Understanding

Investment
CHAPTER THEME
lfa person has idle funds or can commit the funds foraparticular period, he should invest the funds
But how and where? Should the investment decision be acasual decision or should it be asystematic,
careful and rational decision based on facts and figures? What considerations and factors should he
look for? The terms like risk and return are often used in investment perspective. but what do they
mean? Which one risk or return or liquidity, be preferred? Is the investment same thing as speculation?
An understanding of these things will initiate the process of discussion on investment management.

CHAPTER PLAN
Investment Investment Decision Process
Investrnent and Speculation Return
Real Assets and Financial Assets Risk
Factors of Sound Investment Risk-Return Trade-Off
- Liquidity Direct and Indirect Investing
- Risk of an Investrment O Manoeuvring with Investment
- Capital Appreciation O Points to Remember
Tax Aspects of Investments Objective Type Questions and Self-Review
Investment Horizon Assignments
O Relevance of Investment Analysis
4 INVESTMENT MANAGEMENT
The term investment is used to deseribe the process of investing (or divesting) money in shares,
debentures, fixed deposits, gold, renl assets, life policies, elc. These outlets where the money is
invested are known as investment nssets. Analysis, decision-making and processes involved in
allocation of funds to these different nssets and more specifically, selection of one or the other
asset is known as investment management, How much are the total funds available for
investment? How much to be invested in long-term assets and how much in (relatively) liquid
asets? How much in real assets and how much in shares and other securities? are some of the
qUestons with which an investor has to deal with. The scope of present text is however restricted
e analysis of investment in financial assets such as shares, debentures, derivatives,etc.
the present chapter focuses attention on presenting the basic principles of investment
hanagement and explaining some of the concepts used in the investment management. The
background presented in this chapter will providea useful perspective for the discussion that
follows in other chapters.
INVESTMENT
The term investment refers to exchange of money wealth into some
tangible wealth. The money wealth here refers to the money (savings) By investing, an
which an investor has and the term tangible investor commits the
the investor acquires by sacrificing the wealth refers to the assets
money wealth. By investing, an present funds to one
investor commits the present funds to one Or more assets to be
some time in expectation of some future or more assets to be held tor held for some time in
(revenue) or capital gain. Investment can bereturn in terms of interest
defined as commitment of expectation of some
funds that is expected to generate future return in
described as vehicle into additional money. It may also be
which funds are placed with the terms of interest
that the funds would grow in value or expectation
generate some return. (revenue) or capital
Keeping the money in a cupboard is notwould gain.
money in a savings bank account is an an investment but keeping
particular company in expectation of getting investment. An investor buys (invests) shares of a
terms of appreciation in the market price of a dividend stream and/or getting a capital gain in
to the debentures of a his holding. Similarly, when an
company or depositing money in
bank, he is expecting a fixed interest
investor is
fixed deposit scheme ofa subscribing
value at maturity. In case a person stream for the given period and
return of a
commercial
for his own dwelling or for
rental
buys house, he invests his money now
a redemnption
and uses the house
these cases, there is sacrifice or income. When he resells, he will get the market value. In
commitment
investor in expectation of some future return or of funds or other
resources at present by an
can be identified as benefits.
common all types of investment. These
to There are three basic features which
1. There is a are:
2. There is an
commitment of present funds,
expectation of some return or benefits from such
3. There is always
In the context of
some risk involved in respect of
return and
commitment in future, and
the principal amount
making process employed by an investor to investment process is used to refer toinvested.
investment, the term
decision
decide about
steps as follows : what assets to invest in and when to
make investment. It includes several
(a) Setting investors
objectives and amount of investible wealth.
(6) Analysis of different assets
(c) Constructing a securities to identify thOse which are suitable for
portfolio investments and determining the
of investment.
invested in each one. proportion of wealth to be
UNDERSTANDING INVESTMENT 5
(d) Periodic repetition of the above three steps to revise and improve the portfolio in view
of changing situations. This
in terms of the may entailthe evaluation of performance of the portfolio
risk and return of the
The term investment environment encompassesportfolio. all
and the market structure that facilitates buving and types of investment opportunttes
of securities, institutional set-up and the selling these investments. Different type
investment environment. narket intermediaries are the components O

