantage: The big advantage the binomial model has over the Black-Scholes model is that it can be
used to accurately price American options. This is because, with the binomial model it’s possible to
check at every point in an option’s life (ie at every step of the binomial tree) for the possibility of early
exercise (eg where, due to a dividend, or a put being deeply in the money the option price at that point
is less than its intrinsic value).
Where an early exercise point is found it is assumed that the option holder would elect to exercise and

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the option price can be adjusted to equal the intrinsic value at that point. This then flows into the calculations
higher up the tree and so on.
Limitation: As mentioned before the main disadvantage of the binomial model is its relatively slow
speed. It’s great for half a dozen calculations at a time but even with today’s fastest PCs it’s not a
practical solution for the calculation of thousands of prices in a few seconds which is what’s required for
the production of the animated charts.

The Black & Scholes Model

The Black & Scholes model was published in 1973 by Fisher Black and Myron Scholes. It is one of the
most popular options pricing models. It is noted for its relative simplicity and its fast mode of calculation:
unlike the binomial model, it does not rely on calculation by iteration.
The intention of this section is to introduce you to the basic premises upon which this pricing model rests.
The Black-Scholes model is used to calculate a theoretical call price (ignoring dividends paid during the
life of the option) using the five key determinants of an option’s price: stock price, strike price, volatility,
time to expiration, and short-term (risk free) interest rate.
The original formula for calculating the theoretical option price (OP) is as follows:
OP = SN(d1) - XertN(d2 )

The variables are:

S = stock price
X = strike price
t = time remaining until expiration, expressed as a percent of a year
r = current continuously compounded risk-free interest rate
v = annual volatility of stock price (the standard deviation of the short-term returns over one year).
ln = natural logarithm
N(x) = standard normal cumulative distribution function
e = the exponential function
Lognormal distribution: The model is based on a lognormal distribution of stock prices, as opposed to
a normal, or bell-shaped, distribution. The lognormal distribution allows for a stock price distribution of
between zero and infinity (ie no negative prices) and has an upward bias (representing the fact that a
stock price can only drop 100 per cent but can rise by more than 100 per cent).
Risk-neutral valuation: The expected rate of return of the stock (ie the expected rate of growth of the
underlying asset which equals the risk free rate plus a risk premium) is not one of the variables in the Black-
Scholes model (or any other model for option valuation). The important implication is that the price of an
option is completely independent of the expected growth of the underlying asset. Thus, while any two

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investors may strongly disagree on the rate of return they expect on a stock they will, given agreement to
the assumptions of volatility and the risk free rate, always agree on the fair price of the option on that
underlying asset.
The key concept underlying the valuation of all derivatives — the fact that price of an option is independent
of the risk preferences of investors — is called risk-neutral valuation. It means that all derivatives can be
valued by assuming that the return from their underlying assets is the risk free rate.
Limitation: Dividends are ignored in the basic Black-Scholes formula, but there are a number of widely
used adaptations to the original formula, which enable it to handle both discrete and continuous dividends
However, despite these adaptations the Black-Scholes model has one major limitation: it cannot be
used to accurately price options with an American-style exercise as it only calculates the option price at
one point in time — at expiration. It does not consider the steps along the way where there could be the
possibility of early exercise of an American option.
As all exchange traded equity options have American-style exercise (ie they can be exercised at any
time as opposed to European options which can only be exercised at expiration) this is a significant
The exception to this is an American call on a non-dividend paying asset. In this case the call is always
worth the same as its European equivalent as there is never any advantage in exercising early.
Advantage: The main advantage of the Black-Scholes model is speed — it lets you calculate a very
large number of option prices in a very short time.

Bull Market Strategies

Calls in a Bullish Strategy

An investor with a bullish market outlook should buy call options. If you expect the market price of the
underlying asset to rise, then you would rather have the right to purchase at a specified price and sell
later at a higher price than have the obligation to deliver later at a higher price.
The investor breaks even when the market price equals the exercise price plus the premium.

Puts in a Bullish Strategy

An investor with a bullish market outlook can also go short on a Put option. Basically, an investor
anticipating a bull market could write Put options. If the market price increases and puts become out-of-
the-money, investors with long put positions will let their options expire worthless.
By writing Puts, profit potential is limited. A Put writer profits when the price of the underlying asset
increases and the option expires worthless. The maximum profit is limited to the premium received.
However, the potential loss is unlimited. Because a short put position holder has an obligation to
purchase if exercised. He will be exposed to potentially large losses if the market moves against his
position and declines.
The break-even point occurs when the market price equals the exercise price: minus the premium. At
any price less than the exercise price minus the premium, the investor loses money on the transaction.
At higher prices, his option is profitable.
An increase in volatility will increase the value of your put and decrease your return. As an option writer, the
higher price you will be forced to pay in order to buy back the option at a later date, lower is the return.

178 Investment Planning PDP

Bullish Call Spread Strategies
A vertical call spread is the simultaneous purchase and sale of identical call options but with different
exercise prices.
To “buy a call spread” is to purchase a call with a lower exercise price and to write a call with a higher
exercise price. The trader pays a net premium for the position.
To “sell a call spread” is the opposite, here the trader buys a call with a higher exercise price and writes
a call with a lower exercise price, receiving a net premium for the position.
An investor with a bullish market outlook should buy a call spread. The “Bull Call Spread” allows the
investor to participate to a limited extent in a bull market, while at the same time limiting risk exposure.
To put on a bull spread, the trader needs to buy the lower strike call and sell the higher strike call. The
combination of these two options will result in a bought spread. The cost of Putting on this position will
be the difference between the premium paid for the low strike call and the premium received for the
high strike call.
The investor’s profit potential is limited. When both calls are in-the-money, both will be exercised and
the maximum profit will be realised. The investor delivers on his short call and receives a higher price
than he is paid for receiving delivery on his long call.
The investor’s potential loss is limited. At the most, the investor can lose is the net premium. He pays a
higher premium for the lower exercise price call than he receives for writing the higher exercise price call.
The investor breaks even when the market price equals the lower exercise price plus the net premium.
At the most, an investor can lose the net premium paid. To recover the premium, the market price must
be as great as the lower exercise price plus the net premium.

An example of a Bullish call spread

Let’s assume that the cash price of a scrip is Rs. 100 and you buy a September call option with a strike
price of Rs. 90 and pay a premium of Rs. 14. At the same time you sell another September call option on
the same scrip with a strike price of Rs. 110 and receive a premium of Rs 4. Here you are buying a lower
strike price option and selling a higher strike price option. This would result in a net outflow of Rs 10 at
the time of establishing the spread.
Now let us look at the fundamental reason for this position. Since this is a bullish strategy, the first
position established in the spread is the long lower strike price call option with unlimited profit potential.
At the same time to reduce the cost of puchase of the long position a short position at a higher call strike
price is established. While this not only reduces the outflow in terms of premium but his profit potential
as well as risk is limited. Based on the above figures the maximum profit, maximum loss and breakeven
point of this spread would be as follows:
Maximum profit = Higher strike price - Lower strike price - Net premium paid
= 110 - 90 - 10 = 10
Maximum Loss = Lower strike premium - Higher strike premium
= 14 - 4 = 10
Breakeven Price = Lower strike price + Net premium paid
= 90 + 10 = 100

PDP Investment Planning 179

Bullish Put Spread Strategies
A vertical Put spread is the simultaneous purchase and sale of identical Put options but with different
exercise prices.
To “buy a put spread” is to purchase a Put with a higher exercise price and to write a Put with a lower
exercise price. The trader pays a net premium for the position.
To “sell a put spread” is the opposite: the trader buys a Put with a lower exercise price and writes a put
with a higher exercise price, receiving a net premium for the position.
An investor with a bullish market outlook should sell a Put spread. The “vertical bull put spread” allows
the investor to participate to a limited extent in a bull market, while at the same time limiting risk exposure.

Bear Market Strategies

Puts in a Bearish Strategy

When you purchase a put you are long and want the market to fall. A put option is a bearish position. It will
increase in value if the market falls. An investor with a bearish market outlook shall buy put options. By
purchasing put options, the trader has the right to choose whether to sell the underlying asset at the exercise
price. In a falling market, this choice is preferable to being obligated to buy the underlying at a price higher.
An investor’s profit potential is practically unlimited. The higher the fall in price of the underlying asset,
higher the profits.

Calls in a Bearish Strategy

Another option for a bearish investor is to go short on a call with the intent to purchase it back in the
future. By selling a call, you have a net short position and needs to be bought back before expiration and
cancel out your position.
For this an investor needs to write a call option. If the market price falls, long call holders will let their out-
of-the-money options expire worthless, because they could purchase the underlying asset at the lower
market price.
The investor’s profit potential is limited because the trader’s maximum profit is limited to the premium
received for writing the option.
Here the loss potential is unlimited because a short call position holder has an obligation to sell if
exercised, he will be exposed to potentially large losses if the market rises against his position.
The investor breaks even when the market price equals the exercise price: plus the premium. At any
price greater than the exercise price plus the premium, the trader is losing money. When the market
price equals the exercise price plus the premium, the trader breaks even.

Bearish Put Spread Strategies

A vertical put spread is the simultaneous purchase and sale of identical put options but with different
exercise prices.
To “buy a put spread” is to purchase a put with a higher exercise price and to write a put with a lower
exercise price. The trader pays a net premium for the position.
To “sell a put spread” is the opposite. The trader buys a put with a lower exercise price and writes a put
with a higher exercise price, receiving a net premium for the position.

