1 INVESTMENTS : AN OVERVIEW

C H A P T E R

leaRnInG oUtcomes
After reading this chapter you will be able to
 Understand the concept of investment
 Differentiate financial investment from real investment
 Know various features and objectives of investment
 Differentiate between investment and speculation
 Analyse investment environment
 Understand investment decision process
 Differentiate between direct and indirect investing

Investment is the backbone of any economy. Savings of an economy must

be channelized into productive investment to generate income. The higher
the level of investment in an economy the greater will be its gross nation-
al income and economic growth. A conducive business environment is
essential for boosting investment and investors confidence. In fact the pri-
mary source of funds for investment in an economy is household savings.
These savings are channelised into productive investment avenues to gen-
erate more income. An individual may keep his savings in a bank account
or invest in financial and/or real assets. In India savings bank account does
not provide high interest income. Therefore the investors, who wish to earn
higher returns, have to explore other avenues for investment such as equity
shares, bonds, gold, property etc. Hence the need for financial literacy on
the part of individual investors. This chapter provides an overview of the
basic concept of investment, investment decision process and investment
environment.
1
Para 1.2 Investments : An overview 2

1.1 Investment
The term investment implies employment of current funds to earn com-
mensurate return in future. It implies sacrifice of current consumption
for expected income in future because the amount which is not spent on
current consumption is saved and invested. An investor foregoes current
consumption and invests his savings in investments in anticipation of higher
future consumption. It is important to note here that investment does not
always guarantee higher future returns. At times losses are also incurred.
Hence the environment of investment is quite uncertain. We are in fact
facing a VUCA (Volatile, Uncertain, Complex, Ambiguous) environment in
the context of investments.
“In 1986, Microsoft Corporation first offered its stocks to public and with-
in 10 years, the stocks value had increased over 5000%. In the same year,
Worlds of Wonder also offered its stock to public and ten years later the
company was defunct.”
The word ‘investment’ connotes different meanings to different people.
To a layman, it may mean purchase of shares, bonds or others financial
instruments. To an economist it implies purchase of fixed productive assets
(Capital assets) such as plant and machinery. To a businessman as well,
investment refers to purchase of fixed assets such as land, building, plant,
machinery etc.
Irrespective of its context, the word investment requires commitment of
funds in some assets at present so as to be able to generate higher income
in future.

1.2 Financial Investment vs. Real Investment

Depending upon the type of asset, all the investments can be classified as
financial or real investment :
u Financial investment is investment of funds in financial assets. Finan-
cial assets are claims over some real/physical assets. The examples of
financial assets are shares, bonds, mutual fund units etc. The return
of financial investment is in the form of interest, dividend and/or
appreciation in value.
u Real Investment (or Economic Investment) is investment in real
assets or physical assets. Real assets are those long term (or fixed)
assets which are used in the production process. The examples of
real assets are plant, machinery, equipments, building etc.
An individual investor invests in financial assets and commodity assets (e.g.
gold, silver etc.). Now-a-days real estate investment has also become an
3 Objectives of investment Para 1.3

important part of individual investor’s portfolio. Real estate is investment

in tangible house/commercial properties to get income in the form of rent
and/or capital gain due to price appreciation.
Security analysis and portfolio management is primarily concerned with
investment in securities. A security, as defined under “The Securities
Contracts (Regulation) Act, 1956” include the following—
(i) shares, scrips, stocks, bonds, debentures, debenture stock or other
marketable securities of a like nature in or of any incorporated
company or other body corporate;
(ii) derivative;
(iii) units or any other instrument issued by any collective investment
scheme to the investors in such schemes;
(iv) security receipt as defined in clause (zg) of section 2 of the Securiti-
sation and Reconstruction of Financial Assets and Enforcement of
Security Interest Act, 2002 (54 of 2002);
(v) units or any other such instrument issued to the investors under any
mutual fund scheme;
(vi) any certificate or instrument (by whatever name called), issued to an
investor by any issuer being a special purpose distinct entity which
possesses any debt or receivable, including mortgage debt, assigned
to such entity, and acknowledging beneficial interest of such investor
in such debt or receivable including mortgage debt, as the case may
be;
(vii) Government securities;
(viii) such other instruments as may be declared by the Central Govern-
ment to be securities; and
(ix) rights or interests in securities.
This book primarily deals with investment in financial assets or securities.

1.3 objectives of Investment

Individual investors make investment keeping in mind certain objectives.
After all they forego current consumption in order to avail of higher income
and hence consumption in future. The ultimate objective of investment is
to minimize risk and maximize return. However due to the fact that risk
and return move hand-in-hand, it is not always possible to get very high
return at very low risk. Other objectives which are kept into mind while
making investment may be regular income, tax benefits, safety of capital.
Para 1.3 Investments : An overview 4

An investor’s investment objectives depend upon his risk tolerance, which

in turn depends on his age, marital status, family responsibilities, education
and investment experience. The following is the list of certain objectives
kept in mind while making investment.
(i) Return : Total return from an investment is the main objective kept
in mind while making investment in a particular asset. Every investor
wants to maximise total return given the constraints in terms of risk
tolerance, investment horizon etc.
(ii) Regular income or stability of Income : Some of the investors,
especially, old aged and retired persons may have the objective of
regular income or stability of income from the investment. Therefore
they prefer fixed income securities over equity shares.
(iii) Capital Appreciation : Another objective of investment may be capital
appreciation or growth of capital. Young people, who do not want
regular income and can take risk may have the objective of capital
appreciation and prefer equity shares and real estate over fixed in-
come securities.
(iv) Tax Benefits : Some people invest in securities so as avail of the tax
benefits attached to it. Investment in mutual funds in India is primarily
guided by the objective of tax benefits.
(v) Safety of Capital : In every investment, safety of capital should be
the primary objective. Other objectives can be achieved only when
capital is safe.

