UNIT 3 INVESTMENT PLANNING AND MANAGEMENT CHAPTER 8 INVESTMENT PLANNING AND MANAGEMENT @ Introduction Meaning of Investment @ Investment and Speculation Objective of Investment @ Investment Planning‘conTENTS: ‘enefits of Investment Planning nvestment Process Risk and Return ‘Concept of Return Measurement of Return ‘© Holding Period Return Expected Return ‘© Real Rate of Return, Impact of Taxes on Investment Decisions Concept of Risk Risk vs, Uncertainty © Types of Risk © Systematic Risk = Unsystematic Risk © Sources of Risk Measurement of Total Risk Risk - Return Trade-off Portfolio Management © Activities involved in the Portfolio Management © Portfolio Return ‘© Portfolio Risk ‘ Portfolio Diversification Investment Alternatives and Finance Products © Stock © Debentures and Bonds ‘© Mutual Funds ‘© Post Office Monthly Income Scheme ‘© Fixed Deposits © Real Estate * Gold «© Derivatives 810 a1 12 813 813 813 813 814 ais 816 818 819 819 820 820 821e@ Money Market Instruments ment Saving Schemes ife Insurance Solved Problems Review Questions Practical Exercises CHAPTER 9 MUTUAL FUNDSInvestment Planning and Management Pd |e learning from this chapter will enable students |» get an insight into investment, its types and how it varies from specu- lation |» get to know why the investment of important and need/benefits for’ | investment planning |» knowledge of different types of investments options available in the market | » how to calculate the return and risk of an investment and the need for a trade-off INTRODUCTION Investment is broadly interpreted as a sacrifice of current money for future benefit. Today's fast-paced world offers a plethora of choices to individuals for lnvsting their money. However, it is important to understand that no single investment or Investment strategy is suitable for everyone. Every individual has due financial objectives and goals according to their financial requirement. tre the financial goal into reality, sound planning including those specific Theginents which are appropriate to meet individual requirements is necessary. “sore investment planning plays a crucial roe inthe financial planning pro- lemlsotderto understand and perform this step, it is typically necessary for imeets © understand the concept of investment, investment plan, benefits of ment planning, and various investment alternatives available at their end. 8384 SINT < INVESTMENT BLANOUNG AND MAKAGEMENTT Mi ! IEANING OF INVESTMENT ered proven i Sent an ase GURGd Band wake el peves the formating the money wo slr er eree ts anttipeton of el debenture! 2tUn inthe future, tite werent ean comprise stl OBJEC that a fens al esate derives gous Taya OBE inert 88 the potenti to generate neon tinerese dividend, oF pang increase in value in the future i i stment. son ire is an investment me pu Investing can be defined as directing financial resources, usually money p educatio an aca ecient into purchasing an asset that has the potential to an income or profit an appro Investments consist of Financial Investment and Real Investment. ened d Financial Investment: Financial Investment isthe allocation of fnamagil conserva ‘Sources, ie, money in financial assets, The financial assets represent the, goal is th Syer the Issuer of financial assets such as a company or government * To Shares, mutual funds, bonds, and debentures are a few examples of pa facets The motive behind financial investments isto get a return either iy form of interest/dividend or in the form of capital appreciation, whene @ fixe appreciation is an increase in the price ofa financial asset from its issug ist Real Investment: Real investment is the investment in physical sou land, machinery, car, artwork, etc. The real investment is made either inv Sumption or investment purpose. For example, the artwork Is an em met real investment, Now the artwork can be used for consumption puipo wit can be a great addition to ana + Gro of ir ther over are s hight an as time Sain ¢ * Liqui insta 1m see Examy com. ther na here cape issue assets rer for cm, example — hetic val irchasing® e OBJECTIVE OF INVESTMENT an appropriate plan. The goal f framed decides what shall be th conservatively investment decisi pals the roadmap for the inves Baressively or we can say that the financial stment program. The investment objectives ne * Be tnerease the Current Income: People