Skip to main content

The Dynamics Of Diversification

Ever Wondered Why Equity Corrects When Interest Rates Rise Or Why Gold Prices Rise When Stock Markets Fall?

Various markets are intertwined. Normally, when the interest on fixed income instruments goes up, the equity market is down. Similarly, when the equity market is down, gold is up. An example should explain why this happens.

Assume company A has equity capital and debt of `100 crore each. Its earnings before interest and tax is `20 crore. The interest on borrowings is 10 per cent a year. The earnings after interest and before tax will be `10 crore. Assume the interest on borrowing goes up from 10 per cent to 12 per cent.

The earnings after interest and before tax will go down to `8crore. Thus, in a rising interest rate scenario, the bottom line of companies fall. Similarly, in a falling interest rate scenario, the bottomline grows. As a result, the share price moves up due to better valuation when the interest rate moves down and goes down when interest rates go up.

The changes in rates affect the value of companies and their shares. This is because; a company's share market value is its projected future cash flows, discounted to the present, using the investor's required rate of return.

If interest rates fall and everything else is held constant, the share value should rise. That's why the market cheers when the Reserve Bank announces a rate cut. Conversely, if the RBI raises rates (holding everything else constant), share values fall.

Another reason for the inverse relationship is that more money will be diverted to fixed income instruments when interest rates are moving up, which affects To look at the correlation between the Nifty, the gold price and interest rates, we have tabulated the values of the S&P CNX Nifty, Gold BeES (Gold Benchmark Exchange-Traded Scheme) and State Bank of India's deposit rate for a one-year deposit.

A look at the historic data brings out the variation in the movement of the S&P CNX Nifty values, gold prices and interest rates. We assessed the relationship between the three at the end of every year from March 31, 2007, till date.

As can be seen from the table, the value of the S&P CNX Nifty, Gold BeES and interest rates moved up in 2007-2008 due to bullish sentiments in all markets. In 20082009, the Nifty value was down by 36 per cent, whereas Gold BeES was up by 24 per cent, showing the inverse relationship in the two markets. The interest rate were more or less stable during the period. In 2009-2010, the Nifty value was up Building a suitous classes of assets like debt, equity, real estate, gold and so on. Even From the example, it can be seen that the investor who invested in equities in March 2009 is reaping a bumper windfall even now. Similarly, in a four-year period, gold has doubled its value, whereas the S&P CNX Nifty has increased by only about 50 per cent. Putting money in a fixed income instrument enables you to have an assured fixed income, safety of capital and at times earn better returns when the rates are high.

The idea behind diversification is primarily to ensure the different assets in one's portfolio do not move in the identical direction at all times. If so, there would be no hedge against losses.

TAKEAWAYS

Various markets are intertwined and affect each other

Normally, when the interest on fixed income instruments goes up, the equity market is down

When the equity market is down, gold prices are up

Diversification helps to tide over imbalances of various markets

Investors need to diversify across sub-classes of a particular asset class

Popular posts from this blog

Mutual Fund Review: Religare Tax Plan

Tax Plan is one of the better performing schemes from Religare Asset Management. Existing investors can redeem their investment after three years. But given the scheme's performance, they can continue to stay invested   Given the mandated lock-in period of three years, tax saving schemes give the fund manager the leeway to invest in ideas that may take time to nurture. Religare Tax Plan's investment ideas revolve around 'High Growth', which the fund manager has aimed to achieve by digging out promising stories/businesses in the mid-cap segment. Within the space, consumer staples has been the centre of attention for the last couple of years and can be seen as one of the key reasons for the scheme's outperformance as compared to the broader market. It has, however, tweaked its focus and reduced exposure in midcaps as they were commanding a high premium. The strategy seems to have worked as it returned a 22% gain last year. Religare Tax Plan has outperformed BSE 100...

Nifty F&O

  1. What is a straddle? A strategy using Nifty options usually before a major event or when one is uncertain of market direction. Comprises purchase of a Nifty call and put option of the same strike price. Usually strikes are purchased closer to the level of the underlying index. 2. What is better ­ buying or selling a straddle? It depends.Implied volatili ty of options, or near-term expectations of price swings in an un derlier like Nifty , usually peaks before an event and falls when the outcome plays out ­ like Infy re sults in past years. However, once the event plays out, a sharp rise or fall in Nifty could result in price of the straddle rising ­ benefiting buy ers. But, normally , those who sell or write options charge hefty premiums from buyers in the hope that fall in volatility would ensure the options end out-of-the-money, hurting buyers. 3. So, do straddle sellers end up winning most of the time? Yes. That's invariably the case when market volatility is trending on the...

JP Morgan launches Emerging Markets Opportunities Equity Offshore Fund

Download Tax Saving Mutual Fund Application Forms Invest In Tax Saving Mutual Funds Online Buy Gold Mutual Funds Leave a missed Call on 94 8300 8300 JP Morgan launches Emerging Markets Opportunities Equity Offshore Fund    The new fund offer opens for subscription on 16 th June and closes on 30 th June. JP Morgan Mutual Fund today announced the launch of its open end fund of fund called Emerging Markets Opportunities Equity Offshore Fund. The fund will invest in an aggressively managed portfolio of emerging market companies in the underlying fund - JPMorgan Funds - Emerging Markets Opportunities Fund, says a JP Morgan press release. Noriko Kuroki, Client Portfolio Manager, Global Emerging Markets Team (Singapore), JPMAM said, "Emerging markets have been out of favour for several years, as growth decelerated and earnings struggled. However, in a world of globalisation, we believe that EM will eventually re-couple with DM, leading to the long-aw...

Good time to invest in Infrastructure Funds

Download Tax Saving Mutual Fund Application Forms Invest In Tax Saving Mutual Funds Online Buy Gold Mutual Funds Leave a missed Call on 94 8300 8300   Good time to invest in infrastructure The Sensex has gained almost 10 per cent from May 15 till date, while the CNX Infrastructure Index has gained almost 17 per cent in the period. The price to earnings ( P/ E) ratio of the BSE Sensex is 18.96; for the CNX Infrastructure Index, it is 24.57. The estimated P/ E for next year is 14.04 for the Sensex. Of the 24 companies that make up the CNX Infrastructure Index, six have a P/ E higher than 20. Does this mean infrastructure is fairly valued? Or, has it run up quite a bit? According to experts, barring stray companies, the infra sector is fairly valued and it is a good time to invest. Even if some companies are facing debt restructuring problems, once interest rates come down and regulatory norms become flexible, they will start giving good re...

Mutual Funds: Past Performance is not just everything

Many a times your agent / distributor / relationship manager tries to push you some mutual fund schemes by enticing you with a typical sales pitch…"Sir, this scheme has generated 20% returns in the past one year." And this sales pitch often gets louder when the market conditions have been favourable. Some of the agents / distributors / relationship managers have another unique way of luring you. They say, "Sir / madam this scheme has been awarded the best scheme award in the past by a leading business channel"... And hearing all these sales talks you investors very often get attracted and sign a cheque in favour of the respective scheme.   But please ask yourself do you hear these sales talks when the capital markets turn turbulent? Why is it so that your agent / distributor / relationship manager avoids talking to you during turbulent times of the capital markets and doesn't boast about returns generated by the respective funds or awards being conferred on t...
Related Posts Plugin for WordPress, Blogger...
Invest in Tax Saving Mutual Funds Download Any Applications
Transact Mutual Funds Online Invest Online
Buy Gold Mutual Funds Invest Now