1.3.1 Features (or Factors affecting Investment)

Every investment possesses certain common features or factors. These
are explained below –
(i) Return
Every investment is expected to provide certain rate of return over a peri-
od in future. Return is the income generated by investment expressed as
a percentage of the cost of investment. For example if a person buys an
equity share at a cost of Rs.100 and gets Rs.10 as dividend at the end of
10
the year, his return on share would be × 100 = 10% . Here we assume no
100
change in share price at the end of the year. If the share price also increases
10 + (105 − 100 )
to Rs.105 then his return would be × 100 = 15% .
100
5 Objectives of investment Para 1.3

Different investment instruments have different returns depending on their

level of risk. For example Treasury bills (T-bills) and govt. securities carry
low return as compared to equity shares.
Moreover, return can also be calculated as holding period return, annu-
alized return, etc. Detailed discussion about returns is given in Chapter 3.
(ii) Risk
Risk is defined as variability in expected return. If return from an invest-
ment is certain, fixed and 100% sure then there is no risk attached to it.
Generally, Government securities are considered to be risk-free. However
recent sovereign debt crisis (in which European Countries government failed
to repay the public debt) casts doubt on government securities being risk
free. Risk can be calculated as standard deviation of the expected returns
from an investment. Different individuals have different risk taking abili-
ties. For example young entrepreneurs may take higher risk than old and
retired people. Therefore investment must be done keeping in mind the
risk bearing ability of the investors. Hence risk assessment is an integral
part of portfolio management.
(iii) Liquidity
It is the “moneyness” of investment i.e. the ease with which investment can
be converted into cash with no or little risk of loss of capital. Some assets
are highly liquid (e.g. equity shares, mutual fund units etc.) and some are
less liquid (e.g. bonds, debentures). It is important to mention here that the
development and efficiency of financial markets depends to a great extent
on the liquidity of the securities traded in it.
(iv) Marketability
A related aspect is marketability i.e. the ease with which an asset can be
bought or sold. An asset may be highly marketable but less liquid (e.g. dis-
tress sale of property). For being marketable it is important that there is a
ready market for the security, where it can be bought or sold.
(v) Tax Benefits
Some of the investments provide tax benefits to inverters. Section 80C of
Income Tax Act, 1961 provides certain investment alternatives (e.g. PPF, NSC
Mutual Funds (ELSS-Equity Linked Savings Schemes etc.) which qualify
for deduction from taxable income upto Rs. 1,50,000. Assessment of tax
benefits is important while undertaking investment because it affects the
actual effective return from investment.
For example Rural Electrification Corporation (REC) has come out with
tax-free bonds at a coupon rate of 8.12% p.a. for 10 years. It implies that
Para 1.4 Investments : An overview 6

interest income from these bonds will be exempt from tax. If an individual
is in 30% tax bracket then the effective pre-tax interest rate would be
8.12%
= 11.6%
1- 0.30
(vi) Hedge against Inflation
A good investment should provide hedge against the purchasing power
risk or inflation. The investor must ensure that the return generated by
his investment is higher than the prevailing inflation rate. Then only he is
benefited by making investment, otherwise he is worse off. For example if
the prevailing inflation rate is 8%, the investor should look for investment
options which provide more than 8% return otherwise his real worth of
investment will go down. Inflation erodes purchasing power of money and
hence hedge against inflation is an important consideration in investment.
Generally, equity shares are considered to be a good hedge against inflation
because of their varying return. It is expected that in times of inflation, equity
shares generate higher return. On the other hand fixed income securities
like bonds are not a good hedge against inflation due to the fact that their
interest incomes are fixed and do not increase in times of rising inflation.
(vii) Safety of Capital
Safety of capital should come first. The investor must secure his principal
amount which he invests. That is, he should not be impressed by very high
rate of return on an investment if the amount invested is not safe. For this
credit rating agencies play an important role in providing bond-ratings.
Generally bonds which have lower than AAA ratings are considered to be
not so safe. For example many NBFCs come out with fixed deposit schemes
at an attractive interest rate but safety of investment is less.

1.4 Speculation
Speculation is investment in an asset that offers a potentially large return
but is also very risky; a reasonable probability that the investment will
produce a loss. It can be defined as the assumption of considerable risk
in obtaining commensurate gain. Considerable risk means that the risk is
sufficient to affect the decision. Commensurate gain means a higher risk
premium. Speculative assets are high risk-high return assets and hence
should be invested in with caution. Generally large investors hold specu-
lative assets so as to make quick gains.
Stock market is identified with two types of speculators - bulls and bears.
Bull speculators expect increase in stock prices while bear speculators expect
decline in prices. It must be noted here that speculation, per se is not bad.
Rather it is essential for smooth functioning of stock market and to maintain
7 Speculation Para 1.4

price continuity and liquidity. However excessive speculation is bad as it takes

the prices away from their true fundamental values. Therefore SEBI keeps
a check on excessive speculation in Indian stock market, through various
rule and guidelines under SEBI Act, 1992.
It must be noted here that the same asset can be held by an investor for
investment and by the other for speculation. For example shares of RIL,
if held by a small investor for long term, amounts to investment, but if it
is held by an FII for making quick return over short run then its implies
speculation.

Speculation vs. Investment

Investment and speculation can be distinguished on the following grounds :
Basis of Investment Speculation
Difference
1. Time horizon Long, generally exceeding Short may be as short as
one year intra-day
2. Risk Low to Moderate Very high
3. Return (expected) Low to moderate and consis- Very high and inconsistent
tent
4. Funds Here own funds are used for Speculators also borrow
investment funds and/or do margin
trading
5. Income Dividend, Interest etc. Change in price of asset
6. Source of Fundamental factors of the Herd instincts, inside infor-
Information company are analysed mation etc.

