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Unit I

Lesson 1



1.1 Background/Introduction
1.2 Benefits of Financial Planning
1.3 What Are You Planning For
1.4 Components of a Financial Plan
1.5 Globally Accepted Steps in Developing Financial Planning Process
1.6 General Principles of Cash Flow Planning
1.7 How Components Relate to Cash Flows
1.8 General Principles of Budgeting
1.9 Sources of Information
1.10 Overview of Risk Management
1.11 Risk management Process
1.12 Legal Aspects of Financial Planning
1.13 Self-Assessment Questions

1.1 BACKGROUND / INTRODUCTION (Eliud Bundi Ondara, 2016)

“Financial Planning” is essential for each and every person, for almost every decision
involving finance or money. The decision could be related to organizing an event, party or
any celebration, planning for further higher studies, for buying house or land, for managing
daily household expenditures etc. There are number of uncertainties in a person’s life. Thus,
to achieve financial goals, one must possess a good understanding of financial planning &
management. So, it is advisable to start as early as possible. Only the one can get what he or
she wanted in life. Every individual is required to understand the need & importance to
manage his or her finances.

First step should understand financial needs or objectives of an individual, and then the
person could plan how to achieve these goals.

For example-if we are planning a trip, we should find out the available transportation options
with approximate fare details, and then we can evaluate the various options according to our
suitability & select the one which matches our requirements & is within our budget too. After
that we can decide about the accommodation, food & guide charges etc., in a similar manner,
this is how we can plan a trip. Just like that people might want to earn money, in the form of
interest or dividend, capital appreciation etc. For this many investment plans are available in
the market to suit the risk preferences of varied investors.

If a person has knowledge about the financial planning then he could build his portfolio on
his own, otherwise if he can opt for the expert guidance of a financial advisor but for that he
needs to pay the fee to the advisor. When you make your own financial decisions you need to
be more concerned about the each and everything related to spending, financing and

An understanding of finance will help in many ways, a person can judge the advice given by
the financial advisor whether it is useful or not, a person can guide someone in investing or
financing, he can pursue a career in the same field as financial advisors, because many
people lack an understanding of personal finance.

The idea of personal financial planning is very much similar to the idea of planning for
almost anything. You figure out where you are (your current financial position), where you
would like to be (your desired financial position), and planning is required when there is any
difference between the two positions. The process is difficult due to number of factors that
needs to be considered, by their complex relationships with each other, and by the profound
nature of these decisions, because how you finance your life, will to a large extent determine
the life that you live. One of the factors which make the process difficult is risk. In that case
one has to take decision after collecting information so that risk can be minimised.

Personal financial planning is a continuous process. A financial plan has to be revised time to
time. It has to be flexible enough to be responsive to unanticipated needs and desires, robust
enough to advance toward goals, and all the while be able to protect from unimagined risks.
One of the most critical resources in the planning process is information. But to use that
information you have to understand what it is telling, why it matters, where it comes from,
and how to use it in the planning process. You need to be able to put that information in
context, before you can use it wisely. That context includes factors in your individual
situation that affect your financial thinking, and factors in the wider economy that affects
your financial decision making.


If you have knowledge related to personal finance, this can help you accomplish your goals.
In fact, it can help you define your goals. Questions like- Should you go to college? Should
you buy a car? Should you work part-time or focus only on school and try to get a
scholarship? Should you apply for credit card? What are the pros and cons of that decision?
Will get the answer.

If you have good understanding of personal finance, this will help you make informed
decisions about your personal situation. In case if a person has better knowledge of financial
planning so he could have used the money to buy a household necessity item, rather than
buying the ticket for amusement park. He could have also put the money in savings account.
Learning about financial decision making may help an individual to begin thinking in these
terms. We all know money can’t buy happiness, but financial security certainly makes life
easier. Good financial decisions lead to flexibility and allow an individual to achieve true
desires in due time without fear of not being able to make the payments.

Thus, we can say that the understanding of financial planning provides the following
 You can make your own financial decisions
 You are able to judge the advice of financial advisers
 You can also become a financial adviser

1.3 WHAT ARE YOU PLANNING FOR? (Jeff Madura, 2007 & SEBI)

Every person has his or her own personal goals which are different for each individual. These
can range from starting a business to taking a dream vacation. Some of your goals are short-
term in nature, and others may require years to accomplish. When you are thinking of buying
a cycle is a short-term goal whereas saving enough money to buy a house is obviously a
long-term goal. With good financial planning, you can identify your goals and begin working
toward short-term, intermediate-term, and long-term goals—all at the same time. Some areas
in which planning & decision making are required are as follows:

 Education One of the major decisions that you will be required to make is whether to
pursue a college degree or some other type of high school education. There is a
significant relationship between your educational qualification and your earnings
potential. At this point in your life, you should start exploring various career options

and determine the education required to pursue each option. Education is costly and
needs time to complete any course. One should always focus on a career that holds
your interest, and it is also important to investigate the expected payoffs. You should
spend some time planning your career choice and then engage in financial planning to
determine how to pay for that education.

 Emergencies Fund Emergencies can occur to any person at any point of time, such
as car breakdowns may occur. Good financial planning will help you establish an
emergency fund to deal with any future financial crisis. Financial planning guides you
to think about and plan for those unexpected expenses or the possibility of an
interruption in earnings as the result of illness or job loss. If a person starts planning
for any unexpected emergency before time, he can have enough money to cover those

 Buying a Car whenever you want to buy a new car, what sources you can avail. Will
your parents help in buying? Or will you have to pay for it with your own money?
When do you want to buy it? At age 25? At age 30? A good financial planning can
help you determine whether you can eventually afford the car. It can also help you
identify the steps you need to take to buy & own such assets.

 Buying a House every person has this dream in mind to buy his own house. Some of
you might want to travel the world. One can begin saving now for the down payment
of home. What better time to accumulate wealth than when you are young & not
financially burdened? It gets increasingly more difficult to save money when you
have to pay rent and buy groceries. The earlier you begin the less money you have to
set aside on a regular basis. If you plan carefully, you can set aside money for long-
term goals without making any compromises on your short term needs.

 Retirement Financial planning can give you the option of retirement planning as
well. You can begin to build your wealth at an early age. This may allow you to retire
without any worries for post retirement expenses.

 Charity A number of people want to donate some of their money to worthy causes,
and charitable giving is an important component of many financial plans. Some
people may prefer to accumulate wealth and provide a large sum to a specific charity.
Others may donate in smaller amounts on a regular basis. Knowledge of financial
planning can help you achieve whatever goals you may have in this area.


A complete financial plan contains your personal finance decisions related to six key

1. Budgeting and tax planning

2. Managing your liquidity
3. Financing your large purchases
4. Protecting your assets and income (insurance)
5. Investing your money
6. Planning your retirement and estate

All these components are different. For making an overall financial plan we need to
concentrate on each component separately.

1. Budgeting and Tax Planning Budgeting is the process of forecasting future expenses and
savings. The decision of savings and expenditure is different for each individual. It depends
on the preference & requirement of each person. If a person has received Rs.10,000 in a
month, and might have spent Rs.7,000, so the amount which he has not spent on anything
i.e., Rs.3,000 is the amount which will be treated as his saving. Some individuals are big
spenders and some are big savers. The big spenders have lesser of saving and the big savers
will definitely have more of the savings. Budgeting may help a person in estimating how
much of the income will be required to cover monthly expenses so that an individual can
save some portion of his income every month.

Thus the first step talks about the evaluation of income, expenses, assets and liabilities.
Where assets are what you own and liabilities are what you owe, so when we subtract
liabilities from the assets we will get net worth. By calculating the net worth a person could
have the idea about how much saving he has with him, and he can also invest the saved
amount in other investment opportunities. Many financial decisions are affected by tax laws,
as some forms of income are taxed at a higher rate than others. By understanding how your
alternative financial choices would be affected by taxes, you can make financial decisions
that have the most favourable effect on your cash flows. Budgeting & tax planning decisions
are the main component in the decision process as they affect decisions in the all other parts
of your financial plan.

In other words, it involves asking how much you plan to spend next week or next month, and
what is the expected source of that money. The purpose of a budget is to plan your spending
and saving, given your income level, so that you can meet your needs and wants.

Creating a Budget Involves Four Steps

Step 1: Determining Your Net Worth The first step in budget planning is to determine
your current financial position. Do you have money in the bank? Do you owe people money?
Do you have a job? What are your total expenses? Answering these questions can help you to
get an accurate picture of your current financial position. This will help you recognize how
far—or near—you are from your goals and help you set budget priorities. The formula for
determining your net worth is as follows:

Net Worth = Assets - liabilities

Step 2: Establishing Your Income A key factor in shaping a budget is to know your
income. Income is the money coming in through wages earned, allowances received, or other
sources. Having an income is the major means by which a person saves money, builds
wealth, acquires assets, and fulfills wants and needs. Your income will determine many of
the details in your budget. A person’s income is often positively correlated to his education
and career choice. In general, more education or specialized training translates into more
income. Think about the people you know who are making good money. What jobs do they
do? You will probably list a number of professions, some that require a college degree, such
as medical professionals and teachers. Others, such as electricians, mechanics, and plumbers
require specialized training. In almost every case, you will find that higher income comes
with higher levels of education and/or training.

Step 3: Identifying Your Expenses Your expenses are also important in your budget. When
you create your budget, you will estimate how much money you are spending every month.
Typical expenses might be on food, clothing and entertainment. Some of you might even
have a car payment and related expenses. Note that your consumption patterns are highly
dependent on your life stages & thus will change over time accordingly. You will need to
have accurate estimates of your expenses to determine how much you can save. Remember
that saving for the future requires you to cut down on expenses today.

Step 4: Considering the Impact of Taxes Income taxes—money owed to government on

earned income may also impact your budget. In general, more the money you make, the
higher the taxes you pay. As your income level increases, you might want to begin to include
tax planning in your financial plan. For example, you may want to save some of your income
in ways that help you put off or avoid taxes. Examples include certain retirement or college
savings plans. Tax laws change constantly, and many of your financial decisions will have
tax impacts that you will want to consider.

2. Manage Liquidity liquidity means access to funds to cover any short-term cash
deficiencies. A person should always have certain amount of cash with him for the short term
cash needs because you unexpected expenses which may arise in near future. A person can
enhance his/her liquidity by using money management and credit management.

Money Management is the decision to decide how much should be retained by the person in
liquid form and how much should be invested in the short term investment plans. If a person
has access to money to cover cash needs, it means he has sufficient liquidity and vice versa.
So a person should decide how much to invest and where to invest for receiving some
amount of return. Even the decision regarding liquidity should also be taken into
consideration. Thus if any unexpected expenditure arises in the near future, he/she has
sufficient cash for the same. Money management involves making decisions about how
much cash to keep in reserve and how much to invest in less liquid assets, such as real estate
(land & buildings). If a person finds out that he doesn’t have enough money to cover his
immediate needs, then you need more liquidity. Sometimes you may have the money
invested but that is not easily and quickly accessible. In that situation you should think
wisely. Money management helps you determine how much money to keep liquid to avoid
cash shortfalls.

Credit Management is the use of borrowed funds, while investing or utilizing it for the
daily expenditure. So here the person should do the research on- from where to borrow and
how much to borrow. Credit, however should be used only when necessary, it can be very
costly, as you will need to pay back borrowed funds with interest (and the interest expenses
may be very high). For example- credit cards can be very costly. When you use credit
(borrow money), the lender charges interest on the money you borrow. Think of the interest
rates, some lenders charge higher interest than others. In general, it is not wise to rely on
credit cards if you will not be able to pay back the borrowed money quickly. Whenever a
person doesn’t have sufficient cash, credit management helps in that situation and also
enhances the liquidity. Credit is commonly used to cover immediate cash shortfalls, so it
increases liquidity. A financial plan should contain a credit management plan. This might
involve details such as limiting the number of credit cards you have and the amount of credit
you can use at any one time.

Thus, liquid assets include cash and assets that can be quickly and easily turned into cash.
Your level of liquidity, then, refers to how much readily available cash you have in hand for
meeting immediate wants and needs. Note that your liquidity is very different from your net
worth. You may have a number of valuable assets, but if they are not liquid, they will be of
little use to you when facing a short-term financial need. For example, what if your car

breaks down or you need new tires? Or, what if, you need Rs 2000 to pay for a field trip?
The fact that you own a car worth 500,000 will do little to help you solve such problems.

3. Planning for Financing loans are needed to finance large expenditures or capital
expenditures, such as the purchase of a car or a home, payment of the college fees etc. The
amount of financing needed is the difference between the amount of the purchase and the
amount of money you have available with you. So the choice of loan will depend on the
ability to pay the loan back, maturity of the loan and one with the least interest rate. Major
purchases such as cars, houses etc. typically require borrowing money for long periods of
time as people don’t have enough cash to pay for such huge expenses. However, it is
common to pay a portion of the cost of a house or car and to take a loan for—or finance—the
remaining amount.

4. Planning for Protection of Assets and Income To protect your assets, you can go for the
insurance planning. For the protection of vehicles there is an automobile insurance and even
there is facility to protect your home and factory. For the medical expenses we have health
insurance by different companies. And for protecting the income we have life insurance. As
you accumulate assets, you need to devise a plan to protect those assets. For example, if you
buy a car, what happens if that car is stolen or rammed in a parking lot by another car?
Unless you have insurance on that car you will suffer the loss of that asset yourself. You are
assuming all the risk—the possibility of a financial loss. Risk is related to the likelihood of
loss. If there is a greater chance of your suffering a financial loss, then the risk is higher. For
that reason many people purchase insurance.

Insurance planning is a component of your financial plan that determines the types and
amounts of insurance you need. What other assets should you have insured? People typically
insure houses, boats, cars etc. However, you also need insurance to cover you in case of other
unexpected events, such as an illness or injury. Your parents also have life insurance that will
provide a cash amount in the event of their death which provides financial safeguard to the
loved ones left behind.

5. Planning for Investing The meaning of investments is that a person will sacrifice some
amount of income at present in expectation of future returns. The return will be varying due
to the investment proposals available to the investor. Thus any funds that a person has
beyond what is needed to maintain liquidity should be invested. Investment opportunities
available to the investors are equity shares, mutual funds, bonds, stocks and real estate etc.
All these investments have certain level of risk. The variation in the return is called risk.
Hence this needs to be managed so that the risk is limited to a tolerable level. You know you
need to accumulate some funds for liquidity to meet day-to-day expenses and to pay for

sudden unexpected events. Any other funds that you do not spend should be invested with
the expectation of earning even more money.

6. Planning for Retirement and Estate One should think about the source of income after
retirement. So he should invest in some retirement plans well before the retirement and could
get the sufficient amount of money after the retirement. The money which is invested in
retirement plans is also protected from the tax until it is withdrawn from the retirement
account. How many of you know people who are retired? Have you noticed that some people
retire earlier than others? People who retire early are often people who began planning for
retirement while they were young.

Retirement planning involves determining how much to save for retirement every year and
how to invest that money. The government provides several ways to save for retirement that
allow you to accumulate wealth without paying taxes until you retire. By putting off paying
taxes until later, you increase the amount invested. This, in turn, may increase the amount of
money the investment earns.

Whereas estate planning is the act of planning how the wealth will be distributed before or
upon your death. Effective estate planning protects the wealth against unnecessary taxes, and
ensures that the wealth is distributed in the manner that a person desire.


PLANNING PROCESS (Jeff Madura, 2007)

Step 1: Establish Financial Goals

A person should specify his/her goals in the form of purchases that he/she wishes to make
someday, or his goals may simply be to get out of debt or improve the credit history. If an
individual simply wants to accumulate a specific amount of savings over time so that he can
afford to do whatever he wants in the future, help other family members, or contribute to a
worthy cause. An individual should also have this in mind that the goal needs to be realistic.
You have read several times that planning can help you achieve your goals. But what are
your goals? What do you want to accomplish in the future? Needless to say, you cannot
reach a goal if you do not know what it is. Establishing clear goals is essential to any
successful plan. You can categorize your financial goals in terms of when you hope to
accomplish them as follows:

 Short-term goals are those you plan to accomplish within the next year. For
example- To save enough money to buy an MP3 player in a few weeks.
 Intermediate-term goals are those you aim to meet within the next one to five
years. For example- To save enough to buy a nice car next year.
 Long-term goals will take more than five years to accomplish. For example-To
save enough money for the down payment on a house in the next 10 years.

As your goals become more involved, you will need a more specific and ambitious financial
plan. It is essential that you set realistic goals. Goals must be achievable. It does not do any
good to set a goal that you can never reach. If you focus on unrealistic goals, you will likely
become discouraged when you do not achieve them. On the other hand, establishing an
achievable goal encourages you when you accomplish it or as you see that you are making
progress toward it. Remember you will set a number of goals for your financial life. In
particular, you will want to set goals for each of the components of your financial plan.

Step 2: Consider the Current Financial Position

Second step in the financial planning process is concern about considering the current
financial position. Even in the day to day life activities or events people consider their
current situation. Let’s take a case of planning for a trip. And if you are new to the place and
don’t know how to reach the destination. Then before starting your journey, you need to
make a plan and your current position, because your selection of transport is based on your
current financial position. The same principle is true for your personal finances. You need an
accurate picture of your current personal and financial situation. Only then you can plan
effectively. Your decisions about how much money to spend next month, how much to save,
and how often to use your credit card depend to a large extent on your current situation. A
person with a lot of debt and no assets will make different decisions about spending and
saving than a person with low debt and a lot of assets. People with no dependents make
different decisions than married people with children. People make different decisions at age
18 than at age 50. So we can say that different people see things differently.

Since financial goals depend on your income, you can see that they are based on your level
of education and your choice of career. Simply saying, having a good, solid income allows
you to set more and loftier goals. You may know where you are and where you want to be,
but you also need to know what roads to take to get there. A forecast is a projection about
what will happen in the future. For business and personal finance, forecasts typically involve
making projections about cash flows money you have coming in (inflow) and going out
(outflow). Obviously, when we are evaluating our financial position, it is helpful to make
projections about the future. For individuals, cash inflow is referred to as income. You can

get income from some external source, such as a job, allowance from your parents, or a
scholarship. You may also get income from savings or investments—for example, interest
earned on a savings account. Most people also have cash outflows to consider. We refer to
these as expenses. An expense is anything on which we spend money. Examples include the
phone bill and car payments. Some expenses we are obligated to pay every month and may
be fixed. For example, rent of Rs 6000 a month would be a fixed expense. Fixed expenses,
by definition, remain the same from period to period. Other expenses may be variable, or
change from one period to the next. Your phone bill is an example of a variable expense.
Each bill differs depending on how many minutes you use in the billing period.

Step 3: Identify and Evaluate Alternative Plans that Could Achieve Your Goals

Individual must identify and evaluate the alternative financial plans that could achieve his or
her goals, given the financial position. For example, to accumulate a substantial amount of
money in 10 years, you could decide either to save a large portion of your income over those
years or to invest your initial savings in an investment that may grow in value over time. The
first plan is a more conservative approach, but requires you to save money consistently over
time. The second plan does not require as much planning, because it relies on the initial
investment to grow substantially over time. However, the second plan is more likely to fail
because there is risk related to whether the value of the initial investment will increase as

Step 4: Select and Implement the Best Plan for Achieving Your Goals

After you develop multiple ways to achieve a goal, you need to decide which option is most
realistic and suitable for you. Two people who seem to be in identical situations may still opt
for two different plans. Your tolerance for risk and your self-discipline often determine
which particular plan offers the best option for achieving a specific goal. Risk is often
defined as the likelihood of loss. Think about different tolerances for risk in terms of a game.
Your school may be playing last year’s state championship in the opening game. Some of
your team members are dreading the game because they realize the risk that they will lose is
very high. These players have a low risk tolerance. However, some other team members
welcome the risk. They are excited about the game because even though the risk is high, the
potential reward is huge. They realize that if they are able to beat the state champs, they will
achieve much recognition. Neither of these two attitudes is right or wrong. Each indicates
different tolerances for risk. You can apply the same thought process to your financial
decision making and financial plan. Some of you will choose plans that have a higher level
of risk of loss but also have a higher potential payoff. Others will pick plans with lower risk
that are more certain to accomplish the ultimate goal.

Step 5: Periodically Evaluate Your Financial Plan

After selecting a plan, you need to monitor the progress because sometimes plans may falter
or get off track. Unless you are monitoring your progress toward your goals, it is likely that
you will not notice a problem and make any needed adjustments. So the question which
arises are- is your financial plan working properly? That is, will it enable you to achieve your
financial goals or not?

Step 6: Revise Your Financial Plan

What will happen if you find out that your plan is unachievable? If you find that it is difficult
to follow the financial plan that you developed, you need to revise it. But keep in mind, any
revision to one part of your financial plan may impact other aspects of your plan. By the
time, your financial position will change, especially upon specific events such as graduating
from colleges, marriage, a career change, or any big event. As your financial position
changes, your financial goals may change as well. You need to revise your financial plan to
reflect such changes in your means and priorities.

For example- Arjun’s original financial plan required that he should save Rs.5000 a month
for 2 years in order to have Rs.120000 for the down payment of a car. However, after one
year he has managed to save only Rs50000. What will Arjun need to do in order to
accomplish his original goal?
Solution: In this case Arjun needs to save another Rs 70000 to reach his original goal (i.e.
120000-50000=70000). To accomplish that goal he needs to save rs70000/12 = Rs 5833.33
per month. Hence he will have to increase his savings to Rs 5833 approx. per month to
accumulate Rs 120000 by the end of next year. So whatever the plan is, this needs to be
monitored periodically. And revise the plan whenever it is necessary.


Just like business plan, a set of financial statements providing information related to cash-
flow is essential. This will provide details of actual cash required by your business on timely
basis may be day-to-day, month-to-month and year-to-year basis. The needs of a business
entity constantly changes and cash flow will highlight any shortfalls in cash. And it is
required at that time to think for those shortfalls. Even there should be some measures to
overcome these deficiencies. Many established and even profitable businesses fail due to
cash not being available when they need it most. Good cash flow management is critical to
run a successful business. You must have certain amount as reserve so that you are able to

pay your bills while you await payment from your customers. There are many well-
documented cases of businesses failing not because they were not profitable but because of
poor cash flow management.

It is said that you're in business to make a profit. You won't be able to stay in business,
however, unless you have cash, hence the famous adage 'cash is king'. There will probably be
a time lag between your business providing its goods or services and getting paid. This
means you have to make sure that there is sufficient cash in your company's bank account for
the payment of all its bills in the meantime. Whether these are related to invoices from
suppliers, employees' wages, rent, taxes or anything else. Even if the business is profitable,
there may be times when you are short of cash because may be you are awaiting payment for
a large order. This is likely to be a particular problem during your first year when you are
building up your business and don't have regular cash inflows.

The General Principle of Cash Flow Management is that

 You should speed up your cash inflows (customer payments, interest from bank
accounts etc.) and
 Slow down your cash outflows (purchase of stock and equipment, loan repayments
and tax charges etc.) as much as possible.

It can be difficult to affect your outflows other than extending your credit terms with your
suppliers, which will often occur on fixed dates in the month and your employees and
suppliers might also not take too kindly to you delaying payment to them. But there is more
scope for you to improve your cash inflows. This could mean billing regularly, chasing bad
debt, selling your debt to a third party (factoring), negotiating extended credit terms with
suppliers, managing your stock effectively (which could entail ordering little and often) and
giving your customers 30-day payment terms. Also, as businesses naturally have peaks and
troughs, it is important that you put money away during the peaks so that you can dip into it
during the troughs. It is a good idea to think about investing in some accounting software to
help you manage your cash flow.

There are many software providers: an internet search should reveal the most common. Most
provide software that can help you with cash flow analysis and forecasting, so that your
business is never caught short of cash in the bank. Your accountant should be able to help
advice you on which software package to buy.

and Shepherd G. Pryor IV, 2006)

A person receives cash inflows in the form of income from the employer and uses some of
that cash to spend on products and services. Income focuses on the relationship between the
income and the spending. The budgeting decisions determine how much of the income to
spend on products and services. The residual funs can be allocated for the personal finance
needs. Liquidity management focuses on depositing excess cash or obtaining credit if the
person is short on cash. Financing focuses on obtaining cash to support the large purchases.
Protecting your assets and income focuses on determining your insurance needs and
spending money on insurance premiums. Investing focuses on using some of the cash to
build the wealth. Planning for the retirement focuses on periodically investing cash in the
retirement account.

In case if you need more cash, you should invest the money which is left after using for day
to day expenses. For that you should invest your savings in some of the investment plans (as
per the risk preference of the investor).

Basic Principles to Consider When Preparing Cash Flow Forecasts and Plans

1. Understand cash flow contributions of different product lines and/or business units
and overall strategies and risk involved.
2. Involve those who will be accountable.
3. Identify and communicate key performance measures.
4. Adapt the cash flow planning and update processes to the organisational capability.
5. Encourage open debate and fact-finding on the cash flow plan.
6. Quantify the magnitudes and likelihood of risks and opportunities to the base plan.
7. Monitor execution weekly or daily.
8. Update assumptions and renew outlook weekly.
9. Communicate thoroughly.
10. Recognize owner and stakeholder priorities.
11. Focus on significant improvements and strategic initiatives.
12. Measure and monitor the results.


Creating a budget is a key part of your financial plan. A budget is a forecast of future cash
inflows and outflows. Once you have identified your personal goals, you need some specific
plans about how to reach those goals. Your household budget provides that guidance. It gives
you a detailed road-map to your financial future. He wants to pay off his credit cards, save
some money for a rainy day, and treat himself to a few things he wants. Can he accomplish
all those goals? If he plans well and doesn’t attempt to do all of them at once, he can achieve
his goals. A budget will be a detailed plan of action for the next several years.

Step 1: Create a Personal Cash Flow Statement

The first step in the budgeting process is to identify your current cash inflows and outflows.
Any money that is coming is a cash inflow. The primary cash inflow for most people is their
salary, hourly wages, or any money they earn. However, some people may have income from
savings accounts or other similar sources. Others may receive an allowance and perquisites
of some type. In addition, if you receive money from a scholarship, that is income, too.

Any money that is going out is a cash outflow. Expenses such as car payments or insurance
premiums are cash outflows. At some point you may begin paying rent and utilities or your
cell phone bill. These are all cash outflows. Typically, family size, age, and your personal
spending habits have an impact on cash outflows. Your personal cash flow statement records
both cash inflows and outflows. This allows a person to easily track where your money
comes from and where it goes.

Step 2: Turn Your Cash Flow Statement into a Budget

The next step is to turn your personal cash flow statement into a budget. To do this, you must
forecast your net cash flows for a period of time into the future. A good budget should cover
anticipated cash inflows and outflows for several months to a year or more. As you work on
this step, it’s important to think about how your cash flows might change from month to
month. Will you spend more money at certain times of the year, or are your cash flows
similar from month to month? What about the holiday seasons? Be sure that you consider
expected but irregular expenses. Examples include activity fees for school functions or
money for your summer break activities. A yearly vacation is another example of an expense
that will not show up in the typical month.

Indeed, many people find that expenses occur unexpectedly. Accidents or medical
emergencies are unpredictable. What happens when you are at college and you unexpectedly

need to return home for a weekend? Who will pay for the gas? A good budget will force you
to set aside money to take care of unexpected expenses and to take advantage of unexpected
opportunities. Taking your personal cash flow statement and turning it into a budget for an
entire year involves some guesswork and estimating. Obviously, you cannot plan the exact
cost of events or expenses that have not occurred yet. You can always go back and adjust the
budget as you get more information. This annual budget can help you identify times when
you can save money and times when you will have more outflows than inflows.

Step 3: Working with and Improving Your Budget

We know that a budget is a great planning tool. A budget can help you save money for major
purchases, unexpected expenses, and unexpected opportunities. One of the primary benefits
of a budget is that it will help you anticipate future cash shortfalls. This may be tempting for
individuals to satisfy all their desires at once, perhaps by continuing to overuse their credit
card. However, this is a risky path that leads many people into financial disaster. With a good
budget, people can meet their wants and needs without a costly and unwise dependence on

Step 4: Assessing the Accuracy of the Budget

One of the things you need to do is periodically evaluate your forecasts and compare these
with the actual cash flows. It’s a good idea to look at last month’s forecasts or the last three
months’ forecasts and compare those with actual numbers. The best way to know exactly
how you spend your money is to keep an expense details. Write down every rupee you spend
during a week or a month. It might really surprise you where your money is going.
Sometimes you will find that you underestimated your cash outflows or were too optimistic
regarding your cash inflows. The difference between what you forecast and what actually
happens is known as forecast error. After knowing the forecast error, you may find that you
need to adjust your spending. If you continue to come up short of money at the end of each
month, you need to increase your income or decrease your outflow.

It is important to have a good knowledge of budgeting principles that can make the
difference in the financial health of the organisation. Failure to engage in sound budgeting
processes would be the main reasons why companies and organisations fail. Even for
personal financial planning these steps should be followed. An individual should always
keep in mind that panning at each level is required. And comparison of forecasts and actual
budget will tell the position of an individual. And that person can work on that difference to
make his position better.

1.9 SOURCES OF INFORMATION (M. Ranganathan and R. Madhumathi and

It may seem difficult to think about some aspects of financial planning right now. Goals may
seem too numerous or out of reach. The stakes of good and bad decisions may seem high.
Fortunately, there are many resources available to help you make good choices. The 4 main
areas are:

1. Print and media Books, periodicals, newsletters, television and radio programs
2. Digital sources websites, blogs, phone apps, online videos, social media
3. Financial experts seminars courses with financial planners, bankers, accountants,
insurance agents, credit counsellors, tax preparers
4. Financial institutions materials from credit unions, banks, investment, insurance,
real estate companies

The Internet can be a wonderful source of information about a number of financial aspects
of your life. You can use the Internet to research prices of major purchases or look up
investment performance data. There are a number of Websites that provide payment
calculators, benefits or information on wealth building. However, the Internet also poses
some dangers. You need skill and care to evaluate the quality of information you find there.
And you must always be cautious about advice from sources that are selling a service. The
Internet has its share of unethical people trying to defraud you and increase their wealth at
your expense.

Understanding personal financial planning will help you make good decisions about how to
spend money, finance purchases such as cars and houses, and save and invest your money.
However, many of you may want to turn some of these decisions over to professionals who
understand all the tax laws and can monitor your investments more closely. Many people
spend more time picking out music to download than they spend choosing a financial
advisor. Understanding financial planning will help you determine whether an advisor is
giving you advice that is in your best interest.

Again, the Internet is a good source of information about financial planners. Stick with
planners who have reputable credentials such as a Certified Financial Planner (CFP) or
Certified Public Accountant (CPA), since credentials indicate a certain level of knowledge
about financial planning. Remember that no matter who you hire to help you with your
finances, you are responsible for monitoring your own investments. Be cautious. Never rush
into a financial decision. If someone tries to rush a decision, it is rarely good for you. There

are many resources available to help you make your financial decisions. One resource is the

Other resources include financial planners or advisors. Financial planners or advisors can
help you with all aspects of your financial decisions including monitoring your investments
and keeping you posted on tax law.

1.10 OVERVIEW OF RISK MANAGEMENT (Prasanna Chandra, 2012)

Every organization, no matter how large or small, inherently possesses exposures to risk.
They change constantly and are rarely stationary. Employees come and go, new services and
programs are provided, outdated services and programs are eliminated, equipment wears out
and must be replaced, facilities are built, renovated, demolished, laws change, the state’s
business marches on. Thus, management of these risks requires a coordinated, disciplined
managerial approach to eliminate or control the risks. This managerial approach is called
―risk management.‖

A Risk Exposure is the possibility of loss or injury because of some peril or cause of a loss.
Management is the process of planning, organizing, staffing, leading, and controlling human
and physical resources in order to achieve the organization’s objectives and goals. Therefore,
Risk Management, by definition of its component terms, is the management process of
planning, organizing, staffing, leading, and controlling an organization’s resources to
minimize the possibility of loss or injury from various causes of loss. Simply stated, risk
management is the process of identifying and controlling an organization’s losses.

Quite often, risk management is too narrowly defined. The term is often thought to simply
mean a safety program. Or, it is thought of as being the arm of the organization that deals
only with insurance matters. Safety and insurance are both components of a risk management
program. However, because risk exposures exist in all areas of the organization, a
comprehensive risk management program involves the risk management staff in accounting
and finance, law, human resources, and all operations of the organization.

Benefits of Risk Management

A well-conceived, comprehensive risk management program requires a significant

commitment of time and resources by the organization. However, the cost of this
organizational commitment is fully mitigated by the realization of the following benefits to
the organization that are the direct result of the risk management program:

 Reductions in misuse, theft, and/or losses to equipment and property
 Reductions in the frequency and severity of accidents
 Reductions in the expenditures of claims
 Reductions in legal expenditures
 Increased productivity
 Improved employee morale.

Objective and Goals of Risk Management

Reducing the cost of risk is the primary objective of a risk management program. The cost of
risk for a specified loss is the total value of all related costs and resources, both direct and
indirect. The total cost of risk to an organization is the sum of the following:
 The replacement value of all equipment and property damaged or lost Total claims
expenditures, including legal expenditures.
 The costs of insurance premiums, lost productivity, Administrative and overhead

Since reduction of the cost of risk is the primary objective of a risk management program,
specific goals that support this primary objective are to minimize exposures to financial
losses- Protect physical assets, Reduce the frequency and severity of accidents. Provide a
reasonably safe environment for employees and the public Minimize interruptions of services
provided to the public.

1.11 RISK MANAGEMENT PROCESS (Stephanie Ray, Oct 2017)

The steps of the risk management process

1. Identification of Risk It allows operations staff to become aware of potential

problems. Not only should risk identification be undertaken as early as possible, but it
also should be repeated frequently.

2. Analyze and Prioritize Risk analysis transforms the estimates or data about specific
risks that developed during risk identification into a consistent form that can be used
to make decisions around prioritization. Risk prioritization enables operations to
commit resources to manage the most important risks.

3. Plan and Schedule Risk planning takes the information obtained from risk analysis
and uses it to formulate strategies, plans, change requests, and actions. Risk
scheduling ensures that these plans are approved and then incorporated into the
standard day-to-day processes and infrastructure.

4. Track and Report Risk tracking monitors the status of specific risks and the progress
in their respective action plans. Risk tracking also includes monitoring the
probability, impact, exposure, and other measures of risk for changes that could alter
priority or risk plans and ultimately the availability of the service. Risk reporting
ensures that the operations staff, service manager, and other stakeholders are aware of
the status of top risks and the plans to manage them.

5. Control & Learn Risk control is the process of executing risk action plans and their
associated status reporting. Risk control also includes initiating change control
requests when changes in risk status or risk plans could affect the availability of the
service or service level agreement (SLA). Risk learning formalizes the lessons learned
and uses tools to capture, categorize, and index that knowledge in a reusable form that
can be shared with others.

Management of Risk with the Help of Following Measures

(a) Investment, (c) Retirement solutions,

(b) Insurance, (d) Tax and estate planning.

(a) Investment

Investment planning is an essential part of the financial planning process. Without a proper
investment plan, the client is unlikely to reach the set target in funding his/her retirement and
educational needs. In investment planning, some of the important factors that need to be
considered are as follows:

 What is the person's risk profile - How averse is he to investment risk? This will help
determine proper asset allocation and selection of investment vehicles. A more
conservative investor should opt for an asset allocation that takes into account his
aversion to high investment risk taking.

 What is his time horizon - How much time does the person have to achieve his
financial objectives? If the time horizon is long, investments having a higher risk and
potential returns may be resorted to or may be to produce a better yield.

 What are the person's financial objectives? To accomplish anything, it is necessary to
set targets. This is especially so in the realm of investments.

In finance, an investment is a monetary asset purchased with the idea that the asset will
provide income in the future or will be sold at a higher price for a profit. The term
"investment" can be used to refer to any mechanism used for the purpose of generating future
income. In the financial sense, this includes the purchase of bonds, stocks or real
estate property. Additionally, the constructed building or other facility used to produce goods
can be seen as an investment. The production of goods required to produce other goods may
also be seen as investing.

Taking an action in the hopes of raising future revenue can also be an investment. Choosing
to pursue additional education can be considered an investment, as the goal is to increase
knowledge and improve skills in the hopes of producing more income. Investment products
are available for individual and institutional investors, and are purchased in an attempt to
generate a profit. Some investment products, such as certain types of bonds, provide a fixed
interest payment in addition to a return of the initial investment at the time of maturity. Other
types of investment products, such as stocks, which have greater risk and on the other hand
earnings are not guaranteed.

Thus, Investment means to purchase various financial instruments which will pay you a
return on some future date. The difference between savings and investment is that savings is
simply idle cash while investments help your funds to grow over a period of time. We can
meet our short-term needs with our savings but to meet our long term goals we need to make
investments. Savings help to protect our principal while investments help us earn returns
over our investments.

(b) Insurance

Insurance is a means of protection from financial loss. It is a form of risk

management primarily used to hedge against the risk of an uncertain loss. An entity which
provides insurance is known as an insurer, insurance company, or insurance carrier. A person
or entity who buys insurance is known as an insured or policyholder. The insurance
transaction involves the insured assuming a guaranteed and known relatively small loss in
the form of payment to the insurer in exchange for the insurer's promise to compensate the
insured in the event of a covered loss. The loss may or may not be financial, but it must be
reducible to financial terms, and must involve something in which the insured has an
insurable interest established by ownership, possession, or pre-existing relationship.

The insurer receives a contract, called the insurance policy, which provide details related to
the conditions and circumstances under which the insured will be financially compensated.
The premium is the amount of money charged by the insurer to the insured for the coverage
set forth in the insurance policy. If the insured experiences a loss which is potentially
covered by the insurance policy, the insured submits a claim to the insurer for processing by
a claims adjuster.

Methods of Insurance

In accordance with study books of The Chartered Insurance Institute, there are the following
types of insurance:

 Co-insurance risks shared between insurers

 Dual insurance risks having two or more policies with same coverage
 Self-insurance situations where risk is not transferred to insurance companies and
solely retained by the entities or individuals themselves
 Reinsurance situations when Insurer passes some part of or all risks to another
Insurer called Reinsurer

(c) Tax and Estate Planning

While tax evasion is illegal and punishable under the law, it is lawful to minimise one's tax
obligations if done legally. The financial planner will normally work in hand with a tax
adviser to help the client derive and implement a tax plan that will minimise the tax outlay of
the client.

In estate planning, the financial planner helps the client to develop and implement an estate
plan that will enhance and preserve the client's assets during his lifetime, minimise his estate
duty liabilities upon his death and ensure that the estate is managed and distributed to
beneficiaries in accordance with the client's wishes. Such recommendations may involve the
drawing of wills and trust instruments. Nominated executors and guardians will have to be
thoroughly briefed and conveyances may have to be effected to achieve the desired

Estate planning is even farther into the future than retirement but is something you should be
aware of. Estate planning is the process of determining how your wealth will be allocated on
or before your death. In other words, what happens to your assets when you die? Do you
want them to go to the state, to a particular charity, or to your children and grandchildren? If

you resolve these questions prior to your death, you are more likely to have your wishes
honoured. It will also make it easier on your loved ones.

(d) Retirement Planning

India and other countries too currently face a problem of an aging population. The future
increase in the elderly population will pose questions such as:

 How will their medical needs be taken care of?

 How can they remain useful and productive?
 How will their financial needs be met?

One of the government's answers to these questions is to increase public awareness of

financial planning and to encourage people to obtain proper financial planning advice so that
their retirement needs will be taken care of during their golden years.

The financial planner assists their clients by deriving and implementing a suitable retirement
plan to realise their retirement objectives. He helps the clients calculate their retirement
funding needs and comes up with a savings and investment plan for them.


In the area of legal practice, financial planning can play a useful role in helping the lawyer
give more holistic and complete legal advice to their clients. This is particularly so in areas
that impinges on the personal financial affairs of the client. Apart from knowing the
technicalities of the law, an understanding by the lawyer of the financial aspects of a legal
problem can help address the more fundamental needs of the client. Some examples can be
found in the areas of:

(a) Family law; (b) Wills and estate matters; and

(c) Bankruptcy matters.

(a) Family Law

Financial planning is particularly useful in the area of family law practice. Under most
divorce matters, maintenance and division of matrimonial property are important matters that
have to be addressed by the courts.

The courts, in deciding on maintenance issues, will have to look into the financial needs of
the family and how the spouse should contribute, particularly in meeting the financial needs
of the children. In many cases, however, the party that needs the support may not be
knowledgeable enough to determine exactly what his/her needs or the dependants' needs
should be.

More often than not, they end up giving estimates which may not be accurate. Should there
subsequently be a shortfall, a further application to the court may be necessary to seek
redress. This often results in additional legal costs and time spent. However, if the lawyer is
armed with relevant financial planning knowledge, he can advise his clients and guide them
in a manner where accurate computation of maintenance needs can be derived. Sometimes a
party may agree to pay a lump sum to the other spouse as provision of maintenance, and then
the financial needs of that spouse throughout her entire life would be a relevant
consideration. In such cases, financial planning advice will be useful in determining the
global amount.

An important factor for the courts to consider in deciding on maintenance is what amounts
the payer can afford. The courts in making a decision will, among other things, need to
balance the interest of all parties concerned. The application of the financial planning process
will enable the payer to determine his own personal needs and, if they are properly derived,
the courts will be better persuaded to accept his position and submissions when allocating

(b) Wills and Estate Matters

Financial planning can be very useful to the lawyer in estate matters, such as the drafting of
wills. Under most circumstances, a lawyer normally takes instructions from the client and
drafts a will in accordance with such instructions. The lawyer is mainly concerned with
ensuring that the will is technically and legally valid and in accordance with the instructions.
However, the lawyer is often unable to advice as to whether the instructions are suitable to
the client's real needs. The lawyer can add further value to his legal advice by addressing
these concerns, some of which are:

 How can the will and other legal instruments, like trust and insurance policies, be
utilised so as to minimise the estate duty in the event of death?
 How should the estate be distributed to the desired beneficiaries? For example, if a
client is afraid that the beneficiary may fritter away the assets, the lawyer may give
advice on the suitability of using instruments like trust and annuities.

 What sort of powers should be allocated to the executor? For example, if the client's
main asset is his business, the lawyer could advise the client about extending the
executor's authority and allowing him to continue the business before selling it at a
desired price, thus preventing the business assets from being forcefully sold at
unattractive prices.
 Who should be appointed as the children's guardian in the event of death of both

 How should the estate be managed by the executor in the event of the testator's death
and pending distribution?

In using financial planning knowledge to advise the client, not only can the lawyer advise on
whether the instructions of the client are legal, but also whether these instructions can
achieve the client's needs and desires.

(c) Bankruptcy Matters

In bankruptcy matters, a client will be faced with severe financial and maybe legal
constraints should be adjudicated a bankrupt? The lawyer can assist the client in the legalities
of the bankruptcy and if he has financial planning knowledge, such knowledge can be used to
help the client assess the financial impact of the bankruptcy on him and his family so that he
can make the most suitable decision under the given circumstances.

The simple objective of financial planning is to make the best use of your resources to
achieve your financial goals. The sooner you develop your goals and a financial plan to
achieve those goals, the easier it will be to achieve your objectives. Your financial planning
decisions allow you to develop a financial plan, which involves a set of decisions on how
you plan to manage your spending, financing, and investments. We can say that all
components of financial plan are related. In the planning process, budget determines how
much money you can set aside to maintain liquidity or to invest in long-term investments.
Also the way you obtain funds to finance large purchases such as a car or a home is
dependent on whether you sell any of your existing investments to obtain all or a portion of
funds needed. Your need for insurance is dependent on the types of assets you own. Your
ability to save for retirement each month is dependent on the amount of funds you need to
pay off any existing credit balance or loans.
The cash flow statement measures your cash inflows, cash outflows and their difference over
a period of time. Cash inflows generally result from your salary or from income generated by
your investments. And cash outflows result from your spending. Budget can help you in

forecasting net cash flows, which is based on forecasted cash inflows and outflows for an
upcoming period. The budget process allows you to control your spending. And by
comparing the forecasted and actual income and expenses conclusion can be drawn whether
you were able to stay within the budget or not. This will help in modifying the spending in
the future or perhaps adjust the future budgets.

Your budget decisions dictate your level of spending and saving and therefore affect the
other parts of the financial plan. The amount you save affects your liquidity, the amount of
financing necessary, the amount of insurance that you can afford and need, the amount of
funds that you can invest, and the level of wealth that you will need for retirement.


1. Fill in The Blanks

(a) _____________ is the process of planning your spending, financing, and investing to
optimize your financial situation. (Financial planning)
(b) The financial planning process involves ______ steps. (Six)
(c) You can forecast net cash flows by creating a __________. (Budget)
(d) The ______________ process allows you to control spending. (Budgeting)
(e) The personal balance sheet measures the value of your assets, your liabilities, and
your ____________ (net worth)
(f) The difference between total assets and total liabilities is net worth, which is a
measure of your __________ (wealth)
(g) Your budget decision dictates your level of spending and saving and therefore affects
the other parts of the __________________. (Financial plan)
(h) Your budget determines how much money you can set aside to maintain
__________or to invest in long-term investments. (liquidity)

2. Long Answer Questions

Q1. Define financial planning. What types of decisions are involved in a financial plan?

Q2. What are the benefits associated with understanding of financial plan?

Q3. What are the six key components of a financial plan? Why there is a need to revise
your financial plan?

Q4. Define budget planning. What elements must be assessed in budget planning?

Q5. What is the meaning of liquidity? What two factors are considered in managing

Q6. What is the primary objective of investing? What else must be considered?

Q7. How does each element of financial planning affect your cash flows?

Q8. Once your financial plan has been implemented, what is the next step? Why is it

Q9. Why there is a need to revise your financial plan?

Q10. Define cash inflows and cash outflows and identify some sources of each. How can
you modify your cash flows to enhance your wealth?

Q11. What is budget? What is the purpose of a budget? How can a budget help when you
are anticipating cash shortages or a cash surplus?

Q12. How do you think people who do not create a budget deal with cash deficiencies?
How can this affect their personal relationships?


1. Madura, Jeff. (2007). Personal Finance. (ed. 3rd). Florida Atlantic

University, Pearson.

