Editorial Board
Dr. Kanu Jain
Assistant Professor, Shri Ram College of Commerce, University of Delhi
Dr. Vidisha Garg
Assistant Professor, Maitreyi College, University of Delhi
Content Writers
Mr. Vikki Sharma, Mr. Atulit Singh, Ms. Anusha Goel,
Dr. Priyanka Ahluwalia, Ms. Palak Kanojia, Mr. Ankit Suri,
Mr. Yogesh Sharma, Mr. Gurdeep Singh
Academic Coordinator
Mr. Deekshant Awasthi
© Department of Distance and Continuing Education
ISBN: 978-81-19417-10-0
1st Edition: 2023
E-mail: ddceprinting@col.du.ac.in
management@col.du.ac.in
Published by:
Department of Distance and Continuing Education
Campus of Open Learning/School of Open Learning,
University of Delhi, Delhi-110007
Printed by:
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© Department of Distance & Continuing Education, Campus of Open Learning,
School of Open Learning, University of Delhi
Contents
PAGE
Lesson 1 : Introduction to Wealth Management
1.1
Learning Objectives
1
1.2
Introduction
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© Department of Distance & Continuing Education, Campus of Open Learning,
School of Open Learning, University of Delhi
L E S S O N
1
Introduction to Wealth
Management
Mr. Vikki Sharma
Assistant Professor
Shri Ram College of Commerce
University of Delhi
Email-Id: vikkisharma019@gmail.com
STRUCTURE
1.1 Learning Objectives
1.2 Introduction
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1.1 Learning Objectives
‹
Understand the Concept of Wealth Management.
‹
Identify the Need for Wealth Management.
‹
Define the Components of Wealth Management.
‹
Understand the overall wealth management process from initial assessment to ongoing
monitoring.
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BMS
Notes
1.2 Introduction
The term “wealth management” refers to a variety of different financial
services and strategies that are devised to assist individuals and families
in more effectively managing their wealth. It includes a wide range of
aspects, including estate planning, investment management, financial
planning, risk management, and tax planning. By combining all of these
aspects, wealth management offers an all-encompassing strategy for the
management and expansion of wealth that takes into account an individual’s
specific circumstances, goals, and level of comfort with risk.
This chapter will help you to have a better understanding of why individuals
and families seek the assistance of wealth management professionals, as
well as the benefits that come along with doing so. The potential dangers
and difficulties that come with managing wealth on one’s own, as well
as the importance of seeking professional assistance and developing a
comprehensive financial plan will also be discussed.
Following this, a more in-depth discussion of the aspects of wealth
management. The process of managing investments entails coming to
educated conclusions regarding asset allocation, investment selection, and
the ongoing monitoring of portfolios. Setting financial goals, creating a
budget, managing debt, saving money, investing, planning for retirement
and education, and other life events are the primary focuses of financial
planning. The objective of risk management is to identify potential
monetary problems and devise solutions for dealing with them, such as
purchasing insurance or diversifying investments. Tax planning assists in
maximising after-tax returns and reducing tax liabilities, whereas estate
planning facilitates the orderly transfer of assets to beneficiaries and
reduces the amount of taxes payable on those assets in the event of death.
In the final part of the chapter, we will discuss the process of managing
wealth. You will gain an understanding of the sequential steps that are
involved, beginning with the setting of goals and conducting a financial
assessment, and continuing on to the development, implementation, and
ongoing monitoring of the strategy. We are going to stress how important
it is to conduct regular evaluations and make necessary changes in order
to adapt the wealth management strategy to the ever-evolving needs and
objectives.
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WEALTH MANAGEMENT
Throughout the course of this chapter, you will acquire a firm grounding
in the fundamentals of wealth management, comprehend the significance
of each component, and realise the significance of integrating them into
a comprehensive strategy. By the time you reach the end of this chapter,
you will be armed with the knowledge and understanding necessary to
make well-informed decisions regarding your finances and to begin your
journey towards effective management of your wealth.
Notes
Let’s take this opportunity to explore the realm of wealth management
and learn how it can assist you in realising your monetary goals and
establishing a foundation for a financially stable future.
1.3 Meaning and Definition of Wealth Management
Wealth management is the term for services like professional advice and
financial planning that help people and families manage their money well.
It includes a wide range of plans and strategies to grow, protect, and
share wealth over time. Wealth management includes a lot of different
things, such as managing investments, planning finances, planning taxes,
managing risks, planning, and more. The goal of wealth management is
to make sure that people are financially secure, get the most out of their
investments, and reach certain financial goals.
Wealth management is usually done by experienced financial advisors
or wealth managers. They work closely with their clients to learn about
their financial goals, evaluate their current financial situation, and come
up with personalised plans to help their wealth grow and stay safe. Some
of these strategies are managing investments, planning for retirement,
minimising taxes, protecting assets, and making an estate plan.
In short, wealth management is a service that helps people and families
manage their money well, make smart financial decisions, and work
towards their long-term financial goals by combining financial expertise,
strategic planning, and ongoing guidance.
According to Investopedia: “Wealth management is a professional
service that combines financial and investment advice, accounting and
tax services, retirement planning, and legal or estate planning for highnet-worth individuals. The goal of wealth management is to sustain and
grow long-term wealth.”
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Notes
Example: A person with a lot of money hires a wealth management firm
to handle their investments, make a complete financial plan, help them
plan their taxes, and help them plan their estate so that their wealth grows
for themselves and the future generations.
According to the Financial Times: “Wealth management involves providing
a range of financial services to high-net-worth individuals and families
to help them achieve their financial goals, including investment advice,
financial planning, tax optimization, and risk management.”
Example: A wealth management advisor works closely with a client to
create a personalised investment portfolio, review their finances on a
regular basis, set up a retirement plan, and give advice on how to pay
the least amount of taxes and protect their assets with insurance.
1.4 Importance of Wealth Management
1. Goal Clarity: Wealth management is a service that helps individuals
and families achieve their financial goals. Wealth managers are in
charge of giving their clients advice on how to use and grow their
assets in a way that helps them reach their goals. They do this
by first making sure their goals are very clear and then making
a detailed financial plan. Wealth management makes sure that the
right resources are used to make it more likely that a goal will
be reached, whether that goal is saving for retirement, paying for
school, or buying a home. Saving for retirement, paying for school,
and buying a home are all examples of this.
2. Financial Security: Wealth management is a practice that helps a
lot with making sure money is safe. Wealth managers help their
clients protect their assets from accidental erosion. They do this by
putting in place risk management strategies like insurance planning
and emergency savings accounts. The goal of wealth management
is to keep money and give people peace of mind by figuring out
and reducing different kinds of financial risk.
3. Investment Expertise: Wealth managers are experts in a lot of things,
and one of those things is managing investments. They know a
lot about different ways to invest, different financial markets, and
different strategies for allocating assets. By using their knowledge,
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School of Open Learning, University of Delhi
WEALTH MANAGEMENT
wealth managers are able to put together investment portfolios for
their clients that are well-diversified and fit the clients’ risk profiles
and financial goals. Their ability to keep an eye on investments and
make changes in response to changes in the market could increase
returns and lower risk.
Notes
4. Tax Efficiency: Effective wealth management includes strategies
for tax planning. Wealth managers work closely with tax experts
to find investment vehicles that are good from a tax point of view
and to come up with ways to minimize tax obligations. Careful tax
planning can help people increase their after-tax income and keep
their wealth over the long term.
5. Estate Planning: Estate planning is an important part of managing
wealth because it makes sure that a person’s wealth is passed on
smoothly to the next generation. Using estate planning tools like
wills, trusts, and beneficiary designations, people can make sure that
their assets are given to the people they want and keep estate taxes
and other costs to a minimum. In estate planning, these tools are
used. A well-planned estate can help protect wealth and make sure
that assets go to the right people after the death of the decedent.
6. Risk Mitigation: Wealth management is a way for people and
families to reduce the amount of financial risk they face. By
analysing and managing risks like market volatility, inflation, and
economic uncertainty, wealth managers can come up with plans
that protect and grow their clients’ wealth over time. In this case,
“diversification” means that holdings are spread out over a wide
range of asset classes, investment sectors, and geographic regions.
It also includes using tools like hedging strategies to manage risks.
7. Time Optimization: For wealth management to work, you need time,
knowledge, and constant monitoring. When people and families hire
qualified professionals to manage their wealth, they can get back the
time they need to focus on their jobs, their personal lives, and other
things. Clients can take advantage of the wealth managers’ expertise
while focusing on other parts of their lives that are important to
them. This is because the wealth managers handle the day-to-day
investment decisions, financial analysis, and administrative tasks.
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© Department of Distance & Continuing Education, Campus of Open Learning,
School of Open Learning, University of Delhi
BMS
Notes
In conclusion, wealth management is important for reaching goals, staying
financially secure, learning how to invest, lowering taxes, making an
estate plan, reducing risk, and making the most of available time. When
people and families use the knowledge and skills of wealth managers,
they are better able to handle the complexities of financial management,
improve their chances of reaching their financial goals, and improve their
overall financial well-being.
1.5 Need for Wealth Management
1. Goal Achievement: Wealth management helps people and families
figure out what their financial goals are and work towards achieving
them. A professional in wealth management can help you set realistic
goals, come up with a plan for your money, and keep track of your
progress. This advice makes it more likely that long-term financial
goals will be met, like saving for retirement, paying for school, or
buying a home.
2. Financial Organization: Wealth management is a field that teaches
people how to organise and run their finances in a methodical
way. This includes making a budget, keeping track of your money,
and paying off your debt. People can get back in control of their
finances, reduce their debt, and make better use of their resources
if they use effective ways to organise their finances.
3. Investment Expertise: People who are good at managing money
usually know a lot about the financial markets and the different
ways to invest. They can look at market trends, figure out how
much risk there is, and make investment plans that are unique to
each client’s risk tolerance and goals. Because of this knowledge,
investment decisions will always be well-informed and in line with
the goal of building wealth over time.
4. Risk Mitigation: Wealth management expert’s help their clients identify
and reduce different types of financial risk. This means figuring
out how comfortable you are with risk, spreading your investments
across different types of assets, and putting risk management plans
into action. The goal of wealth management is to protect and keep
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School of Open Learning, University of Delhi
WEALTH MANAGEMENT
wealth by lowering the risks that come with market volatility,
inflation, and other things that can’t be planned for.
Notes
5. Tax Optimization: The goal of tax planning strategies in wealth
management is to pay as little tax as possible and make as much
money as possible after taxes. Tax experts stay up to date on
the latest tax laws, use investment vehicles that reduce their tax
liability, and look into deductions and credits that are available. Tax
optimisation is a set of strategies that help people get the most out
of their investments and reduce the effect of taxes on their wealth.
6. Estate Planning: Estate planning is a part of managing your money.
This process makes sure that assets are safe, distributed fairly, and
given to beneficiaries in the way that saves the most money on
taxes. Wills, trusts, and other documents for estate planning can
be written with the help of people who work with clients. People
can make sure that their wealth is kept and passed on in the way
they want if they pay attention to their estate planning needs and
plan accordingly.
7. Long-Term Financial Security: The main goals of wealth management
are to help people get richer over time and to keep their money safe.
When making financial decisions, professionals look at a number
of things, such as inflation, changing market conditions, and the
needs of their clients, which are always changing. People are more
likely to be able to live a comfortable life and reach the level of
financial independence they want if they put long-term financial
security plans into action. This makes it possible for people to be
financially more independent.
8. Professional Guidance: By taking part in wealth management,
people can get help and advice from professionals. Wealth managers
are experts in many areas of money and can offer solutions that
are unique to each person’s situation. This advice makes sure that
clients’ financial decisions are well thought out and in line with
their own goals and needs.
9. Access to Financial Tools and Resources: One of the benefits
of wealth management is that it gives you access to advanced
financial tools, research, and resources. Some of these resources
include software for analysing and planning investments, reports
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School of Open Learning, University of Delhi
BMS
Notes
on market research, and financial planning software. When people
use these tools, they can make better-informed decisions, compare
their different investment options, and keep a better eye on their
financial progress.
10. Peace of Mind: At the end of the day, wealth management gives
people and families a feeling of security and peace of mind.
Knowing that their money is being handled by experts who have
their best interests in mind can make people feel less worried and
less stressed. With the help of professionals in wealth management,
people can worry less about how their money is being handled and
focus on other parts of their lives.
11. Education Planning: Wealth managers help people and families
save and invest money so they can pay for their children’s college
costs. This is part of the process of planning for education costs.
12. Retirement Planning: The main goal of wealth management is to
help people plan for their retirement in the long term. This means
helping people save money for retirement and come up with ways
to make money after they retire.
13. Cash Flow Management: People and families can benefit from the
help of wealth managers by getting better at managing their cash
flow and making sure they have enough money for expenses and
investments.
14. Market Insights: Wealth managers are always learning about the
latest changes in the market, economic indicators, and investment
opportunities so that they can give their clients good advice and
information.
15. Behavioural Finance: Wealth managers help their clients make smart
financial choices by addressing behavioural biases and emotional
factors that can hurt investment results. This keeps clients from
making financial decisions that aren’t good for them.
16. Financial Education: Wealth management gives clients educational
resources and advice, which helps them learn about different financial
topics and makes it easier for them to make good decisions.
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WEALTH MANAGEMENT
1.6 Components of Wealth Management
Notes
Wealth management is a comprehensive approach to financial planning
and investment management. Its main goal is to help individuals and
families grow, protect, and share their wealth in the best way possible.
The term “wealth management” refers to a comprehensive way to plan
your finances and handle your investments. It does this by using a lot of
different parts and strategies, all of which are designed to meet the specific
needs and goals of each customer. Here is a list of the most important
parts of wealth management, along with detailed explanations of each:
1. Financial Planning: Planning your money well is the first step to
managing your money well. It involves putting together a plan that
will help people reach their financial goals. This means looking at
one’s current financial situation, setting goals, deciding how much
risk one is willing to take, and making a plan that includes things
like budgeting, saving, investing, tax planning, retirement planning,
and estate planning, among other things.
2. Investment Management: Investment management is about making
sure that investors are exposed to as little risk as possible while
getting the most money back for their money. Wealth managers look
at their clients’ risk profiles, investment goals, and time horizons to
come up with personalised investment plans for them. This could
mean spreading your assets across a variety of asset classes, like
stocks, bonds, real estate, and commodities, and using a variety of
investment vehicles, like mutual funds, exchange-traded funds, and
alternative investments.
3. Risk Management: The goal of risk management is to find, assess,
and then take steps to reduce any possible risks that could hurt a
person’s financial well-being. This includes figuring out what kinds
of insurance are needed (such as life, health, property, and liability
insurance), setting up an emergency fund, and putting plans in place
to protect against unplanned events or changes in the market.
4. Tax Planning: Tax planning is the process of minimising the effect
of taxes on a person’s wealth and making sure that taxes are paid
as efficiently as possible. Financial advisors and tax professionals’
work together to find possible tax deductions, credits, and ways to
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School of Open Learning, University of Delhi
BMS
Notes
lower tax liabilities. This could mean using tax-efficient investment
vehicles, using retirement accounts, or putting in place strategies
like “tax-loss harvesting”.
5. Retirement Planning: The goal of planning for retirement is to save
money and manage it wisely so that you can have a comfortable
and safe retirement. Wealth manager’s help their clients figure out
how much money they will need in retirement, estimate how much
money they will need, and come up with a plan to build wealth and
put as much money as possible various into retirement accounts and
pension plans. They also give advice on how to split your income
in different ways during retirement.
6. Estate Planning: Estate planning is the process of organising a
person’s assets and affairs in a way that makes it easy for them
to pass on their wealth to the people they choose and reduces the
amount of money they have to pay in taxes and probate. Wealth
managers and estate planning attorneys often work together to write
wills, trusts, powers of attorney, healthcare directives, and other
important legal documents. They also talk about giving to charity,
planning for the future, and how important it is to leave a legacy.
7. Wealth Preservation: The maintenance and growth of one’s wealth
over the course of one’s lifetime are the twin aims of various
strategies aimed at wealth preservation. The implementation of plans
for the protection of assets, methods for the transfer of wealth, and
estate tax planning may all be part of this process. Wealth managers
are also responsible for monitoring the investment portfolios of
their clients and making any necessary adjustments to bring those
portfolios in line with their clients’ ever-evolving financial goals
and the shifting conditions of the market.
8. Philanthropy and Charitable Giving: Some people and families
want to make a big difference in the world by giving to charities
and philanthropy. These people and their families give a lot to
groups that help other people. Wealth managers can help with
making plans for charitable giving, setting up family foundations
or donor-advised funds, and making sure that charitable funds are
used in the best way possible.
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© Department of Distance & Continuing Education, Campus of Open Learning,
School of Open Learning, University of Delhi
WEALTH MANAGEMENT
9. Wealth Education and Communication: The role of wealth managers
in educating their clients about various financial topics, investment
strategies, and market trends is an extremely important one. They
maintain consistent communication with clients and provide updates
to keep customers abreast of any developments in their financial
situation that may necessitate alterations to the wealth management
strategies they have in place.
Notes
To summarise, wealth management is an approach to financial well-being
that integrates a variety of aspects to produce a holistic strategy. This
strategy ensures that individuals and families can effectively manage,
grow, and protect their wealth over the course of time. The precise
proportions of these components will vary from person to person based
on their specific circumstances, objectives, and personal preferences.
1.7 Process of Wealth Management
Wealth management refers to the process of taking an all-encompassing
approach to managing an individual’s or family’s financial resources
to assist them in accomplishing their financial goals and ensuring the
financial future of the family or individual. It encompasses a wide
range of services, including, among others, risk management, investment
management, financial planning, tax planning, and estate planning. The
administration of one’s wealth typically involves carrying out the tasks
listed in the following paragraphs:
1. Establishing Goals and Objectives: To properly manage a client’s
wealth, the first thing that needs to be done is to find out what their
short-term and long-term financial goals are. This means figuring out
what their goals are, which could be to get rich, plan for retirement,
pay for their children’s education, or keep their estate safe.
2. Risk Assessment: After setting goals, the client’s ability to take risks
is carefully looked at. This helps them figure out how much risk
they are willing to take with their investments and the best way to
divide up their assets.
3. Financial Planning: One of the most important parts of managing
money is making a plan for your finances. It involves looking at the
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School of Open Learning, University of Delhi
BMS
Notes
client’s current assets, liabilities, income, and expenses. After that,
a financial plan is made, which might include budgeting, managing
debt, planning for insurance and taxes, and other financial strategies.
4. Investment Management: A client’s investment plan is made after
the client’s goals, objectives, and level of comfort with risk are
taken into account. This means choosing investments like stocks,
bonds, mutual funds, real estate, and other investments. It also
means allocating assets, diversifying holdings, and making it more
likely that a positive return will be made. The client’s portfolio is
constantly watched and rebalanced to make sure it stays in line
with the client’s goals.
5. Tax Planning: Wealth management also includes ways to plan for
taxes. The goal of these strategies is to lower taxes and make as
much money as possible after taxes. This could include things like
investing in a way that reduces taxes, giving to charities, putting
money into retirement accounts, and planning for how estates will
be taxed.
6. Estate Planning: Proper estate planning is very important for keeping
wealth and passing it on to the next generation. Steps in this process
include making a plan for the distribution of all assets, minimising
the effects of estate taxes, and setting up trusts or other ways to
manage and protect assets.
7. Risk Management: Risk management is another part of wealth
management, and there are many different insurance policies that
can help with this. This includes buying insurance to protect against
unplanned events and possible financial losses, such as liability
insurance, long-term care insurance, disability insurance, and life
insurance.
8. Regular Monitoring and Review: Wealth management is an ongoing
process that requires regular monitoring and review of the client’s
changing situation, as well as their own finances and how their
investments are doing. Changes are made as needed to make sure
that the plan keeps going as planned and stays in line with what
the client wants.
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WEALTH MANAGEMENT
IN-TEXT QUESTIONS
Notes
1. What is wealth management?
(a) Managing personal expenses
(b) Managing financial assets and investments
(c) Managing real estate properties
(d) Managing business operations
2. Why is wealth management important?
(a) To accumulate large debts
(b) To maximize tax liabilities
(c) To achieve financial goals
(d) To increase personal expenses
3. Which of the following is not a component of wealth management?
(a) Financial planning
(b) Tax planning
(c) Estate planning
(d) Stock Trading
4. What is the main purpose of financial planning in wealth
management?
(a) Minimizing tax liabilities
(b) Maximizing investment returns
(c) Achieving financial goals
(d) Reducing personal expenses
5. Which component of wealth management focuses on minimising
tax obligations?
(a) Risk management
(b) Estate planning
(c) Investment management
(d) Tax planning
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© Department of Distance & Continuing Education, Campus of Open Learning,
School of Open Learning, University of Delhi
BMS
Notes
6. What does risk management involve in wealth management?
(a) Identifying profitable investment opportunities
(b) Minimizing investment losses
(c) Maximizing tax deductions
(d) Estate distribution planning
1.8 Summary
A comprehensive method of managing a person’s financial resources and
investments to maximise that person’s long-term financial well-being is
what we mean when we talk about wealth management. This article offers
a concise summary of the most important aspects of wealth management,
including the reasons why it is necessary, the various aspects that makeup
wealth management, and the steps that are involved.
The need for wealth management arises for those people who have amassed
significant assets and who want to effectively preserve, grow, and pass
on their wealth to future generations. It helps address complex financial
challenges, such as investment planning, tax optimisation, retirement
planning, estate planning, and risk management, among other things. The
objective of wealth management is to provide clients with individualised
strategies that are tailored to the financial goals and circumstances of
each client.
Components of Wealth Management:
(a) Investment Planning: The process of developing a bespoke investment
strategy for the client by considering their risk appetite, financial
objectives, and time horizon.
(b) Tax Planning: Reducing a client’s overall tax burden by maximising
the effectiveness of legally permissible tax strategies and working
to improve the client’s overall financial structure.
(c) Retirement Planning: the process of preparing for a comfortable
and financially secure retirement using various strategies for saving
money and investing.
(d) Estate Planning, which includes minimising the amount of taxes owed
on an estate, protecting assets, and facilitating the orderly transfer
of wealth to beneficiaries.
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WEALTH MANAGEMENT
(e) Risk Management: The process of identifying and mitigating potential
risks using insurance solutions and asset protection strategies.
Notes
(f) Implementing Strategies to Protect and Preserve Wealth for Future
Generations Putting in place strategies to safeguard and preserve
wealth for future generations.
Process of Wealth Management:
(a) Discovery: Obtaining a comprehensive understanding of the client’s
current financial situation, goals, and risk tolerance through in-depth
conversations and the collection of pertinent information.
(b) Analysis: The process of conducting a comprehensive evaluation of
the client’s financial status, including the client’s assets, liabilities,
income, and expenses, in order to identify areas in which the client
could improve.
(c) Strategy Development: The process of developing a customised
plan for wealth management that is in line with the client’s goals
and incorporates various aspects of financial planning, including tax
planning, retirement planning, estate planning, and risk management.
(d) Implementation: The process of putting the wealth management plan
into action by distributing assets, putting investment strategies into
action, and establishing appropriate accounts and structures.
(e) Monitoring and Review: This involves conducting regular reviews
and evaluations of the performance of the wealth management
plan, making necessary adjustments to the strategies, and keeping
the client informed about their progress towards achieving their
monetary objectives.
Wealth management is an ongoing process in which the client and their
wealth management advisor must work together. This is because the process
is both changing and going on at the same time. Wealth management is
the process of making sure that a person’s money goes as far as it can,
that their wealth grows as much as it can, and that they have peace of
mind. This is done by using specialised knowledge and skills.
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© Department of Distance & Continuing Education, Campus of Open Learning,
School of Open Learning, University of Delhi
BMS
Notes
1.9 Answers to In-Text Questions
1. (b) Managing financial assets and investments
2. (c) To achieve financial goals
3. (d) Stock Trading
4. (c) Achieving financial goals
5. (d) Tax planning
6. (b) Minimizing investment losses
1.10 Self-Assessment Questions
1. What is wealth management, and why is it important for individuals
with significant assets?
2. Identify and describe at least three components of wealth management.
3. Why is investment planning a crucial aspect of wealth management?
Explain.
4. How does tax planning contribute to effective wealth management
strategies?
5. Discuss the importance of retirement planning in the wealth management
process.
6. What are the key considerations involved in estate planning within
wealth management?
7. Explain the concept of risk management and its role in wealth
management.
8. Outline the steps involved in the process of wealth management from
discovery to monitoring and review.
9. How does wealth preservation fit into the overall wealth management
strategy?
10. Assess your own financial goals and risk tolerance. How would
you develop an investment strategy aligned with these factors?
11. Discuss the potential tax optimization strategies that could be
implemented in your personal wealth management plan.
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WEALTH MANAGEMENT
12. Evaluate your current retirement savings and investment strategies.
What adjustments could you make to improve your retirement
planning within the context of wealth management?
Notes
13. Consider your own financial situation and assets. How would you
approach estate planning to ensure a smooth transfer of wealth to
your beneficiaries?
14. Identify potential risks that could impact your financial well-being.
How would you mitigate these risks through risk management
strategies?
15. Reflect on the components of wealth management and their interplay.
How would you prioritize and integrate these components into a
comprehensive wealth management plan?
1.11 References
‹
Kapoor, J.R., Dlabay, L.R., & Hughes, R. J Personal Finance, 2020,
McGraw-Hill Education.
‹
Grinblatt, M., & Titman, S., Financial Markets and Corporate Strategy,
2016, McGraw-Hill Education.
‹
Gitman, L.J., & Joehnk, M.D., Personal Financial Planning, 2020
Publisher: Cengage Learning.
‹
Malkiel, B.G., A Random Walk Down Wall Street, 2020 Publisher:
W.W. Norton & Company.
‹
Stanley, T.J., & Danko, W.D., The Millionaire Next Door: The Surprising
Secrets of America’s Wealthy, 2010, Taylor Trade Publishing.
1.12 Suggested Readings
‹
Agarwal, B.L., Wealth Management: Concepts and Practices, 2018,
Vikas Publishing House Pvt. Ltd.
‹
Jha, P., Wealth Management: Principles and Practices, 2019, Himalaya
Publishing House.
‹
Mehta, P., Wealth Management: An Integrated Approach, 2017, Oxford
University Press.
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© Department of Distance & Continuing Education, Campus of Open Learning,
School of Open Learning, University of Delhi
BMS
Notes
‹
Das, S., Wealth Management in India: A Guide to Building, Managing,
and Preserving Wealth, 2015, Vision Books.
‹
Bodie, Z., Kane, A., & Marcus, A.J., Investments, 2021, McGrawHill Education.
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© Department of Distance & Continuing Education, Campus of Open Learning,
School of Open Learning, University of Delhi
L E S S O N
2
Concept of Investment and
Investment Environment
Atulit Singh
Assistant Professor
Shri Ram College of Commerce
University of Delhi
Email-Id: sh.atulit@gmail.com
STRUCTURE
2.1
2.2
2.3
2.4
2.5
2.6
2.7
2.8
2.9
2.10
2.11
2.12
2.13
2.14
2.15
Learning Objectives
Introduction
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Suggested Readings
2.1 Learning Objectives
‹
Investigate various investing strategies: Understanding the ideas and techniques
associated with various investment styles, such as active investing, passive investing,
value investing, growth investing and income investing.
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School of Open Learning, University of Delhi
BMS
Notes
‹
Understand the process of investment decision-making: Understanding
the investment decision-making process, which includes defining
investment objectives, assessing risk tolerance, and aligning investments
with individual circumstances and financial goals.
‹
Recognise common investment objectives in the context of wealth
management: Students will get acquainted with common investment
goals in the context of wealth management, such as capital appreciation,
income creation, risk management, capital preservation, and legacy
planning.
‹
Examine the role of investments in wealth management: Recognise
how investments can contribute to the greater objective of long-term
wealth preservation and growth, along with the possible rewards
and risks involved with investing.
‹
Learning about the Indian Securities Market and its components
2.2 Introduction
Consider the following scenario: You have a miraculous tree in your
garden that grows money. It creates a rich crop of income every year,
which you may utilise to realise your hopes and objectives. Isn’t that
incredible? Investing is comparable to tending to that money tree so it
will blossom and expand over time so you can reap the benefits.
Investing is a powerful instrument that everyone can use to develop
wealth, achieve financial objectives, and ensure a brighter future; it is
not just for the rich or financial specialists. Whether you want to travel
the world, establish a business, or retire comfortably, investing may help
you make your goals a reality.
Have you ever been puzzled by someone’s discussion of stocks, bonds,
or mutual funds? Is the mention of investing or financial subjects
intimidating? Understanding the fundamentals of financial investing can
be an excellent starting point for learning how to invest, planning your
retirement, or maximising the rate of return on your money.
Before that, we must first define what an investment is. An investment
is described as ‘putting money, time, or effort into anything, whether it
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School of Open Learning, University of Delhi
WEALTH MANAGEMENT
is a tangible or intangible, with the expectation of profit or advantage
in the future’. Over time, the investment may accrue return or rise in
value. Essentially, when a person invests in anything, they want to be
better off in the long run as the item grows in value.
Notes
2.3 Objectives or Features of Investment
Investment objectives are often connected with the larger goal of
conserving and expanding wealth over the long term in the context of
wealth management. Here are some frequent investing goals in the domain
of wealth management:
1. Capital Appreciation: Capital appreciation, or increasing the value of
invested assets over time, is one of the major goals of investment.
Investors strive to create returns that outperform inflation and
increase the total worth of their capital by carefully distributing
assets across multiple investment vehicles such as stocks, bonds,
real estate, mutual funds etc.
2. Income Generation: Investments can also be made to provide
consistent revenue streams. Individuals seeking present income
may find dividend-paying equities, bonds, rental properties, or
income-oriented funds to be ideal investments. These investments
are designed to generate a consistent stream of income to satisfy
current living demands or to fund specific financial goals.
3. Risk Management and Diversification: Wealth management emphasises the significance of diversifying investment portfolios
in order to successfully manage risk. Individuals can reduce the
impact of any single investment’s performance on the total portfolio
by spreading investments over several asset classes, industries,
geographical locations, or investing strategies. The goal here is
to decrease the possibility of substantial losses while achieving a
steadier, risk-adjusted return over time.
4. Capital Preservation: One of the primary goals of investment in
wealth management is to preserve and safeguard capital. While
investments contain risks, wealth managers strive to identify assets
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School of Open Learning, University of Delhi
BMS
Notes
and strategies that are in line with an individual’s risk tolerance while
minimising downside hazards. Capital preservation is preserving the
value of invested assets while avoiding significant losses, particularly
during economic downturns or market volatility.
5. Legacy Planning and Wealth Transfer: Wealth management includes
thinking about future generations and transferring money. Investment
goals may involve not just increasing one’s wealth during one’s
lifetime, but also safeguarding assets to be passed down to heirs
or for various charitable purposes. Estate planning, trusts, and taxefficient investments can all be used to optimise wealth transfer
and ensure a lasting legacy.
Investing objectives are hardly universal. Various factors can influence
investing objectives. Individual circumstances, financial goals, risk tolerance,
and time horizons can all influence specific investing objectives under
wealth management:
1. Individual Circumstances: Investment objectives consider an
individual’s unique circumstances, such as age, income level, job
position, and family situation. A younger person, for example, with
a longer time horizon for wealth creation may prioritise growthoriented investments to maximise their wealth over time. In contrast,
someone approaching retirement may prioritise capital preservation
and income generation from their investments.
2. Financial Objectives: The expected financial outcomes are important
in setting investment objectives. These aims may include covering
college expenditures, acquiring a home, obtaining retirement income,
starting a company, or leaving a legacy. Investment plans are
developed to match with these objectives, considering elements
such as the time horizon, the quantity of cash required, and the
risk tolerance associated with each alternative.
