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1. Asset Classes and Subclasses


2. Inflation

Many people just assume that mutual funds are the best way to save, but like most "conventional wisdom," it's often wrong.

Conventional wisdom will tell you to put your money in a mutual fund. Well, conventional wisdom does not apply in the stock market. Today, there are more mutual funds with various schemes than there are stocks to buy from the stock indices. A mutual fund can be your worst investment decision.

There is an enormous amount of money being put into mutual funds every year. These so-called "safe" investments have been consistently under performing the markets over the years.

That's right, when the market goes up 40%, your mutual fund probably returned 25%. What happens when the market goes down? And believe us, it does go down! If the market is down 20%, your fund will probably be down 30% and you lose both ways.

If there are almost more mutual funds than there are stocks, then how do you pick a mutual fund?

Do you need a mutual fund that helps you pick a mutual fund? Sounds silly, doesn't it? Guess what, they already exist. There are mutual funds that take your money and pick different mutual funds to invest in.

With all the free information available today, you're better off picking the stocks yourself. You would save yourself a lot of money.

You can dramatically reduce your investment expenses by cautiously selecting your individual stocks, and minimizing the number of your trades. The average mutual fund has fees and expenses of over 1.00% per year for the privilege of underperforming the market. Between 85% and 95% of mutual fund managers underperform the indices, depending on who's doing the counting.

One of the big advantages of mutual funds is diversification. Your mutual fund manager pools your money with thousands of other people and builds a portfolio containing hundreds of securities representing companies in dozens of industries.

Unfortunately, too much diversification isn't good for you. You don't need to hold hundreds of securities to be properly diversified. Increasing the number of securities held does reduce your risk, but the reduction becomes negligible once the portfolio reaches 20 or 25 securities, spread across several industries.

If you need only 25 securities to be completely diversified, why is your fund manager holding 200 securities in your mutual fund?

He can't buy enough stock in the companies he likes, so he has to add second and third rate issues to remain fully invested. Even if your mutual fund manager is a bona fide genius, it's unlikely he has more than 5 or 6 good investment ideas a year. You want your mutual fund manager's best ideas, not the 200 mediocre ones.

Once a mutual fund gets too large, the manager has to buy large capitalization stocks for liquidity. Also there are restrictions on how much of any one stock they can hold.

So, how do you decide what stocks to buy?

People have many different ways to pick stocks. Some people will only look at companies which have good earnings and sound fundamentals.

Others will look at the core of the business and determine if the products or services offered is better than it's competitors or they might only look at the charts of stocks and try to determine if the stock is going higher or lower.

Many might even not look at anything and just get in and get out of stocks in matter of seconds.

Do you think that you don't have time to become an amateur securities analyst?

In such a case stock picking answer is really simple:

Just listen to equity analysts and evaluate their stock research and investment ideas in terms of company background, past performance, management views, dividend payments & risk involvement. Check your risk factor and accordingly break up your stock investments by investing in Small, Mid & Large cap stocks. 

Many people believe that buy and hold is the best strategy to employ for the long term.

However, over a period of couple of years, a person who buys 100 XYZ shares at 100 each, sees them rise to 140, sees them decline to 70, and then rise back up to 135, he is not getting an overall return as good as he thinks.

What he has lost is the opportunity cost associated with the down period of time.

However, the return over the same period would have been much greater, if the investor had sold the securities and then bought them back at a lower price.

This works whether the investor takes the cash proceeds from the sale and puts them to work in a savings account, or any other investment.

Of course, the overall return will vary depending on the alternative investment and the prices at which the transactions are executed.

The reason for the return being greater is because in the middle years the investor did not suffer the drawdown he did in the buy and hold example. And he was able to purchase more than 100 shares the next time he bought XYZ.

Instead of the drawdown he received an extra positive return, because he had the cash available when XYZ did turn around and begin to climb back up.

Therefore, he was able to invest the entire proceeds in more than the original 100 shares.

In real life, the investor would not sell exactly at the top and he would not buy exactly at the bottom. He would sell below the top and buy above the bottom.

Nevertheless, the return is still superior to the buy and hold strategy.

Before you can begin to build a successful investment portfolio, you should understand the basic elements of investing and how they can affect the potential value of your investments over the years.

