CHAPTER 1

Introduction to Investment Analysis & Portfolio Management

Question And Answers
1. What is Speculation? How it differs from investment?

Speculation is an activity in which a person assumes high risk, often without regard for safely
of invested amount, to achieve large capital gains in short duration, it is indulged in on the basis
of some privileged information or as known in stock market based on some 'tips'.

Investment and Speculation may be distinguished as below :

Basis Investment Speculation

i) Risk Element Limited or very low Very High

ii) Income stability Reasonably Stable Uncertain and fluctuating

iii) Time Span Long-term Short-term

iv) Source of income Interest, dividends etc. Capital Gains

v) Investment pattern Cautious and conservative Daring and care less

vi) Basis for purchase Scientific Analysis of intrinsic value Tips, rumours, inner feelings.

2. What is an economic investment? How is it different from financial investment?

This means net increase in capital stock of society e.g. addition to buildings, machinery,
construction of roads, bridges etc.

This is allocation of funds to assets that are expected to yield some return. Financial
investment involves contracts written on paper such as shares and debentures. Financial
investments are made with the hope of getting some benefits which will accrue in the form of
interest, dividend, premium, appreciation in value etc. In this book we are more interested in
studying financial investments.
The examples of financial investment are :

Purchasing equity shares in a company.

Depositing money in bank FD.

Buying units of Mutual Funds.

Purchasing land for reselling at a higher price.

Depositing money in PPF A/c.

Following are not financial investment, but are personal investment :

Purchasing a computer for own use.

Paying 1,00,000/- as fees for MBA.

Every financial investment is eventually converted into an economic investment, for e.g.
investment in Road Development Bonds issued by Government of India is an example of
financial investment. But the money so raised by Government of India will be used to build
roads across the country which is nothing but economic investment, similarly money raised by a
company from a public issue is an example of financial investment but the money so raised will
be used by the company in its business to purchase various economic assets like Land &
Building, office premises, etc.

3. What is an investment?

The word 'Investment' has many meanings. Investment normally refers "to employment of
funds with the aim of earning income or securing growth in the value of money".

Investment means "the current commitment of funds for a period of time in order to derive a
future flow of funds that will compensate investor for the time the funds are committed, for the
expected rate of inflation and also for uncertainty involved in the future flow of funds". Investors
expect return on his investment which should compensate them for the risk they take in forgoing
current consumption of money for future consumption and for inflation.

4. What are investment objectives?

Investment Objectives are the goals to be achieved by making various investments.

Objectives or goals are the starting point of investment process. Investment objectives may be
classified on the basis of priority as.
Short term high priority objectives :These are the objectives to which the funds are committed
on high priority basis and desire to achieve the objective as early as possible. An example of this
would be buying a new house by a young couple. Any individual would like to invest a major
part of the available funds in such assets and then invest left over funds in other types of assets.

Long term high priority objectives : These are the objectives to which funds are committed on
high priority basis but the investor has time to accumulate funds for the same. An example for
such objective would be providing funds for child's higher education or marriage, the time frame
available for achieving this objective will be long enough for a young couple having a small
child. Therefore such a couple would start investing money in relatively safer securities for
achieving such objective in long term. Such an investment would be on year to year basis in
small instalments to achieve the objective on long term basis (may be a time frame of 10 to 15
years).

Low Priority objectives :After high priority objectives are achieved remaining funds may be
diverted to low priority objectives. These objectives get the left over funds because failure to
achieve them will not make much of a difference in the life of an individual. The assets desired
to be purchased are more of personal in nature, some examples of low priority objectives are : (a)
Purchase of domestic appliances, (b) Providing for travelling during vacation, (c) Purchase of
jewellery.

Money making objectives : Any surplus funds available after achieving all the above objectives
are invested to achieve this objective. The main motive behind this objective is wealth
maximisation; the most common investment therefore is equity shares of companies which
provide capital appreciation as well as regular income from dividends. Some other investment
avenues to achieve this objective are : (a) investing in gold or gold bonds (not jewellery), (b) real
estate (it does not include a house purchased to live in), etc.

Investment objectives may also be classified as :Financial Objectives

These are goals desired by every the investor :

Safety :It refers to reasonable assurance about repayment of funds invested. An investor has to
study credibility of company and reliability of market before investing his money. Different
investments provide different degree of safety, for e.g. Deposit in Post Office Saving Bank is
100% safe while deposit with a limited company is less safe.

