As per CBCS Syllabus

FUNDAMENTALS
OF
INVESTMENT

DR. PREETI SINGH

(M.Com., Ph.D. Delhi University)
Professor
Jagannath International Management School,
New Delhi.

ISO 9001:2008 CERTIFIED

© Author
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 PREFACE

T his book on ‘Fundamentals of Investment’ has been written as an introduction to a

reader to be aware of the different types of securities in the market and to construct a
portfolio of their funds. The investor has to select the right avenue for investments because
savings must be utilized in a suitable manner. In India, several changes can be seen in the
stock markets. It is dynamic in nature and changes are very frequent. It is fascinating and
exciting and students find the world of investments very interesting as they think that they
will become ‘super rich’ in a shortwhile through trading on the stock market. This book is
for those investors who not only want to trade but also to save money and plan for a long-
term period of time. Such investors are required to calculate risk and return framework and
hold the investments over a period of time to get good returns.
This book explains to the investors the pitfalls of investments and makes them aware of
different kinds of available investments opportunities. It discusses the different theories of
investment which they should know before making an investment. They should also
understand that no one investor can constantly outperform the market.
The book explains the importance of risk and return and how risk should be measured to
match the expectation level of the investor. It explains the functions of the financial markets,
the interlinking between the new issue market and stock exchange and a basic understanding
of how to manage a portfolio through careful risk and return analysis.
This book provides the theories of fundamental analysis, technical analysis and efficient
market theory to analyze investments. The work of the pioneers like Harry Markowitz and
William Sharpe have been discussed for making an analysis of the portfolio and to diversify
it, to get the maximum return.
This book has been written for students of management, commerce, accounting and finance
who would like an exposure to the investment environment in India. It is a simple, student-
friendly book with many examples, solved illustrations, objective type questions, important
points, concepts and latest developments in Indian stock markets. The book has thirteen
chapters and has been divided into five Units.
 Unit One discusses the Investment Environment, consisting of four Chapters. These
are Introduction to Investment Management, The Indian Securities Market, Trading of
Securities and Risk and Return.
 Unit Two explains valuation of Fixed Income Securities in Chapter 5.
 Unit Three consists of four chapters. It gives the different approaches to Equity
Analysis. Chapters 6, 7, 8 and 9 give the investor various techniques of investing into
equities based on theories for equity analysis. Chapter 6 gives the valuation techniques
 of equity shares as an Investment. Fundamental Analysis is the subject matter of
Chapter 7 while Chapter 8 shows the technical analysis focused mainly on Dow Theory
of analyzing stocks through charts, bar diagrams and moving averages. Chapter 9
discusses the efficient market theory and in particular the Random Walk Theory.
 Unit Four covers basic portfolio management, mutual funds and other investment
alternatives and financial derivatives.
 Unit Five is on investor protection measures by Securities and Exchange Board of
India (SEBI) which plays the role of a regulator and develops the new issue and stock
market
This book has been incorporated according to the new syllabus of Orissa University.
Finally, I would like to acknowledge the constant encouragement of my publishers
M/s Himalaya Publishing House particularly Mr. Niraj Pandey and production coordinator
Nimisha Kadam.
I would like to thank Brajendra Kumar for the secretarial assistance in preparing the
manuscript of this book.
Finally, I would like to thank all my students who have supported my work and given
suggestions and feedback. I welcome comments and suggestions by all the readers and
students.

Dr. Preeti Singh

 CONTENTS

Unit I: Investment Environment

1. Introduction to Investment Management 3 – 21
Introduction 3
Understanding the Term Investment 3
Financial and Economic Meaning of Investment 4
Investment and Speculation 4
Investment and Gambling 6
Investment and Arbitrage 6
Real and Financial Assets 7
Why are Investments Important? 8
Factors Favourable for Investment 9
Risk-less vs. Risky Investment 12
Investment Alternatives/Media 13
Features of an Investment Program 16
The Investment Process - Stages in Investment 17

2. The Indian Securities Market 22 – 36

Financial System: An Introduction 22
Indian Securities Market 23
Participants in the Securities Market 24
Other Financial Markets 24
Market Intermediaries/Participants 27
Financial Instruments 27
Financial Engineering Instruments 28
Security Market Indices 30
Sources of Financial Information 32
3. Trading of Securities 37 – 87
The Relationship of the New Issue Market and Stock Exchange 37
Structure of the Indian Capital Market with Participants 38
Intermediaries/Participants in the New Issue Market 39
Issue of Capital in New Issue Market 43
Functions of the New Issue/Primary Market 46
Secondary/Stock Markets 51
Listing of Securities 52
Depository System or Paperless Trading 55
Broker System of Trading of Securities 58
Control of Indian Capital Market: SEBI 68
Developments in the Stock Market 70
Important Stock Markets in India: NSE, BSE, OTCEI, ISE, NCDEX 78

4. Risk and Return 88 – 121

Risk and Return 88
Investor’s Attitude towards Return and Risk 90
Types of Risk — Systematic and Unsystematic 93
Systematic Risk 94
Un-systematic Risk 97
Measurement of Risk 98
Return 104
Measurement of Return 104
Capital Asset Pricing Model (CAPM Model): Share Valuation 107
Impact of Taxes on Investment 108
Impact of Inflation on Return 109
Beta as a Measure of Risk 109

Unit II: Fixed Income Securities

5. Fixed Income Securities Analysis and Valuation 125 – 173
Debt Instruments 125
Features of Bonds and Debentures 126
The Bond Indenture 129
Regulation of Bonds in India 129
Types of Bonds/Debentures 130
 Objectives of Issuing Bonds 136
Credit Rating 136
Bond Yield 139
Bond Valuation 145
Bond Value, Market Interest Rate and Coupon Rate 152
Valuation of Preference Shares 158

