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  1. 1. INVESTMENT PLANNING (Approved Course Book for CFP Certification Education) Published by The Indian Institute of Financial Planning
  2. 2. Investment Planning The course material is exclusively designed and published for the use of the Students of the IIFP. The Indian Institute of Financial Planning has exclusively a copyright on the whole of the contents of this book. No part of this publication may be reproduced or copied or sold/distributed in any form or any means, electronic, mechanical, photocopying, and recording or stored in a data base or retrievable system without the explicit permission of the institute. 2nd Edition January 2009 Published by the Indian Institute of Financial Planning, Atma Ram House, 1 Tolstoy Marg, Connaught Place, New Delhi - 110 001 ii The Indian Institute of Financial Planning
  3. 3. FOREWORD Welcome to IIFP- Power Your Growth….. We thank you for choosing the IIFP as your preferred education provider for CFP certification programme. We are one of the leading education providers for CFP certification programme and we are basically a No Frills-Pure Education institute imparting high quality financial planning education in India. IIFP has been promoted by Kush Education Society which has been formed and backed by eminent industrialists and educationists of India. Kush Education Society was formed in the year 2001 and it also runs the prestigious Delhi Public School (DPS), Varanasi. We are constantly engaged in research and development of new study tools which can help our students to crack this highly professional CFP certification programme in the first attempt. Wishing you Good Luck…. Faculty and Content Team, IIFP The Indian Institute of Financial Planning iii
  4. 4. Curriculum CURRICULUM MODULE: 4 COURSE TITLE: Investment Planning Investment Planning COURSE DESCRIPTION: This module includes introduction to Investment Planning, Investment vehicles, investment strategies, Regulation of an investment advisor, Application to clients, etc. LEARNING OBJECTIVES: At the end of this module, a student should be able to: Understand the importance of investment planning in the Financial Planning process, ethical issues for advisors, regulation of advisors. Understand the choice of investment products in terms of their risk-return characteristics. Evaluate investment choices in the context of client’s Financial Planning needs. Understand how client investment portfolios are created, monitored and rebalanced based on their objectives and needs. Recommend a portfolio of investment products. DETAILED CLASS OUTLINE: Introduction to Investment Planning 1. How investment planning is different from selling investment products 2. Investment risk Definition of risk Types of risk Market risk Reinvestment risk Interest rate risk Purchasing power risk Liquidity risk Political risk Exchange rate risk The Indian Institute of Financial Planning v
  5. 5. Investment Planning 3. Measuring risk Standard deviation Beta 4. Managing risk Diversification Diversifiable and un-diversifiable risk Product diversification Time diversification Hedging 5. Returns Relationship between risk and return Compounding Types of returns CAGR Total returns Risk-adjusted returns Post-tax returns Tax on capital gains Tax on income Holding period return Yield to maturity 6. Investment portfolio Risk and return on a portfolio Measuring portfolio risk Effect of diversification on portfolio risk and return Investment vehicles Concept, structure, returns measurement (income and/or capital gains), tradability, liquidity and legal issues of the following investment vehicles. The objective is to provide an essential understanding of the products from a risk-return perspective, so that proper product recommendations can be made. 7. Small savings vi The Indian Institute of Financial Planning
  6. 6. Curriculum 8. Fixed income instruments Securities Government securities Corporate Securities Deposits Bank deposits Corporate deposits 9. Insurance-based investments 10. Mutual funds The concept and role of mutual funds Fund structures and constituents Legal and regulatory environment The prospectus/offer document Fund distribution and sales practices Accounting, taxation and valuation norms Investor services Investment management Measuring and evaluating mutual fund performance 11. Equity shares 12. Derivatives Essential features Application to investment portfolios 13. Real estate Forms of real estate investment Financing real estate Costs of buying and maintaining 14. Other investments Bullion Collectibles Precious metals Investment strategies The Indian Institute of Financial Planning vii