Gambling
Gambling is a game undertaken for someone’s excitement e.g. horse race,
card games, lotteries. Here although the winner makes big money but that
cannot be classified as return because that is not consistent or regular.
Gambling is a zero sum game – someone’s loss is other party’s gain. It is
purely by chance that one party wins over the other. Therefore gambling
is highly uncertain and may involve complete loss of funds put in it.
Have you ever thought that in a bull market everybody is making profit
and become happy. Then why is it that in a bear market everybody is
sad? In that market also bear speculators make profit.
Hint : In a bull market, investors net worth increases while in a bear
market company’s market capitalization falls and hence investors wealth
decline. Only speculators make money in such a market.
Para 1.5 Investments : An overview 8

1.5 Risk Return Trade off

Investors like returns but they dislike risk. All the investors are risk averse
as they try to avoid risk. However returns cannot be certain or fixed. The
value of investment also varies overtime due to uncertainties prevailing in
the investment environment. Hence returns cannot be separated from risk.
In the process of investment, the investor may first decide about the level
of risk he is willing to undertake. Once the risk tolerance level is decided
then the objective should be maximization of return for that level of risk.
In order to earn higher returns, investors have to assume high risk. This
is because there is a positive relationship between risk and return. Both
return and risk move together. Let us assume that there are two securities
available in the market. Security A and B. Both the securities have same
level of risk but security A has higher return. In such a case every investor
will sell security B and instead invest in security A. There will be selling
pressure on security B which will drive its price downwards and hence
the cost of investment will be lower. Since return from an investment is
negatively related with the cost of investment, the returns from security B
will rise. Decline in purchase price will result in higher return from Security
B. On the other hand there will be heavy demand for security A and this
would push its price upward. Increase in price will result in higher cost
of investment and hence lower returns from security A. This process will
come to an end when the returns from both security A and B become equal.
If the risk level of two securities is same then both of them must provide
same return, otherwise investors will never chose to buy security providing
less return. Hence risk and return move together. Higher return is possible
only if investor assumes higher risk. But investor wants to maximize return
and minimize risk. This is known as Risk Return Tradeoff. The expected
return from an investment must be commensurate with the risk of that
investment. If returns are abnormally higher there will be mad rush for that
security and if returns are abnormally lower then no investor will choose
that security. Hence investors must always make investment decisions after
careful consideration of Risk-Return Tradeoff. A variety of securities are
available in capital markets which have different return-risk relationships
or Return risk tradeoff as shown in Table 1.1:
Table 1.1 : Risk Return Relationship of different
types of Investments
Investment Return Risk
Treasury bills Very low Nil (or negligible)
Bonds and debentures Low Low
Preference shares Medium Medium
Equity shares High High
9 Investment environment Para 1.6

The return from an investment has two components:

i. Risk free rate of return which is actually the time value of money.
It is the compensation or reward for time. It is common for all the
investments. Every investment including a risk free asset like Trea-
sury bills must earn this much of return.
ii. Risk premium : risk premium is the compensation for assuming risk.
It is specific to an individual investment. If risk in an investment is
higher, risk premium must be higher and if risk in an investment is
lower, then risk premium will be lower. It is the risk premium that
varies across different types of investments.
Required Return from an Investment = Risk free return + Risk premium
An investor may select an investment depending upon his risk return
preferences. He may select equity shares if he is willing to assume higher
risk for higher expected returns. On the other hand a retired person, who
wants lower risk, may select to invest in bonds and debentures.

1.6 Investment Environment

The investment environment implies various types of securities which are
available for investment and the entire mechanism or process through
which these securities can be bought or sold.
The investment environment comprises of three main aspects - securities
(also referred as financial assets or financial instruments); securities mar-
kets (i.e. financial market) and intermediaries in securities markets. The
investment environment now a days is characterized as VUCA(Volatile,
Uncertain, Complex, Ambiguous).
i. Securities :
An investor can invest in a variety of securities such as equity shares,
bonds, debentures, derivatives, mutual funds, exchange trade funds
etc. One may also invest in commodities and bullions (such as gold
and other precious metals). However, here we are primarily concerned
with investments in financial assets or securities as defined under Sec.
2(h) of Securities Contracts (Regulation) Act, 1956. The term security
means that the holder of the security has a claim to receive future
benefits under certain conditions. These securities may be transferred
from one owner to the other without much difficulty. Various types
of securities can be classified into the following categories on the
basis of their peculiar features as well as risk return relationships.
Para 1.6 Investments : An overview 10