Unit III: Approaches to Equity Analysis

6. Equity Stock as an Investment 177 – 204
Introduction 177
Features of Equity Shares 177
Equity Shares as an Investment 179
Equity Shares Valuation 180
Valuation of Equity Shares – Accounting Concept 180
Valuation of Equity Shares – Dividend Concept 181
Valuation of Equity shares – Earnings Concept 186

7. Fundamental Analysis 205 – 232

Introduction to Fundamental Analysis 205
Economic Analysis 206
Industry Analysis 207
Company Analysis 209
Ratios Relevant for Equity Shareholders 211
Economic Value Added (EVA) 222
Sources of Financial Information 223

8. Technical Analysis 233 – 251

Introduction 233
Distinction between Technical and Fundamental Analysis 234
The Dow Theory 235
Type of Charts 241
Construction of Charts 243
Other Theories 244
 Theory of Contrary Opinion 245
Analysis of Indicators 247
Limitation of Technical Analysis 248

9. Efficient Market Theory 252 – 264

Introduction 252
Concept of Efficient Market Theory 253
Efficient Market Hypothesis 254
Weak Form 255
Semi Strong Form 255
Strong Form 255
Empirical Analysis 256
Random Walk Conclusions 261

Unit IV: Portfolio Analysis and Financial Derivatives

10. Portfolio Management 267 – 310

Introduction 267
Traditional vs. Modern Portfolio Analysis 267
Modern Portfolio Theories 269
The Rationale of Diversification of Investments 269
The Effect of Combining Two Securities: Risk and Return 270
Interactive Risk through Covariance 272
Theories of Portfolio Selection and Management 278
Markowitz Model — Portfolio Theory 279
Capital Market Theory — Capital Asset Pricing Model (CAPM) 287
Distinction between Capital Market Line and Security Market Line 293

11. Mutual Funds and Other Investments 311 – 335

Introduction 311
Concept of Mutual Funds 311
Features of Mutual Funds 311
Structures of a Mutual Fund 312
Mutual Funds in India 313
Growth of Mutual Fund Industry in India 315
 Mutual Fund Schemes 317
Plans of Mutual Funds 320
Net Asset Value 321
Costs and Loads in Mutual Fund Investments 321
Return from Mutual Fund 322
SEBI and Mutual Fund Regulation 323
Review of Mutual Funds as Investment Option in India 324
Other Forms of Investments 325

12. Financial Derivatives 336 – 362

Derivatives 336
Types of Derivatives 337
Characteristics of Derivatives 338
Participants in Derivatives Market 339
Financial Derivatives 339
Types of Transactions 340
Forward Contracts 340
Options 341
Futures 349
Swaps 351
Derivatives Market in India 353

Unit V: Investor Protection

13. Securities and Exchange Board of India 365 – 374
Introduction 365
Guidelines for Investor Protection 366
Investor Protection and Guidelines for Companies 366
Listed Companies and Model Code of Conduct 367
Investor Grievances 367
Departments of SEBI and Their Activities 368
OMBUDSMAN 2003 368
National Stock Exchange and Arbitration Facilities 369
Investor Education 369
Prohibition of Fraudulent and Unfair Trade Practices Relating to
Securities Market Regulation 370
 Prohibition of Insider Trading 370
Disclosure of Interest 371
MAPIN 372
Investors' Protection Fund 372

Annexure 375 – 386

Glossary 387 – 403
Index 404 – 406
 UNIT I

INVESTMENT ENVIRONMENT

Chapter 1: Introduction to Investment Management

Chapter 2 : The Indian Securities Market
Chapter 3 : Trading of Securities
Chapter 4 : Risk and Return
 INTRODUCTION TO INVESTMENT
1 MANAGEMENT

Contents of this Chapter

1.1 Introduction
1.2 Understanding the Term Investment
1.3 Financial and Economic Meaning of Investment
1.4 Investment and Speculation
1.5 Investment and Gambling
1.6 Investment and Arbitrage
1.7 Real and Financial Assets
1.8 Why are Investments Important?
1.9 Factors Favourable for Investment
1.10 Risk-less vs. risky investment
1.11 Investment Alternatives/Media
1.12 Features of an Investment Program
1.13 The Investment Process - Stages in Investment

1.1 INTRODUCTION
Money does not have any value unless it is invested. If a person has a large sum of money
and he keeps it in his cupboard it will not grow. It has to be invested in some financial asset
to get a return. There can be no return without risk. It is within this framework of risk and
return that investment has to be made. It is assumed that a person is risk averse and at the
same time he expects a good return on the money that he invests. Therefore, an investor has
to trade-off between risk and return. This chapter is an introduction to the terms investment,
speculation and gambling. It also presents the media for investments and explains the
investment process.

1.2 UNDERSTANDING THE TERM INVESTMENT

Investment is the commitment of funds with a long-term time framework the objective being
additional income to regular receipts and growth in the value of funds of an investor.
Investment involves ‘waiting’ for a future reward in terms of income through regular interest,
dividends, premiums, or appreciation in the value of the principal capital. The term
‘Investment’ is understood differently by economists and financial experts. Economists
consider it as new and productive capital and financial experts emphasize on allocation and
transfer of resources from one person to another. It is also different to the terms speculation
and gambling and they differ in terms of risk, time frame-work and gains.
4 Fundamentals of Investment

 It must be clearly established that investment involves long-term commitment.

 Financial and Economic meaning of investment are different and must be understood in
terms of use of capital.
 Investment speculation and gambling can be distinguished from each other through their
risk, time period of commitment and gains.

