Podcast | A beginner's guide to investing - Series 2

Welcome to Moneycontrol’s podcast series on personal finance. In the curtain raiser, we looked at some basic terminologies and the prerequisite for all investments – budgeting. We also touched upon things like portfolios, asset classes and the different types of financial instruments.

Today, in the second episode, we will discuss asset classes in some detail, their taxes and the returns you can expect from them.

So, to recall, we defined asset classes as a group of securities that exhibits similar characteristics and behavior in the marketplace and is subject to the same laws and regulations. Asset classes are of three types: equities, or stocks; fixed income, or bonds; and cash equivalents, or money market instruments. Some experts also include a fourth asset class - Real estate or other tangible assets.

Here’s an analogy that can help us understand better. Let’s assume you have invested in types of fruits and vegetables – apples, bananas, cabbage, and palak or spinach. Your general asset classes now are fruits and vegetables.

The big general asset classes can be broken down into sub-classes by size, industry, location, etc.

The first is Equities or stocks. When you buy equity, you basically own a piece of a company. How large or small depends on how much of the company’s stock you buy.

The second type is Fixed Income or debt. Here, you are lending money to a company or government for interest. So instruments like government bonds, other types of bonds, and certificates of deposit are good examples of this category.

The third type is Cash and cash equivalents. The money in your savings account, in your pocket, or hidden under your piggy bank – that stuff. The stuff we always seem to spend too quickly.

The fourth asset class is Real Estate and Commodities. This includes something tangible, physical - like property, natural resource commodities and precious metals like gold.

Every financial product you ever come across will fall into one of these asset classes.

At this point, we can further categorize each asset class in much more detail.  For instance, fruit doesn’t tell us the flavor of the food item. Similalry, stock doesn’t tell us precisely what the flavor or specific type our investment is. Stocks can be Indian, foreign, those belonging to start-ups or MNCs, value or growth etc.

Let’s begin with our asset class number one. Equity. Or stocks and shares.

More of the world's wealth is held in stocks than in real estate or gold. Equity has been gaining popularity in India since the 1990s. For our purposes, equity translates to ownership. When you invest in equity, it means you have bought ownership into a business. For example, when you buy stocks of TCS or RIL, you become a part owner of that business. Even the RSU, or Restricted Stock Units, and ESPP, or ‘Employee Share Purchase Plan’ - equity investments that you get from the company you work for, - these make you a small investor in the company.

This, on paper, also means you control the same percentage of the voting rights in the company should any big issue arise, though often there are different classes of shares so you have will less voting rights. Needless to say, most individual investors need not particularly concern themselves with voting rights.

Now, as is obvious, when you invest in business, you get a percentage ownership. If the company you invested in hits a big payday,  your overall worth shoots up. But there is the minor issue of time – a business grows over time, usually years or decades. It also faces ups and downs, and these good times and bad times reflect in the stock price of the company. Some analysts have worked out that over a 10-year-period, the BSE gives around 12% returns or more, eight out of ten times.

However, equity returns are pretty unpredictable, due to which many, if not most, people are wary of from investing in mutual funds or direct stocks. But market data seems to indicate that these are real wealth creators for investors who play the long game. There are mutual funds from various asset management companies that have proven track records of success for investors.

This brings us to an important point. Any company’s management is supposed to focus on increasing shareholder value, but they often have conflicting interests. Their primary focus tends to be on getting rich. Which is natural. If you are buying stock in a company where the management does not have a large equity stake, or in companies from Emerging Markets countries, market experience will tell you that shareholder value is not the number one priority for management.

An organisation might spend Rs 100 in making something using raw materials, land, labour and technology. The end product might carry a worth of Rs 120 to its customers. That’s a value of Rs 20. This value creation changes depending on the economic situation of the world. For large businesses like Apple and Google, the sky is the limit, but even average businesses generally need to do better than inflation in order to survive.

So what can you, as an investor, expect from equity investments? Well, in India the stock markets have generally given returns of 12-16% averaged annually over the long term in the past, as I’ve mentioned earlier. Long term here is investing for at least one business cycle, typically 6-7 years or more.