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An example of a bearish put spread.
Lets assume that the cash price of the scrip is Rs. 100. You buy a September put option on a scrip with a
strike price of Rs. 110 at a premium of Rs. 15 and sell a September put option with a strike price of Rs. 90
at a premium of Rs. 5.
In this bearish position the put is taken as long on a higher strike price put with the outgo of some
premium. This position has huge profit potential on downside, if the trader may recover a part of the
premium paid by him by writing a lower strike price put option. The resulting position is a mildly bearish
position with limited risk and limited profit profile. Though the trader has reduced the cost of taking a
bearish position, he has also capped the profit portential as well. The maximum profit, maximum loss
and breakeven point of this spread would be as follows:
Maximum profit = Higher strike price option - Lower strike price option - Net premium paid
= 110 - 90 - 10 = 10
Maximum loss = Net premium paid
= 15 - 5 = 10
Breakeven Price = Higher strike price - Net premium paid
= 110 - 10 = 100

Bearish Call Spread Strategies

A vertical call spread is the simultaneous purchase and sale of identical call options but with different
exercise prices.
To “buy a call spread” is to purchase a call with a lower exercise price and to write a call with a higher
exercise price. The trader pays a net premium for the position.
To “sell a call spread” is the opposite: the trader buys a call with a higher exercise price and writes a
call with a lower exercise price, receiving a net premium for the position.
To put on a bear call spread you sell the lower strike call and buy the higher strike call. An investor sells
the lower strike and buys the higher strike of either calls or puts to put on a bear spread.
The investor’s profit potential is limited. When the market price falls to the lower exercise price, both out-
of-the-money options will expire worthless. The maximum profit that the trader can realize is the net
premium: The premium he receives for the call at the higher exercise price.
Here the investor’s potential loss is limited. If the market rises, the options will offset one another. At any
price greater than the high exercise price, the maximum loss will equal high exercise price minus low
exercise price minus net premium.
The investor breaks even when the market price equals the lower exercise price plus the net premium.
The strategy becomes profitable as the market price declines. Since the trader is receiving a net premium,
the market price does not have to fall as low as the lower exercise price to breakeven.

Volatile Market Strategies

Straddles in a Volatile Market Outlook

Volatile market trading strategies are appropriate when the trader believes the market will move but
does not have an opinion on the direction of movement of the market. As long as there is significant
movement upwards or downwards, these strategies offer profit opportunities. A trader need not be

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bullish or bearish. He must simply be of the opinion that the market is volatile.

n A straddle is the simultaneous purchase (or sale) of two identical options, one a call and the other
a put.
1. To “buy a straddle” is to purchase a call and a put with the same exercise price and
expiration date.
2. To “sell a straddle” is the opposite: the trader sells a call and a put with the same exercise
price and expiration date.
A trader, viewing a market as volatile, should buy option straddles. A “straddle purchase” allows the
trader to profit from either a bull market or from a bear market.
Here the investor’s profit potential is unlimited. If the market is volatile, the trader can profit from an up-
or downward movement by exercising the appropriate option while letting the other option expire worthless.
(Bull market, exercise the call; bear market, the put.)
While the investor’s potential loss is limited. If the price of the underlying asset remains stable instead of
either rising or falling as the trader anticipated, the most he will lose is the premium he paid for the
In this case the trader has long two positions and thus, two breakeven points. One is for the call, which
is exercise price plus the premiums paid, and the other for the put, which is exercise price minus the
premiums paid.

Strangles in a Volatile Market Outlook

A strangle is similar to a straddle, except that the call and the put have different exercise prices. Usually,
both the call and the put are out-of-the-money.
To “buy a strangle” is to purchase a call and a put with the same expiration date, but different exercise
To “sell a strangle” is to write a call and a put with the same expiration date, but different exercise prices.
A trader, viewing a market as volatile, should buy strangles. A “strangle purchase” allows the trader to
profit from either a bull or bear market. Because the options are typically out-of-the-money, the market
must move to a greater degree than a straddle purchase to be profitable.
The trader’s profit potential is unlimited. If the market is volatile, the trader can profit from an up- or
downward movement by exercising the appropriate option, and letting the other expire worthless. (In a
bull market, exercise the call; in a bear market, the put).
The investor’s potential loss is limited. Should the price of the underlying remain stable, the most the
trader would lose is the premium he paid for the options. Here the loss potential is also very minimal
because, the more the options are out-of-the-money, the lesser the premiums.
Here the trader has two long positions and thus, two breakeven points. One for the call, which breakevens
when the market price equal the high exercise price plus the premium paid, and for the put, when the
market price equals the low exercise price minus the premium paid.

Advantages of option trading

Risk management: Put options allow investors holding shares to hedge against a possible fall in their
value. This can be considered similar to taking out insurance against a fall in the share price.
Time to decide: By taking a call option the purchase price for the shares is locked in. This gives the call

182 Investment Planning PDP

option holder until the Expiry Day to decide whether or not to exercise the option and buy the shares.
Likewise the taker of a put option has time to decide whether or not to sell the shares.
Speculation: The ease of trading in and out of an option position makes it possible to trade options with
no intention of ever exercising them. If an investor expects the market to rise, they may decide to buy
call options. If expecting a fall, they may decide to buy put options. Either way the holder can sell the
option prior to expiry to take a profit or limit a loss. Trading options has a lower cost than shares, as there
is no stamp duty payable unless and until options are exercised.
Leverage: Leverage provides the potential to make a higher return from a smaller initial outlay than
investing directly. However, leverage usually involves more risks than a direct investment in the underlying
shares. Trading in options can allow investors to benefit from a change in the price of the share without
having to pay the full price of the share.
Income generation: Shareholders can earn extra income over and above dividends by writing call
options against their shares. By writing an option they receive the option premium upfront. While they
get to keep the option premium, there is a possibility that they could be exercised against and have to
deliver their shares to the taker at the exercise price.
Strategies: By combining different options, investors can create a wide range of potential profit scenarios.
To find out more about options strategies read the module on trading strategies.

PDP Investment Planning 183

Review Questions:
1. In an options contract the option lies with which one of the following:
a. Buyer
b. Seller
c. Both
d. The stock exchange
2. The potential returns on a futures contract are:
a. Limited
b. Unlimited
c. A function of the volatility of the index
d. None of the above
3. On 13th August 2006 Mr. Ashwin Mehta bought a Aug Nifty futures contract of 100 Nifties which
cost him Rs. 3,40,000/-. He paid a margin of Rs. 51,000/- On expiry date Nifty closed at 3430.
How much profit/loss Mr. Ashwin Mehta made in this transaction?
a. Profit of Rs. 6000
b. Profit of Rs. 300
c. Profit of Rs. 3000
d. Loss of Rs. 6000
4. A stock currently sells at Rs. 240. The put option to sell the stock at Rs. 255 costs Rs 19. The time
value of the option is:
a. Rs. 19
b. Rs. 5
c. Rs. 4
d. Rs. 15
5. A put option gives the ———————— the right but not the obligation to —————— the
underlying asset at a specified price:
a. seller, buy
b. seller, sell
c. owner, buy
d. owner, sell
6. If spot Nifty is 3400 and the interest rate is 12% p.a. what should be the fair price of One month
Nifty futures contract?
a. 3412
b. 3424
c. 3434
d. 3452

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7. A speculator thinks that India Cements is going to rise sharply. He has a long position on the cash
market in India Cements to the extent of Rs. 20 lacs. India Cements has a beta of 1.3. Which of
the following positions on Index futures gives him a complete hedge?
a. Long Nifty Rs. 26 lacs
b. Short Nifty Rs. 26 lacs
c. Long Nifty Rs. 20 lacs
d. Short Nifty Rs. 20 lacs
8. In the first week of September you observe that the spread between the September and October
of Siemens futures has narrowed down to Rs.10 as against the usual Rs. 20. How can you profit
from this observation?
a. By buying the September futures and selling October futures
b. By selling the September futures and buying the October futures
c. By both
d. None of the above
9. On 1st September 2006 a call option of Nifty with a strike price of Rs 3400 is available for trading.
Expiry date for September 2006 contracts is 27. The “T” that is used in Black- Sholes formula
should be:
a. 27
b. 0.074
c. 0.061
d. None of the above
10. An American Option can be exercised :
a. At any time till expiry
b. Only on expiry
c. It is not used in India
d. None of the above
11. An European Option can exercised :
a. At any time
b. Only on expiry
c. Both at any time and on expiry
d. None of the above
12. At any given time the F&O segment of NSE provides trading facility for ——— Nifty futures contracts:
a. 1
b. 3
c. 2
d. 9

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13. An investor buys two market lots of Sep 3400 Nifty calls at Rs. 76 per call and sells two market
lots of Sep 3400 Nifty call at Rs. 40 a call. Each market lot of Nifty is 100. If Nifty closes at 3460
on the expiration date, the pay off, net of costs from this bull spread will be :
a. profit of 4,800
b. loss of 4,800
c. loss of 2,400
d. profit of 2,400
14. A bull spread is created by
a. buying a call and buying a put
b. buying a call and selling a call
c. buying two puts
d. buying two calls

1. a
2. b
3. c
4. c
5. d
6. c
7. b
8. b
9. b
10. a
11. b
12. b
13. a
14. b

186 Investment Planning PDP

Chapter 13

PDP Investment Planning 187

Real Estate

L et’s look at real estate as an investment vehicle where the income earning capacity and capital
appreciation over time become more important than occupation for self use.

Characteristics of real estate investments

Higher capital requirement

It is possible for an investor to participate in debt or equity through small investments; say Rs. 5,000/-
where as in the case of direct investment in real estate the amounts required will be much higher. That
also essentially means that this asset class would some time become the most important (heavily
weighted) in value terms in one’s portfolio. The heavy capital cost keeps a large number of small investors
away and that also contributes in reducing the number of investors who participate in real estate. Indirect
investments in real estate through Mutual fund realty funds have cleared the legal requirements and are
set to be launched in India where after retail participation in realty may become easier.

