Basics of investments

The world of finance can be complicated and quite intimidating at times. We believe investments, as a practice
is inherently simple, once you understand the basics of investments and the terms associated with them. In this
section, we endeavour to educate current or potential investors on the basics of investing from the ground up.

When one thinks of investments, typically most investors would think of fixed deposits, insurance, infrastructure
bonds etc. Mutual funds offer an interesting investment opportunity. However as a category they are not so
well-known. In this section, we also attempt to explain mutual fund basics and demystify the basics of
investments in mutual funds.

While you contemplate or plan your investments, please understand that investing is not a get-rich-quick
phenomenon. It involves meticulous planning and control over your personal financial practices with a
deepened sense of discipline and common sense. Every investment made will have its risks and rewards.
These two factors will always go hand in hand. Taking control of your personal finances will require hard work,
and, yes, there will be a learning curve. But the rewards will far outweigh the required efforts. So to know more,
do read this section on basics of investments and mutual fund basics.

fundamentals
Go

The world of finance can be complicated and quite intimidating at times. We believe investments, as a practice
is inherently simple, once you understand some of the major concepts and the lingo associated with them. In
this section we endeavour to educate current or potential investors on the practice of investing from the ground
up.

What is investing?

It's actually pretty simple: investing means putting your money to work for you–actually, it's a different way to
think about how to make money. Growing up, most of us were taught that you can earn an income only by
getting a job and working. And so that's what most of us do. But there's a limit to how much we can work and
how much money we make out of it–not to mention the fact that having a bunch of money is no fun if we don't
have the leisure time to enjoy it.
So, since you cannot create a duplicate of yourself to increase your working time, you need to send an
extension of yourself–your money–to work. That way, while you are putting in hours for your employer,
sleeping, reading the paper, or socializing with friends, you can also be earning money elsewhere. Quite
simply, making your money work for you maximizes your earning potential whether or not you receive a raise,
decide to work overtime, or look for a higher–paying job.

There are many different ways you can go about making an investment. This includes putting money into
stocks, bonds, mutual funds, real estate, gold etc. The point is that no matter the method you choose to invest,
the goal is always to put your money to work so it earns you an additional profit. Even though this is a simple
idea, it's the most important concept for you to understand.

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What investing is not?

Investing is NOT gambling. Gambling is putting money at risk by betting on an uncertain outcome with the hope
that you might win money. Part of the confusion between investing and gambling, however, may come from the
way some people use investment vehicles. For example, it could be argued that buying a stock based on a 'hot
tip' you heard at the water cooler is essentially the same as placing a bet at a casino.

A 'real' investor does not simply throw his or her money at any random investment; he or she performs
thorough analysis and commits capital only when there is a reasonable expectation of profit. Yes, there still is
risk, and there are no guarantees, but investing is more than simply hoping lady luck is on your side.

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Why bother investing?

Obviously, to earn more money.

However, investing is becoming less of an extra thing to do and more of a necessity. For the average person,
investing is the only way they can retire and yet maintain their present standard of living.

By planning ahead you can ensure financial stability during your retirement.

Now that you have a general idea of what investing is and why you should do it, it's time to learn about how
investing lets you take advantage of one of the miracles of mathematics: compound interest.
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Compound interest

Albert Einstein said that compound interest is 'the greatest mathematical discovery of all time.'

The wonder of compounding (sometimes called 'compound interest') transforms your money into an income-
generating tool. Compounding is the process of generating earnings (multiplying your money) on presently
invested money. To work, it requires two things: (1) the re-investment of earnings, and (2) time. The more time
you give your investments, the more you are able to accelerate the income potential of your original
investment, which takes the pressure off of you.

To demonstrate, let's look at an example:

If you invest INR1,000 today at 6 per cent, you will have INR1,060 in one year (INR1,000 x 1.06). Now let's say
that rather than withdraw the INR60 gained from interest, you keep it in there for another year. If you continue
to earn the same rate of 6 per cent, your investment will grow to INR1,123.6 (INR1,060 x 1.06) by the end of
the second year.

Because you re-invested that INR60, it works together with the original investment, earning you INR123.6 in
total, as against INR120 that you would have earned if you had kept INR1000 for two years without reinvesting
the INR60. This is INR3.60 more interest than the previous year. This little bit extra may seem a paltry amount
now, but let's not forget that you didn't have to lift a finger to earn the extra INR3.60. More importantly, this
INR3.60 also has the capacity to earn interest. After the next year, your investment will be worth INR1,191.016
(INR1,123.6 x 1.06). This time you earned INR191.016, which is INR11.016 more interest than the first year.
This increase in the amount made each year is compounding in action: interest earning interest on interest and
so on. It'll continue as long as you keep re-investing and earning interest.

