Security Analysis & Portfolio Management: 18MBA301B

Module1
Investment Overview

Investment refers to the allocation of monetary resources to assets expected to yield returns over
time. It involves committing saved resources with the goal of gaining future benefits, such as
income from interest, dividends, rent, premiums, or capital appreciation. Common examples of
investments include stocks, bonds, and real estate.

Types of Assets

1. Financial Assets: These include paper or electronic claims on issuers such as

governments or companies. Examples include bonds, stocks, and treasury bills.
2. Marketable Securities: These are financial assets that can be easily and cheaply traded
in organized markets, like stocks on the New York Stock Exchange.
3. Real Assets: Tangible items like gold, silver, diamonds, and real estate that have inherent
value.

Importance of Investment

The main reason for investing is to increase future consumption possibilities. By choosing to
save and invest today, individuals can grow their wealth and improve their financial situation for
the future. If one does not invest their savings, they miss out on potential returns, and the value
of their money decreases over time due to inflation.

Problems with Investment

Investing comes with challenges:

 Sacrifice: Delayed consumption today in the hope of future returns.

 Inflation: The value of investments can be eroded by inflation if it outpaces the returns.
 Risk: There is always the possibility of losing part or all of the invested amount.

Compensation to Investors

To compensate for the risks and sacrifices involved in investing, investors expect a required rate
of return (RRR). This includes the opportunity cost of investing and a premium for the risk and
potential inflation.

Features of Investment
Investments are evaluated based on several factors:

 Liquidity: The ease of converting the investment into cash.

 Safety of Principal: The security of the original investment amount.
 Tax Benefits: Whether there are tax advantages associated with the investment.
 Income Stability: The reliability of the investment's returns.
 Purchasing Power: Whether the investment protects against inflation.
 Capital Growth: The potential for the investment to increase in value over time.

Speculation

Speculation involves committing funds to high-risk investments with uncertain returns, usually
over a short period. Speculators tend to buy assets with the hope of making a quick profit from
price changes, unlike investors who generally hold assets for a longer period.

Investment vs. Speculation

The key difference between investment and speculation is the time horizon and risk tolerance.
Investors typically have long-term goals, assume moderate risk, and base their decisions on
fundamental analysis. Speculators, on the other hand, take on higher risks, rely on short-term
price movements, and may use technical analysis or market psychology for decision-making.

Differences Between Investors and Speculators

Investors generally have longer planning horizons and hold investments for a year or more,
allowing them to benefit from long-term growth and weather market fluctuations. They assume
moderate risk and focus on fundamental factors like a firm’s prospects. In contrast, speculators
have shorter planning horizons, are willing to assume higher risks, and often rely on market
psychology to make quick profits. Speculators also tend to borrow money to amplify their gains,
unlike investors who use their own funds.

Gambling

Gambling is characterized by high-risk activities where the outcomes are largely determined by
chance. Unlike investments or speculative ventures, which are driven by economic activities and
market trends, gambling involves uncertain returns based purely on luck. Common examples of
gambling include horse racing, card games, and lotteries. Gambling is not based on analysis or
strategy and often provides immediate results.

Gambling vs. Investment and Speculation

Gambling differs from both investment and speculation in that its outcomes are much more
immediate, and it is primarily done for entertainment rather than income generation. Unlike
investment or speculation, gambling does not involve analyzing market trends or economic
fundamentals and is driven purely by artificial risks.

Arbitrage

Arbitrage is a strategy that allows investors to take advantage of price differences in different
markets. For example, an arbitrageur might buy a stock on one exchange where it is priced lower
and sell it on another where the price is higher, profiting from the price differential. Arbitrage
opportunities often arise from market inefficiencies.

Understanding the differences between investment, speculation, gambling, and arbitrage is

essential for making informed financial decisions. While investing focuses on long-term growth
and managing risks, speculation and gambling involve higher risks with shorter time horizons.
Arbitrage allows savvy investors to profit from market inefficiencies, further highlighting the
diverse strategies available in the financial world.

