Investment:

Investment is an activity that is engaged in by people who have

savings and investments are made from savings. But all savers are not

investors so investment is an activity which is different from saving.

If one person has advanced some money to another, he may

consider his loan as an investment. He expects to get back the money

along with interest at a future date.

Another person may have purchased one kilogram of gold for

the purchase of price appreciation and may consider it as an investment.

Yet another person may purchase an insurance plan for the

various benefit it promises in future. That is his investment.

Investment involves employment of funds with the aim of

achieving additional income or growth in values or the commitment of

resources which have been saved in the hope that some benefits will

accrue in future.

Thus, investment may be defined as, “ a commitment of funds made

in the expectation of some positive rate of return”.

In the financial sense, investment is the commitment of a

person’s funds to derive future income in the form of interest, dividend,

premiums, pension benefits or appreciation in the value of their capital.

Purchasing of shares, debentures, post office savings certificates,

insurance policies are all investments in the financial sense. Such

investments generate financial assets.

In the economics sense, investment means the net additions to

the economy’s capital stock which consists of goods and services that

are used in the production of other goods and services. Investment in

the sense implies the formation of new and productive capital in the

form of new constructions, plant and machinery, inventories etc. Such

investments generate physical assets.

The money invested in financial investments are ultimately

converted into physical assets. Thus, all investments result in the

acquisition of some assets either financial or physical.

Characteristics of Investment:

Return:

Investments are made with the primary objective of deriving a return. Thereturn may be received in the form of capital appreciation plus yield. Thedifference between the sales price and the purchase price is capitalappreciation. The dividend or interest received from the investment is theyield.

Risk:

Risk may relate to loss of capital, delay in repayment of capital, non-payment of interest, or variability of returns. While some investments likegovernment securities and bank deposits are riskless, others are more risky.

The risk of an investment depends on the following factors :

1) The longer the maturity period, the larger is the risk.

2) The lower credit worthiness of the borrower, the higher is the risk.

3) Investments in ownership securities like equity shares carry higher riskcompared to investments in debt instruments like debentures and bonds.

Risk and return of an investment are related. Normally, the higher the risk, the

higher is the return.

Safety:

Safety is another feature which an investor desires for his investments.

The safety of an investment implies the certainty of return of capital without

loss of money or time. Every investor expects to get back his capital on

maturity without loss and without delay.

Liquidity:

An investment which is easily saleable or marketable without loss of

money and without loss of time is said to possess liquidity. Some investments

like company deposits, bank deposits, P.O. deposits, NSC, NSS etc are not

marketable. Some investment instruments like preference shares and

debentures are marketable but there are no buyers in many cases and hence

their liquidity is negligible. Equity shares of companies listed on stock

exchanges are easily marketable through the stock exchanges.

An investor generally prefers liquidity for his investments, safety of his

funds, a good return with minimum risk or minimisation of risk and

maximisation of return.

Objectives of Investment:

The main objectives of investments are:

Maximisation of return

Minimisation of risk

Other subsidiary objectives are:

Maintaining liquidity

Hedging against inflation

Increasing safety

Saving tax

Maximisation of return:

The rate of return could be defined as the total income the investor receives

during the holding period, stated as a percentage price at the beginning of the

holding period.

Return = Capital Appreciation + Yield ( Dividend, Interest)

Return = End period value – Beginning period value + Yield value

Beginning period value

If a particular share is bought in 2011 at Rs.50 and sold in 2012 at Rs.60 and

the dividend yield is Rs.5, then what would be the return?

Minimizing the risk:

The risk of holding securities is related to the probability of the actual

return becoming less than the expected return. If we consider the financial

assets available for investment, we can classify them into different risk

categories. Government securities would constitute the low risk category as

they are practically risk free. Debentures and preference shares of companies

may be classified as medium risk assets. Equity shares of companies would

form the high risk category of financial assets.

Maintaining Liquidity:

Liquidity depends upon marketing and trading facilities. If a portion of

the investment could be converted into cash without much loss of time, it helps

the investor to meet emergencies. Stocks are liquid only if they command a

good market by providing adequate returns through dividends and capital

appreciation.

