Section I: Overview of the Portfolio Formation Process

1. INVESTMENT ENVIRONMENT
1.1. Introduction to Investment
Investment is an activity that is engaged in by people who have savings, i.e. investments are made
from savings, or in other words, people invest their savings. It may mean many things to many
persons from many viewpoints. Basically, investment involves employment of funds with the aim
of achieving additional income or growth in values. The essential quality of an investment is that
it involves waiting for a reward. It involves the commitment of resources which have been saved
in the hope that some benefits will accrue in future. Investment can further be looked at from
financial and economic viewpoint.
- In the financial sense, investment is the commitment of a person’s funds to derive future
income in the form of interest, dividend, premiums, pension benefits or appreciation in the
value of their capital. Such investments generate financial assets.
- In the economic sense, investment means the net additions to the economy’s capital stock
which consists of goods and services that are used in the production of other goods and
services. Such investments generate physical assets.

1.2. Objectives of Investments [1]

An investor has various alternative avenues of investments for his savings to flow to. Savings kept
as cash are barren and do not earn anything. Hence, savings are invested in assets depending on
their risk and return characteristics.
 Capital appreciation: is concerned with long-term growth. This strategy is most familiar
in retirement plans where investments work for many years inside a qualified plan.
However, investing for capital appreciation is not limited to qualified retirement accounts.
If this is someone’s objective, he/she is planning to hold the stocks for many years. He/she
is content to let them grow within his/her portfolio, reinvesting dividends to purchase more
shares. A typical strategy employs making regular purchases. He/she is not very concerned
with day-to-day fluctuations, but keep a close eye on the fundamentals of the company for
changes that could affect long-term growth.

 Current Income: If someone’s objective is current income, he/she is most likely interested
in stocks that pay a consistent and high dividend. He/she may also include some top-quality
real estate investment trusts (REITs) and highly-rated bonds. All of these products produce
current income on a regular basis. Many people who pursue a strategy of current income
are retired and use the income for living expenses. Other people take advantage of a lump
sum of capital to create an income stream that never touches the principal, yet provides
cash for certain current needs (college, for example).
 Capital Preservation: Capital preservation is a strategy one often associates with elderly
people who want to make sure they don’t outlive their money. Retired or nearly retired
people often use this strategy to hold on the detention has. For this investor, safety is
 extremely important – even to the extent of giving up return for security. The logic for this
safety is clear. If they lose their money through foolish investment and are retired, it is
unlike they will get a chance to replace it. Investors who use capital preservation tend to
invest in bank CDs, U.S. Treasury issues, savings accounts.
 Speculation: The speculator is not a true investor, but a trader who enjoys jumping into
and out of stocks as if they were bad shoes. Speculators or traders are interested in quick
profits and used advanced trading techniques like shorting stocks, trading on the margin,
options, and other special equipment. They have no love for the companies they trade and,
in fact, may not know much about them at all other than the stock is volatile and ripe for a
quick profit. Speculators keep their eyes open for a quick profit situation and hope to trade
in and out without much thought about the underlying companies. Many people try
speculating in the stock market with the misguided goal of getting rich. It doesn’t work that
way. If one wants to try, he/she should make sure that he/she is using money, can afford to
lose.

1.3. Attributes of Investment

All investments are characterized by certain features. They are illustrated as follows:
- Return: All investments are characterized by the expectation of a return. Investments are
made with the primary objective of deriving a return. The return may be received in the
form of yield plus capital appreciation. Return depends upon the nature of the investment,
the maturity period and risk associated with it.
- Risk: Risk is inherent in any investment. This risk may relate to loss of capital, delay in
repayment of capital, non-payment of interest, or variability of returns. Risk and return of
an investment are related. Normally, the higher the risk, the more the return is.
- Safety: The safety of an investment implies the certainty of return of capital without loss
of money or time. Safety is another feature which an investor desires for his investments.
Every investor expects to get back his capital on maturity without loss and without delay.
- Liquidity: An investment which is easily saleable or marketable without loss of money
and without loss of time is said to possess liquidity. An investor generally prefers liquidity
for his/her investments.

1.4. Investment Management Process: As with any investment in life - a family, a home, a
college education, the best results are achieved by carefully constructing a plan and following
that plan consistently over time. A well-crafted investment plan allows one to set specific
investment goals and the strategies by which to attain those goals. While each investor’s
situation is unique, investment plans always address certain factors, including the reasons for
the investment, the investing horizon and the degree of risk that an investor can comfortably
tolerate. To construct a good investment plan there are some factors to be considered and some
steps to be followed. [2]
 Analyze Internalize
Investor’s Profile. Investor’s Goals.