Characteristics and Types of Investments

Investing is a key element of financial planning, and investors need to understand the
characteristics and types of investments to match their financial goals and risk tolerance. One of
the primary characteristics of investments is objective fulfillment. Each investment must align
with the investor's personal goals, whether it's growing wealth, generating income, or preserving
capital. Achieving these objectives becomes challenging due to the inherent uncertainties of the
market, so selecting the right investment options is critical to fulfilling these objectives.

Safety is another important characteristic. Investors typically prioritize the safety of their
principal, especially ordinary investors who want the assurance that they will get back their
initial investment after maturity. While absolute safety is rare, government securities are
considered the safest because of the government's guarantee of repayment. Return is also central
to investing, as investors seek to earn a return on their investment. Generally, higher returns
come with higher risks, meaning that investments offering low risk, such as government
securities, also tend to provide lower returns.

Liquidity is an essential consideration for investors, as they often favor investments that can be
easily converted to cash. Market conditions or unexpected financial needs can make it important
to sell an asset quickly without suffering significant losses. Another important characteristic is
the ability of investments to hedge against inflation. Long-term investors, in particular, seek
investments that protect the purchasing power of their money by generating capital gains that
outpace inflation. Tax considerations also play a major role in investment decisions. Many
investors look for tax advantages, whether it's through tax savings during the investment period
or tax relief when realizing their investment gains.

Types of Investments
Investments can be broadly categorized into growth investments and defensive investments.
Growth investments aim to increase the value of the original investment and are suitable for
investors with a higher risk tolerance who are focused on long-term capital appreciation. Shares
are a common type of growth investment, with the potential to increase in value over time,
though they can also be volatile and risky. Property is another growth investment, with real
estate having the potential for significant long-term gains. However, property values can also
fluctuate, making these investments riskier.

Defensive investments, on the other hand, focus on generating consistent income and are
considered safer compared to growth investments. Cash investments, such as savings accounts
and term deposits, offer low returns but are secure and provide a regular income stream. Fixed
interest investments, such as bonds, are another form of defensive investment. Governments or
companies issue bonds, which pay investors regular interest. Bonds are generally less risky than
shares or property, though they also offer lower potential returns.

Understanding the Investment Decision Process

The investment decision process is driven by the need to earn a return while assuming an
appropriate level of risk. Different approaches guide investors in making decisions. The
fundamental approach is based on the intrinsic value of securities, determined by factors such as
company performance, industry conditions, and the overall economy. Investors using this
approach rely on analyzing financial statements and macroeconomic data to determine a
security’s true value.

In contrast, the psychological approach focuses on investor emotions and market sentiment. This
approach emphasizes understanding how investor behavior under different market conditions,
such as waves of optimism or pessimism, impacts stock prices. The academic approach assumes
that markets are efficient, with stock prices reflecting intrinsic value and reacting quickly to new
information. This approach also asserts that risk and return are positively correlated, meaning
higher risks come with the potential for higher returns.

The electric approach combines elements of fundamental, psychological, and academic

perspectives. It uses fundamental analysis to establish benchmarks, technical analysis to assess
market sentiment, and recognizes the risk-return correlation seen in the academic approach. This
approach offers a comprehensive view, allowing investors to use a wide range of insights to
make more informed decisions.

Investment Decision Process

The investment decision process involves five key steps. The first step is understanding the
investor's needs. This requires analyzing the investor’s financial goals, risk tolerance, and tax
considerations. By understanding these factors, a benchmark can be established for evaluating
the performance of the investment portfolio. The second step is the asset allocation decision.
This step involves determining how to allocate investments across different asset classes, such as
equities, fixed income, and real estate. Investors also need to decide whether to invest in
domestic or international markets, considering the broader economic environment.

The third step is portfolio strategy selection. Investors must choose a strategy that aligns with
their objectives, and there are two main types of strategies. Active management aims to
outperform the market by making calculated bets, such as buying undervalued securities or short-
selling overvalued ones. Passive management, on the other hand, aims to mirror market returns,
following the market’s movements without attempting to outperform it.

The fourth step is the asset selection decision, which involves picking specific investments
within each asset class. For example, within equities, investors must decide which stocks to buy,
while in fixed income, they must select the appropriate bonds. It’s crucial that these selections
align with the investor’s overall objectives and policies to ensure the portfolio remains effective.
The fifth and final step is evaluating portfolio performance. This step involves measuring the
investment’s performance against a benchmark to ensure the investor’s goals are being met. If a
portfolio underperforms, it may be necessary to rebalance the investments to realign the risk and
return levels with the investor’s objectives.

