Tuesday, November 17, 2015

Financial Concepts: The Optimal Portfolio

The optimal portfolio concept falls under the modern portfolio theory. The theory assumes (among other things) that investors fanatically try to minimize risk while striving for the highest return possible. The theory states that investors will act rationally, always making decisions aimed at maximizing their return for their acceptable level of risk. 

The optimal portfolio was used in 1952 by Harry Markowitz, and it shows us that it is possible for different portfolios to have varying levels of risk and return. Each investor must decide how much risk they can handle and than allocate (or diversify) their portfolio according to this decision.
The chart below illustrates how the optimal portfolio works. The optimal-risk portfolio is usually determined to be somewhere in the middle of the curve because as you go higher up the curve, you take on proportionately more risk for a lower incremental return. On the other end, low risk/low return portfolios are pointless because you can achieve a similar return by investing in risk-free assets, like government securities. 

You can choose how much volatility you are willing to bear in your portfolio by picking any other point that falls on the
 efficient frontier. This will give you the maximum return for the amount of risk you wish to accept. Optimizing your portfolio is not something you can calculate in your head. There are computer programs that are dedicated to determining optimal portfolios by estimating hundreds (and sometimes thousands) of different expected returns for each given amount of risk.


Financial Concepts: Efficient Market Hypothesis

Efficient market hypothesis (EMH) is an idea partly developed in the 1960s by Eugene Fama. It states that it is impossible to beat the market because prices already incorporate and reflect all relevant information. This is also a highly controversial and often disputed theory. Supporters of this model believe it is pointless to search for undervalued stocks or try to predict trends in the market through fundamental analysis or technical analysis. 

Under the efficient market hypothesis, any time you buy and sell securities, you're engaging in a game of chance, not skill. If markets are efficient and current, it means that prices always reflect all information, so there's no way you'll ever be able to buy a stock at a bargain price. 

This theory has been met with a lot of opposition, especially from the technical analysts. Their argument against the efficient market theory is that many investors base their expectations on past prices, past earnings, track records and other indicators. Because stock prices are largely based on investor expectation, many believe it only makes sense to believe that past prices influence future prices.

Financial Concepts: Random Walk Theory

Random walk theory gained popularity in 1973 when Burton Malkiel wrote "A Random Walk Down Wall Street", a book that is now regarded as an investment classic. Random walk is a stock market theory that states that the past movement or direction of the price of a stock or overall market cannot be used to predict its future movement. Originally examined by Maurice Kendall in 1953, the theory states that stock price fluctuations are independent of each other and have the same probability distribution, but that over a period of time, prices maintain an upward trend. 

In short, random walk says that stocks take a random and unpredictable path. The chance of a stock's future price going up is the same as it going down. A follower of random walk believes it is impossible to outperform the market without assuming additional risk. In his book, Malkiel preaches that both technical analysis and fundamental analysis are largely a waste of time and are still unproven in outperforming the markets. 

Malkiel constantly states that a long-term
 buy-and-hold strategy is the best and that individuals should not attempt to time the markets. Attempts based on technical, fundamental, or any other analysis are futile.
While many still follow the preaching of Malkiel, others believe that the investing landscape is very different than it was when Malkiel wrote his book years ago. Today, everyone has easy and fast access to relevant news and stock quotes. Investing is no longer a game for the privileged. Random walk has never been a popular concept with those on
 Wall Street, probably because it condemns the concepts on which it is based such as analysis and stock picking. 

It's hard to say how much truth there is to this theory; there is evidence that supports both sides of the debate. Our suggestion is to pick up a copy of Malkiel's book and draw your own conclusions.

Financial Concepts: Asset Allocation

It's no secret that throughout history
 common stock has outperformed most financial instruments. If an investor plans to have an investment for a long period of time, his or her portfolio should be comprised mostly of stocks. Investors who don't have this kind of time should diversify their portfolios by including investments other than stocks. 

