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Investments

1.1  What is investment? Saving vs investment

• A household's income and spending seldom match: in some life stages it earns more than it consumes, in others less, so it either borrows or builds a surplus. The surplus can be kept idle or handed to someone who needs funds, on condition that more is returned later; that increment is the return for postponing consumption.
• Saving = money earned − money spent. Investment = committing those savings for a specific period in the expectation of getting back a larger amount, i.e. putting savings to work to earn a return.
• Savers keep money in liquid, short-term deposits or securities for short-term goals. Investors commit funds to real assets, stocks, bonds and other longer-term, less liquid holdings for goals such as a retirement corpus or a child's college costs. Hence every investor is a saver, but a saver need not be an investor.
• Financial assets (shares, debentures, bank deposits, PPF, mutual fund units) offer liquidity, flexibility, convenience, easy upkeep and the ability to invest small amounts often. Most are held for income, though equity-oriented holdings are kept mainly for long-term growth.
• Real (physical) assets include gold, diamonds, other precious metals and real estate.

1.2  Investment versus speculation

• The two are closely intertwined in practice. They can be distinguished on two criteria: time horizon and the decision-making process.
• Time horizon alone is a weak test. Transactions occur over every horizon from fractions of a second to perpetuity, so calling all short-term activity speculation and all long-term ownership investment is not appropriate.
• The stronger test is process. An investor first works out an asset's intrinsic value and buys only when that value is above the market price. A speculator ignores value, acts on conjecture without firm evidence and chases profit with little regard for risk.
• Exam trap: speculation does not always lead to higher returns; profit is simply its main motive.

1.3  Investment objectives

• Investment objectives are the investor's goals expressed in terms of risk, return and liquidity preferences. Goals stated only as return (e.g. wanting wealth to double within a year) lead to unsuitable asset allocation and excessive risk-taking.
• Principle: risk leads return, not the reverse. So the investor's risk appetite, meaning both willingness and ability to bear risk, must be analysed before any target return is discussed.
• The return objective can be reduced to four broad types, summarised below.

1.4  Estimating the required rate of return

• An investor who commits rupees for a period expects three components: (a) the pure time value of money for postponing consumption, (b) compensation for expected inflation over the period and (c) a risk premium for uncertainty about future payments.
• Pure rate of interest (real risk-free rate) = return demanded when there is no inflation and no uncertainty. Giving up ₹1,000 now for a certain ₹1,020 later implies (1,020 − 1,000) ÷ 1,000 = 2%. It is set by subjective factors (the desire for current consumption) interacting with objective ones (available investment opportunities, driven by the economy's real growth rate).
• Time value of money: ₹100 invested at a risk-free 5% grows to ₹105 in a year (future value); a certain ₹105 due in a year is worth ₹105 ÷ 1.05 = ₹100 today (present value). FV = PV × (1 + r)^n and PV = FV ÷ (1 + r)^n, so future value depends on both the rate and the time period.
• Nominal risk-free rate = real risk-free rate adjusted for expected inflation. Exact formula: NRR = (1 + real rate) × (1 + expected inflation) − 1; with a 2% real rate and 6% inflation, NRR = (1.02 × 1.06) − 1 = 8.12%. For small values the additive shortcut applies: nominal ≈ real + inflation (2% + 6% = 8%).
• Required rate of return = nominal risk-free rate + risk premium. It is the minimum return the investor will accept. It is not a guaranteed or assured return, and it is distinct from both expected (forecast) return and realised return.
• Risk premium = extra return over the risk-free rate demanded when the amount or timing of cash flows is uncertain. Government securities (with some caveats) are the usual risk-free benchmark. Higher risk → higher risk premium.
• Risk and return are positively related: required return rises as expected volatility rises. The relationship is non-linear (return does not rise in proportion to each unit of risk) and differs between individuals according to their risk aversion.

1.5  Types of risks in investments

• Risk = the possibility that actual returns differ from expected returns. Statistically it is the dispersion of returns around the average expected return, measured by standard deviation.
• Currency rule: for someone holding foreign-currency assets, a weaker home currency increases returns and a stronger home currency reduces them.
• Liquidity risk affects both equity and debt markets. It limits portfolio flexibility, because when buyers are scarce an exit may only be possible at a lower price.
• Political vs geopolitical: political risk comes from government action or instability within a country; geopolitical risk comes from conflict and tension between countries. Both are commonly mitigated by global diversification.

1.6  Types of investments

• Financial investments (equity, bonds, etc.) are claims on future cash flows; non-financial or real investments include real estate, gold and commodities. The term 'securities' usually covers transferable instruments such as equity, bonds and derivatives.
• Equity: ownership stake with capital appreciation and dividends. Historically it has given the highest long-run returns, with higher volatility. Diversifying across sectors, geographies and market caps limits damage from any single stock. Stocks are analysed through fundamental analysis (financials, competitive position, management, growth), and periodically realigning the portfolio to market conditions and risk tolerance is called rebalancing.
• Fixed income: regular interest (coupons) plus return of principal at maturity, e.g. government, corporate and municipal bonds and T-bills. Pluses: predictable income, capital preservation if held to maturity without default, and lower volatility than equity. Government bonds are low-risk because of sovereign backing; corporate bonds pay more for higher credit risk. Risks: interest rate risk (prices fall when rates rise), credit risk and inflation risk.
• Soft commodities (corn, wheat, soybean, soybean oil, sugar) are perishable and highly volatile. Their prices depend on business cycles and weather, they have low correlation with stocks and bonds (a diversifier), and exposure is usually via forwards or futures.
• Hard commodities (gold, silver, oil, copper, aluminium) are priced by global demand and supply. Gold is a 'safe haven' and an inflation hedge. Commodities generate no current income, so the return comes only from price appreciation.
• Real estate (residential, commercial, industrial, and specialised uses such as healthcare facilities or student housing) gives rental income plus appreciation and hedges inflation. Drawbacks: illiquidity, high upfront and financing costs (worse when rates rise), management effort, maintenance and local regulation.
• Structured products combine bonds or equities with derivatives to create a customised risk-return profile (capital protection, enhanced returns, targeted market exposure). They are complex, opaque, often illiquid before maturity and carry the issuer's credit risk, so they suit sophisticated investors, HNIs and institutions, after due diligence.
• Non-traditional assets such as art, paintings, horses (prize money, stud fees, resale) and distressed assets bought at a discount add diversification. They suffer from illiquidity, hard valuation, high transaction costs and niche-market risk.

1.7  Channels for making investments

• Direct route: the investor buys securities, gold or silver personally; for financial securities, intermediaries (distributors, brokers, advisers) facilitate deals for a fee or commission. Indirect route: regulated, professionally managed vehicles (mutual funds, PMS, AIFs) paid through fees, profit-sharing or both.
• Distributors connect product providers such as AMCs with retail and institutional investors, supply information and earn commission or fees on products sold. They should make sure the products match the investor's goals and risk appetite.
• Brokers execute trades in stocks, bonds and derivatives through stock exchanges for brokerage. Full-service brokers add research, advice and portfolio management; discount brokers offer low-cost platforms with little advice.
• SEBI-registered Investment Advisers (RIAs) offer advice, wealth management and financial planning, matching goals and risk appetite to suitable products. They follow a fiduciary, client-first standard.
• Mutual funds pool money from many investors into a diversified portfolio run to the scheme's objective. They are closely regulated by SEBI, allow easy purchase and sale of units, and regularly disclose NAV and portfolio holdings.
• AIF categories: Category I covers start-ups, VC funds and social ventures; Category II covers private equity and debt funds; Category III covers hedge funds and long-short funds.