INVESTMENT AND SPECULATION

The terms investment and
used interchangeably. However, speculation are overlapping and |n speculation, there is an
two are quite different. In
speculation, there is an investment of funds with an expectation investment of funds with
of some return in the fornm of capital profit
price change and sale of investment. resulting from the an expectation of some
return in the form of
Speculationofis relatively a apital profit resulting
short-term investment. The degree of uncertainty
is definitely higher in case of' speculation than in future return from the price change and
case of investment, the investor has an intention investment. In
of keeping the sale of investment.
investment for some period whereas in speculation, the investor Speculation is relatively a
looks for an opportunity of making a profit and 'exit out' by short-term investment.
selling the investment. In case of speculation, the decision is based on
or perception of the investor. In speculation,there is an 'market waves', 'rumours'
the speculator wants to capitalise that opportunity. If he expectation
of movement of prices and
expects an increase, he buys and takes
a long position. On the other hand, if he expects a decrease in price, he sells
now to buy it back
at a later stage at a lower price. Speculators are willing to take on risk because they expect to
earn a risk-premium. They find a favourable risk-return trade-offintaking speculative position.
On the other hand, gambling is the assumption of risk just for the purpose of enjoying risk and
even without having a prospect of a risk-premium. However, investment decisions are based
on fundamental and economic analysis of the investment. The terms investment and speculation
have been differentiated in Table 1·1.
Table 1.1: Differences in Investment and Speculation
Factor Investment Speculation
1. Degree of Risk Relatively Lesser Relatively higher
2. Basis of Return Income of the Investee Change in Market Price
3. Basis for Decision Analysis of Fundamentals Rumours, tips,etc.
4. Position of Investor Ownership Party to an Agreement
5. Investment Period Long-term Short-term
CONCEPT
CHECK TEST YOURSELF-1
At a particular point of time,T-bills issued in India (T denominated) and issued in Italy (Lira
denominated) are offering equal yield. Both are short-term, liquid and default-fre. However,
an Indian investor who invests in T-bills issued in Italy is subject to exchange rate risk
because the Lira earned in Italy eventually will be exchanged for at some future exchange
rate (which is likely to fluctuate). The Indian investor is engaged in speculation or gambling?
6 INVESTMENT MANAGEMENT
commitment of funds to
As already discussed, the term investment is used to denote the
in expectation of some future
One or more assets that are to be held for some period and Real assets and financial assets.
return. These investments may beclassiñed into two eroups:

REAL ASSETS AND FINANCIAL ASSETS

estate (land, buildings), plant and machinery,
Kealassets are the tangible aNsets such as realphysica/tangible
Turniture.gold, silver, art, ete. Real aRsets imly a asset which may be movable
are generally used by the investor
Or immovable; marketatble or non-marketable. These assets
toderive benefits or in production of other goods and services.
the claims against the investee. "There are
Un the other hand, financial assets refer todebentures,
ditterent types of financial assets such as shares, bonds, fixed deposits, derivative
contracts, certification of deposits, bills, loans, investments in subsidiaries, lease rentals, etc. A
tinancial asset represents a financial claim documented by some form of legal presentation.
represented
The financial assets are also known as paper securities as these are financial claims
by securities. These securities are the evidence of claim on the issuer. Financial assets represent
a claim on the income generated by real assets of some other party. A security may also be
considered as a legalright of the holder to receive prospective Financial assets represent a
future benefits under the given terms and conditions. For claim On the income
example, an investor may not own an automobile plant, but by generated by real assets of
buying the shares of Telco, he can acquire a claim against the some other party.
income generated by Telco by the use of plant and machinery
(real assets) at the Telco factory.
Difference between real and financial assets can be further explained as follows :A person
wants to builda house on a plot of landalready owned by him. He uses some of his savings for
this purpose. The rest of funds are procured from a housing finance company. The house is a
real investment for the individual, but the housing finance company has a financial asset against
the individual in terms of loan given to him.
Table 1-2.
Both real assets and financial assets can be classified in different categories as given in
Table 1.2: Categories of Real Assets and Financial Assets
Real Assets Financial Assets
1. Real Estate 1. Equity Claims-Direct
- Residential Apartments Equity Shares
Office Complex Warrants
-Shoping Malls and Complexes 2. Equity Claims--Indirect
2. Gems and Metals
Mutual Funds Units
Diamond
-Gold
-Convertible Bonds
Silver
Convertible Preference Shares
3
3. Redeemable Preference Shares
Antiques 4. Creditors' Claims
-Art Pieces Debt Securities
Stamps -Commercial Papers
-Coins, etc. -Loans and Deposits
Savings Account
UNDERSTANDING INVESTMENT 7
CONCEPT
CHECK TEST YOURSELF-2
Which of the following are Financial Assets?
(a) Business Goodwill.
(b) Deposit under Systematic
(c) Lease Rentals Investment Plan.
(d) Gold ETE. Receivables.
(e) Certificate of Deposit.
Financialassets are generally marketable and
traded in the organised markets. Though the sametransferable.
These can be easily and cheaply
principles are applicable to other types of
assets also, yet the emphasis throughout this text is exclusively on the marketable financial
assets. may be noted, however, that the financial assets
lt
the investors but these are liabilities from the point of viewareofassets from the point of view of
the issuer of these securities.
For example, if an investor has debentures of face value 10,000 (cost), it is an
him because it gives him a claim against the company. It is a asset for
obligated tomake payment ofinterest and principal tothe investor. liability of the company which is

