Smart Investment Questions

Continuing with our series of "Investment Thinking", here's a list of questions that you should ask yourself before making an investment:

1. Do you believe in the business the company is in?

2. Does the sector have growth potential?

3. Are you sure you want to be part of it?

4. Are you willing to stay in for the long haul?

5. Are you willing to not get perturbed by temporary price setbacks?

If you have answered yes to all the questions, you are on your way to making a smart investment!

When to Say No to an IPO

Are you planning to invest in an IPO either because you are getting the shares at par value or because the company you are investing in is sound and stable? WAIT!! Play safe and ensure you are not duped.

Par value is the face value of the share. This par value is arrived at through an accounting decision and bears no relation to either the intrinsic value of the company or how the public view the company. For example, XYZ Co. share has a par value of Rs 5, but it's market price could be around Rs 3,000 per share. When the share is traded in the stock market, however, this value may go up or down depending on the supply of and demand for the stock. If everyone wants to buy the shares, the price will go up. If nobody wants to buy them, and/ or many want to sell them, the price will fall. This price is referred to as the market price. A share with a face value of Rs 10 may be quoted at Rs 55 (market price higher than the face value) or even Rs 9 (market price lower than the face value).

The fact that you are getting shares at par value is no guarantee that the company is going to do well and you are going to rake in big bucks. Often, most companies come out with shares that are at a premium to their face value. Those that come with shares at face value seem to appear more alluring.

Some companies whose shares are already available for trading come out with a fresh lot of shares. This is referred to as a new issue or a Follow-on Public Issue (FPO). A common bait investors fall for is the fact that the price of the new issue is cheaper than the current market price. For example, the current market share may be Rs 100, while the FPO may be offered at Rs 90.

Don't let this be the only reason you buy those shares. Sometimes, the prices of the stock may get manipulated in the market to keep the prices high before a new issue is announced. So, while you think you are getting a good deal because the shares are available at a discount to the market price, the reality is that the market price has been artificially hyped up because of manipulation by brokers.

A share that is being oversubscribed does not mean it's a good investment for you. The process is that investors have to bid for shares in an IPO. When the bids exceed the number of shares, the issue is said to be oversubscribed. There could be a number of reasons why this happens.It could be that many banks and financial institutions are liberally offering loans to apply for the issue. This could result in oversubscription. Also, institutional investors (as against retail investors like you and me) don't have to put up money upfront when they make their bids. That means they can put in any amount of bids, hoping that the resulting hype about oversubscription will lure more investors.

At the same time, just because you are investing in a sound and stable company, it does not mean you have to pay a very high price for it. It would be a futile investment if the company was excellent but the price of the issue was sky high.

So think about these issues next time you go shopping (IPO shopping that is ;-) )

When to Say Yes to an IPO

When the stock market is on fire, everybody seems to be making money on IPOs. You buy an IPO for a simple reason: you get it cheaper. Often, companies come out with a cheaper issue price. An issue price is the price at which you can buy a share when you apply for an IPO. When the shares are listed on the stock exchange and are available for trading, the price generally rises.

Take, for example, the Jet Airways IPO. It had an issue price of Rs 1,100 per share. On March 14, 2005, the day it was listed and made available for trading, the price rose to a high of Rs 1,339. In just a few weeks, you would have made a profit of more than Rs 200 per share.

So, besides getting the shares cheaper, those who want to make a quick buck sell it soon after it is listed. Within a short span of a few weeks, they make a neat profit.

This is the reason why investors flock to IPOs.

It is not mandatory that the price of the stock rises on listing. There could be instances where it does not. Much depends on the timing of your sale. The price may rise on listing, but you may hold on for just a few days longer and it could slump. Those who invested in the Jet Airways IPO at Rs 1,100 per share were thrilled as the share price kept rising. Soon after listing (as we mentioned above), the price rose. On March 14, 2005, it was Rs 1,339 per share and rose to Rs 1,361 per share on June 1, 2005. However, after that, it has generally been going downhill. On December 6, 2005 it touched Rs 1,269; on January 6, 2006, it was Rs 1,148. On February 3, 2006, it was Rs 983.Those who did not sell at the initial levels would be rather dismayed.

The best reason to invest in an IPO is because you believe in the company and are willing to hold on to the shares for the long term. Often, companies that are going public offer their shares cheap and go on to become very successful. An IPO thus offer investors the chance to participate in the company's potential prosperity.While the chief attraction may be making a profit the moment the price of the share rises, don't let it be the only one.

Asset Allocation for Dummies

Asset allocation is dividing and allocating your money (or investable assets) among different asset classes. For example, asset allocation may be as simple as dividing your money equally among stock index funds and bonds or dividing it among large-caps, mid-caps, and small caps. An asset allocation plan (also known as an investment plan) is important because without an investment plan, people tend to buy what they shouldn’t buy! I know a lot of people who invest their savings in the fund that performed the best last year. The chances of that fund performing better this year are pretty slim.

The importance of asset allocation can be best understood with the help of an example. Suppose I invest in the following manner according to my asset allocation plan:

25% or Rs. 25,000 - Large-Cap fund

25% or Rs. 25,000 - Mid-Cap fund

25% or Rs. 25,000 - Small-Cap fund

25% or Rs. 25,000 - Bond fund

Let’s say the different funds had the following rates of return this year:

Year I

+10% - Large-Cap fund

+08% - Mid-Cap fund

+15% - Small-Cap fund

-02% - Bond fund

My portfolio would look like this:

The formula for calculating return for one year is:

Beginning Amount * (1 + the rate of return )

25,000 * 1.10 = 27,500 Large-Cap fund

25,000 * 1.08 = 27,000 Mid-Cap fund

25,000 * 1.15 = 28,750 Small-Cap fund

25,000 * 0.98 = 24,500 Bond fund

Total Portfolio value at end of Year I = 107,750 or a 7.75% rate of return.

Most people would probably want to sell all of their bond fund and put it all in the small-cap fund. That’s human nature. Nobody likes to hold an investment that seems to be losing money. However, suppose the next year, the fund’s returns were like this:

Year II

- 05% - Large-Cap fund

+03% - Mid-Cap fund

- 20% - Small-Cap fund

+05% - Bond fund

At the end of Year II, the portfolio would like this:

27,500 * 0.95 = 26,125 Large-Cap fund

27,000 * 1.03 = 27,810 Mid-Cap fund

53,250 * 0.80 = 42,600 Small-Cap fund

The portfolio would be worth Rs. 96,535 (one year LOSS of 10.41%!)

Finally, had this person stuck with his asset allocation plan and reallocated 25% to each of the 4 funds, he would have had a loss of only 4.25% instead of 10.41%:

26,937 * 0.95 = 25,950 Large-Cap fund

26,937 * 1.03 = 27,810 Mid-Cap fund

26,937 * 0.80 = 21,550 Small-Cap fund

26,937 * 1.05 = 28,284 Bond fund

The portfolio would be worth Rs. 103,170 (one year loss of 4.25% which is MUCH better than the 10.41% loss)