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MF0010-Unit-01-Investment A Conceptual Framework Unit-01-Investment A Conceptual Framework


1.1 Introduction


1.2 Real Asset Vs Financial Asset

1.3 Meaning of:




Security Analysis

Portfolio Management

1.4 Modes of Investment

Security form of Investment

Non-Security form of investment

1.5 Characteristics of Investment

1.6 Investment & Speculation

Investment & Gambling

1.7 Investment process

1.8 Common Errors in Investment Management

1.9 Qualities of a Smart Investor

1.10 Summary

1.11 Terminal Questions

1.12 Answers

1.1 Introduction

Investment is a process of sacrificing something now for the prospects of gaining something in the future. Investment means conversion of cash or money into a monetary asset or a claim on future money for a return.

This subject deals with various investment avenues that are available in the financial environment, how to evaluate a security, how fundamental and technical analysis of the security is made, efficient market hypothesis, mutual fund operations and the behavioral aspects of an investor

In this unit, you will learn about with the meaning of various terminologies, modes of investments, characteristics of investments, the difference between investment and speculation and between investment and gambling. You will learn the steps involved in the investment process, common errors in investment management and qualities that are essential for successful investment.


After going through this unit, you should be able to:

Explain the meaning of real asset and financial Asset

Define investment, security, security analysis and portfolio management

Explain different modes of investment

Explain various characteristics of investment

Differentiate between investment and speculation and between investment and gambling

List the investment process

Analyze common errors in Investment Management

Identify the qualities of a Smart Investor

1.2 Real Asset and Financial Assets

The material wealth of a society is determined by the productive capacity of its economy. The productive capacity is the function of the real assets of the economy which could be in the form of land, building, knowledge and machines that are used to produce goods and services.

On the other hand, a financial asset which represents various financial instruments such as shares, bonds, debentures instrument per se do not represent a societys wealth. They do not directly contribute to the productive capacity of the economy but indirectly facilitate in the wealth creation.

Financial assets facilities transfer of funds from millions of individual investors to funds starved enterprise. The value of the financial asset derives from and depends on the value of the underlying real asset of the firm.

1.2.1 Difference between Real Asset and Financial Asset Real Asset

Financial Asset

Appear only on the asset side of the balance sheet

Always appears on both assets side and liabilities of the balance sheet

It is destroyed only by accident or by wearing out overtime.

It is created and destroyed in the ordinary course of business

Self Assessment Questions:

1. ________ do not directly contribute to the productive capacity of the economy.

2. The value of the financial asset derives from and depends on the value of the __________________of the firm.

3. State true or false: Real asset is created and destroyed in the ordinary course of business.

1.3 Meaning of Investment:

Investing is committing your funds to one or more assets that will be held over some future time period. When you invest your money in a fixed deposit, stock or mutual fund you do so, because you think its value will appreciate over a period of time.

The funds that you invest come from savings or from borrowing money or by liquidating assets already owned by you. By foregoing consumption today and investing the savings, we expect to enhance our future consumption possibilities.

An investment is a sacrifice of current money or other resources for future benefit. It denotes conversion of cash or money into a monetary asset or claim on future money for a return. The two key factors that determine

investment decisions are return and risk which are dealt in subsequent units


Securities are financial assets in various categories with different characteristic. Securities take the form of shares, bonds, debenture, money market instruments, derivatives etc.

Securities Contract Regulation Act has defined the security as Inclusive of shares, scripts, stocks, bonds, debenture stock or any other marketable instruments of a like nature in or any other debenture of a company or body corporate, the government and semi-government body etc. It includes all rights and interest in them including warrants and loyalty coupons.


Portfolio is the combination of assets held by the investors. These combinations may be of various asset classes like equity, debt corporate debentures, warrants, money market instruments etc.

A Portfolio is a combination of financial securities or other assets with different risk-return characteristics. A portfolio is built out of the wealth or income of an investor over a period of time with a view to suit his risk and return preference.