FACTORS OF SOUND INVESTMENT

Investment management involves analysis and selection of investments. For an individual
investor as well as for other investors, investment management is a part of overall finanCial
decision-making. An investor should draw an overall financial plan stating how much total
funds to be invested, how much to be invested in real assets., etc. Such a financial plan should
include decision whether to buy or not a house, as it is a major investment decision for an
individual. Other aspects to be considered may be how much to invest in life policies, future
endowment funds, e.g., provident funds, etc. Once a financial plan is prepared, an investor
would be interested in constructing and managing the optimum combination of the investment
alternatives. The objective of construction of such a combination is to enhance the wealth of
the investor. The combination of investments is known as portfolio and the practice of including
several investment alternatives in the portfolio is known as diversification which aims at
reducing the risk of the investor. For example, an investor has 100 shares of Reliance Industries
Ltd., 50 shares of Tata Steel Ltd., 100units of a mutual fund and 50,000 balance of public
provident fund. This is called the portfolio of the investor.
Funds for investment may come from savings In selecting specific investments,
(consumption foregone), borrowed money or from sale of investors need specific ideas about
assets already held. An investor may borrow funds torthe features which the portfolio
making fresh investment ashe might be expecting moreshould possess.
return from investment than the cost of borrowing the
funds. Sometimes, an investor may liquidate existing assets to invest the funds elsewhere. In
case of investment of savings (consumption foregone), an investor expects to enhance future
consumption. In all these situations, the investors have to manage their investments effectively.
In selecting specific investments, investors need specific ideas about the features which the
portiolio should pOSsess. There are several features for which the investor should look into an
investment. It may be noted that these features must be consistent with the objectives of the
investors. Following are some of the features which an investor looks into an investment :
is saleable
1. Liquidity :Liquidity, with reference to investments, means that the investment the speed
oT convertible into cash without delay, In other words, liquidity refers to
 8 INVESTMENT MANAGEMENT

and ease with which an investment (asset) can be sold for afair Different types of
price, i.e., it is a relationship between the time dimension and investments offer Uarying
price dimension of the sale of an investment. Liguidity provides degree ofhas
liquidity. Ana
to build
a chance to the investor that he can exit and get back his investor
honey. This is particularly relevant in case an emergencyportfolio containing agood
appears before the investor and the funda are immediately proportion of investme nts
equred. Ditterent types of invest1ments offer varying degree ofwhich have relatiuely
higher
liquidity.
proportion
An investor
of
has investments
to build aportfolio containing
which
ahave
good degree of liqudiy
necessitates that the funds are not committed
etvey hgher degree of liquidity, Liguidity instruments are more liquid than the capital market
0r a long period.Cash and money market
estate investnents. For example,
nstruments which in turn are more liouid than the real
deposited in Savings Ale and Fixed Deposit Alc in a bank is more liquid than the
oney
investment made in shares or debentures of acompany. short notice and in the light of
Investors do consider how likely they are to require cash at should have in their portfolio.
this lhkelihood they establish the minimum levelofliquidity they
Investors have tocarefully consider their own position to assess the need for liquidity. In case,
immediate liquidity
next instalment of ahousing lo¡n is due in few davs or in next few months,
is essential.
2. Risk of an Investment : Risk of an investment is to be analysed from two different angles.
These are:Safety of Principal and the Stability of Return.
(a)Safety ofPrincipal : An investor should take care that the amount of investment (principal)
1S safe. The safety of an investment depends upon several factors such as the economicconditions,
organisation where investment is made, earnings stability of that organisation, etc. Guarantee
or collateral available against the investment should also be taken care of. For example, bonds
issued by the Reserve Bank of India are completely safe investments as compared with the bonds
of aprivate sector company. With reference to investment made in a particular company,
investment made in debentures of that company is safer than investment in preference shares of
the same company. Further, investment in preference shares is still safer than that in the equity
shares of the same company. The reason being that in the case of liquidation of the company,
order of payment is debentureholders, preference shareholders and then the equity
shareholders. It may be noted that the safety of investment and the expected return from that
investment are interrelated.
(6) Stability of Return :An investment is considered a good investment if it offers stable
returns. The prime objective of making every investment is to earn a stable return. If returns
are not stable, then the investment is termed as risky. It may be noted that riskiness of returns
refers to the position that the returns may fluctuate. For example, return (interest) from
Savings Alc, Fixed Deposits A/e, Bonds and Debentures are stable but the expected dividends
from equity shares are not stable. The rate of dividend on equity shares may fluctuate depending
upon the earnings of the company.
3. Capital Appreciation: Some investments such as
land,
equity shares provide opportunities of capital appreciation. Onbuildings,
the other Chances of capital
hand, there are some investments such as fixed deposits, debentures, appreciation 0r
etc., where the initial value and maturity value are same. Investors Capital loss add to the
always prefer those investments which have more chances of capital risk of the
appreciation. But this isonly one side of the coin. Chance investment.
of capital appreciation implies chance of capital loss as well. Investment in equity share is one
which has chances of capital appreciation as well as capitalloss. In case of debentures, capital
 UNDERSTANDING INVESTMENT
loss may appearifthe company is wound up. An investorr has to consider the chances of capital
appreciation in the investment decision process, Chances of capital appreciation or capital loss
add to the risk of the investment. Investors differ with respect to perception about capua
appreciation and the degree of risk-bearing capacity, Investors need to understand that there is
generallya trade-offbetween the revenue income and capital appreciation
both in one type of asset is unlikely. opportunities. Finane
4. Tax Aspects of Investments :
Investments differ
investment, return from investment and redemption with respect to tax treatment of initial
proceeds. For example, investment in
Public Provident Fund has tax benefits in respect of all the three characteristics noted above.
However, investment in equity shares entails exemption from taxability of dividend income
but the transactionsof sale and purchase are subject to
Securities
CapitalGains. Sometimes, the tax treatment depends upon theTransaction Tax or Tax on
type
consequences are of prime relevance to investment decisions. The investor. Taxof the
of any investment decision should be measured by its
after tax
performance
rate of return. For example, between 8.5% Public Provident The performance of any
Fund and 8.5% Debentures, former should be preferred as it is investment decision should
exempt from tax while the latter is subject to tax in the hands be measured by its after tax
of the investor. rate of return.
5. Investment Horizon : Investment horizon
refers to the planned liquidation date of the
investment. Investment horizon must be considered by investors while choosing and selecting
investments. The maturity period of an investment (say, bonds) makes it more attractive if it
coincides with the date when funds would be needed.
It may be noted that all the factors given above must be considered
one by one. The investment decision should be based on the overall effectsimultaneously and not
of all these factors.

