Economists call it a decline in the purchasing power of money. Remember we encountered this term while getting acquainted with saving, borrowing and investing? The 'purchasing power of money' is the amount of merchandise that a unit of money (say a rupee) can buy.
And the term 'inflation' has its roots right there. When the purchasing power of money dwindles with time, the phenomenon is called 'inflation'. This is manifested in a general rise in prices of goods and services.
But why do prices rise?
Let us understand why this happens with the help of a simple example:
Onions are an integral part of any food preparation in our country. Can you think of having a meal without having a dish that contains onion? Why, onion and chapattis constitute the staple diet for many people.
Let us assume the onion crop fails in a particular year, for whatever reasons.
What happens then? The supply of onions in the market drops. However, people still need onions. Inevitably, the price of onion shoots up as people scramble to buy the limited supply of onions.
Remember November 1998? Such a situation actually happened in several parts of the country. It nearly brought down the government! The price of onions rose to as high as Rs40 per kg or more.
But how does a simple thing like a one-off drop in onion supply cause prices to rise across the board in sutained fashion?.
In the winter of 1998, the dabbawallas and restaurants were forced to hike their prices in response to the rising prices of onions. Even your local barber and maidservant demanded a higher pay to meet their higher daily expenses. All thanks to the (mighty?) onion. And this set off a chain reaction.
How?
Think again. It is not only onions that we consume in the course of a day. There is a whole basket of products and services that we draw on, on a day-to-day basis.
Hence, some of you decide to use more of garlic to make up for the lack of onion. The demand for garlic goes up. A few who eat raw onions decide to substitute it with more of tomato and cucumber. The local sabjiwala senses this shift in consumption happening. The smart businessman that he is, he hikes prices of all vegetables. He starts earning more money. Now his children demand that he should get them a new 21" TV with 100 channels.
And with all sabjiwalas rushing to the nearest TV shop, the sales for TV picks up. The TV company makes more money. Noticing the ballooning profits, the employees of the company demand a hike in their salaries. You are lucky to be working for one such company. You have more money in your pocket. And you have always wanted to buy a car...
We could go on and on, but you get the idea,don't you? The price rise is here to stay. Any guesses on who actually benefits and who loses from this rise? Can 'inflation' lead to prosperity?
But, for now we just need to understand the concept of inflation. After all, the main objective is to figure out how inflation affects the three friends we met last time - saver, borrower and investor.
Last time we understood how important it is for all of us to save. We all need to save for the day when we will not be earning but will still need to spend money on food, clothing and the occasional movie.
What would have happened if my grandfather had saved a rupee fifty years back to buy rice now? Oh boy! It would have been a total rip-off. He would receive a few grains of rice in exchange for that amount.
In short, inflation is one BIG enemy of savers.
So, why should we save?
A good and important question. But we will come back to it later. We need to find out how this monster they call 'inflation' impacts our two other friends.
We have already discovered that 'borrowing is the opposite of saving'. So if the saver is losing, our borrower must be winning.
Yes, of course. After all, the borrower borrows to spend today and repay later. Imagine if my grandfather had saved a rupee fifty years ago and my grandfather's neighbour had borrowed it from him. The neighbour could have bought 40kg of rice then and had a feast. In case he repaid the money to my grandfather now, all that my grandfather would have been able to buy is a few grains of rice!
To top it all, the borrower spends NOW and adds to the inflation effect, doesn't he? And compounds the misery of our saver.
What about our last friend, investor, the slightly difficult one to understand?
Imagine once again (just one last time, we promise) that my grandfather's friend had invested a rupee in a paddy field, that is bought a paddy field with a rupee. The smart guy would have been raking in money today, selling a kg of rice at Rs20!
Our investor friend seems a lot better off than even our borrower who benefits from inflation.
No wonder investing is always considered as a good thing to do to beat inflation. It is what textbooks call 'hedging inflation'.
Showing posts with label Personal Finance. Show all posts
Showing posts with label Personal Finance. Show all posts
Friday, January 7, 2011
Tuesday, January 4, 2011
What is an Index?
To understand the use and functioning of the index derivatives markets, it is necessary to understand the underlying index. A stock index represents the change in value of a set of stocks, which constitute the index. A market index is very important for the market players as it acts as a barometer for market behavior and as an underlying in derivative instruments such as index futures.
The Sensex and Nifty
InIndia
While the BSE Sensex was the first stock market index in the country, Nifty was launched by the National Stock Exchange in April 1996 taking the base ofNovember 3, 1995 . The Nifty index consists of shares of 50 companies with each having a market capitalization of more than Rs 500 crore.
Futures and stock indices
For understanding of stock index futures a thorough knowledge of the composition of indexes is essential. Choosing the right index is important in choosing the right contract for speculation or hedging. Since for speculation, the volatility of the index is important whereas for hedging the choice of index depends upon the relationship between the stocks being hedged and the characteristics of the index.
Choosing and understanding the right index is important as the movement of stock index futures is quite similar to that of the underlying stock index. Volatility of the futures indexes is generally greater than spot stock indexes.
Everytime an investor takes a long or short position on a stock, he also has an hidden exposure to the Nifty or Sensex. As most often stock values fall in tune with the entire market sentiment and rise when the market as a whole is rising.
Retail investors will find the index derivatives useful due to the high correlation of the index with their portfolio/stock and low cost associated with using index futures for hedging.
The Sensex and Nifty
In
While the BSE Sensex was the first stock market index in the country, Nifty was launched by the National Stock Exchange in April 1996 taking the base of
Futures and stock indices
For understanding of stock index futures a thorough knowledge of the composition of indexes is essential. Choosing the right index is important in choosing the right contract for speculation or hedging. Since for speculation, the volatility of the index is important whereas for hedging the choice of index depends upon the relationship between the stocks being hedged and the characteristics of the index.
Choosing and understanding the right index is important as the movement of stock index futures is quite similar to that of the underlying stock index. Volatility of the futures indexes is generally greater than spot stock indexes.
Everytime an investor takes a long or short position on a stock, he also has an hidden exposure to the Nifty or Sensex. As most often stock values fall in tune with the entire market sentiment and rise when the market as a whole is rising.
Retail investors will find the index derivatives useful due to the high correlation of the index with their portfolio/stock and low cost associated with using index futures for hedging.
Learn from others mistakes. Common pitfalls to be avoided
1. Not being disciplined and failing to cut losses at 8% below the purchase price A strategy of selling while losses are small is a lot like buying an insurance policy. You may feel foolish selling a stock for a loss -- and downright embarrassed if it recovers. But you're protecting yourself from devastating losses. Once you've sold, your capital is safe. The 7%-8% sell rule is a maximum, not an average. Time your buys right, and if the market goes against you the average loss might be limited to only 3% or 4%.
Again its to be kept in mind, do not to sell a winning stock just because it pulls back a little bit.
2. Do not purchase low-priced, low quality stocks.
3. One should follow a system or set of rules.
4. Do not let emotions or ego get in the way of a sound investing strategy You may feel foolish buying a stock at 60, selling at 55, only to buy it back at 65. Put that aside. You might have been too early before, but if the time is right now, don't hesitate. Getting shaken out of a stock should have no bearing on whether you buy it at a later date. It's a new decision every time
5. Invest in equities for long term and not short term
6. Do not make unplanned investing and starting without setting clear investment objectives and time frame for achieving the same.
7. Not having an eye on what the big players / mutual funds buy & sell is a pitfall and an opportunity lost to pick the right stocks. It takes big money to move markets, and institutional investors have the cash. But how do you find out where the smart money is going? Make sure the stock you have your eye on is owned by at least one top-rated fund. If the stock has passed muster with leading portfolio managers and analysts, it's a good confirmation its business is in order. Plus, mutual funds pack plenty of buying power, which will drive the stock higher
8. Patience is a virtue in investing. Do not panic on your existing stocks. It's so important, we repeat: Be patient for your stocks to reap rewards.
9. Do not be unaware of what is happening around in the market. As always, knowledge is power and in investing, it's also a comfort. Dig for more information other than just the top stories that are flashed.
10. Do not put all your money on the same horse. Diversify your portfolio ideally into five industries and ten stocks.
11. Margin is not a luxury, it is a deep-seated risk, know your risk profile and use margin trading sparingly. You as an investor might lose control of your investments if you borrow too much.
12. Greed is dangerous; it may wipe out the gains already made. Once a reasonable profit is made the investor should get out of the market quickly.
Again its to be kept in mind, do not to sell a winning stock just because it pulls back a little bit.
2. Do not purchase low-priced, low quality stocks.
3. One should follow a system or set of rules.
4. Do not let emotions or ego get in the way of a sound investing strategy You may feel foolish buying a stock at 60, selling at 55, only to buy it back at 65. Put that aside. You might have been too early before, but if the time is right now, don't hesitate. Getting shaken out of a stock should have no bearing on whether you buy it at a later date. It's a new decision every time
5. Invest in equities for long term and not short term
6. Do not make unplanned investing and starting without setting clear investment objectives and time frame for achieving the same.
7. Not having an eye on what the big players / mutual funds buy & sell is a pitfall and an opportunity lost to pick the right stocks. It takes big money to move markets, and institutional investors have the cash. But how do you find out where the smart money is going? Make sure the stock you have your eye on is owned by at least one top-rated fund. If the stock has passed muster with leading portfolio managers and analysts, it's a good confirmation its business is in order. Plus, mutual funds pack plenty of buying power, which will drive the stock higher
8. Patience is a virtue in investing. Do not panic on your existing stocks. It's so important, we repeat: Be patient for your stocks to reap rewards.
9. Do not be unaware of what is happening around in the market. As always, knowledge is power and in investing, it's also a comfort. Dig for more information other than just the top stories that are flashed.
10. Do not put all your money on the same horse. Diversify your portfolio ideally into five industries and ten stocks.
11. Margin is not a luxury, it is a deep-seated risk, know your risk profile and use margin trading sparingly. You as an investor might lose control of your investments if you borrow too much.
12. Greed is dangerous; it may wipe out the gains already made. Once a reasonable profit is made the investor should get out of the market quickly.
Monday, January 3, 2011
Measuring Portfolio Performance
The performance of a portfolio has to be measured periodically – preferably once a month. The performance of the individual will have to be compared against the overall performance of the market as indicated by various indices such as the Sensex or Nifty. This way a relative comparison of performance can be developed.
Lets now learn to compute the “Total Yield”. For example if the portfolio value of Mr. X is Rs 2,00,000 at the beginning of this month. During the month he added Rs 8000 to the fund. During this month he also received a dividend income of Rs 1000. Assuming the value of the portfolio at the end of this month is Rs 2,20,000.
The total yield will be = ((220000 – (2,00,000 + 9000)) / ( 2,00,000 + (1/2 * 9000)) ) *100 = 5.38% per month
To elaborate, in the numerator we are trying to find out the increase in value of portfolio after deducting the extra amount of Rs 8000 and the income of Rs 1000. It is assumed that this sum of Rs 9000 is put to use somewhere in the middle of the month and hence only half of Rs 9000 is added to the value of the fund at the beginning. The denominator can be adjusted as per the amount that you reinvest (part or fully) out of dividend income and what point of time during the period do you actually plough back such part of the money.
