Chapter 01 Nature and Scope of Investment Decisions

Part I : The Investment EnvironmentC1 Nature and Scope of Investment Decisions 1 Chapt er Nature and Scope of Investment Decisions Copyright © 2008, Sudhindra Bhat 1± 1 SECURITY ANALYSIS AND PORTFOLIO MANAGEMENT Sudhindra Bhat Excel Books Part I : The Investment Environment C1 Nature and Scope of Investment Decisions Definition of Investment Investment 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. Copyright © 2008, Sudhindra Bhat 1± 2 SECURITY ANALYSIS AND PORTFOLIO MANAGEMENT Sudhindra Bhat Excel Books This includes protecting our assets from inflation. obtaining the most from it.Part I : The Investment Environment C1 Nature and Scope of Investment Decisions Why Invest? We invest in order to improve our future welfare. Regardless of why we invest. possibly in retirement when we are less able to work and produce for our daily needs. taxes and other factors. By foregoing consumption today and investing the savings. we expect to enhance our future consumption possibilities. and savings or foregone consumption. borrowed money. such as education funds for children or by ourselves. we should all seek to manage our wealth effectively. Sudhindra Bhat 1± 3 SECURITY ANALYSIS AND PORTFOLIO MANAGEMENT Sudhindra Bhat Excel Books . Copyright © 2008. Funds to be invested come from assets already owned. Anticipated future consumption may be by other family members. there would be several different levels of risk and different associated expectations of return. And the dictum of µrationality¶ combined with the attitude of µrisk aversion¶ imparts to investment their basic nature. The basic investment decision would be a trade-off between risk and return. Sudhindra Bhat 1± 4 SECURITY ANALYSIS AND PORTFOLIO MANAGEMENT Sudhindra Bhat Excel Books . 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. They are risk averse which implies that they would be unwilling to take risk just for the sake of risk. Copyright © 2008. They would assume risk only if an adequate compensation is forthcoming.Part I : The Investment Environment C1 Nature and Scope of Investment Decisions Nature of Investment Decisions Investment decisions are premised on an important assumption that investors are rational and hence prefer uncertainty. Undertake security analysis. 3. Copyright © 2008. Determine the investment objectives and policy. Review the portfolio. 2. forms the basis of the investment process. in turn.Part I : The Investment Environment C1 Nature and Scope of Investment Decisions The Investment Process A typical investment decision undergoes a five step procedure which. Construct a portfolio. 4. Sudhindra Bhat 1± 5 SECURITY ANALYSIS AND PORTFOLIO MANAGEMENT Sudhindra Bhat Excel Books . 5. Evaluate the performance of the portfolio. These steps are: 1. Copyright © 2008. Hence.Part I : The Investment Environment C1 Nature and Scope of Investment Decisions 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. Sudhindra Bhat 1± 6 SECURITY ANALYSIS AND PORTFOLIO MANAGEMENT Sudhindra Bhat Excel Books . 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. The second approach is known as µfundamental approach¶. Sudhindra Bhat 1± 7 SECURITY ANALYSIS AND PORTFOLIO MANAGEMENT Sudhindra Bhat Excel Books . The aim here is to know if it is worthwhile to acquire these securities for the portfolio. Copyright © 2008. And there are two broad approaches to finding out the µmispriced status¶ of individual securities. One approach is known as µtechnical analysis¶.Part I : The Investment Environment C1 Nature and Scope of Investment Decisions Security Analysis This step would consist of examining the risk-return characteristics of individual securities or groups of securities identified under step one. Sudhindra Bhat 1± 8 SECURITY ANALYSIS AND PORTFOLIO MANAGEMENT Sudhindra Bhat Excel Books .Part I : The Investment Environment C1 Nature and Scope of Investment Decisions 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. Copyright © 2008. Portfolio construction address itself to three major problems via. timing. and how best to combine then in a way that risk is reduced to a minimum for a given level of expected return. Cont«. and diversification. when to buy. The related questions would be: which specific shares/debentures to buy.. selectivity. In a way. He would liquidate the unattractive securities and acquire the new stars from the market. for doing so.Part I : The Investment Environment C1  Nature and Scope of Investment Decisions Portfolio Revision As time passes. must be developed.  Portfolio Performance Evaluation A rational investor would constantly examine his chosen portfolio both for average return and risk. acquires considerable significance since the tasks involved are quantitative measurement of actual risk and return their evaluation against objective norms. Measures. This step in the investment process. Copyright © 2008. In view of such developments it would be necessary for him to review the portfolio. he repeats the first three steps of the investment process. Also. thus. Also. new securities with promises of high returns and relatively low risk have emerged. the investor would discover that securities that once were very attractive have ceased to be so. the calculated risk-return positions must be compared with certain yardsticks or norms. Sudhindra Bhat 1± 9 SECURITY ANALYSIS AND PORTFOLIO MANAGEMENT Sudhindra Bhat Excel Books . The three elements of the investment environment viz. institutions and markets Copyright © 2008. which are the objects of purchase and sale. Investors have to be fully aware of this environment for making optimal investment decisions. the mechanism which expedites transfers from one owner to another comprises of a host of intermediaries. Then there are securities or financial instruments. Finally.. instruments.Part I : The Investment Environment C1 Nature and Scope of Investment Decisions The Investment Environment Investment decisions to buy/sell securities taken by individuals and institutions are carried through a set of rules and regulations. Sudhindra Bhat 1± 10 SECURITY ANALYSIS AND PORTFOLIO MANAGEMENT Sudhindra Bhat Excel Books . in turn. All these elements comprise the investment environment. There are markets ² money and capital ² which function subject to such rules and established procedures and are. regulated by legally constituted authority. 