2. Madura, Jeff, Mike Casey, Sherry J. Roberts. (2010) personal financial literacy.
Retrieved from

3. Eliud Bundi Ondara. (2016). Financial Planning. Retrieved from

4. Sullivan University Library. Retrieved from

5. Madura, Jeff. Personal finance, (6th ed.). Retrieved from

6. M. Ranganathan and R. Madhumathi. Investment Analysis and Portfolio
Management. Pearson Education, New Delhi.

7. Donald E. Fischer and Ronald J. Jordon. Security Analysis and Portfolio

Management, PHI.

8. Chandra, Prasanna. (28th june 2012). Investment Analysis and Portfolio Management.
(4th ed). McGraw-Hill, Delhi.

9. Lawrence J. Gitman, Michael D. Joehnk, Randy Billingsley. (2010). Personal

financial planning. (12th ed.). Cengage Learning

10. MCX Stock Exchange and Ft Knowledge Management Company. (July2010).

Retrieved from
df. Published by SEBI.

11. Ray, Stephanie. (Oct19th2017). Risk Management. Retrieved from

12. William J. Hass and Shepherd G. Pryor IV. (2006). Building Value through Strategy,
Risk Assessment and Renewal. Chicago. Retrieved from http://board-

13. R. P. Rustagi. (2008). Investment analysis and portfolio management. (2nd ed.). Sultan
Chand & Sons.

14. Vikaspedia. A knowledge portal. Common information sources for financial planning.
Retrieved from

15. Lessons on financial planning for young investors, publication securities Exchange
Board of India.

Unit II
Lesson 2



2.1 Investment
2.2 Speculation
2.3 Factors of Sound Investment
2.4 Investment Process
2.5 Portfolio Management
2.6 Types of Investment
2.7 Equity Shares
2.8 Bonds
2.9 Mutual Funds
2.10 Fixed Deposits
2.11 PPF
2.12 Financial Derivatives
2.13 Commodity Derivatives
2.14 Gold and Bullion
2.15 ETFs
2.16 REITs
2.17 Certificate of Deposits
2.18 Real Estate
2.19 Objectives & Rewards of Investing
2.20 Self-Assessment Questions

2.1 INVESTMENT (Prasanna Chandra, 2012 and V K Bhalla, 2009)

An investment is an asset or an Item which is acquired with the objective of income

generation and value appreciation. Investment is a commitment of funds made in the
expectation of some positive return. For the investment one needs to sacrifice some portion
of his/her present funds for a specified time period for uncertain future rewards, where some

risk is also involved. There are risk-free investments or investments having minimal risk
available for an investor. These are government bonds and certificate of deposit which are
considered as risk free investments. Some investors are willing to take high risk because of
the expectation that the high risk will be rewarded with high returns. We know that there are
many ways to invest money. Of course, to decide which investment option is suitable for an
investor, we need to know their characteristics and why they may be suitable for a particular
investing objective. So we can say that it also depends on the objective of the investor. If the
investor is risk lover, he would like to invest in most risky securities. And if the investor is
risk averse then he will go for less risky or risk-free investment options. In case of short term
gain, investor would prefer to invest in shares and in case of long term gain the choice will
be PPF, mutual funds, real estate and post office saving scheme.

Capital Market A market where buying and selling of equity and debt instruments takes
place. Capital markets channel savings and investment between suppliers of capital such as
retail investors and institutional investors, and users of capital like businesses, government
and individuals. Capital markets are vital to the functioning of an economy, since capital is a
critical component for generating economic output. Capital markets include primary markets
which is a new issue market, and secondary markets which trade existing securities. There
are numerous participants in the capital market. The participants are individual investors,
institutional investors such as pension funds and mutual funds, governments, corporate and
organisations, banks and financial institutions.

Money Market The money market is where financial instruments those having high
liquidity and short maturities are traded. It is used by investors as a means for borrowing and
lending in the short term, with maturities that usually range from overnight to just under a
year. Among the most common money market instruments are euro dollar deposits,
certificate of deposits (CDs), banker’s cheque, Treasury bills, commercial paper, etc.

2.2 SPECULATION (M. Ranganathan and R. Madhumathi)

Speculation is a process includes buying and selling of securities with a view to earn profits
due to price fluctuations. High risk is involved with speculation.

Points of Investment Speculation Gambling

Planning Longer planning Short planning horizon Short planning
horizon horizon horizon

Basis for Scientific analysis of Inside information, Based on tips and
decision Intrinsic worth of the hearsays, markets rumours
security psychology
Return Moderate rate of return High rate of return Negative returns are
expectation expected
Risk Moderate risk High risk Artificial risk
Funds Use of own funds Use of borrowed funds Unplanned activity
Motive Reasonable return on a One time, large return Entertainment while
consistent basis rather quickly earning


Bhalla, 2009)

 Stability of Return This factor is the important factor as mostly every investor wants
to have a stable return. Life insurance is considered as the best investment option.
As a primary benefit, it offers financial protection to the policyholder and his/her
nominee or family. For example, fixed deposits A/c, bonds and debentures, interest
from savings account in a bank, etc.

 Risk Investors has a concern for risk associated with the investment. Because more
the risk more the return will be. That’s why people with risk appetite will invest in
more risky securities.

 Liquidity liquidity of any investment plan will also have an impact on the decision of
the investor. As it gives a benefit of easy convertibility into cash. Liquidity describes
the degree to which an asset or security can be quickly bought or sold in the market
without affecting the asset's price.

 Tax Shelter A tax shelter is a vehicle used by taxpayers to minimize their tax
liabilities. Tax shelters can range from investments or investment accounts that
provide favourable tax treatment, to activities or transactions that lower taxable
income. The most common type of tax shelter is an employer-sponsored 401(k) plan.
Investment in PPF has tax benefits too.

 Safety of Principal some investors will invest in those securities which will give
assurance related to safety of principal amount. People who want safety of principal

will invest in PPF, national saving certificates etc. As they give assurance of safety of
principal and also provide tax shelter.

 Hedge Against Inflation An inflation hedge is considered to provide protection

against the decreased purchasing power which results from the loss of its value
because of rise in prices (inflation). It typically involves investing in an asset that is
expected to maintain or increase its value over a specified period of time.
Alternatively, the hedge could involve taking a higher position in assets, which may
decrease in value less rapidly than the value of the currency.

2.4 THE INVESTMENT PROCESS (Bodie, Kane and Marcus, 2013)

Investment decision process is a dynamic and continuous process. The investment decision
process starts with designing an investment policy. After that E-I-C analysis takes place
(where E is economy, I is Industry and C is company). Next step is the valuation of
investment opportunities available to an investor. Diversification and allocation is the next
step in the process. Where diversification is the risk management process, which includes
wide variety of investments within a portfolio. Last step is the most important step as it
includes appraisal and revision of investment. In this an investor will do the evaluation and if
necessary revise the portfolio. Revision may include deletion of previous security or may be
an inclusion of new profitable security.

The Investment Process Includes Two Steps

Step 1: Asset Allocation Decision the investor has to decide about the broad classes of
investments. These classes may be shares, bonds, gold, real estate, commodities, etc. Asset
allocation is to identify and select the assets classes appropriate for a specific investment
portfolio, and determining the proportions of these assets within the given portfolio. Some
factors which needs to be considered are objective of the investment, risk associated with the
investment, and the time horizon of the investment.

Step 2: Security Analysis the investor has to select a specific security. It involves analysis
of available securities that currently appear to be worth buying or worth selling. Security
analysis includes fundamental analysis and technical analysis.

 Fundamental Analysis follows the EIC approach. This approach attempts to study
the economic scenario, industry position and company expectations.

o Economic Analysis business cycles, monetary policy, fiscal policy, inflation,
interest rate structure, GDP growth, unemployment, foreign trade, etc.
o Industry Analysis demand-supply relationship, industry structure and
competition, cost structure, quality control standards, responsiveness to
income, etc.
o Company Analysis expected earnings, dividends, funds position, accounting
policies, risk-returns, quality of management, etc.

 Whereas, Technical Analysis is based on the proposition that the securities prices
and volume in past suggest their future price behaviour. Technical analysis may also
be called the market analysis because it uses the market record and market
information to predict the volume and prices. It is based on the principle that let the
market narrates its own story.

2.5 PORTFOLIO MANAGEMENT (Prasanna Chandra, 2012)

Portfolio is a combination of securities with their own risk and return characteristics.
Portfolio management is the dynamic function of analysing, selecting, evaluating and
revising the portfolio in terms of stated investor objectives. The two approaches to portfolio
management are traditional portfolio management which includes selection of those
securities that best fit the personal needs and desires of the investor. It may yield less than
optimum results and the second is modern portfolio management which is a scientific
approach i.e., based on estimates of risk and return of the portfolio.

Investment Categories

 Real Assets tangible, material things like, automobiles, real estate (land & building),
plant & machinery, furniture, gold, silver, etc. Real assets are heterogeneous, thus less

 Financial Assets paper claims that represent an indirect claim on the real assets of an
entity. E.g.,: debt or equity instruments like equity shares, mutual funds, preference
shares, commercial papers, savings account, loans and deposits, etc. Financial assets
offer the benefit of liquidity to the investor.


There are many types of investments and styles of investment available to an investor. Shares
(equity or preference), mutual funds, ETFs, bonds or fixed income securities, financial
derivatives, real estate etc. are few examples. The first priority of any investor will always be
liquidity. And liquidity needs can be fulfilled by investing in certificate of deposit (CD). But
where an investor is willing to take risk, there are wide variety of investments available.

There are several different money market securities like certificate of deposit, money market
deposit account, and money market funds. Most money market securities provide interest
income. Even if your liquidity needs are considered, you may invest in these securities to
maintain a low level of risk.

2.7 EQUITY SHARES (V K Bhalla, 2009 and R. P. Rustagi, 2008)

An equity share, commonly referred to as ordinary share also represents the form of
fractional or part ownership in which a shareholder, as a fractional owner, undertakes the
maximum entrepreneurial risk associated with a business venture. The holders of such shares
are members of the company and have voting rights.

A first thing that comes to investors mind while talking about equity is a risk. A risk is the
probability of permanent loss of capital. If risk is reduced or eliminated, equity will become
the first choice for the investors. Motives for investing in equity can be broadly explained as
ownership & control and Periodic gain & appreciation.

Benefits of Equity Share Investment

 Dividend An investor is entitled to receive a dividend from the company. It is one of

the two main sources of return on his investment.
 Capital Gain The other source of return on investment apart from dividend is the
capital gains. Gains which arise due to rise in market price of the share.

 Limited Liability Liability of shareholder or investor is limited to the extent of the

investment made. If the company goes into losses, the share of loss over and above
the capital investment would not be borne by the investor.

 Exercise Control By investing in the company, the shareholder gets ownership in the
company and thereby he can exercise control. In official terms, he gets voting rights
in the company.

 Claim over Assets and Income An investor of equity share is the owner of the
company and so is the owner of the assets of that company. He enjoys a share of the
incomes of the company. He will receive some part of that income in cash in the form
of dividend and remaining capital is reinvested in the company.

 Bonus Shares At times, companies decide to issue bonus shares to its shareholders. It
is also a type of dividend. Bonus shares are free shares given to existing shareholders
and many times they are given in lieu of dividends.

 Liquidity The shares of the company which is listed on stock exchanges have the
benefit of any time liquidity. The shares can very easily transfer ownership.

Disadvantages of Equity Share Investment

 Dividend The dividend which a shareholder receives is neither fixed nor controllable
by him. The management of the company decides how much dividend should be

 High Risk Equity share investment is risky as compared to any other investment like
debts etc. The money is invested based on the hope an investor has in the company.
There is no collateral security attached with it.

 Fluctuation in Market Price The market price of any equity share has a wide
variation. It is always very difficult to book profits from the market. On the contrary,
there are equal chances of losses.

 Limited Control An equity investor is a small investor in the company; thus, it is

hardly possible to impact the decision of the company using the voting rights.

 Residual Claim An equity shareholder has a residual claim over both the assets and
the income. Income which is available to equity shareholders is after the payment of
all other stakeholders’ viz. debenture holders etc.

Classification of Equity Meaning
Blue Chip shares shares of well-established, financially strong companies with
impressive earnings
Income shares Shares of companies with stable operations, relatively limited
growth opportunities and high-dividend payout ratio
Growth shares Shares of companies which have an above-average rate of
growth & profitability
Cyclical shares Shares of companies that have a pronounced cyclicality in
their operations
Defensive shares Shares of companies that are relatively unaffected by ups and
downs in general business conditions
Speculative shares Shares that fluctuate widely. A lot of speculative trading in
these shares

Pricing of Equity Shares

1. Valuation based on accounting concepts

2. Valuation based on dividend (dividend discounting models)
3. Valuation based on earnings (relative methods)

1. Valuation Based on Accounting Concepts

Book Value (B.V.) ͇ Equity Share Capital + Accumulated Profits - Accumulated Losses
No. of Equity Shares

 It ignores profitability of firm

 Incorporates historical figures, most of which might have become outdated
 Assumption: all assets are expected to realise an amount equal to their B/S value.

Liquidation Value

L.V. = amount of cash that will be received if all its assets are sold and liabilities are paid.

 L.V. of shares might be zero

 Based on current realisable values than historical value.

 Limitation of L.V., it lacks consideration of profitability of firms.
 Requires finding out realisable values of all assets, not an easy task.

2. Valuation Based on Dividends (Dividend Discounting Models)

Zero Growth Model

Po = D/Ke (same amount of dividend every year)

Po = value of equity shares
D = annual dividend
Ke = required rate of return (market capitalisation rate)

Constant Growth Model

Po = D1/(Ke-g)
Po = present value of stock
D1 = dividend expected one year hence
Ke = required rate of return
g = rate of growth of dividend

Multiple Growth Model

Po = D1/(1+K)1 + D2/(1+K)2.........+ P∞/(1+K)∞

3. Valuation of Dividend on The Basis of Earnings

Gordon’s Model

Po ͇ EPS (1-b)
Po = price of a share
EPS = earning per share at the end of year 1
b = retention ratio
r = rate of return on investment
Ke = required rate of return on equity

Walter’s Model

Po ͇ DPS + r/Ke (EPS−DPS)

Ke Ke

2.8 BONDS (V K Bhalla, 2009)

"Bond" is a term for any type of debt investment. When you buy a bond, you loan money to
an entity (a corporation or the government, for example) and they pay you back over a set
period of time with a fixed interest rate. The rate of interest is also denoted as coupon rate. In
some cases, however, no interest are payable to debenture holders. These are known as zero
coupon bonds. The value of a bond is equal to the present value of the cash flows expected
from it. Some examples are:

 Junk Bonds
 Floating Rate Bonds
 Callable and Putable Bonds
 Deep Discount Bonds
 Inverse Floaters
 Municipal Bonds
 Indexed Bonds

Bonds are basically a certificate that function-promises to repay a certain amount of money
at some future time. For example, a company or government decides to issue a series of
bonds valued at Rs 1,000 each. An investor agrees to buy one of these bonds by giving Rs
1,000 to the bond issuer. In return, the bond issuer agrees to pay interest to the owner of the
bond, and also to repay the principal Rs 1,000 at some point in the future. So, when you buy
the bond, you are essentially loaning the issuer money. The issuer will pay you interest until
the maturity date and at that time they will pay back Rs 1,000. People buy bonds with the
expectation of receiving interest income while they hold the bond and getting their money
back when the bond matures. However, bond issuers are not always able to pay interest or
even to return the principal amount. Because of this reason, investing in bonds involves some

 The coupon rate is fixed for the term of the bond

 The coupon payments are made every year

 The bond is redeemed at par on maturity; however, it may be different also. In some
cases bond securities are redeemed by conversion into equity shares.
 In case of liquidation of the company, the claim of the debt holders is settled in
priority over all shareholders, and generally other unsecured creditors also.
 Each coupon payment is receivable exactly a year later than the preceding payment

Requisites to Determine Value of a Bond

(a) Estimate of expected cash flows

(b) Estimate of the required return

Valuation of bonds
P ͇ ∑ C + M
t-1 (1+t)t (1+r)n

P = value (in Rs.)
n = number of years
C = annual coupon payment (in Rs.)
r = periodic required return
M = maturity value
t = time period when the payment is received

2.9 MUTUAL FUNDS (R. P. Rustagi, 2008)

Mutual funds are another investment option available to an investor. A team of professional
fund managers manages these investments. The shareholders see an increase or decrease in
the value of their shares based on the overall performance. Investors who buy individual
stocks and bonds can achieve diversification on their own, but it takes many purchases—and
a considerable amount of money. So investors with limited funds who want to diversify may
choose a mutual fund. It is possible to make a mutual fund investment with minimum amount
of Rs 500, and this investment in a well-managed fund will be diversified.

Another advantage of mutual funds is that they are managed by experienced people. Such
people may be better at picking good investments than a newcomer to the game of buying

and selling stocks and bonds. Of course, not all mutual fund managers are successful, and
some funds clearly have a better record than others. There are thousands of mutual funds that
invest in stocks and bonds, with many specializing in certain types of securities. Mutual fund
companies and rating services categorize their funds by level of risk or whether the fund
goals are producing long-term growth in share value or providing steady income for

Investors can purchase mutual funds through a brokerage. They can also buy funds directly
from the companies. One type of fund that is increasing in popularity is an exchange-traded
fund (ETF). ETFs provide diversification benefits similar to mutual funds, but they are
typically designed to mimic a stock index like the Standard & Poor’s 500. In addition, ETFs
typically have very low management fees. Investors can buy and sell ETFs in the same way
they buy and sell stocks. This ease of buying and selling makes ETFs more accessible to
small investors and has attracted billions to ETF investments in the past decade.

There are different ways in which various mutual fund schemes can be classified.

Classification on the Basis of Types

1. Life span close-ended scheme, open-ended scheme

2. Income mode income scheme, growth scheme
3. Portfolio Equity schemes, debt schemes, balanced
4. Maturity of securities Capital market schemes, money market
5. Sectors Different sectoral schemes
6. Load basis Load schemes, no load schemes
7. Special schemes Index schemes, offshore schemes, gilt
securities schemes, exchange traded funds,
funds of funds

Benefits of Mutual Funds Mutual funds are attractive to some investors for several reasons.
Few reasons are listed below

 The mutual fund professionals will devote time for analysis so the investor’s time will
be saved.
 An investor is able to get the services of professionals and experts at a nominal cost.
 He gets an ownership of a diversified portfolio.

 MFs have large funds to invest. So, economies of scale are available to them and also
available to the unit holders.
 Different types of mutual fund schemes are available to an investor.
 Mutual fund investment is risk-hedging mechanism.

2.10 FIXED DEPOSITS (D. Muraleedharan, 2014)

A fixed deposit (FD) is a financial instrument provided by banks which provides investors
with a higher rate of interest than a regular savings account, until the given maturity date. It
may or may not require the creation of a separate account. It is known as a term
deposit or time deposit in Canada, Australia, New Zealand, and the US, and as a bond in
the United Kingdom and India. They are considered to be very safe investments. Term
deposits in India are used to denote a larger class of investments with varying levels
of liquidity. The defining criterion for a fixed deposit is that the money cannot be withdrawn
from the FD as compared to a recurring deposit or a demand deposit before maturity. Some
banks may offer additional services to FD holders such as loans against FD certificates at
competitive interest rates. It's important to note that banks may offer lesser interest rates
under uncertain economic conditions. The interest rate varies between 5.75 and 6.85 percent
(SBI rates). The tenure of an FD can vary from 7 or 45 days to 10 years. These investments
are safer than Post Office Schemes as they are covered by the Deposit Insurance and Credit
Guarantee Corporation (DICGC).

Fixed deposits are a high-interest -yielding Term deposit and offered by banks in India. The
most popular form of Term deposits are Fixed Deposits, while other forms of term Deposits
are Recurring Deposit and Flexi Fixed Deposits (the latter is actually a combination of
Demand deposit and Fixed deposit).

To compensate for the low liquidity, FDs offer higher rates of interest than saving accounts.
The longest permissible term for fixed deposits is 10 years. Generally, the longer the term of
deposit, higher is the rate of interest. But a bank may offer lower rate of interest for a longer
period if it expects interest rates, at which the Central Bank of a nation lends to banks ("repo
rates"), will dip in the future.

Usually in India the interest on FDs is paid every three months from the date of the deposit.
(E.g. if FD a/c was opened on 15th jan, first interest instalment would be paid on 15 april).
The interest is credited to the customers' Savings bank account or sent to them by cheque.
This is a Simple FD. The customer may choose to have the interest reinvested in the FD

account. In this case, the deposit is called the Cumulative FD or compound interest FD. For
such deposits, the interest is paid with the invested amount on maturity of the deposit at the
end of the term.

Although banks can refuse to repay FDs before the expiry of the deposit, they generally
don't. This is known as a premature withdrawal. In such cases, interest is paid at the rate
applicable at the time of withdrawal. For example, a deposit is made for 5 years at 8%, but is
withdrawn after 2 years. If the rate applicable on the date of deposit for 2 years is 5 per cent,
the interest will be paid at 5 per cent. Banks can charge a penalty for premature withdrawal.
Banks issue a separate receipt for every FD because each deposit is treated as a distinct
contract. This receipt is also known as the Fixed Deposit Receipt (FDR) that has to be
surrendered to the bank at the time of renewal or encashment of fixed deposit.

Many banks offer the facility of automatic renewal of FDs where the customers do give new
instructions for the matured deposit. On the date of maturity, such deposits are renewed for a
similar term as that of the original deposit at the rate prevailing on the date of renewal.

Nowadays, banks give the facility of Flexi or sweep in FD, where in an investor can
withdraw his money through ATM, through cheque or through funds transfer from your FD
account. In such case, whatever interest is accrued on the amount withdrawn will be credited
to the savings account (the account that has been linked to your FD) and the balance amount
will automatically be converted in new FD. This system helps an investor in getting his funds
from the FD account at the times of emergency without wasting time.

Benefits Associated With FDs

Customers can avail loans against FDs up to 80 to 90% of the value of deposits. The rate of
interest on the loan could be 1 to 2 percent over the rate offered on the deposit. Residents of
India can open these accounts for a minimum of 3 months.

Tax is deducted by the banks on FDs if interest paid to a customer at any bank
exceeds Rs. 10,000 in a financial year. This is applicable to both interests payable or
reinvested per customer. This is called Tax deducted at Source and is presently fixed at 10%
of the interest. Banks issue Form 16A every quarter to their customers, as a receipt for Tax
Deducted at Source.

However, tax on interest from fixed deposits is not 10%; it is applicable at the rate of tax slab
of the deposit holder. If any tax on Fixed Deposit interest is due after TDS, the holder is
expected to declare it in Income Tax returns and pay it by himself.

If the total income for a year does not fall within the overall taxable limits, customers can
submit a Form 15 G (below 60 years of age) or Form 15 H (above 60 years of age) to the
bank when starting the FD and at the start of every financial year to avoid TDS.

2.11 PUBLIC PROVIDENT FUND (The Public Provident Fund Scheme, 1968)

The Public Provident Fund is a savings-cum-tax-saving instrument in India, introduced by

the National Savings Institute of the Ministry of Finance in 1968. The aim of the scheme is to
mobilize small savings by offering an investment with reasonable returns combined with
income tax benefits. The scheme is fully guaranteed by the Central Government. Balance in
PPF account is not subject to attachment under any order or decree of court. However,
Income Tax & other Government authorities can attach the account for recovering tax dues.

A minimum yearly deposit of Rs. 500 is required to open and maintain a PPF account. A PPF
account holder can deposit a maximum of Rs 1.5 lakhs in his/her PPF account (including
those accounts where he is the guardian) per financial year. There must be a guardian for
PPF accounts opened in the name of minor children. Parents can act as guardians in such
PPF accounts of minor children. Any amount deposited in excess of Rs 1.5 lakhs in a
financial year won't earn any interest. The amount can be deposited in lump sum or in a
maximum of 12 instalments per year. PPF account can be opened at any post office and some
authorized branches of banks. Nomination facility is also available in PPF accounts.

The Ministry of Finance, Government of India announces the rate of interest for PPF account
every quarter. The current interest rate effective from 1 October 2016 is 8.0%
p.a.(compounded annually) which was revised from 8.10% effective from 1 April 2016.
Interest will be paid on 31 March every year. Interest is calculated on the lowest balance
between the close of the fifth day and the last day of every month.

In a generalized view, if an individual deposits an amount of 1 lakh every year for 15 years
without any exception, then he would receive a total sum of more than 30 lakh. This reflects
the huge amount of benefit applicable on PPF account, for a total investment of 15 lakh (1
lakh every year * 15 years) interest received is more than 16 lakh, which is also in fact non-

Subscriber has 3 options once the maturity period is over. Withdrawal from PPF: one can
make one withdrawal per year starting from your seventh year (through an application vide
Form C). The first withdrawal can be done after the expiry of 5 full financial years from the
end of the year in which your initial subscription was made. The amount of withdrawal will

be limited to 50% of the balance at credit at the end of the fourth year immediately preceding
the year in which the amount is to be withdrawal, or the balance at the end of the preceding
year, whichever is lower, as per the PPF rulebook. Thereafter, you can make one withdrawal
per year.

Benefits of Having a PPF

Investments into PPF account are deductible U/S 80C of the income tax act, 1961 subject to
the maximum permissible limit of Rs 150000 in the financial year. The interest earned on the
investment is completely exempt from tax. The return of 8.1% p.a. is tax-free.

At the time of maturity, the proceeds are exempt from tax. PPF account can be extended after
the completion of 15 years, subscriber doesn’t need to put any amount after the maturity.
This is the default option meaning if subscriber doesn't take any action within one year of his
PPF account maturity this option activates automatically. Any amount can be withdrawn
from the PPF account if the option of extension with no contribution is chosen. Only
restriction is only one withdrawal is permitted in a financial year. Rest of the amount keeps
earning interest.

Extend the PPF account with contribution - With this option subscriber can put money in his
PPF account after extension. If subscriber wants to choose this option then he needs to
submit Form H in the bank where he is having a PPF account within one year from the date
of maturity (before the completion of 16 yrs in PPF). With this option subscriber can only
withdraw maximum 60% of his PPF amount (amount which was there in the PPF account at
the beginning of the extended period) within the entire 5 yrs block. Every year only a single
withdrawal is permitted.

2.12 FINANCIAL DERIVATIVES (R. P. Rustagi, 2008)

A derivative is a security with a price that is dependent upon or derived from one or more
underlying assets. The derivative itself is a contract between two or more parties based upon
the asset (assets). Its value is determined by fluctuations in the underlying asset. The most
common underlying assets include stocks, bonds, commodities, currencies, interest
rates and market indexes. Financial derivatives can be classified into- forwards, futures,
options and swaps.

Since 1993, when the SEBI banned forward trading and badla system, there has been a
demand for the introduction of some product which can provide hedging facility and risk

containment. In response to this, SEBI appointed a committee i.e., L.C. Gupta committee in
November 1996 ―to develop appropriate regulatory framework of derivatives trading in
India.‖ This committee was basically concerned with financial derivatives and the equity
derivatives in particular. The L.C. Gupta committee on derivatives concluded that there was
an urgent need for introducing equity derivatives in Indian Capital Market from the point of
view of market development as it lacks hedging facility against market risk to which all
equity holders are exposed.

Derivatives either be traded over-the-counter (OTC) or on an exchange. OTC derivatives

constitute the greater proportion of derivatives in existence and are unregulated, whereas
derivatives traded on exchanges are standardized. OTC derivatives generally have
greater risk for the counterparty than do standardized derivatives.

Financial derivatives are financial instruments that are linked to a specific financial
instrument or indicator or commodity, and through which specific financial risks can be
traded in financial markets in their own right. Transactions in financial derivatives should be
treated as separate transactions rather than as integral parts of the value of underlying
transactions to which they may be linked. The value of a financial derivative derives from the
price of an underlying item, such as an asset or index. Unlike debt instruments, no principal
amount is advanced to be repaid and no investment income accrues. Financial derivatives are
used for a number of purposes including risk management, hedging, arbitrage between
markets, and speculation.

Financial derivatives enable parties to trade specific financial risks (such as interest rate risk,
currency, equity and commodity price risk, and credit risk, etc.) to other entities who are
more willing, or better suited, to take or manage these risks—typically, but not always,
without trading in a primary asset or commodity. The risk embodied in a derivatives contract
can be traded either by trading the contract itself, such as with options, or by creating a new
contract which embodies risk characteristics that match, in a countervailing manner, those of
the existing contract owned. This latter is termed offsetability, and occurs in forward
markets. Offsetability means that it will often be possible to eliminate the risk associated
with the derivative by creating a new, but "reverse", contract that has characteristics that
countervail the risk of the first derivative. Buying the new derivative is the functional
equivalent of selling the first derivative, as the result is the elimination of risk. The ability to
replace the risk on the market is therefore considered the equivalent of tradability in
demonstrating value. The outlay that would be required to replace the existing derivative
contract represents its value—actual offsetting is not required to demonstrate value.

2.13 COMMODITY DERIVATIVES (R. P. Rustagi, 2008)

An exchange traded derivatives or over the counter derivative with an underlying reference
based on nonfinancial commodities including chemicals, energy, base and precious metals,
livestock, grains. A commodity derivative can be structured as a commodity future,
commodity forward, commodity options, or commodity swap.

Today, the commodity derivatives market is global, and includes both exchange-traded and
over-the-counter (OTC) derivatives contracts. It consists of a wide range of
segments: agriculture, base metals, coal, commodity index products, crude oil, emissions,
freight, gas, oil products, plastics products, power, precious metals and weather.

Thousands of companies of all sizes, in all industries and in all regions use commodity
derivatives. Manufacturers, energy companies, farmers, agriculture and food companies, IT
companies – these and other types of firms make up the global commodity derivatives
markets. They all contribute to the supply of needed commodities for ever-rising earth’s
population. In this respect, the first half of the 21st century is a critical moment. The world’s
population is expected to reach 9 billion in 2050, creating ever-increasing demands on
limited resources and providing a challenge for industrial producers, market intermediaries,
policy makers, governments and international organizations.

This leads to concerns about price increases and volatility, as Nobel Prize-winning economist
Paul Krugman pointed out that volatility exists in our markets because we live in a ―finite
world‖ where there is not, at any given moment in time, an inexhaustible supply of oil,
wheat, milk or other physical commodities to meet the global demand for such products.
Simply put, prices are higher because the demand for a product around the globe is greater
than the supply.

Thus, fundamental factors will significantly put pressure on production, transportation,

storage and delivery of commodities.

2.14 GOLD AND BULLION (Nawaz, Nishad & vr, Sudindra, 2013)

Of all the precious metals, gold is the most popular as an investment. Investors generally buy
gold as a way of diversifying risk, especially through the use of futures
contracts and derivatives. The gold market is subject to speculation and volatility as are other
markets. Compared to other precious metals used for investment, gold has the most effective

safe haven and hedging properties across a number of countries. Bullion refers to precious
metals as metals, as opposed to jewellery or coins. When you buy gold or silver bullion
you're usually buying bars, blocks or other standardized shapes, sometimes referred to as
ingots. By buying the metal in this more industrial form, you save money and come closer to
paying only its "melt value."

Like most commodities, the price of gold is driven by supply and demand including demand
for speculation. However unlike most other commodities, saving and disposal plays a larger
role in affecting its price than its consumption.

When evaluating the performance of gold as an investment over the long term, it really
depends on how long a term one is considering. Over a 45-year period, gold has
outperformed stocks and bonds; over a 30-year period, stocks and bonds have outperformed
gold; and over a 15-year period, gold has outperformed stocks and bonds.

2.15 FUNDS (Bodie, Kane and Marcus, 2013)

Funds can fall under any of the main categories of investments. They're not specific
investments, but a general term for a group of investments. The Guardian defines investment
funds as: a pool of money which is professionally managed to achieve the best possible
return for investors. When money is paid in the manager uses it to buy assets, typically
stocks and shares.

Basically, an investment company picks a collection of similar assets for you. It can be a
group of stocks or a group of bonds. Or, the fund can be even more specific—there are funds
made up of all international stocks, for example. In return for curating your investments,
you'll pay a fee, or an "expense ratio." But they aim to be a more convenient investment, with
picks that provide a better return than anything you would probably pick on your own.

The Different Terms Associated With Funds

Index Funds A type of mutual fund meant to mirror the return of a specific market, like the
S&P 500. Index funds are mutual funds, but instead of owning maybe twenty or fifty stocks,
they own the entire market. (Or, if it's an index fund that tracks a specific portion of the
market, they own that portion of the market.) For example, an index fund like
Vanguard's VFINX, which attempts to track the S&P 500 stock-market index, tries to own
the stocks in its target index (the S&P 500, in this case) in the same proportions as they exist
in the market.

Because they're meant to mirror the market, index funds are "passively managed", which
means there isn't a team of investors constantly analyzing, forecasting and adjusting the
assets in the fund (known as active management). As a result, they tend to have lower
expense ratios, which means you keep more of your money.

Exchange Traded Funds (ETFs) (R. P. Rustagi, 2008) These are very similar to index
funds in that they're meant to track an index, or a measure of a specific market. The biggest
difference is the way they're traded. ETFs can be traded like stocks, and their prices adjust
like stocks throughout the day. ETFs do not sell their units directly to the investor. Rather a
security firm creates an ETF by depositing a portfolio of shares in line with an index
selected. The security firm creates units against this portfolio of shares. These units are sold
to the retail investors. So, the ETF has portfolio of shares as well as a liability towards the
holders of ETF units.

Mutual and index funds don't work this way. The biggest difference between these two
products is the frequency with which they are priced and traded. Index mutual funds are,
after all, mutual funds, and as such they are priced once a day after markets close. ETFs–
including both active and passive ETFs–are priced throughout the day, and can be bought or
sold whenever the markets are open.

ETFs provide diversification benefits similar to mutual funds, but they are typically designed
to mimic a stock index like the Standard & Poor’s 500. In addition, ETFs typically have very
low management fees. Investors can buy and sell ETFs in the same way they buy and sell
stocks. This ease of buying and selling makes ETFs more accessible to small investors and
has attracted billions to ETF investments in the past decade.

ETF units are created by an institutional investor depositing a specified block of securities
with the ETF. In return for this deposit, the institutional investor receives a fixed amount of
ETF shares, some or all of which may then be sold on a stock exchange. The institutional
investor may obtain its deposited securities by redeeming the same number of ETF shares it
received from the ETF. Retail investors can only buy and sell ETF units once they are listed
on an exchange, in the same way in which the investors can buy or sell any listed equity
securities. Unlike an institutional investor, a retail investor cannot purchase or redeem shares
directly from the ETF, as with a traditional mutual fund or unit investment trust.

ETF portfolio created once does not change. The market value of the units of ETF changes in
line with the index automatically. The fund managers are not required to actively manage the
portfolio resulting in lower expense level of the fund. As they are listed on a stock exchange,
they provide a lot of liquidity and price is determined by the demand and supply forces and

the market value of the shares held. The rate at which ETF units are traded at stock exchange
is close to its NAV.

UTI mutual fund has launched an ETF called SUNDERS, which is listed at national stock
exchange and value of one unit of SUNDERS is 1/10 of NIFTY. Certain ETFs traded at
American Stock Exchange are QUBES (representing NASDAQ 100), SPIDERS
(representing S&P 500), DIAMONDS (representing Dow Jones industrial Average), etc.

Hedge Fund Hedge funds are like mutual funds, with a few very important differences.
First, they're not regulated by the U.S. Security and Exchange Commission (SEC). They're
also considered riskier than regular mutual funds, because their assets can include a broader
range of investments. Depending on where you're at with investing, many of these may or
may not be on your radar. Most beginners will likely find CDs and mutual funds to be most
useful. As you learn more about investing and how to diversify your portfolio, you might
consider REITs or TIPs.

With so many terms associated with investing, knowing what exactly to invest in can seem
complicated. But once you organize these terms into categories, it's actually pretty easy to
understand how they work.

2.16 REAL ESTATE INVESTMENT TRUSTS-REITs (Jeff Madura, 2007 and Bodie,
Kane and Marcus, 2013)

Real Estate Investment Trusts are another way to invest in real estate. Instead of buying your
own property, you work with a company that earns profit from their own real estate
investments. Really, an REIT can be an ownership investment or a lending investment,
depending on what type you buy. You can buy an REIT that gives you a share in the real
estate itself. This would count as an ownership investment.

When you buy a share of a REIT, you are essentially buying a physical asset with a long
expected life span and potential for income through rent and property appreciation. But you
could also invest in the mortgage of the real estate, which would make it a lending
investment. REITs offer investors the benefits of commercial real estate investment along
with the advantages of investing in a publicly traded stock. The investment characteristics of
income-producing real estate has provided REIT investors with historically competitive long-
term rates of return that complement the returns from other stocks and from bonds. REITs
are required to distribute at least 90 percent of their taxable income to shareholders annually
in the form of dividends. Significantly higher on average than other equities, the industry's

dividend yields historically have produced a steady stream of income through a variety of
market conditions.

In addition to the historical investment performance and portfolio diversification benefits,

REITs offer several advantages typically not found in companies across other industries.
Because of these benefits REITs have become increasingly popular with investors over the
past several decades. REITs' reliable income is derived from rents paid to the owners of
commercial properties whose tenants often sign leases for long periods of time, or from
interest payments from the financing of those properties.

Most REITs operate along a straightforward and easily understandable business model: By
leasing space and collecting rent on its real estate, the company generates income which is
then paid to the shareholders in the form of dividends. When reporting financial results,
REITs, like other public companies, must report earnings per share based on net income as
defined by generally accepted accounting principles (GAAP).

Thus we can say that REITs over time have demonstrated a historical track record providing
a high level of current income combined with long-term share price appreciation, inflation
protection, and prudent diversification for investors across the age and investment style

2.17 CERTIFICATE OF DEPOSIT (V K Bhalla, 2009)

A certificate of deposit or CD is a promissory note issued by a bank in exchange for your

money. You've probably seen your bank offer these. They're a type of savings account, but
they're a little different. Instead of taking your money out at any time, you commit to leaving
it in the account for a set period. In return, they'll offer a higher interest rate based on how
long you invest in them. Savings accounts can also be considered lending investments, if you
think about it. You're giving your money to a bank that loans it out. But your return is
usually pretty low (lower than the inflation rate), so most people don't consider it a true

Certificates of deposit are a financial product offered by many financial institutions. A

certificate of deposit (CD) is essentially a contract between an individual and the financial
institution that specifies the length of time an individual will leave a certain amount of
money deposited at the particular bank at a specified interest rate. CDs have a specific
maturity date i.e., a future date when you can cash in the CD. Common CD maturities are
one month, three months, six months, one year, three years, and five years.

Typically, CDs offer a higher interest rate than savings accounts because the bank can count
on the money being there for them to loan out. A bank makes money by loaning out money
that it has on deposit. If the money is likely to be withdrawn at any time, the bank cannot
loan as much of it. Again, the financial institution pays a higher interest rate for a CD
because the money is locked up until maturity. You can access your money prior to maturity,
but you will pay a penalty for early withdrawal. Therefore, you should consider CDs only
when you know that you will not need the money until after the CD matures.

Grouped under the general category called fixed-income securities, the term bond is
commonly used to refer to any securities that are founded on debt. When you purchase a
bond, you are lending out your money to a company or government. In return, they agree to
give you interest on your money and eventually pay you back the amount you lent out.

The main attraction of bonds is their relative safety. If you are buying bonds from a stable
government, your investment is virtually guaranteed, or risk-free. The safety and stability,
however, come at a cost. Because there is little risk, there is little potential return. As a result,
the rate of return on bonds is generally lower than other securities.

2.18 REAL ESTATE (Jeff Madura, 2007)

Many people have used real estate as an investment. In fact, one way millions of people
invest in real estate is to buy a home. Housing values move up and down over time
depending on the supply and demand for homes in an area. For example, if a factory
suddenly closes in your area and a lot of people are forced to move to find work, you will see
a lot of houses for sale. Sellers of those houses may lower their prices in order to sell faster.
More sellers than buyers will tend to push home prices down. The reverse is true if you have
a growing region where a lot of people are moving into an area. More buyers than sellers will
create a market where housing prices will be going up.

In general, home prices have increased over the very long run and created wealth for
homeowners. In addition, investing in real estate offers tax benefits, or the ability to take
advantage of rules in the tax code that may reduce your tax liability. And, of course, you
need a place to live. These factors make buying a home a good investment for most people.
However, the financial crisis of 2008–2009 provided a clear illustration of the dangers of
buying a house that is above your price range and how the type of financing you chooses can
have a tremendous impact on your budget. Thousands of homeowners lost their homes when
they were unable to make the higher payments required due to interest rate resets on their
adjustable rate mortgages.

Some people invest in real estate by buying rental property. You may know someone who
owns apartments that he or she rents out on a monthly basis. Or you may know someone who
owns and rents commercial property. Very often, real estate investors find that the rent they
receive covers the payments on the loan they took to buy the property. Profits will come
from the real estate increasing in value over time. Real estate includes homes, rental
property, farms, and other land. Rental property includes houses or commercial property that
is rented out to others. Some people buy timberland or farms with the expectation that it will
generate revenue over time and also increase in value.

Any real estate you buy and then rent out or resell is an ownership investment (though it can
sometimes be classified as an alternative investment). By their terms, the home you own
fulfills a basic need, so it doesn't fall under this category. After demonetization, there is a
significant reduction of black money in the market. This has created an adverse impact on the
real estate. Real estate returns are extremely poor in recent times. At most of the location, we
have observed a decline in property rates.


Lawrence J. Gitman, 2017)

Investing is all about taking a risk. The key is to understand the return you want, and then give
yourself a chance of achieving it by taking that level of risk which you are comfortable with.
It’s easy to say that you’d like to achieve the highest return possible, but if that meant all your
money could disappear because it was dependent on only a small number of risky investments,
you might be less comfortable. If you go out and invest all of your money in shares in just one
company you could get very lucky and do very well indeed if its share prices go up – probably
far better than you would do by spreading your investment across a number of companies. But
if that company falls flat you could see your investment wiped out and you could even lose
everything. Putting your money in several different companies, and investing in different ways,
such as through shares and bonds, means your risk is spread and the danger of any one of them
failing and losing you money is reduced.

Some investors like to pick the individual companies and bonds they invest in, for those who
do not want to do so there are funds and investment trusts that will do it for them.
Alternatively, they could decide to use a tracker fund to simply follow an index rather than
paying a fund manager to actively try and pick winners. The thing to remember about risk is
that it very much depends on your personal circumstances. Most investors will see risk
differently depending on their age and objective.

But there are two basic categories of risk worth considering, systematic and unsystematic. It
is hard to protect yourself from systematic risk as it often can’t be predicted, but you can tackle
unsystematic risk by diversifying your investments across different types of assets, regions and
sectors. There are also risks specific to assets. For example bonds have a risk of default or their
yields becoming uncompetitive, while shares could be hit by a company suffering a blow to its
fortunes, such as a decline in profits or market share, or an entire sector being hit by trouble.

Both bonds and shares are also exposed to economic and political effects. Another problem is
to simply buy when things are too expensive or sell when things are too cheap. The price you
pay is an important point when considering the traditional perception of bonds as safer and
shares as riskier. If bonds are very expensive but shares are cheap, the former could have the
potential to lose more value if the market turns and they are sold before maturity.

Why Diversification Matters The best way of navigating your way through most of these
problems of risk is through diversification. For example, if you built a whole portfolio based
on mining and energy companies, a falling oil price would hit your returns. But an investor
could protect himself and make up any losses by having money in different assets, which could
be doing well while other parts of his portfolio struggle. If an investor constructs his own
portfolio of shares and bonds he will need to look at how everything fits together.

 Do you hold enough different companies and bonds?

 Do they do different things?

If you invest in active funds or investment trusts, a fund manager can do some of this work for
you by building a balanced portfolio of different shares, bonds, or even across different assets.


Fill in the blanks

(a)___________is a combination of securities with their own risk and return


(b)_________________, are another way to invest in real estate. (Real Estate Investment

(c)A ____________is a security with a price that is dependent upon or derived from one or
more underlying assets.( derivative)

(d)The __________________ is a savings-cum-tax-saving instrument in India, introduced by
the National Savings Institute of the Ministry of Finance in 1968.(Public Provident Fund)

(e)When you buy a bond, you loan money to an entity and they pay you back over a set
period of time with a _________interest rate. (fixed)

(f)____________ are a high-interest -yielding Term deposit and offered by banks in India
(Fixed deposits).

(g)Investors with limited funds who want to diversify may choose a ___________. (Mutual

(h)Shares of well-established, financially strong companies with impressive earnings are

termed as_________________. (Blue chip shares)

(i)____________is a commitment of funds made in the expectation of some positive rate of

return. (Investment)

(j)The purpose of ______________analysis is to find out the intrinsic value of a security.

(Fundamental analysis)

(k)___________, trust that pool investments from individuals and use the proceeds to invest
in real estate.( REITS)

Long Answer Questions

Q1. Define the term investment. How is it different from speculation?

Q2. What factors should an investor consider while making investment decisions?

Q3. What do you mean indirect investing? How is it different from direct investing? What
are the advantages available to the investors in mutual funds?

Q4. What do you mean by security analysis? Describe the basic approaches to security

Q5. What are the different approaches to valuation of an equity shares?

Q6. What are real estate investment trusts? What are some attractive characteristics of
REITS? How can REITS help diversify a portfolio?

Q7. What is a derivative? What are the characteristics of derivative investments and
derivative market?

Q8. ―The Public Provident Fund is a savings-cum-tax-saving instrument in India‖, explain
the statement.

Q9. What are the characteristics of fixed deposit? Also explain its benefits available to an

Q10. How an exchange traded fund (ETF) is created? Explain the mechanism and benefits of
investment in an ETF.


1. Madura, Jeff (2007). Personal Finance. (ed. 3rd). Florida Atlantic University, Pearson.

2. M. Ranganathan and R. Madhumathi: Investment Analysis and Portfolio Management,

Pearson Education, New Delhi.

