Chapt Er: Nature and Scope of Investment Decisions

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SECURITY ANALYSIS AND PORTFOLIO MANAGEMENT Sudhindra Bhat
Copyright 2008, Sudhindra Bhat
Part I : The Investment Environment
Nature and Scope of Investment Decisions
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Chapt
er
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Nature and Scope
of Investment
Decisions
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Definition of Investment
Investment involves making of a sacrifice in the present with the hope of
deriving future benefits. Investment has many meanings and facets. The
two most important features of an investment are current sacrifice and
future benefit.
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We invest in order to improve our future welfare. Funds to be invested come
from assets already owned, borrowed money, and savings or foregone
consumption. By foregoing consumption today and investing the savings, we
expect to enhance our future consumption possibilities. Anticipated future
consumption may be by other family members, such as education funds for
children or by ourselves, possibly in retirement when we are less able to work
and produce for our daily needs. Regardless of why we invest, we should all
seek to manage our wealth effectively, obtaining the most from it. This includes
protecting our assets from inflation, taxes and other factors.
Why Invest?
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Investment decisions are premised on an important assumption that
investors are rational and hence prefer uncertainty. They are risk averse
which implies that they would be unwilling to take risk just for the sake of
risk. They would assume risk only if an adequate compensation is
forthcoming. And the dictum of rationality combined with the attitude of risk
aversion imparts to investment their basic nature. The question to be
answered is: how best to enlarge returns with a given level of risk? Or how
best to reduce risk for a given level of return? Obviously, there would be
several different levels of risk and different associated expectations of
return. The basic investment decision would be a trade-off between risk and
return.
Nature of Investment Decisions
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The Investment Process
A typical investment decision undergoes a five step procedure which, in
turn, forms the basis of the investment process. These steps are:
1. Determine the investment objectives and policy.
2. Undertake security analysis.
3. Construct a portfolio.
4. Review the portfolio.
5. Evaluate the performance of the portfolio.
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Investment Objectives and Policy
The investor will have to work out his objectives first and then evolve a policy
with the amount of investible wealth at his command. Hence, the objectives of
an investor must be defined in terms of risk and return.
The next step in formulating the investment policy of an investor would be the
identification of categories of financial assets he/she would be interested in.
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Security Analysis
This step would consist of examining the risk-return characteristics of
individual securities or groups of securities identified under step one. The
aim here is to know if it is worthwhile to acquire these securities for the
portfolio. And there are two broad approaches to finding out the mispriced
status of individual securities. One approach is known as technical
analysis. The second approach is known as fundamental approach.
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Portfolio Construction
This consists of identifying the specific securities in which to invest and
determining the proportion of the investors wealth to be invested in each.
Portfolio construction address itself to three major problems via., selectivity,
timing, and diversification. The related questions would be: which specific
shares/debentures to buy, when to buy, and how best to combine then in a
way that risk is reduced to a minimum for a given level of expected return.
Cont.
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Portfolio Revision
As time passes, the investor would discover that securities that once were very
attractive have ceased to be so. Also, new securities with promises of high
returns and relatively low risk have emerged. In view of such developments it
would be necessary for him to review the portfolio. He would liquidate the
unattractive securities and acquire the new stars from the market. In a way, he
repeats the first three steps of the investment process.
Portfolio Performance Evaluation
A rational investor would constantly examine his chosen portfolio both for
average return and risk. Measures, for doing so, must be developed. Also,
the calculated risk-return positions must be compared with certain yardsticks
or norms. This step in the investment process, thus, acquires considerable
significance since the tasks involved are quantitative measurement of actual
risk and return their evaluation against objective norms.
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The Investment Environment
Investment decisions to buy/sell securities taken by individuals and
institutions are carried through a set of rules and regulations. There are
markets money and capital which function subject to such rules and
established procedures and are, in turn, regulated by legally constituted
authority. Then there are securities or financial instruments, which are the
objects of purchase and sale. Finally, the mechanism which expedites
transfers from one owner to another comprises of a host of intermediaries.
All these elements comprise the investment environment. Investors have to
be fully aware of this environment for making optimal investment decisions.
The three elements of the investment environment viz., instruments,
institutions and markets
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Financial Intermediaries
Financial intermediaries perform the intermediation function i.e., they bring
the users of funds and the suppliers of funds together. Many of them issue
financial claims against themselves and use cash proceeds to purchase the
financial assets of others.
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Investment versus speculation
Basis Investment Speculation
Type of contract Creditor Ownership
Basis of acquisition Usually by outright purchase Often-on-margin
Psychological attitude of participants Cautious and conservative Daring and careless
Reasons for purchase Scientific analysis of intrinsic worth Hunches, tips inside dope", etc.
Quantity of risk Small Large
Stability of income Very stable Uncertain and erratic
Length of commitment Comparatively long-term For a short time only
Source of income Earnings of enterprise Change in market price
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Investment versus Gambling speculation
Speculation typically lasts longer than gambles but are briefer than
investments. A speculation usually involves the purchase of a salable asset in
hopes of making a quick profit from an increase in the price of the asset which
is expected to occur within a few weeks or months. Those involved in
speculations are reluctant to refer to this activity as speculation because they
dislike the connotations of the word; they prefer to refer to speculations as
investment activities.
A gamble is usually a very short-term investment in a game of chance. The
holding period for most gambles can be measured in seconds. That is, the
result of so-called investments is quickly resolved by the roll of the dice or the
turn of a card. Such activities have planning horizons that are far too brief to
do the research that should precede any investment activity.
Cont.
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Speculation is not the same as gambling and the two should never be
confused. The difference between speculation and gambling is that in
gambling, artificial and unnecessary risks are created whereas in speculation
the risks already exist and the question is simple who shall bear them?
Gambling is a far cry from the carefully planned research and scientific
procedure which underlies the best speculative practice. The gambler plays
rumours, tips, hunches and other unreliable intuitions which should not play
any but a negative role in the trained speculators process. Speculation is a
reasoned anticipation of future conditions. It does not rely upon hearsay or
labels. It attempts to organise the relevant knowledge as a support for
judgements. It is as legitimate and moral as any other form of risk-taking
business activity.
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Investment Attributes/Factors influencing selection of
investment
For evaluation of investment avenue, the following attributes are relevant:
1. Returns
2. Capital Appreciation
Conservation