Portfolio analysis is an analysis of the risk return characteristics of individual securities or assets in the portfolio, changes that may take place in combination with other securities due to interaction among themselves and the impact of each one of them on others.

Security Analysis:

Security analysis involves the projection of future earnings, forecast of the share price in the future and estimating the intrinsic value of a security. Intrinsic value is derived by forecasting the future cash flows of the security both annual cash flows (dividends/interest) and terminal value (redemption value) of the security.

Security analysis is based on fundamental analysis of a security like understanding the strength and weaknesses of the firm, gathering information on promoters track record, financial performance and also on risk return analysis.

Portfolio Management:

The traditional portfolio theory aims at the selection of such securities that would match with the asset preferences, needs and choices of the investor.

Modern Portfolio theory focuses on maximization of return or minimization of risk which would result in optimum returns. The return on the portfolio is the weighted average of return of individual stocks and the weights are proportioned to each stocks percentage in the total portfolio. The risk taking ability of the investor are only initial factors for investment decision and that continuous risk return analysis is the basis for optimization of returns.

Portfolio analysis includes portfolio construction, selection of securities, revision, evaluation and monitoring of the performance of the portfolio on a regular basis.

Self Assessment Questions

4. The factors that determine investment decisions are _______ and __________.

5. The return on the portfolio is the ____________________ of return of individual


6. __________ are combination of assets held by the investors.

7. A Portfolio is a combination of financial securities with different __________________.

1.4 Modes of Investment

There are different types of securities conferring different sets of rights on the investors and different conditions under which these rights can be exercised. The various avenues for investment ranging from riskless to high risk investment opportunities consist of both security and non-security form of investment. As an investor you have a wide variety of investment alternatives available to choose

Marketable / Security form of investments:

The term Security is generally used for those documents evidencing liabilities of the issuer. When you buy a financial instrument say fixed deposit from a bank, you are issued a document called Fixed Deposit Receipt or Certificate. This receipt is a liability to the bank as the bank has to safe guard the investment; provide interest for using the funds and to return back the invested amount on maturity. This document also outlines the rights of the investor and sets conditions under which the investor can exercise his or her rights.

Security forms of investment are those instruments which are transferable and traded in any organized financial market.

Equity Shares:

Equity shares represent ownership capital. An equity shareholder enjoys both ownership stake and residual interest in income & wealth. The issue of equity shares could be in the form of initial public offer, rights issue, bonus issue, preferential allotment and private placement.

Investors has a choice to select equity shares which are broadly differentiated as blue chip shares, growth shares, income shares, cyclical shares and speculative

Bonds/Debentures: Bonds represent long-term debt instruments. The issuer of a bond promises to pay a stipulated payment (interest and principal) to the bond holder. Bond indenture is a contract between the issuer and the bond holder, which specifies the detail of the issue such as par value of the bond, its coupon rate, maturity period, maturity date, call/put options etc.

Internationally, a secured corporate debt instrument is called a corporate bond while an unsecured corporate debt instrument is called a corporate debenture. In India, corporate debt instrument is referred as debentures although they are secured.

Government bonds are issued by Central and State Governments. These bonds are called gilt edged securities. There are different types of bond Straight bonds, Zero coupon bonds, Floating rate bonds, bonds with embedded options, commodity linked bonds etc. These are dealt in detail in the later units.

Money Market Instruments: Debt instruments which have a maturity of less than one year at the time of issue are called M.M Instruments. The important money market instruments are:

a) Treasury Bills

b) Commercial paper

c) Certificate of deposits

d) Repurchase Agreements Repos & Reverse Repos

Mutual Funds: Mutual funds are also known as indirect investments. It is an alternative route of buying equity shares or fixed income securities through various schemes floated by mutual funds companies. There are three broad types of mutual fund schemes.

1) Equity schemes

2) Debt schemes

3) Balance schemes

Non Security form of financial Investment:

Non security form of investments are neither transferable nor traded in any organized financial market

Life Insurance Policies: Life insurance may be viewed as an investment which suffices the protection and savings needs of an investor. Policies that provide protection benefits are designed to protect the policy holders from the financial consequences of unwelcome events such as death/long term sickness/accidents/disability etc.