Steps need to be followed: Factors

1- Setting the Investment Objectives: -

Implement is&that the investor
The first and the basic step for investment Develop
shouldInvestment
set his investment objectives.
These investment objectives Monitor the Strategy.
vary from person to person. ForStrategy.
example, for an individual the
objective may be to optimize the rate of return.

2- Establishing Investment Policy: -

Establishing investment policy refers to the allocation of asset amongst the major allocated assets
in the capital market. The range of allocated asset is from equities, debt, fixed income securities,
real estate, foreign securities to currencies. Restraint of environment and that of investor should
be kept in mind while establishing the investment policy.

3- Selecting the Portfolio Strategy: -

The portfolio strategy selected should be in accordance and in conformity with the investment
objectives and investment policies. If these are not in accordance with each other than the whole
investment management process will collapse.

4- Selecting the Assets: -

The assets to be placed in the portfolio have to be selected by the investor. This is the point where
real creation of portfolio will take place after the selection of assets in which to invest by the
manager or investor. That asset will be selected which will give best return in available resources
and which involves lowest risk. The assets can be shares, stocks, art objects, securities, gold,
property etc.

5- Measuring and Evaluating Performance: -

In this step the performance of the portfolio will be measured in comparison to the realistic
benchmark or the standard set by the investor. Risk and return will be evaluated by the manager.
Measuring and evaluating the portfolio will give the feedback to the investor and will in turn help
the investor to improve the quality as well as the performance of the portfolio of investment.

1.5. Financial Assets: Financial assets refer to assets that arise from contractual agreements on
future cash flows or from owning equity instruments of another entity. To qualify as a financial
asset, three important conditions must be met. It must be:
 1. Something you can own
2. Something of monetary value
3. That monetary value is derived from a contractual claim

1.5.1. Measurement of Financial Assets: The most important accounting issue for financial assets
involves how to report the values on the balance sheet. Considering all financial assets, there is no single
measurement technique that is suitable for all assets. When investments are relatively small, the market
price at that time would be a relevant measure. However, for a company that owns a majority of shares in
another company, the market price is not particularly relevant because the investor doesn’t intend to sell its
shares. [3]

1.5.2. Common Types of Financial Assets [4]

 Stocks are financial assets with no set ending date. An investor buying stocks becomes part
owner of a company and shares in its profits and losses. Stocks may be held indefinitely or
sold to other investors. Bonds are one-way companies or governments finance short-term
projects. The bonds state how much money is owed, the interest rate being paid and the
bond's maturity date.
 A certificate of deposit (CD) allows an investor to deposit an amount of money at a bank
for a set time with a guaranteed interest rate. A CD pays monthly interest and can typically
be held for three to six months or one, three or five years
 Money is an official medium of exchange consisting of cash and coin defined by a
government. Money, currency, cash, legal tender - they all mean the same thing. They are
all a symbol of a central bank's commitment to sustain, as best they can, that money's value.
Money is a financial asset because the value of the asset itself doesn't come from the paper
or metal it is printed on; it comes from the faith and credit of the government that issued
that money.

Securities Market: A security is any financial instrument that has an underlying value including
equity, bonds, options, futures, credit default swaps, derivatives, mortgage backed, etc. Hence a
security market consists of a marketplace where all or various instruments are traded.

Characteristics: [5]

 Growth Capital: Issuing of stock is the cornerstone of capital formation for enterprise in
capitalist economic systems. The stock market provides a way for companies to issue stock
to the investing public.
 Liquidity: The free and transparent trading that takes place in the stock market prices all
stocks according to demand and supply, bid and ask. In this way it provides liquidity for
investors seeking to transact sales of their holdings through this active pricing mechanism.
  Transparency: The public nature of trading maintains transparency in financial
transactions. Efficiency, growth, freedom and variety are all possible because of
transparency that allows all participants to access the bid and ask prices of all securities
traded on the market and because all participants have access to the same information.
 Organization: The stock market provides a degree of protection to investors through
oversight by the SEC, FINRA and other legal regulatory and self-regulating bodies on state
and professional levels that serve to create an organized and liquid group of stock
exchanges and stock trading platforms.
 Economic Indicator: One of the ten components of the Leading Economic Indicators is
made up of the Standard & Poor's 500 Stock Index, one of the major stock market indexes.
The direction of trading activity in the stock market provides an indication of the state of
commerce and overall confidence in the economy.
 Regulated Risk/Reward: An organized and regulated stock market serves as a way for
investors who seek large returns on their investments to access organized, liquid, regulated
and transparent risk investing.