RELEVANCE OF INVESTMENT ANALYSIS

Individuals as well as institutions do make investments. Individuals have savings which
are to be invested. Institutions have occasions when they have to invest the provident fund
money or idle funds. Senior citizens want to invest the retirement funds. Corporates are often
faced with the situation to park their short-term liquidity. Study of investments is
becoming more and more relevant and important over tme.
rowStudy
of financial markets in terms of turnover, volume and number of of investments is
investors also support the view. The growing interest of small becoming more and
individualinvestorsin the capitalmarket is evidenced by the fact important
more relevant and
over time.
that the number of mutual funds is increasing regularly.
Investors should understand the investment analysis to earn better returns in relation to
the riskassumed. Acareful and systematic investment analysis can provide asound framework
for both the management of wealth and increasing the wealth. Investors may find suggestions
to some or all of the following queries :
() What are the financial assets available in the market?
) What is the risk-return relationship of each of these?
(m) What is the difference between the rate of return and yield?
(iw) How diversification can be used to reduce risk?
(0) How fundamental and technical analysis help in investment decisions?
(vi) How to select mutual funds for investment?
An attempt has been made in the nresent text to answer these and other related questions.
10 INVESTMENT MANAGEMENT
INVESTMENT DECISION PROCESS
investor should proceed in
ne investment decision process is concerned with as to how an () how diversified the
making decision about () what marketable securities to invest in,
nvestments should be, and o)when the investment should be made. There is a well-knit
estment decision process involved therein, Investment decision process can be Viewed in
two perspectives. Fìrst, at the time of constructing the first portfolio, andsecond, at the time of
rebuilding or reshaping the portfolio by selling existing assets and buying new assets, or by
investing fresh funds to inerease the overall size of the portfolio. In both situations, however,
investors make two types of decisions, These are :
8) Asset Allocation Decision : The investor. ffrst. has to decide about the broad classes of
investments, These classes may be shares, bonds, real estate, gold, commodities, ete. These
assets perform differently depending upon economic factors. So,an investor has to keep good
alance among these assets. While finalising an asset allocation plan, three factors must be
considered and looked into. These are:
(a)Goals and ObËectives of the
(6)Risk-tolerance of the investor,
investor, and
(c) Time-horizon of the investment. Of course, these
factors are interrelated.
(u) Security Analysis : Second, the investor has to select a specific
1s the 'security analysis'. It involves examining several security. What is involved
securities with the basic purpose of
identifying those securities that currently appear to be worth buying or worth selling. Security
analysis consists of Fundamental Analysis and Technical
valuation and assessment of different securities for inclusion intoorAnalysis. These involve the
Security analysis has been discussed in detail in Chapters 5, 6 andexpulsion
7
from the portfolio.
of the book.
The investment decision process must be critically
organised
investment decisions and different activities required for that.analysing the basic nature of
decisions is the analysis of risk and return attached with a Underlying all investment
particular
parameters and the trade off betweenthem have been analysed in detailinvestment. These two
a brief idea has been in Chapter 3, however
presented hereunder.
RETURN
Investors always wish to earn a return on the funds
that there is always an invested in assets. The reason being
opportunity cost of funds. Return from
realising that opportunity cost. The return from an an investment helps the
investor
investment may be available in terms
revenue return (dividend or interest) and/or in of
The net return is the sum of terms of capital return (capital
Durchases a share (FV 10) forrevenue return and capital return. For
