Personal Finance 2.01

Ever wondered what to do with your money?…thought of investing but didn’t know where?..or how to begin?…wanted some help and guidance but didn’t know where to find it…most of us face this…and its not a very good idea to start investing without knowing what you want to do with your money…well I guess you are aware of the consequences and hence you are reading this very article..

Before you begin to invest, it would be advisable for you to make a few notes..Note down your requirements. You need to know if you only want to preserve and safeguard your money… That is capital preservation or do you want capital appreciation…Do you want short term income from your investments? Or long term?..Do you want regular payments of interests? Do you want to earn your earnings on investments after a few years?… Are you ready to take high risk?…do you depend heavily on this very investment income?..If no then maybe you can think of taking a high risk!

As an investor it is important for you to know that your returns will vary as per your risk. This simply means that the higher risk you are ready to undertake, the higher return you can expect. This is because as an investor you have to be compensated for the risk that you bear, this is done by paying you higher returns.

Simply consider that you invest in a fixed deposit for say 3 years, the amount you earn will be lower as compared to that you would earn in the same fixed deposited for 5 years right?..The time duration increases…in other terms think of it as a risk …which obviously increases…so you are compensated with a higher return…

Now there are various financial instruments that cover various risks for which the investors are paid returns. But what you as investor, need to understand is that not every instrument would be suitable for you and that you should understand the impact of the investment on your portfolio as a whole and not just consider that one particular investment. You should always consider the impact on the risk and returns of your entire portfolio before investing. Remember… investing in a mutual fund or bond or an equity may not be beneficial to you just because it proved to your neighbor…You have to always consider your end requirements and the effect on your total portfolio

As the name suggests, stock split is basically division of a share into a specified no of shares.  The split of division takes place in a way that the total market capitalization*** after and before the split of stocks remains the same.

****Market capitalization is calculated by multiplying a company’s shares outstanding by the current market price of one share. The investment community uses this figure to determining a company’s size, as opposed to sales or total asset figures.

Frequently referred to as “market cap”

Approximate categories of market capitalization are:

Large Cap: $10 billion plus and include the companies with the largest market capitalization.
Mid Cap: $2 billion to $10 billion
Small Cap: Less than $2 billion

Coming back to stock splits…these occur in the ratios like 2 for 1, 3 for 1, 3 for 2 . These ratios mentioned above are the most common ratios. However, it is interesting to know that these stock splits can actually occur in any ratio that is possible. Splits in the ratios of 4 for 3 , 5 for 4 or 5 for 2  is also used in practice. Though these ratios are less frequent, investors will sometimes receive cash payments in lieu of fractional shares.

Motivation behind stock splits:

One reason as to why stock splits are performed is that a company’s share price has grown so high that to many investors, the shares are too expensive to buy in round lots. This would in turn reduce the volume of the shares trading in the market as it becomes difficult for investors to buy shares of such huge amount. Also the risk involved from an investor’s perspective increases.

Investor’s view:

Lets move on to an investor’s side. If you own a stock in a company that declares a stock split, the no of shares you own would increase however the price per share reduces. This is because the market capitalization ( explained above) remains the same. So, as an investor, the price you get on each share is actually reducing although the total holding of your shares in terms of quantity increases.

Let’s say stock A is trading at $40 and has 10 million shares issued, which gives it a market capitalization of $400 million ($40 x 10 million shares). The company then decides to implement a 2-for-1 stock split. For each share shareholders currently own, they receive one share, deposited directly into their brokerage account. They now have two shares for each one previously held, but the price of the stock is split by 50%, from $40 to $20. Notice that the market capitalization stays the same – it has doubled the amount of stocks outstanding to 20 million while simultaneously reducing the stock price by 50% to $20 for a capitalization of $400 million. The true value of the company hasn’t changed one bit.

An easy way to determine the new stock price is to divide the previous stock price by the split ratio. In the case of our example, divide $40 by 2 and we get the new trading price of $20. If a stock were to split 3-for-2, we’d do the same thing: 40/(3/2) = 40/1.5 = $26.6.

It is also possible to have a reverse stock split : a 1-for-10 means that for every ten shares you own, you get one share. In a reverse stock split you would get 1 share for your 10 shares and the value of the share increases. It is important to remember the fact that in the end, the market capitalization of the company remains the same. As an investor you hold 1 share equivalent to the value of previous held 10 shares.

The rationale behind the reverse stock split from the company’s perspective could be that the company wishes to increase their per share value in the market. The effect essentially is reversed however the fact remains true that the market cap remains constant.

Advantages for Investors

There are plenty of arguments over whether a stock split is an advantage or disadvantage to investors. One side says a stock split is a good buying indicator, signaling that the company’s share price is increasing and therefore doing very well. This may be true, but on the other hand, you can’t get around the fact that a stock split has no affect on the fundamental value of the stock and therefore poses no real advantage to investors except the fact that the no of shares an investor hold increases.