Real estate is difficult to acquire and more difficult to sell because of absence of organized markets as in the
case of bonds and equities That makes it a tall task for the investor to search for real estate worth investing;
time and money are spent in finding investment options – same is the case at the time of sale. The real
estate then becomes essentially a long term investment option where liquidity is a very big problem.

Title and legal problems

The property laws are not investor friendly. Buying property involves not just selection of a good property
with scope for income and or appreciation but also with a good marketable title. Numerous cases have
come up where titles have been challenged many decades after deals on the properties have been
entered into. With the judiciary taking a long time to settle matters of title in properties the laws in respect
to real estate are cumbersome and can easily put off enthusiastic investors. “Buyers beware” is the
most applicable jargon and can prove quite tricky in real estate deals.

Government controls; policies, etc.

Real estate holdings involve a lot of legislation on who can own; etc. Many of these are State legislations
and hence require specialist advice on these matters. Documentation involving payment of stamp duties,
at arbitrary rates fixed by Stamp offices, mandatory registration, etc. not only increase the cost of
transactions but involve physical presence of the buyers and sellers for executing the transfer documents.
In other words, physical inconvenience and heavy costs make real estate investments that much less

Legal complexities
The legal contracts between property owners, financiers and tenants are quite complex and require
legal interpretation and construction. This aspect of real estate brings in not only additional costs but the
choice of right legal consultant.

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Management burden
Buying real estate is a complex process but holding on to it is also not easy. It involves considerable cost
of maintenance; taxes – municipal and other charges, etc. Being able to retain possession, especially in
case of vacant lands, can be a challenging management task where many times “possession is considered
ownership” and the onus then falls on the owner to prove his title – in legal battles for possession that
can stretch to decades.

Inefficient market
Real estates don’t have a market place as equities or bonds have. The market is not properly structured.
Because of the very nature of immovable properties the market is also highly localized where local
factors play a very vital role. A national market has not developed in real estate because of physical
limitations as they exist today – in other words a person in New Delhi may find real estate in Bangalore
a very attractive proposition but it will be physically impossible for him to participate in this investment
opportunity. There is a need for a national and structure market to emerge in order to attract large scale
investments – but because of typical state laws it may become difficult in India to have a very dynamic
and liquid real estate market.

Advantages of real estate

1. Scope for capital appreciation – the longer one holds on to properties, it has been observed, higher the
capital appreciation – demand for houses has been on the rise thanks to increasing income levels and
lower cost of housing loans and the input costs like steel, cement, etc. have also been rising.
2. Income stream – where the property can be rented out – property rentals have been going up
because of large scale employment generation in urban centres where people from smaller places
move in to rental accommodation as ownership is beyond them at least in the initial years of
3. Sense of security – properties are considered less volatile compared to paper securities like bonds
or shares – falling prices are quite rare – capital loss may not be incurred – obviously these are
perceptions and may not be right.
4. Sense of pride – It gives a sense of pride to the individual that he stays in a house owned by him
and this can not be measured in monetary terms.
5. Self occupation – house properties are bought more for self occupation than for reasons of investment
– at the point of self occupation these are not investments – but at the time of retirement people
may shift to smaller cities in which case the ownership houses in bigger cities can be sold at
substantially higher prices and this shall provide retirement capital as well. Sometimes people may
shift from smaller homes to bigger ones or from one locality to another when their older homes
fetch them handsome prices compared to purchase costs thus making them a very good investment.
6. Tax shelter – the income earned on rented properties is subject to some deduction; the tax on
capital gains made on real estate can be saved totally through planning; a housing loan gives the
investor tax advantages – which we shall consider in greater details later. These tax advantages
make real estate an attractive proposition for high net worth in di vi du al s, c orpo ra te s, e tc .
Numerous tax advantages exist in the case of agricultural land – agricultural income being exempt
from Income tax even though it may have a nominal impact of taxation in the lower income tax
bracket while capital gains on sale of agricultural land is fully exempt.
If an investor is able to analyze carefully take professional advice and legal help and invests for long
term the scope for appreciation is quite high and this vehicle can yield handsome returns not only in

PDP Investment Planning 189

percentage terms but in quantitative terms as well because of inherent high value investment involved.

Disadvantages of real estate

Legal issues
There are a large number of legal issues involved in investing in real estate. Many of the legislations are
State legislations and hence a good understanding of local laws is essential. For example lands can be
bought and registered only in the name of farmers – i.e. you can buy agricultural land only if you already
own agricultural land in that state. Land ceiling laws are applicable in certain states which makes buying
a large piece of land highly risky. Popular tenancy laws exist in many states where the tiller becomes the
owner of the agricultural land. These legal issues are complex and an investment in agricultural land,
not withstanding the tax advantages, can be considered only if an investor has a thorough understanding
of these complex legal issues.

High cost of maintenance

Urban house property owners are required to pay maintenance charges to co operative housing societies
for common facilities – like lifts, security, water, common lighting, etc. These are essential costs of
maintenance and these costs are rising at alarming rates. If one holds house properties for just capital
appreciation and not for self use or renting out then the costs become all the more heavy and can impact
the over all returns on this property investment.

Municipal and other levies

An owner of land or house property is required to pay the local authority certain taxes on a regular basis.
These are essentially charges for the services such as drainage, water supply, etc. that are provided by
the local bodies. These costs have also risen substantially over time. Besides usage based charges
local bodies charge property tax and there are proposals that these taxes could become “ad valorem” -
that is on value – in other words if a house property is of high value then it may attract very high
municipal property tax. This means that holding costs in respect of high value house properties can go
up astronomically making it uneconomical to hold them as long term investments.
There are numerous other disadvantages such as higher investment quantum, illiquidity, lack of organized
market, absence of uniform laws, etc. which we have discussed under the “characteristics of real estate
Real estates essentially involve high capital outlay. In order to attract retail investors the market players
have found many ways. Some of them are listed below:

Realty funds
Mutual funds have now been permitted by SEBI, the regulator, to launch realty funds. These funds
collect corpus from retail investors and large investors – pool the funds and invest directly in properties
– residential and or commercial; shares and bonds of housing finance companies and real estate and
property companies. In other words through the mutual funds route it has now become possible for a
small investor to participate in the property market and reap the benefits of the same in an indirect way.

Time Share
Some companies have floated novel schemes where an investor can own properties for a part of the
year; say for enjoying holidays for a few days in a year. There is rotational ownership with maintenance
and other matters being managed by the company itself. The returns you get on this is essentially cost
free holidays without hassles of maintaining the properties. You own it on a right to use concept.

190 Investment Planning PDP

Lease back arrangements
Some builders sell house properties to investors and they assure a minimum guaranteed lease rental on
these properties. The investor makes a lump sum investment and buys a house property and in return
the builder arranges to rent out the property at a fixed rent ensuring that the investor gets a minimum
assured return on the property. This helps the investor in arriving at an investment decision because he
knows the possible returns on the property and he is saved the trouble of hunting for an occupant. The
builders normally assure through this process a fixed rental income per month for a fixed period of time.
These concepts have become very popular especially in tourist centres like Goa, etc.

Valuation of real estate

It is important to have a clear idea of valuation of a property both at the time of purchase as well as at
the time of sale. The parameters of valuation are complex and the valuations are many times highly
subjective. The price for a property is arrived at mutually by the buyer and the seller while the value
could be different. They tend to be very close to each other if both the buyer and seller are making
informed decisions.

Considerations for value

1. Location – accessibility to public conveyance (nearness to local railway station in the case of
Mumbai city) – nearness to schools, work place, hospitals, temples, bus stand, railway station,
gardens, parks, etc. are important considerations. Many housing complexes try to provide most of
these facilities like schools, shopping centres, play grounds, hospitals, etc. inside the complex to
make it an attractive investment at a good price.
2. Proximity to employment opportunities: Shuttle cities near major cities have developed into good
centres because of nearness to mega cities. Investors who cannot afford property investments in
mega cities tend to invest in these suburbs or shuttle cities. Because major employment opportunities
generally exist in major cities these shuttle cities also develop over a period of time providing
appreciation and income to the investors in these smaller cities/towns. Values of properties in
cities like Bangalore have gone up because IT sector companies have moved into the city in a big
way, providing huge employment opportunities.
3. Environment – the general environment is also considered while making investment decision –
whether the area is growing in importance or static or declining.
4. Infrastructure: Easy accessibility through good road, drainage, water and power supply, clean
surroundings, etc. are important considerations.
5. The quality of construction, amenities provided, quality of other facilities provided.. etc. are important
factors while buying house property.

Traditional approaches to valuation

a. Capitalization approach
It is important to find out based on a market research what kind of yields are obtainable on comparable
properties. Secondly it is required to work out the net income derived from the property by deducting
expenses like repairs, insurance, etc. from the gross income and finally capitalize the net income for the
market yield on the property.

Let’s presume that rent fetched is generally around 8.5% of property values.

PDP Investment Planning 191

If rental income of say Rs. 20,000/- p.m. is earned on a property and expenses to the tune of say
Rs. 20,000/- are incurred every year on insurance, repairs, etc. then the net annual rental income
from the property would amount to 12*20000 -20000 = 220000/-
Capitalising net income of Rs. 2,20,000/- for an yield of 8.5% as follows, we get the capital value of the
property: 2,20,000/0.085 = Rs. 25,88,235/-

b. Discounted cash flow method

If the property was bought earlier and has been earning regular income on a year on year basis we have
to work out the present value of cash flows using our standard formula used in annuity calculations.
Value of the property is the present values of all cash flows to be received by owning the property as well
as expected cash flow on sale of the property after a definite period of time. It is difficult to predict the
future prices while a reasonable estimation of possible rental income can be made. Rentals also tend to
fluctuate and normally go up over a period of time. If we are given the present price, expected price at
which the property will be sold after a few years and the quantum of rental income on a yearly basis then
we can work out the return on this investment the same way as we calculate the YTM of bonds.