  7. 7. Investment Planning 15. Active and passive strategies Market timing Securities selection Maturity selection Buy/hold 16. Asset allocation Strategic and tactical asset allocation Fixed and flexible allocation Rebalancing strategies Formulae based monitoring and revision of portfolios Regulation of an investment advisor 17. The regulatory functions, rules and codes of conduct pertaining to planners Banks: RBI Mutual funds and collective investment schemes: SEBI Equity shares: SEBI Derivatives: SEBI Grievance mechanisms Application to clients 18. Matching investment vehicles to needs of clients Asset allocation and portfolio rebalancing according to client needs Case studies Single persons Young couples Mature couples with grown children Empty nesters viii The Indian Institute of Financial Planning
  8. 8. Contents CONTENTS Investment Planning 1. Investment : An Introduction 1. Introduction 2. Financial Markets 3. Constituents of a Financial System 4. Financial Intermediaries/Institutions 5. Financial Assets - Direct and Indirect Investing 2. Return 1. Introduction 2. Arithmetic Average 3. Geometric Average 4. Other Return terms commonly used 3. Investment Risk - Measuring and Managing 1. Introduction 2. Defining Risk 3. Measuring Risk 4. Types of Risk 5. Implications of Risk 6. Beta and Risk 7. Risk and Diversification 4. Investment Portfolios 1. Introduction 2. Return of a Portfolio 3. Risk of the Portfolio 4. Correlation coefficient The Indian Institute of Financial Planning ix
  9. 9. Investment Planning 5. Small Savings 1. Introduction 2. Post Office Savings Accounts 3. Post Office Time Deposit Accounts 4. Post Office Recurring Deposit Accounts 5. Post Office Monthly Income Accounts 6. National Savings Certificate (VIII Issue) 7. Kisan Vikas Patra 8. Public Provident Fund Scheme 9. Deposit Scheme for Retiring Government Employees 10. Deposit Scheme for Retiring Employees of Public Sector Companies 11. Senior CItitzens Savings Scheme 6. Fixed Income Instruments 1. Introductioin Money Market Instruments 2. Money Market Instruments : The short term money market 3. Repo Transactions 4. Call / Notice Money 5. CBLO 2 6. Bill Rediscounting 7. Money Market Instruments : The long term money market 8. Commercial Paper 9. Certificate of Deposit 10. Capital Market Debt Instruments 11. Indian Debt Market 12. Terms associated with Debentures 13. Valuation of a Bond 14. Relationship between interest rates and bond prices 15. Measures of yield 16. Risk and Bonds 17. Bonds Pricing Theorems 18. Bonds and Duration 19. Computing Duration x The Indian Institute of Financial Planning
  10. 10. Contents 7. Fixed Income - Deposits 1. Introduction 2. Bank Deposits 3. Current Account 4. Account Opening and Operation of Deposit Accounts 5. Company Fixed Deposits 6. How to choose a good company deposit scheme 8. Insurance Based Investments 1. Unit Linked Insurance Plans 2. Assessing Fund Performance 3. Unit linked Insurance Policies and Endownment Plans 4. Which is better, unit linked or ‘with profits’ 5. Pension Funds 9. Mutual Funds 1. Inception 2. Definition 3. Structure of Mutual Funds 4. Other Fund Constituents 5. Legal and Regulatory Environment 6. Types of Mutual Funds 7. Offer Document 8. Fund Distribution and Sales Practices 9. Sales Practices - Norms for Mutual Funds 10. Accounting Valuation and Taxation 11. Accounting Polices 12. Taxation 13. Capital Gains 14. Investor Servicing 15. Measuring and Evaluation Mutual Fund Performance 16. Annual Performance of the Fund 17. Returns are calculated as 18. Fund Management Expenses & Management Expenses Ratio (MER) The Indian Institute of Financial Planning xi
  11. 11. Investment Planning 19. Volatility of Monthly Rate of Return 20. The Fund’s Rank by Quartile 21. Market Timing using Beta 22. R-Square 23. Risk Adjusted Return 10. Equity Shares 1. IntroductionValuing Equity 2. Valuing Equity 3. Relative Valuation 4. Preferred Shares 5. Warrants 11. Equity Shares - Capital Asset Pricing Model 1. Introduction 2. The Basis of CAPM 3. Beta 4. Systematic and Unsystmatic Risk 5. Portfolio Beta 6. Relationship between Return and Risk in the CAPM 12. Derivatives 1. Introduction 2. Definition 3. Derivative Product 4. Participants in the Derivatives Markets 5. Forward Contract 6. The Cost of Carry Model 7. Futures 8. Introduction to Options xii The Indian Institute of Financial Planning
  12. 12. Contents 13. Real Estate and Alternative Investments 1. Introduction 2. Types of Real Estate 3. Valuation of Real Estate 4. Investing in Real Estate 5. Forms of Real Estate Investment 6. Some Real Estate Terms 7. Investing in Gold 8. Investing in Art 9. Art Funds 14. Asset Allocation 1. Introduction 2. Sample asset allocations 3. Change and Asset Allocation 4. Allocation Strategies 5. Portfolio Rebalancing 15 Investment Strategies 1. Introduction 2. Active and Passive Strategies 3. Aspects of various Strategies 4. The Four Phases of Markets 5. Buy and Hold 6. Security Selection 7. Risk Profile and Investment Planning 8. Mutual Funds 9. Sample Asset Allocations 16 Regulatory Framework for Planners 1. Introduction 2. Association of Mutual Funds in India 3. Other The Indian Institute of Financial Planning xiii
  13. 13. Contents CONTENTS Chapter 1 Investment : An Introduction Page No. 1. Introduction 1 2. Financial Markets 1 3. Constituents of a Financial System 2 4. Financial Intermediaries/Institutions 3 5. Financial Assets - Direct and Indirect Investing 7 The Indian Institute of Financial Planning