Continuous monitoring is essential to ensure that the portfolio remains in line with the investor’s
goals, and adjustments may be required to address underperforming assets or changing market
conditions. This process helps maintain the investor’s risk-return profile and ensures long-term
investment success.

Systematic and Unsystematic Risk

Systematic Risk refers to the inherent risk that affects the entire market or a large portion of it,
stemming from external factors such as political events, macroeconomic changes (interest rates,
inflation), or natural disasters. These risks cannot be eliminated through diversification. They are
sometimes called market risks because they impact the overall market, affecting almost all
securities. Examples include economic recessions, wars, or changes in government policies.
Systematic risk is often measured by beta (β), which assesses the sensitivity of a stock or
portfolio to movements in the overall market. Higher beta values indicate greater exposure to
systematic risk.

Unsystematic Risk, on the other hand, is specific to a company or industry and can be
diversified away by holding a portfolio of different assets. This risk arises from internal factors
such as a company's management decisions, financial health, production processes, or customer
demand for its products. Examples include a company going bankrupt, labor strikes, or product
recalls. Since unsystematic risk is company-specific, investors can reduce it by investing in a
variety of securities across different sectors.

Risk and Return on Investment

Risk and return are two sides of the same coin in the world of investing. Return refers to the
profit earned from an investment over time, and it can take the form of capital gains (increase in
the value of an asset) or income (such as dividends or interest payments). Risk refers to the
uncertainty or variability of returns. Investors face a trade-off between risk and return:
investments that offer the potential for higher returns typically come with higher risks.

 Expected Return: The anticipated profit or loss from an investment over a period,
usually calculated as a weighted average of possible returns.
 Risk-Return Tradeoffs: Investors must decide how much risk they are willing to take to
achieve their desired return. Conservative investors prefer low-risk investments with
lower returns, while aggressive investors seek high-risk investments with the potential for
higher returns.
 Risk Tolerance: The level of variability in returns an investor is willing to withstand. It
varies among individuals based on financial goals, time horizon, and psychological
factors.

Measuring Risk and Return on a Single Asset

When evaluating a single asset, investors focus on two key metrics: return and risk.

 Return: The return on a single asset is calculated based on the change in value of the
asset over a given period, including any income generated (e.g., dividends or interest).
o Formula: Return = (Ending Price - Beginning Price + Dividends) / Beginning
Price
o Expected Return is a forecast of the average return over time, taking into
account all possible scenarios and their likelihood.

 Risk (Standard Deviation): The risk of a single asset is measured by the variability of
its returns. Standard deviation quantifies how much the returns deviate from the average
(mean) return.
o Variance is the average of the squared deviations from the mean, which shows
the asset's overall risk.
o Standard Deviation is the square root of variance, giving a more tangible figure
for assessing risk.

Measuring Risk and Return on a Portfolio

When assets are combined into a portfolio, the goal is often to maximize return while minimizing
risk. The principles of diversification help achieve this by investing in assets that do not move
perfectly in sync with each other.

 Portfolio Return: The expected return of a portfolio is the weighted average of the
returns of the individual assets.
o Formula: Portfolio Return = Σ (Weight of Asset i * Return of Asset i)
o Each asset's return is multiplied by its proportion (or weight) in the portfolio.
  Portfolio Risk (Variance and Covariance): Risk in a portfolio depends not only on the
risk of individual assets but also on how the assets move relative to each other
(correlation).
o Variance measures the total risk of the portfolio.
o Covariance measures how two assets move together. Positive covariance means
they tend to move in the same direction, while negative covariance indicates they
move in opposite directions.
o Correlation is derived from covariance and standard deviations of the individual
assets. A correlation of 1 means the assets move perfectly in tandem, and -1
means they move inversely. Lower correlation between assets in a portfolio can
reduce overall risk.

 Diversification: By combining assets with low or negative correlations, investors can

reduce unsystematic risk. Diversification helps smooth out the highs and lows of
individual asset returns, reducing the overall volatility of the portfolio.