Form of return
Aggressive growth
Speculation
Periodic cash receipts
Capital gain
3. Safety and security of funds
Risk
Liquidity
Tax considerations
Conveyance
Concealability
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Investment Alternatives
Equity
Preference shares
Debentures
Bonds or fixed income securities
Government securities
Savings bonds
Private sector debentures
PSU bonds
Preference shares
Money market instruments
Treasury bills
Certificates of deposits
Commercial paper
Repos
Cont.
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Non-marketable financial assets
Bank deposits
Post office time deposits (POTD)
Monthly income scheme of the post office (MISPO)
Kisan Vikas Patra (KVP)
National savings certificate
Company deposits
Employees provident fund scheme
Public provident fund scheme
Cont.
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Real estate
Residential House
Sources of Housing Finance
Features of Housing Loans
Guidelines for Buying a Flat
Commercial Property
Agricultural Land
Suburban Land
Time Share in a Holiday Resort
Cont.
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Precious objects
Gold and Silver
Precious Stones
Art Objects
Insurance policies
Endowment Assurance
Money Back Plan
Whole Life Assurance
Unit Linked Plan
Term Assurance
Immediate Annuity
Deferred Annuity
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Investments and Innovation
Technology
Advancements in computing power and Internet technology
More complete and timely information delivery
Globalization
Domestic firms compete in global markets
Performance in regions depends on other regions
Causes additional elements of risk
Globalization continues and offers more opportunities
Securitization continues to develop
Derivatives and exotics continue to develop
Strong fundamental foundation is critical
Integration of investments and corporate finance
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According to Dr Jeff of the University of Melbourne, identifies three broad
types of investors found operating in the stock market
The contrarians
Trend followers and
Hedgers and holders.
Types of Investor
Other Type according to Researcher
Measured Investor
Reluctant Investor
Competitive Investor
Unprepared Investor

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