Tag: Modern Marketing Bangalore University BBA Notes

Goals-based planning is the process of helping clients prioritize their financial goals and determine the optimal plan to fund them. Goals-based planning expands your focus into all aspects of your client’s financial life and eliminates the retirement-only focus.

Goal based financial planning is a method which can help you achieve multiple goals across different stages of life. There are some common life-stage goals of most investors e.g. buying a house, children’s higher education and marriage, retirement planning and leaving an estate for your loved ones. In addition to these goals, some clients may have other goals specific to their individual needs and aspirations e.g. planning for a foreign vacation, buying / building a vacation home, saving a corpus to start a business, accumulating for early retirement etc. Goal based planning is the process of defining different goals, quantifying these goals factoring in inflation and having an investment plan to meet these goals.

First, you need to know your various financial goals which you wish to achieve over various time periods. Then you need to figure out the time you have in hand to reach those goals. Once you are clear about these two – goal and the time frame work out the present cost of each of these goals. Now, apply inflation to the current cost and you know the future value of your goal.

For example: your current cost of a future goal, which is 10 years away from now, is Rs 20 Lakhs. Assuming the average annual inflation rate at 6%, the future goal value would be Rs approx 36 Lakhs. Therefore, you need to plan investments to reach the goal of Rs 36 Lakhs and not Rs 20 Lakhs.

A great many wealth management firms claim they are financial planners by defining a few large goals such as saving for retirement or leaving a legacy and recommending investment strategies to help you achieve those objectives. However, goals-based planning digs much deeper working with you to crystalize precisely what those vague future concepts actually mean to you.

It can be a difficult challenge to work from a blank piece of paper and write those first few sentences of your financial planning story. Questions such as “What are some of the important financial goals you hope to achieve?” or “How do you envision your retirement lifestyle?” might initially be daunting. But by asking more personal questions, carefully listening to you and offering examples of what certain elements of that story might look like, a good planner can help you bring it to life. A goal of retiring at a certain age and traveling the world is merely a starting point. Meaningful planning then probes deeper into where you hope to travel, how many trips you would like to take each year, and who would be traveling with you.

Life Goal’s

• Buying a house
• Buying a car
• Children’s education
• Children’s marriage
• Retirement planning
• Aiming for early retirement
• International holiday
• Purchasing other high-value items like a diamond ring for your wife
• Putting an Emergency Fund in place
• Modifying your house
• Starting a business

Goal based financial planning is usually a six step process:

• Setting goals: You should lay-out all your goals in different stages of life. You should estimate how much money you need for each and always factor in inflation, especially for your long term financial goals.
• Expense Budgeting: You should assess your post tax income, your expenses (essential and discretionary), assets (bank deposits, mutual funds etc.), liabilities (car loans, home loans etc.) and create your budget. Once you have a budget, you know how much you can save and invest in a systematic way for your financial goals. Suggested reading: Maximise your SIP returns in volatile markets
• Assessing your risk appetite: This is an important step in financial planning because you need to take the right amount of risk to achieve your financial goals. If you take too much risk, you may lose your hard earned money due to adverse market movement at the time you need it. If you take too little risk, you may not be able to get sufficient returns to meet your goals. Your risk appetite depends on your age, stage of life, goal time-lines and financial situation. You should always invest according to your risk appetite.
• Asset allocation according to goals and risk appetite: Risk and returns are interrelated higher risk, higher returns in the long term and vice versa. Different asset classes have different risk profiles, e.g. equity has a higher risk profile compared to gold or fixed income. Remember that for different financial goals, you should invest in the right asset class depending on the goal and risk appetite.
• Prepare an investment plan: This is the final step of the financial planning process. Once you know your goals, risk appetite and asset allocation profile, the rest of the job is simply to calculate how much you need to save and invest based on goal amount, goal horizon and expected return on investment based on your asset allocation. Sometimes in this step, you may realize that you need to save more and cut down some discretionary expenses. Do not despair, if you are not able to save more. You should start with what you can save. Over period of time, as your income goes up, you will be able to save and invest more. You can use facilities like Top-up SIPs, to increase your investments over time and achieve your goals.