Beta Factor “Beta” indicates the proportion of the yield of a portfolio to the yield of the entire market (as indicated by some index). If there is an increase in the yield of the market, the yield of the individual portfolio may also go up. If the index goes up by 1.5% and the yield of your portfolio goes up by 0.9%, the beta is 0.9/1.5 i.e 0.6. in other words, beta indicates that for every 1 % increase in the market yield, the yield of the portfolio goes up by 0.6%. High beta shares do move higher than the market when the market rises and the yield of the fund declines more than the yield of the market when the market falls. In the Indian context a beta of 1.2% is considered very bullish.
You can be indifferent to market swings if you know your stocks well. Or you can put your portfolio into neutral or bias for the upside if you're bullish or a little for the downside if you're bearish. One way to do that is to have a mix of stocks that have certain betas in your portfolio. When investors are bullish on the market, they like to have high beta stocks in their portfolios because if they're right, then their stocks go up faster than the market in general, and their performance is better than the market. If investors are bearish on the market, then they use the low beta or negative beta stocks because their portfolios will go down less than the market and their performance will be better than the general market. And if they want to be neutral, they can then make sure that they have stocks with a beta of 1 or develop a portfolio that has stocks with betas greater than 1 and less than 1 so that they have the whole portfolio with an average beta of 1.
A beta for a stock is derived from historical data. This means it has no predictive value for the future, but it does show that if the stock continues to have the same price patterns relative to the market in general as it has in the past, you've got a way of knowing how your portfolio will perform in relation to the market. And with a portfolio with an average beta of 1, you can create your own index fund since you'll move more or less in tandem with the market.
Learn To Manage Your Portfolio
Importance of diversification.
Diversification helps you protect your investments from market fluctuations. Diversifying means allocating your money to different investments avenues and shields you from price risks. As you pick the best stocks from the hottest sectors, the fluctuation risk of the stock eroding your investment rises correspondingly. Since some stocks in the IT and media sectors are highly volatile, you need to protect your portfolio by investing in some defensive stocks or other industry groups. It would also be wise to diversify your investments into bonds or FDs as these are low risk - fixed income avenues.
The primary objectives of any Portfolio management are
Diversifying means buying stocks belonging to different industries with very low correlation i.e to find securities that do not have tendencies to increase or decrease in price at the same time.
What you're working towards should be at least five industries for the stock portion of the portfolio with each stock being the best stock, in your opinion, in their respective industry group. There should still be money invested in a money market fund (the equivalent of cash) as well as some in fixed income.
On the flip side, a diversified portfolio is unlikely to outperform the market by a big margin for exactly the same reason.
Portfolio – Age relationship.
Your age will help you determine what is a good mix / portfolio is
Age | Portfolio |
below 30 | 80% in stocks or mutual funds 10% in cash 10% in fixed income |
30 t0 40 | 70% in stocks or mutual funds 10% in cash 20% in fixed income |
40 to 50 | 60% in stocks or mutual funds 10% in cash 30% in fixed income |
50 to 60 | 50% in stocks or mutual funds 10% in cash 40% in fixed income |
above 60 | 40% in stocks or mutual funds 10% in cash 50% in fixed income |
These aren't hard and fast allocations, just guidelines to get you thinking about how your portfolio should look. Your risk profile will give you more equities or more fixed income depending on your aggressive or conservative bias. However, it's important to always have some equities in your portfolio (or equity funds) no matter what your age. If inflation roars back, this will be the portion of your investments that protects you from the damage, not your fixed income.
Also, the fixed income of your portfolio should be diversified. If you buy bonds and debentures directly or if you invest in FDs, then make sure you have at least five different maturities to spread out the interest rate risk.
Diversifying in equities and bonds means more than buying a number of positions. Each position needs to be scrutinized as to how it fits into the stocks or bonds that already are in your portfolio, and how they might be affected by the same event such as higher interest rates, lower fuel prices, etc. Put your portfolio together like a puzzle, adding a piece at a time, each one a little different from the other but achieving a uniform whole once the portfolio is complete.
Review of portfolio
Portfolio Management is an incomplete exercise without a periodic review. Every security should be subject to severe scrutiny and a case made out for its continuation or disposal. The frequency of review will depend on the size, amount involved and the kind of securities held in the portfolio. Spend a bit of time; you'll get a little bit of results. If you spend more time, your results should improve. We would suggest you spend a minimum of one hour a day during normal times while on the days of high volatility, its suggested that the investor monitor the situation closely.
Look analyze and do some adjusting
Look at your portfolio and do some adjustments. But don't just sell the losers (or the winners) randomly. There are several consequences of any action whether it's the taxes, the asset allocation, or the timing of the transaction. Here are a few things to consider.
If you liked a stock because of its earnings and it continues to deliver, hang on even if the price has not moved up. It will because earnings are the engine of any stock's price. As always, patience is heavily rewarded in the market because it is the rarest commodity.
As for selling a stock and then thinking you can buy it back after some days. There are two problems with that type of thinking. One, you generate two rounds of commissions (sell, then buy) and two, you may not get to buy the stock back at a decent price because the stock might have run dramatically in the month you did not own it. If you sell a stock, do it with finality and move on. Don't try to time the market. No one can do that with perfection.
Another aspect: look at your portfolio allocation. Are you tech heavy? At the moment that's the place to be. But that changes, quickly as we had seen in the month of May 2000. Put your portfolio in shape by allocating your investments evenly over at least five different industry groups and 10 stocks. That way you won't feel the full impact of any one sector getting hit hard.
Sector Rotation
You've probably noticed that tech stocks are hot, financials are not. Neither are the Consumer durables or some of the large-cap FMCG or Pharmaceuticals. If you're thinking about jumping onto tech stocks now because that's where all the action is, think again. While traders can bounce in and out of stocks several times a day, an investor should look to where the action isn’t much, meaning less of “Extreme Volatility”.
Sector rotation happens all the time in the market. Several groups are hot (like ICE – Infotech, Communication and Entertainment Stocks) while other groups are getting dumped (names like Gujarat Ambuja, Grasim, Tata steel are examples). As an investor, you should look at taking profits from stocks that are fully valued and re-investing in stocks that have a big 'Buy' sign written all over them. In other words, dump some of the winners and buy some of the losers who are not down because of major problems that look to be insurmountable but because of temporary concerns that can be closely scrutinized.
Sector rotation occurs because of fear and greed, the two emotions that run markets. The real challenge for an investor is to determine what the right entry price is and what is out of favor at the moment. Some of the Technology stocks such as Infosys have PE multiples of over 100 times. Whereas some of the fundamentally sound stocks such as Tata Steel whose stocks can be bought for less than 10 times earnings.
The very bullish will point out that tech is where the growth is while financials are always hurt in an upward moving interest rate environment. They're right on both counts. However, the tech stocks are priced to perfection. If any of them don't deliver earnings at or better than expected, they're going to get hammered. And the financials are priced for interest rates going up dramatically from here, not another 25 basis points or so.
The point here is not to recommend financial stocks (or non-durables or drug stocks) but to make investors aware of this sector rotation phenomenon. Take the time to build separate portfolios in each of the sectors you have an interest. It becomes very obvious where the money is flowing and where it's coming from. As an investor the challenge is to wait for prices that you can't believe in quality stocks, and then make your move. You will not catch the bottom of the stock (OK, maybe a few of you will). But you will own a stock that will come back into favor whenever the current troubles have passed and sector rotation occurs once again. Only this time, you'll be riding the hot stocks.
Sunday, December 26, 2010
Investment Goals
Investment Goals.
Investment avenues should always be treated as tools which will generate good returns over a period of time. To take a short term view would be fatal. In the stock markets, prices fluctuate very fast for the lay investor. To get the maximum returns begin with a two-year perspective.
Begin with an understanding of yourself.
What do you want from your investments?
It could be growth, income or both.
How comfortable are you to take risks?
It's only human if your first reaction on an adverse market movement is to sell and run away. To shield yourself against short term trading risks one has to take a long-term view. Renowned experts such as Benjamin Graham and Warren Buffet rarely shuffle their portfolio unless there is some change in the fundamentals of a company. Once you see the kind of returns you can generate over time, you'll come to realize that it really doesn't matter if your stock drops or rises over the course of a few hours or days or weeks or even months. Mutual funds are a good way to begin investing in the stock market. Funds render investment services with professionalism and give a good diversification over many sectors. If volatility is not your cup of tea, then you might consider buying fixed income securities.
Planning and Setting Goals: Investment requires a lot of planning. Decide on your basic framework of investments and chart your risk profile.
Ask yourself: What is the investment "time horizon"? Time horizon is the time period between the age at which you would like to start investing and at the age by which you would need a consolidated amount of money for any said purpose of yours.
One should also find out if there are there any short-term financial needs?
Will be a need to live off the investment in later years?
Your investments could be for retirement, a down payment for a house, your child's education, a second home or just for incremental income to take up a better standard of living.
Make clear-cut, measurable and reasonable goals. Be more specific when you decide your goals. For example you must reasonably predict how much amount of money would require and at what time inorder to satisfy any of the above stated needs?
If arriving at these figures looks cumbersome or daunting, our online interactive calculators will help you figure out your future money requirements. The answers to the above will lead you directly to “The type of investments will you make”.
Is time on Your side ?
The time frame you seek to invest on, your investment profile and the moblizable resources are interdependent and are not mutually exclusive.
How much time do you want to spend on investing?
You can be active, allocate an hour every day or just spend a few hours every month.
Another important factor is when do you need the money?
To help put all of this into context, you also need to look at how various types of investments have performed historically. Bonds and stocks are the two major asset classes that have been used by investors over the past century. Knowing the total return on each of the above and the associated volatility is crucial in deciding where you should put your money.
Moblizable Resources
After you zero in on your investments its time to decide on how much money you want to invest. Setting investment goals and checking out on allocable monetary resources go hand in hand. It is necessary to fix your monetary considerations as soon as you decide on the basic investment framework.
Some of your basic monetary considerations could be:-
The amount of initial investments that you can pump in.
The sources for the money that you need for investments.
The foreseeable bulk expense which prevents you from saving or which may force you to liquidate your existing portfolio (this expense itself may be your investment goal).
Money that you need to have as back up for emergencies.
The amount of savings that you can afford to allocate every month on a continual basis for such number of year that you may desire.
Answers to all or atleast the most important of these would logically lead you to where you ideally have to invest your money in, can it be equity, mutual funds or bonds.
Investment avenues should always be treated as tools which will generate good returns over a period of time. To take a short term view would be fatal. In the stock markets, prices fluctuate very fast for the lay investor. To get the maximum returns begin with a two-year perspective.
Begin with an understanding of yourself.
What do you want from your investments?
It could be growth, income or both.
How comfortable are you to take risks?
It's only human if your first reaction on an adverse market movement is to sell and run away. To shield yourself against short term trading risks one has to take a long-term view. Renowned experts such as Benjamin Graham and Warren Buffet rarely shuffle their portfolio unless there is some change in the fundamentals of a company. Once you see the kind of returns you can generate over time, you'll come to realize that it really doesn't matter if your stock drops or rises over the course of a few hours or days or weeks or even months. Mutual funds are a good way to begin investing in the stock market. Funds render investment services with professionalism and give a good diversification over many sectors. If volatility is not your cup of tea, then you might consider buying fixed income securities.
Planning and Setting Goals: Investment requires a lot of planning. Decide on your basic framework of investments and chart your risk profile.
Ask yourself: What is the investment "time horizon"? Time horizon is the time period between the age at which you would like to start investing and at the age by which you would need a consolidated amount of money for any said purpose of yours.
