Expert advice

Oct 26, 2013,17.08 IST

Are you a first time investor?

Arnav Pandya

Investing requires a comprehensive look at the available options so that the right choice can be made.  As a first time investor you need to be extra careful so that your start is sound and you can build on a strong foundation. This is possible but in the current complex environment with rapid changes and a large choice you will require a new thought process to be able to succeed and achieve your goals.

Fixed income investing

An investment option that is suitable for a first time investor will be fixed income instruments. These are debt instruments that have a pre determined rate of interest that will be payable to the holders.  The amount raised through the instrument will be repayable by the issuing entity to you after a specific time period. This feature ensures that there is a finite time period for the existence of the instrument so there is clarity on when the amount will be returned.

Also the rate of interest is known upfront so it is easier to calculate the earnings on the instrument over its life. Fixed income instruments are suitable for all those who want a steady and regular flow of income without fluctuations. There are different types of instruments that will fall into this category and will cover fixed deposits, bonds, debentures etc. You can also get an exposure to fixed income instruments through the mutual fund route.

India in perspective

There is a lot of interest in fixed income instruments in India as most investors have an exposure to these instruments. Over the last few years there has been rapid development in the market for these instruments as options choices have emerged like non convertible debentures and tax free infrastructure bonds have become popular. Fixed deposits, bonds, government securities and post office savings schemes are the other options that have large investor interest.

The presence of a range of mutual funds investing in different segments of the debt market is also a positive development. In absolute terms the rate of earnings for a fixed income instrument might seem to be high in India where these could deliver returns of upto double digits over a 1-3 year period but it has to be seen in the context of the inflation present in the economy in which case the real rate of return might not seem to be too high.

The initial steps

A challenge as a first time investor is to select investment options that provide an element of confidence. As a young investor selection of equities as a part of the portfolio is an obvious choice that matches your needs but every investor should look at all aspects of their portfolio while investing. Requirement of a sum of Rs 10,000 each year for specific expenses like education will lead to evaluation of fixed income instruments for use.

Even some long term goals like generating a regular income at retirement could require the use of fixed income instruments. As you start out on your investment journey in life remember to have a proper asset allocation strategy in place and this will guide you in a better manner towards your goals.

Challenges

Fixed income instruments are a stable route as compared to equities where there is a sharp swing in the value over the course of a day. If the instrument is held till its time of maturity then the returns earned by you are easily predictable. However there are certain elements of risk that are present with a fixed income instrument. These risks will need specific steps so that they can be contained and this is something that you should pay specific attention to.

Credit risk

Credit risk is a situation where the issuer of the fixed income instrument defaults and is unable to pay back the capital amount and even part of the interest due. This will be witnessed when the financial condition of the issuing entity deteriorates significantly. This situation poses a risk as you could end up losing capital on your investment. Issuing entities offer a higher rate of interest on instruments that have a lower credit quality so when you see higher rates make sure that you do your homework and understand the reason behind the high rate of interest. There are credit rating agencies which provide credit ratings for issuing entities and these should be checked before actually making the investment.

Reinvestment risk

One of the risks with a fixed income instrument is the ability of your money to keep earning the same or higher rate of return once the time period of the initial investment is over. The fixed income instrument is in existence for specific time duration so when this time period ends and you look to reinvest the money if the available interest rates are lower than before then you could end up earning less than what you were earlier.

If you take a careful look at the details of how your money was invested over a longer time period then there is chance that the situation looks something like the example below. This shows the changes over a period of time as a one year fixed deposit matures so at the end of the first year there is a loss of Rs 3,000 as the interest rates have fallen. Later on there is a gain which narrows and then is converted to a loss as interest rates change in the economy.

Beating inflation

The fixed income instrument offers stability in the sense that the earnings in the form of interest are known at the time of making the investment. While this is a feature  that provides a sense of comfort to you there is also a risk that arises on account of this position. Inflation which is the rise in the level of prices of goods and services reduces the purchasing power of money. Inflation will eat away at the earnings that you are generating on the fixed income instrument.

The amount of inflation in future years is not known and there are times when this can shoot up significantly. The risk is that the inflation could be higher or close to the earnings rate which would mean that the earnings from the instrument in real terms is close to zero or in some cases even negative.

The actual figures of annual inflation on the consumer price front as shown by World Bank data gives  an idea of how can change over a period of time. The annual rate of inflation rose from 6.4 percent in 2007 to 12 percent in 2010 which was a time period when a lot of fixed income investors found  that they were earning less than the inflation rate.

Matching goals

Planning for the long term can ensure that there is an effective  way in which you can achieve  your goals. If the details about your targets are known upfront then there  is a way in which you can plan  your investments by including fixed income instruments to achieve these goals. For example if there is a sum of Rs 9,000 that is required to achieve a goals of buying a specific consumer durable for the house then looking at a fixed income instrument it is possible to know the  amount of investment that will give rise to this kind of return.

Thus if the rate of interest prevailing is 9 per cent then you will require an investment of Rs 1 lakh to generate the sum at the end of one year.  Using other types of instruments could lead to a situation where the irregularity of the income that can even be negative would hurt the chances of achievment of the goals on time.

Benefits of fixed income investing

Lesser risk

Every investment comes along with an element of risk and reducing risk is a major goal for first time investors. This can be achieved by investing in fixed income instruments. Many instruments like fixed deposits are not traded which removes volatility in prices for you. Further there is the ability to raise funds by redeeming or selling the fixed income investment which can tackle liquidity problems. These instruments have a fixed rate of return and regular payments also increase your confidence in their ability to repay the capital amounts at the end of the term.

Diversification

Fixed income investments are debt instruments so they represent an asset class that is distinct from equities or commodities. This makes their movements independent to what several other assets are witnessing and it becomes a way for investors like you to diversify their portfolio. Conditions that impact fixed income instruments are different and hence the changes witnessed here will be distinct from other assets. This again reduces their relation and ability to change in a manner that is similar to other investments. This difference in features will lead to a situation where the benefits of diversification flow to you.

Long term capital accumulation

Fixed income instruments ensure steady stream of earnings in the form of interest. As you start out on your investment journey in life this might look to be moderate in terms of earnings. With time on your side you can ensure that the benefit of compounding works in your favour. An investment of Rs 1 lakh earning 8 per cent per annum that is accumulated and reinvested might just give an earning of Rs 8,000 in the first year.

The earnings will rise to Rs 11,000 by the fifth year and Rs 16,000 by the 10th year. In another 10 years time the investment would be earning nearly Rs 34,000 each year at the same rate of interest. This massive rise in the absolute earnings over a period of time can be possible by simple discipline and it can yield you significant benefits in the later years.

How should I tackle this situation?

There is a need for a slow and steady approach in building your portfolio over a period of time. As a first time investor you should start off with areas that you understand and which you can slowly become comfortable with. Fixed income instruments can play a significant role as this will provide stability and balance to the portfolio while you familiarise yourself with areas like equities. 

Break up your goals over the time periods when they have to be achieved and this will give you a better idea of going about the process. Using fixed income instruments for goals that are not very far away and where you cannot afford to be underfunded would be a good strategy. As your portfolio grows over a period of time ensure that there is a balance maintained among different areas so that it does not become tilted towards a specific instrument or area. 

Video Tutorials

Harsh Roongta

Planning to invest in mutual funds? Here's help

Pankaj Mathpal

Here are a few fund options to invest your money

more

Take a mf iq test

New to Mutual Funds?

Take a test and get a Badge

Take a Test

New to Mutual Funds?

Take a test and get a Badge

Take a Test

New to Mutual Funds?

Take a test and get a Badge

Take a Test