Investment is the employment of funds to achieve additional income or growth in value. It is the allocation of monetary resources to assets that are expected to yield some gain or positive return over a given period.
These assets range from safe investments too risky investments. Investment is a commitment of a person’s funds to derive future income in the form of interest, dividends, rent, premiums, pension benefits or the appreciation of the value of their principal capital. Investment has two attributes namely time and risk.
Present consumption is sacrificed to get a return in the future. The sacrifice is certain but the return in the future may be uncertain. This nature of investment indicates the risk factor.
Growth requires investment which in turn requires a substantial amount of domestic savings. The stock market is a channel through which the savings of the investors are made available to the corporate bodies. Savings are distributed over various assets like equity shares, deposits, mutual funds units, real estate, and bullion. Planning an investment portfolio calls for expertise and time.
One should know and understand the investment opportunities available and be in a position to track them. People do not know what it takes to construct a portfolio and maximize returns from it, which stocks to buy when to sell bonds or fixed deposits. All this can be a difficult time consuming and confusing. Such type of portfolio should be selected that suits one’s risk profile one that serves investment needs and one that spreads risks.
The investment process consists of four stages viz (1) Investment Policy (2) Investment Analysis (3) Valuation of securities (4) Portfolio construction. As regards Investment policy the investor has to see that he should be able to create a fund which as an element of liquidity and quick convertibility of securities into cash.
The investor should then analyze the securities available for investment and must make a comparative analysis of the type of industry and kind of security. The primary concern of the investor at this stage is to analyze the returns and associated risk concerning the security. For the valuation of securities investment value, in general, is taken to be the present worth to the owners of future benefits, from investments.
The last stage that is portfolio construction requires a knowledge of the different aspects of securities. Traditionally portfolio management was the selection of securities to suit the particular requirements of an investor but the modern portfolio theory emphasizes the maximization of returns through a combination of securities.
The modern portfolio is based on a scientific approach that is based on estimates of risk and returns of the portfolio and the attitude of the investor towards a risk-return trade-off through analysis and screening of individual securities.
Though diversification of securities is important the securities have to be evaluated and thus diversified to some limited extent within which the maximum achievement can be sought by the investor. The investor’s portfolio should consist of the following (1) Safety of principal (2) Adequate liquidity (3) Stability of income (4) Capital growth and (5) Purchasing power stability.
Safety of principal demands careful review of economic and industry trends before deciding types and timing of investment. Adequate liquidity implies that the investment is a liquid asset if it can be converted into cash without delay at full market value in any quantity.
The portfolio of an investor should contain a planned proportion of high grade and readily saleable investment. The investor should also consider the stability of monetary income and purchasing power income. Capital growth has now become an important principle.
The ideal growth stock is the right issue in the right industry bought at the right time. Lastly, the investment must involve the commitment of current funds to receive a greater amount of future funds. For this, the investor has to study the degree of price level inflation he expects and the possibility of gain and loss in the investment.
Traditionally investment analysis emphasized only the projection of prices and dividends, but the modern approach is to analyze the risk and return of the common stock rather than rely on price and dividend estimates. Making sound investment decisions requires both knowledge and skill.
Knowledge is required regarding the complex investment alternatives available in the economic environment. The skill required to evaluate risk and return associated with an investment. The investment includes 3 elements viz (1) Return (2) Relationship of return and risk and (3) Time factor.
Returns known as rewards from investments include current income as well as capital gains or losses that arise by the increase or decrease of the security prices. The ultimate objective of the investor is to derive a portfolio of securities that meets his preferences for risk and expected return and the investor will select only those securities that maximize his utility. Thus the decision involves the “trade-off” between risk and expected returns.
To arrive at this trade-off the investor should decide whether his portfolio should contain only bonds or only common stock. In case it is decided to have a mix what should be the combination of the two kinds of securities i.e. what part should contain stocks and what part bonds. The investments are then examined over the period and expected risk and returns are measured. In this case, the investor usually selects a period and return tat meets the expectation of return and risk.
