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Investment: Investment refers to the process of allocating money or resources with the expectation of generating future income, profit, or appreciation. It involves committing funds to an asset, venture, or project with the goal of obtaining returns over a specified period. Investments can take various forms, including stocks, bonds, real estate, mutual funds, commodities, or starting a business. Definition: An investment is a purchase of an asset or a financial product that is expected to generate income or appreciate in value over time." - Warren Buffett Security
- According to the Securities Contract regulation Act 1956 “Securities include shares, scrips, stocks, Bonds, Debentures or other marketable securities of any incorporated company or other corporate body or government.” ❖ They are instruments which represent a claim over an asset or any future cash flows. ❖ Securities are classified on the basis of return and source of issue. Return Fixed income securities Variable income securities Issuers
- Government
- Quasi-Government
- Public Sector Enterprises
- Corporates Speculation: Speculation refers to engaging in financial transactions or investments with a high degree of risk, uncertainty, and the potential for significant gains or losses. It involves making bets or taking positions based on predictions about
future price movements or market conditions without necessarily relying on thorough analysis or fundamental factors. Gambling: Gambling refers to activities that involve risking money or valuables on uncertain outcomes, primarily driven by luck or chance. It typically takes place in casinos, sports betting, poker games, or other games of chance. While gambling may involve strategic decision-making and skill in certain instances, its outcomes are predominantly determined by luck rather than fundamental analysis or economic factors.
Distinction between Gambling, Speculation and
Investment
Investment Process:
- Setting Investment Objectives: Begin by clearly defining your investment objectives. Determine what you want to achieve through your investments, such as capital appreciation, income generation, or wealth preservation. Your objectives will guide the rest of the investment process. a. Capital Appreciation b. Income Generation c. Wealth Preservation
- Risk Assessment and Risk Tolerance: Evaluate your risk tolerance, which is your willingness and ability to tolerate fluctuations in the value of your investments. Assess your financial situation, time horizon, investment knowledge, and comfort level with risk. This will help you determine the appropriate level of risk for your investments. a. Financial Situation b. Time Horizon c. Comfort with Volatility
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Monitoring
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- Asset Allocation: Determine the optimal asset allocation for your investment portfolio. Asset allocation involves dividing your investments among different asset classes, such as stocks, bonds, cash, and alternative investments. The allocation should be based on your investment objectives, risk tolerance, and time horizon. Consider diversification to spread risk across different investments. a. Stocks b. Bonds c. Cash d. Alternative Investments
- Investment Selection: Select specific investments within each asset class. Conduct thorough research and analysis to identify investment opportunities that align with your investment criteria. Evaluate factors such as historical performance, financial fundamentals, management expertise, and market conditions. Choose investments that fit within your asset allocation strategy. a. Research and Analysis b. Historical Performance c. Financial Fundamentals d. Market Conditions
- Portfolio Construction: Build a well-diversified investment portfolio based on your asset allocation and investment selections. Balance your investments across different sectors, industries, and geographic regions to reduce the impact of individual investment performance on your overall portfolio. Monitor and adjust the portfolio as needed. a. Diversification b. Balance Across Sectors and Regions c. Monitor and Adjust
- Risk Management: Implement risk management strategies to protect your investments. This can include using stop-loss orders, setting risk limits, and regularly monitoring your investments for changes in market conditions or individual security performance. Regularly review and rebalance your portfolio to maintain the desired asset allocation. a. Stop-Loss Orders b. Risk Limits c. Regular Monitoring 7. Performance Monitoring: Continuously monitor the performance of your investments and assess whether they are meeting your investment objectives. Review investment statements, track investment returns, and compare them against relevant benchmarks. Make adjustments to your portfolio as necessary based on changes in your goals, risk tolerance, or market conditions. a. Investment Statements b. Track Returns c. Compare to Benchmarks
Mutual Funds: Mutual funds pool money from multiple investors to invest in a diversified portfolio of stocks, bonds, or other securities. They are managed by professional fund managers who make investment decisions on behalf of the investors. Real Estate: Real estate investments involve purchasing properties such as residential homes, commercial buildings, or land for the purpose of generating income through rent or appreciation in property value. Commodities: Commodities include physical goods such as gold, silver, oil, natural gas, agricultural products, and more. Investors can invest directly in commodities or through commodity futures contracts. Options and Derivatives: Options and derivatives are financial instruments that derive their value from an underlying asset. They allow investors to speculate on price movements, hedge against risks, or generate income through options trading strategies. Cryptocurrencies: Cryptocurrencies such as Bitcoin, Ethereum, and others have gained popularity as a digital investment alternative. They operate on blockchain technology and offer potential returns but come with high volatility and risks. Precious Metals: Investments in precious metals like gold, silver, platinum, or palladium can serve as a hedge against inflation or economic uncertainties. Investors can purchase physical metals or invest through exchange- traded funds or mining company stocks. Financial Assets: Financial Assets: Financial assets are intangible instruments that represent a claim to future cash flows or a portion of ownership in an entity. These assets derive their value from a contractual agreement or legal right. Financial assets are typically traded in financial markets and offer investors the opportunity for capital appreciation, income generation, or hedging against risks. They often have higher liquidity and can be easily bought or sold. Common examples of financial assets include: Stocks: Ownership shares in a company, representing a claim to the company's earnings and assets. Bonds: Debt securities issued by governments, municipalities, or corporations, entitling the holder to regular interest payments and the return of principal. Cash and Cash Equivalents: Highly liquid assets, such as bank deposits, money market funds, and short-term Treasury bills. Mutual Funds and ETFs: Investment funds that pool money from multiple investors to invest in a diversified portfolio of financial assets. Derivatives: Financial instruments whose value is derived from an underlying asset, such as options, futures, and swaps. Real Assets: Real Assets: Real assets, on the other hand, are tangible assets with intrinsic value, usually related to physical properties or resources. These assets have an inherent economic value and can include: Real Estate: Residential, commercial, or industrial properties, including land, buildings, and infrastructure. Natural Resources: Assets such as oil, gas, precious metals, minerals, timber, or agricultural land.
