B.Com.(Hons.

) Semester-III Commerce

Skill Enhancement Course (SEC)

Personal Finance and Planning
Reference Material - Unit I, II, IV, V

SCHOOL OF OPEN LEARNING

University of Delhi

Department of Commerce
 CONTENT

Unit I
Lesson 1 Introduction to financial planning
Lesson 2 Personal financial planning
Unit II
Lesson 3 Investment environment
Lesson 4 Risk-return relationship and portfolio management
Lesson 5 Risk aversion and profiling
Lesson 6 Concept of portfolio and diversification
Unit IV
Lesson 7 Insurance Planning
Unit V
Lesson 8 Retirement Planning

Edited by
K.B.Gupta

SCHOOL OF OPEN LEARNING

University of Delhi
5, Cavalry Lane, Delhi-110007
 Unit I
LESSON 1
INTRODUCTION TO FINANCIAL PLANNING

1. STRUCTURE
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

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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 investing.

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.

1.2 BENEFITS OF FINANCIAL PLANNING (Jeff Madura, 2007)

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.
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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 benefits:
• 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

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 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
expenses.

• 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.

1.4 COMPONENTS OF A FINANCIAL PLAN (Jeff Madura, 2007)

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

1. Budgeting and tax planning

2. Managing your liquidity
3. Financing your large purchases
4. Protecting your assets and income (insurance)

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 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:

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 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
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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.
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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.

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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.

1.5 GLOBALLY ACCEPTED SIX STEPS IN DEVELOPING FINANCIAL

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

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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

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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
expected.

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?

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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.

1.6 GENERAL PRINCIPLES OF CASH FLOW PLANNING (Jeff Madura, 2007)

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.
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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.

1.7 HOW THE COMPONENTS RELATE TO YOUR CASH FLOWS (William J. Hass
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.

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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.

1.8 GENERAL PRINCIPLES OF BUDGETING (Jeff Madura, 2007)

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.

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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
credit.

15
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

Vikaspedia)

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
16
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
Internet.

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,
17
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 costs.

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

18
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.
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(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

20
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

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(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 objectives.

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.

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1.12 LEGAL ASPECTS OF FINANCIAL PLANNING (Jeff Madura, 2007)

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
maintenance.

23
 (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
parents?

• 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.

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 (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.

25
1.13 SELF-ASSESSMENT QUESTIONS

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
liquidity?

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
important?

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?

26
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?

SUGGESTED READINGS

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 http://textarchive.ru/c-2512111-pall.html

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

https://www.slideshare.net/ebondara/financial-planning-57558492

4. Sullivan University Library. Retrieved from

https://libguides.sullivan.edu/finance/personalfinance

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

http://cbafaculty.org/personal%20Finance/LN01_Madura_3001_PF_06_LN01.pptx

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
https://www.sebi.gov.in/sebi_data/investors/financial_literacy/College%20Students.p
df. Published by SEBI.

27
11. Ray, Stephanie. (Oct19th2017). Risk Management. Retrieved from
https://www.projectmanager.com/blog/risk-management-process-steps

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

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 http://vikaspedia.in/social-welfare/financial-inclusion/financial-
literacy/seeking-advice-and-help/sources-of-advice

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

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 LESSON 2
PERSONAL FINANCIAL PLANNING
2. STRUCTURE

2.1 Introduction
2.2 Personal Financial Planning Process
2.3 Setting Personal financial goals
2.4 How Financial Planning Affects your Cash Flows
2.5 Lifecycle approach to financial planning
2.6 Components of financial plan
2.7 Developing Financial Plan
2.8 Evaluation of Tax Saving Instruments
2.9 Self-Assessment Questions

2.1 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.

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2.2 PERSONAL FINANCIAL PLANNING PROCESS

“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-worth.

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

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 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 expenses.

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
appetite
situation

Constant Mapping of
Identifying risks
monitoring Assets

Figure 1: Steps of Financial Planning

2.3 SETTING PERSONAL FINANCIAL GOALS (Investopedia, 2018)

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
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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
(mint.com). 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
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 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.

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 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
credit
Budget
cards

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

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 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.

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 Think about
Get Life
your
Insurance
dreams

Pay off student

loans

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 needed.

2.4 HOW FINANCIAL PLANNING AFFECTS YOUR CASH FLOWS (Madura, 2014)

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.

36
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
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 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.

