UNIT – 1

Introduction

Financial planning is the process of taking a comprehensive look at your financial situation
and building a specific financial plan to reach your goals. As a result, financial planning often
delves into multiple areas of finance, including investing, taxes, savings, retirement, your
estate, insurance and more. As you might expect, a financial planner typically offers financial
planning services, though financial advisors often double as planners themselves. To find an
advisor who can help you build a financial plan, try SmartAsset’s free financial advisor
matching tool.

What Is Financial Planning?

Financial planning is the practice of putting together a plan for your future, specifically
around how you will manage your finances and prepare for all of the potential costs and
issues that may arise. The process involves evaluating your current financial situation,
identifying your goals and then developing and implementing relevant recommendations.

Financial planning is holistic and broad, and it can encompass a variety of services, which we
detail below. Rather than focusing on a single aspect of your finances, it views clients as real
people with a variety of goals and responsibilities. It then addresses a number of financial
realities to figure out how to best enable people to make the most of their lives.

Financial planning is not the same as asset management. Asset management generally refers
to managing investments for a client. This includes choosing the stocks, bonds, mutual funds
and other investments in which a client should invest their money.

However, the same professionals who offer asset management services can also offer
financial planning. A financial planner is effectively one type of financial advisor. Advisors
can earn certifications focused on financial planning, the most notable of which is certified
financial planner.

Understanding the Different Types of Financial Planning

A financial planner may offer a variety of services to you. These services will
often be considered in concert with one another. This helps the planner put
together an overall plan that considers all aspects of your current situation
and future aspirations.

Here are eight common services that are generally offered as part of
financial planning:
 Tax planning: Financial planners often help clients address certain tax
issues. They can also figure out how to maximize your tax refunds and
minimize your tax liability. Certain advisors may also be able to actually
help you with preparing your taxes and filing your annual taxes.

 Estate planning: Estate planning seeks to make things a bit easier for your
loved ones after you die. Preparing a will may be part of a financial
planner’s services. Estate planning also helps prepare for any estate tax you
may be subject to.

 Retirement planning: You presumably want to stop working someday.

Retirement planning services help you prepare for that day. They ensure
that you’ve saved enough money to live the lifestyle you want in retirement.

 Philanthropic planning: It’s always nice to give something to people who

need it or help a cause close to your heart. Financial planning can help you
ensure you’re doing it efficiently and getting all the tax benefits you’re
eligible for.

 Education funding planning: If you have children or other dependents

who wish to pursue a college degree, you may want to help them to pay for
it. Financial planning can help make sure you are able to do so.

 Investment planning: Though financial planning doesn’t include the actual

management of your assets, it can still help with your investment portfolio
by mapping out how much you should be investing and in which types of
investments.

 Insurance planning: A financial planner can help you evaluate your

insurance needs. Some financial planners are also licensed insurance agents
and can sell you insurance themselves. However, they’ll likely earn a
commission, which would create a conflict of interest.
 Budgeting: This is perhaps the cornerstone of financial planning. A planner
can make sure you are spending the right amount given your income and
can also make sure that you aren’t going into debt.

How to Make a Financial Plan

 Here are four key facets of a sound financial plan.

 Gauge your net worth – Add everything you own and tally up
everything you owe. This includes physical assets like cars and
residences, and financial assets like stocks, bonds, IRAs and 401(k)s.
The upshot is your net worth. Once you have a sense of what you’ve
got, you’ll be in a position to make a plan.
 Establish financial goals – Step One in the process is making specific
goals. This should be an inclusive, encompassing funding education,
meeting healthcare expenses, creating an emergency fund, planning
for retirement and creating an estate plan.
 Monitor cash flow – This is often the most challenging part of
making a financial plan, partly because many of us don’t pay
particularly close attention to every dollar and dime we spend and
partly because it may not be fun to get up close and personal with
your discretionary spending.
 Create pathways to each of your financial goals – In some cases
that will mean moving money into high-yield savings accounts, which
as of June 2023 were offering up to 4.85% APY. In other cases it will
mean paying down debt, starting with the highest-cost debt, such as
credit card debt. It may also mean adjusting your spending.
 How Much Money Do You Need for Financial
Planning?

The cost of financial planning depends largely on the advisor you work with
and that advisor’s fee schedule. Many financial advisors who offer financial
planning services will do so on either a flat fee or hourly fee basis.

A flat fee means you’ll pay a single fee for all financial planning services.
Your total fee will likely depend on the value of your assets under the
advisor’s management as well as the complexity of the financial planning
services you require. An hourly fee structure means you’ll pay a set fee for
each hour of work that your advisor puts in.

A financial advisor or financial planner who offers both financial planning

and investment advisory services may charge a wrap fee. This means you’ll
pay a single rate for the advisor’s services, transactional fees
and custodial fees. Wrap fee rates are generally based on a percentage of
the client’s overall assets under management (AUM).

The Bottom Line

Financial planning is about looking at all elements of a person’s financial

life and coming up with a plan to help you as an individual meet your
responsibilities and achieve your goals. It can include a number of services
such as tax planning, estate planning, philanthropic planning and college
funding planning. You might pay based on an hourly fee, a flat fee or an
asset-based fee.

Tips for Your Financial Plan

 Financial planning is extremely important, but it can be intimidating to do it

on your own. Finding a financial advisor doesn’t have to
 be hard. SmartAsset’s free tool matches you with up to three
vetted financial advisors who serve your area, and you can interview
your advisor matches at no cost to decide which one is right for you. If
you’re ready to find an advisor who can help you achieve
your financial goals, get started now.

 Before even talking to an advisor, you can think about how you want to
potentially divvy up your investable assets. Use this free asset allocation
calculator to figure out the right balance for you based on your risk
tolerance.