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. Sudhindra Bhat 1± 11 SECURITY ANALYSIS AND PORTFOLIO MANAGEMENT Sudhindra Bhat Excel Books .e. Copyright © 2008..Part I : The Investment Environment C1 Nature and Scope of Investment Decisions Financial Intermediaries Financial intermediaries perform the intermediation function i. Sudhindra Bhat 1± 12 SECURITY ANALYSIS AND PORTFOLIO MANAGEMENT Sudhindra Bhat Excel Books . etc. tips ³inside dope". Large Uncertain and erratic For a short time only Change in market price Copyright © 2008.Part I : The Investment Environment C1 Nature and Scope of Investment Decisions Investment versus speculation Basis Type of contract Basis of acquisition Psychological attitude of participants Reasons for purchase Quantity of risk Stability of income Length of commitment Source of income Investment Creditor Usually by outright purchase Cautious and conservative Scientific analysis of intrinsic worth Small Very stable Comparatively long-term Earnings of enterprise Speculation Ownership Often-on-margin Daring and careless Hunches. Copyright © 2008. 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. Such activities have planning horizons that are far too brief to do the research that should precede any investment activity. Sudhindra Bhat 1± 13 SECURITY ANALYSIS AND PORTFOLIO MANAGEMENT Sudhindra Bhat Excel Books . The holding period for most gambles can be measured in seconds. A gamble is usually a very short-term investment in a game of chance. That is. they prefer to refer to speculations as investment activities.Part I : The Investment Environment C1 Nature and Scope of Investment Decisions Investment versus Gambling speculation Speculation typically lasts longer than gambles but are briefer than investments. the result of so-called investments is quickly resolved by the roll of the dice or the turn of a card. Cont«. Those involved in speculations are reluctant to refer to this activity as speculation because they dislike the connotations of the word. The gambler plays rumours. Sudhindra Bhat 1± 14 SECURITY ANALYSIS AND PORTFOLIO MANAGEMENT Sudhindra Bhat Excel Books . 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. Copyright © 2008. 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 is as legitimate and moral as any other form of risk-taking business activity.Part I : The Investment Environment C1 Nature and Scope of Investment Decisions Speculation is not the same as gambling and the two should never be confused. It attempts to organise the relevant knowledge as a support for judgements. The difference between speculation and gambling is that in gambling. It does not rely upon hearsay or labels. tips. Safety and security of funds  Risk  Liquidity  Tax considerations  Conveyance  Concealability 1± 15 Copyright © 2008.Part I : The Investment Environment C1 Nature and Scope of Investment Decisions Investment Attributes/Factors influencing selection of investment For evaluation of investment avenue. the following attributes are relevant: 1. Sudhindra Bhat SECURITY ANALYSIS AND PORTFOLIO MANAGEMENT Sudhindra Bhat Excel Books . Capital Appreciation  Conservation ‡ ‡  Aggressive growth Speculation Periodic cash receipts Capital gain Form of return ‡ ‡ 3. Returns 2. Part I : The Investment Environment C1 Nature and Scope of Investment Decisions Investment Alternatives Equity Preference shares Debentures Bonds or fixed income securities  Government securities  Savings bonds  Private sector debentures  PSU bonds  Preference shares Money market instruments  Treasury bills  Certificates of deposits  Commercial paper  Repos Cont«. Copyright © 2008. Sudhindra Bhat 1± 16 SECURITY ANALYSIS AND PORTFOLIO MANAGEMENT Sudhindra Bhat Excel Books . Copyright © 2008.Part I : The Investment Environment C1         Nature and Scope of Investment Decisions 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«. Sudhindra Bhat 1± 17 SECURITY ANALYSIS AND PORTFOLIO MANAGEMENT Sudhindra Bhat Excel Books . Copyright © 2008. Sudhindra Bhat 1± 18 SECURITY ANALYSIS AND PORTFOLIO MANAGEMENT Sudhindra Bhat Excel Books .Part I : The Investment Environment C1         Nature and Scope of Investment Decisions 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«. Part I : The Investment Environment C1           Nature and Scope of Investment Decisions Precious objects Gold and Silver Precious Stones Art Objects Endowment Assurance Money Back Plan Whole Life Assurance Unit Linked Plan Term Assurance Immediate Annuity Deferred Annuity Insurance policies Copyright © 2008. Sudhindra Bhat 1± 19 SECURITY ANALYSIS AND PORTFOLIO MANAGEMENT Sudhindra Bhat Excel Books . Sudhindra Bhat 1± 20 SECURITY ANALYSIS AND PORTFOLIO MANAGEMENT Sudhindra Bhat Excel Books .Part I : The Investment Environment C1 Nature and Scope of Investment Decisions Investments and Innovation Technology  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 Copyright © 2008. Sudhindra Bhat SECURITY ANALYSIS AND PORTFOLIO MANAGEMENT Sudhindra Bhat Excel Books . identifies three broad types of investors found operating in the stock market ±    The contrarians Trend followers and Hedgers and holders. Other Type according to Researcher     1± 21 Measured Investor Reluctant Investor Competitive Investor Unprepared Investor Copyright © 2008.Part I : The Investment Environment C1 Nature and Scope of Investment Decisions Types of Investor According to Dr Jeff of the University of Melbourne.