Managing Personal Investments

Assignment - Create a retirement portfolio. (A portfolio that will exist starting now onwards until
you retire. Make logical assumptions such as how much you expect to save by the time you retire)

How unrealized losses can hurt you?

A stock is trading at 100 rupees. In order to reach 150, you need a gain of 50% but to drop back to
100 you only need a loss of 33.33%

Similarly, if you lose 50 rupees, you lose by 50% but in order to gain back the 50 rupees, you would
need a 100% gain.

This is called Asymmetric Returns Effect - It takes a lot of effort to recover unrealized losses than it
takes to give up unrealized gains.

This risk can’t be eliminated, it can only be moderated.

ELSS (Equities linked saving scheme) – Related to section 80C

Simply put, it is an equity mutual fund.

Mutual fund companies come up with an NFO (New fund offer) which goes to SEBI who has to
accept the offer after looking at regulations. Then it comes back to the asset management company
who would sell this offer through their distributors. If it gets income tax approved and you invest to
a max of 1.5 lakhs, you get tax saving benefits.

Equities have higher “expected” returns than bonds.

You cannot take out money from ELSS “under any circumstances” as you enter a lock in period for 3
years.

And in an equity investment having a lock-in period, you see the Asymmetric Returns Effect.

Risk – The possibility of losing money sometime in the future.

Lock-in in a bond is much better than lock-in in equities. In fact, higher the lock-in period of bonds,
the better it is.

If you buy shares of an unlisted company, it is called Private Equity. 1 crore minimum.

Mass affluent investors = Middle class

Developed markets are called Developed Markets (US)

Developing markets are called Emerging markets (India)

Underdeveloped markets are called Frontier Markets (African countries)

Even long-horizon investments need liquidity – Yes, if you are dependent on capital appreciating
investments

Income products Vs Growth products – Lock-in to your income products but not growth products

If you have a lumpsum, invest in a cumulative fixed deposit for a period of 5 years and take out your
money after 5 years. If you intend to save money out of monthly salary, put it in a recurring deposit
and give your bank an auto debit instruction for 5 years. Interest is not credited to your savings
account on a yearly basis in a cumulative fixed deposit and that is a great thing! Breaking the lock-in
period warrants a huge penalty.

Any bond investment apart from PF is taxable at 30%

Diversification

Put money in different instruments that are uncorrelated in order to manage risks so that when one
investment goes down, other remains unaffected.

Mix income generating assets with capital appreciating assets

Google about Hedge!

Investment products have a positive weak correlation with only 1 exception which has a negative
correlation – Volatility.

Volatility based products – Introduced by Goldman Sachs. When equity market crashes, volatility
goes up.

Diversification is not about how many different instruments you have in your portfolio. It is about
how the investments are related to each other. Example – Example - You are invested in 5 different
diversified mutual funds. When market crashes, you see all 5 have gone down as all the diversified
funds have the same stocks.

Suppose you have 50% equity and 50% debt which have a weak correlation. Let’s say equity goes up
by 15% and debt goes up by 6%. By not investing entirely investing in equity you lose 9 percentage
points. But let’s say in a global crisis situation like 2008, all markets and all instruments crash
together, they suddenly have a strong correlation, except for 2 instruments – Gold and US
Government deposits.

Correlation Asymmetry - You have weak correlation between assets during normal markets, but in a
global crisis, the correlation moves towards 1.

For every 1-point increase to the index, related price will go up by 1 point. – VIX (?)

Diversification Heuristics – If we have n number of asset classes and we invest equally in all, we get a
1/n heuristics.
100-Age concept – Example – If your age is 25, then you should invest (100-25)=75% in equity and
25% in other asset classes.

Does this work?

Example – We have 2 people aged 25 years. One works at ITC, one works in the state government.
You have a steady income in state government and job security. The other guy increases shareholder
value and eventually becomes the CEO. You are now under pressure to show revenue growth else
you can lose your job. State government employee’s human capital is bond like (stable), they can
have a risky investment portfolio (follow the 100-Age concept). The one working in the private
company, the human capital is equity like (very volatile. Can’t opt for 100-Age concept because of
existing volatility). So, this rule doesn’t apply to all situations.

Human capital – Present value of all your future active income – Active income – Going to work and
earning money. (Passive money – Money you earn from investments). This is huge when you start
working and gradually decreases over the years.

Investment Capital – It is zero while starting work and increases as you work over the years.

We all have these 2 assets – Human capital and Investment capital.

Why Real Estate feels safe?

It is perceived as safe because there is no price visibility or visible volatility. It is only occasionally
known. For example – Your neighbours selling their house gives you an approximate idea about the
price of your property.

REITs – Real Estate Investment trusts – It is the closest to the real time pricing of real estate

Financial Assets v/s Physical assets – Financial assets provides better portability. Hence it is better for
working folks who have chances of frequent relocations. Upon approaching retirement one can opt
for physical assets.

Insurance vs Investment –

Is insurance an investment?

Insurance companies are not experts in investments. So, buy insurance from insurance firms and
investments from mutual fund companies.

If you apply for a term insurance until age 90 and if you survive age 90, you get nothing. You end up
paying 10k-12k a year

Insurance is NOT an investment

80C offers tax savings until 1.5L

Can you invest in insurance to save taxes? No.

Insurance is taken to protect your family’s standard of living and not because of section 80C benefit
Paradox of choices – More choices, more regret!

Two jargons – Active portfolio, Passive portfolio

How are investment products created?

Relative return strategies

Market Capitalization = Outstanding shares * LTP (Last traded price or CMP – Current market price)

In India, we do not use Market Cap, we use Free Float Market Cap

Sum up the market cap of all 50 stocks in the NIFTY 50 index, it will give you market cap of NIFTY.

Weight of a company such as RIL = Market Cap of RIL / Market cap of NIFTY 50

Let’s say RIL Market Cap / NIFTY 50 Market cap comes to 10%, and you want to earn the same
returns as NIFTY 50 and you are managing a 100-crore fund, you need to buy 10% of 100 crore worth
of RIL stocks. Similarly, for other stocks, you keep doing it to earn the average return as NIFTY 50
does

SBI’s listing was the trigger for Free Float. SBI’s outstanding shares were huge so it had a huge
weightage in NIFTY. So, it used to drag the NIFTY up with every increase or decrease in LTP. So it
triggered the adoption of Free Float.

