chapter 25 guidelines for invst decisions

7/29/2019 Chapter 25 Guidelines for Invst Decisions

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Chapter 25

GUIDELINES FOR INVESTMENTDECISIONS

What it All Comes To


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Outline

Basic GuidelinesThe Ten Commandments

Guidelines for Aggressive Equity Investors

Guidelines for Conservative Equity Investors


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Basic Guidelines: The Ten Commandments

There are ten commandments of investing which should serve as basic guidelines

for all investors.

They are as follows.

1. Start saving early and save regularly.

2. Maintain an adequate cash reserve and an appropriate insurance cover.

3. Accord top priority to a residential house.

4. Match your stock-bond mix to your investment situation.

5. Select stocks and bonds (fixed income instruments) judiciously.

6. Avail of tax shelters.

7. Diversify adequately.

8. Periodically review and revise your portfolio.

9. Check your irrationality.

10. Maximise your lifetime financial success.


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Payoffs from Long-Term Investing

AmountInvestedper year

Numberof Years

8% 10% 12% 15% 18%

10000 10 144,870 159,370 175,490 203, 040 235,21010000 20 457,620 572,750 720,520 1,024,400 1,466,300

10000 30 1,132,830 1,644,940 2,413,300 4,347,500 7,909,500

10000 40 2,590,560 4,425,900 7,670,900 17,791,000 41,632,000


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Importance of Starting Early

The importance of starting the saving programme early can be conveyed

emphatically by looking at the following table which shows the amount

that a person has to save on a monthly basis to accumulate Rs. 10,000

assuming that the annual rate of return is 10 percent and the investments

are made over periods that range from 5 to 30 years

No. of years Monthly savings required30 4400

20 13100

10 48400

5 128100

As John C. Bogle put it: The slope of the financial mountain you have to

climb gets steeper and steeper as time goes on, from a gradual and

manageable slope if you have 30 years to invest to near insurmountableprecipice if the summit must be reached in just five years.

i i


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Retirement PlanningAman Sharma is 45 years old and has an annual income of Rs.

500,000. He expects his income to increase by 12 percent per year till he

retires at the age of 60.

In his post-retirement period, which he expects to be 15 years,

Aman Sharma would like his annual income from his financial investments

to be 40 percent of his salary income in his last working year. Further, he

would like the same to be protected in real terms.

Aman Sharma owns a house and has Rs. 1,000,000 of financial

assets. He wants to bequeath the house and Rs. 12,000,000 to his son when

he dies.

The current financial assets and the future savings of Aman Sharma would

earn a nominal rate of return of 10 percent. The expected inflation rate for

the next 30 years is likely to be 5 percent.

What proportion of his salary income should Aman Sharma save

till he retires so that he can meet his post-retirement financial goals? Thisquestion may be answered in three steps as follows:


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Retirement Planning

Step 1: Estimate the annual income required in the post-retirement period

The present annual income of Rs. 500,000 will grow to Rs. 500,000 (1.12)

15

= Rs. 2,736,783. Forty percent of the same works out to Rs. 1,094,713

Step 2:Figure out the corpus required at the time of retirementThe corpus required at the time of retirement will be:

Present value of the income required in the post-retirement period

+Present value of financial assets to be bequeathed.

The present value of the income required in the post-retirement period is:

PVIFAr,n x Annual income required

PVIFA 4.76%, 15 x 1,094,713

1 -1

x1,094,713

(1.0476) 15

0.476

= Rs. 11,549,346


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Note that for calculating the PVIFA we have used the real rate of

interest (1.10/1.05 1 = 0.0476 or 4.76 percent) because the annual

income required has to be protected in real terms.