Advantages of having a goal while investing

• Disciplined investing: Discipline in investing e.g. sticking to your SIPs irrespective of market conditions, adhering to your asset allocation, regular re-balancing of the portfolio etc., are essential in achieving success. Since there is an emotional attachment with financial goals, investors are likely to be much more disciplined in goal based investing.
• Helps you reduce debt / be debt free: Cost of debt can be a huge burden on your savings and harm your long term financial interests. If you practise goal based investing, you can fund big ticket spending e.g. vacation, buying / upgrading your vehicle, bigger down payment for house etc. from your investments, reduce debt burden and interest payments thereof.
• Save and invest more for your goals: It is a no brainer that the investor who saves and invests more will be able to create more wealth. Attaching investments to goals, instils greater determination and doing what is required to achieve the goals. It has often been seen that families which practise goal based investing save and invest more.
• Save taxes: Having an investment plan can help you save taxes under section 80C and also invest in the most tax efficient investment options according to your financial goals and asset allocation.
• Improve lifestyle in a sustainable way: Despite rising disposable incomes, average household debt in India is rising. This shows that investors are funding their lifestyles through credit cards, personal loans etc. Debt funded lifestyle improvements may not be sustainable. Sometimes it is seen that, parents spend a bulk of their savings on their children’s higher education and then compromise on lifestyle to save for their retirement. If you practise goal based investing, you can improve your lifestyle in sustainable way, without relying on debt or compromising on other financial goals.

Investment risk is defined as the probability or uncertainty of losses rather than expected profit from investment due to a fall in the fair price of securities such as bonds, stocks, real estate, etc. Each type of investment is exposed to some degree of investment risk like the market risk i.e., the loss on the invested amount or the default risk i.e., the money invested is never returned back to the investor.

Liquidity risk

The risk of being unable to sell your investment at a fair price and get your money out when you want to. To sell the investment, you may need to accept a lower price. In some cases, such as exempt market investments, it may not be possible to sell the investment at all.

Market risk

The risk of investments declining in value because of economic developments or other events that affect the entire market. The main types of market risk  are equity risk, interest rate risk and currency risk.

Equity risk: Applies to an investment in shares. The market price of shares varies all the time depending on demand and supply. Equity risk is the risk of loss because of a drop in the market price of shares.

Interest rate risk: Applies to debt investments such as bonds. It is the risk of losing money because of a change in the interest rate. For example, if the interest rate goes up, the market value of bonds will drop.

Currency risk: Applies when you own foreign investments. It is the risk of losing money because of a movement in the exchange rate.

Concentration risk

The risk of loss because your money is concentrated in 1 investment or type of investment. When you diversify your investments, you spread the risk over different types of investments, industries and geographic locations.

Reinvestment risk

The risk of loss from reinvesting principal or income at a lower interest rate. Suppose you buy a bond paying 5%. Reinvestment risk will affect you if interest rates drop and you have to reinvest the regular interest payments at 4%. Reinvestment risk will also apply if the bond matures and you have to reinvest the principal at less than 5%. Reinvestment risk will not apply if you intend to spend the regular interest payments or the principal at maturity.

Horizon risk

The risk that your investment horizon may be shortened because of an unforeseen event, for example, the loss of your job. This may force you to sell investments that you were expecting to hold for the long term. If you must sell at a time when the markets are down, you may lose money.

Foreign investment risk

The risk of loss when investing in foreign countries. When you buy foreign investments, for example, the shares of companies in emerging markets, you face risks that do not exist in Canada, for example, the risk of nationalization.

Liquidity risk

The risk of being unable to sell your investment at a fair price and get your money out when you want to. To sell the investment, you may need to accept a lower price. In some cases, such as exempt market investments, it may not be possible to sell the investment at all.

Credit risk

The risk that the government entity or company that issued the bond will run into financial difficulties and won’t be able to pay the interest or repay the principal at maturity. Credit risk applies to debt investments such as bonds. You can evaluate credit risk by looking at the credit rating of the bond.

Inflation risk

The risk of a loss in your purchasing power because the value of your investments does not keep up with inflation. Inflation erodes the purchasing power of money over time the same amount of money will buy fewer goods and services. Inflation risk is particularly relevant if you own cash or debt investments like bonds. Shares offer some protection against inflation because most companies can increase the prices they charge to their customers. Share prices should therefore rise in line with inflation. Real estate also offers some protection because landlords can increase rents over time

Longevity risk

The risk of outliving your savings. This risk is particularly relevant for people who are retired, or are nearing retirement.

Risk profiling is important for determining a proper investment and asset allocation for a portfolio. Every single person has a different risk profile as the risk appetite depends on psychological factors, loss bearing capacity, investor’s age, income & expenses and many such other things.

A risk profile is an evaluation of an individual’s willingness and ability to take risks. It can also refer to the threats to which an organization is exposed. A risk profile is important for determining a proper investment asset allocation for a portfolio. Organizations use a risk profile as a way to mitigate potential risks and threats.

Traditional finance uses the concepts of classical decision making, modern portfolio theory, and the capital asset pricing model (CAPM) to define the risk profile of an investor. In this model, investors are inherently risk averse and take on additional risk only if they judge those higher anticipated returns will compensate them for it. One of the fundamental results of modern portfolio theory is that, under the assumptions of the CAPM (Sharpe 1964), all investors invest in a combination of the risk-free asset and the market portfolio. The allocation of funds between the risk-free asset and the risky market portfolio is determined only by the risk aversion of the investor. Thus, in the world described by this traditional model, the investor’s risk profile is given by the risk aversion factor in the utility function of the investor.