One should also find out if there are there any short-term financial needs?
Will be a need to live off the investment in later years?
Your investments could be for retirement, a down payment for a house, your child's education, a second home or just for incremental income to take up a better standard of living.
Make clear-cut, measurable and reasonable goals. Be more specific when you decide your goals. For example you must reasonably predict how much amount of money would require and at what time inorder to satisfy any of the above stated needs?
If arriving at these figures looks cumbersome or daunting, our online interactive calculators will help you figure out your future money requirements. The answers to the above will lead you directly to “The type of investments will you make”.
Is time on Your side ?
The time frame you seek to invest on, your investment profile and the moblizable resources are interdependent and are not mutually exclusive.
How much time do you want to spend on investing?
You can be active, allocate an hour every day or just spend a few hours every month.
Another important factor is when do you need the money?
To help put all of this into context, you also need to look at how various types of investments have performed historically. Bonds and stocks are the two major asset classes that have been used by investors over the past century. Knowing the total return on each of the above and the associated volatility is crucial in deciding where you should put your money.
Moblizable Resources
After you zero in on your investments its time to decide on how much money you want to invest. Setting investment goals and checking out on allocable monetary resources go hand in hand. It is necessary to fix your monetary considerations as soon as you decide on the basic investment framework.
Some of your basic monetary considerations could be:-
The amount of initial investments that you can pump in.
The sources for the money that you need for investments.
The foreseeable bulk expense which prevents you from saving or which may force you to liquidate your existing portfolio (this expense itself may be your investment goal).
Money that you need to have as back up for emergencies.
The amount of savings that you can afford to allocate every month on a continual basis for such number of year that you may desire.
Answers to all or atleast the most important of these would logically lead you to where you ideally have to invest your money in, can it be equity, mutual funds or bonds.
Tax aspects of Mutual Funds
Tax Implications of Dividend Income
Equity Schemes
Equity Schemes are schemes, which have less than 50 per cent investments in Equity shares of domestic companies.
As far as Equity Schemes are concerned no Distribution Tax is payable on dividend. In the hands of the investors, dividend is tax-free.
Other Schemes
For schemes other than equity, in the hands of the investors, dividend is tax-free. However, Distribution Tax on dividend @ 12.81 per cent to be paid by Mutual Funds.
Tax Implications of Capital Gains
The difference between the sale consideration (selling price) and the cost of acquisition (purchase price) of the asset is called capital gain. If the investor sells his units and earns capital gains he is liable to pay capital gains tax.
Capital gains are of two types: Short Term and Long Term Capital Gains.
Short Term Capital Gains
The holding period of the Mutual Fund units is less than or equal to 12 months from the date of allotment of units then short term capital gains is applicable.
On Short Term capital gains no Indexation benefit is applicable.
Tax and TDS Rate (excluding surcharge)
Resident Indians and Domestic Companies
The Gain will be added to the total income of the Investor and taxed at the marginal rate of tax. No TDS.
NRIs: 30 per cent TDS from the gain.
Long Term Capital Gains
The holding period of Mutual Fund units is more than 12 months from the date of allotment of units.
On Long Term capital gains Indexation benefit is applicable.
Tax and TDS Rate (excluding surcharge)
Resident Indians and Domestic Companies
The Gain will be taxed
A) at 20 per cent with indexation benefit or
B) B) at 10 per cent without indexation benefit, whichever is lower. No TDS.
NRIs: 20 per cent TDS from the Gain
Surcharge
Resident Indians : If the Gain exceeds Rs 8.5 lakhs, surcharge is payable by investors @ 10 per cent.
Domestic Companies: Payable by the investor @ 2.5 per cent.
NRIs: If the Gain from the Fund exceeds Rs 8.5 lakhs, surcharge is deducted at source @ 2.5 per cent.
Indexation
Indexation means that the purchase price is marked up by an inflation index resulting in lower capital gains and hence lower tax.
Inflation index for the year of transfer
Inflation index = ----------------------------------------------------
Inflation index for the year of acquisition
Equity Schemes
Equity Schemes are schemes, which have less than 50 per cent investments in Equity shares of domestic companies.
As far as Equity Schemes are concerned no Distribution Tax is payable on dividend. In the hands of the investors, dividend is tax-free.
Other Schemes
For schemes other than equity, in the hands of the investors, dividend is tax-free. However, Distribution Tax on dividend @ 12.81 per cent to be paid by Mutual Funds.
Tax Implications of Capital Gains
The difference between the sale consideration (selling price) and the cost of acquisition (purchase price) of the asset is called capital gain. If the investor sells his units and earns capital gains he is liable to pay capital gains tax.
Capital gains are of two types: Short Term and Long Term Capital Gains.
Short Term Capital Gains
The holding period of the Mutual Fund units is less than or equal to 12 months from the date of allotment of units then short term capital gains is applicable.
On Short Term capital gains no Indexation benefit is applicable.
Tax and TDS Rate (excluding surcharge)
Resident Indians and Domestic Companies
The Gain will be added to the total income of the Investor and taxed at the marginal rate of tax. No TDS.
NRIs: 30 per cent TDS from the gain.
Long Term Capital Gains
The holding period of Mutual Fund units is more than 12 months from the date of allotment of units.
On Long Term capital gains Indexation benefit is applicable.
Tax and TDS Rate (excluding surcharge)
Resident Indians and Domestic Companies
The Gain will be taxed
A) at 20 per cent with indexation benefit or
B) B) at 10 per cent without indexation benefit, whichever is lower. No TDS.
NRIs: 20 per cent TDS from the Gain
Surcharge
Resident Indians : If the Gain exceeds Rs 8.5 lakhs, surcharge is payable by investors @ 10 per cent.
Domestic Companies: Payable by the investor @ 2.5 per cent.
NRIs: If the Gain from the Fund exceeds Rs 8.5 lakhs, surcharge is deducted at source @ 2.5 per cent.
Indexation
Indexation means that the purchase price is marked up by an inflation index resulting in lower capital gains and hence lower tax.
Inflation index for the year of transfer
Inflation index = ----------------------------------------------------
Inflation index for the year of acquisition
Choosing a Mutual fund
Mutual fund is the best investment tool for the retail investor as it offers the twin benefits of good returns and safety as compared with other avenues such as bank deposits or stock investing. Having looked at the various types of mutual funds, one has to now go about selecting a fund suiting your requirements. Choose the wrong fund and you would have been better off keeping money in a bank fixed deposit.Keep in mind the points listed below and you could at least marginalise your investment risk.
Past performance
While past performance is not an indicator of the future it does throw some light on the investment philosophies of the fund, how it has performed in the past and the kind of returns it is offering to the investor over a period of time. Also check out the two-year and one-year returns for consistency. How did these funds perform in the bull and bear markets of the immediate past? Tracking the performance in the bear market is particularly important because the true test of a portfolio is often revealed in how little it falls in a bad market.
Know your fund manager
The success of a fund to a great extent depends on the fund manager. The same fund managers manage most successful funds. Ask before investing, has the fund manager or strategy changed recently? For instance, the portfolio manager who generated the fund’s successful performance may no longer be managing the fund.
Does it suit your risk profile?
Certain sector-specific schemes come with a high-risk high-return tag. Such plans are suspect to crashes in case the industry loses the marketmen’s fancy. If the investor is totally risk averse he can opt for pure debt schemes with little or no risk. Most prefer the balanced schemes which invest in the equity and debt markets. Growth and pure equity plans give greater returns than pure debt plans but their risk is higher.
Read the prospectus
The prospectus says a lot about the fund. A reading of the fund’s prospectus is a must to learn about its investment strategy and the risk that it will expose you to. Funds with higher rates of return may take risks that are beyond your comfort level and are inconsistent with your financial goals. But remember that all funds carry some level of risk. Just because a fund invests in government or corporate bonds does not mean it does not have significant risk. Thinking about your long-term investment strategies and tolerance for risk can help you decide what type of fund is best suited for you.
How will the fund affect the diversification of your portfolio?
When choosing a mutual fund, you should consider how your interest in that fund affects the overall diversification of your investment portfolio. Maintaining a diversified and balanced portfolio is key to maintaining an acceptable level of risk.
What it costs you?
A fund with high costs must perform better than a low-cost fund to generate the same returns for you. Even small differences in fees can translate into large differences in returns over time.
Finally, don’t pick a fund simply because it has shown a spurt in value in the current rally. Ferret out information of a fund for atleast three years. The one thing to remember while investing in equity funds is that it makes no sense to get in and out of a fund with each turn of the market. Like stocks, the right equity mutual fund will pay off big -- if you have the patience. Similarly, it makes little sense to hold on to a fund that lags behind the total market year after year.
Past performance
While past performance is not an indicator of the future it does throw some light on the investment philosophies of the fund, how it has performed in the past and the kind of returns it is offering to the investor over a period of time. Also check out the two-year and one-year returns for consistency. How did these funds perform in the bull and bear markets of the immediate past? Tracking the performance in the bear market is particularly important because the true test of a portfolio is often revealed in how little it falls in a bad market.
Know your fund manager
The success of a fund to a great extent depends on the fund manager. The same fund managers manage most successful funds. Ask before investing, has the fund manager or strategy changed recently? For instance, the portfolio manager who generated the fund’s successful performance may no longer be managing the fund.
Does it suit your risk profile?
Certain sector-specific schemes come with a high-risk high-return tag. Such plans are suspect to crashes in case the industry loses the marketmen’s fancy. If the investor is totally risk averse he can opt for pure debt schemes with little or no risk. Most prefer the balanced schemes which invest in the equity and debt markets. Growth and pure equity plans give greater returns than pure debt plans but their risk is higher.
Read the prospectus
The prospectus says a lot about the fund. A reading of the fund’s prospectus is a must to learn about its investment strategy and the risk that it will expose you to. Funds with higher rates of return may take risks that are beyond your comfort level and are inconsistent with your financial goals. But remember that all funds carry some level of risk. Just because a fund invests in government or corporate bonds does not mean it does not have significant risk. Thinking about your long-term investment strategies and tolerance for risk can help you decide what type of fund is best suited for you.
How will the fund affect the diversification of your portfolio?
When choosing a mutual fund, you should consider how your interest in that fund affects the overall diversification of your investment portfolio. Maintaining a diversified and balanced portfolio is key to maintaining an acceptable level of risk.
What it costs you?
A fund with high costs must perform better than a low-cost fund to generate the same returns for you. Even small differences in fees can translate into large differences in returns over time.
Finally, don’t pick a fund simply because it has shown a spurt in value in the current rally. Ferret out information of a fund for atleast three years. The one thing to remember while investing in equity funds is that it makes no sense to get in and out of a fund with each turn of the market. Like stocks, the right equity mutual fund will pay off big -- if you have the patience. Similarly, it makes little sense to hold on to a fund that lags behind the total market year after year.
Risk vs Reward in Mutualfunds
Risk vs Reward
Having understood the basics of mutual funds the next step is to build a successful investment portfolio. Before you can begin to build a portfolio, one should understand some other elements of mutual fund investing and how they can affect the potential value of your investments over the years. The first thing that has to be kept in mind is that when you invest in mutual funds, there is no guarantee that you will end up with more money when you withdraw your investment than what you started out with. That is the potential of loss is always there. The loss of value in your investment is what is considered risk in investing.