1.6. Concept of Portfolio

Investing in securities is profitable as well as exciting. It is indeed rewarding but involves a great
deal of risk. It is rare to find investors investing their entire savings in a single security instead,
they tend to invest in a group of securities. Such a group of securities is called a portfolio. Portfolio
management deals with the analysis of individual securities as well as with the theory and practice
of optimally combining securities into portfolios. It comprises all the processes involved in the
creation and maintenance of an investment portfolio. It is is a complex process which tries to make
investment activity more rewarding and less risky. Portfolio management process encompasses
five phases:
- Security analysis
- Portfolio analysis
- Portfolio selection
- Portfolio revision
- Portfolio evaluation

2. THE ASSET ALLOCATION DECISION

2.1. Asset Allocation & Its Role in Investment Planning
The discussion so far has informed us that risk drives return. Therefore, the practice of investing
funds and managing portfolios should focus primarily on managing risk rather than on managing
returns. Asset allocation is the process of deciding how to distribute an investor’s wealth among
different countries and asset classes for investment purposes. An asset class is comprised of
securities that have similar characteristics, attributes, and risk/return relationships. A broad asset
class, such as “bonds,” can be divided into smaller asset classes, such as Treasury bonds, corporate
bonds, and high-yield bonds. We will see that, in the long run, the highest compounded returns
will most likely accrue to those investors with larger exposures to risky assets. We saw that,
although there are no shortcuts or guarantees to investment success, maintaining a reasonable and
disciplined approach to investing will increase the likelihood of investment success over time. The
asset allocation decision is not an isolated choice, rather, it is a component of a portfolio
management process. Much of an asset allocation strategy depends on the investor’s policy
statement, which includes the investor’s goals or objectives, constraints, and investment
guidelines.

2.2. Investment Policy Statement

A policy statement is a road map. In it, investors specify the types of risks they are willing to take
and their investment goals and constraints. All investment decisions are based on the policy
statement to ensure they are appropriate for the investor. As investor needs change over time, the
policy statement must be periodically reviewed and updated. The process of investing seeks to
peer into the future and determine strategies that offer the best possibility of meeting the policy
statement guidelines.
A policy statement guides the investment process. Constructing a policy statement is an invaluable
planning tool that will help the investor understand his or her needs better as well as assist an
advisor or portfolio manager in managing a client’s funds. While it does not guarantee investment
success, a policy statement will provide discipline for the investment process and reduce the
possibility of making hasty, inappropriate decisions. There are two important reasons for
constructing a policy statement:
- First, it helps the investor decide on realistic investment goals after learning about the
financial markets and the risks of investing.
- Second, it creates a standard by which to judge the performance of the portfolio manager.
A sound policy statement helps to protect the client against a portfolio manager’s inappropriate
investments or unethical behavior. Without clear, written guidance, some managers may consider
investing in high-risk investments, hoping to earn a quick return. Such actions are probably counter
to the investor’s specified needs and risk preferences. Though legal recourse is a possibility against
such action, writing a clear and unambiguous policy statement should reduce the possibility of
such inappropriate manager behavior.
To sum up, a clearly written policy statement helps avoid future potential problems. When the
client clearly specifies his or her needs and desires, the portfolio manager can more effectively
construct an appropriate portfolio. The policy statement provides an objective measure for
evaluating portfolio performance, helps guard against ethical lapses by the portfolio manager, and
aids in the transition between money managers. Therefore, the first step before beginning any
investment program, whether it is for an individual or a multibillion-dollar pension fund, is to
construct a policy statement.
2.3. Investment Style Allocation: Investment style is the method and philosophy followed by an
institutional money manager in managing separate accounts or managed funds. The investment
style of a fund helps set expectations for risk and performance potential. Investment style is also
an important aspect used by institutional managers in marketing and advertising the fund to
investors looking for a specific type of market exposure.