3. Donald E. Fischer and Ronald J. Jordon: Security Analysis and Portfolio Management,

4. Chandra, Prasanna. (28th june 2012), 4th ed. Investment Analysis and Portfolio
Management, McGraw-Hill, Delhi.


PORTFOLIO MANAGEMENT, S Chand, New Delhi, 2009

6. R. P. Rustagi. (2008). Investment analysis and portfolio management (2nd ed.). Sultan
Chand & Sons.

7. Zvi Bodie, Alex Kane, Alan J. Marcus – Investments. (2013). McGraw-Hill

Education.(10th edition).

8. D. Muraleedharan.(2014) Modern Banking: Theory And Practice. PHI Learning Pvt. Ltd.
p. 274.

9. The Public Provident Fund Scheme, 1968. Retreived from


10. Nawaz, Nishad & vr, Sudindra. (2013). A study on various forms of gold investment.
Retreived from


11. Randy Billingsley, Lawrence J. Gitman. (2017). Personal financial planning. Cengage
Learning. (14th edition)

Unit II

Lesson 3




3.1 Investment Objectives

3.2 Investment Constraints
3.3 Preparation of Financial Plan
3.4 Portfolio Management
3.5 Risks vs. Returns
3.6 The Power of Compounding
3.7 Net Worth
3.8 Inflation Effects on Investments
3.9 Time Value of Money
3.10 Diversification
3.11 How not to lose money?
3.12 Tax Planning
3.13 Sources of Financial Information
3.14 Mutual Funds
3.15 Self Assessment Questions


In the previous chapter, we have discussed about what the investment is. Now we will see the
other aspects related to financial decision process.

Individuals often consider their goals and objectives while investing, but they often fail to
focus on their personal constraints. However, investor constraints require equal consideration
as they play a substantial role in one’s investment strategy or planning. Investment objectives
and constraints are the cornerstones of any investment policy statement. A financial advisor
or a portfolio manager needs to formally document these before commencing the portfolio

management. Any asset class that is included in the portfolio has to be selected only after a
thorough understanding of the investment objective and constraints. Following are various
types of objectives and constraints to be considered and several steps to correctly determine
these objectives.
Investment objectives are related to what the investor wants to achieve with the portfolio of
investments. Generally, the objectives are concerned with return and risk considerations.
These two objectives are interdependent as the risk objective defines how high the investor
can place the return objective.

The Investment Objectives are Mainly of Two Types

1. Risk Objectives Risk objectives are the factors that are associated with both the
willingness and the ability of the investor to take the risk. When the ability to accept all types
of risks and willingness is combined, it is termed as risk tolerance i.e., the investor is ready to
take risk. When the investor is unable and not willing to take the risk, it indicates risk
aversion behaviour of the investor.

The following steps can be undertaken to determine risk objective

 Specifies Measure of Risk Measurement of risk is the most important issue

in portfolio management. Risk either measured in absolute or relative terms. Absolute
risk measurement will include a specific level of variance or standard deviation of
total return. Relative risk measurement will include a specific tracking risk.

 Investor’s Willingness Individual investors’ willingness to take risk is different from

institutional investors. For individual investors, willingness to take risk is determined
by psychological or behavioural factors. Factors like spending needs, long-term
obligations or wealth targets, financial strength, and liabilities are examples that
determine the willingness to take the risk by an investor.

 Investor’s Ability The ability of an investor to take risk is dependent on financial

factors that bound the amount of risk taken by the investor. An investor’s short-term
horizon will negatively affect his ability. Similarly, if the investor’s obligation and
spending are less than his portfolio, he clearly has more ability.

2. Return objectives The following steps are required to determine the return objective of
the investor

 Specify Measure of Return A measure of return needs to be specified. It can be
specified in an absolute term or a relative term. It can also be specified in nominal or
real terms. Nominal returns are not adjusted for inflation, whereas real returns are.
One may also distinguish pre-tax returns from post-tax returns.

 Desired Return A return desired by the investor needs to be determined. The desired
return indicates how much return is expected by the investor.

 Required Return A return required by the investor also needs to be determined. A

required return indicates the return which needs to be achieved at the minimum for
the investor.

 Specific Return Objectives The investor’s specific return objectives also need to be
determined so that they are consistent with his risk objectives. An investor having a
high return objective needs to have a portfolio with a high level of expected risk.
Because higher the risk, higher the return will be and vice versa.

3.2 INVESTMENT CONSTRAINT (Prasanna Chandra, 2012)

Constraints are limitations or restrictions that are specific to each person. Investment
constraints are the factors that restrict or limit the investment options available to an investor.
The constraints can be either internal or external constraints. Internal constraints are
generated by the investor himself while external constraints are generated by an outside
entity, like a governmental agency.

The following are the types of investment constraints

1. Liquidity Constraints Liquidity constraints identify an investor's need for liquidity

or cash. For example, within the next year, an investor needs Rs.20,00,000 for the
purchase of a new home. The Rs20,00,000 would be considered a liquidity constraint
because it needs to be set aside for the investor. Thus prudent investors will want to
keep aside some money for unexpected cash requirements. The financial advisor
needs to keep liquidity constraints in mind while considering an asset’s ability to be
converted into cash without impacting the portfolio value significantly. The need to
always have some cash in hand to deal with daily expenditures or planned purchases
necessitates that one should avoid certain investment options for a portion of one’s

Most investors require a portion of their assets in cash to cover required expenditures,
such as loan payments, rent, food, transportation and other necessary living costs.
Some experts recommend maintaining 2-3 months spending in emergency funds. In
these uncertain economic times, when there is a higher probability of employment
loss, it would be recommended to keep 3-6 months costs in the emergency fund.

Many individuals plan to make major personal expenditures in the near future. This
could be a car, home, travel; anything that requires a large payment at a specific date.
Planned acquisitions usually require individuals to structure their investments such
that the required amounts are available in cash at the due date. This will result in
liquidity constraints as you set aside other funds to make the major expenditure.

If you want to maintain Rs10,000 in liquid assets for emergency funds, you should
not be using it to invest in a illiquid investment projects. In this case, the need for
ready cash constrains your investment choices to highly liquid and secure

As you get older and accumulate some wealth, you should keep a small portion of
your assets in liquid form at all times. This allows you to take advantage of
investment opportunities that may suddenly arise. If you do not have any liquid
assets, then you will have to dispose of another asset in order to take purchase the
new investment. And when you are forced to sell something at a time other than of
your own choosing, often you will not get the best price for it. But by maintaining
about 5% of your wealth in liquid assets, you should always be able to take advantage
of interesting opportunities.

2. Time Horizon A time horizon constraint develops a timeline of an investor's various

financial needs. The time horizon also affects an investor's ability to accept risk. If an
investor has a long time horizon, the investor may have a greater ability to accept risk
because he would have a longer time period to recover any losses. This is unlike an
investor with a shorter time horizon whose ability to accept risk may be lower
because he would not have the ability to recover any losses. An investor may have to
pay for college education for children or needs the money after his retirement. Such
constraints are important to determine the proportion of investments in long-term and
short-term asset classes. As the time horizon until your objective decreases, the
variety of assets in which to invest also diminishes. Also, the less the time horizon,
the less risk an investor can tolerate in his portfolio.

3. Tax Issues For an individual investor, realized gains and income generated by his
portfolio are taxable. The tax provisions needs to be kept in mind while drafting the
policy statement. Often, capital gains and investment income are subjected to
differential tax treatments. After-tax returns are what investors should be most
concerned. Your investment goal should always be to maximize after-tax returns, not
gross returns.

The tax bracket that the investor is in will impact investment decisions. If an investor
is currently in the highest bracket, he may want to avoid investments that generate
taxable income while he is in the top tax bracket. Instead, he may prefer to invest in
assets that experience future capital gains. Hopefully, these gains will not crystallize
until he has moved into a lower tax bracket. The same applies to an investor who is in
a secondary tax bracket. He may need to be careful about generating too much annual
interest or dividend income to avoid being pushed into a higher marginal tax rate.

In both examples, the investors may also be very interested in tax-free investments.
The availability of these investments varies greatly between tax jurisdictions. If you
reside in a country that has different tax rates for different types of investment
income, it should affect your investment choices to some extent.
For example, perhaps you live in a jurisdiction where interest income is taxed at a
higher rate than dividend income. You have to choose between two investments of
equal risk, both offering the same gross return. One pays out interest, the other
dividends. You would like to select the one with the better after-tax return.

4. Legal and Regulatory The legal and regulatory environment may also constrain
one’s investment decisions. Typically this is a more important consideration for
institutional investors than for individuals. However, there are areas in trusts and
foundations where legal issues can be a problem for investment options. For those of
you planning to enter the world of public accounting, banking, or law, you may
experience issues. For example, if you audit a public company, you may be precluded
from owning shares in that company. Or if your bank is performing certain work on a
company, you may have a blackout period for trading shares in that corporation.

Such constraints are mostly externally generated and may affect only institutional
investors. These constraints usually specify which asset classes are not permitted for
investments or dictate any limitations on asset allocations to certain investment
classes. Legal and regulatory constraints often can't be changed and must not be

5. Unique Circumstances Any special needs or constraints not recognized in any of the
constraints listed above would fall in this category. An example of a unique
circumstance would be the constraint an investor might place on investing in any
company that is not socially responsible, such as a tobacco company. The Importance
of Asset Allocation is the process of dividing a portfolio among major asset
categories such as bonds, stocks or cash. The purpose of asset allocation is to reduce
risk by diversifying the portfolio. The ideal asset allocation differs based on the risk
tolerance of the investor.

Such constraints are mostly internally generated and signify investor’s special
concerns. Some individuals and philanthropic organizations may not invest in
companies selling alcohol, tobacco or even defence products. Such concerns and any
special circumstance restricting the investor’s investments should be well considered
while formulating investment policy statement.

Certain investors may believe in ethical investing. That is why they do not want to
invest in companies that they consider unethical. This might include tobacco or
alcohol companies. It may also include companies that operate in certain countries.
The US currently has legislation that severely restricts trade or investment in Iran. If
you try to invest in Iran or Iranian companies, you may be subject to prosecution.
Note that this could also be considered a legal constraint.

Other unique circumstances include the ability to purchase certain investments.

After this discussion now you should have some ideas on what some of your investment
objectives are, and some of the constraints that you face. You also may have formed an
opinion on your risk tolerance and investor profile. A financial advisor or portfolio manager
design and manages the portfolio for an investor after formally documenting the investment
policy statement. The job starts from the moment the investor articulates his objectives and
constraints. It is for the benefit of both the investor and the manager that the objectives and
constraints are correctly determined and not just documented for formality. The more
diligence is paid while formalizing objective and constraints, the better is portfolio aligned to
the needs of the investor.

3.3 PREPARATION OF FINANCIAL PLAN (Jeff Madura, 2007 and SEBI lesson)

One should prepare their financial plan depending upon various factors like his income, risk
taking ability, age and investment objective. This is because the income for two individuals
may not necessarily be the same and his personal needs could also be different. A financial

planner needs to note such differences and then accordingly suggest investment avenues for
the investors. If he considers all the investors to be the same then an investor might not be
able to meet his financial needs or objectives and the basic purpose of financial planning
would not be met with. You must understand that since your needs are different from others
you need to make investments that would suit your profile. Many individuals in the hope of
making big profits invest most of their funds into below investment grade investments which
offer high returns. One may profit if they perform well or else they may lose money. Every
individual has a different risk appetite and needs to keep this in mind before he chooses
which product to invest in.

Risk appetite is the risk taking ability of an investor. This varies from person to person. If I
am a rich person and my monthly income ranges to lakhs of rupees, I might feel that losing a
few thousand rupees would not be a matter of concern if I can make high returns. People who
are rich or who have a high net worth are willing to invest aggressively unlike others. But if I
am a middle class worker, then I might not be able to accept such huge losses. As a rich
man, I can afford taking losses or in other words I am willing to take high risks. But as a
middle class worker, I can’t afford to take high risks. I might be able to take up losses in a
few hundred rupees only. If I am a retired individual, my risk appetite would be different as I
would need a regular income to support my personal needs like medical bills, health
supplements, etc., which means that I would not be willing to take risks. Risk appetite is
allotted to individuals on a scale from low to high. For a retired individual, the risk appetite
would be low whereas for the businessman the risk appetite would be high. But for a middle
class worker it would be moderate. There are various investment avenues like equity, debt,
commodities, Forex, etc., each of which is termed as an asset class. You can choose to invest
in any of these asset classes provided you understand that each of these asset classes differ
from one another in terms of risks and returns. Thus one should make investments depending
upon his/her risk taking ability.

Implementing a financial plan- After preparing your financial plan you need to review and
revise your plan to stay up-to-date and relevant to the economic climate and your changing

3.4 PORTFOLIO MANAGEMENT (Prasanna Chandra, 2012)

The collection of different investment options you take is termed as the portfolio. Suppose
you have Rs 1000 and you invest 40% in equity and the rest in debt securities. Your entire
investment would be your portfolio which has a value of Rs 1000 currently. This value might
increase or decrease depending upon the market movements, which will bring a change in

the value of the securities. Nowadays investors use various portfolio management services to
help them manage their investments. Every asset is different from the other in terms of risk
and returns. Every step in the process of financial planning is equally important. Most of the
investors declare their income, risk tolerance levels and also make investments but neglect
monitoring their investments. If you do not watch over your investments, even if it had been
making gains it may become a loss making investment. Thus there is a need to periodically
review your portfolio and make changes in the portfolio as the situation demands. Suppose
the equity investments have not performed well for the last quarter and you hold up to 60%
of your portfolio in the shares of these companies, then you cannot continue holding the
same portfolio. You might have to shift your funds to other asset classes that are less risky
like bonds till the markets recover.

3.5 RISK vs. RETURN (R. P. Rustagi, 2008 and M Ranganatham & R Madhumathi)

Every individual has their own risk taking capacity. Your risk-return profile is your level of
risk tolerance. If you invest in a high risky business like a start up firm your risk would be
high. There are three types of risk return profiles which you can fall under depending upon
your source of funds and the investments you choose to make. They are:

a. Conservative or risk averse i.e. you take minimal risks ensuring your funds are secure.
You prefer investing in post office deposit schemes, bank fixed deposits, government
b. Moderate i.e. you are willing to take some risks and prefer investing in mutual fund
c. Aggressive or risk lover i.e. you are willing to take high risks and prefer investing in
equity, commodities markets and you may even be speculating for returns.

There is an important investment principle which says the level of your returns depends on
the level of risk you take. While you stay invested it is crucial you take necessary measures
to manage your risk. Once you invest in any asset class you should monitor your investments
and keep yourself updated about various market happenings to avoid any pitfalls. Always
check the potential risks when quoted returns are unusually high. So one should always keep
an eye on the return and risk and also redesign the portfolio whenever it is required.

3.6 THE POWER OF COMPOUNDING (Jeff Madura, 2007)

Time is an influential factor when it comes to investments. Your returns depend upon the
time you enter and exit. Compounding is a concept which when followed with dedication
gives great rewards. However, it rewards better when savings are compounded over longer
horizons. Compounding, in short, basically means earning interest on previously earned
interest. Let us look at an example:

If you set aside a sum of say Rs 5,000 every month from the age of 25, at a return interest
rate of 10%, in 60 years you will have with you funds worth Rs 1 crore (Rs 10 million) and
more. However, if you start at 40 with the same amount and return rate of interest, the
retirement fund will amount to only around Rs 33 lakh (Rs 3.3 million).

Thus compounding is a tool that helps you make phenomenal growth in your investments
over a period of time. Thus the more time you have, the more money you are capable of
making and this is exactly why financial planning is so very important for each and every
person. Recurring deposits and SIPs can help you on this front.

3.7 NET WORTH (R. P. Rustagi, 2008)

Net worth is the difference between your assets and your liabilities. In other words, if you
sold all of your assets today and paid off your debt (liabilities), the remaining amount would
be your net worth. Some people find that they have a negative net worth and may be on the
verge of bankruptcy.

Net Worth = Value of Your Total Assets - The Sum of Your Total Liabilities

e.g., Isha’s car is worth about Rs6,00,000 and she still owes Rs2,00,000 on it. She has an out-
standing credit card balance of Rs1,00,000. What is her net worth?
Ans: Isha’s net worth is 600000 - 200000 - 100000 = 300000.

Liabilities represent the amount of debt a person owes. Liabilities can be split into two
categories- current liabilities and long-term liabilities.

Current Liabilities are debts that must be paid off within one year. Credit card balances are
the most common form of a current liability for individuals. When you charge something on
your credit card, you will be billed for those charges during the next billing cycle. In other
words, when used properly, a credit card acts like a short-term loan that should be paid off
every month. When you pay that credit card bill, you are eliminating that current liability.

Long-Term Liabilities are debts that will take longer than one year to pay off. Student
loans, car loans, and home mortgages are common examples of long-term liabilities. Each
payment you make contains an interest component and some amount that will reduce the
initial liability i.e., the principal amount. After making all the required payments on time, the
long-term liability is eliminated.

Note that many people use credit cards in a way that creates a long-term liability. They make
purchases with their cards that they cannot pay off quickly. As a result, they pay interest on
their debt and reduce their liability by only a very small portion every month. In general,
using credit cards to create a long-term liability is a bad move. The interest rates charged on
most credit cards far exceeds the interest rate individuals could get at a bank or credit union
for long-term financing. It is much better to pursue other kinds of financing, such as bank
loans, for long-term liabilities.

Why is it important to manage your finances?

If you manage your finances, you would be able to use your money in a better way. If you
don’t, you would not be able to meet your needs. Let’s say today is the first day of the
month. You have got your salary and you spend all the funds on clothes and other
accessories, then you would not have any money left to pay off your monthly bills and other
payments through the month. Learning to save is essential or else you cannot meet your basic
needs even though you earn a handsome pay.

After that identify your financial goals

It is said that one needs to identify his or her investment objective before he starts planning
his finances. Defining one’s investment objective is vital before planning for finances. The
goals will tell you how you should manage your finances so that when you wish to meet your
goals you have enough funds with you. You can then plan accordingly how much you need
to save today for the future plans and how much returns you will receive on your investments
to fulfill your future needs.

Your goals may be either short term, medium term or long term. Your short term goals could
be say to pursue an MBA, to purchase a two-wheeler etc. Short terms goals are defined to be
met in up to three years. Medium term goals could be financing your marriage expenditure,
to gift your parents a vacation package etc. These goals are defined as those needs which
have to be met up to 5 years. Your long term goals could be to purchase a new house and
these would have to be met after tenure of 5 years. You could further define the target date

for each of these goals along with an approximate amount of funds you would require to
meet these needs.


Inflation is rise in prices for goods and services. As the prices rise, lesser number of people
can buy them. Let’s say the rate of petrol changes from Rs 40 to Rs 45, with no change in
quality. Then the price difference indicates inflation.

If you are earning returns of 10% over your investment of Rs 5000 which is Rs. 500 after a
year and the inflation rate is 11% then you will end up giving your returns due to high
inflation rates. Hence always ensure your returns are above the inflation rates. You should
also understand the time value of money.

3.9 TIME VALUE OF MONEY (Prasanna Chandra, 2012)

If you find out the value of things in your house, which you use the most, and to list down
their price or value today and their value 5 years back. You found out that when you
compared their values, their value today was much higher. This is because of the time value
of money. As time passes you will realize that if 10 years back you could afford to purchase
a full lunch for Rs 100, today you might afford to get few pieces of vegetables only. This
means that the value of a thousand rupee note would be higher today than after five years. If
you invest Rs 1000 today, at 5% per annum, then after a year you would receive Rs 1050.
Thus Rs 1000 received today is equivalent to Rs 1050 received after a year. In order to
protect one’s money from losing its value people invest their money. When you borrow you
take up a liability that is you agree to repay and the amount you repay is the original amount
you had borrowed along with an interest payment, which is levied upon the amount you

List down the various items you often use and write down their value today and its value 10
years back. Compare the two values and observe how the value of money has changed over

Suppose the amount available with you for investing is Rs 10,000. You make investments in
various assets. You invest Rs 3500 each in equity (which are shares or stock of a company)
and bonds which may be government securities or corporate bonds. The rest of the funds are

allocated to commodities, let’s say gold or silver, which is termed as bullion in commodity
markets. Now, say the company’s shares in which you have invested have not performed
well then there is a possibility that you may lose money on the capital invested in these
shares. However, since you have invested in other asset classes the decrease in value of any
one asset will be balanced by the gain in other asset classes. This is the benefit of

3.10 DIVERSIFICATION (Prasanna Chandra, 2012 and V. K. Bhalla, 2009)

Diversification reduces the risk of the portfolio. If two asset classes are correlated, it implies
that when one asset class does not perform well the other asset also loses value depending
upon the extent to which they are correlated. If they are positively correlated the direction of
movement would be the same but if they are negatively correlated they would move in
opposite directions. Investors park their funds in different asset classes with a motive to even
out the losses in one asset with the gains in other asset classes. One should always analyze
the fundamentals of the company before investing in its products. If one wishes to invest in
equity markets, he or she may choose to do so by investing in blue chip companies which
have good fundamentals rather than investing in companies whose business you do not

Asset Allocation Every asset class has its own risks and returns. Equity investments are
considered to be risky investments as they might lead to erosion of entire capital invested,
whereas government bonds are considered to be risk free as you are confident that the
government will not default on its interest payments. When it comes to choosing what
investments would suit you, a financial planner will tell you about various asset classes and
will help you allocate your funds appropriately. This is termed as asset allocation.

In other words, now you would begin implementing your financial plan. Asset allocation is a
technique for investing your money into various asset classes. Your planning consultant will
suggest assets that would suit you according to your income and risk appetite. If your risk
appetite is high, he would suggest risky assets, but if your risk appetite is low, then he would
suggest less risky assets. While allocating your funds to various assets, it is important to see
that you distribute your funds across various assets to benefit from diversification.


Updating oneself with the current happenings is a must for every investor as he will then be
aware of various events in the financial markets. In addition to this, there are various matters
that need to be looked into to keep a check on your portfolio. If you do not then you will end
up losing all your returns

You should make a habit of analyzing your investments, valuing your investments and
rebalancing your portfolio. If you are investing in mutual funds, you can keep a watch on the
daily NAV (Net asset value) of the particular fund just like you watch the daily stock prices.
You should also be aware of various financial ratios like profit margins, solvency ratios and
liquidity ratios, which give you an idea of how the said company is in terms of profitability
of its projects, share value and other factors. If you are investing in bonds you should be
aware of the bond’s maturity, the rate of interest and other elements of the bond. If you are
aware that the company has earlier defaulted on its interest payments on its borrowings, then
it is better not to invest in securities of that firm. It is always safer to have a good know-how
on valuation techniques like ratio analysis and investment pay-off.

You should keep an eye on how the value of your investments changes depending upon
fluctuations in the markets, economic issues and other factors. You can analyze your
investments by looking at financial statements of the companies, see how they have
performed in the past and if you expect that the company will perform well in future, then
you can think of investing in that company. You should try to familiarize yourself

3.12 TAX PLANNING (Jeff Madura, 2007)

Every individual should know about the tax implications on his or her investments. Every
individual is charged income tax but the charges vary depending upon under which tax
bracket he falls.

However when it comes to investments you can get a tax rebate. Section 80C of the Income
Tax Act allows you to get a rebate up to a limit of Rs. 1,00,000 which is irrespective of under
which tax bracket you are. This includes- provident fund, public provident fund, life
insurance premium, pension plans, equity linked savings scheme of mutual funds, national
savings certificate. Section 80D of the Income Tax Act also allows you to get a rebate over
premium payments of medical insurance plans. This is over and out of the Rs 1 lakh limit
offered by Section 80C. 80D provides a deduction up to Rs 30,000. For senior citizens, the

deduction up to Rs. 20,000 is allowable. This deduction is available for premium paid on
medical insurance for oneself, spouse, parents and children. It is also applicable to the
cheques paid by proprietor firms. This act also exempts home loan payments. For self-
occupied properties, interest paid on a housing loan up to Rs 150,000 per year is exempt
from tax. However, this is only applicable for a residence constructed within three financial
years after the loan is taken and also the loan if taken after April 1, 1999.



Following are some of the key sources for obtaining financial, industry, and company
information. Much of this is Wall Street Information that is less than 6 days old, so use it
and use it wisely. If you find other sources that are helpful, please e-mail me so that your
information might help other students.

Primary Data Company financial data of publicly listed companies is generally the easiest
to obtain and can be obtained from a number of financial information websites. These
sources will include company annual reports and quarterly reports. Primary data is your first
choice for information. The company’s own website is also a key primary source.

Secondary Data Enter Company or industry name and hit Search. This will give you a list of
possible companies. Then select your company and click on it. You will be brought into a
screen that has company profile, news, magazines, investment reports, rankings, suits and
claims, products, industry overview and associations. If you go to investment reports, you
will have a number of different Research Reports on your company (generally) all by major
Wall Street and International brokerage firms. This is a great resource to not only understand
what is going on in the company, but to also understand which ratio’s and other financial
variables Wall Street analysts deem critical.

Company Write-up Information Annual Reports, Value line Books, Bloomberg terminals,
Company web site,, Company Annual Reports, Competitors reports,, (Beware the hype on this website)

Range of Sources

Before we make any investment, we must check numerous sources of information. This is
because every source that you use may have its own way of looking at a financial product.
Using only a single source is likely to give you incomplete information about the product.

So, always check more than one source and form your own opinion about which product
suits you best. Here is a list of sources from which information is available:

1. TV Programmes There are many business channels on television these days. Some
of them are more basic and explain the foundations of finance and other products
while others are more advanced. Some merely tell us the business and economic
news. We must watch a good mix of education, news and analysis programmes.

2. Newspapers and Magazines As long as we are able to read, there are plenty of
articles available that will give us education, news and analysis. While reading these
may take more time than watching television, they are likely to give us more in dept
information that the Television since it is not possible to clutter a TV programme with
facts and figures. A printed source also allows us to revisit information from time to
time to make sure we have understood it well and in the right context.

3. Annual Reports If we invest in shares, we must keep a track of the performance of a

company through its annual report. The annual report not only tells us about the
financial performance of the company during the past year(s), it also tells us about the
management’s plans for the future of the company.

4. Company/Bank Websites Websites of firms tell us a lot about their performance,

achievements, attitude towards the business and future plans. If we learn the basic use
of the internet, we can easily find information on any company that we want to know
more about.

5. Searches on the Internet and Blogs Sometimes we want to know more about an
industry or an issue. This information may not be available on the websites of
companies. If we learn to search for information, with the help of search engines such
as Google or Yahoo, we can get the answers to most of the questions that we have in
our minds. If we are still not satisfied, we can go to the blog sites of people who share
their views on various topics and put forward our queries there. Remember, however,
that every answer that we receive on internet blogs should be checked with other
sources too.

6. Brokers and Financial Experts People with experience in finance are sometimes a
valuable source of information. They are likely to understand your query like no other
source and give you a specific reply to it. Here again, make sure that you do not act
only on the advice of one or two people. Your investment decisions should be based
on a broad understanding gathered through various sources.

Some Advisors That You Can Turn To Are

 Certified Financial Advisors (by FPSB),

 Licensed Stockbrokers (By SEBI/NSE/BSE),
 Authorized insurance agents (By IRDA/Insurance Company),
 Financial Literacy and Credit Counselling Centers (By RBI/Nationalized Bank) and
 Authorized Business Correspondents (By RBI /Banks)
They could not only give you advice but help you with your financial planning exercise also.

3.14 MUTUAL FUNDS (R. P. Rustagi, 2008)

Mutual fund is an option available to an investor where a team of professional fund managers
manages these investments. The shareholders see an increase or decrease in the value of their
shares based on the overall performance. Investors who buy individual stocks and bonds can
achieve diversification on their own, but it takes many purchases—and a considerable
amount of money. So investors with limited funds who want to diversify may choose a
mutual fund. It is possible to make a mutual fund investment with minimum amount of Rs
500, and this investment in a well-managed fund will be diversified.

Another advantage of mutual funds is that they are managed by experienced people. Such
people may be better at picking good investments than a newcomer to the game of buying
and selling stocks and bonds. Of course, not all mutual fund managers are successful, and
some funds clearly have a better record than others. There are thousands of mutual funds that
invest in stocks and bonds, with many specializing in certain types of securities. Mutual fund
companies and rating services categorize their funds by level of risk or whether the fund
goals are producing long-term growth in share value or providing steady income for

Investors can purchase mutual funds through a brokerage. They can also buy funds directly
from the companies. One type of fund that is increasing in popularity is an exchange-traded
fund (ETF). ETFs provide diversification benefits similar to mutual funds, but they are
typically designed to mimic a stock index like the Standard & Poor’s 500. In addition, ETFs
typically have very low management fees. Investors can buy and sell ETFs in the same way
they buy and sell stocks. This ease of buying and selling makes ETFs more accessible to
small investors and has attracted billions to ETF investments in the past decade.

In India the operations of mutual funds are supervised and regulated by SEBI Regulations,
1996 which provide for the structure of a mutual fund also. Growth of mutual fund was
restricted till 1987 when UTI was the sole mutual fund operating in India. Thereafter, private
banks, commercial banks and foreign sponsors have been gradually allowed to establish
mutual funds. After 1996, two notable features about mutual funds in India were found and
they were (i) several innovative schemes have been offered to the investors, (ii) there have
been amalgamation and take-overs of mutual funds. SEBI Regulations, 1996 contain
different provisions relating to operations of mutual funds in India, particularly relating to
investors’ protection.

Benefits of Mutual Funds Mutual funds are attractive to some investors for several reasons.

 The mutual fund professionals will devote time for analysis so the investor’s time will
be saved.
 An investor is able to get the services of professionals and experts at a nominal cost.
 He gets an ownership of a diversified portfolio.
 MFs have large funds to invest. So, economies of scale are available to them and also
available to the unit holders.
 Different types of mutual fund schemes are available to an investor.
 Mutual fund investment is risk-hedging mechanism.

There are different ways in which various mutual fund schemes can be classified.

Classification On The Basis Of Types

1. Life Span close-ended scheme, open-ended scheme

2. Income Mode income scheme, growth scheme
3. Portfolio Equity schemes, debt schemes, balanced
4. Maturity of Securities Capital market schemes, money market
5. Sectors Different sectoral schemes
6. Load Basis Load schemes, no load schemes
7. Special Schemes Index schemes, offshore schemes, gilt
securities schemes, exchange traded funds,
funds of funds

NAV Calculation mutual fund’s value can be determined by its net asset value (NAV).
Funds collected under a particular scheme are known as corpus assets under management.

After the collection, the corpus is invested in different securities. The ownership interest of
the unit holders is represented by these securities. Investment made by investors is
represented by units. Net assets value refers to the ownership interest per unit of the mutual
fund, i.e., the amount which a unit holder would receive per unit if the scheme is closed.

NAV ͇ Value of Securities – Liabilities

No. of Units Outstanding

NAV of any scheme tells as to how much each unit is worth. It may be taken as the simplest
measure of performance of a MF SEBI Regulations, 1996 provide that while determining the
price of the units, the mutual fund has to ensure that the repurchase price is not lower than
93% of the NAV and the selling price is not higher than 107% of the NAV. Further that the
difference between the selling price and the repurchase price shall not exceed 7%, calculated
on the selling price of the units. The NAV varies from time to time and is published in
newspapers so as to enable the investors to know the value of their investments. SEBI
Regulations, 1996 require that the NAV of a mutual fund scheme shall be calculated and
published at least in two daily newspapers at an interval of not exceeding one week.

Costs Related to Mutual Funds

There are Two Types of Costs

1. Load an investor is required to bear the load at the entry level (purchase of units)
and/or at exit (sale of units). Open end MF can be either load funds or no-load funds.
No-load MFs sell directly to investors and do not charge a fee. Brokers are less likely
to recommend them to investors. On the other hand, load MFs charge a fee or load at
the time of purchase of MF. This fee goes to stockbrokers or other financial service
advisers who execute transactions for investors in load mutual funds. No load funds
provide better and higher returns to investors as compared to load funds. SEBI
regulations provide that the sum of entry and exit load cannot exceed 7% of the NAV
in case of open-ended MFs.

There are Two Types of Loads

a. Entry Load an entry load is the cost or commission payable at the time of
buying a unit.
b. Exit Load mutual funds may charge an exit load from the investor at the time
of repurchase of units.

Some mutual funds charge both loads and some charge either one.

2. Operating Expenses operating expenses are the costs incurred by mutual funds in
respect of management of portfolio of assets on behalf of the investors. The operating
expenses include the administrative expenses and the advisory fees payable to the
trustees, etc. However, the brokerage paid for buying or selling of assets is added to
the cost of the asset. Return from a mutual fund can be calculated as per the following

Return ͇ Div + CG + (NAV1 – NAV0) × 100

Div = dividend for the period
CG = capital gain distributed, if any
NAV1 = net asset value at the end of the year
NAV0 = net asset value in the beginning

Systematic Investment Plans

SIP or systematic investment plans are an excellent means by which you can start investing
small, fixed sums of money at regular intervals, (commonly 1 month). The amount is
invested in units of the mutual fund at the prevailing NAV of the scheme.

Advantages of SIP

 Systematic and user friendly.

 Get better return in the long run by investing every month.
 Investors have an option of either taking dividend payout or taking a growth option.
 SIP gives you the option to invest even a minimal amount of Rs 500 each month.
 Payment though post dated cheques or a debit facility.
 Easy and disciplined transfer
 Dividend- growth option
 Affordable

SIP uses the concept of rupee cost averaging. As the securities prices are volatile, the NAV
of the mutual fund schemes also keeps changing. An SIP allows you to invest small amounts
of money over time to build a corpus. By spreading out investments over a period of time,
they help investors average their purchase cost. This prevents you from committing all your

money at a market peak and hence maximizes returns. SIPs also bring discipline to investing
and make investing a habit. The frequency of SIPs can vary; you can do a monthly, weekly
or daily SIP. Also, there are various types of SIPs. You are better off sticking to an ordinary
SIP, preferably on a monthly basis.

SIPs have limited use in debt schemes as they are not as volatile or risky as equity schemes.
SIP is a systematic way of investing your money in mutual funds. You can invest every
month or quarter or year, it depends on the plan you have chosen. It encourages investors to
save money and in the end, they can redeem better returns.

A few features of SIP are that investors don’t have time to keep an eye on market and hence
can pour in money into SIP. In SIP, one can also get the benefits of compounding i.e., you
can reinvest the interest earned from the SIP. In the long run, it can make a huge positive
impact on your returns.

Systematic Transfer Plan

Generally, one starts with an STP when there is a lump sum to invest. An STP helps spread
investments over a period of time to average the purchase cost and rule out the risk of getting
into the market at its peak. With an STP, an investor can invest a lump sum in one scheme
(mostly a debt scheme) and transfer a fixed amount regularly to another scheme (mostly an
equity scheme). The basic idea behind an STP is to earn a little extra on the lump sum while
it is being deployed in equity. Debt funds excel over the normal savings bank account.
Depending on the lump-sum amount, the investor can decide the period over which he wants
to deploy the money in the market.

An STP can be done from an equity fund to a debt fund as well. If you are saving for some
important goal, like your child's education, buying a home or retirement and you are nearing
your goal, don't wait till the target date. Begin moving your money from equity to debt well
before the time when you need the money.

STP is an automated way of transferring money from one mutual fund to another. This plan
is chosen when one wants to invest a lump sum amount but wants to avoid the marketing-
timing risk. The most common way of doing STP is to transfer money from a debt fund to
an equity fund.

Systematic Withdrawal Plan

An SWP allows you to withdraw a designated sum of money from a fund at regular intervals.
Such a system is particularly suited to retirees, who are looking for a fixed flow of income.
SWPs provide the investor a certain level of protection from market instability and help
avoid timing the market.

Funds are generally withdrawn either to rebalance the existing portfolio by investing in other
funds or for meeting personal expenses. It is somewhat the reverse of SIP. If you invest lump
sum in a mutual fund, you can set an amount you’ll withdraw regularly and the frequency at
which you’ll withdraw.

SWP may be available in 2 options

1. Fixed withdrawal, where a fixed specified amount is withdrawn on monthly or

quarterly basis.
2. Appreciation withdrawal, where 90% (or some other) of the appreciated amount can
be withdrawn on monthly or quarterly basis.

In India the operations of mutual funds are supervised and regulated by SEBI (mutual funds)
Regulations, 1996 which provide for the structure of a mutual fund also. Growth of MFs was
restricted till 1987 when UTI was the sole mutual fund operating in India. Thereafter,
commercial banks, private sectors, and foreign sponsors have been gradually allowed to
establish mutual funds. After 1996, two notable features about mutual funds in India are that
(i) several innovative schemes have been offered to the investors, (ii) there have been
amalgamations and take-overs of mutual funds. SEBI (Mutual Funds) Regulations, 1996
contain different provisions relating to operations of mutual funds in India, particularly
relating to investor’s protection.


Fill in the blanks

(a) Variation in expected return from an investment is known as _______. (risk)

(b) Mutual fund is a type of a __________ investment. (Indirect investment)

(c) ________________ of a mutual fund is the value of ownership per unit with the
investors. (net asset value)

(d) In India the operations of mutual funds are supervised and regulated
by____________________. (SEBI (mutual fund) Regulations, 1996)

(e) Mutual funds are_______________ managed. (professionally)

(f) Investors do not __________money to the mutual fund, rather they invest. (lend)

(g) On the basis of life span, the MFs are of two types, namely-open ended and
___________. (Close ended)

(h) In_______, the investor can invest smaller amounts in different instalments rather than a
lump sum. (SIP)

(i) _______is a facility provided by a mutual fund to its unit holders to withdraw money from
the scheme on a regular basis. (SWP)

(j) When an investor in the MF scheme has instructed the mutual fund to transfer a specific
amount from one scheme to another scheme, is_____________________. (systematic
transfer plan)

(k) All close ended funds have __________life span. (limited)

(l) The essential feature of an open ended mutual fund scheme is the__________. (liquidity)

Long Answer Questions

Q1. What is a mutual fund’s net asset value? How is the NAV calculated and reported?

Q2. What are mutual funds? What are the different types of mutual funds available to an
investor? Do investors select the securities the mutual fund invests in?

Q3. What do you mean by systematic investment plan (SIP)? How is it different from
systematic withdrawal plan (SWP)? How SIP is beneficial to investors?

Q4. Explain the different objectives of investment? And what are the investment constraints?

Q5. Write short note on the following:

(i) Portfolio management

(ii) Risks vs. Returns
(iii) The power of compounding
(iv) Net Worth
(v) Inflation effects on Investment
(vi) Time Value of Money
(vii) Diversification


1. Madura, Jeff (2007). Personal Finance. (ed. 3rd). Florida Atlantic University, Pearson.

2. M. Ranganathan and R. Madhumathi: Investment Analysis and Portfolio Management,

Pearson Education, New Delhi.

3. Chandra, Prasanna. (28th june 2012), 4th ed. Investment Analysis and Portfolio
Management, McGraw-Hill, Delhi.


PORTFOLIO MANAGEMENT, S Chand, New Delhi, 2009

5. R. P. Rustagi. (2008). Investment analysis and portfolio management (2nd ed.). Sultan
Chand & Sons.

6. Zvi Bodie, Alex Kane, Alan J. Marcus – Investments. (2013). McGraw-Hill

Education.(10th edition).

7. Lessons on financial planning for young investors, publication Securities Exchange Board
of India.

Unit III




4.1 Risk Profiling

4.2 Components of Risk Profiling
4.3 How to create a Risk Profile
4.4 Risk Aversion
4.5 Financial instruments and associated risks
4.6 Asset Classes
4.7 Types of Investments and Returns
4.8 Power of Compounding
4.9 Time Value of Money
4.10 Rupee Cost Averaging


Risk profiling is a process for finding the optimal level of investment risk for your client
considering the risk required, risk capacity and risk tolerance, where, (Stepaheadia, 2014)

➢ Risk required is the risk associated with the return required to achieve the client’s
goals from the financial resources available,
➢ Risk capacity is the level of financial risk the client can afford to take, and
➢ Risk tolerance is the level of risk the client is comfortable with.

Measure Assess

Manage Evaluate

Figure 1: Risk Management

Risk required and risk capacity are financial characteristics calculated using your financial
planning software. Risk tolerance is a psychological characteristic which is best determined
by way of a psychometric test.

Risk profiling requires each of these characteristics to be separately assessed so that they can
be compared to one another. Risk capacity and risk tolerance both act separately as
constraints on what your client might otherwise do to achieve their goals (risk required). It is
unusual for a client to be able to achieve their goals from the resources available within both
their risk capacity and risk tolerance.

Where a mismatch between risk required, risk capacity and risk tolerance has been found, the
advisor’s role is to guide the client through the trade-off decisions that are required to reach
an optimal solution.

The final step in the risk profiling process is to ensure that the client has realistic risk and
return expectations so that the advisor can be given the clients properly informed consent to
implement the investment strategy.

Risk profiling is one of the most fundamental aspects of determining a suitable investment
solution for an individual. It is also one of the most misunderstood. This situation results in
many ill-advised approaches, both to determining various components of a client’s risk
profile and to using them in arriving at an appropriate solution. Among these ill-advised
approaches are (Davies, 2017):

• using a client’s actual behaviour (their “revealed preferences”) to determine the risk
tolerance used to construct their long-term portfolio;
• using components of a client’s attitudes toward risk other than long-term risk
tolerance as inputs into portfolio “optimization,” rather than helping the client to
mitigate and control them;
• trying to elicit risk tolerance on subcomponents of a client’s overall wealth, rather
than as a feature of the person as a whole;
• using over-engineered and unstable approaches to establishing risk tolerance when
simpler measures would be not only sufficient but also better;
• putting too much effort into spuriously precise measures of risk tolerance and far too
little into understanding risk capacity, which in many cases is the more important
component of a risk profile; and
• using “required” returns as inputs to determine the investment solution, rather than
guiding the client to reasonable expectations as an outcome of the client’s
circumstances and of the returns available in markets.


Risk profiling lies at the heart of financial planning and is the process for determining an
appropriate investment strategy with regard to risk. Risk has three primary aspects:

1. Risk required: the risk associated with the return that would be required to achieve the
client’s goals (a financial characteristic).
2. Risk capacity: the extent to which the future can be less favourable than anticipated
without derailing the client’s plans (a financial characteristic).
3. Risk tolerance: the level of risk the client prefers to take (a psychological characteristic).

Each of these three risk aspects has an impact on the selection of an appropriate investment

Risk profiling involves: making separate assessments of risk required, risk capacity and risk
tolerance so that they can be understood and compared; comparing the assessments to
identify any mismatches; and finding a resolution for any such mismatches.

As with many aspects of investment advising, good practice requires sound processes, robust
tools and advisory skills making it a blend of art and science.

Advisors and clients share a common interest: neither one wants the relationship to end
unhappily. Sloppy risk profiling makes advisors vulnerable to (legal) claims by unhappy
clients. One of the most likely causes of an abrupt, unhappy ending to the advisor/client
relationship is mismanaged risk. In a bear market, what was previously thought of as a “risk”
becomes a reality. This may trigger, at best, simple dissatisfaction and, at worst, a claim for
losses sustained.

On the other hand, sound risk profiling practices will result in suitable advice, where
investors understand the potential consequences of their portfolio decisions. Matching
tolerance to potential outcomes results in happier clients who are easier to service and more
likely to refer, and to greater investment persistency.



Risk Risk
Capacity Tolerance

Figure 2: Risk Profile


The financial Planners role is crucial in determining the risk profile of the client. This is
achieved by questioning the client extensively along the following lines:

• How concerned are they about having their portfolio keep pace with inflation?

• How concerned are they about tax effective investments?

Further, to undertake risk profiling effectively, we need to have a clear idea of what it is
we’re trying to understand. Broadly speaking, a comprehensive risk profile requires
understanding two characteristics of a client:

1. their willingness to take risk

2. their ability to take risk

But what exactly do we mean by these terms, and what do we need to understand about the
client in order to put them to practical use?

Willingness to take Risk: It is often variously, and ambiguously, referred to as risk attitude,
risk tolerance, risk aversion, or risk appetite. Moreover, It is important is that there is a
crucial distinction to be made between:

a. risk tolerance (an investor’s stable, reasoned willingness to take risk in the long term)
b. Behavioural risk attitudes (the unstable, behavioural, short-term willingness to take
risk exhibited through an investor’s actions i.e., the investor’s “revealed”

From the perspective of investment suitability, the former reflects the normative level of risk
we should seek to deliver for a client over the long term.

The latter, in contrast, frequently reflects transient and context-dependent preferences that
would result in poor satisfaction of the investor’s long-term needs if we mistakenly take them
to be a guide to long-term risk preferences.

This second set may contain a whole range of different influences on risk attitude, including
loss aversion, ambiguity aversion, risk perceptions, and probability distortion. Apart from
being unstable, these are also context dependent, myopic, present biased, and pro-cyclical and
often lead to absurd levels of risk aversion when aggregated. They are not attitudes we should
want in the driver’s seat for our long-term portfolio optimization. If used to determine the
“suitable” risk level of the portfolio, these attitudes can deliver an undesirable long-term
solution based on an assessment of fleeting point-in-time preferences, with on average a
much lower level of risk than the investor’s own long-term willingness to take risk and with
the added danger of buying low and selling high.

In the end, the role of suitability is to steer investors to better outcomes, not replicate (and
optimize for) all the silly things they do already.

Ability to take Risk: In addition to ascertaining how much risk investors are willing to take,
it is important to understand how much risk they are able to take. This concept also goes by
many loosely defined labels, such as risk capacity, capacity for loss, and ability to bear loss.
At their core, these are all variations on the underlying notion that the amount of risk an
investor might be willing to take could nonetheless be ill-advised if it endangers the
investor’s ability to fund future financial commitments from the portfolio. I shall refer to this
notion as risk capacity throughout this article, using it to encompass all the terms listed
above. Since risk capacity concerns the investor’s ability to meet any future liabilities, it
depends on a number of elements of the investor’s holistic financial position. These all help
determine the degree to which the investor will be able to continue to fund future required
cash flows in the event his portfolio value declines:

1. First, the size of the total investable assets relative to total net wealth. Investable assets
are where the investment risk resides, so the fewer investable assets clients have relative
to other assets, the higher their capacity to take risk. Investors who invest only a small
portion of their net wealth have more capacity to take risk without jeopardizing future
commitments. The value of these other assets may vary substantially in value and indeed
is only likely to be realized when the investor’s circumstances are pressured. This implies
that a very conservative assessment of the value of non-investment wealth is appropriate.
Nonetheless, an investor with other wealth to fall back on will have greater risk capacity
than one who doesn’t.

