A process of acquiring an asset is called investment. There are different types of investments available in the market. Not all investments suit all investors. Each of these has varying levels of risks. Hence investors have to choose those types of investments that best suit their financial plan and goals. In this article, we have covered about investment, how they work, and different types of investments.
What is an investment?
Investment is a process of acquiring an asset with an aim to generate money from it. Generating income from an asset can be through regular income or appreciation of the asset. Appreciation is the increase in the value of the asset over time.
When an asset is purchased for the purpose of investment, the investor will not consume it. Instead, the investor will use it to generate wealth from it. The main purpose of investing is to acquire an asset right now and sell it at a higher price at a future date.
There are various types of investments available in the market. The most popular ones are stocks or equities, real estates, fixed deposits, gold and real estate. Mutual funds, Public Provident Fund, government bonds, corporate bonds, Exchange Traded Fund, and National Pension Scheme are few other well-known investment options. Each of these differ based on the returns they offer, level of risk, tenure, taxation, and whether the returns are guaranteed or market-linked.
Investors need to understand their goals, set an investment horizon, contemplate on their understanding of risk, understand the taxation of each of the investment products before choosing an investment option. They should never stick to just one investment option and should invest in multiple investment vehicles. Having a diversified portfolio will help them spread their investment risk across multiple asset classes. Moreover, having an investment portfolio with more than one type of investment will help boost portfolio returns. It is essential to have a balanced asset allocation for earning optimal returns. Asset allocation varies with age, investment goals, and risk tolerance of the investor.
How does the investment work?
Investing is a way to get money to work for you. When one invests in stocks and bonds or a piece of land, they aim to generate money from it in the form of dividend, interest or capital appreciation. Hence investing is spending money today on something that will help generate income in the future.
Investing is different from saving. In saving, one is setting aside money for future use. Whereas, in investing, one is purchasing an asset with an intent to generate growth from it in the future. Saving will not give returns that will help beat inflation. In contrast, returns from investing , if done right, are higher than the rate of inflation. Saving comes with no risk while investing has certain risk involved. Saving suits for short term or immediate goals. Whereas, investing is best for medium-term and long-term goals such as child’s education, marriage, and retirement planning.
Investing is not just about purchasing an asset; it also means taking an action that will help generate revenue in the future. For example, when one individual chooses to study an additional course or does a Masters in a particular field to develop skills, they might help generate future income.
Investing involves risk of losing the investment money. Since investing is about generating future income, there is always a risk. For example, investing in shares of a company can look like a viable option today as the company performs well. However, in the future, there are chances of the company going bankrupt. Hence, investing always comes with an element of risk. Investors need to understand this before choosing to invest in any of the investment options.
With a wide range of investment options available in the market, it is often quite difficult to shortlist the right one. Hence one can hire a financial advisor to help with investment planning. Though a financial advisor charges a fee for their services, their expertise would help one achieve financial goals.
Read also about the Bonds vs Stocks
Types of investments
There are different types of investment in the market, and we have bifurcated them into three main categories. They are
- Fixed income investments
- Market linked investments
- Other investments
Fixed Income Investments
These investments give guaranteed returns in the form of interest. These are low-risk investments. Below is a list of few of the best fixed-income investments.
Fixed deposits or popularly known as FDs are usually offered by banks and financial institutions. FDs offer guaranteed returns and hence are the most popular investment type in India. They have a tenure ranging between 7 days and ten years. Fixed deposit interest rates range between 3%-7%. Moreover, senior citizens are offered additional interest on their FD investments. The FD interest rates are higher than the savings account interest rate. The interest payments are made monthly, quarterly, half-yearly, annually or at the time of maturity as per investor’s choice.
Investment in tax-saving FDs qualifies for tax benefits under Section 80C of the Income Tax Act, 1961. Moreover, the interest income is taxable as per the individual investor’s income tax slab rates. If the interest income exceeds INR 40,000 per annum (INR 50,000 for senior citizens), then the bank levies a TDS of 10% (20% if PAN Card are not disclosed).
Bonds are fixed-income instruments that offer a fixed rate of interest to the investors against the money invested. The investors lend money to the Government and corporations and get regular income in the form of interest. Bond issuers are the borrowers who raise money publicly or privately for funding various projects. A bond is an instrument that includes information on the interest, due date, maturity date, and bond terms. Investors of bonds are paid the entire amount after the bond expires (upon maturity). Investors can also sell the bond before maturity in the secondary market at higher prices and get profits.
