LECTURE THREE

Investment decision making

Investors should have diverse investment strategies with the primary aim of achieving
superior performance. Investment strategies can be broadly classified under four
approaches as follows:
1. Fundamental approach: In this approach the investor is concerned with the
intrinsic value of the investment instrument. Given below are the basic rules
followed by the fundamental investor.

There is an intrinsic value of a security, which in turn is dependent on the underlying

economic factors. This intrinsic value can be ascertained by an in-depth analysis of the
fundamental or economic factors related to an economy, industry and company.

At any point in time, many securities have current market prices, which are different
from their intrinsic values. However, sometime in the future the current market price
would become the same as its intrinsic value. We as fundamental investors can achieve
superior results by buying undervalued securities and selling overvalued securities.

2. Psychological approach: The psychological investor would base his investment

decision on the premise that stock prices are guided by emotions and not reason.
This would imply that the stock prices are influenced by the prevalent mood of the
investors. This mood would swing and oscillate between the two extremes of
'greed' and 'fear'. When 'greed' has the lead stock prices tend to increase. And
when 'fear' takes over stock prices get depressed to lower levels.

As psychic values seem to be more important than intrinsic values, it is suggested that it
would be more profitable to analyze investor behavior as the market is swept by
optimism and pessimism. Which seem to alternate one after the other. This approach is
called 'Castle-in-the-air' theory.
3. Technical analysis. In this approach the investor uses some tools of technical
analysis, with a view to study the internal market data, towards developing trading
rules to make profits. In technical analysis the basic premise is that price
 movement of stocks have certain persistent and recurring patterns, which can be
derived from market trading data. Technical analysts use many tools like bar
charts, point and figure charts, moving average analysis, etc. Invest when the
prices are increasing and sell when prices start to decline.

4. Academic approach: Over the years, the academics have studied many aspects of
the securities market and have developed advanced methods of analysis. The
basic rules are:

The stock markets are efficient and react rationally and fast to the information flow over time.
So, the current market price would reflect its intrinsic value at all times. This would
mean "Current market price = Intrinsic value". Stock prices behave in a random fashion
and successive price changes are independent of each other. Thus, present price
behavior cannot predict future price behavior. In the securities market there is a
positive and linear relationship between risk and return. That is the expected return
from a security has a linear relationship with the systemic or non-diversifiable risk of the
market.

5. Eclectic approach: This approach draws upon the three approaches discussed
above.
The basic rules of this approach are:

1. Fundamental analysis would help us in establishing standards and benchmarks.

2. Technical analysis would help us gauge the current investor mood and the relative strength
of demand and supply.

3. The market is neither well-ordered nor speculative. The market has imperfections, but reacts
reasonably well to the flow of information. Although some securities would be mispriced,
there is a positive correlation between risk and return.
2.3.5 Investment management process
Investment management process describes how an investor should go about making decisions.
This process involves the following stages:
1. Setting of investment policy
This is the first and very important step in investment management process. Investment
policy includes setting of investment objectives. The investment policy should have the
specific objectives regarding the investment return requirement and risk tolerance of
the investor. For example, the investment policy may define that the target of the
investment average return should be 15 % and should avoid more than 10 % losses. The
investment policy should also state other important constrains which could influence
the investment management. Constrains can include any liquidity needs for the
investor, projected investment horizon, as well as other unique needs and preferences
of investor. The investment horizon is the period of time for investments. Projected
time horizon may be short, long or even indefinite. Setting of investment objectives for
individual investors is based on the assessment of their current and future financial
objectives. This stage of investment management concludes with the identification of
the potential categories of financial assets for inclusion in the investment portfolio.

2. Analysis and evaluation of investment vehicles.

When the investment policy is set up, investor’s objectives defined and the potential
categories of financial assets for inclusion in the investment portfolio identified, the
available investment types can be analyzed. This step involves examining several
relevant types of investment vehicles and the individual vehicles inside these groups.
For example, if the common stock was identified as investment vehicle relevant for
investor, the analysis will be concentrated to the common stock as an investment. The
one purpose of such analysis and evaluation is to identify those investment vehicles that
currently appear to be mispriced. There are many different approaches how to make
such analysis. Most frequently two forms of analysis are used: technical analysis and
fundamental analysis. Technical analysis involves the analysis of market prices in an
attempt to predict future price movements for the particular financial asset traded on
the market. This analysis examines the trends of historical prices and is based on the
assumption that these trends or patterns repeat themselves in the future. Fundamental
analysis in its simplest form is focused on the evaluation of intrinsic value of the
financial asset. This valuation is based on the assumption that intrinsic value is the
present value of future flows from particular investment. By comparison of the intrinsic
value and market value of the financial assets those which are underpriced or
overpriced can be identified. This step involves identifying those specific financial assets
in which to invest and determining the proportions of these financial assets in the
investment portfolio.