An investor wants to purchase a property which will fetch him a net rental income of Rs. 25,000/- p.a.
steadily for the next 3 years at the end of which he will be able to sell the property for Rs. 3,00,000. If the
investor wants a return of 12% p.a. what price he should pay for the property?
PV = [25000/(1.12)] +[ 25000/(1.12)2]+ [(25000+300000)/(1.12)3]
= 22321.42 +(25000/1.2544)+(325000/1.405)
=22321.42 +19929..84 + 231316.72
= 273356.98 say Rs. 2,73,400/-
He will get desired return of 12% p.a. on a rent of Rs. 25,000/- p.a. for the next 3 years if he purchases
the property now for Rs. 2,73,400/- sells it after 3 years for Rs. 3,00,000/-

Taxability of real estate investments

Taxability of income
n Rental income is taxable.
n Certain deductions are permitted from the income in computing taxable income on house property.
1. The permitted deductions are:
2. 30% of rent as a standard deduction
3. Interest paid on borrowed capital – the limit of Rs. 1,50,000/- is applicable for self occupied
properties where the rental income is NIL.
4. Municipal taxes actually paid
n Repayment of principal amount of housing loan is entitled to be deducted from income u/s 80C up
to a maximum limit of Rs. 1,00,000/- p.a.
n In case of joint ownership of house property deductions of interest amounts as loss on self occupied
property as well deduction u/s 80C are allowed for each one in the same proportion. In other words
increased tax benefit and each of the joint holders can enjoy tax advantages.

192 Investment Planning PDP

Taxability of capital gains
It is defined that if a piece of land or house property had been held for a minimum period of 36 months
before selling then it is long term capital gains and if sold with in 36 months the gains on sale shall be
treated as Short Term Capital Gains.
Short term capital gains = Sale consideration (sale price) *

n Expenses like brokerage, advertisement on sale

n Expenses like society transfer charges
n Cost of acquisition
n Cost of improvement
Long Term capital gains = Sale consideration (sale price)*

n Expenses like brokerage, advt, etc on sale

n Expenses like society transfer charges
n Indexed cost of acquisition#
n Indexed cost of improvement
*Sale consideration shall be the actual sale price as mentioned in the sale deed or value adopted by
stamp duty valuation authority whichever is higher.
# Indexed cost of acquisition is arrived at by multiplying the actual cost with the inflation index (as
published from time to time) for the year of sale and dividing by the inflation index in the year of purchase.
In case of properties bought/acquired/inherited before 1st April 1981 the market value, as per approved
valuer, shall be taken as the cost of purchase.

Rate of Tax
1. STCG is added to income under the head “Income from other sources” and taxed at the rate
applicable to the tax payer.
2. LTCG is taxed at 20% after arriving at the figure of taxable LTCG as shown above

Saving tax on LTCG

It is possible to save tax payable on LTCG and the provisions have been laid down below:
Sec 54 – Sell a house property and buy or construct another house property

n Applicable for individuals and HUF

n The sold house need not be a self occupied house property
n The sold house need not be the only house property
n The sold house should have been held for more than 36 months from purchase
n New house should be purchased within one year before sale or two years after sale
n New house, if constructed, should be within 3 years after sale
n If the cost of the new house is lower than net sale consideration then the difference will be taxable
n If the assessee sells the new house within three years of its purchase then this becomes STCG
and the cost of acquisition will be taken as NIL (if the cost of new house is lower than LTCG made
on old house)

PDP Investment Planning 193

n In the previous explanation if the cost of new house was equal to or more than LTCG on old house
the cost of new house will be computed as actual cost – LTCG on the old house
n It may take some time to purchase or construct a new house – the amount of LTCG will have to
kept in a special account designated as “Capital Gains Account” with a specified bank before filing
returns for the Previous year in which the old house was sold – the funds in the account can be
utilized for buying the new house.
Sec 54 B – sell agricultural land and buy agricultural land -deals with sale of agricultural land, LTCG on
sale can be saved by buying another agricultural land as per same terms and conditions listed above for
a house property.
Sec 54 EC – sell any long term asset and invest in infrastructure bonds .
An assessee might have made LTCG on sale of any long term capital asset like house, gold and jewellery,
land, etc.

n If the entire sale proceeds are invested in bonds of Government companies like Rural Electrification
Corporation Ltd. and/or National Highway Authority of India, Ltd. then the tax on LTCG can be
saved fully.
n If part of the proceeds are invested in such bonds proportionate deduction from LTCG will be
n The investment in bonds u/s 54EC should be made within 6 months of sale
n The lock in period for the bonds will be minimum of 3 years
n The interest on the bonds is taxable
n The rate of interest is decided by the PSU companies – it is currently around 5 -5.5% p.a.
Sec 54 F – sell any long term asset and buy a house property

n The tax payer should be individual or HUF

n The LT asset sold should not be a house property
n The new residential house should be purchased with in one year prior to sale or two year after the
sale of the old asset or
n The new house should be constructed with in 3 years from the sale of the old asset
n The deduction is applicable to an assessee even if he is already owning a house property.
n If the cost of the new house property is less than LTCG made on the old asset then a proportional
deduction will be available under this section and balance tax will have to be paid as tax on LTCG.
n If the tax payer sells the new house with in 3 years of purchase the conditions as spelt out earlier
u/s 54E will become applicable.
n It may take some time to purchase or construct a new house – the amount of LTCG will have to be
kept in a special account designated as “Capital Gains Account” with a specified bank before filing
returns for the Previous year in which the old asset was sold – the funds in the account can be
utilized only for buying the new house property.

194 Investment Planning PDP

Review Questions:
1. Mr. Wankhede is planning to sell his house and buy a bigger new house. When should he buy a
new house with reference to sale of his old house in order to avail of full benefit of Sec 54 of the
Income Tax Act?
a. With in 1 year after sale
b. Within 3 years after sale
c. Within one year prior to sale or 2 years after sale
d. Within two years prior to sale or 2 years after sale
2. An investor is considering a purchase of house property which shall fetch him a rental income of
Rs. 15,000/- p.m. The investor is looking for 10% returns and he is confident that he can sell the
property after 3 years for Rs. 5,00,000/- What price should he pay for this house property now?
a. Rs. 4,12,000/-
b. Rs. 3,66,000/-
c. Rs. 3,87,000/-
d. Rs. 4,32,000/-
3. If an individual who has made LTCG wants to save the tax on the same fully, he should invest
within what period of sale to avail benefit u/s 54EC of IT Act?
a. 6 months
b. 12 months
c. 3 years
d. 2 years
4. Husband and wife have together bought a new house and have availed of housing loan from a bank.
They have contributed 50% each to cost of the house. If the total amount of interest paid by them on
the home loan for self occupied house property during a financial year has been Rs. 2,40,000/- what
deduction will each one get from income as ‘Loss under house property”?
a. Either one of them can get a deduction not exceeding Rs. 1.50 lacs but not both
b. Both can get deduction – but the deduction will be restricted to Rs. 1,20,000/- each
c. Only the first holder on the loan will get a deduction and it will be restricted to Rs. 1,50,000/-
d. Both can get deduction – but the deduction will be Rs. 1,50,000/- each

1. c
2. a
3. a
4. b

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Chapter 14

196 Investment Planning PDP

Investment strategies

Passive strategy

S ome investors perceive that the securities markets, particularly the equity markets, are efficient.
There is a belief that the stock market is a barometer of the economy and that the market perfectly
reflects the strengths and weaknesses of the economy over long term while in the short term there can
be temporary aberrations (and over reactions of optimism and pessimism). In an efficient market, the
prices of securities do not depart for any length of time from the justified economic values that investors
calculate for them. Economic values for securities are determined by investor expectations about earnings,
risks, and so on, as investors grapple with the uncertain future. If the market price of a security does
depart from its estimated economic value, investors act to bring the two values together. Thus, as new
information arrives in an efficient marketplace, causing a revision in the estimated economic value of a
security, its price adjusts to this information quickly and, on balance, correctly. In other words, securities
are efficiently priced on a continuous basis and the long term investors who are holding on to securities
need not resort to any action of buying and selling but continue to hold.
These investors believe that it is not worth their efforts in terms of time and cost to trade on the temporary
aberrations but hold on to qualitative securities that shall perform in line with the market over a period of
time. That is, after acting on information to trade securities and subtracting all costs (transaction costs
and taxes, to name two), the investor would have been as well off with a simply buy-and-hold strategy.
If the market is economically efficient, securities could depart somewhat from their economic (justified)
values, but it would not pay investors to take advantage of these small discrepancies.
A natural outcome of this belief in efficient markets is to employ some type of passive strategy in owning
and managing common stocks. If the market is totally efficient, no active strategy should be able to beat
the market on a risk-adjusted basis. The Efficient Market Hypothesis has implications for fundamental
analysis and technical analysis, both of which are active strategies for selecting common stocks.
Passive strategies do not seek to outperform the market but simply to do as well as the market. The
emphasis is on minimizing transaction costs and time spent in managing the portfolio because any
expected benefits from active trading or analysis are likely to be less than the costs. Passive investors
act as if the market is efficient and accept the consensus estimates of return and risk, accepting current
market price as the best estimate of a security’s value.
In adopting the passive strategy the investor will simply follow a buy-and-hold strategy for whatever
portfolio of stocks is owned. Alternatively, a very effective way to employ a passive strategy with common
stocks is to invest in an indexed portfolio. We will consider each of these strategies in turn.