Infrastructure: Public or private facilities, such as roads, bridges, airports, utilities, and telecommunications networks. Commodities: Physical goods, including agricultural products (wheat, corn, coffee), metals (gold, silver, copper), energy resources (crude oil, natural gas), and more. Real assets tend to have a longer investment horizon, offer potential for income generation (e.g., rental income from real estate) and can serve as a hedge against inflation. However, they often require substantial initial investment, have lower liquidity, and may involve operational considerations. Non-marketable financial assets: Non-marketable financial assets, also known as non-tradable financial assets, are financial instruments that cannot be easily bought or sold on a public market or exchange. These assets typically lack liquidity and are not readily convertible into cash. Here are some examples of non-marketable financial assets: Private Equity: Private equity investments involve acquiring ownership stakes in privately-held companies or assets that are not publicly traded. These investments are typically held for a longer term and involve a higher degree of risk and potential return. Venture Capital: Venture capital investments are made in early-stage companies with high growth potential. These investments provide capital to support the company's development and expansion but are often illiquid and can involve a higher level of risk. Angel Investments: Angel investments refer to investments made by individuals or groups in startup companies in exchange for equity ownership. These investments are typically made in the early stages of a company's development and are not easily tradable. Restricted Stock: Restricted stock refers to shares of a company's stock that are granted to employees or insiders with certain restrictions on their sale. These restrictions may be in place for a specific period or tied to certain conditions. Employee Stock Options: Employee stock options grant employees the right to purchase company shares at a predetermined price within a specified period. These options are often subject to vesting schedules and may have restrictions on their transferability. Certificates of Deposit (CDs): CDs are time deposits offered by banks and financial institutions. They have fixed terms and interest rates but cannot be easily sold before maturity without penalties. Retirement Accounts: Retirement accounts, such as 401(k) plans or individual retirement accounts (IRAs), may offer investment options that are not easily tradable. These investments are designed for long-term retirement savings and often have limitations on withdrawal or transfer. Non-marketable financial assets generally require a longer investment horizon and may involve higher risk compared to publicly traded assets. Investors often require specific knowledge, expertise, and access to participate in these investments. Due to their illiquidity, investors should carefully consider their investment objectives and potential constraints before committing to non-marketable financial assets Money Market Instruments: Money market instruments are short-term debt securities with high liquidity and low risk. Examples include Treasury bills, certificates of deposit (CDs), commercial paper, and short-term government bonds. These instruments are typically used by investors and institutions for short-term cash management and to preserve capital.
HPR is calculated by subtracting the initial investment value from the final investment value, adding any income received, and dividing the result by the initial investment value. It is typically expressed as a percentage. Example 1. Fred invested $10,000 in the shares of ABC Corp. Each year, the company distributed dividends to its shareholders. Each year, Fred received $100 in dividends. Note that since Fred received $100 in dividends each year, his total income is $300. Today, Fred sold his shares for $12,000, and he wants to determine the HPR of his investment. Solution: Using the HPR formula, we can find the following: Thus, Fred’s investment in the shares of ABC Corp. earned 23% for the entire period of holding the investment. (Further Problems discussed in worksheet)
- Relative Return : Relative return measures the performance of an investment relative to a benchmark or a comparable investment. It compares the return of the investment to the return of the benchmark over the same period. The relative return can be positive, indicating that the investment outperformed the benchmark, or negative, indicating underperformance. Relative return helps investors assess the skill of a fund manager or the performance of a specific investment in comparison to its peers or a market index. Relative Return = Absolute Return of Asset - Absolute Return of Benchmark.