Risk capacity applies to the objective ability of an investor to take on financial risk. Capacity depends on objective economic circumstances, such as the investor’s investment horizon, liquidity needs, income, and wealth, as well as tax rates and other factors. The primary distinguishing feature of risk capacity is that it is relatively immune to psychological distortion or subjective perception. Risk aversion, however, may be understood as the combination of psychological traits and emotional responses that determine the investor’s willingness to take on financial risk and the degree of psychological or emotional pain the investor experiences when faced with financial loss. These emotional factors are often even more important for practitioners to understand than the objective economic circumstances of the investor; yet, they are harder to measure.

Aggressive

Willing to take significant risks to maximise returns over the long term

*Possible Allocation – Equity: 90-100%; Debt and others: 0-10%

Moderately Aggressive

Seeking to maximise returns over medium to long term with high risk

*Possible Allocation – Equity: 70-90%; Debt and others: 10-30%

Moderate

Looking for relatively higher returns over medium to long term with modest risk

*Possible Allocation – Equity: 40-60%; Debt and others: 40-60%

Moderately Conservative

Willing to take small level of risk for potential returns over medium to long term

*Possible Allocation – Equity: 10-30%; Debt and others: 70-90%

Conservative

Seeking safety of capital, minimal risk and minimum or low returns

* Possible Allocation – Equity: 0-10%; Debt and others: 90-100%

Rights of Insured

• Once you fill the proposal form, you should hear from your insurer within 15 days about the decision to issue or refuse the grant of life insurance
• You can appoint one or more nominees. When you do so, the sum assured will be divided among them
• If your proposal is accepted, the policy bond should reach you within a reasonable period of time
• You can ask for altering the mode of premium paid and the term of policy
• In case of loss of the policy document, you can get a duplicate copy that confers the same rights as the original policy except 15 days Free Look period.
• You can cancel your life insurance policy within 15 days from the date of receiving the policy documents.
• You can change the nominee details once the policy is issued by intimating your insurer

Responsibilities of Insured

• Fill up the proposal form correctly
• Pay premiums on time
• Don’t hide any information, however immaterial it may seem
• Don’t disclose your policy number and other confidential information to imposters identifying themselves as IRDAI officials. IRDAI never makes such calls.
• Inform your life insurance company immediately if you lose your policy documents

Rights and Responsibilities of Insurer

Duty to Defend

Depending on the nature of your agreement, your insurer may have a duty to indemnify or defend you under certain circumstances. The duty to defend provides you with legal representation if you’re sued. The duty to indemnify pays for any legal judgments against you. Both are dictated by the terms of your policy.

Insurance Contract

Your insurer must honor any responsibilities outlined in your policy. It’s free to provide you with rights above and beyond those provided by law, so your agreement may have extra responsibilities. Additionally, if a provision in your policy is found to be ambiguous it’s interpreted by a court as being in your favor if there’s a dispute.

Claim adjustment

An insurer must treat its insured’s interests with the same consideration it gives its own interests. This means that a claims adjuster must give the policy holder the benefit of the doubt. The claims adjuster should be looking for reasons to find coverage, not for reasons to deny coverage. The claims adjuster should be looking for reasons to pay the claim, not reasons to deny it. Unfortunately, sometimes insurance companies lose sight of this fundamental rule.

General Duties

An insurance company has a legal duty to fully investigate your claim, not just the parts that support their position. It must also provide you with all necessary information so you can protect your claim under the policy. Additionally, the company must respond to your communications and promptly pay your claim if it’s found valid.

Fair Deal

An insurance company’s duty of good faith and fair dealing means it must always act in the client’s best interest. This responsibility, implied in all insurance agreements, prevents the company from acting in bad faith in transactions involving your claim. If it breaches this responsibility you are entitled to sue for damages.

Payment

If payment is owed, an insurer must promptly pay the claim. In Wisconsin, an insurer must pay a claim that is owed within 30 days, or the insurer may be subject to paying the policy holder 12 percent interest per year. Even though this is the law, there is no good reason for an insurance company to hold payment for 30 days if it owes benefits under a policy.

India is grappling with several health problems. It has turned into the diabetes capital of the world. Around one million new cancer patients register, every year and the rising rate of non-communicable diseases (NCDs) causes 61% of deaths in the country. No doubt, medical advancement bringing new hopes to the health care sector. But, at the same time, it is giving rise to medical inflation. Diagnosis, medication, treatment, and hospitalization costs are burning holes in the pockets and become unaffordable for the common mass. Either one has to sell the assets or lend money whenever there is a medical emergency. It results in financial distress for the entire family. So, to combat such a medical crisis, we offer mediclaim insurance that covers your risks and provides you with financial support whenever you need it.