The management of investment is thus a complex study of maximizing returns. It is done based on three approaches i.e. (1) Fundamental Analysis Approach (2) The Technical Analysis (3) Efficient Market Theory.
The fundamental analysis approach is a method of finding out the future price of a stock which an investor wishes to buy. The method of forecasting the future behavior of investments and the rate of return on them is clearly through an analysis of the broad economic forces in which they operate and the analysis of the company’s internal working through statements like income statement balance sheet and statement of changes of income.
Thus in case of fundamental analysis the security analyst or prospective investor analyses factors such as economic influences, industry factors and company information such as product demand, earnings, dividends, and management to calculate an intrinsic value for the firm’s securities. He reaches an investment decision by comparing their value with the current market price of the security.
In the case of Technical Analysis, the prices of securities are determined by the demand and supply of securities in the market. The technical analysts thus believe that the forces of demand and supply are reflected in patterns of price and volume of trading. By examination of these patterns, he predicts whether prices are moving higher or lower and even by how much. He also believes that price movements whatever be their cause once in force persist for some time and can be detected.
In the rising market, investors purchase the shares in greater volumes driving the prices higher. At some time in the downtrend, investors may be very eager to get out of the market by selling the shares and thus bring down the share prices. The technical analyst believes that the past behavior of stock prices indicate the future of the stock prices.
Thus technical analysis is a method of presenting financial data of the past behavior and to find out the history of price movements and depict then on a chart. These charts have a method of prediction of significant price movements projecting meaningful patterns. These patterns are used to find out the trend of the market but many people raise the question of whether today’s stock prices contain any indication of the future.
According to efficient market theory share price fluctuations are random and do not follow any regular pattern. The accuracy and the quickness in which the market translates the expectation into prices are termed as market efficiency.
Market efficiency, in particular, refers to informational efficiency which is a measure of the swiftness or the market’s reaction to new information. New information in the form of economic reports, company analysis political statements, policy decisions of the Government, the announcement of new industrial policy is received by the market frequently and security prices adjust very rapidly and accurately to this market information for the eg. announcement of bonus shares of any company would increase in the price of that stock.
Portfolio analysis begins where investment analysis ends. A portfolio is a combination of securities. The investor should decide how best to reach the goals with the securities available. He tries to attain maximum returns with minimum risk. A diversified portfolio is comparatively less risky than holding a single portfolio. Diversification of securities is done to reduce risk in an economy in which every asset returns are subject to some degree of uncertainty. Most investors think that if they hold several assets, even if one goes bad others will protect from an extreme loss.
There are several ways to diversify the portfolio i.e. Debt and equity diversification where debt instrument provides assured return with limited capital appreciation. Common stocks, on the other hand, provide income and capital gain but they are uncertain. Both debt and equity are combined to complement each other. Similarly, there is an industry diversification Banking industry share that may provide regular returns but with limited capital appreciation.
The Information Technology stock yield high return and capital appreciation but their growth potential is not predictable. Similarly, security may be diversified amongst various industries like the utility industry, mining industry manufacturing groups, etc.
Holding one stock each from mining, utility, and manufacturing group is superior to holding three mining stocks. There is company diversification also where securities from different companies are purchased to reduce risk. Based on the diversification of debt and equity, industry and company the securities are selected.
A wide variety of investment avenues are open to investors to suit their needs and nature. Knowledge about the different avenues available enables investors to choose investments accordingly. The required level of return and the risk tolerance level decide the choice of the investor. In choosing specific investments investors will need definite ideas regarding features that their portfolio should possess.
To do a proper job of portfolio planning the investor must be aware of the investment process. The basic problem of portfolio planning is to establish an investment goal or objective and then decide how best to reach that goal with the securities available. By planning an investment portfolio the investor tries to obtain the maximum return with minimum risk on his investments.
By Dr. Arati Pant, Lecturer, Nainital Kumaun University, Published in Life Insurance Today, December 2007