3. Risk Tolerance: The capacity and willingness of an individual to
bear prospective losses or volatility in investment prices is referred
to as risk tolerance. Financial stability, time horizon, investing
expertise, and emotional tolerance for market volatility are all
elements that impact it. Those with a higher risk tolerance may
seek out more aggressive growth-oriented investments that provide
larger potential returns but also more volatility. Individuals with a
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WEALTH MANAGEMENT
lower risk tolerance may select more conservative investments that
prioritise capital preservation while producing consistent income.
Notes
4. Time Horizons: The time horizon, or estimated duration of
investment, has a considerable influence on investing goals. Longer
time horizons provide for greater flexibility in dealing with short-term
market volatility and pursuing growth-oriented tactics. Investment
objectives may emphasise capital appreciation and wealth growth
for long-term purposes such as retirement planning or generational
asset transfer. Shorter time horizons, such as financing a near-term
cost, necessitate more conservative investing strategies focused on
capital preservation and rapid income generation.
It is the job of a wealth manager to collaborate extensively with clients to
understand their specific requirements and develop investment strategies
that correspond with their goals, assisting them in achieving long-term
financial success.
2.4 Broad Classification of Investments: Financial
Investment and Real Investment
Financial Investment and Real Investment. To grasp the distinction between
financial and real investment, we must first understand the distinction
between a financial asset and a real asset.
2.4.1 Understanding Financial Investments
Financial Assets are highly liquid assets that can be exchanged to cash easily.
Stocks and bonds are examples of investments. The main characteristic
of financial assets is that they have some economic worth that can be
easily realized. However, it has little inherent worth on its own.
Investing in financial assets entails devoting cash to various financial
assets such as stocks, bonds, mutual funds, real estate, or other investment
vehicles in order to grow wealth over time.
The idea is that you will be able to sell it at a greater price later or generate
money from it while you hold it. You may want to grow something in
the next year, such as saving for a car, or over the following 30 years,
such as retirement savings.
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BMS
Notes
It is critical to realise that financial investments are chosen after
thorough assessment of aspects such as risk, possible return, liquidity,
and diversification mentioned above. When defining financial investment,
keep the following elements in mind:
1. Funds (Capital) Allocation: Financial investing is deploying funds in
various financial assets with the hope of profit. Financial objectives,
risk tolerance, and investment horizon all influence allocation
decisions.
2. Return Generation: The basic goal of financial investing is to create
a good return on the cash invested. Capital appreciation (growth in
the value of the investment) or income creation (such as interest
payments, dividends, or rental income) can provide these returns.
3. Risk and Reward: Different levels of risk are involved with different
financial investments. bigger-risk investments offer the potential
for bigger profits, but they also have a higher danger of loss. Risk
must be assessed and managed through diversification and other
risk management measures.
4. Investigation, Analysis and Decision-Making: To evaluate investment
prospects, financial investing need study and research. To analyse
the investment’s underlying worth, growth possibilities, and potential
hazards, fundamental analysis, technical analysis, and other valuation
approaches can be applied.
5. Long-term view: Financial investments are frequently undertaken
with a long-term view in mind, with the goal of accumulating wealth
over time. Short-term market changes should not drive investing
decisions, and a disciplined approach is critical to meeting investment
objectives.
Investors can choose from a variety of financial assets. The underlying
assets, risk profiles, possible returns, and investing characteristics of
these investment alternatives differ. Here are some examples of popular
financial investments:
1. Stocks: Stocks, also known as equities or shares, indicate ownership
of a corporation. Investing in stocks entails purchasing stock in
publicly listed corporations in the hopes of capital appreciation
and potential dividends. Stocks are typically considered higher-risk
investments, but they have the potential for larger long-term profits.
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WEALTH MANAGEMENT
2. Bonds: Bonds are debt instruments issued to raise money by
governments, municipalities, or companies. When investors purchase
bonds, they are effectively lending money to the issuer in exchange
for periodical interest payments (coupons) and repayment at maturity.
Bonds are frequently considered lower-risk investments than stocks
since they provide fixed income and varied levels of stability.
Notes
3. Mutual funds: They aggregate money from different individuals to
invest in a diverse portfolio of stocks, bonds, or other securities.
Professional fund managers administer them and make investment
choices on behalf of the investors. Mutual funds provide diversification
and access to a diverse variety of asset types, making them appropriate
for individuals with varied risk profiles and investment objectives.
4. Exchange-exchanged Funds (ETFs): Like mutual funds, ETFs are
exchanged on stock exchanges much like individual equities. They
are a collection of assets (such as stocks, bonds, or commodities)
that provide investors with exposure to a certain market index or
sector. ETFs provide liquidity, diversity, and the opportunity to
trade at market prices.
5. Derivatives: Derivatives are financial products that derive their value
from an underlying asset or benchmark. Options, futures, swaps, and
other sophisticated financial contracts are among them. Derivatives
can be used in investing portfolios to hedge, speculate, or manage
risk exposure.
6. Alternative Investments: These include a wide range of non-traditional
investment possibilities such as private equity, hedge funds, venture
capital, etc. These investments frequently have greater minimum
investment requirements, restricted liquidity, and may include more
complicated strategies or structures.
It’s crucial to remember that each investment type has its own set of
features, risk-return profiles, and suitability for certain individuals. Before
choosing on the proper mix of assets for their portfolios, investors should
carefully consider their financial goals, risk tolerance, and investing time
horizon. Diversification across different investment kinds is frequently
advised to control risk and maximise rewards.
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BMS
Notes
2.4.2 Understanding Real Investments
Real assets, on the other hand, are value-driven actual things that a person
possesses. They include real estate, buildings, automobiles, commodities
etc. Its distinguishing feature is that they have intrinsic worth on their
own and do not rely on trades to be valuable.
Real investment may be of several sorts that are typically considered as
part of a complete wealth management plan from the standpoint of wealth
management. Let us attempt to list a few of them.
1. Residential Real Estate: One of the most prevalent forms of real
investments are residential properties such as houses, flats, or
condominiums. They can be held for the purpose of generating rental
income, capital appreciation, or as personal dwellings. Residential
real estate investments may provide consistent income streams, tax
benefits, and long-term capital creation.
2. Commercial Real Estate: Another sort of real investment is commercial
real estate, which includes office buildings, retail spaces, industrial
warehouses, and mixed-use complexes. These properties are often
leased to businesses, generating rental income as well as the
possibility of capital appreciation. Commercial real estate investments
can provide better rental rates as well as prospects for long-term
growth.
3. Real Estate Investment Trusts (REITs): REITs are investment entities
that hold and manage rental properties. Investors can indirectly
invest in a diverse range of real estate assets through them. When
opposed to directly owning buildings, REITs provide the advantages
of regular income distribution, expert management, and liquidity.
They might be traded publicly on stock markets or privately held.
4. Infrastructure Investments: Infrastructure investments entail devoting
resources to critical physical structures and systems such as transportation
networks, utilities, renewable energy projects, and communication
infrastructure. These assets provide long-term income potential,
consistent cash flows, and diversification advantages. Infrastructure
investments can be done directly, through infrastructure funds, or
through publicly listed infrastructure corporations.
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WEALTH MANAGEMENT
5. Farmland and Agriculture: Investing in farmland or agricultural
assets can give exposure to the agriculture industry as well as an
opportunity for generating income. Farmland investments might
include leasing land to farmers or actively investing in agricultural
businesses. These investments provide diversification, inflation
protection, and exposure to global food demand.
Notes
6. Timberland: Investing in timberland entails owning or managing
trees for the purpose of producing wood. Timberland investments
provide the potential for long-term growth through timber harvesting
and selling. They can offer diversity, inflation protection, and longterm investment prospects.
7. Natural Resources: Investing in natural resources such as oil, gas,
minerals, or precious metals may provide both income and capital
appreciation. Direct ownership of resource rights, investment in
resource exploration and production businesses, or membership in
commodities funds are examples of these investments.
8. Private Equity Real Estate: Private equity real estate investments
entail investing in non-publicly traded real estate projects or
enterprises. These investments provide you access to specialised
real estate possibilities as well as the possibility for better profits.
To pool finance for larger-scale real estate developments, private
equity real estate funds or partnerships are frequently employed.
Real investments are frequently done to provide long-term profits, capital
appreciation, or income streams. Real investments are significant to wealth
management in the following ways:
1. Diversification: By adding a physical asset component to an investment
portfolio, real assets provide diversity advantages. Diversification
across asset types, such as real estate, infrastructure, and natural
resources, can help decrease portfolio risk while increasing returns.
Real estate investments frequently have minimal correlation with
traditional financial assets such as stocks and bonds, which can act
as a buffer during market turbulence.
2. Wealth Preservation: Long-term wealth preservation can be aided
by real investments, especially in steadily rising and stable markets.
Real estate and infrastructure investments, for example, may serve
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BMS
Notes
as an inflation hedge and a store of value. These assets have lower
volatility than financial markets and can provide a consistent revenue
stream through rental income or lease payments.
3. Income Generation: Real estate investments can create consistent
income, which is useful in wealth management techniques. Rental
income, dividends from Real Estate Investment Trusts (REITs), or
revenue from infrastructure projects can all generate a consistent
cash flow. This money can be reinvested or utilised to cover living
expenditures, retirement plans, or other financial objectives.
4. Risk Minimization: Real assets can act as a buffer against certain
dangers. Investing in real assets such as precious metals or commodities,
for example, might act as a hedge against inflation or currency
depreciation. Furthermore, because they are frequently supported
by long-term contracts or regulated income streams, infrastructure
investments may provide stability and regular profits.
5. Capital Appreciation: Real assets, particularly in growing sectors or
high-demand locations, have the potential for capital appreciation.
Real estate, for example, has traditionally demonstrated the potential
to increase in value over time. Capital appreciation may considerably
help to wealth growth and long-term financial goals.
6. Estate Planning: Real investments may be an important aspect of
estate planning plans. Properties, land, and other physical assets
can be inherited or placed in trust for future generations. Real
investments may aid in wealth transfer while potentially lowering
taxes and giving recipients a concrete legacy.
IN-TEXT QUESTIONS
1. The main characteristic of real investments is that they:
(a) Generate income in the form of dividends or interest
payments
(b) Are intangible assets with no physical presence
(c) Have a primary objective of capital appreciation
(d) Involve ownership of physical or tangible assets
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WEALTH MANAGEMENT
2. Which of the following is an example of a financial investment?
Notes
(a) Buying a residential property for rental income
(b) Investing in a startup business
(c) Purchasing corporate bonds
(d) Acquiring agricultural land for farming purposes
2.5 Two Different Terms: Investment and Speculation
Consider a person who performs extensive study on several organisations,
including their financial performance, competitive advantages, management
team, and industry trends. They select a fundamentally sound firm with
great growth potential based on their investigation. They buy the stock
with the idea of owning it for a long time and profiting from capital
appreciation and dividends. Rather than short-term market swings, the
investor concentrates on the company’s fundamental worth, earnings
potential, and long-term growth. To mitigate risk, they may also diversify
their portfolio across different sectors or businesses.
Consider another person who participates in speculative trading in
the stock market. They may purchase and sell stocks regularly based
on short-term market trends, rumours, or pricing patterns without any
analysis. Rather than fundamental analysis, their decision-making is
mainly influenced by gut feeling, hear-say, rumours, etc. They seek to
profit from short-term market fluctuations and may apply tactics during
trading. Speculators generally have a shorter time horizon and may lack
a thorough knowledge of the underlying value or long-term prospects of
the firms in which they trade.
In this scenario, the first person treats the stock market as an investment,
concentrating on the long-term potential of the firms in which they invest
and completing extensive research. They aim to accumulate wealth over time
through capital appreciation and dividends. The second person speculates,
placing short-term transactions based on market trends, stock tips, gut
feeling, or rumours. They seek to benefit from short-term price swings
without regard for the equities’ long-term prospects or fundamental worth.
Investment and speculation are two different ways of financial decisionmaking, with different goals, time horizons, and risk profiles.
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© Department of Distance & Continuing Education, Campus of Open Learning,
School of Open Learning, University of Delhi
BMS
Notes
1. Objectives: The basic goal of investing is to earn an adequate return
on money by acquiring assets with the potential to rise in value
or provide income. Investors often consider variables such as an
asset’s fundamental worth, growth possibilities, and the possibility
for regular income streams. Speculation, on the other hand, entails
making wagers on the price fluctuations of assets, frequently without
a clear grasp of their underlying worth, in order to make short-term
profits.
2. Time Horizon: Typically, investments have a longer time horizon,
spanning years or even decades. Investors want to accumulate wealth
steadily over time by generating income or capital appreciation.
Speculation, on the other hand, is generally limited to shorter time
horizons spanning from hours to days to months. Speculators seek
to benefit from short-term price swings or inefficiencies in the
market.
3. Risk and Uncertainty: Generally, investments entail a determined
evaluation of risk and prospective reward. To reduce risk and make
educated decisions, investors frequently do extensive study and
research. While investments may still be subject to risks such as
market volatility or asset-specific issues, they are generally seen
less risky as compared to speculation. Speculators frequently make
forecasts based on market trends, rumours, etc., and their outcomes
are significantly impacted by short-term market swings, making
their holdings more sensitive to losses.
4. Asset Selection: Choosing assets that match with one’s financial
goals and risk tolerance is a common step in the investment process.
Stocks, bonds, mutual funds, real estate, and business endeavours
are all common investment possibilities. Diversification allows
investors to spread risk across multiple asset groups. Speculation,
on the other hand, frequently concentrates on high-risk assets or
derivative instruments with the possibility for significant short-term
profits, such as options, futures, etc.
5. Decision-Making Approach: Typically, investment decisions are
based on fundamental analysis, which considers aspects such as
financial statements, market trends, industry analysis, and the
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general economic outlook. Investors seek out undervalued assets
and make long-term investments. Sometimes, they use technical
analysis, charts, patterns, and short-term market sentiment also for
investing. Speculators may use short-selling, leverage, or margin
trading as strategies to increase or decrease prospective gains or
losses.
Notes
Table 2.1: Investment vs. Speculation - What is the difference?
Objective
Time Horizon
Risk
Decision-making
Asset Selection
Focus
Investment
Long-term wealth creation
Long-term (years or
decades)
Calculated risk assessment
Fundamental analysis
(value, growth potential)
or technical analysis
(market trends, patterns)
'LYHUVL¿FDWLRQDFURVV
various assets
Fundamental value and
income potential
Market View
Long-term trends and
fundamental factors
Research
Thorough analysis and
research
Time Commitment Patiently holds positions
over time
Speculation
6KRUWWHUPSUR¿W
Short-term (hours to days
to months)
Higher risk and
uncertainty
Rumours, stock tips, gut
feeling
High-risk assets or
derivative instruments
Short-term market
ÀXFWXDWLRQVRUSULFH
movements
Short-term market
sentiment or rumours.
No focus on detailed
analysis
Frequent buying and
selling
2.6 Risk-Return Trade-Off
Higher risk relates to a higher likelihood of higher return, whereas lower
risk is associated with a higher probability of lower return. The risk return
trade off refers to the trade-off that an investor must make between risk
and return while making investing decisions.
The risk-reward trade-off is one of the most important factors that investors
evaluate while making investing decisions and appraising their assets.
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Notes
The risk-return trade-off is a trading concept that associates high levels
of risk with high levels of reward.
When deciding whether to invest, Rohan, for example, must consider the
risk-reward trade-off. If he deposits all of his money in a saving bank
account, he will get a poor return (the bank’s interest rate), but his money
will be covered up to Rs. 5,00,000 (the Deposit Insurance and Credit
Guarantee Corporation in India now offers insurance up to Rs. 5,00,000).
However, if he invests in stocks, he runs the danger of losing a significant
portion of his capital while still having the opportunity to earn a significantly
larger return than a savings deposit in a bank.
Several factors influence the best risk-return trade-off, including an
investor’s risk tolerance, the number of years until retirement, and the
investor’s capacity to replenish lost assets. This trade-off implies that in
order for an investor to get higher returns on their investment, they must
first be ready to accept a higher risk.
Risk tolerance of any investor can be known by the investor’s investment
profile. The market communicates that greater-risk investments offer higher
predicted returns. As a result, the major emphasis of an investor’s action
in the investing game is controlling the risk-return trade-off. In Lesson
3 – Return and Risk, you will learn more about how this relationship is
calculated and quantified.
2.7 An Overview of Securities Market
The securities market is a marketplace for the purchase and sale of various
financial instruments known as securities. It is a trading platform where
ordinary and institutional investors may exchange assets such as stocks,
bonds, derivatives, and other financial instruments. The securities market
allows firms, governments, and other entities to raise funds and investors
to purchase and sell financial assets.
The Indian securities market is the system and infrastructure in India
that allows for the purchase and sale of financial securities such as
stocks, bonds, derivatives, and other investment instruments. Individuals,
businesses, and organisations can use the market to raise funds, exchange
securities, and manage investment portfolios.
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The following is a quick overview of the important components and
entities in the Indian securities market:
Notes
1. Regulators and Exchanges
(a) Securities and Exchange Board of India (SEBI): SEBI is the
major regulatory institution in charge of the Indian securities
industry. It controls and oversees various market participants,
protects investors, and encourages fair and transparent business
practices.
(b) National Stock Exchange (NSE): The NSE is one of India’s
largest stock exchanges, offering an electronic trading platform
for stocks, equity derivatives, bonds, and other financial
products.
(c) Bombay Stock Exchange (BSE): The BSE is Asia’s oldest
stock exchange, facilitating the trade of a variety of assets
like as equities, derivatives, and debt instruments.
2. Market Segments
(a) Equity Market: The equity market allows investors to become
partial owners (shareholders) of corporations by trading stocks
(shares) issued by those companies.
(b) Debt Market: Instruments in the debt market include government
bonds, corporate bonds, debentures, and other fixed-income
securities. It serves as a platform for borrowing and lending
cash at predetermined interest rates and maturity dates.
(c) Derivatives Market: Investors can trade financial products
generated from underlying assets such as equities, indices,
or currencies in the derivatives market. Futures, options, and
other derivative products are included.
3. Market Participants
(a) Investors: Individual investors, institutional investors (such as
mutual funds, insurance companies, and pension funds), and
international (foreign) investors all play an active role in the
Indian stocks market.
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Notes
(b) Brokers and Trading Members: Brokers are registered middlemen
that help investors purchase and sell stocks. Trading members
are companies that are permitted to trade on stock exchanges.
(c) Depositories: The National Securities Depository Limited
(NSDL) and Central Depository Services Limited (CDSL)
are two central depositories that keep and preserve electronic
records of dematerialized securities.
(d) Clearing Companies: Clearing companies assure trade settlement
and control transaction risk by providing clearing and settlement
services to market participants.
(e) Listed Companies: Companies that are listed on Indian stock
exchanges allow the public to trade their shares. They must
follow SEBI requirements and provide financial information
to shareholders and the public on a regular basis.
4. Market Indices
(a) Nifty 50: The NSE’s flagship index, the Nifty 50, is made up
of 50 actively traded large-cap equities representing diverse
sectors of the Indian economy.
(b) BSE Sensex: The BSE Sensex is a widely recognised benchmark
index of 30 frequently traded equities from various industries.
5. Regulatory Framework: SEBI built a well-defined regulatory structure
for the Indian securities industry. It covers disclosure standards,
investor protection, trading practices, listing requirements, company
governance, and market monitoring.
Over the years, the Indian securities market has grown significantly,
drawing both domestic and foreign investors. The market is critical for
channelling cash into the economy, encouraging capital development,
and allowing investors to participate in the growth of Indian enterprises.
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Notes
Market Participants
Investors
Regulators and Exchangers
Brokers and Trading Members
Securities and Exchange Board of India
National Stock Exchange
Bombay Stock Exchange
Depositories
Changing Companies
Listed Companies
Regulatory Framework
Indian Securities
Market
Commodities Market
Derivatives Market
BSE Sensex
Nifty 50
Debt Market
Equity Market
Market Indices
Market Segments
Figure 2.1: Broad Components of the Indian
Securities Market (Summary)
2.8 Investment Decision Process: How Do Investors
Decide?
Several critical processes are involved in the process of investment
decision-making in the context of wealth management to ensure that
investments correspond with an individual’s financial goals, risk tolerance,
and overall wealth management strategy.
It is critical to understand that the investing decision-making process in
wealth management is a continuous, iterative process rather than a onetime occurrence.
Here’s an explanation of the procedure:
1. Define Financial Goals: The first stage is to describe your financial
goals and objectives. This involves establishing short- and long-term
objectives such as retirement planning, education funding, asset
preservation, and capital growth. Setting specified, measurable,
attainable, relevant, and time-bound goals (SMART) is critical for
driving investment decision-making.
2. Risk Assessment: Following that, a thorough risk assessment is
performed to determine an individual’s risk tolerance, i.e., Capacity
to take on investing risks. Age, investment horizon, financial
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Notes
commitments, and personal preferences are all considered when
determining the proper risk level for an investment portfolio.
3. Asset Allocation: An asset allocation strategy is developed based on
the financial goals and risk assessment. Asset allocation is the process
of establishing the optimal mix of asset classes (e.g., stocks, bonds,
real estate, cash, and alternative assets) in an investment portfolio.
The objective is to diversify assets in order to disperse risk and
optimise returns based on the risk tolerance and time horizon of
the investor.
4. Investment Research and Analysis: Extensive research and analysis
are carried out to find investment possibilities that are consistent
with the asset allocation plan. This entails examining numerous
investment possibilities, reviewing their performance, assessing
risks, and considering aspects such as past returns, future growth
potential, management quality, and market circumstances.
5. Investment Selection: After identifying prospective investment
possibilities, the next stage is to choose assets. Comparing investment
options entails considering aspects such as fees, liquidity, investment
minimums, and investment time horizons. Investments are chosen
based on their fit with the investment goals, risk profile, and
suitability for the individual’s financial situation.
6. Portfolio Development: The chosen investments are then integrated
to form a diverse investment portfolio. Based on the individual’s
asset allocation strategy, the portfolio is meant to balance risk and
return. Portfolio creation may entail defining the weighting of each
asset class, picking individual securities or investment vehicles
within each asset class, and considering issues such as rebalancing
needs and tax consequences.
7. Ongoing Monitoring and Review: Once the portfolio is built, it
must be monitored and reviewed on a regular basis. This involves
monitoring the performance of individual assets, examining market
circumstances, and comparing the portfolio’s total performance to
the financial objectives stated. Adjustments to the portfolio, such
as rebalancing or reallocating investments, may be made as needed
to guarantee alignment with changing financial goals and market
circumstances.
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8. Regular Portfolio Reassessment: As personal circumstances, financial
goals, or market conditions change, it may be necessary to evaluate
the investment portfolio. Regular portfolio reassessments entail
assessing and updating the investment strategy, considering changes
in risk tolerance, and making any required modifications to asset
allocation or investment selection to meet the revised goals and
risk profile.
Notes
9. Professional assistance: Seeking assistance from financial advisers,
wealth managers, or investment experts who can give knowledge,
insights, and specialised recommendations is a common part of wealth
management. These specialists may help with investment decisions,
portfolio assessments, and continuing direction and assistance to
help reach the desired financial results.
2.9 Approaches to Investing
Approaches to investing’, refers to different techniques, methodologies,
or philosophies that investors may use to make investment decisions and
manage their portfolios. These
techniques are founded on
numerous concepts, beliefs,
and objectives that govern
the activities and investing
strategies of the investor. The
technique used can have a
major influence on investment
performance and overall
investing experience. You
can think of these approaches
as styles.
Investing styles are not
mutually exclusive, and
investors frequently blend
components of several
approaches based on their
investment goals, risk tolerance,
and preferences. The strategy
Figure 2.2: FISEQ
*ARABIC 2 - Investing
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BMS
Notes
used can have a substantial influence on investing strategies, portfolio
composition, and the amount of investor interaction necessary.
Some common approaches to investing include direct investing, indirect
investing, active investing, passive investing, value investing, growth
investing, income investing and diversification. Let us have a look at
these approaches:
1. Value Investing: This strategy entails looking for undervalued investments
in the market. The investors continuously seek opportunities in which
the market price of an investment is lower than its inherent worth,
with the expectation that the market would ultimately recognise
and rectify the undervaluation, resulting in potential profit.
2. Growth Investing: Growth investors seek out firms or industries
with great growth potential. Investors look for firms with aboveaverage growth and are frequently ready to pay higher prices in
anticipation of future growth and development.
3. Income Investing: This strategy focuses on establishing an ongoing
source of income from assets. Bonds, dividend stocks, and Real
Estate Investment Trusts (REITs) are popular choices for income
investors because they generate monthly interest payments, dividends,
or rental income.
4. Diversification: Diversification is a strategy for spreading investment
risk by allocating assets among several asset classes, industries,
geographies, or investment kinds. The objective is to limit the
influence of individual investment performance while increasing
the portfolio’s total risk-adjusted returns.
2.9.1 Direct and Indirect Investing: Meaning and Differences
Direct and Indirect investing are two separate investment methodologies
with unique tactics and goals. Here’s an explanation of each, as well as
the distinction between the two:
Direct Investing: The practice of actively picking and managing individual
assets is referred to as direct investing. Investors use this strategy to make
particular investment decisions, such as purchasing or selling stocks,
bonds, real estate holdings, or other assets. To establish and maintain their
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WEALTH MANAGEMENT
investment portfolios, direct investors often perform their own research,
analysis, and decision-making. They use active management to outperform
the market or to meet specific investing goals.
Notes
Indirect Investing: Also known as indirect ownership or pooled investing,
indirect investing entails participating in collective investment vehicles
or funds that combine cash from various participants. Investors indirectly
engage in a diversified portfolio of securities or assets through investment
vehicles such as mutual funds, Exchange-Traded Funds (ETFs), hedge
funds, or private equity funds, rather than directly owning individual
assets. Fund managers or experts make investing choices on behalf of
investors, such as asset allocation, asset selection, and rebalancing.
There are differences between direct and indirect investing. These
distinctions are as follows:
1. Ownership and Control: In direct investing, investors own individual
assets and have complete control over investment decisions. They
have the ability to purchase, sell, and manage their possessions.
Investors in indirect investing possess shares or units in investment
vehicles, while fund managers or experts make investment choices
on their behalf.
2. Diversification: Because direct investing allows investors to choose
individual assets or securities for their portfolio, it might result in
concentrated holdings. Indirect investing, such as mutual funds or
Exchange-Traded Funds (ETFs), provides built-in diversification
because these funds often maintain a broad portfolio of assets across
multiple sectors, industries, or locations.
3. Expertise and Time Commitment: Direct investing necessitates
investors having knowledge, expertise, and the time to do research,
analyse, and manage individual assets. Because investment choices
are handled by experienced fund managers or investment teams,
indirect investing relieves investors of the necessity for significant
study and monitoring.
4. Opportunity Access: Direct investment allows investors to have
access to certain assets or securities that may not be available
through indirect investing choices. Direct investing, for example,
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BMS
Notes
may allow investors to participate in particular stocks, private equity
ventures, or specific real estate holdings that are not available
through investment funds.
5. Costs and Expenses: Because investors do not pay for the services
of professional fund managers, direct investing may have reduced
management fees. Direct investment, on the other hand, may incur
transaction charges and expenses connected to research, analytical
tools, and custodial services. Management fees and other expenses
related with the fund’s operation are incurred when investing
indirectly through investment funds.
6. Risk Management: Because direct investing requires investors to
actively manage and monitor their assets, it is critical that they
understand the risks involved and implement proper risk management
procedures. Risk management is often managed by fund managers
or specialists in indirect investing, who apply different tactics for
the same.
Table 2.2: Direct Investing vs. Indirect Investing
Direct Investing
Investors personally own
individual assets and
have direct control over
investment decisions
Indirect Investing
Ownership
Investors own shares
or units in investment
and Control
vehicles, with professional
managers making
investment decisions
'LYHUVL¿FDWLRQ May lead to concentrated %XLOWLQGLYHUVL¿FDWLRQ
positions, limited
through pooled
GLYHUVL¿FDWLRQXQOHVV
investments in various
actively managed
assets or securities
Expertise and Requires investor
Relieves investors from
knowledge, expertise,
extensive research
Time
and time for research,
and monitoring, as
analysis, and management professional managers
handle investment
decisions
Access to
2IIHUVDFFHVVWRVSHFL¿F Provides access to
a diverse range of
Opportunities assets or securities that
may not be available
investment opportunities,
through investment funds including asset classes
and sectors
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WEALTH MANAGEMENT
Cost and
Expenses
Risk
Management
Examples
Minimal management
fees, but may incur
transaction costs and other
expenses
Investors actively manage
and monitor risks
Buying individual
stocks, bonds, real estate
properties
Management fees and
other expenses associated
with the operation of
investment vehicles
Risk management handled
by professional managers
WKURXJKGLYHUVL¿FDWLRQ
and risk mitigation
Investing in mutual funds,
ETFs, hedge funds, or
private equity funds
Notes
2.9.2 Active and Passive Investing: Meaning and Differences
Active and passive investing are two separate investment methodologies
with unique tactics and goals. Their definitions are as follows:
Active Investing: Active investing is a financial strategy in which investors
make active investment decisions based on research, analysis, and market
insights. Active investors actively purchase and sell assets in their portfolios
in order to outperform the market or accomplish specific investing goals.
In order to capitalise on market inefficiencies, mispricing, or developing
possibilities, they often conduct intensive research, meticulous analysis,
and regular modifications to their holdings. Active investors frequently
depend on their talents, knowledge, and judgment to create returns that
outperform the market as a whole.
Passive Investing: Also known as index investing or buy-and-hold investing,
passive investing includes a more hands-off strategy in which investors
strive to track the performance of a given market index or asset class
rather than actively picking individual assets. Passive investors believe
in the efficient market hypothesis, which states that markets are typically
efficient and that outperforming them using active tactics is difficult.
Instead, they seek to duplicate the performance of a market index or a
specific asset class through the use of index funds or Exchange-Traded
Funds (ETFs). Passive investing is characterised by less frequent trading
and a longer investment horizon.
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BMS
Notes
These two styles of investing have essential distinctions, which are as
follows:
1. Investment Strategy: Active investing is making particular investment
decisions based on research, analysis, and market insights in order
to outperform the market. Passive investing, which does not include
active decision-making or stock selection, seeks to duplicate the
performance of a given market index or asset class.
2. Portfolio Turnover: Active investing often includes greater portfolio
turnover since active investors constantly purchase and sell assets in
order to capitalise on market opportunities or change their holdings
in response to market circumstances. Passive investing typically
results in lower portfolio turnover since investors want to maintain
a long-term investment strategy that closely reflects the selected
index or asset class.
3. Cost: Because of research charges, transaction fees, and possible
fees for expert advice or active management, active investing can
be more expensive. Passive investing is typically less expensive
since it entails investing in index funds or ETFs with reduced
management fees and less trading activity.
4. Expected Risk and Return: Active investment has the potential
for both larger profits and higher dangers. Active investors seek to
beat the market, but success is not guaranteed, and bad investing
selections can lead to underperformance. Passive investing seeks
to replicate the returns of the chosen market index or asset class,
giving investors with wide market exposure without the expectation
of significant outperformance.
5. Time and Effort: Active investing necessitates a substantial time
commitment since investors must do research, analyse data, and
actively manage their portfolios. It includes keeping current on
market trends, financial news, and specific company performance.
Passive investing necessitates less time and effort since investors
depend on the performance of the chosen index or asset class rather
than continuing research or active management.
6. Investor Involvement: Active investing necessitates that investors
participate actively in decision-making and regularly monitor their
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© Department of Distance & Continuing Education, Campus of Open Learning,
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WEALTH MANAGEMENT
investments. Passive investing allows investors to take a hands-off
approach, depending on the success of the selected index or asset
class rather than making active decisions.
