Authored by Neha Kalia, Consultant-The AZAD Programme
Personal Finance can be a very challenging sphere for some of us who find financial jargon very confusing. If your eyes glaze over when someone talks about things like ‘investment horizon’ and ‘risk adjusted returns’, read on so you can learn to make sense of some of the common terms which sound very complex but are actually not that complicated to understand.
– (pronounced as maur-gage) It’s when you take a bank loan for buying a property and the property is marked as collateral or security by the Bank. So if you don’t repay the loan in a timely manner, the Bank can repossess your property.
Usually having a debt is viewed as a burden but if taken at the right stage in life, a mortgage allows you to accomplish the dream of having your own home significantly earlier than you could afford to otherwise. Of course that’s provided you don’t stretch beyond your means and make the effort to choose a property carefully.
2. Mutual Fund
Imagine you are a group of 10 friends who have some money to invest but no expertise to make or manage the investment. You get together and hire a well-educated, qualified and experienced money manager. He takes your individual investments, pools them together and makes investments with that pool of money.
If the investments do well, the pool grows and so does your share. If the investments don’t do well, the reverse happens. The money invested is yours along with any gain or loss made. The money manager charges a certain percentage of your fund value for expenses including his salary.
There are various types of mutual funds based on the kinds of investments the manager invests in.
3. Investment Horizon
It’s how long you plan to stay invested in a particular investment product at the time of making the investment. So if at the time of investing Rs 100 in a fixed deposit, if you plan to invest for 2 years…you tell the bank to put it in a 2 year fixed deposit. So in this example, your investment horizon is 2 years. If your circumstances change, you could encash the deposit and pay a penalty for the early withdrawal. But at the time of placing the money your investment horizon was two years.
This is an important concept in personal finance, as your investment horizon should be used to determine which investment avenues are suitable for you. To draw an analogy, at the start of a race,you should know whether you are running a 100m sprint or a marathon. This will help you decide what running strategy you should adopt for getting best results.
It simply means to what extent something fluctuates over time. In the personal finance world the term is usually used in reference to returns or interest rates or share prices etc.
So for example the more the fluctuation in returns, we say higher the volatility. If returns are stable over time, we say the volatility is low. In the investment context in general, the more volatile something is, the higher is the risk associated with it.
5. Risk adjusted returns
If you make 8% interest on a fixed deposit but could alternatively get 100% returns on a ‘double or nothing’ bet…which is a better investment and which has a higher return? Its like comparing apples with oranges!
The gambling bet could fetch you very high returns but the risk is also exceptionally high. You could end up with a 100% loss! While the 8% interest seems very timid in comparison, you can be fairly certain that you will not only get your principal back but also the promised return of 8%.
So when you compare these two options, you can’t just compare 8% vs 100% when choosing the better option. You have to factor in the risk that you are undertaking as well. That is called comparing risk-adjusted returns i.e. returns adjusted for the accompanying risk.
6. Risk Appetite
Its simply how much risk you are comfortable with. Risk levels of investments are directly related to returns. Therefore, the higher your appetite for risks, the more risk you are willing to assume for your investment and consequently you have the opportunity to earn higher returns. If your risk appetite is very low, then it means that you are willing to accept fairly low returns so as not to expose your invested capital to much risk.
If you know that you have a tendency to be sea-sick, would you opt for a cruise on a lake or would you prefer a white water rafting experience? Surely you would choose the former. But if you are not prone to seasickness i.e. if you are comfortable with the ups and downs of a rapid, then that’s an experience you’ll really cherish. And if you really enjoy the thrills of the rapids then you’ll be bored on a placid lake.
At the time of making an investment, you should know what your risk appetite is and if the investment you are contemplating matches your appetite. If you are risk averse, you will be very dissatisfied with a risky product even though it may fetch you higher returns. Similarly if you have a considerable appetite for risk, you will be very disappointed if you invest in a low return product even if it means you have exposed yourself to lower risk.
7. Asset Allocation
There are many different types of assets or investment options available for example Bank deposits, Shares, Equity based Mutual Funds, Bonds, Property, Gold etc. Asset Allocation refers to following a particular strategy when deciding how much of your portfolio to invest in which type of asset. i.e. how you allocate your money across different types of assets. Which strategy you choose could depend on your age, stage in life cycle, risk appetite, investment goals etc.
It’s very similar to deciding how you plan a diet for yourself. The ideal diet for a growing child would be very different from that of an athlete or a person trying to loose weight or a pregnant woman. No one diet is suitable for all. But every ideal diet should have a well-balanced approach suitable for that individual.
It’s simply the opposite of ‘putting all your eggs in one basket’. Once you allocate your money across various asset classes, you should also diversify your investments within each asset class.
For example, based on your asset allocation strategy if you have to invest 6 lacs in Equity, then instead of investing all 6 lacs in one equity mutual fund, you should spread your investments across different products. For instance the 6 lacs could be spread across 3-5 different equity mutual funds.
Diversification is a very simple strategy to bring down the overall risk of your portfolio. It mitigates the risk of concentration. For example, when seeking college admissions, it’s why we apply to multiple colleges and not just one.
9. Debt Investment
Debt usually means taking a loan. In the personal finance context a Debt Investment means investing in a product that gets its value from being a debt owed by someone.
For example if you invest in bonds of a company, it means that you have lent money to the company and you are a creditor. The company then has to pay you the promised interest on that debt before it calculates its profits and pays dividends to its shareholders. So a bond would be categorised as a Debt Investment. A mutual fund that invests in bonds would also be called a Debt investment. Debt Investments are typically characterised by fixed income. And as an asset class are considered less risky than equity based investments.
10. Equity Investment
Equity means the owner’s interest in a company. So if you have invested in the shares of a company, it means you own a certain portion of that company and will share in its profits or losses. Investing in shares means you have invested in Equity.
If you invest in a mutual fund that in turn buys shares of companies, your investment is also an Equity based investment. You will earn a profit only if the underlying shares increase in value. And you will lose money if the share values decrease. As an asset class, equity based investments are characterised by higher returns and risks as compared to Debt based investments