  14. 14. Chapter 1 : Investment an Introduction Chapter 1 Investment : An Introduction 1. Introduction: Investment is simply the act of investing or putting in money for the purpose of earning a profit. In finance, it is the purchase of a financial product or other item of value with an expectation of favorable future returns. In business, however, it is defined as the purchase by a producer of a physical good such as durable equipment or inventory in the hope of improving future business. 1 Everyone right down from the lowest end of the economic segment to the richest does some sort of investment. What differs is the nature of investment, the time duration, the amount invested and the purpose of investment. The act of investment possibly originated with the explicit purpose of saving for a rainy day or for meeting a family obligation. Since then apart from these two reasons for investment, there is also a third that is linked to the first two is to possibly be able to improve one’s economic status. Typically during one’s life cycle of saving and investment, in the early years one tends to borrow, during the peak earning years, one will repay what one has borrowed as well as save for one’s retirement and finally during the retirement phase one will once again spend more than earnings. Apart from that one would also keep some of precautionary chest for unforeseen happenings. If investment during the peak earnings years is done sensibly, it can go a long way in ensuring a comfortable retirement. For this one requires the right asset allocation and the right financial instruments that suit one’s requirements both in terms of return as well as risk profile. As of today, financial systems are highly developed, globally connected and networked. A financial system consists of institutional units and markets that interact, typically in a complex manner, for the purpose of mobilizing funds for investment, and providing facilities, including payment systems, for the financing of commercial activity.2 This has led to a variety of investment instruments that are designed to suit the needs of investors who range from totally unsophisticated to those investors who deal with highly complicated and risky instruments that have payoffs linked to other financial products. In fact the major role of a financial system is to intermediate between those that provide funds and those that need funds and typically involves transforming and managing risk. Financial markets, financial institutions and financial instruments are integral parts of a financial system. 2. Financial Markets: A financial market is a place where buyers and sellers interact. It can be a formal network or an informal one. It can also be a physical location as well one that has online boundaries. Stock exchanges are also part of financial markets. Financial markets perform the following functions:-3 Borrowing and Lending: Financial markets permit the transfer of funds (purchasing power) from one agent to another for either investment or consumption purposes. 1 2 3 http:/ The Indian Institute of Financial Planning 1
  15. 15. Investment Planning Price Determination: Financial markets provide vehicles by which prices are set both for newly issued financial assets and for the existing stock of financial assets. Information Aggregation and Coordination: Financial markets act as collectors and aggregators of information about financial asset values and the flow of funds from lenders to borrowers. Risk Sharing: Financial markets allow a transfer of risk from those who undertake investments to those who provide funds for those investments. Liquidity: Financial markets provide the holders of financial assets with a chance to resell or liquidate these assets. Efficiency: Financial markets reduce transaction costs and information costs. 3. Constituents of a Financial System4 3.1 The financial markets can be divided into different subtypes: 3.1 (a) Capital markets which consist of: i) Stock markets, which provide financing through the issuance of shares or common stock, and enable the subsequent trading thereof. ii) Bond markets, which provide financing through the issuance of Bonds, and enable the subsequent trading thereof. b) Commodity markets: For facilitation of trading in commodities. c) Money markets: For providing short term debt financing and investment. d) Derivatives markets: For management of financial risk. e) Foreign exchange market: For buying and selling and hedging of foreign currency 4 2 The Indian Institute of Financial Planning