2. Second, the degree to which the investor is willing or able to realize the value in non-
investment assets to cover liabilities in the event that they can’t be funded from the
investment portfolio. More liquid assets and those practically and emotionally easier to
sell if circumstances require doing so, will provide more risk capacity than those the
investor can’t or won’t realize the value of until they are in dire straits.

3. Third, the degree to which future spending might be met using the client’s expected
future income, which may be thought of as human capital or net future wealth. It depends
on the following:

i. Future income expectations: More certain and stable future income will more
reliably increase risk capacity than variable or uncertain income streams (e.g.,
don’t count too much on distant inheritance expectations when determining
today’s risk capacity).
ii. The future liabilities themselves: The greater an investor’s goals and spending
needs, the more her investment portfolio needs to provide for and, therefore, the
lower her capacity to place the capital value at risk. Note that in this sense, the
greater the wealth “required” to fund future liabilities, the lower the capacity to
take risk, contrary to many approaches that use “required returns” as an excuse to
increase portfolio risk.
iii. Flexibility regarding future liabilities and expenses: If the investor has
discretion over whether to incur a future expense, then expenses can be reduced or

delayed in the event of poor market performance. Such an investor thus has
greater risk capacity.

These last elements show the essential, and close, connection between any reasonable
assessment of risk capacity and both (a) a truly holistic view of the client’s current
circumstances and (b) a coherent approach to goal-based investing. Risk capacity, correctly
conceived, is the vital pivot between goal-based cash-flow-planning approaches and
investment solutions. It turns the information gleaned from a thorough planning process into
a measure that helps define the appropriate level of risk for the investment process.

Interestingly, this observation also reveals that even risk capacity, usually thought of as being
about the investor’s objective financial circumstances, is strongly behavioural. One of the
most effective routes to increasing risk capacity is to manage client aspirations, expectations,
goals, and future financial commitments. The less you want, the more you can take risk to
grow your wealth and the more you may wind up with.

As mentioned, this article is not the place to develop a full framework for measuring risk
capacity. However, understanding what it is—and isn’t—is vital to being able to approach a
client’s willingness to take risk and to understand some of the future directions for assessing
risk tolerance. It also helps us understand why developing ever more precise measures of risk
tolerance may not be the best use of resources.

For most investors, risk capacity is overwhelmingly more important than risk tolerance; the
right level of risk for their investments is far more likely to be constrained by their lack of
capacity to cope with capital losses than by their psychological aversion to long-term risk.
And yet, because it is inherently more difficult to measure, with more moving parts, risk
capacity is also largely neglected.

The relative importance of getting risk capacity and risk tolerance right is related to the ratio
of the flow of income and expenditure to the stock of wealth. Investors with small flows in
and out of their balance sheet relative to the size of the balance sheet (typically very wealthy
people with large net asset values) will be likely to have high risk capacity, since they have
significant wealth with which to fund future liabilities as they arise. For them, risk tolerance
is far more likely to be the binding constraint.

For most investors, however, the future expenditures they will have to fund from their
investible assets are substantial relative to their stock of wealth. For them, risk capacity is a
far more important notion than risk tolerance, and yet it is one that many investment
suitability processes largely gloss over. Even investors with high willingness to take risk
should avoid doing so if the potential losses will mean they’re unlikely to be able to fund
future commitments. And yet the bulk of the industry debate (to which, admittedly, this
article is contributing) is devoted to how to better measure risk tolerance, a stable feature of
someone’s personality easily measured to an adequate degree of accuracy with a simple
psychometric scale.

However, part of the reason there is little agreement on how to categorize risk capacity and
the two broad categories of risk attitudes (risk tolerance and behavioural responses) is that all
of this appears hugely complicated. It is very easy for confusion to arise or for those with
vested interests in particular views to obfuscate the debate. So, let us try to isolate each of
these three components with a thought experiment that strips away all the extraneous detail
and allows us to focus on the essential features.

4.4 RISK AVERSION (Finance Train, 2018)

Risk aversion is the behavior of humans (especially consumers and investors), when exposed
to uncertainty, in attempting to lower that uncertainty. It is the hesitation of a person to agree
to a situation with an unknown payoff rather than another situation with a more predictable
payoff but possibly lower expected payoff. For example, a risk-averse investor might choose
to put their money into a bank account with a low but guaranteed interest rate, rather than into
a stock that may have high expected returns, but also involves a chance of losing value.

A risk averse investor is an investor who prefers lower returns with known risks rather than
higher returns with unknown risks. In other words, among various investments giving the
same return with different level of risks, this investor always prefers the alternative with least
interest. A risk averse investor avoids risks. He/She stays away from high-risk investments
and prefers investments which provide a sure shot return. Such investors like to invest in
government bonds, debentures and index funds.

We have seen that different asset classes such as bonds, stocks, and commodities provide
different levels of risk and return to investors. However, we also know that these investment
options are not equally preferred by all investors. An equity stock providing high returns may
be suitable for one investor but another investor may want to avoid such an investment. This
happens because of the different attitudes of investors towards risk. A portfolio manager will
consider the risk profile of his client investors and try to match his portfolio investment in
such financial instruments that have the similar risk-return profile. This concept is called risk
aversion. In general, risk aversion refers to the behaviour of investor to prefer less risk to
more risk. A risk averse investor will:

• Prefer lower to higher risk for a given level of expected return

• Accept high risk investment only if expected returns are greater

Let’s take a simple example to understand this. Assume that an investor has been offered two
choices. In the first choice he will receive Rs.100 for sure. In another choice, there is a 50%
chance that he will receive Rs.200 and another 50% chance that he will receive nothing. We
can have some understanding of what kind of an investor he is depending on the choice he
makes. The following figure shows the risk-return profiles of different types of investors.

Figure 3: Risk Aversion

1. Risk Neutral Investor: A risk neutral investor is someone who is only concerned about
the return but does not worry about the risk posed by the investment. As long as an
investment provides high returns, this type of investor will go for it. In our example, a
risk-neutral investor will be indifferent between the two choices. He will look at both
choices 1) Rs.100 for sure, and 2) 50% nothing and 50% Rs.200, as the same. In general,
investors are not risk neutral. An investor may be risk neutral if the investment is not so
significant. For example, a very wealthy investor will be indifferent to whether he
receives Rs.100 guaranteed or goes for the gamble.

2. Risk Averse Investor: As we mentioned earlier, most investors are risk-averse, that is,
they want to reduce the amount of risk they take for a given level of return. If the returns
provided are higher, they will be willing to take proportionately higher risk. In our
example, such an investor will go for guaranteed $100. In fact, depending on his risk
aversion, he may even be willing to accept slightly lower returns (say $90 instead of
$100) for the certainty he gets. Different investors will exhibit different degrees of risk
aversion. In the figure above, the two investors IP and IQ have different levels of risk
aversion. Investor IP is more risk averse than investor IQ as investor IP demands more
return for every additional unit of risk in the investment.

3. Risk Lover/Risk Seeker: The third category of investor is a risk lover. In our example,
such an investor will choose to gamble because it’s not about the returns. Rather he loves
taking risk, and gets additional pleasure by taking the risk. A risk lover definitely wants to
increase his returns but his utility (level of happiness) increases from the extra risk that he
takes. For risk lovers, the risk-return curve slopes downwards, i.e. the return they receive
reduces and the risk increases. This is the typical profile of a gambler.


Financial instruments involve various risks and therefore it is essential to study the nature of
the instrument and the risks it entails before deciding on making an investment. It is
important that the investor does not trade in financial instruments unless he/she is fully aware
of the risks involved in such transactions and that he/she takes into account his/her financial
strength and experience in trading in such investments.

The following shall be kept in mind when assessing whether a financial instrument is suitable
for an investor:

a. The investor must possess sufficient knowledge and experience to evaluate the
financial instrument in question.
b. The investor must be aware of the risks associated with investing in the financial
instrument in question and the impact that the investment may have on the investor’s
assets and financial capacity.
c. The investor must acquaint him-/herself with and understand the terms which apply to
the financial instrument in question and the markets where the instrument is traded.
d. The investor must be able to assess (either on its own or with the assistance of an
advisor) the impact of external factors such as economic fluctuations, changes in
interest rates and other similar factors which may impact an investment in the
financial instrument in question.

General Risk Factors

Financial instruments involve various risks, but several risk factors apply to any type of
financial instrument and are discussed below:

a. Market Risk: The risk that changes in market prices have adverse effect on financial
b. Interest Rate Risk: The risk that changes in interest rates have adverse effect on the
value of a financial instrument.
c. Currency Risk: Exchange rates fluctuate and financial instruments that are registered
in foreign currency can entail currency risk. Changes in currency rates can cause
profit or loss although the currency value in which the underlying instrument is
registered does not change.
d. Liquidity Risk: The risk that an investor cannot easily sell or buy a specific financial
instrument at a certain point in time, or is only able to do so on terms that are
considerably poorer than the norm in an active market at any time. This can be caused
by various factors, such as inactive market with a particular instrument, contract size
and other factors that may affect the supply and demand and market participants’
e. Economic Risk: Economic fluctuations often affect the prices of financial
instruments. The fluctuations are variable, they can variate in time and magnitude and
can affect different industries in various ways. When deciding on an investment an

investor must be aware of the general impact of economic fluctuations, including
between countries and different economies, on the value of financial instruments.
f. Country Risk: The risk includes, among other things, political risk, currency risk,
economic risk and risk relating to capital transfers. This refers to the economic factors
that could have a significant impact on the business environment in the country in
which the financial instrument is registered.
g. Legal Risk: The risk that the government makes changes to existing laws or
regulations that can have adverse effect on financial instruments, for example changes
in tax laws or laws regarding capital transfers across borders.
h. Inflation Risk: When investors assess the yield of a specific financial instrument, it is
necessary to do so with regard to inflation and inflation outlook to estimate the
expected real return on investment and current asset value.
i. Counterparty Risk: The risk that a counterparty will not meet his contractual
obligations in full.
j. Settlement Risk: The risk related to a counterparty not meeting the contractual
obligations on the settlement date. Settlement loss may occur due to default or due to
the different timings of the settlement between relevant parties.

Risks Associated With Individual Financial Instruments

1. Shares: Shares are issued to a shareholder as evidence of the holder’s ownership interest
in the limited company in question. Shares may be issued as written instruments or
electronically in a central securities depositary. A shareholder enjoys the rights provided
by law and the company’s Articles of Association. Investing in shares may involve the
following risks:

a. Company Risk: By purchasing shares, the investor contributes funds to the company
concerned and in turn becomes an owner of the company along with other
shareholders. Therefore, the shareholder, as owner, is involved in the development of
the company and the changes which occur to its assets and liabilities. It can be
difficult to estimate the return that the shareholder may expect to receive on the
investment. In the event of bankruptcy, the shareholder may lose the funds that it
originally contributed since priority is not given to shareholders’ claims during
bankruptcy proceedings.

b. Price Risk: The price of shares may fall and/or rise without it being possible to
predict the timing or duration of such fluctuations. Price risk must be distinguished
from company risk; however, jointly or separately, these factors influence the price of
shares with resultant risks for investors.

c. Dividend Risk: The amount of dividends, if any, which investors receive from their
shareholdings, is determined by the profits of the company in question and its
dividend policy. Dividend payments may cease should the company suffer losses.

2. Bonds: Bonds are written declarations in which the issuer unilaterally and
unconditionally accepts its obligation to pay a certain amount of money at a given time in
accordance with the stated terms. Bonds are generally issued by companies and
government bodies. The bond terms, such as interest and maturity, are always determined
in advance. Interest can either be fixed or variable. Bonds can also be index-linked, in
which case the principal of the debt will be adjusted in accordance with a specific price
index, e.g. the consumer price index. The principal of the debt is either paid in one sum
on the final maturity date or on predetermined due dates. The purchaser of a bond (the
creditor) has a claim against the issuer (the debtor) for the payment of money in
accordance with the terms of the bond. Investing in bonds may involve the following

a. Issuer Risk: A bond issuer may become unable to pay its obligations. Such
insolvency may be temporary or permanent. Economic and political developments in
the sector and the countries in which the issuer operates may impact its payment
capacity. In the same manner, the issuer’s credit rating may change as a result of
positive and/or negative developments in the issuer’s operations and influence the
market price. Normally there is a connection between the interest on the issuer’s
bonds and its credit rating, the lower the credit rating the higher the interest rate.

b. Interest Rate Risk: The market risk factor which has the greatest impact on bond
prices can change in interest rates in the relevant market. An increase in general
interest rates leads to a reduction in the market value of the bonds and vice versa. This
risk becomes greater as the maturity of the bond in question is longer.

c. Call Risk: Bonds may be callable by the issuer prior to maturity. Such redemption
may affect the expected yield of the bond in question, for instance if market interest
rates are lowered.

d. Risk Associated with Different Types of Bonds: Risks other than those listed above
may be involved in investments in different types of bonds. Investors are therefore
advised to familiarize themselves with the terms of each individual bond issue as they
are presented in the prospectus for the bond class and not to make a decision to invest
until an assessment of all the risk factors associated with the bonds in question has
been carried out.

3. Funds: The sole purpose of UCITS and investment funds is to accept funds from
investors for collective investments in financial instruments and other assets on the basis
of diversification, in accordance with the fund’s existing investment strategy. The
difference between these funds lies principally in their investment authorizations. UCITS
and investment funds are always subject to redemption and unit holders can therefore
request to redeem their holdings whenever it suits them. Management companies can also
set up a professional investment fund, which does not accept funds from the public. There
are no legal restrictions on investments in funds of this kind and investments in them are

therefore considerably riskier than in other funds. Professional investment funds are not
subject to redemption and generally have a predetermined life span. There are many funds
with different investment strategies and the legal rules that govern their activities can also
vary. Investing in funds can entail the following risks and investors are advised to
familiarize themselves with the investment strategy of the relevant fund before making an
investment decision:

a. Sale and Redemption: There is no certainty of there being an active secondary

market for UCITS or shares in the relevant fund and it might therefore be difficult for
investors to sell their shares. Moreover, in some funds there are restrictions on and/or
fees connected to the redemption of shares. UCITS and investment funds are,
however, always subject to redemption. However, situations can arise in the securities
market in which trading in the underlying assets of funds is restricted, due to
temporary uncertainty regarding the issuers of financial instruments owned by the
fund. In such cases, it is permissible to temporarily suspend redemptions in the fund if
it is considered necessary to protect the overall interests of the unit holders in the

b. Legal Risk: The operations of specific funds may fall under Icelandic or foreign laws,
which may mean that certain forms of investor protection or operational restrictions
which may apply in one jurisdiction do not apply in other jurisdictions.

c. Leveraging: Some funds are authorized to finance certain parts of their activities with
loans and to invest in derivatives agreements. This kind of leveraging can increase the
risk of the fund’s operations and entail costs that can result in a decline in the value of
the investor’s shares in the fund.

d. Right to Participate: Investors in the fund generally have little or no right to

participate in and/or have any influence on the activities of the relative fund.

e. Investment Strategy: The investment strategies of funds can vary a great deal. Some
funds make specialized investments and, for example, only invest in certain kinds of
financial instruments and/or in certain market areas. The risk that the fund bears is
therefore primarily connected to the relative financial instruments and/or market
areas. Funds may also invest in areas where there is a lot of competition and where
there are therefore fewer investment opportunities. Risk policies and diversification
differs between funds, but generally speaking the risk is higher in funds that have less
risk diversification.

f. Evaluation: If a fund invests in assets which are not liquid it may be difficult to
estimate the value of its units/shares.

g. Underlying Assets: There can be a variety of underlying assets in a fund, such as

shares, bonds, investments in other funds and derivatives. Funds may be subject to

market risk and risk inherent in their investment strategies, such as investments
outside the regulated securities markets, short selling financial instruments and
leveraged purchases and/or sales which can result in losses for the relevant fund. In
evaluating the risk inherent in investing in certain funds one should bear in mind the
risk factors that can have an impact on the value of the underlying assets in the fund.

h. Management: The activities and performance of individual funds depends on the

competence of its management and staff. The fund manager generally makes
investment decisions in accordance with the fund’s investment strategy. Bad decisions
by the management can result in losses for the fund and investors. If an agreement
between a fund manager and key staff members is terminated, there is no guarantee
that competent staff can be recruited without the fund suffering losses.

4. Derivatives: A derivative is an agreement in which the settlement clauses are based on

the variation of a particular factor during a particular period, such as interest rates,
exchange rates, securities prices, securities indices or commodity prices. Derivative
agreements give investors rights, which may be optional, to buy or sell certain underlying
assets or request a cash settlement. The value of these agreements is based on the
development of these underlying factors from the contract date to the settlement date.

Investments in derivatives are often leveraged so that a slight change in the value of the
underlying assets can have a proportionately high impact on the value of the derivative
agreement with accompanying positive or negative consequences for the relevant
investor. Derivative agreements are temporary and can therefore be worthless when they
expire, if prices do not develop as the investor had anticipated.

Investments in derivatives should only take place when investors are prepared to
withstand considerable losses. Investments in derivatives agreements are subject to
certain terms, such as collateral requirements and margin calls, which investors are
advised to acquaint themselves with before making an investment. Examples of varying
derivatives contracts are:

a. Forward Contracts: Forward contracts stipulate the obligations of the contracting

parties to buy or sell certain assets at a certain price and a predetermined time.
Contracts of this kind can also be settled in cash. Forward contracts are very risky
investments, particularly in view of the fact that investors often only have to
contribute a part of the amount that is invested and therefore take a loan for the
difference. This leverage means that a slight change in the prices of the underlying
assets can have a proportionately high impact on the value of the agreement and
consequently increase or decrease the market value of the agreement.

b. Options: An option is a contract which gives one contracting party, the buyer, the
right but not the obligation to buy or sell specified assets at a predetermined price at a
specified time or within specified time limits. As a payment for that right, the other

contracting party, the seller, receives a certain fee which is determined by the market
value of the option at the beginning of the contract. There are many different types of
option agreements and each has its own characteristics. What matters the most,
though, is whether the investor is the buyer or seller of such an agreement.

i. Purchase of Options: The purchase of an option agreement entails less risk than
the sale of one because, if the price development of the underlying assets is
unfavorable for investors, they can decide not to exercise their option. The
maximum loss of the investor is therefore the option fee that was paid at the
beginning of the agreement.

ii. Sale of Options: The sale of an option agreement entails considerably more risk
than the purchase of one. By selling an option agreement, the investor assumes the
obligation to buy or sell the underlying asset if the buyer of the option exercises
his/her right. The investor who sells the option agreement may need to put up
collateral at the beginning of the agreement and additional collateral if the value
of the agreement develops unfavorably for the seller and, at the moment of
settlement, the seller may suffer a loss which far exceeds the option fee which the
seller was paid at the beginning of the option agreement. In the case of a put
option in which the investor owns the assets, which he/she has undertaken to sell,
the risk is less. If the investor does not own the assets he/she has undertaken to
sell the risk can be unlimited.

c. Financial Contracts for Differences: In some forward agreements and option

agreements, the settlements are only permitted to be made in cash. Investments in
agreements of this kind entail the same risk as investments in regular forward
agreements and/or option agreements.

d. Swap Agreements: A swap agreement is an agreement between parties to swap

different payment flows over a certain period. There are different types of swap
agreements, but the most common types are interest rate agreements and currency
swap agreements. The main risk factors in interest rate and currency swaps are
interest rate risk and currency risk:

i. Interest Rate-Swap Agreements: This is an agreement in which the parties swap

interest payments on specified principals for a certain period in the same currency.
In most cases one of the parties pays fixed interest on the specific principal and in
exchange receives variable interest.

ii. Currency Swap Agreements: This is an agreement in which parties swap interest
payments on a principal in two different currencies and the swapping of principals
occurs at the beginning and end of the agreement period. Thus currency swaps can
be used to convert loans or assets from one currency to loans or assets in another

e. Derivatives outside the Regulated Securities Market: Trading in derivatives
frequently occurs outside the regulated securities market and financial undertakings
are obliged to inform investors when this occurs. Investing in derivatives outside the
regulated securities market may entail the risk of investors not being able to settle
open derivatives agreements because there is no market for the relevant financial
instrument, in addition to which the value of these agreements may be unclear.

5. Unlisted Securities: Unlisted securities are, for example, bonds and shares that are not
listed on regulated securities markets, such as Nasdaq Iceland. Investments in unlisted
securities bear higher risk than in listed securities. Investing in unlisted securities may
involve the following risks:

a. Liquidity Risk: Unlisted shares are not listed on regulated securities markets and can
therefore often be illiquid and their price formation may be imperfect and lack

b. Shortage of Information: There are fewer information disclosure requirements

placed on unlisted companies than there are on listed ones, in addition to which there
is generally less news and analytical data on unlisted companies than on listed ones.
The operations of these companies are therefore less transparent and risk increases
since less information regarding their operations is publicized.

c. Small Cap Risk: The operations of unlisted public limited companies are often
considerably smaller than those of listed public limited companies. Operations are
therefore considerably more vulnerable to changes in general economic developments
and/or political circumstances which entail economic consequences.

4.6 ASSET CLASSES (Investopedia, 2018)

An asset class is a group of securities that exhibits similar characteristics, behaves similarly
in the marketplace and is subject to the same laws and regulations. The three main asset
classes are equities, or stocks; fixed income, or bonds; and cash equivalents, or money market
instruments. Some investment professionals add real estate and commodities, and possibly
other types of investments, to the asset class mix.

1. Breaking Down 'Asset Class': Asset classes and asset class categories are often
mixed together. Financial advisors view investment vehicles as asset class categories
that are used for diversification purposes. Each asset class is expected to reflect
different risk and return investment characteristics, and performs differently in any
given market environment. Investors interested in maximizing return often do so by
reducing portfolio risk through asset class diversification.

Financial advisors focus on asset class as a way to help investors diversify their
portfolio. Different asset classes have different cash flows streams and varying
degrees of risk. Investing in several different asset classes ensures a certain amount of
diversity in investment selections. Diversification reduces risk and increases your
probability of making a return.

2. Asset Class and Investing Strategy: Investors looking for alpha employ investment
strategies focused on achieving alpha returns. Investment strategies can be tied to
growth, value, income or a variety of other factors that help to identify and categorize
investment options according to a specific set of criteria. Some analysts link criteria to
performance and/or valuation metrics such as earnings-per-share growth (EPS) or the
price-to-earnings (P/E) ratio. Other analysts are less concerned with performance and
more concerned with the asset type or class. An investment in a particular asset class
is an investment in an asset that exhibits a certain set of characteristics. As a result,
investments in the same asset class tend to have similar cash flows.

3. Asset Class Types: Equities, or stocks; bonds, or fixed-income securities; cash, or

marketable securities; and commodities are the most liquid asset classes and therefore
the most quoted asset classes. There are also alternative asset classes such as real
estate, artwork, stamps and other tradable collectibles. Some analysts also refer to an
investment in hedge funds, venture capital, crowdsourcing or even bitcoin as
examples of alternative investments. The more alternative the investment, in general,
the less liquid. That said, an asset's illiquidity does not speak to its return potential; It
only means it may take more time to find a buyer to convert the asset to cash.


Common Types of Investments: Common types of investments include money market

securities, stocks, bonds, mutual funds, and real estate. Each type of investment is unique in
how it provides a return to its investors.

When individuals make an investment, they typically assess the performance of the
investment based on its return. The means by which various types of investments generate
returns to investors are described here.

Return from Investing in Stock

Stocks can offer a return on investment through dividends and stock price appreciation. Some
firms distribute quarterly income to their shareholders in the form of dividends rather than
reinvest the earnings in the firm’s operations. They tend to keep the dollar amount of the
dividends per share fixed from one quarter to the next, but may periodically increase the
amount. They rarely reduce the dividend amount unless they experience relatively weak
performance and cannot afford to make their dividend payment. The amount of dividends
paid out per year is usually between 1% and 3% of the stock’s price.

A firm’s decision to distribute earnings as dividends, rather than reinvesting all of its earnings
to support future growth, may depend on the opportunities that are available to the firm. In
general, firms that pay high dividends tend to be older, established firms that have less

chance for substantial growth. Conversely, firms that pay low dividends tend to be younger
firms that have more growth opportunities. The stocks of firms with substantial growth
opportunities are often referred to as growth stocks. An investment in these younger firms
offers the prospect of a very large return because they have not reached their full potential. At
the same time, an investment in these firms is exposed too much higher uncertainty, because
young firms are more likely to fail or experience very weak performance than mature firms.

The higher the dividend paid by a firm, the lower its potential stock price appreciation. When
a firm distributes a large proportion of its earnings to investors as dividends, it limits its
potential growth and the potential degree to which its value (and stock price) may increase.
Stocks that provide investors with periodic income in the form of large dividends are referred
to as income stocks.

Return from Investing in Bonds

Bonds offer a return to investors in the form of coupon payments and bond price
appreciation. They pay periodic interest (coupon) payments, and therefore can provide a fixed
amount of interest income per year. Thus, they are desirable for investors who want to have
their investments generate a specific amount of interest income each year.

A bond’s price can increase over time and therefore may provide investors with a capital
gain, representing the difference between the prices at which it was sold by an investor versus
the price at which it was purchased. However, a bond’s price may decline, which could cause
investors to experience a capital loss. Even the prices of Treasury bonds decline in some

Return from Investing in Mutual Funds

The coupon or dividend payment generated by the mutual fund’s portfolio of securities is
passed on to the individual investor. Since a mutual fund represents a portfolio of securities,
its value changes over time in response to changes in the values of those securities.
Therefore, the price at which an investor purchases shares of a mutual fund changes over
time. A mutual fund can generate a capital gain for individual investors, since the price at
which investors sell their shares of the fund may be higher than the price at which they
purchased the shares. However, the price of the mutual fund’s shares may also decline over
time, which would result in a capital loss.

Return from Investing in Real Estate

Real estate that can be rented (such as office buildings and apartments) generates income in
the form of rent payments. In addition, investors may earn a capital gain if they sell the
property for a higher price than they paid for it. Alternatively, they may sustain a capital loss
if they sell the property for a lower price than they paid for it.

The price of land changes over time in response to real estate development. Many individuals
may purchase land as an investment, hoping that they will be able to sell it in the future for a
higher price than they paid for it.

Measuring the Return on Your Investment

For investments that do not provide any periodic income (such as dividends or coupon
payments), the return (R) can be measured as the percentage change in the price (P) from the
time the investment was purchased (time t–1) until the time at which it is sold (time t):

R = Pt - Pt-1/ Pt-1

For example, if you pay $1,000 to make an investment and receive $1,100 when you sell the
investment in one year, you earn a return of:

R =$1,100 - $1,000/$1,000
= .10, or 10%

Incorporating Dividend or Coupon Payments

If you also earned dividend or coupon payments over this period, your return will be even
higher. For a short-term period such as one year or less, the return on a security that pays
dividends or interest can be estimated by adjusting the equation above. Add the dividend or
coupon amount to the numerator.

The return on your investment in stocks accounts for any dividends or coupon payments you
received as well as the change in the investment value over your investment period. For
stocks that pay dividends, the return is:

R = (Pt - Pt-1) + D/ Pt-1

Where R is the return, Pt-1 is the price of the stock at the time of the investment, Pt is the price
of the stock at the end of the investment horizon, and D represents the dividends earned over
the investment horizon.

Illustration 1: You purchased 100 shares of stock from Wax, Inc., for ₹ 50 per share one
year ago. During the year, the firm experienced strong earnings. It paid dividends of ₹1 per
share over the year, and you sold the stock for ₹ 58 at the end of the year. Your return on
your investment was:
R = (Pt - Pt-1) + D/Pt-1
R= (58-50) + 1/50
= .18, or 18%

The Return is the gain or loss accruing from a financial instrument and is the principal reward
in any investment process. It is usually expressed as a percentage. Return may be defined in
terms of-

Realised Return: It is the return which has actually been earned.

Expected Return: In this, an investor anticipates to earn over some future investment period.
In other words, it is a predicted or estimated return which may or may not occur.

Holding Period Return: It is defined as the rate of return at which an asset or portfolio has
grown during the period over which it was held. It can be calculated as:

k=P1 - P0 + D1

Where, k i.e. Holding period returns

P0= Market price at time 0

P1= Market price at time 1, and

D1= Cash dividend for the period 1

The above equation reflects that the rate of return on investment, k, is the sum total of capital
gain/loss (P1-P0) and the cash dividends (D1) over the period.

Illustration 2: Hindustan Ltd. is evaluating the rate of return on two securities A and B.
Security A was purchased a year ago for ₹ 3,00,000 and since then it has generated cash
inflows of ₹ 20000. Currently, it can be sold for a price of ₹ 3,40,000. Security B was
purchased a few years ago and its market price in the beginning and end of the current year
was ₹ 240000 and ₹ 2,16,000 respectively. Security B has generated cash inflows of ₹ 84,000
during the year. Calculate the rate of return on these securities.

The rate of return on these securities can be calculated with the help of the following


For security A,

k= (340000-300000) +20,000/300000= 20%

For security B,

k= (216000-240000) +84,000/240000= 25%

The rate of return on security B is higher than that of security B even though its capital value
has declined from ₹ 2,40,000 to ₹ 2,16,000 over the period. The reason for the higher rate of
return is the relatively higher cash inflows of ₹ 84,000 from security B during the year.

Expected Rate of Return: The expected rate of return can be defined as weighted average
return which is determined by multiplying the possible return with the respective

For this, we need a probability distribution of returns which gives the likelihood
(probabilities) for the occurrences of each of the values of returns.

The expected return can be calculated as follows:

Where, r= expected return

pi= Probability of ith return

xi= Possible return

n= Number of years

Illustration 3: The following information is available in respect of return from asset ‘G’
under different economic conditions-

Economic Conditions Return Probability

Good 20% 0.1

Average 15% 0.4

Bad 10% 0.3

Poor 4% 0.2

Find out the expected return of asset ‘G’.


The expected return can be calculated with the help of the following equation:

Economic conditions Return (xi) Probability (pi) pi. xi

Good 20% 0.1 2

Average 15% 0.4 6

Bad 10% 0.3 3

Poor 4% 0.2 0.8

Thus, the expected rate of return= 2+6+3+0.8=11.8%. However, the actual return of the
investor may be more or less than that.

Risk: Future returns from investment in any asset or security are unpredictable. This results
in risk. Risk arises due to the possibility that the actual return earned by the investor may

differ from the expected return. An investment having greater chances of variations in returns
is perceived to be more risky than those with lesser variations.

Sources of Risk: Following are the various sources of risk:

a. Market Risk: This is the risk that arises due to variation in returns as a result of
changes in market price of securities. Investors may react favourably or adversely to
different social, political, economic and firm specific events which affect the market
prices of equity shares. For example The United Kingdom’s decision to exit the
European Union (also called ‘Brexit’) shook investors’ confidence leading to a sharp
fall in Sensex.

b. Interest Rate Risk: Interest rates tend to fluctuate over a period of time and as a
result, bond prices fluctuate. A rise in interest rates will depress the market price of
outstanding bonds and vice versa. Interest rate risk is measured by the percentage
change in the value of a bond in response to a given interest rate change.

c. Credit Risk: There is a risk that the borrower may not pay interest or the principal
amount on time. Bonds which carry a higher default risk trade at a higher Yield to
maturity (YTM). This means that they trade at a lower price as compared to risk-free

d. Inflation Risk: During periods of high inflation, it may happen that inflation
increases at a much faster rate than the return on investment. In such a situation,
inflation erodes the purchasing power of the investor’s future cash inflows, sometimes
leading to a negative rate of return. The government may increase interest rates to
combat increasing inflation. This, in turn would lead to lower bond prices.

e. Reinvestment Risk: If the prevailing interest rates fall, investors may have to reinvest
their interest payments at the new, lower interest rates. This is called reinvestment
risk. This risk is greater for bonds with longer maturity and for bonds with higher
interest payments.

f. Liquidity Risk: Except some popular government securities which are traded
actively, most of the debt instruments have very weak liquidity. As a result, investors
face difficulty in trading debt instruments. They may have to accept the quoted price
which is at a discount while selling and premium when buying. However, liquidity
risk is not a major concern for an investor who plans to hold the security until

Measurement of Risk

Risk can be measured more precisely by using statistical measures like range, standard
deviation and coefficient of variation.

• Range: This is the easiest way to measure risk. Risk is measured by calculating the
range of possible returns, i.e. the difference between the highest and lowest expected
return. For example, the return from a security may fluctuate between 10% and 16%.
Thus, we can say that the expected return from the security has a range of variation of

• Standard Deviation: The variability of returns can also be measured by standard

deviation σ of possible returns. It measures the degree of spread of possible returns
around the expected return.

It can be calculated as follows:

Coefficient of Variation: A limitation of standard deviation as a measure of risk is that it is

an absolute measure of risk and does not consider the dispersion of expected return in relation
to expected values. So, standard deviation is not a very reliable measure for comparing the
risk of two or more investments. For this purpose, an improvised version of standard
deviation can be used. This measure is called coefficient of variation and is calculated by
dividing the standard deviation (σ) for the investment by the expected return (x), Hence, CV=
σ/ x.

Illustration 4: Bhavya, an investor has short listed two securities X and Y for investment.
The expected returns and probabilities for these securities are as follows:

Security X Security Y

Return Probabilities Return Probabilities

4% 0.1 -2% 0.2

6% 0.3 18% 0.5

10% 0.4 27% 0.3

15% 0.2

Find out the expected return and standard deviation for both the securities. Which security
should be preferred?

For Security X-

Return (xi) Probabilities (pi) pi. xi pi(xi-r)2

4% 0.1 0.4 0.1(4-9.2)2 =2.704
6% 0.3 1.8 0.3(6-9.2)2=3.072
10% 0.4 4 0.4(10-9.2)2= 0.256
15% 0.2 3 0.2(15-9.2)2=6.728

Thus, the expected rate of return on security X = 9.2%.

Standard deviation of security X= √12.76 = 3.57%.

C.Vx= 3.57/9.2=0.388

Security Y

Return (xi) Probabilities (pi) Pi-xi pi(xi-r)2

-2% 0.2 -0.4 0.2 (-2-16.7)2=69.938
18% 0.5 9 0.5(18-16.7)2=0.845
27% 0.3 8.1 0.3(27-16.7)2=31.827

Thus, the expected rate of return on security Y = 16.7%.

Standard deviation of security Y= √102.61 =10.13%.

C.Vy= 10.13/16.7= 0.607

Though the return of security X is lower, still it seems to be better because it has a lower
standard deviation and coefficient of variation. Thus, security X should be preferred.

The Risk-Return Trade Off: The risk-return trade-off is the trade-off which an investor
faces between risk and return while making investment decisions. Higher levels of risk are
associated with greater probabilities of higher return and lower levels of risk are associated
with greater probabilities of lower return.

This implies that if an investor is unwilling to assume much risk then he/she cannot expect to
earn higher returns. On the other hand, investors willing to undertake high levels of risk can
expect to earn high returns. In fact, they will be willing to invest in high-risk securities only if
compensated by higher returns.

This is the reason why government securities that are considered risk-free provide the lowest
returns as compared to bonds and equity shares. Bonds provide a higher rate of return as
compared to government securities but a lower return as compared to equity shares (as they
are considered less risky than equity shares). Equity shares which are most risky are also
expected to provide the highest rate of return.

Figure 4: Risk Return Relationship


Compounding is the ability of an asset to generate earnings, which are then reinvested in
order to generate their own earnings. In other words, compounding refers to generating
earnings from previous earnings. The wonder of compounding (sometimes called "compound
interest") transforms your working money into a highly powerful income-generating tool.
Compounding is the process of generating earnings on an asset's reinvested earnings. To
work, it requires two things: the reinvestment of earnings and time. The more time you give
your investments, the more you are able to accelerate the income potential of your original
investment. (Investopedia, 2018)

Example (Valueresearchonline, 2018): Sachin Tendulkar started playing cricket at the age of
16. At 29, he has already amassed over 12,000 runs in one-day matches. On the other hand,
Robin Singh joined the Indian team at the age of 25 and has retired now. He could manage
only 2,336 runs in one-day matches. Before you begin to wonder if we have lost our marbles,
let us tell you what we are trying to arrive at here. The idea is simple: the earlier you start
investing, the more likely it is that you would end up making more money. While runs scored
in cricket don't multiply automatically, investment does. Surprised? Well, the fundamental
principle of compounding helps you realize this.

Let's see how the concept of compounding works. Suppose Sachin started investing Rs.2000
per year at the age of 19 and when he reaches 27, he stops investing and locks all his
investments till retirement. Robin, however, doesn't make any investment till he is 27. At 27,
he starts investing Rs.2000 a year till the age of 58. The adjacent table tells you how their
investments would turn out when they both are 58, assuming that the growth rate is 8 per cent
per annum. The results are eye-popping (see Compounding: A Tale of Two Investors).

Figure 5: Compounding: A Tale of two investors

What is compounding? Benjamin Franklin once wrote somewhere: '''tis the stone that will
turn all your lead into gold Remember that money is of a prolific, generating nature. Money
can beget money, and its offspring can beget more.'' Compounding is a simple, but a very
powerful concept. Why powerful? Because compounding is similar to a multiplier effect
since the interest that is earned by the initial capital also earns an interest, the value of the
investment grows at a geometric (always increasing) rate rather than an arithmetic (straight-
line) rate (see How Compounding Works). The higher the rate of return, the steeper the curve
will be.

Figure 6: How Compounding works

For example, at an annual interest rate of 8 per cent, a ₹ 1,000-investment every year will
grow to ₹ 50,000 in 20 years. While at a 10 per cent rate of interest, the same investment will
fetch you ₹ 63,000 in 20 years. So, it is quite clear that a 2 per cent difference in the interest

rate can make you richer or poorer by ₹ 13,000. And, by staying invested for a longer period,
your capital will earn more money for you.

Basically, compounding is a long-term investment strategy. For example, when you own a
mutual fund, compounding allows you to earn interest on your principal. Compounding also
occurs when you re-invest your earnings. In the case of mutual funds, this means re-investing
your interest or dividend, and receiving additional units. By doing such a thing, you are
earning a return on your returns and the principal. When the principal is combined with the
re-invested income, your investment will grow at an increased rate.

The best way to take advantage of compounding is to start saving and investing wisely as
early as possible. The earlier you start investing, the greater will be the power of

Example (Mutual Funds Sahi Hai, 2018): To many, the power of compounding seems like a
difficult topic. But it is not so. We’ll help you understand this in a simple manner.

Let’s assume that Mehul, invested ₹10,000 @ 8% p.a. The interest for the year would be ₹
800. However, when the interest is reinvested in the same investment, the earning next year
would accrue on original investment of ₹ 10,000 as well as on the additional investment of ₹
800. This means the earning for the second year would be ₹ 864. As the years pass, the
interest for the year keeps increasing since there is additional investment each year.

How much money would be accumulated after a certain time period if the returns are
reinvested? Let us see.

Investment: ₹ 1, 00,000

Rate of return: 8% p.a.

Power of compounding

Period of Investment Amount Accumulated Earning

5 years ₹ 1.47 Lacs ₹ 0.47 Lacs
10 years ₹ 2.16 Lacs ₹ 1.16 Lacs
15 years ₹ 3.17 Lacs ₹ 2.17 Lacs
20 years ₹ 4.66 Lacs ₹ 3.66 Lacs
21 years ₹ 5.03 Lacs ₹ 4.03 Lacs

The above table shows some interesting pattern. As the investment is held for longer periods,
the earning keeps growing faster. While the earning in the first 5 years was ₹ 0.47 Lacs, the
same for the next 5-year period was ₹ 0.69 Lacs (₹ 2.16 Lacs - ₹ 1.47 Lacs). The earning in
the 21st year i.e. a single year was ₹ 0.37 Lacs.

“As the time goes, the earnings do not multiply, but grow exponentially.”

Essentially, compounding is the process of earning income on your principal investment plus
the income earned. Thus, the income also starts to earn as the same is reinvested.

Benefits of Investing Early

Peter Hafner (2017) once said, “When you are young, time is on your side, but as you grow
older, it becomes more precious and you can't get lost time back”. Many Baby Boomers are
wishing they had some time back. They would have made different financial decisions. Or so
they think anyway.”

The best way young people can get on a productive financial path is by beginning to invest as
early as possible. Even if they begin with small amounts of money, they can experience the
benefits of investing early. And these benefits are powerful.

Investing early is generally not something people just starting out in their careers do. It seems
to be a term most people associate with either old age or when they start earning extra money.
This happens to be one of the biggest mistakes in personal finance since the benefits of
investing early (via lump sum or SIP) are huge and well worth putting some cash in advance.
(Fincash, 2018):

1. Secure Future: Thoughts about investing early for a secure future are often overlooked,
especially by the newly employed since ‘Carpe Diem’ seems to be the phrase to live up
to. But, given the volatile market conditions and the shaky global economy, investing
early for a stable future is wise. Your 20s are the years where you have comparatively
fewer responsibilities and more disposable income. The first step is to identify your
financial goals and learn about the different investment options like mutual funds, stocks,
fixed deposits (FDs), etc. Depending on your short-term and long-term goals, the next
step is to choose the options which suit your investment needs. Having time on your side
means having a longer duration to find investments that give higher returns. To begin
investing early means you can experiment with your investments, customising and re-
prioritizing your portfolio as per your changing lifestyle and financial goals. Also, the
earlier you start, the lesser you will need to invest later, as compound interest does
wonders while building a huge corpus.

Figure 7: Investing early vs. late

2. Improves Quality of Life and Spending Habits: By investing early, your investments
grow over time. Later on, you can afford things which people who are new to investing
can’t. Thus, investing early improves your quality and standard of life. Research says that
people who start investing early on are much less likely to have issues with overspending
over the long run. Therefore, keeping your spending habits in check.

3. Tax Benefits: Investments like Public provident funds (PPFs), Equity Linked Savings
Scheme (ELSS), Unit Linked Insurance Plans (ULIPs), etc. offer tax deductions under
Section 80C of the Indian Income Tax Act. So, instead of paying more taxes, you can
legally save your tax liability by investing in these schemes. Investing early is definitely
not easy but it is surely worth it in the long run. Simply start with small amounts and give
them time to grow. As Warren Buffett rightfully quoted, ” The earlier you start
(investing), the better. ” So take your baby steps towards the road of investing today and
be a millionaire tomorrow.

4.9 TIME VALUE OF MONEY ( Cedar Spring Software, 1998-2002)

Time Value of Money (TVM) is an important concept in financial management. It can be

used to compare investment alternatives and to solve problems involving loans, mortgages,
leases, savings, and annuities.

TVM is based on the concept that a rupee that you have today is worth more than the promise
or expectation that you will receive a rupee in the future. Money that you hold today is worth
more because you can invest it and earn interest. After all, you should receive some
compensation for foregoing spending. For instance, you can invest rupee for one year at a 6%
annual interest rate and accumulate Rs.1.06 at the end of the year. You can say that the
future value of the dollar is ₹1.06 given a 6% interest rate and a one-year period. It follows
that the present value of the ₹ 1.06 you expect to receive in one year is only Rs.1.

A key concept of TVM is that a single sum of money or a series of equal, evenly-spaced
payments or receipts promised in the future can be converted to an equivalent value today.
Conversely, you can determine the value to which a single sum or a series of future payments
will grow to at some future date.

You can calculate the fifth value if you are given any four of: Interest Rate, Number of
Periods, Payments, Present Value, and Future Value.

Importance of Time Value of Money (Madura, 2014)

The value of money is affected by the point in time it is received. Would you rather receive
₹1,000 five years from now or one year from now? It is better to receive the money one year
from now because its value is higher if received in one year than in five years. If you wanted
to spend the money, you could buy more with the money today than if you waited for five
years. In general, prices of the products you might purchase rise over time due to inflation.
Therefore, you can buy more products with ₹1,000 in one year than in five years.

If you wanted to save the money that you receive, you could earn interest on it if you
deposited the money in an account with a financial institution. If you receive the money in
one year, you would be able to earn interest on that money over the following four years. Its
value would accumulate and would be worth more than the money received four years later.
Thus, the value of money received in one year would be greater than the value of money
received in five years.

Would you rather receive ₹1,000 now or ₹1,000 at the end of one year from now? As with the
example above, it’s better to receive the money now because its value is higher now than it
will be in one year. If you wanted to spend the money, you could buy more with the money
today than if you waited for a year. If you wanted to save the money, you could earn interest
on money received today over the next year. Thus, the value of money received today would
be greater than the value of money received in one year.

In general, the value of a given amount of money is greater the earlier that it is received. A
Rupee today has more value than a Rupee received in one year. A Rupee received in one year
has more value than a Rupee received in five years. A Rupee received in five years has more
value than a Rupee received in ten years.

The time value of money is especially important when considering how much money you
may have at a specific point in the future. The earlier that you start saving, the more quickly
your money can earn interest and grow, and the greater the amount of money you can
accumulate by a given future point in time.

The time value of money is most commonly applied to two types of cash flows: a single
Rupee amount (also referred to as a lump sum) and an annuity. An annuity is a stream of
equal payments that are received or paid at equal intervals in time. For example, a monthly
deposit of ₹50 as new savings in a bank account at the end of every month is an annuity.
Your telephone bill is not an annuity, as the payments are not the same each month.


