Post office Monthly Income Scheme (MIS)

Post Office Monthly Income Scheme (MIS)
This is one of the very good scheme from post office the best part is it gives you interest every month. you can open this account in following ways at the post office near by your home

• An adult individual in his own name
• An adult on behalf of minor
• An adult jointly with maximum joint holder restricted to three.

How Much

• Minimum Rs 1,000/-
• Maximum Rs. 3,00,000/- in single account
• Maximum Rs 6,00,000/- in joint account

This limit has been increased recently to 4,50,000 for individual

Interest

• 8% per annum payable monthly
• In some post office ECS facility is available where the interest is credited every month directly to saving bank account of the depositor.
• Depositor may open SB account with the same post office where he deposited his MIS and give standing instruction for crediting the interest amount directly to the SB account on monthly basis.

Term

• 6 year Interest rate remains the same for the entire period

Withdrawals

• No premature repayment is permitted within one year of deposit
• After one year but before completion of 3 years, premature withdrawal of entire balance is permitted with 2% penalty on the deposit amount, no deductions on interest already paid
• If withdrawn after 3 years the penalty is restricted to 1% of the deposit amount.
• Part withdrawals are not permited. ( TIP: that is why even if you want to deposit 3 lakh , you should deposit 3 different amounts of 1 lakh)

Bonus on maturity

• A bonus of 5% of deposit amount is payable on maturity (end of six years)

Public Provident Fund (PPF)

Public Provident Fund (PPF)
can be opened in
1. Head Post-Office
2. GPO
3. Any branch of SBI
4. Selected branches of Nationalized bank like Central bank of India etc

Conditions

• Minimum investment of Rs. 500 in a financial year
• Maximum of Rs. 70,000/- in a financial year
• can be invested in lump sum or in convenient instalments
• you cannot deposit more then 12 times in a year

Interest

• 8% p.a credited to the account, once a year, as on 31st March of each year.
• Deposits made before 5th of every month are eligible for interest for that month. Date of deposit is considered for this purpose
• Interest can be changed by the Government of India at any time

Past Interest rate were as under
upto 14.1.2000 - 12%
15.1.2000 to 28.2.2001 - 11%
1.3.2001 to 28.2.2002 - 9.5%
1.3.2002 to 28.2.2003 - 9%
1.3.2003 onwards - 8%

Term

• PPF is 15 year account
• The term of the account can be extended by 5 years at a time by making an application in specified form to the deposit office, within one year
• An account can be extended any number of times
• The entire balance can be withdrawn in full after the expiry of 15 years from the close of the financial year in which the account was opened.

Loan

• The depositor can take a loan in the third financial year from the financial year in which the account was opened
• loan can be taken upto 25% of the amount standing at the end of the second preceding financial year
• The loan shall be repayable in 36 instalments and shall bear interest at the rate of 1%. No loan can be obtained after the end of 5th year.

Withdrawals

• Depositor is permited to make one withdrawal every financial year.
• withdrawal is permitted from the 7th financial year
• Amount of withdrawal can not exceed 50% of the balance to his credit at the end of the fourth year immediately preceding the year of withdrawal or at the end of the preceding year, whichever is less

Tax Benefits

• The interest earned on PPF account (including interest during the extension period) is excluded from income tax u/s 10(1).
• The entire deposit in the account is exempt from wealth tax.
• The annual contribution to the account is eligible for deduction u/s 80c

Transferability

• A PPF account with one deposit office can be transferred to another deposit office

Nomination

• PPF account is necessarily opened in a single name. Nomination facility is available
• A depositor can nominate more than one person and stipulate the percentage of sharing among nominees

How does Diversification help us ?

Diversification help us when ?
1) Combining two securities with positive correlation with each other provides no reduction in portfolio risk. as more securities are added the risk remain weighted average. There is no risk reduction.
2)Combining two securities with zero correlation (each is independent of other)with each other reduces the risk of the portfolio. If more securities are added the uncorrelated returns are added to the portfolio and significant risk reduction can be achieved.
3) Combining two securities with negative correlation with each other could eliminate risk altogether. This is the principle used in hedging strategies.

4) In real world this extreme cases are rare, most of the securities typically have positive correlation with each other. So risk can be reduced but it cannot be eliminated. Other things being equal investor should find securities with least positive correlation possible. Ideally they should look for negative of low positive correlation.

Three factors determine the risk of portfolio.
1) The variance of each security.
2) The Co-variance between securities.
3) The portfolio weights for each security.