Policies that are designed as savings contracts allow the policyholders to build up funds to meet specific investment objectives such as income for a particular event, retirement planning or repayment of a loan.

The important types of insurance policies in India are Endowment assurance policy, Money back policy, Term assurance policy, Unit linked Plan, Deferred Annuity and Whole life policy.

Bank Deposits:

Bank deposits are the simplest and most common form of investment. There are various kinds of deposit accounts: current account, savings account and fixed deposit account. The deposit made in current account does not earn any interest while deposit made in savings account and fixed deposit accounts earn interest. The interest rate depends upon the tenure. Bank deposit enjoys high liquidity due to premature withdrawals. Also loans can be raised on the fixed deposit certificates.

Deposit Insurance Corporation provides guarantee to all deposits in schedule bank up to Rs.100000 per depositor of a bank.

Post office Accounts

There are various types of accounts namely post office savings account, post office time deposit account, Monthly income schemes, Kisan Vikas Patra, National Savings Certificates. Some are pure savings schemes, while others are tax savings schemes.

Corporate Fixed Deposits

Certain large and small corporates raise funds through fixed deposits form

the public. While fixed deposits mobilized by manufacturing companies are regulated by Company Law board and fixed deposit mobilized by finance companies are regulated by Reserve bank of India. A manufacturing firm can mobilize up to 25 percent of its net worth in the form of fixed deposit from public and an additional 10 percent of its net worth from its shareholders. The interest rates on company deposits are higher than those on bank fixed deposits.

Employee Provident Fund Scheme

Employee Provident Fund is an important component of savings for a salaried person. Each employee has a separate provident fund account in which both the employer and employee are required to contribute a certain sum of money on a monthly basis. While the contribution made by the employer is fully tax exempt, the contributions made by the employee is eligible for tax deductions under Sec 80C. The provident fund contribution earns compound interest rate that is totally exempt from taxes. The balance in provident fund account is fully exempt from wealth tax and it is not subject to attachment under any order or decree of a court.

Public Provident Fund Scheme

This scheme of post office is the most attractive investment option. Individuals and HUFs can invest in this scheme. The investment period is 15 years and the minimum deposit is Rs100 per year and the maximum permissible deposit per year is Rs.70000. Deposits in a PPF account is eligible for tax concession under Sec 80C.The deposit earns a compounded interest rate of 8 percent per annum which is totally exempt from tax.

Self Assessment Questions:

8. __________ represent long-term debt instruments.

9. Fixed deposits mobilized by manufacturing companies are regulated by ___________

10. The investment period of PPF scheme is ________.

1.5 Characteristics of Investment:

While choosing specific investment, the investors will need to know the features of investment. These features should be consistent with the investors general objectives. Most prominent features are:

1. Rate of Return When we invest, we defer current consumption in order to add to our wealth so that we consume more in the future. Return on investment is the change in the wealth resulting from this investment. This change in wealth can be either due to cash inflow (annual income in the form of dividends/interest) or caused by a change in the price of the asset (capital appreciation/depreciation)

2. Risk: Risk is the likelihood that your investment will either earn money or lose money. It is the degree of uncertainty about your expected return from an investment, including the possibility that some or all of your investment may be lost. No investment, whether domestic or international, is risk-free. That is a fact you should not ignore. Even money lying securely in a savings account is at risk from inflation.

3. Marketability: Marketability of an investment is measured on various parameters such as:

a. How quickly the instrument can be transacted ie., can be bought or sold.

b. The transaction cost of buying and selling an instrument is maintained low

c. The price change between two successive transactions is negligible.

4. Tax Shelter: Tax planning is essential for those investors who are in high tax bracket. Tax benefits are of three forms Initial tax benefit, continuing tax benefit and terminal tax benefit.

a) An initial tax benefit refers to the tax relief enjoyed at the time of making the investment.

b) Continuing tax benefit refers to the tax shield is associated with period returns from the investment,

c) Terminal tax benefit refers to relief from taxation when an investment is realized on maturity or when it is sold.