example,
appreciation).
of 10) from the 130. After one year, he receives a dividend of 3 an investor
company and
normal rate of return is 11 + sells it for 138. His total
return is
(30% on FV
130, i.e. , 8.46%. 11, i.e., 3+8. The
In the same case, if he is able
(i.e.. 7372) only. The annual ratetO ofsell the share only for 128, then his net return is 1
In the context of return in this case is .77% (i.e., 1 130).
investment analysis, the return can be classified into :
(a) Expected Return : The
expected return refers to the anticipated return for
period. It may be noted that all investment decisions some future
are made in the light of expected
The expected return is return.
estimated on the basis of actual returns in the past
periods. The
UNDERSTANDING INVESTMENT 11
returns inthepast periods provide good basis for estimation of prospective behaviour. However,
ncase of fixed interest invest1ments (e.g.. fixed deposits, bonds, etc.), the expected return is
equal to fixed interest plus capital change, if any, during the
holding period.
(6) Realised Returns:The realised return is thenet actual return earned by the investor oo
the holding period. It refers to the actual return over
some past period.
Initially, investors invest for the future in the light of expected return, and when e
investment period is over, they are left with the realised return. The actual return or realised
return maybe more or less than the expected return. The difference between the expected and
the realised return give rise to the risk attached with the return. So, while identifying the
expected return, investors think of the risk also. This is in fact the essence of the investment
process.

RISK
Investors invest for anticipated future returns, but these returns
can rarely be predicted precisely. As noted above, there may be The chance that the
difference between the expected return and the realised return and actual return from an
latter may deviate from the former. This deviation is defined as the investment would differ
risk. The chance that the actual return from an investment would rom uts expected return
is referred to as the risk.
differ from its expected return is referred to as
the risk. The risk of an investment is related to the uncertainty associated with the outcomes
from an investment. Afixed deposit witha commercial bank is risk-less whereas investment in
equity shares from where the return may be as high as 100% in one year or may be even
negative, is considered riskier. Similarly, treasury bills maturing in short period have no practical
risk because there seems to be no chance that the government would not be able to fulfil its
commitment to redeem these bills on the due date. However, there is definitely some risk,
howsoever small, that a blue-chip company would not be able to redeem its 5-year or 10-year
debt. The government bonds are known as risk-free investments while other investments are
risky investments.
All investors, in general, would prefer investments with highest Investors are rational
possible return but for getting this higher return, he has to pay the and prefer less risky
price in terms of accepting higher risk too. Investors are rational investments to riskier.
and prefer less risky investments to riskier investmnents. Investors
are risk-averse in the sense that they do not assume risk for its own sake but they will not
incur any level of risk unless there is an expectation of adequate compensation for undertaking
that risk.

RISK-RETURN TRADE-OFF
Investors do assume risk and it is not irrational to incur Some investors are ready to
even higher degree of risk if the investor expects to be take even higher risk but
Compensated for it. Investors select the level of risk they are only with the expectation of
ready to assume. Some investors are unwilling to undertake higher returns.
much risk and they need not exect to earn higher returns.
Some investors are ready to take even higher risk but only with the expectation of higher
returns. ln fact, investors cannot expect to earn higher returns without undertaking larger
risk. Ifhigher expected return can be earned without bearing extra risk, every investor would
12 INVESTMENT MANAGEMENT

