part 1: introduction and overview of investment a broad map of the territory 1s.b.khatri - aim
TRANSCRIPT
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.
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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.
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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
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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)
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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
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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
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Investment Attributes
• For evaluating an investment avenue, the following attributes are relevant:
1. Rate of Return2. Risk3. Marketability4. Tax Shelter5. Convenience
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1. Rate of Return
Price Beginning
Price) Beginning - Ending(
Price Beginning
Income Annual (%)Return of Rate
Current Yield Capital Gain/Loss Yield
Rate of Return of any investment instrument can be calculated
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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.
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3. Marketability (Liquidity)
• An investment is highly marketable or liquid if:a) It can be transacted quicklyb) The transaction cost is lowc) The price change between two successive
transactions is negligible• Liquidity of a market may be judged in terms
of its – depth, – breadth and – resilience
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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.
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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.
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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.
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5. Convenience
• Ease with which the investment can be made and looked after.
a) Can the investment be made readily?b)Can the investment be looked after easily?
• Savings Account – made easily, no maintainance• Property – too many processes, high
maintenance.
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Current yield
Capital
appreciation Risk
Marketability/ Liquidity Tax Shelter Convenience
Equity Shares Low High High Fairly high High High
Non-convertible Debentures
High Negligible Low Average Nil High
Equity Schemes Low High High High High Very high
Debt Schemes
Moderate Low Low High No tax on dividends
Very high
Bank Deposits Moderate Nil Negligible High Nil Very high
Public Provident
Fund Nil Moderate Nil
Average Tax Benefit
Very high
Life Insurance Policies
Nil Moderate Nil
Average Tax Benefit
Very High
Residential House Moderate Moderate Negligible Low High Fair
Gold and Silver
Nil Moderate Average Average Nil Average
Return
EVALUATION OF VARIOUS INVESTMENT AVENUES
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Investment vs. SpeculationInvestor 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 19S.B.Khatri - AIM
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
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Financial Markets (Functions)
1. Financial Markets facilitate price discovery– Interaction between numerous buyers and sellers
2. Financial Markets provide liquidity to financial assets– Negotiability and transferability
3. Financial makrets considerably reduce cost of transacting.– Search and Information cost is reduced significantly
4. Financial Markets give opportunity for risk reduction– Diversification opportunity
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PORTFOLIO MANAGEMENT PROCCESS
SPECIFICATION OF INVESTMENT OBJECTIVES
AND CONSTRAINTS
CHOICE OF ASSET MIX
FORMULATION OF PORTFOLIO STRATEGY
SELECTION OF SECURITIES
PORTFOLIO EXECUTION
PORTFOLIO REVISION
PORTFOLIO EVALUATION 24S.B.Khatri - AIM
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
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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.
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3. Formulation of Portfolio Strategy
• Two broad choices are available:1. Active Portfolio Strategy2. 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.
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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.
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5. Portfolio Execution
• Implementing the portfolio plan by buying and/or selling specified securities in given amounts.
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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
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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.
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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
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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.
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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)
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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.
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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.
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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.
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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.
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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)
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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
Risk
Return
BA
A
B
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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.
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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)
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Financial Intermediaries
• Commercial Banks• Investment Banks• Mutual Funds• Building Societies• Unit Trusts• Investment Trusts• Etc...
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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.
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….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:a) Tall and unjustified claims made by people with vested
interestb) Exceptional performance of some portfolio they have seen
or managed, which may be attributable mostly to fortuitous factors
c) Promises made by tipsters, operators and others• In most of the case, such expectations reflect investor naiveté
and gullibility. 47S.B.Khatri - AIM
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.
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…..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.
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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.
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….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.”
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….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.
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….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.
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….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.
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….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.
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….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 company’s products and the return of its equity stock.
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….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.
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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.
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….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.
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Investment vs. Consumption
A
B
100
80
60
40
20
40 60 80 100income in period 0
income in period 1
Some investors will prefer A
and others B
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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.
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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.
185 200 Dollars Now
Dollars Next Year
210
194
A invests $185 now and consumes $210 next year
G invests $185 now, borrows $200 and consumes now.
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How do we get There?
Where you are now.
Where you want to be.
Creating a good Road Map to success
(Good Investment Strategy)
TodayFuture
Environment Integrated “Functional” Planning
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Fund Flows via Intermediary and Market
Markets
Intermediaries
Surplus Units Deficit Units
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Funds Flow via Markets and Intermediaries
Markets
Intermediaries
Surplus Units Deficit Units
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