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Starting early

Consider two individuals, we'll name them Ram and Sham. Both Ram and Sham are the same age. When Ram
was 25 he invested INR15,000 at an interest rate of 8.0 per cent. For simplicity, let's assume the interest rate
was compounded annually. By the time Ram reaches 60, he will have INR221,780 (INR15,000 x [1.08^35]) in
his bank account.
Ram's friend, Sham, did not start investing until he reached age 35. At that time, he invested INR15,000 at the
same interest rate of 8 per cent compounded annually. By the time Sham reaches age 60, he will have
INR102,727 (INR15,000 x [1.08^25]) in his bank account.

What happened? Both Ram and Sham are 60 years old, but Ram has INR119,053 (INR221,780 - INR102,727)
more in his savings account than Sham, even though he invested the same amount of money! By giving his
investment more time to grow, Ram earned a total of INR206,780 in interest and Sham earned only INR87,727.

Both Ram and Sham's earnings rates are demonstrated in the following chart:

You can see that both investments start to grow slowly and then accelerate, as reflected in the increase in their
curves' steepness. Ram's line becomes steeper as he nears his 60s not simply because he has accumulated
more interest but because this accumulated interest is itself accruing more interest.

In fact even if Sham had invested INR20,000 at the age of 35 he would have accumulated INR136,970, which
is still lower than what Ram would have accumulated had he invested INR15,000 only. This clearly
demonstrates the power of compounding and the benefits of investing early. So keep your hands off the
principal invested and interest earned !

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Knowing yourself
Even though all investors are trying to make money, they all come from diverse backgrounds and have different
needs. It follows that specific investing vehicles and methods are suitable for certain types of investors.
Although there are many factors that determine which path is optimal for an investor, we'll look at three main
categories: investment objectives, timeframe, and your personality.

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Investment objectives

Generally speaking, investors have a few primary objectives: safety of capital, current income, or capital
appreciation. These objectives depend on a person's age, stage/position in life, and personal circumstances. A
65-year-old widow living off her retirement savings is far more interested in preserving the value of investments
than a 33-year-old business executive would be. Because the widow needs income from her investments to
survive, she cannot risk losing her investment. The young executive, on the other hand, has time on his or her
side and can therefore risk losing his money simply because he has time to make more money

An investor's financial position will also affect his or her objectives. A multi-millionaire is obviously going to have
very different goals compared to a newly married couple just starting out.

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Timeframe

As a general rule, the shorter your time horizon, the more conservative you should be. If your investment is for
a long-term objective like retirement planning and you are still in your 20s, then you still have time to make up
for losses and can therefore invest in aggressive investment vehicles like stocks. At the same time, if you start
when you are young, you have the power of compounding on your side.

On the other hand, if you are about to retire, then the opportunity to recover losses on your investments is
limited and therefore it is critical to invest your assets conservatively.

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Your personality

Peter Lynch, one of the greatest investors of all time, has said that the 'key organ for investing is the stomach,
not the brain.' In other words, you need to know how much volatility you can stand to see in your investments.
Figuring this out is difficult; but there is some truth to an old investing maxim: you've taken on too much risk
when you can't sleep at night because you are worrying about your investments. This is an indicator of your
investment personality.

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Putting it all together: your risk tolerance

By now it is probably clear to you that the main thing determining what works best for an investor is his or her
capacity to take on risk (to get an indication of your risk taking ability, use our Risk Profiler).

The core factors that define your risk tolerance are:

• Investment Objectives
• Timeframe
• Your personality

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Types of investments

Bonds

Grouped under the general category called 'fixed-income' securities, the term 'bond' is commonly used to refer
to any founded on debt. When you purchase a bond, you are lending out your money to a company or
government. In return, they agree to give you interest on your money and eventually pay you back the amount
you lent out.

The main attraction of bonds is their relative safety. If you are buying bonds from a stable government, your
investment is virtually guaranteed (or "risk-free" in investing parlance). The safety and stability, however, come
at a cost. Because there is little risk, there is little potential return. As a result, the rate of return on bonds is
generally lower than other securities.

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Stocks
When you purchase stocks (or 'equities' as your advisor might put it), you become a part owner of the
business. This entitles you to vote at the shareholder's meeting and allows you to receive any profits that the
company allocates to its owners–these profits are referred to as dividends.

While bonds provide a steady stream of income, stocks are volatile. That is, they fluctuate in value on a daily
basis. When you buy a stock, you aren't guaranteed anything. Many stocks don't even pay dividends, making
you any money only by increasing in value and going up in price–which might not happen.

