03 November 2013

Sunday, November 03, 2013

Somehow I always thought that I was rich. That was till I got married and decided to buy a house, around a decade back. It quickly dawned on me how poor I was :-) I couldn’t afford a house in Bangalore even if I sold or mortgaged my soul. That was pretty bad.

© Secret Millionaires Club,
Warren Buffett teaching kids investing, with cartoons

However, something good came out of it. I started to think beyond fixed deposits for my saving surplus. Couple of months later, my boss’s boss Dharma gave a talk on retirement planning. I figured that with power of compounding, I could build retirement corpus of ₹1 Crore by investing ₹10k/month at 6% for 30 years, which was reassuring. Later my friend and colleague Piyush Agarwal gave me a personal tutorial on investments. I knew nothing and it was akin to Warren Buffett teaching kids basics of investing. From those seeds, I slowly grew plants. I will share some of the saplings from those seeds in this and the next article.

First step is to learn about investment types, asset classes, and their return, reward and liquidity. It will help you in cutting through a lot of financial jargon and assess whether an investment suits your needs.

Risk, Reward, and Liquidity

Risk is the possibility that actual return on an investment could vastly differ from expectation, including the likelihood of loosing part or full investment amount. Higher that possibility and wider the gap between actual and expected returns, higher the risk. It is typically measured by calculating the standard deviation of the historic average returns of an investment. Higher the standard deviation, higher the risk.

Returns or reward is the gain (or loss), typically in percentage, on the original invested amount in a given period of time.

Liquidity is the ability to convert an investment or asset to cash (and vice versa) quickly without affecting the price of the asset. Both time taken to liquidate an asset, as well as potential price movement during that time determines the degree of liquidity. For example, buying or selling a house or a privately held business can take quite a bit of time, and price can fluctuate due to economic events during that period.

Liquidity is often ignored, but it is a very important factor in making investment decisions. For someone with long time horizon, investing a small slice of portfolio in a illiquid and risky but potentially highly rewarding investment is a worthwhile pursuit. But the same is an absolutely bad idea if it makes your portfolio highly concentrated in that one highly illiquid asset and you need money back in, say, one year timeframe. So you should always consider troika of risk, reward and liquidity while evaluating investment alternatives.

Investment Types

There are three basic kinds of investments: ownership, lending, and cash equivalents.

Ownership: These are investment which you own fully or partially. For examples, share in a company or a business, a house or any other real estate, gold or other precious materials, paintings or other valuable art works. Ownership investments are among riskiest and most profitable types of investments.

Lending: These investments are the kind of loans you have given with an expectation of getting the principal back along with fixed return rate. For example, a government or a company may issue a bond where it pays a fixed amount to bond buyer over certain period of time. Lending carries a risk of default where borrower is not able to pay back the interest and/or the principal. Lending investments tend to have lower risks and reward, and are typically more liquid than ownership investments.

Cash Equivalents: These are investments that as good as cash, i.e. can be quickly and easily converted to cash. For example, you can withdraw your money anytime in a saving bank account in a reputed Indian bank. Similarly mutual funds that invest in liquid or ultra-short term assets pay back the redemption amount in a day or two. The risk as well as returns are very small.

Asset Classes

There are five main asset classes commonly available to investors in India:

Asset classes and their characteristics
Asset Class (other names) Investment Type Underlying Security Risk Returns Liquidity Examples
Cash Cash Equivalents Cash Low Low High Saving/checking/money-market accounts, liquid or ultra-short term mutual funds
Bonds (debt, fixed-income) Lending Debt/Loan Low-Medium Low-Medium Low-Medium Bank fixed deposits, Provident fund (PF), PPF, government bonds, company bonds and deposits, debt/income mutual funds
Gold Ownership Physical Gold Medium Medium High Physical gold, Certificates of gold deposits with banks, Gold Exchange Traded Funds (ETF)
Equity (Stocks) Ownership Shares in publically traded companies High High Low-High Stocks, Equity Mutual Funds, Equity-ETFs
Real Estate Ownership Real Estate properties High High Low Residential properties, office/retail properties, Real Estate Investment Trust (REIT)

Low/medium risk investments are also referred as defensive or asset protection/preservation investments, while high risk investments are known as aggressive or growth investments. You need to devise a combination of these asset classes, that suits your needs and risk profile, into your personal finance plan, and execute that plan methodically.

Mutual Funds

As you probably noticed that mutual funds are mentioned for all asset classes in the table above (ETF and REIT are also a kind of mutual fund). Mutual funds collect and pool money from many investors and invest those in one or more asset classes to achieve investment objective declared in the mutual fund prospectus and offering documents. These are operated by professional fund managers and regulated by competent authorities like SEBI. Main advantage is that it gives a professionally managed diversified portfolio of a particular asset class small investors, which is often difficult to create with small investment capital. It also takes overhead of monitoring, purchasing and selling of assets off from the investor. Of course, it comes with a price as these funds charge management fees, and risk of fund manager making poor choices. Value Research Online is a great resource for analyzing mutual funds in India, and it champions cause of small investors. We will get into mutual funds in much more details in future articles.

In the next article, I will discuss how to put together a low time overhead financial plan through passive investment strategy of asset allocation and rebalancing.

Do you have any questions or suggestions, please share them in comments.

What do you think?

  1. Hey, I noticed that you didn't mention ULIPs...

    1. ULIPs are not an asset class, they are hybrid of mutual funds and insurance and invest in some mix of debt and equity asset classes. Similarly endowment insurance policies are hybrid of insurance and debt mutual funds. Both of these products are actually inferior from investor's point of view. I think ULIPs are designed to earn more commission for agents and management fees for the insurance company offering it. I plan to cover these in what NOT to do under insurance.