Profitability : Every investor looks for some returns/income from the money invested. The % of
return, its periodicity, regularity and taxability will differ for different modes of investment, for
e.g. PPF gives return at 8% p.a. while Bank deposit may give return at 7% p.a. as against this
investment in equity shares may give higher returns of 15 to 20% p.a. but with higher degree of
risk.
Liquidity : Liquidity refers to the time period an investment can be converted into cash. In cases
of emergency liquid investments prove to be more useful, for e.g. Bank deposit can readability
be withdrawn hence it is most liquid, whereas investment in PPF is less liquid.

Personal Objectives

Apart from common financial objectives, every investor has his own personal objectives as
per his personal needs, family commitments etc. Some examples are :

To provide for own house

To provide for retirement pension

To provide for children education

To avail of tax benefits.

To achieve emotional satisfaction for e.g. buying car for old parents, etc.

5. What step should an investor follow for making his investments?

Any rational investor has to go through certain steps to make sound investments. These steps
can be summarised as below :

Review of Investment avenues/alternatives : The first step in investment process is to take a

look at available options for making investment, for e.g. A small investor will have Post Office,
Bank, Mutual funds as his options, he will not consider real estate as his option, due to his
limited availability of funds.

Determination of investment objectives and constrains : Investor has to consider the goal(s)
he wants to achieve by making investment. Investment objectives would include return on
investment, safely of investment it may also include other goals such as need for retirement
benefit, need for purchasing own house etc. Investor also may have to face certain constrains like
lack of sufficient funds, irregular flow of income, high rates of tax, etc.

Every investor should review his own objectives and constrains before choosing any
investment alternative.

Investment Analysis :After reviewing available avenues and his own objectives, investor has to
analyse the available avenues. Investor has to study the nature of security, type of industry,
regularity of return, chances of default, price of security etc. Investors can use techniques like
technical analysis and fundamental analysis to evaluate securities.
Portfolio Construction : Portfolio refers to combined holding of multiple securities. Portfolio
construction involves identifying specific assets for investment, and also to determine the
amount to be invested in each asset, for this an investor can use inputs from earlier steps i.e.
investment objectives and investment analysis. Investor has to take a balanced decision to
achieve various objectives. Investor should wait till suitable 'time' for making investment.
Various strategies, theories and statistical tools are available to aid portfolio construction.

Portfolio Performance Evaluation :An investor should evaluate the performance of his
investments. Performance evaluation should be done periodically and objectively. Performance
evaluation provides meaningful inputs for improving the quality of investment management.
Investor would like to know how far his objectives were achieved by selecting a particular
investment.

Portfolio Revision : Every investor has to review his investment regularly. The market
conditions, securities prices, interest rates all keep on changing. Investor has to revise his
portfolio accordingly. Investor's objectives may also change over a period of time. There is a
famous saying in investment analysis i.e. 'never marry an investment'. Portfolio revision involves
repetition of all earlier steps.

6. What are financial investments? Give some example.

This is allocation of funds to assets that are expected to yield some return. Financial
investment involves contracts written on paper such as shares and debentures. Financial
investments are made with the hope of getting some benefits which will accrue in the form of
interest, dividend, premium, appreciation in value etc. In this book we are more interested in
studying financial investments.

The examples of financial investment are :

Purchasing equity shares in a company.

Depositing money in bank FD.

Buying units of Mutual Funds.

Purchasing land for reselling at a higher price.

Depositing money in PPF A/c.

Following are not financial investment, but are personal investment :

Purchasing a computer for own use.

Paying 1,00,000/- as fees for MBA.

 Every financial investment is eventually converted into an economic investment, for e.g.
investment in Road Development Bonds issued by Government of India is an example of
financial investment. But the money so raised by Government of India will be used to build
roads across the country which is nothing but economic investment, similarly money raised by a
company from a public issue is an example of financial investment but the money so raised will
be used by the company in its business to purchase various economic assets like Land &
Building, office premises, etc.

7. What is portfolio? What is portfolio management?

Portfolio refers to a combination of various assets in which investors can invest there money
instead of investing it in one single security. Portfolio consists of carefully blended asset
combination within a cohesive framework. Though portfolio consists of a variety of assets, it is
managed as one unit.