Hedging against inflation:

The rate of return should ensure a cover against inflation to protect against a rise

in prices and fall in the purchasing value of money. The rate of return should be

higher than the rate of inflation otherwise the investor will experience loss in

real terms.

Increasing safety:

The selected investment avenue should be under the legal and regulatory

framework. If it is not under the legal framework, it will be difficult to represent

grievances. Approval of the law itself adds a flavour of safety. From the safety

point of view, investments can be ranked as follows: bank deposits, government

bonds, UTI units, nonconvertible debentures, convertible debentures, equity

shares and deposits with non-banking financial companies.

Investment and Speculation:

Investment and speculation involve purchase of assets like shares and

securities. Traditionally, investment is distinguished from speculation with

respect to three factors, viz., risk, capital gain and time period.

speculation is about taking up the business risk in the hope of achieving

short-term gain. Speculation essentially involves buying and selling activities

with the expectation of making a profit from price fluctuations.

Ex: If a person buys a stocks for its dividend, he may be termed as an investor. If

he buys with the anticipation of a price rise in the future and the hope of selling it

again, he would be termed as speculator. The dividend line between speculation

and investment is very thin because people buy stocks for dividends and capital

appreciation.

Difference between investor and speculator:

Investor Speculator

Time horizon Plans for a longer time horizon. His

holding period may be from one

year to few years.

Plans for a very short

period. His holding period

varies from few days to

months.

Risk Assumes moderate risk. Willing to undertake high

risk.

Return Likes to have moderate rate of

return associated with limited risk.

Like to have high returns

for assuming high risk.

Decision Considers fundamental factors and

evaluates the performance of the

company regularly.

Consider inside

information, hearsays and

market behavior.

Funds Uses his own funds and avoids

borrowed funds.

Uses borrowed funds to

supplement his personal

resources.

Safety He chooses the investment

alternative which has high degree of

safety. Here safety is primary and

Focuses more on return

than the safety.

Investment and Gambling:

A gamble is usually a very short-term investment in a game or chance.

Gambling is different from speculation and investment. Typical example of

gambling are horse races, card games, lotteries etc. The time horizon involved in

gambling is shorter than in speculation and investment. Earning an income from

gambling is a secondary factor. Risk and return trade-off is not found in gambling

and negative outcomes are expected.

Investment Process:

Investment Process

Investmen

t PolicyAnalysis Valuation

Portfolio

Construction

Portfolio

Evaluatio

n

Investible

fund

Objectives

Knowledge

Market

Industry

Compan

y

Intrinsic value

Future value

Diversificatio

n

Selection

and allocation

Appraisal

Revision

Stages of the Investment

Process

The investment process involves a series of activities leading to the purchase of securities or other investment alternatives.

The process can be divided into five stages:

1. Framing of the investment policy

2. Investment analysis

3. Valuation

4. Portfolio construction

5. Portfolio evaluation.

1) Framing of the investment policy:

For systematic functioning, the government or investor, formulates the

investment policy before proceeding to invest. The essential ingredients of the

policy are:

a) Investible funds:

Funds may be generated through savings or from borrowings. If the funds are

borrowed, the investor has to be extra careful in the selection of investment

alternatives. He must make sure that the returns are higher than the interest he

pays.

b) Objectives:

The objectives are framed on the premises of the required rate of return,

need for regular income, risk perception and the need for liquidity. The risk

taker’s objective is to earn a high rate of return in the form of capital

appreciation whereas the primary objective of the risk-averse is the safety of

principal.

c) Knowledge:

Knowledge about investment alternatives and markets plays a key role in

policy formulation. Investment alternatives range from security to real estate.

The risk and return associated with investment alternatives differ from each

other.

The investor should be aware of the stock market structure and functions

of the brokers. The modes of operations are different in the BSE, NSE and

OTCEI. Brokerage charges are also different. Knowledge about stock

exchanges enables an investor to trade the stock intelligently.

2) Security Analysis:

Securities to be brought are scrutinized through market, industry and company analyses after the formulation of investment policy.

a) Market analysis

The growth in Gross Domestic product and inflation is reflected in stock

prices. Recession in the economy results in a bear market. Stock prices may

fluctuate in the short run but in the long run, they move in trends. The investor

can fix his entry and exit points through technical analysis.

b) Industry analysis:

An analysis of the performance, prospectus and problems of an industry of

interest is known as industry analysis. The risk factors related to the automobileindustry are different from those related to the information technology industry.The performance of an industry reflects the performance of the companies itconsists of.

c) Company analysis:

The purpose of company analysis is to help the investors make better

decisions. The company's earnings, profitability, operating analysis, capital

structure and management have to be screened. A company with a high product

market share is able to create wealth for investors in the form of capital

appreciation.

