Part 1: Introduction and Overview
of Investment
A broad map of the territory
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Introduction
• In its broadest sense, an investment is a sacrifice of
current money or other resources for future benefits.
• Two key aspects of investment: TIME AND RISK
– The sacrifice takes place now and is certain.
– The benefit is expected in the future and tends to be
uncertain
• In certain investments, like government bonds, time
element is dominant attribute.
• In others, like stock options, risk element is dominant.
• Yet, in others, like equity shares, both are important.
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Portfolio
• The portfolio is likely to comprise of:
– Financial assets (bank deposits, bonds, stocks and
so on)
– Real assets (bike, house and so on)
• Almost everyone
investments.
owns
a
portfolio
of
– May be the result of haphazard decisions or may
be the result of deliberate and careful planning.
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Investment Alternatives
Non marketable financial assets
Bonds
Mutual Fund Schemes
Real Estate
Equity Shares
Money Market Instruments
Life Insurance Policies
Precious Objects
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Investment Alternatives (contd..)
• Non-marketable financial assets
–
–
–
–
Bank Deposits
Post office deposits
Company deposits
Providend fund deposits
• Equity shares – ownership capital
–
–
–
–
–
Blue chip shares
Growth shares
Income shares
Cyclical shares
Speculative shares
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Investment Alternatives (contd..)
• Bonds – Debt Instruments
–
–
–
–
–
–
Government Bonds (Gilts)
Savings Bonds
Government agency bonds
PSU Bonds
Debentures of private sector companies
Preference Shares
• Money Market Instruments
– Treasury Bills
– Commercial Paper (CP)
– Certificates of Deposits (CD)
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Investment Alternatives (contd..)
• Mutual Funds – Portfolio of shares and bonds
–
–
–
–
–
Equity Schemes
Debt Schemes
Balanced Schemes
Gilt Schemes
Diversified Schemes
• Life Insurance
–
–
–
–
Endowment assurance policy
Money Back Policy
Whole life policy
Term assurance policy
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Investment Alternatives (contd..)
• Real Estate
–
–
–
–
Residential Land
Agricultural Land
Semi-urban Land
Commercial Property
• Precious Objects
– Gold and Silver
– Precious Stones
– Art Objects
• Financial Derivatives – value derived from the value of
underlying assets
– Options
– Futures
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Investment Attributes
• For evaluating an investment avenue, the
following attributes are relevant:
1.
2.
3.
4.
5.
Rate of Return
Risk
Marketability
Tax Shelter
Convenience
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Investment Attributes (contd....)
• Current Yield
Rate of • Capital Gain/Loss Yield
Return
Risk
• Variance
• Standard Deviation
• Beta
• Depth
Market • Breadth
ability • Resilience
• Initial Tax Benefit
Tax • Continuing Tax Benefit
Shelter • Terminal Tax Benefit
• Made
Conve • Looked After
nience
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1. Rate of Return
Rate of Return (%) 
Annual Income
Beginning
Price
Current Yield

( Ending
- Beginning
Beginning
Price)
Price
Capital
Gain/Loss Yield
Rate of Return of any investment
instrument can be calculated
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2. Risk
• Risk = Variability of the rate of return
• Common Measures in finance:
• Variance – squares of deviations of individual returns
around their average value
• Standard Deviation – square root of variance
• Beta – reflects how volatile the return from an
investment is , in response to market swings.
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3. Marketability (Liquidity)
• An investment is highly marketable or liquid if:
a) It can be transacted quickly
b) The transaction cost is low
c) The price change between two successive
transactions is negligible
• Liquidity of a market may be judged in terms
of its
– depth,
– breadth and
– resilience
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3. Marketability (Liquidity)......
• Depth:
– Refers to the existence of buy as well as sell orders
around the current market price
• Breadth:
– Implies the presence of such orders in substantial
volume
• Resilience:
– Means that new orders emerge in response to price
changes.
