Professional Documents
Culture Documents
having an increased amount available for consumption in the future. For institutional
investors, there are professional investment and portfolio managers. But for an individual, the
management of personal investment becomes difficult, as he or she is not aware of the nitty-
gritty of the investment world. The emergence of new investment avenues and increasing
financial insecurity coupled with socioeconomic changes are driving individuals to invest in
order to attain financial security. The funds available for with any individual for personal
investments comprise of two parts namely, savings and postponement of present consumption
of funds.
Today, an individual is more knowledgeable and better informed about the availability of
investment avenues, but lack the adequate knowledge to manage them. The avenues for
investment have increased, thanks to Financial Engineering. Investors can today invest both in
the form of physical assets as well as financial assets. Many new instruments and securities
are emerging to suit the varied requirements of individual investors.
An investor has various alternative avenues to invest his savings in. Hence, savings are
productively invested in assets depending on their risk and return characteristics. The
objective of the investor is to minimize the risk involved in investment and maximize the
return from the investment. Savings kept in the form of cash are not only unproductive as
they do not earn anything, but also loses its value because of the rise in prices. Thus, rise in
prices or inflation erodes the value of money. Savings are invested to provide a hedge or
protection against inflation. If the investments cannot earn at par with the rise in prices, the
real rate of return will be negative. Thus, the basic objectives of an investor can be
maximization of return, minimization of risk and hedge against inflation.
Investment is distinct from gambling or speculation. Investment is a planned task of
construction and management of personal investment portfolio by an individual, and is done
as per his requirements and life-stage. It is an activity, whose outcome should match the
short-term and long-term financial needs of an individual and/or his family. All individuals can
be specifically differentiated on various parameters, and depending on the various attributes,
their investment decisions are influenced by different factors.
If we consider a situation where a conservative investor has a portfolio containing two
different funds, one fund invests primarily in natural resource-oriented stocks, which normally
do well in inflationary periods. The other fund invests primarily in financial stocks – such as
Central Government and Financial Institutions securities, which typically do well in
disinflationary periods. If a portfolio is constructed consisting of both funds, their fluctuations,
will, in part, tend to cancel one another as inflation rates vary over time. As a consequence,
the risk level of the overall portfolio will be reduced below the risk level of either individual
fund. But an investor should remember that every individual fund must also invest in
numerous stocks located within many different industries to further limit the business risk.
Taking the fullest possible advantage of the portfolio effect requires diversifying in two
important ways i.e. diversification by investment style and diversification by investment
objective.
All individuals can be specifically differentiated on various parameters, and depending on the
various attributes, their investment decisions are influenced by the following factors. Let us
discuss each in detail.
Required Return
Any investment is made with the primary objective of earning returns on the invested sum.
Based on the type of investment avenues, returns can have one or more of the following
components. In any case, the expected return should be calculated by adding the return on
risk-free securities, reward for taking risk and compensation for inflation.
The returns can be of two types, repetitive cash receipts, capital gain or loss. The gain or loss
of capital makes the difference between the purchase price and the selling price of the
security. The total return on a security should be calculated by adding all cash receipts to the
change in price of the security over a period of time divided by the purchase price of the
security. The more the riskiness of a security, the more the return an investor requires from a
security.
Risk Taking Capability
Depending on the degree of risk an individual can take, he/she can be classified as a risk
taker, risk averter or indifferent towards risk. Risk takers usually prefer to invest in risky
securities like shares and risk averters invest in risk free securities.
Time Frame
The time duration of investment can vary from a few hours to few months or even several
years. Short-term investments are usually considered to be less risky in comparison to long-
term investments.
Knowledge and Information
Personal investment is affected by the level of knowledge an individual investor possesses
about different investment opportunities. The knowledge of the relationship between risk and
return along with the knowledge of industrial sectors, economic indicators, companies'
performance analysis techniques, portfolio management techniques, etc., affect the
investment decisions of individuals. The sources of information regarding investment avenues
also guide the investment decisions.
Taxable Income
The contemporary tax liabilities of an individual and the effect of taxation on the income
generated from investment along with its understanding influences an individual's investment
decisions.
Safety
In general, safety is associated with the principal amount while the risk is related to the
returns expected on the investment. The safety of the funds invested should be the first
priority of any investment and then the returns should be in proportion to the level of risk
taken.
Availability of Funds
One of the most important factors affecting personal investments is the availability of
disposable funds. If the difference between net income and expenditure is either zero or
negative, there will be limited amount available for investment. It is only because of the
limited availability of funds, that the investor is forced to choose from various mutually
exclusive investment opportunities. Each individual should calculate the minimum contingency
amount which should be kept as liquid assets and any amount beyond this should then be
appropriately invested.
Cash Reversibility
The funds invested should be convertible into cash in the hour of need and this is an important
factor which affects personal investments. The degree of reversibility of securities into cash
should be considered while making personal investments.