The present value of the financial assets of Rs. 12 million to be

bequeathed, evaluated at the time of retirement is:

PVIF 10%, 15 x Rs. 12,000,000

0.239 x Rs. 12,000,000

= Rs. 2,868,000

So, the total corpus retirement is:

Rs. 11,549,346 + Rs. 2,868,000

= Rs. 14,417,346


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Retirement Planning

Step 3: Estimate the proportion of salary to savedThe current financial assets of Rs. 1,000,000 will grow to

Rs. 1,000,000 (1.10)15 = Rs. 1,000,000 x 4.177 = Rs. 4,177,000So, the savings during the next 15 years should cumulate to

Rs. 14,417,3464,177,000 = Rs. 10,240,346

Since Aman Sharma will save a fixed proportion (p) of his salary, which in turnwill grow at the rate of 12 percent per year for the next 15 years from the current

level of Rs. 5000,000, the savings stream will be a growing annuity. The value ofthis growing annuity at the end of 15 years will be:

So,

px 500,000 (1.12) 1-(1.12) 15

(1.10)15(1.10)15

0.100.12

= px 36,294,736This should be equal to Rs. 10,240,346

P =10,240,346

= 0.282 or 28.2 percent

36,294,736


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Maintain an Adequate Cash Reserve and an

Appropriate Insurance CoverLife is uncertain and almost everyone experiences unexpected

financial needs. You may lose your job just when your son has metwith an accident. To cope with the catastrophes of life, you need an

adequate cash reserve and an appropriate insurance cover.

Cash reserve some people believe that cash is an idle asset andsitting on a cash balance means foregoing attractive investments.

Yet everyone needs a reserve of safe and liquid assets to meet an

unexpected medical expenses or tide over a period of unemployment.

The amount of this reserve may be 3 to 6 months of your monthly

expenses.

In what form should you maintain this reserve? The most

convenient forms are fixed deposits (which can be prematurely

encashed) with banks and money market mutual fund schemes.


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Insurance Cover

As a protection against various risks, most people need

insurance. Inter alia, you need auto insurance, home insurance,health insurance, disability insurance, and life insurance to

financially protect yourself (or your family) against the consequences

of accidents, illness, disability, and death.

You can take a third party auto insurance cover (which is

minimally required by law) or a comprehensive auto insurance

cover, depending on the level of protection want. You can insure your

home and its valuables upto a desired limit. You can buy health

insurance of the kind that gives you comfort. You can take an

appropriate life insurance cover for protecting your dependents.


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Need For Life Insurance

Phase Financial Available Need forrequirement resources insuranceof dependents elsewhere

Young adulthood (0-25) None Negligible Absent

Family formation and High Meagre to modest Highdevelopment (25-50)

Pre-retirement (50-60) Modest Substantial Diminished

Retirement Small Substantial Absent


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Term Insurance Plan

The primary purpose of insurance is protection, not

accumulation of wealth. So choose an insurance policy whichprovides only insurance and not insurance along with a savings plan.

If the insurance policy carries living benefits, i.e. it provides

monetary benefits to the assured while he is alive, it implies that it

combines insurance with savings. Such a policy earns a modest tax-free return on the savings portion. You can perhaps earn a higher

return if you invest on your own. Hence, you may be better off with a

term assurance policy rather than the more popular endowment

assurance policy. However, if you find that the latter policy

disciplines you to save more, enables you to get the kind of insurance

cover you are looking for, simplifies your investment decision

making, saves you from the chores of investment management, and

prevents you from squandering your savings, you may consider it

favourably.


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Accord Priority to a Residential House

Given the above advantages, your first priority as an investor

should be to buy a residential site in an area where you plan to settledown and, thereafter, construct a house as soon as your resources

position permits you to do so. If you are not likely to live in that

place in the foreseeable future, the construction of the house can be

deferred. It may be noted that the rate of return earned on a wisely

chosen portfolio of financial investments can cover the escalation in

construction cost, but not perhaps the escalation in land cost. Hence,

you should acquire the land as early as possible, preferably through

some housing cooperative society, and undertake construction at an

appropriate time. If the cost of an independent house is beyond yourmeans, choose the alternative of buying a flat. In metropolitan areas,

given the exorbitant land prices, this may be the only option

available to you.


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Additional Real Estate

As people become more affluent they have resources to buy

additional real estate like a second house or commercial property or

urban land or farmland.

If your resources permit, you should look at buying

additional real estate. Real estate has excellent returns over-time

and is perceived to be less risky than stocks to some extent this

may be because you dont see a daily quotation for real estate as you

see for stocks.


