In the article on Importance of asset allocation, we saw that determining your risk profile is the key to making successful asset allocation. We saw that proper asset allocation will protect you from losing your money and will help you become rich. Here we try to see how taking risk will help you achieve high rewards.

We all know that stocks are the riskiest investment option. This is because they have a risk of capital loss. If the company sinks or is mismanaged as in the case of Satyam, you can end up losing all your money. However if you have managed to select a company like Infosys, you will end up making money many times over.

But this is just one type of risk. The other type of risk is interest rate risk. This is common in debt investments like income funds and gilt funds. As the interest rates go up, the yields from these funds go down, thus making investors lose money. The vice versa is also true.

Then there is an inflation risk, where the inflation (the phenomenon of rising prices) erodes the value of your investment. This is also associated with debt investments, having fixed interest rate. So if you have an FD of Rs 10,000 offering 7% interest for 2 years, the value of your principal is less than what it was when you opened the FD account.

To become a successful investor, you need to be aware of the different types of risks involved. This will help you make uniformed decision. The key to achieving perfect allocation is to distribute your portfolio between equities and debt. While equities make ideal investment from long term perspective, debt should be used as a short term investment.

Ajit is a young executive working in a middle level management in an MNC. His financial advisor asked him to invest all his money in equities and equity mutual funds, since the market was touching new highs. Ajit did so, only to find that during the recent market crash, he ended up losing his money. Why did this happen? Where did Ajit err?

Ajit made the biggest mistake made by so many investors. They take fancy to a particular asset, either due to security it offers or high returns it generates. In the process, they ignore other asset classes, thus suffering financial loss.

In order to overcome this problem, it is essential to do proper asset allocation. In asset allocation, you diversify your portfolio amongst stocks, bonds, gold and realty. This is done after taking into account your age, income, investment objectives and investment time frames.  But the main factor that affects the asset allocation is your risk profile.

Those with a conservative profile should focus around 60-70% of their portfolio on bonds, FDs, realty, cash and gold and the rest in equities. For a balanced investor, the proportion of portfolio that can be divided between equity and other assets can be 50:50. An aggressive investor can have 80-85% exposure to equity.

As you become older and near your retirement age or your liabilities or number of dependents increase, you have to keep on rebalancing your asset allocation in order to take into account the new circumstances. This will help you meet the change in your circumstances very easily. Just don’t be swayed by greed or fear as it can cause financial loss in the long term.

Ajit didn’t go for asset allocation also called as diversification. Hence he suffered massive losses.

Credit card can be an expensive credit tool if not used properly. This is because it has many charges that can easily bog you down in financial crisis and destroy your credit rating. Here are some of the most important charges that accompany credit card.

• Late payment fee: When you get your credit card bill, you are given a due date by which you have to pay the outstanding amount. If you fail to pay the amount by this date, you end up paying late payment fee.
• Finance charges: When you use your credit card for making the payment, you are in effect taking an overdraft, which is a type of loan from the bank. You get an interest-free period during which you can pay off this amount. If you don’t pay the full amount by this date, the unpaid amount along with new purchases attracts finance charges. This rate can be as high as 45%, thereby leading you to debt trap.
• Cheque bouncing charge: If your payment cheque bounces, you end up paying this charge along with late payment fee.
• Cash withdrawal charges: Every credit card allows you to withdraw cash from ATMs in case of emergency. But remember, unlike the cash withdrawal using debit card, the cash withdrawal using credit card attracts cash withdrawal charges. So it is advisable to use credit card for cash withdrawal sparingly.
• Annual charges: While most entry-level cards don’t have any annual fees, the hi-end cards charge annual fees. These fees can be very high. So you need to watch out for these fees before deciding to take one.

Last time we understood what bonds are. Now let us see the different types of bonds available in India.

