Investment Basics

Asset Classes Available for Investment

After figuring out the objectives of investment and how long we want to invest, we should decide upon the level of risk we wish to take to achieve our goal. Then we should select the investment asset that suits our objective and risk appetite. For this we need to know the pros and cons of various investment assets available.

First let us understand what do we mean by an investment asset? Investment asset is an asset (tangible or intangible) that generates income or increases in value over a period of time. We buy many assets for us such as house or land, furniture, vehicle, domestic appliances, gadgets etc. Some assets like domestic appliances and furniture are bought for our own use and the value of it starts depreciating once it is bought. Whereas, house or land can generate income for us in the form of rent/ lease and the value of it rises over time. Hence, this can be called an investment asset.

Now let us understand the term asset class. The term asset class is used to identify the investment assets that are grouped according to their similar characteristics. However, though we could find overlap of some characteristics, each investment asset will be unique in their attributes and offers investment opportunity for different purpose and for different time frames.

The asset classes are broadly classified as:

  • Equity
  • Debt
  • Commodity
  • Property
  • Cash

The classification of asset classes and its sub-classes are depicted in the below tree diagram.

Equity and Debt

To understand better the equity and debt, now let us assume Anubhav wants to start a business of manufacturing textiles. To set up a business entity he has to have an office space, factory, machinery and tools, human resource, furniture, computers and other office equipments, vehicles etc. Further he has to get necessary approvals and license to manufacture and trade in the product. He estimates that he needs around Rs.50 lakhs to acquire all these to launch his business.

But he could pull out only Rs.15 lakhs. For the rest of the money he approaches his friends Gaurav and Vaibhav. Gaurav and Vaibhav agrees to give Rs.7.5 lakhs each and they say they do not want interest for the amount they give, rather they want to share in the profit of the company. By this they expressed their desire to be a part owner of the company. Anubhav agrees to this and he allots shares to Gaurav and Vaibhav for the money they pumped in. How did he do this? On what basis he allotted shares to them? Do you remember how much was the cost estimated by Anubhav to launch the business? It is Rs.50 lakhs. Now what he does is, he fixes Rs.10 as par value which is generally called face value and he divides Rs.50 lakhs by Rs.10 and he arrives at a number i.e., 500,000. This 5 lakhs is the number of shares. Now let us see how many shares are allotted to Gaurav and Vaibhav for Rs.7.5 lakhs each they have contributed.

Estimated Cost or the amount he needs Rs.50 lakhs
This Rs.50 lakhs is called AUTHORISED SHARE CAPITAL
Par value (Face Value) Rs.10
Therefore number of shares is 50,00,000/ 10 500,000 shares
Anubhav the initiator (entrepreneur) brings
in Rs.15 lakhs, so number of shares he allots
to himself will be 15,00,000/10 150,000 shares
Number of shares allotted to Gaurav who
agrees to bring in Rs.7.5 lakhs is 750,000/10 75,000 shares
Number of shares allotted to Vaibhav who
agrees to bring in Rs.7.5 lakhs is 750,000/10 75,000 shares

Hence, total number of shares allotted between all three are 300,000 shares @ Rs.10/- each totaling Rs.30 lakhs. This Rs.30 lakhs is called PAID UP EQUITY CAPITAL.

Remember he has the authorization to raise another Rs.20 lakhs as his authorized capital is Rs.50 lakhs, which is also his total estimated cost. So, he needs another Rs.20 lakhs. What he does is, he approaches banks to borrow money. He borrows Rs.5 lakhs as loan from bank on which he will pay interest to the bank as the banker is the lender. And this becomes the company's debt obligation. Still he needs Rs.15 lakhs. Three of his relatives come forward to lend him money for an interest rate. Anubhav gets Rs.5 lakhs from each of his three relatives and gives bond certificate to one person and gives deposit certificate to another and debenture certificate to the third relative. Bonds, public deposits and debentures are some form of instruments given to the lender as proof of money borrowed from them. All these instruments carry interest and these are the debt obligation for the company.

Let us now put all these in a columnar form which will be reflected on the liabilities side of balance sheet.