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 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 entertainment.

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.

2.5 LIFECYCLE APPROACH TO FINANCIAL PLANNING

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.

39
 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.

2.6 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

40
 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 contingency.

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 individual.

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

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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.

2.7 DEVELOPING FINANCIAL PLAN (Madura, 2014)

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.

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 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:

43
 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 needs.

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

44
 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 as:

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 time.

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

45
 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.

2.8 EVALUATION OF TAX SAVING INSTRUMENTS (Trak.in, 2018)

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
46
 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.

2.9 SELF ASSESSMENT QUESTIONS

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
47
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.

SUGGESTED READINGS

Economic times . (2018). Six-step financial planning process . Retrieved from Economic Times:
//economictimes.indiatimes.com/articleshow/64913906.cms?utm_source=contentofintere
st&utm_medium=text&utm_campaign=cppst ..

IFCI Finacial services Ltd. (2018). Components of financial planning. Retrieved from
http://www.ifinltd.in:
http://www.ifinltd.in/OtherServices/FinancialPlanning/Components-Of-FP

Investopedia. (2018). Setting Financial Goals for Your Future. Retrieved from
www.investopedia.com: https://www.investopedia.com/articles/personal-
finance/100516/setting-financial-goals/#ixzz5MoTw2INp

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

Trak.in. (2018). top-tax-saving-instruments-for-investors. Retrieved from http://trak.in:

http://trak.in/income-tax/top-tax-saving-instruments-for-investors/

48
 Unit II
LESSON 3
INVESTMENT ENVIRONMENT
3. STRUCTURE

3.1 Investment
3.2 Speculation
3.3 Factors of Sound Investment
3.4 Investment Process
3.5 Portfolio Management
3.6 Types of Investment
3.7 Equity Shares
3.8 Bonds
3.9 Mutual Funds
3.10 Fixed Deposits
3.11 PPF
3.12 Financial Derivatives
3.13 Commodity Derivatives
3.14 Gold and Bullion
3.15 ETFs
3.16 REITs
3.17 Certificate of Deposits
3.18 Real Estate
3.19 Objectives & Rewards of Investing
3.20 Self-Assessment Questions

3.1 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
49
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.

3.2 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

Difference
Planning Longer planning horizon Short planning horizon Short planning
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

50
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

3.3 FACTORS WHICH INFLUENCE THE DECISION OF AN INVESTOR (V K

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

51
 could involve taking a higher position in assets, which may decrease in value less
rapidly than the value of the currency.

3.4 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.

52
 • 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.

3.5 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
liquid.

• 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.

3.6 TYPES OF INVESTMENT OPPORTUNITIES AVAILABLE TO AN 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
53
income. Even if your liquidity needs are considered, you may invest in these securities to
maintain a low level of risk.

3.7 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.

54
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 given.
• 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

Shares
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
55
 • 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)

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

Constant Growth Model

Po = D1/(Ke-g)
Where,
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)
Ke-br

56
Where,
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
3.8 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 risk.

57
 • 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
n
P ͇ ∑ C + M
t-1 (1+t)t (1+r)n
Where,
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

3.9 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

58
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 shareholders.

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
schemes
4. Maturity of securities Capital market schemes, money market
schemes
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.

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3.10 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
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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.

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3.11 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-taxable.

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.

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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.

3.12 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.

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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.

3.13 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
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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.

3.14 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.

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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.

3.15 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

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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
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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.

3.16 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
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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
spectrums.

3.17 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 investment.

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.

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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.

3.18 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.

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Real estate returns are extremely poor in recent times. At most of the location, we have
observed a decline in property rates.

3.19 OBJECTIVES AND REWARDS OF INVESTING (Randy Billingsley and

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.

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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.

3.20 SELF ASSESSMENT QUESTIONS

Fill in the blanks

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

characteristics.(Portfolio)

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

(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
fund).

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

termed as_________________. (Blue chip shares)

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(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
analysis.

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
investor.

