Question

In 1500 words describe the reasons for investing in the stock market with an emphasis on stocks, mutual funds and bonds. Compare advantages and disadvantages of each of these options (stocks, mutual funds and bonds).

Answer 1

In 1500 words describe the reasons for investing in the stock market with an emphasis on stocks, mutual funds and bonds. Compare advantages and disadvantages of each of these options (stocks, mutual funds and bonds).

Any rational investor invests in various instruments primarily to earn from dividend or capital appreciation on investment over a period of time. The objective may be profit maximization, which is short term or wealth maximization ,which is long term in nature. Investments are made to beat inflation and to maintain a certain standard of life style. If cash is kept idle in bank accounts then it will earn only nominal rate of interest which will not help to beat inflation ,hence the Investors look for alternate investments where they can get higher returns. In principal , higher the risk ,higher is the Expected Return. There are numerous avenues and financial products available for an investor according to his risk appetite. Debt Funds, Equity, Commodities, Real Estate are some of the lucrative investment options.

It is well known fact that power of compounding works wonder. A simple investment of $1000 per month for 10 years would grow on to $191,250 at 10% return. The idea behind investment is that your money should work harder than you. Although it is well accepted fact that investment and returns help to uplift one’s standard of living and full fill the life aspirations with regards to money matters , but it is also true that investments are risky too.

Hence it is important to invest to-

1. Fight Inflation

2. Create Wealth – By investing one can aim to have a better corpus by the end of the defined

time period.

3.Meet life’s financial aspiration - children’s education, marriage, house purchase, retirement holidays etc

4. Fight contingencies and emergencies

Stock Investment implies directly investing in the shares or stocks of the company and becoming the owner of the company to the extent of investment. In return of the investment, the owners are rewarded with dividend if the company is doing well or capital appreciation of the share price if the company is listed in stock exchange. Equity investment is like investing in a business hence it is very important to understand the business and the financials of the company like Statement of Profit and loss, Cash Flow Statement , Balance Sheet before investing.

Few of the questions to understand/ask to understand the business –

No Question Rational behind the question

The Qualitative aspect

1. Management’s background – Who are they, their background, experience, education, do they have the merit to run the business, any criminal cases against the promoters etc

2. Business ethics – is the management involved in scams, bribery, unfair business practices

3. Corporate governance – Appointment of directors, organization structure, transparency

4. Minority shareholders – How does the management treat minority shareholders, do they consider their interest while taking corporate actions

5. Share transactions – Is the management buying/selling shares of the company through clandestine promoter groups

6. Related party transactions

7. Salaries paid to promoters

8. Operator activity in stocks

9. Shareholders – Who are the people with above 1% of the outstanding shares of the company

10. Political affiliation – Is the company or its promoters too close to a political party?

11. Promoter lifestyle – Are the promoters too flamboyant and loud about their lifestyle?

Do they like to display their wealth?

The quantitative aspects

1. Profitability and its growth

2. Margins and its growth

3. Earnings and its growth

4. Matters related to expenses

5. Operating efficiency

6. Pricing power

7. Matters related to taxes

8. Dividends payout

9. Cash flow from various activities

10. Debt – both short term and long term

11. Working capital management

12. Asset growth

13. Investments

14. Financial Ratios

Many Investors are risk averse because they fear losing their capital. Specially after the Global financial crisis of 2008 when the big corporates failed miserably, and many people lost their life long savings which they had invested in the exotic financial instruments hoping for a better return. Another reason of being risk averse is not being able to understand the financial product and gauge one’s risk taking capacities.Lack of financial literacy also keeps investors away from investments.Credit Default Swaps(CDS), Collateral Debt Obligations(CDOs),Futures and Options, Derivatives are some of the complex financial instruments which an investor would keep their hands off because of the complexities involved.Even equity investments are risky if you donot understand the business in which the company deals in, the management ,their financials,product line, etc.

Debt Fund

A company may need more funds for expansion but it may not want to dilute its equity. In such a case it can raise funds through Debt. An investor loans money to the company and the company promises to repay the loan on a specific maturity date and give interest on such loan.