Benefits

• It provides a cashless hospitalization facility during a medical emergency.
• Avail tax benefits under Section 80D of the Income Tax Act up to Rs.1,00,000 for the premium paid for a family floater policy, depending on the age of proposer & insured.
• It has additional add-ons such as an international second opinion you can select according to your healthcare needs for complete protection.
• It offers coverage for your pre and post hospitalization medical expenses such as OPD expenses, diagnosis, doctor’s fee, medication, therapies, etc. It will cover various out-of-pocket medical expenditures.
• One has the lifelong renewability option with additional benefits, such as coverage for alternative treatments, day care procedures, annual health check-ups, etc.
• You can choose the advanced treatment facility on a cashless basis at any in-network hospitals in nearby locations.

Features:

• Coverage for medical expenses during pre and post hospitalization
• Claim settlement either by a cashless facility or by reimbursement up to the sum insured
• Cover for in-patient hospitalization
• Lifelong renewability is easily available
• Minimum 24 hours hospitalization is required to get the claim
• It also has a list of specific exclusions
• No upper age limit for enrolment
• In a family mediclaim, you can pay a lump sum premium instead of paying for individual policies.

Different mediclaim policies:

Individual Mediclaim: An individual mediclaim plan covers only one individual for the specified sum insured. The policy benefits and the entire sum insured are available to the policyholder for the premium applicable.

Family Floater Mediclaim Cover: In a family floater mediclaim insurance policy, the coverage and benefits are available to all the insured family members, including spouse, children, and parents. The policy has a floater sum insured that either one individual or the entire family can utilize for any hospitalization or medical treatment.

Critical Illness Mediclaim: Critical illnesses require long-term medical treatment that may lead to astronomically high medical bills. Critical illness mediclaim policies are designed to cover severe ailments, such as stroke, cancer, heart disease, etc. We offer coverage for 32 critical illnesses.

Senior Citizen Mediclaim Policy: It is a type of mediclaim designed to provide coverage and benefits, including hospitalization cover, for elderly individuals aged above 60 years.

Heart Mediclaim: Heart mediclaim insurance plans provide comprehensive hospitalization and medical treatment coverage for various heart-related ailments, thus saving a person from facing any financial stress. At CHI, our heart care mediclaim covers 16 major heart ailments.

Cancer Mediclaim: Cancer mediclaim plans provide lifelong protection and comprehensive coverage for various cancer treatments along with chemotherapy and radiotherapy cover. It’s wise to invest in this policy early as people already diagnosed with cancer cannot get it.

Mediclaim covers:

Day Care Treatments: If you have to undergo any surgery or treatment or therapy that requires hospitalization for a day, then from room rent to medicine bills, we bear your daycare treatment expenses, up to the sum insured. We cover 540 daycare treatments, the highest in the industry.

In-Patient Hospitalization: If the in-patient hospitalization is for more than 24 hours, we cover your hospitalization expenses. These expenses include your room charges, nursing expenses, ICU, surgeon’s fee, doctor’s fee, blood, oxygen, and OT (operation theatre changers).

ICU Charges: We value every life and know the importance of the right healthcare services. If you are admitted to ICU, we will cover the charges.

Ambulance cover: This policy provides reimbursement against the expenses that you incur on an ambulance during a medical emergency.

Pre and post hospitalization: It covers your pre and post hospitalization expenses that include diagnosis, treatment, and medicine expenses, along with doctor’s fees.

Recharge of Sum Insured: If your coverage amount gets exhausted, you get an automatic recharge of the sum insured. You can use this amount for the treatment of any other insured family member or yourself.

Other Benefits: Organ donor cover, second opinion, NCB, and alternative treatments are other useful benefits.

Annual Health Check-Ups: Under the mediclaim plan, you will get an annual health check-up facility at our empanelled healthcare services providers. It includes complete blood sugar, urine routine, kidney function, ECG check-ups, etc.

Human Life Value (HLV) is a number that tells the present value of future income expenses, liabilities and investments. The HLV number is taken usually to understand how much money would be required to secure the lives of your dependents with term insurance, in case you are no longer around.

Importance

In life insurance, it is important to measure your economic worth. This worth can be expressed in the form of human life value. Thus, HLV is the rupee value of your economic worth in terms of what you create for the people who depend on you. So, if your life is cut short, an amount equivalent to the HLV should be available so that the people dependent on you can lead their life properly.

The Belth yearly rate of return formula:

The yearly rate of return method calculates the rate of return you’re getting annually on the savings (investment) component of your life insurance policy. The figures used in the formula are the same as those used in the Belth yearly price of protection method, although their meanings differ slightly:

i = (CV + D) + (YPT)(DB – CV)(.001) – 1 / (P + CVP)

YPT: The assumed yearly price per $1,000 of protection

P: The annual premium

D: The annual dividend

CV: The cash surrender value at the end of the year

DB: Death benefit

CVP: The cash surrender value at the end of the preceding year

I: The yearly rate of return on savings component, expressed as a decimal

Asset allocation is a very important part of creating and balancing your investment portfolio. After all, it is one of the main factors that leads to your overall returns even more than choosing individual stocks. Establishing an appropriate asset mix of stocks, bonds, cash, and real estate in your portfolio is a dynamic process. As such, the asset mix should reflect your goals at any point in time.