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Match Your Stock-bond Mix to Your

Investment SituationAfter you have provided for your priority needs (cash reserve,insurance cover, and residential house), your most important

decision is concerned with the stock-bond mix. What proportion of

your assets should you allocate to stocks? To bonds?

Your stock-bond mix depend on three factors, in the main:

Investment horizon: this is the period over which you willbuild up and hold your investments.

Risk capacity: this is your financial capacity to withstandinvestment losses.

Risk tolerance: this is your willingness or emotional ability to

accept volatile returns


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Key Guidelines

Longer the investment horizon Greater the proportion of stocks

Greater the capacity for risk Greater the proportion of stocks

Greater the tolerance for risk Greater the proportion of stocks


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Risk - Return Preferences Over Investor Life

Cycle

Return

Early Career

Mid Career

Late Career

Retirement

Risk


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Investment Horizon Versus Living Horizon

The general recommendation that a person should gradually tilt his

portfolio in favour of bonds as he advances in age implicitly assumes

that a persons investment horizon is more or less the same as his

living horizon. This may often not be true because for most peoplethe investment horizon may be longer, indeed much longer, than

their living horizon.


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Select Stocks and Bonds Judiciously

Stock Selection : In general you would do well if you go

largely by fundamentals without losing

sight of technical.

Bond Selection : Go by yield to maturity, tax shelter,

liquidity, and credit rating.


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Avail of Tax Shelters

You must plan to avail of the tax shelters available to you. Some

suggestions in this regard are offered below:

Deposit liberally or invest in (a) a recognised provident fund

scheme and/or the PPF scheme, and (b) life insurance policy to

reduce your tax liability.

Augment your tax-exempt current income by investing in

equity shares, mutual fund schemes, and so on.

Ordinarily, plan to hold your equity shares and other securities

for at least one year to get the benefit of tax exemption.

Avoid/reduce long-term capital gains by investing in specified

securities, specified assets, and residential house as stipulated

under Sections 54EC, 54ED, and 54F of the Income Tax Act.


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Diversify Adequately

Your investment strategy should be to diversify your

holdings within an investment class and to hold different

classes of assets (cash, bonds, stocks, and real estate) in your

portfolio.

Ordinarily you should have at least 10 to 12 stocks in your

equity portfolio spanning at least 4 different industries with

no single industry accounting for more than, say 40 percent of

your equity investment, and no single stock accounting for

more than 20 percent of your equity investment.


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Periodically Review and Revise the Portfolio Since the world of investments is highly dynamic and rapidly

changing, it behooves upon every investor to periodically

review and revise his portfolio.

Periodic review and revision is required to:

Maintain adequate diversification when relative values of

various securities in the portfolio change;

Incorporate new information relevant for risk-return

assessment;

Expand or contract the size of portfolio to absorb funds or

withdraw funds; and

Reflect changes in investor risk disposition.

Ensure that the target asset-mix is maintained.


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Constant Ratio Formula Plan

Market value Market Switch from Switchof stocks value of stocks to from bonds

bonds bonds to stocks

1.1.20X0 50,000 50,000

1.7.20X0 70,000 52,000 9,000

1.7.20X0

(After revision) 61,000 61,000

1.1.20X1 50,000 62,000 6,000

1.1.20X1

(After revision) 56,000 56,000

1.7.20X1 65,000 55,000 5,000

1.7.20X1 60,000 60,000(After revision)


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Checking Your Irrationality

As human beings we are endowed with certain characteristics of

mind and behaviour that lead to imperfect decisions and even

dreadfully serious mistakes.

Often we are not rational and we do not act in our own best interests.

For example:

We ignore the baserate in preference to the case rate. We overreact to good news as well as bad news.

We are impatient.

We tend to be overoptimistic and not realistic. We are proud and unwilling to admit our mistakes.

We are susceptible to hot tip investing.

We naively believe in foolproof schemes.

We easily succumb to herd mentality.


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That is why to succeed as an investor, you must first know yourself.

Your intellectual capabilities and your emotional capabilities will

largely determine your investment success.

Your intellectual capabilities include your ability to analyse financial

statements, your memory and recall power, your capacity to master and

manage knowledge, your flair for developing insights and

understanding from amorphous data and information, and so on.