Elements of financial plan

To explain the importance of financial planning, we will discuss the seven steps involved
in financial planning. We will describe in brief what these steps are:-

 Defining and setting goals: This involves defining your financial goals, timelines by
which you want to achieve these goals and quantifying the goals factoring in inflation.
 Expense budgeting: You need to save money to invest for your financial goals.
Expense budgeting determines how much you can spend, which expenses you can
reduce in order to save more.
 Assessing your risk appetite: In this step, your financial advisor will assess your risk
appetite based on your age, income, expenses and financial liabilities (e.g. loans).
Your advisor may also assess your risk tolerance, which is personality based and how
you react to adverse events.
 Asset allocation: This refers to the mix of different asset classes e.g. equity, fixed
income, gold etc. in your investment portfolio. Asset allocation is essential for risk
diversification and achieving your financial goals. Your asset allocation will depend
on your goals and risk appetite.
 Investment plan: Investment plan is essentially knowing how much to invest and
where to invest. Systematic Investment Plans (SIPs) are usually recommended for
your long term financial goals. Your investment plan may have a mix of equity, debt
and hybrid funds depending on your asset allocation requirements.
 Risk protection plan: An unfortunate death, critical illness or serious accident can
cause financial distress to your family. Risk protection is an important element of
your financial plan. You need to have adequate amount of life and health insurance
cover.
 Monitoring and tracking: You need to track progress of your financial plan towards
different goals and take actions if required. Over a period of time, your goals may also
change and you may have to make changes to your financial plan accordingly.

Why financial planning is important?

Many investors do not understand the significance of financial planning and think that if
they are able to save money, they will have financial security. But saving is not enough. Let
us assume average life span of 75 – 80 years. Your needs for the first 20 – 25 years of your
life are taken care of by your parents. Your working life will typically be about 35 years long
during which you will have to take care of the needs of your family (e.g. spouse, children,
dependent parents etc.) and also save enough, to take care of your needs during the 15 to 20
years of your retired lives.

Inflation reduces the purchasing power of money in the long term and therefore, your money
needs to grow at a faster rate than inflation if you want to achieve your financial goals.
Certain expenses like education, medical etc. are inflating at a much faster rate than CPI
inflation. You need to plan for it. Also, with rising incomes lifestyle changes, which means
more expenses. It is not easy to change your lifestyle once you get habituated to it. You need
that much more savings, if you want to achieve financial independence and also maintain
your lifestyle. Given these challenges, you should know the importance of financial
planning and know how much to save and invest, know where to invest and most
importantly, start saving and investing from an early stage of your working life, in order to
meet all your aspirations.

Benefits of financial planning

 Save and invest more for your goals: Investors who are able to save and invest more
will be able to create more wealth. Saving and investing according to a financial plan
instils a greater sense of purpose in your journey for financial well-being and financial
independence in the long term. The most important aspect of a good financial plan is
goal linkage with investments. We have emotions attached with goals like buying
your own home, children’s higher education, children’s marriage, leaving a estate for
your loved ones etc. The emotional attachment makes your more committed to your
financial plan. This is the significance of financial planning.
 Disciplined investing: Discipline in investing e.g. sticking to your SIP irrespective of
market conditions, adhering to your asset allocation, regular re-balancing etc., are
essential in achieving success. You are likely to be more disciplined if you are
investing according to a plan.
 Helps you reduce debt / be debt free: Cost of debt can be a huge burden on your
savings and harm your long term financial interests. If you invest according to a
financial plan, you can fund big ticket spending e.g. vacation, buying / upgrading your
vehicle, bigger down payment for home purchase etc. from your investments and
reduce your debt burden.
 Better risk diversification: Asset allocation and risk diversification is a critical
component of a financial plan. If you do not have a financial plan, you may invest in
assets that give higher returns in bull markets and this may increase the risk in your
portfolio. One of the benefits of financial planning is to protect your financial goals
from the vagaries of capital markets.
 Improve lifestyle in a sustainable way: Despite rising disposable incomes, average
household debt in India is rising. This shows that investors are funding their lifestyles
through credit cards, personal loans etc. Debt funded lifestyle improvements may not
be sustainable. Sometimes it is seen that, parents spend a bulk of their savings on their
children’s higher education and then compromise on lifestyle to save for their
retirement. If you practise goal based investing, you can improve your lifestyle in
sustainable way, without relying on debt or compromising on other financial goals.
  Save taxes: Having an investment plan can help you save taxes under section 80C
and also invest in the most tax efficient investment options according to your financial
goals and asset allocation.

4 Key Steps Of Successful Financial Planning

To help you get started with financial planning, let’s take a look at the key steps involved in
the process. We will describe in brief what these steps are and then explain them with an
example.

Step 1 – Set SMART Goals

This step in financial planning involves defining your financial goals. And while you do it,
you have to be SMART (Specific, Measurable, Attainable, Relevant, and Timebound). For
example, just saying that you will retire rich is not a SMART goal. But accumulating Rs. 5
crores for post-retirement life by the age of 60 is a SMART goal.

When you write down goals this way, it helps you prioritize the most important goals in your
life. You also become realistic about your goals and work vigorously to achieve them.

Take for example the above goal of accumulating Rs. 5 crores by the age of 60. Say, the
person is 35 years old. So he has 25 years to achieve this target. Now, all he needs to find out
is how much he has to invest and what kind of returns he needs to earn.

Here is a table that explores various possibilities to reach the target of Rs. 5 crore in 25 years:

Required Rate Of Return Monthly Investment Amount Required

7% Rs. 52,500

10% Rs. 37,500

12% Rs. 26,500

Step 2 – Budget Your Expenses

To ensure that you get to your goals securely, you have to invest as much as possible. It will
be possible only when you cut down on discretionary spending or avoidable expenses and use
those savings to invest more.
Step 3 – Find Out Where To Invest

This step involves figuring out where to invest. For instance, if you are investing for long-
term goals you can invest in equities, whereas for short-term goals, you can invest in low-risk
products like fixed deposits or Debt Funds.

