Part 1: Introduction and Overview of Investment

1
Part 1 Introduction and Overview of Investment

• A broad map of the territory

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.

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.

4
Investment Alternatives
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

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)

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

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

9
Investment Attributes

• For evaluating an investment avenue, the
  following attributes are relevant
• Rate of Return
• Risk
• Marketability
• Tax Shelter
• Convenience

10
Investment Attributes (contd....)
11
1. Rate of Return
Current Yield
Capital Gain/Loss Yield
Rate of Return of any investment instrument can
be calculated
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.

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

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.

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.

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.

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.

18
EVALUATION OF VARIOUS INVESTMENT AVENUES
19
Investment vs. Speculation
Investor Speculator
Planning Horizon Longer Holding period at least of a year Short Holding period may be few days or even few months
Risk Disposition Moderate Risk taker Ordinarily willing to assume high risk
Return Expectation Modest High
Basis for Decisions Fundamental Factors Careful evaluation of the prospects of the firm Hearsay Technical Charts Market Psychology
Leverage Normally uses his own funds Normally resorts to borrowings
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

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

22
Classification of Financial Markets
23
Investment and Portfolio Management Process
24
(No Transcript)
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

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.

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.

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.

29
5. Portfolio Execution

• Implementing the portfolio plan by buying and/or
  selling specified securities in given amounts.

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

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.

32
Approaches to Investment Decision Making
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

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.

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)

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.

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.

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.

39
The Investement Environment
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.

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 isnt)

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
B
A
Risk
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 security returns is a
  characteristics of an efficient market- that is,
  a market in which security prices fully reflect
  current information.

44
Contd....

• Is any of the securities is better than the
  others ?
• No.
• The right security or combination of securities
  depends on the investors situation and
  preferences for return relative to his or her
  risk tolerance.
• There may be rightor wrongsecurities 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
  portfolios return, so there is less fluctuation
  in the portfolios 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)

45
Financial Intermediaries

• Commercial Banks
• Investment Banks
• Mutual Funds
• Building Societies
• Unit Trusts
• Investment Trusts
• Etc...

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.

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.

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.

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.

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.

51
.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.

52
.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.

53
.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.

54
.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.

55
.Over-diversification and Under-diversification

• 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.

56
.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 companys products and the return
  of its equity stock.

57
.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 mistakes.

58
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.

59
.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.

60
Investment vs. Consumption
61
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.

62
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.

A invests 185 now and consumes 210 next year
Dollars Next Year 210 194
G invests 185 now, borrows 200 and consumes now.
Dollars Now
185 200
63
How do we get There?
Today
Future
Integrated Functional Planning
Environment
Where you are now.
Where you want to be.
Creating a good Road Map to success (Good
Investment Strategy)
64
Fund Flows via Market
Markets
Surplus Units
Deficit Units
Intermediaries
65
Fund Flows via Intermediary
Markets
Surplus Units
Deficit Units
Intermediaries
66
Fund Flows via Intermediary and Market
Markets
Surplus Units
Deficit Units
Intermediaries
67
Funds Flow via Markets and Intermediaries
Markets
Surplus Units
Deficit Units
Intermediaries
68
Funds Flow Disintermediation
Markets
Markets
Surplus Units
Deficit Units
Surplus Units
Deficit Units
Intermediaries
Intermediaries