Strategic Asset Allocation

This method establishes and adheres to a base policy mix a proportional combination of assets based on expected rates of return for each asset class. You also need to take your risk tolerance and investment time-frame into account. You can set your targets and then rebalance your portfolio every now and then.

A strategic asset allocation strategy may be akin to a buy-and-hold strategy and also heavily suggests diversification to cut back on risk and improve returns.

For example, if stocks have historically returned 10% per year and bonds have returned 5% per year, a mix of 50% stocks and 50% bonds would be expected to return 7.5% per year.

1. Age-Based Asset Allocation

Age-based asset allocation is the simpler of the two techniques of strategic allocation.  In the age-based asset allocation technique, the investment decision is based on the age of the investor using the following formula:

Percentage of Equity in Portfolio = (100 – Age of Investor)

For example,  if you are 35 years old, the recommended percentage of equity in your portfolio should be = 100 – 35 = 65%.

While this approach does provide a starting point for asset allocation, it is clearly not sufficient especially as it does not factor in key variables such as your investment objective or your risk tolerance. The second type of strategic allocation technique risk profile-based asset allocation is designed to overcome this limitation.

2. Risk Profile Based Asset Allocation

This technique of strategic asset allocation is a significant improvement on the age-based method as it uses the investor’s risk tolerance in determining how investments need to be allocated across different types of assets.

This method assigns investors the following 5 labels based on their ability to tolerate risk and volatility in their portfolio:

• Conservative
• Income
• Balanced
• Growth
• Aggressive

In this classification system, Aggressive Investors are the most risk-tolerant hence they have the ability to withstand the highest degree of volatility in the portfolio. This is because Aggressive Investors tend to be return-centric and understand the variability of portfolio returns in the short term. On the other hand, Conservative Investors are the least risk-tolerant and prefer to get consistent returns from their investment.

Tactical Asset Allocation

Over the long run, a strategic asset allocation strategy may seem relatively rigid. Therefore, you may find it necessary to occasionally engage in short-term, tactical deviations from the mix to capitalize on unusual or exceptional investment opportunities. This flexibility adds a market-timing component to the portfolio, allowing you to participate in economic conditions more favorable for one asset class than for others.

Tactical asset allocation can be described as a moderately active strategy since the overall strategic asset mix is returned to when desired short-term profits are achieved. This strategy demands some discipline, as you must first be able to recognize when short-term opportunities have run their course and then rebalance the portfolio to the long-term asset position.

You can avail the benefit of tactical asset allocation by investing in Dynamic Asset Allocation Funds that are also known as Balanced Advantage Funds. These funds use models to change their portfolio exposure to Equity, Debt, and Cash depending on changing market conditions to provide investors an optimal balance between risk and return.

Dynamic Asset Allocation

In this asset allocation strategy, you continuously adjust your asset allocation mix depending on market conditions. The most common dynamic asset allocation strategy used by mutual funds is counter-cyclical strategy. These funds increase their equity allocation (reduce debt allocation) when equity valuations decline (become cheaper) and reduce debt allocations. This is also known as contra strategy. it essentially follows the investment tenet of buying low and selling high. Different fund managers use different valuation metrics for dynamic asset allocation, the most common being P/E and P/B ratios. Some fund managers use multi-factor asset allocation models which combine 2 or more factors e.g. P/E, P/B, Dividend Yield etc. in dynamic asset allocation strategy.

Though dynamic asset allocation based on counter-cyclical or contra strategy is the most common strategy by dynamic asset allocation funds, other asset allocation strategies are also used. A few dynamic asset allocation funds follow a pro-cyclical strategy. The funds increase their equity allocation in rising markets and reduce it in falling markets. Some fund managers believe that following the trend is a good strategy which has worked in the past. Then there are dynamic asset allocation funds, which combine both approaches in what they call, core and tactical approach. The core portfolio (usually 70–80%) follows the typical valuation-based counter-cyclical dynamic asset allocation strategy, while the tactical portion follows a momentum-based approach, which is not dissimilar to the pro-cyclical strategy.

Factors affecting:

1. Risk tolerance

Risk tolerance refers to how much an individual is willing and able to lose a given amount of their original investment in anticipation of getting a higher return in the future. For example, risk-averse investors withhold their portfolio in favor of more secure assets. In contrast, more aggressive investors risk most of their investments in anticipation of higher returns. Learn more about risk and return.