And what about the losses? Stock markets can go up 20% or down 20% in any given year. During the economic crisis of 2008, stock markets went down between 50-60% before recovering. These events, and in general stock market returns, cannot be predicted beforehand with any degree of certainty. Quite simply, if it was possible to predict a crash, the crashes would never have happened. However, despite the crashes and the negative years, stock markets have still delivered above-inflation returns to patient investors.

The next asset class is Fixed Income or debt. This is the most popular asset class in India. Fixed Income refers to the class of financial products where your investment amount is more or less protected, and the returns are either fixed or predictable to a large extent. There is nearly no risk involved in these products.

Investing in fixed income assets is akin to lending your money to someone with an assurance of return with predefined returns. When you open an FD, or a fixed deposit, in a bank, you are not so much “investing” as lending your money to that bank, with an assurance that they will return the principle amount along with a pre-defined interest at the end of the agreed period.

I did say nearly no risk, but this asset class does carry its own tiny bit of risk - what if you don't get your money back at the end of the loan term? Depending on the institution or organization you are loaning money to, the risk can vary from negligible to substantial. But PSU banks, and other institutions backed by the government, are generally considered a safe bet.

Bear in mind that fixed deposits do not beat inflation. Even if you are receiving an 8-9% return on your FD, people sometimes fail to realize that this is the pre-tax return. Fixed deposits are taxable , like every other debt instrument. Once the requisite tax is paid on the returns, the returns usually only figure in the 6-7% range. And adjusting for an inflation of 8-10%, you sometimes may even receive a negative return on your fixed income investments.

All things considered, those investors who want a fixed return, without taking any risk with their money, would be well advised to choose this asset class. There’s a reason fixed income instruments are a huge favourite in our country! FDs are the first word in investment – they’re simple, easy-to-understand financial products.

The same goes for PPF or Public Provident Fund, NSC or National Savings Certificate, Recurring Deposits and various other govt bonds or debt mutual funds. However, do note that this asset class does not beat inflation or only just keeps pace with it. Therefore, over a long term, while your investments amount will grow in amount, the purchasing power or value of the FD could well remain stagnant, maybe even drop. This asset class is a fine way to safeguard your money, not so much for growth.

The third asset class is Cash and cash equivalents. Cash doesn’t just mean hard cash, it is also the money lying in your saving bank account, or liquid mutual funds.

In India, The following items are regarded as cash and cash equivalents - Cash at bank; Cash on hand in the form of notes or coins; Traveller’s Cheques, bank cheques etc; Post Office and other stamps recognized by local authorities and short-term deposits that mature in 3 months.  All of these are cash equivalents which can be converted to cash within three months or less.

The best thing about cash is that it gives you freedom to buy anything you want-  instantly. You can buy a car, a house, a phone or invest your money in other asset classes.

The freedom that cash gives you is quite broad. That’s one reason most people prefer to keep a lot of cash. Further, cash cannot be tracked, unless we’re talking of several crores of rupees. Recall demonetisation and all the cash hoarders who were rounded up?  Many people keep their black money in the form of cash.

In investment jargon, cash carries the lowest investment risk of the all asset classes. Its inherent low risk provides good diversification to riskier assets. Second, holding cash allows you to take advantage of market dips, like investing at a low point. Also, easily accessible savings held in cash can cover sudden unforeseen circumstances, without having to sell better performing assets.

Cash does have one problem though. By its very nature, it does not fight inflation, or very little if it does at all. The money lying in saving bank account earns just 4% interest and that does not really work for you as an investor. Essentially, your returns, as an investor, are pretty low with cash and cash equivalents.

The fourth asset class is Real Estate and Commodities.  Another very popular investment asset class globally, and particularly in India is Real Estate. Its appeal lies in its social status. If you have your own house, you are considered settled. Then there is the obvious tangibility of landed property.

As the adage goes, They are not making any more land. That said, this pithy axiom overlooks the fact that less than 5% of land is inhabited, even in a densely populated country India. With every passing year, more uninhabited land is coming under habitation. So, in a sense, more land is being made for our use. This is also evident from the stagnancy in real estate prices for a few years now. I’m not going to digress into environmental implications here.