Portfolio means combined holding of many kinds of financial securities like shares,
debentures, government securities, units Mutual funds, gold/oil bonds, etc. The securities to be
included in portfolio and their proportion are chosen carefully to achieve objectives of
investment.

Portfolio helps investor to reduce or manage the risk involved in investing funds. It spreads
the risk involved in an investment from one security to a group of different types of securities.
The concept can be understood from the phrase 'don't put all your eggs in one basket'. By
investing money in a portfolio of multiple securities instead of one single security an investor
can save himself from the danger of failure of a particular security to perform as per desired level
or even making losses. The loss incurred in one security can be compensated against profit
earned from some other security in the portfolio.

PORTFOLIO MANAGEMENT

Portfolio management refers to managing efficiently the investments held in portfolio.

Portfolio Management includes proper selection of securities, constant rebalancing/reshuffling of
securities and portfolio performance evaluation. It is an art and science of selecting and revising
the securities according to changing market situation and changing objectives of investment.
Since market condition change every movement, construction of portfolio is not an end, the
constant review of portfolio is equally important. Thus portfolio management is a dynamic
process which involves portfolio planning, construction, revision and evolution.

Portfolio manager is a professional who manages portfolio of other persons for certain fee.
He seeks to improve return on investors' portfolio but at the same time he also has to reduce the
risk. The skill in constructing optimum portfolio lies in balancing risk and return. Modern
portfolio theory is based on scientific approach and it seeks to estimate risk and return though an
analysis and screening of individual security and its behaviours as compared to other securities in
the portfolio.

The riskiness of portfolio is different from riskiness of individual securities. The portfolio risk
can be reduced by proper diversification and choosing securities in such a way that loss in one
security can be compensated by profit of other security.

8. State Basic steps of portfolio management process.

Portfolio management is based on certain basic principles :

Portfolio matters far more than the individual security : Individual securities in a portfolio
are important only to the extent that they affect the aggregate portfolio. For example, a security's
risk should not be based on the uncertainty of its return but, instead, on its contribution to the
uncertainty of the total portfolio's return. Moreover, other aspects such as investor's career or
home should be considered together with the security portfolio. In short, all decisions should
focus on the impact of a particular decision on the aggregate portfolio of all assets held.

Larger expected portfolio returns come only with larger portfolio risk :The most important
portfolio decision is the acceptable degree of risk to an investor, which is determined by the asset
allocation within the security portfolio. This is not an easy decision, since it requires that we
have some idea of the risks and expected returns available on many different classes of assets.
Nonetheless, the risk/return level of the aggregate portfolio should be the first decisions any
investor makes.

Diversification Works : Diversification across various securities will reduce a portfolio's risk.
This is because in a diversified portfolio loss of one company may be compensated by profit of
another company; this will reduce the overall risk of the portfolio as compared to a single
security.

Each portfolio should be tailored as per the needs and requirements of it's the
investor :People have varying tax rates, knowledge, transaction costs, etc. One single strategy
for portfolio construction will not work for all individuals. Individuals who are in a high
marginal tax bracket should stress portfolio strategies which increase after-tax returns.
Individuals who lack strong knowledge of investment alternatives should hire professionals to
provide needed counselling. Young professional with less family responsibilities can take higher
risk; therefore they can select relatively risky security to increase his/her returns as compared to
a married couple having children and old parents to take care of.
9. What are portfolio management objectives?

The major objectives of portfolio management are :

Maximising returns : Portfolio should be such that the returns are improved as compared to
individual securities in it. Every portfolio manager aims to generate maximum profit/returns on
his portfolio. Returns can be in the form of current income or capital gains.

Minimising portfolio risk :Portfolio should be such that the overall risk involved in the
portfolio is minimised as compared to individual securities of the portfolio. This objective can
usually be achieved through scientific diversification of available funds in multiple securities
rather than investing money only in single or very few securities.

Liquidity : Portfolio manger should keep certain proportion of the total funds available in such
securities that are easily convertible into cash. This will help him to acquire new and profitable
securities at the right time and in turn increase overall returns of the portfolio or reduce the total
risk involved or to achieve both the targets of improving returns and reducing risk. Liquidity also
helps the investor to get cash easily in case of urgent need for the same.