rushing
beprices. towardsprices, thehigher
tobuythe only.
assets may
returnassets
higherreturn This would result in driving up their
At higher become unattractive. The reason being
return and vice-versa.
that higher the price, lower would be thepercentage rate of
select investments to minimise
The investors alwayslike to maximise retums.But would they
risk and that is the lower expected
tne risk? No, because there is also a cost of minimisingthe investor holding only risk-iree
Teun. The minimisation of risk would result in everv are two opposite forces
nvestments. So, maximisation of returns and minimisation of risk
trade-o.
WOTKing in the investment decisions. This isknown as the risk-return
The expected return of an investment should be The expected return of an
commensurate with the level of risk attached therewith. At investment should be
this level, investors anticipate a fair return relative to the commensurate with the level
of risk attached therewith.
risk of the investment. If returns are independent of the risk,
there will be a rush to sell high-risk securities and to buy An investor should think in
lower-risk securities. This will make their prices to adiust
terms of the expected risk
and the expected rate of return will rise or fall until the return trade-off that results
Securnties eventually become attractive to be bought or held
the relationship between
Dy an investor. So, there would be a risk-return trade-offfrom expected return and the
with higher-risk assets priced lower than lower-risk assets. the
risk of the investment.
An investor should think in terms of the expected risk-return
trade-off that results from the relationship between the
expected return and the risk of the investment. This risk-return trade-off has been shown in
Figure 1-1.
Return

Risk
Premium Equity Shares
Preference Shares
Unsecured Loans
Bonds and Debentures
Govt. Securities
Risk-free
Rate of Return

0
Risk

Figure 1·1:Risk-Return Relationship of Different

Investments.
Figure 1.1 shows that different types of investments have different
required rate of return. The government securities have rate of returndegrees of risk and the
egual to the risk-free
rate. As the risk increases, the required rate of return also
increases. Equity shares have
UNDERSTANDING INVESTMENT 13
maximum risk (with reference to revenue return as well as the capital gain/Aoss), sothe requtu
rate of return is also highest. Risk-return line in Eigure 1.1shows that higher the risk, more is
the required rate of return of the investment. The risk-return line also explains that ne
required return is comprising of two elements : ())
of return, and (i) Risk-Premium depending uDon theMinimum Return in terms of risk-tree ta
degree of risk attached with the investmenu
The first element, i.e., the minimum returm in terms of risk-free rate of return is comprising
two components :(O The real
is the pure return and an rate ofIreturn, and() Theinflation factor. The real rate of return
investor requires it to part with the money. As it is real, its value is
determined before incorporating inflation in the caleulation. The real rate is also determined
betore considering any specifie risk of the investment. Any anticipated inflation factor must be
added to the real rate of return to arrive at the required rate of return
(before explicitly
considerìng risk), This is rightly called the risk-free rate of return. The risk-free
may be defined as : rate of return
Risk-free Rate of Return = (1+ Real Rate) x (1 + Inflation Rate)- 1
For example, if an investor has a real rate of return of 3% and
expected inflation rate is 4%,
then this risk-free rate is 7.12% i.e., (1 + 0.03) (1 + 0.04) - 1. This
7.12% is common to all investments. However, the other component, risk-free rate of return of
depends upon the degree of risk associated with the investment. This isi.e., the risk-premium
shown in Figure 1.2.

Common to Real Rate of Return

All Risk-Free Rate
Inflation Factor of Retum
Investments

Investment Risk Premium

Specific

Figure 1-2 :Components of Required Rate of Return.

An investor can select any position on the expected return
The upward sloping risk
risk spectrum as shown in Figure 1-1. This is also known as the return trade-off line shows
risk-return trade-offline. The upward sloping risk-return trade that investors will not
off line shows that ínvestors will not assume risk unless they assume risk unless they
expect to be compensated for higher risk. The expected return expect to be compensated
should be sufficient enough to inducethe investor for taking for higher risk.
additional risk, nevertheless, the actually realised
()
return may not be exactly equal to the expected return. This leads to two basic questions :
How to measure the risk of an asset? and (ii)What should be the quantitative trade-offbetween
risk and return? The measurement of risk and return and trade-off between the two have been
taken up in Chapters 3 and 4 of the book.
 INVESTMENT MANAGEMENT
14
DIRECT AND INDIRECT INVESTING investing and indirect
namely, direct
Investing activity may be classified into two groups,
investing. by investors
Investing : Direct investinu invalveg the buving and selling of securities
debentures or
Direct
may he capitnl market securities such as shares,Commercial Bills,
hemseves. The securities instruments such as Treasury Bills,
e products, or money market
Commercial Papers,Certificates of Deposits, etc. indirect investing, the
In case of
Indireet Investing :lnvestors may not directlyunits
investof investors let the
investmnent
and manage the portfolio, rather they buy the company to do all the work
and
funds that hold various types of securities on behalf of decisions (for afee).
investors. The funds are known as mutual funds or make allthe
investment companies and the part owners are known all
In case of indirect investing, the investors let the investment company to d0the
as unit holders, interest in
the work and make all the decisions (for a fee), The unit-holders have ownership share of interest,
company and are entitled to a pro-rata
aSset ot the fund or the investment
dividend and capital gains generated. route for
Indirect investing in a mutual fund or an investment company is an alternative
management of
investment, the sale, purchase and
an investor to invest. In case of direct whereas in case of indirect investment, this work is
investment is undertaken by the investor
done by the fund for a fee. Investment in mutual funds has become popular in recent years.
Different types of mutual funds have been floated with diverse features to suit the requiremnent
Regulatory Provisions relating to mutual
of a variety of investors. Structure, Schemes and
funds in India have been discussed in Chapter 8 of the book. enumnerated in Table 1-3.
Instruments available in direct and indirect investing have been
the Book.
These instruments have been discussed in next few chapters of
Table 1-3 : Instruments of Direct and Indirect Investing