When you invest, there is no guarantee that you will end up with more money when you withdraw your investment than you put in to begin with, and that's a very scary prospect.

Loss of value in your investment is what is considered risk in investing.

Even so, the opportunity for investment growth that is possible through investments far exceeds that concern for most investors.

At the cornerstone of investing is the basic principal that the greater the risk you take, the greater the potential reward.

You get what you pay for and you get paid a higher return only when you're willing to accept more volatility. Risk then, refers to the volatility.

Volatility is the up and down activity in the markets and individual issues that occurs constantly over time. This volatility can be caused by a number of factors such as interest rate changes, inflation or general economic conditions.

It is this variability, uncertainty and potential for loss, that causes investors to worry. We all fear the possibility that a stock or bond we invest in will fall substantially. But it is this very volatility in stocks, bonds and their markets that is the exact reason that you can expect to earn a higher long-term return from these investments than you can from CDs and savings accounts.

Different types of investments have different levels of volatility or potential price changes, and those with the greater chance of losing value are also the investments that can produce the greater returns for you over time.

So risk has two sides:

A. It causes the value of your investments to fluctuate,

B. It is precisely the reason you can expect to earn higher returns.

You might find it helpful to always remember that all financial investments will fluctuate.

There are very few perfectly "safe havens" and those simply don't pay enough to beat inflation over the long run.

Investing in stocks is just one part of your financial life. Before you begin a program of investing in stocks, you should get your financial life in order. Here are steps you should complete before beginning a program to invest in stocks:

Emergency Funds

Every household needs an emergency fund to see them through financial disasters, such as losing a job or a major illness.

Many financial experts say a six-month cash reserve is the minimum. The fund should be sufficient to pay all of your major bills (food, housing, medical and so on) for six months. If the problem may take longer than six months to resolve, the emergency fund will buy you some time to make adjustments in your lifestyle (less expensive housing, cars and so on).

The fund should be perfectly safe from loss, which means bank CDs or other secured funds - absolutely none of your emergency fund should be in the stock market (mutual funds or individual stocks).

Make Your Wishes

Every family should have a will, especially if you have children or other dependents. In addition, if you own real estate or valuable assets, a will can clear any confusion. Estate laws vary from state to state, so it is important to connect with a professional who can prepare your will appropriately. Not only do you need to let your survivors know your wishes, but also a well-prepared will can spare them additional financial burdens and costly legal proceedings.

Retirement Planning

Retirement planning is not something you should put off until later in life. Start with your first job as an adult and when the time comes, you'll be much better prepared for the financial needs of retirement.
However, no matter your age, retirement planning is an important part of putting your finances in order.
Stocks will figure into your retirement plans, but there are some beginning steps. If your employer offers a retirement plan, that is the place to start. If you do not have access to an employer-sponsored program, look into the other options such as annuities.

Funding a retirement program should come before investing in stocks outside of such a program.

Short Term Financial Goals

Short-term financial goals are those you hope to accomplish in five or fewer years, such as saving for a down payment on a house, new car and so on. The stock market is not the right place to save for short-term goals.

Protect Your Assets

Insurance protects you from catastrophic losses, whether it's your house, your income or your life.
It doesn't make sense to work hard accumulating assets only to lose them all in a disaster.

Property insurance, including home and vehicles; health insurance, life insurance and disability insurance all protect you from their respective disasters.

Investing in stocks is a risky business. There are some risks you have some control over and others that you can only guard against.

Thoughtful investment selections that meet your goals and risk profile keep individual stock and bond risks at an acceptable level.

However, other risks are inherent to investing you have no control over. Most of these risks affect the market or the economy and require investors to adjust portfolios or ride out the storm.

Here are four major types of risks that investors face and some strategies, where appropriate for dealing with the problems caused by these market and economic shifts.

Economic Risks

One of the most obvious risks of investing is that the economy can go bad. Following the market bust in 2000 and the terrorists’ attacks in 2001, the economy settled into a sour spell.

A combination of factors saw the market indexes lose significant percentages. It took years to return to same levels and later moved northward only to have the bottom fall out again in 2008-09.