5. Convenience: It refers to the ease with which the investment can be bought or sold in the market. Blue chip stocks can be bought and sold very quickly due to high liquidity while Z category stocks cannot be transacted quickly thereby causing anxiety to the investors.

Self Assessment Questions:

11. How quickly the instrument can be transacted relates to ___________ feature of investment.

12. ___________ refers to relief from taxation when an investment is realized on maturity or when it is sold.

13. ______ is the likelihood that your investment will either earn money or lose money.

1.6 Investment and Speculation

Benjamin Graham in his book Security Analysis, makes a distinction between speculation and investing An investment operation is one which, upon thorough analysis, promises safety of principle and an adequate return. Operations not meeting these requirements are speculative.

Speculation occurs when an asset is purchased with the hope that price will rise rapidly, leading to quick profit. In speculation, significant risks are taken for obtaining quick gains. Example of speculation: Buying an IPO of a stock on the first day, hoping to sell it at a higher price within a short span of time.

Speculation should not be considered as a form of gambling. Speculation, unlike gambling, is not based on random outcomes. Gambling is taking risk for no purpose other than the enjoyment of the risk itself. Speculation is undertaken despite the risk because there is a favorable risk-return tradeoff. Speculators make informed decisions before choosing to acquire the additional risks. However, speculation cannot be categorized as a traditional investment, because the acquired risk is higher than average.

Investment and Gambling

Both investing and gambling require money and both require you to calculate the odds on a given bet and you are taking risk. But that is where the similarities end. The risks of investments can be managed so that the odds are in your favor, and youre betting on the continued growth and success of the economy. If you stay at the gambling table long enough in a casino, you are sure to lose money. However, if you stay invested long enough in the stock market, you would take away profits in the long run.

Investing is not gambling. Gambling is putting money at risk by betting on an uncertain outcome, with the hope that you might win money. The outcome is not based on an economic endeavor, but, rather, random outcomes. Gambling creates risk without expectation of economic benefit.

Self Assessment Questions I

14. __________ occurs when an asset is purchased with the hope that price will rise rapidly, leading to quick profit.

15. ____________ is putting money at risk by betting on an uncertain outcome, with the hope that you might win money

1.7 The Investment Process

It is rare to find investors investing their entire savings in a single security. Instead, they tend to invest in a group of securities. Such a group of securities is called a portfolio. Most financial experts stress that in order to minimize risk; an investor should hold a well-balanced investment portfolio. The investment process describes how an investor must go about making decisions with regard to what securities to invest in while constructing a portfolio, how extensive the investment should be, and when the investment should be made. This is a procedure involving the following five steps:

1. Setting Investment Policy

This initial step determines the investors objectives and the amount of his investable wealth. Since there is a positive relationship between risk and return, the investment objectives should be stated in terms of both risk and return.

This step concludes with the asset allocation decision: identification of the

potential categories of financial assets for consideration in the portfolio that the investor is going to construct. Asset allocation involves dividing an investment portfolio among different asset categories, such as stocks, bonds and cash.

The asset allocation that works best for an investor at any given point in his life depends largely on his time horizon and his ability to tolerate risk.

Time Horizon The time horizon is the expected number of months, years, or decades that an investor will be investing his money to achieve a particular financial goal. An investor with a longer time horizon may feel more comfortable with a riskier or more volatile investment because he can ride out the slow economic cycles and the inevitable ups and downs of the markets. By contrast, an investor who is saving for his teen-aged daughters college education would be less likely to take a large risk because he has a shorter time horizon.

Risk Tolerance Risk tolerance is an investors ability and willingness to lose some or all of his original investment in exchange for greater potential returns. An aggressive investor, or one with a high-risk tolerance, is more likely to risk losing money in order to get better results. A conservative investor, or one with a low-risk tolerance, tends to favour investments that will preserve his or her original investment. The conservative investors keep a "bird in the hand," while aggressive investors seek "two in the bush."