Notes
Table 2.3: Active Investing vs. Passive Investing
Active Investing
Investment Actively select and manage
Approach
investments based on
research and analysis
Portfolio
Higher, frequent buying
Turnover
and selling of investments
Cost
Higher costs due to research
expenses, transaction fees,
and potential fees for active
management
Risk and
Potential for higher returns
Return
and higher risks, aim to
Expectations outperform the market
Time and
Effort
6LJQL¿FDQW WLPH FRPPLWment for research, analysis,
and active management
Investor
Actively involved in deciInvolvement sion-making and monitoring of investments
Examples
Actively selecting individual stocks, frequent trading
Passive Investing
Replicate the performance
RI D VSHFL¿F PDUNHW LQGH[
or asset class
Lower, minimal buying and
selling activity
Lower costs with index
funds or ETFs, typically
with lower management
fees
Aim to match the returns
of the chosen market index
or asset class, without the
H[SHFWDWLRQ RI VLJQL¿FDQW
outperformance
Less time and effort
required, as investors rely
on the performance of the
chosen index or asset class
More hands-off approach,
relying on the performance
of the chosen index or asset
class
Investing in index funds or
ETFs that track a market
index or asset class
IN-TEXT QUESTIONS
3. Which of the following best describes the risk-return trade-off?
(a) Higher risk is always associated with higher returns
(b) Lower risk is always associated with higher returns
(c) Risk and return are unrelated and independent of each
other
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BMS
Notes
(d) Risk and return have a positive relationship, but it is not
always linear
4. Which of the following is a characteristic of passive investing?
(a) Frequent buying and selling of securities to outperform the
market
(b) Long-term buy-and-hold strategy tracking market indexes
(c) Active research and analysis to identify undervalued stocks
(d) Use of complex derivatives to hedge against market risks
2.10 Conclusion
Investing is more than simply a way to build money; it’s a powerful
weapon that allows people to determine their own financial destiny. It
enables us to travel beyond basic savings and into the area of creating
rewards. We can unleash possibilities, manage dangers, and pave the way
to long-term success by allocating our resources wisely.
Investing, however, is not without its difficulties. It necessitates knowledge,
analysis, and an attitude of continual learning. Keeping up with market
developments, comprehending economic statistics, and assessing investing
prospects may be difficult. Nonetheless, the returns might be significant.
Investing enables us to take advantage of the force of compounding,
capitalise on the growth potential of diverse asset classes, and eventually
attain financial independence.
2.11 Summary
‹
Investing helps individuals accomplish their financial objectives and
assure a brighter future.
‹
Financial investments (stocks, bonds, mutual funds) and real investments
(real estate, infrastructure, commodities) are two types of investments.
‹
Setting defined objectives, measuring risk tolerance, and aligning
investments with individual circumstances and financial goals are
all part of investing decision-making.
44 PAGE
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WEALTH MANAGEMENT
‹
Direct investing is owning individual assets individually, whereas
indirect investing entails holding shares or units in investment
vehicles managed by experts.
‹
Active investing entails making investment decisions based on study
and analysis, with the goal of outperforming the market.
‹
Passive investing seeks to mirror the performance of a certain market
index or asset class while requiring less active decision-making and
incurring fewer costs.
‹
Diversification, inflation protection, and possible long-term value
increase are all benefits of real assets in wealth management.
‹
Individual preferences, risk tolerance, and investment objectives all
influence the decision between active and passive investing.
‹
Successful investment necessitates knowledge, ongoing learning,
adaptation, and a methodical approach.
‹
Compounding, capitalising on market movements, and possibly
obtaining financial freedom are all possibilities with investments.
‹
Investing is a journey that involves diligence, intelligent decisionmaking, and the use of professional advice when necessary.
Notes
2.12 Answers to In-Text Questions
1. (d) Involve ownership of physical or tangible assets
2. (c) Purchasing Corporate Bonds
3. (d) Risk and return have a positive relationship, but it is not always
linear
4. (b) Long-term buy-and-hold strategy tracking market indexes
2.13 Self-Assessment Questions
1. What is the difference between investment and speculation? Provide
examples to support your answer.
2. Name three common investment objectives in the context of wealth
management and briefly explain each one.
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BMS
Notes
3. Define diversification and explain why it is important in investment
portfolios.
4. Compare and contrast active investing and passive investing in terms
of their approach, strategy, and expected outcomes.
5. What is the difference between direct investing and indirect investing?
Provide examples of each.
6. Define capital preservation and explain why it is a significant
investment objective in wealth management.
7. Describe the concept of risk management in investments and discuss
some strategies for mitigating investment risks.
8. Explain the difference between real investment and financial investment,
providing examples of each.
9. Name three types of real investments from the perspective of wealth
management and briefly describe each one.
10. Compare and contrast capital appreciation and income generation as
investment objectives, highlighting their differences and potential
investment vehicles.
2.14 References
‹
Kapoor, J., Dlabay, L. R., & Hughes, R. J. (2020). 3HUVRQDO)LQDQFH
(13th ed.).
‹
Gitman, L. J., Joehnk, M. D., Smart, S., & Juchau, R. H. (2015).
Fundamentals of investing. Pearson Higher Education AU.
‹
Arthur, J. N., Williams, R. J., & Delfabbro, P. H. (2016). The
conceptual and empirical relationship between gambling, investing,
and speculation. Journal of behavioural addictions, 5(4), 580-591.
‹
Sabarinathan, G. (2010). SEBI’s regulation of the Indian securities
market: A critical review of the major developments. 9LNDOSD, 35(4),
13-26.
46 PAGE
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WEALTH MANAGEMENT
2.15 Suggested Readings
‹
Graham, B. (2003). 7KH,QWHOOLJHQW,QYHVWRU7KH'HILQLWLYH%RRNRQ
9DOXH ,QYHVWLQJ (Rev. ed.). Harper Business.
‹
Malkiel, B. G. (2022). $5DQGRP:DON'RZQ:DOO6WUHHW(12th ed.).
‹
Bodie, Z., Kane, A., & Marcus, A. J. (2021). ,QYHVWPHQWV (12th ed.)
‹
Geltner, D., Miller, N. G., Clayton, J. P., & Eichholtz, P. M. (2018).
&RPPHUFLDO 5HDO (VWDWH $QDO\VLV DQG ,QYHVWPHQWV (4th ed.).
‹
Grinold, R. C., & Kahn, R. N. (2019). $FWLYH3RUWIROLR0DQDJHPHQW
$ 4XDQWLWDWLYH $SSURDFK IRU 3URGXFLQJ 6XSHULRU 5HWXUQV DQG
&RQWUROOLQJ 5LVN (2nd ed.).
Notes
PAGE 47
© Department of Distance & Continuing Education, Campus of Open Learning,
School of Open Learning, University of Delhi
L E S S O N
3
Return and Risk Analysis
Anusha Goel
Shaheed Sukhdev College of Business Studies
University of Delhi
Email-Id: anusha.goel92@gmail.com
STRUCTURE
3.1 Learning Objectives
3.2 Introduction to Return and Risk
3.3 7\SHV RI 5HWXUQ
3.4 7\SHV RI 5LVN
3.5 &DOFXODWLRQ RI 5LVN
3.6 ,PSDFW RI 7D[HV DQG ,QÀDWLRQ RQ ,QYHVWPHQW
3.7 6XPPDU\
3.8 Answers to In-Text Questions
3.9 6HOI$VVHVVPHQW 4XHVWLRQV
3.10 5HIHUHQFHV
3.11 Suggested Readings
3.1 Learning Objectives
‹
To understand the concept of risk and return involved in an investment.
‹
To explore the various kinds of return namely Absolute Return, Average Return, etc.
discuss their computation method and application in wealth management industry.
‹
To examine the different categories of risk, their causal factors and understand their
role in altering the returns on any investment.
‹
To explore the computation of total risk and its bifurcation into systematic and
unsystematic risk involved in an investment.
48 PAGE
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School of Open Learning, University of Delhi
WEALTH MANAGEMENT
‹
To analyse the different investment alternatives on the basis of
risks and return characteristics and choose the best alternative for
an investor.
‹
To analyse the impact of taxes and inflation on the investments in
the current scenario.
Notes
3.2 Introduction to Return and Risk
Investment refers to putting money in an asset with a view to enhance
income in future. There are a wide range of instruments available in the
market namely treasury bills, corporate bonds, government bonds, shares,
mutual funds etc. Each of these instruments are usually analysed in terms
of prominent characteristics i.e., return and risk. Return is defined as
the income earned on an investment expressed as a proportion of initial
investment value. The return comprises two components namely regular
income and capital gains. Regular income includes dividend received on
shares or interest received on bonds/debentures at regular intervals from
the company. Capital gain is a type of return earned from a change in
the prices of securities over a period of time.
Another important characteristic is risk. Risk refers to volatility in the
expected return of a security. It happens due to frequent changes in social,
political, technological, international environment or labour-management
issues in the company etc. As a result, the varied instruments are exposed
to different degrees of risk. It is said that risk and return move together
in the same direction. Any instrument having a low degree of risk is
expected to generate low returns and those instruments having a high
degree of risk is expected to generate large returns to the investor. For
example, Treasury bills which are issued by the government are less
likely to default in the payment of interest/redemption value and therefore
are considered as the safest form of investment. After this, government
bonds offer low risk and low returns. Corporate bonds come with a
greater amount of risk and offer a higher rate of return as compared
to government bonds. Preference shares are another instrument which
carries the risk of default in the payment of dividend/redemption price
but offers higher return vis-à-vis bonds and treasury bills. Equity shares
PAGE 49
© Department of Distance & Continuing Education, Campus of Open Learning,
School of Open Learning, University of Delhi
BMS
Notes
are believed to be the riskiest and offer the highest level of return among
all these instruments. Therefore, it is advised that an investor should put
his money in numerous instruments to minimize the entire risk and earn
moderate returns from his overall investment.
3.3 Types of Return
There are numerous ways to express returns on investment which are
elaborated as follows:
3.3.1 Absolute Return
Absolute return is the total return generated over the period without
considering the cost of investment. An investor usually purchases bonds
and shares for investment. If the investor put his money in bonds or
debentures, the return would comprise of interest received at the end of
every year and capital gains, if any, earned on the maturity of the bond.
If he invests his money in shares, the returns will include the dividend
received from time to time and capital gains on the sale of such shares.
Accordingly, the absolute return for the period is computed as:
In case of bonds: Year-end price – Purchase price + Interest received
during period.
= (Pt – P0 ™,t
In case of shares: Year-end price – Purchase price + Dividend received
during period.
= (Pt – P0 ™Dt
Eg. 1: An investor has purchased 1000 shares of Ambuja Cements Ltd.
at a price of INR 50 per share on 30th March 2023. Six months later,
they were sold at only INR 175 per share. Calculate the absolute return
of the stock.
Ans.: Absolute return = (Pt – P0 ™ Dt
= 175 – 350
= - 175 per share
Total loss = 175 × 1000 = INR 1,75,000
50 PAGE
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School of Open Learning, University of Delhi
WEALTH MANAGEMENT
Eg. 2: An investor has purchased Stock QTM for INR 120 and sold it
after six months at INR 180. He has also purchased Stock JKL at INR
108 and sold it after three months for INR 132 after the dividend receipt
of INR 3. Calculate the Absolute Return of both investments.
Notes
Ans.: Absolute Return = (Pt – P0 ™ Dt
Stock QTM = 180 – 120 = INR 60
Stock JKL = 132 – 108 + 3 = INR 27
3.3.2 Average Return
A major limitation of absolute returns is that it ignores the amount of
money invested in generating the return and therefore provides inadequate
information about different investment alternatives. It means comparison
can’t be made and selection of best alternative among all possible
alternatives can’t be done. Average return is extremely useful in such a
scenario. Average return is obtained by taking the mean of annual returns
generated over the period of investment. There are two ways of computing
the average returns as follows:
(i) Using arithmetic mean
$YHUDJH 5HWXUQ ™ 5t/N
Rt =
((Pt – Pt-1) + Dt)
P0
× 100
Where Rt = Return generated in year t
N = Number of years
Pt = Price at the end of year t
Pt-1 = Price in the beginning of year t-1
Dt = Dividend received at the end of year t
(ii) Using geometric mean
Average Return = (((1+r1) × (1 + r2) × (1+r3) ... (1 + rt))1/t – 1) × 100
Where r1, r2…….rt = Return generated in each year
t = Number of years
Eg. 3: Mr. Kumar invested INR 200 in a share which has earned 20%
annually for three years. However, it lost 60% in the fourth year and
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© Department of Distance & Continuing Education, Campus of Open Learning,
School of Open Learning, University of Delhi
BMS
Notes
earned 20% per annum for the next three years. Can we conclude that 60%
return is generated over a time frame of seven years? Why or why not?
Ans.: Average Return = (((1+r1) × (1 + r2) × (1+r3) ... (1 + rt))1/t – 1) × 100
= (((1 + 0.20)3 (1 - 0.60) (1 + 0.20)3)1/7 - 1) × 100
= ((1.20)6 × (0.40)1/7 - 1) × 100
= 2.57% p.a.
Since the average return turns out to be 2.57% per annum, we can’t
conclude that 60% return is generated over a time frame of seven years.
Eg. 4: Mr. Gupta is interested in investing money in the shares of Coal
Ltd. which is available at a price of INR 260 on 31 December 2023.
The price of the share at the end of years 2017, 2018, 2019, 2020, 2021
and 2022 were INR 100, 125, 118, 130, 120 and 140. The company did
not pay any dividend to the shareholders. Calculate the average return.
(i) Using arithmetic mean
(ii) Using geometric mean
(iii) What will be the answer in (i) and (ii) if a dividend of INR 2 is
given every year?
Ans.:
Year
2017
2018
Stock price (INR)
Return (%)
100
125
(125 − 100) × 100 = 25%
100
2019
118
(118 − 125)
× 100 = - 5.6%
125
2020
130
(130 − 118) × 100 = 10.16%
118
2021
120
(120 − 130) × 100 = - 7.69%
130
2022
140
(140 − 120) × 100 = 16.67%
120
2023
260
(260 − 14) × 100 = 85.71%
140
52 PAGE
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WEALTH MANAGEMENT
Notes
25 − 5.6 + 10.16 − 7.69 + 16.67 + 85.71
(i $YHUDJH 5HWXUQ ™ 5 t/N =
6
= 20.7%
(ii) Average Return = (((1+r1) × (1 + r2) × (1+r3) ... (1 + rt))1/t – 1) ×
100
= (((1 + 0.25) (1 - 0.056) (1 + 0.1016) (1 - 0.0769) (1 + 0.1667)
(1 + 0.8571))1/6 - 1) × 100
= ((1.25 × 0.944 × 1.1016 × 0.9231 × 1.1667 × 1.8571)1/6 - 1) ×
100
= 17.26%
Year
2017
2018
Stock price
(INR)
100
125
Dividend
(INR)
2
2019
118
2
(118 − 125 + 2) × 100 = - 4%
125
2020
130
2
(130 − 118 + 2) × 100 = 11.86%
118
2021
120
2
(120 − 130 + 2) × 100 = - 6.15%
130
2022
140
2
(140 − 120 + 2) × 100 = 18.33%
120
2023
260
2
(260 − 140 + 2) × 100 = 87.14%
140
(iii $YHUDJH 5HWXUQ ™ 5 t /N =
= 22.36%
Return (%)
(125 − 100 + 2) × 100 = 27%
100
27 − 4 + 11.86 − 6.15 + 18.33 + 87.14
6
Average Return = (((1+r1) × (1 + r2) × (1+r3) ... (1 + rt))1/t – 1) ×
100
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BMS
Notes
= (((1 + 0.27) (1 - 0.04) (1 + 0.1186) (1 - 0.0615) (1 + 0.1833) (1
+ 0.8714))1/6 - 1) × 100
= ((1.27 × 0.96 × 1.1186 × 0.9385 × 1.1833 × 1.8714)1/6 - 1) × 100
= 17.41%
3.3.3 Expected Return
The investment environment is highly volatile. It is difficult to make a
prediction about the returns that can be possibly generated on the future
investment. In order to deal with the situation, an investor should predict
the returns that can be earned under different scenarios and assign the
probability to such scenario. Based on these probabilities, we can calculate
the expected return as follows:
([SHFWHG 5HWXUQ ™ 3i × Ri
where Pi = Probability of generating ith return
Ri = ith Return
Eg. 5: The following information is available in respect of the return
from security X under different economic conditions:
Economic Conditions
Good
Average
Bad
Poor
Return
20%
16%
10%
3%
Probability
0.1
0.4
0.3
0.2
Find out the expected return of the security.
Ans.: ([SHFWHG 5HWXUQ ™ 3i × Ri
Economic
Conditions
Good
Average
Bad
Poor
Return (Ri)
Probability (Pi)
Pi × Ri
20%
16%
10%
3%
0.1
0.4
0.3
0.2
Total
2
6.4
3
0.6
12%
54 PAGE
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WEALTH MANAGEMENT
Eg. 6: The following information is available in respect of return on
security A and B under different economic conditions:
Economic
Conditions
Boom
Normal
Recession
Return on A
Return on B
Probability
10%
8%
5%
15%
12%
7%
0.10
0.40
0.50
Notes
Find out the expected return of both securities and suggest one of them
for investment.
Ans.: ([SHFWHG 5HWXUQ ™ 3i × Ri
Economic
Conditions
Boom
Normal
Recession
Return on
A (Ra)
10%
8%
5%
Return on Probability
B (Rb)
(Pi)
15%
12%
7%
0.10
0.40
0.50
Total
Pi × Ra
Pi × Rb
1
3.2
2.5
6.70%
1.5
4.8
3.5
9.80%
Since the return is higher for security B, it is recommended for investment.
3.3.4 Holding Period Return
Holding period return is the total return earned over the life of an
investment. This return does not distinguish between an investment kept
for 6 months or for 2 years or for 5 years. It is computed as follows:
In case of bonds:
(Pt − P0 ) + ∑ I t
× 100
P0
In case of shares:
Pt − P0 + ∑ D t
× 100
P0
Where Pt = Price at the end of period
P0 = Purchase price
It = Interest received during the period
Dt = Dividend received during the period
PAGE 55
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BMS
Notes
Eg. 7: An investor purchased a share at a price of INR 100 a year ago
and recently got a dividend of Rs. 15 from the company. If the stock is
trading at INR 160 now, calculate the holding period return of the share?
Ans.: Holding Period Return (Pt – P0) =
=
(Pt − P0 ) + D1
× 100
P0
(160 − 100) + 15
× 100
100
= 75%
Eg. 8: A zero coupon bond having a face value of INR 1000 is available
in the market for investment. The bond with different maturity period is
currently priced as follows:
Bond
J
K
L
Time Period
6 months
1 year
20 years
Current Price
INR 960
INR 900
INR 320
Calculate the holding period return on each bond and suggest the best
option.
Ans.: Holding Period Return (HPR) =
Bond
J
(Pt − P0 ) + D1
× 100
P0
Holding Period Return
(1000 − 960)
× 100 = 4.16% over a period of 6 months
960
K
(1000 − 900)
× 100 = 11.11% over a period of 1 year
900
L
(1000 − 320)
× 100 = 212.5% over a period of 20 years
320
Since the holding period of three bonds is different, the return is not
comparable and therefore we could not suggest the best investment option.
Eg. 9: A share is currently available for investment at a price of INR 40.
The dividend income and the year-end price of this investment depends
56 PAGE
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WEALTH MANAGEMENT
upon the economic conditions. There is an equal chance of three such
conditions in the economy. The divided and year-end prices are expected
as follows:
Economic Conditions
Boom
Normal
Recession
Dividend
INR 2
INR 1
INR 0.50
Notes
Year – end Price
INR 50
INR 43
INR 34
Find out the holding period return on the investment under three economic
conditions.
Ans.: Holding Period Return (+35) =
Economic
Conditions
(Pt − P0 ) + D1
× 100
P0
Holding Period Return
Dividend
(Dt)
Year – end
Price (Pt)
Boom
INR 2
INR 50
((50 − 40) + 2)
× 100 = 30%
40
Normal
INR 1
INR 43
((43 − 40) + 1)
× 100 = 10%
40
INR 0.50
INR 34
((34 − 40) + 0.5)
× 100 = -13.75%
40
Recession
3.3.5 Effective Annualized Return
One of the limitations of holding period return is that the investment
alternatives having different time horizons can’t be compared with each
other and accordingly an investment decision can’t be taken by the
individual. To overcome this situation, effective annualized return is
computed. It is the equivalent return earned on the investment on a per
annum basis. It is calculated as follows:
Effective Annualized Return = (((1+r1) × (1 + r2) × (1+r3) ... (1 + rt))1/t
– 1) × 100
Or
= ((1 + HPR)1/t - 1) × 100
PAGE 57
© Department of Distance & Continuing Education, Campus of Open Learning,
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BMS
Notes
Where r1, r2…….rt = Return generated in each year
t
HPR
= Number of years
= Holding period return
Eg. 10: The return on a share of a listed company for the past five years
was 10%, 15%, –5%, 20% and 12%. Calculate the annualized return over
the period.
Ans.: Effective Annualized Return = (((1+r1) × (1 + r2) × (1+r3) ... (1 +
rt))1/t – 1) × 100
= (((1 + 0.10) (1 + 0.15) (1 - 0.05) (1 + 0.20) (1 + 0.12))1/5 - 1) ×
100
= ((1.1 × 1.15 × 0.95 × 1.2 × 1.12)1/5 - 1) × 100
= 10%
Eg. 11: A zero coupon bond having a face value of INR 1000 is available
in the market for investment. The bond with different maturity period
and holding period return is currently priced as follows:
Bond
J
K
L
Time Period
6 months
1 year
20 years
Current Price
INR 960
INR 900
INR 320
Holding Period Return (%)
4.16
11.11
212.5
Calculate the effective annualized return on each bond and suggest the
best option.
Ans.: Effective Annualized Return = ((1 + HPR)1/t - 1) × 100
Bond
Time Period
Holding
Period
Return
J
6 months
4.16%
K
1 year
11.11%
L
20 years
212.5%
Effective Annualized Return
= ((1+ 0.0416)12/6 - 1) × 100
= 8.49%
= ((1+ 0.1111)1 - 1) × 100
= 11.11%
= ((1+ 2.125)1/20 - 1) × 100
= 5.86%
Since the return is highest for Bond K, it is chosen for investment purposes.
58 PAGE
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WEALTH MANAGEMENT
Eg.12: An investor has purchased Stock J for INR 100 and sold it after
six months at INR 150. He has also purchased Stock L at INR 100 and
sold it after three months for INR 125 after the dividend receipt of INR
25. Calculate the Absolute Return, Holding Period Return and Effective
Annualized Return of both investments.
Notes
Ans.: Stock J
Absolute Return = (Pt – P0 ™D1 = 150 – 100 = INR 50
Holding Period Return (+35) =
=
(Pt − P0 ) + D1
× 100
P0
(150 − 100))
100
× 100 = 50%
Effective Annualized Return = ((1 + HPR)1/t - 1) × 100
= ((1+ 0.50)12/6 - 1) × 100
= 125%
Stock L
Absolute Return = (Pt – P0 ™D1 = 125 – 100 + 25 = INR 50
Holding Period Return (HPR) =
=
(Pt − P0 ) + D1
× 100
P0
(125 − 100) + 25
× 100 = 50%
100
Effective Annualized Return = ((1 + HPR)1/t - 1) × 100
= ((1+ 0.50)12/3 - 1) × 100
= 406.25%
3.3.6 Portfolio Return
An investor usually puts his money in a number of securities and creates
a portfolio in a real-life scenario. He would be more interested in knowing
the return generated on the overall portfolio rather than finding the gain/
loss on individual securities. One of the important aspects is the allocation
PAGE 59
© Department of Distance & Continuing Education, Campus of Open Learning,
School of Open Learning, University of Delhi
BMS
Notes
of funds to each and every security known as weights. Therefore, portfolio
return is simply the weighted average of returns earned on each security.
It is found as follows:
3RUWIROLR 5HWXUQ ™ :i × Ri
where Wi = Weight or percentage of funds invested in security i
Ri = Return generated on security i
Eg.13: A company is currently offering a portfolio wherein INR 2,00,000
is invested in Asset X having an expected return of 8.5% p.a., INR
2,80,000 in Asset Y having an expected return of 10.20% p.a. and INR
3,20,000 in Asset Z having an expected return of 12% p.a. What is the
return of the overall portfolio?
Ans.: 3RUWIROLR 5HWXUQ ™ :i × Ri
Asset
Return
(Ri)
Amount of
investment (Rs.)
Weight (Wi)
Wi × Ri
X
8.50%
2,00,000
2, 00, 000
= 0.25
8, 00, 000
2.125
Y
10.20%
2,80,000
2,80, 000
= 0.35
8, 00, 000
3.570
Z
12%
3,20,000
3, 20, 000
= 0.40
8, 00, 000
4.800
Total
8,00,000
10.485%
Eg.14: The market is currently offering two portfolios to an investor with
the following asset composition, returns and investment required. Compute
the portfolio return and suggest a suitable portfolio to the investor.
Asset
A
B
C
Return on
Amount of
Return on
Amount of
Portfolio X investment (Rs.) Portfolio Y investment (Rs.)
5.70%
6,00,000
7.2%
8,00,000
4.20%
10,00,000
3%
6,00,000
15%
4,00,000
15%
6,00,000
Ans.: 3RUWIROLR 5HWXUQ ™ :i × Ri
60 PAGE
© Department of Distance & Continuing Education, Campus of Open Learning,
School of Open Learning, University of Delhi
WEALTH MANAGEMENT
Asset
Return
(Rx)
Amount of
investment (Rs.)
Weight (Wi)
Wi × Rx
A
5.70%
6,00,000
6, 00, 000
= 0.30
20, 00, 000
1.71
B
4.20%
10,00,000
10, 00, 000
= 0.50
20, 00, 000
2.10
C
15%
4,00,000
4, 00, 000
= 0.20
20, 00, 000
3.00
Total
20,00,000
6.81%
Asset
Return
(Ry)
Amount of
investment (Rs.)
Weight (Wi)
Wi × Ry
A
7.2%
8,00,000
8, 00, 000
= 0.40
20, 00, 000
2.88
B
3%
6,00,000
6, 00, 000
= 0.30
20, 00, 000
0.90
C
15%
6,00,000
6, 00, 000
= 0.30
20, 00, 000
4.50
Total
20,00,000
Notes
8.28%
Since, portfolio Y is generating a higher return, it is recommended for
investment.
3.3.7 Risk Adjusted Return
Risk adjusted return is the return generated per unit of risk undertaken by
the investor. There are three popular measures of computing risk adjusted
return. Sharpe ratio is the excess return generated over and above the
risk-free return per unit of total risk. Treynor ratio is the excess return
obtained over and above the risk-free return per unit of systematic risk.
Jensen’s alpha is the return earned over and above the return expected as
per Capital Asset Pricing Model (CAPM). They are calculated as follows:
R −Rf
Sharpe Ratio = i
S.D. i
PAGE 61
© Department of Distance & Continuing Education, Campus of Open Learning,
School of Open Learning, University of Delhi
BMS
Notes
Treynor Ratio =
Ri −Rf
βi
Jensen’s alpha = Actual Return – Required Return as per CAPM
Where Ri = Return on security i
Rf = Risk free rate of return
S.D.i = Standard deviation of security i
ȕi = Beta of security i
Eg.15: A portfolio J is available in the market which is offering a return of
20% p.a. and having a standard deviation of 10% p.a. The return offered
on risk free treasury bonds in the market is 8% per annum. Compute the
sharpe ratio of the portfolio.
Ans.: Sharpe Ratio =
=
Ri −Rf
S.D. i
20 − 8
= 1.2
10
Eg.16: A portfolio KLM is available in the market which is offering a
return of 15.20% p.a., a standard deviation of 10% p.a. and a beta of
0.70. The return offered on risk free treasury bonds in the market is
7.20% per annum. Compute the treynor ratio of the portfolio.
Ans.: Treynor Ratio =
=
Ri −Rf
βi
15.20 − 7.20
= 11.42
0.70
Eg.17: Following information is available regarding four stocks and
market index. Evaluate and comment on their performance on the basis
of Sharpe ratio, Treynor ratio and Jensen’s alpha. The risk-free rate of
return is 10% per annum:
Stocks
P
Q
Actual
Return (%)
11
13
Expected CAPM
Return (%)
9.60
9.50
Risk (%)
%HWD ȕ
14
21
0.90
0.80
62 PAGE
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WEALTH MANAGEMENT
Stocks
R
S
Market
Actual
Return (%)
20
14
15
Ans.: Sharpe Ratio =
Treynor Ratio =
Expected CAPM
Return (%)
15
11.20
10.80
Risk (%)
%HWD ȕ
35
23
20
1.20
1.35
Notes
Ri −Rf
S.D. i
Ri −Rf
βi
Jensen’s alpha = Actual Return – Required Return as per CAPM
Stocks
Sharpe Ratio
Ranking
Performance
P
11 − 10 = 0.0714
14
5
Underperform
Q
13 − 10 = 0.1428
21
4
Underperform
R
20 − 10 = 0.2857
35
1
Outperform
S
14 − 10 = 0.1739
23
3
Underperform
Market
15 − 10 = 0.25
20
2
Stocks
Treynor Ratio
Ranking
Performance
P
11 − 10 = 1.11
0.9
5
Underperform
Q
13 − 10 = 3.75
0.8
3
Underperform
R
20 − 10 = 8.33
1.20
1
Outperform
S
14 − 10 = 2.96
1.35
4
Underperform
Market
15 − 10 = 5
1
2
PAGE 63
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BMS
Notes
Stocks
P
Q
R
S
Market
Jensen’s alpha
11 – 9.60 = 1.40
13 – 9.50 = 3.50
20 – 15 = 5
14 – 11.20 = 2.80
15 – 10.80 = 4.20
Ranking
5
3
1
4
2
Performance
Underperform
Underperform
Outperform
Underperform
IN-TEXT QUESTIONS
1. An investor has purchased Stock ABC for INR 108 and sold
it after six months at INR 280. Calculate the Absolute Return
of the investment.
(a) INR 172
(b) INR 208
(c) INR 310
(d) INR 700
2. An investor has purchased Stock PQR at INR 235 and sold it
after three months for INR 320 after the dividend receipt of
INR 30. Calculate the Absolute Return of the investment.
(a) INR 172
(b) INR 208
(c) INR 310
(d) INR 115
3. Effective annualized return is the equivalent return earned on
the investment on per annum basis.
(True/False)
4. Average return is the return that can be earned under different
scenarios having a different probability of occurrence.
(True/False)
5. Holding Period Return is the total return earned over the life
cycle of an investment.
(True/False)
6. Return is simply the weighted average of returns gained on each
security.
(True/False)
64 PAGE
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3.4 Types of Risk
Notes
Risk refers to the volatility in the expected return of a security. There
are frequent changes taking place in the investment environment because
of which investments may be able to generate the returns which are
different from the initial expectations. In other words, every investment
faces a different degree of risk. Risk may arise due to internal as well
as external factors and accordingly it is classified into systematic risk
and unsystematic risk.
3.4.1 Systematic Risk
Systematic Risk is a part of the total risk occurring due to factors that
can’t be influenced by the issuer company. Such factors include social,
political, technological, economic changes happening in the country or at
global level. The various kinds of systematic risk are market risk, interest
rate risk, purchasing power risk and exchange rate risk. Market risk refers
to the price changes in a large number of securities due to buying or
selling pressure by the investors because of some external event impacting
the whole market or economy. Interest rate risk refers to the fluctuation
in the actual return of existing securities due to changes in the interest
rate in the economy. Purchasing power risk refers to the risk that returns
earned on investment are unable to beat the inflation and enhance the
wealth of the investor. Exchange rate risks refers to the changes in the
returns on foreign investments due to changes in exchange rates.
3.4.2 Unsystematic Risk
Unsystematic Risk is a part of the total risk occurring due to factors that
can be influenced by the issuer company. Such factors include changes
in capital structure or asset composition, issues between management and
labour in the company etc. The various kinds of unsystematic risk are
business risk and financial risk. Business risk refers to the variation in
return on investment due to changes in the general business environment
of the company. Financial risk refers to variation in return on investment
due to use of fixed cost funds/debt in the capital structure of the company.