Overall, your investment plan will have a mix of different assets like Indian equity,
international equity, debt, and gold. The mix of this asset allocation will depend on your risk
profile, which involves assessing how much risk you can take. For instance, you need to find
out if you are comfortable with a 20-30% decline in your portfolio. If the answer is yes, you
can invest in equity. But if the answer is no, you have to minimize your allocation to equities.

This assessment of how much risk you can take is done by factoring in multiple variables
such as your age, income, lifestyle, loans, responsibilities, etc. Determining your risk profile
also involves assessing your personality based and how you react to adverse events.

The old-school way of risk profiling an investor has been labeling them as Conservative,
Moderate, or Aggressive. At ET Money, we never understood that. Nor we do now. We
looked at this deeper and came up with a dynamic risk score. You can find out your risk score
and unique personality here.

Step 4 – Monitoring And Rebalancing

An investment plan is not a one-time thing that you create and forget. After making the
investment plan, you will have to keep tracking your progress toward different goals. From
time to time, you will need to weed out the underperforming investments and include
emerging investment opportunities. You will also need to rebalance your asset
allocation from time to time. Otherwise, your investments may digress from the original asset
allocation and consequently lead to counterproductive outcomes.

What Is Diversification?
Diversification is a risk management strategy that creates a mix of various
investments within a portfolio. A diversified portfolio contains a mix of
distinct asset types and investment vehicles in an attempt to limit exposure
to any single asset or risk.

The rationale behind this technique is that a portfolio constructed of

different kinds of assets will, on average, yield higher long-term returns
and lower the risk of any individual holding or security.

Understanding Diversification
Studies and mathematical models have shown that maintaining a well-
diversified portfolio of 25 to 30 stocks yields the most cost-effective level of
risk reduction. Investing in more securities generates further diversification
benefits, but it does so at a substantially diminishing rate of effectiveness.

Diversification strives to smooth out unsystematic risk events in a portfolio,

so the positive performance of some investments neutralizes the negative
performance of others. The benefits of diversification hold only if the
securities in the portfolio are not perfectly correlated—that is, they respond
differently, often in opposing ways, to market influences.

Diversification Strategies
As investors consider ways to diversify their holdings, there are dozens of
strategies to implement. Many of the methods below can be combined to
enhance the level of diversification within a single portfolio.

Asset Classes
Fund managers and investors often diversify their investments across
asset classes and determine what percentages of the portfolio to allocate
to each. Each asset class has a different, unique set of risks and
opportunities. Classes can include:

 Stocks: Shares or equity in a publicly traded company

 Bonds: Government and corporate fixed-income debt instruments
 Real estate: Land, buildings, natural resources, agriculture,
livestock, and water and mineral deposits
 Exchange-traded funds (ETFs): A marketable basket of securities
that follow an index, commodity, or sector
 Commodities: Basic goods necessary for the production of other
products or services
 Cash and short-term cash-equivalents (CCE): Treasury bills,
certificate of deposit (CD), money market vehicles, and other short-
term, low-risk investments

The theory holds that what may negatively impact one asset class may
benefit another. For example, rising interest rates usually negatively
impact bond prices as yield must increase to make fixed income securities
more attractive. On the other hand, rising interest rates may result in
increases in rent for real estate or increases in prices for commodities.

Industries/Sectors
There are tremendous differences in the way different industries or sectors
operate. As investors diversify across various industries, they become less
likely to be impacted by sector-specific risk.
For example, consider the CHIPS and Science Act of 2022.1 This
legislation impacts many industries, though some companies are more
affected than others. Semiconductor manufacturers will be largely
impacted, while the financial services sector might feel smaller, residual
impacts.

Investors can diversify across industries by coupling investments that may

counterbalance different businesses. For example, consider two major
means of entertainment: travel and digital streaming. Investors hoping to
hedge against the risk of future major pandemic impacts may invest in
digital streaming platforms (positively impacted by more shutdowns). At
the same time, they may consider simultaneously investing in airlines
(positively impacted by fewer shutdowns). In theory, these two unrelated
industries may minimize overall portfolio risk.

Corporate Lifecycle Stages (Growth vs. Value)

Public equities tend to be broken into two categories: growth
stocks and value stocks. Growth stocks are stocks in companies that are
expected to experience profit or revenue growth greater than the industry
average. Value stocks are stocks in companies that appear to be trading at
a discount based on the current fundamentals of a company.

Growth stocks tend to be more risky as the expected growth of a company

may not materialize. For example, if the Federal Reserve constricts
monetary policy, less capital is usually available (or it is more expensive to
borrow), creating a more difficult scenario for growth companies. However,
growth companies may tap into seemingly limitless potential and exceed
expectations, generating even greater returns than expected.

On the other hand, value stocks tend to be more established, stable

companies. While these companies may have already experienced most
of their potential, they usually carry less risk. By diversifying into both, an
investor would capitalize on the future potential of some companies while
also recognizing the existing benefits of others.

Market Capitalizations (Large vs. Small)

Investors may want to consider investing across different securities based
on the underlying market capitalization of the asset or company. Consider
the vast operational differences between Apple and Newell Brands Inc. In
July 2023, both companies were in the S&P 500, with Apple representing
7.6% of the index and Newell Brands representing 0.0065%.3

Each company will have a considerably different approach to raising

capital, introducing new products to the market, brand recognition, and
growth potential. Lower cap stocks have more room to grow, though higher
cap stocks tend to be safer investments.

Risk Profiles
Across almost every asset class, investors can choose the underlying risk
profile of the security. For example, consider fixed-income securities. An
investor can choose to buy bonds from the top-rated governments in the
world or from nearly defunct private companies raising emergency funds.
There are considerable differences between several 10-year bonds based
on the issuer, their credit rating, future operational outlook, and existing
level of debt.