Since promoter holdings are not going to be available in the market for trading, it was decided to
remove the promoter holdings from outstanding shares.

Terms – Private placement shares (Shares with lock-in period)

Free Float = (Total shares – Promoter holding shares – Private placement shares)

Free float shares * LTP = Free Float Market Cap

Large Cap (1- 100 rank - NIFTY 50, NIFTY NEXT 50), Mid Cap (101 – 250), Small Cap (251 – 500)

There is not much liquidity beyond 200 th rank usually. NIFTY has a category Micro Cap (501-750) as
well.

We have a broad cap index called NIFTY 500

Passive Product – It is one which is giving you a return of a benchmark index less the fees (such as
matching the NIFTY 50). No brain is used to manage these products. For example – SBI NIFTY Index
Fund, ICICI Prudential NIFTY 50 Fund, ETFs

Read about ETFs (Exchange traded funds) – New generation fund

Difference between ETF and Index Fund

Active product – Get money and if their benchmark is NIFTY 50, their objective (mandate given by
Investment committee) is to beat that benchmark index after the costs.

Book Value = (Book Value of total Assets – Book value of Liabilities) / (No of shares)

NAV – Net Asset Value – Total Market value of the portfolio

For example, HDFC Large Cap Fund – They have to announce the NAV everyday by taking the (Total
number of shares held * LTP) / (No of units)

Style Indices – NIFTY 50, NIFTY NEXT 50, NIFTY MIDCAP150, NIFTY SMALLCAP 50….so on and so forth

Sectoral Indices – NIFTY AUTO, NIFTY BANK, NIFTY CONSUMER DURABLES, NIFTY FINANCIAL
SERVICES

Thematic Indices – NIFTY Commodities Index, NIFTY CPSE Index, NIFTY Corporate Group, NIFTY
Energy

Strategy Indices –

NIFTY50 equal weight, NIFTY100 Equal weight, NIFTY100 Low Volatility 30, NIFTY100 Alpha 30

How is Thematic separate from Sectoral?

It is a combination of various sectors which together form the Index

CAPM (Capital Asset Pricing Model) – Two types of risk – 1) Systematic and 2) Non-Systematic

Systematic – Market / Non-Diversifiable Risk

In CAPM world, if Steel prices go up, TATA Steels revenue goes up. Translates to higher net profit
which translates to higher stock price. On the other side, Tata Motors would absorb this higher steel
price, cost would increase, revenues would decrease, profit would decrease and hence stock price
would decrease. CAPM argues any of these individual variables which affect the sector or a single
company will have a positive impact on certain stock and negative on certain stocks. These would
eventually cancel each other out and you’ll only be left with the market risk.

Style, Sector and Thematic – Traditional Products.

Strategic is not a traditional product

Beta – Relationship that the stock has with the index to which it belongs. Beta of 1.5 would mean for
every 1 unit increase in index price, the stock goes up by 1.5x

There is no negative beta. Only weak correlation. You can’t go against the market.

Outside the CAPM world, Let’s say NIFTY has 50 stocks and there is a portfolio. Your AMC (Asset
management fund) wants to invest in the NIFTY50 index and have a mandate to beat the index
(Large cap active fund). So, you’ll pick stocks from the NIFTY 50 index which you believe will beat the
index. They will do some analysis on their own and will buy reports from outside. The portfolio
manager thinks HDFC will do well. If HDFC has a 5% weightage in the index, they will allot more than
5% weightage in the portfolio. This is called as overweighting. So for an active fund, you will have to
overweight stocks that you think will outperform and underweight stocks that they think will
underperform relative to the benchmark.

Alpha – Excess returns that a portfolio generated over an associated benchmark over a defined
period

Let’s say NIFTY’s return is 12% and your portfolio generated 13% return. Then alpha is said to be 1 as
the portfolio generated 1 percentage point.

So, even if NIFTY goes down by 10%, and you manage to lose only 8%, you can still generate a 2
percentages point positive alpha.

Alpha strategy space is getting crowded and the number of strategies are getting saturated. So now
folks are creating indices based on the rules that formulate their strategies. So Index Service
Providers help to create these indices. These are non-market cap based index. This is called a
Strategy Index.

Simple example of Alpha strategy– Invest only in those stocks with a debt to equity ratio of less than
1 and positive alpha

RAFI (Research Affiliates Fund Index) popularized Strategic Indices. Dow Jones U.S. Thematic Market
Neutral Low Beta Index

Alternate beta/Smart Beta/Strategy Beta Products (Google)

Beware of Closet Indexing – Picture this! For an AMC it makes sense to have Active funds to
generate more revenue. If they generate phenomenal alpha, you give them more and more money.
So he/she ends up buying same products which results in decreasing revenue. So they set a alpha
and try to maintain it rather than getting a very high alpha in one year but not being able to maintain
the same alpha. This is a disguised Index Fund

Analogy: Getting an A grade and maintaining is difficult than getting a B+ grade and maintaining it
throughout.

So how to identify Closet Indexing Strategies?

An R squared of 0.90 means that 90% of your portfolio returns can be explained by the benchmark.
Sweet spot for an active fund is 0.85-0.90

When an Active fund’s R-squared is 0.92 consistently, then something is wrong. If it is 0.95 or higher
then it is definitely a Closet Indexing fund.
Asset Allocation

How much of my finance should be allocated across asset classes.

Asset Classes – If you bunch securities that have a similar risk-return characteristics, it is an asset
class.

For example: Equity is an asset class which is a bunch of securities based on market risk.

Bonds –

Makes difference if you are a retail investor or institutional investor.

Any interest generating investment is a Bond. For example – Government Bonds, Corporate bonds,
PPFs, EFP, PF

Real Estate – Land, all buildings included is called Real Estate. Not self-occupied houses. Only houses
that are used for investment.

These 3 are called the traditional asset classes.