Understanding States of Nature
When the outcome of an activity is known accurately, it is the state of certainty; on the other
hand, a state of uncertainty prevails when the outcome of an activity cannot be stated for
sure. When there are more than one mutually exclusive outcomes of any activity with a
degree of probability attached to each outcome, then it is the state of risk. Risk is defined as
the probability of deviation of actual outcome from the expected outcome. It is always good to
understand the state of nature prior to investing.
Diversification by investment style: Each investment manager has a special style of investing.
It is always best to diversify into funds with different approaches to the market because these
funds can produce significantly different results. But what precisely is meant by the term
investment style? An investment style is simply a set of rules, guidelines, or procedures
followed by fund managers when selecting stocks. Some of such stocks include blue chip
companies, cyclical stocks, interest sensitive stocks, high-technology stocks, stocks with
strong earning growth rates, undervalued companies, companies with strong cash flows, etc.
Obviously, there are numerous additional categories that might be included. As an investor,
he/she must strive to diversify his/her holdings across different investment styles and seek to
select only the best performers within each particular category.
Diversification by investment objective: The business risk can be further reduced by adopting
this strategy - diversifying across investment objectives. There are different types of funds like
industry specific fund (aggressive fund), diversified and balanced fund (moderate fund), bond
fund (conservative fund) and money market fund (extremely conservative). Each of these
funds has different objectives. An investor should invest a proportion of his/her investible
resources among all these funds so that his/her risk is further reduced
There are basically three types of investments from which the investors can choose. The
three kinds of investment have their own risk and return profile and investor will decide to
invest taking into account his own risk appetite. The main types of investments are: -
Economic investments:-
These investments refer to the net addition to the capital stock of
the society. The capital stock of the society refers to the investments made in plant,
building, land and machinery which are used for the further production of the goods. This
type of investments are very important for the development of the economy because if the
investment are not made in the plant and machinery the industrial production will come down
and which will bring down the overall growth of the economy,because if the investment are
not made in the plant and machinery the industrial production will come down and which will
bring down the overall growth of the economy.
Financial Investments:-
This type of investments refers to the investments made in the marketable securities which
are of tradable nature. It includes the shares, debentures, bonds and units of the mutual
funds and any other securities which is covered under the ambit of the Securities Contract
Regulations Act definition of the word security. The investments made in the capital market
instruments are of vital important for the country economic growth as the stock market index
General Investments:-
These investments refer to the investments made by the common investor in his own small
assets like the television, car, house, motor cycle. These types of investments are termed as
the household investments. Such types of investment are important for the domestic
economy of the country. When the demand in the domestic economy boost the over all
productions and the manufacturing in the industrial sectors also goes up and this causes rise
in the employment activity and thus boost up the GDP growth rate of the country. The
organizations like the Central Statistical Organization (CSO) regularly takes the study of the
investments made in the household sector which shows that the level of consumptions in the
domestic markets.
CHARACTERISTICS OF INVESTMENT
Certain features characterize all investments. The following are the
main characteristics features if investments: -
1.Return:-
All investments are characterized by the expectation of a return. In fact, investments are
made with the primary objective of deriving a return. The return may be received in the form
of yield plus capital appreciation. The difference between the sale price & the purchase price
is capital appreciation. The dividend or interest received from the investment is the yield.
Different types of investments promise different rates of return. The return from an
investment depends upon the nature of investment, the maturity period & a host of other
factors.
2.Risk: -
Risk is inherent in any investment. The risk may relate to loss of capital, delay in repayment
government securities & bank deposits are almost risk less, others are more risky. The risk
The risk varies with the nature of investment. Investments in ownership securities like equity
share carry higher risk compared to investments in debt instrument like debentures & bonds
3. Safety: -
The safety of an investment implies the certainty of return of capital without loss of money or
time. Safety is another features which an investors desire for his investments. Every investor
expects to get back his capital on maturity without loss & without delay.
4. Liquidity: -
An investment, which is easily saleable, or marketable without loss of money & 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 instrument like
preference shares & debentures are marketable, but there are no buyers in many cases &
hence their liquidity is negligible. Equity shares of companies listed on stock exchanges are
An investor generally prefers liquidity for his investment, safety of his funds, a good return
the development of the country itself. The developed countries like the USA and the Japan
provide variety of investments as compared to our country. In India before the post
liberalization era there were limited investments avenues available to the people in which
they could invest. With the opening up of the economy the number of investments avenues
have also increased and the quality of the investments have also improved due to the use of
the professional activity of the players involved in this segment. Today investment is no
longer a process of trial and error and it has become a systematized process, which involves
the use of the professional investment solution provider to play a greater role in the
investment process.
Earlier the investments were made without any analysis as the complexity involved the
investment process were not there and also there was no availability of variety of
instruments. But today as the number of investment options have increased and with the
variety of investments options available the investor has to take decision according to his
Investment
EQUITY
Fixed Income
Deposits
Life Insurance
Precious
Tax Sheltered
Real Estate
Financial Derivatives
Mutual Fund
The term risk, in the context of investments, refers to the variability of the expected returns.
It is an attempt to quantify the probability of the actual return being different from the
expected return. Though, there is a subtle distinction between uncertainty1 and risk, it is
common to find the use of both the terms interchangeably.