  16. 16. Chapter 1 : Investment an Introduction The capital markets consist of primary markets and secondary markets. Newly formed (issued) securities are bought or sold in primary markets. Secondary markets allow investors to sell securities that they hold or buy existing securities. While primary markets help to create assets, it is the secondary market that creates liquidity. An efficient primary market requires an equally efficient secondary market and vice-versa. For financial markets to function effectively one requires a host of financial intermediaries performing host of services and functions. In other words, a market is primary if the proceeds of sale go to the issuer of the securities sold whereas in case of secondary market the proceeds go from one investor to another investor. Example: In case of initial public offer by the companies the proceeds of the issue go to the company issuing the securities. 4. Financial Intermediaries/Institutions 4.1 Financial intermediaries perform the following functions:- Risk transformation: Financial intermediaries transform risk through risk spreading and risk pooling by diversifying their portfolio through numerous borrowers by investing in different firms and projects. Risk screening: In the process of dealing with numerous projects and firms, financial intermediaries acquire skills of risk screening. This assumes importance for individual lenders who instead of trying to select different firms for direct lending can instead just select a particular intermediary who in turn will be able to screen credit worthy borrowers. Risk Monitoring: As part of the lending agreement, borrowers are required to give details of performance and cash flows to lenders on a regular basis. Financial intermediaries in view of their specialized expertise are best positioned to monitor the borrowers on an ongoing basis which individual lenders both on account of lack of knowledge and time would find it difficult to do so. Maturity intermediation:5 Financial intermediaries can purchase financial assets with long maturities (“lend long”) while at the same time selling financial assets (acquiring liabilities) with short maturities (“borrow short”). Thus, illiquid long-maturity assets (e.g., mortgages) are transformed into a more liquid form (e.g., deposit accounts); and the buyers of the more liquid assets are charged a premium for this liquidity in the form of a lower rate of return. The gap between the average maturity of an intermediary’s assets and the average maturity of its liabilities is referred to as the maturity gap of the intermediary. Reduction of transactions and information costs: 6Intermediaries are able to reduce the transactions costs entailed during the process of matching borrowers with lenders. Intermediaries are also able to reduce the transactions costs associated with the writing and communicating of contract terms for borrowers and lenders. Since intermediaries perform the task of bringing borrowers and lenders together though indirectly, they are able to reduce substantially transactions costs due to the economies of scale. In addition, information costs incurred as a result of monitoring and enforcement of contract terms are reduced by centralizing these functions in one agent with extensive experience. This is particularly important in cases in which would-be lenders are relatively unsophisticated compared to would-be borrowers. As long as the intermediary’s own return is tied to the success of these monitoring and enforcement functions, it has an incentive to perform these functions in a reliable manner. Diversification: Since financial intermediaries have access to large amounts of funds, it can well afford to diversify their portfolio across numerous borrowers, projects, instruments each having its own maturity and cash flows. Such portfolio diversification is not possible for an individual borrower. 5 6 4 The Indian Institute of Financial Planning 3
  17. 17. Investment Planning Liquidity: Despite the illiquidity of the portfolio, financial intermediaries are in a position to provide liquidity to those who lend to them simply because it functions on the principle that all those who need liquidity do not need it at the same time. That is the withdrawals made by an individual are unrelated to others and therefore would not translate into mass withdrawals. 4.2 Types of Financial Intermediaries There are numerous financial intermediaries ranging from banks, brokers, pension funds, insurance companies, mutual funds, financial advisors, development institutions, co-operative institutions and a host of other institutions. Some of the major Financial intermediaries include: 4.2 (a) Banks: A bank is a financial institution that acts as a payment agent for customers, and borrows and lends money. Banks act as payment agents by conducting checking or current accounts for customers, paying cheques drawn by customers on the bank, and collecting cheques deposited to customers’ current accounts. Banks also enable customer payments via other payment methods such as telegraphic transfer, EFTPOS, and ATM. EFTPOS: Electronic Fund Transfer Point of Sale refers to the technology that allows a retailer to directly debit a customer’s bank account by using a debit card. The Banking Regulation Act of India, 1949 defines Banking as “accepting, for the purpose of lending or investment of deposits of money from the public, repayable on demand or otherwise and withdrawable by cheques, draft, order or otherwise.” Banks essentially perform the following functions :7 Accepting Deposits from public/others (Deposits) : Banks are also called custodians of public money. Basically, the money is accepted as deposit for safe keeping. But since the Banks use this money to earn interest from people who need money, Banks share a part of this interest with the depositors. Lending money to public (Loans) : Lending money is the second major activity of the bank. The bank acts an intermediary between the people who have the money to lend and those who have the need for money to carry out business transactions Transferring money from one place to another (Remittances): Banks also carry out, on behalf of their customers the act of transfer of money - both domestic and foreign.