The same can be said for other types of investments. Real estate
development projects with more risk may carry greater upside than
established operating properties. Meanwhile, cryptocurrencies with longer
histories and greater adoption, such as Bitcoin, carry less risk relative to
smaller market cap coins or tokens.

Maturity Lengths
Specific to fixed-income securities such as bonds, different term lengths
impact risk profiles. Generally, the longer the maturity, the higher the risk
of fluctuations in the bond's prices due to changes in interest rates. Short-
term bonds tend to offer lower interest rates; however, they also tend to be
less impacted by uncertainty in future yield curves. Investors more
comfortable with risk may consider adding longer term bonds that tend to
pay higher degrees of interest.

Maturity length is also prevalent in other asset classes. Consider the

difference between short-term lease agreements for residential properties
(i.e., up to one year) and long-term lease agreements for commercial
properties (i.e., sometimes five years or greater). Though there is more
security in collecting rent revenue by locking into a long-term agreement,
investors sacrifice flexibility to increase prices or change tenants.

Physical Locations (Foreign vs. Domestic)

Investors can reap further diversification benefits by investing in foreign
securities. For example, forces depressing the U.S. economy may not
affect Japan's economy in the same way. Therefore, holding Japanese
stocks gives an investor a small cushion of protection against losses
during an American economic downturn.

Alternatively, there may be a greater potential upside (with associated

higher degrees of risk) when diversifying across developed and emerging
countries. Consider Pakistan's current classification as a frontier
market participant (recently downgraded from an emerging market
participant).4 Investors willing to take on higher levels of risk may want to
consider the higher growth potential of smaller yet-to-be-fully established
markets such as Pakistan.

Tangibility
Financial instruments such as stocks and bonds are intangible
investments; they can not be physically touched or felt. On the other hand,
tangible investments such as land, real estate, farmland, precious metals,
or commodities can be touched and have real-world applications.
These real assets have different investment profiles as they can be
consumed, rented, developed, or treated differently than intangible or
digital assets.

There are also unique risks specific to tangible assets. Real property can
be vandalized, physically stolen, damaged by natural conditions, or
become obsolete. Real assets may also require storage, insurance, or
security costs to carry. Though the revenue stream differs from financial
instruments, the input costs to protect tangible assets are also different.

Diversification Across Platforms

Regardless of how an investor considers building their portfolio, another
aspect of diversification relates to how those assets are held. Though this
is not an implication of the investment's risk, it is an additional risk worth
considering as it may be diversifiable.

For example, consider an individual with $400,000 of U.S. currency. In all

three of the situations below, the investor has the same asset allocation.
However, their risk profile is different:

 The individual may deposit $200,000 at one bank and $200,000 at a

second bank. Both deposits are under the FDIC insurance limit per
bank and are fully insured.
 The individual may deposit $400,000 at a single bank. Only a portion
of the deposit is covered by insurance. In addition, should that single
bank experience a bank run, the individual may not have immediate
access to cash.
 The individual may physically store $400,000 of cash in their home.
Though immediately accessible, the individual will not yield any
interest or growth on their cash. In addition, the individual may lose
capital in the event of theft, fire, or by misplacing it.

The same concept above relates to almost every asset class. For
example, Celsius Network filed for bankruptcy in July 2022.5 Investors
holding cryptocurrency with the exchange experienced the inability to
withdraw or transfer funds. Had investors diversified across platforms, the
risk of loss would have been spread across different exchanges.

Diversification and Retail Investors

Time and budget constraints can make it difficult for noninstitutional
investors—i.e., individuals—to create an adequately diversified portfolio.
This challenge is a key to why mutual funds are so popular with retail
investors. Buying shares in a mutual fund offers an inexpensive way to
diversify investments.

While mutual funds provide diversification across various asset classes,

exchange-traded funds (ETFs) afford investor access to narrow markets,
such as commodities and international plays, that would ordinarily be
difficult to access. An individual with a $100,000 portfolio can spread the
investment among ETFs with no overlap.

There are several reasons why this is advantageous to investors. First, it

may be too costly for retail investors to buy securities using different
market orders. In addition, investors must then track their portfolio's weight
to ensure proper diversification. Though an investor sacrifices a say in all
of the underlying companies being invested in, they simply choose an
easier investment approach that prioritizes minimizing risk.

Pros and Cons of Diversification

The primary purpose of diversification is to mitigate risk. By spreading your
investment across different asset classes, industries, or maturities, you are
less likely to experience market shocks that impact every single one of
your investments the same.

There are other benefits to be had as well. Some investors may find
diversification makes investing more fun as it encourages exploring
different unique investments. Diversification may also increase the chance
of hitting positive news. Instead of hoping for favorable news specific to
one company, positive news impacting one of dozens of companies may
benefit your portfolio.

However, there are drawbacks to diversification. The more holdings a

portfolio has, the more time-consuming it can be to manage—and the
more expensive, since buying and selling many different holdings incurs
more transaction fees and brokerage commissions. More fundamentally,
diversification's spreading-out strategy works both ways, lessening the risk
and the reward.
For instance, imagine you've invested $120,000 equally among six stocks,
and one stock doubles in value. Your original $20,000 stake is now worth
$40,000. You've made a lot, sure, but not as much as if your entire
$120,000 had been invested in that one company. By protecting you on
the downside, diversification limits you on the upside—at least in the short
term.

Pros

 Reduces portfolio risk

 Hedges against market volatility

 Offers potentially higher returns long-term

 May be more enjoyable for investors to research new investments

Cons

 Limits gains short-term

 Time-consuming to manage

 Incurs more transaction fees, commissions

 May be overwhelming for newer, unexperienced investors

Diversifiable vs. Non-Diversifiable Risk

The idea behind diversification is to minimize (or even eliminate) risk within
a portfolio. However, there are certain types of risks you can diversify
away, and certain types of risks exist regardless of how you diversify.
These types of risks are called unsystematic and systematic risks.