Alternative Asset Classes –

1) Commodity – You need commodities in your satellite portfolio. It is too volatile to be in your
goal-based portfolio. It is a 24X5 market. Example – Crude Oil, Gold, Silver
Commodities market is open till 12am midnight.

2) Wine
3) Art
4) Antiques
5) Volatility

Lifecycle Investing –

The duration of your life in which you make investments.

There are 3 phases –

1) Accumulation phase – Working phase (Ballpark until 45 years of age if you plan to retire at
60)
2) Consolidation Phase (46-60 years of age)
3) Decumulation Phase (Spending phase) – Retiree/Retirement period

Asset Allocation will change based on which phase you are in.
Investing Lifecycle and Asset Classes – 25-30% equity to about 70% until age 45 (gradually increase
from 25 to 70% over these years).

Then you should de-risk your portfolio. Start cutting your equity from age 45 over the next 10 years
until age 55. Last 5 years of your working life, you should maintain that equity level. Now you should
be having 30% equity and 70% bonds.

This is called as the Glide Path.

In the US, they used Glide Path to recommend a single stop solution for retirees. They sell a <year >
target date fund. So, if you’re retiring in 2030, you buy the 2030 target date fund.

Google NPFs (National pension fund)

RISK

Risk tolerance – it has 2 factors –

1) Ability to take risk (Function of how much you earn and how much you’re saving. For
example – Everything remaining constant, someone earning 1 cr has more ability to take risk
than someone earning 12 lakhs. But there is also a psychological factor involved which is the
willingness to take risk)
2) Willingness to take risk –

Tolerating risk is different than tolerating loss. As risk is merely a projection but loss is the actual
painful event!

In a developed market, the equity returns and bond interest rates drop.

The good thing about equity is liquidity. The bad thing about equity is liquidity.

We do not have just 1 risk personality.

Someone who likes an adventurous sport like F1, wouldn’t necessarily be inclined towards investing
in equity.

Post tax returns for bonds would be less than 5%, whereas for equity it would be around 10%.
Almost double.

Whenever you have to prioritize between 2 goals, just ask if one of the goals can be postponed. If
yes, then it is not a high priority.

The higher priority should have a less risky underlying investment for example bonds over equity (It
should be conservative)

Core portfolio (Beta) – Passive products

Satellite portfolio (Alpha) – Active products

Understanding Passive-Passive and Active-Passive

We can take ETF (Passive fund), put it in my core portfolio and generate beta returns or we could
take the same ETF, put it in my satellite portfolio and generate alpha returns by actively trading it on
the satellite portfolio (Buy on dips and sell on market highs and repeat)

SIP on an ETF – Simplest to manage in core portfolio.

1) Passive – Passive (First one is for us, the investor. Second is for the portfolio manager. For
example: ETF in the core portfolio where we just buy the ETF and hold until maturity)
2) Active – Passive (Where we are actively trading the ETF but the portfolio manager still
manages the portfolio passively as it is a passive product)
3) Passive – Active (Where you buy an active product like a mutual fund. You setup an SIP and
the portfolio manager times the market for you thereby actively managing)
4) Active – Active XXXXXXX (DO NOT TRY THIS!)

Lumpsum money investment in mutual fund will lead to regret. Opt for SIP.

Rupee cost averaging (RCA) – Spreading the investment over a period not longer than 6 months
(Auto-debit once a month for a short duration). This leads to averaging out the cost.

There is a subtle difference between RCA and SIP. In RCA you have an option of investing lumpsum.

As we know, we’re supposed to trim our equity exposure as we approach our life goals, we are
cutting down the risk and the returns as well. So, in order to compensate, we have to save more.
Without increasing the income, how do we save more?

Money Market Instruments – Treasury Bills (Liquid fund)

Marked to Market (Google)

Download the November Fact Sheet of Sundaram Mutual Fund – Sundaram Select Focus Mutual
Fund

(LTP/EPS = Price Earnings Multiple) [Google]

120/10 = 12, Means market is willing to pay 12 times for earning 1 rupee.

Arrange NIFTY50 stocks from high -> low PEM. Take the median. The one above the median are
called growth stocks and the ones below are called value stocks. But when market crashes, these can
get reversed. So Size (Large, Mid, Small) is more relevant than style (Value, Blend, Growth)

Bonds Vs Bond Funds – Google.

Bond funds are mutual funds which invest in corporate and government funds. They are not worth it
as they carry similar risk as equity but provide a lower alpha which makes equity a better option.
NAV is involved in bond funds whereas Bonds have a steady cash flow without any concept of NAV.
 Bonds NABARD – Series 1 NABARD – Series 2
Tenors 10 years 15 years
Interest Payable Annually Annually
Coupon Rates (Retail 7.29% 7.64%
investors)

Which of these 2 options would be a better pick? These are bonds. The above bonds are tax-free
bonds (no longer available) and you DO NOT have a time horizon for this. You also have surplus so
you don’t need the money in the near future.

If you’re pursuing a 15-year goal then you’ll go for a 15-year bond even if it gives a lower return than
a 10-year bond.

You can’t compare a 10 year and 15-year bond, so we have to make them equivalent by investing in
10-year bond and then reinvesting the proceeds in another 5-year bond in the 11 th year and then
compare the interest. So, we will have to find out the interest rate for those 5 years of additional
investment in the 11th year such that there is no difference between the two options. That 5-year
rate is called as the Forward Rate or the Breakeven rate.

(1.0764) ^ 15 = (1.0729) ^ 10 * (1+f) ^ 5

=> f = 8.34%

So, we will choose the 10-year option only if we are confident that in 10 years-time, the 5-year tax
free bond rate will be greater than 8.34%. If not, then go for 15-year bond.

Interest Risk, Credit Risk, Reinvestment risk – Jargons from CF!

MAR – Minimum Acceptable Return

(Let’s say you want to make a down-payment of 1.5 crores in 10 years for a house. You start a
monthly SIP of 20k. You take into account housing inflation of 10%. So [2cr * (1.10) ^ 10] is your

Amount I decide to save every month, you need to find the compounded annual rate so that you can
save 1.5cr by the end of 10 years. Let’s say the compounded annual rate is 8.5%. This is your MAR.
Let’s say expected return on equity is 12%, and on bonds is 5%. Post tax returns are 10.5% and 3.5%
respectively.