Even so, the opportunity for investment growth that is possible through investments in mutual funds far exceeds that concern for most investors. Here’s why.
At the cornerstone of investing is the basic principal that the greater the risk you take, the greater the potential reward. Or stated in another way, you get what you pay for and you get paid a higher return only when you're willing to accept more volatility.
Risk then, refers to the volatility -- the up and down activity in the markets and individual issues that occurs constantly over time. This volatility can be caused by a number of factors -- interest rate changes, inflation or general economic conditions. It is this variability, uncertainty and potential for loss, that causes investors to worry. We all fear the possibility that a stock we invest in will fall substantially. But it is this very volatility that is the exact reason that you can expect to earn a higher long-term return from these investments than from a savings account.
Different types of mutual funds have different levels of volatility or potential price change, and those with the greater chance of losing value are also the funds that can produce the greater returns for you over time. So risk has two sides: it causes the value of your investments to fluctuate, but it is precisely the reason you can expect to earn higher returns.
You might find it helpful to remember that all financial investments will fluctuate. There are very few perfectly safe havens and those simply don't pay enough to beat inflation over the long run.
Types of risks
All investments involve some form of risk. Consider these common types of risk and evaluate them against potential rewards when you select an investment.
Market Risk
At times the prices or yields of all the securities in a particular market rise or fall due to broad outside influences. When this happens, the stock prices of both an outstanding, highly profitable company and a fledgling corporation may be affected. This change in price is due to "market risk". Also known as systematic risk.
Inflation Risk
Sometimes referred to as "loss of purchasing power." Whenever inflation rises forward faster than the earnings on your investment, you run the risk that you'll actually be able to buy less, not more. Inflation risk also occurs when prices rise faster than your returns.
Credit Risk
In short, how stable is the company or entity to which you lend your money when you invest? How certain are you that it will be able to pay the interest you are promised, or repay your principal when the investment matures?
Interest Rate Risk
Changing interest rates affect both equities and bonds in many ways. Investors are reminded that "predicting" which way rates will go is rarely successful. A diversified portfolio can help in offseting these changes.
Exchange risk
A number of companies generate revenues in foreign currencies and may have investments or expenses also denominated in foreign currencies. Changes in exchange rates may, therefore, have a positive or negative impact on companies which in turn would have an effect on the investment of the fund.
Investment Risks
The sectoral fund schemes, investments will be predominantly in equities of select companies in the particular sectors. Accordingly, the NAV of the schemes are linked to the equity performance of such companies and may be more volatile than a more diversified portfolio of equities.
Changes in the Government Policy
Changes in Government policy especially in regard to the tax benefits may impact the business prospects of the companies leading to an impact on the investments made by the fund
Effect of loss of key professionals and inability to adapt business to the rapid technological change.
An industries' key asset is often the personnel who run the business i.e. intellectual properties of the key employees of the respective companies. Given the ever-changing complexion of few industries and the high obsolescence levels, availability of qualified, trained and motivated personnel is very critical for the success of industries in few sectors. It is, therefore, necessary to attract key personnel and also to retain them to meet the changing environment and challenges the sector offers. Failure or inability to attract/retain such qualified key personnel may impact the prospects of the companies in the particular sector in which the fund invests.
Having understood the basics of mutual funds the next step is to build a successful investment portfolio. Before you can begin to build a portfolio, one should understand some other elements of mutual fund investing and how they can affect the potential value of your investments over the years. The first thing that has to be kept in mind is that when you invest in mutual funds, there is no guarantee that you will end up with more money when you withdraw your investment than what you started out with. That is the potential of loss is always there. The loss of value in your investment is what is considered risk in investing.
Even so, the opportunity for investment growth that is possible through investments in mutual funds far exceeds that concern for most investors. Here’s why.
At the cornerstone of investing is the basic principal that the greater the risk you take, the greater the potential reward. Or stated in another way, you get what you pay for and you get paid a higher return only when you're willing to accept more volatility.
Risk then, refers to the volatility -- the up and down activity in the markets and individual issues that occurs constantly over time. This volatility can be caused by a number of factors -- interest rate changes, inflation or general economic conditions. It is this variability, uncertainty and potential for loss, that causes investors to worry. We all fear the possibility that a stock we invest in will fall substantially. But it is this very volatility that is the exact reason that you can expect to earn a higher long-term return from these investments than from a savings account.
Different types of mutual funds have different levels of volatility or potential price change, and those with the greater chance of losing value are also the funds that can produce the greater returns for you over time. So risk has two sides: it causes the value of your investments to fluctuate, but it is precisely the reason you can expect to earn higher returns.
You might find it helpful to remember that all financial investments will fluctuate. There are very few perfectly safe havens and those simply don't pay enough to beat inflation over the long run.
Types of risks
All investments involve some form of risk. Consider these common types of risk and evaluate them against potential rewards when you select an investment.
Market Risk
At times the prices or yields of all the securities in a particular market rise or fall due to broad outside influences. When this happens, the stock prices of both an outstanding, highly profitable company and a fledgling corporation may be affected. This change in price is due to "market risk". Also known as systematic risk.
Inflation Risk
Sometimes referred to as "loss of purchasing power." Whenever inflation rises forward faster than the earnings on your investment, you run the risk that you'll actually be able to buy less, not more. Inflation risk also occurs when prices rise faster than your returns.
Credit Risk
In short, how stable is the company or entity to which you lend your money when you invest? How certain are you that it will be able to pay the interest you are promised, or repay your principal when the investment matures?
Interest Rate Risk
Changing interest rates affect both equities and bonds in many ways. Investors are reminded that "predicting" which way rates will go is rarely successful. A diversified portfolio can help in offseting these changes.
Exchange risk
A number of companies generate revenues in foreign currencies and may have investments or expenses also denominated in foreign currencies. Changes in exchange rates may, therefore, have a positive or negative impact on companies which in turn would have an effect on the investment of the fund.
Investment Risks
The sectoral fund schemes, investments will be predominantly in equities of select companies in the particular sectors. Accordingly, the NAV of the schemes are linked to the equity performance of such companies and may be more volatile than a more diversified portfolio of equities.
Changes in the Government Policy
Changes in Government policy especially in regard to the tax benefits may impact the business prospects of the companies leading to an impact on the investments made by the fund
Effect of loss of key professionals and inability to adapt business to the rapid technological change.
An industries' key asset is often the personnel who run the business i.e. intellectual properties of the key employees of the respective companies. Given the ever-changing complexion of few industries and the high obsolescence levels, availability of qualified, trained and motivated personnel is very critical for the success of industries in few sectors. It is, therefore, necessary to attract key personnel and also to retain them to meet the changing environment and challenges the sector offers. Failure or inability to attract/retain such qualified key personnel may impact the prospects of the companies in the particular sector in which the fund invests.
Types of Mutual Funds
Types of Mutual Funds
Getting a handle on what's under the hood helps you become a better investor and put together a more successful portfolio. To do this one must know the different types of funds that cater to investor needs, whatever the age, financial position, risk tolerance and return expectations. The mutual fund schemes can be classified according to both their investment objective (like income, growth, tax saving) as well as the number of units (if these are unlimited then the fund is an open-ended one while if there are limited units then the fund is close-ended).
This section provides descriptions of the characteristics -- such as investment objective and potential for volatility of your investment -- of various categories of funds. These descriptions are organized by the type of securities purchased by each fund: equities, fixed-income, money market instruments, or some combination of these.
Open-ended schemes
Open-ended schemes do not have a fixed maturity period. Investors can buy or sell units at NAV-related prices from and to the mutual fund on any business day. These schemes have unlimited capitalization, open-ended schemes do not have a fixed maturity, there is no cap on the amount you can buy from the fund and the unit capital can keep growing. These funds are not generally listed on any exchange.
Open-ended schemes are preferred for their liquidity. Such funds can issue and redeem units any time during the life of a scheme. Hence, unit capital of open-ended funds can fluctuate on a daily basis. The advantages of open-ended funds over close-ended are as follows:
Any time exit option, The issuing company directly takes the responsibility of providing an entry and an exit. This provides ready liquidity to the investors and avoids reliance on transfer deeds, signature verifications and bad deliveries. Any time entry option, An open-ended fund allows one to enter the fund at any time and even to invest at regular intervals.
Close ended schemes
Close-ended schemes have fixed maturity periods. Investors can buy into these funds during the period when these funds are open in the initial issue. After that such schemes can not issue new units except in case of bonus or rights issue. However, after the initial issue, you can buy or sell units of the scheme on the stock exchanges where they are listed. The market price of the units could vary from the NAV of the scheme due to demand and supply factors, investors’ expectations and other market factors
Classification according to investment objectives
Mutual funds can be further classified based on their specific investment objective such as growth of capital, safety of principal, current income or tax-exempt income.
In general mutual funds fall into three general categories:
1] Equity Funds are those that invest in shares or equity of companies.
2] Fixed-Income Funds invest in government or corporate securities that offer fixed rates of return are
3] While funds that invest in a combination of both stocks and bonds are called Balanced Funds.
Growth Funds
Growth funds primarily look for growth of capital with secondary emphasis on dividend. Such funds invest in shares with a potential for growth and capital appreciation. They invest in well-established companies where the company itself and the industry in which it operates are thought to have good long-term growth potential, and hence growth funds provide low current income. Growth funds generally incur higher risks than income funds in an effort to secure more pronounced growth.
Some growth funds concentrate on one or more industry sectors and also invest in a broad range of industries. Growth funds are suitable for investors who can afford to assume the risk of potential loss in value of their investment in the hope of achieving substantial and rapid gains. They are not suitable for investors who must conserve their principal or who must maximize current income.
Growth and Income Funds
Growth and income funds seek long-term growth of capital as well as current income. The investment strategies used to reach these goals vary among funds. Some invest in a dual portfolio consisting of growth stocks and income stocks, or a combination of growth stocks, stocks paying high dividends, preferred stocks, convertible securities or fixed-income securities such as corporate bonds and money market instruments. Others may invest in growth stocks and earn current income by selling covered call options on their portfolio stocks.
Growth and income funds have low to moderate stability of principal and moderate potential for current income and growth. They are suitable for investors who can assume some risk to achieve growth of capital but who also want to maintain a moderate level of current income.
Fixed-Income Funds
Fixed income funds primarily look to provide current income consistent with the preservation of capital. These funds invest in corporate bonds or government-backed mortgage securities that have a fixed rate of return. Within the fixed-income category, funds vary greatly in their stability of principal and in their dividend yields. High-yield funds, which seek to maximize yield by investing in lower-rated bonds of longer maturities, entail less stability of principal than fixed-income funds that invest in higher-rated but lower-yielding securities.
Some fixed-income funds seek to minimize risk by investing exclusively in securities whose timely payment of interest and principal is backed by the full faith and credit of the Indian Government. Fixed-income funds are suitable for investors who want to maximize current income and who can assume a degree of capital risk in order to do so.
Balanced
The Balanced fund aims to provide both growth and income. These funds invest in both shares and fixed income securities in the proportion indicated in their offer documents. Ideal for investors who are looking for a combination of income and moderate growth.
Money Market Funds/Liquid Funds
For the cautious investor, these funds provide a very high stability of principal while seeking a moderate to high current income. They invest in highly liquid, virtually risk-free, short-term debt securities of agencies of the Indian Government, banks and corporations and Treasury Bills. Because of their short-term investments, money market mutual funds are able to keep a virtually constant unit price; only the yield fluctuates.