Compared to bonds, stocks provide relatively high potential returns. Of course, there is a price for this potential:
you must assume the risk of losing some or all of your investment.

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Mutual Funds

A mutual fund is a collection of stocks and bonds. When you buy a mutual fund, you are pooling your money
with a number of other investors, which in turn enables you (as part of a group) to pay a professional manager
to select specific securities for you. Mutual funds are all set up with a specific strategy in mind, and their distinct
focus can be nearly anything: large stocks, small stocks, bonds from governments, bonds from companies,
stocks and bonds, stocks in certain industries, stocks in certain countries, and the list goes on.

The primary advantage of a mutual fund is that you can invest your money without needing the time or the
experience in choosing investments. To know more about mutual funds, please visit our learning centre.

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Alternative Investments: Options, Futures, FOREX, Gold, Real Estate, Etc.

So, you now know about the two basic securities: equity and debt, better known as stocks and bonds. While
many (if not most) investments fall into one of these two categories, there are numerous alternative vehicles,
which represent more complicated types of securities and investing strategies.

The good news is you probably don't need to worry about alternative investments at the start of your investing
career. They are generally high-risk/high-reward securities that are much more speculative than plain old
stocks and bonds. Yes, there is the opportunity for big profits, but they require some specialized knowledge. So
if you don't know what you are doing, you could get yourself into a lot of trouble. We would therefore suggest
that you start with simpler investment avenues and leave these investment vehicles for the experts.
Mutual Fund basics
Go

As you probably know, Mutual Funds have become pretty popular over the last few years. What was once just
another obscure financial instrument is now a part of our lives and here to stay. According to sources, more
than 80 million people, or one half of the households in America, invest in Mutual Funds. That means that, in
the United States alone, trillions (yes, with a 'T') of dollars are invested in Mutual Funds.

It's common knowledge that investing in mutual funds is (or at least should be) better than simply letting your
cash waste away in a savings account, but, for most people, that's where the understanding of funds ends.

Originally Mutual Funds were meant to allow the common man to get a piece of the market considering that the
common man would be less knowledgeable about financial markets and would have smaller investments to
transact with. Instead of spending all your free time buried in the financial pages of the Economic Times, all you
have to do is buy a mutual fund and you'd be set on your way to financial freedom. As you might have
guessed, it's not that easy. Not all Mutual Funds are the same, and investing in mutual funds isn't as easy as
throwing your money at the first salesperson who attracts your attention.

This is why we've written this tutorial. The basics of Mutual Funds and the myths surrounding them are
addressed to help you make a more informed decision.

What is a Mutual Fund?

A Mutual Fund is a trust that pools the savings of a number of investors who share a common financial goal. It
is essentially a diversified portfolio of financial instruments - these could be equities, debentures/bonds or
money market instruments. The corpus of the fund is then deployed in investment alternatives that help to meet
predefined investment objectives. 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. Thus a Mutual Fund
is a suitable investment for the common man as it offers an opportunity to invest in a diversified, professionally
managed basket of securities at a relatively low cost.

You could make money from a Mutual Fund in three ways:

• Income is earned from

dividends declared by
 Mutual Fund schemes from
time to time
• If the fund sells securities
that have increased in price,
the fund has a capital gain.
This is reflected in the price
of each unit. When investors
sell these units at prices
higher than their purchase
price, they stand to make a
gain
• If fund holdings increase in
price but are not sold by the
fund manager, the fund's
unit price increases. You
can then sell your Mutual
Fund units for a profit. This
is tantamount to a valuation
gain

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What are the benefits of investing in a Mutual Fund?

