Investment Analysis and

Portfolio Management
Lecture – 1
Introduction
Why Do Individuals Invest ?
• Savings or scarce resources or borrowed money
• Savings can be defined as the excess of income over expenditure
• By saving scarce money (instead of spending it), individuals tradeoff present
consumption for a larger future consumption.
• All savers need not be investors.
• Future expectations of returns distinguish the investor from a saver
and is hence an essential characteristic of investment.
• Investment, hence, involves the commitment of resources at present
that have been saved in the hope that some benefits will accrue from
them in the future.
Defining an Investment
A current commitment of $ for a period of time in
order to derive future payments that will
compensate for:
• the time the funds are committed
• the expected rate of inflation
• uncertainty of future flow of funds.
Investment
• Investment is defined as a sacrifice made now to obtain a return later
• It is current consumption that is sacrificed
• Two forms of investment can be defined
• Real investment is the purchase of land, machinery, etc. that increase assets
of a business or an individual
• Financial investment is the purchase of a "paper" contract, that ensures direct
future returns in form of money

• Financial investment can provide finance for real investment decisions

Characteristics of an Financial Investment
Liquidity:
• An investment that is easily saleable or marketable without loss of
money and without loss of time is said to possess the characteristic of
liquidity.
• Some investments such as bank deposits, post office deposits,
national savings certificate, etc. are not marketable.
Characteristics of an Financial Investment
Contd..
Safety:
• The safety of investment is identified with the certainty of return of
capital without loss of money or time.
• A highly reputed and successful corporate entity assures the investors
of their initial capital. For example, investment is considered safe
especially when it is made in securities issued by the government of a
developed nation.
Characteristics of Financial Investments
Contd..
Return:
• All investments are characterised by the expectation of a return.
• The expectation of a return may be from income(yield) as well as
through capital appreciation.
• Capital appreciation is the difference between the sale price and the purchase
price of the investment.
• The dividend or interest from the investment is the yield.
• Holding Return Vs Expected return
• The expectation of return from an investment depends upon the
nature of investment, maturity period, market demand etc.
Characteristics of an Financial Investment
Contd..
Risk:
• Risk may relate to loss of capital, delay in repayment of capital, non-
payment of interest, or variability of returns.
• The risk of an investment is determined by the investment’s maturity
period repayment capacity, nature of return commitment etc.
• Some Securities can be risk free, or with nominal risk.
Objective of Investment
• The main objective of an investment process is to minimise risk while
simultaneously maximising the expected returns from the investment
and assuring safety and liquidity of the invested assets.
• Investors look for growth/increase in current wealth through investment
opportunities
• Investments are made with the objective to provide a hedge or protection
against inflation over the investment duration.
• The objective of safety and liquidity helps an investor to design a retirement
plan
Financial Investment Environment
Financial Investment Environment
• There are numerous components to financial investment
• Lenders (Investors) /borrowers
• Markets: where assets are bought and sold, and the forms of trade
• Securities: the kinds of securities available, their returns and risks
• Financial Intermediaries
• Investment process: the decision about which securities, and how
much of each
• Financial theory: the factors that determine the rewards from
investment (and the risks)
Types of Investors
• There are two types of investors:
• Individual investors;
• Institutional investors.
• Individual investors are individuals who are investing on their own.
Sometimes individual investors are called retail investors. Institutional
investors are entities such as investment companies, commercial banks,
insurance companies, pension funds and other financial institutions.
• Investors are also classified as:
• A risk seeker - capable of assuming a higher risk.
• A risk avoider - choose instruments that do not show much variation in returns.
• Risk bearers - assume moderate levels of risk.
Markets
• A market is any organized system for connecting buyers and sellers
• There are many types of security markets
• Markets may have a physical location
• Or exist only as computer networks
• Markets vary in the securities that are traded and in the way
securities are traded
Markets Contd..
• There are a number of ways to classify markets
• Primary/Secondary
• Primary markets are security markets where new issues of securities are
traded
• A secondary market is a market where securities are resold
• Most activity on stock exchanges is in the secondary market
Markets Contd..
• Trades on the primary market raise capital for firms
• Trades on the secondary market do not raise additional capital for
firms
• The secondary market is still important
• It gives liquidity to primary issues. New securities would have a lower value if
they could not be subsequently traded
• It signifies value. Trading in assets reveals information and provides a
valuation of the assets and business . This helps to guide investment decisions
Markets Contd..
• A second way to classify markets is the times of trading
• Call/continuous
• In a call market trading takes place at a specified time intervals
• Some call markets have a provision that limits movement from the prior price.
This is to prevent a temporary order imbalance from dramatically moving the
price
• In a continuous market there is trading at all times the market is open
Markets Contd..
• Markets can also be characterized by the lifespan of the assets traded
• Money/Capital
• Money market: the market for assets with a life of less than 1 year
• Capital market: the market for assets with a life greater than 1 year
• Some assets, such as most bonds, have a fixed lifespan
• Common stock have an indefinite lifespan
Securities
• The standard definition of a security
is:
"A legal contract representing the
right to receive future benefits under a
stated set of conditions"
• The piece of paper defining the
property rights held by the owner is
the security
• These instruments may be marketable
or non-marketable.
• Money market securities
• Capital market securities (debt and
Equity)
Financial Intermediaries
• The financial intermediaries which intermediate the lending and
borrowing process.
• They interpose themselves between the lenders and borrowers, and earn a
margin for the benefits of intermediation (including lower risk for the
lender).
• Sometimes they buy the securities of the borrowers and issue their own to
fund these.
• Financial intermediaries exist because there is a conflict between lenders
and borrowers in terms of their financial requirements (term, risk, volume,
etc.).
• a surplus company may wish to lend for 3 months, while a deficit company may wish
to borrow for 2 years
Brokers
• A broker is a representative appointed by an individual investor
• Brokers have two roles, they can be either
• An advisor: a broker can offer investment advice and information
• A sales person: brokers are rewarded through commission and have an
incentive to encourage trade
• A full-service broker is a brokerage house that can offer a full range of
services including investment advice and investment management
Brokers Types
• A discount broker offers a restricted range of services at a lower price.
• To complete a trade additional brokers are needed