It is rightly said! No One Can Time the Market; the biggest challenge of any investor is
“what is the good time to buy, what is the good time to sell and vice-versa”. Therefore it is
very difficult to measure the good or bad time for any investment. No one can predict
whether market will go up or down in future, but there is one mechanism which helps in
getting decent return (in case of losses, it can be minimized) in any volatile market and helps
in reducing the risk from ups and down of market which is known as Rupee Cost Averaging
(RCA). (Succinct fp, 2018)

It is the technique of buying a fixed rupee amount of a particular investment on a regular

schedule, regardless of the share price. More shares are purchased when prices are low, and
fewer shares are bought when prices are high. Eventually, the average cost per share of the
security will become smaller and smaller. Rupee-cost averaging lessens the risk of investing a
large amount in a single investment at the wrong time. The concept of rupee cost averaging
lies in averaging out the cost at which one buys units of a mutual fund. The equity markets

have always been volatile reflecting the ups and downs of the economy. As per the law of
demand, a higher quantity of a commodity is purchased when it is least expensive.
Conversely, the demand tends to reduce the price of the commodity rises. The fundamental
principle of investing reinforces the same thing. It guides the investor to “buy-low and sell-
high”. It means that you should buy more units of a mutual fund when the markets are down
and fewer units when the markets are up. However, most of the investors end up doing just
the opposite. They start buying when the markets are rising and suddenly redeem upon a
slump. Ultimately, their average cost of investing increases and returns fall. (Succinct fp,

For example, you decide to purchase ₹100 worth of XYZ each month for three months. In
January, XYZ is worth ₹33, so you buy three shares. In February, XYZ is worth ₹25, so you
buy four additional shares. Finally, in March, XYZ is worth ₹20, so you buy five shares. In
total, you purchased 12 shares for an average price of approximately ₹25 each.

In the India, it is known as “Rupee-Cost Averaging (RCA)”

To understand Rupee Cost Averaging (RCA), its better we can take two scenarios;

• One investor had been investing ₹ 2,000 per month for one year in one mutual fund
scheme in Systematic Investment Plan (SIP).

• At the same time another investor who invested ₹ 24,000 lump sum in the same
scheme for one year of horizon.

Now if you can see that the person who had invested lump sum ₹ 24,000 at the beginning
with a buying price (NAV) of ₹ 200 and the number of units he bought was 120, but due to
fall in market ₹ 24,000 of investment have gone down to ₹ 23,760, it means the investment
loss is straight 1.00% on the principal.

On the other side the investor who invested on monthly basis in the same scheme and due to
volatility within the NAV he was able to average out his cost of investments by investing a
fixed amount every month which fetches him more number of units in falling market. Thus at
the end of the tenure he made a profit of ₹ 1,667 [₹ 25,667 – ₹ 24,000] i.e. straight 6.94% on
the principal.

Figure 8: Rupee Cost Averaging

Now after observing both the scenarios you can very well make out, the investor who was
investing every month rather investing lump sum in a volatile market made money because
he was averaging out his cost by buying at highs and lows therefore he was able to maintain
returns in positive side. Since it is an average price it will always be higher than the lowest
value and lower than the highest value.

Thus RCA is a simple way to smooth out the ups and downs of financial markets is to make
smaller regular investments rather than one large lump sum.

Also remember; every investment has its own benefits and limitations. RCA may not work as
expected in a growing market as the units/shares purchased at any time will be higher than
the previous purchase, thus final value will not be that attractive which could have been
expected from the lump sum investments.

Applicability of Rupee Cost Averaging (Money Matters, 2018):

The rupee cost averaging is applicable in the following situations:

1. The investors do not have a sum of investment.

2. The investors are to build a fund and invest some money for a future date.

3. The investor would invest a constant sum of rupees in specific stock of a particular
portfolio on a continuous basis.

After thoroughly studying the stock prices, rupee cost average should be made. Rupee cost
average plan advises to buy when the security prices are low. This will reduce the transaction
costs like commission and brokerage.

Rupee Cost Average programme is useful over long periods of time and when greater
fluctuations in prices bring benefits to the investors. It gives importance to selection, the right
quality of stocks and the timing of purchase or sale.

Advantages of Rupee Cost Averaging Plan (Money Matters, 2018):

1. Rupee cost averaging plan reduces the average cost per share and brings gains to the
investor over a long period.
2. Rupee costing average plan avoids the pressure of timing the stock purchase from
3. It enables the investor to have a rough plan of investment in respect of commitment of
4. It is highly beneficial when the stocks are acquired in a declining market.

Limitations of Rupee Cost Averaging Plan (Money Matters, 2018):

1. Frequent purchase and sale of securities in small quantities lead to higher transaction
2. Rupee cost average plan is merely a strategy for buying of securities and it does not
indicate when to sell them.
3. Appropriate intervals between purchases are not indicated by this formula plan.
4. If the stock prices show a downward movement, the averaging plan does not bring
profit to the investor.
5. When stock prices have cyclical pattern, the plan works efficiently.


True and false Questions:

Indicate whether the following statements are true or false:

a) Risk capacity is the level of financial risk the client can afford to take
b) Knowing how concerned is your client about tax effective investments, is an important
aspect of creating a Risk profile
c) A risk averse investor is an investor who prefers higher returns with little known risks
d) Holding period return is the return which an investor anticipates to earn over some future
investment period
e) Statistical measures like range, standard deviation and coefficient of variation are
required to calculate Risk.

Long Answer Questions

Q1. In a portfolio of a company, ₹ 2,00,000 have been invested in security X which has an
expected return of 6.5%, ₹3,80,000 in security Y which has an expected return of 10% and ₹
4,20,000 in security Z which has an expected return of 12%. What is the expected return for
the portfolio?
Q2. Following information is available in respect of the rate of return of two assets A and B
in different economic conditions:
Condition Probability Return on asset A Return on asset B
Recession 0.3 -15% 10%
Normal 0.5 20% 20%
Boom 0.2 50% 30%
Find out the expected return and risk for these two assets.


Cedar Spring Software. (1998-2002). Time Value of Money. Retrieved from Get Objects:

Stepaheadia. (2014). Retrieved from Stepaheadia:


Davies, G. B. (2017). New Vistas in Risk Profiling. U.S.A: The CFA Institute Research

Finance Train. (2018). Risk Aversion of Investors and Portfolio Selection. Retrieved from

Fincash. (2018). THE BENEFITS OF INVESTING EARLY. Retrieved from Fincash:

Investopedia. (2018). Asset Classes. Retrieved from Investopedia:

Investopedia. (2018). The Effect Of Compounding. Retrieved from Investopedia:

Islandsbank. (2018). Financial Instruments and Associated Risks. Retrieved from

Islandsbank: /financial

Madura, J. (2014). Personal Finance. U.S.A: Pearson.

Money Matters. (2018). Rupee cost average in Portfolio Revision. Retrieved from

Mutual Funds Sahi Hai. (2018). What is Power of Compounding. Retrieved from Mutual
Funds Sahi Hai:

Succinct fp. (2018). Rupee cost Averaging. Retrieved from succintfp:

Valueresearchonline. (2018, January 5). Power of compounding. Retrieved from


Unit III

5.1 Portfolio
5.2 Building a Portfolio
5.3 Portfolio Management
5.3.1 Objectives of Portfolio Management
5.3.2 Key Elements of Portfolio Management
5.3.3 Need for Portfolio Management
5.3.4 Types of Portfolio Management
5.3.5 Who is a Portfolio Manager?
5.4 What is Diversification
5.5 How Diversification Reduces Risk
5.6 Benefits of Portfolio Diversification
5.7 Factors that Influence Diversification Benefits
5.8 Strategies for Diversifying
5.9 Asset Allocation Strategies
5.10 Strategic Asset Allocation
5.11 Tactical Asset Allocation
5.12 Approaches to portfolio analysis
5.13 Self-Assessment Questions

5.1 PORTFOLIO (Investopedia, 2018)

A portfolio is a grouping of financial assets such as stocks, bonds, commodities, currencies

and cash equivalents, as well as their fund counterparts, including mutual, exchange-traded
and closed funds. A portfolio can also consist of non-publicly tradable securities, like real
estate, art, and private investments. Portfolios are held directly by investors and/or managed
by financial professionals and money managers. Investors should construct an investment
portfolio in accordance with their risk tolerance and their investing objectives. Investors can
also have multiple portfolios for various purposes. It all depends on one's objectives as an

An investment portfolio can be thought of as a pie that is divided into pieces of varying sizes,
representing a variety of asset classes and/or types of investments to accomplish an
appropriate risk-return portfolio allocation. Many different types of securities can be used to
build a diversified portfolio, but stocks, bonds and cash are generally considered a portfolio's
core building blocks. Other potential asset classes include, but aren't limited to, real estate,
gold and currency.

Impact of Risk Tolerance on Portfolio Allocations

While a financial advisor can develop a generic portfolio model for an individual, an
investor's risk tolerance should have a significant impact on what a portfolio looks like.

For example, a conservative investor might favor a portfolio with large-cap value stocks,
broad-based market index funds, investment-grade bonds, and a position in liquid, high-grade
cash equivalents. In contrast, a risk-tolerant investor might add some small-cap growth stocks
to an aggressive, large-cap growth stock position, assume some high-yield bond exposure,
and look to real estate, international and alternative investment opportunities for his or her
portfolio. In general, an investor should minimize exposure to securities or asset classes
whose volatility makes them uncomfortable.

Impact of Time Horizon on Portfolio Allocations

Similar to risk tolerance, investors should consider how long they have to invest when
building a portfolio. Investors should generally be moving to a more conservative asset
allocation as the goal date approaches, to protect the portfolio's principal that has been built
up to that point.

For example, an investor saving for retirement may be planning to leave the workforce in five
years. Despite the investor's comfort level investing in stocks and other risky securities, the
investor may want to invest a larger portion of the portfolio's balance in more conservative
assets such as bonds and cash, to help protect what has already been saved. Conversely, an
individual just entering the workforce may want to invest their entire portfolio in stocks,
since they may have decades to invest, and the ability to ride out some of the market's short-
term volatility. Both risk tolerance and time horizon should be considered when choosing
investments to fill out a portfolio.


One can reduce your risk by investing in a portfolio, which is a set of multiple investments in
different assets. For example, your portfolio may consist of various stocks, bonds, and real
estate investments. By constructing a portfolio, you diversify across several investments
rather than focus on a single investment. Investors who have all of their funds invested in
stock or bonds of a firm that goes bankrupt typically lose their entire investment. Given the
difficulty in anticipating when a particular investment might experience a major decline in its
value, you can at least reduce your exposure to any one stock or bond by spreading your
investments across several firms’ stocks and bonds. A portfolio can reduce risk when its
investments do not move in perfect tandem. Even if one investment experiences very poor
performance, the other investments may perform well and can offset the adverse effects.
(Madura, 2014)

Steps for Building a Portfolio (Value research, 2016):

The first step towards building a portfolio is to have a clear goal. Once you have that, then it's
relatively easy to build the rest of the portfolio in a way that's suitable for meeting your goals.

Goals that need to be fulfilled in the short-term are fundamentally different from long-term
goals. Short-term goals are best fulfilled using fixed-income investments. These could be a
bank or a fixed deposit or it could be a post office deposit.

If you are saving gradually towards such a goal, then the post office recurring deposit is a
reasonable tool. It yields a return of 7.5 per cent per annum. However, this should only be
used for savings targets that are no more than two to three years away. Any longer and the ill-
effects of the low returns will start becoming more and more meaningful.

Figure 1: Risk and Return in Mutual Funds

For fulfilling long-term financial goals, the best option is to use a portfolio comprising of
equity mutual funds. As we have read, equity is the only type of asset that can ensure that
your money grows faster than inflation and does not actually lose value in real terms. Fixed-
income investing is safer, but generally cannot beat inflation.

However, equity mutual funds can be volatile and thus only suitable for long-term
investments. Over the short-term, the ups and downs of the stock markets could very well
lead to temporary losses. Because of this, we do not recommend investing in equity mutual
funds if your financial goal is nearer that about three to five years.

This point is beautifully illustrated in the accompanying graph. This graph traces the growth
of an investment over ten years in three different types of investments. We have chosen three
types of funds and calculated the average performance of all funds that are more than ten
years old. What looks risky in the short-term can work very well in the long-term. What looks
like volatility can actually bring great returns.

Two of these funds are equity oriented. Of them, one invests in large companies while the
other invests in smaller companies. The third type is very short-term fixed-income funds

called liquid funds. These funds are heavily regulated to be closest to risk-free investments.
For the purpose of understanding returns in this graph, they can be considered equivalent to
bank and other deposits.


Portfolio management is the art and science of making decisions about investment mix and
policy, matching investments to objectives, asset allocation for individuals and institutions,
and balancing risk against performance. Portfolio management is all about determining
strengths, weaknesses, opportunities and threats in the choice of debt vs. equity, domestic vs.
international, growth vs. safety and many other trade-offs encountered in the attempt to
maximize return at a given appetite for risk. (Investopedia, 2018)

Portfolio management can by either passive or active, in the case of mutual and exchange-
traded funds (ETFs). Passive management simply tracks a market index, commonly referred
to as indexing or index investing. Active management involves a single manager, co-
managers or a team of managers who attempt to beat the market return by actively managing
a fund's portfolio through investment decisions based on research and decisions on individual
holdings. Closed-end funds are generally actively managed. (Investopedia, 2018)

5.3.1 Objectives of Portfolio Management (efinancemanagement, 2018)

When a portfolio is built, following objectives are to be kept in mind by the portfolio
manager based on an individual’s expectation. The choice of one or more of these depends on
the investor’s personal preference.

1. Capital Growth
2. Security of Principal Amount Invested
3. Liquidity
4. Marketability of Securities Invested in
5. Diversification of Risk
6. Consistent Returns
7. Tax Planning

Investors hire portfolio managers and avail professional services for the management of
portfolio by as paying a pre-decided fee for these services.

5.3.2 The Key Elements of Portfolio Management (Investopedia, 2018):

1. Asset Allocation: The key to effective portfolio management is the long-term mix of
assets. Asset allocation is based on the understanding that different types of assets do
not move in concert, and some are more volatile than others. Asset allocation seeks to
optimize the risk/return profile of an investor by investing in a mix of assets that have
low correlation to each other. Investors with a more aggressive profile can weight
their portfolio toward more volatile investments. Investors with a more conservative
profile can weight their portfolio toward more stable investments.

2. Diversification: The only certainty in investing is it is impossible to consistently
predict the winners and losers, so the prudent approach is to create a basket of
investments that provide broad exposure within an asset class. Diversification is the
spreading of risk and reward within an asset class. Because it is difficult to know
which particular subset of an asset class or sector is likely to outperform another,
diversification seeks to capture the returns of all of the sectors over time but with less
volatility at any one time. Proper diversification takes place across different classes of
securities, sectors of the economy and geographical regions.

3. Rebalancing: This is a method used to return a portfolio to its original target

allocation at annual intervals. It is important for retaining the asset mix that best
reflects an investor’s risk/return profile. Otherwise, the movements of the markets
could expose the portfolio to greater risk or reduced return opportunities. For
example, a portfolio that starts out with a 70% equity and 30% fixed-income
allocation could, through an extended market rally, shift to an 80/20 allocation that
exposes the portfolio to more risk than the investor can tolerate. Rebalancing almost
always entails the sale of high-priced/low-value securities and the redeployment of
the proceeds into low-priced/high-value or out-of-favor securities. The annual
iteration of rebalancing enables investors to capture gains and expand the opportunity
for growth in high potential sectors while keeping the portfolio aligned with the
investor’s risk/return profile.

5.3.3 Need for Portfolio Management (Management Study Guide, 2018):

1. Portfolio management presents the best investment plan to the individuals as per their
income, budget, age and ability to undertake risks.
2. Portfolio management minimizes the risks involved in investing and also increases the
chance of making profits.
3. Portfolio managers understand the client’s financial needs and suggest the best and
unique investment policy for them with minimum risks involved.
4. Portfolio management enables the portfolio managers to provide customized investment
solutions to clients as per their needs and requirements.

5.3.4 Types of Portfolio Management (Management Study Guide, 2018):

Portfolio Management is further of the following types:

1. Active Portfolio Management: As the name suggests, in an active portfolio management

service, the portfolio managers are actively involved in buying and selling of securities to
ensure maximum profits to individuals.
2. Passive Portfolio Management: In a passive portfolio management, the portfolio
manager deals with a fixed portfolio designed to match the current market scenario.
3. Discretionary Portfolio Management Services: In Discretionary portfolio management
services, an individual authorizes a portfolio manager to take care of his financial needs
on his behalf. The individual issues money to the portfolio manager who in turn takes

care of all his investment needs, paper work, documentation, filing and so on. In
discretionary portfolio management, the portfolio manager has full rights to take
decisions on his client’s behalf.
4. Non-Discretionary Portfolio Management Services: In non-discretionary portfolio
management services, the portfolio manager can merely advise the client what is good
and bad for him but the client reserves full right to take his own decisions.

5.3.5 Who is a Portfolio Manager? (Management Study Guide, 2018):

1. An individual who understands the client’s financial needs and designs a suitable
investment plan as per his income and risk taking abilities is called a portfolio manager. A
portfolio manager is one who invests on behalf of the client.
2. A portfolio manager counsels the clients and advises him the best possible investment
plan which would guarantee maximum returns to the individual.
3. A portfolio manager must understand the client’s financial goals and objectives and offer
a tailor made investment solution to him. No two clients can have the same financial

5.4 WHAT IS DIVERSIFICATION (Investopedia, 2018)

Diversification is a risk-management technique that mixes a wide variety of investments

within a portfolio. The rationale behind this technique contends that a portfolio constructed of
different kinds of investments will, on average, yield higher returns and pose a lower risk
than any individual investment found within the portfolio.”

Also known as ‘Asset Allocation’, diversification is an important strategy for investors, in

which many financial advisors will divide investments by equities and bonds, depending on
risk and age. There are other asset classes to consider, including private equity, hedge funds,
real estate and collectibles."

There is an old saying that is good advice for investors: “Do not put all of your eggs in one
basket.” Diversification strives to smooth out unsystematic risk events in a portfolio so the
positive performance of some investments neutralizes the negative performance of others.
Therefore, the benefits of diversification hold only if the securities in the portfolio are not
perfectly correlated.

Studies and mathematical models have shown that maintaining a well-diversified portfolio of
25 to 30 stocks yields the most cost-effective level of risk reduction. Investing in more
securities yields further diversification benefits, albeit at a drastically smaller rate.

Further diversification benefits can be gained by investing in foreign securities because they
tend to be less closely correlated with domestic investments. For example, an economic
downturn in the U.S. economy may not affect Japan's economy in the same way; therefore,
having Japanese investments gives an investor a small cushion of protection against losses
due to an American economic downturn.

Most non-institutional investors have a limited investment budget and may find it difficult to
create an adequately diversified portfolio. This fact alone can explain why mutual funds have
been increasing in popularity. Buying shares in a mutual fund can provide investors with an
inexpensive source of diversification.


If you knew which investment would provide the highest return for a specific investment
period, investment decisions would be easy. You would invest all of your money in that
particular investment. In the real world, there is a trade-off between risk and return when
investing. Although the return on some investments (such as a Treasury security or a bank
CD) is known for a specific investment period, these investments offer a relatively low rate of
return. Many investments, such as stocks, some types of bonds, and real estate, offer the
prospect of high rates of return, but their future return is uncertain. They could offer a return
of 20% or more this year, but they could also experience a loss of 20% or even worse.

Standard Diversification in a Portfolio

Fund managers and investors often diversify their investments across asset classes and
determine what percentages of the portfolio to allocate to each. These can include stocks and
bonds, real estate, ETFs, commodities, short-term investments and other classes. They will
then diversify among investments within the assets classes, such as by selecting stocks from
various sectors that tend to have low return correlation, or by choosing stocks with different
market capitalizations. In the case of bonds, investors select from investment-grade corporate
bonds, Treasuries, state and municipal bonds, high-yield bonds and others.


Because the returns from many types of investments are uncertain, it is wise to allocate your
money across various types of investments so that you are not completely dependent on any
one type. Asset allocation is the process of allocating money across financial assets (such as
stocks, bonds, and mutual funds). The objective of asset allocation is to achieve your desired
return on investments while maintaining your risk at a tolerable level. Further following
reasons supports diversification/asset allocation:

1. Lower Risk: The number one reason for diversifying is that it lowers your overall
risk. The more you spread your assets out, the less likely it is that a single event will
negatively impact your portfolio. Think about it like this: if you have all of your
investments in a single stock and that stock loses 50 percent of its value over the
course of a year, you’ve just lost 50 percent of your portfolio. But if that stock only
makes up 3 percent of your portfolio, a massive 50 percent drop-off won't affect you
as much. That’s the beauty of diversification -- it lowers risk and allows you to ride
out just about any economic downturn.

2. Different Investment Styles: There are multiple types of investment strategies. Two
of the more common are value and growth. “A value manager tends to consider,

among other things, the fundamental strength of a company and its management team,
and whether that company’s stock price is undervalued based on estimates of its true
worth,” Sentry Investments has explained on its site. “A growth manager doesn’t
necessarily take into consideration the price of the company’s stock. Instead, it
considers how fast the company has been growing and whether new products or other
competitive advantages should accelerate earnings in the future, which would likely
benefit the stock price.” If you were to only take a value approach, you’d miss out on
the many benefits of growth investing (and vice versa). By spreading your
investments across both of these styles (among others), you can enjoy the benefits of

3. Limits Home Country Bias: In investing, there’s something known as “home

country bias.” This is an investor’s natural tendency to be attracted to domestic
markets. It’s even possible for an investor to focus more narrowly on his or her own
state or industry. The problem is that home country bias limits your willingness to
invest in other markets that may be more lucrative, simply because they’re outside of
your comfort zone. When you diversify, you force yourself to work past your home
country bias. This opens you up to international markets, which ultimately diminishes
your risk during times of domestic economic recession.

4. Provides More Opportunity: Ultimately, diversification opens you up to more

opportunities. While additional opportunities could theoretically expose you to more
risk, the hope is that you’ll make savvy choices that bring balance to your financial
portfolio. For example, say your natural inclination is to invest in stocks. If you only
invest in stocks, and an opportunity to invest in a piece of lucrative real estate arises,
you might shrug it off because you don’t feel comfortable moving beyond stocks. As
a result, you could lose thousands of dollars in potential earnings. But if you’re
already accustomed to diversification, you’re much more likely to give a good
opportunity a second look.

Once you understand the full benefits of diversification, you’ll find it easier to start practicing
it in your own life. Contrary to popular belief, diversification isn’t something that’s difficult
to do. You simply need some good financial guidance and a healthy dose of patience.
Diversifying your portfolio won’t bring you quick riches, but it will steadily build wealth
over time.



A portfolio’s risk is often measured by its degree of volatility, because the more volatile the
returns, the more uncertain the future return on the portfolio. Some portfolios are more
effective at reducing risk than others. By recognizing the factors that reduce a portfolio’s risk,
you can ensure that your portfolio exhibits these characteristics. The volatility of a portfolio’s

returns is influenced by the volatility of returns on each individual investment within the
portfolio and by how similar the returns are among investments.

• Volatility of Each Individual Investment: As Exhibit 18.2 illustrates, the more volatile
the returns of individual investments in a portfolio, the more volatile the portfolio’s
returns are over time (holding other factors constant). The left graph shows the returns of
investment A (as in Exhibit 18.1), C, and an equal-weighted portfolio of A and C. The
right graph shows the individual returns of investments A and D along with the return of
an equal-weighted portfolio of A and D. Comparing the returns of C on the left with the
returns of D on the right, it is clear that C is much more volatile. For this reason, the
portfolio of A and C (on the left) is more volatile than the portfolio of A and D (on the

• Impact of Correlations among Investments: The more similar the returns of individual
investments in a portfolio, the more volatile the portfolio’s returns are over time. This
point is illustrated in Exhibit 18.3. The left graph shows the returns of A, E, and an
equal-weighted portfolio of the two investments. Notice that the investments have very
similar return patterns. When investment A performs well, so does E; when A performs
poorly, so does E. Consequently, the equal-weighted portfolio of A and E has a return
pattern that is almost identical to that of either A or E. Thus, this portfolio exhibits
limited diversification benefits.


There are many different strategies for diversifying among investments. Some of the more
popular strategies related to stocks are described here.

1. Diversification of Stocks across Industries: When you diversify your investments

among stocks in different industries, you reduce your exposure to one particular industry.
For example, you may invest in the stock of a firm in the publishing and music industry,
the stock of a firm in the banking industry, the stock of a firm in the health care industry,
and so on. When demand for books declines, conditions may still be favorable in the
health care industry. Therefore, a portfolio of stocks diversified across industries is less
risky than a portfolio of stocks that are all based in same industry. When adding more
stocks to the portfolio, the diversification benefits are even greater because the
proportional investment in any stock is smaller. Thus, the portfolio is less exposed to poor
performance of any single stock.

Limitations of Industry Diversification: Although diversification among stocks in

different industries is more effective than diversification within an industry, the portfolio
can still be highly susceptible to general economic conditions. Stocks exhibit market risk,
or susceptibility to poor performance because of weak stock market conditions. A stock
portfolio composed of stocks of U.S. firms based in different industries may perform
poorly when economic conditions in the United States are weak. Indeed, during the weak
economic conditions in the 2008–2009 period, there were some months in which the
returns of stocks in most industries experienced significant losses, so investors who
diversified across industries still experienced significant losses. Thus, diversification will
not necessarily prevent losses when economic conditions are poor, but it can limit the

2. Diversification of Stocks across Countries: Because economic conditions (and
therefore stock market conditions) vary among countries, you may be more able to reduce
your risk by diversifying your stock investments across countries. For example, you may
wish to invest in a variety of U.S. stocks across different industries, European stocks,
Asian stocks, and Latin American stocks. Many investment advisers recommend that you
invest about 80% of your money in U.S. stocks and allocate 20% to foreign countries.

Diversifying among stocks based in some countries outside of the United States makes
you less vulnerable to conditions in the United States. Economic conditions in countries
can be interrelated, however. In some periods, all countries may simultaneously
experience weak economic conditions, causing stocks in all countries to perform poorly at
the same time. When investing in stocks outside the United States, recognize that they are
typically even more volatile than U.S.-based stocks, as they are subject to more volatile
economic conditions. Therefore, you should diversify among stocks within each foreign
country rather than rely on a single stock in any foreign country. It is also important to
keep in mind that the returns in stock markets of small developing countries may be very
volatile, so an international portfolio may be less risky if it is focused on developed
countries that have well-established stock markets with very active trading.


When investors make asset allocation decisions, they should not restrict their choices to
stocks. All stocks can be affected by general stock market conditions, so diversification
benefits are limited. Greater diversification benefits can be achieved by including other
financial assets, such as bonds, real estate investment trusts (REITs), and stock options. The
size of your portfolio and knowledge level will help determine the financial assets you will
include in your portfolio.

1. Including Bonds in Portfolio: The returns from investing in stocks and from investing in
bonds are not highly correlated. Stock prices are influenced by each firm’s expected
future performance and general stock market conditions. Bond prices are inversely related
to interest rates and are not directly influenced by stock market conditions. Therefore, by
including bonds in your portfolio you can reduce your susceptibility to stock market
conditions. The expected return on bonds is usually less than the return on stocks,
however, As you allocate more of your investment portfolio to bonds, you reduce your
exposure to market risk, but increase your exposure to interest rate risk. Your portfolio is
more susceptible to a decline in value when interest rates rise, because the market values
of your bonds will decline. In general, the larger the proportion of your portfolio that is
allocated to bonds, the lower your portfolio’s overall risk The portfolio’s value will be
more stable over time, and it is less likely to generate a loss in any given period. Investors
who are close to retirement commonly allocate much of their portfolio to bonds because
they are relying on it to provide them with periodic income. Conversely, investors who
are 30 to 50 years old tend to focus their allocation on stocks because they can afford to
take risks in order to strive for a high return on their portfolio.

2. Investment in Real Estate: Many individuals include real estate investments in their
portfolio. One method of investing in real estate is to purchase a home and rent it out.
Doing this requires a substantial investment of time and money, however. You must
conduct credit checks on prospective renters and maintain the property in good condition.
An alternative is to invest in real estate investment trusts (REITs), which pool
investments from individuals and use the proceeds to invest in real estate. REITs
commonly invest in commercial real estate such as office buildings and shopping centers.
REITs are similar to closed-end funds in that their shares are traded on stock exchanges;
the value of the shares is based on the supply of shares for sale (by investors) and investor
demand for the shares. REITs are popular among individual investors because the shares
can be purchased with a small amount of money.

Unfortunately India currently doesn’t have REIT’s available for investors however;
sometime later this year, India may see its first Real Estate Investment Trust (REIT) list
on the bourses, with the Blackstone-backed Embassy group planning to float one.

3. Including Stock Options in Your Portfolio: When making your asset allocation
decisions, you may want to consider stock options, which are options to purchase or sell
stocks under specified conditions. Like stocks, stock options are traded on exchanges.
Some employers include stock options in compensation packages, so you should be aware
of them.

• Call Options: A call option on a stock provides the right to purchase 100 shares of a
specified stock at a specified price (called the exercise price or strike price) by a
specified expiration date. The advantage of a call option is that it locks in the price you
have to pay to purchase the stock and also gives you the flexibility to let the option
expire if you wish. The price that you pay when purchasing a call option is referred to as
a premium. The premium of a call option is influenced by the number of investors who
wish to buy call options on that particular stock. Investors can purchase call options
through their brokerage firm, which charges a commission for executing the transaction.

• Put Options: A put option on a stock provides the right to sell 100 shares of a specified
stock at a specified exercise price by a specified expiration date. You place an order for a
put option in the same way that you place an order for a call option. The put option locks
in the price at which you can sell the stock and also gives you the flexibility to let the
option expire if you wish. You buy a put option when you expect the stock’s price to

The Role of Stock Options in Asset Allocation: Although stock options have become a
popular investment for individual investors who want to achieve very high returns, options
are still very risky and should therefore play only a minimal role (if any) in asset allocation.
Since asset allocation is normally intended to limit exposure to any one type of investment,
any allocation to stock options should be made with caution.


Strategic asset allocation is a traditional approach to building a portfolio. With strategic asset
allocation you determine how much of your money should be invested in broad categories of
investments, such as stocks or bonds, and once you have decided upon an allocation you stick
with that allocation for many years.

The basis of strategic asset allocation lies in something called Modern Portfolio Theory,
which says that markets are efficient, and rather than trying to "bet" on the direction things
will go, you should follow a static allocation to take advantage of the efficiency. By using a
disciplined strategic approach you can avoid making emotional short-term decisions based on
current market events.

Strategic asset allocation calls for setting target allocations and then periodically rebalancing
the portfolio back to those targets as investment returns skew the original asset allocation

• The concept is akin to a "buy and hold" strategy, rather than an active trading

• Of course, the strategic asset allocation targets may change over time as the client's
goals and needs change and as the time horizon for major events, such as retirement
and college funding, grows shorter.

How It Works?

The allocation process starts with assessing your tolerance for risk and your investing time-
frame. Can you reasonably foresee not needing your invested money for an extended period
of time? That means you can be more aggressive and allocate more to stocks. Do you remain
calm, cool, and collected when the market is jumping up or down? That would also mean that
emotionally you would not be disturbed by the high volatility that accompanies a more
aggressive allocation.

Once you know how aggressive you can be you determine how much of your money should
be in each asset class (such as cash, bonds or stocks) by looking at the long-term expected
returns and risk levels of each asset class. Then, each asset class is broken down into
additional categories; stocks, for example, would be broken down into large cap, small cap,
U.S., international and emerging markets, just to name a few sub-categories. You then
develop a strategic asset allocation plan that assigns a target percentage allocation for each
underlying category; such as 5% to emerging markets, 10% to U.S. small cap, etc.

You can follow a strategic asset allocation approach by using a balanced mutual fund which
chooses and monitors the allocation for you. Many 401(k) plans also offer "model" portfolio
allocations which do the work for you.

What Does Strategic Asset Allocation Look Like?

A strategic asset allocation recommendation might suggest that you have 70% stocks/20%
bonds/10% cash, or 60% stocks/40% bonds. You might see such an allocation referred to as a
“70/20/10” portfolio or a “60/40” portfolio. You can use an online risk questionnaire and
calculator to see a sample of a strategic asset allocation plan based on your answers to the
risk questions.

Once your strategic asset allocation is determined, the portfolio is typically re-balanced on a
pre-determined basis, annually for example, back to its original allocation.

For example, let's assume you have an allocation model which targets a stock allocation of
60% and a bond allocation of 40%. Stocks have been great, and now 70% of your portfolio is
composed of stocks. Strategic asset allocation says to take profits by selling the excess 10%
in stocks in order to bring your stock allocation back down to 60%. You will now reinvest the
money into bonds. Some investment sub-categories will always do well while others are not
doing so well. Rebalancing forces you to take profits from categories that have done well.

The strategic asset allocation approach involves sticking with your original allocation over
long periods of time rather than reacting to what is currently occurring in the markets.

One thing to think about: you may have the same risk tolerance your whole life - meaning
your comfort level with volatile markets may be just fine. However, as the time to withdraw
funds in retirement comes near, you may want to have less exposure to risk.


Tactical asset allocation (TAA) is an investment style in which the three primary asset classes
(stocks, bonds and cash) are actively balanced and adjusted. The purpose of tactical asset
allocation is to maximize portfolio returns while keeping market risk to a minimum, as
compared to a benchmark index. Tactical asset allocation allows for a range of percentages in
each asset class (such as stocks = 40-50%).

• These are minimum and maximum acceptable percentages that permit the IA to take
advantage of market conditions within these parameters.
• Thus, a minor form of market timing is possible, since the IA can move to the higher
end of the range when stocks are expected to do better and to the lower end when the
economic outlook is bleak.

Why Tactical Asset Allocation is more important than Investment Selection

Investors and financial advisors who choose to invest using tactical asset allocation are
looking at the "big picture." They likely subscribe to the Modern Portfolio Theory, which
essentially states that asset allocation has a greater impact on portfolio returns and market risk
than individual investment selection.

You don't need to be a statistician to understand the basic premise behind tactical asset
allocation. Imagine a fundamental investor who has done a good job of research and analysis.
Perhaps they have a portfolio of 20 stocks that has consistently matched or out-performed
S&P 500 index funds for three consecutive years. This would be good, right?

To answer the question, consider this scenario: During the three year period from the
beginning of 1997 through the end of 1999, many investors found it easy to out-perform the
S&P 500.

However, during the 10-year period from January 2000 through December 2009, even a solid
portfolio of stocks would have had roughly a 0.00% return and would have been out-
performed by even the most conservative mix of stocks, bonds, and cash.

The point is that asset allocation is the greatest influencing factor in total portfolio
performance, especially over long periods of time.

Therefore, an investor can be poor at investment selection but good at tactical asset allocation
and have greater performance, compared to the technical and fundamental investors who may
be good at investment selection but have poor timing with asset allocation.

How to Apply the Tactical Asset Allocation Strategy

The investor employing tactical asset allocation, for example, may arrive at a prudent mix of
assets suitable for their risk tolerance and investment objectives. If this investor chooses a
moderate portfolio allocation, it may be targeted at 65% stocks, 30% bonds and 5% cash.

The part of this investing style that makes it tactical is that the allocation will change
depending upon the prevailing (or expected) market and economic conditions. Depending
upon these conditions, and the investor's objectives, the allocation to a particular asset (or
more than one asset) can be either neutral weighted, over-weighted or under-weighted.

For example, consider the 65/30/5 allocation given above. This may be considered the
investor's target allocation; all of the assets are "neutral-weighted." Now assume that market
and economic conditions have changed and valuations for stocks become relatively high and
a bull market appears to be in the maturity stages.

The investor now thinks stocks are over-priced and a negative environment is near. The
investor may then decide to begin taking steps away from market risk and toward a more
conservative asset mix, such as 50% stocks, 40% bonds and 10% cash.

In this scenario, the investor has under-weighted stocks and over-weighted bonds and cash.
This reduction in risk may continue in steps as it appears a new bear market and recession are
drawing closer. The investor may attempt to be almost completely in bonds and cash by the
time bear market conditions are evident. At this time, the tactical asset allocator will consider
slowly adding to their stock positions to be ready for the next bull market.

It is important to note that tactical asset allocation differs from absolute market timing
because the method is slow, deliberate and methodical, whereas timing often involves more
frequent and speculative trading.

Tactical asset allocation is an active investing style with some passive investing, buy and
hold qualities because the investor is not necessarily abandoning asset types or investments
but rather changing the weights or percentages.

Using Index Funds, Sector Funds and ETFs for Tactical Asset Allocation

Index funds and Exchange Traded Funds (ETFs) are good investment types for the tactical
asset allocator because, once again, the focus is primarily on assets classes, not the
investments themselves. This is a kind of big picture, forest-before-the-trees methodology, if
you will. For example, the mutual fund investor can simply choose stock index funds, bond
index funds and money market funds, as opposed to building a portfolio of individual
securities. The specific fund types and categories for stocks can also be simple with
categories, such as large-cap stock, foreign stock, small-cap stock, and/or sector funds and

When sectors are selected, the tactical asset allocator may choose sectors he or she believes
will perform well in the near future and intermediate term. For example, if the investor feels
Real Estate, Health and Utilities may have superior returns compared to other sectors over the
coming several months or few years, they may buy ETFs within those respective sectors.


1. Harry Markowitz’s Approach To Portfolio Analysis

Portfolio Return
RP = ∑ Xi Ri

RP = Expected Return to portfolio
Xi = proportion of total portfolio invested in security i
Ri = expected return to security i
N = total number of securities in portfolio

The risk in a portfolio is less than the sum of the risks of the individual securities taken
separately whenever the returns of the individual securities are not perfectly positively

Thus, the smaller the correlation between the securities, the greater the benefits of
diversification and hence less is the risk. Diversification depends upon the right kind of

securities and not the number alone. Less is the correlation between the returns of the
securities more is the diversification and less is the risk.

2. Two Security (Asset) Case

σP = √ xx2σx2 + xy2σy2 + 2xxxy(rxyσxσy)

σP = portfolio standard deviation
xx = percentage of total portfolio value in stock X
xy = percentage of total portfolio value in stock Y
σx = standard deviation of stock X
σy = standard deviation of stock Y
rxy= correlation coefficient of X and Y

Kabir has selected 2 securities, A and B, for his portfolio. The following information is
provided by him:

If he invested 40% of his fund in A and 60% in B, find the return of portfolio. Also find the
maximum and minimum risk of such portfolio.

Security Expected Return Standard Deviation

A 10% 5%
B 15% 7%

Return on Portfolio = (0.4) x (10%) + (0.6) x (15%) = 13%

Risk is Maximum (when coefficient of correlation, r = 1)

Risk (variance) = [(0.05)2 (0.4)2 + (0.07)2 (0.6)2 + 2 (0.5) (0.4) (0.05) (.07) (+1)]

Risk (variance) = 0.0004 + 0.001764 + 0.00168 = 0.003844

Risk (Standard deviation) = Sqr root of 0.003844 = 6.2%

Risk is Minimum (when coefficient of correlation, r = - 1)

Risk (variance) = [(0.05)2 (0.4)2 + (0.07)2 (0.6)2 + 2 (0.5) (0.4) (0.05) (.07) (-1)]

Risk (variance) = 0.0004 + 0.001764 - 0.00168 = 0.000484

Risk (Standard deviation) = Sqr root of 0.000484 = 2.2%


True and false Questions:

Indicate whether the following statements are true or false:

a) People hire a portfolio manager to build an effective portfolio

b) Portfolio Diversification is an important technique for spreading of risk and reward
within an asset class
c) Investors are not advised to diversify stocks across countries
d) In India, Real estate investment trusts (REITs) is considered a popular investment
option among individual investors
e) Strategic asset allocation is an investment style in which the three primary asset
classes (stocks, bonds and cash) are actively balanced and adjusted

Long Answer Questions

Q1. Consider the 3 different securities A,B and C having return of 12%,14% and 18%
respectively .If an individual makes a portfolio by combining 50% of A,30% of B and 20% of
C .What is the expected Return of the portfolio.

Q2. Two shares P and Q, have the following expected returns, standard deviation and
Expected Return 18% 15%
Standard Deviation 23% 19%
Correlation coefficient = 0
Determine the minimum risk combination for a portfolio of P and Q
If the correlation of returns of P and Q is -1.0, then what is the minimum risk portfolio of P
and Q?

Q3. Consider the data given below:

Particulars Stock ABC Stock XYZ
Return (%) 12 or 16 22 or 10
Probability 0.5 each return 0.5 each return

Expected return and variance of Stock ABC and Stock XYZ Risk and Return of portfolio
comprising 15% of stock ABC and 85% of stock XYZ.
What should be the combination of securities if the required return on portfolio is 15%?
What should be risk of portfolio made of above securities which will offer a return of 15%?


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Edwards, S. (2017, 7 20). The Importance of Portfolio Diversification for Your Investments.
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Fincash. (2018). The Benefits Of Investing Early. Retrieved from Fincash:

Investopedia. (2018). Asset Classes. Retrieved from Investopedia:

Investopedia. (2018). Diversification. Retrieved from Investopedia:

Investopedia. (2018). Portfolio. Retrieved from investopedia:

Investopedia. (2018). Portfolio Management. Retrieved from investopedia:

Investopedia. (2018). The Effect Of Compounding. Retrieved from Investopedia:

Islandsbank. (2018). Financial Instruments and Associated Risks. Retrieved from


Madura, J. (2014). Personal Finance. U.S.A: Pearson.

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Concepts. Retrieved from

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Succinct fp. (2018). Rupee cost Averaging. Retrieved from succintfp:

THUNE, K. (2018, April 24). What Is Tactical Asset Allocation (TAA)? Retrieved from

Value research. (2016). How to build a portfolio. Retrieved from Value research:

Unit IV

6.1 Introduction
6.2 Personal Financial Planning Process
6.3 Setting Personal financial goals
6.4 How Financial Planning Affects your Cash Flows
6.5 Lifecycle approach to financial planning
6.6 Components of financial plan
6.7 Developing Financial Plan
6.8 Evaluation of Tax Saving Instruments
6.9 Self-Assessment Questions

6.1 INTRODUCTION (Madura, 2014)

Where does it all go? It seems like the last paycheck is gone before the next one comes in.
Money seems to burn a hole in your pocket, yet you don’t believe that you are living
extravagantly. Last month you made a pledge to yourself to spend less than the month before.
Somehow, though, you are in the same position as you were last month. Your money is gone.
Is there any way to plug the hole in your pocket?

What are your expenses? For many people, the first obstacle is to correctly assess their true
expenses. Each expense may seem harmless and worthwhile, but combined they can be like a
pack of piranhas that quickly gobble up your modest income. What can you do to gain
control of your personal finances?

The task is not easy because it takes self-discipline and there may be no immediate reward.
The result is often like a diet: easy to get started, but hard to carry through. Your tools are the
personal balance statement, the personal cash flow statement, and a budget. These three
personal financial statements show you where you are, predict where you will be after three
months or a year, and help you control expenses. The potential benefits are reduced spending,
increased savings and investments, and peace of mind from knowing that you are in control.

You may commonly ask whether you can afford a new television, a new car, another year of
education, or a vacation. You can answer these questions by determining your financial
position. Specifically, you use what you know about your income and spending habits to
estimate how much cash you will have at the end of this week, or quarter, or year. Once you
obtain an estimate, you can decide if there are ways in which you can either increase your
income or reduce your spending in order to achieve a higher level of cash.


“So what is the right way about planning our finances? The answer lies in following six steps
to financial planning” (Economic times , 2018):

1. Identifying Current Financial Situation: If we don't know what our income and
expenses are, how we will know how much the surplus is. So, all incomes and
expenses (no matter how small) have to be accounted for. Even expenses on
festivities, vacations, attending marriage functions have to be accounted for. Once this
is done over a period of about six months, we will get an idea of the surplus. Also, as
all existing investments are scattered across assets such as debt and equity including
shares, mutual funds, fixed deposits, life insurance policies etc., the financial planning
process will have to take into account all asset classes, to get the individual's net-

2. Managing Risk Appetite: Every person will have a different risk appetite which can
be 'aggressive', 'moderate', 'conservative', and lastly 'not sure'. However, in reality,
most advisors force their own risk appetite on investors. In practice, while undergoing
the financial planning process, a risk profiling questionnaire helps to identify each
person's risk taking ability. "Still, we don't strictly go by what the results show and
over a period of time we conclude what the person's risk appetite is". "Initially, we
remain conservative and gradually increase risk in the investor's portfolio to make it
more comfortable for the investor."

3. Identifying Goals: Identifying goals is mostly misunderstood. According to experts,

people are aware of goals but we talk about goals on today's value. However, value of
goals is important and not the current value. For example, if someone who wishes to
send their kid abroad to study after 18 years whose current cost is Rs.35 lakh, needs to
save for the future value of the course. It is only then can we find how much we have
to save towards that goal and invest across investments to achieve it.

4. Mapping of Assets: There could be existing investments say earmarked for specific
goals. So, we have to map them for the underlying goals and invest only for the
shortfall. Therefore, mapping each and every asset with each and every goal is
important before one starts investing. Thereafter, according to the current situation, it
can be seen where exactly we have to invest, whether its mutual funds, fixed deposits,
FMPs. This is where we have to decide on the asset allocation.

5. Identifying Risks: Even though planning is required and is done, one needs to
account for unforeseen events too. Risk analyzing is most important and chasing
returns is not the only way. Protection plays an equally important role in financial
planning. Life insurance through a term plan (which is the purest form of insurance) is
the right plan to opt for. An important thing while buying insurance is for how many
years should the term of the plan be. Almost 90-95 percent planners will tell you to
get the term plan for its maximum tenure. While, the thumb rule says to get cover till
liabilities exist, keeping the cover for 15-20 years. As far as health insurance is
concerned, its importance cannot be undermined but how much to buy is the question.
About 95 percent people say to keep Rs.5 lakh cover and gradually move to Rs.10
lakh. However, as per the current scenario, hospitalization costs are going up by
almost 20 percent annually. Also, increasing risk cover in later years is not easy. If
detected with a problem, insurers deny claims, and then there are exclusions. And
while getting a cover, don't go cheap. It is just a myth that a higher cover will cost too
much. Contrary to popular belief, you needn't pay higher premiums to get more
coverage. Finally, get a disability insurance cover. These days, health and disability
are more challenging than death as they lead to higher living expenses, i.e., medical

6. Constant Monitoring: A key element to financial planning is to constantly monitor

your plan. "People think creating a plan is financial planning - you create it and it's
over. But, financial planning is all about constant monitoring as there are lot of
changes every year. There could be changes in valuation of goals as things may not go
as planned for. What if the returns expected were 14 percent annually but the actual
annual return has been around 6 percent for 4-5 years, then we have to move on and
change investments.

