Need for Investment and Various Alternatives for Investment Finance Essay Essay
Investment Management is a broad term that encompasses employing, monitoring and evaluating the performance of assets held in various financial instruments. It deals with financial instruments and the major entities involved include financial institutions, insurance firms, banks, individuals, etc. The markets these days being highly volatile, investment management is of prime importance generating returns on assets by combating the risk involved due to surrounding factors. The paper basically focuses on the need for investment, various alternatives for investment, timing of investment and the investment process involved. Moreover, the paper also describes the major investment avenues (options) available to investors and the factors and approach that will be taken into consideration while making the investment decision. The paper also throws light on stock market fluctuations and corresponding investment behaviour. It covers the concept of time value of money and margin of safety. The author has also made an effort to describe the capital asset pricing model and arbitrage pricing theory. Futures and options have also been briefly described.
Introduction to Investment Management
Investment Management involves employing money in financial instruments in the present with an expectation of positive rate of return in the future. The financial instruments may be securities, bonds, assets, etc. Investors such as banks, companies, insurance firms or individuals seek to invest money in order to achieve their financial goals. The money required for investment usually comes from savings of an individual which he uses to get returns in the future. In the modern day scenario, there exist a lot of financial products which provide individuals with a variety of options to entities. Moreover, considering the volatility of markets and frequently changing regulations governing the various financial instruments, investment management is certainly the need of the hour. The money invested needs to be spread across various instruments in order to gain maximum return from the investment. Investment managers indulge into discretionary or advisory management to help the investors accomplish their objectives. In advisory investment management, the investment manager suggests alternatives regarding where and when to invest and when to sell the concerned financial instruments. In discretionary investment management, the investment manager has the authority to manage the financial instruments without the approval by the investor. Before investing, the investor has to find answers to few questions in order to come up with a plan for investment. These questions typically are: – Why to Invest? What to Invest? Where to Invest? When to Invest? How to Invest? These questions have been answered with reference to investment management as under: –
Why to Invest?
An investor would probably invest to generate an additional source of income to fund his future requirements. Now, when we talk about investment, a person’s income majorly involves savings and consumption. Savings are deposited in savings account in bank and are liable to receive 4-5% on interest per annum. Considering the rising levels of inflation, these savings lose value over a period of time. So, the individual switches to fixed deposits which provides him 7-8% per annum of interest rate. So, fixed deposit provides the individual with an acceptable rate of return with minimum or zero potential risk. When we talk about other instruments like shares or securities, it involves potentially high amount of risk due to fluctuating markets. So, the rational behaviour of the investor might not always work.
What to Invest?
The investor would typically invest his/her savings and financial reserves.
Where to Invest?
Investment alternatives are spread over a wide range and mainly include: – Investment in Bank Deposits Investment in Real Estate Investment in Currencies (Foreign Exchange) Investment in Gold Investment in Equities Investment in Commodities and Derivatives Investment in Government Bonds The investor should typically invest by diversifying his investment among various alternatives to maximize rate of return on his assets with minimum potential exposure to risk.
When to Invest?
It involves deciding upon the time during which to buy and sell the concerned financial instruments keeping the return on investment in mind. Moreover, the investor’s residence should be owned and not mortgaged. The investor must be earning sufficiently to meet the demand for current expenses. Moreover, the investor must also be able to take out time and demonstrate control over his emotions for successful management of his investment.
How to Invest?
Answering this question will enable the individual to define an investment system and an overall investment strategy with rules and regulations for the targeted investment.
Investment Management Process
The investment management process consists of 5 steps that mainly include: – Setting the Investment Objective Establishing Investment Policy Selecting the Portfolio Strategy Selecting the Assets Measuring and Evaluating Performance
Setting the Investment Objective
Investment objectives may vary from entity to entity be it banks, financial institutions, insurance firms or individuals. For an individual, it may to maximize return on investment with a minimum risk. On the contrary for a bank, it may be minimum interest spread over their cost of funds. Investment objective can be specified in terms of Income, Investment Capital Growth, Stability of investment and Implementation. Before setting the investment objective, SWOT analysis is done to get a better view of individual’s current financial situation. It could be done as shown below in the diagram: – Moreover in setting the investment objective, a tentative risk tolerance review is also conducted in order to assess the risk associated with each of the alternatives.