invest thelr money ta generate ae amare. which complements their current income, Hess thee invest in those products which offer returns regularly for inser ak fixed deposits, bonds, and stocks. The source of income for such ners isin the form of dividends or interest. Retirees prefer source of income to meet their needs and expenses so they dese thors investments which can offer high returns at low risk. Also, if any family member has an adverse health problem, the recurring medical expenses with the rise in healthcare costs can heavly affect the family budget so, an additional income from the securities can be a vital source of income, * Growth: Some investors give due importance to growth as an objective of investment. These investors invest to receive capital gain meaning thereby they invest with the vision of their invested amount growing over some time. The investment opportunities available to such investors are stock, mutual funds, real estate, commodities, et. Iti important to highlight here that the capital gain which isan increase in the amount of an asset from the price it was purchased attracts capital gain taxes, the time period of the capital gain decides whether it isa short-term capital gain or long-term capital gain and hence the percentage of tax varies, * gut: guy means an asset or security canbe converted int cash isan without os oft investment Some investors preerto vest in Securities that canbe easily converted into cash during emergencies. Examples of liquid investments are money market funds and sto companies that are actively traded on a stock exchange. * Tax Benefit: Some people invest their money in eat ania to minimise their tax liability A tax benefit is any tax ly vidual.|AND MANAGEMENT rom PPR, and interes, fr . fom tax. we assets and Securitieg inst inflation smptions, deductions, et types of tax benefits ke tax exemptions er ; team on REC tax-free bonds is fully exempted aerate oppress avait india SOS gy selves against inflation includes buying global stocks, vyintvnen people consider inflation, estate investment trusts (RTS), et, We oo ees i Shae ef a lg on seek investment as a vehicle tp hi ney value. ni INVESTMENT PLANNING Investment Planning is a core subset of financial planning. It is a process tht ‘matches how with the accumulated money one can meet their financial gos and objectives. Investment planning can be accomplished once an individualé precisely clear with his financial goals and objectives. This statement highligh that the foremost step isthe identification of goals and objectives. Consequeft we design an investment plan where two sets of factors are considered: one nancial goal an ebectve andthe secon investment capital). “pa an ta An investment plan is a statement that investment plan call e and luxurious life.r H.9- 1st ine 8 ayy Baten, 6 AN wy an ear ic Ma ing J nappened 0 the earn mem, — e ; to mitigate uncertainties OF he toy such gy ee Sey Meeting Maior Expenditure, 1, na ome to help linse juny either current income or 1a)or ty ‘i savin Penditre © to ingliti expenditure from today than inyeqtes S8Fable to gg oe8 8 chunk of "Buang Mig | Ghee aon tol a Sing yur be prepa ene te ey for major ne earned mon ne earned money once, jin hee | mony mae expend oh wm a ee te Inna no inane? £F 8 chiles eqs Pealtte can be & donre hat ig ty purchase, lavshing marriage, OF an expen cation, any hours hat int can help to build capital with nae Objective jy ao": A wellto-do plan o Sndare of Living: I Gc ts, these aa mentare quite beneficial, For © tha ptYINBS Produced by the ave instance, the invest Vehige has a significant impact on the teye wy285Fthe family's readwine regard a ‘son's investment serves he level of life, At that point, the a ; afety ue per *erVeS aS a valuable sox ae spe ce of income forthe fami ing. Imtt| _¢ Tax Benefit: The well-thought inve 4 terms of tax benefits. Va lan provides an advantage in in rious Investment avenues vie: | arddeductonsForinstane aber arate emp pilebrion. Fon Scan be availed in insurance plans under section 80C and Section 10(10D) ofthe imeone n ey, 1961 OCess ts INVESTMENT PROCESS _ vent | islear that when an asset is purchased by an individual he invests is money lig | tht asset with an intention and anticipation af retary ce eee ee Pighlights| soe quent id: oneis| St? 1: Setting up the Investment Policy noney ar| Tie are