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Notes
3.5 Calculation of Risk
3.5.1 Total Risk
Risk refers to the volatility in the expected return of a security. There
are three important measures of computing risk i.e., range, standard
deviation and coefficient of variation. Range is defined as the difference
between highest and lowest return on a security. Standard deviation shows
the variation of actual return from the average returns over the period.
Coefficient of variation represents the quantum of risk undertaken per
unit of return generated on a security. They are computed as follows:
Range = Highest return – Lowest return
⎡ ∑ (R i − R bar) 2 ⎤
Standard Deviation = ⎢
⎥
N
⎣
⎦
1/2
Or
™ 3L 5i – R bar)2)1/2
Coefficient of Variation =
S.D.
Mean return
Where Ri = Return on security i
Pi = Probability of generating ith return
R bar = Average return of the security
S.D. = Standard deviation of the security
N = Number of observations
Eg.18: An investor wants to make an investment in the Stock XYZ. The
stock has the chances of generating the following returns with respective
probabilities. Calculate the expected risk of the stock.
Return on XYZ (%)
15
20
25
30
Probability
0.2
0.4
0.3
0.1
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WEALTH MANAGEMENT
Notes
Ans.:
Probability
(Pi)
0.2
0.4
0.3
0.1
Return on
XYZ (Ri)
15
20
25
30
Total
6WDQGDUG 'HYLDWLRQ
Pi × Ri
(Ri – R bar)2
3
8
7.5
3
21.5
42.25
2.25
12.25
72.25
Pi (Ri – R
bar)2
8.45
0.90
3.675
7.225
20.25
™ 3L 5i – R bar)2)1/2
= (20.25)1/2
= 4.5%
Eg. 19: Mr. Narender is analysing the risk and return characteristics of
the following securities:
Security
M
N
P
Return (%)
22
35
30
S.D. of Returns (%)
15
20
18
Can we conclude that security N is the riskiest and security M is the
least risky security?
Ans.:
Coefficient of Variation =
S.D.
Mean return
Security M = 15/22 = 0.681
Security N = 20/35 = 0.571
Security P
= 18/30 = 0.600
Since the coefficient of variation is the highest for security M and the
lowest for security N therefore, we conclude that security M is the riskiest
and security N is the least risky security.
Eg. 20: An investor wants to make an investment in either of the two
stocks namely JKL and RST. These stocks had generated the following
returns over the previous period. Which one is to be considered as riskier
and why?
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Notes
Year
1
2
3
4
Return on JKL (%)
15
20
25
20
Return on RST (%)
10
25
30
15
Ans.: Stock JKL
$YHUDJH 5HWXUQ ™ 5t/N = 15 + 20 + 25 + 20 = 20%
4
Range = Highest – Lowest = 25 – 15 = 10%
⎡ ∑ (R i − R bar) 2 ⎤
Standard Deviation = ⎢
⎥
N
⎣
⎦
1/2
⎡ ((15 − 20) 2 + (20 − 20) 2 + (25 − 20) 2 (20 − 20) 2 ) ⎤
= ⎢
⎥
4
⎣
⎦
0.5
= 3.53%
Coefficient of Variation =
S.D.
= 3.53/20 = 0.176
Mean return
Stock RST
$YHUDJH 5HWXUQ ™ 5t/N =
10 + 25 + 30 + 15
=20%
4
Range = Highest – Lowest = 30 – 10 = 20%
⎡ ∑ (R i − R bar) 2 ⎤
Standard Deviation = ⎢
⎥
N
⎣
⎦
1/2
⎡ ((10 − 20) 2 + (25 − 20) 2 + (30 − 20) 2 + (15 − 20)) 2 ⎤
= ⎢
⎥
4
⎣
⎦
= 7.90%
Coefficient of Variation =
S.D.
= 7.90/20 = 0.395
Mean return
68 PAGE
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0.5
WEALTH MANAGEMENT
Since the coefficient of variation is lower for stock JKL therefore it is
preferable for investment.
Notes
3.5.2 Calculation of Systematic and Unsystematic Risk
Systematic risk is that part of the total risk occurring due to factors that
can’t be influenced by the issuer company. It is measured in terms of the
extent to which returns on a security is affected by changes in the return
on market index. The level of change is captured by the beta coefficient.
Systematic risk is a product of beta coefficient and standard deviation
of return on market index. While unsystematic risk is that part of the
total risk occurring due to factors that can be influenced by the issuer
company. It is given as the difference between total risk and systematic
risk of a security. They are computed as follows:
Total variance = (S.D.i)2
6\VWHPDWLF ULVN ȕ î 6'P
2
Unsystematic risk = Total variance – Systematic risk
Where S.D.i = Standard deviation of security i
S.D.m = Standard deviation of market index
ȕ
%HWD RI VHFXULW\ L
Eg. 21: The total risk of a security is measured in terms of standard
deviation, and it is found to be 12%. The beta of such security is 1.4
and standard deviation on market index is 6%. Compute the total risk,
systematic and unsystematic risk of the security.
Ans.: Total risk= (S.D.i)2 = (12)2 = 144% squared
6\VWHPDWLF ULVN ȕ î 6'P
2
= (1.4 × 6)2
= 70.56% squared
Unsystematic risk = Total risk – Systematic risk
= 144 – 70.56
= 73.44% squared
PAGE 69
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Notes
IN-TEXT QUESTIONS
7. A portfolio JKL is available in the market which is offering a
return of 15.80% p.a., a standard deviation of 10% p.a. and a
beta of 0.90. The return offered on risk free treasury bonds in
the market is 7.80% per annum. Compute the sharpe ratio of
the portfolio.
(a) 1.72
(b) 0.80
(c) 3.10
(d) 1.20
8. Systematic risk is a part of the total risk occurring due to factors
that can’t be influenced by the issuer company. (True/False)
9. Unsystematic risk is a part of the total risk occurring due to
factors that can’t be influenced by the issuer company.
(True/False)
10. A portfolio JKL is available in the market which is offering a
return of 15.80% p.a., a standard deviation of 10% p.a. and a
beta of 0.90. The return offered on risk free treasury bonds in
the market is 7.80% per annum. Compute the treynor ratio of
the portfolio.
(a) 1.72
(b) 0.80
(c) 3.10
(d) 8.88
3.6 Impact of Taxes and Inflation on Investment
Taxes act as a crucial factor affecting the choice of investment. This is
because each instrument of investment is subject to a different level of
tax. For example, an investor need not pay any tax on interest earned on
bonds and fixed deposit up to the limit specified by tax authorities. Any
interest earned beyond that limit is taxed as per the income tax slab. If
the investor generates the capital gain on the sale of shares, these gains
70 PAGE
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are classified as short term or long-term capital gains which are taxed at
different rates. Therefore, it is important to compare the post tax returns
of all instruments and choose the most suitable options for the investor.
Notes
Inflation is also a crucial factor for investment decision making. If the
investor puts his money in bonds, he is assured of a fixed amount of
interest every year. This reduces his credit risk on investment, but the
returns may not be able to beat the inflation. On the other hand, the return
on shares usually rises along with the inflation level in the economy but
it involves a higher risk that the selected shares may generate gains or
incur losses to the investor. For example, the treasury bill with a maturity
period of 364 days issued by government has generated a yield of 4.26%
and 6.90% in the year 2021 and 2022 respectively. The return is able to
cope up with the inflation in few months as the country has experienced
a monthly inflation in the range of 4.0 – 6.3% and 5.7 - 7.7% in these
years. Conversely, the shares of Reliance Industries Ltd. remained highly
volatile as it generated a phenomenal return of 18.72% in the year 2021
but fell sharply to 5.99% in the next year.
3.7 Summary
Investment refers to putting money in an asset with a view to enhance
income in future. There are a wide range of instruments available in the
market which are usually analysed in terms of prominent characteristics i.e.,
return and risk. Return is defined as the income earned on an investment
expressed as a proportion of initial investment value. Risk refers to the
volatility in the expected return of a security. Systematic risk is a part
of the total risk occurring due to factors that can’t be influenced by the
issuer company. Unsystematic risk is a part of the total risk occurring
due to factors that can be influenced by the issuer company. There are
three measures of computing total risk i.e., range, standard deviation
and coefficient of variation. These are bifurcated into systematic and
unsystematic risk. Systematic risk is a product of beta coefficient and
standard deviation of return on market index. While unsystematic risk is
given as the difference between total risk and systematic risk of a security.
PAGE 71
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Notes
3.8 Answers to In-Text Questions
1. (a) INR 172
2. (d) INR 115
3. True
4. False
5. True
6. False
7. (b) 0.80
8. True
9. False
10. (d) 8.88
3.9 Self-Assessment Questions
1. Mr. Gupta is interested in investing money in the shares of Swine
Ltd. which is available at a price of INR 360 on 31 December 2023.
The price of the share at the end of years 2017, 2018, 2019, 2020, 2021
and 2022 were INR 120, 145, 138, 150, 140 and 160. The company did
not pay any dividend to the shareholders. Calculate the average return.
(i) Using arithmetic mean
(ii) Using geometric mean
(iii) What will be the answer in (i) and (ii) if a dividend of INR 10 is
given every year
2. The following information is available in respect of return on security
J and K under different economic conditions:
Economic
Conditions
Boom
Normal
Recession
Return on J
Return on K
Probability
12%
10%
7%
17%
14%
9%
0.20
0.40
0.40
Find out the expected return of both securities and suggest one of them
for investment.
72 PAGE
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WEALTH MANAGEMENT
3. A share is currently available for investment at a price of INR 400. The
dividend income and the year-end price of this investment depends upon
the economic conditions. There is equal chance of three such conditions
in the economy. The divided and year-end prices are expected as follows:
Economic Conditions
Boom
Normal
Recession
Dividend
INR 20
INR 10
INR 5
Notes
Year – end Price
INR 500
INR 430
INR 340
Find out the holding period return on the investment under three economic
conditions.
4. A zero coupon bond having a face value of INR 100 is available in
the market for investment. The bond with different maturity period and
holding period return is currently priced as follows:
Bond
Time Period
Current Price
J
K
6 months
1 year
INR 96
INR 90
Holding Period
Return (%)
4
11
L
10 years
INR 32
21
Calculate the effective annualized return on each bond and suggest the
best option.
5. The market is currently offering two portfolios to an investor with the
following asset composition, returns and investment required. Compute
the portfolio return and suggest a suitable portfolio to the investor.
Asset
X
Y
Z
Return on
Amount of
Return on
Amount of
Portfolio A investment (Rs.) Portfolio B investment (Rs.)
15.20%
2,00,000
16%
4,00,000
8%
8,00,000
10%
11,00,000
13%
10,00,000
13%
5,00,000
6. Following information is available regarding four stocks and market
index. Evaluate and comment on their performance on the basis of Sharpe
ratio, Treynor ratio and Jensen’s alpha. The risk-free rate of return is 8%
per annum:
PAGE 73
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Notes
Stocks
Actual
Return (%)
9
11
18
12
13
A
B
C
D
Market
Expected CAPM
Return (%)
10
10.50
16
9.20
8.80
Risk (%)
%HWD ȕ
12
19
30
21
18
0.80
0.90
1.30
1.10
7. An investor wants to make an investment in the Stock BAC. The
stock has the chances of generating the following returns with respective
probabilities. Calculate the expected risk of the stock.
Return on BAC (%)
Probability
10
22
28
27
0.20
0.35
0.25
0.20
8. An investor wants to make an investment in either of the two stocks
namely EST and RLM. These stocks had generated the following returns
over the previous period. Which one is to be considered as riskier on the
basis of standard deviation and coefficient of variation?
Year
Return on EST (%)
Return on RLM (%)
1
2
3
4
15
20
25
20
10
15
20
15
9. The total risk of a security is measured in terms of standard deviation,
and it is found to be 14%. The beta of such security is 1.2 and standard
deviation on market index is 8%. Compute the total risk, systematic and
unsystematic risk of the security.
3.10 References
‹
Chandra, P. (2017). Investment Analysis and Portfolio Management.
New Delhi: Tata McGraw Hill Education Private Limited.
74 PAGE
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WEALTH MANAGEMENT
‹
Investopedia (2023). Excess Returns Meaning, Risk, and Formulas.
Retrieved from https://www.investopedia.com/terms/e/excessreturn.
asp.
Notes
3.11 Suggested Readings
‹
Fischer, D.E. and Jordan, R.J (2020). Security Analysis & Portfolio
Management. New Delhi: Pearson Education.
‹
Sharpe, W.F., Alexander, G.J. & Bailey, J. (2002). Investments. New
Delhi: Prentice Hall of India.
‹
Reilly, F. K. & Brown, K.C. (2012) Analysis of Investments and
Management of Portfolios. New Delhi: Cengage India Pvt. Ltd.
PAGE 75
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L E S S O N
4
Approaches to Security
Analysis
Dr. Priyanka Ahluwalia
Assistant Professor
New Delhi Institute of Management
Email-Id: ahluwalia.priyanka@gmail.com
STRUCTURE
4.1 Learning Objectives
4.2 Introduction
4.3 Security Analysis
4.4 Fundamental Analysis
4.5 Fundamental Analysis: Quantitative and Qualitative Analysis
4.6 Technical Analysis
4.7 (I¿FLHQW 0DUNHW +\SRWKHVLV
4.8 Summary
4.9 Answers to In-Text Questions
4.10 Self-Assessment Questions
4.11 References
4.12 Suggested Readings
4.1 Learning Objectives
‹
To understand the purpose of investment analysis.
‹
To develop an understanding about the various tools and techniques used for investment
analysis.
‹
To comprehend the sources of market inefficiencies.
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4.2 Introduction
Notes
In finance, securities are referred to the financial instruments that are
traded in the financial markets. These represent a financial entitlement in
the underlying asset. These financial instruments act as a bridge between
the investors and the corporates, governments or individuals who raise
funds to meet their capital requirements. Some of the common types of
financial securities are Equity shares, Bonds, Mutual funds, Options,
futures etc.
4.3 Security Analysis
Thus, security analysis in finance refers to the evaluation of the financial
securities to determine their fair value, potential risks, and returns.
Security analysis helps the investors in making informed decisions about
investment tenure, returns and the associated risks. It also enables the
corporates to assess the firm’s value to make divestment and corporate
restructuring decisions. The most prominent methods of security analysis
are fundamental analysis and technical analysis. However, it’s important to
note that fundamental analysis is just one approach to investment analysis,
and investors may also consider other factors such as market sentiment,
and risk management strategies when making investment decisions.
4.4 Fundamental Analysis
Fundamental analysis is a technique for determining the true worth of a
financial instrument. It entails examining numerous elements that can affect
the asset’s value, such as economic, financial, and qualitative components.
Fundamental analysis is an examination of the most important aspects
influencing the firm’s worth. These essential indicators are divided into
qualitative and quantitative indicators. Thus, qualitative and quantitative
analysis are both included in fundamental analysis.
Fundamental analysis is a synthesis of economic analysis, industry analysis,
and corporate analysis. To undertake basic analysis, the researcher can
use either a top-down or bottom-up strategy. According to the top-down
technique, the analyst starts with economic analysis, then moves on to
industry analysis, and lastly to company analysis to determine the intrinsic
PAGE 77
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Notes
value of the equity shares. This is also known as the EIC method. The
analyst can, however, use the bottom-up technique (CIE approach). In
this approach, the analyst begins with knowing the company, then the
industry, and lastly, the economy.
Economic Analysis
The process of investigating and evaluating various economic aspects
and indicators in order to understand the current situation and future
possibilities of an economy is known as economic analysis. Making
informed decisions and forecasts requires examining the entire fiscal
environment, including macroeconomic indicators, patterns, and policies.
The following are the main components of economic analysis:
Macroeconomic Indicators: Analysing major macroeconomic indicators
such as Gross Domestic Product (GDP), inflation rate, unemployment rate,
interest rates, consumer expenditure, company investment, and government
fiscal and monetary policies.
‹
Economic Trends: Recognising and monitoring long-term economic
trends to understand their effects on the economy, including
demographic changes, technological breakthroughs, globalisation,
income distribution, and productivity growth.
‹
Market Dynamics: Analysing the dynamics of supply and demand in
a variety of markets, such as those for labour, goods, and services,
in order to evaluate market effectiveness, price patterns, and market
structures.
‹
Policy Analysis: Evaluating the effects of laws, rules, and government
interventions on the economy, such as monetary and fiscal policies
(interest rates, money supply) to understand their effects on inflation,
economic growth, and stability.
‹
Sector Analysis: Analysing particular economic sectors, such as
manufacturing, finance, healthcare, technology, and agriculture, to
comprehend their performance, future growth prospects, and potential
threats.
‹
International Factors: Analysing global economic factors that affect
the home economy, such as global economic integration, international
commerce, exchange rates, and geopolitical events.
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‹
Economic Forecasting: Predicting and forecasting future economic
circumstances, such as GDP growth, inflation rates, and employment
levels, using economic models, statistical analysis, and historical
data. In order to make educated judgments on policies, investments,
strategic planning, and risk management at macro level, a variety
of organisations, including government agencies, central banks,
financial institutions, research organisations, and enterprises, conduct
economic analysis.
Notes
Industry Analysis
The practice of investigating and assessing the dynamics, trends, and
competitive landscape of a certain industry is known as industry analysis.
It entails researching the elements that influence the structure, profitability,
and growth potential of the industry. Industry analysis assists businesses,
investors, and other stakeholders in understanding the opportunities and
difficulties that exist within a specific area. Typically, industry analysis is
carried out by a combination of research, data analysis, interviews with
industry experts, and evaluation of pertinent reports and publications.
Industry analysis insights may assist organisations and investors in making
informed decisions such as finding investment possibilities, reviewing
market entrance tactics, understanding competitive positioning, and building
effective business strategies.
The following are the essential elements and approaches involved in
industrial analysis:
‹
Market Size and Growth: It involves determining the industry’s
current size and historical growth rate. This includes looking at
things like demographic trends, customer preferences, and market
demand drivers.
‹
Industry Structure: Analysing the competitive dynamics and
industry structure. This includes determining the number and size
of competitors, the distribution of market share, entry barriers, and
the degree of product differentiation.
‹
Porter’s Five Forces Analysis: Using Michael Porter’s Five Forces
framework to understand the industry’s competitive forces. This
analysis entails assessing suppliers’ and buyers’ negotiating power,
the threat of new entrants, the threat of replacement products or
services, and the degree of competitive rivalry.
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Notes
‹
Value Chain Analysis: Examining the industry’s value chain to
understand the many activities and processes involved in delivering
a product or service. This analysis aids in the identification of
prospective cost-cutting opportunities, points of differentiation, and
potential disruptions.
‹
Technology and Innovation: Evaluating the industry’s impact on
technical breakthroughs and innovation. This includes examining
issues like as R&D spending, patents, intellectual property, and the
adoption of innovative technology.
‹
Regulatory Environment: Knowledge of the regulatory framework
and government policies affecting the industry. Analysing industryspecific legislation, licensing requirements, environmental regulations,
and potential legal or political concerns are all part of this process.
Key Success Factors: Identifying the important characteristics that
contribute to industry success. Factors such as economies of scale,
distribution networks, brand reputation, access to important resources,
and technological knowledge may all be considered. Performing a SWOT
analysis (Strengths, Weaknesses, Opportunities, and Threats) to examine
the internal and external aspects that can influence the industry’s prospects
would be helpful.
Company Analysis
Company analysis, also known as company research or stock analysis,
is assessing a firm’s overall performance, financial health, and future
prospects by reviewing its financial and non-financial components. It
offers information about the company’s activities, competitive position,
and prospective investment worth. Financial statement analysis, industry
research, competition analysis, and interviews with company management
and industry experts are common qualitative and quantitative research
methodologies used in company analysis. The knowledge gathered by
company analysis assists stakeholders in making educated decisions about
investing in the firm’s shares, providing finance, forming partnerships, or
engaging in other business connections. The following are some of the
important elements and techniques involved in company analysis:
‹
Financial Statements: Examining the financial statements of the
company, including the income statement, balance sheet, and cash
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flow statement. Assessing revenue growth, profitability, liquidity,
debt levels, and cash flow generation are all part of this process.
‹
Important Financial Ratios: Profitability ratios (e.g., gross profit
margin, net profit margin), liquidity ratios (e.g., current ratio, quick
ratio), solvency ratios (e.g., debt-to-equity ratio, interest coverage
ratio), and efficiency ratios (e.g., inventory turnover, accounts
receivable turnover). These ratios reveal information about the
company’s financial performance and efficiency.
‹
Understanding the Company’s Business Model and Competitive
Advantage: Understanding the company’s business model, products
or services, target market, and competitive advantages. This includes
evaluating aspects like brand strength, market positioning, unique
selling propositions, intellectual property, and entry obstacles.
‹
SWOT Analysis: Performing a SWOT analysis (Strengths, Weaknesses,
Opportunities, and Threats) to assess the internal and external aspects
that can affect the company’s performance. This study assists in
identifying areas of strength, areas for improvement, prospective
growth possibilities, and risks or obstacles that the organisation
may face.
‹
Management Evaluation: Assessing the management team’s quality
and track record. This includes analysing their expertise, talents,
strategic decision-making, corporate governance processes, and
alignment with shareholders’ interests. Strong and capable management
is often regarded as a positive predictor for a company’s success.
Notes
IN-TEXT QUESTIONS
1. ______________ Is a method used to evaluate the worth of
security by studying the financial data of the issues.
(a) Qualitative analysis
(b) Fundamental analysis
(c) Security analysis
(d) None of the above
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2. ____________ is the variability in a security’s returns resulting
from fluctuations in the aggregate market.
(a) Market Risk
(b) Inflation Risk
(c) Credit Risk
(d) Interest Rate risk
3. A group of securities is known as:
(a) Investment
(b) Portfolio
(c) Security
(d) Gambling
4.5 Fundamental Analysis: Quantitative and Qualitative
Analysis
Quantitative analysis entails the examination of measurable data in
general, the company’s financial accounts for the previous five years
are examined. The expected financial statements are indicated based on
prior data analysis. Based on the numerous valuation methodologies and
industry peculiarities, these estimates are then used for value purposes.
In finance, valuation is the cornerstone of any choice, and every decision
made in a business setting influences the business’s valuation. Thus,
valuation establishes a standard which helps to assess the effectiveness
of various investment, financing, and dividend decisions. According to
Damodaran (2006), valuation is used in corporate finance to evaluate and
enhance firm value, in portfolio management to compare and generate
higher profits than the benchmark index, and in investment management
to generate higher profits than the benchmark index.
The following are some of the quantitative critical parameters that analysts
typically study for quantitative analysis using the EIC approach.
‹
Economic Factors: Investigating larger economic indicators such as
GDP growth, inflation rates, interest rates, and unemployment figures
to gain a better understanding of the macroeconomic environment
and its potential influence on the organisation.
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‹
Industry Analysis: Examining the industry in which the firm operates,
including growth prospects, competitive landscape, market share,
and industry-specific issues that can affect the company’s success.
‹
Financial Statements: Examining financial statements such as
the income statement, balance sheet, and cash flow statement to
determine a company’s financial health, profitability, liquidity, and
cash flow.
‹
Company Performance: Assessing the company’s past and current
performance, such as revenue growth, Earnings Per Share (EPS),
Return on Equity (ROE), and profit margins.
Notes
Numerous valuation models are employed in quantitative analysis to
assess the asset’s fair value. The topic intends to go into detail on equity
market valuation methodologies.
Quantitative valuation approaches use numerical data and mathematical
models to evaluate the value of an asset or investment. To estimate a fair
value for an asset, these methodologies analyse numerous financial and
non-financial variables. Here are a few examples of common quantitative
valuation methods:
1. Market Multiple Valuation: The value of an asset is determined by
applying a market-derived multiple to a relevant financial statistic,
such as earnings or revenue. For example, if similar companies in
the market are selling at an average Price to Earnings ratio of 20,
the target company’s earnings can be approximated by multiplying
them by 20.
2. Comparable Company Analysis (CCA): CCA entails comparing a
target company’s financial ratios and multiples to similar companies
in the same industry. Price-to-Earnings (P/E), Price-to-Sales (P/S),
and Price-to-Book (P/B) multiples are common multiples employed
in this study. The valuation assumes that the target company’s
valuation multiples will be similar to those of its peers.
3. Comparable Transaction Analysis (CTA): CTA compares the prices
and valuation multiples of recent similar transactions in the market
rather than financial measures. This strategy is frequently used in
mergers and acquisitions to evaluate a company’s value based on
the prices paid for similar companies.
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4. Asset based Valuation: This method assigns a monetary value
to an asset based on its underlying tangible or intangible assets.
Intangible assets include patents, copyrights, and brand value, while
tangible assets include real estate, machinery, and merchandise.
The valuation is determined by adding the estimated values of all
individual assets, less liabilities.
5. Discounted Cash Flow (DCF) Analysis: DCF is a popular valuation
method that calculates an investment’s present value by discounting
its predicted future cash flows. Future cash flows are projected
over time and then discounted back to the present using a suitable
discount rate.
It’s important to note that while quantitative valuation methods give a
framework for determining value, they frequently rely on subjective inputs
and assumptions. To arrive at a full valuation, it is critical to supplement
quantitative analysis with qualitative considerations and expert judgment.
Qualitative Analysis
Qualitative analysis incorporates subjective judgment based on unquantifiable
information such as management competence, industry cycles, R&D
strength, labour relations, and so on. Web sources, annual reports, business
publications and newspapers, industry reports, and company updates are
the most commonly used sources.
The following are some of the qualitative key factors that analysts typically
study for quantitative analysis using the EIC approach:
‹
Competitive Advantage: Determining the company’s competitive
strengths and disadvantages, such as its distinctive products or
services, brand value, market position, patents, and intellectual
property.
‹
Management Evaluation: Evaluating the company’s management
team’s quality and track record, including strategic decisions,
corporate governance practices, and capacity to execute business
strategies.
‹
Methods of valuation: Using valuation methodologies such as
Discounted Cash Flow (DCF) analysis, Price-to-Earnings (P/E) ratio,
Price-to-Sales (P/S) ratio, and other financial ratios to calculate
the asset’s fair value and evaluate whether it is undervalued or
overvalued.
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4.6 Technical Analysis
Notes
Technical analysis is a way of studying historical price and volume data
to evaluate financial assets such as stocks, currencies, commodities, or
indices. It entails analysing charts and employing a variety of technical
indicators and patterns to forecast future price movements and find
potential trading opportunities. Technical analysis assumes that historical
price patterns repeat themselves and can be used to forecast future price
movements.
Fundamentals of Technical Analysis:
1. Markets alternate between expanding and contracting their ranges.
2. A continuation of the trend is more likely than a reversal.
3. Trends come to an end in one of two ways: Climax or rollover.
4. Price always precedes momentum.
Here are some of the important elements and techniques in technical
analysis:
Price Charts: Technical analysts primarily rely on price charts to analyse
and interpret price movements over time. Different types of charts are
used, including line charts, bar charts, and candlestick charts. These charts
display the historical price data, such as the opening, closing, high, and
low prices, for a given period.
Trend Analysis: Identifying and analysing trends in price movements.
Trends can be classified as uptrends (higher highs and higher lows),
downtrends (lower highs and lower lows), or sideways trends (consolidation).
Trend lines are drawn on the chart to visually represent the direction and
strength of the trend.
(Source: Pandian (2012))
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Support and Resistance Levels: Identifying levels at which the price
has historically struggled to move above (resistance) or below (support).
These levels are considered important because they often act as barriers
where the price may reverse or experience increased buying or selling
pressure.
Technical Indicators: The technical analysts use mathematical methods
which are applied to price and volume data to develop signals and
insights. Technical indicators include moving averages, Relative Strength
Index (RSI), stochastic oscillator, MACD (Moving Average Convergence
Divergence) etc. These indicators help traders identify overbought or
oversold conditions, momentum, trend strength, and potential trend reversals.
Chart Patterns: Recognizing and interpreting chart patterns that can
provide insights into future price movements. Examples of chart patterns
include head and shoulders, double tops and bottoms, triangles, flags,
and wedges. These patterns are understood to signal potential trend
continuation or reversal.
Figure 4.1 Chart Pattern - Head and Shoulder
6RXUFH $XWKRU 0RQH\FRQWURO
Volume Analysis: Under this, the trading volumes are analysed in
conjunction with price movements. Volume can provide insights into the
strength and validity of price trends. High volume during price advances
or declines is considered supportive of the trend, while low volume during
consolidations may indicate indecision or lack of conviction.
Timeframes: Technical analysis can be applied to different timeframes,
such as intraday, daily, weekly, or monthly charts. Different timeframes
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provide different perspectives and may be used by traders with different
trading strategies and investment horizons.
Notes
Essentially, technical analysis only focuses on price and volume data and
ignores fundamental aspects like earnings, financial ratios, and economic
indicators. Technical analysis assumes that all essential information is
already reflected in the price and that patterns and indications can provide
insight into future price movements.
Technical indicators are mathematical calculations or statistical tools
used by traders and analysts in financial markets to evaluate and analyse
historical price and volume data. Following are the widely used technical
indicators:
1. Moving Average (MA): A moving average is a popular indicator that
smoothes out price data by determining the average closing price
over a given time period. It aids in identifying trends and probable
levels of support and resistance.
2. Relative Strength Index (RSI): The RSI is a momentum oscillator
that monitors the pace and direction of market changes. It oscillates
between 0 and 100 and is used to indicate overbought and oversold
market conditions.
3. Bollinger Bands: Bollinger Bands are made up of a moving average
(usually 20 days) and two standard deviation bands above and below
the moving average. They aid in identifying volatility and probable
price reversals as prices approach the upper or lower bands.
4. Moving Average Convergence Divergence (MACD): The MACD
is a momentum indicator that estimates the difference between two
moving averages and is used to track trends. When the MACD
line crosses above or below the signal line, it creates buy and sell
signals.
5. Stochastic Oscillator: The stochastic oscillator compares an asset’s
current price to its price range over a given time period. It aids
in the identification of overbought and oversold levels, as well as
prospective trend reversals.
6. Fibonacci Retracement: Fibonacci retracement levels are horizontal
lines based on significant Fibonacci ratios that signal potential
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Notes
support and resistance levels. Traders use them to detect probable
price reversal levels during a trend retracement.
7. Volume: Volume indicators, such as On-Balance Volume (OBV) or
Volume-Weighted Average Price (VWAP), provide information on
a certain asset’s trading activity and liquidity. They can aid in the
confirmation of price trends as well as the identification of probable
trend reversals.
However, one must understand that no single indication can guarantee
correct predictions or trading success. To make informed trading decisions,
traders frequently employ a combination of indicators as well as other
considerations such as market fundamentals and news events.
While technical analysis can be a valuable tool for short-term traders
and active investors, it does have limitations. Technical patterns can be
overridden by market mood, unanticipated news events, and fundamental
considerations. As a result, it is frequently used in conjunction with other
types of analysis, such as fundamental analysis and risk management
measures, to help investors make well-informed investment decisions.
Although technical analysis is commonly utilised by traders and investors
to make investment decisions, there are many limits to be aware of. Some
of the major limits of technical analysis are as follows:
‹
Subjectivity: Technical analysis heavily relies on subjectively
interpreting charts, patterns, and indicators. The same chart or
pattern may be interpreted differently by different analysts, resulting
in opposing conclusions and trading methods.
‹
Historical Price and Volume Data: Technical analysis relies heavily
on past price and volume data. It assumes that historical price patterns
and trends will be repeated in the future. Market circumstances
and dynamics, on the other hand, might change, making historical
patterns less trustworthy for forecasting future price changes.
‹
Lack of Fundamental Information: Technical analysis relies primarily
on price and volume data, neglecting fundamental information about a
firm or asset. Technical analysis does not directly incorporate factors
such as financial performance, industry trends, and macroeconomic
indicators, which can have a substantial impact on prices.
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‹
Restrictive Predictive ability: Technical analysis can uncover shortterm price trends and patterns, but it has little predictive power
when it comes to long-term price changes. Market dynamics, news
events, and shifts in investor mood can all disrupt technical patterns
quickly, making them less dependable for long-term forecasting.