Identifying Managing risk

current financial Identifying goals

Constant Mapping of
Identifying risks
monitoring Assets

Figure 1: Steps of Financial Planning


Setting short-term, mid-term and long-term financial goals is an important step toward
becoming financially secure. If you aren’t working toward anything specific, you’re likely to
spend more than you should. You’ll then come up short when you need money for
unexpected bills, not to mention when you want to retire. You might get stuck in a vicious

cycle of credit card debt and feel like you never have enough cash to get properly insured,
leaving you more vulnerable than you need to be to handle some of life’s major risks.

Annual financial planning gives you an opportunity to formally review your goals, update
them (if necessary) and review your progress since last year. If you’ve never set goals before,
this planning period gives you the opportunity to formulate them for the first time so that you
can get – or stay – on firm financial footing.

Here are goals, from near-term to distant, that financial experts recommend setting to help
you learn to live comfortably within your means and reduce your money troubles.

Short-Term Financial Goals: Setting short-term financial goals can give you the confidence
boost and foundational knowledge you need to achieve larger goals that will take more time.
These first steps are relatively easy to achieve. While you can’t make $2 million appear in
your retirement account right now, you can sit down and create a budget in a few hours, and
you can probably save a decent emergency fund in a year. Here are some key short-term
financial goals that will start helping right away, and get you on track to achieving longer-
term goals.

i) Establish a Budget: “You can’t know where you are going until you really know
where you are right now. That means setting up a budget,” says Lauren Zangardi
Haynes, a fee-only financial planner with Evolution Advisers in Midlothian, Va. “You
might be shocked at how much money is slipping through the cracks each month.”

An easy way to track your spending is to use a free budgeting program like Mint
( It will combine the information from all your accounts into one place and
let you label each expense by category. You can also create a budget the old-
fashioned way by going through your bank statements and bills from the last few
months and categorizing each expense with a spreadsheet or on paper.

You might discover that going out to eat with your coworkers every day is costing
you $315 a month, at $15 a meal for 21 workdays. You might learn that you’re
spending another $100 per weekend going out to eat with your significant other. Once
you see how you are spending your money, you can make better decisions, guided by
that information, about where you want your money to go in the future. Are the
enjoyment and convenience of eating out worth $715 a month to you? If so, great – as
long as you can afford it. If not, you’ve just discovered an easy way to save money
every month: You can look for ways to spend less when you dine out, substitute some
restaurant meals for homemade ones or do a combination of the two.

ii) Create an Emergency Fund: An emergency fund is money you set aside specifically
to pay for unexpected expenses. To get started, $500 to $1,000 is a good goal. Once
you meet that goal, you’ll want to expand it so your emergency fund can cover larger
financial difficulties, like unemployment.

Ilene Davis, a certified financial planner™ with Financial Independence Services in
Cocoa, Fla., recommends saving at least three months’ worth of expenses to cover
your financial obligations and basic needs, but preferably six months’ worth,
especially if you are married and work for the same company as your spouse or if you
work in an area with limited job prospects. She says finding at least one thing in your
budget to cut back on can help fund your emergency savings.

Another way to build emergency savings is through de-cluttering and organizing, says
Kevin Gallegos, vice president of Phoenix sales and operations with Freedom
Financial Network, an online financial service for consumer debt settlement,
mortgage shopping and personal loans. You can make extra money by selling
unneeded items on eBay or Craigslist or holding a yard sale. Consider turning a hobby
into part-time work where you can devote that income to savings.

Zangardi Haynes recommends opening a savings account and setting up an automatic

transfer for the amount you’ve determined you can save each month (using your
budget) until you hit your emergency fund goal. “If you get a bonus, tax refund or
even an ‘extra’ monthly paycheck – which happens two months out of the year if you
are paid biweekly – save that money as soon as it comes into your checking account.
If you wait until the end of the month to transfer that money, the odds are high that it
will get spent instead of saved,” she says.

While you probably have other savings goals, too, like saving for retirement, creating
an emergency fund should be a top priority. It’s the savings account that creates the
financial stability you need to achieve your other goals. (See Why You Absolutely
Need an Emergency Fund.)

iii) Pay off Credit Cards: Experts disagree on whether to pay off credit card debt or
create an emergency fund first. Some say that you should create an emergency fund
even if you still have credit card debt because without an emergency fund, any
unexpected expense will send you further into credit card debt. Others say you should
pay off credit card debt first because the interest is so costly that it makes achieving
any other financial goal much more difficult. Pick the philosophy that makes the most
sense to you, or do a little of both at the same time.

As a strategy for paying off credit card debt, Davis recommends listing all your debts
by interest rate from lowest to highest, then paying only the minimum on all but your
highest-rate debt. Use any additional funds you have to make extra payments on your
highest-rate card.

The method Davis describes is called the debt avalanche. Another method to consider
is called the debt snowball. With the snowball method, you pay off your debts in
order of smallest to largest, regardless of interest rate. The idea is that the sense of
accomplishment you get from paying off the smallest debt will give you the
momentum to tackle the next-smallest debt, and so on until you’re debt free. (See
Debt Avalanche vs. Debt Snowball: Which Is Best for You?)

Gallegos says debt negotiation or settlement is an option for those with $10,000 or
more in unsecured debt (such as credit card debt) who can’t afford the required
minimum payments. Companies that offer these services are regulated by the Federal
Trade Commission and work on the consumer’s behalf to cut debt by as much as 50%
in exchange for a fee, typically a percentage of the total debt or a percentage of the
amount of debt reduction, which the consumer should only pay after a successful
negotiation. Consumers can get out of debt in two to four years this way, Gallegos
says. The drawbacks are that debt settlement can hurt your credit score and creditors
can take legal action against consumers for unpaid accounts. Still, it can be a better
option than bankruptcy, which should be a last resort because it destroys your credit
rating for up to 10 years.

Pay off
Establish a

Create an
emergency fund

Figure 2: Short-Term Financial Goals

Mid-Term Financial Goals: Once you’ve created a budget, established an emergency fund
and paid off your credit card debt – or at least made a good dent in those three short-term
goals – it’s time to start working toward mid-term financial goals. These goals will create a
bridge between your short- and long-term financial goals.

i) Get Life Insurance and Disability Income Insurance: Do you have a spouse or
children who depend on your income? If so, you need life insurance to provide for
them in case you pass away prematurely. Term life insurance is the least complicated
and least expensive type of life insurance and will meet most people’s insurance
needs. An insurance broker can help you find the best price on a policy. Most term
life insurance requires medical underwriting, and unless you are seriously ill, you can
probably find at least one company that will offer you a policy.

Gallegos also says you should have disability insurance in place to protect your
income while you are working. “Most employers provide this coverage,” he says. “If
they don’t, individuals can obtain it themselves until retirement age.”

Disability insurance will replace a portion of your income if you become seriously ill
or injured to the point where you can’t work. It can provide a larger benefit than
Social Security disability income, allowing you (and your family, if you have one) to
live more comfortably than you otherwise could if you lose your ability to earn an
income. There will be a waiting period between the time you become unable to work
and the time your insurance benefits will start to pay out, which is another reason why
having an emergency fund is so important.

ii) Payoff Student Loans: Student loans are a major drag on many people’s monthly
budgets. Lowering or getting rid of those payments can free up cash that will make it
easier to save for retirement and meet your other goals. One strategy that can help you
pay off your student loans is refinancing into a new loan with a lower interest rate.
But beware: If you refinance federal student loans with a private lender, you may lose
some of the benefits associated with federal student loans, such as income-based
repayment, deferment and forbearance, which can help if you fall on hard times.

If you have multiple student loans and won’t stand to benefit from consolidating or
refinancing them, the debt avalanche or debt snowball methods can help you pay them
off faster.

iii) Think About Your Dreams: Mid-term goals can also include goals like buying a
first home or, later on, a vacation home. Maybe you already have a home and want to
upgrade it with a major renovation – or start saving for a larger place. College for
your children or grandchildren or even saving for when you do have children are other
examples of mid-term goals. Once you've set one or more of these goals, start figuring
out how much you need to save to make a dent in reaching it. Fantasizing about the
type of future you want is the first step toward achieving it.

Think about
Get Life

Pay off student


Figure 3:Mid-Term Financial Goals

Long-Term Financial Goals: The biggest long-term financial goal for most people is saving
enough money to retire. The common rule of thumb says that you should save 10% to 15% of
every paycheck in a tax-advantaged retirement account as a first step. But to make sure
you’re really saving enough, you need to figure out how much you'll actually need to retire.

i) Estimate Your Retirement Needs: The most important long-term financial goal for
almost everyone is to save for retirement. For most people, this is a priority over
saving for anything else. The first step to reaching your retirement goal is to develop
good saving and investing habits. Establishing a financial plan when you’re young
can help with this. Also, start contributing to an employer’s EPF plan or a PPF as
soon as you start working. Consistently save, and you’ll be on the right track to gain
enough money for your retirement years.

ii) You Can become a Disciplined Saver and Investor Several Ways:
• Set up automatic contributions to your retirement plans and investment portfolio
from each paycheck. When you don’t see money in your bank account, you won’t
spend it. Instead, you’ll save for your goals and your investment account will
grow over time.
• Try not to be emotional about your investments. Don’t jump in and out of your
holdings based on what’s going on in the markets.
• Watch your investments and risk tolerance, and adjust your portfolio when


Budgeting helps in forecasting future expenses and savings. When budgeting, the first step is
to create a personal cash flow statement, which measures your cash inflows and cash
outflows. Comparing your cash inflows and outflows allows you to monitor your spending
and determine the amount of cash that you can allocate toward savings or other purposes.

• Cash Inflows: The main source of cash inflows for working people is their salary, but
there can be other important sources of income. Deposits in various types of savings
accounts can generate cash inflows in the form of interest income. Some stocks also
generate quarterly dividend income.

• Cash Outflows: Cash outflows represent all of your expenses, which are the result of
your spending decisions. Expenses are both large (for example, monthly rent) and
small (for example, dry cleaning costs). It is not necessary to document every
expenditure, but you should track how most of your money is spent. Recording
transactions in your checkbook when you write checks helps you to identify how you
spent your money. Using a credit card or debit card for your purchases also provides a
written record of your transactions. Many people use software programs such as
Quicken and Microsoft Money plus Sunset to record and monitor cash outflows.

To enhance your wealth, you want to maximize your (or your household’s) cash inflows and
minimize cash outflows. Your cash inflows and outflows depend on various factors such as:

Factors Affecting Cash Inflows

Cash inflows are highly influenced by factors that affect your income level. The key factors
to consider are the stage in your career path and your job skills.

1. Stage in Your Career Path: The stage you have reached in your career path
influences cash inflows because it affects your income level. Cash inflows are
relatively low for people who are in college or just starting a career. They tend to
increase as you gain job experience and progress within your chosen career. Your
career stage is closely related to your place in the life cycle. Younger people tend to
be at early stages in their respective careers, whereas older people tend to have more
work experience and are thus further along the career path. It follows that cash
inflows tend to be lower for younger individuals and much higher for individuals in
their 50s.

a. There are many exceptions to this trend, however. Some older people switch
careers and therefore may be set back on their career path. Other individuals
who switch careers from a low-demand industry to a high-demand industry
may actually earn higher incomes.

b. Many women put their careers on hold for several years to raise children and
then resume their professional lives. The final stage in the life cycle that we
will consider is retirement. The cash flows that come from a salary are
discontinued at the time of retirement. After retirement, individuals rely on
Social Security payments and interest or dividends earned on investments as
sources of income. Consequently, retired individuals’ cash inflows tend to be
smaller than when they were working. Your retirement cash inflows will come
from income from your investments and from your retirement plan.

2. Type of Job: Income also varies by job type. Jobs that require specialized skills tend
to pay much higher salaries than those that require skills that can be obtained very
quickly and easily. The income level associated with specific skills is also affected by
the demand for those skills. The demand for people with a nursing license has been
very high in recent years, so hospitals have been forced to pay high salaries to outbid
other hospitals for nurses. Conversely, the demand for people with a history or an
English literature degree is low because the numbers of students who major in these
areas outnumber available jobs.

3. Number of Income Earners in Your Household: If you are the sole income earner,
your household’s cash inflows will typically be less than if there is a second income
earner. Many households now have two income earners, a trend that has substantially
increased the cash flows to these households.

Factors Affecting Cash Outflows

The key factors that affect cash outflows are a person’s family status, age, and personal
consumption behavior.

1. Size of Family: A person who is supporting a family will normally incur more
expenses than a single person without dependents. The more family members, the
greater the amount of spending, and the greater the cash outflows. Expenses for food,
clothing, day care, and school tuition are higher for families with many dependents.

2. Age: As people get older, they tend to spend more money on expensive houses, cars,
and vacations. This adjustment in spending may result from the increase in their
income (cash inflows) over time as they progress along their career path.

3. Personal Consumption Behavior: Most people’s consumption behavior is affected

by their income. For example, a two-income household tends to spend more money
when both income earners are working full-time. Yet, people’s consumption behavior
varies substantially. At one extreme are people who spend their entire paycheck
within a few days of receiving it, regardless of the size of the paycheck. Although this
behavior is understandable for people who have low incomes, it is also a common
practice for some people who have very large incomes. At the other extreme are “big
savers” who minimize their spending and focus on saving for the future.

Some consumers spend excessively to achieve immediate satisfaction, without any

attempt to plan for their financial future. Their consumption may be intended to match
what they consider to be their peer group. They attempt to have a car or a home that is
at least the same value as those of their peers. This behavior can lead to financial
problems for consumers whose cash inflows are less than those of their peers, because
they may not be able to afford their lifestyle. Alternatively, they may be attempting to
match peers who are also living beyond their means. They (and perhaps even their
peers) may need to constantly borrow in order to support their excessive consumption,
which could ultimately result in credit problems.

You can assess your spending behavior by measuring the proportion of your cash
outflows over a recent period (such as the last month) for each purpose. First, classify
all of your spending into categories such as car, rent, school expenses, clothing, and

Then determine the proportion of your cash outflows that are allocated toward each of
these categories. If a very high percentage of your cash outflows are allocated toward
your car, it might suggest that your car dictates your lifestyle, because it leaves very
little money for you to spend on anything else. You can also determine the proportion
of your income that is spent on each category, so that you can assess where most of
your money is spent.


Financial Planning can have the following benefits:

a) Freedom from Shortage of Money: Allocation of Money via Budgeting can negate
the Probability of shortage of money like in following cases,
• Enough Savings For Retirement,
• Saving For Kids Education,
• Earmarking Savings For Short Term Or Yearly Financial Goals, Increase
Savings In Line With Increase In Income, Don't Charge Savings For
Discretionary Expenses.

b) Freedom from Uncertainty: Unforeseen events often drain the financial position of
individuals. It can be avoided by planning in this respect like, buying an insurance
cover for life, insurance for health for at-least 5-7 lakhs for self and family, build a
contingency fund to sustain monthly expenses if in unsecured job, personal accidental
or disability cover and insure home and other assets.

c) Freedom from Loss: match investment horizon with asset class also with financial
goals, establish a diversified portfolio, rebalance portfolio once a year but review
twice a year. Don't chase extraordinary returns

d) Freedom from Debt: your EMI should not be more than 50% of your income, don't
borrow for frivolous expenses, differentiate wants from needs and take loans only in
extreme cases, ensure timely and regular payments to avoid interest or penal charges
on late payments, avoiding loan repayment for spending or new expenses is a worst
thing to do.

e) Freedom from Frauds: in case you follow the above four there will be minimal
chances of putting your money into instruments which offer extraordinary returns on
feeble foundations, understand features of insurance policy before purchasing as it
could land you in huge loss and no money at the time of crucial needs, adopt safety
measures while using credit cards and online transactions, don't fall for fraudulent
offers for easy money.

How to Differentiate Between a Need and a Want?

When someone wants to buy any item or article the purchase of such article/ item should be
postponed for 3/4 weeks and gauge whether there is any disruption in your daily routine or a
difficulty is faced in daily life, if so then it is your need but if NOT then it is a want. Avoid
the wants.

6.6 COMPONENTS OF FINANCIAL PLAN (IFCI Finacial services Ltd, 2018)

A key to financial planning is recognizing how the components of your financial plan are
related. The decisions that you make regarding each component affect your cash flows and
your wealth. The components are summarized next, with information on how they are
interrelated. A good financial plan should include the following things

1. Contingency Planning: Contingency means any unforeseen event which may or may not
occur in future. Contingency planning is the basic and the very first step to financial
planning. It was found that a large number of people have invested in financial planning
instrument but have ignored their contingency planning. There are many possibilities that
due to illness, injury or to care of family member a huge amount of money is required.
Moreover it’s not assured that the next job will be available at the earliest. These are
temporary situation that can last for a short period but cannot be ignored.

If person has not planned for contingencies, he will use his long term investment to fund
such crises. It is possible that long term investment may not give enough returns if
withdrawn early. There is also a possibility of capital erosion. In such a situation, all the
financial plans made are of waste. With long term planning, person also needs to take
care of present situation in order to truly achieve financial goals. It is a thumb rule that
one should have three times money of monthly salary in liquid form to support

2. Risk Planning: Every individual is exposed to certain type of risk whether it is due to
loss or damage of personal property, loss of pay due to illness or disability; or even due to
death. Such risk cannot be determined but on occurrence there may be a financial loss to
the individual or their family. Proper personal financial planning should definitely include
insurance. One main area of the role of personal financial planning is to make sure that
one has the ability to carry on living in case of some unforeseen and unfortunate event.
Basically, insurance provides a safety net to provide the necessary funds when one meets
with events like accidents, disabilities or illnesses. One main contribution of insurance is
that it helps provides peace of mind, knowing that enough funds are at hand in the event
when things do not go the way it should be. This peace of mind leaves one with the
energy and confidence to move forward.

i. Life Risk: Every individual is prone to risk of losing life but what is not certain is the
time of death. In this sense everyone is prone to life risk, but the degree of risk may
vary. In terms of financial planning, covering life risk means insuring the life of the
person through proper life insurance plan. It is extremely important that every person,
especially the breadwinner, covers the risks to his life, so that his family's quality of
life does not undergo any drastic change in case of an unfortunate eventuality. There
are various plans offered by insurance companies that can suite various needs of an

ii. Health Risk: Lifespan of an Indian is known to have increased nowadays, and senior
citizens strive to stay healthy and active as they age. However, as the person gets
older, extensive health care is needed. Health insurance is an insurance policy that
insures against any medical expenses. Insured medical expenses will be taken care of
by the insurance company provided person pays their premium regularly. Cover
extends to pre-hospitalization and post-hospitalization for periods of 30 days and 60
days respectively. Domiciliary hospitalization is also covered.

iii. Property Coverage: Property Coverage insures personal property from damage,
destruction or theft. Dwelling coverage also known as Homeowners Insurance offers
protection against direct physical damage caused to the dwelling, including rooms,
fireplaces, carpeting, tile floors and elements of decor. Structures, which are attached
to the insured dwelling on the same foundation, such as a garage, are also liable to
coverage under this section of Homeowners Insurance. Besides, this section of policy
covers materials and supplies necessary to rebuild or repair home. Person Property
Coverage can insure the contents of home

3. Retirement Planning: A retirement plan is an assurance that a person will continue to

earn a satisfying income and enjoy a comfortable lifestyle, even when they are no longer
working. Due to the improved living conditions and access to better medical facilities, the
life expectancy of people is increasing. This has led to a situation where people will be
spending approximately the same number of years in retirement as what they have spent
in their active working life. Thus it has become imperative to ensure that the golden years
of the life are not spent worrying about financial hardships. A proper retirement planning,
to a very large extent, will ensure this. Planning ahead will let us enjoy the retirement that
we deserve. The retirement strategies decided upon, makes a fundamental difference to
the degree of financial freedom one will experience when they do decide to take their
pension. Planning for retirement and choosing a pension strategy to safeguard financial
security can be a minefield.

4. Tax Planning: Tax planning is what every income earner does without fail and this is
what financial planning is all to them. A good plan is one which takes the maximum
advantage of various incentives offered by the income tax laws of the country. Financial
planning objective should be getting maximum advantage of various avenues. It is to be
remembered that tax planning is a part and not financial planning itself. Primary objective
of a good financial plan is to maximize the wealth, not to beat the taxmen. With the
knowledge of the Income Tax (IT) Act one can reduce income tax liability. It also helps
to decide, where to invest and to claim deductions under various sections. The income
earned is subject to income tax by the government. The rate of income tax is different for
different income levels, and thus, the income tax payable depends on the total earnings in
a given year.

5. Investments: When making investments, recall that your main choices are stocks, bonds,
and mutual funds. If you want your investments to provide periodic income, you may

consider investing in stocks that pay dividends. The stocks of large, well-known firms
tend to pay relatively high dividends, as these firms are not growing as quickly as smaller
firms and can afford to pay out more of their earnings as dividends. Bonds also provide
periodic income. If you do not need periodic income, you may consider investing in
stocks of firms that do not pay dividends. These firms are often growing at a fast pace and
therefore offer the potential for a large increase in the stock value over time.


Six steps are involved in developing each component of your financial plan.

1. Establishing Financial Goals: Firstly identify your general goals in life. These goals do
not have to be put in financial terms. For example, you may have goals such as a family,
additional education, a vacation to a foreign country for one week every year. You may
envision owning a five-bedroom house, or having a new car every four years, or retiring
when you reach age 55.

i. Types of Financial Goals: Your general goals in life influence your financial
goals. It takes money to support many of your goals. If you want to have a family,
one of your financial goals may be that you and your spouse earn enough income
and save enough money over time to financially support a family. If you want a
vacation to a foreign country every year, one of your financial goals may be that
you earn enough income and save enough money to financially support your
travel. If you want a large home, one of your financial goals should be that you
earn enough income and save enough money over time to make a substantial real
estate purchase. If you want to retire by age 55, this will require you to save
enough money by then so that you could afford to stop working. You may also
establish financial goals such as helping a family member or donating to charities.

ii. Set Realistic Goals: You need to be realistic about your goals so that you can
have a strong likelihood of achieving them. A financial plan that requires you to
save almost all of your income is useless if you are unable or unwilling to follow
that plan. When this overly ambitious plan fails, you may become discouraged and
lose interest in planning. By reducing the level of wealth you wish to attain to a
realistic level, you will be able to develop a more useful plan.

iii. Timing of Goals: Financial goals can be characterized as short term (within the
next year), intermediate term (typically between one and five years), or long term
(beyond five years). For instance, a short-term financial goal may be to
accumulate enough money to purchase a car within six months. An intermediate-
term goal would be to pay off a school loan in the next three years. A long-term
goal would be to save enough money so that you can maintain your lifestyle and
retire in 20 years. The more aggressive your goals, the more ambitious your
financial plan will need to be.
2. Consider your Current Financial Positions: Your decisions about how much money to
spend next month, how much money to place in your savings account, how often to use
your credit card, and how to invest your money depend on your financial position. A
person with little debt and many assets will clearly make different decisions than a person
with mounting debt and few assets. And a single individual without dependents will have
different financial means than a couple with children, even if the individual and the
couple have the same income. The appropriate plan also varies with your age and wealth.
If you are 20 years old with zero funds in your bank account, your financial plan will be
different than if you are 65 years old and have saved much of your income over the last
40 years.

Since your financial planning decisions are dependent on your financial position, they are
dependent on your education and career choice, as explained next:

i. How Your Future Financial Position is tied to your Education: Your financial
position is highly influenced by the amount of education you pursue. The more
education you have, the higher your earnings will likely be. Your education can
also influence your ability to find employment.

ii. How your Future Financial Position is tied to your Career Choice: Before you
choose a major, consider your skills, interests, and how your choice can prepare
you for different career paths. A major in biology or chemistry may allow you to
pursue careers in the biotechnology industry, while a major in English may allow
you to pursue a career in journalism.

Your career choices affect your income and potential for spending and saving
money. If you become a social worker, you will be in a different financial position
than if you choose to work as an electrical engineer. As a social worker, you will
need to save a much higher proportion of your income to achieve the same level
of savings that you could achieve as an electrical engineer. If you choose a career
that pays a low salary, you will need to set attainable financial goals. Or you may
reconsider your choice of a career in pursuit of a higher level of income. However,
be realistic. You should not decide to be a doctor just because doctors’ salaries are
high if you dislike health-related work. You should choose a career that will be
enjoyable and will suit your skills. If you like your job, you are more likely to
perform well. Since you may be working for 40 years or longer, you should
seriously think about the career that will satisfy both your financial and personal

iii. How your Future Financial Position is tied to the Economy: Economic
conditions affect the types of jobs that are available to you and the salary offered
by each type of job. They also affect the price you pay for services such as rent,
the value of assets (such as a home) that you own, and the return that you can earn

on your investments. For e.g. the financial crisis of 2008–2009 affected the
financial position of individuals in many ways. First, it caused a reduction in new
job opportunities. Second, it resulted in the elimination of some jobs. Third, it
resulted in lower salaries for the existing job positions, as employers could not
afford to give high raises to their employees. These first three effects resulted in a
general decline in income for many individuals.

3. Identify and Evaluate Alternative Plans that could achieve your Goals: You must
identify and evaluate the alternative financial plans that could achieve your financial
goals, given your financial position. For example, to accumulate a substantial amount of
money in 10 years, you could decide to save a large portion of your income over those
years. This plan is likely to achieve your goal of accumulating a substantial amount of
money in 10 years. However, this plan requires much discipline. Alternatively, you could
plan to save only a small portion of your income, but to invest your savings in a manner
that earns a very high return so that you can accumulate a substantial amount of money in
10 years. This alternative plan does not require you to save as much money. However, it
places more pressure on you to earn a high return on your investments. To earn such a
high return, you will likely have to make risky investments in order to achieve your goals.
You might not achieve your goals with this alternative plan because your investments
might not perform as well as you expected.

4. Select and Implement the best plan for achieving your Goals: You need to analyze
and select the plan that will be most effective in achieving your goals. The type of plan
you select to achieve your financial goals will be influenced by your willingness to accept
risk and your self-discipline.

• Using the Internet: The Internet provides valuable information for making financial
decisions. It also provides updated information on all parts of the financial plan, such

o Current tax rates and rules that can be used for tax planning
o Recent performance of various types of investments
o New retirement plan rules that can be used for long-term planning

Many Web sites offer online calculators that you can use for a variety of financial
planning decisions, such as:

o Estimating your taxes

o Determining how your savings will grow over time
o Determining whether buying or leasing a car is more appropriate

When you use online information for personal finance decisions, keep in mind that some
information may not be accurate. Use reliable sources, such as Web sites of government
agencies or financial media companies that have a proven track record for reporting

financial information. Also, recognize that free personal finance advice provided online
does not necessarily apply to every person’s situation. Get a second opinion before you
follow online advice, especially when it recommends that you spend or invest money.

5. Evaluate your Financial Plan: After you develop and implement each component of
your financial plan, you must monitor your progress to ensure that the plan is working as
you intended. Keep your financial plan easily accessible so that you can evaluate it over

6. Revise your Financial Plan: If you find that you are unable or unwilling to follow the
financial plan that you developed, you need to revise the plan to make it more realistic. Of
course, your financial goals may have to be modified as well if you are unable to maintain
the plan for achieving a particular level of wealth. As time passes, your financial position
will change, especially upon specific events such as graduating from college, marriage, a
career change, or the birth of a child. As your financial position changes, your financial
goals may change as well. You need to revise your financial plan to reflect such changes
in your means and priorities.


Following are some of the tax-saving options available to individuals in India:

1. Public Provident Fund: Public Provident Fund, or PPF, is a long-term, statutory scheme
of the Central GOI. Currently, the interest rate offered through government-backed small
savings scheme is around 8%, which is compounded annually. On maturity, you pay
absolutely no tax under Section 80C. This long-term scheme is for 15 years; hence if your
investment horizon is short-term in nature, PPF is not meant for you as it locks your
liquidity for a relatively long period of time. In this scheme, you need to invest a
minimum deposit of Rs.500 and up to maximum of Rs.150000 in a financial.

2. Unit-linked Insurance Plans: Unit-linked Insurance Plans (ULIPs), which are eligible
for Section 80C tax rebate, are investment products that provide dual benefits of life
insurance and savings element as a one stop solution for an individual’s financial goal.
However, if you don’t need insurance, going with ULIP is not the best investment bet on
the horizon. Recently, insurance regulator IRDA had initiated a few corrective measures
by hiking the threshold limit for ULIPs from 3 years to 5 years of lock-in period and
mandated a minimum guarantee for such plans. Now, the policyholders can also opt for
pre-mature exit without any penalty.

3. Equity-linked Savings Scheme: Equity-linked Savings Scheme (ELSS) is mutual funds

that help you save taxes under Section 80C as well as generate decent long-term returns
from the equity markets. Such schemes are typically characterized by a three-year lock-in
period. However, the tax benefits of ELSS will be phased out with the introduction of the
Direct Tax Code (DTC) starting from April 1, 2012. But, the revised code mandates that

existing ELSS funds will be able to claim tax-exemptions. So, this might just be your last
opportunity to put money is lucrative tax-saving mutual funds.

4. Five-Year Bank Fixed Deposits: You might be thinking how come bank fixed deposits
are included in tax-saving schemes? Since 2006, Bank Term Deposits which are of over 5
year’s tenure and up to Rs.1 lakh are allowed exemption under Section 80C of the Income
Tax Act, 1961. Such deposits should necessarily be in the RBI mentioned list of
Scheduled Banks. Most of such tax-saving fixed deposit avenues are of fixed tenure and
do not allow pre-mature withdrawal facility. Further, such term deposits cannot be
pledged to secure a loan. Most importantly, the biggest drawback of this scheme is that
the interest for the amount deposited is taxable.

5. Employee’s Provident Fund: Salaried individuals are compulsorily required to

contribute 12% of the sum of basic pay and dearness allowance to Employee’s Provident
Fund (EPF). This sum is deducted by the employers from the monthly payroll of
employees as a social security scheme akin to a forced-saving towards retirement
planning. EPF brings with it key benefits as a fixed-income instrument providing tax
benefits under Section 80C at the time of investment. Even the returns from EPF are tax
free on maturity. The employer also has to make a matching contribution to the EPF.

6. National Savings Certificate: The 8% returns from National Savings Certificate (NSC)
are not only assured and tax exempt under Section 80C, but also government guaranteed.
Unlike PPF, NSCs have no upper limit on the maximum amount that can be invested in a
fiscal year. This small saving scheme offers tax-free initial deposit for 6 years. However,
interest in NSC is taxable. But, the interest for the first 5 years is eligible for a deduction
as NSC is a cumulative scheme – where interest is reinvested and is qualified under fresh
deduction in NSC.

7. Infrastructure Bonds: In Union Budget 2010, Finance Minister Pranab Mukherjee

proposed the deduction for funds flowing in long-term infrastructure bonds in India up to
₹20,000 under Section 80 CCF of the IT Act, 1961. These bonds issued by RBI-notified
entities carry long tenures of 5-10 years for facilitating investment in infrastructure
projects within the country. The interest earned can vary from 7.5% to 8.5% depending
upon the issuer and investment option chosen. For the investors at highest tax bracket,
such investments can bring in savings of up to around ₹ 6000.

8. Insurance, Health Premiums & Tuition Fees: You can claim tax benefits for the health
insurance premiums to the extent of ₹ 15000 under Section 80D. Moreover, you can also
claim an equal amount of deduction for buying medical policies for your parents. Any
amount paid towards life insurance premium for yourself or your family is eligible for tax
break under Section 80C. If you’re paying tuition fees for your children’s full-time
education, you are eligible for tax deduction under Section 80C. Mind you, the said tax
benefit is not for the donations paid to such institutions.


True and false Questions:

Indicate whether the following statements are true or false:

a) Cash Inflows represents all your expenses and yearly expenditure

b) Contingency and Risk planning are crucial components of a financial plan
c) A person must start thinking about a Retirement plan only after reaching the age of 50
d) Public Provident fund and Equity linked savings scheme are tax saving options available
in India
e) Infrastructure bonds are issued by RBI notified entities for tax saving purposes;

Long Answer Questions

Q1. What are the ways of planning the finances and why setting personal financial goal is
important for a secure future?

Q2. What are the components of a financial plan and how is it developed.


Economic times . (2018). Six-step financial planning process . Retrieved from Economic
erest&utm_medium=text&utm_campaign=cppst ..

IFCI Finacial services Ltd. (2018). Components of financial planning. Retrieved from

Investopedia. (2018). Setting Financial Goals for Your Future. Retrieved from

Madura, J. (2014). Personal Finance. U.S.A: Pearson. (2018). top-tax-saving-instruments-for-investors. Retrieved from

Unit IV

7.1 Introduction
7.2 Objective of a Will
7.3 How to create a valid Will
7.4 Key points related to a Will
7.5 Types of Will
7.6 Living Will
7.7 Power of Attorney
7.7.1Types of Power of Attorney
7.8 Need for an Insurance
7.9 Benefits of getting Insurance
7.10 Types of Insurance
7.11 Types of Life Insurance
7.12 Types of General Insurance
7.13 Planning a Health Insurance
7.14 Self-Assessment Questions


Making a will is considered to be a thing for the old age; however the right time to make a
will is now. You should be considering writing your will as on this day itself. Here’s why.
There is a famous saying ‘where there is a will there is a way’ and indeed in India the saying
holds a truth. If there would be no ‘Will’ there would be law-suits, court cases, disputed
properties and a waste of time and money for the survivors of the deceased. It has seen many
a times petty financial and property disputes among kin can be avoided if only the parent,
guardian or relative whose property or financial estate is in question; bothered to write a will.
(Vaishnav, 2018)

All the finances, property, investments that we have worked so hard to create, achieve, and
manage can be locked up in legal tangles for ages, just because we fail to make a will in
India. There are quite a few real-life examples that come to mind where the families end up in
disputes over who gets what and why just because making a will was not that important to the
deceased person. For Example: Raj and Sameer are in a constant legal battle over a flat that is
not occupied by their families but was taken by their father as investment. The Raj claims
that being the older son he deserves equal share in the flat, while Sameer had actually made a
small contribution towards the purchase of the flat and he feels he should not be sharing it
with anyone else. Valuable time and money is being spent on the legalities of it and not to

forget the harm it is causing to a family and the relationship between the brothers just because
their father never realized why is will important in India. (Vaishnav, 2018)

Estate or Property planning is important because it ensures that your estate is distributed in
the manner that you desire. In addition, proper planning may allow your estate to be legally
insulated from taxes, so that your entire estate can be distributed to your family members or
other beneficiaries that you identify in your will. In the absence of a properly-executed Will,
however, the ways ahead may sometimes be not only too many, but also too complicated.
Ask the Birla clan, the Ranbaxy family, the Ambani brothers or even your neighborhood
uncle. They will all agree that the road to inheritance globally is usually paved with ill Will
stories. Still, in India at least, ‘Will planning’ is hardly seen as a part of financial
management (Vaishnav, 2018).


A will is critical to ensure that your estate is distributed in the manner that you desire. Once
you have a positive net worth to be distributed upon your death, you should consider creating
a will. In your will, you can specify the persons you want to receive your estate—referred to
as your beneficiaries (or heirs). In case you die intestate (without a will), the court will
appoint a person (called an administrator) to distribute your estate according to the laws of
your state. In that case, one family member may receive more than you intended, while others
receive less. If there is no surviving spouse, the administrator would also decide who would
assume responsibility for any children. Having an administrator also results in additional
costs being imposed on the estate. (Madura, 2014)

An estate represents a deceased person’s assets after all debts are paid. At the time of a
person’s death, the estate is distributed according to that person’s wishes. Estate planning is
the act of planning how your wealth will be allocated on or before your death. One of the
most important tasks in estate planning is the creation of a will, which is a legal request for
how your estate should be distributed upon your death. It can also identify a preferred
guardian for any surviving children who are minors. (Madura, 2014)

Who Should Make a Will? (Vaishnav, 2018)

In India if you are 21 years or above you are legally allowed to make a will. A plain piece of
paper with your handwriting on it mentioning you are of sound mind and health when writing
this will and who gets what in your absence and signed by you is a will that is acceptable
legally. This simple step can negate a lot of disputes and legal hassles in your absence. People
who are blind or deaf or dumb can also make a Will, provided they understand the results of
their actions as well as the legal consequences. A person who is ordinarily insane may also
make a Will, but only when he/she has a sound mind. However, if a person does not know
what he is doing, he can’t possibly make a Will in such a state of mind.

Will planning is important because the document always acts as an inventory of the assets left
behind by the deceased. A clear and well-written ‘Will’ also helps in avoiding any bickering
among the natural heirs. And, if a person wants to distribute his/her wealth to anyone other
than the natural heirs, the Will assumes paramount importance. Make a will, right now at this
very moment and mention how you would want to distribute your estate. In case you want to,
you can always make changes to a will as and when required, so the final will can always be
amended by you periodically if you feel so


It is not very difficult to create a will. You need not be a ‘Rocket Scientist’ since there is no
legal format or pre-defined template. You may design your own will in just four parts
(, 2015):

1. Start with Declaration: A Will should start with a declaration specifying your name,
address, age, etc. at the time of writing the will and declaring that you are writing this
will in your full senses without any pressure.

2. Provide list Details of Property and Assets: Then you start with the list of assets like
house, other properties, fixed deposits, shares, bonds etc. It is better to prepare the list
with some categorization like Properties, Cash and Bank Deposits, jewelry, Shares etc.
Normally, high value items are written on the top or in the bottom. In front of every item,
mention its current value and location or place where it is lying to avoid confusion and
ease to locate the same in your absence. It is better to mention and define the process of
release of these items if it under some locks in or safe deposit. Do not hesitate in
mentioning even the small value items also.

3. Define the Ownership Division: Once you define the detail of your properties and other
valuable assets, start with the division of the same. Clearly state the name, relation and
proportion of asset for each item that you wish to give distribute among family member.
In case, you are giving your property to a minor and define a trust worthy custodian for
the same till he becomes major (above 18 years). It is important to distribute inherited
properties as per applicable laws however other wealth or properties that are created with
your own efforts/earnings may be distributed the way you want.

You may also define certain scenarios where conditional division or distribution may take
place due to life events. However, you need to be very careful while doing that to avoid
any clash with above stated distribution or any other confusion’s. Generally, these
confusions are the big reasons for clashes among the family members.

4. Sign the Will in front of 2 Independent Witnesses: Do sign on each and every page and
specify the page numbers as “1 of 5″, 2 of 5” and so on. Witnesses should be independent
and should not be the direct beneficiaries of the will. Do mention the date and place of the

will at the end. Keep the will in sealed envelope containing your signature and date of
sealing on the seal.


Following are some of the key points related to Will (, 2015):

1. Execution: Execution of the will is done after the demise of the person by an
Executor. Executor is the person who is responsible for dividing the wealth among the
beneficiaries. Although not essential, the will may be executed in the presence of
public notary or Magistrate, nominated by the government authorities and sealed in
their presence.

2. Changing the Will: A will can be changed any time by the person when he is alive
however should clearly mention that it supersedes all the earlier prepared will(s). A
testator can change his Will, at any time, in any manner he deems fit. A Will, obtained
by force, coercion or undue influence, is a void Will as it takes away the free agency
of the person. A Will, made under influence of intoxication or in such a state of body
or mind, sufficient to take away free agency of the testator, is void.

3. Codicil to the Will: If a testator intends to make a few changes to the Will, without
changing the entire Will, he can do so by making a codicil to the Will. The codicil can
be executed in a similar way as the Will. One must note that a Will or codicil is not
unalterable or irrevocable. They can be altered or revoked at any time. In case any
objections are raised by any of the heirs, a citation has to be served, calling upon them
to consent. This has to be displayed prominently in the court. If no objection is
received, the probate will be granted. It is only after this that the Will comes into

4. Making a Will through lawyer: People prepare their will though a Lawyer to avoid
confusions and contradictions within the will. Also the purview of the will is defined
as per the Indian law which leads to avoidance of any legal disputes of family

5. Registration of a Will: A Will can be executed on a plain paper and remains fully
valued even if unregistered, i.e., it is not compulsory to register it under law.
However, that does not stop a person from registering the same simply to put an end
to any doubts raised over its authenticity. If one wants one’s Will to be registered, one
has to visit the sub-registrar’s office along with witnesses. There are sub-registrars for
various districts and one has to find out from the concerned office about the one who
will help in registering it.

6. Other Important Points:

• The Will should be prepared on a good quality of paper and signed with clearly
visible ink.
• The two witnesses should be younger than you preferably a doctor, lawyer or a
respected family friend.
• The witnesses should not be the beneficiary of the will.
• In case of Hindus, inherited properties should be clearly identified and thus ownership
defined accordingly.
• Previous wills should either be destroyed or kept with newer will to avoid wrong
execution. Better is to destroy after preparation of newer one.
• Avoid cutting while mentioning date, name, figures and other relevant details.
• The value of assets should be mentioned as to how much each beneficiary will
receive, in percentage terms rather than absolute numbers.


There are mainly two kinds of Wills: privileged and unprivileged (Indiafillings, 2018):

1. Privileged Will: Privileged Wills are Wills that maybe in writing or made by word of
mouth by those in active services like soldier, airman or mariner. The legal requirement
for validity of a privileged Will has been reduced to enable certain persons to quickly
make a Will. The following conditions are applicable for a privileged Will:

• The Will can be written wholly by the testator, with his own hand. In such case the
Will is handwritten, it need not be signed or attested.
• A privileged Will can be written wholly or in part by another person and signed by the
testator. In such a case, there is no requirement for attestation.
• A document purporting to be a Will written wholly or partly by another person and
not signed by the testator can be deemed a valid Will, if it is proved that it was written
by the testator’s directions or that the testator recognized it as his/her Will.
• A half completed privileged Will can also be held as valid, if by reason of
circumstances it can be proved that non-execution was a due to some other reason and
does not appear to be an abandonment of intentions to create a Will.
• A privileged Will can be made by word of mouth by declaring intentions before two
• If a soldier or airman or mariner has given written or verbal instruction for preparation
of a Will, but has died before it could be prepared and executed, it would still be
considered to be a valid Will.

2. Unprivileged Will: Will created by a person who is not a soldier employed in an

expedition or engaged in actual warfare or a mariner at sea is known as an unprivileged
Will. For an unprivileged Will to be valid, it must satisfy the following conditions:

• The person creating the Will must sign or affix his/her mark to the Will. Else, it
should be signed by some other person as per the directions of the testator (Person
creating the Will) in his/her presence.
• The signature or mark of the testator or the signature of the person signing for the
testator must be placed so that it appears that it was intended to give effect to the
writing as Will.
• The Will should be attested by two or more witnesses. The witnesses must have seen
the testator sign or affix his mark to the Will or has seen some other person sign the
Will, in the presence and by the direction of the testator.

3. Conditional or Contingent Will: A Will can be expressed to take effect only in the event
of satisfying certain conditions or can be contingent upon other factors. Such a Will,
which is valid only in the event of happening of some contingency or condition, and if the
contingency does not happen or the condition fails, is called a conditional or contingent

4. Joint Will: Joint Will is a type of Will wherein two or more persons agree to make a
conjoint Will. If a Joint Will is intended to take effect after the death of both persons, then
it would not be enforceable during the life-time of either. A joint Will can be revoked by
either or the person at any time during the joint lives or after the death of one, by the

5. Concurrent Will: Concurrent Will is written by one person wherein two or more Wills
provide instructions for disposal of property for the sake of convenience. For instance, a
Will could deal with the disposal of all immovable property whereas another Will deals
with the disposal of all movable property.

6. Mutual Will: In a Mutual Will, the testators confer upon each other reciprocal benefits.
Mutual Will can be executed by a husband and wife during their lifetime to pass on all
benefits to the other person during their lifetime.

7. Duplicate Will: Duplicate Will can be created by a testator for the sake of safety or
safekeeping with a bank or executor or trustee. However, if the testator destroys the Will
in his/her custody, then the other Will is also considered revoked.

8. Sham Will: Sham Wills are wills executed purporting to be a Will, but held invalid as the
testator did not intend it to have been executed as per his/her wishes. As per the Indian
Succession Act, a Will made by fraud or coercion or by taking away the free agency of
the testator is considered invalid.

9. Holograph Will: Holograph Will are written entirely in the handwriting of the testator.


In addition to creating a Will, Estate Planning involves some other key decisions regarding a
living will and power of attorney.

Living Will: A living will is a simple legal document in which individuals specify their
preferences if they become mentally or physically disabled. For example, many individuals
have a living will that expresses their desire not to be placed on life support if they become
terminally ill. In this case, a living will also has financial implications because an estate could
be charged with large medical bills resulting from life support. In this way, those who do not
want to be kept alive by life support can ensure that their estate is used in the way that they
prefer (Madura, 2014).

“Indian Supreme court in March 2018 made a landmark Judgment allowing people to draw
up "living wills", meaning they can seek what is known as passive euthanasia. It means
medical treatment can be withdrawn to hasten a person's death, if strict guidelines are
followed. This would apply to patients suffering from terminal illness and who are in a
vegetative state. The history of living wills dates back to 1969 when the American lawyer
Louis Kutner first proposed it. He viewed it as a simple device to allow patients to say no to
life-sustaining treatment that they did not want, even if they were too ill to communicate.”

Following are the requirements for drawing up a living will and the elements that must be a
part of it (Raja, 2018):

• The person drawing up the ‘living will’ must be an adult, who is of sound mind and is
capable of communicating his/her decision clearly.
• This is a voluntary process and the ‘living will’ cannot be obtained under duress or
• The ‘living will’ must be in writing and the contents of it must clearly state that
treatment may be withdrawn.
• A declaration stating that the person is drawing up the ‘living will’ has understood the
consequences of executing the will must be mentioned.
• The ability to revoke any instructions made in the ‘living will’ must also be
mentioned clearly.
• The name of a guardian or relative authorized to decide on behalf of the patient in
adverse situations must also be clearly mentioned.
• The ‘living will’ must be signed by the person making it in the presence of two
witnesses, countersigned by a jurisdictional judicial magistrate first class.
• The witnesses and the judicial magistrate must record their satisfaction that the
document has been drawn up and executed voluntarily without any coercion.
• One copy of the ‘living will’ shall be preserved in the office of the judicial magistrate,
and one copy shall be forwarded to the registry of the district court.

• The onus of informing the immediate family members of this ‘living will’ be on the
judicial magistrate.
• One copy also must be handed over to the municipal corporation for their record.
• One copy of the directive must be handed over to the family physician.