Capital Asset Pricing Model (CAPM)

The CAPM is a model used to determine the expected return on an asset, given its systematic
risk as measured by beta (β).

 CAPM Formula: Expected Return = Risk-Free Rate + Beta * (Market Return -

Risk-Free Rate)
o The Risk-Free Rate is the return on a risk-free asset, like government bonds.
o Market Return is the expected return of the overall market.
o Beta (β) measures how much the asset moves in relation to the market. A beta of
1 means the asset moves with the market; a beta above 1 indicates higher
sensitivity, and a beta below 1 indicates less sensitivity.

Risk and Return for ‘n’ Assets Portfolio

For a portfolio with multiple assets, the complexity of measuring risk increases because investors
must account for both the risk of each individual asset and how they interact with one another.

 Expected Portfolio Return: This is calculated as the weighted sum of the expected
returns of the individual assets, similar to a two-asset portfolio.
 Portfolio Risk: For a portfolio with 'n' assets, risk (variance or standard deviation) must
account for the individual risks of each asset, as well as the covariances (or correlations)
between each pair of assets. The formula expands to include the variances of the assets
and the covariances between them.
o Formula: Portfolio Variance = Σ Σ (Weight of Asset i * Weight of Asset j *
Covariance between Asset i and Asset j)
o Reducing overall portfolio risk depends heavily on choosing assets with low or
negative correlations to each other.
Sharpe Ratio

The Sharpe Ratio is a common measure used to assess the risk-adjusted return of an investment.
It is calculated as the difference between the portfolio's return and the risk-free rate, divided by
the portfolio's standard deviation (risk).

 Formula: Sharpe Ratio = (Portfolio Return - Risk-Free Rate) / Portfolio Standard

Deviation
o A higher Sharpe ratio indicates better risk-adjusted performance.

Efficient Frontier and Optimal Portfolio

The Efficient Frontier represents the set of portfolios that offer the maximum expected return
for a given level of risk. It is part of Modern Portfolio Theory (MPT), which suggests that
investors should seek portfolios on the efficient frontier because they provide the best return for
their level of risk.

 Optimal Portfolio: The point on the efficient frontier that touches the highest possible
indifference curve (investor's preferences between risk and return). The optimal portfolio
maximizes an investor's utility based on their risk tolerance.

Risk Management in Investment Portfolios

Effective risk management involves identifying, assessing, and prioritizing risks, and taking
steps to minimize or eliminate them. In investment portfolios, this process involves:

 Hedging: Using financial instruments like options and futures to offset potential losses.
 Asset Allocation: Distributing investments across various asset classes to minimize
exposure to risk.
 Rebalancing: Adjusting the asset mix in a portfolio to maintain the desired level of risk
as market conditions change.

Understanding and managing risk is essential for achieving the desired return on investment.
Whether dealing with a single asset or a diversified portfolio, investors must balance the trade-
off between risk and return, leveraging tools like CAPM, portfolio theory, and the Sharpe ratio to
make informed decisions. Diversification and proper risk assessment are key to reducing risk and
achieving long-term investment success.

Computation of Risk and Return on a Portfolio

When evaluating a portfolio, investors need to compute both the expected return and the risk
associated with the portfolio. This requires understanding the weighted contributions of each
asset to the overall portfolio and how the assets interact with each other in terms of risk
(volatility).
Expected Return on a Portfolio

The expected return of a portfolio is the weighted average of the expected returns of the
individual assets in the portfolio. Each asset's expected return is multiplied by its respective
weight in the portfolio, and then these values are summed to determine the total expected return.

Formula for Expected Portfolio Return:

Where:

Risk (Standard Deviation) of a Portfolio

Risk in a portfolio context is measured by the portfolio’s standard deviation, which reflects the
total volatility of the portfolio’s returns. The risk of a portfolio is more complex to calculate than
the expected return because it depends not only on the individual asset volatilities (standard
deviations) but also on the correlation between the assets in the portfolio.

For a portfolio with two assets, the formula to calculate portfolio variance (which can be square-
rooted to find standard deviation) is:

Formula for Portfolio Variance:

Where:
For portfolios with more than two assets, the formula becomes increasingly complex, as it
requires considering the covariances between all pairs of assets.

