Basics of Personal Finance Course – Week 2 of 4 | Financial Planning Demystified

Welcome to Week 2 of the 1-Month course “Basics of Personal Finance”.

Last week, we learnt about Incomes Tax. This week, let’s focus on Investments.

What are Stocks / Shares / Equities?

Shares represent an ownership interest in the company. This means that if you own shares in a company, you own a part of it.

When a company is incorporated (or formed), it needs capital (or money) for buying fixed assets like plant, machinery and offices, and for its day-to-day operation. Various people, called the company’s promoters, contribute funds for this. These people, in turn, are issued shares or stock in the company. The number of shares issued is proportional to the funds contributed by them.

A company may decide to go public, in which case, its shares are traded on the stock markets. To become publicly traded, the company has to come out with an Initial Public Offering (IPO), in which the shares are issued to the general public and institutions in return for their funds.

Your ownership interest in the company is proportional to the number of shares held by you. For example, if a company has issued a total of 100 shares, and you own 1 share of this company, you are 1/100th owner of the company. In other words, you own 1% of the company.

What should be the philosophy behind stock investment?

We all know about volatility of the stock markets. One day, the market would move up by a couple of percentage points, and on the next day, it would fall!

Does this mean that stock markets are unpredictable? Well, in the short term, yes. No one can predict where the market would be the next day or week.

But we can predict where the market would be after a couple of years, and with a fair amount of accuracy.

Most companies make a profit, and this profit, expressed per share, is its Earning Per Share or EPS. When people invest in a company, they are willing to pay a certain multiple of this EPS as the price. This multiple is called the PE Ratio.

Now, in general, companies grow over years. Their sales grow, and their profits grow too. (At the least, we should consider only those companies for investment that are growing, or have a potential to grow)

This means that their EPS would also grow over years. Now, even if investors are willing to pay the same PE multiple for the company, the price of the stock would increase because its EPS has increased.

Thus, a company’s stock price would naturally, and certainly, go up in the long run by virtue of growth in its profit. And therefore, investment in stocks should always be for the long term.

Even from income tax point of view, long term investment in stocks presents a favourable picture – long term capital gains from stocks is totally exempt from income tax!

What are Mutual Funds (MFs)

A mutual fund pools money from various investors, and invests it collectively. Even small investors can invest in an MF, as its corpus is divided into small parts called Units.

Mutual funds can invest in stocks, debt securities, or any combination of these.

Why should you invest in stocks using mutual funds?

MFs have experienced fund managers, having a good understanding of stock markets.
MFs hire researchers, who have an in-depth knowledge of various industries. They also understand various valuation principles well.
These experts work full time on researching companies, and are therefore able to better identify good companies.
MF researchers often talk directly to the management of the companies, so they get a better insight into the company’s strategies.
Mutual Funds collect money from many investors, and invest collectively on their behalf. This obviously results in larger transaction volumes, which in turn results in lower percentage transaction costs.
MFs manage very large sums of money, as they collect small amounts from many investors. This money is invested on many good companies. This means that if you invest in MFs, you can diversify very well even with small amounts.
Since MFs are managed by fund managers whose full time job is to manage money, they can react to any sudden developments in a timely manner.

Analysis of Your Current Mutual Fund (MF) Portfolio

Get accurate buy / hold / sell recommendationfor the MF schemes you hold based on their market performance and potential performance
Get names of MF schemes you should be investing in (if the recommendation for any of your schemes is “sell”)
Get your MF portfolio judged for concentration risk (too much investment in similar schemes)

Get your MF portfolio analyzed by an expert now – get better performance out of your portfolio with minimal effort on your part!

What is Real Estate?

By real estate, we refer to various fixed assets. It can be divided into three classes:

Residential Property: It includes flats, apartments, bungalows and row houses
Commercial Property: It includes shops, offices and godowns
Land: It includes farmhouse plots, industrial plots, and agricultural and non-agricultural land.

Real Estate Investment

Usually, residential and commercial property is given out on rent, so that you get a recurring rental yield over and above the capital appreciation in the price of the property.

Land is usually held for a long term, and the only purpose of an investment in land is to get capital appreciation.

Please remember that buying a property for your own use doesn’t count as real estate investment.

Characteristics of Real Estate Investments

Large Investment Needed

Investment in real estate requires a very large corpus. Even a small apartment in a small city doesn’t cost less than Rs. 10 Lakhs these days. Thus, you need a lot of money to invest even in a single property. Therefore, direct real estate investment is not for small investors.

Illiquid Investment

The investment in real estate is illiquid – you can’t sell it in a short time in case you need the money, or in case you need to book profit. Stocks and mutual funds can be bought and sold in an instant on the stock exchanges. Compared to this, there is no such ready marketplace for real estate.

Price Discovery

The lack of a proper marketplace for property also means that price discovery is that much more difficult. The only way to find out the price is to enquire in the market and find out the prevailing rate! At times, you would get rates of deals that have happened 4-5 months back, and you would have to arrive at a proper rate on your own.

Legal Issues

It is very important to verify the title of the property – this means that you need to ensure that the seller is indeed the owner of the property, and has the right to sell it. You also need to ensure that the property is not mortgaged to a bank. You should also duly register the sale deed. Failure to take care of these things can result in legal issues at a later stage.

Why should you invest in Gold?

Negative correlation with other asset classes

Gold has strange price movements – when the price of everything else (like oil, real estate and stocks) is rising, the price of gold is usually subdued. But when the price of other assets is going down, the price of gold strengthens!

This is because gold is seen as the safest investment – even safer than investing in government backed securities! Therefore, when the price of other assets is going down, people start investing in gold for safety.

Hedge against downturns

When there is a downturn, price of all other assets decreases, as people lose faith in the future of the economy. But since gold is safer even compared to government bonds, people start buying gold as a hedge. And due to this reason, the price of gold increases in the time of economic slowdowns.

Therefore, if you have gold in your portfolio, you would be hedged against economic slowdowns to that extent.

Hedge against inflation

On an average, Gold beats inflation by a small margin over the long term. Gold has maintained its purchasing power over several millenniums!

If you have gold investments, you would lower your overall returns during the times of economic booms, but at the same time, you would preserve your returns in times of economic slowdowns – that’s the tradeoff we have to make!

Other articles that you would like to read:

I guess that’s enough information for you to go over in a week! Next week, we would discuss various investments. Till then, good bye…

With regards,
Raag Vamdatt.