Therefore, they are an attractive alternative to bank accounts. With yields that are generally competitive with - and usually higher than -- yields on bank savings account, they offer several advantages. Money can be withdrawn any time without penalty. Although not insured, money market funds invest only in highly liquid, short-term, top-rated money market instruments. Money market funds are suitable for investors who want high stability of principal and current income with immediate liquidity.
Specialty/Sector Funds
These funds invest in securities of a specific industry or sector of the economy such as health care, technology, leisure, utilities or precious metals. The funds enable investors to diversify holdings among many companies within an industry, a more conservative approach than investing directly in one particular company.
Sector funds offer the opportunity for sharp capital gains in cases where the fund's industry is "in favor" but also entail the risk of capital losses when the industry is out of favor. While sector funds restrict holdings to a particular industry, other specialty funds such as index funds give investors a broadly diversified portfolio and attempt to mirror the performance of various market averages.
Index funds generally buy shares in all the companies composing the BSE Sensex or NSE Nifty or other broad stock market indices. They are not suitable for investors who must conserve their principal or maximize current income.
Getting a handle on what's under the hood helps you become a better investor and put together a more successful portfolio. To do this one must know the different types of funds that cater to investor needs, whatever the age, financial position, risk tolerance and return expectations. The mutual fund schemes can be classified according to both their investment objective (like income, growth, tax saving) as well as the number of units (if these are unlimited then the fund is an open-ended one while if there are limited units then the fund is close-ended).
This section provides descriptions of the characteristics -- such as investment objective and potential for volatility of your investment -- of various categories of funds. These descriptions are organized by the type of securities purchased by each fund: equities, fixed-income, money market instruments, or some combination of these.
Open-ended schemes
Open-ended schemes do not have a fixed maturity period. Investors can buy or sell units at NAV-related prices from and to the mutual fund on any business day. These schemes have unlimited capitalization, open-ended schemes do not have a fixed maturity, there is no cap on the amount you can buy from the fund and the unit capital can keep growing. These funds are not generally listed on any exchange.
Open-ended schemes are preferred for their liquidity. Such funds can issue and redeem units any time during the life of a scheme. Hence, unit capital of open-ended funds can fluctuate on a daily basis. The advantages of open-ended funds over close-ended are as follows:
Any time exit option, The issuing company directly takes the responsibility of providing an entry and an exit. This provides ready liquidity to the investors and avoids reliance on transfer deeds, signature verifications and bad deliveries. Any time entry option, An open-ended fund allows one to enter the fund at any time and even to invest at regular intervals.
Close ended schemes
Close-ended schemes have fixed maturity periods. Investors can buy into these funds during the period when these funds are open in the initial issue. After that such schemes can not issue new units except in case of bonus or rights issue. However, after the initial issue, you can buy or sell units of the scheme on the stock exchanges where they are listed. The market price of the units could vary from the NAV of the scheme due to demand and supply factors, investors’ expectations and other market factors
Classification according to investment objectives
Mutual funds can be further classified based on their specific investment objective such as growth of capital, safety of principal, current income or tax-exempt income.
In general mutual funds fall into three general categories:
1] Equity Funds are those that invest in shares or equity of companies.
2] Fixed-Income Funds invest in government or corporate securities that offer fixed rates of return are
3] While funds that invest in a combination of both stocks and bonds are called Balanced Funds.
Growth Funds
Growth funds primarily look for growth of capital with secondary emphasis on dividend. Such funds invest in shares with a potential for growth and capital appreciation. They invest in well-established companies where the company itself and the industry in which it operates are thought to have good long-term growth potential, and hence growth funds provide low current income. Growth funds generally incur higher risks than income funds in an effort to secure more pronounced growth.
Some growth funds concentrate on one or more industry sectors and also invest in a broad range of industries. Growth funds are suitable for investors who can afford to assume the risk of potential loss in value of their investment in the hope of achieving substantial and rapid gains. They are not suitable for investors who must conserve their principal or who must maximize current income.
Growth and Income Funds
Growth and income funds seek long-term growth of capital as well as current income. The investment strategies used to reach these goals vary among funds. Some invest in a dual portfolio consisting of growth stocks and income stocks, or a combination of growth stocks, stocks paying high dividends, preferred stocks, convertible securities or fixed-income securities such as corporate bonds and money market instruments. Others may invest in growth stocks and earn current income by selling covered call options on their portfolio stocks.
Growth and income funds have low to moderate stability of principal and moderate potential for current income and growth. They are suitable for investors who can assume some risk to achieve growth of capital but who also want to maintain a moderate level of current income.
Fixed-Income Funds
Fixed income funds primarily look to provide current income consistent with the preservation of capital. These funds invest in corporate bonds or government-backed mortgage securities that have a fixed rate of return. Within the fixed-income category, funds vary greatly in their stability of principal and in their dividend yields. High-yield funds, which seek to maximize yield by investing in lower-rated bonds of longer maturities, entail less stability of principal than fixed-income funds that invest in higher-rated but lower-yielding securities.
Some fixed-income funds seek to minimize risk by investing exclusively in securities whose timely payment of interest and principal is backed by the full faith and credit of the Indian Government. Fixed-income funds are suitable for investors who want to maximize current income and who can assume a degree of capital risk in order to do so.
Balanced
The Balanced fund aims to provide both growth and income. These funds invest in both shares and fixed income securities in the proportion indicated in their offer documents. Ideal for investors who are looking for a combination of income and moderate growth.
Money Market Funds/Liquid Funds
For the cautious investor, these funds provide a very high stability of principal while seeking a moderate to high current income. They invest in highly liquid, virtually risk-free, short-term debt securities of agencies of the Indian Government, banks and corporations and Treasury Bills. Because of their short-term investments, money market mutual funds are able to keep a virtually constant unit price; only the yield fluctuates.
Therefore, they are an attractive alternative to bank accounts. With yields that are generally competitive with - and usually higher than -- yields on bank savings account, they offer several advantages. Money can be withdrawn any time without penalty. Although not insured, money market funds invest only in highly liquid, short-term, top-rated money market instruments. Money market funds are suitable for investors who want high stability of principal and current income with immediate liquidity.
Specialty/Sector Funds
These funds invest in securities of a specific industry or sector of the economy such as health care, technology, leisure, utilities or precious metals. The funds enable investors to diversify holdings among many companies within an industry, a more conservative approach than investing directly in one particular company.
Sector funds offer the opportunity for sharp capital gains in cases where the fund's industry is "in favor" but also entail the risk of capital losses when the industry is out of favor. While sector funds restrict holdings to a particular industry, other specialty funds such as index funds give investors a broadly diversified portfolio and attempt to mirror the performance of various market averages.
Index funds generally buy shares in all the companies composing the BSE Sensex or NSE Nifty or other broad stock market indices. They are not suitable for investors who must conserve their principal or maximize current income.
Why invest in Mutual Funds
Investing in mutual has various benefits which makes it an ideal investment avenue. Following are some of the primary benefits.
Professional investment management
One of the primary benefits of mutual funds is that an investor has access to professional management. A good investment manager is certainly worth the fees you will pay. Good mutual fund managers with an excellent research team can do a better job of monitoring the companies they have chosen to invest in than you can, unless you have time to spend on researching the companies you select for your portfolio. That is because Mutual funds hire full-time, high-level investment professionals. Funds can afford to do so as they manage large pools of money. The managers have real-time access to crucial market information and are able to execute trades on the largest and most cost-effective scale. When you buy a mutual fund, the primary asset you are buying is the manager, who will be controlling which assets are chosen to meet the funds' stated investment objectives.
Diversification
A crucial element in investing is asset allocation. It plays a very big part in the success of any portfolio. However, small investors do not have enough money to properly allocate their assets. By pooling your funds with others, you can quickly benefit from greater diversification. Mutual funds invest in a broad range of securities. This limits investment risk by reducing the effect of a possible decline in the value of any one security. Mutual fund unit-holders can benefit from diversification techniques usually available only to investors wealthy enough to buy significant positions in a wide variety of securities.
Low Cost
A mutual fund let's you participate in a diversified portfolio for as little as Rs.5,000, and sometimes less. And with a no-load fund, you pay little or no sales charges to own them.
Convenience and Flexibility
Investing in mutual funds has it’s own convenience. While you own just one security rather than many, you still enjoy the benefits of a diversified portfolio and a wide range of services. Fund managers decide what securities to trade, collect the interest payments and see that your dividends on portfolio securities are received and your rights exercised. It also uses the services of a high quality custodian and registrar. Another big advantage is that you can move your funds easily from one fund to another within a mutual fund family. This allows you to easily rebalance your portfolio to respond to significant fund management or economic changes.
Liquidity
In open-ended schemes, you can get your money back promptly at net asset value related prices from the mutual fund itself.
Transparency
Regulations for mutual funds have made the industry very transparent. You can track the investments that have been made on you behalf and the specific investments made by the mutual fund scheme to see where your money is going. In addition to this, you get regular information on the value of your investment.
Variety
There is no shortage of variety when investing in mutual funds. You can find a mutual fund that matches just about any investing strategy you select. There are funds that focus on blue-chip stocks, technology stocks, bonds or a mix of stocks and bonds. The greatest challenge can be sorting through the variety and picking the best for you.
Professional investment management
One of the primary benefits of mutual funds is that an investor has access to professional management. A good investment manager is certainly worth the fees you will pay. Good mutual fund managers with an excellent research team can do a better job of monitoring the companies they have chosen to invest in than you can, unless you have time to spend on researching the companies you select for your portfolio. That is because Mutual funds hire full-time, high-level investment professionals. Funds can afford to do so as they manage large pools of money. The managers have real-time access to crucial market information and are able to execute trades on the largest and most cost-effective scale. When you buy a mutual fund, the primary asset you are buying is the manager, who will be controlling which assets are chosen to meet the funds' stated investment objectives.
Diversification
A crucial element in investing is asset allocation. It plays a very big part in the success of any portfolio. However, small investors do not have enough money to properly allocate their assets. By pooling your funds with others, you can quickly benefit from greater diversification. Mutual funds invest in a broad range of securities. This limits investment risk by reducing the effect of a possible decline in the value of any one security. Mutual fund unit-holders can benefit from diversification techniques usually available only to investors wealthy enough to buy significant positions in a wide variety of securities.
Low Cost
A mutual fund let's you participate in a diversified portfolio for as little as Rs.5,000, and sometimes less. And with a no-load fund, you pay little or no sales charges to own them.
Convenience and Flexibility
Investing in mutual funds has it’s own convenience. While you own just one security rather than many, you still enjoy the benefits of a diversified portfolio and a wide range of services. Fund managers decide what securities to trade, collect the interest payments and see that your dividends on portfolio securities are received and your rights exercised. It also uses the services of a high quality custodian and registrar. Another big advantage is that you can move your funds easily from one fund to another within a mutual fund family. This allows you to easily rebalance your portfolio to respond to significant fund management or economic changes.
Liquidity
In open-ended schemes, you can get your money back promptly at net asset value related prices from the mutual fund itself.
Transparency
Regulations for mutual funds have made the industry very transparent. You can track the investments that have been made on you behalf and the specific investments made by the mutual fund scheme to see where your money is going. In addition to this, you get regular information on the value of your investment.
