Table of Contents

Investors and their Financial Goals:

  • The discussion of investments should start with the purpose of investment, the "why" behind it.
  • Financial goals are the needs for money that cannot be fulfilled through current income.
  • Examples of financial goals include funding a child's education, retirement funding, buying a house, and generating regular income.
  • Goal setting is important in investment planning and involves identifying events, assigning priorities, and setting timelines and funding amounts.
  • Financial goals can be classified as short-term needs or long-term goals.
  • It is crucial to plan for important but not urgent goals to avoid them becoming urgent and overwhelming.
  • Inflation must be considered when assigning amounts to financial goals, as costs tend to rise over time.
  • Inflation impacts the affordability of long-term goals, while immediate and near-term goals may not be significantly affected.
  • Cash flow mismatches are common in financial goals, which can be addressed by accumulating savings and investing wisely.

Table: Financial Goals Matrix

Critically important (responsibilities or needs)DreamsGood-to-have
Immediate termRetirement fundingBuying a houseGrand vacation
Near termChild's education fundingStarting a businessSabbatical
Medium termMarriage expensesRenovating a houseBuying a vehicle
Long termHealthcare expenses in retirementHigher educationLifestyle in retirement

Note: The matrix classifies financial goals based on their importance and timeline, categorizing them as critically important, dreams, or good-to-have goals in the immediate, near, medium, and long term.

Savings or Investments:

  • Saving and investing are not the same. Saving focuses on the safety of money, while investing aims to earn profits.
  • Saving is the first step towards investing, as one needs to save money before investing it.
  • The three important factors to evaluate investments are safety, liquidity, and returns.
  • Safety refers to the safety of capital invested and the surety of income from the investment.
  • Liquidity measures how easily an investment can be converted to cash and considers factors like lock-in periods or penalties for early withdrawal.
  • Returns include current income (periodic income received without selling the investment) and capital gains (realized when the investment is sold).
  • Convenience should be considered in terms of investing, withdrawing money, checking the value of the investment, and receiving income.
  • Ticket size indicates the minimum amount required for investment, which varies across different investment options.
  • Taxability of income is an important factor to consider, as it affects the amount retained after taxes.
  • Tax deductions may be available for certain investments, but they may come with lock-in periods or specific conditions.
  • All factors should be evaluated together, considering the investor's situation and goals.

Table: Factors to Evaluate Investments

SafetySafety of capital invested and the surety of income from the investment
LiquidityEase of converting the investment to cash and divisibility
ReturnsCurrent income (periodic income) and capital gains
ConvenienceEase of investing, withdrawing, checking value, and receiving income
Ticket sizeMinimum investment amount required
Taxability of incomeTax implications on investment earnings
Tax deductionAvailability of tax deductions for certain investments

Different Asset Classes:

  • Asset classes group various investment avenues based on similar characteristics.
  • The four broad asset categories are Real Estate, Commodities, Equity, and Fixed Income.
  • Real estate includes residential, commercial, and land properties. It offers capital appreciation and can generate current income through rent.
  • Commodities include gold and silver. They are globally accepted assets, primarily providing capital appreciation and not current income.
  • Fixed income involves bonds and debentures issued by governments, corporations, banks, etc. It offers regular interest payments and can be considered safer than equity.
  • Equity represents ownership in a business through shares. It historically generates higher returns than other investments, offering capital appreciation and dividends.
  • Asset classes differ in terms of form (financial or physical), purpose (investment or consumption), and ownership (lender or owner).
  • Different investment avenues fall under each asset class, such as stocks, mutual funds, real estate investment trusts (REITs), gold funds, and debt instruments.
  • Hybrid asset classes combine elements from multiple asset classes, such as hybrid mutual funds or investments in rare coins and art.
  • It is essential to understand the characteristics and risks associated with each asset class before making investment decisions.