Bonds are considered low-risk investments. However, there are certain risks attached to them. The most common risk is the default risk. Bond issuers can default on interest and principal repayment. However, investors can assess the risk in the bond before investing. They can do so by checking the credit rating of the bond. Bonds with higher credit rating are less likely to default on the payments than bonds with low credit rating. Bonds with AAA rating are considered the safest. Having bonds in one’s portfolio helps investors diversify their investment risk.
The Public Provident Fund is one of the post office savings schemes launched by the National Savings Institute. However, some private and nationalised banks are authorised to accept PPF investments. Returns from the scheme are guaranteed as the Government of India backs it. Hence are considered as low-risk investments. Furthermore, the PPF investments come with a 15 years lock-in period. Also, in case the investor wishes to extend the scheme, they can do so in blocks of 5 years. Furthermore, for the purpose of tax savings, one can invest in PPF.
The PPF interest rates are announced every quarter. The current rate is 7.10% for (Jan – March 2021). Also, the interest payments are made every year on the 31st of March. However, the interest is calculated monthly on the minimum PPF balance between the 5th and 30th each month.
Investment up to INR 1,50,000 per annum, qualifies for tax exemption under Section 80C of the Income Tax Act 1961.
Market Linked Investments
Market linked investments are those investments that do not guarantee returns and their returns are dependent on the market movements. These are considered high-risk investments. However, the returns from these investments are also high when the market rallies. Below is the list of the best market-linked investment options.
Investment in stocks is known as an equity investment. Buying stocks or shares would give investors a part of the ownership of that company. Investors invest in stocks with a motive to earn regular income in the form of dividends and also gain from capital appreciation. When the stock prices rise, investors can benefit from selling the shares.
Returns from stocks are market-linked and hence is considered the riskiest investment type. Share prices fluctuate based on market demand and supply and market sentiments. A bullish sentiment will lead to an unexpected rally of the market, while a bearish sentiment will lead to a drop in share prices.
Investing in the share market should be done with a long term investment horizon. In the short term, the market will fluctuate, which might lead to unexpected losses. Investors need to be patient while investing inequities.
To invest in shares, investors need to have a demat and trading account. A demat account will hold the shares while a trading account will facilitate the purchase and sale of shares. Short term capital gains from stock investing (below one year) are taxable at 15%. At the same time, long term capital gains are taxable at 10%, if the gains are above INR 1,00,000 per annum.
Mutual funds are investment vehicles that pool money from investors to invest in assets like equity and debt. A mutual fund invests in shares, government bonds, corporate bonds, and other assets strategically. The fund house appoints a portfolio manager or fund manager manages the mutual fund.
Every mutual fund has an investment objective, and the fund’s investments revolve around this. Mutual funds can be of several types based on the assets. For example, equity funds, debt funds and hybrid funds are three types of mutual funds based on the asset class. Similarly, funds can also be categorised based on their strategy, structure and investment option. There are also mutual funds that offer tax benefits. These are called Equity Linked Savings Scheme. or ELSS funds. Investment in these funds qualifies for tax deduction under Section 80C of the Income Tax Act, 1961.
Returns from mutual funds are taxable as per the investment holding period. Short term capital gains are subject to short term capital gains tax (STCG tax). At the same time, the long term capital gains are subject to long term capital gains tax (LTCG tax). Furthermore, tax rates vary for equity and debt mutual funds.
Exchange-Traded Funds (ETF)
The exchange-traded fund is a passive investment option that usually replicates the underlying index. In other words, ETFs portfolio matches the composition of an Index in the same proportion. An exchange-traded fund mimics and tracks the performance of the index. Hence ETFs are not actively managed by a portfolio manager. Furthermore, exchange-traded funds do not attempt to outperform their respective index.
There are different types of ETFs, for example, equity ETFs, bond ETFs, currency ETF, commodity ETFs, etc. Also, one can easily buy or sell them on the stock market.
National Pension Scheme (NPS)
National Pension Scheme (NPS) is a scheme suitable for retirement. Investors who wish for regular income post their retirement and also save tax can invest in NPS. The Central Government backs them and hence are considered as low-risk investments.
An investor can invest during the period of their employment at regular intervals. The scheme allows the investor to withdraw a percentage of the accumulated amount post-retirement. Also, the investor receives the remaining amount monthly as a pension post-retirement.
NPS has two types of accounts, namely NPS Tier I Account and NPS Tier II Account. Tier I account is a default account, while the Tier II account is a voluntary account.
NPS investments up to INR 1,50,000 qualify for tax benefits under Section 80C of the Income Tax Act, 1961. Furthermore, an additional INR 50,000 is eligible for tax deduction under Section 80CCD of the Income Tax Act, 1961.
Investments that do not come under fixed income or market-linked investments are other investments. These are also called alternative investments. Below is the list of the most popular alternative investment products.