‹
Inefficient Markets: Technical analysis may be ineffective in efficient
markets, where prices promptly reflect all available information.
According to the Efficient Market Hypothesis, utilising technical
analysis to continuously outperform the market is difficult since
any mispricing or trends are immediately exploited and corrected
by other market participants.
‹
Over Reliance on Indicators: Traders that rely primarily on technical
indicators may become unduly reliant on them, ignoring other critical
considerations. Overuse or misinterpretation of indicators can lead
to biased decision-making and herd behaviour, in which a large
number of market players make the same trading decisions based
on the same indicators, potentially exacerbating market volatility.
Notes
While technical analysis has limits, it is nonetheless frequently employed
as part of the investment decision-making process by many traders and
investors. However, it is frequently used in conjunction with other types
of analysis, such as fundamental analysis, to acquire a more thorough
view of the market and make sound investment decisions.
Differentiate between Fundamental and Technical Analysis
Basis
Data
Sources of
Data
Analysis
Tools
Fundamental Analysis
Uses past and present data
Annual reports, news, journals,
market index
Financials ratios, Company Data,
Economy, Industry Data, Qualitative
analysis
Analyst type Generally, a long-term investor
Purpose
Is conducted for long term investment
strategy and short term as well
Usefulness
+HOSV LQ LGHQWL¿FDWLRQ RI XQGHU
valued or overvalued stocks
Technical Analysis
Only uses past data
Various types of charts
Bars and Charts diagrams
Generally, short term investor
Is conducted for comparatively
short-term investment
+HOSVLQLGHQWL¿FDWLRQRIHQWU\
and exit points of a stock
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Notes
4.7 Efficient Market Hypothesis
The Random Walk Hypothesis proposes that stock market and other
financial market prices follow a random pattern and cannot be anticipated.
Changes in stock prices, according to this hypothesis, occur at random
and are uninfluenced by prior price movements or any other causes.
Efficient Market Hypothesis (EMH) is strongly related to the Random Walk
Theory. It is one of the EMH’s assumptions that financial markets are
efficient, and that all important information is immediately and completely
reflected in stock prices. If markets are efficient, stock prices will follow
a random walk pattern. In other words, there are no predictable patterns or
trends in stock prices that may be exploited to achieve abnormal profits.
Randomness and Efficiency: The randomness of price fluctuations
indicates that they are unpredictable and follow a random distribution. If
markets are efficient and all available information is swiftly reflected in
prices, then any new information will be immediately absorbed into stock
prices, making trading based on prior price patterns hard to continuously
profit from.
EMH and Fundamental Analysis: The theory acknowledges the necessity
of fundamental analysis, which entails examining a company’s financial
health, industry prospects, and other important aspects to determine its
value. Fundamental analysis is concerned with long-term prospects rather
than short-term price forecasts.
EMH and Technical Analysis: This theory calls into doubt the validity
of technical analysis, which relies on analysing past price and volume
data to forecast future price movements. According to the belief, technical
analysis cannot provide an edge in forecasting future stock prices because
market movements are random and unpredictable.
The Efficient Market Hypothesis (EMH) proposes that it is impossible
to locate inexpensive stocks or generate money by predicting market
movement trends. As a result, neither fundamental nor technical analysis
can be used to generate adjusted excess returns.
The EMH is based on the premise that in a well-functioning and transparent
market, prices adjust fast to reflect new information. This makes it difficult
for investors to regularly outperform the market since they cannot foresee
future price changes based on historical data. Proponents of the EMH
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claim that finding mispriced securities is difficult to acquire a competitive
advantage in the market since any disparities are immediately exploited
and remedied by other investors.
Notes
The efficiency of the market according to EMH is classified into three
forms :
1. Weak Form: This form implies that all previous market prices and
information have already been reflected in current pricing. To put
it another way, past price patterns and trading volumes cannot be
utilised to forecast future prices.
2. Semi-Strong Form: Like the weak form, this form implies that all
past and publicly available information, such as financial statements,
news announcements, and market data, has already been factored
into the prices. As a result, basic analysis or the study of public
information cannot consistently produce excess returns.
3. Strong Form: This form extends the semi-strong form by assuming
that all information, both public and private, is reflected in prices.
Even insider information would not provide an investor an advantage
in consistently outperforming the market.
Critics of the EMH contend that it oversimplifies the complexities of
financial markets and that there are scenarios in which investors might
profit from market inefficiencies. They suggest that there may be times
when the market is irrational or when particular information is not
completely reflected in pricing, allowing competent investors to identify
mispriced securities and earn excess profits.
Overall, the Efficient Market Hypothesis is a widely discussed financial
concept, with substantial implications for investment strategies, portfolio
management, and the role of active vs. passive investing. However,
the EMH has been subjected to criticisms and anomalies that call its
assumptions into question.
Here are some well-known deviations from the Efficient Market Hypothesis:
‹
The January Effect refers to a historical pattern in which stock
values tend to increase in January. The EMH posits that stock prices
react instantaneously to new information; however, the January
Effect suggests that there may be predictable patterns or seasonal
trends in stock prices that the EMH does not explain.
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Notes
‹
Momentum Effect: The momentum effect is the phenomena in
which previous winners continue to outperform and previous losers
continue to underperform in the near term. The EMH argues that
stock prices quickly reflect all available information, making it
difficult to profit consistently from stock price trends or momentum.
‹
Size Effect: The size effect is the finding that small-cap companies
outperform large-cap equities over the long term, contradicting the
EMH’s assumption that all information is efficiently priced into
shares. This effect shows that investing in smaller companies can
result in anomalous returns for investors.
‹
The value impact refers to the tendency of firms with lower
Price-to-Earnings (P/E) ratios or other value-based indicators to
outperform stocks with higher P/E ratios. This oddity defies the
EMH’s assumption that investors cannot regularly outperform the
market by selecting inexpensive stocks.
‹
Overreaction and Underreaction: According to the EMH, prices
should adjust to new information rapidly. Behavioural finance
research, on the other hand, has revealed evidence of overreaction and
underreaction, in which investors either overestimate or underestimate
the influence of new information on stock prices. This implies
that markets may not be completely efficient in integrating new
knowledge.
Anomalies in Long-Term Returns: Numerous studies have revealed
that some investment methods, such as low-risk, high-dividendyield, or investing based on specific fundamental variables, can
offer anomalous long-term returns. These data call into question
the EMH’s claim that continually outperforming the market is
impossible.
It is crucial to note that while these anomalies call into question the EMH’s
assumptions, they do not necessarily undermine the overall hypothesis.
The EMH is still a hotly disputed and researched idea in finance, with
several variations of the hypothesis presented to account for some of
these anomalies.
‹
Markets Inefficiency
Inefficient markets, as the name implies, are markets that are not efficient.
Inefficient markets are those in which asset prices do not reflect the asset’s
fair worth. Some of the causes of market inefficiency include information
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WEALTH MANAGEMENT
asymmetry, a lack of market participants (buyers and sellers), excessive
transaction costs, human behaviour, market attitudes, and so on. To some
extent, all markets exhibit inefficiency. Extreme market failure, on the
other hand, might lead to market failure.
Notes
4.8 Summary
Investors and Traders are always looking for the most reliable and
accurate estimates of the return on investments. All classes of investors
whether short term or long term rely on the basics of wealth management.
Fundamental and technical analysis plays a significant role supporting the
analysts and investors in taking well informed decisions. Thus, to make
money in somewhat inefficient markets needs a lot of in-depth knowledge
of the key elements of security analysis and management.
4.9 Answer to In-Text Questions
1. (b) Fundamental analysis
2. (a) Market Risk
3. (b) Portfolio
4.10 Self-Assessment Questions
1. Following table indicates the financial data for AMCO Ltd.
Particulars
Assets
Short Term Liabilities
8% Debentures
10% bonds
Common Stock
Surplus
2018
6000
450
1250
500
3500
300
Particulars
Revenues
Operating Expenses
EBIT
Interest
EBT
Taxes
Dividend
2018
6600
5950
650
150
500
200
50
Calculate the following financial ratios and discuss the financial
position of the company:
(i) Asset Turnover
(ii) Debt Equity Ratio
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Notes
(iii) Dividend Pay-out Ratio
(iv) Effective Tax Rate
(v) Effective Interest Rate
On the basis of the above ratio analysis, discuss whether the investor
should invest in AMCO Ltd.
Solution:
(i) 1.1
(ii) 0.63
(iii) 16.28
(iv) 0.4
(v) 0.07
2. Discuss the methods adopted to analyse the financial statements of
a company.
3. Fundamental analysis and Technical Analysis are complementary to
each other. Comment.
4. Briefly discuss the various forms of market efficiency.
5. Explain the random walk theory and Efficient market hypothesis
interrelationship.
4.11 References
‹
Commonly used methods of valuation. (2012). In Business Valuations:
Fundamentals, Technique & Theory (12th ed., Vol. 1, pp. 1-50).
National Association of Certified Valuators and Analysts (NACVA).
‹
Damodaran, A. (2006). Market Approach. In Investment valuation:
Tools and techniques for determining the value of any asset. Hoboken,
NJ: Wiley.
4.12 Suggested Readings
‹
Reilly, F. and J. Brown, (2006) Investment Analysis and Portfolio
Management, Cengage.
‹
Pandian (2012) Security Analysis and Portfolio Management, Vikas
Publishing House.
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L E S S O N
5
Traditional Portfolio
Management for
Individuals
Palak Kanojia
Assistant Professor
Shri Ram College of Commerce
Email-Id: kanojiapalak1@gmail.com
STRUCTURE
5.1 Learning Objectives
5.2 Introduction
5.3 2EMHFWLYHV RI 3RUWIROLR 0DQDJHPHQW
5.4 &RQVWUDLQWV DQG )DFWRUV LQ 3RUWIROLR 0DQDJHPHQW
5.5 Asset Allocation
5.6 3RUWIROLR 0DQDJHPHQW 6HUYLFHV
5.7 Summary
5.8 Answers to In-Text Questions
5.9 Self-Assessment Questions
5.10 References
5.11 Suggested Readings
5.1 Learning Objectives
‹
To analyse objectives, constraints and factors of portfolio management.
‹
To understand the process and various investment options available to individuals.
‹
To examine the asset allocation pyramid and investor life-cycle approach.
‹
To compare passive and active portfolio management.
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Notes
5.2 Introduction
The process of financial planning involves various aspects, such as creating
a budget, making informed investment decisions, setting specific and
achievable goals (SMART goals), selecting appropriate asset allocation,
and developing a retirement plan, among others. It begins with assessing
one’s current financial situation and setting goals for the future. Financial
planning aids in attaining both short-term and long-term objectives,
ultimately leading to financial independence.
One approach to attaining financial independence involves reducing
expenses by adopting a lifestyle change known as downshifting, which
entails simplifying one’s way of life and adjusting to a lower standard
of living. Another method is portfolio management, which offers greater
flexibility. A portfolio consists of a diverse range of investment instruments
and tools, such as stocks, mutual funds, bonds, and policies. Portfolio
management involves the careful selection and monitoring of investments
to align with specific financial goals, while also considering risk tolerance
and achieving a well-balanced investment mix.
5.3 Objectives of Portfolio Management
Portfolio management aims to assist individuals in selecting the most
suitable investment options based on their income, age, time horizon,
and risk tolerance. The primary objective of portfolio management is
to optimize returns while minimizing risks in order to achieve financial
goals. Some key objectives of portfolio management include:
(a) Maximizing Return on Investment: The goal is to generate profits
and minimize losses on investments. A well-managed investment
portfolio should provide a consistent income stream that meets
or exceeds the opportunity cost of the funds invested. Return on
investment may be in the form of capital appreciation as well
referring to the rise in the market value of an asset, such as stocks
or real estate. The asset’s capital gain is computed by deducting
the asset’s acquisition price from its current value.
(b) Enhancing Portfolio Flexibility and Efficiency: Portfolio management
aims to strike a balance between long-term financial goals and
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WEALTH MANAGEMENT
short-term liquidity needs. It also seeks to provide tax advantages
to the portfolio owner. Inactive or underperforming stocks or funds
can negatively impact the marketability of a portfolio.
Notes
(c) Optimal Resource Allocation: Efficient portfolio management
involves allocating funds to different investment instruments while
diversifying risks. The strengths and weaknesses of each option are
considered to protect the investor according to their risk tolerance.
(d) Investment Safety: Portfolios should align with the investor’s risk
capacity to prevent losses that they cannot afford. Minimizing risk
is a crucial aspect of portfolio management.
Portfolio management plays a vital role in managing immediate financial
needs, long-term financial planning, and securing future financial stability.
5.4 Constraints and Factors in Portfolio Management
The portfolio management procedure must be customised to the unique
circumstances and constraints of the portfolio owner. The amount of the
assets, the need for liquidity, the time horizon, & external constraints like
taxes and laws are the main determinants of asset allocation. In the case
of smaller portfolios, there may be constraints related to their size. These
portfolios might face challenges in achieving adequate diversification
across different asset classes. Additionally, limited resources may hinder
their ability to effectively monitor a complex investment program. On the
other hand, larger-scale asset owners may encounter difficulties due to
liquidity conditions and higher trading costs. Various factors come into
play when making decisions regarding portfolio investment as discussed
below:
Time Horizon: The time horizon of investments in line with the financial
objectives is a significant factor in portfolio management. Shorter time
horizons call for a conservative approach focused on preserving capital,
while longer time horizons allow for more aggressive strategies seeking
higher returns. The timing of investing in specific options is crucial
for building a profitable portfolio. Investors who are getting close to
retirement are encouraged to put more of their money in higher-yielding
investments and to dedicate a smaller amount of their portfolio to safer
investments like cash and bonds. On the other side, people just starting
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BMS
Notes
their careers are urged to allocate a larger amount of their portfolio to
long-term investments in high-risk, high-reward options. They can tolerate
short-term market volatility and losses because of a longer time horizon.
Long-term objectives favour assets like real estate, gold, equity funds,
stocks, and debt mutual funds whereas short-term objectives tend to favour
recurring deposits, liquid mutual funds, treasury bills and government
bonds. Financial goals also affect how a portfolio is allocated.
Current Wealth: The amount of money an individual earns significantly
impacts asset allocation as it directly relates to their investing power.
Current wealth plays a crucial role in portfolio management, influencing
various aspects:
(a) Asset Size: The amount of investment capital accessible depends
on the disposable income which in turn depends on the current
affluence. Capital must be allocated among several asset types,
such as equities, bonds, real estate, and commodities to have a
diversified portfolio. The allocation percentages for each asset
class are influenced by the current level of wealth, providing for
better diversification and access to a wider choice of investment
possibilities. The size of an individual’s portfolio may limit access
to certain asset classes or strategies if it’s too small to capture their
returns efficiently.
(b) Risk Tolerance: Current wealth influences an investor’s risk tolerance.
Higher wealth levels provide a greater capacity to tolerate shortterm fluctuations and take on higher risks in pursuit of potentially
higher returns. Conversely, individuals with lower current wealth
may have a lower risk tolerance and prioritize capital preservation
over aggressive growth.
(c) Investment Strategies: The amount of current wealth can impact
the choice of investment strategies. Wealthier investors may have
access to exclusive opportunities like private equity, hedge funds, or
venture capital that may be unavailable to smaller investors. They
may also engage in more complex strategies such as derivatives
trading or alternative investments.
(d) Liquidity Needs: Current wealth affects an investor’s liquidity
requirements. Individuals with higher wealth have more flexibility
in managing liquidity and can allocate a portion of their portfolio
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to illiquid investments with longer lock-up periods. Conversely,
individuals with lower wealth may have immediate liquidity needs,
requiring a higher proportion of their portfolio to be in liquid assets.
Notes
(e) Financial Goals: Current wealth plays a vital role in determining
an investor’s financial objectives. The level of wealth influences
desired lifestyle, retirement plans, legacy goals, and funding for
specific milestones such as education or major purchases. Portfolio
management considers the investor’s current wealth and aligns
investment strategies to achieve these financial goals.
Tax Considerations: Tax implications have a significant impact on
portfolio management decisions and can affect various aspects of investment
strategies and asset allocation. Paying taxes on gains reduces the actual
returns earned by individuals. Efficient tax planning and management in
portfolio management can help minimize tax liabilities, maximize aftertax returns, and improve overall portfolio performance.
(a) Capital Gains Taxes: Profits from the sale of investments at a
profit above the original cost are subject to capital gains taxes.
The holding time of the investment and the investor’s tax bracket
determine the capital gains tax rate. Long-term capital gains are
taxed at a preferred rate for investments held for longer than one
year, while short-term capital gains are subject to the individual’s
marginal tax rate based on their income tax bracket. It is important
to consider the holding period of an investment before selling to
assess the tax implications.
(b) Dividend Taxes: Dividend income received from investments in
stocks and other dividend-paying assets is taxable. The tax rates
on dividends can vary depending on factors such as the type of
dividend (qualified or non-qualified) and the investor’s tax bracket.
When selecting dividend-paying securities for a portfolio, portfolio
managers need to consider the tax impact of dividend income.
(c) Tax-Efficient Asset Allocation: Portfolio managers may strategically
allocate assets to optimize tax efficiency. This involves considering
the tax implications of different asset classes and their distributions.
For example, tax-efficient asset allocation may involve holding
tax-exempt bonds or tax-managed funds in taxable accounts, while
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allocating tax-inefficient assets such as high-yield bonds or actively
managed funds to tax-advantaged accounts.
(d) Tax-Loss Harvesting: Selling investments that have incurred losses in
order to offset taxable gains in other areas of the portfolio is known
as tax-loss harvesting. By strategically realizing losses, portfolio
managers can reduce tax liabilities and improve after-tax returns.
Tax-loss harvesting is often done towards the end of the financial
year to take advantage of potential capital gains tax savings.
(e) Tax Law Changes: Changes in tax laws and regulations can
significantly impact portfolio management. Portfolio managers
need to stay updated on tax reforms, deductions, credits, and other
tax-related provisions that may influence investment strategies and
decision-making.
Liquidity Requirements: Liquidity refers to the ease of trading an asset
(such as equity shares, bonds, debentures, etc.) in the stock market for
liquid money or cash. Liquidity risk is commonly associated with bonds
or mutual funds like ELSS that have a fixed and lengthy lock-in period.
This risk implies that investors may find it challenging to sell their
investments without incurring losses. Additionally, it can be difficult
to sell investments at a time that investors consider appropriate due to
insufficient buyers in the market. Real estate is an example of an asset
with significant liquidity constraints, while open-ended mutual funds or
equity shares offer greater liquidity.
Anticipated Inflation: Inflation refers to the sustained increase in prices
over time. The risk associated with inflation is the potential loss of
purchasing power as prices rise. When the rate of return on investments
fails to keep up with the rate of inflation, investors are exposed to this
risk. Investors will only get a net real return of 2%, for example, if the
rate of return is 5% and the inflation rate is 3%. If the investment’s rate
of return is 2%, the real rate of return will be negative (i.e., -1%) since
inflation will diminish the returns’ profits as prices rise. Thus, inflation
helps investors to anticipate the percentage return their investments need
to achieve in order to maintain their profitability in real terms.
A comprehensive approach to portfolio management considers these
factors holistically to develop an investment plan that best aligns with
the investor’s specific circumstances and objectives.
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Notes
IN-TEXT QUESTIONS
1. The primary objective of portfolio management is____.
(a) Maximizing capital appreciation
(b) Minimizing investment risks
(c) Achieving financial goals
(d) Enhancing portfolio flexibility
2. In portfolio management diversification aim to achieve ______.
(a) Maximizing return on investment
(b) Minimizing market risks
(c) Enhancing portfolio flexibility
(d) Improving capital appreciation
3. How is capital appreciation calculated?
(a) Subtracting the purchase price from the current value
(b) Adding the purchase price to the current value
(c) Dividing the current value by the purchase price
(d) Multiplying the purchase price by the current value
Effective portfolio management is essential for assisting investors in
developing an investing strategy that fits their risk tolerance, income
and age. A customised and planned strategy is required because every
person or organisation has a different investment portfolio based on their
own financial objectives. The portfolio management process involves the
following steps:
Planning
Execution
‹
Identify
Objectives
‹
Estimate
Risks
‹
Develop
Strategy
Feedback
‹
Invest in
Profitable
Securities
‹
Monitor and
Evaluate
Portfolio
‹
Minimise
Risks
‹
Revise and
Rebalance
Composition
Figure 5.1: Process of Portfolio Management
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Step 1: Identify Objectives - The investor must determine their specific
objectives, which may include capital appreciation or consistent returns.
Step 2: (VWLPDWH 5LVNV - Examine the expected returns, prospects of
liquidity, and associated hazards of the different asset classes in the
capital market to estimate risks.
Step 3: 'HYHORS6WUDWHJ\ - Based on investment objectives, risk tolerance,
time horizon, and market conditions, develop a solid investment plan and
tailored asset allocation.
Step 4: Invest in Profitable Securities - Implement the planned investment
strategy by carefully selecting and investing in a portfolio of securities
after conducting thorough assessments of their fundamentals, liquidity,
marketability, tax implications, time horizon and credibility.
Step 5: 0LQLPLVH 5LVNV - Diversify the investment mix based on budget,
timeline, and financial goals. By spreading investments across different
assets, one can protect their investments against the constantly changing
market environment.
Step 6: 0RQLWRUDQG(YDOXDWH3RUWIROLR - Regularly monitor and evaluate
the performance of the portfolio in terms of risk and return over a period.
This step is crucial for improving efficiency and ensuring that the portfolio
aligns with expectations.
Step 7: 5HYLVH DQG 5HEDODQFH WKH &RPSRVLWLRQ - It is important to
periodically rebalance the portfolio (every six to twelve months) to
realign investments with the investment strategies and goals. Portfolio
rebalancing helps bring investments back on track.
By following these steps in portfolio management, investors can create
and maintain an investment plan that is tailored to their needs and helps
them achieve their financial objectives.
Investment Options for Individuals
Money Market Instruments: Large quantities of debt instruments with
short maturities, including short-term reserves or commercial paper, are
traded on the money market. It concentrates on transactions concerning
debt with a shorter than one-year maturity. To ensure steady cash flow and
generate modest returns, governments, businesses, and investors use the
money market. Although money market accounts have greater minimum
balance requirements and withdrawal limits than standard savings accounts,
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they provide higher interest rates. A Treasury bill (T-Bill) is a short-term
government debt security with a maturity of one year or less and is issued
by the Treasury Department. A Certificate of Deposit (CD), on the other
hand, is a savings instrument that yields interest on a one-time payment
for a predetermined length of time.
Notes
Capital Market Instruments: The purchase and sale of long-term debt
and equity securities is the main emphasis of the capital market, in
contrast. A government can pay its expenditures and liabilities by issuing
bonds as a kind of debt security. Bonds have an expiration date and are
seen to be less risky than equities. Investors, generally, receive both the
principal and interest at maturity in case of bonds. Bonds contribute to
reducing risk in a portfolio of investments.
Alternatively, stocks signify ownership in a business. The quantity of firm
stocks a person has determines their ownership stake in the company.
Dividends, which are paid to stockholders in the form of a portion of
the company’s earnings, are their right. By selling their equities for more
money, investors can also generate larger returns. Stocks are seen as a
component of an investment portfolio that generates rewards but come
with significant risks.
Derivatives: These contracts derive their value from an underlying
asset. Futures, options, forwards, and swaps are some of the typical
derivatives. An agreement between two parties to acquire or sell an asset
at a predetermined price at a later period is known as a futures contract.
Futures contracts are used by traders to manage risk or make predictions
about the value of the underlying asset. Similar to a futures contract, an
options contract does not require the buyer to execute the agreed-upon
purchase or sell orders necessarily. Derivatives are exposed to market
sentiment and market risk. Changes in supply and demand can cause the
price and liquidity of derivative contracts to fluctuate.
Mutual Fund: A mutual fund is a kind of investment vehicle that collects
funds from numerous individuals to invest in a variety of securities,
including stocks, bonds, and other securities. It is administered by a
qualified fund manager or group of managers who choose investments
on the clients’ behalf. Mutual funds are a popular investment option for
individuals looking to participate in the financial markets without having
to directly manage their investments. Mutual funds offer several advantages
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to investors. They provide diversification by investing in a variety of
securities, reducing risk. Professional fund managers handle the investment
decisions, leveraging their expertise. Mutual funds are accessible to a
wide range of investors, with lower investment minimums. They also offer
liquidity, allowing investors to buy or sell shares as needed. Transparency
is maintained through regular reports and disclosures. However, there are
some disadvantages to consider. Mutual funds charge costs in the form
of fees and expenses, which can impact overall returns. Market risk is
present, as the value of investments can fluctuate. Investors have limited
control over the specific securities held in the fund. It is important for
investors to carefully assess these factors before investing in mutual funds.
5.5 Asset Allocation
The planned division of an investor’s resources among various investment
kinds is known as asset allocation. This involves distributing investments
across different asset classes, taking into consideration the investor’s
investment objectives and tolerance for risk. The aim is to achieve
significant returns while minimizing risk. The goal of financial professionals
is to match an investor’s asset allocation to their financial objectives
and risk tolerance. This makes sure that an individual’s portfolio is
diverse and well-balanced across various investment possibilities. Risk
tolerance plays a crucial role in this process. Each asset class has its own
unique risk-return characteristics and combining them in a portfolio can
help mitigate the impact of poor performance from any one asset. By
diversifying across multiple asset classes, investors can reduce the risk
associated with investing in just one asset class or mutual fund scheme.
This diversification increases the likelihood of achieving better returns
for the investor.
Asset Allocation Pyramid
The asset allocation pyramid is a visual representation that illustrates
the recommended allocation of investments across different asset classes
according to their risk and return characteristics. It provides a hierarchical
structure that assists investors in effectively allocating their assets to
achieve their financial objectives while managing risk. As you ascend
the pyramid, the risk level increases, but the allocation of overall funds
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available for investment becomes smaller. Consequently, higher up the
pyramid signifies higher risk but also greater potential returns.
Notes
High Risk
Derivatives
Real estate,
commodities
Stock, equity funds,
mutual funds
Bonds/fixed income
securities
Cash/term deposits
Low Risk
Figure 5.2: Asset Allocation Pyramid
The foundation of the pyramid comprises low-risk and highly liquid
investments, such as cash and cash equivalents. These assets offer stability
and form the basis of the portfolio, being easily accessible and suitable
for emergency funds or short-term requirements. The next tier includes
fixed-income securities, like bonds and bond funds, which provide relatively
higher returns compared to cash while carrying a lower level of risk than
equities. They generate income through regular interest payments and can
preserve capital while achieving modest growth.
Moving up further, the third tier encompasses diversified equity investments,
such as stocks and equity funds. Equities possess a greater potential for
growth but also entail more risk. They present opportunities for longterm capital appreciation and play a significant role in a well-rounded
portfolio. The fourth tier consists of alternative investments, such as real
estate, commodities, hedge funds, or private equity. These assets exhibit
unique risk-return characteristics and often display lower correlation with
traditional asset classes. Including alternative investments in the portfolio
can enhance diversification and potentially improve overall returns. At the
top of the pyramid, we find speculative investments or individual stocks
of high-risk companies, representing the apex. These investments carry
the highest level of risk and are subject to significant volatility. They
should only be considered by investors with a high-risk tolerance and a
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deep understanding of the associated risks. Additionally, derivatives like
options and futures can be found at the summit of the pyramid.
The asset allocation pyramid serves as a guideline for investors to determine
the appropriate blend of asset classes based on their risk tolerance,
investment objectives, and time horizon. It underscores the significance
of diversification in spreading risk and optimizing returns. It is worth
noting that the specific allocation within each tier of the pyramid may
vary based on individual circumstances and market conditions. Regular
monitoring and adjustments to the asset allocation are crucial to maintaining
the desired risk-return profile and aligning with evolving financial goals
and market dynamics.
Investor Life Cycle Approach
The Investor Life Cycle Approach is a framework used to understand
the different stages and needs of investors as they progress through their
financial journey. It provides a structured approach for financial advisors
and investors to tailor investment strategies and financial planning based on
an individual’s unique circumstances and goals. This approach recognizes
that investors have varying risk tolerances, investment objectives, time
horizons, and financial situations at different stages of their lives. The
different stages an investor goes through are explained with the help of
a graph (see Figure 5.3) where net worth (on y-axis) refers to the value
of financial assets an investor holds during the age of the investor (on
x-axis).
The Investor Life Cycle typically consists of four main stages: Accumulation,
Consolidation, Preservation, and Distribution. Let’s explore each stage
in detail:
1. Accumulation Stage: This stage usually begins in early adulthood
when individuals start earning income and have the opportunity to
save and invest for the future. During this stage, the primary objective
is to accumulate wealth and grow investments. Investors may have
long-term goals such as buying a house, saving for education, or
planning for retirement. They typically have a longer time horizon and
can afford to take higher risks to pursue higher returns. Investment
strategies in this stage may include equity investments, diversified
portfolios, and exposure to growth-oriented assets.
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Notes
Figure 5.3: Investor Life Cycle Approach
2. Consolidation Stage: The consolidation stage typically occurs in midlife when investors have built a considerable investment portfolio.
At this point, the focus shifts from aggressive growth to preserving
and enhancing the wealth already accumulated. Investors may have
additional financial responsibilities such as paying off mortgages,
supporting dependents, or planning for their children’s education.
The investment strategies during this stage aim to balance growth
and risk mitigation. Diversification, asset allocation, and periodic
portfolio rebalancing are common strategies to manage risk and
maintain a stable investment base.
3. Preservation Stage: As investors approach retirement, the preservation
stage becomes more prominent. The primary objective is to safeguard
the accumulated wealth and ensure it lasts throughout retirement.
Investors become more risk-averse and focus on capital preservation
and generating a consistent income stream. Strategies may involve
a shift towards more conservative investments such as fixedincome securities, dividend-paying stocks, and annuities. Capital
preservation, income generation, and risk management become
crucial considerations.
4. Distribution Stage: The distribution stage begins in retirement when
investors start withdrawing funds from their investment portfolio to
cover living expenses. The primary goal is to generate a sustainable
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income stream that can support their lifestyle throughout retirement.
Investors may consider various income-generating strategies such as
systematic withdrawals, annuity products, and dividend reinvestment.
Tax-efficient planning, estate planning, and managing healthcare
costs also become important aspects during this stage.
The Investor Life Cycle Approach recognizes that individuals may not
follow a linear progression through these stages. Life events such as career
changes, marriage, divorce, inheritance, or unexpected financial challenges
can disrupt the expected trajectory. Therefore, it is essential for investors
and financial advisors to regularly review and adjust investment strategies
based on changing circumstances. Moreover, the approach emphasizes
the importance of ongoing financial education, goal reassessment, and
risk management. It encourages investors to work closely with financial
advisors who can provide personalized guidance, monitor progress, and
make appropriate adjustments to the investment plan. Overall, the Investor
Life Cycle Approach provides a comprehensive framework to guide
investors and financial advisors in making informed investment decisions
aligned with the individual’s life stage, goals, risk tolerance, and financial
situation. It promotes a holistic approach to financial planning and helps
investors navigate their financial journey with confidence and clarity.
IN-TEXT QUESTIONS
4. Which step in portfolio management involves developing a
strong investment strategy and customized asset allocation?
(a) Step 1: Identify Objectives
(b) Step 2: Estimate Risks
(c) Step 3: Develop Strategy
(d) Step 4: Invest in Profitable Securities
5. Which investment strategy aims to extract maximum returns
from the market without frequent trading?
(a) Active portfolio management
(b) Passive portfolio management
(c) Speculative portfolio management
(d) Dynamic portfolio management
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5.6 Portfolio Management Services
Notes
A portfolio manager is an individual or service provider who assists in
creating and implementing a well-diversified and highly profitable financial
investment plan. On the behalf of investors, they oversee and manage
investments, assisting them in achieving long-term financial objectives,
maximising returns based on earnings, budget, and time duration, and lowering
risk tolerance. Portfolio managers also provide advice on unanticipated
risks, stability in the markets, investment possibilities, and the best time
to make investments. They fulfil these responsibilities with expertise and
ease. The main duties of a portfolio manager include informing clients
about relevant investment tools, developing and implementing customized
investment solutions, selecting the most suitable asset class based on
investment goals, monitoring and evaluating financial portfolios, measuring
performance and managing risk, and rebalancing portfolios based on market
conditions. A skilled portfolio manager takes into account factors such as
age, budget, and goals to assist clients in making informed investment
decisions and recommends appropriate levels of risk.