Tax benefits : Portfolio managers should consider tax benefits which can be availed, for e.g.
investment in shares of Indian companies will yield dividends that are tax free in the hands of
investor, even the capital gains on such shares will be exempt from tax if they are sold after a
specified time period, as against this dividends on debentures is taxable in the hands of investor,
but there are some other securities like NSC, PPF which provide interest income that is exempt
from income tax in the hands of investor.

Other objectives : Investors may demand some special features for e.g. an old couple may have
high priority monthly/regular income in form of retirement benefit to take care of there day to
day living needs. As against this a young couple earning high salaries may look for capital gains
from there portfolio instead of regular income, this is because they may want to utilise all or
major part of the portfolio in one go for there child's higher education after certain years.

Chapter 1

Introduction to Investment Analysis & Portfolio Management

Short Note

10. Write Short Notes on :

a) Technical Analysis

Technical analysis refers to study of market prices and volumes in order to predict future
prices. The term 'Technical analysis' is used to mean fairly wide range of techniques, all based on
the concept that past information on market prices and trading volume gives a picture of what
lies ahead. Technical analysts believe that movement in share price is the result of demand and
supply for a particular share. Technical analysis attempts to explain and forecast changes in
security prices by studying only the market data rather that information about a company or its
prospects as is done by fundamental analyst. The technician attempts to correctly catch changes
in trend and take advantage of them. Technician should remember to anticipate and not react.

Assumptions of Technical Analysis :

The price of security is related to the demand and the supply of that security.

The prices of security move in a particular direction for some length of time i.e. if there is an
uptrend it will continue for sometime barring certain minor fluctuations.

Charts are drawn to depict market price trends; such charts are useful for predicting trend.

Patterns which are projected by charts can be studied over a long period of time. The patterns
are used by analysts to make forecast about the movement of prices in future.

There are both rational and irrational factors which surround the supply and demand factor of
a security.

All information related to profitability, financial position, and industry trends affecting the
company is available to the market and they are discounted by market in determining market
price.

b) Fundamental Analysis

Fundamental Analysis is based on the assumption that price of a security is based on benefits
the holders of the security expect to receive in future.

The analysis is mainly used to determine 'intrinsic' value or true worth of the share. Investor
considers expected dividend and capital appreciation while purchasing the share.
Fundamentalists believe that every share has a particular 'intrinsic value'. Whereas, actual market
value of the share would differ depending on market conditions or fluctuations. An investor
should buy a share if it is available below its 'intrinsic value' and should sell a share if its market
value is more that intrinsic value.

To determine the 'intrinsic value' of share or its true worth investor has to forecast profits of
the company, likely dividends, likely appreciation in its share value.

Fundamental analysis includes :

(a) Economic Analysis

(b) Industry Analysis

(c) Company Analysis.

Economic analysis : A major factor having impact on fortunes of a company is overall economic
environment. This includes national income, inflation, agricultural and industrial output, the
monitory policy in terms of interest rates, money supply, various laws, taxation policy, and
international markets. Investor has to study trends in population, Research and Development,
Capital Formation, availability of natural resources, impact of national and international political
environment etc. These investors should give more importance to the probable direction of
movement for the overall economy.

Industry analysis : After studying overall economic environment, certain industry specific
factors should be given due importance. Investor should try to judge whether the industry is
growing or stagnating. Investment in growing industry like software, bio-technology is likely to
be very profitable. Investor usually study demand and supply for products, installed production
capacity, availability of raw materials, competition of cheap imports, possibility of getting export
market, Government Policy regarding that industry, Labour relations in the industry. Industry
analysis helps in deciding how much amount may be invested in a particular industry.

Company analysis : After considering economy and industry factors, finally investor has to
study a particular company. Company analysis involves judging inherent capabilities of the
company. Analyst has to study company performance, ratios, its market share, competitive
position, and human resources etc to evaluate the company. Time series and cross sectional
analysis may be used in company analysis.

c) Investment and Speculation

Both investment and speculation involve on element of risk. But an investor normally takes a
limited risk and expects to hold investment for a long term to earn stable return in form of
interest or dividends, while a speculator takes high risk and expects to make money out of price
fluctuations in the market.

d) Investment media

Various types of alternative investments available to an investor are referred to as Investment

Media. Each media has its own features to suit the varying needs of investors. An investor has to
choose investment media as per his individual need.