3) Valuation:

Valuation helps the investor determine the return and risk expected from an

investment in common stock.

Intrinsic value of the share is measured through the book value of the share and

price earning ratio. Simple discounting models can be adopted to value the

shares.

Future value of securities can be estimated by using a simple statistical

technique like trend analysis. The analysis of the historical behavioral of price

enables the investor to predict the future value.

4) Construction of a portfolio:

A portfolio is a combination of securities. By constructing a portfolio, investors attempt to spread risk by not putting all their eggs into one basket and it also helps to meet their goals and objectives.

a) Diversification:

The main objective of diversification is the reduction of risk in the form of

loss of capital and income. A diversified portfolio is comparatively less risky than

holding a single portfolio. Several models are available to diversify a portfolio.

i) Debt and equity diversification:

Debt instruments provide assured returns with limited capital appreciation.

Common stock provide income and capital gain but with a flavor of uncertainty.

ii) Industry diversification:

Banking industry shares may provide regular returns but with limited capital

appreciation. Information technology stocks yield higher returns and capital

appreciation.

iii) Company diversification:

Securities from different companies are purchased to reduce the risk.

Technical and fundamental analysts suggest the investors to buy the securities.

b) Selection and allocation:

Securities have to be selected based on the level of diversification and funds

are allocated for selected securities.

5) Portfolio Evaluation:

It is the process which is concerned with assessing the performance of the

portfolio over a selected period of time in terms of return and risk.

a) Appraisal:

Developments in the economy, industry and relevant companies from

which stocks are bought have to be appraised. The appraisal warns of the loss

and steps can be taken to avoid such losses.

b) Revision:

It depends on the results of the appraisal. Low-yielding securities with

high risk are replaced with high-yielding securities with low risk factor. The

investor periodically revises the components of the portfolio to keep the

return at a level.

Investment Avenues:

Investment Avenues

Securities Deposits Postal Schemes Insurance Real Assets

StocksBonds/SecuritiesG-securitiesMoney market instrumentsDerivativesMutual Funds

Bank Deposits Non-Banking Financial Company (NBFC) deposits

Monthly Income Scheme(MIS) National Saving Scheme(NSS)Vikas PatrasPublic Provident Fund(PPF)

Life Insurance policies Unit Linked Insurance Plan (ULIP)

Real estatePrecious metalsArt and antiques

Investment Avenues:

1) Negotiable investments

2) Non-negotiable investments

I) Negotiable investments:

a) variable income securities

b) Fixed income securities

Variable income securities - Equity shares

Equity shares are commonly referred as common stock or ordinary shares.

The most common classification under this shares are:

a) Large-cap, mid-cap and small-cap stocks:

The large-cap stocks are shares of high market capitalization, the small-

cap ones have a low market capitalization and the mid-cap ones fall in between

these two.

b) Blue chip shares:

The shares of companies which have a consistent track record and are doingexceedingly well compared with other companies are known as blue chipshares. Ex: Reliance, SBI, ICICI, HDFC, ONGC, Infosys, TCS, Wipro, HLL,ITC, Tata Steel and Jindal Steel.

c) Growth shares:

Stocks that have a higher rate of growth in profitability than the industrygrowth rate are referred to as growth shares.

d) Income shares:

These stocks belong to companies that have stable operations and payregular dividends.

e) Defensive shares:

Defensive stocks are relatively unaffected by market movements. Ex: ahost of pharmaceutical stocks posted returns even in the period of marketslowdown.

f) Cyclical shares:

The upward and downward movements of the business cycle affect thebusiness prospects of certain companies and their stock prices. Such sharesprovide low to moderate current yield. Ex: automobile sector stocks are affectedby business cycle.

g) Speculative shares:

Shares that have a lot of speculative trading in them are referred to asspeculative shares.