Factoring in Commissions

 
Historically, buying before the split was a good strategy because of commisions that were weighted  by the number of shares you bought. It was advantageous only because it saved you money on commissions. This isn’t such an advantage today because most brokers offer a flat fee for commissions, so you pay the same amount whether you buy 10 shares or 1,000 shares. The flat rate therefore covers most trades, so it does not matter if you buy pre-split or post-split.

Conclusion
The most important thing to know about stock splits is that there is no effect on the worth (as measured by market capitalization) of the company. A stock split should not be the deciding factor that entices you into buying a stock.

Hybrid home loans have been around since the past decade. It gives the customer greater flexibility in deciding the pace of repayment. It also provides a way to reduce the overall interest and loan tenure. It basically allows the customer to use idle money if any lying in his bank account to reduce the principal outstanding on the loan. Reducing the interest liability and enabling the loan to be repaid much faster.

Here, a current account will be opened which is then linked to the home loan account. The loan schedule is drawn for a specific tenure with a fixed payment at a fixed interest rate. The interest rate is generally 0.5 % higher typically to compensate for the prepayment risk. However, this higher interest can be offset by an average bank balance. Any amount lying in your current account earns no interest, whereas normal savings account balance earns 3.5 percent interest per annum.

On the other hand, in a hybrid loan, any balance lying in your hybrid loan current account is deducted from the home loan outstanding. The bigger part of the EMI is reduced and a bigger portion is utilized towards principal repayment. So, the account balance basically earns the same rate of interest at which you took home loan. While signing up for a home loan, customers must consider utilizing any surplus to drive down the effective interest rate and also the loan tenure. Any investment that earns less than your home loan rate should be put in your home loan account as it reduces the interest outflow.

 When a person with a net monthly income of Rs 70,000 takes a simple loan of Rs 30 lakhs for 20 years at an interest rate of 10% p.a. he would typically pay an interest amount of Rs 39,48,156 over the loan’s duration. However, in a hybrid loan he can use his average monthly balance and surplus savings to pay off the loan much faster, saving on the total interest payment. The prime benefit comes from the incremental surplus in your current account which significantly reduces the loan tenure and total interest outflow. Even an incremental surplus of Rs 1,000 per month can reduce the tenure to 217 months and the total interest payment to Rs 36, 89,782, saving Rs 2,58,374.

One should access his financial standing and examine if there is regular scope of having surpluses in his account in future. Otherwise, it would be better to go for a traditional home loan.

Mutual funds (MFS) pool individual investor’s money and in their behalf invest in various assets such as equity and debt. The returns received from debt and equity are the returns on the mutual fund and help achieve the investors’ financial goals. The working of a specific mutual fund thus depends on the underlying asset class and also on the nature of the fund.

Equity MFS:

Mutual funds that invest and individual investor’s money into equity shares of companies is called equity Mutual funds. The returns from such funds that have equity as their underlying asset are volatile in nature and hence ideal for long term investment.

Depending on the objective of specific funds an investor has a choice to invest in large cap, small cap or mid cap company funds. Some may even invest in a mix of these. The basic motive is to generate capital appreciation over a longer time frame. Diversified equity funds are those that invest in stocks across various sectors of the economy thus avoiding sector specific risks. Then there are certain other funds that invest only in the top 50, 100 or 200 stocks, these are also diversified but they tick to stocks that have high level of trading volume. The high level of volumes impart enough liquidity to the portfolio.

Then there are those equity mutual funds that are comparatively risky. These include sector specific funds or thematic funds. For instance, information technology funds would invest only in IT sector. The fortune of these funds depends entirely upon the sector performance. Thematic funds include funds that invest in stocks of companies that revolve around a specific theme like real estate, services, etc.

Equity is considered to give a higher inflation adjusted return as compared to other asset classes. The time horizon in investing through equity mutual funds should typically be long and be linked to long term financial goals. The returns from Equity MFS emerge from the dividend payout from the fund scheme or from the change in the Net Asset Value of the fund if there is growth.

Debt MFS:

Investors having a low appetite for risk, volatility and who wish regular income should invest in debt funds. Such funds invest in fixed income instruments like government securities and also corporate bonds. Typically debt funds buy debt instruments at a certain price and then sell them. The difference between this cost and sale price is nothing but the appreciation or depreciation in the fund’s value.

Any debt instrument’s market price ultimately depends on the value of the underlying asset, which in turn in decided by the interest rates i.e.  the coupon rate and also the credit rating of its holdings. Thus it is obvious that market prices of debt instruments are affected due to changes in interest rates. If interest rates in the economy fall , new debt instruments will be issued in the market that would offer lower interest rates. The price of the underlying increases with rise in yield which would lead to an increase in the fund’s NAV value.

Debt instruments can be short term as well as long term. Funds with longer horizon typically invest in securities with maturities beyond a year and provide a steady income with less volatility.

GILT funds are those that invest in securities issued by government of India. These can be short term or long term. Liquid funds are those that invest typically in shorter term securities. The disadvantage of extreme volatility is shut out with the help of these debt mutual funds.