Passive Portfolio Management
Passive portfolio management is a favoured strategy among long-term
investors as it aims to achieve maximum returns from the market without
the need for frequent trading. The practice of buying securities with
the goal of holding them for a long time is known as a “buy and hold”
approach. The Efficient Market Hypothesis, which holds that financial
markets are fairly valued and that all investors have equal access to
similar information without any benefits, forms the foundation of the
idea behind passive portfolio management. This strategy entails creating
and managing a set basket of index funds, like as ETFs, that are in line
with the state of the market. Although these funds could have smaller
returns, they are usually more reliable and successful over the long term
with lesser costs.
Index Funds: Index fund is a kind of mutual fund which is meant to
mimic the elements of an index of the financial markets. A mutual fund
that tracks an index, for instance the BSE Sensex or NSE Nifty, would
invest in stocks that closely resemble that index. The funds in this category
are passively managed, which means the manager does not change the
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portfolio’s asset allocation and trades in the same securities in the exact
same proportions as the underlying index. An index fund that follows
the NSE Nifty Index, for instance, would have 50 equities distributed
similarly across its portfolio. The index fund makes sure to invest in
all of the securities that the index tracks. Because index funds follow
market indices, the returns they earn frequently resemble those of the
index. As a result, these funds are frequently chosen by investors who
want predictable returns and low-risk equities investments.
Systematic Investment Plans (SIP) are a mutual fund investing approach
that allows investors to invest a specified amount in a scheme of mutual
funds at periodic intervals, such as every month or every three months,
rather than making a single lump-sum payment. SIP is a wealth creation
strategy that offers several advantages. It promotes financial discipline and
regular saving habits, eliminates the need to manage market fluctuations,
and provides convenience through automatic investments at regular
intervals. The key benefits of investing in SIP are as follows:
(a) Rupee Cost Averaging: SIP incorporates the concept of Rupee Cost
Averaging, where more units are purchased when the market is low
and fewer units when the market is high. This feature allows for
a lower average cost of investment and potentially higher gains
during market corrections.
(b) Power of compounding: SIP leverages the power of compounding,
whereby small amounts invested over a long period generate better
returns compared to a one-time investment.
(c) Flexibility: SIPs are open-ended funds that can be withdrawn based
on the investor’s choice. They do not have a fixed tenure like
Public Provident Fund or Unit Linked Insurance Plans. Investors can
withdraw either the full or a partial amount from their investment
without incurring any losses. Additionally, the investment amount
can be increased or decreased as per the investor’s preferences.
The buy and hold strategy in passive investing avoids significant capital
gain taxes and other taxes. Transparency is ensured as the assets included
in index funds are clearly defined. Investing in and owning an index or a
group of indices is easier to implement and understand. However, passive
investing is still subject to market risks as index funds track the overall
market performance. One limitation of passive investing is the lack of
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flexibility, as the core holdings of passive investments are locked in to
track the market and cannot outperform the market.
Notes
Active Portfolio Management
Active portfolio management entails proactively handling an investment
portfolio in order to outperform benchmarks for the market or indexes.
The main goal is to outperform the outcome of the underlying reference
index. Active management is based on the assumption that a qualified
portfolio manager, assisted by a professional investment organization,
may select assets that outperform the industry average or other portfolio
performance indicators. Investors pay the portfolio manager a fee for
their skill in security selection. Portfolio managers use active portfolio
management to proactively purchase and sell securities in order to maximise
gains for portfolio owners. They choose securities and distribute assets
according to market conditions, using either qualitative or quantitative
techniques in order to beat the market.
Market Timing: Market timing refers to the practice of attempting to
predict the overall market direction and making investment decisions
based on those predictions. Active strategies often involve timing the
market by moving investments in or out of financial markets or switching
between asset classes based on predictive methods. By predicting market
movements, investors aim to generate profits from those movements.
Portfolio managers analyse economic indicators, market trends, news
events, and other factors to determine when to allocate assets into or out
of the market or specific sectors.
Fundamental Analysis: This approach involves analysing a company’s
financial statements and performance indicators to determine its intrinsic
value and growth potential. Active portfolio managers use fundamental
analysis to identify undervalued securities that they believe will outperform
the market in the long term.
Technical Analysis: Technical analysis involves studying historical price
patterns, market trends, and trading volumes to predict future price
movements. Active managers use charts and market data to identify trends
and patterns. Technical analysis helps them identify short-term trading
opportunities and time the market to optimize returns and manage risk.
Style Investing: Style investing categorizes securities into different
styles, and portfolio allocation is based on selecting styles rather than
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individual securities. Managers use their knowledge and understanding
of the market to select securities within specific style parameters, such
as size and value/growth characteristics for equities or terms and credit
for fixed-income investments.
Active portfolio management offers the potential for higher returns
compared to market benchmarks, allowing investors to diversify across
asset classes, sectors, and geographies to reduce risk and increase returns.
It allows customization of investment portfolios based on specific goals
and risk tolerance. However, accurately predicting market movements
can be challenging, as markets are complex. Active management tends
to be more expensive than passive strategies due to higher fees. There is
also a higher risk of underperformance associated with active portfolio
management.
IN-TEXT QUESTIONS
6. What is the purpose of market timing in active portfolio
management?
(a) To maximize profits from short-term trading opportunities
(b) To select securities based on their style characteristics
(c) To reduce risk through diversification
(d) To allocate assets based on market trends and conditions
7. What is the underlying philosophy behind passive portfolio
management?
(a) Efficient Market Hypothesis
(b) Random Walk Theory
(c) Active investment strategy
(d) Behavioural finance theory
5.7 Summary
Portfolio management aims to optimize returns and minimize risks in order
to achieve financial goals. It involves taking a comprehensive approach
that considers various factors to develop an investment plan tailored to
the investor’s circumstances and objectives. By following the steps in
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portfolio management, investors can create and maintain an investment
plan that aligns with their needs and helps them achieve their financial
objectives. Asset allocation plays a crucial role in portfolio management,
which involves dividing an investor’s resources among different investment
types. This approach considers the investor’s objectives and risk tolerance,
aiming to achieve substantial returns while minimizing risk.
Notes
5.8 Answers to In-Text Questions
1. (c) Achieving financial goals
2. (b) Minimizing market risks
3. (a) Subtracting the purchase price from the current value
4. (c) Step 3: Develop Strategy
5. (b) Passive portfolio management
6. (a) To maximize profits from short-term trading opportunities
7. (a) Efficient Market Hypothesis
5.9 Self-Assessment Questions
1. What are the objectives of portfolio management?
2. Discuss the steps in traditional portfolio management for individuals.
3. Explain the asset allocation pyramid.
4. Discuss the major factors which may act as constraints in portfolio
management.
5. How can a portfolio be managed keeping the investor life cycle?
6. Compare the passive and active portfolio management.
7. Explain two types of investment strategies of passive portfolio
services.
5.10 References
‹
Borad, S.B. (2022). Portfolio Investment. H)LQDQFH0DQDJHPHQW. https://
efinancemanagement.com/investment-decisions/portfolio-investment.
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Notes
‹
Capoonam. (2022). Portfolio Management Services income taxable
under ‘Capital gains.’ TaxGuru. https://taxguru.in/income-tax/portfoliomanagement-services-income-taxable-capital-gains.html.
‹
Hayes, A. (2023). Portfolio Management: Definition, Types, and
Strategies. ,QYHVWRSHGLD. https://www.investopedia.com/terms/p/
portfoliomanagement.asp.
‹
Medury, R. K. (2023). Tax-Efficient Portfolio Management: Maximising
Returns and Minimising Tax Liability. Jama Wealth Equity Investment
Advisory | Personal Financial Advisor. https://jamawealth.com/blog/
tax-efficient-portfolio-management-india/
‹
Movement, Q.-. P. a. P. W. (2022, August 18). Inflation: How Should
It Affect Your Investment Portfolio? Forbes. https://www.forbes.com/
sites/qai/2022/08/18/inflation-how-should-it-affect-your-investmentportfolio/?sh=34a915843136.
5.11 Suggested Readings
‹
Chandra, Prasanna: Investment Analysis and Portfolio Management.
McGraw Hill Education.
‹
Randall S. Billingsley, Lawrence J. Gitman, and Michael D. Joehnk
(2017): Personal Financial Planning. Cengage Learning.
‹
Susan M. Tillery, and Thomas N. Tillery: Essentials of Personal
Financial Planning. Association of International Certified Professional
Accountants.
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L E S S O N
6
Portfolio Analysis and
Evaluation
Ankit Suri
Senior Research Fellow
Atal Bihari Vajpayee School of Management and Entrepreneurship
Jawaharlal Nehru University
New Delhi
Yogesh Sharma
Atal Bihari Vajpayee School of Management and Entrepreneurship
Jawaharlal Nehru University
New Delhi
Email-Id: ankitsuridse@gmail.com; yogesh.ysharma93@gmail.com
STRUCTURE
6.1
6.2
6.3
6.4
6.5
6.6
6.7
6.8
6.9
6.10
6.11
Learning Objectives
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Portfolio Return
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Summary
Answers to In-Text Questions
Self-Assessment Questions
References
Suggested Readings
6.1 Learning Objectives
‹
Understand the concept and importance of portfolio management and its role in
achieving investment objectives.
‹
Calculate and analyze portfolio return using different measurement techniques.
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‹
To understand the concept and to identify the factors that contribute
to portfolio risk and evaluate their impact on investment decisionmaking.
‹
Gain knowledge of various evaluation techniques used in portfolio
analysis.
‹
Understand the concept of portfolio rebalancing and its role in
maintaining an optimal asset allocation strategy.
6.2 Introduction to Portfolio Management
The art and science of managing a portfolio involves selecting investments
strategically in order to maximise profits while minimising risk. To
accomplish specific monetary objectives, it entails the thoughtful allocation,
selection, and administration of a variety of investment assets. In a
volatile and unpredictably changing market, portfolio management is
essential for individuals, organisations, and fund managers to fulfil their
investment goals. Diversification is one of the fundamental ideas in
portfolio management. Spreading investments over several asset classes,
industries, and geographical areas is known as diversifying a portfolio
in order to lower risk. Investors may be able to reduce the overall risk
of their portfolio by keeping a mix of assets that have low or negative
correlations with one another. For example, a portfolio that includes a
combination of stocks, bonds, and real estate properties is likely to be
less susceptible to the volatility of any single asset class.
The goal of portfolio management is to balance risk and return. Higher
potential profits on investments frequently come with higher degrees of
risk. For portfolio managers to effectively manage this trade-off, they
must fully understand it. An investor seeking steady income and capital
preservation, for instance, would allocate a bigger amount of their portfolio
to fixed-income assets, which typically have lower risk but provide modest
returns. On the other side, an investor with a longer investment horizon
and a higher risk tolerance may devote a larger amount of their portfolio
to stocks, which historically have produced higher long-term returns but
are more volatile.
Determining the best asset allocation for a portfolio depends on the risk
tolerance, time horizon, and investment objectives of the individual. The
distribution of investments among various asset classes, such as stocks,
bonds, cash, and alternative assets, is referred to as asset allocation.
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Investors can take advantage of various market conditions and potentially
increase profits while reducing risk by strategically distributing their
investments. For instance, a portfolio manager may suggest increasing
the allocation to stocks during economic expansions and increasing the
proportion to fixed-income assets during recessions.
Notes
In order to maintain the appropriate asset allocation, portfolio management
also entails routine evaluation and modifications. Rebalancing involves
readjusting the asset allocation of the portfolio to its original or targeted
target allocation. In order to do this, assets are bought or sold based on
their performance and divergence from the desired allocation. For instance,
the portfolio may need to be rebalanced by selling some equities and
purchasing other underrepresented asset classes in order to restore the
correct allocation if equity investments have outperformed other asset
classes and their proportion in the portfolio has increased significantly.
6.2.1 How Portfolio Management Works in Real life
Take Sarla, a hypothetical individual investor, as an example. Middleaged professional Sarla wants to save money for her children’s future
education costs. She has a moderate risk tolerance. To aid her in achieving
her goal, she decides to look for a portfolio manager. To get started,
the portfolio manager thoroughly evaluates Sarla’s financial status, risk
tolerance, and time horizon. The portfolio manager suggests a diversified
portfolio made up of a combination of equities, bonds, and mutual funds
after considering her investing preferences.
The portfolio manager discusses the idea of diversification and its
usefulness in risk management with Sarla in the initial meeting. Sarla
discovers that by diversifying her asset allocation, she may be able to
reduce the effect of the performance of any one investment on her whole
portfolio. The portfolio manager also highlights the tension between risk
and return, emphasising the possibility of larger returns from stocks while
also admitting the volatility that comes with them. The portfolio manager
continuously evaluates Sarla’s holdings to gauge their performance and
confirm that they are consistent with her investment goals. The manager
might recommend rebalancing the allocation if certain asset classes,
like stocks, have outperformed others and now make up a higher share
of the portfolio. For instance, the portfolio manager might recommend
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selling some of the stocks and reallocating the proceeds to bonds or other
investment vehicles to maintain the desired risk level.
Sarla can successfully deploy her funds to meet her aim of saving for her
children’s college expenses by putting portfolio management principles into
practice. Sarla benefits from the portfolio manager’s direction in navigating
the complexities of investing options, managing risk, and coming to wise
decisions that are in line with her long-term financial goals.
The portfolio management experience of Sarla in this case serves as an
illustration of the significance of a customised investment strategy based
on unique goals and risk tolerance. Sarla can work to create a portfolio
that attempts to provide the required cash for her children’s education
while minimising the impact of market swings through diversification,
risk management, and routine portfolio reviews.
6.3 Portfolio Return
A portfolio’s total performance or profitability is measured by portfolio
return. Investors and portfolio managers utilize it as a crucial statistic to
assess the effectiveness of their investment approach. People can evaluate
how well their investments have done over a certain time period by
calculating their portfolio return.
6.3.1 Weighted Portfolio Return
Each asset’s return in a weighted portfolio is multiplied by its specific
weight or allocation within the portfolio. The weighted portfolio return
is just the weighted average mean of the individual portfolio returns with
the weights set at the proportion of each asset in the entire portfolio. The
following is the weighted portfolio return formula:
Portfolio Return = (Weight of Asset 1 × Return of Asset 1) + (Weight
of Asset 2 × Return of Asset 2) + ... + (Weight of Asset n × Return of
Asset n)
......Eq. 1
For example, consider a portfolio with two assets:
Asset 1: Weight = 60%, Return = 10%
Asset 2: Weight = 40%, Return = 8%
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Portfolio Return = (0.6 × 0.10) + (0.4 × 0.08)
Notes
= 0.06 + 0.032
= 0.092 or 9.2%
Therefore, the weighted portfolio return is 9.2%.
6.3.2 Unweighted Portfolio Return
In an unweighted portfolio, each asset’s return is given equal importance
regardless of its allocation in the portfolio. The formula for unweighted
portfolio return is as follows:
Portfolio Return = (Return of Asset 1 + Return of Asset 2 + ... + Return
of Asset n)/Number of Assets
......Eq. 2
For example, consider a portfolio with three assets:
Asset 1: Return = 12%
Asset 2: Return = 9%
Asset 3: Return = 6%
Portfolio Return = (0.12 + 0.09 + 0.06)/3 = 0.27/3 = 0.09 or 9%
Therefore, the unweighted portfolio return is 9%.
It should be noted that, Unweighted and Weighted portfolio return is
similar in the sense that unweighted portfolio return is equal to weighted
portfolio return where the weights are equal.
Let’s consider an investor named Rakesh who has a portfolio consisting
of three assets:
Asset 1: Weight = 40%, Return = 12%
Asset 2: Weight = 30%, Return = 8%
Asset 3: Weight = 30%, Return = 6%
To calculate the weighted portfolio return:
Portfolio Return = (0.4 × 0.12) + (0.3 × 0.08) + (0.3 × 0.06)
= 0.048 + 0.024 + 0.018
= 0.09 or 9%
Thus, the weighted portfolio return for Rakesh’s portfolio is 9%.
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Notes
A portfolio returns of 9% denotes that throughout the stated time period,
Rakesh’s total investments have produced a return of 9%. The performance
of each item in the portfolio and its weighting has an impact on this
return. The portfolio return in this instance is most significantly impacted
by Asset 1, which has the largest weight.
An appropriate statistic for assessing the success of investing choices
is portfolio return. Investors can make informed judgments about asset
allocation, rebalancing, and changes to their investment strategy by
tracking the portfolio return over time.
It’s crucial to remember that issues like transaction costs, taxes, and
inflation are not taken into account when calculating portfolio return.
These extra factors may have an effect on the investor’s real net return.
IN-TEXT QUESTIONS
1. An investor has a portfolio consisting of two assets. The
allocation and returns of each asset are as follows:
Asset 1: Weight = 40%, Return = 12%
Asset 2: Weight = 60%, Return = 8%
Calculate the portfolio return.
2. An investor has a portfolio consisting of four assets. The
allocation and returns of each asset are as follows:
Asset 1: Weight = 25%, Return = 12%
Asset 2: Weight = 20%, Return = 10%
Asset 3: Weight = 30%, Return = 8%
Asset 4: Weight = 25%, Return = 6%
Calculate the portfolio return.
6.3.3 Factors that affect Portfolio return
Several factors can affect the portfolio return, and understanding these
factors is crucial for investors and portfolio managers. Here are some
key factors that influence portfolio return:
1. Asset Allocation: The distribution of investments among various asset
classes, such as stocks, bonds, cash, and alternative assets, is referred
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to as asset allocation. Portfolio return is significantly influenced
by the asset allocation choices. Risk and return possibilities differ
among various asset classes. Portfolio performance can be affected
by strategically allocating investments based on an investor’s risk
tolerance and financial objectives.
Notes
2. Individual Asset Performance: The entire return of the portfolio is
directly impacted by the performance of each individual item inside
it. Company performance, the state of the economy, interest rates,
and market movements are just a few examples of the variables
that might affect the returns of stocks, bonds, mutual funds, or
other investment vehicles. The ability of an asset to provide returns,
whether through capital growth or income generation, affects the
overall return of the portfolio.
3. Market Conditions: Market circumstances, such as political developments, economic statistics, and market mood, can have a big impact on portfolio return. Portfolio returns often increase during bull
markets that are characterised by rising stock prices and optimistic
investor sentiment. On the other hand, bear markets that feature
falling stock prices and pessimistic mood can harm portfolio performance. In order to manage portfolio return, one must be able to
traverse various market conditions and adjust investment methods
as necessary.
4. Diversification: Spreading investments over several asset classes,
industries, and geographical areas is referred to as diversification.
Investors try to lower risk and maybe increase returns by diversifying
their portfolios. A well-diversified portfolio can lessen the effects of
a single investment’s subpar performance. The correlation between
the different assets in the portfolio determines how diversification
affects portfolio return. Reduced portfolio risk and maybe higher
returns might result from assets having reduced correlations.
5. Investment Costs: Portfolio returns may be reduced by investment
expenses such taxes, management fees, brokerage fees, and transaction
charges. High costs might significantly affect the portfolio’s overall
return on investment. Portfolio returns can be maintained by reducing
expenses through careful product selection, cost-efficient trading
techniques, and tax-efficient investing strategies.
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Notes
6. Time Horizon: An investment’s time horizon has a significant role
in determining portfolio performance. Longer time horizons typically
offer more opportunity for investments to increase in value and
earn compound returns. Longer-term investors may be better able
to withstand short-term market swings and gain from the potential
rewards of longer-term investments.
7. Risk Management: Achieving desired portfolio returns requires
effective risk management. Since each investor has a different level
of risk tolerance, controlling risk within the portfolio is essential
to adjusting it to each investor’s preferences. Investors can guard
against downside risk and possibly improve returns by using risk
management tactics such asset diversification, hedging strategies,
and prudent position sizing.
8. Investor Behaviour: The return on a portfolio can be significantly
impacted by investor behaviour. Fear, greed, and impatience are
just a few of the emotions that can cause people to make illogical
judgments about their assets, such as panic selling during market
downturns or chasing speculative investments during market booms.
More steady portfolio returns can be achieved by keeping a disciplined
and logical attitude to investing, sticking to a long-term investment
strategy, and refraining from impulsive decisions based on transient
market moves.
6.4 Portfolio Risk
A key term in finance is portfolio risk, which quantifies the possible
variability or unpredictability of returns of a portfolio of investments.
Investors and portfolio managers must understand portfolio risk because
it helps them determine the potential of suffering losses or experiencing
volatility in the value of their investment holdings. Individuals can make
educated judgments to limit and mitigate future losses by assessing
portfolio risk.
The variance or standard deviation of a portfolio’s return serves as a
measure of its risk. While standard deviation is the square root of variance,
variance measures the dispersion of returns around the average or expected
return of the portfolio. These statistical measurements reveal information
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about the portfolio’s return spread and amount of volatility. Portfolio risk
is not merely the weighted average of the hazards of those individual
securities, whereas the expected return on a portfolio is determined as
the weighted average of the expected returns of individual securities
inside the portfolio. In the majority of real-world scenarios, the returns
on securities tend to show some degree of correlation, which means that
the return on one asset is influenced by the return on another asset. As
a result, the portfolio risk cannot be determined by simply weighing the
risks of the individual securities.
Notes
Analysing the aggregate risk of many assets within a portfolio is central
to the idea of portfolio risk. Two important variables must be taken into
account in order to determine portfolio risk: the risk of each security and
the correlations or links between their returns.
Let’s use the straightforward example of a portfolio with only two assets
to learn the calculation for portfolio risk:
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î ı î ı @
(T Where:
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w1 and w2 are the weights of securities 1 and 2 in the portfolio,
respectively.
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securities 1 and 2, respectively.
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and 2.
The formula consists of three terms. The first term represents the weighted
risk of security 1, the second term represents the weighted risk of security
2, and the third term captures the contribution of the co-movement between
the returns of the two securities.
%\VTXDULQJWKHVWDQGDUGGHYLDWLRQV ı2DQGı2), we obtain the variances
of the individual securities. The weights (w1 and w2) are squared and
multiplied by their respective variances to calculate the weighted risk for
each security. The third term accounts for the covariance between the
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coefficient) multiplied by the individual standard deviations of security
1 and 2.
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Notes
Taking the square root of the entire expression yields the portfolio risk,
which represents the overall volatility or uncertainty associated with the
combined returns of the two securities in the portfolio.
To illustrate let us calculate the expected return and risk of a portfolio
having two securities with coefficient of correlation (r) = 0.65. The detail
of the portfolio is as under:
Assets
ABC
XYZ
Weight
0.25
0.75
Expected Return
0.15
0.12
Standard Deviation
0.2
0.15
Using the formula for Expected return:
Expected Return of the Portfolio = (Weight_ABC × Expected Return_
ABC) + (Weight_XYZ × Expected Return_XYZ)
= (0.25 × 0.15) + (0.75 × 0.12)
= 0.0375 + 0.09
=0.1275 or 12.75%
To calculate the standard deviation of the portfolio, we use the formula
that takes into account the weights, standard deviations, and correlation
coefficient:
6WDQGDUG'HYLDWLRQRI3RUWIROLR 5LVNRIWKH3RUWIROLR ¥> :HLJKWB$%&2
× Standard Deviation_ABC2) + (Weight_XYZ2 × Standard Deviation_
XYZ2) + (2 × Weight_ABC × Weight_XYZ × Correlation Coefficient
î 6WDQGDUG 'HYLDWLRQB$%& î 6WDQGDUG 'HYLDWLRQB;<= @
= ¥ > 2 × 0.202) + (0.752 × 0.152) + (2 × 0.25 × 0.75 × 0.65 × 0.20
î @
= ¥ > @
= ¥ >@
=0.1498 or 14.9%
It should be noted that the portfolio risk is not simply the weighted average
risk of the individual securities. Rather it is affected by the coefficient
of correlation between the individual securities.
Let us consider the case where the correlation is 0.75.
3RUWIROLR ULVN ¥ > 2 × 0.202) + (0.752 × 0.152) + (2 × 0.25 × 0.75
î î î @
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¥ > @
Notes
¥ >@
= 0.1536 or 15.36%
The benefit of diversity is offered by assets with low correlation, and as
a result, such portfolios’ risk is also minimal. Low correlation between
assets indicates that their returns do not move exactly in lockstep with
one another. As a result, the other asset may not always react similarly
when one asset sees a good or negative return. Investors may be able to
balance the volatility of individual assets and lower the portfolio’s overall
risk by including assets with low correlation.
Correlation and Portfolio Risk
Correlation
between assets
in the portfolio
Portfolio risk
Figure 6.1: Relation between correlation and portfolio risk
6.4.1 Factors affecting portfolio risk
Several factors contribute to portfolio risk, and understanding these factors
is crucial for effective investment decision-making. The following are
key factors that influence portfolio risk:
1. Asset Class Composition: A portfolio’s risk is greatly impacted by
the distribution of its assets among various asset classes. The risk
profiles of various asset types, including stocks, bonds, real estate,
and commodities, differ. A higher allocation to lower-risk assets
like bonds can reduce risk, whereas allocating a larger share of the
portfolio to higher-risk asset classes like equities might increase it.
2. Correlation Among Assets: A portfolio’s risk is significantly
influenced by the correlation between the assets in the portfolio.
The degree of movement between the returns of several assets is
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Notes
measured by correlation. A significant positive correlation suggests
that assets have a propensity to move together, increasing portfolio
risk. However, a low or negative correlation offers the benefit of
diversification and lowers the risk of the portfolio.
3. Concentration Risk: Concentration risk is when a large amount of
the portfolio is allocated to a single security, industry, or geographic
area. A portfolio’s performance may be significantly impacted by
unfavourable developments in a single sector or stock if it is overly
concentrated in that stock. Investment diversification across many
securities and industry sectors helps reduce concentration risk.
4. Market Conditions: Portfolio risk can be influenced by market
conditions, such as the economy, interest rates, inflation, and
geopolitical events. Market conditions that are uncertain or volatile
tend to raise the overall risk level. Recessions in the economy,
unrest in the political system, or abrupt increases in interest rates
can all have a negative impact on the profitability of the portfolio.
5. Investor’s Risk Tolerance: The degree of risk appropriate for a
portfolio depends significantly on the investor’s risk tolerance.
Individuals’ levels of risk tolerance vary depending on things like
their financial objectives, investing horizon, and personal preferences.
Higher risk-tolerant investors might feel more at ease with volatile
investments, whereas lesser risk-tolerant investors might favour
more cautious options.
6. Time Horizon: The time horizon of the investment objective also
affects portfolio risk. Longer investment horizons provide more
flexibility to recover from short-term fluctuations and potentially
take on higher-risk investments. Shorter time horizons necessitate
a more conservative approach to minimize the impact of potential
market downturns.
7. Risk Management Strategies: The implementation of risk management
strategies can help mitigate portfolio risk. Techniques such as
diversification, asset allocation, and risk-adjusted performance
analysis can assist in controlling and reducing risk exposure.
Investors can manage and optimise portfolio risk by taking these factors
into account and determining their impact. Striking a balance between risk
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and return is crucial, and the portfolio should be tailored to the investor’s
goals, risk appetite, and market conditions. To respond to changing
circumstances and maintain an ideal risk profile, regular monitoring and
adjustments to the portfolio’s composition and risk management measures
are necessary.
Notes
IN-TEXT QUESTIONS
3. Which of the following factors helps reduce portfolio risk
through diversification?
(a) High correlation between assets
(b) Low correlation between assets
(c) Investing in a single asset class
(d) Concentrating investments in a single stock
4. Portfolio risk can be measured by:
(a) Expected return
(b) Standard deviation
(c) Beta coefficient
(d) Price-to-earnings ratio
6.5 Evaluation and Management Techniques
For investors to evaluate and optimise the performance and risk of their
investment portfolios, portfolio evaluation and management approaches are
crucial tools. Analysing the relationship between prospective returns and
hazards connected to various investment portfolios is known as portfolio
risk-return analysis. By evaluating the trade-off between potential profits
and the level of risk that the investor is willing to tolerate, this approach
aids investors in making wise selections.
6.5.1 Risk Return Graphs
The link between expected return and amount of risk associated with
various investment portfolios is graphically represented by the riskreturn graph. Visually evaluating the trade-off between possible returns
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Notes
and the volatility or risk of the portfolio is a frequent tool in portfolio
analysis. The x-axis on a risk-return graph shows portfolio risk, which
is typically calculated using the standard deviation of portfolio returns.
The average expected return from the portfolio is shown on the y-axis,
which is represented by the portfolio return.
Figure 6.2: Relationship between Risk and Return
Following are the key features of Risk-Return Graphs:
1. Positive Slope: The risk-return graph typically has a positive slope,
indicating that as the level of risk increases, so does the potential for
higher returns. This positive relationship reflects the basic principle
that higher returns generally come with a higher level of risk.
2. Efficient Frontier: The portfolios with the highest return for
each level of risk, or the lowest risk for each level of return, are
represented by a curve known as the efficient frontier. It identifies
the greatest possible collection of portfolios for balancing risk and
return. Because they provide the highest return for a given level of
risk or the lowest risk for a given level of return, portfolios that
are located on the efficient frontier are regarded as efficient.
3. Risk-Seeking and Risk-Averse Portfolios: Investors’ preferences
for risk vary. Investors that desire more returns at the expense of
greater risk may have portfolios that are located in the upper region
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of the risk-return graph. Risk-averse investors, on the other hand,
like lower levels of risk and may select portfolios that are located
in the lower region of the risk-return graph.
Notes
4. Comparing Portfolios: Investors can evaluate the risk-return profiles
of various portfolios by comparing them using the risk-return graph.
Due to the fact that they provide better returns for a given level
of risk or lower risks for a given level of return, the portfolios
above and to the left of other portfolios on the graph are regarded
as superior. Based on their level of risk tolerance and desired rate
of return, investors can assess and choose portfolios.
5. Risk Diversification: The risk-return graph also highlights how crucial
diversification is when building a portfolio. By distributing their
investments over various asset classes, industries, or geographical
areas, diversification enables investors to lower portfolio risk.
Investors who spread their bets may be able to earn bigger returns
without taking on too much risk.
6.5.2 Modern Portfolio Theory
Harry Markowitz’s Modern Portfolio Theory (MPT) is a framework for
constructing optimal investment portfolios that seek to balance risk and
return. It was introduced by Markowitz in 1952 and revolutionized the
field of investment management. MPT provides a mathematical approach
to diversification by considering the correlation between different assets
in a portfolio. The central idea behind MPT is that an investor should not
solely focus on the expected return of an investment but also consider
the associated risk. MPT assumes that investors are risk-averse and prefer
higher returns with lower risk. By diversifying investments across multiple
assets, investors can reduce their exposure to individual security risk and
potentially enhance their risk-adjusted returns.
Suppose an investor has $100,000 to invest and is evaluating two stocks:
Stock A and Stock B. The investor expects Stock A to generate an annual
return of 10% with a standard deviation (a measure of risk) of 15%.
Stock B is expected to generate an annual return of 8% with a standard
deviation of 10%. MPT advises the investor to construct a portfolio that
includes both Stock A and Stock B in a proportion that optimizes the
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Notes
risk-return trade-off. The key principle of MPT is to find the portfolio
that maximizes return for a given level of risk or minimizes risk for a
given level of return.
To determine the optimal portfolio, the investor needs to consider the
correlation between Stock A and Stock B. If the two stocks are perfectly
positively correlated (correlation coefficient = +1), their returns move
in the same direction. In this case, the investor would not gain much
diversification benefit by holding both stocks. However, if Stock A and
Stock B have a low or negative correlation, their returns may not move in
tandem. This lack of correlation reduces the overall risk of the portfolio.