a. Equity shares : Equity shares are also known as ‘Common

stocks’ in western economies. An equity share represents an
ownership claim in a company. The owner of the equity share
is termed as equity shareholder in the company and enjoys all
voting rights in corporate matters. Equity shareholders get fu-
ture benefits in the form of dividends (i.e. the amount of profit
distributed as dividends) and in the form of price appreciation
(or capital gains). However it is not obligatory on the part of
the company to declare dividends every year and the amount
of dividends, if any, may also vary from year to year. Hence
equity shares are also referred to as ‘variable income securities’
and do not promise fixed return. Due to variability in returns,
equity shares are highly risky securities. They may generate a
very high return or very high loss during the investment hori-
zon. Worldwide equity shares are expected to generate higher
returns (as they have higher risk) over long term.
b. Bonds and debentures : Bonds and debentures are fixed income
securities. A bond is an IOU (I Owe You) of the borrower. It
arises out of a lending-borrowing contract wherein, the borrow-
er (or the issuer of the bond) promises to pay a fixed amount
of interest to the lender (or the bond holder) periodically and
repays the loan either periodically or at maturity. Most of the
bonds and debentures are redeemed at maturity only and they
carry a fixed coupon rate or fixed rate of interest. Bonds may
be corporate bonds or government bonds, short term bonds or
long term bonds, secured bonds or unsecured bonds etc. Bonds
and debentures may also be convertible or non-convertible.
Since bonds and debentures carry a fixed rate of interest, their
future benefits are known in advance, Therefore they have
relatively lower risk than equity shares. At the same time they
generate relatively lower return.
c. Treasury Bills : Treasury bills are the securities issued by
Central Government in the context of a lending- borrowing
contract. An investor in Treasury bills actually lends money
to the central government. This type of security carries min-
imum (or negligible risk) risk of non-payment of the amount
as promised. Hence the default risk in case of Treasury bills
is negligible. These bills are issued at discount and redeemed
at par and hence the rate of return is known with certainty in
the very beginning of the investment. Because of this feature,
Treasury bills are also referred to and used as “Risk free asset”
in research studies.
11 Investment environment Para 1.6

d. Other securities : Besides above, a number of new securities

have been introduced in securities market over the past two de-
cades. These securities include- mutual funds, exchange traded
funds (ETFs), derivatives (financial derivatives and commodity
derivatives), warrants, mortgaged backed securities, deep dis-
count bonds, catastrophe bonds, collective investment schemes,
REITS (Real Estate Investment Trusts) etc. These securities
have enriched the investment environment and provided a
variety of choice to the investors.
ii. Securities Market:
Securities market bring together the buyer and seller of securities
and provide operational mechanism to facilitate the exchange of
securities. An efficient and developed security market is a prerequisite
for increased investment in securities. There are many types in which
securities market can be classified. The basic classification is in terms
of time or tenure of securities. On the basis of time securities market
is classified as - Capital Market and Money Market. Capital market is
the market for long term financial investment and instruments (more
than one year), while money market deals with short term securities
(one year or less). Capital market primarily deals with equity shares,
long term bonds and debentures, while money market deals with
Treasury bills, short term debts such as commercial paper, certificates
of deposits etc. Capital Market in India is further classified into the
following two segment - Equity Market and Wholesale Debt Market.
Capital Market Money Market
1 It is the market for long term capital It is the market for short term
instruments such as equity shares, financial instruments having
debt etc. These instruments have a maturity in less than 1 year. These
period of 1 year or more. instruments are certificates of
deposits, commercial papers,
Treasury bills etc.
2 Capital market can be further sub- Money market can be sub-divided
divided into the following three into the following segments—
segments— (i) Treasury bills market
(i) Equity market (ii) Commercial papers market
(ii) Wholesale Debt market (iii) Certificate of Deposits market
(iii) Derivatives market (iv) Call money market
3 Capital market instruments have Money market instruments have
medium liquidity except equity very high liquidity
and derivatives.
Para 1.6 Investments : An overview 12

Capital Market Money Market

4 Capital market is used by Money market is used by
participants for the purpose of participants as a means for
raising funds or capital for medium borrowing and lending in short
to long term term, with maturities that usually
range from overnight to just under
a year
5 The rates of return in capital The rates of return in money
market is relatively high due to market is relatively low due to short
longer maturity period maturity period
6 Capital market is essential for Money market is essential for
overall growth of the economy maintaining liquidity in the
economy.
A security market can be further classified as Primary market or
Secondary market. Primary market is the market where new
securities are issues for the first time; while secondary market provides
the platform where existing (or second hand) securities are bought
or sold. A well functioning primary market is essential for the growth
of investments in an economy. At the same time a transparent and
efficient secondary market that ensures speedy transfer of ownership
of securities, is a prerequisite for investment in a particular security.
For example in India, secondary market for bonds is not properly
developed and hence growth in bond market in India is lagging behind
as compared to growth in other countries bond markets.
Every security is characterized by market intermediaries which are
positioned between the buyer and seller of securities. Stock exchange,
its brokers and sub-brokers act as market intermediaries in secondary
market.
Difference between primary and secondary market
Sl. Basis Primary Market Secondary market
No.
1 Meaning It is a market where new It is the market for trad-
securities are issued for ing of already issued and
the first time by an existing existing securities.
or new company.
2 Price deter- The issuer company itself Price of securities is deter-
mination decides the price of securi- mined by the interplay of
ties for the first time using market forces of demand
the book building method. and supply operating at
It can decide the amount the stock exchange.
of premium also.
13 Investment decision process Para 1.7

Sl. Basis Primary Market Secondary market

No.
3 Variability in Prices (the issue price) of Prices of securities vary
prices securities are fixed. on the basis of demand
and supply forces.
4 Buying and The new securities are The buying and selling of
selling parties sold by the company and securities usually happens
involved bought by investors. between investors.
5 Financing for Primary market is a plat- There is no fund raising by
business form for companies to companies because there
raise finance for expan- is no issue of securities in
sion, diversification, etc. secondary market. Only
trading of existing secu-
rities is done here.
6 Capital for- Primary market directs Secondary markets pro-
mation v/s the flow of funds to pro- vide liquidity to investors,
Liquidity ductive use in business, thereby indirectly leading
thereby directly resulting to capital formation.
in capital formation.
7 Financial in- Main intermediaries oper- Secondary market has in-
termediaries ating in primary market termediaries like brokers,
are merchant bankers, sub-brokers, etc.
underwriters, registrar
to issue, collection banks,
etc.
iii. Regulation of securities Market:
The investment environment and hence securities market is well
regulated. Securities market is not a laissez faire market but ade-
quately regulated by regulatory bodies such as SEBI (Securities and
Exchange Board of India), RBI (Reserve bank of India), Department
of Company affairs, Ministry of finance etc. The multiplicity of reg-
ulatory agencies sometimes prove detrimental to the growth and
efficient regulation of securities market. Hence recently there is a
move towards reducing the number of regulatory bodies in India.
On 28th September 2015, Forwards markets Commission has been
merged with SEBI.