3. ANALYSIS OF EXCHANGE MARKETS: [6]

Exchange market is the market in which participants are able to buy, sell, exchange and speculate
on currencies. Exchange markets are made up of banks, commercial companies, central banks,
investment management firms, hedge funds, and retail forex brokers and investors.
3.a. Technical Analysis:
Technical analysis comes in the form of both manual or automated systems. Forex systems use
past price movement to determine where a given currency may be headed. A manual system
typically means a trader is analyzing technical indicators and interpreting that data into a buy or
sell decision. An automated trading analysis means that the trader is "teaching" the software to
look for certain signals and interpret them into executing buy or sell decisions. Where automated
analysis could have an advantage over its manual counterpart is that it is intended to take the
behavioral economics out of trading decisions. Automated technical analysis and manual trading
strategies are available for purchase through the internet. However, it is important to note that there
is no such thing as the "holy grail" of trading systems in terms of success. If the system was a fail-
proof money maker, then the seller would not want to share it. This is evidenced in how big
financial firms keep their "black box" trading programs under lock and key.

3.b. Weekend Analysis

There are three basic reasons for doing a weekend analysis.

 The first reason is that you want to establish a "big picture" view of a particular market in
which you are interested. Since the markets are closed and not in dynamic flux over the
weekend, you don't need to react to situations as they are unfolding.
 Secondly, the analysis will help you to set up your trading plans for the coming week.
Weekend analysis is akin to an architect preparing a blueprint to construct a building to
ensure a smoother execution. Remember, shooting from the hip can leave a hole in your
pocket!
 Finally, a weekend analysis helps build a routine so you can establish the necessary mindset
for the upcoming week.
3.1. Order: Types of Orders [7]

The most common types of orders are market orders, limit orders, and stop-loss orders.
 A market order is an order to buy or sell a security immediately. This type of order
guarantees that the order will be executed, but does not guarantee the execution price. A
market order generally will execute at or near the current bid (for a sell order) or ask (for a
buy order) price. However, it is important for investors to remember that the last-traded
price is not necessarily the price at which a market order will be executed.
 A limit order is an order to buy or sell a security at a specific price or better. A buy limit
order can only be executed at the limit price or lower, and a sell limit order can only be
executed at the limit price or higher. Example: An investor wants to purchase shares of
ABC stock for no more than $10. The investor could submit a limit order for this amount
and this order will only execute if the price of ABC stock is $10 or lower.
 A stop order, also referred to as a stop-loss order is an order to buy or sell a stock once
the price of the stock reaches the specified price, known as the stop price. When the stop
price is reached, a stop order becomes a market order.
 A buy stop order is entered at a stop price above the current market price. Investors
generally use a buy stop order to limit a loss or protect a profit on a stock that they have
sold short. A sell stop order is entered at a stop price below the current market price.
Investors generally use a sell stop order to limit a loss or protect a profit on a stock they
own.

3.2. Exchange Membership: [8]

A person, normally a broker, who has membership on a stock exchange. This means that he/she is
allowed to make trades on the floor of that exchange. Most exchanges do not allow firms to be
members, so the membership for a member firm formally belongs to one or more of its employees.
Memberships are bought and sold at market price because most exchanges have a finite number.

3.2.a. Member Firm: A broker-dealer firm in which at least one of the principal officers is allowed
to trade on the floor of an exchange. To become a member, one needs to purchase a membership
or a seat on the exchange, which can be very expensive. There are usually a set number of
memberships to an exchange; for example, on the New York Stock Exchange, there are 1,366
seats, which may cost up to $1 million each, and which may be bought or sold to different firms.
Most exchanges do not recognize member firms, only individual members; that is, they consider
members to be the brokers or dealers on the floor, rather than the firms they represent.

4. MARGIN [9]
Margin is the difference between the total value of securities held in an investor's account and the
loan amount from a broker. Buying on margin is the act of borrowing money to buy securities.
The practice includes buying an asset where the buyer pays only a percentage of the asset's value
and borrows the rest from the bank or broker. The broker acts as a lender and the securities in the
investor's account act as collateral. In a general business context, the margin is the difference
between a product or service's selling price and the cost of production. Margin can also refer to the
portion of the interest rate on an adjustable-rate mortgage (ARM) added to the adjustment-index
rate.

4.1. Margin on Long Purchase [10]: A long (or long position) is the buying of a security such as
a stock, commodity or currency with the expectation that the asset will rise in value. In the context
of options, long is the buying of an options contract. An investor that expects an asset’s price to
fall will go long on a put option, and an investor that hopes to benefit from an upward price
movement will be long a call option.