While setting the investment policy, the investor also selects the portfolio management style (active vs. passive management).

Active Management is the process of managing investment portfolios by attempting to time the market and/or select undervalued stocks to buy and overvalued stocks to sell, based upon research, investigation and analysis.

Passive Management is the process of managing investment portfolios by trying to match the performance of an index (such as a stock market index) or asset class of securities as closely as possible, by holding all or a representative sample of the securities in the index or asset class. This

portfolio management style does not use market timing or stock selection strategies.

2. Performing Security Analysis

This step is the security selection decision: Within each asset type, identified in the asset allocation decision, how does an investor select which securities to purchase. Security analysis involves examining a number of individual securities within the broad categories of financial assets identified in the previous step. One purpose of this exercise is to identify those securities that currently appear to be mispriced. Security analysis is done either using Fundamental or Technical analysis (both have been discussed in subsequent units).

Fundamental analysis is a method used to evaluate the worth of a security by studying the financial data of the issuer. It scrutinizes the issuers income and expenses, assets and liabilities, management, and position in its industry. In other words, it focuses on the basics of the business.

Technical analysis is a method used to evaluate the worth of a security by studying market statistics. Unlike fundamental analysis, technical analysis disregards an issuers financial statements. Instead, it relies upon market trends to ascertain investor sentiment to predict how a security will perform.

3. Portfolio Construction

This step identifies those specific assets in which to invest, as well as determining the proportion of the investors wealth to put into each one. Here selectivity, timing and diversification issues are addressed. Selectivity refers to security analysis and focuses on price movements of individual securities. Timing involves forecasting of price movement of stocks relative to price movements of fixed income securities (such as bonds). Diversification aims at constructing a portfolio in such a way that the investors risk is minimized.

The following table summarizes how the portfolio is constructed for an active and a passive investor.

Asset Allocation

Security Selection

Active investor

Market timing

Stock picking

Passive investor

Maintain pre-determined selections

Try to track a well-known market index like Nifty, Sensex

4. Portfolio Revision

This step is the repetition of the three previous steps, as objectives might change and previously held portfolio might not be the optimal one.

5. Portfolio performance evaluation

This step involves determining periodically how the portfolio has performed

over some time period (returns earned vs. risks incurred).

Self Assessment Questions

16. _________________ is a method used to evaluate the worth of a security by studying the financial data of the issuer.

17. _____________ refers to security analysis and focuses on price movements of individual securities

18. _____________________step involves determining periodically how the portfolio has performed over some time period (returns earned vs. risks incurred).

1.8 Common Errors in Investment Management

When investment mistakes happen, money is lost. Mistakes can occur for a variety of reasons, but they generally happen because of the clouding of the investors judgment by the influence of emotions, due to the misunderstanding of basic investment principles, or due to misconceptions about how securities react to varying economic, political, and fear-driven circumstances. The investor should always keep a calm, cool and rational head, and avoid these common investment mistakes:

Not having a clearly-defined investment plan. A well-thought out investment plan does not need frequent adjustments, and there is no place in a wellmanaged plan for speculations and hot picks. Investment decisions should be made with an investment plan in mind. Investing is a goal-oriented activity that should include considerations of time, risk-tolerance, and future income.

Investors become bored with their plan or the rate of growth too quickly, change direction frequently, and make drastic rather than measured adjustments. Investing should always be regarded as a long-term activity and the investor should have this in mind before adjusting his portfolio.

Investors tend to fall in love with securities that rise in price and forget to book their profits. Profits that are not realized are just book profits; they may disappear when the market goes down, While one should not be in a hurry to realize his profits, it is also true that he must not become so blinded by the beauty of unrealized gain that he forgets the basics of prudent investing. The investor may have the unwilling-to-pay-the-taxes problem little realizing that the investment may ultimately end up as a realized loss on the tax return.

