10.1 Savings and Investments

  • Savings is the income left after meeting the expenses.If an individual wants to save it from loss in value, he normally keeps it in a secured place like a bank.
  • Investments are savings when they are used in an investment opportunity which can be either a physical or financial product. 

10.2 Inflation Risk

  • Inflation risk is the risk that the returns on the investment will be wiped away because of inflation. Suppose a person invests in an instrument which will provide him a return of 6%, but that year inflation is 8%. Hence, even though the investment provided a return, but because of inflation the real rate of return was in negative and the value of investment was eroded.
  • Returns on investment are expressed in nominal rate. When nominal rate is reduced by inflation, it is called real rate of return. The formula for calculation of real rate of return is –
Real Rate of Return = [(1 + Nominal Rate) ÷ (1 + Inflation Rate)] – 1 
  • Example: If nominal rate of an investment is 12% and inflation is 8%, real rate is = [(1 + 0.12)/(1 + 0.08)] – 1 = 3.7%.
  • Inflation risk is highest in fixed return instruments. Bonds, debentures, fixed deposits are fixed return instruments. Their investors are paid periodic interest and repaid the principal amount at maturity. Both the amounts are fixed. If during the period of investment inflation is high, it will greatly reduce the returns.
  • Inflation risk is highest for retirees whose income is fixed. Such an investor should consider investing part of his portfolio in - 
    • short term debt securities – so that he can take advantage of rising interest rates
    • equity or commodity – which are capable of earning high returns to beat inflation 

10.3 Financial and Physical Asset

10.3.1 Concept

  • Assets like land, building, jewellery, etc are physical assets. Physical assets can be touched and seen. They don’t just provide financial value, they can actually be used by the investor for something.
  • Assets like shares, debentures, fixed deposit, mutual fund schemes are financial assets. Financial assets have value but they cannot be touched or seen. A person who owns financial assets is entitled to their benefits. E.g. A person who has fixed deposit will get a certain amount repaid back to him after certain time, A person owning shares will have a share in net worth of the company. 

10.3.2 The Implication

  1. Comfort
  • A physical asset is under direct possession and control of the investor. An investor who has invested in a physical asset gets psychological comfort from the idea that he can see, touch and use the asset no matter what happens in outside world.
  • Financial assets, on the other hand, provide a right to earnings. There value depends on some other organisation or instrument. This can create concern in an investor like –

?  What if the company, of which he is a shareholder, closes? or

?  What if the mutual fund scheme, in which he has invested, goes bust?

  • Indian investors have more than half of their wealth in physical assets mainly because of difference in comfort.
  1. Unforeseen Events 
  • Unforeseen events like fire, floods, earthquakes can destroy physical assets. Their value can be greatly reduced or they can even become worthless. 
  • The same events have no impact on financial assets. Investee organisations keep a record of their investors. Even if an investor misplaces proof of ownership, he can go to the investee company, prove his identity and claim the financial asset. If the asset is in dematerialised form, this process becomes even simpler. 
  1. Economic Context 
  • Investment in physical assets like land, art, gold coin, etc. does not benefit the economy
  • Investment in financial assets helps the economy because that investment can be further mobilized by the investee organisation. For example, when an investor buys shares, keeps money in his bank account or invests in a mutual fund scheme, that money is used by the companies, banks, etc to carry out further economic activity. 
  1. Liquidity 
  • It is easier to liquidate financial assets like shares, mutual funds than it is to liquidate physical assets like land, buildings. Though, there is cost of liquidating financial assets, such cost may be higher in physical asset. Further, the process of liquidating a financial asset is easier. E.g. in case of mutual fund redemption or selling of shares, liquidation can be done by just filling out a form. Selling land on the other hand requires much more effort. 
  • Another advantage is that it is possible to sell only part of a financial asset. A physical asset in most cases has to sold off in whole even the money needed is less. 
  1. Maintenance 
  • Holding a physical asset takes time, effort and money. Owner of a physical asset also have to spend on insurance, maintenance cost and taxes. 
  • In case of financial assets, there are no such costs. Even if some recurring cost has to be paid like demat fees, the cost is very low. 
  • Transmission of asset – In the case of holder of asset dies, the asset has to be transferred to the person entitled by the holder. This process is easy in case of financial asset, while complicated in case of physical asset.  

10.4 How should an investor hold gold – in physical form or financial form?

Gold can be held in physical form or in financial form. 

