Investing

Fundamentals
Chapter-8
CHAPTER OVERVIEW
 Rules for investing
 Returns from investing in stocks

 Tax on returns

 Risk from investing

 Trade-off between risk and return

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RULES FOR INVESTING-
 Investment is an activity where you set aside some
money now, in anticipation of receiving a higher amount
in the future.
 There are two primary reasons everyone should invest:
 To counter inflation
 To meet financial goals

 Considering the unpredictability of markets, these are

three golden rules that all investors must follow:
1. Invest early
2. Invest regularly
3. Invest for long-term
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POWER OF COMPOUNDING
Compounding is growth via reinvestment of
returns earned on savings.

Compounding has a snowballing effect

because you earn income not only on the
original investment but also on the
reinvestment of dividend/interest
accumulated over the years.

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 FIRST
• RULES FORPRIORITY
INVESTING-SHOULD BE
TO ENSURE ADEQUATE
LIQUIDITY

• MAKE SHORT TERM

INVESTMENTS TO MAINTAIN
LIQUIDITY AND EARN SOME
RETURNS

• AVOID UNUSUALLY HIGH

RETURN INVESTMENTS-IT
MAY BE RISKY 5
INVESTMENT AVENUES
 There are many types of investments available in the
market. But all investment instruments are broadly based
on the following four basic investment areas or assets
classes:
• Equity Markets
• Debt Markets
• Real Estate, &
• Gold

 Pick the right investment tool based on your risk

appetite, financial goals and investment time horizon,
etc. 6
EQUITY
 Equity investments include direct investment in shares,
equity mutual funds, etc.
 Stocks can be bought/sold from exchanges (secondary
market) or via IPOs – Initial Public Offerings (primary
market).
 Stocks are among the best long-term investment options
wherein market volatility and the resultant risk of losses,
if given enough time, are mitigated by the general
upward momentum of the economy.

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Return from investing in stocks-
Dividends

Price appreciation also called capital appreciation

or capital gain
 Bonds
 Return from investing in bonds is in
the form of coupon payments and
price appreciation

 Mutual Funds
 Return from investing in mutual funds comes from coupon or
dividend payments generated by the portfolio of the fund

 Real estate
 Buying a home or purchasing rental property or land
 Return from investing in real estate
comes in the form of rent payments and selling the property
for a higher price than paid for it
Growth Stocks Vs Income Stocks
# Income stocks- generally older, established firms
that have less chance for substantial growth and less
variable earnings
Coal India, NHPC, BPCL, ITC
The income companies believe in declaration of high dividends.
# Growth stocks- generally younger firms that have
more growth opportunities and more variable earnings
Amazon, IOL chemical, Bajaj Steel
The growth companies give low dividends
# Blue Chip Stocks- well known companies, have a very good
management team, very strong product and dominance in the
market. Such companies are not affected by temporary adverse
market conditions. Ex- HDFC Bank, ITC, L&T, Reliance ind.
INVESTMENT RETURN AND RISK
Measuring the return on your investment

Total return = Cash payment received + price change over

the period
Purchase price of the asset

 Example: If you pay $1,000 to make an investment and

receive $1,100 when you sell the investment in one year,
you earn a return of:

R= $1,100 - $1,000 = .10 or 10%

$1,000
 COMPOUND ANNUAL GROWTH RATE
CAGR = (Ending value / Beginning value) (1 / n) -1
Where n = number of years

CAGR=[(1+R1​)(1+R2​)…(1+Rn​)]1/n −1

where:∙R1​…Rn​are the percentage returns of an asset

Example- Suppose you invested $10,000 in a portfolio on Jan 1, 2005.

Unsurprisingly, your portfolio would likely grow at an inconsistent rate. Let
us assume that by Jan 1, 2006, your portfolio had grown to $13,000. Let us
also assume that it then grew to $14,000 by the same time in 2007, and
spiked during that year, ending up at $19,500 by Jan 1, 2008
DIFFERING TAX RATES ON
RETURNS
 Income received as interest payment is classified as ordinary income
 The income from sale of investments is called CAPITAL GAIN

Long term capital gain (LTCG)-Capital gains resulting from sale of

investments -
 Shares, equity MFs, listed bonds etc.-held more than 12 months

 Unlisted shares, land, building- held for more than 24 months.