1.3 FINANCIAL AND ECONOMIC MEANING OF INVESTMENT

Financial Investments are the allocation of monetary resources ranging from risk free to
risky investments and with the expectation of a good return that varies with risk. The investor
has to aim at a trade-off between risk and return. The investors are the suppliers of ‘capital’
and in their view, 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. To the financial investor, it is not important whether money is
invested for a productive use or for the purchase of secondhand instruments such as existing
shares and stocks listed on the stock exchanges. Most investments are considered to be
transfers of financial assets from one person to another.
The economist understands the term ‘Investment’ as net additions to the economy’s capital
stock which consists of goods and service that are used in the production of other goods and
services. For them, the term investment implies the formation of new and productive capital
in the form of new construction, new producers’ durable equipment such as plant and
equipment, including inventories and human capital.
The financial and economic meaning of investment cannot be separated because the term
draws a relationship with the economists and financial experts. Investment is a part of the
savings of individuals which flow into the capital market either directly or through
institutions; they may be divided in ‘new’ or ‘secondhand’ capital financing. Investors as
‘suppliers’ and investor as ‘users’ of long-term funds find a meeting place in the market.
In this book, however, investment will be used in its ‘financial sense’ and investment will
include those instruments and institutional media into which savings are placed.

1.4 INVESTMENT AND SPECULATION

Investment is distinguished from speculation in three ways which are based on the factors of
risk, time period and gains.
1. Risk
The term ‘risk’ has significance in the financial meaning of investment. Whatever amount is
invested has the probability of incurring a gain or a loss in a financial transaction.
Investment is not considered to involve high risk but it has limited risk and risk can be
calculated through different techniques and the capital can be invested in avenues where the
principal is safe. ‘Speculation’ is correlated with ‘high risk’ and short commitment. There are
degrees of risk, and arbitrary judgements are made between high risk and low risk. An
investor cannot have completely risk-free investments because there are certain non
Introduction to Investment Management 5

controllable risks that cannot be calculated. The purchasing power risk or the fall in the real
value of the interest and principal is beyond the control of a person. The money rate risk or
the fall in market value, with the rise in interest rates also cannot be controlled.
These risks affect both the speculator and the investor. High risk and low risk are, therefore,
general indicators to help an understanding between the terms investment and speculation.

2. Capital Gain
Speculation is buying low and selling high in a short time to make large capital gains. The
motive in speculation is primarily to achieve profits through price changes. This can be
distinguished from investment where securities are purchased by an investor through proper
evaluation, analysis and review with the view of receiving a stable return over a long-term
period of time.

3. Time
Time period explains the difference between investment and speculation. A fund allocation
over a long-term period is called investment. A short-term holding is associated with trading
for the ‘quick turn’ and is called speculation. The speculator is not interested in holding a
security for current income but for high short-term gains.
The distinctions between investment and speculation help to identify the role of the investor
and speculator. To summarize the above discussion:
The investor constantly evaluates the worth of a security through fundamental analysis,
whereas the speculator is interested in market action and price movement.
1. There is a very fine line of division between investment and speculation. There are no
established rules and laws that identify securities which are permanently for investment.
There has to be a constant review of securities to find out whether it is a suitable
investment for long-term or for quick turn of speculative profit. Long-term commitment
becomes investment of the same security which if sold immediately on purchase only for
profit becomes speculation.
2. Some financial experts have called investment ‘a well grounded and carefully planned
speculation’, or good investment is a successful speculation. Speculation is planned short
term investment based on haunches and beliefs. Investment is planned, evaluated and
analyzed long-term commitment of funds.
3. Speculation is to achieve high returns though risk of loss is high. Investments are for
minimizing risk of investors with the expectation of high returns. Therefore, investment
and speculation are a planning of risks.
4. A speculator expects high return for his investment and to make gains he can commit his
own funds as well as use borrowed funds. An investor is cautious by nature and usually
uses his own funds for investing in securities.
6 Fundamentals of Investment

The distinction between investment and speculation is given in Table 1.

TABLE 1: Distinction between Investment and Speculation
Investment Speculation
Time Long-term time framework Short term planning holding assets even
Horizon beyond 12 months. for one day.
Risk It has limited risk. High Returns though risk of loss is
high.
Return It is consistent and moderate over There are high profits and gains as well
a long period. as high losses. It is not consistent.
Use of funds The investor uses his own funds Speculation is through own and
through savings. borrowed funds.
Decisions Safety, liquidity, profitability and Market behavior information,
stability considerations and judgments on movement in the stock
performance of companies. market. Haunches and beliefs.

1.5 INVESTMENT AND GAMBLING

Gambling is artificial and unnecessary risk created for increased expected returns. The
difference between investment and gambling is very clear. From the above discussion, it is
established that investment is an attempt to carefully plan, evaluate and allocate funds in
various investment outlets which offers safety of principal, moderate and continuous returns
and long-term commitment.
Gambling is quite the opposite of investment. It connotes high risk and the expectation of
high returns. It consists of uncertainty and high stakes for thrill and excitement. Typical
examples of gambling are horse racing, game of cards, lottery, etc. Gambling is based on tips,
rumors and hunches, it is unplanned, non-scientific and without knowledge of the exact
nature of risk.
The distinctions between investment, speculation and gambling give us a basic idea of their
nature, purpose and role.

