1. Equity

Equity, typically referred to as shareholders' equity, represents the amount of money that would be returned to a company’s shareholders if all of the assets were liquidated and all of the company's debt was paid off. Equity represents the shareholders' stake in the company, identified on a company's balance sheet. An equity investment is money that is invested in a company by purchasing shares of that company in the stock market.

Equity is a wonderful asset class which has the potential to give great returns on your investment. But remember, unanticipated negative shocks are part and parcel of equity investing. In fact, this risk is why there is a premium on equity investing, on why equities can earn more than fixed deposits and such. The investment industry, by talking about risk tolerance and risk modelling and such things, has created the impression that risk is something predictable. It's not. In fact, it's the very definition of risk that it's not predictable.

Decision-making under risk and uncertainty lies at the heart of equity investing. We don't know what's going to happen, but that does not mean that we don't know what to do. That may sound strange at first but actually that's true of all equity investing, whether in good times or bad times.

So what should we do as investors? The answer is simple: a relentless focus on quality. Not just in the situation of a market crash, but all the time. Over the last few decades, there have been plenty of times when the markets have fallen 20-50% and have soon - within a couple of years - gained back the losses. However, in these episodes, quality really shines through. Here's a great example: back in 2008, HDFC Bank fell to half its value. If you had bought it before that crash, when it was at the peak of that time, your money would today be 5X after absorbing that huge loss. From the bottom, it's about 10x. Conversely, there were many stocks - almost all infra stocks - that fell 70-90% in that crash and never came up again.

There's no way of anticipating extreme events and then trying to clean up your act hurriedly. Instead, this has to be a continuous thing. The trick is very simple. Every time you buy a stock, you should be aware of what happens if a disaster strikes immediately. What would happen to your investment if that happens? You will buy only if you are reasonably certain of the fundamentals of the business and the stock, right? That’s exactly what you have to do.

If you don't have time, understanding and temperament, don't even think of investing in stocks directly. Without the necessary patience and discipline to buy and sell stocks at the right time, your stock investments may go out of control. When it comes to investing in stocks, one cannot speculate, as it is a sure-shot way of quickly losing one's capital.

Another factor that may act as a hurdle for amateur investors to build an ideal portfolio is an individual's incompetency to track all the stocks across various industries. Let's assume an IT expert is trying to test his luck in the stock market, he can be good in evaluating the investment opportunities that lies in the IT sector because of his expert knowledge but at the same time, he may not be able to identify the enormous opportunities that lie in the other niche sectors like pharmaceuticals, biotech, etc. because of his/her incompetency to understand the business. Due to the failure in diversifying the portfolio, an individual may end up losing money. This failure can be caused due to the individuals' inability to identify opportunities in the different sectors as discussed above.

Considering these factors, investing in equity mutual funds can be an excellent alternative. Equity funds invest your money in stocks. Here, a professional fund manager takes care of your investments and strives hard to provide reasonable returns. Capital appreciation is an important objective for these funds. They are a good choice if you want to invest for long term goals such as retirement planning or buying a house as the level of risk comes down over time.

2. Debt

Debt instruments are fixed-income instruments like bonds or fixed deposits. The issuers of such instruments borrow money from lenders against these instruments. Debt funds are a type of mutual fund that generate returns from investors' money by investing in fixed-income instruments like bonds or deposits of various kinds.

A bond is like a certificate of deposit that is issued by the borrower to the lender. Even individual investors do something similar when they do something as simple as make a fixed deposit in a bank. When you make an FD with a bank, you are basically lending money to the bank. You can also buy bonds, for example the tax-rebate bonds issued by various companies like REC and HUDCO.

This is exactly what debt funds do, except for a few differences. One, they are able to invest in many types of bonds that are not available to individuals. For example, the Government of India issues bonds. It is in fact, by far the largest borrower (and thus bond-issuer) in the country. Bonds are also issued by many large and medium sized businesses (companies) in the country. Mutual funds also invest in these bonds.

A simple way of understanding debt funds is to think of them simply as a way of passing through the interest income that they receive from the bonds they invest in. There are a couple of further complexities to this.

One, unlike the FDs that individuals invest in, mutual funds invest in bonds that are tradable, just like shares are tradable. The way there is a stock market where shares are traded, there's also a debt market where bonds of various types are traded.

Two, in this debt market, the prices of different bonds can rise or fall, just like they do in the stock markets. If a mutual fund buys a bond and its price subsequently rises, then it can make additional money over and above what it would have made out of the interest income alone. This would result in higher return for investors. Obviously, the opposite is also true.

But why would bond prices rise or fall? There can be a number of reasons. The major one is a change in interest rates, or even the expectation of such a change. Suppose there's a bond that pays out interest at a rate of 9 per cent a year. Then, suppose the interest rates in the economy fall and newer bonds start getting issued at 8 per cent. Obviously, the old bond should now be worth more than earlier. After all, a given amount of money invested in it can earn more money. Its price would now rise. Mutual funds that hold it would find their holdings worth more and they could make additional profits by selling this bond. Again, the reverse could happen when interest rates rise.

There are different types of Debt Funds differentiated according to the type of fixed-income instruments in which they invest. These different types of fixed-income instruments can be government bonds, corporate bonds, commercial papers, certificate of deposits, treasury bills and other such debt and money market instruments. They are called "debt" because the issuers of such instruments borrow money from lenders against these instruments. These instruments come with different maturities and they can generate income periodically or at maturity.

Since most debt instruments are not available for direct purchase by retail investors (because the minimum amount required to invest is pretty high), debt mutual funds are the ideal way to invest in them. A debt mutual fund (also known as a fixed-income fund) invests your money in fixed-income instruments like government bonds, debentures or corporate bonds and other money-market instruments. This is a relatively stable investment avenue that could help to generate wealth.

Debt fund investors should understand that the Net Asset Value (NAV) of a debt fund can change in three primary ways:

• The interest income from the bonds in the portfolio will increase the NAV of a debt fund, a little each business day.
• NAV can change positively or negatively when the credit rating of the bonds in the portfolio changes.
• NAV is sensitive to demand for bonds. Longer the duration of the bonds in the portfolio, the more sensitive it will be to demand and supply changes.

For example, Rising interest rates in the market can have a negative impact on prices of bonds in the portfolio and hence the NAV goes down. The reverse is true in case of a falling interest scenario.

Another example; If for some reason, foreign portfolio investors start selling Indian bonds resulting in a sudden loss of demand, bond prices go down and the NAV goes down. It does not matter if the bond is Government Bond or AAA-rated Bond, a sudden mismatch of sellers and buyers (sellers > buyers) will lead to a fall in the NAV.