1.7 Investment Decision Process

The process of investment broadly comprises of the following steps :
1. Setting up the investment policy
2. Building up an inventory of securities
3. Performing security analysis
Para 1.7 Investments : An overview 14

4. Constructing portfolios, analyzing portfolios and selecting the optimal

portfolio
5. Portfolio revision
6. Portfolio performance evaluation and management
These steps are discussed in detail as under :
1. Setting up the Investment Policy : The first step involves setting
up the investment policy for the investor. The investment policy
is based on investment goals or objectives, investible funds, tax
status and investment horizons. Different investment objectives
of an investor may be capital appreciation, regular income, tax
benefits etc. The investment objectives are framed as per the
risk return preferences of the investors. Every investor has
a different risk appetite or risk profile which is an essential
ingredient in investment policy. The investment objective is
also related to the period of investment or investment horizon.
Investment policy sets the broad framework for investment
decision making by an individual investor.
2. Building up an inventory of securities : This step involves build-
ing up a list of all available securities wherein an investor may
make his investment. Depending upon investment objectives
and investment horizon, the securities may be filtered. For ex-
ample, if an investor’s objective is to receive regular income at
low risk, then equity shares which do not pay regular dividends
may not be included in the list of securities where an investor
may invest.
3. Performing Security Analysis : Once an inventory or list of
available securities has been made, the next step is to analyze
these securities primarily with respect to risk and return char-
acteristics. This is known as security analysis. The main idea in
security analysis is to estimate the expected return and risk of
individual securities. This may also help investors in detecting
undervalued or overvalued securities and timing of buy or sell
decision.
There are various approaches of security valuation - Fun-
damental analysis, Technical analysis and Efficient Market
Hypothesis (EMH). As per fundamental analysis, in the long
term, the price of a security is equal to its intrinsic value or
true worth. Intrinsic value of a security is the present value
of all future cash inflows associated with the security. Hence
the investor first calculates the intrinsic value of the security
15 Investment decision process Para 1.7

using some appropriate discount rate and then compares it with

the prevailing market price to ascertain whether the security
is undervalued (intrinsic value> market price) or overvalued
(intrinsic value <market price). The investor should choose
undervalued securities for investment purposes. Fundamen-
tal analysis comprises of analysis of Economy, Industry and
Company level factors in order to ascertain the expected cash
inflows from the security. This is termed as Top Down approach
or EIC framework of analysis.
Technical analysis, on the other hand, is based on the premise
that ‘history repeats itself’ and hence future price behaviour is
predictable on the basis of past prices and volume information.
Past trend analysis, chart patterns and a number of technical
indicators can be used to predict future prices. On the basis of
future prediction of prices, an investor may decide whether it
is the right time to buy or sell. Hence technical analysis helps
an investor in market timing. Efficient Market Hypothesis
(EMH) assumes that current security prices fully reflect all
available information about that security. Hence the market
price is nothing but the fair price or true price of a security. As
per EMH anytime is a good time to buy or sell as there is no
consistent overpricing or underpricing in an efficient security
market.
4. Constructing portfolios, portfolio analysis and portfolio
selection : A portfolio is a combination of two or more securities
in which an investor may prefer to hold investments rather
than in all the securities available for investment. Therefore,
after security analysis, the next step is to construct all feasible
portfolios or portfolio opportunity set and selecting optimal
portfolio for the concerned investor. Portfolio opportunity set
is also termed as Investment opportunity Set. It must be noted
that there may be many feasible portfolios by combining various
securities in different proportions, but all of them may not be
efficient. An Efficient portfolio is one which provides maximum
return for a given level of risk or which has minimum risk for
a given level of return. Such efficient portfolios may also be
large in numbers. Hence in order to select the optimal or best
portfolio for the investor, one needs to consider risk return
preferences of the investor. For example for a young person,
who is willing to undertake risk to maximize return, we may
have an optimal portfolio comprising 70% of equity and 30%
Para 1.8 Investments : An overview 16

of bonds. On the other hand for a retired, old aged investor

the optimal portfolio may be 10% equity and 90% bonds and
debentures or fixed deposits.
5. Portfolio Revision : The fifth step in investment decision process
is portfolio revision. It consists of the repetition of the previous
four steps in the light of changes in investment environment.
Moreover the investment objectives of the investor may also
change overtime and hence there is a need to revise the origi-
nally selected portfolio periodically. Due to changes in security
prices, the originally built portfolio may not remain optimal
and hence the investor needs to revise it or build up a new
portfolio. Changes in security prices may also make certain
securities attractive, which were not selected earlier due to
higher prices or may make certain securities already include
in the portfolio, unattractive. All this calls for periodic revision
of the portfolio.
6. Portfolio performance Evaluation and Management : The last
step in the investment process is to evaluate the performance
of the portfolio. It implies determining periodically whether the
portfolio has performed better than the benchmark portfolio
or other similar portfolios or not. Portfolio performance evalu-
ation may be done using absolute return as well as various risk
adjusted return measures such as Sharpe ratio, Treynor’s ratio
or Jensen’s alpha. Sharpe ratio is calculated by dividing excess
return (i.e. risk premium) by the total risk of the portfolio. It
is a measure of excess return per unit of risk. The higher this
ratio the better is the performance of the portfolio. Detailed
discussion about portfolio performance evaluation is provided
in Chapter 10.