 Other Capital assets such as gold, debt MFs, antiques etc. - held for
more than 36 months.
Short term capital gain (STCG)- if held for shorter durations as in the
above cases.

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Differing tax rates on returns
 Share dividends- From FY 20-21, all dividends in the hands of investors are
taxable as per slab rates.
 STCG from investments in stocks (if levied STT) are taxed at 15%
 LTCG from sale of stocks (if levied STT) are not taxable up to CG of Rs 1 lakh.
Above Rs 1 lakh- tax rate is 10% without indexation
 LTCG – except for sale of equity shares – 20%

CAPITAL ASSETS
 STCG from sale of capital assets are taxed as ordinary income.
 LTCG from sale of capital assets are taxed at 20% with indexation (Sale –
Indexed cost)
(LTCG = sale price – indexed cost of acquisition)
Indexed Cost of Acquisition or inflated cost = Actual Purchase Price * (Cost
Inflation index during the year of sale / Cost Inflation Index during the year of
purchase)
Cost of acquisition includes expenses incurred for acquiring the asset such as
registration charges, brokerage etc. Any cost of improvement can also be added to
the cost of acquisition.
Let us try to understand this with a simple example.

An asset was purchased in FY 2005-06 for Rs. 12 lacs. This asset was sold in
FY 2020-21 for Rs. 60 lacs. Cost Inflation Index for 2005-06 is 117 and in
2021-22 it is 317.

So, indexed cost of acquisition: Rs. 12,00,000 * (317/117) = Rs. 32,51,282

Long Term Capital Gains would be calculated as :

Capital Gain= Selling Price of an asset – Indexed Cost i.e. Rs. 60,00,000 –
Rs. 32,51,282 = Rs. 27,48,718.

Therefore tax payable will be 20% of Rs. 27,48, 718 which comes to Rs.
5,49,744

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OLD TAX REGIME:
Income Tax Slab for Individual Tax Payers (Less Than 60
Years Old)

Income Slab Tax Rate

Income up to Rs 2,50,000* No tax

Income from Rs 2,50,000* – Rs 5,00,000 5%

Income from Rs 5,00,000 – 10,00,000 20%

Income more than Rs 10,00,000 30%

*300000 for senior citizen and 500000 for super senior citizen

Surcharge: 10% of income tax, where total income exceeds Rs.50

lakh up to Rs.1 crore.

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Health and Education Cess: 4% on total of (income tax + surcharge).

Carry forward and set off of capital loss
•In an equity investment, capital gains are taxed as mentioned above but
losses can also be adjusted.

•Any loss under the head capital gains can be set off with income against
that head only. It cannot be set off against any other income head like
salary, business income, etc.

• Long-term capital losses can be set off only against LTCG and short-term
capital losses are allowed to be set off against both LTCG and STCG.

•There is also a provision to carry forward losses if you are unable to set off
your entire loss in the same financial year. Both short-term and long-term
capital losses can be carried forward for eight assessment years immediately
following the assessment year in which the loss was first computed.

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Problems-

1. Joel purchased 100 shares of a company for Rs200 per

share. During the year, he received dividend amounting to
Rs1500. Joel sold the stocks for Rs320 per share within one
year. What was Joel’s return on the stock after tax?

What would be the return if he held the stock for more than
a year, assuming he sold it for the same amount?

2. Suppose, you bought 100 shares of ABC Ltd. @ Rs. 1000

per share and sold all the shares @Rs. 1050 after 6 months.
What is the after tax return?

