chapter 01

Excel Books1– 1 SECURITY ANALYSIS AND PORTFOLIO MANAGEMENT Sudhindra Bhat

Copyright © 2008, Sudhindra Bhat

Part I : The Investment Environment

Nature and Scope of Investment DecisionsC1

Chapter1

Nature and Scope of

Investment Decisions





Definition of InvestmentInvestment involves making of a sacrifice in the present with the hope of

deriving future benefits. Investment has many meanings and facets. The

two most important features of an investment are current sacrifice and

future benefit.





We invest in order to improve our future welfare. Funds to be invested come

from assets already owned, borrowed money, and savings or foregone

consumption. By foregoing consumption today and investing the savings, we

expect to enhance our future consumption possibilities. Anticipated future

consumption may be by other family members, such as education funds for

children or by ourselves, possibly in retirement when we are less able to work

and produce for our daily needs. Regardless of why we invest, we should all

seek to manage our wealth effectively, obtaining the most from it. This includes

protecting our assets from inflation, taxes and other factors.

Why Invest?





Investment decisions are premised on an important assumption that

investors are rational and hence prefer uncertainty. They are risk averse

which implies that they would be unwilling to take risk just for the sake of

risk. They would assume risk only if an adequate compensation is

forthcoming. And the dictum of ‘rationality’ combined with the attitude of ‘risk

aversion’ imparts to investment their basic nature. The question to be

answered is: how best to enlarge returns with a given level of risk? Or how

best to reduce risk for a given level of return? Obviously, there would be

several different levels of risk and different associated expectations of

return. The basic investment decision would be a trade-off between risk and

return.

Nature of Investment Decisions





The Investment Process

A typical investment decision undergoes a five step procedure which, in

turn, forms the basis of the investment process. These steps are:

1. Determine the investment objectives and policy.

2. Undertake security analysis.

3. Construct a portfolio.

4. Review the portfolio.

5. Evaluate the performance of the portfolio.





Investment Objectives and Policy

The investor will have to work out his objectives first and then evolve a policy

with the amount of investible wealth at his command. Hence, the objectives of

an investor must be defined in terms of risk and return.

The next step in formulating the investment policy of an investor would be the

identification of categories of financial assets he/she would be interested in.





Security Analysis

This step would consist of examining the risk-return characteristics of

individual securities or groups of securities identified under step one. The

aim here is to know if it is worthwhile to acquire these securities for the

portfolio. And there are two broad approaches to finding out the ‘mispriced

status’ of individual securities. One approach is known as ‘technical

analysis’. The second approach is known as ‘fundamental approach’.





Portfolio Construction

This consists of identifying the specific securities in which to invest and

determining the proportion of the investor’s wealth to be invested in each.

Portfolio construction address itself to three major problems via., selectivity,

timing, and diversification. The related questions would be: which specific

shares/debentures to buy, when to buy, and how best to combine then in a

way that risk is reduced to a minimum for a given level of expected return.

Cont….




Nature and Scope of Investment DecisionsC1 Portfolio Revision

As time passes, the investor would discover that securities that once were very attractive have ceased to be so. Also, new securities with promises of high returns and relatively low risk have emerged. In view of such developments it would be necessary for him to review the portfolio. He would liquidate the unattractive securities and acquire the new stars from the market. In a way, he repeats the first three steps of the investment process.

Portfolio Performance Evaluation

A rational investor would constantly examine his chosen portfolio both for average return and risk. Measures, for doing so, must be developed. Also, the calculated risk-return positions must be compared with certain yardsticks or norms. This step in the investment process, thus, acquires considerable significance since the tasks involved are quantitative measurement of actual risk and return their evaluation against objective norms.





The Investment Environment

Investment decisions to buy/sell securities taken by individuals and

institutions are carried through a set of rules and regulations. There are

markets — money and capital — which function subject to such rules and

established procedures and are, in turn, regulated by legally constituted

authority. Then there are securities or financial instruments, which are the

objects of purchase and sale. Finally, the mechanism which expedites

transfers from one owner to another comprises of a host of intermediaries.