The types of investment media are :

Security form of investment : This form of investment is evidenced by a 'certificate' or a piece

of paper. Such investments can be easily transferred and have higher liquidity some examples are
: (a) Shares (b) Debentures/Bond (c) Unit Trust of India/Mutual Funds Units (d) Treasury Bills
(e) Government Securities. etc.

Non-security form of investments : This form of investments are not readily transferable and
are not represented by a 'certificate'/ document. Some examples are : (a) Deposit with Bank, (b)
Company Fixed Deposit, (c) Public Provident Fund (PPF), (d) Post Office Saving Bank Schemes
like monthly scheme, NSC. (e) Retirement Benefit Plan. (f) Purchase of land. (g) Life Insurance
Policies/ULIPs.

No one investment media can suit a particular investor. An investor has to choose a
combination of various alternatives in such a way that it suits his needs the most.

Different types of investment media has been discussed in detail in the latter chapter
'Investment alternatives'.

e) Industry Analysis.

After studying overall economic environment, certain industry specific factors should be
given due importance. Investor should try to judge whether the industry is growing or stagnating.
Investment in growing industry like software, bio-technology is likely to be very profitable.
Investor usually study demand and supply for products, installed production capacity, availability
of raw materials, competition of cheap imports, possibility of getting export market, Government
Policy regarding that industry, Labour relations in the industry. Industry analysis helps in
deciding how much amount may be invested in a particular industry.

f) Portfolio revision

Every investor has to review his investment regularly. The market conditions, securities
prices, interest rates all keep on changing. Investor has to revise his portfolio accordingly.
Investor's objectives may also change over a period of time. There is a famous saying in
investment analysis i.e. 'never marry an investment'. Portfolio revision involves repetition of all
earlier steps.

g) Portfolio Performance Evaluation

An investor shoud evaluate the performance of his investments. Performance evaluation

should be done periodically and objectively. Performance evaluation provides meaningful inputs
for improving the quality of investment management. Investor would like to know how far his
objectives were achieved by selecting a particular investment.

h) Portfolio Management Objectives

The major objectives of portfolio management are :

Maximising returns : Portfolio should be such that the returns are improved as compared to
individual securities in it. Every portfolio manager aims to generate maximum profit/returns on
his portfolio. Returns can be in the form of current income or capital gains.

Minimising portfolio risk : Portfolio should be such that the overall risk involved in the
portfolio is minimised as compared to individual securities of the portfolio. This objective can
usually be achieved through scientific diversification of available funds in multiple securities
rather than investing money only in single or very few securities.

Liquidity : Portfolio manger should keep certain proportion of the total funds available in such
securities that are easily convertible into cash. This will help him to acquire new and profitable
securities at the right time and in turn increase overall returns of the portfolio or reduce the total
risk involved or to achieve both the targets of improving returns and reducing risk. Liquidity also
helps the investor to get cash easily in case of urgent need for the same.

Tax benefits : Portfolio managers should consider tax benefits which can be availed, for e.g.
investment in shares of Indian companies will yield dividends that are tax free in the hands of
investor, even the capital gains on such shares will be exempt from tax if they are sold after a
specified time period, as against this dividends on debentures is taxable in the hands of investor,
but there are some other securities like NSC, PPF which provide interest income that is exempt
from income tax in the hands of investor.

Other objectives : Investors may demand some special features for e.g. an old couple may have
high priority monthly/regular income in form of retirement benefit to take care of there day to
day living needs. As against this a young couple earning high salaries may look for capital gains
from there portfolio instead of regular income, this is because they may want to utilise all or
major part of the portfolio in one go for there child's higher education after certain years.

i) Markowitz Approach to Portfolio Management

During 1950's Harry Markowitz first developed certain theories that formed basis for modern
portfolio management. The approach uses statistical techniques to develop a portfolio to
maximise returns with minimum risk. This approach considers expected return and risk on each
individual security. For a given level of risk, a security giving highest return is selected.
Alternately, amongst securities giving same return, security with lowest risk is chosen. The
approach helps us in building optimum portfolio using scientific method.
j) Interior Decorating Approach to Portfolio Management.

As the name suggests, in this approach the portfolio is constructed to suit the needs of individual
investor. Based on investor's needs and objectives like need for safety, monthly income
retirement benefit the investment avenues are chosen to suit the same.

In other words this approach develops a portfolio that is tailor-made considering objectives
and requirements of each investor.