Investment Concepts

Inflation refers to a continuous rise in general price level, which shrinks the value of money or purchasing power over a certain length of time. It is calculated in terms of per cent change in the value of price index consisting of a range of goods or services. An inflation rate of 8% means that the general level of prices of goods and services has increased by 8% over the previous period.

In other words, purchasing the same amount of goods and services will cost you 8% more than what it would have cost you in the previous period. Thus, Inflation can also be explained as a decline in the real value of money – a loss of purchasing power in the means of exchange, which is also the monetary unit of account.

There are several inflation measures available in India – the most commonly used are based on Consumer Price Index (CPI) and Wholesale Price Index (WPI). Within these, there are several sub-indices (e.g. CPI for Industrial Workers, CPI for Urban Non Manual Labourers, etc.) as well. These sub-indices are designed to see how price increases affect different set of people. Since WPI is available on a weekly basis, inflation based on that is the most commonly referred inflation measure in India.

Risk is defined as the uncertainty or deviation in the return expected from an asset class. This risk could be measured in terms of standard deviation of an asset class. Risk can be classified as below:

Systematic Risk

Systematic risk is defined as a risk that takes place in all the risky assets because of macro-economic factors like earthquakes, floods, war, etc. However, it cannot be eliminated through diversification.

Unsystematic Risk

Unsystematic risk is defined as a risk that is unique to a particular asset class and can be eliminated or reduced by diversifying a portfolio.

A security's return is calculated by its holding-period return: the change in price plus any income received, expressed as a percentage of the original price. An improved measure would be to take into consideration the timing of dividends or other payments, and the rates at which they are reinvested. The total return on an investment has two components: the expected return and the unexpected return. The unexpected return comes about because of unanticipated events. The risk from investing stems from the possibility of an unexpected event.

Relationship between risk and return

A simple relationship exists between risk and return – the higher the potential return, the higher the level of risk involved. Whilst everyone would like to maximize return and minimize risk and would prefer to have a return every year of approximately 15-20% with no opportunity of investments falling in value, the reality is that these investments do not exist. As a common rule, the bigger the potential investment return, the higher the investment risk and the longer the investment time horizon.

An asset class is a specific category of investment such as stocks, bonds, real estate or cash. Investing is a trade-off between risk and expected return. Depending on the risk appetite of an individual, he can choose to invest in a combination of asset classes that would optimize his returns. Some of the most common asset classes are as follows:

Cash

Cash assets comprise of near currency assets viz., T-Bills, commercial paper, money market instruments, and short-term government bonds that are liquid (i.e. they can be easily converted to hard currency at short notice).

Equity

Equity (also known as a stock or share) is a portion of the ownership of a company. A share in a corporation gives the owner of the stock a stake in the company and its profits. As the individual buys more stocks, he increases his ownership stake in the company. Stocks are generally more risky; along with providing an opportunity to earn significant returns, they also carry the risk of part or complete loss of the invested amount.

Bonds

A bond is a formal contract that obligates the borrower to repay the borrowed money with interest to the issuer of the bond. In India, the corporate bond market mainly consists of issuers of three different categories – government-owned financial institutions (FIs), government-owned public sector undertakings (PSUs) and private corporate entities.

Real Estate

Recently, investing in real estate has become increasingly popular making it a common investment vehicle. Although the real estate market has plenty of opportunities for making significant amounts of money, real estate as an asset class is not readily accessible to the retail investor. However, with the introduction of real estate mutual funds (REMF), investors across various sections of the society will be able to take advantage of the growth in this sector.

Gold

Of all precious metals, gold is the most popular as an investment. It is renowned as a hedge against inflation and has limited downside risk.

Diversification indicates building/ creating an investment portfolio that includes securities from different asset classes. It spreads risks across various financial investments, reducing the impact that poor returns from any one investment are likely to have on the overall portfolio. The prices of shares, bonds, listed property and other investments often do not rise and fall in tandem. When one type of investment is on the rise, another may be on the decline. The result is that your portfolio’s overall performance is likely to be less volatile. The objective of diversification is to reduce the risk involved in building a portfolio. Diversification reduces the risk for an investor because all investments may not move in the same direction in the same proportion at the same time.

A diversified portfolio should be constructed to reflect your personal goals and individual risk tolerance. There are many ways to diversify across several asset classes. Asset allocation is a method of strategically dividing your investment portfolio among stock, bond and cash investments to help protect your portfolio from the rise and fall in any one investment.

Diversification will help to:

Ease potential risk to overall portfolio
Improve chances for attaining consistent returns
Avoid the downside that can come from regularly readjusting your portfolio to follow current market developments

Loading...