Variety
There is no shortage of variety when investing in mutual funds. You can find a mutual fund that matches just about any investing strategy you select. There are funds that focus on blue-chip stocks, technology stocks, bonds or a mix of stocks and bonds. The greatest challenge can be sorting through the variety and picking the best for you.
Sunday, September 19, 2010
Growth of Mutual Funds
The Indian Mutual fund industry has passed through three phases.The first phase was between 1964 and 1987 when Unit Trust of India was the only player.By the end of 1988,UTI had total asset of Rs 6,700 crores. The second phase was between 1987 and 1993 during which period 8 funds were established (6 by banks and one each by LIC and GIC).This resulted in the total assets under management to grow to Rs 61,028 crores at the end of 1994 and the number of schemes were 167.
The third phase began with the entry of private and foreign sectors in the Mutual fund industry in 1993. Several private sectors Mutual Funds were launched in 1993 and 1994. The share of the private players has risen rapidly since then. Currently there are 34 Mutual Fund organisations in India. Kothari Pioneer Mutual fund was the first fund to be established by the private sector in association with a foreign fund.
This signaled a growth phase in the industry and at the end of financial year 2000, 32 funds were functioning with Rs. 1,13,005 crores as total assets under management. As on August end 2000, there were 33 funds with 391 schemes and assets under management with Rs. 1,02,849 crores. The Securities and Exchange Board of India (SEBI) came out with comprehensive regulation in 1993 which defined the structure of Mutual Fund and Asset Management Companies for the first time.
The third phase began with the entry of private and foreign sectors in the Mutual fund industry in 1993. Several private sectors Mutual Funds were launched in 1993 and 1994. The share of the private players has risen rapidly since then. Currently there are 34 Mutual Fund organisations in India. Kothari Pioneer Mutual fund was the first fund to be established by the private sector in association with a foreign fund.
This signaled a growth phase in the industry and at the end of financial year 2000, 32 funds were functioning with Rs. 1,13,005 crores as total assets under management. As on August end 2000, there were 33 funds with 391 schemes and assets under management with Rs. 1,02,849 crores. The Securities and Exchange Board of India (SEBI) came out with comprehensive regulation in 1993 which defined the structure of Mutual Fund and Asset Management Companies for the first time.
Saturday, September 18, 2010
INDIAN RUPEE
Introduction
Rupee is the name given to the official currency that is used in several countries including India, Bhutan, Pakistan, Sri Lanka, Nepal, Mauritius, Maldives and Indonesia. The name rupee comes from the Sanskrit language word ‘rupyakam’ meaning silver coin. Rupee in different regions is denoted with different symbols most commonly Rs, ₨ and Rp. One unit of the currency is equivalent to one hundred equal paise.
Among all the countries mentioned above that have rupee as their national currency; the Indian rupee is the most important with respect to value, preference and popularity. India stands among those countries that discovered the need for a currency and the first rupee coins were issued as early as in the 16th century. The currency code and numeric code for Indian rupee according to the ISO 4217 standard are INR and 356 respectively. The currency in India is denoted with the sign Rs.
Overview
India retains the reputation of issuing the some of the earliest coins in the history of mankind. The currency of India i.e. the Indian rupee is also one of the well-established currencies in the world. The importance of the Indian rupee in the world market is characterized by the fact that Bhutan and Nepal peg their currencies to the Indian rupee. Moreover, the Indian rupee is considered a legal tender in Bhutan that has dollorized the currency. Indian rupee does not use the western number system and has a number system of its own. As in the western number system, the large values of money are counted in terms of hundred, thousand, million and billion respectively, in the Indian number system the large values are counted as hundred, thousand, lakh and crore. The Indian number system is also popular among the countries like Pakistan, Nepal, Myanmar, Bhutan and Bangladesh.
Earlier the rupee coins were made up of silver and that is where this name ‘rupee’ is derived from as the word ‘rupyakam’ means silver coin in the Sanskrit language. But when the large silver mines were discovered in the United States of America and parts of European continent, the value of silver declined drastically as compared to gold on which all the other strong economies were based. As a result, the value of Indian rupee also declined as compared to other currencies in the world and this incident is called the ‘fall of rupee’.
Structure
Indian rupee did not use the decimal system and rather was subdivided into 16 annas till 1957. In 1957, the decimal monetary system was adopted and one unit of rupee was restructured equivalent to 100 equal paise. The currency in the country is issued in the form of banknotes and coinage, the Reserve Bank of India and the Government of India possessing the issuing authority for banknotes and coins respectively. The central bank i.e. the reserve bank of India is entitled to change the banknote series and the Mahatma Gandhi series, which is in circulation currently, was launched in 1996. The notes are issued in 7 denominations i.e. Rs 5, Rs 10, Rs 20, Rs 50, Rs 100, Rs 500, Rs 1000. Two more denominations for banknotes i.e. Rs 1 and Rs 2 are still in circulation but no new notes are being printed as coins for both these denominations are being minted now. Each note depicts the face value of the note in 17 languages. The notes also have some unique features quite often called the security features that help in avoiding the duplicity and illegal circulation of the notes. These features include
Coins for the Indian currency are minted in 7 denominations namely 10 paisa, 20 paisa, 25 paisa, 50 paisa, Rs 1, Rs 2 and Rs 5 under the Coinage act 1906. The country has four coin mints one each at Mumbai (Maharashtra), Hyderabad (Andhra Pradesh), Kolkata (West Bengal), Noida (Uttar Pradesh). Like in the case of banknotes, the management of circulation of coins is in the hands of the Reserve Bank of India.
History
India is the place where the concept of coinage developed at its earliest in around 6th century BC which later on built the base for other currencies of the world. according to the historians, the Indian currency i.e. rupee was brought into existence by Sher Shah Suri in the 16th century and it was evaluated as equal to 40 copper coins per rupee. The dominance of Mughals over India started diminishing when the British arrived in the country. The paper money was introduced under their reign in the latter part of the 18th century. Bank of Hindostan made the earliest rupee notes issues in the year 1770.
It was followed by some more issues of the currency notes by private and presidency banks. For 100 odd years, the issue of bank notes by the private and presidency banks continued but with the formation of The Paper Currency Act in 1861, the issue of notes was monopolized by the Government of India. The government of India (British India) initially appointed the presidency banks as their agents to help it with the circulation of bank notes as it was a tough job to promote the use of common note over a wide stretch of area. The notes had to be made a legal tender due to the problem arising from the redemption of these notes.
In 1867, the presidency banks were dismantled from the positions as the agents to the Government of India and the responsibility of the management of the currency was given to the mint masters, account generals and the controller of the currency. The first series of notes that was issued by the government of India was the Victoria portrait series. The notes in the series were uni-faced and were issued in 5 denominations. This series was replaced by the underprint series of notes in 1867 which was kept in use for than 50 years. This long duration of time observed many positive changes in the bank note quality and introduction of a few security features as well. The need to issue small denominations note arose with the beginning of the world war I and Rs 1 note was issued for the first time.
In 1923, the underprint series was replaced by the king’s portrait series and they were continued to be used till 1935. The reserve bank of India took over the authority to print and circulate banknotes from the government of India. The notes bearing the portrait of George V was replaced by the notes bearing the portrait of George VI in 1938. In 1940, the one rupee note was re-launched due to the emergence of second world war. The notes with the portrait of George VI were in circulation till 1947 and were taken off the money market with the independence of India. The Indian rupee was adopted as a sole currency of the country and the use of all other domestic coinage was put to an end. The country adopted the decimalization standards in the year 1957. The current Mahatma Gandhi's portrait series was introduced in the year 1996.
Factors affecting the exchange rates between two countries
The volatility in the foreign exchange rates depends upon a numerous macro economic factors that have different degrees of importance to different economies of the world. Some special and exceptional factors affecting the rates may also exist in the case of different countries. Following are shown the common factors on which the foreign exchange rate depends
Rupee is the name given to the official currency that is used in several countries including India, Bhutan, Pakistan, Sri Lanka, Nepal, Mauritius, Maldives and Indonesia. The name rupee comes from the Sanskrit language word ‘rupyakam’ meaning silver coin. Rupee in different regions is denoted with different symbols most commonly Rs, ₨ and Rp. One unit of the currency is equivalent to one hundred equal paise.
Among all the countries mentioned above that have rupee as their national currency; the Indian rupee is the most important with respect to value, preference and popularity. India stands among those countries that discovered the need for a currency and the first rupee coins were issued as early as in the 16th century. The currency code and numeric code for Indian rupee according to the ISO 4217 standard are INR and 356 respectively. The currency in India is denoted with the sign Rs.
Overview
India retains the reputation of issuing the some of the earliest coins in the history of mankind. The currency of India i.e. the Indian rupee is also one of the well-established currencies in the world. The importance of the Indian rupee in the world market is characterized by the fact that Bhutan and Nepal peg their currencies to the Indian rupee. Moreover, the Indian rupee is considered a legal tender in Bhutan that has dollorized the currency. Indian rupee does not use the western number system and has a number system of its own. As in the western number system, the large values of money are counted in terms of hundred, thousand, million and billion respectively, in the Indian number system the large values are counted as hundred, thousand, lakh and crore. The Indian number system is also popular among the countries like Pakistan, Nepal, Myanmar, Bhutan and Bangladesh.
Earlier the rupee coins were made up of silver and that is where this name ‘rupee’ is derived from as the word ‘rupyakam’ means silver coin in the Sanskrit language. But when the large silver mines were discovered in the United States of America and parts of European continent, the value of silver declined drastically as compared to gold on which all the other strong economies were based. As a result, the value of Indian rupee also declined as compared to other currencies in the world and this incident is called the ‘fall of rupee’.
Structure
Indian rupee did not use the decimal system and rather was subdivided into 16 annas till 1957. In 1957, the decimal monetary system was adopted and one unit of rupee was restructured equivalent to 100 equal paise. The currency in the country is issued in the form of banknotes and coinage, the Reserve Bank of India and the Government of India possessing the issuing authority for banknotes and coins respectively. The central bank i.e. the reserve bank of India is entitled to change the banknote series and the Mahatma Gandhi series, which is in circulation currently, was launched in 1996. The notes are issued in 7 denominations i.e. Rs 5, Rs 10, Rs 20, Rs 50, Rs 100, Rs 500, Rs 1000. Two more denominations for banknotes i.e. Rs 1 and Rs 2 are still in circulation but no new notes are being printed as coins for both these denominations are being minted now. Each note depicts the face value of the note in 17 languages. The notes also have some unique features quite often called the security features that help in avoiding the duplicity and illegal circulation of the notes. These features include
- Mahatma Gandhi watermark
- Silver security
- Latent image
- Micro-lettering
- Fluorescence
- Optically variable ink
- Back to back registration
Coins for the Indian currency are minted in 7 denominations namely 10 paisa, 20 paisa, 25 paisa, 50 paisa, Rs 1, Rs 2 and Rs 5 under the Coinage act 1906. The country has four coin mints one each at Mumbai (Maharashtra), Hyderabad (Andhra Pradesh), Kolkata (West Bengal), Noida (Uttar Pradesh). Like in the case of banknotes, the management of circulation of coins is in the hands of the Reserve Bank of India.