For this reason, the concept of asset allocation was developed. Asset allocation is an investment portfolio technique that aims to balance risk and create diversification by dividing assets among major categories such as bonds, stocks, real estate, and cash. Each asset class has different levels of return and risk, so each will behave differently over time. At the same time that one asset is increasing in value, another may be decreasing or not increasing as much. 
The underlying principle of asset allocation is that the older a person gets, the less risk he or she should take on. After you retire, you may have to depend on your savings as your only source of income. It follows that you should invest more conservatively because asset preservation is crucial at this time in life. 

Determining the proper mix of investments in your
 portfolio is extremely important. Deciding what percentage of your portfolio you should put into stocks, mutual funds, and low risk instruments like bonds and treasuries isn't simple, particularly for those reaching retirement age. Imagine saving for 30 or more years only to see the stock market decline in the years before your retirement! For many, this is what happened during the bear market of 2000 and 2001. To determine your asset allocation plan, we strongly suggest that you speak to an investment advisor who can customize a plan that is right for you.

Financial Concepts: RupeeCost Averaging

If you ask any professional investor what the hardest investment task is, he or she will likely tell you that it is picking
 bottoms and tops in the market. Trying to time the market is a very tricky strategy. Buying at the absolute low and selling at the peak is nearly impossible in practice. This is why so many professionals preach about rupee cost averaging .(RCA) 

Although the term might imply a complex concept, RCA is actually a fairly simple and extremely useful technique. Rupee cost averaging is the process of buying, regardless of the share price, a fixed dollar amount of a particular investment on a regular schedule. More shares are purchased when prices are low, and fewer shares are purchased when prices are high. The cost per share over time eventually averages out. This reduces the risk of investing a large amount in a single investment at the wrong time. 

Let's analyze this with an example. Suppose you recently got a bonus for your previously unrecognized excellence (just imagine!), and now you have Rs.10,000 to invest. Instead of investing the lump sum, with RCA, you'd spread the investment out over several months. Investing Rs.2,000 a month for the next five months, "averages" the price over five months. So one month you might buy high, and the next month you might buy more shares because the price is lower, and so on.

This plan is also applicable to the investor who doesn't have that big lump sum at the start, but can invest small amounts regularly. This way you can contribute as little as Rs 500 a month to an investment. Keep in mind that rupee cost averaging doesn't prevent a loss in a steadily declining market, but it is quite effective in taking advantage of growth over the long term.

Monday, November 16, 2015

Financial Concepts: Diversification

Many individual investors can't tolerate the short-term fluctuations in the stock market. Diversifying
your portfolio is the best way to smooth out the ride. 

Diversification is a risk-management technique that mixes a wide variety of investments within a portfolio in order to minimize the impact that any one security will have on the overall performance of the portfolio. Diversification lowers the risk of your portfolio. Academics have complex formulas to demonstrate how this works, but we can explain it clearly with an example:
Suppose that you live on an island where the entire economy consists of only two companies: one sells umbrellas while the other sells sunscreen. If you invest your entire portfolio in the company that sells umbrellas, you'll have strong performance during the rainy season, but poor performance when it's sunny outside. The reverse occurs with the sunscreen company, the alternative investment; your portfolio will be high performance when the sun is out, but it will tank when the clouds roll in. Chances are you'd rather have constant, steady returns. The solution is to invest 50% in one company and 50% in the other. Because you have diversified your portfolio, you will get decent performance year round instead of having either excellent or terrible performance depending on the season. There are three main practices that can help you ensure the best diversification: 

1.    Spread your portfolio among multiple investment vehicles such as cash, stocks, bonds, mutual funds and perhaps even some real estate. 
2.    Vary the risk in your securities. You're not restricted to choosing only blue chip stocks. In fact, it would be wise to pick investments with varied risk levels; this will ensure that large losses are offset by other areas. 
3.    Vary your securities by industry. This will minimize the impact of industry-specific risks.

Diversification is the most important component in helping you reach your long-range financial goals while minimizing your risk. At the same time, diversification is not an ironclad guarantee against loss. No matter how much diversification you employ, investing involves taking on some risk.

