Chapter 1

PDP

Investment Planning

Fundamentals of Investment Planning

What is Investing?

nvestment refers to a commitment of funds to one or more assets that will be held over some future time period. It is important to understand the difference between Savings and Investments. Anything not consumed today and saved for future use can be considered as savings. Almost all of us save money. In fact we are a nation of savers where the domestic savings is a high percentage of Gross Domestic Product sometimes as high as 26-27%. It is important to channel these savings into productive investment avenues. Almost all individuals have wealth of some kind, ranging from the value of their services in the workplace to tangible assets to monetary assets.. For our purposes, investment will mean a measurable asset retained in order to increase ones personal wealth. A financial asset is one that generates income and contributes to accumulation and growth of wealth over a period of time. The two elements in investments are generation of income on a periodic basis and/or growth in value over a period of time. Investment scenario in India A pick-up in investment, reflecting the high business optimism, not only strengthened industrial performance but also reinforced the growth outlook itself. The rally in gross domestic capital formation (GDCF) that had commenced in 2002-03 continued and as a proportion of GDP it reached a high of 30.1 per cent in 2004-05.1 The increasing trend in gross domestic savings, which provided most of the resources for investment, as a proportion of GDP observed since 2001-02 continued with the savings ratio rising from 26.5 per cent in 2002-03 to 28.9 per cent in 2003-04 and further to 29.1 per cent in 2004-05.2 India is a nation of savers and the domestic savings is a very high percentage of GDP. That is extremely good. It is shocking to note that more than 45% of domestic savings is invested in bank deposits and only about 2/3% in equity and equity related investments. This clearly shows that while as a nation we are very good savers we are very poor investors because it is equally important for the savers to invest in avenues that fetch decent returns after considering factors like inflation, taxation, etc. Bank deposits not only offer lower returns but they are hardly tax efficient and thus do not serve the cause of earning high post tax & net of inflation returns. In developed countries the proportion of savings being diverted to equity and equity related instruments is in the region of 20-25% of GDP while around 20% of savings are parked in bank deposits. Some investors have failed to recognize the less obvious, but potentially more damaging, risk of diminished income from staying completely invested in low yielding fixed income securities or bank deposits. The financial planner should ensure that investors take a hard look at the fixed income components of their portfolios and rethink this strategy in the context of more comprehensive, long-term objectives. Understanding where the clients are coming from, the priorities in their life and the challenges they face in a rapidly changing investment horizon. Succeeding in career, planning childrens education, marriages and having more than enough for an enjoyable retirement are some of the objectives most people aim at.

Economic Survey 2005-2006

Economic Survey 2005-2006

Investment Planning

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The financial planner in India hence, has a very important role to play. The planners job in India is more challenging because of Indian mind set and the aversion to risk. It will be part of his job to educate his clients on concepts of risks and returns and their relationship. Why Invest? We all work for money. It is equally important to ensure that money works for us. We should inculcate the habit of reliance on a secondary source of income. We invest to improve our future welfare. Funds to be invested come from assets already owned, borrowed money, and savings or foregone consumption. By foregoing consumption today and investing the savings, we expect to enhance our future consumption possibilities. Anticipated future consumption may be by other family members, such as education funds for children or by ourselves, possibly in retirement when we are less able to work and produce for our daily needs. Regardless of why we invest we should all seek to manage our wealth effectively, obtaining the most from it. This includes protecting our assets from inflation, taxes and other factors. Investment fundamentals Some of the fundamental rules of investments are: START EARLY INVEST REGULARLY ENSURE HIGHER RETURNS ON YOUR INVESTMENTS The following table will demonstrate the difference, very graphically: It is assumed that an investor invests Rs 1,000/- p.m., at the end of each month, systematically, in different invest plans which yield 5%, 8%, 12% and 15% p.a. returns. Look at the big difference in the maturity values as the term gets longer and longer and as the returns are higher.

Indian investors have always preferred fixed income securities where the returns are assured and have compromised on the returns. In general investors are risk averse and more so Indian investors. It is the job of the financial planner to advise the investors on the concept of focusing on higher returns for better stability and higher capital building over a longer period of time. The above table very clearly illustrates how a higher rate of return over longer period of time can make a world of difference to the capital at the end of the term.