Buy And Hold Strategy

A buy-and-hold strategy means exactly that - an investor buys stocks and basically holds them until
some future time in order to meet some objective. The emphasis is on avoiding transaction costs,
additional search costs, and so forth., The investor believes that such a strategy will, over some period
of time, produce results as good as alternatives that require active management whereby some securities
are deemed not satisfactory, sold, and replaced with other securities. These alternatives incur transaction

PDP Investment Planning 197

costs and involve inevitable mistakes.
Notice that a buy-and-hold strategy is applicable to the investor’s portfolio, whatever its composition. It
may be large or small, and it may emphasize various types of stocks. Also note that an important initial
selection must be made to implement the strategy. The investor must decide initially to buy certain
stocks and not to buy certain other stocks.
Note that the investor will, in fact, have to perform certain functions while the buy-and-hold strategy is in
existence. For example, any income generated by the portfolio may be reinvested in other securities.
Alternatively, a few stocks may do so well that they dominate the total market value of the portfolio and
reduce its diversification. If the portfolio changes in such a way that it is no longer compatible with the
investor’s risk tolerance, adjustments may be required. The point is simply that even under such a
strategy investors must still take certain actions. In other words a passive strategy also requires some
action on the part of the investors – much less frequently compared to active strategies.
An interesting variant of this strategy is to buy-and-hold the 10 highest dividend-yielding stocks among
the BSE Sensex at the beginning of the year, hold for a year, and replace any stocks if necessary at the
beginning of the next year with the newest highest-yielding stocks in the BSE Sensex. This strategy
does not require stock selection since it is based only on using the easily calculated dividend yield for 30
identified stocks, and making substitutions when necessary.

Index Funds
Some investors prefer indirect investment to direct investment in equities. For this class of investors
the best passive strategy could be buying into an Index Fund. In an Index fund the fund manager pools
the resources of a number of investors and invests in stocks that comprise the index in the same
weightage as in the Index. These funds are designed to duplicate as precisely as possible the
performance of some market index.
A stock-index fund may consist of all the stocks in a well-known market average such as the NSE Nifty.
No attempt is made to forecast market movements and act accordingly, or to select under-or overvalued
securities. Expenses are kept to a minimum, including research costs (security analysis), portfolio
managers’ fees, and brokerage commissions. Index funds can be run efficiently by a small staff.
Surprisingly, at times the passive index funds have been found to perform better than some most actively
managed funds – mainly because the active funds might have under performed the market during that
period of time. These are open ended funds where the loads are the least and the returns in line with the
market index which they propose to replicate.

Active strategy
Investors, who do not accept the Efficient Market Hypothesis and those who believe that it is possible to
out perform the market consistently over a period of time through active management of stocks selected,
pursue active investment strategies. These investors believe that they can identify undervalued securities
and that lags exist in the market’s adjustment of these securities’ prices to new (better) information.
These investors generate more search costs (both in time and money) and more transaction costs, but
they believe that the marginal benefit outweighs the marginal costs incurred. Investors adopt two pronged
strategies to perform better than the market – proper stock selection and timing the entry and exit points.

Stock Selection
Most investment techniques involve an active approach to investing. In the area of common stocks the
use of valuation models to value and select stocks indicates that investors are analyzing and valuing
stocks in an attempt to improve their performance relative to some benchmark such as a market index.

198 Investment Planning PDP

They assume or expect the benefits to be greater than the costs.
Pursuit of an active strategy assumes that investors possess some advantage relative to other market
participants. Such advantages could include superior analytical or judgment skills, superior information,
or the ability or willingness to do what other investors, particularly institutions, are unable to do.
Individual investors enjoy certain advantages over institutional investors:

n They can invest in small cap stocks

n They need not have highly diversified portfolio
n They have go short on the market
For example, many large institutional investors cannot take positions in very small companies, leaving
this field for individual investors. Furthermore, individuals are not required to own diversified portfolios
and are typically not prohibited from short sales or margin trading as are some institutions.
Most investors still favour an active approach to common stock selection and management, despite the
accumulating evidence from efficient market studies and the published performance results of institutional
investors. The reason for this is obvious - the potential rewards are very large, and many investors feel
confident that they can achieve such awards even if other investors cannot.
The most traditional and popular form of active stock strategies is the selection of individual stocks
identified as offering superior return-risk characteristics. Such stocks typically are selected using
fundamental security analysis or technical analysis and sometimes a combination of the two. Many
investors have always believed, and continue to believe despite evidence to the contrary from the
Efficient Market Hypothesis, that they possess the requisite skill, patience, and ability to identify
undervalued stocks.
We know that a key feature of the investments environment is the uncertainty that always surrounds
investing decisions. Most stock pickers recognize the pervasiveness of this uncertainty and protect
themselves accordingly by diversifying. Therefore, the standard assumption of rational, intelligent investors
who select stocks to buy and sell is that such selections will be part of a diversified portfolio.
How important is stock selection in the overall investment process? Most active investors, individuals or
institutions, are, to various degrees, stock selectors. The majority of investment advice and investment
advisory services are geared to the selection of stocks thought to be attractive candidates at the time.
Stocks are, of course, selected by both individual investors and institutional investors. Rather than do
their own security analysis, individual investors may choose to rely on the recommendations of the
professionals. Many brokerage houses employ research personnel and put up research reports on
various companies.
One of the most important responsibilities of an analyst is to forecast earnings per share for particular
companies because of the widely perceived linkage between expected earnings and stock returns.
Earnings are critical in determining stock prices, and what matters is expected earnings). Therefore, the
primary emphasis in fundamental security analysis is on expected earnings, and analysts spend much
of their time forecasting earnings.
Studies indicate that current expectations of earnings, as represented by the average of the analysts’
forecasts, are incorporated into current stock prices.
An active strategy that is similar to stock selection is group or sector rotation. This strategy involves
shifting sector weights in the portfolio in order to take advantage of those sectors that are expected to do
relatively better, and avoid or de-emphasize those sectors that are expected to do relatively worse.

PDP Investment Planning 199

Investors employing this strategy are betting that particular sectors will repeat their price performance
relative to the current phase of the business and credit cycle.

Timing The Market

n Market timers attempt to earn excess returns by varying the percentage of portfolio assets in equity
securities. One has only to observe a chart of stock prices over time to appreciate the profit potential
of being in the stock market at the right times and being out of the stock market at bad times.
n When equities are expected to do well, timers shift from cash equivalents such as money market
funds to common stocks.
n When equities are expected to do poorly, the opposite occurs.
n Alternatively, timers could increase the Betas of their portfolios when the market is expected to rise
and carry most stocks up, or decrease the Betas of their portfolio when the market is expected to
go down.
n One important factor affecting the success of a market timing strategy is the amount of brokerage
commissions and taxes paid with such a strategy as opposed to those paid with a buy-and-hold
n Like many issues in the investing arena, the subject of market timing is controversial. Evidence
indicates it is difficult for investors to regularly time the market efficiently enough to provide excess
return on a risk-adjusted basis.
n On a pure timing basis, only a small percent of the stock timing strategies tracked over the most
recent five-and eight-year periods outperformed a buy-and-hold approach.
Much of the empirical evidence on market timing comes from studies of mutual funds. A basic issue is
whether fund managers increase the beta of their portfolios when they anticipate a rising market and
reduce the beta when they anticipate a declining market. Several studies found no evidence that funds
were able to time market changes and change their risk level in response.
Considerable research now suggests that the biggest risk of market timing is the investors will not be in the
market at critical times, thereby significantly reducing their overall returns. Investors who miss only a few
key months may suffer significantly. If anybody thinks that market timing as a strategy suitable for the
average individual investor he is wrong and the market has proved this time and again all over the world. It
has been proved without doubt that security market returns will depend more on the “time” than “timing” .

Aggressive investors adopt the bank financing route to invest in stock s a certain number of times their
own capital through the process of buying stocks and pledging with bank, raising money on the stocks
and buying more stocks. Thus, on a given capital, thanks to bank borrowing against stocks they are able
to build a portfolio much higher in value but at a cost, namely the interest cost. These investors are
highly aggressive and are always under pressure that the stocks selected by them should perform and
deliver returns superior to the rate of interest payable on the borrowal accounts – banks lend against
securities at a much higher rate of interest compared to priority lending or prime lending rates.
This route of bank borrowing is used by many investors in India when they apply to new issues of
shares, through the book building route of Initial Public Offerings (IPO) or Follow up Public Offerings
(FPO) of existing listed companies. These investors while applying for the IPO essentially put in the
margin money alone; which is around 40% of the application money and thus manage to increase the
number of shares for which they could apply with a given capital, thereby increasing the chances of

200 Investment Planning PDP

allotment of shares. These investors shall benefit only if they get substantial allotment and only if the
shares list at prices much higher than the issue price because they incur interest costs on the money
financed by the banks. These costs are incurred, in any case, not withstanding whether these investors
are allotted any shares in the public offering or not.
Some investors use the futures market route to leverage on the available capital. A trader in the futures
segment of the market, when he takes a position is not required to pay the full market value of this
position but only a certain percentage. Thus in the futures segment the trader gains a market exposure
which is much higher than his available capital. The potential to earn returns as the market goes up or
down increases because of leveraging. This is a high risk high return game – not suitable for average
market investors but only for those with very high risk appetite.
We have essentially discussed the two types of strategies namely the passive strategy and active strategy
followed in investing. The success lies in developing the right strategy that would suit the investor’s risk
profile and his financial goals. It has been proved without doubt, the world over, that success in investing
is about following a disciplined approach with clearly spelt out goals and the manner of achieving the
same. One of the time tested strategies for success in investing is an “Asset Allocation Plan” decided
well in advance before making the investments and sticking to same and acting on it periodically in
consultation with a financial advisor. In a later topic we shall discuss in detail about the types of asset
allocation models and how we go about implementing the same.