a few key considerations to be kept in mind during the initial stage ofsetting up the investment policy which includes: investment objectives, time torizon, and risk tolerance. The investment objectives will drive decision-mak- LEME Pa wheter to invest funds to ave 2 1ecuntg ae gain oo c different asset classes, through capital appreciation, how much to allocate to different ass reert| 4 What types of investments to choose. The time horizor isthe time frame iferi| hich an investor expects to achieve his objective, Broadly, tis categorised © dem | shoreterm, medium-term, or longterm, The risk tolerance corespands to ent n i bear. The risk-return reward is such es] ye ittuations in value an investor can bear. The rire ea rae a wst| ‘Mt there is a direct relationship between risk a of niver',| Potentially higher but it also means more volatility. nye eee sidering all these key fac- fie investment policy statement canbe famed considering al these Ky fe sty to accomplish the investment goal fener figaSallocation targets, and performance Ptr lldefined rent investment alternatives avaliable to -term goals. tment policy will help in achieving long-term & <List of Inves ‘step 2: Develop ‘This step outlines the list of investt ‘vesting his funds in an investment: considering an investor's investmen For example, an old man wants to invest, source of income at low risk. In that case, a desirable choice and shall not ‘made to invest investors’ money. step 3: Performing Investment Analysis ment opt Once the list of investment altern: an investor, is made, the next step s to the risk and return characteristics. to examine the risk and return It helps investors to make a firm decisiot priced and which are overpriced. hall inclu Step 4: Creating Portfolios, Portfolio Analysis, ‘An investor considers myriads of options to ‘return. A single investment cannot desired need of an investor. Hence, itis always desiral in different securities considering the risk: all the money in one basket. ‘Uwe 9s ives PLANNING AND available for is stment Avenues investor fOr in available 102”. chosen after — "The investment be included in th satives, acco! In the analyst ‘of each inves! mn concerni MANAGEMENT tions ef ‘ options Cg risk appetite, the would be IMT ares Won't be investing 2 ment ven need and objective of alysis accordi verforming an ana ng ide Peri step, the primary focus jg vent option included in the ls, ing which options are Under ‘and Choosing a Portfolio invest in and holds them to generate possess all the characteristics to meet the ible to make investments return characteristics than nesting ‘A portfolio comprises two or more securities that may be selected by an inves tor from the universe of the securities. So, the next step is to build a v. portfolios that investors can acquire. It must portfolios, an investor selects the most favoi his investment objective. An efficient portfol of be noted here that from a varietyal rable or efficient portfolio to met lio can be summarised as a portioe that can provide a maximum ret um return at a give flea here return, given level of risk and minimum ri inentl,an investor selects an optimal portfolio as Pert and investment goals, For ‘equity and bonds. So, fate rs A Young pers the future, so it ma 80 it may be an ids. Whereas a retired ith 10% equity a “vision and Evaluation per his risk-return appetit that the main class of assets a ‘on wants to invest to acquire 80-20 strategy for him, ie, 80¥! Person with a different objective! ind 90% bonds an optimal pot stor’ | ee that i grailable, 2 nd risk. 7 investment ‘Therefore, return of ¢ dynamics c inseparable without be: CONCEP Retum can Petiod of ti benefit rece Nvestment, Return can4 to conti 8 POTO evant, WAC ; oo meymance at sk tolerance, They shoutg“e®F thou Sen ih | pee fiocation is in line with there 0als an®® COnsider wheres hele Overs Songs | So, investors may decide ty fo ad objectives, eter thelr a reg) ie hanees could include Sling some at 1 ther gaat te roe MAE assets to ailferent asset clare ts, baying a ravetly| afi ts, oF rea Ment | gure anges © 2 HESTON strategy gg tS) sakinrs However itis importane to cat Bea neue : miber lecsion for some feved regulary and revised as needed ty ques at Potolis should bee loing so, investors ee portfolio remains aligned with tyes tour aed iar an help ensure gsKAND RETURN ; focus