So, Weight of equity * 10.5% + (1-weight of equity) * 3.5% = 8.5% [This will help us to determine the
weightage of equity and bonds needed to achieve MAR]

Risk can also be defined by the chance of earning returns lower than the MAR.

You can’t take out the unrealized gains in this case as it needs to stay in the portfolio to get
compounded. So, to avoid the Asymmetric Loss Effect, so take out the unrealized gains above 12%.
Now take this money and put it in a regular FD where you will get some interest return. So, in the
years where there is a shortfall in your portfolio and equity doesn’t perform well, then re-invest the
money from your FD back into your portfolio. You can’t afford to fall below 12% pre-tax return as the
losses will also get compounded. Now coming to the bond part of the portfolio. You need to earn 5%
pre-tax level interest. The risk you will have to reinvest the interest income you’re getting at a lower
rate (than the deposit rate you’re earning), is called the reinvestment risk.
By choosing Recurring Deposit to save monthly income and Cumulative Fixed deposit to save
lumpsum, we move ourselves away from this reinvestment risk, we give the risk to the bank.

Interest Rate Risk –

If interest rate goes up, then bond prices go down and vice versa. Also, in anticipation of interest
rate going up, bond prices will go down and vice versa. This is called the Inverse Price Yield
Relationship. The risk when I’m buying a bond and want to sell the bond in the secondary market for
a lower price when interest rate goes up is called Interest Rate Risk. This can be offset by just holding
the bond till maturity.

Credit Risk – Don’t lend money to your friend! 😊

You lend money to a bank and the bank is unable to give back the money. This is credit risk.

Currency Risk - Today if you want to buy $1 for 74 rupees and rupee depreciates to 80 rupees for a
dollar, then you won’t get that $1. This is the risk you get into if you take money outside your home
currency (expenditure in a non-home currency) For example – Student loan at an IVY league Uni.

So, to avoid this DO NOT start a 15-year SIP in India and convert it to dollars in the 15 th year,
INSTEAD start the SIP in the US in US dollars itself. Here every month, you have to convert Rupees to
dollars. Some months dollar would have appreciated and in some months the Rupee would have, so
the risk cancels out eventually.

Liability Driven Investment –

Liability means the lumpy expenditure you’ve incurred or would be incurring in the future. In this
case let’s say down-payment of 2cr in 10 years. So, you will now look for investments to
achieve/meet this liability. Simple. It doesn’t let you take additional risk for greater return. It is only
concerned with investments that meets your liabilities exactly.

If your goal-based portfolio needs foreign investment, then you can take money outside India.

If you want to invest in betting on Hurricane in Florida bets (present in CME), then you can take your
money outside India. Part of your satellite portfolio.

If you want to invest in an emerging or frontier market to enhance your returns, then you can take
your money outside India.

Do not invest outside India for the sake of Diversification.

Strategic Diversification –

3 scenarios. First, 1 year from now, you expect the economy to go into a recession. 2 nd, 1 year from
now, you expect the economy to become inflated. 3 rd, you expect everything to be hunky dory in the
next 1 year. For all the 3 scenarios, you will invest in all three asset classes. How will you invest in
these 3 asset classes?
For 2nd scenario, you’ll choose commodities as it could be commodities that lead to the inflation in
the future.

For the 1st scenario –

Portfolio managers invest in bonds for capital appreciation and not for interest returns. We invest
for interest returns. In case of recession, the interest rates would be lowered, bond prices will go up.
So, you will invest in bonds now for capital appreciation.

For 3rd scenario –

This is a goldilocks zone, a perfect economy with the right amount of inflation and unemployment.
You should go for equities in this case.

Another Asset allocation approach - Threshold Value Approach -

Let’s say you want to buy your dream house, which is our high priority goals. So, you’ll be
conservative with your investments (can’t have much of equity in the portfolio). If your dream house
is going to cost 5 crores, figure out your next best dream. Let’s say it is a 3-crore house. Invest in RD
in such a way that your maturity is 3 crores. The remainder 2 crores can be invested in equity and
since usually not all the money can be lost in equity, you’ll make some gains out of the equity
investment. SIP can be figured by taking 10.5% post tax returns compounded annually to reach 2
crores at the end of the required time period.

Another practical approach –

You can’t invest so much money in RD to get those 3 crores. You’ll have to look for an alternate
approach. You can take a look at CPPI (Constant Proportion Portfolio Insurance). Google this!

Wealth Mapping Process

Aspiration Assets Lifestyle Assets

Protective Assets

Protective Assets –

One should first protect your existing standard of living and then aspire to enhance your standard of
living.

This involves Health insurance, Life insurance and Contingency fund.

Once you start working again, go for a contingency fund which is also called emergency fund. Helpful
during contingencies such as medical issues, getting fired from job etc.

You would need liquidity in this case. So, you need to protect your nominal capital. You can’t go for
equity investments or gold. You can’t go for risks or returns. You only need to be able to handle your
contingencies.
There is something called Sweep Accounts. Suppose you invest 1 lakh, then the bank will split it into
10 * 10k. They will keep 10k in the savings account and invest the remaining 90k in 9 FDs of 10k each
which will earn you a higher rate of interest. Some banks will usually charge a fee during the sweep
from FD account back to savings account.

How much to save in your contingency fund? A good place to start is 3 times your average monthly
expenses. Gradually increase it to 6 times over the next few years. Since your standard of living
would also get better over time, you will have to regularly increase the value in this fund. This fund
will stay until your entire investing cycle till retirement.

Lifestyle Assets – Basic lifestyle needs. Fancy house and car.

Aspirational – Buying an island 😊

HealthCare Portfolio –

Tier 1 – Contingency Reserve

Tier 2 – Healthcare insurance – From employer + any top up plan you want

Tier 3 – All equity portfolio (As healthcare inflation is quite high. So, the expected return on equity
would be high enough to meet this high inflation)

P.S Equity is not a hedge for inflation. The commodities market (Managed Futures in the US) is the
best hedge option. We don’t have any inflation adjusting investment products in India.