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

SUGGESTED READINGS

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, PHI.
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4. Chandra, Prasanna. (28th june 2012), 4th ed. Investment Analysis and Portfolio Management,
McGraw-Hill, Delhi.
5. Bhalla V K, INVESTMENT MANAGEMENT: SECURITY ANALYSIS AND
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 lawsindia.com/Advocate
Library/Amendments/PPF_SCHEME/MAIN...
10. Nawaz, Nishad & vr, Sudindra. (2013). A study on various forms of gold investment.
Retreived from
https://www.researchgate.net/publication/303898266_A_study_on_various_forms_of_gold_i
nvestment
11. Randy Billingsley, Lawrence J. Gitman. (2017). Personal financial planning. Cengage
Learning. (14th edition)

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 LESSON 4

RISK-RETURN RELATIONSHIP AND PORTFOLIO MANAGEMENT

4. STRUCTURE

4.1 Investment Objectives

4.2 Investment Constraints
4.3 Preparation of Financial Plan
4.4 Portfolio Management
4.5 Risks vs. Returns
4.6 The Power of Compounding
4.7 Net Worth
4.8 Inflation Effects on Investments
4.9 Time Value of Money
4.10 Diversification
4.11 How not to lose money?
4.12 Tax Planning
4.13 Sources of Financial Information
4.14 Mutual Funds
4.15 Self Assessment Questions

4.1 INVESTMENT OBJECTIVES (V K Bhalla, 2009)

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
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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

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 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.
4.2 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 assets.
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.

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 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 investments.

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
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 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 overlooked.

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.

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 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.

4.3 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.

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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
lifestyle.

4.4 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.
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4.5 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
bonds
b. Moderate i.e. you are willing to take some risks and prefer investing in mutual fund
schemes.
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.

4.6 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

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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.

4.7 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.

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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.

4.8 INFLATION EFFECTS ON INVESTMENT (R. P. Rustagi, 2008)

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.

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4.9 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 borrow.

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
time.

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 diversification.

4.10 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 understand.

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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.

4.11 HOW NOT TO LOOSE MONEY? (SEBI lesson)

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

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4.12 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.

4.13 SOURCES OF FINANCIAL INFORMATION (M. Ranganatham and R.

Madhumathi)

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

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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, Yahoofinance.com, Company Annual Reports, Competitors reports,
Multex.com, Analyzeindices.com/ind (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.

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 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.

4.14 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

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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 shareholders.

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

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 3. Portfolio Equity schemes, debt schemes, balanced
schemes
4. Maturity of Securities Capital market schemes, money market
schemes
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
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 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
formula:

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

NAV0
Where,
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.
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 • 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.

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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.

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4.15 SELF ASSESSMENT QUESTIONS

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?

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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

SUGGESTED READINGS

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.

5. Bhalla V K, INVESTMENT MANAGEMENT: SECURITY ANALYSIS AND

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.

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 LESSON 5
RISK AVERSION AND PROFILING

5. STRUCTURE

5.1 Risk Profiling

5.2 Components of Risk Profiling
5.3 How to create a Risk Profile
5.4 Risk Aversion
5.5 Financial instruments and associated risks
5.6 Asset Classes
5.7 Types of Investments and Returns
5.8 Power of Compounding
5.9 Time Value of Money
5.10 Rupee Cost Averaging

5.1 RISK PROFILING

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

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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.

5.2 COMPONENTS OF RISK PROFILING

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:
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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
strategy.

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
Required

Risk
Profile

Risk Risk
Capacity Tolerance

Figure 2: Risk Profile

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5.3 HOW TO CREATE A RISK PROFILE (Davies, 2017)

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) and
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” preferences).

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.

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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.
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 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

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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.

5.4 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

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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
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 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.

5.5 FINANCIAL INSTRUMENTS AND ASSOCIATED RISKS (Islandsbank, 2018)

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
instruments.
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,
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 such as inactive market with a particular instrument, contract size and other factors that
may affect the supply and demand and market participants’ behaviour.
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

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 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 risks:

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.

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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 fund.

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

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 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:

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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.

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 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 currency.

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
transparency.

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

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 therefore considerably more vulnerable to changes in general economic developments
and/or political circumstances which entail economic consequences.

5.6 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

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 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.

5.7 TYPES OF INVESTMENTS & RETURN (Madura, 2014)

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

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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 periods.

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%

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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

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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 equation:

k=P1-P0+D1/P0

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 probabilities.

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
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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’.

Solution:

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.

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 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 securities.

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 maturity.

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 6%.

• 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.

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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

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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

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5.8 POWER OF COMPOUNDING

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).

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 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 compounding.

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.

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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

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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

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 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.

5.9 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

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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.