For young investors, the best strategy is often to just hunker down and ride out these downturns. If you can increase your position in good solid companies, these troughs are often good times to do so.

Foreign stocks can be a bright spot when the domestic market is in the dumps if you do your homework. Thanks to globalization, some Indian companies earn a majority of their profits overseas.

However, in collapses like the 2008-09 disaster, there may be no truly safe places to turn.

Older investors are in a tighter bind. If you are in or near retirement, a major downturn in stocks can be devastating if you haven’t shifted significant assets to bonds or fixed income securities.

Inflation

Inflation is the tax on everyone. It destroys value and creates recessions.

Although we believe inflation is under our control, the cure of higher interest rates may at some point be as bad as the problem. With the massive government borrowing to fund the stimulus packages, it is only a matter of time before inflation returns.

Investors historically have retreated to “hard assets” such as real estate and precious metals, especially gold, in times of inflation.

Inflation hurts investors on fixed incomes the most, since it erodes the value of their income stream. Stocks are the best protection against inflation since companies have the ability to adjust prices to the rate of inflation.

A global recession may mean stocks will struggle for a protracted amount of time before the economy is strong enough to bear higher prices.

It is not a perfect solution, but that is why even retired investors should maintain some of their assets in stocks.

Market Value Risk

Market value risk refers to what happens when the market turns against or ignores your investment.

This happens when the market goes off chasing the “next hot thing” and leaves many good, but unexciting companies behind.

It also happens when the market collapses - good stocks as well as bad stocks suffer as investors stampede out of the market.

Some investors find this a good thing and view it as an opportunity to load up on great stocks at a time when the market isn’t bidding down the price.

On the other hand, it doesn’t advance your cause to watch your investment flat-line month after month while other parts of the market are going up.

The lesson is don’t get caught with all you investments in one sector of the economy. By spreading your investments across several sectors, you have a better chance of participating in growth of some of your stocks at any one time.

Conservative Investors 

There is nothing wrong with being a conservative or careful investor. However, if you never take any risk it may be difficult to reach your financial goals.

You may have to finance 15 to 20 years of retirement after crossing age of 58 or 60. Keeping it all in savings instruments may not get the job done.

Investor with a long-term horizon should not be worried by volatile market movements and hold on to their positions. The current market correction has given a good opportunity for investors looking at building an equity portfolio.

Below are some significant aspects of building and managing an equity portfolio in these conditions:

Risk & Returns

It is very important to set realistic expectations from your equity investments. An investor's expectations of unrealistically high returns from the stock markets force him/her to take some irrational decisions where he/she will end up losing his/her hard-earned money.

It is important for you to understand your risk profile which depends on many individual factors like age, financial background, earning visibility and stability and family background. This also helps in taking decisions on picking the right set of stocks.

Equity investments should be a part of the total investment portfolio. You should also look at other instruments such as life insurance cover, medical insurance cover, investments in tax-saving instruments etc, apart from maintaining sufficient liquidity.

Picking Stocks

In the equity markets, stocks are categorised into sectors based on their business focus and industry. It is advisable to identify sectors whose outlook is good in the current market conditions. Look at diversification in terms of identifying more than one sector, and within a sector, selecting more than one stock to invest in.

An ideal equity portfolio will have 10-12 carefully selected stocks.

Do evaluate your equity portfolio on regular time intervals, this will help you to know whether stocks in your portfolio are meeting your expectations as compared to peers in the same sector in terms of QonQ as well as YonY growth, expansion plans, dividend payouts etc.

Stock Analysis

An analysis is very important before investing in any stock. This includes past performance of the stock with respect to market indices, outlook of the sector , management guidelines for the future on business/earnings visibility etc. An analysis is recommended even more for investors who are new in the markets and mostly rely on tips.

Analysis and questioning helps in increasing your understanding of stocks, and taking the right decisions based on your investment objectives and risk profile.

Stock Tips & Recommendations

Many investors rely on tips from analysts, stock brokers, and the media. Try to understand the basis of these recommendations rather than just following the advice. Discuss with other investors to identify stocks to invest in. This also helps in building knowledge about the market as well as stocks.