2. Goal factors

Goal factors are individual aspirations to achieve a given level of return or saving for a particular reason or desire. Therefore, different goals affect how a person invests and risks.

3. Time horizon

The time horizon factor depends on the duration an investor is going to invest. Most of the time, it depends on the goal of the investment. Similarly, different time horizons entail different risk tolerance.

For example, a long-term investment strategy may prompt an investor to invest in a more volatile or higher risk portfolio since the dynamics of the economy are uncertain and may change in favor of the investor. However, investors with short-term goals may not invest in riskier portfolios.

Active Investing

Active investing, as its name implies, takes a hands-on approach and requires that someone act in the role of a portfolio manager. The goal of active money management is to beat the stock market’s average returns and take full advantage of short-term price fluctuations. It involves a much deeper analysis and the expertise to know when to pivot into or out of a particular stock, bond, or any asset. A portfolio manager usually oversees a team of analysts who look at qualitative and quantitative factors, then gaze into their crystal balls to try to determine where and when that price will change.

Active investing requires confidence that whoever is investing the portfolio will know exactly the right time to buy or sell. Successful active investment management requires being right more often than wrong.

Pros of Actively Managed Funds

Alpha generating funds: If the investor wants a bit extra than what the benchmarks are offering, then actively managed funds are better. The main objective of actively managed funds is to beat the returns of the Sensex and Nifty and generate ‘alpha’. Here the fund manager uses his/her experience, knowledge and time for market research.

Flexibility: Active managers aren’t required to follow a specific index. They can buy those “diamond in the rough” stocks they believe they’ve found.

Hedging: Active managers can also hedge their bets using various techniques such as short sales or put options, and they’re able to exit specific stocks or sectors when the risks become too big. Passive managers are stuck with the stocks the index they track holds, regardless of how they are performing.

Tax management: Even though this strategy could trigger a capital gains tax, advisors can tailor tax management strategies to individual investors, such as by selling investments that are losing money to offset the taxes on the big winners.

Cons

Expensive: Naturally every good thing in life comes at a cost and so is the expertise of a fund manager. Investors will have to pay charges (namely expense ratios) for the fund manager’s expertise and decision making.

Risk: Actively managed funds seek to generate higher returns and hence the risk associated with them is also higher than passive funds. This is because man-made decision-making processes may be prone to error.

Passive Investing

If you’re a passive investor, you invest for the long haul. Passive investors limit the amount of buying and selling within their portfolios, making this a very cost-effective way to invest. The strategy requires a buy-and-hold mentality. That means resisting the temptation to react or anticipate the stock market’s every next move.

The prime example of a passive approach is to buy an index fund that follows one of the major indices like the Nifty 50/Nifty next 50/Nifty100. Whenever these indices switch up their constituents, the index funds that follow them automatically switch up their holdings by selling the stock that’s leaving and buying the stock that’s becoming part of the index. This is why it’s such a big deal when a company becomes big enough to be included in one of the major indices: It guarantees that the stock will become a core holding in thousands of major funds.

When you own tiny pieces of thousands of stocks, you earn your returns simply by participating in the upward trajectory of corporate profits over time via the overall stock market. Successful passive investors keep their eye on the prize and ignore short-term setbacks even sharp downturns.

Pros of Passively Managed Funds

Cheaper: Their expense ratios are way lower than active funds. According to Sebi regulations, the expense ratio for ETFs cannot exceed 1%. The expense ratio for the earlier example we took, the HDFC Sensex Fund is hardly 0.05% as on May 11.

Cons of Passively Managed Funds

Cannot beat benchmarks: Such funds have moderate returns. Returns may be equal to the benchmark’s returns or lesser. They may be cheaper but do carry some charges which may lower the returns but marginally.

Other Funds

ETFs are a slight variation of the index fund. Like an index fund, the ETF also creates a portfolio of index stocks in the same proportion. The only difference is that the ETF is listed on a stock exchange and can be bought and sold on any recognized stock exchange. When you buy or sell an ETF, it only leads to transfer of ownership and not to shift in the AUM of the ETF. Additionally, ETFs are also available on other benchmarks like ETFs on gold, ETFs on silver, ETFs on equity indices, ETFs on debt market indices etc. ETF units can be bought and sold through your existing equity trading account and can be held in your regular demat account.

There is a slight variation of passive investing which entails buying and holding a portfolio of dividend yield stocks. Dividends are tax-free in the hands of the investor up to a limit of Rs.1 million per year. Thus a stock that offers a dividend yield of 6% will actually be paying an effective tax- adjusted return of {6%/(1-0.3)} = 8.57%. Most high dividend yield stocks are saturated stocks and hence the volatility risk is quite low in such stocks.

Leading Indicators

Leading indicators are a heads-up for economists and investors who hope to anticipate trends. Bond yields are thought to be a good leading indicator of the stock market because bond traders anticipate and speculate about trends in the economy. However, they are still indicators, and are not always correct.