Managed futures – Mutual fund in the US. Take money from institutions and invest in commodities
market. Only high institutional investors invest in this.

Cookie Jar Approach

Behaviourally Optimal

Our risk personality is not a stable trait. As we progress, as we age, our risk-taking appetite will
reduce. You get conservative as you grow. It’s a function of age and nothing else.
If we have 3 goals, our risk appetite for these 3 goals is not going to be the same. The more
important the goal is, the more conservative your risk should be.

(As per research, it is very difficult to pursue more than 3 goals at once. Your expenditure might
exceed your income)

E(R bonds) = 3.5% [Expected returns on bonds currently]

Fix which of the 3 goals is important (Cannot be postponed? Then it is a High priority goal)

Northcore Parkinson – Was a British historian.

He said work expands to fill time. 1 st rule is how to treat assignments. If assignment is given on Dec
15 and deadline is Jan 14 th then you start working on Jan 12 th. But if assignment is given on Jan 12 th
with same deadline, you will not do it and would revolt.

2nd observation – Expenditure rises to meet income.

Spending is natural to us whereas saving is not. It takes a lot of time to earn but no time to spend.

We should save first and whatever remains can be spent. This is why SIP becomes important.

SIP is an investment process, nothing to do with mutual funds. You just need to have enough money
in the bank while setting up auto-debit

Savings Account (Salary Account, Bank X) -> Setup another savings account (Master investment
account, Bank X or Bank Y) [Includes credit card payment, rent, utilities]

Lets say you use Savings to invest in FD, the bank will credit interest to the same account. But this
should NOT be done, you should use your master investment account.

Let’s say you’re planning to save 40k a month. Transfer 40k to Master Investment account on the
day your salary is credited. Then setup all your SIPs on this master investment account.

When you invest in equity for your goal-based portfolio, then do not time the market. It should be a
buy and hold portfolio with periodic rebalancing.

To recap, a NAV is the (market value of portfolio – Liabilities if any) / (No of units)

Anything involved with NAV has market risk.

When any investment has income returns, there is no market risk. Market risk is only involved in
investments dealing with capital appreciation.

Rebalancing – Let’s say I have 100 rupees and decide to put 60% in equity and 40% in bonds. I do not
wish to have more than 65% in equity at any moment. Let’s say equity market gave me phenomenon
returns that year and my equity is now at 70. Bond remains at 40 because it doesn’t have capital
appreciation. Since equity is already over 65%, I redeem some of the units (realize the extra gain)
and assign it to bonds (cumulative FD). This is an annual task, should not be done more than once a
year.

[Do not do rebalancing if equity becomes 68%. 3 percentage point is not significant enough to do
rebalancing]

65% = Capital contribution + unrealized gains

Let’s say in year 4, you decide to rebalance. You have 80L in your equity portfolio and 1crore is your
total portfolio size (Equity + Bond + Post tax Accrued interest). You need to reduce your equity
portfolio to 65L. Let’s say NAV on that day is 40, we will sell (15L / 40) units of equity.

When you cut your equity holdings and invest in bonds, you will miss out on some pre-tax returns
which is called Expected returns on the portfolio (E( R ) P). If you expected 12% pre-tax returns on
equity and in bonds you get 5% pre-tax returns, you will lose out on the 7 percentage points of
expected returns.

Glide Path – Reducing your equity holding gradually over time till retirement. You are losing out on a
higher income generating asset (equity) and increasing bonds (lower returns generating asset). You
have to increase savings in this case without reducing your expenditure. Employer comes to the
rescue here. If your salary is 1L per month and you save 30% of it, and then you get a hike of an extra
15k a month, then increase savings to 50% of this extra 15k and setup an SIP in advance for this
expected hike.

So, if you continue to use the same “Weights” for equity for the entire 10 year duration of your goal,
those transfer of extra equity returns to bonds will result in a huge downfall of expected returns
where you might not be able to meet your goals. This is because you calculate initial investment in
equity and bonds based on these weights.

Accrued Interest – Interest you have earned but has not been credited yet. In Regular FD you get
interest each year credited but in Cumulative FD, you get the entire amount at the end of the
maturity period. However, in Cumulative FD, you will get a interest statement for Income tax
purposes and you have to pay 30% of it (each year, even though you haven’t received it)

Total investment amount therefore is going to be Equity + Bond + (70% of interest returns)

Learn about Capital gains tax, income returns tax, Section 80C, D, CCF – Google for your personal
finance

Why SIP is good?

Inertia, Regret Aversion and Immediate Gratification (Downsides of not doing SIP, these are
behavioural biases)–

If there is a world where there is no SIP, you might procrastinate and forget to debit – Inertia

Regret Aversion – We know lumpsum money investment is not a good idea. We don’t get to spread
our investment and take advantage of Rupee Cost Averaging. Even if we spread it, we take an active
decision to invest. This would involve opening up a portal and making that investment. Let’s say 3
days later market crashes, you would have regret. Distance yourself from active action. After doing
an SIP, it is out of sight and out of mind, so you get to distance yourself from active action and there
would be no regret.
Immediate Gratification – If we have to manually have to transfer and just at that time we see an
offer that we wanted (TV, Laptop), you believe you will get instant happiness. So you decide not to
make that transfer and you spend it today. Present happiness > present value of future happiness

SIP – Equity Mutual Fund: Let’s say you decide to invest 25000 on 3 rd of every month, you fixed the
amount. The only variable is the number of units that will be credited based on the NAV. Biggest
advantage when you’re doing this is that you are setting up an account where you don’t have to
manually intervene.

Things to do – Look at 2 Personal Finance Website

If you want to invest in active funds, look at the top 5 Large cap funds over the last 5 years in the 2
websites. If one is present in both, it might be a good pick. The fund might be able to give alpha
returns.

