Investment Analysis & Portfolio Management

UNIT ONE
AN OVERVIEW OF INVESTMENT
What is an investment?
In finance, an investment is a monetary asset purchased with the idea that the asset will provide
income in the future or appreciate and be sold at a higher price. In other word, an investment is the
commitment of money or capital to purchase financial instrument or other assets in order to gain
profitable return in form of interest, income, or appreciation of the value of the instrument. In
financial sense investment include the purchase of bonds, stocks, short-term financial assets or real
estate property. Beside to these, in economics discipline an investment is defined as the purchase of
goods that are not consumed today but used in the future to create wealth.

In general, an investment is the current commitment of money or other resources in the expectation of
obtaining future benefits. For example, an individual might purchase shares anticipating that the
future proceeds from the shares will justify both the time that his/her money is tied up as well as the
risk of the investment.
Investment vs. Speculation

There is often some confusion between the terms investment, speculation and gambling. This confusion is often
linked with investment made in the stock market.

John Maynard Keynes, described investment as “the activity of forecasting the prospective yield of assets over
their life time”. In contrast, speculation means “the activity of forecasting the psychology of the market”.
Speculation has come to mean different things to different people. However, its original meaning is to reflect or
speculate without a factual basis.

A speculator can be defined as someone that seeks to buy and sell in order to take advantage of market price
fluctuations. An investor is someone who holds on the securities that provide a good income or capital gain by
virtue of them being based on something of real and increasing value.

The most realistic distinction between the investor and the speculator is found in their attitude toward market
movements. The speculator's primary interest lies in anticipating and profiting from market fluctuations . The
investor's primary interest lies in acquiring and holding suitable securities at suitable prices.

Investment vs. Gambling

Many beginner investors often confused about the differences between investing and gambling.
 Gambling is defined as, an act putting money at risk by betting on an uncertain outcome with the hope
that you might win money. In other word, gambling is an act of taking the risk of losing money in the
expectation of a desired result.
 Investing means committing money in order to earn a financial return.
The definitions seem to indicate a higher element of chance or randomness in gambling, while investing
appears to be more rational.

~1~
 Investment Analysis & Portfolio Management
It could be argued that buying a stock based on a “hot tip” is essentially the same as placing money on a casino
which is considered as gambling. “Hot-tip” investors throw their money at any random investment, but “real”
investor not throws his money at any random investment.

For Example: Assume that there are playing card games, like poker, that demand skill. However, you cannot
choose the cards dealt out to you. In investing, you can choose your investment. This is the fundamental
difference between investing vs. gambling

In general; what does "real" investing mean? The essence of true investing is buying into companies behind the
stock and not just the stock itself. This means that you carefully research the fundamentals of the company, buy
it at a good price, and hold it for a meaningful period (typically a few years, unless the reasons you bought the
stock in the first place are not valid anymore).

"Buy and hold", a doctrine recommended by the majority of investors, means you buy something with the
intention of holding it as long as possible. The analysis is done on the basis that the business being bought is to
be held for quite some time, and there is more of a focus on valuation and the business operations of the
company than the price action in the market.

Buying stocks based on "hot tips", trading frequently by following the fluctuation of the market, and holding on
to certain stocks based on pure sentiment (emotion) is not investing. It's speculation.

INVESTMENT OBJECTIVES

i) INCOME: Investors who seek investments primarily focused on the continued receipt of current income,
while recognizing and accepting market and issuer risks inherent in investments of this type. Investors in
the category are usually seeking income above the market average, but carry higher risks and can be more
volatile than the general market.

ii) GROWTH: Investors who seek investments primarily focused on achieving high capital appreciation with
little emphasis on the generation of current income. Investors using this approach expect to have higher-
than-average increases in revenues and returns and accept a higher risk.

iii) SPECULATION: This investment approach seeks maximum gain and accepts maximum risks. Investors who
seek investments focused on speculation seek the highest gains without regard to holding period and accept
the potential of the entire loss of their principal in return for the potential gain.

iv) GROWTH & INCOME: For investors who seek both higher returns from capital appreciation and some
current income by investing the portfolio primarily in growth equities which produce little or no current
income and in income producing investment of all grades, while recognizing and accepting the increased
risks associated with investment of this type. Investors accept some risk and greater volatility than the
“income” objective in this category.