1.6 INVESTMENT AND ARBITRAGE

Investment is planned commitment of funds from a person savings into different outlets with
the expectation of safe, stable and fare return. Arbitrage is the mechanism of minimizing risk
through hedging and taking advantage of price differences in different markets. An arbitrage
transaction is the simultaneous purchase of the same or similar security in two different
markets. Short-term gains can be expected through such transactions. An investor can also be
an arbitrageur if he buys and sells securities in more than one stock exchange to take
advantage of the price differentials in such exchanges. Derivatives introduced in the Indian
market have a great potential for arbitrage transactions. Arbitrage transactions help in
enhancing efficiency and liquidity in the stock market and in increasing the volume of trade.
Introduction to Investment Management 7

Hedgers, speculators and arbitrageurs can minimize risks and make profits through the
arbitrage process.

1.7 REAL AND FINANCIAL ASSETS

Real assets are tangible goods in possession of a person. Financial securities represent papers
that are dependant on real assets for creating wealth.

1. Real Assets
Real assets are used to produce goods or services. They are tangible assets that have a
physical form. Some examples of real assets are land and buildings, furniture, gold, silver,
diamonds, or artifacts. They may be marketable or nonmarketable. They may also have the
feature of being moveable or non-moveable.

2. Financial Assets
Financial assets are called paper securities. Some examples of these assets are shares, bonds,
debentures, bills, loans, lease, derivatives and fixed deposits. Financial assets represent a
claim by securities, on the income generated by real assets of some other parties. Such assets
can be easily traded, as they are marketable and transferable. Financial assets are transactions
between two or more parties for example if a person takes an insurance policy of ` 1,00,000
of Life Insurance Corporation. The contract is a liability of LIC but an asset of the person
insuring himself because he has a claim over the insurance company to receive the principal
sum with interest on the happening of an event or on the completion of a certain number of
years.
TABLE 2 : Distinction between Real and Financial Assets

Real Assets Financial Assets

Land and building, furniture, machinery Shares, debentures, bonds, derivatives,
fixed deposits, bills, loans
Tangible assets moveable, immoveable, These are called paper securities as they
marketable and non – marketable. deal with claims generated on the issuer.
Theses assets are used for production of These assets are financial claims
goods and services represented by securities

3. Commodity Assets
Commodities are a new form of investment in India. Examples of commodity assets are
wheat, sugar, potatoes, rubber, coffee and other grains. Commodities are also in the form of
metal like gold, silver, aluminum and copper. Cotton, crude oil and foreign currency are other
examples of commodities. Importers and exporters invest in commodities to diversify their
portfolios. Traders hedge or transact in commodities to make gains. A National Commodity
and Derivatives Exchange Ltd. (NCDEX) has been setup in India in 2003 as a public limited
company to transact in commodities.
8 Fundamentals of Investment

The promoters of NCDEX were ICICI Bank Ltd., National Bank for Agriculture and Rural
Development (NABARD), Life Insurance Corporation of India, Punjab National Bank,
Canara Bank, CRISIL Ltd., Indian Farmers Fertilizer, Cooperative Ltd. (IFFCO) and National
Stock Exchange of India Ltd. (NSE). All these institutions subscribed to the equity shares of
NCDEX.
The above explanations of the terms of investment have provided a background to the
meaning of investment, this chapter now presents the importance of investments,
opportunities conducive to investment, media available for investment, investment features
and the process of investment.

1.8 WHY ARE INVESTMENTS IMPORTANT?

Investments are important due to increase in life expectancy of a person, planning for
retirement income, high planning for additional income due to high rates of taxation and
inflationary pressure in an economy, the expectation of continuous stable income in the form
of regular dividends, interests and other receipts. The following discussion provides an
explanation of these issues.

1. Longer Life Expectancy

Investment decisions have become significant because statistics show that life expectancy has
increased with good medical care. People usually retire between the ages of 60 and 65. The
income shrinks at the time of retirement because the annual inflow of earnings from
employment stops. If savings are invested at the right age and time wealth increases if the
principal sum is invested adequately in different saving schemes.
The importance of investment decisions is enhanced by the fact that there is an increasing
number of women are working in organizations. Men and women are responsible for planning
their own investments during their working life so that after retirement they are able to have a
stable income through balanced investments.

2. Taxation
Taxation introduces an element of compulsion in a person’s savings. Every country has
different tax saving schemes for bringing down taxation levels of a person. Since investments
provide regular and stable income and also give relief in taxation they are considered to be
very important and useful if investments are made by proper planning.

3. Interest Rates
Interest rates vary according to the choice of investment outlet. Investors prefer safe
investments with a good return. A risk-less security will bring low rates of return.
Government securities are risk free. However, market risk is high with high rates of return.
Before allocations of any amount the different types of securities must be analyzed to
calculate their benefits and their disadvantages. The investor should make his portfolio with
Introduction to Investment Management 9

several kinds of investments. Stability of interest is as important as receiving a high rate of

interest. This book is concerned with determining that the investor is getting an acceptable
return commensurate with the risks that are taken.

4. Inflation
In a developing economy there are rising prices and inflationary trends. A rise in prices has
several problems coupled with a falling standard of living. Before funds are invested, they
must be evaluated to find the right choice of investments to tide over inflationary situations.
The investor will look at different investment outlets and compare the rate of return/interest
to cover the risk of inflation. Security and safety of capital is important therefore he/she
should invest in those securities that have an assured and regular return. An investor has to
consider the taxation benefit decides the safety of capital and its continuous return.

5. Income
Investment decisions are important due the general increase in employment opportunities and
an understanding of investment channels for saving in India. New and well paying job
opportunities are in sectors like software technology; business processing offices, call centres,
exports, media, tourism, hospitality, manufacturing sector, banks, insurance and financial
services. The employment opportunities gave rise to increasing incomes. Higher income has
increased a demand for investments and earnings above the regular income of people.
Investment outlets can be selected to make investments for supporting the regular income.
Awareness of financial assets and real assets has led to the ability and willingness of working
people to save and invest their funds for return in their lean period leading to the importance
of investments.