Fixed Income Securities:

Fixed income shares are categorized as follows:

a) Preference shares:

The biggest advantage is the tax-exempt status of the preference share’sdividend.

b) Debentures / Bonds:

Debentures are generally issued by the private sector companies as a long-term promissory note for raising loan capital. The company promises to payinterest and principal as stipulated whereas bond is a long-term debt instrumentthat promises to pay a fixed annual sum as interest for a specified period of time.Public sector companies and financial institutions issue bonds.

c) Government Securities:

The securities issued by the central government, state government and quasi-government agencies are known as government securities or gilt-edged securities.It is a secure financial instrument, which guarantees the income and capital.

d) Money market securities:

These have a short term maturity, say less than a year. Common money

market instruments are treasury bills, commercial paper and certificate of deposit.

i) Treasury bills:

It is fundamentally an instrument of short-term borrowing by the government

of India to help the cash management requirements of various segments of the

economy. Generally, treasury bills are of 91 days. Since the interest rates offered

on treasury bills are low, individuals very invest in them.

ii) Commercial Papers:

It is a short term negotiable instrument with a fixed maturity period. It is an

unsecured promissory note issued by the company either directly or through

Banks.

iii) Certificate of deposit:

It is a marketable receipt of funds deposited in a bank for a fixed period at a

specified rate of interest.

II) Non-negotiable instruments:

Deposits:

a) Bank deposits:

The banks offer current account, savings account and fixed deposit account

with a fixed rate of return.

b) Non-Banking Financial Companies (NBFC) :

It is one of the financial intermediate company which comes under the

purview of RBI. Security of the deposits with the NBFCs is lower than of the

deposits with banks.

Postal Savings:

Postal savings like National Savings Certificate (NSC), Kisan Vikas Patra

(KVP), Monthly income scheme, Senior citizen scheme, PPF are considered as

reliable form of investment because they are backed by the Government of India

under Indian Postal department. Postal savings schemes offered to lower-middle

class and lower class investors but now middle income and higher-income groups

are also considering this avenue with the increase in the uncertainties.

Life Insurance:

It is contract for payment of a sum of money to the person assured on the happening of the event insured against. The core feature of the is protection and elimination of risks. Insurance emerge as a combination of both investment and assurance. The major advantages it includes are : protection, easy payment, liquidity and tax relief.

Unit Linked Insurance Plan (ULIP):

This is a market-linked insurance plan. It provide life insurance combined with savings at market-linked returns. The premiums is mainly invested in risk-free securities like government securities and fixed income securities.

Real Assets:

• Gold

• Silver

• Real estate refers to various fixed assets which can be classified into three categories: Residential Property, Commercial property, Land.

•Art

•Antiques

Risk return trade-off:

The principal that potential return rises with an increase in risk. Low levels

of uncertainty (low risk) are associated with low potential returns whereas high

levels of uncertainty (high risk) are associated with high potential returns.

According to risk return trade-off, invested money can render higher

profits only if it is subject to the possibility of being cost.

The trade off which an investor faces between risk ad return while

considering investment decisions is called Risk Return Trade-off.

Ex: Mr. Rohan faces a risk return trade-off while making his decision to invest.

If he deposits all his money in a SB account, he will earn a low return, but all his

money will be insured up to an amount of Rs. 1 Lakh.

The risk return spectrum also called the risk return trade-off which is the

relationship between the amount of return gained on an investment and the

amount of risk undertaken in that investment. The more return sought, the more

risk that must be undertaken.

Capital Market:

Capital market deals with medium term and long term funds. It refers to all

facilities and the institutional arrangements for borrowing and lending term funds

(medium term and long term). The demand for long term funds comes from private

business corporations, public corporations and the government. The supply of

funds comes largely from individual and institutional investors, banks and special

industrial financial institutions and Government.

It is the market segment where securities with maturities of more than one

year are bought and sold. Equity shares, preference shares, debentures and bonds

are the long-term securities traded in the capital market.

Capital market is classified in two ways:

1) Primary Market ( New Issue Market)

2) Secondary Market ( Stock Market)

Primary Market:

• Primary market is the new issue market of shares, preference shares anddebentures.

• Stocks available for the first time are offered through the new issue market.The issuer may be the new company or the exit company.