Establishing the Investment Policy
It involves defining a policy that helps in allocation of assets among equities, debt, fixed income securities, real estate and foreign currencies. While defining the policy, the constraints of the investment environment as well as the investor need to be kept in mind. Environmental Constraints include government rules and regulations as well as working of the market place. Individual Constraints include financial capability, risk profile, time available, and understanding of the investment environment. Defining the investment policy for the individual will involve coming up with a strategy and tactics for investment which are in sync with the available alternatives and the operating investment environment.
Selecting the Portfolio Strategy
Again the portfolio strategy has to be in accordance with the investment objective and the established investment policy and guidelines. It mainly involves an active or a passive strategy. Active strategies have a higher expectation when it comes to the factors influencing the performance of various financial instruments. Passive strategies have minimum expectation input. Active portfolio strategy also takes into consideration the purchase of stocks and subsequent holding period to maximize returns. It also takes into account the spread of portfolio over several sectors and industries and checks the investment worthiness of the current stock. Moreover, the investor also needs to have an investment philosophy depending on the forces affecting the stock market and movement of stock prices.
Selecting the Assets
This would involve defining the portfolio in a way that risk commensurate with returns. The available alternatives in terms of asset classes involve equity, fixed income securities, real estate, debt instruments, currencies, art objects, rare stamps, etc. The investor has to manage his portfolio from time to time and balance all of the above instruments in accordance with the objectives.
Measuring and Evaluating Performance
This involves analysing the performance of the portfolio against a realistic benchmark. An investor or manager would mainly consider the risk-return profile while evaluating the performance and this evaluation will provide him with feedback regarding the improvements that can be made in the quality of portfolio.
Investment environment is of prime importance as it helps the investor know about the demand supply gap that exists in case of various commodities and services. Each country has its own economy and several markets enable interaction among these economies. The market basically consists of: – The Regulator (E.g. SEBI in case of India) The Trading Platform and its system (E.g. National Stock Exchange) Brokers (E.g. Broking Firms) Participants/ Investors (E.g. Financial Institutions, Mutual Funds, etc.) A particular economy may be affected by events taking place in various parts of the world and so the overall investment environment has a major role to play in investment management.
There are a large number of alternatives available as far as the financial instruments for investment are concerned. However, these could be categorized into 4 major categories: – Financial Securities: – These include equity shares, convertible debentures, preference shares, gilt-edged securities, public sector bonds, savings certificate, money market securities, etc. These are freely tradable and negotiable. Non-securitized Financial Securities: – These include bank deposits, post office deposits, provident fund schemes, life insurance, etc. and are neither tradable, transferrable nor negotiable. Mutual Fund Schemes: – These are mainly equity or debt oriented schemes which are used when an investor does not want to invest in the market. Real Assets: – These include physical investments typically in real estate, gold and silver, stamps, art objects, etc.
The major attributes to be considered when deciding upon an investment avenue include: – Rate of Return: – It comprises of annual income and capital gain or loss. It is given by Rate of Return= Annual Income+ (Ending Price-Beginning Price)/Beginning Price Risk: – It refers to variance in the rate of return expected. Put in other words, it is the deviation of actual outcome of investment from expected value. Various techniques employed to measure risk include variance, standard deviation, etc. Marketability: – Here the instrument must have a low transaction cost and must be easily tradable. Moreover, price change between 2 transactions is expected to be very low. Thus, an instrument must be highly marketable. Taxes: – This attribute considers whether the investment avenue provides tax benefits. Tax benefits occur mainly in the form of Initial tax benefits, Continuing tax benefits and Terminal tax benefits. Convenience: – It involves the degree and ease with which an investment can be managed.