• High marketability is a desired attribute of a good
investment instrument.
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How does one evaluate marketability
of non-marketable securities like PF
and Bank Loan?
• If a substantial portion of the accumulated
balance can be withdrawn without significant
penalty.
• If loans can be taken against the deposit.
• A loan (representing a significant portion of the
accumulated balance) can be raised at a rate of
interest that is only slightly higher than the rate
of interest earned on investment itself.
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4. Tax Shelter
• Initial Tax Benefit:
– Tax relief enjoyed at the time of making investment
– Eg. Investment in Providend Fund
• Continuing Tax Benefit:
– Tax shield associated with the periodic returns from the
investment
– Eg. Dividend income and income from certain other
sources are tax-exempt, upto a certain limit, in the hands
of receipient.
• Terminal Tax Benefit:
– Relief from taxation when an inveswtment is realized or
liquidated.
– Eg. Withdrawal from the PPF account is not subject to tax.
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5. Convenience
• Ease with which the investment can be made and
looked after.
a) Can the investment be made readily?
b) Can the investment be looked after easily?
•
•
Savings Account – made easily, no maintainance
Property – too many processes, high
maintenance.
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EVALUATION OF VARIOUS INVESTMENT AVENUES
Return
Current yield
Capital
appreciation
Equity
Shares
Nonconvertible
Debentures
Equity
Schemes
Debt
Schemes
Bank
Deposits
Public
Provident
Fund
Life
Insurance
Policies
Residential
House
Gold and
Silver
Risk
Marketability/
Liquidity
Tax Shelter
Convenience
Low
High
High
Fairly high
High
High
High
Negligible
Low
Average
Nil
High
Low
High
High
High
High
Very high
Moderate
Low
Low
High
No tax on
dividends
Very high
Moderate
Nil
Negligible
High
Nil
Very high
Nil
Moderate
Nil
Moderate
Moderate
Moderate
Negligible
Low
High
Fair
Nil
Moderate
Average
Average
Nil
Average
Nil
Nil
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Average
Average
Tax Benefit
Tax Benefit
Very high
Very High
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Investment vs. Speculation
Planning Horizon
Risk Disposition
Investor
Speculator
• Longer
• Holding period at least
of a year
• Short
• Holding period may be
few days or even few
months
• Moderate Risk taker
• Ordinarily willing to
assume high risk
Return Expectation • Modest
Basis for Decisions
Leverage
• High
• Fundamental Factors
• Careful evaluation of
the prospects of the
firm
• Hearsay
• Technical Charts
• Market Psychology
• Normally uses his own
funds S.B.Khatri - AIM
• Normally resorts to
borrowings
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Gambling
• Fundamentally different from investment and
speculation in the following respects:
– Result of gambling is known more quickly
– Rational people gamble for fun, not for income.
– Gambling doesnot involve a bet on an economic
activity.
– It is based on risk that is created artificially
– Gambling creates risk without providing any
commensurate economic return
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Financial Markets (Functions)
1. Financial Markets facilitate price discovery
– Interaction between numerous buyers and sellers
2. Financial Markets provide liquidity to financial
assets
– Negotiability and transferability
3. Financial makrets considerably reduce cost of
transacting.