6. Investment outlets
The availability of a large number of investment outlets has made investments useful an
important. Apart from putting aside savings in savings banks where interest is low, investors
have the choice of a variety of instruments. The question to reason out is which is the most
suitable channel? Which investment will give a balanced growth and stability of return? The
investor in his choice of investment has the objective of a proper mix between high rate of
return and stability of return to get the benefits of both types of investments.
Thus, the objectives of investment are to achieve a good rate of return in the future,
reducing risk to get a good return, liquidity in time of emergencies, safety of funds by
selecting the right avenues of investments and a hedge against inflation.

1.9 FACTORS FAVOURABLE FOR INVESTMENT

The investment market should have a favourable environment to function effectively.
Business activities are marked by social, economic and political considerations. It is
important that the economic and political factors are favourable. Generally, there are four
basic considerations which foster growth and bring opportunities for investment. These are
10 Fundamentals of Investment

legal safeguards, stable currency and existence of financial institutions to aid savings and
forms of business organization.

1. Legal Safeguards
A stable government which frames adequate legal safeguards encourages accumulation of
savings and investments. Investors will be willing to invest their funds if they have the
assurance of protection of their contractual and property rights.
In India, the investors have the dual advantage of free enterprise and control. Freedom,
efficiency and growth are ensured from the competitive forces of private enterprises.
Statutory control exerts discipline and curtails some element of freedom. In India, the
political climate is conducive to investment. In fact the new economic reforms were brought
in the country in 1991 for liberalization and globalization and for extending investments in
other countries.

2. A Stable Currency
A well organized monetary system with definite planning and proper policies is a necessary
prerequisite to an investment market. Most of the investments such as bank deposits, life
insurance and shares are payable in the currency of the country. A proper monetary policy
will give direction to the investment outlets. The monetary policy should be made to bring
growth to industries and development to the economy as a whole. If there is an inflationary
pressure or deflation in an economy, it should be controlled.
Inflation reduces the purchasing power of investments. When interests after taxes is received
by the investor it should be evaluated and if it is less than the rise in the price level, the
investor should plan to shift his investments in other outlets. Inflation occurs generally in
unstable conditions like war or floods but it is also discernible in peace conditions especially
in developing countries because of huge government deficit in creating infrastructure.
Deflation is equally disastrous because the nominal values of inventories, plant and
machinery and land and building tend to shrink. An example of the recent financial crisis that
started in 2007 may be cited its effects become global and many countries had a shrunk
market in investments and disasters in jobs. In India the market is improving in August 2009
but it is not stable yet. A reasonable stable price level which is produced by wise monetary
and fiscal management contributes towards proper control, good government, economic well-
being and a well disciplined growth oriented investment market and protection to the investor.

3. Existence of Financial Institutions and Services

The presence of financial institutions and financial services encourage savings, direct them to
productive uses and helps the investment market go grow. The financial institutions in
existence in India are mutual funds, development banks, commercial banks, life insurance
companies, investment companies, investment bankers, mortgage bankers. The financial
services include venture capital, factoring and forfaiting, leasing, hire purchase and consumer
finance, housing finance, merchant bankers and portfolio management. Investment bankers
Introduction to Investment Management 11

are merchants of securities. They buy bonds and stocks of companies for re-sale to investors.
The investment bankers are distinguished from security brokers who act as agents in buying
and selling already issued securities for commission. Mortgage bankers sometimes act as
merchants and sometimes as agents on mortgage loans generally on residential properties.
They serve as middlemen between investors and borrowers and perform collateral service in
connection with loans. Commercial banks and financial institutions also act as mortgage
bankers in giving mortgage loans and servicing the loans.
In India, there are a large number of financial institutions under Central Government, State
Government, rural bodies and private financial institutions that have encouraged the growth
of savings and investment. Life insurance companies and mutual funds offer a wide variety of
schemes for savings and give tax benefits also. Banks offer a wide variety of schemes for
encouraging savings and investment. These institutions lend an element of strength to the
capital market and promote discipline while encouraging growth.
Since 1991 there has been a development of the private corporate sector. Many new financial
institutions have emerged in the private sector. Insurance companies, mutual funds, and
venture capitalists leasing companies have been opened up to private financing agencies.
Foreign banks have been allowed to do business.
Thus, there is the presence of a large number of institutions and services which act as a
channel for the funds in productive directions.

4. Form of Business Organization

The form of business organization which is permanent in existence promotes savings and
investment. The public limited companies are considered to be the best form of organization.
The three characteristics of the corporation which have been very useful for investors are
limited liability of shareholders, perpetual life and transferability and divisibility of stocks
and shares. The public limited company with the ability to continue its business irrespective
of members comprising it, gives longevity and soundness to its business activity. In contrast
to a public limited company whose shareholders have limited liability, the sole proprietor or a
partner in a partnership firm is liable for all the debts of the firm to the full extent of his
personal wealth. In these conditions, investors are hesitant to risk their savings in these forms
of organizations. Besides unlimited liability, the partnership and proprietor also suffer from
short life of the organization. With the death or retirement of any of the partners, a
partnership firm is dissolved. Similarly, a sole proprietor carries on business only during his
lifetime. In these unstable and unsure conditions, investors would not like to make their
investments. Finally, the public limited company lends an element of liquidity to its shares. In
contrast, partnership restricts stability and transferability freely from person to person. The
public limited company, therefore, is a popular form for investment as the investors benefit
from liquidity, convenience and longevity.
In India since 1991 there is the existence of large corporate organizations. There have been
many mergers and amalgamations and consolidation has taken place. Business has become
more permanent in nature. Family businesses have expanded and are now stable and well
organized. Indian business is taking new forms and being recognized in the world. With
12 Fundamentals of Investment

increased awareness and stability the investor has many favorable outlets for making
investments.
5. Choice of Investment
The growth and development of the country leading to greater economic activity has led to
the introduction of a vast array of investment outlets. Apart from putting aside savings in
banks investors have the choice of a variety of instruments. The question to reason out is
which is the most suitable channel? Which media will give a balanced growth and stability of
return? The investor in his choice of investment will have to try and achieve a proper mix
between high rate of return and stability of return. Some of the instruments available are
equity shares, bonds, financial engineering securities, provident fund, life insurance, fixed
deposits, and mutual funds schemes.