Characteristic of Investment
The sophisticated nature of investing means that a lot goes into making an investment decision. Since there is
much at stake, an investor should consider the basic attributes of investments when deciding on a suitable
option.

~2~
 Investment Analysis & Portfolio Management
At least four investment attributes are integral to sound decisions in this sphere:

1) Safety 3) Liquidity

2) Rate of return 4) Duration

(1) Safety: - Although the degree of risk varies across investment types, all investments bear risk. Therefore, it is
important to determine how much risk is involved in a selected option. The average performance of an
investment normally provides a good indicator. However, past performance is merely a guide to future
performance – not a guarantee. Some instruments, like variable annuities, may have a safety net while
others expose the investor to comprehensive losses in the event of failure. Investors should also consider
whether they could manage the associated safety risk – financially and psychologically.

(2) Rate of return: - Investments generally provide higher rates of return compared to other asset classes, such
as cash and income options. The rate of return compensates for the level of risk involved. Therefore, higher
risks should necessarily bear higher rates of return to attract investors. It is important not to be preoccupied
with the rate of return without assessing its relation to safety.

(3) Liquidity: - This refers to how easily you can convert to cash or cash equivalents. In other words, a liquid
investment is tradable – there are sufficient buyers and sellers on the market when it is liquid. An example
of this is currency trading. When you trade currencies, there is always someone willing to buy when you
want to sell and vice versa. With other investments, like stock options, you may hold an illiquid asset at
various points in your horizon.

(4) Duration: - Investments typically have a longer horizon than cash and income options. Their duration,
particularly how long it may take to generate a healthy rate of return, is a vital consideration for an
investor. The investment horizon should match the period that your funds must be invested for or how long
it would take to generate a desired return.

A good investment has a good risk-return trade-off and provides a good return-duration trade-off as well.
Given that there are several risks that an investment faces, it is important to use these attributes to assess the
suitability of an option. A good investment is one that suits your investment objectives. To do that, it must have
a combination of attributes that satisfy you.

Investment Avenues

There are a large number of investment instruments available today. To make our lives easier we would classify
or group them under 4 main types of investment avenues. We shall name and briefly describe them.

1) Financial securities: These investment instruments are freely tradable and negotiable. These would include
equity shares, preference shares, convertible debentures, non-convertible debentures, public sector bonds,
savings certificates, gilt-edged securities and money market securities.

2) Non-securitized financial securities: These investment instruments are not tradable, transferable nor
negotiable. And would include bank deposits, company fixed deposits, provident fund schemes, national
savings schemes and life insurance.

~3~
 Investment Analysis & Portfolio Management
3) Mutual fund schemes: If an investor does not directly want to invest in the markets, he/she could buy
units/shares in a mutual fund scheme. These schemes are mainly growth (or equity) oriented, income (or
debt) oriented or balanced (i.e. both growth and debt) schemes.

4) Real assets: Real assets are physical investments, which would include real estate, gold & silver, precious
stones, rare coins & stamps and art objects.

Before choosing the avenue for investment the investor would probably want to evaluate and compare them.
This would also help him in creating a well diversified portfolio, which is both maintainable and manageable.

The investors have the following investment alternatives:

Indirect investing

Indirect investing is the buying and selling of the shares of investment companies which hold portfolios of
securities. Examples are: the assets of mutual funds which the most popular type of Investment Company.
Households also own a large, and growing, amount of pension fund reserves, and they are actively involved in
the allocation decisions of pension funds through plans and other self-directed retirement plans. Most of this
amount is being invested by pension funds, on behalf of households, in equity and fixed-income securities, the
primary securities of interest to most individual investors. Pension funds (both public and private) are the
largest single institutional owner of common stocks.

Direct Investing

The investment alternatives available through direct investing involves securities that investors not only buy
and sell themselves but also have direct control over. Investors, who invest directly in financial markets, either
using a broker or by other means, have a wide variety of assets from which to choose.

Non-marketable investment opportunities, such as savings accounts at saving institutions, are discussed briefly
since investors often own, or have owned these assets and are familiar with them. However, in this course we
concentrate on marketable securities. Marketable securities may be classified into one of three categories: the
money market, the capital market, and the derivatives market.

