One of the parts of developing a comprehensive financial plan is the development of an investment plan. Investment Planning is the process of finding the right mix of investment option based on your future goals, time horizon, and risk profile. There are six steps that you should follow when you are developing your investment plan.
The Means to Invest
In order to even begin this portion of your financial plan, you must determine that you are ready to invest. In this step, you will determine if you are going to use the money for some good or service (spend it), or if you will invest or save the money.
Investment Time Horizon
In this step, you will be determining how long you plan to invest and when you will need the funds to meet your financial objective(s). You must decide, based on the time horizon of your objectives, among short-term investments, long-term investments or some combination. In this step, you are going to be determining what you will be saving for, which should give some indication of your time horizon.
Risk and Return
You will need to determine what your level of risk tolerance is. As the level of risk tolerance increases so does the potential for higher returns as well as larger losses.
Based on 1, 2 and 3 above, investments should be selected to meet your goals. These investments must satisfy your time horizon and your risk tolerance.
Once investments are chosen and expectations are established, the performance of your investments should be determined by comparing the actual realized returns against the expected returns. The returns should also be compared to a benchmark, such as the Sensex or Nifty index. In addition, the investments should be reevaluated to determine if they continue to meet your investment criteria.
Adjust Your Portfolio
Your portfolio should be adjusted to maintain your goals and your investment criteria. If your goals change, your investments should be reviewed to determine if they continue to meet your objectives.
Benefits of Investment Planning
Investment planning helps you:
- Generate income and/or capital gains.
- Enhance your future wealth.
- Strengthen your investment portfolio.
- Save on taxes.
Investment Strategies – Passive vs. Active Strategy
Passive strategies do not seek to outperform the market but simply to do as well as the market. The emphasis is on minimizing transaction costs and time spent in managing the portfolio because any expected benefits from active trading or analysis are likely to be less than the costs. Passive investors act as if the market is efficient and accept the consensus estimates of return and risk, accepting the current market price as the best estimate of a security’s value.
A buy-and-hold strategy means exactly that – an investor buys fund or stock and basically holds them until some future time in order to meet some objective. The emphasis is on avoiding transaction costs, additional search costs, and so forth. The investor believes that such a strategy will, over some period of time, produce results as good as alternatives that require active management whereby some securities are deemed not satisfactory, sold, and replaced with other securities. These alternatives incur transaction costs and involve inevitable mistakes.
An active strategy involves shifting sector weights in the portfolio in order to take advantage of those sectors that are expected to do relatively better and avoid or de-emphasize those sectors that are expected to do relatively worse. Investors employing this strategy are betting that particular sectors will repeat their price performance relative to the current phase of the business and credit cycle.
Most of the Mutual funds in India are actively managed. The goal of active management is to beat a particular benchmark. Because the markets are inefficient, the anomalies and irregularities in the capital markets are exploited by the active fund manager. Prices react to information slowly enough to allow skillful investors to systematically outperform the market.
Building an Investment Portfolio
Investors often consider the investment decision as consisting of two steps:
The asset allocation decision refers to the allocation of portfolio assets to broad asset markets; in other words, how much of the portfolio’s funds are to be invested in stocks, how much in bonds, money market assets, and so forth. Each weight can range from zero percent to 100 percent.
The asset allocation decision may be the most important decision made by an investor.
The rationale behind this approach is that different asset classes offer various potential returns and various levels of risk, and the correlation coefficients may be quite low.
Portfolio construction involves the selection of securities or mutual funds to be included in the portfolio and the determination of portfolio weights. The Modern Portfolio theory provides the basis for a scientific portfolio construction that results in efficient portfolios. An efficient portfolio is one with the highest level of expected return for a given level of risk or the lowest risk for a given level of expected return.
Portfolio construction begins with the basic building blocks of asset classes, which are the following major categories of investments:
- Cash (or cash equivalents such as money market funds)
- Real Estate (including Real Estate AIF)
- Commodity, bullion or others
Each investor must determine which of these major categories of investments is suitable for him/her. The next step is to determine which percentage of total investable assets should be allocated to each category deemed appropriate.
Risk Reduction in the Portfolio
One has to remember that no investment is Risk-free. Every investment has the potential gain as well as losses. The diversification is not a guarantee against any potential loss. Based on your goals, time horizon, and tolerance for volatility, diversification may provide the potential to improve returns for that level of risk.
A diversified portfolio is built by a judicious mix of assets—stocks, bonds, cash, or others—whose returns haven’t historically moved in the same direction, and to the same degree. This way, even if a portion of your portfolio is declining, the rest of your portfolio, hopefully, is growing. The intention of using this strategy is that the loss incurred due to the negative performance of a particular asset class is partially or wholly offset by gains via the positive performance of another asset class. Another important aspect of building a well-diversified portfolio is that you try to stay diversified within each type of investment.
Modern Portfolio Theory
Covariance is a measure of the co-movements between securities returns used in the calculation of portfolio risk. We could analyze how security returns move together by considering the correlation coefficient, a measure of association learned in statistics.
As used in portfolio theory, the correlation coefficient is a statistical measure of the relative co-movements between security returns. It measures the extent to which the returns on any two securities are related; however, it denotes only association, not causation. It is a relative measure of association that is bounded by +1.0 and -1.0, with
Pi,j = +1.0, perfect positive correlation
Pi,j = -1.0, perfect negative (inverse) correlation
Pi,j = 0.0, zero correlation
With perfect positive correlation, the returns have a perfect direct linear relationship. Knowing what the return on one security will do allows an investor to forecast perfectly what the other will do.
With perfect negative correlation, the securities’ returns have a perfect inverse linear relationship to each other.
With zero correlation, there is no relationship between the returns on the two securities. Knowledge of the return on one security is of no value in predicting the return of the second security.
Rupee Cost Averaging
The systematic investment with mutual funds, along with consistent periodic new purchases of the mutual fund, creates risk reduction by creating a lower cost per unit owned over time. This is known as rupee cost averaging. This strategy allows one to take away the guesswork of trying to time the market. You invest a fixed amount of money at a regular interval, regardless of whether the market is high or low. By doing so, you buy fewer units when the prices are high and more units when the prices are low. Because rupee cost averaging involves regular investments during periods of fluctuating prices, you should consider your financial ability to continue investing when price levels are low. However, this approach reduces the effects of market fluctuation on the average price you pay for your shares. Additionally, it helps you maintain a regular investing plan.
Even the best-laid investment plan will fail if you can’t control your behaviour. That’s one of the biggest reasons for keeping your disciplined investment strategy as simple as possible.
It’s much easier to control how you behave with a simple strategy since you won’t be tempted to jump in and out of the market or find the next best investment trend. And basing your decisions on complex and structured products won’t keep you in your plan when turmoil hits.
There is enough statistical evidence to suggest that if you invest regularly for a long term, your money will grow on a consistent basis.
Investments: Analysis and Management by Charles P. Jones
- US SEC