Due to the dynamic nature of the stock markets, it is very difficult for an individual to track and react to significant developments. Investors can share their views with others in the same community, various financial websites with discussion forums is a good platform to learn through interaction and be attentive to many significant market developments.

You probably know it is not a smart decision to put all of your investments in a single stock.

Diversifying your stock portfolio is a smart way to reduce - but not eliminate - risk. Diversification spreads your investments so no one piece will be deadly to your portfolio if it fails.

But, what is the best way to diversify?

You should spread your stock investments in the following ways:

1. Own big, middle and small companies as measured by market capitalization. The more conservative your strategy is, the larger percentage of big companies.
2. A more aggressive strategy will favor middle and small companies, since they offer the most opportunity for growth (or failure).
3. Own companies in different industry sectors - some manufacturing, some financial, some telecom and so on.
4. Mix up growth and value stocks. If you are more risk oriented, favor growth over value.
5. Add a small percentage of foreign stocks (usually no more than 5-10 percent).  
6. You can probably do this with 8 to 12 individual stocks. If you are concerned about picking foreign stocks, buy a good low-fee mutual fund or an Exchange Trade Fund. 

There are two other components you need to consider in diversifying your total portfolio:

• Bonds should be in all but the youngest investors portfolio. Subtract your age from 100 and that's a good place to start. The answer is how much you should have in stocks. 
• Cash is always good. When interest rates are low, cash may not provide much of a return, however some part of your total portfolio should be in cash (money market funds, short-term Treasury issues, bank CDs, for example).

If you want to take diversification a step further, add in hard assets such as precious metals or real estate.

There are no hard and fast rules on diversification, but these guidelines will get you started.

Make adjustments based on your investment goals and tolerance for risk. Once you find a mixture you like, stick with it. That means at least once a year you should rebalance your portfolio if needed.

We’ve all heard about the value of diversification in reducing risk in our portfolio, but be sure you understand that there are two types of diversification.

The purpose of diversification is to reduce volatility and improve overall performance. It works if you do diversification correctly.

The first type of diversification is the one most commonly understood as “don’t put all you eggs in one basket.”

This simply means don’t just own one or two stocks. One common way people get in trouble is owning too much of their employer’s stocks.

You may get a good deal on company stock and load up in your retirement fund and buy more for your investment fund because you believe in your company.

It may even seem disloyal not to buy lots of company stock. However, it is not in your best interest if most or your entire portfolio in your company’s stock.

To be truly diversified in your stock selection, you need to own stocks in different industries and in different size companies.

You want your investments spread over large, medium and small companies in a variety of industries. It is especially important to watch the relationship between the stocks so they are not all affected by the same economic factors.

For example, if all of the stocks you owned were extra sensitive to interest rates, then you would not be diversified. The stocks would move in correlation with the interest rates and each other.

Stocks that have a low degree of correlation don’t move as one unit and therefore are less likely to react the same way to bad economic news.

The lesson here for investors is that if a sector of the market is really hot, avoid the temptation to dump “all your eggs into one basket.” However, you should also be aware of those market or economic influences that may adversely affect a group of your stocks.

Don’t put all your eggs in one basket and don’t put all you baskets in the same wagon.

Another type of Diversification:

(Another type of diversification involves the other parts of your portfolio)

If you tie up all of your investments in stocks, no matter how uncorrelated, you are still not diversified in the sense of reducing risk and improving performance.

You need to also spread your investments over different asset classes such as bonds, cash, real estate, precious metals and other alternative investments.

Averaging down is a strategy to lower your average cost in a stock that has dropped in price. Is this a good idea or throwing good money after bad?

The answer depends on several factors. First, let us describe how it works. You buy 500 shares at Rs50 per share, but the stock drops to Rs46 per share. You then buy another 500 shares at Rs46 per share, which lowers your average price to Rs48 per share.

Admittedly, this is a simple example, but you get the idea.

Good Strategy or Bad?

Now, is this a good strategy or not? If the stock rebounds to Rs60 per share, then it was a great strategy. However, if the stock continues falling, you have to decide to keep averaging down or bail out and take a loss.
Which brings us back to the question, is averaging down a good strategy or not? Before we can answer that question, we need to decide if we are investing in a stock or a company. The distinction is very important.