Consider the impact of COVID-19. Due to the global health crisis, many
businesses stopped operating. Employees across many industries were
laid off, and consumer spending across all sectors declined. On one hand,
the economic slowdown negatively impacted almost every sector. On the
other, nearly every sector then benefited from government intervention and
monetary stimulus. The impact of COVID-19 on financial markets was
systematic.

In general, diversification aims to reduce unsystematic risk. These are the

risks specific to an investment that are unique to that holding. Examples of
diversifiable, non-systematic risks include:
  Business risk: The risk related to a specific company based on the
nature of its company and what it does in the market.
 Financial risk: The risks related to a specific company or
organization's financial health, liquidity, and long-term solvency.
 Operational risk: The risk related to breakdowns in manufacturing
or goods distribution processes.
 Regulatory risk: The risk that legislation may adversely impact the
asset.

Through diversification, investors strive to reduce the risks above, which

are controllable based on the investments held.

Measuring Diversification
It can become complex and cumbersome to measure how diversified a
portfolio is. In reality, it is impossible to calculate the actual degree of
diversification; there are simply too many variables to consider across too
many assets to truly quantify a single measure of diversification. Still,
analysts and portfolio managers use several measurements to get a rough
idea of how diversified a portfolio is.

Correlation Coefficient
A correlation coefficient is a statistical measurement that compares the
relationship between two variables. This statistical calculation tracks the
movement of two assets and whether the assets tend to move in the same
direction. The correlation coefficient result varies from -1 to 1, with
interpretations ranging from:

 Closer to -1: There is strong diversification between the two assets,

as the investments move in opposite directions. There is a strong
negative correlation between the two variables being analyzed.
 Closer to 0: There is moderate diversification between the two
assets, as the investments have no correlation. The assets
sometimes move together, while other times, they don't.
 Closer to 1: There is a strong lack of diversification between the two
assets, as the investments move in the same direction. There is a
strong positive correlation between the two variables being
analyzed.

Standard Deviation
Standard deviation (SD) measures how often and far an outcome occurs
away from the mean. For investments, standard deviation measures how
far away from an asset's average return other returns fall. Analysts use SD
to estimate risk based on return frequency.
For example, imagine two investments, each with an average annual
return of 5%. One has a high standard deviation, which means the
investment returns can vary greatly. The other investment has a low
standard deviation, meaning its returns have been closer to 5%. The
higher the standard deviation, the more risk there is—but there is a chance
for higher returns.

A portfolio full of investments with high standard deviations may have

higher earning potential. However, these assets may be more likely to
experience similar risks across asset classes.

Smart Beta
Smart beta strategies offer diversification by tracking underlying indices
but do not necessarily weigh stocks according to their market cap. ETF
managers further screen equity issues on fundamentals and rebalance
portfolios according to objective analysis, not just company size. While
smart beta portfolios are unmanaged, the primary goal becomes the
outperformance of the index itself.

Count/Weighting
In its most basic form, a portfolio's diversification can be measured by
counting the number of assets or determining the weight of each asset.
When counting the number of assets, consider the number of each type for
the strategies above. For example, an investor can count that of the 20
equities they hold, 15 are in the technology sector.

Alternatively, investors can measure diversification by allocating

percentages to what they are invested in. So, in this view, the investor with
15 equities in tech has 75% of their equity holdings in a single industry.

On a broader portfolio basis, investors more often compare equity, bonds,

and alternative assets to create their diversification targets. For example,
traditional portfolios tended to skew towards 60% equities and 40% bonds
—though some strategies call for different diversification based on age.
Other theories claim that holding alternative assets has added benefits (for
example, 60% equities, 20% bonds, and 20% alternatives).

Example of Diversification
Imagine an aggressive investor, who can assume a higher risk level,
wishes to construct a portfolio composed of Japanese equities, Australian
bonds, and cotton futures. They could purchase stakes in the iShares
MSCI Japan ETF, the Vanguard Australian Government Bond Index ETF,
and the iPath Bloomberg Cotton Subindex Total Return ETN.
With this mix of ETF shares, due to the specific qualities of the targeted
asset classes and the transparency of the holdings, the investor ensures
true diversification in their holdings. Also, with different correlations, or
responses to outside forces, among the securities, they can slightly lessen
their risk exposure.

What Are the Benefits of Diversification?

In theory, holding investments that are different from each other reduces
the overall risk of the assets you're invested in. If something bad happens
to one investment, you're more likely to have assets that are not impacted
if you were diversified. Diversification may result in a larger profit if you are
extended into asset classes you wouldn't otherwise have invested in. Also,
some investors find diversification more enjoyable to pursue as they
research new companies, explore different asset classes, and own
different types of investments.

What Are the Methods of Diversification?

There are many different ways to diversify; the primary method of
diversification is to buy different types of asset classes. For example,
instead of putting your entire portfolio into public stock, you may consider
buying some bonds to offset some market risk of stocks.

In addition to investing in different asset classes, you can diversify into

different industries, geographical locations, term lengths, or market caps.
The primary goal of diversification is to invest in a broad range of assets
that face different risks.

Is Diversification a Good Strategy?

For investors seeking to minimize risk, diversification is a strong strategy.
That said, diversification may minimize returns, as the goal of
diversification is to reduce the risk within a portfolio. By reducing risk, an
investor is willing to take less profit in exchange for the preservation of
capital.

The Bottom Line

Diversification is a very important concept in financial planning and
investment management. It is the idea that by investing in different things,
the overall risk of your portfolio is lower.
Instead of putting all your money into a single asset, spreading your wealth
across different assets puts you at less risk of losing capital. With the ease
of transacting and investing online, it is now incredibly easy to diversify
your portfolio through different asset classes and other strategies.