Your emotional capabilities include your ability to maintain

composure in a chaotic environment and your capacity to deal

rationally with volatility and disruptions that you face everyday.


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Maximise Your Lifetime Financial Success

There are five stages or dimensions of your lifetime financial success:

Earning Saving

Investing

Contributing

Estate planning

You should strive to maximise achievement in each of these areas,

within the set of opportunities available to you, while enjoying a full

and balanced life.

If you have resources in excess of what you wish to transfer to

your family and others you care about, you have rewarding

opportunities to contribute to worthwhile causes.


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Advance Worthwhile Causes

You may find great fulfillment in converting your financial resources

(which represent the stored values of your hardwork, skills, and goodfortune) into actions that advance causes that you truly care about.

Here are some possibilities:

Provide scholarship to young children who are economically

deprived.

Support hospitals and shelter homes that help the needy and

indigent.

Contribute to organisations engaged in scientific or medicalresearch.

Espouse institutions that work for environmental protection.


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In addition to contributing money, you should also commit your

time, talents, and energy to initiatives and endeavours that you believe

in. It can be profoundly rewarding to see how real, living people and

institutions benefit from your active participation and involvement. As

Charles Ellis put it: As with other areas of investing, its wise to plan

ahead, to be conservative (within limits), and to make productive use of

time by beginning early and sustaining your commitments over as long

a period as you can provide yourself.


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Write a Will

You must write a will so that your wealth is distributed according to

your wishes after you are gone. In the absence of a will, your heirs

may squabble among themselves, incur unnecessary litigation

expenses, strain their relationships, and suffer a lot of avoidable

bitterness.

Bear in mind the following things about a will.

Although a will can be oral (wherein a person speaks ones intention

in front of witnesses) or written, it is advisable to have a written will,

preferably handwritten.

A will can be written on plain paper and it requires two witnesses.

A will can always be re-freshed or altered.


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A will can be registered with the state authorities for a nominal fee.

If there are several registered wills the last one prevails.

Every will needs an executor who probates the willa probate is a

court-supervised procedure for distributing the decedents estate.

Nominated by the maker of will, the executor may be a beneficiary

of the will or a neutral person.

It may take five to six months of probation period before the will is

finally accepted by the court. If immovable property is involved, a

court fees is payable for its valuation and it is usually 3 percent of

the total value.

If all the inheritors amicably accept the will, a family settlement

can be arrived at out of the court to save on the court expenses.

However, nobody can subvert a will and arrive at a family

settlement.


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A General Guideline for Equity Investing

In choosing equity shares go largely by fundamentals but do not lose

sight of technicals. This broad guideline may be implemented in terms

of three sub-guidelines.

Establish value anchors

Assess market psychology

Combine fundamental and technical analysis

A i A i


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Fundamental AnalysisUndervalued Overvalued

Technical Weak Wait Sell

Analysis Strong Buy Wait

Fundamental Analysis And Technical

Analysis

G id li F A i E it I t


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Guidelines For Aggressive Equity Investors

1. Focus on investments you understand and play your own

game.

2. Monitor the environment with keenness.

3. Scout for special situations in the secondary market.

4. Pay heed to growth shares.

5. Beware of the games operators play.

6. Anticipate earnings ahead of the market.

7. Leverage your portfolio when you are bullish.

8. Take swift corrective action.


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Investment Sweet Spot

Zone of

comfort

Zone of

competence

Sweet

Spot

Guidelines For Conservative Equity Investors


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Guidelines For Conservative Equity Investors

1. Avoid certain kinds of shares.

2. Apply stiff screening criteria.

3. Look for relatively safe opportunities in the primary market.

4. Participate in the schemes of mutual funds.

5. Join a suitable portfolio management scheme.

6. Consult an investment advisor.

7. Refrain from short-term switch hitting.


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Summing Up

There are ten commandments of investing which should serveas basic guidelines for all investors.

Aggressive equity investors play the equity game actively and

vigorously. In addition to general guidelines, there are some

special guidelines relevant for them.

Conservative equity investors seek to minimise the

investment risk as well as the time and effort devoted to

portfolio management. In additional to general guidelines,there are some special guidelines relevant for them.

chapter 25 guidelines for invst decisions

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