• The issuing houses, investment bankers and brokers act as the channels ofdistribution for a new issue. They take responsibility for selling the stocks to thepublic.

•The issuer can be considered as manufacturer.

Types of Issues:

• Public Issue which is a method of raising a funds through the issue of shares toinvestors in the primary market by companies.

• Preferential issue means when listed companies issue securities to a selectedgroup of persons. It may be financial institutions, mutual funds or high networth individuals.

• Rights issues means an issue of capital offered by a company to its existingshareholders through a letter of offer. In other wards, a listed company issuesfresh securities only to its existing shareholders.

Parties involved in the new issue:

1) Managers to the issue:

• Drafting the prospectus

• Preparing a budget expenses related to the issue.

• Suggesting the appropriate timing of the public issue

•Assisting in marketing the public issue successfully.

•Advising the company in the appointment of parties involved in it.

• Directing the various agencies

2) Registrar to the issue:

The registrar to the issue is appointed in consultation with the lead

managers. They receive the share applications from various collections centers.

They arrange for the dispatch of the share certificates. They hand over the

details of the share allocation and related documents to the company.

3) Underwriters:

Underwriting is a contract in which an underwriter gives an assurance to

the issuer that the he will subscribe to the securities offered in the event of non-

subscription by the persons to whom they are offered. Ex: financial institutions,

banks, brokers and approved investment companies.

4) Bankers to the issue:

Bankers to the issue are responsible for collecting the application money along

with the application form. They charge commission as brokerage.

5) Advertising Agents:

Advertising plays s key role in promoting a public issue. The advertising

agencies take responsibility for giving publicity to the issue through appropriate

platforms.

Secondary Market:

Secondary market deals with securities which have already been issued and

are owned by investors. The buying and selling of securities already issued and

outstanding take place in stock exchanges. Hence, stock exchanges constitute the

secondary market in securities.

Stock Exchange:

The stock exchange were once physical market places where the agents of

buyers and sellers operated through the auction process. These are being replaced

with electronic exchanges where buyers and sellers are connected only by

computers over a telecommunication network.

Auction trading is giving way to “screen-based” trading where bid prices

and offer prices are displayed on the computer screen. Bid price refers to the price

at which an investor is willing to buy the security and offer price refers to the

price at which an investor is willing to sell the security.

A stock exchange may be defined in different ways. In simple terms, stock

exchange is “ A centralized market for buying and selling stocks where the price is

determined through supply-demand mechanisms”.

According to the Securities Contracts Act, 1956, “ Stock exchange means

any body of individuals, whether incorporated or not, constituted for the purpose

of assisting, regulating or controlling the business of buying, selling or dealing in

securities”.

Functions of Stock Exchange:

Maintains Active Trading

Shares are traded on the stock exchanges, enabling the investors to buy andsell securities. The prices may vary from transaction to transaction. Acontinuous trading increases the liquidity or marketability of the shares tradedon the stock exchanges.

Fixation of Prices

Price is determined by the transactions that flow from investors’ demand andsupplier’s preferences. Usually the traded prices are made known to the public.This helps the investors to make better decisions.

Ensures Safe and Fair Dealing

The rules, regulations and by-laws of the stock exchanges’ provide a measureof safety to the investors. Transactions are conducted under competitiveconditions enabling the investors to get a fair deal.

Aids in Financing the Industry

A continuous market for shares provides a favorable climate for raising capital.The negotiability of the securities helps the companies to raise long-termfunds. When it is easy to trade the securities, investors are willing to subscribeto the initial public offerings. This stimulates the capital formation.

Dissemination of Information

Stock exchanges provide information through their various publications. Thepublish the share prices traded on daily basis along with the volume traded.Directory of Corporate information is useful for the investors’ assessmentregarding the corporate. Handouts, handbooks and pamphlets provideinformation regarding the functioning of the stock exchanges.

Performance Inducer

The prices of stock reflect the performance of the traded companies. Thismakes the corporate more concerned with its public image and tries tomaintain good performance.

Self-regulating Organization

The stock exchanges monitor the integrity of the members, brokers, listedcompanies and clients. Continuous internal audit safeguards the investorsagainst unfair trade practices. It settles the disputes between member brokers,investors and brokers.

How a trade actually takes place on a stock exchange?