Every investor should try for an efficient portfolio defined by Markowitz's as the one that has smallest portfolio risk for given level of expected return or the largest expected return for the given level of risk.

Rupee cost averaging
The systematic investment plans in mutual funds, along with consistent periodic new purchases of shares, creates risk reduction by creating lower cost per share owned over time. This is known as rupee cost averaging.

Building of an Investment Portfolio; Asset Allocation, Security selection

While Building an Investment portfolio two major things you should consider

• Asset Allocation
• Security Selection

The asset allocation decisions is the most important one what percentage of portfolio should be allocated to Stocks and how much to bonds. It is also advisable to invest a some percentage globally. What percentages should be invested to each of the countries. Whithin each asset class also what percentage to which sector and how much for each particular stock.
Also asset allocation is closely related with the age of investor this is called Lif-Cycle theory. The investor with age of 50 nearing to retirement should take very little risk for his investments and the person who is just starting his carrer can take high risk because he has time on his hand. So ideally younger the investor more allocation to stocks and older the investor less allocation to stocks.
List out the asset classes
1) Cash or savings account
2) Stocks
3) Bonds
4) Real Estate
5) Foreign Securities
Financial planner in consultation with the investor should plan out percentages to be allocated to each of the assets. The next step would be about individual securities within each asset class.

Average portfolio risk can be reduced by 19% as we keep on adding securities to the portfolio the total risk associated with the portfolio of stocks declines rapidly. The first few stocks cause a large decrease in portfolio risk. based on actual data 51 percent of the portfolio standard deviation is eliminated as we go from 1 to 10 securities. unfortunately the benefits of adding more securities after a point is very small and it keeps getting smaller and smaller.

Modern portfolio theory according to Markowitz.
Markowitz developed an equation that calculates the risk of a portfolio as measured by the variance or standard deviation. His equation accounts for two factors.
1) Weighted Individual Security risks that is variance of each individual security, weighted by percentage of investible funds placed in each individual security.
2) Weighted co-movements between securities returns that is the covariance between the securities returns, again weighted by the percentage of investible funds placed in each security.

Measurement of Portfolio performance

It is very simple to measure Individual security's measure. It is also good to measure the performance of an entire portfolio.

Evaluating the performance of a particular portfolio involves measuring both the realized return and the differential risk of the portfolio and recognize any constraint the portfolio manager may face. A 14% return by itself is meaningless figure unless it is viewed in comparison with benchmark figure or average return of that category over same time frame and similar level of risk taken.

Measure of return is always done in relation to risk taken.
In order to evaluate performance properly, we must determine whether returns are good enough for the amount of risk taken. We must always asses risk-adjusted returns.

An equity portfolio consisting of sensex stocks should be evaluated relative to BSE sensex. on the other hand equity portfolio of small cap stock should not be judged against sensex.

Risk-adjusted returns
It is important to evaluate portfolio not only with performance but also how much risk is taken. William Sharpe, Jack Treynor and Micheal Jensen developed the measures of portfolio performance.

Sharpe Ratio
Reward-to-variability ration (RVAR). The measure uses benchmark based on the ex post capital market line. Sharpe used RVAR to:

• Measure the excess return per unit of total risk(as measured by standard deviation)
• Rank portfolios by RVAR ( the higher the RAVR, better the portfolio performance)

RVAR = Rp - Rf/SD

Rp = Return of the portfolio
Rf = Risk free return
SD = Standard Deviation or portfolio (total risk)


Trey nor Measure
Jack Treynor measures called reward-to volatility ratio (RVOL).
RVOL = Rp - Rf


Jensen's Index
It measure the portfolio performance with differential return measure(ALPHA).
It attempts to measure the constant return that the portfolio manager earned above or below the return of an unmanaged portfolio with the same market risk.

Jensen's index = Rp - [Rf + (Rm- Rf)*B]

Rp = return of portfolio
Rf = risk free return
Rm = Market return (Index return)
B= Beta of portfolio (Beta is the measure of market risk of the portfolio)

Measuring Investment Returns !

The returns are of two types Realized return is what is ex post or after the fact return. Realized has occurred and it is the fact and measure of accurate data. Estimated return is what we hope or expect to gain, this return is subject to uncertainty and may or may not occur.

Historical returns of any product plays a large part in estimating future returns.