1.8 Direct Investing and Indirect Investing

An investor can invest in securities directly or indirectly.
Direct investing involves the purchase or sale of securities by the investors
themselves. In this case the investor has the entire control over the invest-
ment decision i.e. which securities are to be purchased and sold as well as
when to purchase or sell. The securities may be securities of capital market
(such as equity shares, bonds, debentures), or of derivatives markets (such as
futures and options) or of money market (such as treasury bills, certificates
of deposits, commercial papers etc.). The investor is required to perform all
the steps of investment decision process, as explained above, on his own.
17 Direct Investing and Indirect Investing Para 1.8

Therefore direct investing requires investing skills and expertise. Moreover

it is a time consuming process of investing. In case of direct investment,
the cost of analysis and monitoring is incurred by the investor directly.
Indirect investing involves investing in mutual funds (open ended as well
as closed-ended funds), exchange- traded funds or collective investment
schemes including Alternative Investment Funds (such as venture capi-
tal funds, hedge funds, REITs, SME fund etc.). In this case, the investor
does not invest directly in various securities. He has no control over the
composition of the fund’s investment; the investor only controls whether
to buy or sell the shares or units of the fund. Therefore, the investor only
decides which mutual fund or investment company to invest in. The ulti-
mate investment decision is made by the fund or investment company in
case of indirect investing. The investor buys or sell the units (or shares)
of the Fund, which in turn makes investment in securities and build up
portfolios as per investment objective of the Fund or Scheme. The investor
becomes unit holder in the fund and has ownership interest in the asset of
the fund or investment company and is entitled to interest, dividends and
price appreciation (or decline). Thus Indirect investing in a mutual fund,
ETF or investment company or even in alternative investment funds, is
an alternative route for investor to invest. It is convenient and ideal form
of investing for investors who are not skilled enough or who do not have
time to perform security analysis and portfolio management process. In
case of investment in mutual funds or any other investment company,
the investment costs are incurred by the fund or company but ultimately
these costs are passed on to the investors in terms of management fees
or expenses. These expenses or fee reduce the value of the portfolio or
investment done by the fund or company.
Direct Investing Indirect investing
Meaning Direct investing involves pur- Indirect Investing implies invest-
chase or sale of securities by ment in mutual fund or other
the investors themselves. investment companies rather than
directly in securities.
Instruments of Capital Market - such as equity Mutual funds - open ended, closed
Investment shares, bonds, debentures etc. ended
Money Market - such as trea- Exchange traded funds
sury bills, certificates of depos- Collective Investment Schemes
its, commercial papers etc.
Alternative Investment Funds-
Derivatives Markets - such as such as Venture capital funds,
futures and options hedge funds, SME funds, Real
Estate Investment Trusts (REITS)
etc.
Para 1.9 Investments : An overview 18

Direct Investing Indirect investing

Control Investor has the entire control Fund or investment company has
over the investment decision direct control over the investment
i.e. which securities are to be decision i.e. which securities are to
purchased and sold as well as be purchased and sold as well as
when to purchase or sell. when to purchase or sell.
Costs Costs of analysis and monitor- Costs are incurred by the Fund or
ing is incurred by the investor Company but ultimately passed on
directly to the unit holders in terms of fee
or management expenses.
Skills and Time Direct investing requires in- Indirect investing does not require
vesting skills and expertise. investing skills and expertise by the
Moreover it is a time consum- individual investor. The fund or the
ing process of investing by an investment company where inves-
individual investor. tor invests is expected to provide
such expertise and professional
funds management. They have
professional fund managers.
Convenience Direct investing may not be Indirect investing is very con-
convenient to small investors venient and preferred mode of
who do not possess requisite investment to small investors who
investing skills and who do not do not possess requisite investing
have much time to perform skills and who do not have much
security analysis. time to perform security analysis.

1.9 Approaches to Investing - Active Investing

(Investment) and Passive Investing (Investment)
Besides the classification of investing as direct investing and indirect
investing as explained above, another popular classification of investing
is active investing (or Active Investment) and passive investing (or Passive
Investment).
Active Investing implies making investment in securities after actively and
carefully analyzing all the securities and portfolios. Such an approach to
investing requires that the investor is actively engaged in the task of security
analysis, selection and building up suitable portfolios. Portfolios are then
revised and their performance is assessed at regular intervals. The choice of
securities is made in such a manner that the investor gets maximum return
for a given level of risk. The idea behind active investing is that investment
analysis can yield superior returns to the investors. Active investing requires
investment skills and is a time consuming and continuous process.
Passive Investing implies making investment in Index Funds or Exchange
traded funds. An index funds is a fund that tracks the performance of a
19 Diversification, Hedging and Arbitrage Para 1.10

broad based market index. Buy and hold is also termed as passive invest-
ing. In case of passive investing the investor is content with the market
return at market risk. He does not expect to earn returns over and above
the one that is given by the market. The idea behind passive investing is
that nobody can earn superior returns in an efficient market. Hence it is
better to buy and hold the market portfolio or market index which is the
underlying asset of the Index Funds or ETFs. Passive investing does not
require much investment skills and is not a time consuming or continuous
process. Once investment is made in Index fund, the investor holds it over
the investment horizon.