History
India is the place where the concept of coinage developed at its earliest in around 6th century BC which later on built the base for other currencies of the world. according to the historians, the Indian currency i.e. rupee was brought into existence by Sher Shah Suri in the 16th century and it was evaluated as equal to 40 copper coins per rupee. The dominance of Mughals over India started diminishing when the British arrived in the country. The paper money was introduced under their reign in the latter part of the 18th century. Bank of Hindostan made the earliest rupee notes issues in the year 1770.
It was followed by some more issues of the currency notes by private and presidency banks. For 100 odd years, the issue of bank notes by the private and presidency banks continued but with the formation of The Paper Currency Act in 1861, the issue of notes was monopolized by the Government of India. The government of India (British India) initially appointed the presidency banks as their agents to help it with the circulation of bank notes as it was a tough job to promote the use of common note over a wide stretch of area. The notes had to be made a legal tender due to the problem arising from the redemption of these notes.
In 1867, the presidency banks were dismantled from the positions as the agents to the Government of India and the responsibility of the management of the currency was given to the mint masters, account generals and the controller of the currency. The first series of notes that was issued by the government of India was the Victoria portrait series. The notes in the series were uni-faced and were issued in 5 denominations. This series was replaced by the underprint series of notes in 1867 which was kept in use for than 50 years. This long duration of time observed many positive changes in the bank note quality and introduction of a few security features as well. The need to issue small denominations note arose with the beginning of the world war I and Rs 1 note was issued for the first time.
In 1923, the underprint series was replaced by the king’s portrait series and they were continued to be used till 1935. The reserve bank of India took over the authority to print and circulate banknotes from the government of India. The notes bearing the portrait of George V was replaced by the notes bearing the portrait of George VI in 1938. In 1940, the one rupee note was re-launched due to the emergence of second world war. The notes with the portrait of George VI were in circulation till 1947 and were taken off the money market with the independence of India. The Indian rupee was adopted as a sole currency of the country and the use of all other domestic coinage was put to an end. The country adopted the decimalization standards in the year 1957. The current Mahatma Gandhi's portrait series was introduced in the year 1996.
Factors affecting the exchange rates between two countries
The volatility in the foreign exchange rates depends upon a numerous macro economic factors that have different degrees of importance to different economies of the world. Some special and exceptional factors affecting the rates may also exist in the case of different countries. Following are shown the common factors on which the foreign exchange rate depends
- Flow of imports and exports between the countries
- Flow of capital between the countries
- Relative inflation rates
- Fluctuation limits on exchange rate imposed by the governments of the countries
- Merchandise trade balance
- Rate of inflation in the country
- Flow of funds between the countries for the payment of stock and bond purchases
- Relative growth
- Short term and long term interest rate differentials
- Cost of borrowings
Position Sizing Strategy
Now that the market is in a short term downtrend and stock tip threads have mostly disappeared I think it is a good time to discuss what is really important in trading - Position Sizing / Money Management Strategies. I Would like to hear/discuss the different sorts of position sizing strategies experienced traders here use for stock trading.
For new traders:
"Position Sizing" is the way you determine the number of shares of a stock you would buy when you decide to initiate a trade (and also how many shares you would continue to hold throughout the duration of the trade). It also decides how much equity will be allocated to a single position. Position Sizing is used by everyone even though they might not think about it (usually traders just buy 100 or 50 shares or any number that they are comfortable with or can afford). But good position sizing is what makes or breaks a trader, it is the strategy that keeps a trader in the business longer. It turns a mediocre trading system into an excellent one (but won't help a losing system).
The most popular/recommended position sizing strategy is to risk not more than 2% on any single position.
New traders - make sure you go thru' previous threads in "Risk & Money Management" section of this forum, there are good posts on risk & money mgmt by Traderji & CreditViolet.
Books on position sizing:
Trade Your Way To Financial Freedom by Dr. Van Tharp
Portfolio Management Formulas by Ralph Vince
The Mathematics of Money Management by Ralph Vince
The Trading Game by Ryan Jones
My Strategy:
I use a combination of percent risk & percent volatility strategy. Here are the rules I use:
- My main aim is to ensure that I stay in the business longer so my trading system gets a fair chance to realise its potential.
- No position should be greater than 10% of my total trading equity
- I don't risk more than 1% of my total trading equity on any single position
- I make sure my positions are "volatility balanced". In other words I make sure that all my positions fluctuate approximately the same each day in the market. I do this using Average True Range of the stock.
Example:
Say I am planning to buy HINDLEVER, here is what I would do to determine the number of shares I would buy:
Total Equity : 100,000.00
Max Equity for each trade : 10,000.00 (10% of total equity)
Risk Amount : 1,000.00 (1% of total equity)
Volatility Amount : 500.00 (0.5% of total equity. This is the fluctuation level per day per position)
Average True Range (10 Day Avg) : 5.63
Last Market Closing Price : 173.20 (For simplicity assume this is the entry price)
Stop Loss at : 163.40 (Will get out just below previous reaction low)
Number of shares to buy (percent risk model) = Risk Amount / (Entry Price - Stop Loss Price)
Number of shares to buy (percent risk model) = 1000 / (173.20 - 163.40)
Number of shares to buy (percent risk model) = 102 Shares
Number of shares to buy (percent volatility model) = Volatility Amount / Average True Range (10 Day)
Number of shares to buy (percent volatility model) = 500 / 5.63
Number of shares to buy (percent volatility model) = 88 shares
Number of shares to buy (based on Max Equity for each trade) = Max Equity for each trade / Last Market Closing Price
Number of shares to buy (based on Max Equity for each trade) = 10000 / 173.20
Number of shares to buy (based on Max Equity for each trade) = 57 shares
I will buy minimum number of shares determined from the above three models. So in the above case I would buy 57 shares.
So here is what I basically do. I am still trying to fine tune these things. The above parameters used are what I am currently using but I am in the process of doing trial & error to come up with parameters that fit me well. I would now like to hear what the experienced traders here do.
For new traders:
"Position Sizing" is the way you determine the number of shares of a stock you would buy when you decide to initiate a trade (and also how many shares you would continue to hold throughout the duration of the trade). It also decides how much equity will be allocated to a single position. Position Sizing is used by everyone even though they might not think about it (usually traders just buy 100 or 50 shares or any number that they are comfortable with or can afford). But good position sizing is what makes or breaks a trader, it is the strategy that keeps a trader in the business longer. It turns a mediocre trading system into an excellent one (but won't help a losing system).
The most popular/recommended position sizing strategy is to risk not more than 2% on any single position.
New traders - make sure you go thru' previous threads in "Risk & Money Management" section of this forum, there are good posts on risk & money mgmt by Traderji & CreditViolet.
Books on position sizing:
Trade Your Way To Financial Freedom by Dr. Van Tharp
Portfolio Management Formulas by Ralph Vince
The Mathematics of Money Management by Ralph Vince
The Trading Game by Ryan Jones
My Strategy:
I use a combination of percent risk & percent volatility strategy. Here are the rules I use:
- My main aim is to ensure that I stay in the business longer so my trading system gets a fair chance to realise its potential.
- No position should be greater than 10% of my total trading equity
- I don't risk more than 1% of my total trading equity on any single position
- I make sure my positions are "volatility balanced". In other words I make sure that all my positions fluctuate approximately the same each day in the market. I do this using Average True Range of the stock.
Example:
Say I am planning to buy HINDLEVER, here is what I would do to determine the number of shares I would buy:
Total Equity : 100,000.00
Max Equity for each trade : 10,000.00 (10% of total equity)
Risk Amount : 1,000.00 (1% of total equity)
Volatility Amount : 500.00 (0.5% of total equity. This is the fluctuation level per day per position)
Average True Range (10 Day Avg) : 5.63
Last Market Closing Price : 173.20 (For simplicity assume this is the entry price)
Stop Loss at : 163.40 (Will get out just below previous reaction low)
Number of shares to buy (percent risk model) = Risk Amount / (Entry Price - Stop Loss Price)
Number of shares to buy (percent risk model) = 1000 / (173.20 - 163.40)
Number of shares to buy (percent risk model) = 102 Shares
Number of shares to buy (percent volatility model) = Volatility Amount / Average True Range (10 Day)
Number of shares to buy (percent volatility model) = 500 / 5.63
Number of shares to buy (percent volatility model) = 88 shares
Number of shares to buy (based on Max Equity for each trade) = Max Equity for each trade / Last Market Closing Price
Number of shares to buy (based on Max Equity for each trade) = 10000 / 173.20
Number of shares to buy (based on Max Equity for each trade) = 57 shares
I will buy minimum number of shares determined from the above three models. So in the above case I would buy 57 shares.
So here is what I basically do. I am still trying to fine tune these things. The above parameters used are what I am currently using but I am in the process of doing trial & error to come up with parameters that fit me well. I would now like to hear what the experienced traders here do.
What is money management?
Money management is the process of analyzing trades for risk and potential profits, determining how much risk, if any, is acceptable and managing a trade position (if taken) to control risk and maximize profitability.
Many traders pay lip service to money management while spending the bulk of their time and energy trying to find the perfect (read: imaginary) trading system or entry method. But traders ignore money management at their own peril.
The importance of money management can best be shown through drawdown analysis.
Drawdown
Drawdown is simply the amount of money you lose trading, expressed as a percentage of your total trading equity. If all your trades were profitable, you would never experience a drawdown. Drawdown does not measure overall performance, only the money lost while achieving that performance. Its calculation begins only with a losing trade and continues as long as the account hits new equity lows.
Suppose you begin with an account of 10,000 and lose 2,000. Your drawdown would be 20%. On the 8,000 that remains, if you subsequently make 1,000, then lose 2,000, you now have a drawdown of 30% (8,000 + 1,000 - 2,000 =7,000, a 30% loss on the original equity stake of 10,000). But, if you made 4,000 after the initial 2,000 loss (increasing your account equity to 12,000), then lost another 3,000, your drawdown would be 25% (12,000 - 3,000 = 9,000, a 25% drop from the new equity high of 12,000).
Maximum drawdown is the largest percentage drop in your account between equity peaks. In other words, it's how much money you lose until you get back to breakeven. If you began with 10,000 and lost 4,000 before getting back to breakeven, your maximum drawdown would be 40%. Keep in mind that no matter how much you are up in your account at any given time--100%, 200%, 300%--a 100% drawdown will wipe out your trading account. This leads us to our next topic: the difficulty of recovering from drawdowns.
Even worse is that as the drawdowns deepen, the recovery percentage begins to grow geometrically. For example, a 50% loss requires a 100% return just to get back to break even (see Table 1 and Figure 1 for details).
Professional traders and money mangers are well aware of how difficult it is to recover from drawdowns. Those who succeed long term have the utmost respect for risk. They get on top and stay on top, not by being gunslingers and taking huge risks, but by controlling risk through proper money management. Sure, we all like to read about famous traders who parlay small sums into fortunes, but what these stories fail to mention is that many such traders, through lack of respect for risk, are eventually wiped out.
Guidelines that should help your long-term trading success.
1. Risk only a small percentage of total equity on each trade, preferably no more than 2% of your portfolio value. I know of two traders who have been actively trading for over 15 years, both of whom have amassed small fortunes during this time. In fact, both have paid for their dream homes with cash out of their trading accounts. I was amazed to find out that one rarely trades over 1,000 shares of stock and the other rarely trades more than two or three futures contracts at a time. Both use extremely tight stops and risk less than 1% per trade.
2. Limit your total portfolio risk to 20%. In other words, if you were stopped out on every open position in your account at the same time, you would still retain 80% of your original trading capital.