Portfolio Standard Deviation (Risk):

Covariance and Correlation in Portfolios

The covariance and correlation between assets in a portfolio are crucial in determining the total
risk. Covariance measures how two assets move together, while correlation standardizes this
value between -1 and +1.

 Positive Correlation: Assets tend to move in the same direction, increasing overall
portfolio risk.
 Negative Correlation: Assets move in opposite directions, which can reduce overall
portfolio risk through diversification.

Assets with low or negative correlations are more effective at reducing portfolio risk, making
diversification an essential principle in portfolio management.

Interpretation of Portfolio Risk and Return

Understanding the risk and return characteristics of a portfolio is key to interpreting whether the
portfolio aligns with an investor's objectives.

Portfolio Return Interpretation

 Positive Expected Return: Indicates the potential for profit. If the expected return is
high, the investor can anticipate higher earnings, but this could be associated with higher
risk.
 Risk-Return Tradeoff: Investors must decide if the return justifies the risk. High-risk
portfolios may have high expected returns but could also lead to significant losses.

Portfolio Risk Interpretation

 Standard Deviation: A higher standard deviation means greater volatility, implying that
the portfolio's returns could fluctuate widely. Investors must assess whether they are
comfortable with such volatility.
 Diversification Effect: If a portfolio contains assets with low or negative correlations,
the overall risk (volatility) can be reduced, even if individual assets have high volatility.
This is the key benefit of diversification.
 A well-diversified portfolio may offer a similar expected return as a less diversified one,
but with lower risk.

Risk-Adjusted Return

To evaluate whether a portfolio’s return is worth its risk, risk-adjusted return metrics are used.
One common measure is the Sharpe Ratio, which assesses the portfolio’s return relative to its
risk.

Sharpe Ratio: S= (Rp−Rf)/σp

Where:

 Rp = Portfolio return
 Rf= Risk-free rate
 σp= Portfolio standard deviation

A higher Sharpe ratio indicates a better risk-adjusted return, meaning the portfolio generates
more return per unit of risk. Portfolios with a Sharpe ratio greater than 1 are considered good,
while those below 1 may indicate that the risk taken is not justified by the return.

Importance of Portfolio Optimization

Investors aim to construct an optimal portfolio, one that maximizes return for a given level of
risk or minimizes risk for a given level of return. Portfolio optimization can be achieved using
models like the Efficient Frontier, which represents a set of portfolios that offer the highest
expected return for each level of risk.

Capital Asset Pricing Model (CAPM) and Portfolio

The CAPM is widely used to understand the relationship between risk and expected return. It
helps investors determine the expected return for an asset or portfolio, considering its systematic
risk (beta).

In the context of a portfolio, the CAPM formula can be applied to assess whether the portfolio is
generating a return that compensates for its systematic risk relative to the market.

Portfolio risk and return are critical concepts for evaluating the performance of a group of assets.
By computing expected return and risk, investors can assess whether their portfolio aligns with
their investment goals and risk tolerance. Diversification plays a key role in reducing portfolio
risk, while risk-adjusted return measures like the Sharpe ratio help investors judge the adequacy
of their portfolio’s performance. Understanding these concepts enables investors to make more
informed decisions in pursuit of optimal portfolio outcomes.

Basics of Stock Market Operations in India

The Indian stock market is a crucial component of the country's financial system, allowing
companies to raise capital and providing investors with opportunities to grow their wealth.
Here’s a comprehensive overview of stock market operations specific to India:

Stock Market Overview in India

The Indian stock market consists of various exchanges where securities are traded. The two
primary stock exchanges are:

 Bombay Stock Exchange (BSE): Established in 1875, it is one of the oldest stock
exchanges in Asia, located in Mumbai.
 National Stock Exchange (NSE): Established in 1992, it is the largest stock exchange in
India by trading volume and was the first to offer electronic trading.