• A floor broker is located on the floor of the exchange and does the actual
buying and selling

• A specialist ensures trade happens by holding an inventory of stock and

posting prices
Investment Process
• The process of investment includes five stages:
• Investment Policy: The policy is formulated on the basis of investible funds,
objectives and knowledge about investment sources.
• Security Analyses: Economic, industry and company analyses are carried out
for the purchase of securities.
• Valuation: Intrinsic value of the security is measured.
• Portfolio Construction: Portfolio is diversified to maximise return and
minimise risk.
• Portfolio Evaluation: The performance of the portfolio is appraised and
revised.
Investment policy
• The investor before proceeding into investment formulates the policy for
the systematic functioning.
• ingredients of the policy are the investible funds, objectives and the
knowledge about the investment alternatives
• The essential Investible funds : May be generated through savings or from
borrowings.
• Objectives: Are framed on the premises of the required rate of return, need
for regularity of income, risk perception and the need for liquidity.
• Knowledge: about the investment alternatives and markets plays a key role
in the policy formulation. The investment alternatives range from security
to real estate. The risk and return associated with investment alternatives
differ from each other.
Security analysis
• After formulating the investment policy, the securities to be bought
have to be scrutinized through the market, industry and company
analysis.
• Market analysis
• Industry analysis
• Company analysis
Valuation
• The valuation helps the investor to determine the return and risk
expected from an investment in any security.
• The real price of the security is compared with the market price and
then the investment decision are made.
• Future value of the securities could be estimated by using a statistical
technique like trend analysis or discounting models. The analysis of the
historical behaviour of the price enable the investor to predict the future
value.
Construction of portfolio

• A portfolio is a combination of securities. The investor tries to attain

maximum return with minimum risk.
• The portfolio is constructed in such a manner to meet the investor’s
goals and objectives.
• The investor diversifies his portfolio and allocates funds among the
securities.
• Diversification: Debt and equity diversification, Industry diversification,
Company diversification
Evaluation
• The portfolio has to be managed efficiently, this requires evaluation of
the portfolio.
• This process consists of portfolio appraisal and revision.
• Appraisal: The return and risk performance of the security vary from time to
time. The variability in returns of the securities is measured and compared.
The developments in the economy, industry and relevant companies from
which the stocks are bought have to be appraised. The appraisal warns the
loss and steps can be taken to avoid such losses.
• Revision: Revision depends on the results of the appraisal. The low yielding
securities with high risk are replaced with high yielding securities with low risk
factor. To keep the return at a particular level necessitates the investor to
revise the components of the portfolio periodically