- from one place to another. This activity is known as “remittance business” Banks issue Demand Drafts, Banker’s Cheques, Money Orders etc. for transferring the money. Banks also have the facility of quick transfer of money also know as Telegraphic Transfer or Tele Cash Orders. Acting as trustees: Banks also act as trustees for various purposes. For example, whenever a company wishes to issue secured debentures, it has to appoint a financial intermediary as trustee who takes charge of the security for the debenture and looks after the interests of the debenture holders. Other Functions: Bankers also provide security to the money and valuables of the general public in the form of lockers. It also carries out the government business in terms of carrying out its tax and non tax receipts. 7 4 The Indian Institute of Financial Planning
  18. 18. Chapter 1 : Investment an Introduction 4.2 (b) Financial Adviser: A financial advisor is a professional who renders investment advice and financial planning services to individuals and businesses. Ideally, the financial adviser helps the client maximize their net worth while minimizing risk by using proper asset allocation. Financial advisers use stocks, bonds, mutual funds and insurance products to meet the needs of their clients. Many financial advisers receive a commission payment for the various financial products that they broker, although “fee-based” planning is becoming increasingly popular in the industry. A further distinction should be made between “fee-based”, i.e., they charge fees and collect commissions, and “fee-only” advisers. Fee-only advisers receive 100% of their compensation directly from their clients and have no outside conflicts of interest created by commissions or referral fees paid by other product or service providers. 4.2 (c) Insurance Companies: Insurance companies provide or sell insurance to hedge against the risk of catastrophic financial loss. Insurance itself is defined as the equitable transfer of the risk of a potential loss, from one entity to another, in exchange for a premium and duty of care. For the insurance services provide insurance companies charge premium which among other things is dependent on the amount of insurance coverage. From the point of view of the insurance company there are four general criteria for deciding whether to insure events or not. 1. There must be a larger number of similar objects so the financial outcome of insuring the pool of exposures is predictable. Therefore, they can calculate a “fair” premium. 2. The losses have to be accidental and unintentional (i.e., on the insured’s part). 3. The losses must be measurable, identifiable in location and time, and definite. An insurer also requires that losses cause economic hardship. This so that the insured has an incentive to protect and preserve the property to minimize the probability that the losses occur. 4. The loss potential to the insurer must be non-catastrophic, i.e., it cannot put the insurance company in financial jeopardy. 5. Losses must be uncertain of occurrence Insurance companies can be classified as life insurance companies and non life insurance companies. Life insurance companies sell life insurance, annuities and pensions products. Non-life or general insurance companies sell other types of insurance. These companies are subject to usually different tax and accounting rules. While life insurance is usually long term in nature, non life insurance cover is for a shorter period such as one year. Third party administrators are companies that perform underwriting and sometimes claim handling services for insurance companies. These companies often have special expertise that the insurance companies do not have. 4.2 (d) Mutual funds: Mutual Fund is a trust that pools the savings of a number of investors who share a common financial goal. The money thus collected is then invested in capital market instruments such as shares, debentures and other securities. The income earned through these investments and the capital appreciation realised are shared by its unit holders in proportion to the number of units owned by them. The major advantage for investors is the reduction in investment risk by spreading investments across asset class. SEBI has prescribed a formal structure for mutual funds in India. This can be diagrammatically represented as follows:-8 8 The Indian Institute of Financial Planning 5