Returns of an Investment has two components.
1) Yield: This is periodic cash flow from any investments like interest or dividend. most FDs have interest generated yearly, or quarterly. and Stocks , Mutual funds declared dividends from time to time. Yield is the measure of cash flow to the price of a security.

2) Capital Gain (loss) : The second component is the capital appreciation(or depreciation) in the price of an asset, price of a stock.

Total return = Yield + Price Change(capital gain)

Current yeild
It is simple measure of returns on any security and is = annual interest/price of security.

Yeild to Maturity(YTM)
Returns of bonds most often quoted for investors is Yield to Maturity (YTM), It is defined as promised compounded rate of return an investor will receive from bond purchased at market rate and hold till maturity.

computation of YTM
P = C/(1+r) + C/square(1+r) + C/ntime(1+r) + M/ntime(1+r)

P= price of security
C=annual interest
r= rate of interest
M=Maturity value
n=number of years

Compounding vs Discounting
The concept of compounding, that is interest on interest is an important concept.

Post Tax Returns (Tax Adjusted Returns)
As an investor you should learn that taxes can eat up lot of your returns so what is more important is what you keep rather then what you make.

example: if you make 50% in a product 'A' , out of which 30% will go for tax payment so you have left is just 20%
If you have product 'B' which gives just 30% returns with tax being nil on it because it is tax free. so the final returns you gain is net 30% from product B.
So Definately even though product A gives more returns but for investor product B is better option.

Real Return(Inflation Adjusted return)
All the returns we calculate are Rupee returns. It does not actually talk about purchasing power of these rupees. In 1950 you could see movie for less then Rs 1 now even if your 1 rupee has grown 50 times you will still be not able to see the movie today as it cost over Rs 100.
so the inflation has killed your purchasing power instead of your wealth being increase if you look at inflation adjusted returns it has actually diminished.

Real return = { (1+ Nominal Return) / (1+ Inflation rate) } - 1
Note: merely subtracting inflation rate from the nominal return will get less accurate result.

How to Manage Risk in Investments ?

Diversification:
Investments need to be made to get much better returns but keeping the risk to the minimum. The well know established fact of reducing the risk is through diversification.

• Diversification across different asset class - equity, debt, commodities,real estate
• Across geographies - different city, different country
• Across different securities - different stocks , different bonds, different FDs
• Across Maturities - short term, medium term, long term

Portfolio of securities

Investment in stocks is usually advisable to have investments in number of stocks rather then one single stock. The stocks should also be from different sectors and sectors should also be not related. If you 10 different stock but all from IT pack then if the IT sector goes down your entire portfolio will go down. so all stocks should be deversified across different sectors be IT, real estate, FMCG, OIL and Gas, Auto , manufacturing, commodities etc.

Note: Over diversification in stocks is also not good. If you diversify too much then returns will also be average your portfolio will then not outperform the markets.

Ideally for an individual investor should limit number of stocks between 5 and 30.

Risk Reduction through Product Diversification

It is important to have product diversification like direct equity, indirect equity through mutual funds, balanced fund, debt - corporate and government, fixed income like small savings scheme,Bank FD, PPF, post office term deposit.

Risk is in the portfolio can be reduced throught investments in different products in pre-determined proportion depending on the risk profile of the investor. The proportion should be managed periodicaly atleast once in six months.

Risk reduction through Time Diversification

when investing in equities it is an established fact the individual investor cannot time the market. Most of my clients will say the price of stock went down after he purchased it and whenever he sells a stock the price will go up. Rather then putting energy in predicting when the bottom is reached and when it is peak it is better to invest in equities through SYSTEMATIC INVESTMENT PLANS. All most all mutual funds have SIP facility to invest in mutual fund systematically and conveniently via ECS. Another strategy would be to park all your money in debt fund and transfer part of it regularly to an equity fund.

Hedging

Diversification reduces nonsystematic risk but systematic risk or market risk still exist. It cannot be diversified but systematic risk can be hedged.

Portfolio 50 Nifty stocks now this portfolio has dependence of failure of fortune for each company with a chance of 1 in 50. but if the market will swing each way then the portfolio will fluctuate with overall market. Now this risk cannot be reduced but hedged.

If your portfolio of 30 lacs and NSE nifty is trading at 3000 then 10 futures contracts of nifty can be sold to effectively offset the market risk. So if your portfolio decreases by 5% then the nifty contracts will increase by 5% as you have already sold it. hence your portfolio is immuned to market movements.