– Search and Information cost is reduced significantly
4. Financial Markets give opportunity for risk
reduction
– Diversification opportunity
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Classification of Financial Markets
Nature of
Claim
Maturity of
Claim
Seasoning
of Claim
Timing of
Delivery
Organizatio
nal
Structure
• Debt Market
• Equity Market
• Capital Market
• Money Market
• Primary Market (Seasoned and Unseasoned New Issues)
• Secondary Market
• Cash or Spot Market
• Forward or Futures Market
• Exchange Traded Market
• Over the counter Market
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Investment and Portfolio Management Process
Specification
of Investment
Objectives and
Constraints
Performance
Evaluation
Choice of the
Asset Mix
Formulation of
Portfolio
Strategy
Portfolio
Revision
Portfolio
Execution
Selection of
Securities
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PORTFOLIO MANAGEMENT PROCCESS
SPECIFICATION OF
INVESTMENT OBJECTIVES
AND CONSTRAINTS
CHOICE OF ASSET MIX
FORMULATION OF
PORTFOLIO STRATEGY
SELECTION OF SECURITIES
PORTFOLIO EXECUTION
PORTFOLIO REVISION
PORTFOLIO EVALUATION
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1. Specification of Investment
Objectivies and Constraints
• Objectives may be:
– Current Income
– Capital Appreciation
– Safety of Principal
• Relative importance of these objectives should be
specified
• Constraints:
–
–
–
–
Liquidity
Time Horizon
Tax
Special CircumstancesS.B.Khatri - AIM
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2. Choice of Asset Mix
• Concerned with the mix of various types of
securities.
• How much proportion of Stocks, Bonds etc ?
• The appropriate “Stock-Bond” mix depends
mainly on the risk tolerence and investment
horizon of the investor.
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3. Formulation of Portfolio Strategy
• Two broad choices are available:
1. Active Portfolio Strategy
2. Passive Portfolio Strategy
• Active Portfolio Strategy strives to earn
superior risk-adjusted returns by resorting to
market timing, or sector roation or security
selection or some combination of these.
• Passive Portfolio Strategy involves holding a
boradly diversified portfolio and maintaining a
pre-determined level of risk exposure.
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4. Selection of Securities
• Generally investors pursue an active stance
with respect to security selection.
• For stock selection, investors commonly go by
fundamental analysis and/or technical analysis
• The factors that are considered in selecting
bonds (or any fixed incomes securities) are
yield to maturity, credit rating, term to
maturity, tax shelter, and liquidity.
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5. Portfolio Execution
• Implementing the portfolio plan by buying
and/or selling specified securities in given
amounts.
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6. Portfolio Revision
• The value of a portfolio as well as its
composition – the relative proportions of
stock and bond components – may change as
stocks and bonds fluctuate.
• In response to such changes, periodic
rebalancing of the portfolio is required.
• It may call for sector rotation as well as
security switches
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7. Performance Evaluation
• The performance of a portfolio should be
evaluated periodically.
• Key dimensions of portflio performance
evaluation are risk and return and the key
issue is whether the portfolio return is
commensurate with its risk exposure.
• Sure a review may provide useful feedback to
improve the quality of the portfolio
management process on a continuous basis.
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Approaches to Investment Decision
Making
Fundamental
Approach
Psychological
Approach
Approaches to
Investment
Decision Making
Academic Approach
Eclectic Approach
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1. Fundamental Approach
• There is an intrinsic value of a security, which depends upon
underlying economic (fundamental) factors.
• The intrinsic value can be established by a penetrating
analysis of the fundamental factors relating to the company,
industry, and economy.
• At any given point of time, there are some securities for which
the prevailing market price will differ from the intrinsic value.
• Sooner or later, of course, the market price will fall or rise in
line with intrinsic value.
• Superior returns can be earned by buying under-valued
securities and selling over-valued securities
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2. Psychological Approach
• Stock prices are guided by emotion rather than reason.
• Stock prices are believed to be influenced by the psychological mood of
investors.
• When greed and euphoria sweep the market, prices rise to dizzy heights.
• When fear and despair envelop the market, prices fall to abysmally low
levels.
• It is more profitable to analyse how investors tend to behave as the market
is swept by waves of optimism and pessimism which seem to alternate.
• Generally advocates the use of technical analysis – believing that there are
certain persistent and recurring patterns of price movements which can be
discerned by analysing market data.
• Technical analyst use a variety of tools like bar chart, point and figure chart,
moving average analysis, breadth of market analysis etc.
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3. Academic Approach
• Fairly sophisticated methods of investigation are used by
academic community to study various aspects of capital market.