Investors should understand money market securities, particularly Treasury bills, but they typically will not
own these securities directly, choosing instead of own them through the money market funds. Within the
capital market, securities can be classified as either fixed - income or equity securities. Finally, investors may
choose to use derivative securities in their portfolios. The market value of these securities is derived from an
underlying security such as common stock.

~4~
 Investment Analysis & Portfolio Management
DIRECT INVESTING INDIRECT INVESTMENT

Markets Securities Investment companies Assets

Non marketable _ Savings deposits Mutual Funds _ Money market mutual funds
_ Nonnegotiable certificates of deposit
_ Stock, bond, and income funds
_ Savings bonds
Money market  Treasury bills Pension Funds Pension Funds Assets
 Negotiable certificates of deposit
 Commercial paper
 Equity securities
 Repurchase agreements  Fixed-income securities
 Banker’s acceptances
Capital market Fixed income
Government bonds
Municipals bonds
Corporate bonds
Equities (Stocks)
 Preferred stock
 Common stock
Derivatives market  Options contracts
 Future contracts

Financial Market

In economics, a financial market is a mechanism that allows people to buy and sell (trade) financial
securities (such as stocks and bonds), commodities (such as precious metals or agricultural goods), and
other fungible items of value at low transaction costs and at prices that reflect the efficient-market hypothesis.

Both general markets (where many commodities are traded) and specialized markets (where only one
commodity is traded) exist. Markets work by placing many interested buyers and sellers in one "place", thus
making it easier for them to find each other.

The term "market" is sometimes used for what are more strictly exchanges, organizations that facilitate the
trade in financial securities, e.g., a stock exchange, foreign exchange or commodity exchange. This may be a
physical location (like the NYSE) or an electronic system (like NASDAQ).

In finance, financial markets facilitate:

 The raising of capital (in the capital markets)
 The transfer of risk (in the derivatives markets)
 The transfer of liquidity (in the money markets)
 International trade (in the foreign exchange markets)
 And are used to match those who want capital to those who have it.

Types of Financial Markets

The financial markets can be divided into different sub-types:

 Capital markets which consist of:
 Stock markets, which provide financing through the issuance of shares or common stock, and
enable the subsequent trading thereof.

~5~
 Investment Analysis & Portfolio Management
 Bond markets, which provide financing through the issuance of bonds, and enable the
subsequent trading thereof.
 Money markets, which provide short term debt financing and investment.
 Commodity markets, which facilitate the trading of commodities.
 Derivatives markets, which provide instruments for the management of financial risk.
 Futures markets, which provide standardized forward contracts for trading products at some future
date.
 Insurance markets, which facilitate the redistribution of various risks.
 Foreign exchange markets, which facilitate the trading of foreign currencies.
 The capital markets consist of primary markets and secondary markets. Newly issued securities are
bought or sold in primary markets. Secondary markets allow investors to sell securities that they hold or
buy existing securities.
Functions of Financial Markets

Economic system relies heavily on financial resources and transactions, and economic efficiency rests in part on
efficient financial markets.

Financial markets consist of agents, brokers, institutions, and intermediaries transacting purchases and sales of
securities. The many persons and institutions operating in the financial markets are linked by contracts,
communications networks which form an externally visible financial structure, laws, and friendships. The
financial market is divided between investors and financial institutions.

The term financial institution is a broad phrase referring to organizations which act as agents, brokers, and
intermediaries in financial transactions. Agents and brokers contract on behalf of others; intermediaries sell for
their own account. Financial intermediaries purchase securities for their own account and sell their own
liabilities and common stock. For example, a stockbroker buys and sells stocks for us as our agent, but a savings
and loan borrows our money (savings account) and lends it to others (mortgage loan). The stockbroker is
classified as an agent and broker, and savings and loan is called a financial intermediary. Brokers and savings
and loans, like all financial institutions, buy and sell securities, but they are classified separately, because the
primary activity of brokers is buying and selling rather than buying and holding an investment portfolio.
Financial institutions are classified according to their primary activity, although they frequently engage in
overlapping activities.