If gold is held in physical form, there is a risk of loss by theft. If stored in bank locker, there is the cost of locker rent. 

In financial form, gold can be held in following forms – 

  1. Gold ETF
  • Gold ETFs are open-ended schemes with no fixed maturity.
  • These funds are traded on stock exchange like shares of a company so an investor can buy and sell his units in gold ETF whenever he wants. 
  1. Gold Sector Fund
  • Gold sector funds invest in the shares of the companies involved in gold mining and processing.
  • They don’t track price of gold closely like Gold ETFs. If gold prices increase, funds that have invested in companies holding reserves of gold will earn much higher returns than just increase in the value of gold and vice versa if value of gold falls.
  • The return of these funds is affected not just by price of gold but by other factors as well such as management of company, etc. 
  1. Gold Futures Contract
  • These are traded in commodity exchanges like National Commodity and Derivatives Exchange (NCDEX). Value of such contracts increases or decreases in line with increase or decrease in price of gold.
  • Futures contract have a limited duration e.g. 3 month gold contract. After the end of such time period, the investor will have to enter in to a new contract, if he wishes to remain invested in gold.
  • With futures contract investors can leverage. This means that the investor has to pay only a portion of the contract value (margin money) and he can enter into contracts of value much larger than the money available. However, investor needs to be cautious of the risks associated with leveraging. 
  1. Gold deposit scheme
  • This scheme is offered by some banks. An investor deposits gold in the bank for a specified period.
  • Bank pays interest at regular intervals on the value of gold deposited.
  • On maturity of the scheme, either the same quantity of gold or its equivalent value is paid back to the investor.  

10.5 How should an investor hold real estate – in physical form or financial form?

  • Holding real estate in physical form gives rise to many risks like – 
  1. Loss by Fire and other Hazards – Fire, earthquakes, floods can cause loss. 
  1. High Investment Amount – Amount required to purchase real estate is very high 
  1. Concentration Risk – Since investment amount is very high, most investors will not be able to buy many properties of different varieties in different places. Hence, investor incurs concentration risk. 
  1. Encroachment Risk – Land can be encroached upon. Hence, it should be properly guarded. There is a risk that a person can lose ownership of land. 
  1. Liquidity Risk – Real state has low liquidity compared to financial assets and even some physical assets like gold. There is no standardized mechanism for ascertaining transparent price and the process of finding a buyer and selling real estate may take quite a long time 
  1. High Transaction Cost – Transaction costs such as stamp duty and registration charges are high and the regulatory processes are lack transparency and are complicated. 
  1. Ownership Risk and Credit Risk – Tenant of property may fail to pay rent or refuse to vacate the property and claim the property and go for litigation. 
  • Real Estate Funds are financial assets that mitigate above mentioned risks to an extent. The ticket size to invest in such funds is smaller. These funds are managed by professional real estate managers who have better knowledge about the market. These managers can negotiate better prices, diversify investments and can take advantage of economies of scale.  

10.6 How can Mutual Funds be used to meet Investor Goals

10.6.1 Fixed Deposits vs Mutual Funds 

Advantages of Fixed Deposits over Mutual Funds 

– If a bank fails then deposit insurance scheme of the government will pay Rs. 1 Lakh to all the people who had fixed deposits. There is no such insurance scheme in mutual funds. 

Advantages of Mutual Funds over Fixed Deposits 

The mutual fund schemes that can be considered comparable to fixed deposits or saving bank accounts are some debt schemes. Their advantages are – 

– Higher Returns – 
  • Fixed deposits pay interest at a fixed rate. Fixed deposit holder will not earn higher interest even if market conditions are good. Mutual funds don’t guarantee returns but a good fund manager can invest in such securities that may give higher return than fixed deposit.
  • Active Investors can invest in short term debt funds when interest rates are rising and long term debt funds when interest rates are falling. 
– Different objectives of different schemes  There are different debt schemes with different objectives. Example –
  • An investor with a fixed horizon can invest in Fixed Maturity Plans (FMPs).
  • An investor looking for an alternative to savings bank account can invest in liquid fund or ultra-short term fund.
  • Investor who can take higher risk can invest in Income Fund or Dynamic Bond Fund which invest in Corporate Bonds and Gilt. 
– Tax Benefits
  • In bank fixed deposits, interest is taxed every year. In mutual funds, if the investor allows his investment to grow then income tax is not payable on year to year accretions. Hence, money can grow faster.
– Choice of Mutual Fund Schemes
  • Mutual funds offer facility to move funds around in various schemes. There is no such facility in bank deposit. 