1.10 RISK-LESS VS. RISKY INVESTMENTS

Most investors are risk averse but they expect maximum return from their investments. Every
investment must be analyzed because there is some risk in it. Only government securities are
risk-less. The Indian investment scene has many schemes to offer to an individual. On an
analysis of these schemes, it appears that the investor has a wide choice. A vast range of
investments is in the government sector. These are mostly risk free but low return yielding.
Several incentives are attached to it. The private sector investments consist of equity and
preference shares, debentures and financial engineering securities. These have the features of
high risk. Ultimately, the investor must make his investment decisions.
The dilemma faced by the Indian investor is the reconciliation of profitability, liquidity and
risk of investments. Government securities are risk free and the investor is secured. However,
to him the return or yield is very important as he has limited resources and would like to plan
an appreciation of the investments for his future requirements. Government securities give
low returns, and do not fulfil his objective of money appreciation.
Private sector securities are attractive though, risky. Reliance, Infosys, Wipro, Tatas give to
the investor the expectation of future appreciation of investment by several times. The
multinational and blue chip companies offer very high rates of return and also give bonus
shares to their shareholders.
Real Estate and Gold have the advantage of eliminating the impact of inflation, since the
price rises experienced by them have been very high. The Indian investor in this context
cannot choose his investments very easily.
An investor can maximize returns with minimum risk involved if he carefully analyses the
information published in the prospectuses of private companies. Contents as the past
performance, name of promoters and board of directors, the main activities, its business
prospects and selling arrangements should be assessed before the investor decides to invest in
the company.
Introduction to Investment Management 13

From the point of view of an investor, convertible bonds may under proper conditions, prove
an ideal combination of high yield, low risk and potential of capital appreciation.

1.11 INVESTMENT ALTERNATIVES / MEDIA

Many types of investment alternatives or channels for making investments are available. A
sound investment programme can be constructed if the investor familiarizes himself with the
various alternative investments available. Investment media are of several kinds – some are
simple and direct, others present complex problems of analysis and investigations. Some
investments are appropriate for one type of investor and another may be suitable to another
person.
The ultimate objective of the investor is to derive a variety of investments that meet this
preference for risk and expected return. The investor will select the portfolio, which will
maximize his utility. Securities present a wide range of risk-free instruments to highly
speculative shares and debentures. From this broad spectrum, the investor will have to select
those securities that maximize his utility. The investor, in other words, has an optimization
problem. He has to choose the security, which will maximize his expected returns subject to
certain considerations. The investment decision is an optimization problem but the objective
function varies from investor to investor. It is not only the construction of a portfolio that will
promise the highest expected return but it is the satisfaction of the need of the investor. For
instance, one investor may face a situation when he requires extreme liquidity. He may also
want safety of securities. Therefore, he will have to choose a security with low returns.
Another investor would not mind high risk because he does not have financial problems but
he would like a high return. Such an investor can put his savings in growth shares, as he is
willing to accept risk. Another important consideration is the temperament and psychology of
the investor. Some investors are temperamentally suited to take risks; there are others who
are not willing to invest in risky securities even if the return is high. One investor may prefer
safe government bonds whereas another may be willing to invest in blue chip equity shares of
at company.
Many alternative investments exist. These can be categorized in many ways. The investment
alternatives are given below in Table 3.
14 Fundamentals of Investment

TABLE 3:
Investment Media

Direct Investment Alternatives Indirect Investment Alternatives

Fixed Principal Investments Pension Fund
Cash Provident Fund
Savings Account Insurance
Savings Certificate Investment Companies and
Government Bonds Mutual and Unit Trust of India
Corporate Bonds and Debentures Funds

Variable Principal Securities Non-Security Investments

Equity Shares Real Estate
1. Convertible Debentures
Direct and Indirect Investmentsor Mortgages
Preference Securities Commodities
Art, Antiques and Other Valuables

The media alternatives have been categorized as direct and indirect investment alternatives.
Direct investments are those where the individual makes his own choice and investment
decision. Indirect investments are those in which the individual has no direct hold on the
amount he invests. He contributes his savings to certain organizations like Life Insurance
Corporation (LIC) or Unit Trust of India (UTI) and depends upon them to make investments
on his and other people’s behalf. So there is no direct responsibility or hold on the securities.
An individual also makes indirect investment for retirement benefits, in the form of provident
funds and pension, life insurance policy, investment company securities and securities of
mutual funds. Individuals have no control over these investments. They are entrusted to the
care of the particular organization. The organizations like Life Insurance Corporation or Unit
Trust of India, provident funds are managed according to their investment policy by a group
of trustees on behalf of the investor. The examples of indirect investment alternatives are an
important and rapidly growing segment of our economy. In choosing specific investments,
investors will need definite ideas regarding a number of features that their portfolio should
have. To summarize:
Introduction to Investment Management 15

 Direct investments are those where the individual has a direct hold on his investment
decision.
 Indirect investments are those where the investor is dependent on another organization.