Diversified Portfolio Example

Financial Navigating in the Current Economy: Ten Things to
Consider Before You Make Investing Decisions

Invest Wisely: An Introduction to Mutual Funds. This publication explains the

basics of mutual fund investing, how mutual funds work, what factors to consider before
investing, and how to avoid common pitfalls.
/investor/pubs/inwsmf.htm

Financial Navigating in the Current Economy: Ten Things to Consider Before

You Make Investing Decisions

Given recent market events, you may be wondering whether you should make changes
to your investment portfolio. The SEC’s Office of Investor Education and Advocacy is
concerned that some investors, including bargain hunters and mattress stuffers, are
making rapid investment decisions without considering their long-term financial goals.
While we can’t tell you how to manage your investment portfolio during a volatile
market, we are issuing this Investor Alert to give you the tools to make an informed
decision. Before you make any decision, consider these areas of importance:

1. Draw a personal financial roadmap.

Before you make any investing decision, sit down and take an honest look at your entire
financial situation -- especially if you’ve never made a financial plan before.

The first step to successful investing is figuring out your goals and risk tolerance – either
on your own or with the help of a financial professional. There is no guarantee that
you’ll make money from your investments. But if you get the facts about saving and
investing and follow through with an intelligent plan, you should be able to gain financial
security over the years and enjoy the benefits of managing your money.

2. Evaluate your comfort zone in taking on risk.

All investments involve some degree of risk. If you intend to purchase securities - such
as stocks, bonds, or mutual funds - it's important that you understand before you invest
that you could lose some or all of your money. Unlike deposits at FDIC-insured
banks and NCUA-insured credit unions, the money you invest in securities typically is not
federally insured. You could lose your principal, which is the amount you've invested.
That’s true even if you purchase your investments through a bank.

The reward for taking on risk is the potential for a greater investment return. If you have
a financial goal with a long time horizon, you are likely to make more money by carefully
investing in asset categories with greater risk, like stocks or bonds, rather than
restricting your investments to assets with less risk, like cash equivalents. On the other
hand, investing solely in cash investments may be appropriate for short-term financial
goals. The principal concern for individuals investing in cash equivalents is inflation risk,
which is the risk that inflation will outpace and erode returns over time.
3. Consider an appropriate mix of investments.

By including asset categories with investment returns that move up and down under
different market conditions within a portfolio, an investor can help protect against
significant losses. Historically, the returns of the three major asset categories – stocks,
bonds, and cash – have not moved up and down at the same time. Market conditions
that cause one asset category to do well often cause another asset category to have
average or poor returns. By investing in more than one asset category, you'll reduce the
risk that you'll lose money and your portfolio's overall investment returns will have a
smoother ride. If one asset category's investment return falls, you'll be in a position to
counteract your losses in that asset category with better investment returns in another
asset category.

In addition, asset allocation is important because it has major impact on whether you
will meet your financial goal. If you don't include enough risk in your portfolio, your
investments may not earn a large enough return to meet your goal. For example, if you
are saving for a long-term goal, such as retirement or college, most financial experts
agree that you will likely need to include at least some stock or stock mutual funds in
your portfolio.

4. Be careful if investing heavily in shares of employer’s stock or any

individual stock.

One of the most important ways to lessen the risks of investing is to diversify your
investments. It’s common sense: don't put all your eggs in one basket. By picking the
right group of investments within an asset category, you may be able to limit your losses
and reduce the fluctuations of investment returns without sacrificing too much potential
gain.

You’ll be exposed to significant investment risk if you invest heavily in shares of your
employer’s stock or any individual stock. If that stock does poorly or the company goes
bankrupt, you’ll probably lose a lot of money (and perhaps your job).

5. Create and maintain an emergency fund.

Most smart investors put enough money in a savings product to cover an emergency,
like sudden unemployment. Some make sure they have up to six months of their
income in savings so that they know it will absolutely be there for them when they need
it.

6. Pay off high interest credit card debt.

There is no investment strategy anywhere that pays off as well as, or with less risk than,
merely paying off all high interest debt you may have. If you owe money on high
interest credit cards, the wisest thing you can do under any market conditions is to pay
off the balance in full as quickly as possible.

7. Consider dollar cost averaging.

Through the investment strategy known as “dollar cost averaging,” you can protect
yourself from the risk of investing all of your money at the wrong time by following a
consistent pattern of adding new money to your investment over a long period of time.
By making regular investments with the same amount of money each time, you will buy
more of an investment when its price is low and less of the investment when its price is
high. Individuals that typically make a lump-sum contribution to an individual
retirement account either at the end of the calendar year or in early April may want to
consider “dollar cost averaging” as an investment strategy, especially in a volatile
market.

8. Take advantage of “free money” from employer.

In many employer-sponsored retirement plans, the employer will match some or all of
your contributions. If your employer offers a retirement plan and you do not contribute
enough to get your employer’s maximum match, you are passing up “free money” for
your retirement savings

9. Consider rebalancing portfolio occasionally.

Rebalancing is bringing your portfolio back to your original asset allocation mix. By
rebalancing, you'll ensure that your portfolio does not overemphasize one or more asset
categories, and you'll return your portfolio to a comfortable level of risk.

You can rebalance your portfolio based either on the calendar or on your investments.
Many financial experts recommend that investors rebalance their portfolios on a regular
time interval, such as every six or twelve months. The advantage of this method is that
the calendar is a reminder of when you should consider rebalancing. Others recommend
rebalancing only when the relative weight of an asset class increases or decreases more
than a certain percentage that you've identified in advance. The advantage of this
method is that your investments tell you when to rebalance. In either case, rebalancing
tends to work best when done on a relatively infrequent basis.