If you invest in active fund, you’re getting into active risk. If index gives 12% return, and you get a
return lower than that. It is called active risk. (Negative alpha)

Let’s say you are chasing the dual objective that I want to make down payment for house as well as
beat the index, then you have to go for an active fund but be sure that it will generate alpha returns
over these 7 or whatever years. How to analyse if this is possible? Because alpha returns involve luck
and skill, so it is very difficult to analyse. No tool will tell us if returns is coming from luck or skill. You
go for alpha because you hope the portfolio manager will beat the benchmark index. Performance
appraisal is needed for the active fund every year. Once SIP is setup, set it up for 12 months and
then appraise your investment to know if the fund has delivered what you wanted. So, if NIFTY has
given returns of 12%, see if your investment has given returns greater than 12%. If you do not see
those returns, go and see if the product manager, no matter how fantastic, has run into bad luck this
year. Hope the investment will recover next year, so renew your SIP.

You should have max of 2-3 active funds and they should be large cap mutual funds. Because in
Large cap mutual funds, the risk of Momentum crash is low. The speed of stock price coming down is
much faster than stock price going up. You do not need mid-caps or small-caps in your core
portfolio. Hence you should have large cap fund.

Most large cap funds have similar stocks in them such as giants like Reliance, Tata etc. The only
differentiating factor between 2 large cap funds is the weights.

SEBI guidelines after 2018 states that if you’re a large cap fund, you cannot have more than 80% of
portfolio in large caps. Remaining 20% you can slip in mid-caps and still compare with NIFTY
benchmark index.

Remember for Large cap funds, Alpha is not scalable. The returns you got from 500 to 1000, might
not happen 1000 onwards.

If a fund has portfolio size of 10000 crores (Assets under management), don’t get overwhelmed. If it
had 2500 crores in 2017, then we don’t want a fund with that much growth in such a short time.
If a fund is able to give phenomenal returns, then portfolio size will increase and in addition existing
investors will pour in more money and new investors will be attracted and hence portfolio size will
eventually go from 2500 to 10000 crores. How to understand the picture?

(AUM / No of units) = NAV

So, if more and more investors are coming in, units will be assigned to them and denominator will go
up. So, if fund is not generating enough returns and is only selling more and more units then NAV
growth will be slower. So, compare NAV growth and AUM growth. If AUM is growing higher than
NAV, then it is not good as fund is just selling more and more units and folks are coming in. If NAV
growth is more than AUM growth then brilliant.

Now you have setup SIP, investment is going well, suddenly you find a better investment
opportunity. You have only 10 days to make a call. So you decide to break your current SIP and give
it to the new opportunity.

Commitment Devices (Prevalent in India, it’s a behavioral psychology thing) – You should be tied to
an investment but there is always a temptation to move out (Stop SIP, transfer etc). Typical Indian
parent want you to start saving at 22, so they make you buy a house by paying an EMI. It is very
difficult for individuals to default EMI on your self-occupied house.

3 commitment devices –

1) Product Lockbox (PPF. By nature of product. No market risk in this.)

2) Regulatory Lockbox (ELSS. By nature of guidelines. This has Asymmetric returns effect so this
is not good.)
3) Process Lockbox

Lockbox – Cannot take money out

Do not keep your portfolio credentials with yourself. Give it to a trustworthy family member or
friend. As we take bad decisions in haste and regret later. The one who has the credentials can ask
you questions or talk you out of the decision.

Age for active investing – Till age 45 it is optimal.

What is so magical about 45? 15 years until retirement, you need to be in consolidation phase. You
have to reduce equity exposure. In order to save yourself from market risk and active risk, consider
stopping active funds after age 45.

Dividend Option vs Growth Option

All MF will give you 4 NAVs.

NAV1, NAV2, NAV3, NAV4.

NAV1, NAV3 for direct plan. NAV2, NAV4 for regular plans.

NAV1, NAV2 will be dividend option. NAV3, NAV4 would be growth option.

Optimal choice considering current tax structure and SEBI guidelines is Directplan-Growth (NAV3)
Difference between regular and Direct plan is that –

1) In regular there would be a middleman through which person invests in a bank/fund

2) Regular plan has 50-70% basis points (Total expense ratio) higher fees compared to Direct
plan in order to give commission to the middleman.

Difference between dividend and Growth option –

In an active fund, they time the market. It consists of stocks at its market price + Realized gains +
unrealized gains + dividends. If you choose dividend plan, MF company will give some of the
invested money back so they can only give you the realized gains and the dividends but not
unrealized gains and stocks. They do this if they feel it doesn’t make sense for a large sum of money
to sit in the fund and they do not intend to buy more stocks with it. So, they transfer it to the
investor who agrees to the terms and conditions by applying for a dividend option that they will be
fine with this decision. You can’t go and request. It is the MF company that has the right to do this.

Growth is where you tell the MF manager not to give you the money. So, they will hold the Realized
gains and dividends and invest it back to the market whenever it seems right.

Dividends are taxed at marginal tax rate - 30%

But LTCG are taxed at 10%, so if it stays longer in your portfolio, you will be taxed less, hence go for
the Growth option.

Hence Direct + Growth is the best option.

NAV for dividend funds is always lower than NAV for growth funds as you’re giving out cash in the
former.

FMP – Fixed Maturity Plans

Bond funds come in 3 flavours (Structure) –

1) Open end (Redeem anytime during business day and get money in 48 hours)
2) Closed end (Won’t give money at all, until fund is closed)
3) Interval funds (Subset of closed end funds but they allow to redeem once or twice a year
where window is open for a week or so)

FMP has to do with how the portfolio is managed under the bond fund. It is basically a closed end
fund or Interval fund.

In Government bonds, you are assured that you will get back your par value at maturity. If you had
invested 100 rupees, you will for sure get it back at maturity.

Amfiindia.com (Association of mutual funds in India)

Focused Fund – Fund that cannot have more than 30 stocks in the portfolio (Could be a mix of large
cap, mid cap, anything)

Value Fund/Contra Fund – Stock today is trading at a discount and you buy it after using some
metrics.
Take NIFTY 50 index. Arrange them from high to low PEM (Price earnings multiple) and then
everything above median is Growth and everything below median is value. It is a naïve way to
understand what value means. A cement company is trading at 10 but peers are trading at 35.
Analyze the reason why this is the case? Others are betting against this stock but you see value in
this stock and invest anyway, betting that things will come around. You feel market is overreacting to
this stock and it is undervalued.