1.10 Diversification, Hedging and Arbitrage

Investment in securities may involve the following three strategies - diver-
sification, hedging and arbitrage.
Diversification : Investors are risk averse i.e. they avoid risk and assume
risk only when it is adequately rewarded in terms of higher returns.
Diversification means investment in a large number of unrelated securities
so as to reduce risk. The basic idea behind diversification is “Don’t put all
your eggs in one basket”. Hence investors choose a variety of securities and
build up diversified portfolios so as to reduce risk. If an investor invests all
his funds in only one type of security then he would incur huge losses if
that security performs badly. By having a diversified portfolio of a variety
of securities, it is possible to reduce risk because if some securities perform
badly then there are others which might perform well. Hence portfolio risk
will be lower.
Hedging : Hedging means investing in a security or contract that can fully
or partially offset some risk. When an investor already has an existing
security, he is exposed to price risk i.e. the risk that the price of that security
may decline in future. In order to eliminate or reduce such a risk, he may
take a counter position in derivatives market such as futures or options.
He may sell futures or he may decide to buy a put option. This is termed as
Hedging. A hedge asset or security is one which has negative relationship
with the existing security. A perfect hedge security is perfectly negatively
correlated with the existing security. Hedging is sometimes also referred
to as matching positions.
Arbitrage : In general, arbitrage is the riskless exploitation of price differ-
entials in different markets. It refers to a situation where an investor takes
a buy and sell position on the same asset simultaneously but in different
markets so as to make risk free profits. For example if the market price of
SBI share is Rs. 2500 on NSE but Rs. 2450 on BSE, then there is an arbitrage
opportunity. An investor may take a buy position on BSE, buy the share at
Para 1.11 Investments : An overview 20

Rs. 2450 and simultaneously take a sell position on NSE and sell the share
at higher price of Rs. 2500. By doing this he makes a risk less profit of
Rs. 50 (i.e. 2500-2450). However this arbitrage opportunity will be exploited
by all the active investors and hence soon the price of SBI share will decline
on NSE (due to selling pressure) and rise on BSE (due to demand pressure).
This arbitrage will come to an end when the market price of SBI becomes
equal in both the exchanges. Therefore arbitrage in fact works as a process
of bringing equilibrium. It must be noted that here we assume that there
is no restriction on short selling.

1.11 Impact of Taxes on Investment

Taxes play an important role in investment decision making. Personal taxes
are levied on individual’s income under the head salary, house property,
business and profession etc. Income from investment is also subject to
tax. However the rate of tax differs from investment to investment. Some
incomes from investments are also exempt from tax such as tax free bonds.
Besides, there are some investments which are deductible while calculating
taxable income and hence provide tax savings.
In order to compare alternative investments, one needs to take into con-
sideration the impact of taxes and compare the alternative investment’s
benefits either pre-tax or post-tax.
Post Tax rate = Pre tax Rate (1-Tax rate)
Or alternatively
Post tax rate
Pre Tax rate =
(1- Tax rate)
Taxable Equivalent Yield : In case of Tax free investments (such as Tax
free bonds) no tax is to be paid on the annual interest income. The interest
income is exempt from tax in such a case. Here we can calculate taxable
equivalent yield to compare it with an investment the yield of which is tax-
able. Taxable equivalent yield is the equivalent pre tax yield of a tax free
investment. It can be calculated using the following formula
Tax free rate
Taxable equivalent yield = (1 − Tax rate)
If tax free rate is 10% and the investor is in 30% tax bracket, then taxable
equivalent yield will be 14.3%.
0.10
Taxable equivalent yield = = 0.143 or 14.3%
1- 0.30
21 Impact of Inflation Investment Para 1.12

1.12 Impact of Inflation Investment

Inflation erodes the purchasing power of money. Therefore it is necessary
to consider prevailing inflation rate while making investment. Now-a-days
inflation is very high around 9 to 10%, and hence any investment alterna-
tive which generates less than this much of the return is actually making
a loss in real terms.
We can understand the impact of inflation on investment by calculating real
rate of return rather than nominal rate of return. Real rate of return is the
return adjusted for inflation i.e. it does not have any element of inflation
rate. Nominal rate of return is the prima-facie rate of return earned on an
investment and contains the element of inflation rate. We can calculate
real rate of return as given below :
 1 + Nominal Rate of return 
Real Rate of Return =   -1
 1 + Inflation Rate
As an approximation
Real Rate of Return = Nominal Rate of Return - Inflation Rate
Hence if nominal rate of return on investment is 12% and inflation rate is
9% then real rate of return is
(1 + 0.12)
Real Rate of Return = -1 = 0.0275 or 2.75%
(1 + 0.09)
It implies that in real terms the investment is generating only 2.75% return,
although it appears to a layman that the return is 12%. That is the real net
worth of individual is increased only by approx. 2.75% return and not by 12%.
In times of higher inflation the amount of investment falls in an economy
because individuals prefer current consumption to future consumption
due to decline in the purchasing power of money.
In times of increasing inflation, a rational investor should search for
securities, the returns of which increase with increase in inflation. In such a
case the real rate of return may not decline. It must be noted that in times
of inflation bond or other fixed income securities are not so appropriate
because the return on fixed income securities is fixed in nominal terms
and does not increase with increase in inflation. Hence every year the real
rate of return declines as inflation increases.
Equity shares are generally considered to be good hedge against inflation
and hence an appropriate investment in times of increasing inflation. The
underlying reason is that return on equity shares (in the form of dividend
and capital gain) increases in times of inflation and hence real rate of return
is not affected much by inflation.
 Investments : An overview 22