10. Avoid circumstances that can lead to fraud.

Scam artists read the headlines, too. Often, they’ll use a highly publicized news item to
lure potential investors and make their “opportunity” sound more legitimate. The SEC
recommends that you ask questions and check out the answers with an unbiased source
before you invest. Always take your time and talk to trusted friends and family
members before investing

What is the ideal time to exit from a badly performing

mutual fund?
Investments in mutual funds can be beneficial for building wealth over the
long term, but they are also subject to a variety of risks. The most common
types of risks associated with investing in mutual funds are market risk,
credit risk, liquidity risk, interest rate risk, and inflation risk; as a result, your
mutual fund performance may suffer. You can manage your portfolio and
avoid a slump by having a basic understanding of these risks. Usually,
when a mutual fund begins to perform poorly, a lot of investors withdraw
their money from the scheme and prefer to make an exit, but are they really
required to do so? Let's take opinions from our different industry experts on
what is the ideal time to exit from a worst performing mutual fund.

Santosh Navlani, COO, ET Money

When you invest in equities, you should be ready to witness ups and
downs in the short term. You will have to deal with the nature of the beast.
However, your fund's volatility will depend on its category and market
conditions. For instance, a mid-cap fund will be much more volatile than a
large-cap fund. Therefore, it's imperative to ensure your fund is an
underperformed.
If the fund returns fall when the stock market goes down, and other funds,
too, see a similar trend, you cannot call it underperformance. So what
constitutes underperformance? If you have invested in a diversified equity
fund, compare its performance to the benchmark and category average.
You can call it an underperformer if it is lower than both for at least two
consecutive years.So, monitor the fund if it underperforms its benchmark
and category for one year. Exit it only if it continues to underperform for
another year.Investors must avoid sector and thematic funds as they are
highly volatile. They can give high returns for a year or two and
underperform for many consecutive years.
Gautam Kalia, Senior VP and Super Investor at
Sharekhan by BNP Paribas
Mutual fund investment is for long term but the investor should review his
portfolio regularly. While reviewing the fund performance, the investor
should not only look at the point to point performance but should look at the
rolling returns of the fund compared to its benchmark along with the risk
adjusted performance. If the fund is performing poorly in these parameters,
then substitute funds should be looked at.

S. Ravi Promoter & Managing Partner, Ravi Rajan & Co.

LLP
It's important to remember that all investments come with a level of risk,
and it's impossible to guarantee positive returns. When markets are
volatile, for eg; the impact of the Russia-Ukraine war has impacted the
investors wealth related to mutual funds. However, if a mutual fund is
consistently underperforming and failing to meet its objectives, it may be
time to reconsider the investment.
Before making a decision to exit a mutual fund, investors should evaluate
their financial goals, risk tolerance, and investment time horizon. They
should also consider consulting with a financial advisor to get a better
understanding of the fund's performance and potential future outlook.
Investors should not make hasty decisions based on short-term fluctuations
in performance but should re-evaluate their investments if a fund
consistently underperforms its benchmark over a period of 2-3 years.

Alekh Yadav, Head of Investment Products, Sanctum

Wealth
The exit decision shouldn't be based solely on the performance. Every
investment style goes through phases and hence May underperform in
certain market situation. The investor needs to ascertain whether the
underperformance is because of an investment style not working or
because the fund manager is deviating from stated philosophy.
If a manager deviates from stated philosophy, also called a style drifts, it
generally is a clear sign to exit. If the underperformance is because of the
investment style not working, then investors need to understand if reason
for the same is temporary or structural. If it's structural then that's yet again
a reason to exit.
Rahul Jain, President & Head, Nuvama Wealth
A mutual fund can perform poorly in two ways. It could be due to a poor
market or the fund manager's scant fund management skills. If the reason
is the former, investors should continue to invest. However, if poor fund
management is dragging down performance, investors should immediately
exit the fund and reinvest in a fund with a proven track record of
performance.

Investors must evaluate the fund differently to distinguish between market

and fund manager-led underperformance. If the fund outperforms the
underlying benchmark, the market is to blame. However, if the fund's
performance lags behind its respective benchmark and peers over multiple
time periods, investors should take notice. They must exit the fund
immediately if the underperformance can be attributed to inferior stock or
sector selection and poor market entry and exit timing.
Aniruddha Bose, Chief Business Officer, FinEdge
The thumb rule for exiting a mutual fund is to not exit it in a hurry! Many
investors end up exiting a fund based on short term outperformance (9-12
months) only to discover that the fund that they redeemed didn’t just
recover, but outperformed the pack over the next few quarters.
Investors often end up redeeming outperformers because their frame of
reference is incorrect. For example, small caps or the technology sector
may have underperformed in a particular year compared to large caps.
However, your small cap fund may have fallen the least!
So, exercise caution while evaluating your fund’s performance by choosing
the correct frame of reference. If your goals are long term, you should
resolutely continue your SIP’s in that fund because the turnarounds can
result in explosive capital growth in a short period of time, and you don’t
want to be sitting out.
Some red flags to consider while exiting a fund are – material changes in
the fund management team, consistent deviations from trueness to label,
inordinate amounts of speculative risks being taken (for instance, penny
stocks or junk bonds), turmoil within the AMC such as a change in
ownership that is resulting in changes to the AMC’s core philosophies, etc.
Besides that, if your fund is consistently languishing in the bottom quartile
for 8-12 quarters, you may want to have a chat with your advisor on
whether its still suitable for your goals or not.