These indicators generally signal changes before changes actually occur in the economy. However, few leading indicators anticipate both expansions and recessions well. Examples of leading indicators include the New Residential Construction report (excellent for identifying a future expansion), the Consumer Sentiment Index (good for identifying an upcoming recession), and the PMI (formerly known as the Purchasing Managers’ Index and a well-rounded indicator for identifying both expansion and contraction).

• Confidence index

Consumer confidence measures the degree of confidence of consumers on the state of the economy. If consumer confidence is high, they would spend and make more purchases adding to strong aggregate demand and economic growth.

Low confidence would suggest that consumers prefer to save and spend less, indicating a fall in consumption expenditure. Similarly, business confidence measures the optimism of businesses regarding economic strength.

• Durable goods consumption

Durable goods are those goods that have a longer life, and high economic value. They represent a significant portion of the total retail consumption expenditure. Some examples of durable goods are furniture, jewellery, automobiles etc.

• Yield curve

Yields are the interest rates of bonds traded in the market. The sovereign yield curve is a graphical representation of the interest rates of government bonds with different maturities. It describes the relation between short term interest rates and long term rates and inherently captures the market’s expectation of future interest rates.

• Capacity Utilization

Capacity utilization is an indicator of slack in the manufacturing sector provides insights into the state of the business cycle. In other words, it tells us as to what extent the production capacity in the economy is idle or used. It is measured as a proportion of the actual output produced to that of potential output which can be produced with the installed capacity.

• Bank Credit growth

Bank credit refers to the lending of funds by scheduled commercial banks (SCB) to various sectors in the economy. Non-food credit forms a bulk of the total credit and comprises loan given to different sectors (Industry, Agriculture and services) along with personal loans to individuals.

Lagging Indicators

Lagging indicators can only be known after the event, but that doesn’t make them useless. They can clarify and confirm a pattern that is occurring over time. The unemployment rate is one of the most reliable lagging indicators. If the unemployment rate rose last month and the month before, it indicates that the overall economy has been doing poorly and may well continue to do poorly.

The Consumer Price Index (CPI), which measures changes in the inflation rate, is another closely watched lagging indicator. There are few events that cause more economic ripple effects than price increases. Both the overall number and prices in key industries like fuel or medical costs are of interest.

Changes in the economy occur before lagging indicators change. For example, employment as shown by the Employment Situation report tends to continue to fall or grow very slowly as the economy comes out of a recession (even though unemployment rates often rise as the economy enters a recession). Lagging indicators may not tell the future, but they’re great for confirming where the economy has been and whether it’s heading toward recession or expansion.

• Balance of trade

Also called the Net exports, Balance of trade refers to the difference between a country’s total value of exports and imports. It tells us whether the country is in a trade surplus (higher exports) or trade deficit (higher imports).

A surplus is generally desirable as it indicates more money flowing into the country. If the surplus is due to high exports, it signals a strong demand for the country’s exports from other countries. A high trade deficit is a negative indicator of economic growth, and markets react negatively.

• Unemployment rate

Another measure of economic performance is the Unemployment rate, which is measures the number of people unemployed as a percentage of the total labour force. Higher unemployment indicates a poor state of the economy companies less willing to hire, reduced aggregate demand and further layoffs. It has been observed that the unemployment rate is negatively correlated to the prices in the stock market.

• Gross domestic product

The most popular measure for the size of the economy is the Gross Domestic Product (GDP). It is the total value of all goods and services produced within a country in a particular time period. The growth rate of GDP indicates the health of the economy.

The GDP data for India is calculated quarterly and is released by the Central Statistics Office. High growth in GDP indicates growth in income and strong aggregate demand, and corporates are likely to perform better in such an environment.

Concurrent Indicators

Coincident indicators are analyzed and used as they occur. These are key numbers that have a substantial impact on the overall economy.

Personal income is a coincident indicator of economic health. Higher personal income numbers coincide with a stronger economy. Lower personal income numbers mean the economy is struggling. The gross domestic product (GDP) of an economy is also a coincident indicator.

These indicators may not offer much in the way of forecasting ability, but they do tell a lot about current economic conditions. Examples include the Gross Domestic Product (GDP) report and the Personal Income and Outlays report (specifically the personal income statistics).

• Inflation

This is a measure of the change in prices of goods and services over a period of time. A little positive inflation signifies strong demand that promotes economic growth, whereas very low or negative inflation is a signal of weak demand and usually coincides with low growth in the economy.

In developing countries like India, high inflation can be a cause of worry as it reduces the real disposable income of consumers and businesses may face a reduction in their profit margins due to an increase in the cost of inputs. Various indices are used to measure inflation. An index tracks the changes in the prices of a basket of goods and services.