Financial markets provide our specialized, interdependent economy with many financial services, including
time preference, distribution of risk, diversification of risk, transactions economy, transmutation of contractual
arrangements, and financial management.

Time Preference: - Time preference refers to the value of money spent now relative to money available for
spending in the future. Businesses are frequently making decisions among short-term and long-term uses of
funds, and business executives must judge between outlays which provide a return in the near term and those
which pay off many years from now. They must decide upon commitments requiring funds now and those

~6~
 Investment Analysis & Portfolio Management
requiring funds later, by allocating not only funds that they expect to receive currently, but also those that they
expect to receive in the future.

The money and capital markets price funds so that businesses and governments can make rational economic
allocations of capital. The price of capital is set in a competitive marketplace by supply and demand forces. The
market price of capital is compared by businesses to the expected returns in proposed capital expenditures.
Businesses allocate their capital to real investments whose return is at above the cost of capital. Long-term
investments are compared to short-term investments using the financial-market-determined cost of capital.
Consequently, the allocation of capital between short-and long-term investments depends on the free play of
supply and demand in an open market.

Like businesspersons, consumers may decide upon a time pattern for expenditures that does not necessarily
coincide with their current or expected income flows. Financial markets allow us to implement time
adjustments in the payments for goods. Without them, there would be no opportunity to earn interest on
savings, and expenditures would be limited to current receipts and cash. Savings allows many consumers to
postpone consumption and to receive returns from investments.

Risk Distribution: - The financial markets distribute economic risks. Employment and investment risks are
separated by the creation and distribution of financial securities. On a larger scale, the money and capital
markets transfer the massive risks from people actually performing the work (employment risks) to savers who
accept the risk of an uncertain return. The chance of failure for a 100 million € mobile phones manufacturer
may be divided among thousands of investors living and working all over the world. If the mobile phones
business fails, each investor loses only part of his or her wealth and may continue to receive income from other
investments and employment.

Diversification of risk: - In addition to permitting individuals to separate employment and investment risks, the
financial markets allow individuals to diversify among investments. Diversification means combining securities
with different attributes into a portfolio. Ordinarily, a diversified portfolio of financial claims is less risky than a
portfolio consisting of one or at most a handful of similar securities. Total risk is reduced because losses in some
investments are offset by gains in others. The benefits of diversification are possible due to the existence of
large, diversified financial markets where investors may buy and sell securities with minimum transactions
cost, regulatory interference, and so forth.

Approaches to investment Decision Making

The stock market is thronged by investors pursuing diverse investment strategies which may be subsumed
under four broad approaches.
(i) Fundamental approach
(ii) Psychological approach
(iii) Academic approach
(iv) Eclectic approach
Fundamental Approach: The basic tenets (principles) of the fundamental approach, which is perhaps most
commonly advocated by investment professionals, are as follows:

~7~
 Investment Analysis & Portfolio Management
(i) There is an intrinsic value of a security, which depends upon underlying economic (fundamental)
factors. The intrinsic value can be established by a penetrating analysis of the fundamental factors
relating to the company, industry, and economy.

(ii) At any given point of time, there are some securities for which the travailing market price will differ
from the intrinsic value. Sooner or later, of course, the market price will fall in line with the intrinsic
value.

(iii) Superior returns can be earned by buying undervalued securities (securities whose intrinsic value
exceeds the market price) and selling over valued securities (securities whose intrinsic value is less
than the market price).

Psychological Approach: The psychological approach is based on the premise that stock prices are guided by
emotion rather than reason. Stock prices are believed to be influenced by the psychological mood of investors.
When greed and euphoria sweep the market, prices rise to dizzy heights. On the other hand, when fear and
despair envelop the market prices fall to abysmally low levels.

A conventional valuation which is established as the outcome of the mass psychology of a large number of
ignorant individuals is liable to change violently as the result of a sudden fluctuation of opinion due to factors
which do not really make much difference to the prospective yield.

Since psychic values appear to be more important than intrinsic values, the psychological approach suggest that
it is more profitable to analyze how investors tend to behave as the market is swept by waves of optimism and
pessimism which seem to alternate. The psychological approach has been described vividly as the castles in the
air theory by some economists.