the ig} jnestors invest by deferring their consum, tion in ex, fon ‘ation of risk-return trade-offs for different inestments is an important component in the selection process of investments Shera: therefore, itis essential to understand the concept and measurement ofc and ett arn of diferent investments before delving deeper into understanding the tmens| namics of stocks and bonds. It may be emphasized that risk and reture are Nestiy inseparable. It is difficult to visualise the expected return from an investment without bearing the risk ety) CONCEPT OF RETURN FV ew can be defined asthe total beet reseed rom an invesen oes »miel| period of time expressed as a percentage of the cost of investment. The ta rtfole| benefit received can be in terms of dividend, interest, or capital g m rit) investment. return. fetun can be further divided into historical return and oa a ai fined as the annui Historical Return - The historical return cane defined ns he ed ‘med over the holding period of investment. I mee Siyected Return - The expected return can be defined 99 9 PONE Tt Ahitvestor anticipates earning from an investment rn over a future or expects t0 ea an be called an estimated return an investor OXPOT MOT epialy nestnent period, which can be let’ say o0€ Yea" THES cre expec: based onthe historical performance of investmé ofthe industry and economy. iilor loss {Holding period return may be computed as the total ga on Cee ing period ofan investment expressed a percetae of HE ‘made. It is computed as follo ‘Total Income + Change in Price Holding Period Return = __of asset from purchase Price_ pe pe Probabi i= Possible Where ee tio T, = Total income (Interest/ Dividend) from the asset purchase usta Fy Purciase price pers P, = Price atthe end of the holding period Fra jumber of years for which asset is held — = Mlustration: The investor wants to determine the rate of return of Re A and B. Stock A was purchased at € 40 last year and it generated @ ‘Solution: of £2, Stock B was purchased at ® 60 last year and it generated a dh = 3. Currently, the market price of stocks A and B is 46 and %64 reg = Calculate the rate of return, Prosperous Solution: Stagnant Total Income + Change in price == Holding Period Return = _ of asset from purchase price =e Purchase price of the asset Repectea fi T+ (P,- s aac Expected § fe =6+ 64. +(46- 294 For stock a = 2*(46- 40) _ 6. 7 20% sige 3 + (64 - 60) For stock B = : ee itemExpected Ret W pected Return = Y%, py where, Probability of jth return possible return outcome y= Number of years ustration: Calculate the expected return of the security. State Probability tears = om = | Stagnant Tindal we oa Recessed 030 aa deni Solution: nd) or zs ively State Probability (p) | Returns (%)(F) | Pr, Fires 030 20 | [Seen 40. 7] aaa z | Resa 030 =10 3 Expected Return = SN, p,r, Eipected Return = 0.30 x 20 + 0.40 x 16 + 0.30 x -10 =6+64-3 =94% Real Rate of Return ‘he eal rate of return is the return earned a rates the income earned in the hands of “of inflation must be taken into account whi ster adjusting for inflation. Inflation the investor: Hence, the prevailing making an investment decision,eee ~~ {UT INVESTMENT PLANNING AND MANAGEMENT ae = rf (cof return a Ral amore ( + Nominalrateof return) T+ Inflation rate 1 ial erate of i Mustration: The rate of return on investment Is 129% and REO eye {s 5%, Taking both of these into consideration, compute the ust Solution: of Eo | solutio ‘taxa = (40.12 Real rate of return = (14012) Taxabl = 10667 - | = 0.0667 CONG = 667 % Risk car either IMPACT OF TAXES ON INVESTMENT DECISIONS aa ‘Taxes are one of the important factors to be considered while making investment ther, itr decisions. Income earned from the investment is subject to tax. However tie varies. 