3. Formation of diversified investment portfolio

Investment portfolio is the set of investment vehicles, formed by the investor seeking
to realize its defined investment objectives. In the stage of portfolio formation the issues
of selectivity, timing and diversification need to be addressed by the investor. Put your
money into different investments that have low correlation with each other. By
spreading your money among a variety of investments that may rise and fall at different
times, you'll avoid taking those big "hits" that your entire portfolio could suffer when
one asset class is hit hard. You will also need to "rebalance" your holdings occasionally
to make sure the percentages of your portfolio taken up by different assets still fit your
risk tolerance and time horizon.

4. Measurement and evaluation of portfolio performance.

This involves determining periodically how the portfolio performed, in terms of not only
the return earned, but also the risk of the portfolio. For evaluation of portfolio
performance appropriate measures of return and risk and benchmarks are needed.

5. Portfolio revision.
This step is concerned with the periodic revision of the previous stages. This is necessary,
because over time investor with long-term investment horizon may change his / her
investment objectives and this, in turn means that currently held investor9s portfolio may
no longer be optimal and even contradict with the new settled investment objectives.
Investor should form the new portfolio by selling some underperforming investments
and buying other well performing investments not currently held
Check current capital gains rates for your bracket. If they are low by historical standards,
take advantage of the opportunity to sell off shares of a stock, and move some of that
money into other asset classes, thereby diversifying your portfolio. Having too much in
one investment is a risk that may not be worth taking.
FINANCIAL MARKETS
3.1 Introduction
A Financial market refers to any market place where buyers and sellers participate in
the trade of assets such as equities, bonds, currencies and derivatives. Financial
markets are typically defined by having transparent pricing, basic regulations on
trading, costs and fees and market forces determining the prices of securities that
trade. Some financial markets only allow participants that meet certain criteria,
which can be based on factors like the amount of money held, the investor's
geographical location, knowledge of the markets or the profession of the participant
3.2 Lecture objectives
By the end of this lecture you should be able to:

i) Explain the economic functions of a financial market

ii) Describe the various classifications of financial markets
iii) Discuss the efficient market hypothesis

3.3 Lecture outline

3.1.1 Economic functions of a financial market

3.1.2 Classifications of financial markets

3.1.3 Efficient market hypothesis

3.3.1 Economic functions of a financial market

A financial market can be seen as a set of arrangements that allows trading among its
participants. Financial market provides three important economic functions. These are:

1. Financial market determines the prices of assets traded through the interactions
between buyers and sellers;

2. Financial market provides a liquidity of the financial assets;

3. Financial market reduces the cost of transactions by reducing explicit costs, such as
money spent to advertise the desire to buy or to sell a financial asset.

3.3.2 Classifications of financial markets

Financial markets could be classified on the bases of their characteristics as follows:
• Sequence of transactions for selling and buying securities;
 • Term of circulation of financial assets traded in the market;

• Economic nature of securities, traded in the market; From the perspective of a given
country.
Sequence of transactions for selling and buying securities
Under this classification, we have primary and secondary markets
a) Primary market
All securities are first traded in the primary market. If a company9s share is traded in the
primary market for the first time, it is referred to as an initial public offer
b) Secondary market
This is a market where previously issued securities are traded among investors. Generally,
individual investors do not have access to secondary markets. They use security brokers to
act as intermediaries for them. The broker delivers orders received from investors in
securities to a market place, where these orders are executed. Finally, clearing and
settlement processes ensure that both sides to these
Transactions honor their commitment. There are several types of brokers:

i) Discount broker, who executes only trades in the secondary market

ii)
ii) Full service
broker, who provides a wide range of additional services to clients (eg.
advice to buy or sell);