Investors often overdose themselves on information, leading to "paralysis by analysis". Such investors are likely to become confused and indecisive. Neither of these is good news for the health of an investment portfolio. Aggravating this problem for the investor is his inability to distinguish between genuine research and sales pitch of the sale side analyst. A narrow focus on information which has a bearing on the investment is a much more productive means of fact-finding.

Investors are constantly in search of a shortcut or gimmick that will provide them instant success with a minimum of effort; i.e. the get-rich-quick pick syndrome. Consequently, they buy every new product or service that comes along and catches their fancy. Their portfolios become a mixture of Mutual Funds, Index Funds, Hedge Funds, Commodities, Options, etc. that does not fit their investment plan.

1.9 Qualities of a Smart Investor

Smart investors have a plan for investing, and they stick to it: It is very easy to be tempted by a tip about a hot stock that is reported in all the financial papers. But this is not the way that smart investors make money. They look

at their goals, time frame and knowledge of the markets to chart a plan that suits their needs. For example, if they are 40 years old and have twenty years until retirement, they implement a 20-year investment plan. They gather as much information as they can and then invest in assets that are appropriate for their plans, that they know about and that they are comfortable with. If they dont understand a particular type of security, they will not buy it. They only buy securities that they have researched or that someone they trust has recommended. They stay with their investment plan.

Smart investors invest consistently: To succeed year after year, they know that they must keep their money constantly growing. They generally use two methods to do this. First, they invest a part of their funds in securities with a growth potential (like stock and mutual funds). Second, they keep adding to their investment principal regularly.

Smart investors are patient: It often takes time for a good investment to show results. Smart investors understand this, and therefore do not get excited about the daily ups and downs of the market. They understand that success is a long-term affair and therefore patience is required. They dont jump in and out of investments in an effort to time the market. They dont expect instant growth; they are not disappointed by temporary setbacks in the market.

Smart investors are not emotionally tied to their investment positions: They know that to be successful, they must not be emotional towards their investment. No matter how attractive an investment looks, or how badly an investment has performed recently, selling at the right time is just as important as buying. If an investment has consistently lost money, they dont try to wait to recoup their losses. They know that it is necessary to cut losses and move ahead. Similarly, if an investment has appreciated phenomenally, successful investors know how to protect their gains. They are aware that no investment will move up forever, and they are able to sell it when the time is right.

1.10 Summary

Investing is committing ones funds to one or more assets that will be held

over some future time period.

An investment operation is one which, upon thorough analysis, promises safety of principle and an adequate return. Operations not meeting these requirements are speculative.

Investment differs from gambling and speculation.

Investment involves risks. In order to minimize risk, an investor should hold a well-balanced investment portfolio.

The investment procedure involves the following five steps:

- Set investment policy

- Perform security analysis

- Construct a portfolio

- Revise the portfolio

- Evaluate the performance of portfolio

Smart investors have a plan for investing and they stick to it. They invest consistently and wait patiently for gains. They are not emotionally tied to their investment positions.

1.11 Terminal Questions

1. Explain the meaning of investment, security, security analysis and portfolio management.

2. Explain the modes of investment

3. Explain the characteristics of investment

4. Differentiate between investment and speculation and between investment and gambling

5. Describe the investment process

6. What are the common mistakes made in investment management?

7. Explain the qualities of a smart investor.

1.12 Answers to SAQs and TQs


1. Financial assets

2. Underlying real asset

3. False

4. Risk and return

5. Weighted average

6. Portfolio

7. Risk return characteristics

8. Bonds

9. Company Law Board

10. 15 years

11. Marketability

12. Terminal tax benefit

13. Risk

14. Speculation

15. Gambling

16. Fundamental analysis

17. Selectivity

18. Portfolio Performance Evaluation

Answers to TQs:

1. Refer Unit 1.3

2. Refer Unit 1.4

3. Refer Unit 1.5

4. Refer Unit 1.6

5. Refer Unit 1.7

6. Refer Unit 1.8

7. Refer Unit 1.9

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