5.10 RUPEE COST AVERAGING

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

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suddenly redeem upon a slump. Ultimately, their average cost of investing increases and returns
fall. (Succinct fp, 2018)

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.
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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.

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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
investors.
3. It enables the investor to have a rough plan of investment in respect of commitment of
funds.
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 costs.
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.

SELF ASSESSMENT QUESTIONS

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.

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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.

SUGGESTED READINGS

Cedar Spring Software. (1998-2002). Time Value of Money. Retrieved from Get Objects:
http://www.getobjects.com/Components/Finance/TVM/concepts.html

Stepaheadia. (2014). Retrieved from Stepaheadia: http://www.stepaheadia.com/risk-profiling/

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

Finance Train. (2018). Risk Aversion of Investors and Portfolio Selection. Retrieved from
https://financetrain.com/risk-aversion-of-investors-and-portfolio-selection/

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

https://www.fincash.com/b/mutual-funds/investing-early-benefits

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

https://www.investopedia.com/terms/a/assetclasses.asp

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

https://www.investopedia.com/walkthrough/corporate-finance/3/discounted-cash-
flow/compounding.aspx

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

Islandsbank:https://www.islandsbanki.is/library/Files/Investor-Protection /financial
_instruments_and_associated_risks.pdf

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

Money Matters. (2018). Rupee cost average in Portfolio Revision. Retrieved from
Accountlearning: https://accountlearning.com/rupee-cost-average-applicability-
advantages-limitations/

Mutual Funds Sahi Hai. (2018). What is Power of Compounding. Retrieved from Mutual Funds
Sahi Hai: https://www.mutualfundssahihai.com/en/What-is-power-of-compounding

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

http://www.succinctfp.com/index.php/what-is-rupee-cost-averaging-rca/

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

Valueresearchonline:
https://www.valueresearchonline.com/story/h2_storyView.asp?str=4007

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 LESSON 6
CONCEPT OF PORTFOLIO AND DIVERSIFICATION

6. STRUCTURE

6.1 Portfolio
6.2 Building a Portfolio
6.3 Portfolio Management
6.3.1 Objectives of Portfolio Management
6.3.2 Key Elements of Portfolio Management
6.3.3 Need for Portfolio Management
6.3.4 Types of Portfolio Management
6.3.5 Who is a Portfolio Manager?
6.4 What is Diversification
6.5 How Diversification Reduces Risk
6.6 Benefits of Portfolio Diversification
6.7 Factors that Influence Diversification Benefits
6.8 Strategies for Diversifying
6.9 Asset Allocation Strategies
6.10 Strategic Asset Allocation
6.11 Tactical Asset Allocation
6.12 Approaches to portfolio analysis
6.13 Self-Assessment Questions

6.1 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 investor.

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.

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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.

6.2 BUILDING 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)

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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.

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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.

6.3 PORTFOLIO MANAGEMENT

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)

6.3.1 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.
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6.3.2 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.

6.3.3 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.

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6.3.4 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.

6.3.5 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 needs.

6.4 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

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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.

6.5 HOW DIVERSIFICATION REDUCES RISK (Investopedia, 2018)

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.

6.6 BENEFITS OF PORTFOLIO DIVERSIFICATION (Edwards, 2017)

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.

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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 each.

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
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 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.

6.7 FACTORS THAT INFLUENCE DIVERSIFICATION BENEFITS (Madura, 2014)

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 right).

• 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.

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6.8 STRATEGIES FOR DIVERSIFYING (Madura, 2014)

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
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 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 losses.

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.

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6.9 ASSET ALLOCATION STRATEGIES (Madura, 2014)

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
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 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 decline.

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.

6.10 STRATEGIC ASSET ALLOCATION (ANSPACH, 2016)

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 percentages.

• The concept is akin to a "buy and hold" strategy, rather than an active trading approach.

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 • 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.

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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.

6.11 TACTICAL ASSET ALLOCATION (THUNE, 2018)

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.

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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 ETFs.

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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.

6.12 APPROACHES TO PORTFOLIO ANALYSIS

1. Harry Markowitz’s Approach To Portfolio Analysis

Portfolio Return
N
RP = ∑ Xi Ri
i=1

Where:
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 correlated.

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)

Where:
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:
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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%

6.13 SELF ASSESSMENT QUESTIONS

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

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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 correlation:
Stocks
P Q
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

Find:
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%?

