Why do you invest? It is to grow your wealth at a later date — to buy a house, fund your children’s education, live well after retirement and such other reasons. In this article based on Debashis Basu’s book, Plain Truths About Investments, CERS throws light on mutual funds, stocks and bonds.

MUTUAL FUNDS

Mutual funds pool the money of individual investors to buy stocks and bonds. The fund managers have the expertise to select what to buy and figure out when to sell. Investors are promised higher returns at lower risk than if they manage their funds themselves. The fund managers monitor the performance of the investments. They direct the funds’ investments according to the funds’ objectives, such as long-term growth, high current income or stability of principal.

NAV: In return for putting money into the fund, the investor receives units that represent his share in the fund. Each investor shares proportionately in the fund’s income (dividends from shares or interests from bonds). The net asset value (NAV) of a mutual fund is simply its assets minus its liabilities. This number is important to investors because it determines the price per unit of a fund. The NAV divided by the number of units issued is the price per unit. When you buy units, you pay the current NAV plus any fee the fund levies at the time of redemption.

The prices of stocks or bonds a fund owns may rise. When a fund sells them, it makes a capital gain. Funds then distribute these capital gains (minus any losses) to the investors.

Annual Total Return: How do you know whether the mutual fund you have invested in is doing well? Look for consistency of performance. The Annual Total Return is the most widely used indicator of fund performance. It is the percentage change in a fund’s NAV over the year. To calculate it, multiply the number of units by the NAV per unit to get the current value of the investment. Then subtract the original investment to get the increase in value. Add any capital gains or dividend/interest distributions. Expressed as a percentage of the original investment, this is the Annual Total Return.

SIP: One of the best ways to invest in a mutual fund in a regular disciplined manner is to use a Systematic Investment Plan (SIP). It’s your tool to combat market volatility. Under SIP, a small sum of money is automatically deducted from your account and invested in a mutual fund at regular intervals, say monthly or quarterly. This amount gets compounded over time.

Pros: Buying units in a mutual fund is like holding shares in many different companies at the same time. By diversifying, the fund reduces the impact of losses in one scrip or more. Just as you can sell your share at any time, you can sell your units and obtain cash whenever you want. Investing in mutual funds is easy. You can buy units by mail, telephone or over the Internet.

Most fund companies have a variety of mutual funds with different objectives and you can switch from one to the other, depending on your needs or market conditions. Dividends from mutual funds are tax free. Mutual funds are also exempt from wealth tax.

Cons : Mutual fund units fluctuate widely in value in response to changes in the prices of stocks and bonds the fund has invested in. Market risk is the rise and fall in stock prices, usually cyclical, influenced by the profitability of companies, interest rates, economic growth, money supply, foreign exchange and other factors.

In mutual funds you are at the mercy of the fund manager. If there is mismanagement, you are the loser. This is a non-market risk. A classic case of mismanagement is that of the Unit Trust of India (UTI).

Mutual funds churn their portfolio, often increasing your costs. While they advise you to take long-term view and stay invested, they themselves react to short-term changes. Funds may chase a fad. For instance, in 1999-2000, the fad was software and entertainment stocks. By investing too much in such stocks, they may increase risk. Though mutual funds are regulated by the Securities and Exchange Board of India (SEBI), the board often fails in its role. Unlike bank deposits or some fixed income instruments, mutual fund units are not insured or guaranteed by any state agency.

STOCKS

Stocks or shares represent proportional ownership in a company and fetch dividend. If you own stocks in a company, you have a claim on its assets and own a slice of every rupee of profit that the company makes. Though regular dividends are an indication of the health of a company, the way investors seek to earn returns from stocks is by reselling them at higher prices.

IPO : The shares of a company are made available to the investing public for the first time through what is called an Initial Public Offering (IPO). This is the primary market. After an IPO, shares are bought and sold in stock exchanges in what is called a secondary market. In the secondary market the price of a stock moves up or down, depending on the demand and supply, which in turn, is based on expectations of future earnings.

To be traded, shares have to be listed on exchanges and can be bought and sold only through members of exchanges called brokers. Trading is conducted today through an interconnected network of computer terminals. Stock trading is like a continuous auction. The last traded price at the end of the day is the closing price of the stock. The daily rise or fall, no matter what the extent, is not of relevance to what happens even a week later. Stocks, as mentioned earlier, give best results when held over a long period of time.

BONDS

Bonds are issued by the government or companies to borrow money from the public. When a bond is issued, the price paid is known as the face value or par value. You may buy a bond for Rs 1,000 at 6 per cent rate and a 10-year maturity. At the end of 10 years (the maturity date), you will get back the face value plus the interest. The interest rate is also called the coupon rate. In this case the interest earned is Rs 60 every year for 10 years. That is why bonds are called fixed-income investments, making them much less volatile than stocks.

Once a bond is issued it can be traded in the secondary market just like stocks. Bond prices go down when interest rates rise, in case of an inflation, and vice versa. Suppose you bought a bond of face value Rs 1,000 in 1997 which has a coupon rate of 14 per cent. If the coupon rate has fallen to 7 per cent, it is this rate which will apply to all new bonds. The 14 per cent bond of 1997 will be in huge demand and its prices will be far higher than Rs 1,000.

If you hold a bond to maturity you will not lose your principal provided the borrower does not default. Government or Reserve Bank of India (RBI) bonds are the safest. Next come bonds by top-quality companies. Bonds are an essential part of any prudent portfolio to guard against the higher risk of stocks. However, the bond market is not well developed in India.

For more information write to cerc@cercindia.org