Under what Circumstances ‘Living Will’ is implemented? (Raja, 2018)

To ensure that various checks and balances are put in place, there are certain criteria’s that
need to be met before the ‘living will’ can be executed.

The execution of the ‘living will’ can happen only if the medical board grants permission. A
medical board consists of the head of the treating department and at least three experts from
the fields of general medicine, cardiology, neurology, nephrology, psychiatry or oncology
with at least twenty years’ experience. This board, in turn, has to visit the patient in the
presence of guardians/close relatives and form an opinion to certify, or not certify, the
instructions in the living will. This decision shall be regarded as a preliminary opinion.

After the hospital medical board certifies that the instructions contained in the ‘living will’
ought to be carried out, the hospital has to inform the jurisdictional collector about the

• The collector shall constitute another medical board comprising the chief district
medical officer as the chairman and three expert doctors from the fields of general
medicine, cardiology, neurology, nephrology, psychiatry or oncology.
• The chairman of the medical board nominated by the Collector, that is, the Chief
District Medical Officer has to convey the decision of the board to the jurisdictional
judicial magistrate before withdrawing the medical treatment administered to the
• The judicial magistrate shall visit the patient at the earliest and, after examining all
aspects, authorize the implementation of the decision of the Board

Here are some of the Advantages of Living Wills (Raja, 2018):

• They respect the patient’s human rights, and in particular their right to reject medical
• Knowing what the patient want means that doctors are more likely to give appropriate
• They help medical professionals in taking difficult decisions
• A patient’s family and friends don’t have to take the difficult decisions

7.7 POWER OF ATTORNEY (Madura, 2014)

A power of attorney is a legal document granting a person the power to make specific
decisions for you in the event that you are incapacitated. For example, you may name a
family member or a close friend to make your investment and housing decisions if you
become ill. You should name someone who you believe would act to serve your interests.

A durable power of attorney for health care is a legal document granting a person the power
to make specific health care decisions for you. A durable power of attorney ensures that the
person you identify has the power to make specific decisions regarding your health care in
the event that you become incapacitated.

While a living will states many of your preferences, a situation may arise that is not covered
by your living will. A durable power of attorney for health care means that the necessary
decisions will be made by someone who knows your preferences, rather than by a health care

Who Should Use It?

Usually Power of Attorney is created by anyone who cannot do the transactions in person by
himself or herself due to various reasons. The following are the reasons that commonly force
an individual to give the power of performing to another person:

• residing abroad and unable to be present for the task

• illness and bedridden
• old age or senior citizens with health problems
• or any other reason for being unable to conduct the transactions personally

7.7.1 Types of Power of Attorney

Power of Attorney can be of following types (Legal Desk, 2018):

1. General Power of Attorney: This is a written authorization document where a person

(“Principal” or “Donor”) confers authority to another person (“Attorney”, “agent” or
“Donee”) to act on his behalf in matters of property, business affairs, financial and
Banking transactions, legal matters etc.

This document empowers the Attorney to represent the principal in various matters when
the latter is out of country or old and incapacitated or even otherwise not able to take care
of one’s property and finance etc.

Figure 1: General Power of Attorney

2. Special Power of Attorney: The other type of Power granted is the Special power which
means it is granted for only a specific task or work. A Special power of Attorney is to be
made by a person when any particular or specific task or act is to be done. Once the
particular act is completed the Special power of Attorney comes to an end. This is
generally used when someone want to rent out your property or appear for the registration
of any property or appear in a court on behalf of the Principal or to appear before the Tax
authorities etc.

3. Durable Power of Attorney: Durable Power of Attorney or specifying the durability

factor in the deed simply means that the powers of Attorney will remain effective if the
principal becomes incapacitated. Generally, the power of the Attorney is nullified if the
principal is incapacitated if the durable condition is not included.

When to Use?
• When you’re looking for an aide to represent you in important matters
• When a person is unwell and is not in a position to carry out critical transactions

• When a person is abroad and wants to appoint an abettor to assist in domestic
• If you’re preoccupied with other appointments and are unable to concentrate on a

What does it cover?

• Attorney’s powers related to conducting business
• Real estate and property matters
• Selling & Buying investments, operation of bank accounts
• Power to enter into agreements and registrations
• Other basic and vital clauses


Insurance is a way of managing risks. When you buy insurance, you transfer the cost of a
potential loss to the insurance company in exchange for a fee, known as the premium.
Insurance companies invest the funds securely, so it can grow, and pay out when there’s a
claim. Insurance helps you (Cooperators, 2018):

• Own a home, because mortgage lenders need to know your home is protected
• Drive vehicles, because few people could afford the repairs, health care costs and
legal expenses associated with collisions and injuries without coverage
• Maintain your current standard of living if you become disabled or have a critical
• Cover health care costs like prescription drugs, dental care, vision care and other
health-related items
• Provide for your family in the event of a death
• Run a small business or family farm by managing the risks of ownership
• Take vacations without worrying about flight cancellations or other potential issues

Insurance is a shield which protects the financial interests of you and your family in case of
unseen and unpredicted circumstances. For example, anything that guarantees that your
family will not have to pay the home mortgage if something happens to you, is insurance. No
matter how efficient a planner you are, life is full of unforeseen events in which you might
need cash; accident injuries, medical emergencies, car accident, home invasion, natural
calamity, etc. Therefore, to make sure that you or your loved ones are prepared against such
events you need insurance.

Do You Really Need Insurance? (Shetty, Money Control, 2015)

• Life Insurance: Yes, because you might be healthy today, but what happens if there
is an accident or sudden medical emergency or worse, death? If you are the solo bread
earner in your family, then you would definitely want to cover the mortgage
payments, credit card bills, living expenses (rent, food and clothing), etc. Life

insurance makes sure that your family does not have to run post to pillar to arrange for
these expenses.

• Health or Medical Insurance: Definitely, as you or any member of your family

might develop a medical condition that will require immediate surgery or treatment,
in which case you will need major amount of funds. Health insurance covers the
expenses of such medical nature. In India, medical insurance provides for
hospitalization, pre and post hospitalization care, surgery, medical bills and any other
cost incurred. You can get a micro medical insurance for as little as INR 5,000 or a
general medical insurance starting from INR 1 lakh.

• Personal Accident Insurance: Absolutely, if you do not want to land in a terrifying

situation where the condition of permanent disability leaves your family unprotected.
People often do not pay any regard to personal accident insurance which can prove
financially fatal. It should be understood that there are certain circumstances where
neither life insurance nor health insurance comes to aid; disability, injuries or even
death caused by accidental, external, brutal and evident events. For example, if there
has been a road accident which has left you, the only earner, in a disabled condition
then you will need a financial aid to provide for you and your family’s living
expenses, transportation costs, mortgages, etc.

7.9 BENEFITS OF GETTING INSURANCE (Shetty, Money Control, 2015)

Think of the insurance as a tool to manage your financial risks in the future. We are living in
an age where providing for your loved ones, even if you are not around, has become possible
and so easy by just buying an insurance policy. In fact, ask yourself that do your old parents,
spouse, children or younger siblings depend on your income? If the answer is yes, then you
certainly need insurance, as simple as that.

For your further peace of mind, here are some more points which you can go through to
ascertain that there is more to insurance than what you think. Those happy-family
commercials you see, in which everybody is smiling, are not too far from reality.

1. Insurance will protect your loved ones; old parents and grandparents, spouse, young
children, and other family members who depend on you for their medical care,
education, food, shelter, commuting, in other words, regular life.
2. A medical insurance will cover the cost of, for example, weekly dialysis, diabetes
injections, surgery, malfunctioning kidney or liver, dental care, eye care and many
more such conditions suffered by the insurer.
3. Vehicle insurance is important either you have bought a new car or have been driving
for a while now. Think of the times when you put up with a flat tire, empty fuel,
faulty engine or worse, an accident. Especially if the vehicle is driven by your spouse
or children, you need to make sure that you have an auto insurance because these days

auto-insurance comes with a pack of helpful services in any region your vehicle has
broken down; even if it’s a highly remote area.
4. Then there is travel insurance which covers the interests of those who are travelling
against cancellation of flight, lost luggage, theft of personal and valuable belongings,
and any other kind of unforeseen event while your trip.
5. If you run a small business, then too you need to ensure it so that your family does not
need to fret over the business expenses if anything happens to you. Business costs
could be anything from payment to the creditors to procurement of materials for
further operation of business; they could be insured by buying business insurance.
6. If you own a house or have bought a house with mortgage, it is advisable to purchase
the home insurance to cover the costs of monthly loan payments, as well as the risk of
home invasion, fire accidents, damage due to natural calamities or any other kind of


There are two broad types of Insurance (ACKO, 2018):

• Life Insurance
• General Insurance

What is Life Insurance: Life insurance is a contract that offers financial compensation in
case of death or disability. Some life insurance policies even offer financial compensation
after retirement or a certain period of time. Life insurance, thus, helps you secure your
family’s financial security even in your absence. You either make a lump-sum payment while
purchasing a life insurance policy or make periodic payments to the insurer. These are known
as premiums. In exchange, your insurer promises to pay an assured sum to your family in the
event of death, disability or at a set time. Life insurance can help you support your family
even after retirement.

What is General Insurance: A general insurance is a contract that offers financial

compensation on any loss other than death. It insures everything apart from life. A general
insurance compensates you for financial loss due to liabilities related to your house, car, bike,
health, travel, etc. The insurance company promises to pay you a sum assured to cover
damages to your vehicle, medical treatments to cure health problems, losses due to theft or
fire, or even financial problems during travel. Simply put, a general insurance offers financial
protection for all your assets against loss, damage, theft, and other liabilities. It is different
from life insurance.

7.11 TYPES OF LIFE INSURANCE (Hdfclife, 2018)

There are two basic types of life insurance policies viz. Traditional Whole Life and Term Life
Insurance. A whole life is a policy you pay till death of the policy holder and term life is a
policy for a fixed amount of time. The basic types of life insurance policies are:

1. Term Insurance: Term plans are the most basic type of life insurance. They provide
life cover with no savings / profits component. They are the most affordable form of
life insurance as premiums are cheaper compared to other life insurance plans.

Online term insurance plans provide pure risk cover, which explains the lower
premiums. A fixed sum of money - the sum assured – is paid to the beneficiaries if the
policyholder expires over the policy term. If the policyholder survives, there is no pay

2. Endowment Plans: Endowment plans differ from term plans in one critical aspect i.e.
maturity benefit. Unlike term plans which pay out the sum assured, along with profits,
only in case of an eventuality over the policy term, endowment plans pay out the sum
assured under both scenarios – death and survival. However, endowment plans charge
higher fees / expenses – reflected in premiums – for paying out sum assured, along
with profits, in either scenario – death or maturity. The profits are an outcome of
premiums being invested in asset markets – equities and debt.

3. Unit Linked Insurance Plans (ULIP): ULIPs are a variant of the traditional
endowment plan. They pay out the sum assured (or the investment portfolio if it is
higher) on death/maturity.

ULIPs differ from traditional endowment plans in certain areas. As the name suggests,
performance of ULIP is linked to markets. Individuals can choose the allocation for
investments in stock/debt markets. The value of the investment portfolio is captured
by the NAV (net asset value). To that end, there are many similarities between ULIPs
and mutual funds. ULIPs differ in that area as they are a combination of investment
and insurance, while mutual funds are a pure investment avenue

4. Whole Life Policy: A whole life insurance policy covers a policyholder over his life.
The main feature of a whole life policy is that the validity of the policy is not defined
so the individual enjoys the life cover throughout his life. The policyholder pays
regular premiums until his death, upon which the corpus is paid out to the family. The
policy expires only in case of an eventuality as there is no pre-defined policy tenure.

5. Money Back Policy: A money back policy is a variant of the endowment plan. It
gives periodic payments over the policy term. To that end, a portion of the sum
assured is paid out at regular intervals. If the policy holder survives the term, he gets
the balance sum assured. In case of death over the policy term, the beneficiary gets
the full sum assured.

6. Child Plan: This ensures your child’s financial security. In the event of your death,
your child gets a lump-sum amount. The insurer pays the premium amounts after

your death. Your child will continue to get a certain sum of money at specific

7. Pension Plans: This helps build your retirement fund. You can get a regular pension
amount after retirement. In the case of your death, your family can claim the sum

Further, there is tax benefits associated with the above mentioned plans/policies:

• Life insurance not only ensures the well-being of your family, it also brings tax
• The amount you pay as premium can be deducted from your total taxable income.
• However, this is subject to a maximum of Rs.1.5 lakh, under Section 80C of the
Income Tax Act.
• The premium amount used for tax deduction should not exceed 10% of the sum


You can get almost anything and everything insured. But there are five key types available:

• Health Insurance
• Motor Insurance
• Travel Insurance
• Home Insurance
• Fire Insurance

Health Insurance: This type of general insurance covers the cost of medical care. It pays for
or reimburses the amount you pay towards the treatment of any injury or illness. It usually
• Hospitalization
• The treatment of critical illnesses
• Medical bills prior to or post hospitalization
• Day care procedures like Cataract operations

You can also opt for add-on benefits like:

• Maternity cover: Your health insurance covers you for the costs related to childbirth.
This includes pre-delivery check-ups, hospitalization during delivery, and post-natal
• Pre-existing diseases cover: Your health insurance takes care of the treatment of
diseases you may have before buying the health insurance policy.
• Accident cover: Your health insurance can pay for the medical treatment of injuries
caused due to accidents and mishaps.

Further a health insurance can also help in saving tax. Your premium payment can reduce
your taxable income.

Motor Insurance: Motor insurance is for your car or bike what health insurance is for your
health. It is a general insurance cover that offers financial protection to your vehicles from
loss due to accidents, damage, theft, fire or natural calamities. You can also get motor
insurance for your commercial vehicles. In India, you cannot drive or ride without motor
insurance. Following are two types of motor Insurance:

i) Car Insurance: It’s precious—your car. You paid lakhs of rupees to buy that beauty.
Even a single scratch can be painful, forget about bigger damages. Car insurance can
reduce this pain for a few thousand rupees.

How it works:

Insurer pays for

Pay Annual Get car
damages during
Premium Insurance cover
the whole year

Figure 2: Car Insurance

What the insurer will pay for depends on the type of car insurance plan you purchase.

ii) Two-Wheeler Insurance: This is your bike’s guardian angel. It’s similar to Car
insurance. You cannot ride a bike or scooter in India without insurance.

How it works:

Pay the Insurer pays for
between one or
premium liabilities for
three year
amount insured period.

Figure 3: Two-Wheeler Insurance

As with car insurance, what the insurer will pay depends on the type of insurance and what it

Types of Motor Insurance:

• Comprehensive Car Insurance: This covers all kinds of damages and liabilities
caused to you or a third party. It includes damages caused by accidents, sabotage,
theft, fire, natural calamities, etc.
• Third Party Insurance: Compensates for the damages caused to another individual,
their vehicle or a third-party property.

Travel Insurance: Travel insurance compensates you or pays for any financial liabilities
arising out of medical and non-medical emergencies during your travel abroad or within the
country. There are two types of Travel Insurance:

i) Single Trip Policy: It covers you during a trip that lasts under 180 days.
ii) Annual Multi Trip: It covers you for several trips you take within a year.

What All Does Travel Insurance Usually Covers?

• Loss of baggage
• Emergency medical expenses
• Loss of passport
• Hijacking
• Delayed flights
• Accidental death

Home Insurance: Home insurance is a cover that pays or compensates you for damage to
your home due to natural calamities, man-made disasters or other threats. It covers liabilities
due to fire, burglary, theft, flood, earthquakes, and sabotage. It not only offers financial
protection to your home, but also takes care of the valuables inside the property. Some of the
common types of home insurance are:

i) Standard Fire and Special Perils Policy: This covers your home against fire
outbreaks and special perils. The dangers covered are:
• Natural calamities like lightening, flood, storm, earthquake, etc.
• Damage caused due to overflowing or bursting of water tanks, pipes, etc.
• Damage caused due to man-made activities such as riots, strikes, etc.

ii) Home Structure Insurance: This protects the structure of your home from any kinds
of risks and damages. The cover is also extended to the permanent fixtures within the
house such as kitchen and bathroom fittings.

iii) Public Liability Coverage: The damage caused to another person or their property
inside the insured home can also be compensated.

iv) Content Insurance: This covers the content inside the insured home. What’s
commonly covered: Television, refrigerator, portable equipment, etc.

Fire Insurance: Fire insurance pays or compensates for the damages caused to your property
or goods due to fire. It covers the replacement, reconstruction or repair expenses of the
insured property as well as the surrounding structures. It also covers the damages caused to a
third-party property due to fire. In addition to these, it takes care of the expenses of those
whose livelihood has been affected due to fire. Some of the common types of fire Insurance
i) Valued Policy: The insurer firsts value the property and then undertakes to pay
compensation up to that value in the case of loss or damage.
ii) Floating Policy: It covers the damages to properties lying at different places.
iii) Comprehensive Policy: This is known as an all-in-one policy. It has a wide coverage
and includes damages due to fire, theft, burglary, etc.
iv) Specific Policy: This covers you for a specific amount which is less than the real
value of the property.

7.13 PLANNING A HEALTH INSURANCE (wikipedia, 2018)

Health insurance in India typically pays for only inpatient hospitalization and for treatment at
hospitals in India. Outpatient services were not payable under health policies in India. The
first health policies in India were Mediclaim Policies. In Year 2000, Government of India
liberalized insurance and allowed private players into the insurance sector. The advent of
private insurers in India saw the introduction of many innovative products like family floater
plans, top-up plans, critical illness plans, hospital cash and top up policies.

The health insurance sector hovers around 10% in density calculations. One of the main
reasons for the low penetration and coverage of health insurance is the lack of competition in
the sector. IRDA which is responsible for insurance policies in India can create health circles,
similar to telecom circles to promote competition.

Health insurance plans in India today can be broadly classified into these categories:

i) Hospitalization: Hospitalization plans are indemnity plans that pay cost of

hospitalization and medical costs of the insured subject to the sum insured. The sum
insured can be applied on a per member basis in case of individual health policies or
on a floater basis in case of family floater policies. In case of floater policies the sum
insured can be utilized by any of the members insured under the plan. These policies
do not normally pay any cash benefit. In addition to hospitalization benefits, specific
policies may offer a number of additional benefits like maternity and newborn
coverage, day care procedures for specific procedures, pre- and post-hospitalization
care, domiciliary benefits where patients cannot be moved to a hospital, daily cash,
and convalescence.

There is another type of hospitalization policy called a top-up policy. Top up policies
have a high deductible typically set a level of existing cover. This policy is targeted at
people who have some amount of insurance from their employer. If the employer
provided cover is not enough, people can supplement their cover with the top-up
policy. However, this is subject to deduction on every claim reported for every
member on the final amount payable.

ii) Family Floater Health Insurance: Family health insurance plan covers entire family
in one health insurance plan. It works under assumption that not all member of a
family will suffer from illness in one time. It covers hospital expense which can be
pre and post. Most of health insurance companies in India offering family insurance
have good network of hospitals to benefit the insurer in time of emergency.

iii) Pre-Existing Disease Cover Plans: It offers covers against disease that policyholder
had before buying health policy. Pre-Existing Disease Cover Plans offers cover
against pre-existing disease e.g. diabetes, kidney failure and many more. After
Waiting period of 2 to 4 years it gives all covers to insurer.

iv) Senior Citizen Health Insurance: As the name suggest, this kind of health insurance
plans are for older people in the family. It provides covers and protection from health
issues during old age. According to IRDA guidelines, each insurer should provide
cover up to the age of 65 years.

v) Maternity Health Insurance: Maternity health insurance ensures coverage for

maternity and other additional expenses. It takes care of both pre and post natal care,
baby delivery (either normal or caesarean). Like Other Insurance, The maternity
insurance provider has wide range of network hospitals and takes care of ambulance

vi) Hospital Daily Cash benefit Plans: Daily cash benefits are a defined benefit policy
that pays a defined sum of money for every day of hospitalization. The payments for a
defined number of days in the policy year and may be subject to a deductible of few

vii) Critical Illness Plans: These are benefit based policies which pay a lump sum (fixed)
benefit amount on diagnosis of covered critical illness and medical procedures. These
illnesses are generally specific and high severity and low frequency in nature that cost
high when compared to day to day medical / treatment need. E.g. heart attack, cancer,
stroke etc. Now some insurers have come up with option of staggered payment of
claims in combination to upfront lump sum payment.

viii) Pro-active Plans: Some companies like Cigna TTK offer Pro-active living
programs. These are designed keeping in mind the Indian market and provide
assistance based on medical, behavioural and lifestyle factors associated with chronic

conditions. These services aim to help customers understand and manage their health

ix) Disease Specific Special Plans: Some companies offer specially designed disease
specific plans like Dengue Care. These are designed keeping in mind the growing
occurrence of viral diseases like Dengue in India which has become a cause of
concern and thus provide assistance based on medical needs, behavioural and lifestyle
factors associated with such conditions. These plans aim to help customers manage
their unexpected health expenses better and at a very minimal cost.

Key Aspects of Health Insurance:

Payment options:
• Direct Payment or Cashless Facility: Under this facility, the person does not need to
pay the hospital as the insurer pays directly to the hospital. Under the cashless
scheme, the policyholder and all those who are mentioned in the policy can undertake
treatment from those hospitals approved by the insurer.
• Reimbursement at the End of the Hospital Stay: After staying for the duration of
the treatment, the patient can take a reimbursement from the insurer for the treatment
that is covered under the policy undertaken.
Cost & Duration:
• Policy Price Range: Insurance companies offer health insurance from a sum insured
of ₹5000/-[8] for micro-insurance policies to a higher sum insured of ₹50 lacs and
above. The common insurance policies for health insurance are usually available from
₹1 lac to ₹5 lacs.
• Duration: Health insurance policies offered by non-life insurance companies usually
last for a period of one year. Life insurance companies offer policies for a period of
several years.
Tax Benefits: Under Section 80D of the Income-tax Act the insured person who takes out the
policy can claim for tax deductions up to ₹25,000 for self, spouse and dependent children and
₹30,000/- for parents.


True and false Questions:

Indicate whether the following statements are true or false:

a) In India at any age you are legally allowed to make a will?

b) Concept of Living will in India is available since 1969?
c) When a person is unwell and is not in a position to carry out critical transactions they
should go for a will instead of a power of attorney?
d) Home and Fire Insurance comes under Life Insurance?

e) Health insurance in India typically pays for only inpatient hospitalization and for
treatment at hospitals in India?

Long Answer Questions

Q1. What is a will? Why is a will important? What happens if a person dies without a will?
Q2. List the requirements for valid will.
Q3. What is a durable power of attorney for health care? Why is it needed even if you have a
living will?
Q4. How does life insurance protect your wealth? Who needs life insurance?


ACKO. (2018). Types of Insurance. Retrieved from

Cooperators. (2018). Why do we need insurance? Retrieved from

Hdfclife. (2018). Types of Life Insurance. Retrieved from

Indiafillings. (2018). Types of wills in India. Retrieved from

Legal Desk. (2018). Power of attorney. Retrieved from

Madura, J. (2014). Personal Finance. U.S.A: Pearson.

Raja, V. (2018, March 18). Should You Have a ‘Living Will’ Made? Here’s All You Need to
Know. Retrieved from thebetterindia:

Shetty, A. (2015, February 10). Money Control. Retrieved from

Shetty, A. (2015, February 10). Why do you need Insurance? Retrieved from
finance/why-do-you-need-insurance-1253771.html (2015, February 25). The procedure of making Will in India and its
importance. Retrieved from

Vaishnav, A. (2018, March 6). Why is ‘Will’ important to have a ‘Way’? Retrieved from

wikipedia. (2018). Health_insurance_in_India. Retrieved from

Unit V
Lesson 8



8.1 Credit
8.2 Assessment of Credit
– Types, Advantages, Disadvantages
8.3Consumer and Housing Finance Planning
8.4 Valuation of a Home
8.5 Reverse Mortgage
8.6 Education Financing
8.7 Credit Card Management
8.8 Credit Limits
8.9 Overdraft Protection
8.10 Grace Period
8.11 Credit Bureaus
- Individual Credit History and Ranking,
- Identity Theft and Protection against Identity Thefts
8.12 Retirement Planning and Pension Plans
8.13 Self-Assessment Questions

8.1 CREDIT (Jeff Madura, 2010)

Credit is an amount of money that a person makes available to another person with mutual
understanding that the borrower will repay the amount in the near future or may be before the
specified period of time. The one who makes the cash available to another person is known
as lender and the one who gets the amount is known as a borrower. The borrower also agrees
to pay to the lender an additional amount that is known as interest.

Interest is the cost of money. The price paid by the borrower to have the right to utilize the
lender’s money. This amount is calculated as a percentage of the amount borrowed. Interest

can also be understood as a rental fee paid to someone else for making use of borrowed

The understanding of credit can help an individual in building a strong financial plan. Every
individual will almost require using credit at some point of time in their lives. Because each
and every person has needs and wants to fulfill. It could be anything from necessity to
luxurious items. Use of credit and its proper understanding can make it possible to purchase
these things. Else you won’t be able to buy these products or services. Therefore, it is
necessary that you should be aware of the major types of credit, the advantages and
disadvantages associated with each of them, and about the legal aspect that serves to protect
your right to get credit.

8.2 ASSESSMENT OF CREDIT (Jeff Madura, 2010)

8.2.1 Types of Credit

There are many forms that Credit comes in fall into three categories, non installment,
installment, or revolving open-end credit.

1. Non Installment Credit It is a type of credit extended for a short term, usually 30
days or less. The borrower at the time of purchase borrows the money and returns the
whole amount within a short period of time let’s say less than 30 days. When a person
is in need of funds for a shorter period of time and he knows that he could repay the
amount soon, this type of credit is more useful.

2. Installment Credit It is a type of credit where borrowers are given more time to repay
the money. It is also used for specific purchases. In Installment credit, the borrower
will repay the borrowed amount in monthly installment. The installment includes the
total amount of money outstanding on the loan or borrowed funds and it also includes
interest charges. The duration of these types of loans may span a few years. And the
main purposes of these loans are for purchases of items such as car, furniture, house,
and land etc.

3. Revolving Open-End Credit this type of credit is just like credit cards. It allows
customers to borrow up to some pre set maximum limit. A credit limit is set on the
basis of the income level, debt level, and overall credit record of the person seeking
this credit. Revolving credit can be used to make one or many purchases. The
repayment of revolving open-end credit can be made at the end of the month or
payments may be paid over a longer time in installment. As the money borrowed in
the past is repaid, the credit can be continuously used to make additional purchases
given that the set credit limit does not exceeded.

8.2.2 Advantages of Using Credit

Credit helps in making large purchases even when a person does not have sufficient funds
with him. Using credit also makes finances simpler by getting away with the need to carry
cash or checks. For example, one can purchase a laptop on credit basis and pay the amount in
equal instalments may be monthly or bi-annually instalments.

If a person uses credit wisely, it helps in establishing a good credit history for the individual,
which in turn makes using credit less expensive in the near future. The borrowers who are
able to repay their loan amount in time and also paid the interest amount at the specified
time, make their good credit history. Which in turn help him in securing lower interest rate.

8.2.3 Disadvantages of Using Credit

Lack of awareness about the costs associated with credit can result in serious damages to
one's financial life. Consider the following points:

Easier to Get Credit than it is to Pay it Back if a person start borrowing for everything
then it will become a difficult situation for him. If more funds are borrowed and payment
was not made in time, it will result in a bad credit history and in return can make borrowing
more costly and difficult. Borrowing money to make purchases and failing to make
payments, it will create a risky situation where one loses his possessions and all the money
invested in those purchases because the lender will take back the principal amount and also
the security. A representative of the bank or business from which you borrowed the amount
has the power to take away your car or remove you from the house if these were kept a
security. Lastly, failure to pay off credit can lead to bankruptcy, a legal process wherein a
court takes over certain aspects of a person’s financial life.

It would be wiser to save rather than purchasing things today with the borrowed funds and
paying for them at a later date. Credit cards impose very high interest rates, making it costly
to own a credit card, or carrying forward balances from one month to next. It is considered
wisest to use credit cards only for a few purchases you plan to pay off soon, before interest
charges start to add up.

Raymond Forgue, 2018)

Financing a Home

The biggest purchase decision that most people make in their lives is a home. Mostly people
purchase a house by borrowed funds. While preparing your financial plan, it is the biggest
decision that one makes. You should consider each and every factor associated with buying a
home. In some cases people opt for an alternative i.e., to purchase a condominium. A
condominium is when a person owns unit or units of a housing complex but jointly own the
surrounding land & common areas &other amenities. Just like builder flats these days are the
best option to buy a home. And it also allows a person to pay the amount in instalments.

Relying on a Realtor

A real estate broker may provide expert advice when a person makes an analysis of available
options. The person has to decide which option is better. Whether to buy a home or to opt for
builders flat. However, one shouldn't completely rely on the advice. A good real estate
broker focuses on your preferences & then suggests appropriate homes.

Affordable Monthly Mortgage Payments

If a question comes in your mind that how huge a mortgage can you afford? In that case you
should refer to your cash flow statements to understand how much net cash flow is required
to afford mortgage payment. When you plan to buy a home, it also requires some periodic
expenses such as property taxes, home-owner’s insurance etc.
It is not advisable to purchase a house that is to absorb all your current excess cash inflows.
The larger the mortgage payments, the lesser one have to add to savings or other

Criteria Used to Select a Home

People have different preferences related to any investment. And when the investment is for
home then they would prefer to look for different factors. Some factors are listed below:
 Price
 Convenient location

 Personal preferences (no. of rooms, size of kitchen & size of the lawn etc.)
 Maintenance
 Insurance
 Homeowner’s association
 Taxes
 School system
 Resale value

8.4 VALUATION OF A HOME (Jeff Madura, 2007)

Market analysis- Based on the prices of similar home in the area, an estimate of the price of a
home is made. To calculate the market value, we multiply the average price per square feet
of similar homes in the area by the no. of square feet in a home.

House size Price Price per square foot

1200 sq ft 78000 78000/1200=65
1300 sq ft 87100 87100/1300=67
1100 sq ft 66000 66000/1100=66

Average price per square foot = (65+67+60)/3 = 64

Assuming someone wants to buy a house with 1300 square feet area
Market value will be: 1300*64 = 83200

Effects of Business Activity and Zoning Laws

Zoning laws are the laws applicable to areas, as locations are zoned, for industrial use or
residential use. When a business entity start a new project in any area or zone, this step of
business entities create employment. And in return this will increase the demand for houses
in that area. Finally, the price of houses may rise.

Costs of Buying a Home

Buyers seeking to purchase a house also have to pay costs of buying a home such as title
insurance, appraisal fees, home inspection fees, mortgage origination fees, loan application
fees and filing fees which can sum up to lakh. Some buyers resort to “points”; a fee charged
by the lenders when a mortgage loan is provided, equivalent to 1% of the loan amount, to

bring the interest rate down. It is important to consider these costs when shopping for a
mortgage. Some lenders can avoid these closing costs.

Home Equity Loans

A home equity loan makes it possible for a homeowner to borrow against the equity of their
house i.e. the difference between the home’s value and the amount that the homeowner owes
to the lender. For example, Tom owns a house valued at Rs 20,00,000 and he owes
Rs11,00,000 on his mortgage. He then, has Rs 9,00,000 equity in his home. A home equity
loan allows credit against this equity using borrower’s home as collateral. Generally, the
limit set by the lenders of home equity for the total mortgage amount is 80% of the market
value of the home. So, Tom may be allowed to borrow up to another Rs.5,00,000 using a
home equity loan (.80 * Rs 20,00,000 = Rs16,00,000, minus Rs11,00,000 already borrowed
= Rs5,00,000).

Given the benefits of home loans, it is advisable to remain cautious for failing to pay the loan
back, may be equivalent to losing your home. And so, instead of taking a loan, many
homeowners opt for a home equity line of credit. A line of credit is an agreement that allows
borrowing of money as required up to a certain limit. Home equity loans gain popularity in
times when prices of houses were increasing at a rapidly, as generally these are
comparatively inexpensive source of personal loans, with interest rates that are tied to
various market interest rates. In some cases, the interest paid may be tax deductible if the
proceeds are used for home improvement.

Home equity borrowing comes with own risks. Like mortgage, the borrowing is secured by
the home. And so, inability to repay the loan can make the lender seizing the borrower’s
home, even if the amount borrowed is far less than home’s actual full value, because the
borrower must have kept it as a security against loan amount.

Decision Related to Buying versus Renting a Home

Purchasing a house is considered as a dream, and a huge investment is required. However it

is not the only option, and not a good decision in all cases. Renting often proves to be a good

Whether to buy or rent a home can be a difficult decision to take. To begin with, it is not
possible to find homes that are similar, and available for rent and purchase. Additionally, the
following points must be kept in mind while making the decision:

 For how long do you plan to live in this area? As a thumb rule, it is advisable to
purchase a home only when you have planned to live in that particular area for a long
time. Reason being that there are certain expenses associated with such a purchase
and sale that take a few years to recover. It is also required to pay mortgage
origination fees to a lender to buy the house and then a sales commission to a real
estate agent when the house is sold out.

 Do you possess savings for a down payment? Most of the lenders require that some
money be put down and the remainder financed. Even if a lender agrees to make a
loan without or with little down payment, most likely the amount shall be higher than
when a down payment is necessitated.

 What is the rent as compared to the price of homes? In some cases it is better to rent a
house, since; the owner is responsible for maintenance and upkeep, which would
increase the cost if the house is bought. We should keep in mind that owning a home
can come with an added benefit of a tax deduction that can lower tax payable amount.
Also, when one buys a house, a part of what is paid each month may be adding up to
equity and owner's net worth in the hindsight.

 Are houses increasing in value or decreasing in value in the area? Home prices often
rise and fall significantly in any area. Predicting the direction (upward or downward)
of any market is difficult, but if it is predicted as housing prices are likely to fall
rapidly, it might be a good decision to hold off on purchasing.

 Do you have enough knowledge and information of the area to buy? Sometimes
enough information about a neighbourhood can only be found once the person has
lived in the area for long enough. Information related to the nearest shopping centers
should also be gathered before shifting to a new place. The duration taken to
commute to work should be kept in mind too.

 In renting, it is usually required that the tenant pay a security deposit amount to
protect the damage that may be done during the stay, and those who leave without
paying for it. This amount is kept in the custody of the owner until the tenant decides
to move out, then the owner deducts any amount used for repairs of the damage
caused by the tenant, and returns the remainder to the leaving tenant. One needs to
consider cost of the security deposit when determining whether to rent.

 You should also collect the data related to usual security deposits in that area. One
question- will you need to put up an additional pet deposit if you own a pet?

Since buying a house is one of the most important and large purchases made in a lifetime, it
should be made with proper research and caution. For this reason, it can be helpful to set up a
consultation with an expert, such as a real estate agent, who has experience and can help out
in taking the right decisions.

The Importance of Homeowner’s and Renter’s Insurance

Homeowner’s insurance provides insurance protection against unfortunate and damage

causing events such as natural calamities like floods, fire, theft, earthquakes or other serious
property damage. The types of perils that are covered in each policy vary from policy to
policy. It is possible to add policy riders to add numerous additional coverage, jewellery or
valuable heirlooms that are often not fully covered by a typical policy.

Lenders necessitate that homeowners purchase enough insurance so that atleast amount of
the mortgage on the home is covered. This way, even if some unfortunate event destroys the
house, atleast the homeowner will not default on the loan. However, a homeowner's
insurance not only protects the home, but also the owner as it is a vital component of a
financial plan to protect the owner's assets. With each mortgage payment, equity in home and
addition in net worth is being made.

But when it comes to rent, renter's possessions are not protected. If a renter's belongings are
destroyed by a fire that burned down the entire house, in that case they won't be reimbursed
by the owner of the house. In such a case, a renter can purchase a renter's insurance to cover
their living expenses if the property is being repaired, as a result of some event that is
covered in the insurance. Renters who possess valuables must take up such insurance as a
precautionary measure.

Mortgage Loans

Mortgage is a type of loan taken to purchase home. By definition, a mortgage is a legal

instrument by which the home becomes collateral for the loan. Home financing arrangement
is also a way some people refer it to. There are two basic forms of Mortgage, fixed rate and
adjustable rate.

1. Fixed Rate Mortgage The interest rate remains fixed for the term of the loan,
implying that the payment will never go up or down.
2. Adjustable Rate Mortgage (ARM) Also called variable rate mortgages, the interest
rate may go up or down over time (even the monthly mortgage payment going up or
down), with the change occurring at some preset time, say, after a year. The direction
and amount of the change is based on the changes in interest rates and economic

The reasons for choosing an ARM

The starting rate is often lower than available for fixed rate mortgages, implying lower
mortgage payments-at least until it is reset as specified in the agreement. If it is believed that
the interest rates will go down in the foreseeable future, ARM is preferable. It is imperative
to take into account the effects of an increase in interest rate. On large amounts of mortgage,
a change of even a few percentage points can raise monthly payments by a large amount.

For people who frequently shift because of job transfers, ARMS are better option since they
are fixed for the first three or five years. Few ARMs also come with low teaser rates.
Subprime mortgages are higher interest rate mortgage loans that are given to people who
have lower credit scores. Subprime was in the news recently for the higher rate of default.
Many high-risk borrowers were encouraged by mortgage companies to borrow too much
money through these loans. As time passed, many people defaulted as they were unable to
pay. These widespread defaults came to be called “subprime meltdown” or “subprime crisis”
which not only impacted taxpayers and homeowners, but also adversely hit many companies
that lost money.

Mortgages are important on a micro level too. People often take mortgages for long periods
of time, lasting, sometimes more than 30 years. For many borrowers, the monthly mortgage
payment takes up the largest share in the bills that have to pay.

Failure to repay the mortgage amount can lead to huge blunders, from losing your home to
shelling out large amount. It is important to understand about the benefits and drawbacks of
each type of loan and then take wise & informed decisions. That way, when it is time to
purchase a home, you can make a wise decision. Buying a home that will, in the future
demand a payment that is more than you can afford is not a wise decision at all. Be cautious
as not all lenders keep best interest of the borrower in mind. One must look for a secured
opinion on valuation. And it is always better to bargain and negotiate a price.

8.5 REVERSE MORTGAGE (Jeff Madura, 2007)

A reverse mortgage or home equity conversion mortgage (HECM) is a type of home loan for
older home owners that require no monthly mortgage payments. Reverse mortgage allows
accessing the home equity they have built up in their homes now, and defer payment of the
loan until they die, sell or move out of the home.

Because there are no required mortgage payments on a reverse mortgage, the interest is
added to the loan balance each month. The rising loan balance can eventually grow to exceed
the value of the home, particularly in times of declining home values or if the borrower
continue to live in the home for many years. However, the borrower (or the borrower’s
estate) is generally not required to repay any additional loan balance in excess of the value of
the home.

Want to access the equity in their home to supplement their income or have money available
for a rainy day. Some people even use a reverse mortgage to eliminate their existing
mortgage and improve their monthly cash flow.


 Does not require monthly payments from the borrower.

 Proceeds can be used to pay off debt or settle unexpected expenses.
 The money can pay off the existing mortgage.
 Funds can improve monthly cash flow.


 Fees and other closing costs can be high.

 Borrower must maintain the house and pay property taxes and homeowners insurance.
 A reverse mortgage can complicate one's wish to keep the house in the family.

8.6 EDUCATION FINANCING (SEBI lesson and Jeff Madura, 2007)

For many, it is the expense of education versus the expense of buying a home. Even to
become trained enough to be able to earn requires money.

Student loans are a type of personal loans, used to finance the expense of going to college by
students and their families. Student loans go either directly to the student or to the student’s
parents. These loans arrange money for the students' education bills and also to delay the
payments on the money borrowed until after they graduate.

The largest sources of student loans are bank student loans, which are guaranteed by the
government and have the best terms. The government, in these types of loans, acts as the co-
signer and pledges to repay the amount if the student fails to do so. By doing this, the
government encourages education. Earning a degree means likelihood to earn much more
income in life. Higher incomes mean you pay more taxes and are less likely to need other
forms of government assistance.

The Reality of Student Loans

Students often borrow too much in loans and later face difficulty repaying them upon
graduation. After graduation one has more expenses such as rent or house payments, utilities,
a car payment, and groceries etc. will eat up initial income rapidly. Student loans are a
beneficial financial aid, but must be used with caution.

Parents can also borrow to finance their children’s education with varying interest rates,
repayment schedules, and maturities. It is important to learn everything available options
before entering into these contracts with the knowledge that these will have to be repaid in
the future.

8.7 CREDIT CARD MANAGEMENT (E. Thomas Garman and Raymond Forgue,

The trap of easy access to credit—through credit cards and other sources—is attractive. In
fact, credit cards can be a useful financial tool. But easy access to credit of the sort credit
cards and certain other options offer can create serious financial problems. Your financial
future depends on approaching this type of credit thoughtfully.

Credit Cards provide people with circling open-end credit, which they can draw from
frequently upto some pre-set limit. A credit provider, such as a bank, agrees to make a
certain amount of credit available to the cardholder. The cardholder can then use this credit
as he or she needed. Simply by presenting the card at a place of business that accepts the
credit card, the cardholder can make a purchase without using any cash. He or she can

continue to use the card until the credit limit. Each month, the cardholder receives a bill
listing all of the credit card purchases. Then, he/she pays off all or some of the borrowed

A credit card can be a very valuable financial tool. However, it is also perhaps the easiest one
to misuse. Often, people find themselves in financial trouble over the easy access to credit
that credit cards afford them. Anil planned to pay for a spring break trip with a credit card—
even though he had no money to pay off the debt. Does that seem wise?

Ease of Availability and Use

Perhaps the easiest way to establish credit is to apply for a credit card. Many people receive
credit card offers through the mail almost daily. You can apply for a card at banks, through
Web sites, and in many other ways. A credit card allows you to buy products and services
wherever the card is honoured. People typically use credit cards for lower-priced
convenience purchases such as meals, gasoline, clothing, air travel, and groceries. Costly
items such as houses and cars are not typical credit card purchases.

Billing takes place monthly. At the end of each monthly billing cycle, you will receive a
statement that explains purchases you made during the period. The statement gives the total
amount borrowed. It also gives a minimum payment you must pay.

Credit Cards Offer Three Advantages

 First, you can purchase products and services without carrying a large sum of cash or
a cheque book.
 Second, as long as you pay the balance in full at the end of every billing cycle, you do
not experience any interest charges.
 Third, you receive a monthly statement that contains a list of your monthly purchases.

This list can help you keep account of spending. Some cards provide an annual statement that
assists in preparing your taxes. These statements helps you to track annual spending in
various categories and help with budgeting.

Types of Credit Cards

The most common and used brands of credit card include MasterCard, Visa, American
Express, and Discover. MasterCard, Visa, and Discover allow the financing of purchases

over time. If you buy items worth, say, 500 during billing cycle, you have the option of
paying for them all at once or over a period of several months—with added interest. In the
past, this option was unavailable from American Express, but now they offer this payment
elasticity on some cards.

Worldwide Credit Cards are recognized and accepted by most of the merchants. Merchants
accept these cards because it helps them sell goods. They know that the level of purchase in
their business would be affected if the consumer is unable to use a Credit card.

While credit cards help merchants, they also cost them money. That’s because a percentage
of purchase price is charged by the Credit card companies in return of their services. This
way, the credit card companies generate their revenues on your use of the card even if you
pay off your balance every month and never pay a nickel in interest. Most cards receive
between 2% and 4% of the purchase price. For example, if you buy Rs100 worth of goods
from a store and pay with a credit card, that store would pay the credit card company some
amount for this transaction. Thus, the store makes less on a credit card purchase than on
equivalent to cash purchase. Obviously, a large retailer such as Wal-Mart will be able to
convey a better deal with the credit card companies than a small retailer.

MasterCard and Visa credit cards are issued by many financial institutions to individuals.
Each financial institution makes its own arrangements with the credit card companies with
regard to billing and financing for individuals who opt not to pay the balance in full every

In addition to the prime issuers mentioned, there are also several retail cards available. Target
Stores Inc., Sears, and other retail stores issue cards. Oil companies such as Shell and Exxon
Mobil also issue credit cards to use at their retail outlets. In most cases, these types of cards
issued cannot be used at other retail outlets. For example, your gasoline card will not be
accepted at Wal-Mart. But Visa and MasterCard credit cards can be used at almost any retail
outlet. Whenever you use credit cards, you must become familiar with their different features
and options available. Here are some of the more common ones.

8.8 CREDIT LIMITS (E. Thomas Garman and Raymond Forgue, 2018)

Credit card companies evaluate your creditworthiness not only to limit whether to extend
credit but also to establish an individual credit limit. Recall that a credit limit is the
maximum that you can borrow at any one time. In other words, the total outstanding amount

of your debt to the credit card company cannot exceed the credit limit. So, if your credit limit
is 500,000, you can buy up to 500,000 worth of goods or services—until you make a
payment and reduce your outstanding balance to below 500,000. At that point, you can
borrow the difference between that balance and 500,000.

8.9 OVERDRAFT PROTECTION (Jeff Madura, 2007)

Overdraft protection is opted or received by the card holders from the card company, which
is a feature that allows you to “overdraw,” or to exceed your credit limit. Note that overdraft
protection is also a feature to keep a check on accounts, where it protects you in the event
you write a check for more money than you have in your account. With credit cards,
overdraft protection prevents you from trying to use your credit card and having the charge
denied because you are over your limit. This feature should be used only in emergency
situations, since an overdraft charge can be high.

The Credit card Act passed in 2009 prohibits overdraft fees from beyond the amount of the
purchase. So, for example, if you purchase a Rs2000 item that exceeds your credit limit, you
cannot be charged an overdraft fee on that purchase that is greater than Rs2000. However, if
you purchase a larger item that exceeds your limit, the overdraft charge could be substantial.
In addition, an overdraft often generates higher interest rates on any balances you are

Individuals who do not opt-in and accept overdraft protection will simply have their charge
declined because the purchase would cause them to surpass their credit limit. Some
individuals prefer overdraft protection to avoid the embarrassment of being denied a charge.
Others would prefer not to have this feature in order to avoid them from charging too much.