Direct Investing Indirect Investing

Money Market MutualFunds
Treasury Bills Open-ended Funds
Commercial Papers -Close-ended Funds
-Certificates of Deposits Exchange Traded Funds
Capital Market -Securities
Shares
Bonds & Debentures
Capital Market - Derivatives
Futures
-Options
Direct and indirect investing can be differentiated in several ways. First, in direct investing
there is a direct link between the saver (investor) and the user (investee), while there is no link
in case of indirect investing. Second, return in case of direct investing depends upon the
performance and profitability of the investee. But in case of indirect investing, the return
depends upon the efficiency of the investment comnpany in managing the portfolio. Third, the
UNDERSTANDING INVESTMENT 15
ultimate investment decision is made by the investors in direct investing, but by the mutual
fund in case of indirect investing.
The indirect investing accomplishes the same thing asdirect investing. But the
is that the mutual fund or investment company differenee
stands between the investor and the poruon
of securities. Theoretically, investors in indirect investing gain or
activities of the mutual fund in the same way as in lose through investmen
direct investing.
MANOEUVRING WITH INVESTMENTS
Investments in financial assets can be used to build up diverse types of strategies. Some of
these are as under :
Hedging. Every investment by nature is risk-prone. Even if the principal is
may be with respect to the market price of the secured, the risk
investment. Even
which are taken as risk-free, there is a risk that in case the in case of government securities,
prices of these securities may vary. Investorsalways want to interest rates change, the market
is a technique to cover losses. Hedging refers to cover risk in investment. Hedging
taking a counter-action to cover the risk of an
existing asset. Futures and options (as discussed in Chapter
hedging strategies to cover the risk of holding investment in9)can be used to build up different
Arbitrage. Arbitrage refers to a situation where an investorsecurities.
undertakes two simultaneous
actions in an attempt to make risk-less profit. These two actions
different markets or in two different securities. For example, shares ofmay be taken up in two
being traded at 1,050 at NSE and at 1,060 at BSE. An investor may Reliance India Ltd. are
and simultaneously sell the shares at BSE. In the process, he can buy the shares at NSE
make a profit of 10 per
share, without taking any risk. The arbitrage process thus helps the investors
to make risk-less profit by capitalising the price differential of an (called arbitrageurs)
asset in
However, the opportunities to make this profit would soon vanish as more and moretwo markets.
enter the market. Thus, arbitrageurs help in bringing equilibrium in prices of samearbitrageurs
security in
different markets.
Diversification. Diversification refers to the process of spreading away the total investible
funds over different investment assets. This stems from the English proverb: Never put all
the eggs in the same basket'. If an investor invests all of his funds in just one type of asset or one
security, there is a greater risk that he may incur losses if that asset or security fairs poorly.
However, on the other hand, if funds are scattered over different assets, it is quite likely that
some will perform well while others will perform bad and on the whole the risk of incurring
loss is balanced off. The objective of diversification is to reduce risk involved in building a
portfolio. Volatility in value of total investment is limited by the fact that not all assets or
securities move up or down in value at the same time or at the same rate. Diversification
reduces the likelihood of substantial losses and allows for more consistent performance under
a wide range of economic situations.