The benefits of investing in Mutual Funds are as follows -

• Access to professional
money managers -
Experienced fund managers
using advanced quantitative
and mathematical
techniques manage your
money
• Diversification - Mutual
Funds aim to reduce the
volatility of returns through
diversification by investing in
a number of companies
across a broad section of
industries and sectors. It
prevents an investor from
putting 'all eggs in one
basket'. This inherently
minimizes risk. Thus with a
small investible surplus an
investor can achieve
diversification which would
have otherwise not been
possible
• Liquidity - Open-ended
Mutual Funds are priced
daily and are always willing
to buy back units from
investors. This mean that
investors can sell their
holdings in Mutual Fund
investments anytime without
worrying about finding a
buyer at the right price. In
the case of other investment
avenues such as stocks and
bonds, buyers are not
necessarily available and
therefore these investment
avenues are less liquid
compared to open-ended
schemes of Mutual Funds
• Tax efficiency - Mutual
Fund offers a variety of tax
benefits. Please visit the tax
corner section or consult
your tax advisor for details
• Low transaction costs -
Since Mutual Funds are a
pool of money of many
investors, the amount of
investment made in
securities is large. This
therefore results in paying
lower brokerage due to
economies of scale
• Transparency - Prices of
open ended Mutual Funds
are declared daily. Regular
updates on the value of your
investment are available.
The portfolio is also
disclosed regularly with the
fund manager's investment
strategy and outlook
• Well-regulated industry -
All the Mutual Funds are
registered with SEBI and
they function under strict
regulations designed to
protect the interests of
investors
• Convenience of small
investments - Under normal
circumstances, an individual
 investor would not be able to
diversify his investments
(and thus minimize risk)
across a wide array of
securities due to the small
size of his investments and
inherently higher transaction
costs. A Mutual Fund on the
other hand allows even
individual investors to hold a
diversified array of securities
due to the fact that it invests
in a portfolio of stocks. A
Mutual Fund therefore
permits risk diversification
without an investor having to
invest large amounts of
money

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What are the different types of Mutual Funds?

Mutual Fund schemes may be classified on the basis of their structure and their investment objective.

• By structure

Open-ended Funds

An Open-ended Fund is one

that is available for
subscription all through the
year. These do not have a
fixed maturity. Investors can
conveniently buy and sell
units at Net Asset Value
(NAV) related prices.

Close-ended Funds
A Close-ended Fund has a
stipulated maturity period,
which generally ranges from
3 to 15 years. The fund is
open for subscription only
during a specified period.
Investors can invest in the
scheme at the time of the
new fund offer and
thereafter they can buy or
sell the units of the scheme
on the Stock Exchanges, if
they are listed. The market
price at the stock exchange
could vary from the
scheme's NAV on account
of demand and supply
situation, unit holders'
expectations and other
market factors.

• By investment objective

Growth Funds

The aim of Growth Funds is

to provide capital
appreciation over the
medium to long term. Such
schemes normally invest a
majority of their corpus in
equities. Growth schemes
are ideal for investors who
have a long-term outlook
and are seeking growth over
a period of time.
Income Funds

The aim of Income Funds is

to provide regular and
steady income to investors.
Such schemes generally
invest in fixed income
securities such as bonds,
corporate debentures and
Government securities.

Income Funds are ideal for

capital stability and regular
income. Capital appreciation
in such funds may be
limited, though risks are
typically lower than that in a
growth fund.

Balanced Funds

The aim of Balanced Funds

is to provide both growth
and regular income. Such
schemes periodically
distribute a part of their
earning and invest both in
equities and fixed income
securities in the proportion
indicated in their offer
documents. This proportion
affects the risks and the
returns associated with the
balanced fund - in case
equities are allocated a
higher proportion, investors
would be exposed to risks
similar to that of the equity
market.

Balanced funds with equal

allocation to equities and
fixed income securities are
ideal for investors looking for
a combination of income and
moderate growth.

Money market Funds

The aim of Money Market

Funds is to provide easy
liquidity, preservation of
capital and moderate
income. These schemes
generally invest in safer
short-term instruments such
as Treasury Bills,
Certificates of Deposit,
Commercial Paper and
Inter-Bank Call Money.
Returns on these schemes
may fluctuate depending
upon the interest rates
prevailing in the market.

These are ideal for

corporate and individual
investors as a means to park
their surplus funds for short
periods.

• Other equity related

schemes

Tax saving schemes

These schemes offer tax
rebates to the investors
under specific provisions of
the Indian Income Tax laws,
as the Government offers
tax incentives for investment
in specified avenues.

Investments made in Equity

Linked Savings Schemes
(ELSS) and Pension
Schemes are allowed as
deduction under Section 88
of the Indian Income Tax
Act, 1961.

Index schemes

Index Funds attempt to

replicate the performance of
a particular index such as
the BSE Sensex or the NSE
S&P CNX 50.

Sectoral schemes

Sectoral Funds are those

which invest exclusively in
specified sector(s) such as
FMCG, Information
Technology,
Pharmaceuticals, etc. These
schemes carry higher risk as
compared to general equity
schemes as the portfolio is
less diversified, ie restricted
to specific sector(s) /
industry (ies).
What are the different plans that Mutual Funds offer?

To cater to different investment needs, Mutual Funds offer various investment options. Some of the important
investment options include:

• Growth Option

Dividend is not paid-out

under a Growth Option and
the investor realises only the
capital appreciation on the
investment (by an increase
in NAV).