• Stock markets are reasonably efficient in reacting quickly and
rationally to the flow of information. Hence, stock prices reflect
intrinsic value fairly well.
• Stock price behaviour corresponds to a random walk. This means
that successive price changes are independent. As a result, past
price behaviour cannot be used to predict future price
behaviour.
• In the capital market, there is a positive relationship between
risk and return. More specifically, the expected return from a
security is linearly related to its systematic risk (non-diversifiable
risk)
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4. Eclectic Approach
• The eclectic approach draws on all the three
different approaches discussed previously.
• Fundamental analysis is helpful in establishing basic
standards and benchmarks.
• However, since there are uncertainties associated
with fundamental analysis, exclusive reliance on
fundamental analysis should be avoided.
• Equally important, excessive refinement and
complexity in fundamental analysis must be viewed
with caution.
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Eclectic Approach (contd...)
• Technical analysis is useful in broadly gauging the prevailing mood of
investors and the relative strengths of supply and demand forces.
• However, since the mood of investors can vary unpredicatably excessive
reliance on technical indicators can be hazardous.
• More important, complicated technical systems should ordinarily regarded
as suspect, because they often represent figments of imagination rather
than tools of proven usefulness.
• The market is neither well ordered or as academic approach suggests,
nore as speculative as the psychological approach indicates.
• While it is characterized by some inefficiencies and imperfections, it
seems to react reasonably efficiently and rationally to the flow of
information.
• Likewise, despite many instances of mispriced securities, there appears to
be a fairly strong correlation between risk and return.
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Operational implications of the
eclectic approach
• Conduct fundamental analysis to establish certain value
“anchors”
• Do technical analysis to assess the state of the market
psychology.
• Combine fundamental and technical analysis to determine
which securities are worth buying, worth holding, and worth
disposing of
• Respect market prices and do not show excessive zeal in
“beating the market”
• Accept the fact that the search for a higher level of return
often necessisates the assumption of a higher level of risk.
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The Investement Environment
Securities
Financial
Intermediaries
The
Investment
Environment
Risk, Return
and
Diversification
Security
Markets
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Securities
• Claim to receive prospective future benefits under
certain conditions.
• The primary task of security analysis is to evaluate
securities by determining their prospective future
benefits, the conditions under which those benefits
will be received, and the likelihood of occurence of
such contitions.
• Simply put, security analysts attempt to understand
the risk and return characteristics of securities.
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The Risk/Return Tradeoff
Throughout financial theory, we assume that
individuals are risk averse
This means that individuals prefer less risk to
more risk
However, a risk averse individual will accept
almost any level of risk as long as they are
properly compensated
We assume that the risk-return tradeoff is a
linear function (there is no good evidence that
it isn’t)
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 Assume that there are
two securities: A and B
 B is riskier than A
 Therefore, we expect that
B will, on average over
time, earn a higher return
than A
 Otherwise, nobody would
ever invest in B
Return
The Risk/Return Tradeoff Graphically
B
A
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B
Risk
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Risk, Return and Diversification
• Risk – variability of the returns of securities.
• Measured by:
– Variance of the returns
– Standard Deviation
– Beta
• Historical variability is not necessarity an indication of prospective risk.
The former deals with the record over some past period; the later has to
do with uncertainty about the future.
• However, the annual return on a common stock is very difficult to predict
accurately.
• Unless you are very clever or very lucky, you will conclude that past
patterns of stock returns are of little help in predicting future returns.
• It will later be seen that this apparent randomness in security returns is a
characteristics of an efficient market- that is, a market in which security
prices fully reflect current information.
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Contd....
• Is any of the securities is better than the others ?
• No.
• The right security or combination of securities depends on the investor’s
situation and preferences for return relative to his or her risk tolerance.
• There may be “right”or “wrong”securities for a particular person or purpose.
• However, it would be surprising to find a security that is wrong investment for
all.
• Such securities do not exist in the efficient market.