Owner's Funds
Authorised Capital
500,000 shares at a face value of Rs.10/- each Rs.50,00,000/-
Issued & Paid-Up Capital
300,000 shares at a face value of Rs.10/- each Rs.30,00,000/-
Anubhav (entrepreneur) Rs.15 lakhs
Gaurav (friend) Rs.7.5 lakhs
Vaibhav (friend) Rs.7.5 lakhs
Borrowed Funds
Loans from Bank Rs.500,000/-
Bonds issued Rs.500,000/-
Debentures issued Rs.500,000/-
Public deposits accepted Rs.500,000/-
TOTAL Rs.50,00,000/-

Now, Anubhav has managed to get his required capital for his business and he commences production. His business started yielding results and in next 3 years, he was able to get a foothold in the industry. Next he wants to expand his business by installing more production capacities and he needs more money for his expansion projects. In this scenario, let us see what he does to raise money.

During last 3 years, his company has built a reserve of Rs.7 lakhs out of the business profit. But he needs 15 lakhs. By this time, his company has earned good reputation and some private parties are willing to invest in his business. These investors are called private equity investors. Now, since, the new investors are confident of the company's growth they are willing to pay more to acquire shares of the company. Remember, only 3 lakh shares were allotted earlier out of authorized capital of Rs.50 lakhs comprising of 5 lakh shares @ Rs.10/- each. Out of that, Anubhav now issues 50,000 shares to private equity investors @ Rs.30/- each that amounts to Rs.15 lakhs. As the new investors are confident of the company's growth, they are willing to pay a premium of Rs.20 for each share against its face value of Rs.10/- a share. After 2 years, the company proposes to expand further and this time it approaches the public to raise money to meet its expansion cost.

The company approaches the public through a process called “Initial Public Offering” (IPO). The company decides to raise money in the form of both equity capital and debt capital. Out of authorized capital, the company already issued 350,000 shares and it has balance of 150,000 shares. For the expansion projects, the company needs Rs.1 crore. So, it decides to raise money as follows:

Issue of 100,000 equity shares @ Rs.60/- each Rs.60,00,000/-
Issue of 20000 debentures of Rs.150/- each Rs.30,00,000/-
Issue of 10000 bonds of Rs.100/- each Rs.10,00,000/-
TOTAL Rs.100,00,000/-

As a retail investor, if you are investing in the equity shares of this company, you will assume the role of an owner of the company. It means you are buying the ownership of the company. Whereas, if you invest in the debt instruments such as debentures or bonds offered by the company, then you will assume the role of a lender as bonds and debentures are debt instruments and you will receive only the interest on the amount you have invested. However, some bonds and debentures are also traded in stock exchanges which will also offer capital appreciation.

Bonds and debentures

Bonds are secured debt instruments backed by a collateral, whereas debentures are debt instruments that are not backed by any collateral and it is unsecured. Buyer of both the instruments are lenders to the issuing company and are given preference while winding up of the company. In both the instruments, the company is under obligation to repay the loan within a specified period of time with interest. However, in case of debentures, the company can issue two types of debentures – convertible or non-convertible debentures. Convertible debentures come with an option to convert it into equity shares after a specified period.

Government Securities (G-Sec) and Treasury Bills (T-Bills)

So far, we have seen the equity and debt issues of a company. Similarly, government too issues debt instruments to raise money to meet its expenses towards developmental projects like constructing roads and highways etc. These instruments are called Government Securities (G-Sec) and Treasury Bills (T-Bills). The tenure of G-Sec usually ranges from 5 years to 40 years whereas, T-Bills are of three different maturity viz., 91-days, 180-days and 364-days. G-Sec and T-Bills is the safest investment with assured returns by way of interest. Investors looking for long term growth along with capital protection can invest in G-Sec. Investors looking for short term vehicles to park their funds and are also risk averse can opt for T-Bills which has maturity period within a year.

Bank Fixed Deposits

Bank fixed deposits are a risk free investment. It offers fixed income in the form of interest and the capital remains secured. The interest income is subject to tax deduction at source (TDS) @ 10% if it is more than Rs.40000/- from all the fixed deposits with the bank.

Post Office Savings and Deposits

Post office savings and deposits are a form of investment that offers interest income with capital protection. It is a risk free investment. The maturity period varies from 1 year to 15 years according to the various schemes. The scheme with long maturity period can be considered for long term investment to achieve long term goals. Highest interest rate offered currently is 8.7% that is for senior citizens. Interest income is subject to income tax for some schemes. National Savings Certificate (NSC) offers tax rebate.

Hope we got an overall picture of what is equity and debt. To sum up, by investing in equity we become the pride owner of the company and along with capital appreciation we get share in the profit by way of dividend. Whereas, by investing in debt instruments of the company, we become the lender and we receive interest on the amount we have lent.