Maturity Selection
Investors make investments to meet specific demand on funds over a certain period of time. Some of
these time horizon related needs could be:

1. Buying a bigger house in about 5 years

2. Regular income flows every year after a term to meet education expenses of the children
3. Lump sum requirement after a few years to meet marriage expenses of children especially the
4. Regular flow of income, on a monthly basis, after a certain period of time – post retirement needs
and so on …
The investment strategy involved in meeting this type of time related fund requirements would depend
upon the time span after which the requirement will arise:

a. Short term – say requirement within 3/5 years

b. Long term – not less than 5 years
The investment vehicle will be decided upon whether the need is expected to arise over short term or
long term. If the need is short term then it may not be wise to park the funds in equity and equity related
instruments as the risk associated with this avenue is especially higher in the short term. A debt fund or
a fixed income instrument is preferred in such cases.
If the need is medium, say, for meeting education and/or marriage expenses of children over the next 5
to 10 years then an investor can invest in Balanced funds or specific child care funds of mutual funds or
specific children plans of life insurance companies.
The equity or equity related instruments would be ideal for building capital over long period of time. It is
a well established fact that equities have delivered superior returns compared to other asset classes
over longer period of time – while in the short term the returns can be erratic and even negative. At the
same time since this is a high risk avenue the returns also tend to be higher and hence capital building

PDP Investment Planning 201

becomes that much easier.
There are specific deferred annuity plans of life insurance companies where investments are made on
a systematic basis while in service, by the salaried class of investors, so that a certain amount of
pension becomes payable on retirement. These are essentially long term low risk low return kind of
plans most suited for the conservative investors.
Thus one can conclude that the strategy of investments can not only be classified as Passive and Active
but also based on the Time Horizon of the investible funds and the requirements for the funds over time.
Many times it is the time based requirement of funds that determines where the money is invested.

202 Investment Planning PDP

Review Questions:
1. In respect of investing in “Index funds” which one of the following statements is not true?
a. It is suitable to investors who seek returns much in excess of market returns.
b. It is a very aggressive investment strategy
c. It is an active investment strategy
d. It is suitable to investors who expect market returns on the investment
2. “Buy and hold” is a strategy suitable for which of the following type of investors?
a. Investors who want short term returns
b. Investors who want their shares to out perform the market
c. Investors who believe that market is an efficient place and that over long period this strategy pays
d. Aggressive investors
3. Adopting the bank financing route for applying to IPO’s would amount to which of the following?
a. Active strategy of investments
b. Passive strategy of investments
c. Low risk low return strategy
d. “Rupee Cost Averaging” strategy
4. Trading in stock futures in the derivatives segment of the market would amount to which one of
the following strategies?
a. Active
b. Passive
c. Low Risk low return
d. “Rupee Cost Averaging”
5. Which one of the following statements is true regarding market timing?
a. It is easy for the small investor to time the market and maximize the gains
b. “Market Timing” is the most important factor for success in investment decisions for small investors
c. It is the “time” more than the “timing” that has benefited the investors – investors stand to
benefit if they are prepared to invest for longer term rather trying to time the market
d. “Timing” is the key for long term investors
6. An investor plans to invest some capital to meet a requirement that is most likely to crop up within
the next one or two years. He is not very keen on high returns on this investment. Which out of the
following could be the most suitable option for him?
a. A. floating rate debt fund
b. A sector specific equity fund
c. Direct investment in select stocks from the market
d. Keep the money liquid in a saving bank account because returns over this period can be quite
1. d 4. a
2. c 5. c
3. a 6. a

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Chapter 15

204 Investment Planning PDP

Asset Allocation

T he important decision that an investor is required to take is on Asset Allocation. There are different
asset classes like equities, bonds, real estate, cash and even foreign investments … to a limited
extent available to Resident Indian investors now. It has been a well established fact that Asset allocation
has been primarily responsible for portfolio performance more than even stock selection and timing
issues. Asset allocation is the key to portfolio returns and hence it is of paramount importance.
The asset allocation decision involves deciding the percentage of investable funds to be placed in
stocks, bonds and cash equivalents. It is the most important investment decision made by investors
because it is the basic determinant of the return and risk taken. This is a result of holding a well-
diversified portfolio, which we know is the primary lesson of portfolio management. Thus asset allocation
serves the purpose of diversification among different asset classes and diversification among different
securities within an asset class.
The returns of a well-diversified portfolio within a given asset class are highly correlated with the returns
of the asset class itself. In other words the returns on a stock portfolio will depend on the market returns
to a great extent – no stock is expected to give phenomenal returns when the market returns are low or
negative. Within an asset class diversified portfolios will tend to produce similar returns over time. However,
different asset classes are likely to produce results that are quite dissimilar. Therefore, differences in
asset allocation will be the key factor, over time, causing differences in portfolio performance.
Factors to consider in making the asset allocation decision include the investor’s return requirements (current
income versus future income), the investor’s risk tolerance, and the time horizon. This is done in conjunction
with the investment manager’s expectations about the capital markets and about individual assets.
According to some analyses, asset allocation is closely related to the age of an investor. This involves
the so-called life-cycle theory of asset allocation. This makes intuitive sense because the needs and
financial positions of workers in their 50s should differ, on average, from those who are starting out in
their 20s. According to the life-cycle theory, for example, as individuals approach retirement they become
more risk averse and hence they should allocate fewer amounts in percentage terms to equity and
equity related instruments in their portfolio.

Asset class risk

Risk in the context of investments has different meanings for different people. To the common investor
risk means the probability that he may lose his capital or suffer loss on the investment. To the analyst it
is the chance that the investment vehicle may not deliver the required or expected returns and thus not
fulfill the financial goals. It is also well established through research over long periods that equity as an
asset class, international as well as domestic, is the most volatile of asset classes. In equities the range
of returns as well as the potential for capital loss is the greatest, especially in the short term.
While equity may be riskier asset class it also has the potential to earn superior returns over long term. It is
also well established that over the long term equities, foreign as well as domestic, have delivered returns
much higher than other classes of financial assets. Hence equities will find a place in every body’s portfolio
but the extent could vary depending on the risk profile, age, need for higher returns, time frame, etc.

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Types of asset allocation
The two models of asset allocation are Strategic Asset Allocation and Tactical Asset Allocation.

Strategic Asset Allocation

n It is essentially a long term investment plan
n It is the structuring the individual asset classes within a portfolio to meet long term investment objectives.
n No switches between securities or asset classes is normally done in the short term
n Defined exposures are made to different assets providing for some minor adjustments within the
asset class without shifting the focus of the portfolio.
n A right allocation among different classes of assets shall ensure that investors’ investment objectives
are met.
Tactical Asset Allocation
n TAA is a dynamic portfolio technique that seeks to take advantage of the short term movements
and opportunities in the market.
n The asset allocation of a portfolio is changed, in this process, on a short term basis to take advantage
of perceived differences in the values of various asset class changes.
n It works on the underlying principle that in the short term the securities market may not be properly
valued resulting in under valuation and over valuations – it is possible to take advantage of these
aberrations through switches between asset classes and within securities.
n All the same a balance is maintained and it is ensured that each asset class in the model is
maintained within the permitted range for that asset class
n A range for each asset class is fixed and short term movements/switches are made within the
range to take advantage of market movements.
Let’s look at both types of Asset Allocation models in a tabular form to understand the essential differences:

Thus you will find that while the asset classes are the same the difference lies in the manner of allocation
among assets – fixed allocation in SAA while a ranged allocation in TAA.
Let’s look at TAA allocations at different equity market levels:

206 Investment Planning PDP

Thus, at any point in time, investments will be there in all asset classes but the percentage will vary
depending upon the market condition and the out look for the market over the short term but the variation
will be within the fixed limits set for each asset class. We have looked at an example of stock market
valuations affecting allocation to equities similarly interest rate out look and current interest rates will
influence investment in fixed income securities. If the interest levels in the economy hover around very
high levels it is only natural that the fixed income portion would be close to the upper band of allocation
which in the given example is 60%. As the interest rates start falling bonds will fetch capital appreciation
while yields will fall and the weightage will gradually shift from bond to equity.
Obviously while TAA strategy has the potential to earn higher returns it also calls for a very good
understanding of the movements bonds/securities market and the equity market and also swift decisions
of moving funds from one asset class to the other and moving back.

Comparison between SAA and TAA

TAA can be expected to deliver superior on returns. But TAA involves research inputs which are very
vital and also entails frequent transactions. Both these come at substantial cost to the investor. Thus
one needs to work out whether TAA as compared to SAA has given superior returns after taking into
account all the efforts in terms of time and money that has been put in.
TAA essentially deals with timing issues. It is very vital to be able to time entries and exits in bonds as
well as equities consistently to be able to outperform the markets. This is a tough call and very few
specialists have done it consistently over long periods of time.
The taxation issues also need to be considered. Many short term transactions would result in short
gains which are essentially taxed at higher rates.
SAA as being necessarily long term is better on the following counts:

n No great issues of skills of timing the market decisions

n Does not test the competency of the portfolio managers/advisor to the extent required under TAA
n Costs are lower
n Taxation will be lower
n Chances of success are better as compared to TAA where wrong decisions and costs can prove to
be very costly.
We may conclude the discussions on suitable asset allocation models as under:

n Some aggressive clients may be inclined towards TAA as the model, on paper, looks superior – but
the financial planner should make the short comings of TAA clear to the client.
n Advise the clients to essentially adopt a disciplined approach to investment through SAA rather
than TAA
The proportion of allocation to risk instruments, where the returns are uncertain and market related, say
equities is essentially a function of risk appetite, age, time factors, return expectations, etc.