Another question that frequently baffles investors is how many stocks should be bought in order to reach optimal diversification. According to portfolio theorists, adding about 20 securities to your portfolio reduces almost all of the individual security risk involved. This assumes that you buy stocks of different sizes from various industries.

Financial Concepts: The Risk/Return Tradeoff

The risk/return tradeoff could easily be called the "ability-to-sleep-at-night test."
While some people can handle the equivalent of financial skydiving without batting an eye, others are terrified to climb the financial ladder without a secure harness. Deciding what amount of risk you can take while remaining comfortable with your investments is very important.
In the investing world, the dictionary definition of risk is the chance that an investment's actual return will be different than expected. Technically, this is measured in statistics by standard deviation. Risk means you have the possibility of losing some, or even all, of your original investment.
Low levels of uncertainty (low risk) are associated with low potential returns. High levels of uncertainty (high risk) are associated with high potential returns. The risk/return tradeoff is the balance between the desire for the lowest possible risk and the highest possible return. This is demonstrated graphically in the chart below. A higher standard deviation means a higher risk and higher possible return.
A common misconception is that higher risk equals greater return. The risk/return tradeoff tells us that the higher risk gives us the possibility of higher returns. There are no guarantees. Just as risk means higher potential returns, it also means higher potential losses.
On the lower end of the scale, the risk-free rate of return is represented by the return on Government Securities because their chance of default is low.
Determining what risk level is most appropriate for you isn't an easy question to answer. Risk tolerance differs from person to person. Your decision will depend on your goals, income and personal situation, among other factors.

Monday, November 9, 2015

The tax on capital gains

What are the tax implications of investing in mutual funds?
When you sell an asset and make a profit on it, it is known as capital gains. This is applicable to any asset - property, stocks, bonds, mutual funds, art, gold, and so on and so forth. In other words, when you sell your mutual fund units, you incur a capital gains tax.
Capital gains is further split into long term and short term. And the tax implication differs for equity and debt funds.
Equity funds
An equity oriented mutual fund is one where a minimum 65% of the investible corpus is invested in domestic equity.
So gold exchange traded funds, or Gold ETFs, are not treated as equity funds for taxation.
Even international funds are not considered as equity funds in the case of taxation even though they invest in equity. The criteria to qualify for an equity funds is not just investments in stocks but stocks listed in India.
In the case of hybrid or balanced funds, if at least 65% of the assets are invested in domestic equity, they qualify as equity-oriented funds.
If you sell an equity mutual fund after holding it for a period of 12 months, then it qualifies for long-term capital gains. As of now, long-term capital gains on equity funds is nil. So you pay no tax.
If you sell your equity mutual fund before this period, then it qualifies for short-term capital gains, which is 15%.
Another feature of an equity fund is that dividends are not taxed. The dividend is tax free in the hands of the unit holder. Neither does the fund house have to pay any dividend distribution tax.
Debt funds
The non-equity funds qualify as debt funds for the purpose of taxation. So this would include all types of debt funds, international funds, monthly income plans, or MIPs, and Gold ETFs.
Short-term capital gains would be levied if the holding period is less than 3 years. Short-term capital gains are added to the income and taxed as per the individual's income tax slab. From a tax perspective, it is obvious that debt funds no longer offer tax advantages over fixed deposits if the holding period is less than three years.
If you sell the asset after holding it for a period of 36 months, or 3 years, it qualifies as long-term capital gains. This is 20% with indexation.
Indexation is the process that takes into account inflation from the time you bought the asset to the time you sell it. The way it works is that it allows you to inflate the purchase price of the asset (in this case the mutual fund units) to take into account the impact of inflation. The end result is that you get the benefit of lowering your tax liability.
Dividends received in the case of a debt fund unit holder are exempt from tax. However, the fund house has to pay a dividend distribution tax, or DDT, before distributing this income to its investors. The DDT is deducted by the asset management company prior to the disbursal of dividends. So, no tax on dividends is payable in the hands of the investor.

All the tax rates mentioned above do not include surcharge and education cess.