4.2. Margin on Short Sale [11]: A short sale is the sale of an asset or stock the seller does not
own. It is generally a transaction in which an investor sells borrowed securities in anticipation of
a price decline; the seller is then required to return an equal number of shares at some point in the
future. Contrastingly, a seller owns the security or stock in a long position.

Section II: Security Market Indicator Series

5. SECURITY MARKET [12]

Securities market is a component of the wider financial market where securities can be bought
and sold between subjects of the economy, on the basis of demand and supply. Securities markets
encompasses equity markets, bond markets and derivatives markets where prices can be
determined and participants both professional and non-professionals can meet.

5.1. Introduction to Security Market

Securities markets can be split into below two levels. Primary markets, where new securities are
issued and secondary markets where existing securities can be bought and sold. Secondary markets
can further be split into organized exchanges, such stock exchanges and over-the-counter where
individual parties come together and buy or sell securities directly. For securities holders knowing
that a secondary market exists in which their securities may be sold and converted into cash
increases the willingness of people to hold stocks and bonds and thus increases the ability of firms
to issue securities.
5.1.a. The primary market is that part of the capital markets that deals with the issue of new
securities. Companies, governments or public sector institutions can obtain funding through the
sale of a new stock or bond issue. This is typically done through a syndicate of securities dealers.
The process of selling new issues to investors is called underwriting. In the case of a new stock
issue, this sale is a public offering. Dealers earn a commission that is built into the price of the
security offering, though it can be found in the prospectus. Primary markets create long term
instruments through which corporate entities borrow from capital market...

Features of primary markets are:

 This is the market for new long-term equity capital. The primary market is the market where
the securities are sold for the first time. Therefore, it is also called the new issue market (NIM).
 In a primary issue, the securities are issued by the company directly to investors.
 The company receives the money and issues new security certificates to the investors.
 Primary issues are used by companies for the purpose of setting up new business or for
expanding or modernizing the existing business.
 The primary market performs the crucial function of facilitating capital formation in the
economy.
 The new issue market does not include certain other sources of new long-term external finance,
such as loans from financial institutions. Borrowers in the new issue market may be raising
capital for converting private capital into public capital; this is known as "going public."

5.1.b. The secondary market, also known as the aftermarket, is the financial market where
previously issued securities and financial instruments such as stock, bonds, options, and futures
are bought and sold. The term "secondary market" is also used to refer to the market for any used
goods or assets, or an alternative use for an existing product or asset where the customer base is
the second market (for example, corn has been traditionally used primarily for food production
and feedstock, but a "second" or "third" market has developed for use in ethanol production). Stock
exchange and over the counter markets.
With primary issuances of securities or financial instruments, or the primary market, investors
purchase these securities directly from issuers such as corporations issuing shares in an IPO or
private placement, or directly from the federal government in the case of treasuries. After the initial
issuance, investors can purchase from other investors in the secondary market.
The secondary market for a variety of assets can vary from loans to stocks, from fragmented to
centralized, and from illiquid to very liquid. The major stock exchanges are the most visible
example of liquid secondary markets - in this case, for stocks of publicly traded companies.
Exchanges such as the New York Stock Exchange, Nasdaq and the American Stock Exchange
provide a centralized, liquid secondary market for the investors who own stocks that trade on those
exchanges. Most bonds and structured products trade “over the counter,” or by phoning the bond
desk of one’s broker-dealer. Loans sometimes trade online using a Loan Exchange.

6. Security Market Indicator Series: [13]

A security market indicator series (SMIS) is a market index or average that uses the performance
of a sampling of securities to represent the performance of a market or market segment. Security
market indicator series are often used in benchmarking. For example, an analyst may compare a
security that is broadly considered as high growth to a sampling of similarly labeled securities to
see whether the security outperforms or underperforms its market segment Similarly, investors can
use SMIS to rate money managers. In an expanding market, even a mediocre money manager may
deliver a decent return for investors. What’s important in rating a money manager is comparing
his or her returns to the general performance of the market or relevant market segment. Money
managers charge fees to develop and execute investment strategies for their clients. Those fees can
only be justified by performance. Therefore, investors should make sure that their money managers
outperform the market after taking into account fees.

6.1. Market Index: A market index is a weighted average of several stocks or other investment
vehicles from a section of the stock market, and it is calculated from the price of the selected
stocks. Market indexes are intended to represent an entire stock market and track the market's
changes over time.
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