Comparison of Investment Avenues
Investment Decision Making Approaches
Following approaches have been considered when it comes to identifying investment strategies that can be implemented to gain maximum returns from various financial instruments: –
It deals with the intrinsic value of the instrument which is deeply affected factors related to overall economy, industry and company.
This approach is mainly driven by greed and fear which represent optimistic and pessimistic behaviour of investors respectively. Stock prices are driven majorly by emotions and hence the decision regarding investment is based accordingly. Here the investors use internal market data and analyze it through tools like bar charts, moving average analysis, etc. to understand the price movements.
This approach reflects the rational behaviour of the stock markets. It relies on the flow of information over time and hence makes the stock markets much more reliable and efficient. The major equation describing this approach is as under: – Current Market Price=Intrinsic Value
This approach involves all the 3 approaches as mentioned above. Here standards and benchmarks are established through fundamental analysis. Demand-supply gap and investor mood are tracked through technical analysis. It stresses on a positive correlation between risk and return and denies the fact that market is speculative or perfect.
Common Errors in Investment Management
Following are some of the basic errors that investors make due to a lack in perception regarding the existing investment environment: – Unrealistic goals and expectations Ambiguous Investment Policy Overconfidence of the Investor Unnecessary switching of stocks Averaging tendency and inclination for cheap stock Over/Under Diversification Attractiveness of known companies Bad attitude towards profit or losses
Investor v/s. Speculator
Long Holding Period typically atleast a year Very short holding period of, say, few days or months Usually is moderate when it comes to risk taking Assumes to high risk taking Moderate Returns provide less risk High returns on high risk exposure Decision based on proper analysis Decision based on market psychology
Active Asset Allocation
For any investor, there exists a base amount with which he/she starts investing in various financial instruments. This base amount is known as the asset base. For instance one has savings worth INR 5 lacs and inheritance worth INR 25 lacs. Then, if the investor plans to invest this, then his total asset base would be INR 30 lacs. Now, asset allocation involves percentage distribution of various financial instruments in which the investor wishes his/her asset base to be divided among. Here the financial instruments stocks, bonds and cash. Here again there will be a trade off between performance of the portfolio and aversion to risk. Thus, asset allocation involves monitoring and evaluating investment plan to decide upon the optimal allocation of our asset base to various financial instruments in order to meet the performance criteria set for the portfolio.
Asset Allocation Classes
Basically there are 3 classes of asset allocation as mentioned under: –
Long-Term Asset Allocation
It involves a passive process wherein risk and performance are balanced. Here analysis is done in terms of stability and performance about the asset mix which best meets the long-term investment plan.
Active Asset Allocation
It involves an active process wherein the strategy is usually “buy low, sell high”. Here performance of the portfolio is improved through mixing of assets in response to changing market opportunities. It is a dynamic process and hence the investor needs to be aware of the market fluctuations.
It involves an active strategy of “buy high, sell low”. This is usually implemented for shielding the portfolio against adverse market action and hence preventing the performance from degrading.
Asset Allocation Process
Asset allocation process is based on assumptions which state the role of securities market and related returns associated with various asset classes. The first assumption stating that securities market reflects the rate of returns available from various asset classes. The second assumption being that of a normal relationship among these returns. The third assumption being the fact that securities market correct disequilibrium conditions when they occur. Again markets deviating from the equilibrium have better prospects for profits. So, the allocation process should be a step-by-step approach after evaluation of risk return profile of each of the asset class considered.
Portfolio Upgrade and the Use of Futures
A portfolio basically consists of 2 categories of stocks namely the “buy candidates”, which are very attractive and “hold candidates”, which are mildly attractive. Portfolio upgrade is required whenever a need arises to shift from one asset class to another. In an investment decision to move from stocks to cash, an investor may sell “hold candidates” having potentially lower expected returns. Futures are used whenever there is a need to accomplish a change in the existing asset mix of portfolio. Futures reduce the transaction cost and hence are an attractive tool. However, with futures we need to maintain a cash reserve in the portfolio in order to provide for margins involved in the futures trade. Some of the advantages of futures include: – Low Transaction Cost High Liquidity Fast Execution Daily trades possible Potential of Favourable Mispricing However, recording all transactions may pose a disadvantage to the use of futures.