Loans can be raised from public by issuing debentures or bonds by public limited companies. Some of the characteristics of Debentures or Bonds are:-

• Debentures are normally issued in different denominations ranging from 100 to 1,000 and carry different rates of interest.
• Debentures are either secured or unsecured
• Debentures can be divided into the following three categories:

(i) Non-convertible debentures (NCDs)– These types of debentures do not have any feature of conversion and are repayable on maturity.

(ii) Fully convertible debentures– Such debentures are converted into equity shares as per the terms of issue in relation to price and the time of conversion. Interest rates on such debentures are generally less than the non-convertible debentures because of their carrying the attractive feature of getting themselves converted into shares.

(iii) Partly convertible debentures– Those debentures which carry features of both convertible and non-convertible debentures belong to this category. The investor has the advantage of having both the features in one debenture

A bond can be a Fixed Coupon Bond or a Floating rate bond.

1. Fixed Coupon Bond

1. The intrinsic value of a bond is the present value of the future coupon & redemption amount discounted at the required rate of return. If the market price of the bond is lower/higher than the intrinsic value, the bond is underpriced/overpriced and should be purchased/short sold.
2. Yield on bond
   • Current Yield = Coupon Income x 100
                                   Market Price

It is not representative as it doesnot consider cash flows beyond current period.

Example : Consider a 12% Rs.1000 FV 5 year bond which pays coupon semi-annually and is currently trading at Rs.945. Find out the Bond equivalent Current Yield and the effective annual current yield.

Solution : Coupon for 6 months = 12% x 1000/2 = Rs.60

Current Yield for 6 months = 60/945 x 100 = 6.35%

Bond Equivalent Yield (BEY) = 6.35 x 2 = 12.7%

Effective Annual Current Yield = (1.0635)² – 1 = 13.1%

• Yield To maturity (YTM)
  YTM is the IRR of the bond and is therefore computed by equating the outflow with inflow. However in case of constant coupon rate and one shot redemption, there is a shortcut formula given by :

YTM = I + (F-P)/n
                0.4F + 0.6P          Where I = Periodic Coupon Income
                                                F = Redemption Value

                                                                P = Current MP or issue price

                                                                N = number of periods

If YTM is greater than the RoR then the bond is underpriced and should be purchased.

Interest Rate Risk

It refers to the uncertainty of realizing the promised YTM due to change in interest rate. YTM is based on the following two assumptions:

1. The bond shall be held to maturity
2. The intermediate cash flows from the bond shall be re-invested at the promised YTM.

Both these assumptions are unrealistic. Investors may decide to sell a bond prior to maturity , thereby exposing themselves to price risk. Moreover, Interest in a de-regulated and dynamic environment keep on changing. Thus re-investment rate of intermediate cash flows is uncertain resulting in re-investment risk.

So Interest rate risk has two components-

1. Price Risk which is a discounting process
2. Re-Investment risk which is a compounding process

Mutual Fund

A mutual fund is a professionally managed type of collective investment scheme that pools money from many investors and invests it in stocks, bonds, short-term money market instruments and other securities. Mutual funds have a fund manager who invests the money on behalf of the investors by buying / selling stocks, bonds etc.

Advantages of Investing in a Mutual Fund

• Specialized & technically sound person manages the funds ie Professional Management
• Due research
• Offers Diversification
• Economies of scale
• Easy Liquidity
• Transparency
• Tax Benefits

Type of Mutual Fund

• Open Ended
• Close Ended
• Index Funds
• Diversified Large Cap Funds   
• Mid Cap Funds
• Sectorial Funds
• Arbitrage Funds   
• International Equities Fund   
• Fixed Maturity Plans
• Gilt Funds
• Balanced Funds
• Monthly Income Plans (MIPs)
• Exchange Traded Funds (ETFs)
• Liquid Funds

Mutual Fund AMC’s offer various types of plans and options. Some of which are

• Growth and Dividend Options
• Payout and Reinvestment Plans
• Systematic Investment Plan (SIP)
• Systematic Transfer Plan (STP)
• Systematic Withdrawal Plan (SWP)

A Mutual fund unit is calculated on basis of Net Asset Value (NAV)

NAV = Market or Fair Value of Scheme’s Investments + Current Assets Including Accrued Income –       Current Liabilities & Provisions including Accrued Income
          No. of Units Outstanding

I have tried to answer in a very comprehensive way. Hence it is bit lengthy too. Hope this helps. Do let me know in comment section.