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Investment Planning

Example
Mr. Sunil Joshi, a very conservative investor, has been religiously investing Rs. 5,000/- p.m. in a provident fund account which gives him interest at the rate of 8% p.a. compounded annually. Mr. Ashwin Shah, on the advise of his planner, has been investing Rs. 5,000/- p.m. in equity linked investments which have given him around 15% p.a. return. Both start at the same age of 25 years and keep investing for 30 years. Mr. Sunil Joshi will have a capital amount of Rs. 74.50 lacs in his provident fund account while Mr. Ashwin Shah will have accumulated Rs. 3.46 crores which is about 5 times the retirement capital of Mr. Sunil Joshi. These dramatic results have been possible because of the focus on the rate of return. Mr. Sunil Joshi has done well by starting early and investing regularly but he has not focused on the rate of returns on his investments. While assured returns are important it is also important to focus on expected returns on investment, even at a risk. How Do We Invest? If we are making investment decisions today that will directly affect our future wealth, it would make sense that we utilize a plan to help guide our decisions. Surprisingly, the majority of people do not have in place any type of formalized investment plan. Taking some time to put together a financial plan can reap tremendous benefits. First, lets define financial planning. Financial planning is the process of meeting ones life goals through the proper management of your finances. Life goals can include buying a home, saving for childs education or planning for retirement. Financial planning provides direction and meaning to ones financial decisions. It allows one to understand how each financial decision affects other areas of finances. For example, buying a particular investment product might help you pay off your mortgage faster or it might delay your retirement significantly. By viewing each financial decision as part of a whole, one can consider its short and long-term effects on life goals. One can also adapt more easily to life changes and feel more secure that goals are on track. Common Mistakes in the planning process It may be helpful to be aware of some common mistakes people make when approaching investments: 1. 2. 3. 4. 5. 6. 7. 8. 9. Dont set measurable financial goals. Make a financial decision without understanding its effect on other financial issues. Confuse financial planning with investing. Neglect to re-evaluate their financial plan periodically. Think that financial planning is only for the wealthy. Think that financial planning is for when they get older. Think that financial planning is the same as retirement planning. Wait until a money crisis to begin financial planning. Expect unrealistic returns on investments.

10. Think that using a financial planner means losing control. 11. Believe that financial planning is primarily tax planning. These are some of the most common misconceptions about financial planning and it the perhaps one of the first jobs of the financial planner to clear these areas with the prospective client. The financial planner should explain the process of planning; the various steps involved and the ultimate objective of the exercise before hand and make the investor comfortable about disclosing his personal information.

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What Process Do We Use to Invest? Nobody plans to fail but many fail to plan. It is important for the investor to realize that planning is very important. The financial planner has to spend time in educating the investors about the common mistakes and how to come over them. He has to take the client through the systematic process of financial planning outlined below. The financial planning process consists of six steps that help the investor/client take a big picture look at where he is financially. Using these six steps, the investor can work out where he is now, what he may need in the future and what he must do to reach his goals. These six steps are: 1. Establishing and defining the client-planner relationship. The financial planner should clearly explain or document the services to be provided to you and define both his and the clients responsibilities. The planner should explain fully how he will be paid and by whom. The client and the planner should agree on how long the professional relationship should last and on how decisions will be made. 2. Gathering client data, including goals. The financial planner should ask for information about the clients financial situation. The client and the planner should mutually define the personal and financial goals, understand the clients time frame for results and discuss, if relevant, how he feels about risk. The financial planner should gather all the necessary documents before giving the client the advice he needs. 3. Analyzing and evaluating your financial status. The financial planner should analyze the clients information to assess his current situation and determine what he must do to meet his goals. Depending on what services you have asked for, this could include analyzing your assets, liabilities and cash flow, current insurance coverage, investments or tax strategies. 4. Developing and presenting financial planning recommendations and/or alternatives. The financial planner should offer financial planning recommendations that address clients goals, based on the information collected. The planner should go over the recommendations with the client to help him understand them and help the client make informed decisions. The planner should also listen to the clients concerns and revise the recommendations as appropriate. 5. Implementing the financial planning recommendations. The client and the planner should agree on how the recommendations will be carried out. The planner may carry out the recommendations or serve as the coach, coordinating the whole process with the client and other professionals such as attorneys or stockbrokers. 6. Monitoring the financial planning recommendations. The client and the planner should agree on who will monitor the progress towards achieving the goals. If the planner is in charge of the process, he should report to the client periodically to review the situation and adjust the recommendations, if needed, along with life changes.