Flexicap fund – Introduced recently. Earlier multicap funds were free to have a random mix of large
cap, mid cap, small cap etc. Then SEBI imposed guidelines which said 25% has to be large cap, 25%
has to be mid cap and 25% has to be small cap, rest 25% is free to do anything. This was a huge
problem as funds were mostly biased towards large cap and small caps. Then Fund managers
requested SEBI to bring the old multicap back, so Flexicap was introduced where you can have
random mix of stocks without any cap.

Quantum Equity Funds of Funds – These take money from you and buy other mutual funds instead
of stocks.

Here you have to pay multiple fees. First the mutual fund and then all the mutual funds that your
mutual fund invests in.

Picking active funds becomes a nightmare for individuals like us from a technical standpoint. There
are over 30 active funds to choose from. As humans, we will not compare the returns of our active
fund with the benchmark but instead compare our active fund returns with returns of other active
funds. Hence it is best to outsource it and depend on manager selection skill for which you need to
pay a 50-70 percentage basis points as fees.

In the event you choose to hold 4-5 active funds, the minimum investment in each mutual fund is
5000. So not everyone can afford to pay 25k a month for 5 mutual funds. So for such people, Funds
of funds make sense.

Same family fund-of-funds

Here the MF company for example Franklin India Life Stage Fund of Funds invests in other MF
products of Franklin.

It consists of both equity and Bonds. Managers can shift funds from equity to bonds and vice versa
on short term (<1 year) – Tactical Asset Allocation

Hybrid funds of funds do not exist as there aren’t many takers for it.

Third family of funds is called Single-Asset fund-of-Funds

Example Nippon India Gold Savings Fund- Takes money and invest in own gold ETFs.

Given a choice, which one will you pick? Gold ETF vs Gold Savings Fund (fund-of-fund)

Pick Gold ETF if it allows for SIP.

Should you opt for Gold? Yes, it is a good trading asset! Buy financial gold and not physical gold.

Let’s say Fund A has been for 10 years, has a NAV of 80 per unit.

Fund B belongs to the same family and is managed by same manager. It has a NAV of 10 per unit and
is just launching. Both are Large-cap focused.

Which one will you prefer?

People will go for Fund B as it is 1/8 th the cost of Fund A. So this is a repeating pattern. Soon Fund B’s
NAV will increase and Fund C will be launched at 10 per unit NAV, and people will buy that. Soon
there will be many similar MF products and the closet will be full and difficult to close. This will
confuse investors.

The right answer? It doesn’t matter which one you pick as it will give the same returns. Number of
units and NAV doesn’t matter.

To clear the clutter mentioned above, SEBI introduced guidelines saying you can have only 1 large
cap fund, 1 mid cap fund, so on. You can’t have similar funds only to offer at a lower NAV. Older
funds usually also have a lower fee.

Caveat Emptor – Buyer Beware.

To be called a large cap fund, SEBI guidelines states it has to invest 80% in large caps. Most large cap
funds usually invest about 85-90% in large caps.

Goals are usually >1 year, hence it is a long-term asset. If Income tax considers your asset as long-
term asset, you will have to pay Long Term Capital Gains tax. You pay lowest tax in this case. It is
only 10% on gains exceeding 1L.

Short term capital gains tax is 15% on the entire gains.

Tip: In an attempt to not pay taxes, do not stop rebalancing because the risk is greater if you do not
rebalance.

If a fund has both equity and bond, Income tax can’t understand how to tax the investor. Some
might have 30% equity; some might have 70% equity.

So, as per ITD, any portfolio having 65% equity is an equity fund. This is an inclusive definition. No
work arounds.

If it is less than 65%, it will be added to your income and taxed at marginal tax rate (income-slab tax
rate)

Does it make sense to invest in hybrid fund for goal-based portfolio?

You have a fixed amount in mind you need at the end of 10 years. There is a pre-defined asset
allocation that will help you achieve the goal. Now how do you know the portfolio managers are
doing the right asset allocation for your goal? It is a generic product and hence, from that
perspective it doesn’t make sense to go for hybrid fund. Although it brings to the table tactical asset
allocation where the manager of equity and bond funds will talk with each other and dynamically
change the allocation. But we do not want that in a goal-based portfolio.

Section 80C. What all products are available?

1) PPF/PF
2) ELSS (An ELSS is an Equity Linked Savings Scheme, that allows an individual or
HUF a deduction from total income of up to Rs. 1.5 lacs under Sec 80C of
Income Tax Act 1961. Thus if an investor was to invest Rs. 50,000 in an ELSS, then
this amount would be deducted from the total taxable income, thus reducing her tax
burden.)
3) NPS
4) 5-year Bank FD
5) Principal amount of EMI
6) NSC (National saving certificate)
7) ULIPs (Unit linked insurance plan)

Which are not good for goal-based portfolio?

ULIPs, ELSS, Principal amount EMI, NPS (NAV based, Equity is locked in so ARE will be there) , NSC, 5-
year bank FD (as interests are taxable)

So only PPF/PF is left.

PPF is 15-year lock-in for interest. Which is great.

PPF is one of the 3 products in India which follows EEE format. (Exempt-Exempt-Exempt).

Let’s say you invest 1.5L PPF, your salary is XXX and you deduct 1.5L from your salary each year. You
are exempted from any tax on this deduction. Second exemption is the accrued interest on your
investment as opposed to Cumulative FD interest taxation. After 15 years, you get option to renew
for as many times as you want in blocks of 5 years. And you will never never have to pay taxes.
Whatever you get at the end is entirely yours, no taxes.
Retirement Portfolios and Retirement Income Portfolios

Retirement portfolio – you create it during working life (Accumulation)

Retirement Income Portfolio – After retirement you use this portfolio to spend (Decumulation)

Inflation affects all of us but it affects retirees more. Our incomes increase over time which might
help to catch up if not beat inflation but retirees won’t have that option.