1 tax rate to be charged differ based on the kind of investment. For instance, PPE. riskier NPS, and tax-free bonds are a few investment options exempted from tax. Whi) betweer the dividend earned on equity shares or interest received from investmentsis| risky. Ri usually taxable in the hands of investors. The tax rate is also levied based@®) tion, car the time period of investment. The aforementioned statement can be explained with an example, The tax on short-term capital gain on the sale of equity shar) Risk vs on a recognised stock exchange stands at 15% and long-term capital gain) gy, the sale of shares usually attracts 20% plus a surcharge if applicable. diferes™ ferenc ‘Therefore, an investor must incorporate the tax implication while comp bility to the varied alternatives available for investment, however The post-tax rate on investment can be computed as: pected Post-tax rate = Pre-tax rate (1- Tax rate) Types Mlustration: If the interest earned on bond: is s is 15 ir ‘si 30% tax bracket, then compute the post-tax rate? ond he investor The tora Solution: \) sye (1- Tax rate) 0.30)‘a comparison between oxable equivalent return = Gt istration: I the taxtre rate go a of 30% this case, compute the taka te MESO cman F tution: ‘tlvalen return. ‘taxable equivalent return = —T% free rate (1 ~ Tax ratey | taxable equivalent return | CONCEPT OF RISK _ Risk can be defined as the variability in the expe s ' expected return, Risk arises because seer the return i xed or can ibe predied adene eee Bea hot equate withthe expected return, Pur ents cary risk. However, the degree of sk Variability in expected return is considered SS variability of return, i, less difference between the actual return and expected return of a security is considered less risky. Risk can arise due to various factors, for example, market volatility nfl tio, capital structure, and the fundamental position of the company. varies. The investment with greater riskier and the investment with le Risk vs. Uncertainty Often Risk and Uncertainty are used interchangeably. However, there exists a difference between the two terms. In the case of risk, we can assign a proba- bility to the expected outcome of an event based on certain facts and fers however, in the case of uncertainty, we cannot assign the probability to expected outcome of the event. Types of Risk 1 Unsystematic Risk The total risk can be bifurcated into Systematic Risk and Uns} (A) Systematic Risk SYstematic risk, also known a5 no! 4 or economy as a whole. It inherent risk that is present in the oa Jerieaton because affect at annot be diversified away through PO" inate risk is caused eurities in the market to some degree 4 n-diversifiable risk or market is, s thee14 LUNIT 3: INVESTMENT PLANNING AKD MANAGEMENT factors such as economic ms, changes in government policies, nat be eliminated. However, investors can take stops to manage sYStenaue sk diversifying their portfolio across a range of asset classes, sectors 201 Reem pile regions, and by using financial instruments such as futures and OP! day against certain types of systematic risk. (B) Unsystematic Risk Non-systematic risk, also known as specific risk that affects a particular security or company. Its the risk that ts specific tag particular investment and isnot present in the broader market: Non- systema risk can be diversified away through portfolio diversification Pecause It ony affects a specific security or a small group of securities. For example, the shares of a particular company plummeting because of rey entrants as competitors in the industry is a type of non-systematc Fisk a5 only affects the shareholders of that particular company. On the other hand the risk of a decline in the value of the whole stock market is a type of systemate risk because it affects all securities in the market. Investors can manage non-systematic risk by diversifying their portfolios acm a range of securities and asset classes. By holding a diverse portfolio, invest can reduce the impact of specific risks on their overall portfolio. or diversifiable risk, is the rig Sources of Risk Many sources of risk conduce to a variation in the return from an invest Some common sources of risk are as follows: @ Market Risk: This is the risk that the value of an investment fi due to changes in the market. Market risk can arise from the behaviour in the security market which can cause fluctuation in thesh price. Usually, itis seen that investors follow the herd mentality, ie low the same direction as the market or other investors. The ¢h the price of the investment could be due to political, social, or eco conditions. Market risk is generally higher for investments that aT® closely tied to the overall performance of the market, such as Stoo lower for investments that are less sensitive to market movemen as bonds and cash. So, the risk of a decline in the price of security change in the market is termed as Market risk. Since market rs all investments to some degree and cannot be diversified aa ca(CH.