The variability of the return or the risk can be segregated into many components, based on
the factors that give rise to it. Broadly, risk is said to be made up of three components:
business risk, financial risk and liquidity risk. Let us understand them briefly.
Business Risk can be easily understood in the context of an investment in a business entity.
This risk is the variability of returns introduced by the nature of business of the entity invested
in. Changes in prices of raw materials and finished goods, changes in supply and demand for
raw materials and finished goods, changes in wage rates, changes in fuel costs, changes in the
economic lives of assets, changes in tax laws and changes in operating costs are some of the
factors that cause business risk. These factors have a direct impact on the profitability of the
investee and these, in turn, influence the share price and the dividend payment or the ability
of the firm to repay its debt with interest. The share price at the time of sale and the dividend
payments or the interest payments and redemption amount determine the return to an
investor. If we need to draw a parallel in the context of a consumer credit to an employee, it
can be related to job security, career prospects. In the context of a government bond, it may
mean the ability of the government to generate adequate revenues. However, this becomes
less relevant because of its ability to monetize a deficit.
Financial Risk arises from the financing pattern of the investee company. In other words, it is
the variability of the returns from investments made in the company that are brought about
by the financing mix used by the company. If a company uses only equity, its financial risk will
be relatively less, as there are no obligatory payments to be made. A company using debt will
carry more risk, as the obligatory payments on account of interest and repayment of principal
have to be met before any money is available for distribution to the equity investors. And,
inability to meet the obligations may result in compulsory liquidation. These factors create
variability in the profits of the firm and its share price.
Liquidity Risk refers to the uncertainty of the ability of an investor to exit from an investment
when he desires. The exit route primarily depends on the secondary market where the
securities are traded. Though the issuer may step in to provide liquidity in the form of buyback
of shares, options on bonds, redemption of securities, all such provisions have a time
dimension which is determined by the issuer. However, the term liquidity refers to the ability
of the investor to exit according to his requirements. When an investor approaches secondary
market for liquidity, his concerns are two-fold.
• Time taken for liquidation
• Price realization.
If the security is illiquid, it may become necessary to sell at a price lower than the market
price to reduce the time taken for liquidation. Such discount/reduction in price is called Price
Concession. Hence, price concession on a security and liquidity are inversely related.
The buyer too faces the same uncertainties - How long will it take to buy the security and at
what price can it be bought? The greater the uncertainty regarding these two, the higher the
liquidity risk. Investments like T-Bills can be sold or bought instantly while those like
investments in real estate in remote areas take considerable amount of time and effort to buy
or sell.
The risk premium mentioned earlier is, therefore, a function of these three types of risks. To
sum up, the factors causing volatility are the business risk, financial risk and liquidity risk
1) Expected return under different portfolio:-
I.All funds invested in S1
12 x 1 = 12
II. 50% of funds in each of S1 and S2
= (12 x .5) + (20 x .50)
= 6+10 = 16
III. 75% of funds in S1 and 25 % in S2
= (12 x .75) + (20 x .25)
=9+5 =14
IV. 25% of funds in S1 and 75 % in S2
= (12 x .25) + (20 x .75)
= 3 + 15 =18
V. All funds invested in S2
20 x 1 = 20
B) Risk of Portfolio
RP(Sdi)
(Sdi)²=(1.00)²(10)²+ 0²(28)²+2.1.0(15).10.18
= 1.100 + 0+0
(Sdi)² =100
=10%
RP{Sdiii)² = (.75)²(10)²+(.25)²(18)²+2(75)(25)(15)10.18
= (.56)100+(.62)324+360(.0375)
= 56+200.88+13.5
=270.38
(Sdiii)=16.44%
RP(Sd)
(Sdiv)=.25)10²+(.75)18²+2(.25)(.75)(.15)10.18
= (.62)100+(.56)324+13.5
=62+181.44+13.5
=256.94
=16.02%
RP(Sdv)
(Sdv)²= 0².10²+(1)²18²+2.0.1(115)10.18
=0+324+0
=324
=18%
C ) S1 and S2 is best for the Investor because he gets return while risk is 16% return
while risk is 10.93%.
Elaborate on the statement”No Investment is risk free”. How to minimise the risk in an
investment? Also bring out difference between Investment,Speculation and gambling.
Give
features of one of the investment avenue which you may prefer and indicate your reasons
for categorizing the same
As every investment involves risk, it is important to learn techniques and strategies that
minimize the risk associated with investment. The most effective way of minimizing the
risk is diversification.
1.ShortTerm Investment
Short term investment includes money market accounts and Certificate of Deposit.
Compared to Stock markets and bonds, they yield small profits. They may also provide
little protection against rapid inflation. But these kinds of investments usually offer
insured principal. To summarize, to minimize the risks associated with investment, we
should always diversify our portfolio over well researched asset class. It is also important
to diversify within each asset class.
2.Bonds
Bonds are less volatile as compared to stocks, mostly they provide regular income. If you
are more concerned with safety of your investment, it is suggested to assign more of your
portfolio towards US government or insured bond investment rather than stocks.