Table: Investment Avenues Classified under Different Asset Categories

Asset ClassInvestment Avenues
Real EstateResidential/commercial properties, real estate mutual funds, REITs, InvITs
CommoditiesGold, silver, gold funds, commodity ETFs
EquityBlue-chip, mid-sized, and small-sized companies' stocks, equity mutual funds, index funds, foreign stocks
Fixed IncomeFixed deposits, recurring deposits, bonds, debt mutual funds, post office schemes, senior citizens' savings scheme
HybridHybrid mutual funds, rare coins, art, rare stamps

Investment Risks:

  1. Inflation Risk:
    • Inflation erodes the purchasing power of money over time.
    • Investments should aim to protect against inflation by generating returns higher than the inflation rate.
    • Failure to account for inflation can result in falling short of financial goals.
  2. Liquidity Risk:
    • Liquidity refers to the ease of converting an investment into cash without incurring significant costs.
    • Some investments have restrictions or penalties for early withdrawal, limiting liquidity.
    • Real estate and certain fixed-term investments may have low liquidity, requiring time to sell or access funds.
  3. Credit Risk:
    • Credit risk relates to the possibility of default by the borrower or issuer of a debt instrument.
    • Factors affecting credit risk include the stability and profitability of the borrower.
    • Investments in government bonds are generally considered safer than those in corporate bonds or debentures.
  4. Market Risk and Price Risk:
    • Market risk refers to fluctuations in securities' prices due to market-wide factors.
    • Price risk is specific to a particular security and can be influenced by firm-specific or industry-specific factors.
    • Diversification can reduce security-specific risks, but market-wide risks cannot be eliminated through diversification.
  5. Interest Rate Risk:
    • Interest rate risk is the risk that the value of an investment will change due to changes in interest rates.
    • Bond prices and interest rates have an inverse relationship. When interest rates rise, bond prices decrease, and vice versa.
    • Longer-term bonds are more susceptible to interest rate fluctuations compared to shorter-term bonds.

Understanding and managing these risks is crucial for investors to make informed decisions and align their investment strategies with their financial goals. Diversification, asset allocation, and regular review of investments can help mitigate these risks and enhance overall portfolio performance.

Risk Measures and Management Strategies:

  1. Avoidance:
    • Avoid investing in products or asset classes that carry risks one is not comfortable with or does not understand.
    • By avoiding certain investments, the associated risks can be mitigated, but potential returns may also be missed.
  2. Opportunistic Positioning:
    • Take investment positions based on anticipated market developments or events.
    • For example, adjusting bond investments based on expectations of interest rate changes.
    • This strategy requires superior knowledge and market insights, and is generally not recommended for most investors.
  3. Diversification:
    • Spread investments across different asset classes, sectors, and geographic regions.
    • Diversification helps reduce risk by not putting all eggs in one basket.
    • By diversifying, losses in one investment may be offset by gains in others, reducing overall portfolio volatility.
  4. Risk Measurement:
  • Credit risk can be measured through credit ratings and credit spreads.
  • Price volatility risk can be measured using metrics like variance, standard deviation, beta, and modified duration.

Risk management strategies should be aligned with an investor's risk tolerance, investment goals, and time horizon. It is important to regularly review and assess the risk profile of an investment portfolio and make necessary adjustments to manage risk effectively. Working with a financial advisor or professional can provide valuable insights and guidance in managing investment risks.

Behavioural Biases in Investment Decision Making:

Behavioural biases can significantly impact investment decision making. Understanding these biases is crucial for investors to make more informed and rational choices. Some common behavioural biases include:

  1. Availability Heuristic:
    • Relying on readily available examples or experiences when evaluating investment options.
    • May lead to overlooking critical information and risks associated with investments.
  2. Confirmation Bias:
    • Seeking out information that confirms pre-existing beliefs or views.
    • Interpreting new information in a way that supports existing views.
    • Can prevent investors from considering alternative perspectives and risks.
  3. Familiarity Bias:
    • Preferring familiar investments over exploring new opportunities.
    • Limiting diversification and potentially missing out on better investment options.
  4. Herd Mentality:
    • Tendency to follow the crowd and conform to popular investment trends.
    • Can lead to poor decision making and herd-induced market volatility.
  5. Loss Aversion:
    • Preference for avoiding losses over acquiring equivalent gains.
    • May result in missed opportunities and conservative investment choices.
  6. Overconfidence:
    • Excessive belief in one's own abilities or judgment.
    • Can lead to underestimating risks and taking on excessive risks.
  7. Recency Bias:
    • Giving more weight to recent events or experiences when making investment decisions.
    • Overestimating the likelihood of a repeat event, leading to biased decision making.
  8. Behaviour Patterns:
    • Personal factors influencing saving and investment habits.
    • Understanding one's behaviour patterns can help align investment strategies with individual goals.
  9. Interest of the Investors:
    • Decision-making influenced by the investor's personal interest rather than suitability.
    • Can result in imbalanced portfolios and increased concentration of risk.
  10. Ethical Standards:
    • Adherence to ethical principles impacting investment behaviour.
    • Following ethical norms can promote disciplined investing and long-term wealth building.

It is important for investors to recognize these biases and strive for rational decision making. Conducting thorough research, seeking diverse perspectives, and being aware of one's own biases can help mitigate their impact on investment choices.

Understanding Asset Allocation:

Asset allocation is the process of allocating an investor's money across different asset categories to achieve specific objectives. It involves determining the appropriate distribution of funds based on the investor's financial goals and risk profile. There are two popular approaches to asset allocation: strategic asset allocation and tactical asset allocation.

  1. Strategic Asset Allocation:
    • Aligns the allocation with the investor's financial goals.
    • Considers the required returns, time horizon, and risk tolerance.
    • Maintains a target allocation across various asset categories.
    • Determined based on analysis of investor needs and risk appetite.
  2. Tactical Asset Allocation:
    • Involves dynamically changing the allocation between asset categories.
    • Aims to take advantage of market opportunities and improve risk-adjusted returns.
    • May reduce portfolio risk without compromising returns or enhance returns without increasing risk.
    • Typically suitable for experienced investors with a significant investible surplus.


  • Rebalancing refers to making modifications in the asset allocation to restore the target allocation.
  • In strategic asset allocation, periodic rebalancing is required as asset categories may deviate from the target allocation.
  • Rebalancing allows investors to buy low and sell high, aligning the allocation with the original target.
  • It can be done automatically without predicting market directions.
  • Rebalancing is also necessary when the investor's needs or risk appetite change.

SEBI (Securities and Exchange Board of India) has provided guidelines for rebalancing timelines to ensure uniformity across mutual funds. Deviations from mandated asset allocation need to be addressed within 30 business days, except for Index Funds, Exchange Traded Funds, and Overnight Funds.

Rebalancing plays a crucial role in maintaining a disciplined investment approach and managing risk. It helps investors stay on track with their asset allocation strategy and ensures their investments are aligned with their long-term financial objectives.

Do-it-yourself versus Taking Professional Help:

When it comes to managing investments, investors have the option to do it themselves or seek professional help. This decision can be broken down into three components: ability, preference, and affordability.

  1. Can one do the job oneself?
    • Assessing one's ability is crucial. It involves having the necessary skills, knowledge, and time to manage investments effectively.
    • If one lacks the expertise or doesn't have enough time to dedicate to investment management, outsourcing may be a better option.
  2. Does one want to do it?
    • Even if one has the skills and knowledge, personal preferences matter. Some individuals may not enjoy the research, analysis, and administrative tasks involved in managing investments.
    • Prioritizing other activities or one's main profession may also make outsourcing more desirable.
  3. Can one afford to outsource?
    • There is a cost associated with professional help, such as mutual fund management fees.
    • Comparing these fees to the cost of managing investments oneself can be misleading. Hidden costs, such as the value of one's time and potential mistakes made by individual investors, need to be considered.

Considering the value of one's time, it may not be worth spending significant effort for minimal savings in management fees. The emotional attachment to personal finances can also lead to mistakes when managing investments independently.

In most cases, investing through mutual funds is a better option than self-managing portfolios. Mutual funds provide professional expertise, diversification, and management of risks. The next chapter will discuss mutual funds and their role in an investor's portfolio.

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