- Real Return: Real return, also known as inflation-adjusted return, takes into account the impact of inflation on investment returns. It represents the actual purchasing power gained or lost from an investment after adjusting for inflation. To calculate the real return, the nominal return is adjusted by subtracting the inflation rate. Real return provides a more accurate measure of the investment's growth in real terms, considering the eroding effect of inflation on the value of money over time. Cumulative Wealth Index: A return measure like total return reflects changes in the level of wealth. For some purposes it is more useful to measure the level of wealth (or price) rather than the change in the level of wealth. To do this, we must measure the cumulative effect of returns over time, given some stated initial
amount, which is typically one rupee. The cumulative wealth index captures the cumulative effect of total returns. It is calculated as follows: Systematic Risk Systematic risk is the non- diversifiable portion of the total risk. Such risk is attributed to the overall economy-wide factors that affect the pricing of all securities and companies in general. These risks are unavoidable and uncontrollable in nature. Systematic risk causes variations in the return due to movements in the general market. Because the market is inherently unpredictable, the systematic risk always exists in all investment avenues. This portion of the total risk cannot be reduced through diversification. This type of risk accounts for most of the risk in a well-diversified portfolio. The systematic risk can be of different types. A few are listed below: Interest Rate Risk Market Risk Purchasing Power Risk Interest Rate Risk Interest rates account for a major part of the systematic risk in investment activities. The variability in the securities expected rate of return that is caused due to the fluctuations in the interest rates prevailing in the economy is called as interest rate risk. These changes in the interest rates are either on account of regulatory framework or market forces. Since the expected return of an investor rises due to an increase in the general interest rates, the market price of the securities happens to fall and vice versa. In other words, other things being equal, the security prices move inversely to the movements in the interest rates. Fluctuations in the interest rates have a more direct bearing on the bonds and other fixed income securities. Effects on common stocks (equities) are somewhat indirect. Interest Rate Risk Interest rates account for a major part of the systematic risk in investment activities. The variability in the securities expected rate of return that is caused due to the fluctuations in the interest rates prevailing in the economy is called as interest rate risk. These changes in the interest rates are either on account of regulatory framework or market forces. Since the expected return of an investor rises due to an increase in the general interest rates, the market price of the securities happens to fall and vice versa. In other words, other things being equal, the security prices move inversely to the movements in the interest rates. Fluctuations in the interest rates have a more direct bearing on the bonds and other fixed income securities. Effects on common stocks (equities) are somewhat indirect. Market Risk The market price of shares tends to fluctuate consistently in different time periods. The general rise and fall in the market share price is commonly referred to as bullish and bearish trends respectively. These movements can be easily seen in the market indices such as BSE Sensex, NSE Nifty, and etc. While the phases of ups and downs in the share prices in the long run can be considered as a result of business cycles, the short term fluctuations are mainly because of changes in the investors’ psychology. These changes in the investors’ expectations are a result of their reactions to the tangible and intangible events in the economy such as fall of a government, sudden change in the monetary policy, emotional instability of the investors collectively leading to an overreaction. The variation in the security’s return caused due to stock market volatility is referred to as market risk. Purchasing Power Risk
Beta: Beta measures the systematic risk of an investment, specifically its sensitivity to movements in the overall market. A beta of 1 indicates that the investment moves in line with the market. A beta greater than 1 suggests higher volatility, while a beta less than 1 indicates lower volatility. Historical Volatility: Historical volatility measures the past volatility of an investment by analyzing its historical price movements. It provides an estimate of the potential future risk based on past behavior. Covariance: Covariance measures the relationship between the returns of two investments. It indicates how their returns move together. A positive covariance suggests that the returns move in the same direction, while a negative covariance suggests they move in opposite directions. Correlation: Correlation is a standardized measure of the relationship between two variables, such as the returns of two investments. It quantifies the strength and direction of the linear relationship between the variables. A correlation of +1 indicates a perfect positive relationship, - 1 indicates a perfect negative relationship, and 0 indicates no relationship. Total risk= Systematic risk + Unsystematic Risk = General Risk + Specific Risk = Market Risk + Unique Risk Alpha and beta coefficients Alpha and beta coefficients are important measures used in investment analysis to assess the performance of an investment relative to a benchmark. Here's an explanation of alpha and beta and how they are calculated: Alpha : Alpha measures the excess return of an investment compared to its expected return, given its level of risk (as measured by beta). It represents the investment's ability to outperform or underperform the market. A positive alpha indicates that the investment has outperformed the benchmark, while a negative alpha suggests underperformance. Beta: Beta measures the sensitivity of an investment's returns to movements in the overall market or benchmark. It indicates the degree to which an investment's returns move in relation to the market. A beta greater than 1 suggests that the investment is more volatile than the market, while a beta less than 1 indicates lower volatility.
Method 2 to Calculate Beta: β = Correlation (Ri, Rm) * (Standard Deviation of Ri / Standard Deviation of Rm) Relationship between Systematic and Unsystematic Risk: Point of Difference Systematic Risk Unsystematic Risk Definition Risk inherent in the entire market or market segment Risk specific to a particular company, industry, or investment Also Known As Market risk, Non-diversifiable risk Specific risk, Diversifiable risk Impact Affects a wide range of securities simultaneously Affects individual assets or subsets of assets Source Macroeconomic factors, market- wide influences Company-specific factors, industry-specific factors, financial factors, country-specific factors