Girish Jain Associate Professor – Finance Birla Institute

of Management Technology
Investment in equity mutual funds through SIP is a basically long term
investment and a one or two of bad years should not discourage investor.
Equity markets in short terms may be chaotic but long term trend should be
positive. A research by WhiteOak MF shows that for 8 yearlong durations,
chances are 100% for a positive return for SIP.
Poor performance may be due to bad market, compare the difference
between the scheme return and the benchmark return. If poor performance
continues for 2-3 years, investor may look at the following issues before
deciding to exit:
1. Is there a change in fund manager and the underperformance is
because of change in investment style?
2. Nature of MF scheme is changed because of any
reclassification/recategorisation done and as investor you are not
comfortable with the new classification.
Benchmark index may itself be generating negative returns during the
period and investor should give time to a scheme to perform.
Sapna Narang, Managing Partner, Capital League
It would be advisable to monitor for a few quarters relative to the
benchmark and peer group. A discussion with the fund house will further
map out reasons for underperformance and will help understand if there is
any change in philosophy or team. Also at Capital League, we consider an
exit if our outlook on a particular category or sector changes.
However at any given point in time, a well balanced client portfolio will have
a mix of schemes which will simultaneously outperform and underperform
depending on which segment of the market is performing. For example:
Growth vs Value OR Large Cap Vs Small Cap. In such cases, I would
advise against an exit.

HOW TO PREPARE AN INCOME STATEMENT

When it comes to financial statements, each communicates specific

information and is needed in different contexts to understand a company’s
financial health.

The income statement is one of the most important financial statements

because it details a company’s income and expenses over a specific period.
This document communicates a wealth of information to those reading it—
from key executives and stakeholders to investors and employees. Being able
to read an income statement is important, but knowing how to generate one is
just as critical.

Here’s an overview of the information found in an income statement, along

with a step-by-step look at the process of preparing one for your organization.

WHAT IS AN INCOME STATEMENT?

An income statement is a financial report detailing a company’s income and
expenses over a reporting period. It can also be referred to as a profit and loss
(P&L) statement and is typically prepared quarterly or annually.

Income statements depict a company’s financial performance over a reporting

period. Because the income statement details revenues and expenses, it
provides a glimpse into which business activities brought in revenue and
which cost the organization money—information investors can use to
understand its health and executives can use to find areas for improvement.

An income statement typically includes the following information:

 Revenue: How much money a business took in during a reporting period

 Expenses: How much money a business spent during a reporting period
 Costs of goods sold (COGS): The total costs associated with component
parts of whatever product or service a company makes and sells
 Gross profit: Revenue minus costs of goods sold
 Operating income: Gross profit minus operating expenses
 Income before taxes: Operating income minus non-operating expenses
 Net income: Income before taxes
 Earnings per share (EPS): Net income divided by the total number of
outstanding shares
 Depreciation: Value lost by assets, such as inventory, equipment, and
property, over time
 EBITDA: Earnings before interest, depreciation, taxes, and amortization
STEPS TO PREPARE AN INCOME STATEMENT
1. Choose Your Reporting Period

Your reporting period is the specific timeframe the income statement covers.
Choosing the correct one is critical.
Monthly, quarterly, and annual reporting periods are all common. Which
reporting period is right for you depends on your goals. A monthly report, for
example, details a shorter period, making it easier to apply tactical
adjustments that affect the next month’s business activities. A quarterly or
annual report, on the other hand, provides analysis from a higher level, which
can help identify trends over the long term.

2. Calculate Total Revenue

Once you know the reporting period, calculate the total revenue your business
generated during it.

If you prepare the income statement for your entire organization, this should
include revenue from all lines of business. If you prepare the income
statement for a particular business line or segment, you should limit revenue
to products or services that fall under that umbrella.

3. Calculate Cost of Goods Sold (COGS)

Next, calculate the total cost of goods sold for any product or service that
generated revenue for your business during the reporting period. This
encompasses direct and indirect costs of producing and selling products or
services, including:

 Direct labor expenses

 Material expenses
 Parts or component expenses
 Distribution costs
 Any expense directly tied to the production of your product or service
4. Calculate Gross Profit

The next step is to determine gross profit for the reporting period. To calculate
this, simply subtract the cost of goods sold from revenue.

5. Calculate Operating Expenses

Once you know gross profit, calculate operating expenses (OPEX).

Operating expenses are indirect costs associated with doing business. These
differ from cost of goods sold because they’re not directly associated with the
process of producing or distributing products or services. Examples of
expenses that fall under the OPEX category include:
 Rent
 Utilities
 Overhead
 Office supplies
 Legal fees
6. Calculate Income

To calculate total income, subtract operating expenses from gross profit. This
number is essentially the pre-tax income your business generated during the
reporting period. This can also be referred to as earnings before interest and
taxes (EBIT).

7. Calculate Interest and Taxes

After calculating income for the reporting period, determine interest and tax
charges.

Interest refers to any charges your company must pay on the debt it owes. To
calculate interest charges, you must first understand how much money you
owe and the interest rate being charged. Accounting software often
automatically calculates interest charges for the reporting period.

Next, calculate your total tax burden for the reporting period. This includes
local, state, and federal taxes, as well as any payroll taxes.

8. Calculate Net Income

The final step is to calculate net income for the reporting period. To do this,
subtract interest and then taxes from your EBIT. The number remaining
reflects your business’s available funds, which can be used for various
purposes, such as being added to a reserve, distributed to shareholders,
utilized for research and development, or to fuel business expansion.

INCOME STATEMENT EXAMPLE

Below is an example income statement for a fictional company. As you can
see at the top, the reporting period is for the year that ended on Sept. 28,
2019.
During the reporting period, the company made approximately $4.4 billion in
total sales. It cost the business approximately $2.7 billion to achieve those
sales. As a result, gross profit was about $1.6 billion.

Next, $560.4 million in selling and operating expenses and $293.7 million in
general administrative expenses were subtracted. This left the company with
an operating income of $765.2 million. To this, additional gains were added
and losses subtracted, including $257.6 million in income tax.

At the bottom of the income statement, it’s clear the business realized a net
income of $483.2 million during the reporting period.