POINTS TO REMEMBER
lnvestment involves the commitment of funds toone or more asset tobe held for some
period in expectation of some return in future.
Investment is different from speculation in different respects.
Assets may be classified into real and financial. Real assets include tangible aSsets such
as land and building,plant, furniture, etc. Financial assets represent etalis.
 16
12. 11. 10. 9 "
8. 7. 6. 5. 4. 3. 2. State Investment
process "
1. investments. investor.
Hedging, an
debentures
Portolio
Investments attached The
Bxpected returnRiskReturn
Investors investor.
toAs investment
ansoundmake
tnvestment Some Derivatives Fixed
[AnsBuying
Government Sufficient
Risk-return
Liquidity Return A one whether make
princrpal, invest to Financial
Investment InvestmentsAll
Investments a every
financial Speculation person. risk refers oo of
and types and from
(1) : the management
Arbitrage with investment investor the in Deposits,assets
from the each premium return are management Stability
E, risk and of are realised to analysis factors and (such
units trade-off asset same. can the investment tunwilling
he
(2)securities speculation investments and has inalways of direct when
F, isReturn investment.be, from
variability is etc.), can
as
speculation
is a real QUESTIONS OBJECTIVE the TYPE and decisions. rational be
(3) of the classified differs return.
investing
of on Futures
isencompasses
a an long-time assets following Diversification encompasses investment toencompasses relevantreturn, which they Equities broadly
T, objective
mutual results areasset earn comprises decisions.
(4) offer from assume
two is involve of and ahould
always and some in expected
investment
Capital andclassified
(5)
F,fundlower in for have
horizon. statements whereas one risk-averse, the for (such
fundamental
of direct includes risk as
Options).
F,risk-returnavoidance one in
return, of investors be to
is
interest sacrifice
financial building investment building
(6) an but a same are revenue unless appreciation, made. how asinto
revenue investing a return decisions
E,
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the anEquity fixed
(7) liability
of of and they and as
1,because presentassets True strategies risk-free andreturn it investor
trade-off. factors
risk. return. managing to risk-return
(8) fund and the expect managing a
helps Tax can Sharesincome
investing. all (T ) another
E, offor of need
(9) theseinvestment consumption.
earning moneys or indirect
is return difference wellas to them
another
aspects,basedbe makes
which an securities
MANAGEMENT
INVESTMENT
and
E, same False a be tradeoff
(10) are composition indirect depending adequately as composition to decisions
can investing. and capital earn
Investment are Preference
person. a type should (F): expected
between th e
non-taxable.
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(11) decision. investing. the betterLiquidity,
of built helps
analysis. be upon appreciation.
risk about as
F, so invested of Shares compensated. Shares)
(12) upassets premium.
investor the returns
assets ofhoriz0n, Debentures
both through the Safetysecurities
T)
are by for and risk and etc. and
for of
 UNDERSTANDING
INVESTMENT
2. I. 16. 15. 14. 13. 12. 11.
19. Define18.
20. Investment. 17. 10. 9.
8. 7. 6. 5. 4. 3. 2. 1.
b, Laly The
buying
c, investment.on Non-convertible
and of"NoDebentures,
How types Equity
Share,
(ii)Compare Briefly
Investments
) Investment Explain
Diferentiate
examples.
suitable degreeWhat degree
GiveWhatrisk-averse' AriskWhat
of What making
investment
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Differentiate
examples.
assets?
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What Define (c) (Write a)
d Indian
and
(aenominated
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avour
e investment explain and of sound in the
arebond, investor the you
expected you you you you relation the
differentiate
is term notes
financial ANSWERS investment risk." following involve between mean mean mean mean mean between basic of
it or carefully
the aversion?
investor investment
is
against in is different is investment. an
different return? byby decision to Investment. on
speculation, Lira), exposed risk-free." How by by by investment. features ASSIGNMENTS
SELF-REVIEW the
long-term return?
investment
risk? real
assets. TO investments plannedHedging,investment risk-return
indirect
the does does following
On decision? process. assets
CONCEPT from kinds Differentiate Are of How
investor. the to In
inflation not investment
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speculation. Arbitrage investing? assume all and
speculation? view of and trade-off? investors decision is :
redemption investmentsin Whatfinancial it
CHECKS:TEST
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(ivd). (üiterms
affect GolHouse, speculation. different (d) (6)
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outlets
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do Can How Explain Investment
he by inflation
has tYOURSELF different
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risk, investorbe agree?
different [B.
investing writedecision available Do is
exchange
considered tax-shelter: return it(H), an are Com. of
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liquidityand [B.Com. (B.Com.
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[B.Com.
[B.Com. and (B.Com. (H),
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note Com. investments
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and
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features
(H), Analysis.
in ? to speculator also? D.U., 2009, to
rate taxes Give (H), 2015]
D.U.,
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this Bonds (H), (H), on (H), (H), an (H), realised consider
might the investor.
ofinvestment.2018] explain. 2009, 2013,
risk issued affect examples.
D.D.U., D.U.,
2011] D.U., D.U., D.U.,D.U., D.U., investing? have investor of of 2014,
U., meaning varying financial
expected
return.
whilehave return
2016] 2014] 2010] 2008] 2007]2007] same 2012] 2017]while 2019]
n in 17