Those who subscribe to the psychological approach or the castles in the air theory generally use some form of
technical analysis which is concerned with a study of internal market data, with a view to developing trading
rules aimed at profit making. The basic premise of technical analysis is that there are certain persistent and
recurring patterns of price movements which can be discerned by analyzing market data. Technical analysts
use a variety of tools like bar chart, point and figure chart, moving average analysis breadth of market analysis
etc.

Academic Approach: Over the last five decades or so, the academic community has studied various aspects of
the capital market particularly in the advanced countries, with the help of fairly sophisticated methods of
investigation. While there are many unresolved issues and controversies stemming from studies pointing in
different directions, there appears to be substantial support for the following tenets.

(i) Stock markets are reasonably efficient in reacting quickly and rationally to the flow of information. Hence,
stock prices reflect intrinsic value fairly well. Put differently,

Market price = Intrinsic value

(ii) Stock price behavior corresponds to a random walk. This means that successive price changes are
independent. As a result, past price behavior cannot be used to predict future price behavior.

~8~
 Investment Analysis & Portfolio Management
(iii) In the capital market, there is a positive relationship between risk and return. More specifically the
expected return from a security is linearly related to its systematic risk also referred to as its market risk on
non-diversifiable risk (Rama, 2008).

Common errors in Investment Management

Investors appear to be laying face down to the following errors in managing their investments.

(i) Inadequate comprehensive of return and risk

(ii) Vaguely formulated investment policy

(iii) Naïve extrapolation of the past

(iv) Cursory (rapid) decision making

(v) Simultaneous switching

(vi) Misplaced love for cheap stocks

(vii) Over diversification and under diversification

(viii) Buying shares of familiar companies

(ix) Wrong attitude toward losses and profits

(x) Tendency to speculate

Inadequate Comprehension of Return and Risk: What returns can one expect from different investments? What
are the risks associated with these investments? Answers to these questions crucial before you invest. Yet
investors often have nebulous ideas about risk and return. Many investors have unrealistic and exaggerated
expectations from investments, in particular from equity shares and convertible debentures. One often comes
across investors who say that they hope to earn a return of 25 to 30 percent per year with virtually no risk
exposure or even double their investment in a year or so. They have apparently been misled by one or more of
the following; (1) tall and unjustified claims made by people with vested interests; (2) exceptional performance
of some portfolio they have been or managed, which may be attributable mostly to fortuitous factors; and (3)
promises made by tipsters, operators and others. In most of the cases such expectations reflect investor naiveté
and gullibility.

By setting unrealistic goals, investors may do precisely the things that give poor result. They may churn their
portfolio too frequently; they may buy dubious ‘stories’ from Stock Exchange; they may pay huge premiums for
speculative, fashionable stocks they may discard sound companies because of temporary stagnation in earnings;
they may try to outguess short term market swings.

Vaguely Formulated Investment Policy: Often investors do not clearly spell out their risk disposition and
investment policy. This tends to create confusion and impairs the quality of investment decisions. Ironically,
conservative investors turn aggressive when the bull market is near its peak in the hope of reaping a bonanza;
likewise in the wake of sharp losses inflicted by a bear market, aggressive investors turn unduly cautions and
overlook opportunities before them. The fear of losing capital when prices are low and declining, and the greed

~9~
 Investment Analysis & Portfolio Management
for more capital gains when prices are rising, are probably more than any other factors responsible for poor
performance. If you know what your risk attitude is and why you are investing, you will learn how to invest
well. A well articulated investment policy, adhered to consistently over a period of time, saves a great deal of
disappointment.

Naive extrapolation of the past: Investors generally believe in a simple extrapolation of past trends and events
and do not effectively incorporate changes into expectations.

People generally and investors particularly, fail to appreciate the working of countervailing forces; change and
momentum are largely misunderstood concepts. Most investors tend to cling to the course to which they are
currently committed, especially at turning points.

Cursory Decision Making: Investment decision making is characterized by a great deal of cursoriness. Investors
tend to:

1. Base their decisions on partial evidence, unreliable hearsay, or casual tips given by brokers, friends, and
others.

2. Cavalierly brush aside various kinds of investment risk (market risk, business risk, and interest rate
risk) as greed overpowers them.

3. Uncritically follow others because of the temptation to ride the bandwagon or lack of confidence in
their own judgment.