• When securities are combined into a portfolio, the new portfolio will have a
lower level of risk than the simple average of the risks of the securities,
because when some securities are doing poorly, others are doing well.
• This pattern tends to reduce the extremes in the portfolio’s return, so there is
less fluctuation in the portfolio’s value.
• The phenomenon of investing in various securities in order to reduce the over
all risk is called diversification (not putting all the eggs in the same
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basket)
Financial Intermediaries
•
•
•
•
•
•
•
Commercial Banks
Investment Banks
Mutual Funds
Building Societies
Unit Trusts
Investment Trusts
Etc...
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Common Errors in Investment
Management
•
•
•
•
•
•
•
•
•
•
Inadequate comprehension of return and risk
Vaguely formulated investment policy
Naïve extrapolation of the past
Cursory decision making
Simultaneous switching
Misplaced love for cheap stocks
Over-diversification and under-diversification
Buying shares of familiar companies
Wrong attitude towards losses and profits
Tendency to speculate.S.B.Khatri - AIM
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….Inadequate comprehension of
Return and Risk
• Many investors have unrealistic and exaggerated expectations
from investments.
• They have apparently been misled by one or more of the
following:
a) Tall and unjustified claims made by people with vested
interest
b) Exceptional performance of some portfolio they have
seen or managed, which may be attributable mostly to
fortuitous factors
c) Promises made by tipsters, operators and others
• In most of the case, such expectations reflect investor
naiveté and gullibility.
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Contd…..
• By setting unrealistic goals, investors may do
precisely the thing that give poor results.
• They may churn their portfolios too frequently
• They may buy dubious “stories” from the stock
market.
• They may pay huge premiums for speculative,
fashionable stocks.
• They may discard sound companies because of
temporary stagnation in earnings
• They may try to outguess short-term market swings.
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…..Vaguely Formulated Investment
Policy
• Often investors do not clearly spell out their risk
disposition and investment policy.
• This tends to create confusion and impairs the
quality of investment decisions.
• Ironically, conservative investors turn aggressive
when the bull market is near and its peak in the hope
of reaping a bonanza
• Likewise in the wake of sharp losses inflicted by a
bear market, aggressive investors turn unduly
cautious and overlook opportunities before them.
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Contd…
• “The fear of loosing capital when prices are low
and declining, and the greed for more capital
gains when prices are rising, are probably, more
than any other factors, responsible for poor
performance”
• If you know what your risk attitude is and why
you are investing, you will learn how to invest
well.
• A well articulated investment policy, adhered to
consistently over a period of time, saves a great
deal of disappointment.
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….Naive Extrapolation of the Past
• Investors generally believe in a simple extrapolation
of past trends and events and do not effectively
incorporate changes into expectations.
• “People generally, and investors particularly, fail to
appreciate the working of countervailing forces;
change and momentum are largely misunderstood
concepts. Most investors tend to cling to the course
to which they are currently committed, especially at
turning points.”
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….Cursory (Hasty or Hurried)
Decision Making
• Investors tend to:
– Base their decisions on partial evidence,
unreliable hearsay or casual tips given by brokers,
friends, and others
– Brush aside various kinds of investment risk
(market risk, business risk and interest rate risk) as
greed overpowers them.
– Uncritically follow others because of the
temptation to ride the bandwagon or lack of
confidence in their own judgment.
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….Simultaneous Switching
• When investors switch over from one stock to
another, they often buy and sell more or less
simultaneously.
• For eg. An investor may sell stock A and
simultaneously buy stock B.
• Such action assumes that the right time for selling
stock A is also the right time for buying stock B.
• This often may not be so.
• Alternatively, while it might be the right time for
buying B, it might not be the right time for selling A.
• Buying and Selling should be evaluated
independently.
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….Misplaced Love for Cheap Stocks
• Investors often have a weakness for stocks which look
apparently cheap.
• This is revealed in the following behavior:
– They buy a stock that is on its way down because somehow,
a falling share looks a good bargain
– They tend to “average” down. This means that they buy
more of the same stock when its price falls in a bid to lower
their average price.