SUGGESTED READINGS
Stepaheadia. (2014). Retrieved from Stepaheadia: http://www.stepaheadia.com/risk-profiling/

ANSPACH, D. (2016, August 23). What Is Strategic Asset Allocation? Retrieved from
www.thebalance.com: https://www.thebalance.com/what-is-strategic-asset-allocation-
2388300

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

Edwards, S. (2017, 7 20). The Importance of Portfolio Diversification for Your Investments.
Retrieved from www.entrepreneur.com: https://www.entrepreneur.com/article/295560

efinancemanagement. (2018). Portfolio Management. Retrieved from efinancemanagement:

https://efinancemanagement.com/investment-decisions/portfolio-management
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Finance Train. (2018). Risk Aversion of Investors and Portfolio Selection. Retrieved from
https://financetrain.com/risk-aversion-of-investors-and-portfolio-selection/

Fincash. (2018). The Benefits Of Investing Early. Retrieved from Fincash:

https://www.fincash.com/b/mutual-funds/investing-early-benefits

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

https://www.investopedia.com/terms/a/assetclasses.asp

Investopedia. (2018). Diversification. Retrieved from Investopedia:

https://www.investopedia.com/terms/d/diversification.asp

Investopedia. (2018). Portfolio. Retrieved from investopedia:

https://www.investopedia.com/terms/p/portfolio.asp

Investopedia. (2018). Portfolio Management. Retrieved from investopedia:

https://www.investopedia.com/terms/p/portfoliomanagement.asp

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

https://www.investopedia.com/walkthrough/corporate-finance/3/discounted-cash-
flow/compounding.aspx

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

Islandsbank:https://www.islandsbanki.is/library/Files/Investor-
Protection/financial_instruments_and_associated_risks.pdf

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

Management Study Guide. (2018). Portfolio Management - Meaning and Important Concepts.
Retrieved from https://www.managementstudyguide.com/portfolio-management.html

Money Matters. (2018). Rupee cost average in Portfolio Revision. Retrieved from
Accountlearning:https://accountlearning.com/rupee-cost-average-applicability-
advantages-limitations/

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

http://www.succinctfp.com/index.php/what-is-rupee-cost-averaging-rca/

THUNE, K. (2018, April 24). What Is Tactical Asset Allocation (TAA)? Retrieved from
www.thebalance.com:https://www.thebalance.com/what-is-tactical-asset-allocation-
2466851

Value research. (2016). How to build a portfolio. Retrieved from Value research:
https://www.valueresearchonline.com/story/h2_storyview.asp?str=24603&utm_medium=
vro.in
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 Unit IV
LESSON 7

INSURANCE PLANNING

7. STRUCTURE

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
7.7.1 Types 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

7.1 INTRODUCTION

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
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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).

7.2 OBJECTIVE OF A WILL

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
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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

7.3 HOW TO CREATE A VALID WILL

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 (Simplypaisa.com,
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

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 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.

7.4 KEY POINTS RELATED TO A WILL

Following are some of the key points related to Will (Simplypaisa.com, 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 effect.

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 quarrels.

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
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 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.

7.5 TYPES OF WILL

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
witnesses.

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 • 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 Will.

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 survivor.

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.

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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.

7.6 LIVING WILL

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
coercion.
• 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.
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 • 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 proposal.

• 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 patient.
• The judicial magistrate shall visit the patient at the earliest and, after examining all aspects,
authorize the implementation of the decision of the Board

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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
treatment
• Knowing what the patient want means that doctors are more likely to give appropriate
treatment
• 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 facility.

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):

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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

161
 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 business
• If you’re preoccupied with other appointments and are unable to concentrate on a
project/task

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

7.8 NEED FOR AN INSURANCE

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 illness
• 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

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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.

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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 damage.

7.10 TYPES OF INSURANCE

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

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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 out.

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

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 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 intervals.

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 assured.

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 benefits.
• 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 assured.

7.12 TYPES OF GENERAL INSURANCE (ACKO, 2018)

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

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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 covers:
• 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 care.
• 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.
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 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:

Decide
Pay the Insurer pays for
between one or
premium liabilities for
three year
amount insured period.
insurance

Figure 3: Two-Wheeler Insurance

As with car insurance, what the insurer will pay depends on the type of insurance and what it
covers.

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
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 • 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 are:
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.

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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.

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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 expense.

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 days.

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 better.

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.