Summary
1. Investment is employment of current funds to earn commensurate return in
future.
2. Investment may be classified as Real investment and Financial Investment.
3. Real investment is investment in tangible assets which are physical assets
such as plant, machinery, equipments etc.
4. Financial assets are assets that represent claims against the investee or own-
ership claims over real assets such as equity shares, bonds, debentures etc.
5. Speculation is taking high risk in expectation of high and quick returns.
6. Risk and return move together. Hence there is a risk return tradeoff.
7. The investment environment comprises of - securities, securities markets and
intermediaries in securities market.
8. There are six steps in Investment decision process - setting up of investment
policy, making an inventory of securities, security analysis, portfolio con-
struction, analysis and selection, portfolio revision and portfolio performance
evaluation.
9. All feasible portfolios are not efficient.
10. Selection of portfolios is as per risk return preference of the investor.
11. There are two modes of investing - direct investing and Indirect investing.
12. Direct investing means buying and selling of securities by the investor himself.
13. Indirect investing means investment in a mutual funds, ETF or investment
company.
14. Diversification is the process of investing in a large number of unrelated
securities so as to reduce risk.
15. Hedging means taking a counter position so as to reduce risk.
16. Arbitrage means taking simultaneous positions in different markets to exploit
price differential across markets.
17. Arbitrage brings in equilibrium in security market.
18. Investment decisions are affected by taxes and inflation.

Test Yourself

True/False
i. Speculation is always bad.
ii. No asset is risk-free.
iii. Financial investment is done in tangible physical assets.
iv. There are only two features of investment -return and risk.
23 Test yourself

v. Same asset cannot held for the purpose of investment and speculation.
vi. Investment is employment of current funds to earn commensurate return in
future.
vii. Speculation is taking high risk in expectation of high and quick returns.
viii. Risk and return do not move together.
ix. Optimal portfolios are same for all investors.
x. All feasible portfolios are efficient.
xi. Direct investing means investment in a mutual funds, ETF or investment
company.
xii. Diversification is the process of investing in a large number of same type of
securities so as to reduce risk.
xiii. Hedging is possible when securities are negatively related.
xiv. Arbitrage means taking simultaneous positions in different markets to exploit
price differential across markets.
xv. Arbitrage brings in equilibrium in security market.
xvi. Arbitrage opportunities exist for long term in securities market.
xvii. Taxes do not affect investment decisions.
xviii. In times of inflation equity shares is a better investment than bonds.
(Ans i. F, ii. T, iii. F, iv. F, v. F, vi. T, vii. T, viii. F, ix F, x. F, xi. F, xii F, xiii. T, xiv.
T. xv. T, xvi. F, xvii. F, xviii. T)

Theory Questions
1. Explain the term ‘Investment’ and its various types. [Paras 1.1, 1.2]
2. What is Financial Investment? How is it different from real investment?
[Para 1.2]
3. What are the objectives of investment? Explain in detail. [Para 1.3]
4. Differentiate between investment and speculation. Can the same asset be
held for investment by one investor and speculation by the other? [Para 1.4]
5. Define the term Investment. How is it different from speculation?
[Paras 1.1 & 1.4]
6. Explain the following :
i. Diversification [Para 1.10]
ii. Hedging [Para 1.10]
iii. Arbitrage [Para 1.10]
iv. Direct investing [Para 1.8]
v. Indirect investing [Para 1.8]
 Investments : An overview 24

7. State investment decision process. What factors should an investor consider

while making investment decisions?
[B.Com (H)DU2009, 2013] [Paras 1.7 & 1.3.1]
8. What do you mean by Investment environment? Explain various constituents
of investment environment. [Para 1.6]
9. What do you mean by investment decision process? How is it going to help
the investor in making sound investment decisions?
[B.Com (H)DU 2012] [Para 1.7 ]
10. Differentiate between real and financial assets. Are they independent?
[Para 1.2]
11. What do you mean by Risk Return Trade off. Do high risky investments
always provide higher returns? [Para 1.5]
12. What do you mean by risk premium? Is it same for all the securities?
Why? [Para 1.5]
13. “Risk free return is compensation for time”. Explain. [Para 1.5]
14. Speculation is equivalent to gambling. Do you agree? Explain. [Para 1.4]
15. Briefly explain different kinds of investment outlets available to an investor.
 [B.Com (H)DU 2008] [Paras 1.1, 1.2 & 15]
16. Differentiate between Direct investing and Indirect investing. Which mode
of investing is suitable for an old aged investor who wants regular income?
[Para 1.8]
17. Distinguish between active investing and passive investing. Which type of
investing is appropriate in an efficient market? [Para 1.9]
18. How do taxes impact investment decisions? Explain with example.
 [Para 1.11]
19. Investments involve long term commitments. Comment.
[B.Com (H)DU 2007] [Paras 1.1 & 1.2]
20. All investors are risk averse. Does it mean that they do not assume risk?
[Para 1.5]
21. Investment is carefully planned speculation. Comment.
[B.Com (H)DU 2007] [Paras 1.1, 1.2 & 1.4]
22. Compare the following investments in terms of return, risk, liquidity and tax
shelter
i. Equity shares ii. Residential house. iii. Non-convertible debentures
iv. Gold. [B.Com (H)DU 2010] [Para 1.5]
23. Define investment. How does inflation affects investment decision? Give
examples. [B.Com (H)DU 2011] [Para 1.12]
24. Define investment. Discuss the steps involved in the investment decision
process. [B.Com (H)DU 2015] [Paras 1.1, 1.7]
25 Test yourself

25. Distinguish between financial and economic meaning of investment.

 (B.Com. (H), GGSIPU, 2015)
26. “Investment is well grounded and carefully planned speculation”. In the light
of the above statement, explain and differentiate between investment and
speculation. How do they differ from gambling? (B.Com.(H), GGSIPU, 2016)
27. (a) An investor’s motives to invest are inherently different from those of a
speculator yet both are key to efficient functioning of the market. Explain.
(b) Fixed income securities and equities are two totally different classes of
investment avenues. Discuss. (B.Com. (H), GGSIPU, 2017)