• Government Bonds: These bonds are the safest bonds as they do not carry any risk of default. These bonds are issued by RBI and have longer maturity period. These bonds have a fixed coupon rate and maturity period. The interest payments are made once in 6 months. Some common government bonds are NABARD bonds and 8% Taxable Bonds. But they do carry interest rate risk as they are highly liquid. They are also regarded as the benchmark as well as harbinger of the interest rate scenario.
• Corporate bonds: These bonds are issued by companies to finance their projects. They carry higher coupon rate, but are risky as the worth of the bond depends on the financial strength of the issuing company. Hence always choose those corporate bonds that have been highly rated by the credit rating agencies to ensure peace of mind and safety of your money.
• Zero coupon bonds: These bonds don’t have any coupon rate, hence the term zero coupon. Here the maturity value of the bond is higher than the face value. The difference between the two is your profit. E.g. if the face value of the bond is Rs 100 and its maturity value is Rs 150, then the difference of Rs 50 is your income.

What is the distinct feature of Reliance Diversified Power Sector Fund, Reliance Banking Fund and SBI magnum sector fund? Answer – they are all sector funds. But what are sector funds? How do they differ from diversified mutual funds?

A sector fund is the fund that invests exclusively in a particular sector like banking or IT. So a typical banking fund may include SBI, HDFC bank and ICICI bank in its portfolio. On the other hand, a diversified mutual fund includes stocks from banks, IT, retail and other sectors in its portfolio. So its portfolio is much more broad based.

While sector funds were hot for the past few years, it does have its drawbacks. The major drawback is that when the going is good, these funds generate very high returns. But when the tide turns, these funds can languish for an indeterminate period of time. This was evident with the IT funds who suffered heavy losses when the IT sector went down after dotcom bust.

Also when you try to enter this sector, it is quite likely that it has appreciated to a great extent and its downfall is about to begin. So it is quite possible that when you have entered the sector you buy the units at a higher price, only to find their price going down afterwards.

Hence it is advisable to give these funds a miss. However if you do want to invest in these funds, ensure you allocate just 5% of your portfolio to these funds. And that too after investing in diversified mutual funds.

Today Internet has quickly become a popular shopping destination, due to low overheads involved in the transactions. You also benefit by being able to shop at any online store located in any part of the world. However the major drawback of online shopping is that you need to pay for your shopping by using your credit card. This is a major danger as your card is susceptible to be misused. However with these useful tips, you can protect yourself against falling victim to credit card scams.

• Always shop at secure sites. You can detect these sites by looking out for a lock symbol at the lower left hand side of your browser and using https instead of http as its address. These sites are considered to be very secure so your data is transferred securely.
• Keep your antivirus software updated. This is the most important yet often overlooked aspect of security. Keeping your antivirus and firewall updated will prevent your computer from being accessible to online hackers. This will protect your credit card from being compromised.
• Buy online from well-known sites. Don’t go shopping at unknown or dubious sites. Rather stick to bigger sites like rediff, ebay, amazon etc. even though the items available here may be slightly expensive.
• Find out if the site accepts paypal. Paypal is an online electronic payment system. Here you can fund your account with the money from your bank account or credit card. When you pay with paypal, the purchase amount is debited from your paypal account. The main advantage of paypal is that you can ask for refund from the vendor, and you are sure to get it, no questions asked.
• Don’t shop from public computer. When you do so, you are not in charge of the computer, which may be infected with viruses and keyloggers. These programs can send your card details to hackers, who can misuse it, thus leading to credit card fraud.

You have bought stocks just because your aunt, your friend and your milkman had bought stocks. Initially you were euphoric, dreaming about big bucks that the stocks would fetch. But soon your joy turned to sorrow, when you saw the value of your stocks started fluctuating wildly. If you are in this situation, then read on for some tips to safeguard yourself against stock market losses.

