Part 1: Introduction and Overview of Investment

1. Part 1: Introduction and Overview of Investment A broad map of the territory S.B.Khatri - AIM

2. 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. S.B.Khatri - AIM

3. 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 owns a portfolio of investments. • May be the result of haphazard decisions or may be the result of deliberate and careful planning. S.B.Khatri - AIM

4. Investment Alternatives S.B.Khatri - AIM

5. 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 S.B.Khatri - AIM

6. 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) S.B.Khatri - AIM

7. 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 S.B.Khatri - AIM

8. 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 S.B.Khatri - AIM

9. Investment Attributes • For evaluating an investment avenue, the following attributes are relevant: • Rate of Return • Risk • Marketability • Tax Shelter • Convenience S.B.Khatri - AIM

10. Investment Attributes (contd....) S.B.Khatri - AIM

11. 1. Rate of Return Current Yield Capital Gain/Loss Yield Rate of Return of any investment instrument can be calculated S.B.Khatri - AIM

12. 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. S.B.Khatri - AIM

13. 3. Marketability (Liquidity) • An investment is highly marketable or liquid if: • It can be transacted quickly • The transaction cost is low • The price change between two successive transactions is negligible • Liquidity of a market may be judged in terms of its • depth, • breadth and • resilience S.B.Khatri - AIM

14. 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. S.B.Khatri - AIM

15. 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. S.B.Khatri - AIM

16. 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. S.B.Khatri - AIM

17. 5. Convenience • Ease with which the investment can be made and looked after. • Can the investment be made readily? • Can the investment be looked after easily? • Savings Account – made easily, no maintainance • Property – too many processes, high maintenance. S.B.Khatri - AIM

18. EVALUATION OF VARIOUS INVESTMENT AVENUES S.B.Khatri - AIM

19. Investment vs. Speculation S.B.Khatri - AIM

20. 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 S.B.Khatri - AIM

21. Financial Markets (Functions) • Financial Markets facilitate price discovery • Interaction between numerous buyers and sellers • Financial Markets provide liquidity to financial assets • Negotiability and transferability • Financial makrets considerably reduce cost of transacting. • Search and Information cost is reduced significantly • Financial Markets give opportunity for risk reduction • Diversification opportunity S.B.Khatri - AIM

22. Classification of Financial Markets S.B.Khatri - AIM

23. Investment and Portfolio Management Process S.B.Khatri - AIM

24. S.B.Khatri - AIM

25. 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 Circumstances S.B.Khatri - AIM

26. 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. S.B.Khatri - AIM

27. 3. Formulation of Portfolio Strategy • Two broad choices are available: • Active Portfolio Strategy • 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. S.B.Khatri - AIM

28. 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. S.B.Khatri - AIM

29. 5. Portfolio Execution • Implementing the portfolio plan by buying and/or selling specified securities in given amounts. S.B.Khatri - AIM

30. 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 S.B.Khatri - AIM

31. 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. S.B.Khatri - AIM

32. Approaches to Investment Decision Making S.B.Khatri - AIM

33. 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 S.B.Khatri - AIM

34. 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. S.B.Khatri - AIM

35. 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) S.B.Khatri - AIM

36. 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. S.B.Khatri - AIM

37. 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. S.B.Khatri - AIM

38. 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. S.B.Khatri - AIM

39. The Investement Environment S.B.Khatri - AIM

40. 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. S.B.Khatri - AIM

41. 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) S.B.Khatri - AIM

42. The Risk/Return Tradeoff Graphically • 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 B A A B Risk S.B.Khatri - AIM

43. 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 securityreturns is a characteristics of an efficient market- that is, a market in which security prices fully reflect current information. S.B.Khatri - AIM

44. 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 basket) S.B.Khatri - AIM

45. Financial Intermediaries • Commercial Banks • Investment Banks • Mutual Funds • Building Societies • Unit Trusts • Investment Trusts • Etc... S.B.Khatri - AIM

46. 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

47. ….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: • Tall and unjustified claims made by people with vested interest • Exceptional performance of some portfolio they have seen or managed, which may be attributable mostly to fortuitous factors • Promises made by tipsters, operators and others • In most of the case, such expectations reflect investor naiveté and gullibility. S.B.Khatri - AIM

48. 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. S.B.Khatri - AIM

49. …..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. S.B.Khatri - AIM

50. 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. S.B.Khatri - AIM