2. Fixed and Variable Principal Securities

Fixed principal investments are classified as those whose principal amount and the terminal
value are known with certainty. Cash has a definite and constant rupee value, whether it is
deposited in a bank or kept in a cash box. It does not earn any return. Savings accounts have a
fixed return; they differ only in terms of time period. The principal amount is fixed plus
interest is earned on the deposit. Savings certificates are classified as national savings
certificates, bank savings certificates and postal savings certificates. Government bonds,
corporate bonds and debentures are sold having a fixed maturity value and a fixed rate of
income overtime.
The variable principal securities differ from the fixed principal securities because their
terminal values are not known with certainty. The price of preference shares is determined by
demand and supply forces even though preference shareholders have a fixed return. Equity
shares also have no fixed return or maturity date. Convertible securities such as convertible
debentures or preference shares can convert themselves into equity shares according to
certain prescribed conditions and thus have features of fixed principal securities
supplemented by the possibility of a variable terminal value. Debentures, preference shares
and equity shares are examples of securities sold by companies to investors to raise necessary
funds. To summarize:
 Fixed securities terminal values are certain with fixed return and maturity dates.
 Variable principal securities terminal values uncertain. Their price is determined by
demand and supply mechanism.

3. Non-Security Investments
‘Non-Security Investments’ differ from securities in other categories. Real estate may be the
ownership of a single home or include residential and commercial properties. The terminal
value of real estate is uncertain but generally there is a price appreciation, whereas
depreciation can be claimed in tax. Real estate is less liquid than corporate securities.
Mortgages represent the financing of real estate. It has a periodic fixed income and the
principal is recovered at a stated maturity date. Commodities are bought and sold in spot
markets; contracts to buy and sell commodities at a future date are traded in future markets.
Business ventures refer to direct ownership investments in new or growing business before
firms sell securities on a public basis. Art, antiques and other valuables such as silver, fine
china and jewels are also another type of specialized investments which offer aesthetic
qualities also.
These features should be consistent with the investors’ objectives and in addition should have
additional conveniences and advantages. The following features are suggested for a
successful selection of investments.
16 Fundamentals of Investment

1.12 FEATURES OF AN INVESTMENT PROGRAM

The features of an investment program consists of safety of principal, liquidity, income
stability, adequate income, purchasing power stability, appreciation, freedom from
management of investments, legality and transferability.

1. Safety of Principal
The investor, to be certain of the safety of principal, should carefully review the economic
and industry trends before choosing the types of investment. To ensure safety of principal, the
investor should consider diversification of assets. Adequate diversification involves mixing
investment commitments by industry, geographically, by management, by financial type and
by maturities. A proper combination of these factors would reduce the risk of loss.
Diversification in proper investment programmes must be reasonably accomplished.

2. Liquidity
An investor requires a minimum amount of liquidity in his investments to meet emergencies.
Liquidity will be ensured if the investor buys a proportion of readily saleable securities out of
his total portfolio. He may therefore, keep a small proportion of cash, fixed deposits and units
which can be immediately made liquid. Investments like stocks and property or real estate
cannot ensure immediate liquidity.

3. Income Stability
Regularity of income at a consistent rate is necessary in any investment pattern. Not only
stability, it is also important to see that income is adequate after taxes. It is possible to find
out some good securities which pay practically all their earnings in dividends.

4. Appreciation and Purchasing Power Stability

Investors should balance their portfolios to fight against any purchasing power instability.
Investors should judge price level inflation, explore the possibility of gain and loss in the
investments available to them, limitations of personal and family considerations. The
investors should also try and forecast which securities will appreciate. A purchase of property
at the right time will lead to appreciation in time. Growth stock will also appreciate overtime.
These, however, should be done through analysis and not as speculation or gamble.

5. Legality and Freedom from Care

All investments should be approved by law. Law relating to minors, estates, trusts, shares and
insurance be studied. Illegal securities will bring out many problems for the investors. One
way of being free from care is to invest in securities like Unit Trust of India, Life Insurance
Corporation, mutual funds or savings certificates. The management of securities is then left to
the care of the Trust who diversifies the investments according to safety, stability and
Introduction to Investment Management 17

liquidity with the consideration of their investment policy. The identity of legal securities and
investments in such securities will also help the investor in avoiding many problems.

6. Tangibility
Intangible securities have many times lost their value due to price level inflation, confiscatory
laws or social collapse. Some investors prefer to keep a part of their wealth invested in
tangible properties like building, machinery and land. It may, however, be considered that
tangible property does not yield an income apart from the direct satisfaction of possession or
property.
TABLE 4: Features of Investment Avenues

Particulars Risk Return / Capital Liquidity / Tax benefit

Current appr. marketability
Yield
Equity Shares High Low High High High
Debentures Low High Very low Very low Nil
Bank Deposit Low Low Nil High Nil
Public Nil Nil Low Low Moderate
Provident Fund
Life Insurance Nil Nil Low Low Moderate
Policies
Real Estate Low Low High in Moderate Changes
Long-term according
to rules
Gold and Silver Low Nil High in Moderate Nil
long-term

1.13 THE INVESTMENT PROCESS – STAGES IN INVESTMENT

The investment process is generally described in four stages. These stages are investment
policy, investment analysis, valuation of securities and portfolio construction.

1. Investment Policy
The first stage determines and involves personal financial affairs and objectives before
making investments. It may also be called preparation of the investment policy stage. The
investor has to be able to create an emergency fund, an element of liquidity and quick
convertibility of securities into cash. This stage may, therefore, be considered appropriate for
identifying investment assets and considering the various features of investments.
18 Fundamentals of Investment

2. Investment Analysis
When an individual has the types of investments that he requires on his portfolio, the next
step is to analyze the securities available for investment. He must make a comparative
analysis of the type of industry, kind of security and fixed vs variable securities. The primary
concerns at this stage would be to form beliefs regarding future behaviour or prices of stocks
and the expected returns and associated risk.