By combining assets with different correlations, the investor can achieve
a more efficient risk-return profile.
Suppose the correlation between Stock A and Stock B is 0.5. The
investor can calculate the efficient frontier, which represents a range of
portfolios that maximize returns for different levels of risk. Each point
on the efficient frontier corresponds to a different portfolio allocation.
Based on the investor’s risk tolerance and return expectations, they can
choose a portfolio on the efficient frontier that suits their preferences.
This portfolio will typically include a combination of Stock A and Stock
B in a specific proportion that minimizes risk or maximizes return. By
employing MPT, the investor can make an informed decision about
portfolio allocation rather than relying solely on individual stock analysis.
MPT helps investors understand the benefits of diversification and the
trade-off between risk and return, enabling them to construct portfolios
that align with their investment objectives.
‹
The Efficient Frontier: The M-V (Mean-Variance) frontier, also
known as the efficient frontier, is a fundamental concept introduced
by Harry Markowitz in his Modern Portfolio Theory (MPT). The
M-V frontier represents a set of optimal portfolios that offer the
highest expected return for a given level of risk or the lowest risk
for a given level of expected return. The efficient frontier is derived
from the combination of different assets in a portfolio, considering
their expected returns, standard deviations (a measure of risk),
and the correlation between their returns. The goal is to find the
portfolio allocation that provides the highest possible return for a
specific level of risk, or conversely, the lowest risk for a given
level of return.
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Suppose an investor has three investment options: Stock A, Stock B,
and Stock C. Each stock has an expected return and standard deviation
as follows:
Notes
Stock A: Expected return of 10% with a standard deviation of 15%
Stock B: Expected return of 8% with a standard deviation of 10%
Stock C: Expected return of 6% with a standard deviation of 12%
In order to construct the efficient frontier, the investor needs to consider
the expected returns, standard deviations, and the correlation between
these stocks. By systematically varying the weights allocated to each
stock, different portfolios can be created. Using mathematical optimization
techniques, such as the mean-variance optimization, it is possible to
identify the optimal combinations of the three stocks that offer the highest
expected return for a given level of risk. These optimal portfolios form
points on the efficient frontier.
Figure 6.3 : The Efficient Frontier
The M-V frontier is typically depicted as a graph with the expected return
on the y-axis and the standard deviation (or risk) on the x-axis. Each
point on the efficient frontier represents a different portfolio allocation.
The curve connecting these points represents the range of portfolios that
provide the highest expected return for different levels of risk. An investor
with a higher risk tolerance can select a portfolio allocation located on
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the right-hand side of the efficient frontier, which offers higher expected
returns but also higher risk. On the other hand, a risk-averse investor
might prefer a portfolio located on the left-hand side of the efficient
frontier, which provides lower risk but also lower expected returns. The
efficient frontier allows investors to understand the trade-off between risk
and return. It provides a visual representation of the potential portfolios
that achieve an optimal balance between these two factors, given the
available investment options. Investors can use the efficient frontier to
determine the portfolio allocation that aligns with their risk preferences
and investment objectives.
It’s important to note that the shape of the efficient frontier can vary
depending on the available investment options and the correlations between
assets. Additionally, the efficient frontier can be expanded by including
other asset classes, such as bonds, real estate, or commodities, to further
diversify the portfolio and potentially improve risk-adjusted returns.
6.5.3 Sharpe Ratio
The Sharpe ratio is a widely used measure of risk-adjusted performance
in portfolio analysis. It quantifies the excess return earned per unit of
risk taken by a portfolio. The Sharpe ratio helps investors evaluate and
compare different portfolios by considering both their returns and their
volatility or risk. Let’s dive into a detailed explanation of the Sharpe
ratio using numerical examples:
The formula for the Sharpe ratio is as follows:
Sharpe Ratio = (Portfolio Return - Risk-Free Rate)/Portfolio Standard
Deviation
........Eq. 4
Let’s consider a portfolio with an expected return of 12%, a standard
deviation of 10%, and a risk-free rate of 3%.
Portfolio Return = 12%
Risk-Free Rate = 3%
Portfolio Standard Deviation = 10%
Sharpe Ratio = (12% - 3%)/10%
= 0.9
The Sharpe ratio for this portfolio is 0.9.
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The Sharpe ratio represents the excess return earned by the portfolio
above the risk-free rate per unit of risk (standard deviation) taken. In this
example, the portfolio achieved a return of 12% above the risk-free rate
of 3%. For each unit of risk, which is measured by the standard deviation
of 10%, the portfolio earned an excess return of 0.9 units.
Notes
A higher Sharpe ratio indicates better risk-adjusted performance. The
greater the excess return achieved for each unit of risk taken, the higher
the Sharpe ratio, and the more attractive the portfolio is from a riskadjusted perspective.
Investors can use the Sharpe ratio to compare and evaluate different
portfolios. Let’s consider two portfolios:
Portfolio
Portfolio X
Portfolio Y
Expected Return
15%
10%
Standard Deviation
12%
8%
For Portfolio X:
Sharpe Ratio X = (15% - 3%)/12%
= 1.0
For Portfolio Y:
Sharpe Ratio Y = (10% - 3%)/8%
= 0.875
According to the Sharpe ratios, Portfolio X outperforms Portfolio Y
in terms of risk-adjusted performance. This indicates that Portfolio X
was more attractive when considering risk-adjusted returns because it
produced a bigger excess return for every unit of taken risk. It’s crucial to
remember that the Sharpe ratio’s interpretation is based on the investor’s
risk tolerance, investing goals, and the benchmark being utilised for
comparison. Risk-averse investors may prioritise lower volatility even
if it results in lower Sharpe ratios, whereas investors with higher risk
tolerance may favour portfolios with higher Sharpe ratios.
6.5.4 Treynor Ratio
A risk-adjusted performance metric called the Treynor ratio is employed
in portfolio analysis to assess the extra return obtained per unit of
systematic risk (beta). It aids investors in determining how effectively a
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portfolio generates returns in relation to the risks assumed, particularly
the systematic market risk.
The formula for the Treynor ratio is as follows:
Treynor Ratio = (Portfolio Return - Risk-Free Rate)/Portfolio Beta
.......Eq. 5
Let’s break down the components of the formula and understand them
using a numerical example:
Assume we have a portfolio with an expected return of 12%, a beta of
1.2, and a risk-free rate of 5%.
Portfolio Return: The portfolio return represents the expected return of
the portfolio. In our example, the portfolio return is 12%.
Risk-Free Rate: The risk-free rate is the return an investor can earn
from a risk-free asset, such as government bonds. It represents the return
without taking any risk. In our example, the risk-free rate is 5%.
Portfolio Beta: The systematic risk or the sensitivity of the portfolio’s
returns to changes in the broad market returns is measured by beta. When
the beta is 1, the portfolio’s returns move in lockstep with the market;
when the beta is higher than 1, the sensitivity to market changes is greater.
The portfolio beta in our example is 1.2.
Calculating the Treynor ratio:
Treynor Ratio = (12% - 5%)/1.2
= 5.83
The portfolio has produced an excess return of 5.83 units per unit of
systematic risk (beta) according to the Treynor ratio of 5.83. The riskadjusted performance of various portfolios can be compared using this
ratio, allowing investors to choose those that give the highest excess
returns in comparison to their systematic risk. The portfolio’s risk-adjusted
performance improves as the Treynor ratio rises. If the ratio is higher, it
means that the portfolio has produced a greater return in comparison to
the level of systematic risk absorbed. Since they provide more effective
risk-adjusted returns, investors frequently seek out portfolios with higher
Treynor ratios.
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It is important to note that the Treynor ratio primarily focuses on
systematic risk and does not consider unsystematic risk, which can be
diversified away through proper portfolio diversification. Therefore, the
Treynor ratio is most useful when comparing portfolios that have similar
systematic risk exposures.
Notes
IN-TEXT QUESTIONS
5. A Sharpe ratio of 1 indicates that the investment has generated
a return equal to the risk-free rate.
(True/False)
6. An investment with a negative Sharpe ratio is considered to
have underperformed in terms of risk-adjusted returns.
(True/False)
7. Consider an investment portfolio with an average annual return
of 12% and a systematic risk (beta) of 1.5. The risk-free rate
is 4%. Calculate the Treynor ratio for the portfolio.
8. In portfolio management, the ________ risk measures the extent
to which an individual security’s price moves in relation to the
overall market, while the ________ risk measures the unique
risks associated with a specific security.
6.5.5 Jensen’s Alpha
A risk-adjusted performance metric called the Jensen ratio, commonly
referred to as the Jensen’s alpha or excess return, is used in finance to
evaluate the performance of a portfolio of investments or a particular
asset. It assesses an investment’s excess return over the return that would
be anticipated given the level of risk involved.
The formula for calculating the Jensen’s alpha is as follows:
Jensen’s Alpha = Portfolio Return - (Risk-Free Rate + Beta × (Benchmark
Return - Risk-Free Rate))
......Eq. 6
Where:
‹
Portfolio Return = Actual return earned by the portfolio.
‹
Risk-Free Rate = The rate of return on a risk-free investment, such
as T-bills.
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‹
Beta = Measure of the portfolio’s return sensitivity to market
movements. It represents the systematic risk of the portfolio.
‹
Benchmark Return = The return of a chosen benchmark index,
typically used as a reference for evaluating portfolio performance.
Assume we have a portfolio with an actual return of 12%, a benchmark
return of 10%, a risk-free rate of 3%, and a beta of 1.2.
Jensen’s Alpha = 12% - (3% + 1.2 × (10% - 3%))
= 12% - (3% + 1.2 × 7%)
= 12% - (3% + 8.4%)
= 12% - 11.4%
= 0.6%
The Jensen’s Alpha in the case above is calculated to be 0.6%. The
portfolio has surpassed expectations, earning an excess return over what
would be anticipated based on its degree of risk, according to a positive
Jensen’s Alpha. A negative Jensen’s Alpha, on the other hand, denotes
the portfolio has underperformed in comparison to expected return given
the level of risk. The portfolio manager has produced greater returns
compared to the risk taken, which suggests skilled management, according
to a higher Jensen’s Alpha and vice versa.
It’s crucial to remember that this metric has its restrictions. The assumption
is that the portfolio return, and benchmark return have a linear relationship
and that the benchmark return and risk-free rate appropriately reflect the
market return and risk-free rate, respectively. In order to make thorough
evaluations of portfolio performance, this metric should also be understood
in conjunction with other performance indicators and factors.
6.5.6 Asset Allocation
A key component of portfolio management is asset allocation, which entails
carefully dividing investments across various asset types. The objective
of asset allocation is to manage risk while maximising the performance
of the portfolio while taking into account the risk appetite, investing
goals, and market conditions of the investor. Diversification is the main
justification for asset allocation. The overall risk of the portfolio can
be decreased by investing in a variety of asset types that have low or
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negative correlations with one another. This is due to the fact that various
asset classes frequently exhibit variable market performance. When one
asset class is struggling, another one might be doing well, balancing off
losses and possibly improving overall returns.
Notes
Investors must take into account their risk tolerance, or their capacity
and willingness to withstand changes in portfolio value, in order to
implement asset allocation efficiently. A bigger allocation to less volatile
assets, such as fixed-income securities, may be preferred by conservative
investors who have a lower risk tolerance. On the other side, aggressive
investors might be more prepared to accept greater levels of risk and
devote a larger amount of their portfolio to stocks or other high-growth
assets. The investor’s investment objectives should also be taken into
account when allocating assets. Over the long term, predicted returns for
various asset types differ. For instance, fixed-income instruments give
more steady returns but have a smaller potential for growth than equities,
which typically offer higher prospective returns but are also more volatile.
By aligning asset allocation with specific investment goals, investors can
structure their portfolios to match their desired risk-return trade-off.
Asset allocation is significantly influenced by market conditions as well.
The relative attractiveness of various asset classes can be influenced by
economic variables, market trends, and interest rate environments. For
instance, stocks may perform better than bonds during periods of economic
expansion, while fixed-income instruments may provide greater stability
during periods of economic contraction. To maintain an ideal portfolio
strategy, regular market monitoring and asset allocation adjustments are
essential.
Two commonly used strategies in asset allocation are:
‹
Diversification: Diversification involves spreading investments across
multiple asset classes to reduce the concentration risk of relying
heavily on a single asset or sector. By diversifying, investors aim to
reduce the impact of any one investment on the overall portfolio’s
performance.
‹
Rebalancing: Rebalancing involves periodically reviewing and
adjusting the asset allocation to maintain desired targets. This ensures
that the portfolio stays aligned with the investor’s risk tolerance
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Notes
and investment objectives, even as market conditions and asset
performance change over time.
In general, asset allocation is a dynamic process that calls for careful
assessment of market conditions, investment objectives, and risk tolerance.
Investors might seek to create a balance between risk and return that
is suitable for their particular circumstances by strategically allocating
investments across multiple asset classes and periodically monitoring and
modifying the allocation.
6.5.7 Passive Portfolio Management
An investment approach called passive portfolio management, commonly
referred to as passive investing or index investing, tries to mimic the
performance of a certain market index or benchmark. Instead of actively
choosing and maintaining individual securities, passive portfolio management
builds the portfolio to reflect the makeup and weightings of the specified
index. Gaining wide market exposure and producing returns that closely
mirror the performance of the chosen index are the main goals of passive
portfolio management. This strategy is predicated on the idea that active
fund managers struggle to consistently outperform the market over the
long run, according to the efficient market hypothesis. Therefore, passive
portfolio management seeks to capture the overall market return instead
of attempting to beat it.
Key features of passive portfolio management are:
1. Index Replication: Passive portfolio management involves constructing
a portfolio that closely replicates the holdings and weightings
of a specific index. This can be achieved through investing in a
combination of stocks, bonds, or other securities that are included
in the index. The portfolio manager’s role is primarily focused on
maintaining the desired asset allocation in line with the index.
2. Low Portfolio Turnover: Because passive strategies strive to maintain
a long-term investment attitude, they often have low portfolio
turnover. Rather than frequent buying and selling of individual
stocks or bonds, changes to the portfolio are generally driven by
changes in the index composition, such as additions or deletions
of assets.
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3. Cost Efficiency: When opposed to active management, passive
portfolio management is frequently associated with lower expenses.
There is less need for intensive research, analysis, and trading
activity because the portfolio is built to match the index. This may
lead to decreased management fees, transaction expenses, and tax
repercussions, all of which may boost investors’ net returns.
Notes
4. Broad Market Exposure: Investors can gain exposure to a large
market or asset class through passive portfolios. Investors can
diversify their risk across a number of different businesses or issuers
by participating in an index, which provides exposure to a wide
variety of securities. This diversification lessens the possibility of
suffering substantial losses due to the underperformance of particular
stocks or bonds and lessens the impact of risks related to each
individual security.
5. Transparency: Investors benefit from transparency in passive portfolio
management because the holdings and weightings of the underlying
index are frequently made available to the public. Investors may
quickly analyse the composition of the portfolio and monitor its
performance in comparison to the index. This transparency boosts
investor confidence and enables a better assessment of the risk and
return characteristics of the portfolio.
It is crucial to remember that while passive portfolio management seeks
to mimic an index’s performance, it cannot ensure identical results. The
performance of the portfolio and the performance of the index may differ
slightly as a result of factors such tracking error, which quantifies the
departure of the returns from the index of the portfolio, and expenses
related to maintaining the portfolio. Because it is straightforward,
has reduced expenses, and is based on the idea that by capturing the
performance of the entire market, one can generate consistent market
returns, passive portfolio management has become increasingly popular
among both individual and institutional investors. For individuals who
like a more hands-off and methodical approach to investing, it offers a
good alternate technique.
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Notes
6.6 Monitoring and Rebalancing the Portfolio
6.6.1 Portfolio Monitoring
The process of routinely tracking and assessing a portfolio’s performance,
risk, and makeup is known as portfolio monitoring. It involves going over
and examining several facets of the portfolio to make sure it stays in line
with the investor’s objectives, risk tolerance, and market circumstances.
Making informed investment decisions and taking the required steps to
maximise returns while minimising risk are the main goals of portfolio
monitoring. The following are important factors in monitoring the portfolio:
1. Performance Assessment: A crucial component of monitoring is assessing
the portfolio’s performance. This entails contrasting the portfolio’s
actual returns with its predicted returns or benchmark returns. The
portfolio’s performance is evaluated to see if it is accomplishing its
goals and whether any changes or improvements are necessary. It
enables investors to spot outperforming or underperforming periods
and comprehend the variables influencing those outcomes.
2. Risk Analysis: Effective monitoring requires a thorough analysis of
the portfolio’s risk characteristics. This entails evaluating numerous
risk indicators, including beta, standard deviation, downside risk,
volatility, and other pertinent variables. By understanding the
portfolio’s risk profile, investors can evaluate whether the level
of risk is in line with their risk tolerance and make adjustments if
necessary. Additionally, risk analysis aids in locating any portfolio
vulnerabilities or potential concentration hazards.
3. Reviewing Asset Allocation: The deliberate distribution of investments
among various asset classes (such as stocks, bonds, cash, and real
estate) is referred to as asset allocation. Reviewing the present
allocation and contrasting it with the desired or target allocation
constitutes asset allocation monitoring. In order to maintain the
intended risk-return profile, this analysis helps establish whether
the portfolio is sufficiently diversified and whether any adjustments
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are required. The portfolio may need to be rebalanced if the asset
allocation has drastically drifted from the target.
Notes
4. Reviewing Individual Securities: It is crucial to keep track of the
fundamentals and performance of each security in the portfolio.
This entails performing routine assessments of the securities held
in the portfolio in order to evaluate their financial standing, market
dynamics, and any other elements that might affect their performance.
Investors might spot underperforming assets or areas for growth by
examining certain securities.
5. Economic and Market Analysis: Understanding the potential impact
on the portfolio requires close attention to market and broader
economic conditions. This entails keeping up with macroeconomic
indicators, market trends, geopolitical developments, and aspects
unique to a given industry. Investors can measure their portfolio’s
exposure by looking at these variables and then use that information
to decide whether to change their investment strategies or make
adjustments to them.
6. Regular Reporting: A crucial component of portfolio monitoring is
the creation of periodical reports that summarise the performance,
asset allocation, risk metrics, and other pertinent data. With the help
of these reports, investors may make well-informed decisions, get
a quick overview of the condition of their portfolios, and monitor
their progress towards their investment goals. In order to ensure
accountability and transparency, regular reporting is also helpful.
6.6.2 Portfolio Rebalancing
Portfolio rebalancing is a strategic process that involves adjusting the
asset allocation of a portfolio back to its target or desired allocation.
It is an essential aspect of portfolio management aimed at maintaining
the desired risk-return characteristics and aligning the portfolio with the
investor’s goals and risk tolerance. Rebalancing ensures that the portfolio
remains in line with the intended investment strategy over time. Here’s
a detailed explanation of portfolio rebalancing:
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Notes
Monitoring Asset Allocation: The monitoring of the present asset
allocation is the first step in portfolio rebalancing. The portfolio’s
allocation may differ from the desired distribution due to shifting market
circumstances and shifting asset prices. When one asset class outperforms
another, the position may be overweight; when another underperforms, the
position may be underweight. Monitoring the asset allocation enables the
detection of these deviations and signals when rebalancing is necessary.
‹
Assessing Rebalancing Triggers: The right time to make portfolio
modifications is determined by rebalancing triggers. These triggers may
operate on a timer or a threshold. In time-based rebalancing, the portfolio
is reviewed and rebalanced at predetermined times, such as annually or
quarterly. Setting specified percentage thresholds for each asset class is
part of threshold-based rebalancing. Rebalancing is initiated when the
actual allocation wanders above these limits.
‹
Calculating Rebalancing Adjustments: Once a rebalancing trigger is
activated, the next step is to calculate the necessary adjustments. This
involves determining the amount of buying or selling required to bring
the portfolio back to its target allocation. The adjustments are based on
the difference between the current allocation and the target allocation
for each asset class.
‹
Example:
Suppose the target allocation for stocks is 60% and the current allocation
has increased to 65%. To rebalance, it would involve selling a portion
of the stocks to reduce the allocation back to 60%.
Implementing Rebalancing: The portfolio manager or investor executes
the rebalancing trades after calculating the changes. To get the allocation
back on track, this entails either buying or selling stocks within the
portfolio. The particular trades depend on the securities that are offered,
the state of the market, and transaction fees. When rebalancing, it’s
crucial to take tax consequences and transaction expenses into account.
‹
Rebalancing Strategies: Portfolio rebalancing strategies involve different
approaches to bring the asset allocation back to the target allocation. Here
are four common rebalancing strategies, along with illustrations:
‹
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1. Calendar-based Rebalancing:
Notes
This technique calls for periodic rebalancing, such as once a year or every
three months. The portfolio is rebalanced on the predetermined timetable
regardless of the state of the markets.
Illustration:
Let’s consider a portfolio with a target allocation of 60% stocks and
40% bonds. At the beginning of the year, the stocks have performed
well, resulting in a current allocation of 65% stocks and 35% bonds.
According to the calendar-based rebalancing strategy, the portfolio is
rebalanced back to the target allocation by selling a portion of the stocks
and buying bonds.
Before Rebalancing:
Stocks: 65%; Bonds: 35%
After Rebalancing:
Stocks: 60%; Bonds: 40%
2. Threshold-based Rebalancing:
Rebalancing is a part of this technique whenever the allocation of an
asset class veers off course by a predetermined amount. Rebalancing
is initiated when the allocation rises over the upper threshold or drops
below the lower threshold.
Illustration:
Suppose a portfolio has a target allocation of 70% stocks and 30% bonds.
The upper threshold is set at 75% for stocks, and the lower threshold
is set at 65% for stocks. If the current allocation reaches 76% stocks or
drops to 64% stocks, rebalancing is required.
Before Rebalancing:
Stocks: 76%; Bonds: 24%
After Rebalancing:
Stocks: 70%; Bonds: 30%
3. Band-based Rebalancing:
With band-based rebalancing, the portfolio can move over a greater range
or band before rebalancing is started. Rebalancing is triggered whenever
the allocation moves outside of the top or lower range.
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Notes
Illustration:
Consider a portfolio with a target allocation of 50% stocks and 50%
bonds. The upper band is set at 55% for stocks, and the lower band is
set at 45% for stocks. When the current allocation exceeds 55% stocks
or falls below 45% stocks, rebalancing is necessary.
Before Rebalancing:
Stocks: 43%; Bonds: 57%
After Rebalancing:
Stocks: 50%; Bonds: 50%
4. Opportunistic Rebalancing:
Rebalancing based on market conditions or large shifts in asset prices is
known as opportunistic rebalancing. Instead of following a set timeline
or set of thresholds, it seizes market possibilities.
Let’s say the desired allocation for a portfolio is 60% equities and
40% bonds. A market slump results in a large decrease in stock values,
which leads to the present allocation of 50% stocks and 50% bonds. The
portfolio manager takes advantage of this chance to rebalance by buying
more equities at a discount.
Before Rebalancing:
Stocks: 50%; Bonds: 50%
After Rebalancing:
Stocks: 60%; Bonds: 40%
Each rebalancing strategy has its advantages and considerations. The
choice of strategy depends on factors such as investor preferences, risk
tolerance, market conditions, and investment goals. Regular monitoring and
assessment of the portfolio’s asset allocation are crucial to implementing
the most appropriate rebalancing strategy.
Monitoring and Repeat: Rebalancing is a continuous process that
calls for frequent observation and repeated actions. It makes sure that
as market circumstances and investment performance shift, the portfolio
stays in line with the investor’s objectives and risk tolerance. Regular
monitoring makes it easier to determine when rebalancing is required,
allowing investors to make timely changes.
‹
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6.7 Summary
Notes
The essential ideas and significance of efficiently managing investment
portfolios to meet desired goals are covered in depth in the chapter
on portfolio management. It starts off by highlighting the significance
of portfolio management in coordinating investments with particular
objectives. Investors can improve the effectiveness of their investing plans
and increase their chances of success by understanding the concept and
purpose of portfolio management. The ability to compute and analyse
portfolio return is a critical component of portfolio management. The
chapter examines various measurement methods that let investors correctly
gauge the performance of their investments. Understanding the elements
that affect portfolio risk is crucial for making wise investing decisions.
The chapter emphasises the value of comprehending these elements and
how they affect investment choices. Investors can efficiently manage
and limit portfolio risk by taking into account factors including market
volatility, economic conditions, asset correlation, and credit risk. The
chapter also imparts important knowledge about the various evaluation
methods utilised in portfolio analysis. This information enables investors to
make well-informed choices after carefully analysing all of their available
investment possibilities. The final section of the chapter examines the
idea of portfolio rebalancing and how it helps to maintain an ideal asset
allocation plan. Understanding the significance of portfolio rebalancing
allows investors to align their portfolios with their desired risk profile and
investment objectives. By periodically reviewing and adjusting the asset
allocation based on market conditions and investment goals, investors
can optimize their portfolio’s risk-return trade-off.
6.8 Answers to In-Text Questions
1. 9.6%
2. 8.9%
3. (b) Low correlation between assets
4. (b) Standard Deviation
5. False
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Notes
6. True
7. 5.33
8. Systematic; Unsystematic
6.9 Self-Assessment Questions
1. Sarah has a portfolio consisting of three stocks. The weight and
expected returns of each stock are as follows:
Stock A: Weight = 0.4, Expected Return = 0.12
Stock B: Weight = 0.3, Expected Return = 0.08
Stock C: Weight = 0.3, Expected Return = 0.10
Calculate the portfolio return.
Suggest Sarah about which option she should go for from the following
three options:
Option 1: 50 % investment in Stock A, 25 % investment in Stock
B and 25 % investment in Stock C
Option 2: 100 % investment in Stock A
Option 3: 75 % investment in stock A and 25 % investment in Stock
B.
2. Amogh has a portfolio with two stocks. The weight, expected
returns, and standard deviations of each stock are as follows:
Stock X: Weight = 0.6, Expected Return = 0.15, Standard Deviation
= 0.12
Stock Y: Weight = 0.4, Expected Return = 0.10, Standard Deviation
= 0.08
The correlation coefficient between the returns of Stock X and
Stock Y is 0.5. Calculate the portfolio risk. Suppose the correlation
between Stock A and B is 0.4, and between Stock B and C is 0.5,
and between Stock A and C is 0.6 in Sarah’s case in the above
question. Calculate Sarah’s portfolio risk and tell who among Amogh
and Sarah hold a riskier portfolio?
3. Consider two investment portfolios, Portfolio A and Portfolio B, with
the following characteristics:
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Portfolio Average annual
return:
A
10%
B
12%
Standard deviation Beta
of returns:
15%
1.2
18%
1.5
Risk-free Rate
Notes
3%
3%
Calculate and compare the Sharpe ratio and Treynor ratio for both
portfolios.
4. Explain the concept and importance of portfolio management in
achieving investment objectives. Provide examples to support your
answer.
5. Discuss different measurement techniques used to calculate and
analyze portfolio return. Compare and contrast these techniques,
highlighting their advantages and limitations.
6. Identify and explain the factors that contribute to portfolio risk and
evaluate their impact on investment decision-making. Illustrate with
real-life examples.
7. Describe various evaluation techniques used in portfolio analysis.
Discuss how these techniques help investors assess the performance
and risk of their portfolios.
8. An investor is evaluating two investment funds: Fund X and Fund
Y. Fund X has an average annual return of 15% with a standard
deviation of 20%, while Fund Y has an average annual return of
12% with a standard deviation of 16%. The risk-free rate is 6%.
Calculate the Treynor ratio for each fund and determine which fund
provides a better risk-adjusted performance.
9. Elaborate on the concept of portfolio rebalancing and its role in
maintaining an optimal asset allocation strategy. Discuss the benefits
of portfolio rebalancing and provide examples of situations where
rebalancing would be necessary.
10. An investor has a portfolio consisting of four assets: Asset A, Asset
B, Asset C, and Asset D. The average annual returns and betas of
the assets are as follows:
Asset A: Average return = 10%, Beta = 0.8
Asset B: Average return = 12%, Beta = 1.2
Asset C: Average return = 15%, Beta = 1.4
Asset D: Average return = 8%, Beta = 0.9
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The risk-free rate is 5%. Calculate the Treynor ratio for each asset
and identify the asset with the highest risk-adjusted performance.
11. Consider a portfolio with two assets, Asset A and Asset B. The
standard deviation of Asset A is 18%, and the standard deviation
of Asset B is 12%. The correlation between the returns of Asset A
and Asset B is 0.6. The portfolio allocation is 40% in Asset A and
60% in Asset B. Calculate the portfolio standard deviation.
12. An investor is constructing a portfolio with three assets: Asset X,
Asset Y, and Asset Z. The standard deviations of the three assets
are as follows: Asset X - 20%, Asset Y - 15%, Asset Z - 12%. The
correlation coefficients between the assets are X and Y - 0.7, X and
Z - 0.4, Y and Z - 0.6. The portfolio allocation is 30% in Asset
X, 40% in Asset Y, and 30% in Asset Z. Calculate the portfolio
standard deviation.
13. An investor is considering constructing a portfolio with three assets:
Asset X, Asset Y, and Asset Z. The expected returns and standard
deviations of the assets are as follows:
Asset X: Expected return = 15%, Standard deviation = 18%
Asset Y: Expected return = 12%, Standard deviation = 22%
Asset Z: Expected return = 10%, Standard deviation = 15%
The correlation coefficients between the assets are X and Y = 0.6,
X and Z = -0.3, and Y and Z = 0.4. The investor wants to create
a portfolio with an expected return of 11% while minimizing the
portfolio risk.
(a) Calculate the weights (allocation percentages) for each asset that
would achieve the desired expected return.
(b) Determine the portfolio standard deviation for the optimal allocation.
(c) Calculate the Sharpe ratio for the portfolio, assuming a risk-free rate
of 4%.
Note: You may use a calculator or spreadsheet software to perform the
calculations.
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WEALTH MANAGEMENT
6.10 References
‹
Antony, A. (2020). Behavioural finance and portfolio management:
Review of theory and literature. Journal of Public Affairs, 20(2),
e1996.
‹
Baker, H. K., & Filbeck, G. (Eds.). (2013). Portfolio theory and
management. Oxford University Press.
‹
Jeyachitra, A., Selvam, M., & Gayathri, J. (2010). Portfolio risk
and return relationship—an empirical study. Asia Pacific Business
Review, 6(4), 57-63.
‹
Pidun, U., Rubner, H., Krühler, M., Untiedt, R., Boston Consulting
Group, & Nippa, M. (2011). Corporate portfolio management: Theory
and practice. Journal of Applied Corporate Finance, 23(1), 63-76.
‹
Stewart, S. D., Piros, C. D., & Heisler, J. C. (2019). Portfolio
management: Theory and practice. John Wiley & Sons.
Notes
6.11 Suggested Readings
‹
Bhalla, V. (2008). Investment Management (Security Analysis and
Portfolio Management), 19th Ed. India: S. Chand Limited.
‹
Prasanna Chandra (2017). Investment Analysis and Portfolio Management,
McGraw Hill Education.
‹
Kevin, S. (2015), Security Analysis and Portfolio Management,
Prentice Hall of India.
‹
Bodie, Zvi., Kane Alex and Alan J. Marcus (2014), Investments,
McGraw Hill.
‹
Damodaran, A. (2012), Investment Valuation, John Wiley & Sons.
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L E S S O N
7
Estate Planning
Gurdeep Singh
Assistant Professor
Department of Finance and Business Economics
University of Delhi
Email-Id: g.swork@yahoo.com
STRUCTURE
7.1 Learning Objectives
7.2 Introduction
7.3 What is Estate Planning?
7.4 Need for Estate Planning
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7.6 ,PSDFW RI 3URSHUW\ 2ZQHUVKLS DQG %HQH¿FLDU\ 'HVLJQDWLRQV
7.7 'LIIHUHQW $SSURDFKHV WR (VWDWH 3ODQQLQJ
7.8 Estate Planning Documents
7.9 Executing Basic Estate Planning
7.10 Summary
7.11 Answers to In-Text Questions
7.12 Self-Assessment Questions
7.13 Suggested Readings
7.1 Learning Objectives
‹
Describe the concept of Estate Planning.