iii) Online broker is a brokerage firm that allows investors to execute trades
electronically using Internet.
Types of secondary market places:
• Organized security exchanges- Provides the facility for the members to trade
securities and only members may trade there e.g. brokerage firms. Members buy and
sell for their own account. • Over-the-counter market- This is not a formal exchange
market. It is an organized network of brokers and dealers who negotiate sales of
securities. There are no membership requirements and many brokers register as dealers
on the OTC. At the same time there are no listing requirements and thousands of
securities are traded in the OTC market. OTC stocks are usually considered as very risky
because they are the stocks that are not considered large or stable enough to trade on
the major exchange.

• Alternative trading system- This is an electronic trading mechanism developed

independently from the established market places – security exchanges –and designed
to match buyers and sellers of securities on an agency basis. The brokers who use ATS
are acting on behalf of their clients and do not trade on their own account. The distinct
advantages of ATS in comparison with traditional markets are cost savings of
transactions, the short time of execution of transactions for liquid securities, extended
hours for trading and anonymity, often important for investors, trading large amounts.

Term of circulation of financial assets traded in the market

Financial markets classified as Money markets or Capital markets.
a) Money market - in which only short-term financial instruments are traded eg
treasury bills, commercial paper, bankers acceptances
b) Capital market - in which only long-term financial instruments are traded. Eg
common stocks, Preferred stocks, Treasury bonds, corporate bonds, other long-term
investment vehicles
Economic nature of securities, traded in the market Financial
markets are classified as follows:

i) Equity market or stock market

ii) Fixed income market
iii) Debt market

iv) Derivatives market

From the perspective of a given country. Financial

markets are classified as follows:

i) Internal or national market ii)

External or international market

3.3.3 Efficient market hypothesis (EMH)
This is an investment theory that states that it is impossible to "beat the market"
because stock market efficiency causes existing share prices to always incorporate and
reflect all relevant information. According to the EMH, stocks always trade at their fair
value on stock exchanges, making it impossible for investors to either purchase
undervalued stocks or sell stocks for inflated prices. As such, it should be impossible to
outperform the overall market through expert stock selection or market timing, and that
the only way an investor can possibly obtain higher returns is by purchasing riskier
investments. This theory contends that since markets are efficient and current prices
reflect all information, attempts to outperform the market are essentially a game of
chance rather than one of skill.
Although it is a cornerstone of modern financial theory, the EMH is highly controversial
and often disputed. Believers argue it is pointless to search for undervalued stocks or to
try to predict trends in the market through either fundamental or technical analysis.
Meanwhile, while academics point to a large body of evidence in support of EMH, an
equal amount of dissension also exists. For example, investors, such as Warren Buffett
have consistently beaten the market over long periods of time, which by definition is
impossible according to the EMH. Detractors of the EMH also point to events, such as
the 1987 stock market crash when the Dow Jones Industrial Average (DJIA) fell by over
20% in a single day, as evidence that stock prices can seriously deviate from their fair
values.

Forms of efficient market hypothesis

EMH exists in various degrees: weak, semi-strong and strong, which addresses the
inclusion of non-public information in market prices. The weak form of EMH assumes
that current stock prices fully reflect all currently available security market information.
It contends that past price and volume data have no relationship with the future
direction of security prices. It concludes that excess returns cannot be achieved using
technical analysis. The semi-strong form of EMH assumes that current stock prices
adjust rapidly to the release of all new public information. It contends that security
prices have factored in available market and non-market public information. It
concludes that excess returns cannot be achieved using fundamental analysis. The
strong form of EMH assumes that current stock prices fully reflect all public and private
information. It contends that market, non-market and inside information is all factored
into security prices and that no one has monopolistic access to relevant information. It
assumes a perfect market and concludes that excess returns are impossible to achieve
consistently. The efficient market debate plays an important role in decision between
active and passive investing. Active managers argue that less efficient markets provide
an opportunity to outperform the market. However it is important to note that majority
of active managers in a given market underperform the market bench mark in the long
run. This is because active management is a zero sum game in which the only way a
participant can profit is for another less fortunate active participant to lose. If markets
are efficient, the role of professional managers would be to analyze and invest based on
investors risk profile, income and tax bracket