Equity Debt
Ownership role Role of a lender
Capital appreciation and dividend income Fixed Interest Income
Liquidity Fixed maturity period
High Risk High Reward Corporate bonds – Medium to high risk
Government bonds – Risk free

Commodities

Traditionally, we all invest in Gold, silver and diamonds and it forms part of our life. Most of the Indians usually invest in jewelry. But off late, new investment vehicles such as gold ETF, Sovereign Gold Bonds (SGB) and gold mutual fund schemes that invest in gold are available for investment. Hence, in contrast to holding physical gold, now we can hold paper gold in dematerialized form. We will be discussing about dematerialization in detail in next module.

The below table lists out the features of Gold ETF and Sovereign Gold Bonds (SGB).

Gold ETF SGB
Pioneered in 2007 by Benchmark AMC Offered by Government
Subscription as & when offered Subscription offered once in 2-3 months
Listed & traded in stock exchanges Listed and traded
Purity is guaranteed Purity guaranteed
Low cost – expense ratio of 1% Very low cost
Provides Liquidity Maturity more than 8 years
Dividend Income Interest income @ 2.5% p.a
Long term capital gains above 1 lakh are taxed @ 10% Tax exemption on redemption

Gold is usually considered as safe haven during times of economic turmoil and it is usually held as hedge against inflation. Investing in gold offers diversification in the portfolio helping in maintaining a balanced portfolio. Over the last 25 years, the returns from investment in gold has been roughly 7-8%. But gold has given negative returns during 20 year period between 1980 and 2000.

Silver has many industrial use and investment in silver has also yielded good returns in last 15 years. Investment in diamond can also be considered. Increase in diamond prices has been steady and it is less volatile compared to gold. However, as a thumb rule, putting together the precious metals gold, silver and diamond, the percentage of investment could be between 5 to 10% of total portfolio.

Property

Investment in properties includes land and buildings, flats and houses and “Real Estate Investment Trusts” (REITs). It is needless to say that investment in properties requires large amount of money and it requires lot of time and effort to identify the right property. Further it is an illiquid investment and also investing in large land and buildings is not possible for small and medium investors. However, with the introduction of “Real Estate Investment Trusts” (REITs) in India, an opportunity to invest in real estate is opened up to all segments of investors.

A Real Estate Investment Trust (REIT) is a company that owns and operates properties that generates income by way of rent or lease. REITs owns different types of properties such as commercial buildings, apartments, hospitals etc., It will also engage in buying and selling of properties and financing of real estate. REITs are listed and traded in stock exchanges. By investing in REITs, retail investors can have access to large properties, which otherwise is not possible for them to buy individually.

In India, for the first time, a REIT “Embassy Office Parks”, a joint venture of US private equity firm Blackstone group and Embassy group has filed a draft application with SEBI for public issue. On listing of this issue and other issues in future, investors will get opportunities to invest in high quality properties. It will also provide liquidity enabling the investors to exit any time. It will also provide diversification to investors portfolio.

Cash & Cash Equivalent

In any financial portfolio, it is vital to have some part as cash reserve. Maintaining cash component helps mitigate downside risk. It can be held in short term interest bearing savings account, recurring deposits, money market instruments or it can be held as hard cash. The percentage of cash that has to be kept in a portfolio depends upon the risk bearing capacity of the investor. However, generally 5 to 10% of cash is maintained in an investment portfolio.

Key points to remember

  • Investment asset is an asset that generates income and also increases by value.
  • Asset class is grouping of assets that exhibits similar characteristics
  • Asset class can be broadly classified into Equity, debt, commodity, property and cash.
  • Equity offers ownership, capital appreciation and dividend income. It is high risk high reward investment. It is a liquid investment.
  • Bonds/debentures are debt instruments offering interest income and has fixed maturity period.
  • Government securities and T-Bills are risk free debt instruments
  • To invest in gold, various investment vehicles such as ETF and Gold Mutual Funds are available.
  • Investment is large real estate is facilitated through investment in Real Estate Investment Trust (REIT).
  • Maintaining some part of investment as cash and cash equivalent is important.

Roundup

Five major asset class being equity, debt, commodity, property and cash equivalent are available for investment. Under each asset class, various investment vehicles such as mutual funds, ETFs and REITs exist to offer different investment opportunities according to the objectives, tenure and risk appetite of the investors.

 

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