Fixed and flexible allocation

“Fixed allocation” is sticking to an allocation proportion among asset classes and following the same
religiously, till the same is revised based on the changed requirements, advancing age, sudden changes
in the economy, etc. “Flexible allocation” is something similar to TAA where the range is fixed for different
asset classes and periodic switching between asset classes is done. The “flexible asset allocation” is
not necessarily an aggressive investment planning. This helps the alert investor to make use of some

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opportunities that come periodically in the market due to random developments which simply cannot be
predicted in advance.
Asset Allocation is an Investment Planning Tool, not an Investment Strategy... Investment Strategies are
used to select and to manage the securities that are “allocated” to either the Equity or Debt/fixed income
An Asset Allocation Formula is a long-range, semi-permanent, planning decision that has absolutely nothing
to do with market timing or “hedging” of any kind. Certainly, a 40% asset allocation to Fixed Income may
soften the fall in the portfolio bottom line during a stock market downturn, but that has nothing to do with the
purpose of Fixed Income Securities nor is it in any way related to the reasons for having an asset allocation
plan in the first place. Similarly, the movement of a person’s assets from a falling bond market to a rising
stock market or vice versa is about as far away from the principles of asset allocation as one can get!

n Investors should arrive upon the most suitable Asset Allocation Plan
n Investors should not focus exclusively on “market value”,
n Investors should not dwell upon comparisons of one’s own unique portfolio with Market Averages
n Investors should not expect “performance” during specific time intervals as this investment plan is
expected to perform over a long period of time
Portfolio rebalancing
Once an asset allocation plan is finalized; then securities are chosen for investments and the investment
process is completed. Thereafter the portfolio of investments comprising of debt, equity, etc. should be
monitored on a periodic basis. The frequency of review could be once in 6 months or even once a year
– a higher frequency is generally not necessary for a long term investment plan but sometimes, some
economic developments may necessitate an urgent review.
One of the most important factors that will have a big influence on the performance of the portfolio is the
interest rate (which generally moves with inflation). Whenever large scale, protracted interest rate
movements are expected then a rebalancing will become absolutely essential – in a rising interest rate
scenario the corporate profitabilites will suffer and consequently the stock prices will fall. Bond prices dip
to adjust to the current yields of the market. Reducing equity exposure of the portfolio may become
necessary and moving from long term debt swiftly into short term or from fixed rate long term debt funds
to floating rate and short term debts could also become necessary. If economic slow down is seen,
through falling growth rates, then portfolio rebalancing will become necessary again. These economic
factors are external factors that will have to be taken into account as their long term impact on the
portfolios will be severe and hence suitable rebalancing will have to be done. It should simultaneously
be remembered these are turn around situations and these happen over long term.
There can be some internal family developments also that may make portfolio rebalancing necessary.
A portfolio is built to meet certain financial objectives; not all objectives are met at the same time. One
after the other the financial goals get completed, over a period of time, as the investor gets older and
older. Some of the common objectives are buying a bigger home; buying a new car; education of
children; marriage of children; retirement capital etc. As these objectives are fulfilled the return
requirements may come down and it may be necessary to switch to less aggressive asset allocation
plan – reducing the exposure to equities and increasing the exposure to debt may be made. .
It is an established fact that the proposition, that a rebalancing strategy can increase expected return is
incorrect but on the contrary rebalancing costs definitely reduces expected returns.

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Probably the best rule of thumb on rebalancing is to look at the overall stock/bond ratio quarterly, since it
is the primary determinant of expected returns, and examine individual equity asset classes once a
year, or so. Rebalance only when asset classes, and particularly, the equity/fixed ratio, gets out of
balance far enough to produce a significant expected difference in returns.

Monitoring and revision of portfolios

It is the financial planners’ function to monitor clients’ portfolios. When the portfolios are monitored it
could be observed that the proportion among different asset classes has changed substantially.
For example if the original Asset allocation was Equity 40%, Debt 55% and Cash 5% but on monitoring
if it was found to have changed to Equity 50% Debt 45% and Cash 5% then it amounts to higher
exposure to equity than originally planned. This situation might have arisen mainly because of rising
stock market and the appreciation of stocks held in the portfolio. While deciding on an asset allocation
plan a formula is generally discussed and agreed upon. This formula for revision essentially hinges on
defining “substantial shift in emphasis of a particular asset class” or even a particular security in an asset
class. It could be, say 5% which means that if the Equity proportion has moved above the fixed proportion
of 40% by 5% or more, then a rebalancing would be done by selling excess equity and moving to debt
or cash to maintain the Asset allocation proportions decided earlier. Thus monitoring helps in maintaining
a balanced portfolio all the time but also ensures profit booking when the markets are high and buying
when the market prices fall substantially. The formula could vary from investor to investor but it is
essential so that portfolios are properly monitored to deliver the desired returns over the long term.
A portfolio revision may become necessary because of government policy changes; economic factors of
growth rate; budget and fiscal deficits; inflation and interest rates, strength of domestic currency, etc.
While implementing the investment plan certain securities were bought based on their and the over all
economic fundamentals. These factors may change over time; fortunes of companies also fluctuate,
generally in line with the over all economy but some times on their own as well. For example a strong
domestic currency may not be good for export oriented companies but will benefit import dependant
companies. A lower interest rate on loans may not be good news for banks and financial institutions but
good news for consumer durables; automobiles and housing sector as the same spurs demand. While
a Buy and Hold strategy is fine it makes sense to observe crucial economic factors that may specifically
affect some of the securities held and it would be prudent at time to switch out of these securities and
move into others.

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Review Questions:
1. Which of the following statements is not true of Strategic Asset Allocation?
a. It is a long term investment plan
b. The proportion of each asset class is fixed in advance
c. The transaction costs are very high because of frequent switches
d. Taxation will be lower because short term transactions are generally not done
2. Which of the following statement is not true of Tactical Asset Allocation?
a. It is a conservative, long term investment plan
b. The proportion of each asset class is set in a range of values
c. The transaction costs are very high because of frequent switches
d. Taxation will be higher because of short term transactions
3. An investor is very keen on adopting Tactical Asset Allocation plan. What should be your advise
to such an investor?
a. The risks are high and the chances of success are low
b. Requires exceptional skills of timing which nobody in fact can claim to possess
c. Strategic Asset Allocation has a better success rate – as proved in a majority of cases
d. All of the above
4. Frequent portfolio rebalancing will cause which one of the following?
a. Increase the costs without necessarily contributing to increased returns
b. Increase the potential to earn higher returns
c. Decrease the costs
d. Will ensure that investment objectives are achieved quickly
5. Which one of the following could be the rule of thumb for portfolio rebalancing?
a. Keep switching between debt and equity on a quarterly basis
b. Keep on removing and adding securities on a half yearly basis
c. Look at the equity/debt ratio every quarter and individual stock once a year
d. The more frequently it is done the better

1. c
2. a
3. d
4. a
5. c

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Chapter 16

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Structuring Portfolio for Investors

Identification of client needs

A financial planner can go about his job after understanding his client’s needs thoroughly. It is necessary
to collect information from the client about his financial background, investment objectives, time
horizon, expected returns on investments, etc. All clients generally have some existing investments in
shares, mutual funds, fixed income products, tax saving instruments, life insurance, house property,
etc. It is essential to obtain information in respect of the same because while constructing the financial
plan restructuring of existing portfolio is equally important.
Information from clients, therefore, basically comprises of the following components:

n Personal information – name, age, names of other family members, ages, occupation of all family
members, address, telephone number, e mail ID, and such other information that are matters of
record and which shall be helpful in assessing general needs
n Information on their existing investments and levels of income and taxation for each member of the
n Investment objectives – buying a luxury car, bigger apartment, children’s education, children’s
marriage, retirement planning, holidays especially abroad, etc.
n Risk profile; attitude, intentions, required/expected returns on investments, etc.
Information is collected in a manner that is suitable for the investor and the planner. However, in order to
avoid time delays and to facilitate more meaningful discussions, it may be a good idea to obtain personal
information and details of existing investments (the first two out of the parameters listed above in advance).
The financial planners, normally, have a data sheet format where the columns/questions of personal
information are already provided and it is easier for the client to fill the same. The data collection format may
also be made available online or mailed electronically to the client. The client may be encouraged to fill the
same and send through e mail, before the meeting. Thus before the personal meeting the financial planner
has a good idea of the background of the client. This advance collection of information and that too in a
specified format saves a lot of time which other wise is lost during the meeting with the client.
Information on the other two parameters namely the objectives/goals and risk profile, etc. is best gathered
through a personal, informal talk with the client. It may be more useful if both – husband and wife, are
present during the discussions, so that it becomes easier to identify the objectives, etc. (in case of
married clients). It may become necessary to educate the investors primarily, some times, on matters of
risk and return. Many clients may prefer the ultra conservative route – while there is nothing with that
approach, the client in such circumstance should be made to realize the kind of compromise he is
making on returns and whether he can afford to make such compromises.
The ultimate objective of understanding a whole lot of investment avenues available, the risks involved,
the returns that be expected, how to measure the risk and returns on different investment products, etc.
is to empower the financial planner so that he can understand the client’s needs and suggest an investment
plan that shall be able to achieve the investment goals of the investors.
The ultimate financial plan will revolve around the risk profile of the client and the required return. If a

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client is inclined to take a higher risk the same may be advised and accordingly incorporated by the
financial planner in the investment plan provided in the opinion of the planner it is necessary to do so for
getting the desired return. The planner may advise a more conservative approach if high returns are not
required. In case the client is not inclined towards riskier investments and if higher returns are required
to meet the financial goals then the financial planner should explain the consequences of a very
conservative approach and the need for taking risk in a certain proportion.
Quantum of risk is subjective and it is bound to be different for different client profiles. But in general the
extent of risk that a client may be prepared to take is a function of the following factors:

n Age
n Socio economic status
n Background – academic and work place
n General nature – aggressive, modest, timid, humble, practical, etc.
Some economic factors that point towards risk profile of the client are:

n Liquidity – a high concern for liquidity will imply a more conservative approach.
n Income – many investors would prefer to have an income flow on all their investments and too
preferably guaranteed returns. This again is a very conservative approach. Income flow should be
close to the required level and anything received in excess of requirement needs to be deployed
for productive purposes to earn higher returns
n Inflation – a lower concern for inflation will mean more exposure to debt/income oriented investments
and less to growth.
n Taxation – a high concern for taxation will mean higher exposure to growth and equity oriented
instruments where the incidence of taxation is lower compared to deb/income oriented instruments.
n Volatility – some clients are very concerned about loss of capital – that would mean that even a
stock portfolio should contain more defensive and large cap stocks – lower on risk and return.