Product selling Vs. Financial planning

Financial planning is the process through which the planner helps his client to achieve his financial goals. The financial planner may also be an insurance advisor and/or a mutual fund distributor. The planner may have a product bias because of the commissions and brokerages and he may try to push

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these products rather than act in the best interest of his client. This is not only unethical and immoral but is also not a proper strategy for long term business success for the planner. It is a well established fact that success in marketing any product or service is more dependant on motivating a client to buy the product/service rather than resorting to aggressive selling tactics. The client would be better motivated to opt for your service as a planner if you take care of his long term interest rather than your short term interest of brokerage/commissions. It is easier for you to achieve your goals if you help a large number of people achieve their goals. The financial planner plays a very important role in designing an investment plan that would best suit his clients needs. He tries to understand thoroughly the financial goals of his clients; he discusses the various investment options available and finally suggests to his client a financial plan that will serve the purpose of achieving the clients goals. This is a very comprehensive process which requires a thorough understanding of the financial products; markets; economy and also an analysis of the clients risk profile; needs; goals, etc. Thus financial planning is much superior to selling financial products/services; more comprehensive and more rewarding for the client and the planner in the long term. In India many investors have a low level of understanding of the concept of financial risk and hence have conventionally preferred fixed income instruments to market related instruments with uncertain income flows. Thus our investors have a very low risk tolerance. It is one of the most important tasks of the planner to educate his client on the concept of investment risk ; prepare the client mentally to accept volatility in the markets in the short term and explain how patience will be rewarded in the long term. Product selling does not involve these steps of educating and increasing the risk tolerance of the investor. Hence a planner will enjoy a long term advantage and better relationship with his client compared to a product seller. Self-Help or Professional Help? Some investors may feel that they understand financial products better and can do the financial planning themselves rather than entrust the same to a professional financial planner. Investors may prefer some personal finance software packages, magazines or self-help books that can help them do their own financial planning. However, they may decide to seek help from a professional financial planner if: They need expertise that they dont possess in certain areas of finances. For example, a planner can help you evaluate the level of risk in your investment portfolio or adjust your retirement plan due to changing family circumstances. They may want to get a professional opinion about the financial plan they have developed for themselves. They may not have the time to spare to do their own financial planning. Certain changes take place in the family or an immediate need or unexpected life event such as a birth, inheritance or major illness. An investor may feel that a professional adviser could help him improve on how he is currently managing his finances. An investor may feel that he should improve his financial position but does not know where to start and how to go about it. Some of the common problems which are brought before the financial planner are listed below. The list is inclusive and there can a number of other areas as well. How should I create and preserve personal wealth?

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How can I achieve a specific lifetime financial objective? How should I provide for my childrens education? I am receiving a distribution from my employer. What do I do? Do I have enough to retire? I just received a lump-sum inheritance. What do I Do? When should I execute my stock options? How should I best leave wealth to my heirs? Expectations from a financial planner 1. 2. 3. 4. He should believe that a sound financial plan is fundamental to achieving his clients goals and enhancing the quality of life. He should also believe that money is not everything but having control and confidence about managing it can allow the client to concentrate on other things like family, career and future. He should recognize that the issues that brought the client to him are unique and he should try to take result oriented approach to solving the clients concerns. He should adopt a personal, confidential and patient approach to help his client reach decisions on complex choices and alternatives in investments.

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Review Questions 1. Financial Planning is: a. Investing assets to receive the highest rate of return possible b. Keeping taxes as low as possible c. Planning to retire with the maximum income possible d. A process of solving financial problems and reaching financial goals 2. The main reason people fail to plan is: a. They keep on postponing b. They are too old to plan c. They are too young to plan d. They lack the expertise to plan 3. Successful investing can be directly related to I. Starting early II. Investing regularly III. Taking unduly high risks IV. Focusing on risk and return in different investment vehicles a. I & II only b. III only c. I, II and IV only d. All four

Answers: 1. 2. 3. d a c

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