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INVESTMENT FUNDAMENTALS

Financial Concepts

Investing world is highly chaotic, confusing place and once you type in google on financial concept one would be flooded with large no of jargons and sites explaining various financial concepts. Though Investing needs to be kept simple , world has made it very complex. I personally as an advisor believe in the simplicity of the concept and hence have tried to highlight only few concepts which are of atmost necessity in investments.

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

  • Risk Vs Return
  • Diversification
  • Rupee Cost Averaging
  • Asset Allocation
Risk Vs Return:

Risk and Returns are directly proportional. Ie Higher the risk you take , higher should be your returns and vice versa.

But what amount of risk one can take while investing is the most important factor which generally financial planners like us have to take into account.

Risk means Chance that an investment's actual returns will be different than expected. There are 2 types of risk i.e Actual risk vs Perceived Risk. Most of the time when markets are trading at high PE multiples the risk in equities are high and actual returns received should be low , So actual risk is high but in the mind of investor the perceived Risk is low i.e they will readily invest into equities (same happens with all asset classes) based on past returns. Similarly when markets have corrected ie it is trading at low PE mutiples risk in equities is less and actual returns if invested at that time will be high but Perceived risk is high based on past returns and so most investors do not invest during down cycle of equities.

This is one of the major role of financial planners, ie. to make clients understand the risk vs return tradeoff.


Diversification:

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

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

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

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


Rupee Cost Averaging

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

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

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


Rupee Cost Averaging:

If you ask any successful investors about timing the market they will definitely say it is impossible to do it and if one is trying to time the market there are fair chances that investor losses in the long run. Buying at the bottom of the market and selling at the top is impossible for anybody including Fund managers and hence the concept of Rupee cost averaging came into favour.

Rupee cost Averaging is the process where buying fixed amounts into a security/stock/mutual fund at fixed points in time regardless of the prevailing price. It means that when markets are down you buy more units and when higher you buy less units. Thus cost per unit averages over period of time. This reduces the risk of investing large amount on single day which might be a wrong time.

This concept is very simple yet powerful but works only in long term.

The Systematic Investment Plans (SIPs) by mutual funds work on the same principle and are therefore a highly recommended investment option.

Asset Allocation:

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

In case of asset Allocation, age of the person is also taken into consideration which dividing the assets i.e . Older the person, lesser the risk taken and hence higher would be debt allocation. This is called conservative asset allocation. Similarly younger the age , higher the risk taking capabilities and hence higher equity allocation. This asset allocation is known as aggressive asset allocation

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

Job of the financial planner is to determine the proper mix of investment in the portfolio and same is done with atmost care at K K Credible financial services.