Annual Fee

An annual fee is charged by many credit card companies for the privilege of using their card.
People having a good credit history and use their card frequently, companies often waive the
fees. Other cards advertise no annual fees. Still others offer fee-free service for a period of
time, for example, the first year or two. All things being equal, it is better to avoid paying a

Incentives to Use the Card

To encourage people to use their credit cards some credit cards offer bonus incentives. Many
offer cash-back bonuses, airline miles, donations to various charities, or the ability to cash-in
collected points for gifts. Such incentives can be quite valuable for people who make
frequent use of their credit cards—and those who can manage the risk that comes with such

Prestige Cards

Prestige cards are often issued by financial institutions. These cards, often called platinum or
gold cards, provide additional benefits to cardholders, such as special warranties on
purchased products or insurance on travel.

8.10 GRACE PERIOD (Jeff Madura, 2007)

Credit cards typically allow a grace period in which then purchase made by you are interest
free. Legally, grace periods must be of at least 21 days from the time the statement is
“closed” or your bill is calculated and mailed. So, if the received bill is paid within the grace
period, you will not pay any interest on the borrowed amount. This is, in effect, a short-term
free line of credit.

Cash Advances

Many credit cards allow cash advances at banks or automated teller machines (ATMs). That
is, rather than just purchasing a good or service you can use your card to get cash. In
addition, cash advances do not have grace periods. So, the cost of getting cash out of his
credit card rather than using it for the individual purchases he made would certainly have
been higher.

Financing or Interest Charges

Many individuals make purchases with their credit card and then pay just a portion of the
balance for several months or years. Looking from a financial perspective, this is not a good
decision. Most credit cards charge interest rates on carried balances that range between 15%
and 22%. So, while using credit cards as a type of financing is convenient, it is also
extremely expensive. In addition, cardholders who make payments late may pay late fees and

see rates increase more than 30%. Many credit card companies make more money from some
consumers from late fees and other charges than they do from interest charges. Note also that
card companies will sometimes offer low teaser rates for a three- to six-month period to
inspire people to make charges and carry balances. When the teaser rates expire, the cards
revert to the typical high interest rates. Credit cards typically change interest rates as market
interest rates change. If interest rates increase, so do credit card rates.

All of these features—including annual fees, overdraft protection, acceptance by merchants,

interest rates, and other incentives—should be assessed when determining which card to
apply for. Be careful about accepting too many offers. Many consumers find themselves with
10 or more credit cards that they do not necessarily need or use—or, even worse, 10 cards
that they keep charged to the maximum limit.

Prepaid Cash Cards

There are some or another companies, such as Wal-Mart, which authorize you to invest in a
card that you can “load” with cash. Which denotes that, you grant money to the store—say,
Rs1000? Then, while purchasing when you have a look on your card, the price of purchase is
withdrawn from the Rs1000. You can keep using the card until its limit of Rs1000 is not
finished. Other known prepaid cards are which can only be used at some specific stores only
by the recipients. Note that such cards are like actual cash—with the same sort of possible
risk. Experts have judged that a noteworthy percentage of these cards are lost or never used.
In that case, the business issuing the card keeps the cash—and the consumer misplaces

Tips on Using Credit Cards

Credit cards are the ones which are very popular, widely available, and also risky on the
other hand. A person using a credit card should never skip the payment, use the cards for
their needs not for wants and also one most important thing that need to be taken care of, is
that one must always pay off the balance every month.

Use a Credit Card Only If You Can Cover the Bill

Credit card should only be used for convenience and not as a source of financing. In other
words, prior to buying something an individual should always be prepared for the bill at the
end of the month, so we should only make our purchase if we have enough cash to pay the
bill. The cost of borrowing money only depends upon the grace period with a credit card is
just too high. For example, let’s have glance at the following situation. What if you charged a
Rs2,000 item on your credit card that bear an 18% annual rate and you paid least payment
equivalent to 2% of the balance each month? Over the course of the next 12 months you
would make closely Rs500 in payments but minimize the balance only by Rs123.56. It is
much more prudent to save up for main purchases and make them when you have
accumulated enough cash to cover the charge.

Impose a Tight Credit Limit on Yourself

While your credit card company will develop a credit limit for you which important to abide
by, you may find it important to obtrude a stricter standard on your own spending. For
example, a credit card company may establish your maximum limit at Rs500,000. However,
you may realize your cash flows and also get aware of the fact that there is no way you could
pay a 500,000 charge every month. Your self-imposed maximum should correspond to the
amount which you can monthly repay and also very safely for a purpose to prevent carrying
high-interest balances on your card.

Pay Credit Card Bills First

If you do find yourself sustaining credit card balances, pay them off at the earliest. There is
one very important point that needs to be taken care of —credit cards usually charge between
15% and 22% interest. This is a very giant interest rate. Pay credit card balances before
paying off any other, less costly debt. It is generally a good idea to pay off credit card debt in
spite of putting money into savings or investments. These generally earn less interest than
credit card companies charge.

If you Experience Credit Card Debt Problems

It’s good to avoid credit card debt problems if you can. But nobody is perfect. Sometimes,
even people who are careful while spending money overestimate or find themselves in a tight
spot. If you find yourself with high credit card debt, there are steps you can take to deal with
the problem.

First, try to manage new circumstances. In some situations, where you can realise that you
have overextended yourself financially, you may develop the capacity to negotiate better
terms which may also benefit you. Credit card companies will often decrease interest rates or
help work out more complimentary repayment terms if you contact them and request it.
Credit card companies prefer this type of action to bankruptcy or default where they may get
little if any of their money back. Credit counselling agencies are another source of help if

you get into credit card debt. They can often help you negotiate better terms with your

As you try to lower your rates, limit your spending. Do not forget, to pay off debt you will
have to have considerable cash inflow than cash outflow. Reduce your spending to your
basic needs. Take steps to grow cash inflow. Work for more number of hours or take a
second job. You may be able to borrow money from a family member or friend.

Debt consolidation may be an option also which can be considered. Debt consolidation
means combining many small accounts into one larger account that you may be allowed to
finance at underneath rate at a bank or with another lender. This option works best when you
have resources you can commit as collateral against the loan. For example, many people take
a loan from a bank using the equity in their home as collateral. This is a so-called home
equity loan. Such a loan may allow you to pay off your credit card debt, car loan, and other
personal loans. You replace the three or four smaller loans with one larger loan. Rather than
three or four monthly payments, you make one larger payment. If the larger loan is at a lower
rate, this strategy can reduce the overall cost of your borrowing.

However, on the other hand there are some chances of risks with debt consolidation. Large
number of people pays off their credit card debt with a home equity loan—and then use their
credit card balances high again. And, of course, in any case of collapse to pay off a home
equity loan could have harmful consequences—the loss of the home.

Personal bankruptcy is the final resort. Bankruptcy is a procedure in which the courts provide
defence for a person who is unable to pay off his or her debts. The courts will help a
bankrupt individual to propose a plan to repay at least a part of his or her debts. Most
bankruptcy debt workouts require a three to five year repayment plan. Bankruptcy is
delineated to the credit bureau and listed on the person’s credit report for seven years. In
most cases, this will prevent the person from borrowing money during that period to make
certain that the interest rate will be exceedingly high. Bankruptcy is a costly option.

Other Risky Credit Arrangements

An individual wants to buy something today for which he or she does not have to keep the
cash ready. Credit cards are considered one way for people to address this dilemma. But
unfortunately not everyone is able to use a credit card or even is willing to use one. These
people can be served with wide range of options. Nevertheless, most of them are not good
ones. Among them are payday lending, tax refund loans, and pawn shops. It is indispensable
to understand the features and possible drawbacks of these expensive and unsafe credit
options. The employee will actually owe in taxes when tax returns are filed after the
conclusion of the year. If, in fact, the employer withheld too much in income tax, the
employee will get an income tax refund. Also, certain provisions in the tax code also allow
tax “credits” to low income humans who paid no taxes. They, too, may confer a check from
the government at tax time.

The typical fees for these loans are high which can be difficult for someone to afford. In fact,
in some cases, they can be equally relevant to an annual interest rate of over 100%. Another
misconception can be that some individual get their refunds to be lower than expected. In this
kind of situation, the borrower would have a debt that is larger than the refund he or she
receives. Consumers need to be careful of scams related to tax refund advance lending. In
one common scam, the people who are the victims of the scam get a call wanting them to
speed up their tax refund for a fee charged to their credit card. Armed with the victim’s credit
card number, the con artist then uses the card to the available credit limit. The victim is left
with a serious identity theft problem. And, at the end, the victim does not receive the tax
refund any earlier than he or she would have.


Organizations known as credit bureaus collect credit information about individual consumers
and keep a track of their credit history. Potential lenders, employers and others, upon request,
can access the credit report, which shows times applied for credit, whether or not bills were
paid on time, if paid credit cards in full every month or carried a balance, and payment late
fees. Any other public information about personal bankruptcies, court judgments, and
inquiries by various companies or potential employers also appears.

Individual credit reports can be accessed free of charge by people once every 12 months. The
types of records being maintained by these credit bureaus regarding personal credit history
can be accessed by providing some basic personal information.

Credit Reports

Every time you apply for credit, the potential creditor studies your report and decides
whether or not to extend additional credit. This information is also used by employers for
decisions regarding job offers, and insurance companies for determination of insurance rates.
To protect privacy, Fair Credit Reporting Act is a federal law limits the sharing of financial
information only to firms that have a legal purpose to evaluate this information.

Reviewing your credit report now and then is a good exercise to ensure its accuracy.
Companies may commit mistakes in their records which can hurt your financial life by
making into the financial lives. Examining your report can also help detect frauds that set up
fake accounts pretending to you, or someone else.

Credit History (E. Thomas Garman and Raymond Forgue, 2018)

Each person’s credit history is contained in their individual credit report. Information such
number of times credit availed, the timeliness of payments, the frequency of late payments,
etc is collected about everyone who borrows money and is used by lenders every time one
applies for credit. Each credit purchase further adds to your credit history.

Credit history can be helped or hurt in various other ways. Signing up and paying for
utilities, such as electricity, phone, water etc is a method of building up credit history. Utility
companies extend credit by allowing usage of services and then billing for them. Failing to
pay for utility bills, makes that information a part of one's credit history which affects one's
ability to get credit in the future.

Credit Score is a score used to assess your creditworthiness according to your credit history.
It is created by credit bureaus. High credit score bearers get better interest rates as they are at
a lower risk of defaulting. Over a lifetime, good credit score can save you thousands of
dollars in finance costs and interest charges.

Lenders commonly assess the credit payment history provided by one or more credit bureaus
when deciding whether to extend a personal loan. Financial institutions may rely on this
information when they decide whether to approve your credit card application, to provide
you with a car loan, or to provide you with a home loan. The credit score can also affect the
interest rate that is quoted on the loan that you request. A high score could reduce your
interest rate substantially, which may translate into savings of thousands of dollars in interest
expenses over time.

Credit scores are calculated based on a model created by Fair Isaac Corporation, and are
thus, called FICO scores. As a percentage, FICO scores are about 35% based on your credit
history, 30% based on how much of your available credit, and the rest based on other
information contained in your credit report. Any FICO score will range from 300 to 850,
with a higher score indicating better credit. Most people’s credit scores fall in the 600–800
range. In 2008, FICO modified the model slightly, and added weights to the factors.

An alternative scoring system called VantageScore was created in 2006 and has been refined
since the financial crisis. It can range from 501 to 990 and is considered better since the
scale is similar to assigning grades. Scores in the 900s are equivalent to “A” grades, 800s to
“B” grades, and so on. The VantageScore intends to measure the likelihood that the credit
shall be repaid in a timely manner. VantageScore considers the same types of characteristics
that are considered by FICO, such as credit utilization and credit history, though they weigh
the factors differently. In general, both FICO and VantageScore provide approximately the
same indication of creditworthiness. However, VantageScore is not widely used at this time.

A Review of Your Credit Report is Beneficial for the Following Reasons

1. You can make sure that the report is accurate. If there are any errors, you can contact
each of the credit bureaus to inform them of the errors.

2. A review of the report will show you the type of information that lenders or credit
card companies may consider when deciding whether to provide credit.

3. Your credit report indicates what kind of information might lower your credit rating,
so you can attempt to eliminate these deficiencies and improve your credit rating.

Identity Theft (Jeff Madura, 2007)

Identity theft happens when a person, for personal gain, uses your personal information
without your permission. For instance, someone may fraudulently use your personal
information to open a credit account at a departmental store and buy furniture in your name.
And in the event this dishonest person does not pay the bill, it is your credit score that will
suffer. In most cases, people are not even aware that this event has occurred until they
request a copy of your credit report and find out about the fake account.

Some criminals may use your private information to establish totally new identities and
engage in criminal activity using a new, fake identity. In severe cases, people's credit scores
were destroyed so much that they could no longer borrow money. Identity theft is illegal, but
also hard to detect, and is unfortunately, on a rise.

Identity Theft Tactics

1. Shoulder surfing occurs when someone in a public place overhears your

conversation or looks at you view your personal information. Be alert of someone
standing too close to you while using a computer at a public space.
Identity thieves even go to the extent of going through a person’s trash to gather
information. Credit card receipts, banking information, or even unsolicited offers for
credit cards can let someone benefit from your identity. Make sure you shred such
documents before throwing them in the trash bin.

2. Skimming is another common technique, involving simply copying someone's credit

or debit card numbers from your cards. Skimmers may be temporary employees of
businesses. Highly advanced skimmers can even attach card reading devices to ATMs
to get private information.

3. Pretexting occurs when someone improperly accesses your personal information by

pretending to be someone who requires data for some reason. The con artist may pose
as a businessperson or someone conducting a survey. When pretexting occurs online
it is known as phishing. Common phishing techniques include e-mailing prospects
asking them to verify account information.

4. Pharming which is even more complex uses e-mail viruses to redirect people from
legitimate Web sites to an official-looking fake Web site designed to fraudulently
obtain your personal information.

5. Dumpster diving occurs when the identity thief goes through your trash. The identity
thief is looking for things such as credit card receipts, which contain your credit card
number, and pre-approved credit card solicitations. They contact the credit card
company to change the address, and then obtain a card in your name. Other targets
include other discarded information that might contain your social security number,
bank account numbers, or credit card numbers.

Protection Against and Reacting to Identity Theft

Methods employed to prevent identity theft may seem time-consuming and costing money,
but prevention of the theft of your identity is worth the simple investment. The purchase of
identity theft insurance may also suffice.

If you detect a possibility of an identity theft, act quickly. Be sure to keep copies and notes
about all correspondence. Monitoring your credit report from time to time and protecting
yourself from identity theft is critical to your long-term financial health. Good credit
decisions and practices are beneficial over lifetime. Poor decisions lead to increased cost and
limit your options for credit.

Consider the Following Methods to Safeguard your Personal Information

 Check your wallet and remove anything that contains your social security number,
including your essential cards. Other items that you should not carry, unless
absolutely necessary, are your passport, birth certificate, and rarely used credit cards.
Also be sure that you are not carrying any account passwords or PINs in your wallet.
 Buy a shredder and use it. When you dispose of any out dated receipt, shred it.
 Shop online only when there is evidence of a secured Web site. An “s” at the end of
web address and/or a padlock icon indicates a secure site.
 Be suspicious of any phone callers seeking to verify or update your personal
information. If in doubt, tell the caller that you will call back.
 Protect your home computer from hackers and worms by installing a firewall and
virus protection and updating both frequently.

Monitor your Credit Report

It is important to check your credit report from time to time. Some simple mistakes could
harm your credit if left alone. Upon finding inaccurate information, you must immediately
contact the three main credit bureaus and file a dispute related to the false information. The
credit bureaus shall then contact the creditor and verify the accuracy of the information. In
the information is detected are inaccurate, they will make the required change in your credit
history. Monitor your credit carefully, since inaccurate information is common.

Education Colleges and universities provide training by way of education which leads to a
degree. This type of information comes in handy when trying to determine whether to get a
degree in something as specific like accounting or geology, or whether to pursue a broader
degree such as liberal arts. And because the completion of the degree is a person’s ability to
stick to a task and continue to learn, an accomplishment in itself, many companies employ
successful college graduates belonging to any major. At least for entry-level jobs, many
employers find these qualities as important as any particular skills.
University reputations differ significantly, and few may have a better name in the industry
for certain degrees. Some jobs necessitate that the degree is from an accredited or certified

Accreditation is an official recognition that a specific school or program meets a certain

standards. It is important to investigate the type of accreditations that a university possess
and match them with the job or career that interests you. That is, is the program accredited by
those organizations that the employers will rely upon in the future? These are specifically

vital in the field of nursing, technical areas such as automotive or mechanical, and fields of

Learn as much as is possible for you to, about the colleges that you are interested in
attending. What are the rates of graduation in those colleges? Years taken on an average to
graduate? The percentage of recent graduates who passed their certifications? Do conduct on
campus hiring? It is always useful to learn as much as possible.

Expanding your Education Graduate degrees do the job of providing additional specialized
knowledge and skills that qualify its attendees for a better job. However, there are certain
costs associated with pursuing a degree. It costs a lot of money to obtain a graduate degree.
For this reason, it is important to weigh these costs against the gains to determine whether a
graduate degree is appropriate for oneself. Individual costs of tuition, fees, books, room and
board, and the opportunity cost add up to a considerable amount of money. Opportunity cost
is the cost of the opportunity forgone by choosing its alternative. The opportunity cost for a
full-time graduate program is the loss of income from a full-time job and the loss of social
and recreational time that could potentially occur, for the time it takes to complete the
program. Is it worth it? In many cases, it will be. But it all depends upon the person.

In most cases, an advanced or graduate degree adds to one's employability. A lot of job
positions necessitate a graduate degree as the minimum qualification to apply. It is,
sometimes, useful to get a graduate degree in a field different the field of your undergraduate
degree. For example, it may prove to be useful for engineers to get a graduate business
degree as they take up management positions within their engineering firms.

Some may choose to pursue a doctoral degree. It is imperative to evaluate the university
carefully, since reputations vary substantially. If you wish to teach at the college levels, for
example, from where you earn your Ph.D. may be of importance. Some programs may have
a local or regional reputation, others may have it nationally, and still others may enjoy an
international reputation. Remember to select a program that most aligns with your personal

8.12 RETIREMENT PLANNING (Hershey, D.A., Jacobs-Lawson, J.M., McArdle, J.J.

et al. J Adult Dev (2007)

Retirement planning is when a person gets additional income after they retire. You probably
have some short- or intermediate-term savings goals. You might be saving for a car or simply

putting money aside for a house. For many of these goals, you would most likely use the
savings options, such as CDs or savings accounts. But what about long-term goals? Do you
know someone who has achieved a lifestyle you would like to have? How old are they?
When did they begin thinking about financial security? Your primary goal may be short-
term in nature, but you don’t want to neglect the future because time is your best friend when
trying to accumulate wealth. If you begin early and use the large amount of time you have,
even small but steady levels of saving can build to a large stockpile by retirement. As your
savings grow, the amount you have accumulated begins to earn far more than the amount you
contribute each month. Your money begins working for you instead of you working for your

Retirement Plans Sponsored by Employers are of Two Types (Jeff Madura, 2010)

1. Defined- Benefit Plan guarantee a specific amount of income to employees upon

retirement, based on factors such as their salary and number of years of service.

2. Defined- Contribution Plan provide guidelines on the maximum amount that can be
contributed to a retirement account. Individuals have the freedom to make decisions
about how much to invest and how to invest for their retirement.

Saving for retirement is a critical but often neglected part of a young person’s financial plan.
Fortunately, there are several investment and savings options designed to encourage and
facilitate saving for retirement.

Individual Retirement Accounts (IRAs) are a type of savings account created by the
government to encourage people to save for retirement. To make saving in an IRA attractive,
the government offers certain tax benefits that allow investors to reduce their income taxes.
And, to ensure that people use IRAs only for retirement, the government put limits on when
you can use IRA funds. You can withdraw IRA funds beginning at age 59½. If you withdraw
IRA funds prior to age 59½, you will pay a penalty equal to 10% of the money withdrawn, in
addition to income taxes on the amount withdrawn. All IRAs can include a range of different
types of investments. For example, you can have CDs, mutual funds, or both in your IRA

There Are Two Main Types of IRAs (Jeff Madura, 2007)

 Traditional IRAs and

 Roth IRAs

They differ in the type of tax benefit they provide. The key features of a traditional IRA are
that many people can make tax deductible contributions, and all earnings are tax deferred.
What does this mean? Tax deductible means that if you are eligible and contribute, say,
rs.3,000 in a given year, you can deduct rs.3,000 from your taxable income and pay no
federal tax on that amount. This feature allows you to reduce your income taxes for the year
you made the contribution. Some individuals may be able to receive a tax credit for
contributions to an IRA. A tax credit is preferable to a tax deduction since it reduces your tax
liability by the same amount as the credit.

Traditional IRAs are also tax deferred, which means that the account’s earnings, such as
from interest, are not taxed until they are withdrawn after retirement. Tax deferral helps you
in two ways-

(1) A tax-deferred account will grow in value more quickly than one earning the same
rate but in which earnings are taxed, and

(2) When you do withdraw monies, it may be at a lower tax rate because you will be
retired and most likely earning less money.

The tax-deferred benefit of traditional IRAs is available to everyone. However, certain

higher-income individuals are not allowed to deduct contributions from their taxes, and there
are limits on how much a person can contribute to a traditional IRA. The Roth IRA has the
same contribution limits as the traditional IRA, but it has unique features. Roth IRA
contributions are not tax deductible, but the earnings from an eligible account are never

Employer-Sponsored Retirement Plans are set up by the employer, and the employer will
generally make some contributions to the plan on your behalf. These plans are designed to
help you save for retirement and are often used as an incentive to attract high-quality
employees. It’s important to note that employers are not required to offer such plans.
Employer-sponsored plans come in two main forms: the defined-benefit plan and the
defined-contribution plan. There are many variations within each category. But, in both
cases, you do not pay taxes on contributions or earnings until you retire and begin making

Defined-Benefit Plans guarantee you a specific amount of income when you retire. The
benefit is often based on factors such as the number of years worked and the average salary
earned during your peak earning years. Such defined-benefit plans are popularly referred to
as pension plans. Under them, the employer makes contributions to the plan on the
employee’s behalf. The money generally goes into a large fund and professional managers
then invest and manage the fund. The employer establishes guidelines regarding the number
of years a person must work before becoming eligible to withdraw money from the fund.
Note that many of the restrictions and requirements of employer-sponsored retirement plans
are governed by federal law.
When an eligible person retires, he or she receives the agreed-to benefit from the fund. If the
retiree lives five years, he or she gets benefits for five years. If the retiree lives 25 years, he
or she receives benefits for 25 years. This process of earning eligibility for an employer
benefit is known as vesting. For example, a worker might have to work for an employer for
five years before being fully vested and eligible to withdraw full benefits.

Defined-benefit plans are less common now than in the past. This may be because people are
living longer and so employers providing these plans are assuming more financial risk. In
contrast, defined-contribution plans shift the Annuities.

Annuities are a type of financial product that guarantees annual payments to the owner for a
fixed period of time or for a person’s lifetime. The amount invested grows tax free and will
not be taxed until disbursed to the investor/retiree.

Annuities Come in Two Forms

 fixed and
 variable

With a fixed annuity, the return and ultimate payment is a guaranteed amount. With a
variable annuity, the return and ultimate payment depend on the performance of the
investments. One word of caution: Most annuities have very high fees associated with the
initial sale that goes to pay the people who sell them. Also, annuities have fees, known as
surrender charges, for early withdrawal.

In Defined-Contribution Plans, the employer contributes to the employee’s retirement

account but does not guarantee a specific retirement benefit. Such plans often offer the
employee some control over where contributions are invested. Defined-contribution plans
limit the employer’s liability to the individual. The employer agrees to make regular
contributions, but they are not bound to pay benefits for an unknown period of time. These
plans shift more of the retirement risk to the employee, since the employee is primarily
responsible for building and funding his or her own account. When an individual’s funds are
gone, the employer has no other obligation to that individual. The flexibility in investing and
the shifting of risk to the employee has made these plans extremely popular in recent years.
Tax Benefits from investing in a retirement account can be estimated by measuring the
amount of retirement savings once they are converted to cash versus the amount of savings if
you had simply made investments without a retirement account. The tax benefits arise from
deferring tax on income received from your employer until retirement and deferring tax on
income earned from your contributions until retirement. Retirement accounts are the
preferred investment in any comparison because of the tax advantages.


Fill in the Blanks

(a)___________ is the cost of money; the price paid by the borrower to acquire the right to
utilize the lender’s money and is calculated as a percentage of the amount borrowed.

(b) ___________________is a type of credit extended for a short term, usually 30 days or
less. (Non Installment Credit)

(c) A _______________is set on the basis of the income level, debt level, and overall credit
record of the person seeking this credit. (Credit limit)

(d) A ________________is an agreement that allows borrowing of money as required up to a

certain limit. (Line of credit)

(e)_____________ is a legal instrument by which the home becomes collateral for the loan.

(f) In ____________________, the interest rate remains fixed for the term of the loan,
implying that the payment will never go up or down. (Fixed Rate Mortgage)

(g) In______________________, the interest rate may go up or down over time, with the
change occurring at some preset time. (Adjustable Rate Mortgage)

(h) ___________________is opted or received by the card holders from the card company,
which is a feature that allows you to “overdraw,” or to exceed your credit limit. (Overdraft

(i) __________________collect credit information about individual consumers and keep a

track of their credit history. (credit bureaus)

(j) __________________is a score used to assess your creditworthiness according to your
credit history. (Credit score)

(k)_______________ happens when a person, for personal gain, uses your personal
information without your permission. (Identity theft)

(l) _______________occurs when someone in a public place overhears your conversation.

(Shoulder surfing)

(m)________________ is another common technique, involving simply copying someone's

credit or debit card numbers from your cards. (Skimming)

Long Answer Questions

Q1. What is meaning of credit? And also explain its advantages and disadvantages?

Q2. How to start the planning for house? And what measures should be taken into
consideration while housing financial planning.

Q3. What do understand by identity theft and what protection is available against identity

Q4. Briefly explain the key retirement planning decisions an individual must take?

Q5. What is meaning of Reverse mortgage?

Q6. Write short notes on the following:

(i) Credit card management

(ii) Credit limits
(iii) Overdraft protection
(iv) Grace period
(v) Credit Bureaus
(vi) Retirement planning
(vii) Education financing
(viii) Individual credit history and ranking


1. Madura, Jeff, Mike Casey, Sherry J. Roberts, personal financial literacy, 2010,
Retrieved from

2. Dr. S Gurusamy. (2009). capital markets, 2nd edition. Tata McGraw Hill publication.

3. Madura, Jeff (2007). Personal Finance. (ed. 3rd). Florida Atlantic

University, Pearson.

4. Madura, Jeff, Mike Casey, Sherry J. Roberts, personal financial literacy, 2010,
Retrieved from

5. M. Ranganathan and R. Madhumathi: Investment Analysis and Portfolio

Management, Pearson Education, New Delhi.

6. Chandra, Prasanna. (28th june 2012), 4th ed. Investment Analysis and Portfolio
Management, McGraw-Hill, Delhi.

7. Lawrence J. Gitman, Michael D. Joehnk, Randy Billingsley, (2010). PERSONAL

FINANCIAL PLANNING, 12E. Cengage Learning

8. MCX Stock Exchange and Ft Knowledge Management Company. (July2010).

Retrieved from
df. Published by SEBI.

9. Lessons on financial planning for young investors, publication securities Exchange

Board of India.

10. Hershey, D.A., Jacobs-Lawson, J.M., McArdle, J.J. et al. J Adult Dev (2007) 14: 26.
Psychological foundation of financial planning for retirement. Retrieved from

11. Randy Billingsley, Lawrence J. Gitman, Michael D. Joehnk, (2017). Personal

Financial Planning. 14th Edition.

12. Arthur J. Keown. (2014). Personal finance: Turning money into wealth(6th edition).
Pearson education limited.

13. E. Thomas Garman, Raymond Forgue. (2018). Personal Finance (13th edition).
Cengage learning, USA.

14. Reverse mortgage. (n.d.) Financial Glossary. (2011). Retrieved September 14 2018

Unit VI
Lesson 9



9.1 Investors Protection

9.2 Reasons for Establishment of SEBI
9.3 Main Participants
9.4 Objectives of SEBI
9.5 Function of SEBI
9.6 Organisational Structure of SEBI
9.7 Objectives of Committees
9.8 Measures taken by SEBI
9.9 Investors Education
9.10 Rights of Investors
9.11 Various types of Investors Grievances
9.12 Redressal through SCORES
9.13 Self-Assessment Questions

9.1 INVESTOR PROTECTION (Dr S Gurusamy, 2009)

The Indian Capital Market has, over the period of time, undergone rapid structural
transformation. From the year 1947 to 2017 i.e., 60 years, it has evolved itself as a dynamic
and volatile segment where characteristics like institutional build-up, technological
advancement and modernization. And after 1992, primary market turned into a major source
of funding for the corporate entities both in public and private sectors and the secondary
market has modernized itself through advanced technology and transparent trading practices.

In spite of these developments, there were so many issues related to investor’s protection
which requires immediate attention of the authorities. As we know that investors are the
pillars of capital market and hence adequate protection should be provided to them.
Investor’s protection refers to methods and measures adopted by a market regulator like
SEBI, SEC etc. with a view to safeguard the interest of investor. Investors, especially small

investors, are always bear the loss because of the variations taking place in the capital
market. As we are aware about the securities market fluctuations in the Indian capital market,
so the protection of all investors is mandatory.

One of the objectives of SEBI is to provide protection to the investors and to secure their
rights and that there is steady flow of savings into the market and to encourage the
development of and also to regulate the securities market. In the light of the above
objectives, SEBI has four main areas:

 Companies issuing securities

 Primary market intermediaries
 Secondary market intermediaries
 Investors

Investor protection is one of the most important elements of a securities market or other
financial investment institution. Investor protection goals on making sure that investors are
fully informed about their purchases, transactions, affairs of the company in which they have
invested. Guidelines for the protection of the investors have been issued by the Securities
and Exchange Board of India (Disclosure and Investor Protection) Guidelines, 2000.

Securities & Exchange Board of India (SEBI) established in 1988 to regulate the functions of
securities market. SEBI promotes orderly and healthy development in the stock market. But
it was noted that initially SEBI was unable to exercise complete control over the stock
market transactions.

It was left as a watch dog to observe the activities but was found futile in regulating and
controlling them. As a result in May 1992, SEBI was granted legal status. SEBI is a body
corporate having a independent legal existence and perpetual succession.


With the growth of stock markets, lot of violation also started such as price rigging,
unofficial premium on new issue, and delay in delivery of shares, violation of rules and
regulations of stock exchange and listing requirements. Due to these violations the customers
started losing the faith and were feeling not confident in the stock exchange. So government
of India decided to set up an agency or regulatory body known as Securities & Exchange
Board of India (SEBI).

SEBI was set up with the main purpose of keeping a check on malpractices and protect the
interest of investors. Following are the kind of problems faced by the investors, which led to
the introduction of regulatory mechanism:

1. Uncontrolled share broking the deficiency of the Indian capital market and the
resultant lack of control over the activities of brokers and jobbers. There was a time
when brokers used to control the market. This gave rise to a situation of volatile and
uncontrolled fluctuations in the prices of the securities. These situations affected the
investor’s confidence.

2. Lack of adequate instruments as compared to the capital markets in the advanced

countries, there is non-availability of sufficient number of different variety of
financial instruments. Still there is popularity of equity and preference shares and not
of any other alternatives available.

3. Insider trading menace insider trading is a threat for the Indian stock market. It is
the process where insider uses the price sensitive information for their personal
motive or benefit. Insider trading is unethical in nature. And there is law to stop this

4. Inadequate financial disclosure the market is said to be efficient only when there is
a transparency and free flow of unbiased & reliable information. The Companies Act
1956 had a number of norms requiring information disclosure about companies.

5. Price manipulation stock market operators often indulge in the price manipulative
practices to obtain higher premium. It is known as the typical characteristic of the
Indian capital market at the time of new securities at the time of fresh issue.

6. Lack of developed secondary market unfortunately, due to the lack of facilities for
active trading of the securities in the secondary market, resulted in lack of liquidity
for the scrips traded.

7. Lack of institutional support unfortunately, in India, even after the presence of

many financial institutions there is lack of support from their part. This result in
highly susceptible capital market for many insurmountable problems.

9.3 MAIN PARTICIPANTS (Dr. Vanita Tripathi, 2015)

SEBI’s main purpose was to keep a check on any manipulation and unfair trade practices and
protect the interest of investors. It was set up to meet the needs of three groups.

1. Issuers For issuers it provides a market place in which they can raise finance fairly and

2. Investors For investors it provides protection and supply of accurate and correct

3. Intermediaries For intermediaries it provides a competitive professional market.

9.4 OBJECTIVE OF SEBI (Dr S Gurusamy, 2011)

SEBI’s main objectives are to protect the interest of investors and to promote the
development of stock exchange and to regulate the activities of stock market. The objectives
of SEBI are:
 Creating a proper and conducive environment required to raise money from capital
market through the trade practices, rules & regulations, customs & relations among
 Investor protection, ensuring safety of the investments and also to protect the rights of
 Ensuring the fair practices by the issuers of securities.
 To regulate the activities of stock exchange.
 To prevent fraudulent and malpractices.
 Promotion of transparency and efficient services by brokers, merchant bankers and
other intermediaries so that they become competitive and professional.
 To regulate and develop a code of conduct for intermediaries such as brokers,
underwriters, etc.
 Education of investors so as to make them aware of their rights.
 Providing accurate, authenticate and adequate information on a regular basis.

So we can conclude that primary function of SEBI is the protection of the investors’ interest
and the healthy growth of Indian financial markets. No doubt, it is very difficult task for the
regulators to prevent the scams in the markets considering the great difficulty in regulating
and monitoring each and every segment of the financial markets.
9.5 FUNCTIONS OF SEBI (R P Rustagi, 2009 and M. Ranganatham and R

The SEBI performs functions to meet its objectives. To meet three objectives SEBI has three
important functions. These are:

1. Protective functions
2. Developmental functions
3. Regulatory functions.

1. Protective Functions

SEBI performs these functions to protect the interest of investor and provide safety of
investment. As protective functions SEBI performs following functions:

a) SEBI undertakes steps to educate investors so that they can evaluate the securities of
various companies and select the most profitable securities.

b) It Prohibits Insider Trading Any person connected with the company is known as
insider such as auditors, legal advisors, directors, promoters etc. These insiders have
price sensitive information which is not available publicly. If they use this
information to make personal profit, then it is known as insider trading. SEBI strictly
checks when insiders are buying securities of the company and takes strict action on
finding insider trading.

c) It Checks Price Rigging Price rigging refers to manipulating the prices of securities
with the main objective of inflating or discouraging the market price of securities.
SEBI forbids such practice because this can cheat and defraud the investors.

d) SEBI Prohibits Fraudulent and Unfair Trade Practices SEBI does not allow the
companies to give misleading information which is likely to induce the sale or
purchase of securities by any other person.

2. Developmental Functions

SEBI performed these functions to encourage and develop activities in stock exchange and
raise the business in stock exchange. SEBI performs following functions under
developmental categories:

a) SEBI try to focus on and encourages training of intermediaries of the securities

b) SEBI tries to encourage activities of stock exchange by adopting flexible and

adoptable approach in following way:

 SEBI has allowed internet trading through registered stock brokers.

 SEBI has made underwriting optional to reduce the cost of issue.
 Promoting and regulating self regulatory organizations.
 Even initial public offer of primary market is permitted through stock

3. Regulatory Functions

SEBI performs these functions to regulate the business in stock exchange. The following
functions are performed to regulate the activities of stock exchange:

a) SEBI has framed code of conduct and rules and regulations to regulate the working
of intermediaries such as merchant bankers, brokers, underwriters, etc.

b) These intermediaries have been brought under the regulatory purview and private
placement has been made more limited.
c) SEBI registers and regulates the working of stock brokers, sub-brokers, trustees,
merchant bankers, share transfer agents and all those who are associated with stock
exchange in any manner.

d) SEBI registers and regulates the working of collective investment schemes i.e.,
mutual funds.

e) SEBI regulates acquisitions of shares and takeover of the companies.

f) SEBI conducts inquiries and audit of stock exchanges.


SEBI is working as a corporate sector. SEBI’s activities are divided into five departments.
Each department is headed by an executive director. The head office of SEBI is in Mumbai

and it has branch office in Kolkata, Chennai and Delhi. SEBI has formed advisory
committees to deal with primary and secondary markets. Market players, investors
associations and eminent persons are part of these committees. Some of the committees are
as follows:

The G. S. Patel Committee this was the high powered committee. It was constituted in May
1984 under the chairmanship of G. S. Patel. The terms of reference were related to new
issues and listing requirements, investor protection and services, organisational structure and
management of stock exchanges, market mechanism of trading and settlement.

The Narasimham Committee in 1991, pursuing liberalized policies and structural

adjustment program, the government constituted a committee on financial sector reforms
with M. Narasimham as chairman. The committee has given recommendations on banking
reforms and restructuring of capital market regulation.

The M. J. Pherwani Committee (1991) it was set up to initiate orderly growth of the stock
market and promotes investor’s interests. The most important recommendation of the
committee was to establish a National Stock Exchange System, which was established in

The Malegam Committee (1995) the recommendations of this committee were related to
mandatory disclosure and transparency. Disclosure in prospectus related to project
expenditure and loans. Recommendations also include disclosure of technology, market,
competition etc.


1. To advise SEBI to regulate intermediaries.

2. To advise SEBI on issue of securities in primary market.
3. To advise SEBI on disclosure requirements of companies.
4. To advise for changes in legal framework and to make stock exchange more transparent.
5. To advise on matters related to regulation and development of secondary stock exchange.

Note: These committees can only advise SEBI but they cannot force SEBI to take action on
their advice.

9.8 MEASURES TAKEN BY SEBI (Dr S Gurusamy, 2011)

1. Issue of Guidelines SEBI has issued guidelines to companies. These are meant for
bringing transparency in the operations and also for avoiding exploitation of investors. SEBI
keep check on all intermediaries and see that they follow the guidelines in the right manner.
It also takes penal actions when the guidelines are not followed. These steps in turn give
protection to investors.

2. Public Interest Advertisements SEBI issues public interest advertisements to educate

investors. The information could be related to various instruments and minimum precautions
they should take before choosing an investment.

3. Investor Education SEBI tries to make investors aware of their rights. And take initiative
to educate investors through publishing of newsletters. These publications are for the
education, guidance and protection of investors.

4. Dealing with Complaints of Investors The investors can file complaints to SEBI if they
face problems relating to their investment. There are many issues for which SEBI receives
thousands of complaint. Some issues are related to non-receipt of refund orders, allotment
letters, non-receipt of dividend or interest and delays in the transfer of shares and debentures.

5. Disclosures by Companies SEBI has introduced norms for disclosure of half yearly
unaudited results of companies. It has also revised the format of prospectus to provide more
information to investors to ensure transparency.

SEBI conduct inspection, inquiries and audits of stock exchanges, intermediaries and self-
regulating organisations and takes suitable remedial measures wherever necessary. Further, it
penalizes those who undertake fraudulent and unfair trade practices.

9.9 INVESTOR’S EDUCATION (R P Rustagi, 2009)

Securities & Exchange Board of India (SEBI) established in 1988 to regulate the functions of
securities market. SEBI promotes orderly and healthy development in the stock market. It
was solely meant to protect the interest of the investors and it has stood committed to achieve
this goal. Issue of different guidelines which ensure authenticate, adequate and fair
information, is the testimony to this commitment. The Regulatory Guidelines, Rules,
Regulations and Clarifications are all directed towards the objective of bringing more

transparency in the primary and secondary market with a view to safeguard the interest of the
investors. Besides this, the investor’s education has also emerged as a crucial part of SEBI’s
efforts to protect the interest of the investors in securities market. SEBI constituted a
Working group on Investors’ Education to advise SEBI on relating to investors education. As
a part of its efforts, SEBI has introduced an information pamphlet titled “A quick Reference
Guide for Investors” for the benefits of the investors. The objective of this brochure is to
make an investor aware of

 The right he has as a shareholder,

 The responsibility of the investors,
 The risk which is assumed by investors,
 The Procedure relating to trading and transfer of securities, and
 The solutions for problems that he may encounter.

9.10 RIGHTS OF INVESTORS (R P Rustagi, 2009)

As a Shareholder, Investors Have the Following Rights

 To receive the share certificate, on allotment or transfer as the case may be.
 To receive copies of the Director’s Report, Balance Sheet and P & L Alc and the
Auditor’s Report.
 To participate and vote in General Meetings either personally or through proxies.
 To receive Dividends in due time once approved in General meetings.
 To receive all benefits like rights, bonus etc., once approved.
 To inspect the minutes books of the General Meeting and to receive copies thereof.
 To proceed against the company by way of Civil or criminal proceedings.
 To apply to Company Law Board to call or direct the Annual General Meeting.
 To apply for the winding up of the company.
 To receive the residual proceeds.

Besides the above rights which he enjoys as an individual shareholder, he also enjoys the
rights as group.

Rights as a Group

 To requisition an Extra-ordinary General Meeting.

 To apply to CLB to investigate the affairs of the company.
 To demand any resolution.
 To apply to CLB for relief in cases of oppression and/or mismanagement.

As a Debenture-Holder He Has Following Rights

 To receive interest/redemption in due time.

 To revive a copy of the trust deed on request.
 To apply for winding up the company if the company fails to pay its debts.
 To approach the debentures trustee with his grievance.

The Government of India has issued an ordinance on October 31, 1998 with an objective of
establishing a fund to be called Investors Education and Protection Fund (IEPF) to which
amounts in the unpaid dividend and unclaimed application money, matured deposits,
matured debentures and interest accrued thereon would be credited after a period of 7 years
from the date of these becoming due for payment. The fund shall be utilised for protection of
investors’ interest and to increase their awareness.


 Delay in transfer of shares

 Non-receipt of shares/dividends/rights/bonus shares
 Delay/ Non-receipts in issue of duplicate shares
 Delay/ Non-receipt of annual reports
 Delay/ Non-receipt of redemption amount of debentures
 Delay/ Non-receipt of interest on debentures
 Delay/ Non-credit of shares in the account by the broker
 Delay/ Non-payment of sale proceeds by the broker etc
 Manipulation in the accounts statements
 Unauthorized trades and unauthorized movements of shares and funds from the
clients’ accounts
 Dabba Trading/ churning etc. in clients’ accounts
 Delay/ Non-updating of clients’ information in records

Some of these complaints do not appear in case of public issues and dealings in the
dematerialised form. However, in case of physical form of securities, the complaints may
appear. Moreover, investors information centres have been set up in every recognized stock
exchange which in addition to the complaints about the security traded with them, will take
up all complaints regarding the traders affected in the exchange and the relevant members of
the exchange.

Two others avenues are always available to the investors to seek redressal of their grievances

(a) Consumer forums, and

(b) A suit in the court of law.



SEBI launched a centralized web based complaints redressal system 'SCORES' in June 2011.
The purpose of SCORES is to provide a platform for investors, whose grievances if any
pertaining to securities market, remain unresolved by the concerned listed company or
registered intermediary after a direct approach.

SCORES also provides a platform, overseen by SEBI through which the investors can
approach the concerned listed company or SEBI registered intermediary in an endeavour
towards fast redressal of grievances of investors in the securities market. However, this
should be advisable from the SEBI that investors may initially take up their grievances for
redressal with the concerned listed company or registered intermediary, because they have
designated persons/officials for handling issues relating to compliance and redressal of
investor grievances.

The Salient Features of SCORES are

i. Centralised database of investors complaints

ii. Online movement of complaints to the concerned listed company or SEBI registered
iii. Online upload of Action Taken Reports (ATRs) by the Concerned listed company or
SEBI registered intermediary
iv. Online viewing by investors of actions taken on the complaints and its current status

SEBI has issued various circulars/directions from time to time with respect to SCORES. In
order to enable the users to have an access to all the applicable circulars/directions at one
place, this Circular on SCORES consolidates the current provisions.

This Circular inter alia consolidates the following circulars/directions issued by SEBI in this
regards till date and shall come into force from the date of its issue:
i. Circular no. CIR/OIAE/2/2011 dated June 3, 2011
ii. Circular no. CIR/OIAE/1/2012 dated August 13,2012
iii. Circular no. CIR/OIAE/1/2013 dated April 17, 2013


Fill in the Blanks

(a) One of the basic objectives of the constitution of SEBI has been the
_________________(investors’ protection).

(b) Issuer, investor, _________________ are the three main participants in the securities
market. (intermediaries)

(c) SEBI launched a centralized web based complaints redressal system ___________in June
2011.( SCORES)

Long Answer Questions

Q1. What do you understand by investors’ protection? Give SEBI guidelines in this respect.

Q2. What are the objectives of the constitution of SEBI?

Q3. What do you mean by investors’ education? What are the rights and responsibilities of
an investor?

Q4. To meet three objectives SEBI has three important functions. Explain.

Q5. Investors’ protection and education, both are prerequisite for the development of an
efficient capital market. Discuss.


1. R.P. Rustagi. (2009). investment analysis and portfolio management, second edition
2. Dr. S Gurusamy. (2011). capital markets, 2nd edition. Tata McGraw Hill publication.
3. Tripathi, Vanita. (2015). “Securities Analysis & Portfolio Management”. ISBN 978-
93-5071-826-1, Taxmann Publication.
4. Madura, Jeff (2007). Personal Finance. (ed. 3rd). Florida Atlantic
University, Pearson.
5. Madura, Jeff, Mike Casey, Sherry J. Roberts, personal financial literacy, 2010,
Retrieved from
6. M. Ranganathan and R. Madhumathi: Investment Analysis and Portfolio
Management, Pearson Education, New Delhi.
7. Chandra, Prasanna. (28th june 2012), 4th ed. Investment Analysis and Portfolio
Management, McGraw-Hill, Delhi.
8. Lessons on financial planning for young investors, publication securities Exchange
Board of India. Retrieved from
df. Published by SEBI.
9. E. Thomas Garman, Raymond Forgue. (2018). Personal Finance (13th edition).
Cengage learning, USA.