3. Valuation of Securities
The third step is the most important consideration of the valuation of investments. Investment
value, in general, is taken to be the present worth to the owners of future benefits from
investments. An appropriate set of weights have to be applied with the use of forecasted
benefits to estimate the value of the investment assets. Comparison of the value with the
current market price of the asset allows a determination of the relative attractiveness of the
asset. Each asset must be valued on its individual merit. Finally, the portfolio should be
constructed.

4. Portfolio Construction
As discussed earlier under features of an investment programme, portfolio construction
requires knowledge of the different aspects of securities. These are briefly recapitulated here,
consisting of safety and growth of principal, liquidity of assets after taking into account the
stage involving investment timing, selection of investment, allocation of savings to different
investments and feedback of portfolio as given in Table 5.
While evaluating securities, the investor should realize that investments are made under
conditions of uncertainty. These cannot be a magic formula which will always work. The
investor should be concerned with concepts and applications that will satisfy his investment
objectives and constantly evaluate the performance of his investments. If need be, the
investor may consider switching over to alternate proposals.


Refer Page 12, Keith V. Smith and David I. Eiterman (for a more elaborate discussion), Modern Strategy for
Successful Investment, Dow Jones Irvin Inc., Illinois 1978, pp. 11-20.
Introduction to Investment Management 19

TABLE 5: The Process of Investing

INVESTMENT POLICY
Determination of investment wealth
Determination of portfolio objectives
Identification of potential investment assets
Consideration of attributes of investment assets
Allocation of wealth to asset categories
INVESTMENT VALUATION
Valuation of debentures and bonds
Valuation of equity shares
INVESTMENT ANALYSIS
Equity Stock Analysis
Analysis of the Economy
Screening of Industries
Analysis of yield structure
Qualitative analysis
Debentures and Bond Analysis
Consideration of debentures
Quantitative analysis
OTHER ASSETS
Land, Building, Gold, Silver
Quantitative analysis
Qualitative analysis
PORTFOLIO CONSTRUCTION
Determination of diversification level
Consideration of investment timing
Selection of investment assets
Allocation of investible wealth to investment assets
Evaluation of portfolio for feedback
The next chapters, Chapter 2 and Chapter 3, discuss the structure of the financial market and
the secondhand securities market. This will help the investor to understand the working of the
securities markets and how to participate in them.
20 Fundamentals of Investment

SUMMARY
 Investment is employment of funds for achieving additional income and growth in value.
 Investment must be distinguished from speculation and gambling in terms of time horizon,
risk. Return and decision making process. Investment is usually planned whereas
speculation and gambling depend on immediate decisions with also the element of ‘luck’.
 Investments are transfers of financial assets from one person to another. They range from
low risk to high risk.
 Investments are usually long-term and low risk. Speculation is high risk and high return
and for short-term period of time.
 Investments may be financial claims or real and tangible assets the land and buildings,
plant, gold antiques etc.
 Investment may be direct and indirect of securities like shares and debentures.
Investments in provident funds, pension funds and mutual funds are forms of indirect
investments.
 An investment programme should consist of safety of the principal amount liquidity
income and purchasing power stability and appreciation.
 The investment process consists of four stages. These are investment policy investment
analysis Valuation of securities and Portfolio construction.

QUESTIONS
1. Why do people invest? What are the factors which are favourable for making investments
in an economy?
2. What is the meaning of investment? Discuss the different channels or alternatives
available to an investor for making investments?
3. Describe the features of an investment programme? What steps should an investor follow
to make an investment?
4. Distinguish between investment, speculation and gambling. What is the usefulness of a
sound investment plan?
5. Writes notes on (i) commodity assets (ii) process of investment (iii) investment
alternatives.
6. Distinguish between (i) direct and indirect assets (ii) real and financial assets
(iii) investment and arbitrage.
Introduction to Investment Management 21

Objective Type Questions

State whether the following statements are True (T) or False (F).
(i) Investments are concerned with risk and return.
(ii) Investments involve long-term commitments.
(iii) Speculation brings about stable return for long-term period of time.
(iv) Speculation is considered with review and analysis and investments with capital gain.
(v) Investments are based on portfolio construction, valuation, identification and analysis.
(vi) The variable investments consist of cash, bonds and savings certificates.
(vii) The investment objective is high risk and high return.
(viii) Arbitrage is a long-term investment.
(ix) The commodity investment is through saving bank.
(x) Indirect securities consist of mutual fund and life insurance securities.
Answers: (i) T; (ii) T; (iii) F; (iv) F; (v) T; (vi) F; (vii) F; (viii) F; (ix) F; (x) T.
Multiple Choice Questions
1. Investment means
(a) Commitment of funds for future income.
(b) Net additions to economy capital stock.
(c) Short-term commitment of funds.
(d) Capital gain.
2. Speculation can be distinguished from investment in the following way
(a) Investment is high risk speculation is low risk
(b) Investment is short term period of time speculation covers long-term period
(c) Investment is based on planning of funds for safety liquidity profitability
Speculation on haunches and benefits
(d) Investment is your own funds, speculation consists of other peoples funds.
3. A gambler is one who makes planned investment
(a) Believes in low risk
(b) Considers high risk and high profits
(c) Expects other people to plan his resources in one best security
(d) Buying government securities with safety of return.
Answers: 1. (a); 2. (c); 3. (b).