• Short term interest rates

Short term interest rates are very sensitive to current economic conditions and are strongly influenced by the policy rate (Repo rate) set by the Reserve Bank of India. A rise in short term interest rates signals higher economic activity as there is more demand for money.

• Manufacturing activity

Industrial/manufacturing activity is sensitive and quickly adjusts to the current economic scenario. Increased industrial production indicates that there is a strong demand for goods, and since the industrial sector is closely linked to other sectors of the economy, higher industrial activity correlates positively with growth in other sectors.

An index that tracks the growth in manufacturing activity in the economy is the Index of Industrial Production (IIP). The IIP is calculated monthly and released by the Central Statistics Office. Low or negative growth in the IIP is bad for corporate sales and profits; thus, stock prices fall in reaction to it.

Economic factors involve all the determinants of the economy and its state. These are factors that can conclude the direction in which the economy might move. Businesses analyze this factor based on the environment. It helps to set up strategies in line with changes.

Factors are affecting business:

• The inflation rates
• The interest rate
• Disposable income of buyers
• Credit accessibility
• Unemployment rates
• The monetary or fiscal policies
• The foreign exchange rates

The inverse relationship between the interest rate and bond prices can be explained by opportunity risk. By purchasing bonds, an investor assumes that if the interest rate increases, he or she will give up the opportunity of purchasing the bonds with more attractive returns. Whenever the interest rate increases, the demand for existing bonds with lower returns declines as new investment opportunities arise.

Interest Rate High ↑ = Asset’s Vale ↓

Interest rate risk analysis is almost always based on simulating movements in one or more yield curves using the Heath-Jarrow-Morton framework to ensure that the yield curve movements are both consistent with current market yield curves and such that no riskless arbitrage is possible. The Heath-Jarrow-Morton framework was developed in the early 1991 by David Heath of Cornell University, Andrew Morton of Lehman Brothers, and Robert A. Jarrow of Kamakura Corporation and Cornell University.

The risk of value depreciation of bonds and other fixed-income investments is known as interest rate risk. Primarily due to depreciation in their interest rates, this happens because of market fluctuations. Such risk affects many types of investments, though it primarily affects fixed-income investments like bonds and certificates.

Typically, with a rise in the interest rate of a bond or certificate, there is a fall in the price of all related securities. Additionally, opportunity cost increases too, along with a rise in their interest rate. Defined as the cost of missing out on better investment options, this opportunity cost is directly proportional to the interest rate risk.

There are a number of standard calculations for measuring the impact of changing interest rates on a portfolio consisting of various assets and liabilities. The most common techniques include:

• Marking to market, calculating the net market value of the assets and liabilities, sometimes called the “market value of portfolio equity”
• Stress testing this market value by shifting the yield curve in a specific way.
• Calculating the value at risk of the portfolio
• Calculating the multiperiod cash flow or financial accrual income and expense for N periods forward in a deterministic set of future yield curves
• Doing step 4 with random yield curve movements and measuring the probability distribution of cash flows and financial accrual income over time.
• Measuring the mismatch of the interest sensitivity gap of assets and liabilities, by classifying each asset and liability by the timing of interest rate reset or maturity, whichever comes first.

Types of Interest Rate Risks

There are quite a few types of interest rate risks, which must be noted by every investor, be it an individual or a firm. These are explained below in detail.

• Price risk

The risk of change in the price of an investment bond or certificate is known as its price risk. This leads to unforeseen loss or gains while selling security in the future.

• Reinvestment risk

The risk of change in their interest rate might lead to the selling of the securities. In turn, this can lead to a loss of opportunity to re-invest in the current interest rate. Known as reinvestment risk, these types of interest rate risk can be further divided into 2 categories.

Mitigate Interest rate Risk

Purchasing floating-rate bonds: Floating rate bonds, as suggested by its name, have a rate of interest, which is directly related to market fluctuations. It is advisable to invest in these securities since being related to the market fluctuations, the return on these investments go up and down too. These should also be bought in a healthy mix of long-term and short-term investments.

Safer investments: The safest option for investors who are trying to reduce the risks associated with interest rates is to invest in bonds and certificates, which have short maturity tenure. Securities with short maturity tenure are less susceptible to the fluctuations in interest rate. This method for interest rate management reduces the chance of being subjected to interest rate fluctuations since they have low maturity tenure.

Selling long-term bonds: A common method which is often used is that of selling the long-term bonds. This effectively clears up the investment funds for re-investment in bonds with higher returns, thus allowing investors to manage the interest rate risk better.

Hedging: Hedging is an option, which can be used successfully to reduce the risks related to interest rates. Generally referring to the purchase of various types of derivatives which are available, there are many ways of hedging.

Diversification: Among the different options that can be employed by an institution to manage the interest rate risk associated with them, one of the most effective options is to diversify their financial investments.