Asset allocation plan- in structuring client portfolios

After having assessed the clients needs, background, risk profile etc. the next step is deciding on an
Asset Allocation plan that shall best serve the client’s needs. We have studied in detail about various
financial products available in our market - from the point of risk, return, taxability, etc. We have also
studied about the two types of Asset Allocation plans. Based on the client’s background information
which we have obtained though data sheet and meetings we should prepare an Asset Allocation Plan
specifically for the client. The ultimate success of the financial planning process that helps the investor
to meet his financial objectives depends to a large extent on the right Asset Allocation Plan. Hence due
care and lot of thoughts should go into preparing the same.
Basically financial assets are equity oriented and debt oriented. The equity oriented assets whether
direct investment in equities or indirect investments in equities through the mutual funds do not assure
any returns; the returns are market oriented and these act as ideal hedge against inflation. Equity, as an
asset class has delivered superior returns over long periods of time. Hence, equity shall form an integral
part of any portfolio – the proportion will vary according to the profile of the investor. Debt oriented are
fixed income instruments and many of these assets like bank deposits, small savings schemes, corporate
debentures and fixed deposits carry fixed rates of interest and as such there are no uncertainties about
the same. However the indirect investments in debts through the mutual fund route do not offer any
fixed rate of return. These investments are relatively safer with lower rate of return and market oriented

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securities like Government Securities, corporate bonds, etc. face interest rate risk over time. Real
estate/property/commodity/bullion, etc. are not financial assets and hence not considered in structuring
An Asset Allocation Plan but many people do resort to investments in these classes of assets as well.
While considering these assets in evaluating portfolio risk and return it has to be borne in mind that
these assets are risky and the returns are not assured – hence resemble equities rather than debts.
Here are some thoughts how Asset Allocation Plans are made, for different classes of investors:

Example 1
n Old couple
n Age around 60 years
n Retired
n Children financially independent
n Preserving capital; regular income and inflation are their concerns
n Conservative approach – Asset allocation can be as under:

Example 2
n Mature couple with grown children:
n Age around 45 years
n Children undergoing education
n Capital growth at a moderate rate and some income flow are their requirements
n Around this age the income level is quite high; the capacity to invest is high
n Commencement of some retirement planning is also essential
n Moderate risk – The asset allocation suggested can be as under:

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Example 3
n Young couple with small children
n Age around 30 years
n Income flow reasonable
n Outgo on account of home loans, etc. on the higher side
n Expenses high because of small children
n Reasonably aggressive portfolio with emphasis on growth – asset allocation suggested is :

Example 4
n Young single professional
n Age around 20/25 years
n Can afford to take risk
n No liabilities built up
n Need to save on a systematic basis
n High risk portfolio desirable – Asset allocation may be as under:

The actual portfolios

Once the asset allocation is finalized then the next step is selecting the right products under each asset
class. The financial planner should be fully informed about the various financial products, the risk, the
return, track record of performance, suitability to the client and such other features that are relevant.
Based on his assessment, research and the asset allocation plan, as decided, the planner shall
recommend to the client a list of securities – bonds, shares, mutual funds, etc. for investment.
After finalizing the list of securities or the actual investment plan the planner shall forward the same to

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the client for his perusal. It is desirable to meet after the plan is sent to the client and discuss with the
client the rationale for the selection of securities and the structure of the portfolio. The client may have
some doubts and concerns on certain issues or in respect of some products that have been recommended.
The meeting will serve the purpose of clearing such doubts and making the client understand the reasons
for the selection. All issues of related risks and expected returns also should be discussed in the meeting.
If necessary some changes may be made in the suggested portfolio within the broad Asset Allocation
Plan already finalized. The portfolio is then finalized and the plan is put into action through purchase of
securities, making the investments, etc.

Monitoring and review

This is a very important step in the investment process. A proper monitoring and review system is as
critical to the success of the investment plan as selecting the right securities and going ahead with the
right mix of assets.
While monitoring performance of the funds is considered carefully. Funds and stocks have been selected
on the basis of certain criteria. A review is to ensure that these funds/stocks are performing in line with
the expectations. This exercise will enable the investors to take into consideration the developments in
the capital market and various economic factors such as inflation, interest rates, performance of
companies, performance of the economy, etc. Gradual changes in some of these economic fundamental
factors will drive portfolio restructuring decisions.
The portfolio has been created with certain objectives. The percentage of assets within the asset class
– for example the percentage of equity in the portfolio may undergo changes because of changes in the
values of these assets with the market movements. For example when the stock market goes up the
values of equities will go up and consequently the proportion of equities in the total portfolio will also go
up. This will necessitate some selling of equity shares and moving funds to debts to bring down the
proportion of equities to the desired level, as per the asset allocation plan. Thus a rebalancing becomes
necessary in a constant proportion asset allocation model. Rebalancing may be required to adjust the
market risks in a portfolio or because of maturity selection as well.
The client and the planner while implementing the financial plan can lay down certain parameters for
review – generally time based and at times event based. A review can be more frequent; say once in 3
months if active strategies are being employed otherwise a periodic review of debts say once a year and
stocks and equity funds, say once in 3 months could be a good suggestion to the client.

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Review Questions:
1. A retired couple should ideally prefer which of the following asset allocation plans?
a. 60% equity, 35% debt and 5% cash
b. 50% equity, 40% debt and 10% cash
c. 80% equity, 20% debt
d. 30% equity, 60% debt and 10% cash
2. A young man, of 25 years, who has just joined an IT company as a programmer should prefer
which kind of investment planning?
a. Systematic investment plans that take care of capital growth and life insurance
b. Should invest all his monthly savings in Life insurance plans
c. He should leave the job of investments to his father and concentrate on his own job – he is too
young to understand
d. Make lump sum investments in index funds
3. A financial planner should concentrate on which of the following?
a. Understanding the clients’ needs and preparing an asset allocation plan that shall best meet
the client’s financial objectives
b. Distributing financial products to his clients to meet his targets with mutual funds and insurance
c. Constant restructuring and rebalancing of clients’ portfolios resulting in frequent selling and
buying of securities
d. None of the above

1. c
2. a
3. a

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Chapter 17

218 Investment Planning PDP

Regulation of Financial Planners

T he profession of financial planning does not require any licence nor is it regulated in India. Now,
however SEBI is considering regulation of investment advisor and a process of registration so that
the investors get proper advice from qualified, trained, informed investment advisors who will be
accountable to SEBI and the investors.
The financial planners may be selling financial products and providing financial services. Some of the
products are small saving instruments, mutual funds, stocks, insurance linked products, government
bonds, etc.
A mutual fund distributor is required to be registered with Association of Mutual Funds of India (AMFI).
A mutual fund distributor is required to qualify for an examination conducted by National Stock Exchange
on mutual funds before being registered with AMFI. The AMFI registered mutual fund distributor is
required to abide by the code of conduct stipulated by AMFI. The distributor is also required to give an
undertaking on a yearly basis to each mutual fund with whom he is registered that he is abiding by the
code of conduct set by AMFI. Thus mutual fund distributors are regulated and AMFI ensures that
distributors are informed about mutual fund functioning, their products, etc. and that the distributors do
not resort to undesirable practices to push the sales of mutual fund products. If a distributor employs
marketing people/counter staff to market mutual funds it is required that each one of them has passed a
specific examination conducted by NSE. A mutual fund distributor can be inspected by AMFI to ensure
that he complies with all the regulations and code of conduct. The mutual funds are regulated by SEBI.
Stock markets are regulated by stock exchanges in the first place and ultimately by SEBI. Stock brokers
and sub brokers are required to be registered with SEBI. SEBI has clearly spelt out the terms of
operations of stock brokers and sub brokers. One of the most important conditions is client registration.
SEBI has stipulated that all brokers/sub brokers should obtain information from clients in a specified
format along with documentary evidence in support of client personal information – called Know Your
Client (KYC) norms. Then the broker is required to enter into an agreement with the client in a specified
format and allot a unique client ID number to the client. The client’s dealings on the stock exchanges
through the broker will be allowed only after compliance with the above. SEBI has laid down a number
of conditions in the interest of investor protection and the brokers have to comply with the same.
Small savings mobilizations are done through small savings agents. These agents are appointed by
respective state governments on behalf of the Government of India and are subject to terms and conditions
laid by Ministry of Finance, Government of India, on this behalf.
Insurance advisors are registered and subject to the regulations of Insurance Regulatory Development
Authority of India (IRDA). IRDA has laid down the conditions under which an advisor will perform. IRDA
is also the supreme authority in respect of insurance companies as well.
A Certified Financial Planner voluntarily submits himself to a code of conduct laid down by the parent
body “Financial Planning Standards Board, India” and vows to abide by the ethics while practicing as a
Certified Financial Planner.
One of the most important purposes of the regulation of market players in insurance, mutual funds,

PDP Investment Planning 219

stock markets, etc. is that the investor should get informed advice and quality service. It is stipulated by
all the regulators that each distributor/advisor/broker should have investor service departments and
investor grievance redressal mechanisms in place in their respective workplaces.
You will observe that the financial services profession is evolving. In future it will be a much better
regulated place where the advisors will essentially be well informed players who value professional
ethics the most.

220 Investment Planning PDP