10.6.2 What are some Investment Options for Regular Income

Investment options for regular income are – 

Post Office Monthly Income Scheme (MIS)

  • There is an upper limit to the amount that can be invested.
  • Income is taxable in the hands of investor 

Senior Citizen Savings Scheme (SCSS)

  • There is an upper limit to the amount that can be invested.
  • Income is taxable in the hands of investor 

Monthly Income Plan (MIP)

  • This is a debt-oriented hybrid mutual fund scheme which is open ended.
  • These schemes do not guarantee return but there are some schemes which have a good history of paying regular income
  • Payouts from the scheme can be structured either as Dividends or Systematic Withdrawals (taxed as capital gain), whichever is more tax efficient for the investor.  

10.6.3 Equity funds for Equity Investing 

Investing in equity through equity funds gives following benefits –

  • An experienced fund manager carries out extensive research, analysis, monitoring and rebalancing to ensure investor earns good returns. A normal investor does not have time or knowledge to do this.
  • Even a small investor can have a well diversified portfolio which he could not have afforded if he was investing directly in equity because of insufficient corpus.
  • Cost of investing directly in equity is more than the expense charged by mutual fund scheme.  

10.6.4. ELSS for Tax Saving

  • Equity Linked Saving Schemes are equity mutual funds that are permitted under Section 80C.
  • They also provide capital appreciation that can effectively beat inflation as they invest primarily in equity securities. Other investment options like PPF, NSC, Bank Deposits do not provide capital appreciation.
  • The lock in period of ELSS is 3 years while that of PPF is 15 years, NSC is 5/10 years and Fixed Deposit is 5 years.  

10.7 National Pension System (NPS)

Who regulates National Pension Scheme (NPS)?

Pension Funds Regulatory and Development Authority (PFRDA) regulates NPS. 

How many types of pensions accounts are there?

There are two types of pension accounts –

Tier I – Pension account with limited withdrawal facility

Tier II – Savings account – withdrawable to meet financial contingencies. Active Tier I account needed for opening Tier II account. 

In which asset classes can the investors invest?

Investor can invest in –

Asset Class E: Predominantly equity market instruments – Carries highest risk

Asset Class C: Debt securities other than Government Securities – Carries default risk

Asset Class G: Government Securities – Carries lowest risk

Asset Class A: Alternative Investment Products 

What securities does Asset Class A comprise of?

Investment in Asset Class A can be only upto 5 percent. The securities in Asset Class A are –

  • Commercial mortgage based securities
  • Units issued by Real Estate Investment Trusts regulated by SEBI
  • Asset Backed Securities regulated by SEBI
  • Units issued by Infrastructure Investment Trust regulated by SEBI
  • Alternate Investment Funds (AIF Category I and II) regulated by SEBI

 How are funds allocated under Government model of NPS?

Under Government model of NPS, only 15 percent of contributions are invested in equity-oriented investments and the rest in fixed income securities. Subscribers in Government model do not have a choice on how their contributions will be invested. 

How are funds invested in private sector NPS?

Private sector NPS subscribers get two ways of investing – Auto Choice and Active Choice

  • In Auto choice, funds are allocated in different asset classes (E,C,G,A) based on a pre-determined ratio linked to the age of the subscriber. 
  • Active Choice
?   In active choice, the subscriber can choose one of three life cycle funds 

»  Aggressive Life Cycle Fund (LC – 75) – equity investment restricted to 75 percent

»  Moderate Life Cycle Fund (LC – 50) – equity investment restricted to 50 percent

»  Conservative Life Cycle Fund (LC – 25) – equity investment restricted to 25 percent 

  • After the age of 50, equity allocation is gradually reduced. If the allocation in equity becomes more than the maximum limit due to age of the subscriber, the excess portion is moved to G-Sec. 
  • Subscriber will continue to have a choice to allocate his non-equity portion between asset classes C, G & A. 

How are Pension Funds managed?

Pension funds are managed by Pension Fund Managers (PFMs). The PFMs are authorised PFRDA. 

What is Permanent Retirement Account Number (PRAN)?

    • PRAN is a unique ID number of a subscriber for his NPS investments.
    • Same PRAN is applicable across all PFMs where subscriber’s money is invested.
  • When an individual changes employer, his PRAN still remain associated with him.

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