Real estate markets experience the same boom and bust cycles that equities do. For example, in Hyderabad, the average returns from real estate have stayed put for 7-8 years. But real estate is a bit more tempered. The upside is more tempered and so is the downside. Look at it this way - since there is no one announcing a price on TV for your home everyday, one does not experience the anxiety or euphoria that accompanies investment in stocks.

Property funds often invest in commercial property rather than the residential market but an investor should probably consider his or her house and any buy-to-let properties they own as part of their investment portfolio. Fund managers can commit more capital to commercial properties and deal with fewer landlords than investing in residential schemes, as a result. Property funds also allow investors to invest smaller amounts than would be necessary to buy a physical asset.

Real estate investments are highly illiquid. Meaning they require big ticket investments and offer little diversification. Can you, realistically, think of spreading your real estate investments if you are not a billionaire? Real estate also requires maintenance, it is tax-inefficient, and if you need some money, you do not have the option of offloading, say, one room out of your 3BHK flat to make ends meet.

With this asset class, a common investor can expect returns and volatility between that of debt and equity. Considering the illiquidity and the hassles that come with real estate, it does seem like this asset class gets more credit than is due. Not that any of us are going to stop buying property.

Coming to Commodities, this term refer to various types of physical goods and products which we can buy and sell for various uses. Gold, Silver, Copper, Rice, Oil etc. are counted under this asset class. The prices of these products depend on market demand and supply. Some analysts are of the opinion that commodities are not ideal for long term investment, but more for trading, where an investor can benefit from market cycles, predict demand and supply moves and get a profit or loss.

There are two types of traders who trade in commodity futures. The first are buyers and producers of commodities that use commodity futures contracts for the hedging purposes for which they were originally intended. These traders make or take delivery of said commodity when the contract expires. For example, a farmer who plants paddy can hedge against the risk of losing money if the price of rice falls before the crop is harvested. The farmer can sell rice futures contracts when the paddy is planted and guarantee a predetermined price for the rice at the time it is harvested.

The second type of commodities trader is the speculator. These are traders that trade in the commodities markets for the sole purpose of profiting from the volatile price movements. Speculators never intend to make or take delivery of the actual commodity when the futures contract expires. Many of the futures markets are very liquid and have a high degree of daily range and volatility, making them very tempting markets for intraday traders. Many index futures are used by brokerages and portfolio managers to offset risk. Further, since commodities do not typically trade in tandem with equity and bond markets, some commodities can also be used effectively to diversify an investment portfolio.

Returns from the commodities can be rather volatile because each commodity has its own market and dynamics. Just a handful of commodities, like Gold or Silver, are good for long term investing. They can be stored without any diminishing value. But, it is important to note that, in general, more than a 10% permanent allocation to Gold is not recommended by any investment advisor. The reason? Long term returns are similar to inflation. We cannot realistically store any of the other commodities in a similar manner, so trading them in the short term is a more practical approach.

As an individual investor there is nothing wrong with trying to pick, say, TCS versus Infosys as your stock pick, but it is important you not put your entire portfolio in one type of stock. For example, putting all your money into a single asset class is not a wise move.

So, consider these steps to experience some investing success that you can go ahead and build on:

• First, decide on your asset class mix. You should generally take less risk as you age because you have less time to recover from a severe loss. Be careful not to keep too much of your investment portfolio in cash since inflation will make cash worth less overtime.
• Two, within equities, decide how much you want to allocate to growth versus value and small versus large cap.
• Three, make up your mind on if you want to be an active or passive investor. If you want to go with the market index, you are a passive investor. Choose an index fund that matches your desired portfolio allocation and you’re set.
• Four, do you want to pick stocks yourself or pay a professional to do it? You could try picking stocks yourself, but make sure to pick enough. Enough here means not less than twenty companies across your chosen asset allocation so that you are well diversified. Chances are you probably won’t beat the market, but you also won’t do yourself too much harm.
• Number five, look up the fees. Whether you want pick your own actively managed mutual funds, or you want to hire a professional, there are fees involved. These will eat into your returns, so make sure you know how much you will be paying for the advice you seek.
• And finally, leave the investment alone! Once you invest your money in individual stocks then, you probably felt the temptation to sell when they start going down or buy when a hot stock takes off. Well, stop that! Try to avoid panicking every time it moves. Buying and selling too much is generally considered one of the main reasons investors underperform.