All these elements comprise the investment environment. Investors have to

be fully aware of this environment for making optimal investment decisions.

The three elements of the investment environment viz., instruments,

institutions and markets





Financial Intermediaries

Financial intermediaries perform the intermediation function i.e., they bring

the users of funds and the suppliers of funds together. Many of them issue

financial claims against themselves and use cash proceeds to purchase the

financial assets of others.





Investment versus speculation

Basis Investment Speculation

Type of contract Creditor Ownership

Basis of acquisition Usually by outright purchase Often-on-margin

Psychological attitude of participants Cautious and conservative Daring and careless

Reasons for purchase Scientific analysis of intrinsic worth Hunches, tips “inside dope", etc.

Quantity of risk Small Large

Stability of income Very stable Uncertain and erratic

Length of commitment Comparatively long-term For a short time only

Source of income Earnings of enterprise Change in market price





Investment versus Gambling speculationSpeculation typically lasts longer than gambles but are briefer than investments. A speculation usually involves the purchase of a salable asset in hopes of making a quick profit from an increase in the price of the asset which is expected to occur within a few weeks or months. Those involved in speculations are reluctant to refer to this activity as speculation because they dislike the connotations of the word; they prefer to refer to speculations as investment activities.

A gamble is usually a very short-term investment in a game of chance. The holding period for most gambles can be measured in seconds. That is, the result of so-called investments is quickly resolved by the roll of the dice or the turn of a card. Such activities have planning horizons that are far too brief to do the research that should precede any investment activity.

Cont….





Speculation is not the same as gambling and the two should never be

confused. The difference between speculation and gambling is that in

gambling, artificial and unnecessary risks are created whereas in speculation

the risks already exist and the question is simple – who shall bear them?

Gambling is a far cry from the carefully planned research and scientific

procedure which underlies the best speculative practice. The gambler plays

rumours, tips, hunches and other unreliable intuitions which should not play

any but a negative role in the trained speculator’s process. Speculation is a

reasoned anticipation of future conditions. It does not rely upon hearsay or

labels. It attempts to organise the relevant knowledge as a support for

judgements. It is as legitimate and moral as any other form of risk-taking

business activity.





Investment Attributes/Factors influencing selection of investment

For evaluation of investment avenue, the following attributes are relevant:1. Returns2. Capital Appreciation

Conservation

Form of return

• Aggressive growth

• Speculation

• Periodic cash receipts

• Capital gain

3. Safety and security of funds Risk Liquidity Tax considerations Conveyance Concealability





Investment AlternativesEquity Preference sharesDebenturesBonds or fixed income securities Government securities Savings bonds Private sector debentures PSU bonds Preference sharesMoney market instruments Treasury bills Certificates of deposits Commercial paper Repos

Cont….





Non-marketable financial assets Bank deposits

Post office time deposits (POTD)

Monthly income scheme of the post office (MISPO)

Kisan Vikas Patra (KVP)

National savings certificate

Company deposits

Employees provident fund scheme

Public provident fund scheme

Cont….





Real estate Residential House

Sources of Housing Finance

Features of Housing Loans

Guidelines for Buying a Flat

Commercial Property

Agricultural Land

Suburban Land

Time Share in a Holiday Resort

Cont….





Precious objects Gold and Silver

Precious Stones

Art Objects

Insurance policies Endowment Assurance

Money Back Plan

Whole Life Assurance

Unit Linked Plan

Term Assurance

Immediate Annuity

Deferred Annuity





Investments and InnovationTechnology Advancements in computing power and Internet technology More complete and timely information delivery

Globalization Domestic firms compete in global markets Performance in regions depends on other regions Causes additional elements of risk Globalization continues and offers more opportunities Securitization continues to develop Derivatives and exotics continue to develop Strong fundamental foundation is critical Integration of investments and corporate finance





According to Dr Jeff of the University of Melbourne, identifies three broad

types of investors found operating in the stock market –

The contrarians

Trend followers and

Hedgers and holders.

Types of Investor

Other Type according to Researcher

Measured Investor

Reluctant Investor

Competitive Investor

Unprepared Investor

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