Stock Market Participants

The Indian stock market comprises several participants, each playing a unique role:

 Retail Investors: Individual investors who buy and sell shares for personal investment.
 Institutional Investors: Entities like mutual funds, insurance companies, and pension
funds that manage large sums of money and invest on behalf of others.
 Foreign Institutional Investors (FIIs): Foreign entities that invest in Indian markets,
contributing to market liquidity and foreign capital inflow.
 Brokers: Licensed individuals or firms that facilitate stock trading on behalf of clients
and charge a commission for their services.
 Market Makers: Entities that provide liquidity by quoting both buy and sell prices for
stocks, thus ensuring that trades can occur smoothly.

Stock Market Indices in India

Stock market indices are essential for assessing market performance. In India, the most notable
indices include:

 Sensex: Comprising 30 major companies listed on the BSE, it reflects the overall market
movement.
 Nifty 50: Representing 50 companies listed on the NSE, it serves as a benchmark for
mutual funds and other investments.

Initial Public Offering (IPO)

An IPO is the process by which a private company offers its shares to the public for the first
time. Key aspects include:
  Regulatory Approval: Companies must file a prospectus with the Securities and
Exchange Board of India (SEBI) before launching an IPO.
 Price Band: A range within which the stock will be priced during the IPO.
 Subscription: Investors can apply for shares during the IPO period, which can be
oversubscribed (demand exceeds supply).

Trading Mechanisms

The trading of stocks in India occurs through various mechanisms:

 Order Types:
o Market Orders: Executed at the current market price.
o Limit Orders: Executed only at a specified price or better.
o Stop-Loss Orders: Triggered when a stock reaches a predetermined price to limit
losses.
 Trading Hours: The Indian stock market operates on weekdays, from 9:15 AM to 3:30
PM, with a pre-opening session from 9:00 AM to 9:15 AM.

 Settlement Process: The trade settlement occurs on a T+2 basis, meaning transactions
are settled two business days after the trade.

Factors Affecting Stock Prices in India

Several factors influence stock prices in the Indian market:

 Company Performance: Earnings reports, revenue growth, and market share impact
investor perceptions.
 Economic Indicators: GDP growth, inflation rates, and fiscal policies affect investor
confidence and market performance.
 Global Events: International market trends, geopolitical tensions, and global economic
conditions influence local stock movements.
 Market Sentiment: Investor behaviour, driven by news, trends, and social media, can
lead to volatility.
Risk and Return Analysis

Investing in the stock market entails various risks, including:

 Market Risk: The risk of losses due to overall market fluctuations.

 Company-Specific Risk: Risks arising from events affecting a particular company, such
as management changes or product failures.
 Systematic vs. Unsystematic Risk:
o Systematic Risk: Risks that affect the entire market, such as economic downturns
or changes in interest rates.
o Unsystematic Risk: Risks specific to a single company or industry that can be
mitigated through diversification.

Returns in the stock market can be realized through:

 Capital Gains: The profit made from selling a stock at a higher price than the purchase
price.
 Dividends: Periodic payments made to shareholders from a company's profits.

Regulatory Framework

The Securities and Exchange Board of India (SEBI) is the primary regulatory body overseeing
the securities market in India. Key responsibilities include:

 Protecting Investor Interests: Ensuring fair practices and transparency.

 Regulating Market Intermediaries: Licensing and monitoring brokers, mutual funds,
and other market participants.
 Enforcing Compliance: Ensuring companies adhere to regulations concerning
disclosures, insider trading, and corporate governance.

Importance of Stock Market

The stock market plays a vital role in the Indian economy:

 Capital Formation: It provides companies with access to capital for expansion and
growth.
 Wealth Creation: Investors can build wealth through capital gains and dividends.
 Economic Indicators: Market performance reflects the health of the economy,
influencing policymaking and investor sentiment.

Investment Strategies

Investors in the Indian stock market may adopt various strategies, including:
  Value Investing: Focusing on undervalued stocks with strong fundamentals.
 Growth Investing: Targeting companies with high potential for future growth.
 Dividend Investing: Seeking stocks that pay regular dividends.
 Day Trading: Buying and selling stocks within the same trading day for short-term
profits.

Understanding stock market operations in India involves grasping the structure, participants,
mechanisms, and risks associated with trading stocks. With proper knowledge and strategies,
investors can effectively navigate the stock market, aiming for wealth accumulation while
managing associated risks. The Indian stock market continues to evolve, presenting both
opportunities and challenges for participants.