@: INVEST 4g ei e ET PLANING AND acter, at bonds ng such as bonds and deten a tie Cans restos An increase in mgr" WIC of oe ogy | Biled ee Yesa. When na rae? rte ene ed return 5 toh to fil, because new bonds bein’ “the valug ey ome rice tg Sa making them more a tive 1 8 Wl hae bond meorowns a Bond Wh a ae meres rate ge Is means that if an Increases. the bond will become Jerr tt mathe maa stag J prcive €1VESOrs, This mene OMe ifan inven 3 them ese oni perme more valuable. Interest rata ner tenerally higher ts band wl rane cate, Posed to Innere ed changes for em a to changes in interest rates, e38 sensitive Nd, the ing Power or Inflat + Purchasing Se ther eiSk: Inflation ris, also known as Bese wil be eroded by ination, Inflation the gia increase in across sre io Srods and services over time, and f an Jel Value of ’stors aarrcce eth tears ith investment doesnot generate eure | lesppace with ination, ination risk is generally hisher ke investments i Bret returns, such as bonds and Se-income seluatl because ie rae ofthese investments does not increase with Inflation Imes rial Gan manage inflation risk by Investing in assets that have the poteneal gs fenerate returns that keep pace with or exceed inflation, suchas stk realestate, and commodities. These types of investments tend to be more a volatile and carry additional risks, however, so it is important for inves- ne ‘ors to carefully consider their risk tolerance and investment objectives rR before investing in them, ole in J ¢ Business Risk: Business risk is present in all businesses. There is always iid 4 Possibility that a company will not be able to generate sulficient reve: 7a teeny Profits to meet its financial obligations and achieve its business di Sbjetives, which can lead to a decline in the value of the oni h quftles. It can be influenced by numerous internal and pel ate 0 For instance, the company’s management, or ae ee s ition are part of internal factors and economic conditions, 2 ‘that Ait. and change in government policy are part of external factors Sontribute to business risk. ‘ firm won't "Phancial Rise Financial risk refers tothe poss y, eee sae | fetble tofu is financial commitments of pa abuse Manca difficulties, The numerous reason that contr tdrisk is a drop in the business's sales or earnings, a rise in its difficulty in obtaining the required capital. Companies with high | debt and low levels of liquidity (cash and assets that can be co into cash easily) are often at more risk financially. Investors can financial risk by investing in companies with strong financial p and by diversifying their investments across a range of ind ‘companies. MEASUREMENT OF TOTAL RISK Risk can be defined as the variability in expected returns. The total investment can be computed with the help of statistical measures such Standard deviation, and Variance. Range: Range refers to the highest and the lowest possible return ticular investment during a given period of time. The wider the ra be the variability than the narrow range. Hence, the greater will bet Variance or Standard Deviation: The variance or standard deviation sure of risk that describe the dispersion of returns around the mean rem) | Stagnant 4 particular security of portfolio. Variance is a measure of the averg deviation of a set of returns from the mean return, whi the square root of the variance. The risk can i. Application in case of return series Variance = Spf Ri-R) R = Mean Return n= Number of observations 1. Application in case of probability outcome of returnCHD INVEST ug "KING AN a7 eturn at 1 observation c cee M mansit |S jean Ret Posigctt ability of return trieg Ot | 2° ang iSk of a 1S Range, m my) ea A Pas Probability(p) | Returns (9) (R) Jp, = nore wy | [> OP oe risk 030 20 ade Same pan 940 16 4 _| 66 eum | eed 030 10) 3 [494 | ans Savaret || t = iation i SD. = Vi64 SD.= 128 isastatistical measure (oeffcient of Variation: The coefficient otvareaa +e tf dispersion, Standard deviation does not slow yous a coi Aspersion, It does not ore i Ce et hen erefore, the 00 ea sea React two investments, ih oo ten we aed to compare Sil measure of risk than the standare Ott th standard evan 9 more investments. The CV is defined ag ren expres SPected returns divided by the meal riskier the investmen “percentage. The higher the CY, thi