‹
Understand the need of studying Estate Planning.
‹
Explain the importance of studying different approaches to Estate Planning.
‹
Understand the Executing of Basic Estate Planning.
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WEALTH MANAGEMENT
7.2 Introduction
Notes
The life of an individual is not predictable. In planning an estate, one
can consider security for a surviving spouse and kids, protecting the
family wealth, funds education of children or grandchildren as well as
bequeathing your legacy to charity. Estate planning is the process of
preparing for a person’s future incapacity or death by anticipating and
making arrangements for the handling and disposal of the person’s estate
while the person is still alive. Bequests to loved ones, charities, or heirs
are among the planning’s provisions. Incapacity planning, minimising or
eliminating doubts in the handling of a probate and achieving maximum
value of the estate by minimizing the taxes and other costs are all included
in estate planning. The ultimate objective of estate planning depends on
the individual desires of the estate owner and can be as straightforward
or complex as their requirements and wants dictate. In the case of death
or disability, estate planning enables individuals to make arrangements
for financial management and medical care. A person or the heirs may
gain financially from making a financial plan in advance. Additionally,
giving directions on how to manage everything from medical difficulties
to asset distributions makes life simpler for person’s loved ones. One
can make difficult circumstances easier for their loved ones with careful
estate planning. It’s challenging enough dealing with illness, death and
accidents alone. A tragic circumstance is made worse by adding financial
burden. Making sure everything is in place beforehand allows one to
free their family members up to concentrate on handling their emotions.
7.3 What is Estate Planning?
Estate planning is the process of organizing responsibilities to handle a
person’s financial condition in the case of incapacitation or death. The
distribution of assets to heirs, the payment of estate taxes and debts, as
well as additional issues like the guardianship of minors and pets, are all
included in the planning. Estate planning entails deciding how a person’s
possessions will be protected, handled, and distributed in the event of
their death or incapacitated condition. Making a will, establishing trusts,
establishing charitable donations to reduce taxation on estates, designating
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Notes
an executor and beneficiaries, and making funeral preparations are all
aspects of estate planning.
In Other words, the estate planning process is used to determine the manner
in which a person’s assets are to be secured, managed and distributed
when he or she dies. In the event that a person is unable to cope, estate
planning shall take account of how he or she would manage his assets
and liabilities in case of disability. Estate planning is the process of
transferring assets from one generation to the next. Vehicles, Houses,
stocks, fine art, life insurance coverage, retirement savings, as well as
financial obligations are examples of assets that could be included in a
person’s estate. The misconception that estate planning is only for those
with plenty of money. Estate planning is a comprehensive procedure that
uses several sorts of documents to protect assets following a person’s death.
Estate planning entails a number of crucial elements, including a Living
Will, a financial power of attorney safeguards the assets while taking
the family’s financial condition into account, Beneficiary designations.
Will planning and estate planning are essentially the same in most
respects. Although the phrases are interchangeable, in reality, they serve
completely different processes. Both estate planning and will-writing
provide instructions to the heirs regarding how the deceased person’s
assets should be handled following their death. However, estate planning
extends beyond that by laying out a person’s assets, including their health,
money, as well as other things, even while they are alive. A professional
who specialises in estate planning may assist a person in identifying the
type of planning they require and in drafting the necessary paperwork
required for a thorough estate plan. It also specifies who will take over the
company and receive the property and its assets. The testament involves
the selection of an executor, who will be in charge of making sure all
the directions specified in the will are carried out. A will aids in making
legal decisions and prevents family conflicts over property.
Estate planning involves preparing for future requirements for the individual
and their loved ones. The following are the important factors to take into
account with regard to:
Property management
Estate planning entails deciding who will run the business and how it will
run. It is done by taking the person’s perspective into account. listing all
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of the assets one own and determining a comparable value to each one
is crucial. one must also include a list of every beneficiary one intends
to bequeath these assets to.
Notes
Identifying the concerned individual
During the process of estate planning, it is crucial to consider who will
oversee healthcare decisions and provide personal care for the person.
Throughout their lives, who will look after the family’s minor children?
It is also necessary to make a decision on guardianship.
Arrangements for the funeral
How the person wants their funeral to be carried out, including whether
the deceased should be buried or cremated. It is important to consider
each factor.
Asset distribution
Prior to the person’s death, take into account the conditions under which
the estate should be allocated and how to carry out this process. When
the decedent dies, who will receive the assets, and how will they be
distributed among multiple beneficiaries?
All of an individual’s assets, including those that are held in joint ownership
with someone else, such as a spouse, parent, partner in business, or other
people, are included in their estate.
7.4 Need for Estate Planning
For people with a family and close relative, the provision of estate planning
is essential so as to ensure that they are properly protected financially and
in terms of their comfort. Whether a person has high-value assets or not,
estate planning continues to be essential for them. Due to the fact that
estate planning involves more than just distributing assets, it is important
to lay out clearly defined instructions and specify a representative who
can make decisions regarding a person’s personal care, financial affairs,
and healthcare on their behalf. Depending on the individual’s high or low
net worth, estate planning is undertaken. The approach can be utilised for
designated beneficiaries, asset distribution, and debt repayment planning
for low net worth estates of the individual. However, wealthy people with
sizable estates may also benefit from asset safeguarding, lower taxes,
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Notes
and other estate planning services. The purpose of estate planning is to
enable people to have the best possible life even when they cannot make
decisions on their own. The client’s needs and goals are taken into account
in the process of estate planning, which varies depending on his or her
situation. Ensuring that no misinterpretation occurs in relation to estate
distribution and legacy management is a key purpose of the planning
process. Through effective tax planning and other financial instruments,
the estate planning process increases the value of the estate.
Without an estate plan, intestate succession laws may be applied to
the distribution of a person’s assets after death, which may not be in
accordance with the person’s preferences. There may be uncertainty and
even potential disagreements related to the care and custody of a person’s
minor children after a person passes away, which can also lead to family
conflicts, delayed distribution of assets, and substantial legal expenses. In
the absence of Advance Medical Directive and Living Will, it is possible
that a person’s treatment preferences and decisions will not be respected
or known. This may lead to disagreements between family members and
healthcare professionals, as well as sometimes unwanted treatments.
An estate plan anticipates the future, like any other plan. By creating this
plan, a person ensures that their assets and obligations will be managed
as they would prefer when they are unable to communicate their wishes
i.e., when they pass away or become incompetent. To put it another way,
not having an estate plan is the equivalent of not having a legal voice
that gives instructions for the future.
IN-TEXT QUESTIONS
1. What exactly is an estate plan?
(a) An intended strategy of legally protecting a person’s assets
and determining how a person’s assets are distributed
upon death
(b) The strategy developed to create a new home (the estate)
(c) A plan devised by a judge upon the death of a person to
determine which beneficiaries of the estate receive which
assets
(d) None of the above
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2. What is the primary reason for estate planning?
Notes
(a) Ensuring the beneficiaries receive the majority of the estate
(b) Designating guardians for the minor children, if any
(c) Paying the least amount of taxes on an estate
(d) All of the above
3. What sorts of advantages can estate planning provide?
(a) Donate money, assets, or other property to a favourite
charity or cause
(b) Preserve assets for future generations
(c) Ensure that an individual’s preferences are carried out
when he or she is no longer able to control his or her
own affairs
(d) All of the above
7.5 Forced Heirship in Estate Planning
In estate planning, forced heirship is a principle of law that prevents an
individual from choosing who would be the official heir to their estate
upon their death. It automatically gives specified people the authority to
distribute a specific amount of the deceased person’s inheritance. All these
individuals are often referred to as Protected Heirs, and they may be the
surviving spouse, children, as well as other members of the deceased’s
family. Family protection is the underlying principle of forced Heirship.
The Forced Heirship rule prohibits someone from dividing their wealth
without taking care of their dependents.
Intestate succession frequently gets confused with forced heirship. These
exist nearly everywhere, even in nations without forced heirship like
England, or Australia, and they take effect when a person passes away
without making a Will. These laws govern how the deceased person’s
estate will be distributed in such circumstances, and the closest relatives,
particularly the spouse, and children of the deceased person typically
receive the majority of the assets. A legal will, however, supersedes
intestate succession laws and enables the testator to freely leave their
entire estate to a loved one, a charity, someone close to them, or anyone
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Notes
else. On the other hand, in nations with forced heirship, an individual
only has freedom over the portion of an individual’s assets that remains
after the protected heirs obtained their legitimate share. The protected
heirs would probably be successful in challenging a deceased person’s
Will if it contained instructions that conflicted with that.
7.6 Impact of Property Ownership and Beneficiary
Designations
It is usually the case that, when someone signs a will or an irrevocable
trust in order to set out his or her plan for estate distribution upon death,
he or she often believes that the plan is complete. Nevertheless, the result
following death could be substantially different from what was intended
if a person had not carefully considered beneficiary designations for life
insurance policies, retirement accounts or other assets and co-ordinated
them with an estate plan. Wills are not inherently superior to beneficiary
designations; however, beneficiary designations have a tendency to take
precedence over wills. For instance, if a testator has the sum of two million
dollars life insurance policy with the couple’s two children specified as
equal beneficiaries, and the testator’s will names the spouse as the recipient
of everything testator’s own at the time of death, the life insurance passes
to the children rather than the spouse upon the testator’s dying. Assets
with beneficiary designations, such as life insurance, retirement accounts,
and at times bank and brokerage accounts, as well as any assets with a
POD (pay on death) or TOD (transfer on death) designation and those
titled in the names of two or more people as joint tenants with right of
survivorship or tenants by the entirety are examples of assets that are
not included in the probate estate.
Example of unpleasant outcomes that may occur if beneficiary designations
and asset titles fail to co-ordinate with the estate plan include the following:
In accordance with a person’s Will, if one of the person’s children
predeceases the person, the portion of the person’s estate that child
would have received would pass to that child’s descendants per stirpes.
Additionally, a person will also provide trusts to control assets given
to the grandchildren who are under 30. If a person designates his/her
children as TOD (transfer on death) beneficiaries on an account with a
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brokerage firm and one of his/her children passes away before a person,
the beneficiary designation form may specify that the other beneficiaries
named i.e., his/her other children receive the predeceased child’s share,
contrary to what a person intended. Even if the beneficiary designation
form states what a person wants that his/her grandchildren receive their
deceased parent’s share, there won’t be a trust until age 30; instead, the
institution itself could hold the money until the grandchildren turn 18
without allowing anyone to access it for their benefit unless a guardian is
appointed. The money would then be fully distributed to the grandchildren
when they turn 18 and the trust would end.
Notes
A beneficiary designation may also be implied by the way assets are titled.
An asset, for instance, that is titled in the names of two or more people
as joint tenants with right of survivorship will pass to the surviving joint
owner(s) upon the death of one joint owner.
7.7 Different Approaches to Estate Planning
There are many different types of estate planning, one can broadly
categorise them based on the existence or absence of trusts.
By employing trust for Estate Planning
A trust allows for a great deal of customisation and can make handling
someone’s affairs easier after they pass away or become incapacitated.
The rules of the trust may indicate who is in charge of the assets and
what should be done with them. A trust may also assist one in avoiding
the probate, which can be expensive as well as time-consuming.
During Individual’s lifetime, an individual can employ a revocable living
trust as a legal entity. It is revocable, so one can take money out or
end the trust. However, these trusts may be helpful if a person becomes
incapacitated or wants to retain control over their possessions after death.
One can make arrangements for someone else to handle their financial
affairs and provide for the children, for instance, rather than leaving
assets to children right away after a parent’s death.
One usually needs other legal documents to make a strong estate plan,
such as Trust document, Power of attorney, medical directive, Pour-over
will and Living will.
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Notes
Using a Will for Estate Planning
A will, usually referred to as the last will and testament, is a legal
document that specifies how to divide up an individual’s estate’s assets
following the death of the individual. These agreements can also help
people achieve personal goals, such as designating a guardian for minor
children. One will probably need to make more documentation to plan
for things other than death, such as: Power of attorney, Living Will and
Medical directive.
When the circumstances are complicated enough that they justify the
expense and work of creating and funding a trust, trust-based planning
is often the option that makes the most sense. Will-based planning may
be appropriate in situations that are not too complex.
A trust would be a better option, for instance, if someone wanted to decide
when their heirs would get assets after their death. Instead of distributing
the full value as one lump sum to beneficiaries, a trust could distribute a
modest annual income. In this manner, a beneficiary can’t quickly exhaust
the trust and the assets can’t be easily seized by creditors.
7.8 Estate Planning Documents
To complete the estate planning process, one must have a number of
specific documents such as Wills, guardianship designations, and Powers
of Attorney (POAs). These are a few of the most popular ones. Bank
and account statements, comprehensive lists of the holdings (including
assets and liabilities), and beneficiary designations are other documents
that are required.
To further understand how they could fit into the plan, let’s look into
several crucial estate planning documents:
‹ Last Will and Testament: A will is a legally binding document that
specifies how a person wants their property to be allocated after a person
passes away. By making a will, one can ensure that their property is
distributed in accordance with their preferences, preventing potential
arguments and doubts among their heirs. Essential directions on how
to manage their affairs after death are included in the individual’s will.
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For instance, one can designate an executor or personal representative
to oversee the estate and carry out activities like closing accounts and
distribution of assets. Additionally, a person may designate a beneficiary
for any assets in their estate as well as a guardian for any minor children.
State laws often govern what happens to an individual’s possessions and
dependents if the individual passes away without a will. That could be
a problem if the rules produce a result that wasn’t desired. For instance,
if a person has minor children, it’s possible that they’ll end up in the
custody of a relative who wasn’t their first choice to look after them or
oversee their assets.
Notes
Advance Medical Directive and Living Will: Advance directives
give an individual the opportunity to designate health care representatives
and specify preferences in the event that an illness or injury renders an
individual unable to communicate. Specific instructions on the types of
care an individual wants and doesn’t want can be provided by a living
will. Individuals may, for instance, specify the treatments they want
doctors to give them and how long. As an alternative, one can request
that loved ones and carers do everything in their power to prolong an
individual’s life. Making difficult decisions is made easier for family
members when instructions are written down so that doctors and close
family members don’t have to speculate what the patient might have
intended. Additionally, it may be possible to prevent scenarios in which a
family member seeks to adopt a stance that one could find objectionable.
A health care proxy or health care power of attorney is a person who has
been given the authority to communicate and make medical choices on
behalf of another person. Additionally, one might specify whether they
want to donate their organs, which may need to happen right away after
passing away.
‹
Financial Power of Attorney: Anyone with a power of attorney is
qualified to handle financial matters on the other person’s behalf. For
instance, according to the authority granted, they may be able to open
and close accounts, transfer funds, buy and sell properties, etc. There are
two major categories to choose from: When a durable power of attorney
is granted, it becomes effective. It is valid until someone cancels their
authorization or passes away. A springing power of attorney only takes
effect in specific circumstances. Such a power of attorney might be
used, for instance, if a person becomes incapable. Understanding the
requirements is crucial as one considers this choice.
‹
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The person who possesses power of attorney has access to both the
person’s financial assets and confidential data. So, it’s important to
identify someone one can completely rely on. Someone having power
of attorney who is dishonest or has poor financial judgment could cause
serious issues and lead to the loss of assets.
Pour-Over Will: A pour-over will specifies how to handle any assets that
weren’t covered by a trust. When someone passes away, those possessions
become a part of their estate, and a will is necessary to specify how
they should be distributed. Although it would be ideal to have all of an
individual’s assets under a trust, it is not realistic to do so. A pour-over
will can catch all of these assets and make sure they get into the trust.
The trust document then governs what happens to them after that.
‹
It’s beneficial to acquire information about the finances and family
members before starting the estate planning process. The following
documents might help one and the attorney begin assessing the current
situation and potential areas for change: Wills, powers of attorney, trusts,
as well as other existing estate planning papers, Account records from a
bank and a brokerage firm, life insurance coverage, Existing contractual
arrangements, beneficiaries designated on retirement and other funds, A
list of all the assets, such as the property, car, business interests, as well
as other items.
Several negative outcomes may result from failing to create these crucial
estate planning documents:
‹
Distribution of Assets: In the absence of a legal Will, the assets of a
person may be distributed after a person passes away in accordance
with intestate succession laws, which might not be in accordance
with the people’s wishes. Family conflicts, delayed asset distribution,
and substantial legal fees can result from this.
‹
Guardianship of Minor Children: Without a Letter of Guardianship,
there may be ambiguity and even potential disputes regarding the
upbringing and custody of a person’s minor children after a person
passes away. Intervention by the authorities might be necessary,
causing unneeded stress and interruption in the lives.
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‹
Financial Management: In the event a person becomes incapacitated,
no one would be legally authorized to handle a person’s finances
in the absence of a Springing Durable Power of Attorney. Delays,
improper handling of funds, and potential exploitation could take
place.
‹
Medical Care: If a person doesn’t have a living will, their treatment
choices and preferences for their healthcare may not be known or
honoured. Conflicts between relatives and healthcare professionals
may result from this, as well as sometimes undesired treatments.
Notes
By taking the time to prepare these crucial estate planning documents, a
person may ensure that their intentions are carried out, that their loved
ones are safeguarded, and that the transfer of a person’s assets is handled
without any problems.
IN-TEXT QUESTIONS
4. Which legal document specifies how to handle a person’s
property after death?
(a) Will
(b) Deed of Sale
(c) Registry
(d) None of the above
5. What does it refer to in an arrangement where an individual entrusts property to another individual or an organization?
(a) Trust
(b) Will
(c) NGO
(d) None of these
6. When an estate plan is in place, who are the beneficiaries of
an estate?
(a) Only those designated in a will or trust are entitled to a
portion of an estate
(b) Anyone who is related to a deceased person
(c) Only the owner’s closest family members are eligible.
(d) None of the above
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Notes
7. What a person is worth in terms of assets and property is
referred to as
(a) An estate
(b) A Will
(c) A beneficiary
(d) None of these
8. Who are the people who inherit a person’s assets after he or
she dies?
(a) A will
(b) A beneficiary
(c) A gift tax
(d) None of these
9. A written document that specifies who receives what portion
of the deceased person’s estate is known as:
(a) A gift tax
(b) A Will
(c) A beneficiary
(d) None of these
7.9 Executing Basic Estate Planning
A person can legally indicate his or her desires and how they should be
carried out through an estate plan. A carefully prepared plan can keep
information about their family’s financial affairs confidential and assist
in preventing potential conflicts.
Listed below are some essential actions in executing basic estate
planning:
(1) The creation of a detailed list of the assets and liabilities, which
involves the account numbers and contact details as well as the
contact numbers and names of the key advisors. Submit an extra
copy of the statement to the executor of the will and keep it in a
safe, central location with other key documents’ original copies.
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(2) A person can decide exactly what would happen to the assets and
possessions a person owns if the person passed away by creating
an estate plan. It also establishes a documented plan of action so
that, in the event of incapacitation, a person’s family could handle
their business without going through the legal system. This includes
a plan that provides funds in the event of a disability of a person
and for paying for potential caregiving expenses that might arise
in the future.
Notes
(3) Protecting and meeting the needs of loved ones is a major objective
of many estates planning. A person’s estate plan should contain
arrangements for any children, including selecting a guardian for
minors and making provisions for children from a previous marriage
if a person got married again, their assets might not automatically
transfer to them. Additionally, it would expressly address how to
plan for the care and financial requirements of children or other
family members with special needs.
(4) In order to accomplish one’s objectives while minimizing costs and
estate taxes, estate planning is crucial for safeguarding one’s assets
for heirs and a charitable legacy. If required, a person’s estate plan
would contain specific strategies for transferring or disposing of
assets such as shares in a closely held company, ownership of real
estate, or investment properties. Permanent life insurance and trusts
are frequently used by people to safeguard assets and guarantee the
achievement of long-term objectives.
(5) One needs legal documents to make sure that their intentions are
carried out in the event of their death or incapacitation if they
want their assets allocated in a certain way to achieve financial or
personal goals. Identifying beneficiaries for a person’s life insurance
coverage, retirement funds, as well as other assets in keeping with
their goals is a part of this. Additionally, it entails checking the
proper naming of the titles of tangible assets, such as cars and real
estate. A living will that reflects a person’s end-of-life intentions, an
up-to-date will that distributes one’s assets, and powers of attorney
for financial and medical decisions can all be obtained with the
assistance of an attorney.
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Notes
(6) To carry out the estate plan, one needs to designate a representative
to function as the executor of the Will, the legal guardian for the
dependents, the trustee for the assets, and/or power of attorney or
personal representative if one becomes incapacitated. Ensure that
the fiduciaries of a person are aware of and in agreement with
their appointments and that they are aware of where to locate the
individual’s original estate planning documents. Fiduciaries can
include family members, close friends, or professionals who have
been employed, such as lawyers, bankers or corporate trustees.
IN-TEXT QUESTIONS
10. What else is a common component of an estate plan, aside
from a will?
(a) An assignment of power of attorney
(b) A tax-free bank account
(c) A burial plot
(d) None of these
11. What else can a will be used for besides the distribution of a
person’s assets?
(a) Designating guardians for minor children
(b) Selecting a healthcare proxy
(c) Summarising a person’s life philosophy
(d) None of the above
12. What exactly does it mean to die intestate?
(a) Dying without a will
(b) Dying without having any substantial possessions
(c) Dying in a state other than a person’s home state
(d) None of the above
13. Which of the options listed below is a reason to have an estate
plan?
(a) Reduce the estate tax burden
(b) To avoid probate and the associated fees
(c) To assist the family in avoiding stress and conflict
(d) All of the above
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7.10 Summary
Notes
Estate planning is the process of organizing responsibilities to handle a
person’s financial condition in the case of incapacitation or death. The
distribution of assets to heirs, the payment of estate taxes and debts, as
well as additional issues like the guardianship of minors and pets, are all
included in the planning. Estate planning entails deciding how a person’s
possessions will be protected, handled, and distributed in the event of
their death or incapacitated condition. Making a will, establishing trusts,
establishing charitable donations to reduce taxation on estates, designating
an executor and beneficiaries, and making funeral preparations are all
aspects of estate planning. Will planning and estate planning are essentially
the same in most respects. Although the phrases are interchangeable, in
reality, they serve completely different processes. Both estate planning and
will-writing provide instructions to the heirs regarding how the deceased
person’s assets should be handled following their death. However, estate
planning extends beyond that by laying out a person’s assets, including
their health, money, as well as other things, even while they are alive.
A professional who specialises in estate planning may assist a person in
identifying the type of planning they require and in drafting the necessary
paperwork required for a thorough estate plan. For people with a family
and close relative, the provision of estate planning is essential so as to
ensure that they are properly protected financially and in terms of their
comfort. Whether a person has high-value assets or not, estate planning
continues to be essential for them. Due to the fact that estate planning
involves more than just distributing assets, it is important to lay out clearly
defined instructions and specify a representative who can make decisions
regarding a person’s personal care, financial affairs, and healthcare on
their behalf. Depending on the individual’s high or low net worth, estate
planning is undertaken. Without an estate plan, intestate succession
laws may be applied to the distribution of a person’s assets after death,
which may not be in accordance with the person’s preferences. In estate
planning, forced heirship is a principle of law that prevents an individual
from choosing who would be the official heir to their estate upon their
death. It automatically gives specified people the authority to distribute a
specific amount of the deceased person’s inheritance. All these individuals
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Notes
are often referred to as Protected Heirs, and they may be the surviving
spouse, children, as well as other members of the deceased’s family. It is
usually the case that, when someone signs a will or an irrevocable trust
in order to set out his or her plan for estate distribution upon death, he
or she often believes that the plan is complete. Nevertheless, the result
following death could be substantially different from what was intended
if a person had not carefully considered beneficiary designations for life
insurance policies, retirement accounts or other assets and co-ordinated
them with an estate plan. When the circumstances are complicated enough
that they justify the expense and work of creating and funding a trust,
trust-based planning is often the option that makes the most sense. Willbased planning may be appropriate in situations that are not too complex.
IN-TEXT QUESTIONS
14. What is the core concept of estate planning?
(a) Making sure that a person’s assets pass to people to whom
they want them to be distributed after death
(b) Defending a person’s physical property from the government
after death
(c) Arranging a life insurance plan to ensure that a person’s
family is compensated after death
(d) None of the above
15. When does estate planning come into play?
(a) Upon death or incapacitation
(b) Only upon death
(c) Whenever the person desires
(d) None of these
7.11 Answers to In-Text Questions
1. (a) An intended strategy of legally protecting a person’s assets and
determining how a person’s assets are distributed upon death
2. (d) All of the above
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3. (d) All of the above
Notes
4. (a) Will
5. (a) Trust
6. (a) Only those designated in a will or trust are entitled to a portion
of an estate
7. (a) An estate
8. (b) A beneficiary
9. (b) A Will
10. (a) An assignment of power of attorney
11. (a) Designating guardians for minor children
12. (a) Dying without a will
13. (d) All of the above
14. (a) Making sure that a person’s assets pass to people to whom they
want them to be distributed after death
15. (a) Upon death or incapacitation
7.12 Self-Assessment Questions
1. What is the difference between Will planning and Estate planning?
2. What is forced heirship in Estate planning?
3. Is Estate Planning Only for the Wealthy?
4. What types of decisions can a person make with the help of an
estate plan?
7.13 Suggested Readings
‹
Maude, D., Global private banking and wealth management: The
new realities, John Wiley & Sons, Latest edition.
‹
Evensky, H., Horan, S. M., & Robinson, T. R., The New Wealth
Management: The Financial Advisor’s Guide to Managing and
Investing Client Assets, John Wiley & Sons, Latest edition.
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Notes
‹
Billingsley, R., Gitman, L. J., & Joehnk, M. D. (2020). Personal
Financial Planning. (15th ed.). Cengage Learning.
‹
Tillery, S., & Tillery, T. (2018). Essentials of Personal Financial
Planning (1st ed.). Wiley.
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Glossary
Absolute Return: Absolute return is the total return generated over the period without
considering the cost of investment.
Active Investing: An investing strategy that involves frequent purchasing and selling of
assets based on research and analysis in order to outperform the market or achieve specific
financial objectives.
Asset Allocation: The process of distributing investments among different asset classes
(such as stocks, bonds and cash) within a portfolio to achieve a desired risk-return profile.
It involves determining the optimal mix of assets based on investment objectives and risk
tolerance.
Average Return: Average return is obtained by taking the mean of annual returns generated
over the period of investment.
Capital Appreciation: The gradual growth in the value of an investment, resulting in a
capital gain.
Capital Preservation: The goal of preserving the value of invested capital and avoiding
severe losses, particularly during market downturns or high volatility times.
Correlation: A statistical measure that describes the relationship between the returns of
two or more investments. It indicates how closely the returns move together and helps
assess the degree of dependence between assets in a portfolio.
Direct Investing: Investing directly in specific assets or securities, such as individual
stocks or real estate.
Diversification: Spreading assets across several asset classes, industries, or geographic
locations to decrease risk by avoiding overexposure to any particular investment and
improving a portfolio’s total risk-adjusted returns.
Downshifting: Reducing expenses by adopting a lifestyle change by simplifying one’s
way of life and adjusting to a lower standard of living.
Effective Annualized Return: It is the equivalent return earned on the investment on a
per annum basis.
Efficient Markets: It refers to the state of financial markets, where all the information
is about the security is already factored in the stock prices, and all securities are fairly
priced, thereby there is no scope for excess gain or loss.
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Notes
Expected Return: Expected return is the return that can be earned under
different scenarios having a different probability of occurrence.
Financial Investment: The placement of funds in financial instruments
such as stocks, bonds, mutual funds, or other assets in order to generate
profits.
Fundamental Analysis: Fundamental analysis is a technique for determining the true worth of a financial instrument. It entails examining
numerous elements that can affect the asset’s value, such as economic,
financial and qualitative components.
Holding Period Return: Holding period return is the total return earned
over the life cycle of an investment.
Income Generation: The process of generating a steady stream of income
through assets such as stock dividends, bond interest, or rental income
from real estate.
Indirect Investing: Investing through intermediaries or investment
vehicles such as mutual funds, hedge funds, or Real Estate Investment
Trusts (REITs), in which the investor’s money is pooled with others and
professionally managed.
Investment: The act of investing money or resources with the expectation
of earning a profit or increasing capital.
Investment Objectives: The precise aims and objectives that people or
institutions want to achieve via their investing activities, such as capital
appreciation, income production, risk management or asset preservation.
Legacy Planning: The process of preparing for the transfer of money to
future generations or philanthropic organisations, with the goal of leaving
a lasting legacy and transferring capital efficiently.
Long-term Investing: Investing with patience and discipline, concentrating
on long-term goals and staying involved for longer periods of time rather
than indulging in short-term speculation.
Market Timing: The practice of attempting to predict the overall market
direction and making investment decisions based on those predictions.
Mutual Funds: A kind of investment vehicle that collects funds from
numerous individuals to invest in a variety of securities which is
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GLOSSARY
administered by a qualified fund manager or group of managers who
choose investments on the clients’ behalf.
Notes
Passive Investing: An investing strategy that involves watching the
performance of a market index or asset class and implementing a longterm buy-and-hold strategy, frequently using index funds or ExchangeTraded Funds (ETFs).
Portfolio: A collection of investments, such as stocks, bonds, and other
assets, held by an individual or an entity.
Portfolio Management: Process of selecting and monitoring investments
to achieve specific financial goals, while considering risk tolerance and
obtain a well-balanced investment mix.
Portfolio Return: The overall return generated by a portfolio, taking
into account the returns of the individual investments and their respective
weights or proportions within the portfolio.
Real Investment: Long-term investment in actual assets such as real
estate, infrastructure or commodities.
Return: The financial gain or loss on an investment, typically expressed
as a percentage, representing the change in value over a specific period,
including capital gains, dividends and interest.
Risk Adjusted Return: Risk adjusted return is the return generated per
unit of risk undertaken by the investor.
Risk Management: The process of identifying, assessing, and mitigating
risks associated with an investment portfolio. It involves implementing
strategies to minimize the impact of adverse events and protect against
potential losses.
Risk: The uncertainty or potential for losses associated with an investment.
It includes factors such as market volatility, economic conditions, credit
risk and geopolitical events.
Risk-Return Trade-off: The principle that higher potential returns are
generally associated with higher levels of risk. Investors must weigh the
potential rewards against the potential risks when making investment
decisions.
Securities Market: A market for the purchase and sale of financial
products such as stocks, bonds and derivatives.
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Notes
Speculation: It is an act of doing a financial transaction with a view to
make substantial gains within a very short span of time, and the probability
of capital erosion is very high.
Standard Deviation: A statistical measure that quantifies the volatility
or variability of returns from an investment or a portfolio. It provides an
indication of the portfolio’s risk and measures the dispersion of returns
around the average return.
Style Investing: An approach to categorize securities into different
styles, where portfolio allocation is based on selecting styles rather than
individual securities.
Systematic Investment Plan: A mutual fund investing approach that
allows investors to invest a specified amount in a scheme of mutual
funds at periodic intervals.
Systematic Risk: It is a part of the total risk occurring due to factors
that can’t be influenced by the issuer company.
Tax Harvesting: Selling investments that have incurred losses in order
to offset taxable gains in other areas of the portfolio.
Technical Analysis: Technical analysis is a way of studying historical
price and volume data to evaluate financial assets such as stocks.
Time Horizon: The time an investor is expected to hold the investment for.
Treasury Bills: A short-term government debt securities with a maturity
of one year or less and is issued by the Treasury Department.
Unsystematic Risk: It is a part of the total risk occurring due to factors
that can be influenced by the issuer company.
Valuations: It is the act of determining the value or the price of anything.
Wealth Management: The professional service of managing the wealth
of an individual or organisation, including investment planning, financial
advice and asset management.
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