Investments basics

Every client you meet as a PMS distributor already has money. What they need from you is a clear view of where that money should sit, what it should earn, and what could go wrong. The exam starts with investment basics because every later topic, from bond pricing to performance fees, is built on these few ideas.

Saving is not investing

Saving means setting money aside and keeping it safe. A savings account, a fixed deposit or cash in a locker protects the rupee amount but does little to grow it. Investing means putting money into assets that are expected to produce income or grow in value, and accepting some risk of loss in exchange.

The reason saving alone fails is inflation. If prices rise 6% a year and a deposit earns 3.5%, the money buys less every year even though the balance grows. What matters is the real return, the return after inflation.

A deposit at 7.2% with inflation at 6% gives a real return of 1.072 ÷ 1.06 − 1 = 1.13%. The quick subtraction gives 1.2%. The exam may ask for either, so read the question.

Asset classes and what each one does

An asset class is a group of investments that behave in a similar way. The main ones a PMS client holds are:

• Equity. Ownership in companies. Returns come from dividends and price growth. Highest long-term return, highest short-term volatility.
• Fixed income. Loans to governments and companies through bonds, debentures, deposits and debt funds. Returns come mainly from interest. Risks are interest rate movement and default.
• Cash and money market. Treasury bills, commercial paper, liquid funds. Lowest return, highest liquidity, used for near-term needs.
• Real estate and gold. Physical assets, often held for inflation protection. Gold can also be held through ETFs and sovereign gold bonds; property through REITs.
• Alternatives. PMS, alternative investment funds (AIFs), unlisted equity, structured products. Higher minimums, less liquidity, more customisation.

Each class is judged on four things: expected return, risk, liquidity (how fast it converts to cash without a big price cut) and tax treatment. A good portfolio combines classes so the whole is steadier than any one part.

Risk and return go together

Risk is the chance that the actual return differs from what was expected. Higher expected return always comes with higher risk; no regulated product offers one without the other. The exam expects you to name the kinds of risk:

• Market (systematic) risk. The whole market moves, for example on interest rates, war or a pandemic. Diversification within the market cannot remove it.
• Company-specific (unsystematic) risk. One business fails or a sector slumps. Diversification across companies and sectors reduces it.
• Credit risk. A borrower does not pay interest or principal.
• Interest rate risk. Bond prices fall when yields rise.
• Liquidity risk. You cannot sell quickly at a fair price. Small-cap shares and unlisted securities carry more of it.
• Inflation and reinvestment risk. Returns lose purchasing power, or maturing money has to be reinvested at lower rates.

Risk is measured with standard deviation (how much returns swing around the average) and beta (how much a security moves with the market). Both reappear in the performance chapter.

A client's risk profile has two parts. Risk capacity is the ability to absorb a loss, driven by wealth, income, horizon and liabilities. Risk tolerance is the willingness to see a loss and stay invested. A client with high capacity but low tolerance will still panic at a 20% fall; the lower of the two should guide the recommendation.

Time value of money and compounding

A rupee today is worth more than a rupee next year because it can be invested. The future value of a sum grows by the factor (1 + r) every year, and compounding means each year's return earns a return in the following year.

Compounding added ₹45 lakh over simple interest. Inflation then quietly took away almost 45% of the headline figure. The client's lifestyle depends on the last line, not the one above it.

Asset allocation is the big decision

Studies on long-term portfolios show that the split between asset classes explains most of the variation in returns; picking individual securities explains much less. So the first conversation with a client is about allocation: how much in equity, debt, gold and cash, given goals, horizon and liquidity needs. Strategic allocation is the long-term target. Tactical allocation is a temporary tilt based on market views.

A PMS normally occupies the equity (or sometimes the debt) sleeve of a wealthy client's plan. It is one building block, not the whole plan. A distributor who understands this will not put a client's emergency money or a three-year goal into a concentrated equity PMS.

Keep three habits from this chapter: convert every return to a real return before judging it, separate the client's risk capacity from risk tolerance, and get the allocation right before discussing any product.