Most important expense for a retiree is healthcare costs. Healthcare inflation is usually double than
that of general inflation. There are unfortunately inflation-hedging products in India.

TIPS – Treasury Inflation Protection Securities. Adjusts the principal amount based on inflation and
gives interest returns based on the adjusted price. Extremely beneficial and loved in the US.

Any goal you pursue during your work life has a fixed time horizon until retirement. Once you start
using your retirement income portfolio, there is no time horizon. This risk of not having enough
funding until death is called Longevity Risk. If you have a expected life expectancy of 85 years and
you manage to survive your 85th birthday, you might have run out of funds. So, when you outlive
your investments, this is called longevity risk.

How to determine retirement amount?

Suppose you are 25 and you retire at 60. How to start?

We start with monthly expenses (50k). Multiply by 12 to reach annual expenses. (6L)

Find future value of current expenses taking into account the inflation.

So, if inflation is 5%, then

6L [1.05]^35 =33.09L

So, your current expenses now are worth 33.09L in 35 years’ time.

Now, we know for each year post retirement I would need 33.09L. But what is our life expectancy?

Let’s take 85 as life expectancy.

Now we need to inflate the 33L for 24 years. 24 as at age 60, you already have money upfront to
spend till age 61.

Now will we have to discount the expenses for age 61 onwards to age 60. That would be the amount
we would need at retirement.

Annuity Product – Takes care of longevity risk. You pay a lumpsum at age 59, 60 let’s say 8.5 Crores
(purchase price) and in exchange the insurance company will pay you 75000 per month until the day
you die. This in India is not inflation adjusted.

In classical Annuity - The purchase price is entirely that of the insurance company and not a penny
comes to the children of the deceased investor.

In Return of Purchase Price Annuity – In this the 8.5 crores comes back to the children or kin
In US, it is inflation adjusted. This is called COLA. Cost of Living Adjustment.

Joint Life Annuity with Return of Purchase Price – A specific type of annuity that returns the least
amount! But it is something we want. Husband X and Wife Y. Husband X is that annuitant. Goes and
buy the annuity product. He pays lumpsum and then annuity will be paid to X till X dies. If X dies,
then annuity will be paid to Y. If Y dies, the purchase price will be returned to ‘estate’ (wealth of the
deceased available for distributing amongst children) where children can divide it amongst
themselves.

If you already are a part of classical annuity and you want to change it to a Joint Life Annuity, the
purchase price will become higher to 9.75crores as the probability that insurance company will have
to pay annuity is now greater. If you switch it to a Joint Life Annuity with Return of Purchase Price,
then the purchase price will increase even higher to 13crores.

Similarly, if you do not want to change the purchase price from 8.5 crores and want to turn it to a
Joint Life Annuity with Return of Purchase Price, then you will end up getting a substantially lower
42k a month as annuity.

This Joint Life Annuity with Return of Purchase Price has the lowest yield. This yield can be found on
any insurance company’s website. Look for an immediate annuity, take the post-tax yield (taxable at
30%)

Yield * 0.70 = Discount rate (Helps insurance company understand how much can be paid as annuity)

Some assumptions we took to arrive at retirement amount that is subject to change –

1) Life style
2) Inflation
3) Discount rate
4) Tax rate
5) Life expectancy

As we can’t know how our lifestyle will change and how much expenses will increase? So, keep
reviewing this every 5-years until age 45. From age 45-55 review every 3 years and finally 55-60,
review every year.

Early retirement? (45-50)?

Is early retirement good for you? You have lesser working years. You will have shorter active income
period.

Those who retire early are more likely to suffer from dementia as they had a very active work life
and suddenly, they retire and the “routine”-ness fades away which impacts neural network in brain.

Retirement readiness consists of Financial and Emotional readiness.

Early financial freedom is when you have enough money to fund all lifestyle expenses and hence you
retire at 50.

When people achieve this, instead of working 6 days a week, they work 3 days a week, because you
might have enough bargaining power in the company, you join back, they give you half the money.
This is called Phased retirement.

Retirement Risk Zone -

Investing life is defined as the entire time period since working until you die where you can make
investments. Out of these, 10 years are extremely crucial. These 10 years constitute the Retirement
risk zone. If age 60 is the retirement date, then retirement risk zone is 55 to 65 (+5 to -5)

Why is it crucial?

Age 55-60 –

1) Retirement portfolio is the longest horizon portfolio for anyone and has maximum
investment value portfolio
2) Any risk in this time period such as market falling 10%, you lose about 85L if you have
managed to save 8.5crores. It will take more than 5 years for market to catch up.
3) According to glide path, by this time you have already trimmed your equity allocation.

Age 60-65

1) At age 60, your portfolio has maximum value it should contain. You risk attitude will change;
you won’t be as aggressive as you used to be with risk.
2) When you lose money in first 5 years of retirement life, you lose a lot of money and expose
yourself to longevity risk.

Sandwich problem –

Children – Couple – parents

Club Sandwich problem –

Grand children – Children – Couple – Parents – Grand parents

If this occurs during retirement, doooooomed!

Reverse Mortgage –

Let’s say a person needed 10 crores for retirement portfolio but managed to save only 8 crores.

The 2-crore shortfall is a problem. But they do not need the 2 crores immediately.

Let’s say they have a self-occupied house, totally paid for.

They go to the bank and evaluate the property and the property is worth 4 crore. I want 50% of the
money whenever I ask for. Whenever you take the 50%, interest meter would start.

However, banks do not lend loans to retirees because they cannot repay back easily. But this
investor has sold the house to the bank, the bank is now the half owner of the house. When next
generation want the house back, they have to repay the loan and the interest and get the house
back. This is called reverse mortgage line of credit. Reverse mortgage failed in India as in India,
children fight for house even before parents are dead but Reverse mortgage line of credit worked.

NHB – Google National Housing Bank.

Google more about reverse mortgage.

Retirement Income

What are some expenses of retirees?

1) Healthcare
2) Living expenses
3) Leisure expenses

Pretend each of these are separate goals instead of thinking it as one entire goal.