Investment Management and Trading in the Stock Market
Stock Market trading involves buying and selling a quoted stock in a manner that generates profit for the investor. Stock market behaviour is volatile and at every step it may differ. Research findings show that a step is 6.25% of base price. So, if base price of a stock is INR 1000, then one step is INR 62.5.
Phases in the Stock Market: –
Bull Phase: – In this phase the stock prices are consistently rising. Equities traded in stock market at least taking 2 steps forward with 1 step back. Bear Phase: – In this phase there is consistent fall in the stock prices. Equities trade in the stock market at least take 2 steps backward with 1 step forward. Consolidation Phase: – In this phase equilibrium is reached and stocks traded take 1 step forward for every 1 step backward. Depending on the available information, participants tend to drive the stock prices up or down. Distribution Phase: – In this phase prices are at their yearly highs and so strong investors sell to weak investors and after the selling is done, prices again move down.
Determining Intrinsic Value of Stock
Intrinsic value of a stock is determined through following steps: – Calculate the Earnings Per Share of the stock (EPS is based on assumptions about revenue and cost behaviour. Expected EPS is ought to give an idea about the profit generating ability of the company) Calculate price earning multiplier (Reflects investors’ willingness to pay and market’s valuation of company’s stock) Identify Value Anchor and Value Range (Projected EPS * Suitable P/E Ratio)
Margin of Safety
Margin of Safety plays quite a crucial role when it comes to transactions of various financial instruments. The default strategy of buying low and selling high in itself ensures a margin of safety for the investors. However, it is associated with the profits that the enterprise is making. Opportunities for margin of safety arise during bear market conditions. However, the investor has to use technical analysis for making his buy or sell decisions and timing also plays an essential part in these decisions. Consider a stock of, say, XYZ Ltd. priced at INR 200(Base Price). Now, price level below INR 200 means that stock is under-valued and thus it provides the investor with a margin of safety. Now, if the price rises to INR 200 or above, a rational investor would be a seller.
Time Value of Money
Time Value of Money refers to exchange of money at different point of time. The time gap between inflows and outflows in an investment leads to different current values associated with cash flows at different points in time. There are four primary reasons for the fact that money in future is worth less than what it is worth today. These are: – Rising Rate of Inflation Opportunity cost of Lost Earnings Uncertainty associated with future Human Preference to consume the goods now Compounding refers to situations where a current value is being converted to equivalent future value for comparison to another future value. Discounting on the other hand involves moving back in time to convert cash flow to be received in future to its equivalent current value. The concepts of compounding and discounting are widely used in comparison of various investment avenues and the risk associated with each of them. Time Value of Money enables the investor in estimating the amount of money that he needs to save in order to meet interest obligation in future. It also helps in identifying a loan amount an investor can take considering the ability to pay the monthly instalments.
Investment Management and Inflation
Inflation refers to a gradual increase in the level of prices and hence an increase in the supply of money. Although high inflation and rising stock prices is not a good sign for the investors, most investors still consider investing in the stocks, as expected revenues and earnings are expected to grow at the rate of rise in inflation. However, the investor would be paying more for less as there may be no real increase in value of assets.