• Dividend Payout Option

Dividends are paid-out to

investors under the Dividend
Payout Option. However, the
NAV of the Mutual Fund
scheme falls to the extent of
the dividend payout.

• Dividend Re-Investment
Option

Here the dividend accrued

on Mutual Funds is
automatically re-invested in
purchasing additional units
in Open-ended Funds. In
most cases Mutual Funds
offer the investor an option
of collecting dividends or re-
investing the same.

• Retirement Pension
Option

Some schemes are linked

with retirement pension.
Individuals participate in
these options for
themselves, and corporates
participate for their
employees.

• Insurance Option

Certain Mutual Funds offer

schemes that provide
insurance cover to investors
as an added benefit.

• Systematic Investment
Plan (SIP)

Here the investor is given

the option of preparing a
pre-determined number of
post-dated cheques in
favour of the fund. The
investor is allotted units on a
predetermined date
specified in the offer
document at the applicable
NAV.

• Systematic Encashment
Plan (SEP)

As opposed to the
Systematic Investment Plan,
the Systematic Encashment
Plan allows the investor the
facility to withdraw a pre-
determined amount/units
from his fund at a pre-
determined interval. The
investor's units will be
redeemed at the applicable
NAV as on that day.
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What are the types of risks?

Risk is an inherent aspect of every form of investment. For Mutual Fund investments, risks would include
variability, or period-by-period fluctuations in total return. The value of the scheme's investments may be
affected by factors affecting capital markets such as price and volume volatility in the stock markets, interest
rates, currency exchange rates, foreign investment, changes in government policy, political, economic or other
developments.

• Market risk: At times the

prices or yields of all the
securities in a particular
market rise or fall due to
broad outside influences.
When this happens, the
stock prices of both an
outstanding, highly profitable
company and a fledgling
corporation may be affected.
This change in price is due
to 'market risk'.
• Inflation risk: Sometimes
referred to as 'loss of
purchasing power'.
Whenever the rate of
inflation exceeds the
earnings on your
investment, you run the risk
that you'll actually be able to
buy less, not more.
• Credit risk: In short, how
stable is the company or
entity to which you lend your
money when you invest?
How certain are you that it
will be able to pay the
interest you are promised, or
repay your principal when
the investment matures?
• Interest rate risk:
Changing interest rates
affect both equities and
bonds in many ways. Bond
prices are influenced by
movements in the interest
rates in the financial system.
Generally, when interest
rates rise, prices of the
securities fall and when
 interest rates drop, the
prices increase. Interest rate
movements in the Indian
debt markets can be volatile
leading to the possibility of
large price movements up or
down in debt and money
market securities and
thereby to possibly large
movements in the NAV.
• Investment risks: In the
sectoral fund schemes,
investments will be
predominantly in equities of
select companies in the
particular sectors.
Accordingly, the NAV of the
schemes are linked to the
equity performance of such
companies and may be
more volatile than a more
diversified portfolio of
equities.
• Liquidity risk: Thinly
traded securities carry the
danger of not being easily
saleable at or near their real
values. The fund manager
may therefore be unable to
quickly sell an illiquid bond
and this might affect the
price of the fund
unfavorably. Liquidity risk is
characteristic of the Indian
fixed income market.
• Changes in the
government policy:
Changes in Government
policy especially in regard to
the tax benefits may impact
the business prospects of
the companies leading to an
impact on the investments
made by the fund.

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Are returns from Mutual Funds guaranteed?

Generally, Mutual Funds do not offer guaranteed returns to investors. Although, SEBI regulations allow Mutual
Funds to offer guaranteed returns subject to the Fund meeting certain conditions, most Funds do not offer such
guarantees. In case of a guaranteed return scheme, the sponsor or the AMC, guarantees a minimum level of
return and makes good the difference if the actual returns are less than the guaranteed minimum. The name of
the guarantor and the manner in which the guarantee shall be met must be disclosed in the offer document by
the Mutual Fund. Investments in Mutual Funds are not guaranteed by the Government of India, the Reserve
Bank of India or any other government body.

Does investing in Mutual Funds mean investing in equities?

No, this is not necessary. Mutual Funds can be divided into various types depending on asset classes. They
can also invest in debt instruments such as bonds, debentures, commercial paper and government securities
apart from equity.

Every Mutual Fund scheme is bound by the investment objectives outlined by it in its prospectus. The
investment objectives specify the class of securities a Mutual Fund can invest in. Based on the investment
objective, the following types of Mutual Funds currently operate in the country.

• Growth schemes
• Income schemes
• Balanced schemes
• Money market schemes