Simultaneous Switching: When investors switch over from one stock to another, they often buy and sell more or
less simultaneously. For example, an investor may sell stock A and simultaneously buy stock B. Such action
assumes that the right time for selling stock A is also the right time for buying stock B. This may not often be so.
While it may be the right time to sell stock A, it may to necessarily be the right time to buy stock B.
Alternatively, while it may be the right time to buy stock B, it may necessarily be the right time to sell stock A.
Hence, when you contemplate switching, you should first sell if you feel it is the right time to do so or buy if
you feel it is the right time to do so and make the other deal at an appropriate time (Rama, 2008).

Qualities for successful Investing

The game of investment as any other game requires certain qualities and virtues on the part of the investor to
be successful in the long run. What are these qualities? While the lists prescribed by various commentators
tend to vary, the following qualities are found on most of the lists.

(i) Contrary thinking

(ii) Patience

(iii) Composure

(iv) Flexibility and openness

(v) Decisiveness

~ 10 ~
 Investment Analysis & Portfolio Management
Before we dwell qualities point needs to be emphasized. Cultivating these qualities distinctly improves the odds
of superior performance but does not guarantee it.

Traits of the Great Masters: The strategies employed by great masters (investors) based on analysis is prepared
and given under considering the most common traits:

(i) He is realistic

(ii) He is intelligent to the point of genius

(iii) He is utterly dedicated to his craft

(iv) He is disciplined and patient

(v) He is a loner

Contrary Thinking: Investors tend to have a herd mentality follow the crowd. Two factors explain this behavior.
First, there is a natural desire on the part of human beings to be a part of a group. Second, in a complex field
like investment most people do not have enough confidence in their own judgment. This compels them to
substitute others opinion for their own.

Following the crowd behavior however often produces poor investment results. Why? If everyone fancies a
certain share, it soon becomes overpriced. Thanks to bandwagon psychology, it is likely teaming bullish for a
period longer than what is rationally justifiable. However this cannot persist indefinitely because sooner or later
the market corrects itself. And when that happens the market price falls, sometimes very abruptly and sharply
causing widespread losses.

Given the risks of imitating others and joining the crowd, you must cultivate the habit of contrary thinking. It
may be difficult to do because it is so tempting and convenient to fail in line with others. Perhaps the best way
to resist such a tendency is to recognize that investment requires a different mode of thinking than what is
appropriate to everyday living.

Being a joiner is fine it comes to team sports, fashionable clothes, and trendy restaurants. When it comes to
investing, however the investor must remain aloof and suppress social tendencies. When it comes to making
money and keeping it, the majority is always wrong.

The suggestion to cultivate contrary thinking should not, of course be literally interpreted the means that you
should always go against the prevailing market sentiment. If you do so, will miss many opportunities presented
by the market swings. A more sensible interpretation of the contrarian philosophy is this: go with the market
during incipient and intermediate phases of bullishness and bearishness but go against the market when it
moves towards the extremes.

Here are some suggestions to help cultivate the contrary approach to investment:

1. Avoid stocks which have a high price-earnings ratio. A high relative price – earnings ratio reflects that
the stock is very popular with investors.

2. Recognize that in the world of investments, many people have the temptation to play the wrong game.

~ 11 ~
 Investment Analysis & Portfolio Management
3. Sell the optimists and buy from the pessimists. While the former hope that the future will be marvelous
the latter fear that it will be awful. Reality often lies somewhere in between. So it is good investment
policy to bet against the two extremes.

More specifically, remember the following rules which are helpful in implementing the contrary approach:

Discipline your buying and selling by specifying the target pieces at which you will buy and sell. Don’t try
overzealously to buy when the market is at its nadir or sell when the market is at its peak (these can often be
known only with wisdom of hindsight). Remember the advice of Baron Rothschild when he said that he would
leave the 20 percent gains at the top as well as at the bottom for others as his interest was only on the 60
percent profit in the middle.

Never look back after a sale or purchase to ask whether you should have waited. It is pointless to wonder
whether you could have bought a share for Rs 10 less or sold it for Rs 20 more. What is important is that you
buy at a price which will ensure profit and sell at a price where you realize your expected profit.

~ 12 ~