– They like to buy a stock that is quoting low as they feel
comforted when they buy 1000 shares of a company that is
quoting at Rs 10 rather than 100 shares of company that is
quoting at Rs 100.
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….Over-diversification and Underdiversification
• Many individuals have portfolios consisting of
thirty to sixty, or even more, different stocks.
• Managing such portfolios is an cumbersome
task.
• “Over-diversification is probably the greatest
enemy of a portfolio performance”
• As common is under-diversification - carrying
an avoidable risk exposure.
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….Buying shares of Familiar
Companies
• Investors are often tempted to buy shares of
companies and sectors which they are familiar with.
• Perhaps they believe in the adage “a known Devil is
better than an unknown God” and derive
psychological comfort from investing in familiar or
well-known companies.
• However, investors must realize that in the stock
market, there is hardly any correlation between the
fame of a company’s products and the return of its
equity stock.
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….Wrong Attitude towards losses and profits
• Typically, an investor has an aversion to admit his
mistake and cut losses short.
• If the price falls, contrary to his expectations at the time
of purchase, he somehow hopes that it will rebound
and he can break even (he may even buy some more
shares at the lower price in a bid to reduce his average
price)
• Surprisingly, such a belief persists even when the
prospects look dismal and there may be a greater
possibility of further decline.
• This perhaps arises out of a disinclination to admit
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mistakes.
Contd…
• The pain of regret accompanying the realization of losses is
sought to be postponed.
• And if the price recovers due to favorable conditions, there is a
tendency to dispose of the share when its price more or less
equals the original purchase price, even though there may be a
fair chance of further increases.
• The psychological relief experienced by an investors from
recovering losses seems to motivate such behavior.
• Put differently, the tendency is to let the losses run and cut
profits short, rather than to cut the losses short and let the
profits run.
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….Tendency to Speculate
• The tendency to speculate is common,
particularly when the market is buoyant.
• Try to resist this.
• You may find it difficult to follow this advice.
• Yet in the long run you are likely to be better
off if you refrain your speculative instincts.
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Investment vs. Consumption
income in period 1
100
An
80
Some investors will prefer A
and others B
60
40
Bn
20
20
40
60
income in period 0
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100
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Investment vs. Consumption
The grasshopper (G) wants to consume
now. The ant (A) wants to wait. But each
is happy to invest. Each invests $185,000
and returns $210,000 at the end of the
year. G wants to consume now so G
borrows $200,000 and repays $210,000 at
the end of the year. The existence of
capital markets allows G to consume now
and still invest with A in the project.
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Investment vs. Consumption
Dollars
Next Year
210
•
A invests $185 now
and consumes $210
next year
194
The grasshopper (G) wants to consume
now. The ant (A) wants to wait. But
each is happy to invest. Each invests
$185,000 and returns $210,000 at the
end of the year. G wants to consume
now so G borrows $200,000 and repays
$210,000 at the end of the year. The
existence of capital markets allows G to
consume now and still invest with A in
the project.
G invests $185 now,
borrows $200 and
consumes now.
185
200
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Dollars
Now
62
How do we get There?
Today
Environment
Future
Integrated “Functional” Planning
Where you are
now.
Where you want
to be.
Creating a good Road Map to
success
(Good Investment Strategy)
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Fund Flows via Market
Markets
Surplus Units
Deficit Units
Intermediaries
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Fund Flows via Intermediary
Markets
Surplus Units
Deficit Units
Intermediaries
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Fund Flows via Intermediary and
Market
Markets
Surplus Units
Deficit Units
Intermediaries
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Funds Flow via Markets and
Intermediaries
Markets
Surplus Units
Deficit Units
Intermediaries
S.B.Khatri - AIM
67
Funds Flow: Disintermediation
Markets
Surplus Units
Deficit Units
Intermediaries
S.B.Khatri - AIM
68