Inflation

Definition - Inflation is defined as an increase in general price levels. This is measured by comparing the levels of inflation index (based on a set of goods and services normally known as inflation basket) and expressed as a percentage rate of change over a period of time (mostly measured on an annual basis). There are several inflation measures available in India - most commonly used are based on Consumer Price Index (CPI) and Wholesale Price Index (WPI). Within these, there are several sub-indices (e.g. CPI for Industrial Workers, CPI for Urban Non Manual Labourers, etc) as well. These sub-indices are designed to see how price increases affect different set of people. Please note that inflation refers to percentage increase in prices and the daily newspaper reports of inflation coming down just means that the speed of price increase has reduced and doesn't mean the prices are actually coming down. Since WPI is available on a weekly basis, inflation based on that is the most commonly referred inflation measure in India.

Concept of Real Returns - Just like in our daily life, inflation plays a pivotal role in investment as well and the return generated from any asset class has to be higher than the expected inflation. Else, the actual goods and services we can buy at a later date will be less. For example, most of us allow our money to lie idle in our Savings Bank Account that earns a paltry return of 3.5%. Since the average inflation rate in India is much higher (say 5-6%), this will amount to a loss of 1.5-2.5% loss per annum. The excess return (ie "nominal return" less inflation rate) is known as "real return" and in the above-mentioned savings account example one can see that the real return is negative. That explains why we need to "invest" effectively and not just "save" to achieve our long-term goals.

Risk

Definition - According to Webster's, risk is the "possibility of loss or injury." Risk has a similar meaning in the investment world as well. No matter what you decide to do with your savings and investments, your money will always face some risk - however small it may be. For example, you could stash all your cash under the mattress or in a cookie jar, but then you'd face the risk of losing it all due to theft or natural calamities.

Investing in different asset classes like equity, debt, real estate, gold, etc carries risks of various types. For example, default risk (ie the chance of debtors not returning your money) pertains to debt instruments. The liquidity risk (ie the chance of not able to sell when you want to) pertains more for assets like gold, real estate, etc. Volatility risk (ie the chance of actual return varying from expected return) is common for all investment avenues.

Risk-Return trade off - In most circumstances, possible return is directly related to the potential risk. In other words, in order to receive an increased return from your investment portfolio, you need to accept a higher amount of risk. For example, keeping your money in a savings account reduces your risk (ie default risk is very low and there are no liquidity or volatility risks), but it also reduces your return. On the other hand, equities can give you high return in long term, but the returns will be extremely volatile in short-term.

Acceptable Risk - That means, the aim should be to make enough on your investments and at the same time, take only an acceptable amount of risk. What constitutes acceptable risk? It's different for different people. A good rule of thumb followed by many seasoned investors is that you invest in such a manner that you needn't wake up in the middle of the night worrying about your portfolio. If your investments are causing you too much anxiety, it's time to reconsider how you're investing and reduce those securities that are giving you insomnia in favour of investments that are a little less painful. When you find your own comfort zone, you'll know your personal risk tolerance -- the amount of risk you are willing to tolerate in order to achieve your financial goals.

Diversification

The principle of diversification involves investing in a portfolio of securities so that losses in some will offset gains in others, thereby reducing the returns volatility of the overall portfolio. Here again, it should be noted that diversification only reduces the risk and does not completely eliminate it. The part of risk that can be diversified away is known as "unsystematic risk". This usually pertains factors related to a company or industry and therefore, can be diversified away by investing in stocks of other industries. Un diversifiable or "systematic risk" stem from factors that affect the entire market. For instance, macroeconomic factors like monsoon failure can have an adverse effect on almost all equity shares.

Portfolio Size - As per the modern portfolio theory, increasing the number of securities beyond a point does not result in reducing the risk further. As visible from the chart, the addition of new securities reduces the risk drastically in the beginning. However, the effect of diversification comes down with the portfolio size increases. The risk reduction ability reaches almost a saturation point when the portfolio size reaches 25-30. In other words, increasing the number of securities from 30 to 100 will only bring about marginal gains in diversification.

Asset allocation

Asset Allocation goes one step ahead with diversification to reduce the overall portfolio risk further. We have seen from the earlier section that there is always an element of risk that cannot be diversified away within any asset class. Investing in other asset classes can reduce this systematic risk. This is because each asset class (eg: equity, debt, cash, real estate, gold, etc) have unique risk parameters and therefore, behaves quite differently from each other under the same market conditions. When some are falling in value, others may be rising and by strategically diversifying your assets across asset classes, you can smoothen out the ups and downs of your portfolio. But keep in mind that the asset allocation with large low risk investments will reduce the overall return of the portfolio also.

The main advantage of asset allocation is that it induces investment discipline and helps not to get carried away by the market sentiments. For example, the overall equity portfolio can go much above the proposed asset allocation when the stock market booms or can fall well below the proposed asset allocation when the market turns bearish. A regular "re-balancing" helps investors to book profit when the stock market is high and re-invest the same investment when the market comes down.

Factors to consider: An individual's asset allocation strategy should depend on three major factors - age, time period to investment goals, and the overall risk tolerance level.

• Age is the most important factor to consider while doing one's asset allocation. Young investors should include a greater proportion of high-risk high-return assets like equity (or equity funds) in their portfolio. As you grow older, you would much rather ease up on your equity investments and make more room for less volatile but more stable debt securities (or debt funds) in your portfolio. Seasoned investment advisers use "100-Age" as a thump rule. That means, if you are 30, your high-risk component should be 70% (ie 100-30).