Investing in Stock: If you are investing in a stock, you look for buy and sell signals based on a number of indicators. Your goal is to make money on the trade and you have no real interest in the underlying company other than how it might be affected by market, news or economic changes.
In most cases, you don’t know enough about the underlying company to determine if a drop in price is temporary or a reflection of a serious problem. Your best course of action when investing in a stock (as opposed to a company) is to cut your losses at no more than 7%. When the stock drops that much, sell and move on to the next deal.

Investing in a Company: If you are investing in a company (as opposed to a stock), you have done your homework and know what’s going on within the firm and its industry. You should know if a drop in the stock’s price is temporary or sign of trouble.
If you truly believe in the company, averaging down may make sense if you want to increase your holdings in the company. Accumulating more stock at a lower price makes sense if you plan to hold it for a long period.

This is not a strategy you should employ lightly. If there is a heavy volume of selling against the company, you may want to ask yourself if they know something you don’t. The “they” is this case will almost certainly be mutual funds and institutional investors.

Swimming against the current can sometimes prove profitable, but it can also get you swept over the waterfall.

Hence, if you’re playing stocks, averaging down probably doesn’t make any sense. Take a small loss before it becomes a big loss and move on to the next trade.

If you invest in companies, averaging down may make sense if you want to accumulate more shares and are convinced the company is fundamentally sound.

Like the fabled tortoise that beat the hare in the race, the investor who stays in for the long term is more likely to achieve his or her goals than the investor who chases “hot tips” for quick profits in the stock market.

Time is an investor’s best friend (or worst enemy if you wait too long) because it gives compounding time to work its magic. Compounding is the mathematical process where interest on your money in turn earns interest and is added to your principal.

Consider the following four investors ages 25 – 55. Each invests Rs 2,000 per year and earns 8%.

At age 65:

The investor who started at age 25 has over Rs. 585,000

The investor who started at age 35 has just Rs. 250,000

The investor who started at age 45 has just Rs. 98,800

The investor who started at age 55 has just Rs. 30,700

The results are quite dramatic and, as you might expect, the youngest investor comes out the best. However, look at the difference starting 10 years sooner can make. The fewer years invested the more dramatic the difference with the next youngest age. The investor who starts at age 45 still earns over three times as much as the investor who starts at age 55. Of course, part of the difference is the 45-year-old investor has 10 years (Rs. 20,000) more to invest, but the rest of the difference is the power of compounding.

This may not be the most “real life” example, since we can’t go back to age 25 and start over. Let’s look at the power of long-term investing from a different goal. What will it take for each of these investors to accumulate Rs 750,000 at age 65, assuming they all earn 8% and ignoring inflation and taxes?

The investor who started at age 25 needs to invest Rs 213 per month

The investor who started at age 35 needs to invest Rs 500 per month

The investor who started at age 45 needs to invest Rs 1,650 per month

The investor who started at age 55 needs to invest Rs 4,072 per month

While all four investors reach the goal of Rs 750,000, it is obvious that the younger investors get a lot more “heavy lifting” from their investments. The lesson is clear: The earlier you start the less you have to invest to reach your goal.

Problems & Corrections

The examples above describe the mathematical advantage of starting early, however they don’t represent a “real world” situation. It is highly unlikely that you could achieve a constant return of 8% over a long period. The reality is there will be times when your investments earn less and other times when you will lose money. There may also be times when you will earn more.

The investor with a long- term perspective can also correct for mistakes along the way. For example, that stock you thought was going to soar like an eagle turned out to be a turkey. If you have a long-term perspective, you can change investments that aren’t working for other alternatives. However, if you will need the money from your investment in the near future (fewer than 5-7 years), a mistaken investment can create real problems in meeting your goals.

Long-term investors, especially those who invest in a diversified portfolio, can ride out down markets like the one that began in March of 2000 without dramatically affecting his or her ability to reach their goals.

However, for the investor just starting out at age 55, a market downturn can be disastrous. There is no room for error with only 10 years left before retirement at age 65. The reality of investing is that the market will go up and the market will go down. Investors that begin early and stay in the market have a much better chance of riding out the bad times and capitalizing on the periods when the market is rising.