3. Keep your reward-to-risk ratio at a minimum of 2:1, and preferably 3:1 or higher. In other words, if you are risking 1 point on each trade, you should be making, on average, at least 2 points. An S&P futures system I recently saw did just the opposite: It risked 3 points to make only 1. That is, for every losing trade, it took 3 winners make up for it. The first drawdown (string of losses) would wipe out all of the trader's money.
4. Be realistic about the amount of risk required to properly trade a given market. For instance, don't kid yourself by thinking you are only risking a small amount if you are position trading (holding overnight) in a high-flying technology stock or a highly leveraged and volatile market like the S&P futures.
5. Understand the volatility of the market you are trading and adjust position size accordingly. That is, take smaller positions in more volatile stocks and futures. Also, be aware that volatility is constantly changing as markets heat up and cool off.
6. Understand position correlation. If you are long heating oil, crude oil and unleaded gas, in reality you do not have three positions. Because these markets are so highly correlated (meaning their price moves are very similar), you really have one position in energy with three times the risk of a single position. It would essentially be the same as trading three crude, three heating oil, or three unleaded gas contracts.
7. Lock in at least a portion of windfall profits. If you are fortunate enough to catch a substantial move in a short amount of time, liquidate at least part of your position. This is especially true for short-term trading, for which large gains are few and far between.
8. The more active a trader you are, the less you should risk per trade. Obviously, if you are making dozens of trades a day you can't afford to risk even 2% per trade--one really bad day could virtually wipe you out. Longer-term traders who may make three to four trades per year could risk more, say 3-5% per trade. Regardless of how active you are, just limit total portfolio risk to 20% (rule #2).
9. Make sure you are adequately capitalized. There is no "Holy Grail" in trading. However, if there was one, I think it would be having enough money to trade and taking small risks. These principles help you survive long enough to prosper. I know of many successful traders who wiped out small accounts early in their careers. It was only until they became adequately capitalized and took reasonable risks that they survived as long term traders.
10. Never add to or "average down" a losing position. If you are wrong, admit it and get out. Two wrongs do not make a right.
11. Avoid pyramiding altogether or only pyramid properly. By "properly," I mean only adding to profitable positions and establishing the largest position first. In other words the position should look like an actual pyramid. For example, if your typical total position size in a stock is 1000 shares then you might initially buy 600 shares, add 300 (if the initial position is profitable), then 100 more as the position moves in your direction. In addition, if you do pyramid, make sure the total position risk is within the guidelines outlined earlier (i.e., 2% on the entire position, total portfolio risk no more that 20%, etc.).
12. Always have an actual stop in the market. "Mental stops" do not work.
13. Be willing to take money off the table as a position moves in your favor; "2-for-1 money management1" is a good start. Essentially, once your profits exceed your initial risk, exit half of your position and move your stop to breakeven on the remainder of your position. This way, barring overnight gaps, you are ensured, at worst, a breakeven trade, and you still have the potential for gains on the remainder of the position.
14. Understand the market you are trading. This is especially true in derivative trading (i.e. options, futures).
15. Strive to keep maximum drawdowns between 20 and 25%. Once drawdowns exceed this amount it becomes increasingly difficult, if not impossible, to completely recover. The importance of keeping drawdowns within reason was illustrated in the first installment of this series.
16. Be willing to stop trading and re-evaluate the markets and your methodology when you encounter a string of losses. The markets will always be there. Gann said it best in his book, How to Make Profits in Commodities, published over 50 years ago: "When you make one to three trades that show losses, whether they be large or small, something is wrong with you and not the market. Your trend may have changed. My rule is to get out and wait. Study the reason for your losses. Remember, you will never lose any money by being out of the market."
17. Consider the psychological impact of losing money. Unlike most of the other techniques discussed here, this one can't be quantified. Obviously, no one likes to lose money. However, each individual reacts differently. You must honestly ask yourself, What would happen if I lose X%? Would it have a material effect on my lifestyle, my family or my mental well being? You should be willing to accept the consequences of being stopped out on any or all of your trades. Emotionally, you should be completely comfortable with the risks you are taking.
The main point is that money management doesn't have to be rocket science. It all boils down to understanding the risk of the investment, risking only a small percentage on any one trade (or trading approach) and keeping total exposure within reason. While the list above is not exhaustive, I believe it will help keep you out of the majority of trouble spots. Those who survive to become successful traders not only study methodologies for trading, but they also study the risks associated with them. I strongly urge you to do the same.
Many traders pay lip service to money management while spending the bulk of their time and energy trying to find the perfect (read: imaginary) trading system or entry method. But traders ignore money management at their own peril.
The importance of money management can best be shown through drawdown analysis.
Drawdown
Drawdown is simply the amount of money you lose trading, expressed as a percentage of your total trading equity. If all your trades were profitable, you would never experience a drawdown. Drawdown does not measure overall performance, only the money lost while achieving that performance. Its calculation begins only with a losing trade and continues as long as the account hits new equity lows.
Suppose you begin with an account of 10,000 and lose 2,000. Your drawdown would be 20%. On the 8,000 that remains, if you subsequently make 1,000, then lose 2,000, you now have a drawdown of 30% (8,000 + 1,000 - 2,000 =7,000, a 30% loss on the original equity stake of 10,000). But, if you made 4,000 after the initial 2,000 loss (increasing your account equity to 12,000), then lost another 3,000, your drawdown would be 25% (12,000 - 3,000 = 9,000, a 25% drop from the new equity high of 12,000).
Maximum drawdown is the largest percentage drop in your account between equity peaks. In other words, it's how much money you lose until you get back to breakeven. If you began with 10,000 and lost 4,000 before getting back to breakeven, your maximum drawdown would be 40%. Keep in mind that no matter how much you are up in your account at any given time--100%, 200%, 300%--a 100% drawdown will wipe out your trading account. This leads us to our next topic: the difficulty of recovering from drawdowns.
Even worse is that as the drawdowns deepen, the recovery percentage begins to grow geometrically. For example, a 50% loss requires a 100% return just to get back to break even (see Table 1 and Figure 1 for details).
Professional traders and money mangers are well aware of how difficult it is to recover from drawdowns. Those who succeed long term have the utmost respect for risk. They get on top and stay on top, not by being gunslingers and taking huge risks, but by controlling risk through proper money management. Sure, we all like to read about famous traders who parlay small sums into fortunes, but what these stories fail to mention is that many such traders, through lack of respect for risk, are eventually wiped out.
Guidelines that should help your long-term trading success.
1. Risk only a small percentage of total equity on each trade, preferably no more than 2% of your portfolio value. I know of two traders who have been actively trading for over 15 years, both of whom have amassed small fortunes during this time. In fact, both have paid for their dream homes with cash out of their trading accounts. I was amazed to find out that one rarely trades over 1,000 shares of stock and the other rarely trades more than two or three futures contracts at a time. Both use extremely tight stops and risk less than 1% per trade.
2. Limit your total portfolio risk to 20%. In other words, if you were stopped out on every open position in your account at the same time, you would still retain 80% of your original trading capital.
3. Keep your reward-to-risk ratio at a minimum of 2:1, and preferably 3:1 or higher. In other words, if you are risking 1 point on each trade, you should be making, on average, at least 2 points. An S&P futures system I recently saw did just the opposite: It risked 3 points to make only 1. That is, for every losing trade, it took 3 winners make up for it. The first drawdown (string of losses) would wipe out all of the trader's money.
4. Be realistic about the amount of risk required to properly trade a given market. For instance, don't kid yourself by thinking you are only risking a small amount if you are position trading (holding overnight) in a high-flying technology stock or a highly leveraged and volatile market like the S&P futures.
5. Understand the volatility of the market you are trading and adjust position size accordingly. That is, take smaller positions in more volatile stocks and futures. Also, be aware that volatility is constantly changing as markets heat up and cool off.
6. Understand position correlation. If you are long heating oil, crude oil and unleaded gas, in reality you do not have three positions. Because these markets are so highly correlated (meaning their price moves are very similar), you really have one position in energy with three times the risk of a single position. It would essentially be the same as trading three crude, three heating oil, or three unleaded gas contracts.
7. Lock in at least a portion of windfall profits. If you are fortunate enough to catch a substantial move in a short amount of time, liquidate at least part of your position. This is especially true for short-term trading, for which large gains are few and far between.
8. The more active a trader you are, the less you should risk per trade. Obviously, if you are making dozens of trades a day you can't afford to risk even 2% per trade--one really bad day could virtually wipe you out. Longer-term traders who may make three to four trades per year could risk more, say 3-5% per trade. Regardless of how active you are, just limit total portfolio risk to 20% (rule #2).
9. Make sure you are adequately capitalized. There is no "Holy Grail" in trading. However, if there was one, I think it would be having enough money to trade and taking small risks. These principles help you survive long enough to prosper. I know of many successful traders who wiped out small accounts early in their careers. It was only until they became adequately capitalized and took reasonable risks that they survived as long term traders.
10. Never add to or "average down" a losing position. If you are wrong, admit it and get out. Two wrongs do not make a right.
11. Avoid pyramiding altogether or only pyramid properly. By "properly," I mean only adding to profitable positions and establishing the largest position first. In other words the position should look like an actual pyramid. For example, if your typical total position size in a stock is 1000 shares then you might initially buy 600 shares, add 300 (if the initial position is profitable), then 100 more as the position moves in your direction. In addition, if you do pyramid, make sure the total position risk is within the guidelines outlined earlier (i.e., 2% on the entire position, total portfolio risk no more that 20%, etc.).
12. Always have an actual stop in the market. "Mental stops" do not work.
13. Be willing to take money off the table as a position moves in your favor; "2-for-1 money management1" is a good start. Essentially, once your profits exceed your initial risk, exit half of your position and move your stop to breakeven on the remainder of your position. This way, barring overnight gaps, you are ensured, at worst, a breakeven trade, and you still have the potential for gains on the remainder of the position.
14. Understand the market you are trading. This is especially true in derivative trading (i.e. options, futures).
15. Strive to keep maximum drawdowns between 20 and 25%. Once drawdowns exceed this amount it becomes increasingly difficult, if not impossible, to completely recover. The importance of keeping drawdowns within reason was illustrated in the first installment of this series.
16. Be willing to stop trading and re-evaluate the markets and your methodology when you encounter a string of losses. The markets will always be there. Gann said it best in his book, How to Make Profits in Commodities, published over 50 years ago: "When you make one to three trades that show losses, whether they be large or small, something is wrong with you and not the market. Your trend may have changed. My rule is to get out and wait. Study the reason for your losses. Remember, you will never lose any money by being out of the market."
17. Consider the psychological impact of losing money. Unlike most of the other techniques discussed here, this one can't be quantified. Obviously, no one likes to lose money. However, each individual reacts differently. You must honestly ask yourself, What would happen if I lose X%? Would it have a material effect on my lifestyle, my family or my mental well being? You should be willing to accept the consequences of being stopped out on any or all of your trades. Emotionally, you should be completely comfortable with the risks you are taking.
The main point is that money management doesn't have to be rocket science. It all boils down to understanding the risk of the investment, risking only a small percentage on any one trade (or trading approach) and keeping total exposure within reason. While the list above is not exhaustive, I believe it will help keep you out of the majority of trouble spots. Those who survive to become successful traders not only study methodologies for trading, but they also study the risks associated with them. I strongly urge you to do the same.
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