• Study the fundamentals of the company: Many investors are swayed by the stock prices, but ignore the fundamentals of the company. This means if the price you are paying for the stock does not justify its value, then you are sure to lose money in the long run. This is evident from the stock prices of companies like Himachal Futuristics that today are available at Rs 14 from the Rs. 33.40 during 2003. So the investors in this stock have lost heavily.
• Think long-term: Stocks are not a gamble but an asset class that will make you rich over long-term. Many people don’t understand this and so end up losing money.
• Expect volatility: Over the short-term, stocks are expected to be volatile. Markets are irrational and they react to slightest bit of good of bad news. This introduces volatility in the markets.
• Avoid greed and fear: The legendary investor Warren Buffett says, “”The fact that people will be full of greed, fear or folly is predictable. The sequence is not predictable.” It is a fact that greed and fear have been responsible for people losing money in stocks.
• Don’t churn the portfolio: Government and brokers do love it when you keep on churning your portfolio. They are the ones who end up becoming rich, as you have to pay brokerage and taxes each time you buy and sell stocks. So avoid the temptation of churning your portfolio.
• Diversify your portfolio: This is last but the most essential tip. Diversification will help you meet your financial needs during the time of crisis. It will also ensure you don’t have to sell your stocks for a loss, just to meet your crisis.

Looking for a guaranteed and safe income with high returns? Then think about bonds. Bonds are nothing but loans taken by government and corporates from investors for particular project. It could be for a particular project like Rural Electrification Bonds issued by REC to finance its projects. You are primarily a lender, who buys bonds issued by these entities. In return, the issuer agrees to pay you interest on the amount you lend.

The bonds need to be held for a certain period. This is called as maturity period. The rate of interest is called as the coupon rate. Like shares, the bonds also have face value. E.g. a bond with a face value of Rs 100 and a coupon rate of 6% with a maturity period of 10 years, will have a holding period of 10 years and earns an interest of 6% per annum.

However there is a big difference between stocks and bonds. While the returns (dividends) from stocks are not guaranteed, the returns from bonds are assured. As the interest rate on the bond is fixed, you have an idea of how much you will earn during the tenure of the bond. Hence it is one of the fixed income instruments.

However the income from bond is taxed. So you need to be aware of the fact that you will end up paying tax, which will thus increase your tax liability. Hence it is essential to get proper financial advice before investing in bonds.

Till now we have seen the important valuation ratios that help you decide whether the stock is worth buying or not. Now let us take a look at the operational efficiency of the company. It highlights how effectively the company is able to run its business. The first ratio that we look at the Current Ratio.

This ratio tells you the amount of liquidity available with the company in order to fulfill its business commitments. It is obtained by dividing the current assets (those assets that can be quickly sold off to get cash) by its current liabilities (immediate debts).

Current ratio=Current assets ÷ Current liabilities

Usually, if the current ratio of 2:1 for a stock is regarded as suitable, since it gives a sufficient safety margin to the company in order to fulfill its operating cash requirements. If the current ratio is low, the company may have to raise money from other sources like borrowing from lenders both individuals and financial institutions or distribute new equity for fulfilling their commitments.

But if the ratio is very high, it implies the company is not using its assets optimally. It is just sitting on its assets. This can significantly affect the company’s long-term returns. Compare the current ratio of the company you are interested in with that of its rivals.

Another important valuation tool used is price-to-book or P/BV ratio. This ratio indicates to what extent the company’s share price highlights the  shareholders’ portion in the business.
It is calculated as:

P/BV = Share price / Book value of one share (BV)

BV = Share capital + reserves and surplus

A high P/BV ratio (>1) implies the company’s stock is undervalued or the company earns revenue and is expected to see a higher return on the assets. On the other hand, if the ratio is < 1, it implies the stock is overvalued or the company does not earn a good return on the assets.

It is an excellent measure to value stocks of companies involved in capital intensive businesses like banks, auto and manufacturing. But don’t use it for companies operating in IT and pharma sectors as these companies how very low tangible assets.

However even this ratio does have its share of drawbacks.

• It does not represent the true value of stocks in services sector.

• It fails to represent the true value of companies with high debts. This is because high debt offsets the value of the company’s assets. This can lead to errors in taking investing decision.