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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.
7.14 SELF ASSESSMENT QUESTIONS

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?

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SUGGESTED READINGS

ACKO. (2018). Types of Insurance. Retrieved from www.acko.com:

https://www.acko.com/articles/general-info/types-of-insurance/

Cooperators. (2018). Why do we need insurance? Retrieved from www.cooperators.ca:

https://www.cooperators.ca/en/Answer-Centre/how-does-insurance-work/why-do-we-
need-insurance.aspx

Hdfclife. (2018). Types of Life Insurance. Retrieved from www.hdfclife.com:

https://www.hdfclife.com/insurance-knowledge-centre/about-life-insurance/type-of-
insurance

Indiafillings. (2018). Types of wills in India. Retrieved from www.indiafilings.com:

https://www.indiafilings.com/learn/types-wills-india/

Legal Desk. (2018). Power of attorney. Retrieved from https://legaldesk.com:

https://legaldesk.com/power-of-attorney

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: https://www.thebetterindia.com/134058/all-you-need-to-
know-about-making-a-living-will/

Shetty, A. (2015, February 10). Money Control. Retrieved from www.moneycontrol.com:

https://www.moneycontrol.com/news/business/personal-finance/why-do-you-need-
insurance-1253771.html

Shetty, A. (2015, February 10). Why do you need Insurance? Retrieved from
www.moneycontrol.com: https://www.moneycontrol.com/news/business/personal-
finance/why-do-you-need-insurance-1253771.html

Simplypaisa.com. (2015, February 25). The procedure of making Will in India and its importance.
Retrieved from www.simplypaisa.com: http://www.simplypaisa.com/the-procedure-of-
making-will-in-india-and-its-importance/

Vaishnav, A. (2018, March 6). Why is ‘Will’ important to have a ‘Way’? Retrieved from
https://stepupmoney.com: https://stepupmoney.com/why-is-will-important-in-india/

wikipedia. (2018). Health_insurance_in_India. Retrieved from www.wikipedia.org:

https://en.wikipedia.org/wiki/Health_insurance_in_India

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 Unit V
LESSON 8
RETIREMENT PLANNING

8. STRUCTURE
8.1 Credit
8.2 Assessment of Credit
– Types, Advantages, Disadvantages
8.3 Consumer 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 money.

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
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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.

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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.
________________________________________________________________________
8.3 CONSUMER AND HOUSING FINANCE PLANNING (E. Thomas Garman and
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

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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 investments.

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

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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
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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
alternative.

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
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 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.

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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
conditions.
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
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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.

Advantages

• Does not require monthly payments from the borrower.

• Proceeds can be used to pay off debt or settle unexpected expenses.

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 • The money can pay off the existing mortgage.
• Funds can improve monthly cash flow.

Disadvantages

• 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.

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8.7 CREDIT CARD MANAGEMENT (E. Thomas Garman and Raymond Forgue, 2018)

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 money.

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.

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 • 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 month.

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
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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 carrying.

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.

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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
fee.
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 use.

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
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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 everything.

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.
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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
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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 creditors.

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.
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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.

8.11 CREDIT BUREAUS AND CREDIT SCORING (Jeff Madura, 2007)

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
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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”
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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

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 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.

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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
program.

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

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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 trade.

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
goals.

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
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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 money.

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
account.

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,
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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 taxed.

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 withdrawals.

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.
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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

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earned from your contributions until retirement. Retirement accounts are the preferred
investment in any comparison because of the tax advantages.

8.13 SELF-ASSESSMENT QUESTIONS

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. (Interest)

(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.
(Mortgage)

(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
protection)

(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)

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(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
thefts?

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

SUGGESTED READINGS

1. Madura, Jeff, Mike Casey, Sherry J. Roberts, personal financial literacy, 2010,
Retrieved from
https://www.quia.com/files/quia/users/shhstech3/PersonalFinance/Pearson_-
_Credit_Cards_and_Other_Forms_of_Credit_

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.

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4. Madura, Jeff, Mike Casey, Sherry J. Roberts, personal financial literacy, 2010,
Retrieved from http://textarchive.ru/c-2512111-pall.html

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
https://www.sebi.gov.in/sebi_data/investors/financial_literacy/College%20Students.p
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
https://doi.org/10.1007/s10804-007-9028-1.

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
from https://financial-dictionary.thefreedictionary.com/Reverse+mortgage

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