Stock Market Investment Rules
Make investments in larger companies with P/E ratio 10 or below and invest in top 2-3 companies in each of the industry Invest in sunrise industries and keep P/E ratio and EPS in mind. High P/E Ratio means high investor confidence and expected rise in company’s earnings in the near future. Watch out for low EPS Time your buys and sells High Returns can be earned from high priced stocks with reasonable price-earnings ratio Sell when P/E ratio shoots up to unrealistic levels or after a steep rise in stock prices
Stock Market Investment Strategies
Following points need to be taken into consideration when deciding upon an investment strategy in stock market: – Company considered is market leader in its industry and is growing at a rapid pace. Diversify in order to ensure low risk and a margin of safety (Invest in companies in fast growing sectors of economy) Sell stocks only in certain specified conditions Advantages: – Focus on Initial Selection, Savings on transaction costs, High returns from capital appreciation Stocks can be sold to en-cash profit or loss or when P/E ratio crosses 40 or when there is a sustained rise in stocks for a period of 1 year. Do not sell in order to earn short-term gains based on speculations Diversify over time and focus on long-term value creation
Risk and Return
Higher Rate of Returns means high amount of risk involved. Equity returns are mainly influenced by 5 factors as mentioned under: – Unanticipated changes in default risk Unanticipated changes in term structure of interest rates Unanticipated changes in inflation rate Residual market risk and Unanticipated changes in long-run growth rates of profit The 4 types of risk involved include Business Risk, Inflation Risk, Interest Rate Risk, and Market Risk. Here the correlation of security’s return in a diversified portfolio determined its risk. Moreover, risk associated with a portfolio is not a linear function of standard deviation of risk of each individual security. The risk can be measured by standard deviation method is identified to have 2 components namely Non-Diversifiable Risk (Effect cannot be avoided) and Diversifiable Risk (Avoidable and unique to individual security).
Capital Asset Pricing Model
Assumptions of Capital Market Theory
Investors base their investment decisions based on risk-return investments Purchase and sale of stocks can be done in infinitely divisible units Investors can short sell any amount of stocks without any limit Purchase and sell of stock by single investor cannot affect the price of that stock No transaction costs Absence of income tax considerations Consider an investor lending at a rate Rf=0.06(FD rate) which represents a risk free investment. If he places part of his funds at this riskless rate and part in other riskier securities, then he could generate portfolios along a line. Expected return would be given by equation Rp= X*Rm + (1-X)*Rf Rp=expected return on portfolio X=percentage of funds in risky portfolio Rm=expected return on risky assets Now, SDp= X* SDm SDp= expected standard deviation of the portfolio SDm=expected standard deviation of the risky assets If X is percentage of investment capital in risky assets, then if, X=1; Full Risky Portfolio X<=1; Part invested in risky portfolio X>=1; Implies that investor has borrowed funds to augment investment capital under his charge
The Arbitrage Pricing Theory
According to arbitrage theory, the returns on a stock vary depending on a number of expected as well as unexpected events that occur during the time for which investor holds his/her portfolio. According to this model, systemic factors have a larger impact on the performance and these factors pose major risk to the portfolio. In arbitrage pricing theory, the actual return R on any security or portfolio may be given by R= E+ b*f+ e where, E= Expected return on a given security or portfolio b=sensitivity of security to changes in systemic factors f=actual return on the systemic factors e=returns on unsystemic factors Here the major economic factors that can be considered include inflation, changes in levels of industrial production, changes in risk premiums, changes in interest rates, etc.
It describes the operational characteristics of market and is of 2 types mainly: – Internally Efficient: – Cheap Transactions, Brokerage, commissions and other charges included Externally Efficient: – Stock prices reflect all available information 3 forms of market efficiency include: – Weak: -Price fully reflects pricing and trading history of concerned security Semi-Strong: – Price fully reflects all public information, including price and trading history Strong: – Price fully reflects all relevant information, irrespective of the fact whether it is publicly available or not
Role of Options and Futures
Options and futures enable better investment risk management as they help the managers identify the risk patterns and behaviours. An option is a contract in which the writer of the option grants the buyer of the option the right to purchase or sell the writer an underlying security at a specified price. A future is a contract between a buyer and a seller, in which buyer agrees to take delivery and seller agrees to give delivery of some specific product at the end of a designated period of time. Options and futures can be used to create instruments that offer a higher return than a cash market instrument. They can also be used to adjust the risk exposure or alter the stock/bond mix of a portfolio. Future contracts can be used to reduce the transaction cost.
When we think of gaining returns on our savings and reserves, then we need to invest in various financial instruments. However, each of the instruments has a potential risk associated with it and so investment management targets on returns adjusting against risk in order to generate profit for the investor. The investment has to be made at the right time and the portfolio, which comprises of various instruments, needs to be monitored in order to ensure its stability and performance against market uncertainty.