  19. 19. Investment Planning SEBI TRUSTEE SPONSOR OPERATIONS AMC FUND MANAGER MKT. / SALES MKT. / SALES MUTUAL FUND SCHEMES DISTRIBUTOR INVESTOR 4.2 (e) Pension funds:9 Pension fund companies pool assets that are bought with the contributions to a pension plan for the exclusive purpose of financing pension plan benefits. A pension is a steady income given to a person (usually after retirement). Pensions are typically payments made in the form of a guaranteed annuity to a retired or disabled employee. Pension are created by an employer for the benefit of an employee and are commonly referred to as an occupational or employer pension. Labor unions, the government, or other organizations may also fund pensions. Pension plans can be divided into two broad types: Defined Benefit and Defined Contribution plans. Some plan designs combine characteristics of defined benefit and defined contribution types, and are often known as “hybrid” plans. A traditional pension plan that defines a benefit for an employee upon that employee’s retirement is a defined benefit plan. The benefit in a defined benefit pension plan is determined by a formula that can incorporate the employee’s pay, years of employment, age at retirement, and other factors. A defined contribution on the other hand is a plan providing for an individual account for each participant, and for benefits based solely on the amount contributed to the account, plus or minus income, gains, expenses and losses allocated to the account. As of today India has a well developed and vibrant financial sector with numerous financial intermediaries. A brief diagrammatical presentation is given below10:- INSTITUTIONS IN THE FINANCIAL SECTOR 9 10 6 The Indian Institute of Financial Planning
  20. 20. Chapter 1 : Investment an Introduction 5. Financial Assets - Direct and Indirect Investing Each of these financial intermediaries creates as well as buys and sells various financial instruments or financial assets. Financial assets are nothing but claims on the issuers of the securities, which are claims that are negotiable, or saleable in various market places.11 These instruments can be either classified as direct and indirect, Marketable or Non-Marketable. Direct investments are those wherein the investor acquires a direct claim on the security issued by the first issuing authority whereas indirect investment are those investments wherein a secondary claim is issued on the base of the primary securities. Investors acquire units from the financial intermediary who directly invests in the primary securities. The valuation of units is based on the market value of the primary securities. Marketable securities are those securities that can be bought and sold in the market whereas non marketable securities have to be held until maturity and there is no secondary market. These are usually government sponsored small savings schemes or social security schemes and, therefore, are illiquid. However, limited withdrawals subject to conditions and penalties may be permitted in non marketable securities. 5.1 Direct Investing (A) Non- Marketable a. Savings Account/Current Account b. Fixed Deposits/Recurring Deposits in Banks/Corporates/Financial Institutions c. Public Provident Fund/Employee Provident Fund d. Post office deposits e. Senior Citizens Saving Plans f. Kisan Vikas Patra/National Savings Certificate g. RBI relief bonds (B) Marketable a. Money Market i. Treasury bills ii. Certificate of Deposit iii. Commercial Paper iv. Repos v. Bills of Exchange b. Capital Market i. Fixed Income 1. Bonds/Debentures a. Corporate b. Government c. Municipal ii. Equities 1. Common Stock 2. Preferred Stock c. Derivatives Market i. Options ii. Futures iii. Forwards iv. Swaps 11 Jones, Charles P. Investments, Chapter 2, pp 25, 8th edn, Wiley Finance The Indian Institute of Financial Planning 7
  21. 21. Investment Planning 5.2 Indirect Investing (A) Mutual funds (B) Pension Funds (C) Insurance companies Each of these financial instruments has further divisions and sub-divisions each with their own amount and timing of cash flows and more important their risk and return profile. Broadly speaking, most instruments can be broadly divided into categories of fixed income instruments (debt) and equity. Money market instruments too mainly fall into the category of fixed income instruments. While debt has a lower risk and return profile, equity is the most risky of instruments. In recent times there has emerged yet another class of instruments called hybrid instruments which combine characteristics of debt and equity. Investment planning is really about finding the right kind of financial instruments and avenues to meet the various financial objectives keeping in mind the risk and return profile of the investor. It is, therefore, important that before selecting the appropriate investment vehicle to fund one’s investment needs, the concepts of risk and return and how they are measured should be learnt. It is only then can one map the various investment alternatives as per requirements. 8 The Indian Institute of Financial Planning