• Next important factor is the time period to goals (ie the length of time between now and when the money will be spent finally). This can range from buying a car next year, saving for a down payment on a house in three years time, or saving for retirement 25 years from now. Those with a long-term horizon can afford to invest more aggressively in equity (or equity funds) because short-term volatility will usually be overcome by long-term growth. Moreover, the growth potential offered by equity tends to offset the effects of inflation in the long run. However, if your investment horizon is sufficiently short, then your emphasis should be increasingly on more stable investments like debt securities (or debt funds).

• Risk tolerance is also an important indicator of asset allocation. Ask yourself if you are the kind of person who spends sleepless nights every time the stock market drops, say, 20%. If so, you are undoubtedly risk-averse, and therefore your approach towards stock markets (or equity funds) should be more cautious.

Systematic Investment Plan

Investing would have been simple if you could always pick the stocks (or any other asset) when the price is at bottom and sell them at peak. However, timing the market consistently is almost impossible and you could be hit with a loss sooner or later. Instead, what you need is an automatic market-timing mechanism that eliminates the need to time your investments and at the same time helps you accumulate wealth in a disciplined manner over the long-term. Systematic Investment Plan (SIP) is a simple, time-tested strategy designed just for that. Let us take a closer look at its benefits:

• Rupee Cost Averaging - As visible from the table given below, the effective NAV per unit for SIP investor will always be less than the average NAV during that time period, regardless of whether the market is rising or falling or moving sideways. Since the monthly Installments remain same, you will get fewer units when the NAV is high and more number of units when it is low - automatically and in turn help to bring the average cost down. And this is the advantage of rupee cost averaging. Increasing the frequency of SIPs (ie Daily SIPs, Weekly SIPs, etc) will ensure that more ups and downs captured and in turn, helps to augment the magical effect of rupee cost averaging.

Power Of Compounding

Most of us keep postponing the investments thinking that it can be done later. Though this lethargy towards investment seems harmless now, it may result in huge financial burden later. This is because the earlier you invest, the longer your money works for you. And due to the magical power of compounding, the difference between investing early and investing later can be enormous. Let us explain this with the help of few examples.

Sameer and Sanjay are friends, just started their career at 20 and plan to retire at 65. Sameer starts saving Rs 5,000 every year from 20 itself and continues to do so till he reaches 35, after which he stops making any further investment. Sanjay, on the other hand, starts saving Rs 12,000 every year from the age of 35 and continues to do so till he reaches retirement age of 65. If both earn, say, 12% per annum on their investments, which of them would be wealthier when they retire at 65? Sameer. Surprising, isn't it? At 65, Sameer would have accumulated Rs 36.43 lakhs whereas Sanjay's wealth would have been lower at Rs 32.44 lakhs.

Similar will be the results even if one considers the one time investment. For example, assume that Sameer has invested Rs 10,000 at the age of 20 in an instrument that fetches 15% per annum. Sanjay on the other hand invests Rs 100,000 at the age of 40 in the same instrument. When both turns 60, Sameer's Rs 10,000 investment would have grown to Rs 26.78 lakhs, while Sajay's Rs 1 lakh would have grown only to Rs 16.37 lakhs.

The magical power of compounding gets enhanced when the investment period is very long and the rate of return is high. So, don't waste any more time - just start investing right now. And also don't forget to park your very long-term funds in high yielding investment options like equities.

Power Of Triggers

You must be hoping that someone will alert you when any major milestone (say the Sensex crossing 20,000 levels, your initial investment grown by 100%, etc) happens. It will be still better if the fund house takes actual actions (like redemption, switch, etc) based on these milestones defined by you. For this, Principal Mutual Fund has introduced the option of Triggers in our funds. You can specify a specific event, which may be related to time or value, in advance and when this event takes place the trigger is activated. Thus, this facility enables you to keep track of your investments without having to put in time and effort to track portfolio movements on a regular basis. It also helps you maintain a disciplined investment approach that ensures that your investment goals are met. Triggers are of three types - time-based, value-based and event-based.

• Time-based triggers - Time-based triggers are activated on a particular date that you have specified. For example, if you wish to gift some units to your mother on her birthday, a trigger could be set on that date.

• Value based triggers - These triggers are based on the change in value of your investments. For example, you need Rs 7.5 lakh for meeting the expenses of son's higher education after 5 years and you have invested Rs 5 lakhs in an equity scheme for this. If you set a trigger for change in investment value by at least 50%, the money can be shifted to a low risk scheme as soon the value reaches it. That way, the dream of your son's higher education will not go sour even if the market turns bearish later.

• Event-based triggers - You can also set triggers based on the occurrence of a particular external event that affects the value. For example, you want to set the Sensex value of 20,000 as a trigger. If the Sensex is less than 20,000 on the date of allotment, the trigger will be activated when the Sensex closes above 20,000. However, if the Sensex is more than 20,000 on the date of allotment, the trigger will be activated when the Sensex closes below 20,000.

Yield Curve

We normally tend to talk about interest rates going up or going down as if all rates move in tandem, although the reality is that interest rates behave quite differently across maturities. What is, however, important is to determine the overall pattern of interest rate movement and how you can use that to optimize portfolio returns. This is where the yield curve plays a pivotal role.

The graphical depiction of the relationship between the interest rates (or yields) on bonds of the same credit quality and different maturities is known as the yield curve. Here, the time period is plotted on the X-axis and yields on the Y-axis. The curve graphically demonstrates the rate at which market participants are willing to transact debt capital for short-term, medium-term and long-term periods.

Types of Yield Curves - The yield curves can take several shapes under different economic conditions. Predominantly, there are four such shapes - normal curve, steep curve, inverted curve, and flat curve.