Gold has always been a go-to asset or investment for Indians. It is also an asset with great emotional and social value. Buying gold coins, bars, biscuits, and jewellery on auspicious days has been a tradition in India for ages now. An asset with such sentimental value has also become popular in different forms. For example, gold bonds and gold ETFs are gaining popularity recently.
Gold is used as a hedge to protect one’s portfolio against potential market risk. Investing in gold doesn’t provide any regular income in the form of dividends and interest. However, it is a relatively liquid asset and can offer inflation-beating returns.
Investing in real estate involves purchase, ownership and management of the physical property. In other words, any investment in land, building, plant, property, etc. is considered as real estate investment. Investors main aim of investing in real estate is to sell the asset at a higher price in the future or generate regular income by way of rent.
Real estate investing best suits investors with a long term investment horizon. The prices of land and property do not fluctuate a lot in the short term. Hence investors with long term goals should look at investing in real estate. Before investing in real estate, investors have to be prudent and do their research about the market prices and get the papers provided by the seller authenticated by legal experts.
Real estate investing in India has shifted from owning physical property to owning a part of the property with low investment. This is possible through REITs or Real Estate Investment Trusts. Real Estate Investment Trusts (REIT) is an instrument with real estate properties as its underlying assets and investors can buy a share of REIT to earn steady income in the form of dividends. These dividends are paid from the rental income from the underlying properties.
Things to keep in mind while investing
Investing isn’t just about parking money in an instrument. Shortlisting the right asset is utmost important. Also, one should consider multiple aspects before investing in an asset. Following are some of the important things to keep in mind while investing:
Every asset has a unique investment objective. Therefore, it is very important to align one’s investment objective with that of the assets they wish to invest. All investment types do not meet the requirements of all the investors. What may be a good investment option for one investor doesn’t necessarily be the best for another. Hence, carefully aligning the financial plan and investment objective with the financial goal is important. For long term goals such as a child’s education, marriage, and retirement planning one can invest in equities. While for short term goals, one can consider investing in FDs, money market instruments, and other fixed-income investments.
Different types of investment options are suitable for different investment horizons. For example, a fixed deposit has a lock-in period of five years. Similarly, a PPF account has a lock-in period of 15 years. On the other hand, though mutual funds and equity investments do not have a lock-in period, it is advised to stay invested for at least three to five years. Therefore, depending on the investor’s financial goal, it is wise to choose a suitable investment option with the right investment horizon.
Risk translates to volatility in an investment scheme. In other words, it is the measure of price fluctuations of an asset in response to the change in market dynamics. For example, shares or equity investments are subject to high price volatility. While fixed deposits and other government-backed schemes offer guaranteed returns. Not all investors have an understanding of risk. Therefore, it is important to invest in assets with the volatility that one can absorb.
No investment offers the same returns. Few investments offer high returns; however, have significant risk associated with them. While, some investments offer guaranteed returns. All investors invest with an expectation of generating significant returns. Therefore, it is vital to understand the asset’s historical returns and performance. Historic returns do not guarantee future returns. However, it is always a good parameter to analyse the asset’s performance across different market cycles.
Costs and Expense
Every investment has certain cost or expense associated. For example, investing in shares attracts transaction cost. Mutual funds charge fund management cost, exit load, etc. Furthermore, few investments charge a penalty in case of premature withdrawals. Therefore, while shortlisting an investment, it is also important to consider the cost and expenses attached to them. It is always wise to invest in the scheme with low cost and expense.
It is important to invest in assets that offer good liquidity. Liquidity is important to address any unforeseen events. For example, mutual fund investments and stock market investments are highly liquid. One can easily sell their holdings and convert to cash. On the other hand, real estate investments are not highly liquid. An investor may not be able to liquidate the asset as soon as they have a need for money. Therefore, it is important to hold assets with good liquidity in one’s portfolio.
Some investments have a lock-in period. Lock-in period is the minimum duration for which the investor has to hold the investment. For example, PPF has a 15 year lock-in period, FDs too have a lock-in period of 5 years. Investment with lock-in period usually does not allow premature or partial withdrawals. However, in case of emergencies, one can withdraw with some penalty. Therefore, before investing, it is important to be aware that the funds would not be available for the duration of the lock-in period.
Returns from investments are taxable. For example, returns from mutual fund investments are subject to tax on the basis of their holding period and type of fund. While on the other hand, PPF investments are eligible for a tax deduction and the returns are completely tax-free. Hence, it is essential to know the tax obligation on the returns from an investment. One can use an income tax calculator to estimate their tax liability. Scripbox Income Tax Calculator is available online and is free to use. One can use it to estimate their taxable income.