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INVESTMENT RETURN AND RISK
(CONT’D)
 Risk from investing
 Returns are uncertain
 Future values of investments are dependent on demand by
investors
 Before you select an investment, you should assess the risk
Measuring an investment’s risk
All stocks are subject to two forms of risk –

Systematic risk is the risk that all publicly traded equities share face
due to market-wide movements.
Wall Street proverb “a rising tide raises all boats

Non-systematic risk is based on the earnings strength of the

underlying company of your stock, and not the overall market.
Non-systematic risk is generally more manageable than systematic risk for
the individual investor.

The traditional way of offsetting non-systematic risk is diversification

across different sectors and asset classes
 Measures of Risk
1. Range of returns: returns of a specific investment over
a given period
(range = highest return – lowest return)

2. Standard deviation: standard deviation of stocks

monthly returns. It measures the degree of volatility in the
stock’s return over time
A risky stock will normally have a relatively wide range of
returns and a high standard deviation of returns
There are other subjective measures of risk

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3. Beta

Beta measures non-diversifiable risk i.e. Systematic risk.

Beta calculation is performed using a statistical technique called

Regression analysis.

The whole market is assigned a beta of 1.

Stocks that have a beta greater than 1 have greater price

volatility than the overall market and are considered to have
greater risk.

Stocks with a beta of 1 move up and down with the market.

Stocks with a beta less than 1 have less price volatility than the
market as a whole and are considered to have less risk.

Risk relates to return. Investors normally expect that stocks with

a higher beta should command a risk premium, that is provide a
higher return than the market. 22
More risk should mean more reward!
Using Beta to Estimate Returns

Capital Asset Pricing Model-

Rs = Rf + Bs(Rm-Rf)
Where:
Rs = the required return on investment
Rf = risk-free rate of return
Rm = the average return on all stocks
Bs = the stock’s beta

It is easy to see that Rs increases with

increase in its beta.

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Assume a security with a beta of 1.2 is being
considered at a time when the risk-free rate
is 4 percent and the market return is
expected to be 12 percent.

Rs = 4% + (1.2 * (12% - 4%))

= 4% + (1.2 * 8%)
= 4% + 9.6% = 13.6%

The investor should therefore require 13.6%

return on this investment as compensation
for systematic risk assumed , given the
stock’s beta of 1.2.
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TRADEOFF BETWEEN RETURN AND
RISK
 Return-risk tradeoff among stocks
 Small firms tend to have more growth potential, but higher
risk
 IPOs may offer high returns, but also have high risk,
especially for individual investors
 Return-risk tradeoff among bonds
 Large, well-known firms have low return, low risk
 High risk bonds offer higher payments
LEARNING FROM THE INVESTMENT
MISTAKES OF OTHERS
 Making decisions based on unrealistic goals
 Borrowing to invest
 Taking risks to recover losses from
previous investments
 Focus on Ethics: Falling prey to online investment fraud
 Avoid making decisions without facts
PRACTICE QUESTIONS

 Investors agree to invest in high- risk investments if only

A) There are any true speculations
B) The predicted return is satisfactory for taking a risk
C) There are no safe options except for holding cash
D) The return is short
 -------------.means a number of securities/assets put
together.
a) Investment
b) portfolio
c) savings
d) none of these
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PRACTICE QUESTIONS

 Systematic risk is also known as

a) Unavoidable risk
b) unique risk
c) avoidable risk
d) Financial risk

oVolatile stock has beta value

a)Greater than one
b) equal to one
c) less than one
d) none of the above
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PRACTICE QUESTIONS

 Company X has the beta of 1.5 .the expected return is

15% the risk free rate of interest is 5 %.which is the
market return.
a) 6.67%
b) 10.33%
c)15.66%
d) 12.33%

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REFERENCES

1. Medura, Jeff. Personal Finance, 7th Edition, Pearson

Publication, 2020
2. Fischer and Jordan, Security analysis and portfolio
management, 6th edition, Pearson Publication, 1995
3. https://www.icicidirect.com/knowledge-center/learn-
hub/equity/chapter-1-need-for-investment-and-different-
investment-avenues/14064

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