Tag: Change Management BMS Notes

Diversification is a technique that reduces risk by allocating investments across various financial instruments, industries, and other categories. It aims to maximize returns by investing in different areas that would each react differently to the same event.

Most investment professionals agree that, although it does not guarantee against loss, diversification is the most important component of reaching long-range financial goals while minimizing risk. Here, we look at why this is true and how to accomplish diversification in your portfolio.

Let’s say you have a portfolio that only has airline stocks. Share prices will drop following any bad news, such as an indefinite pilot strike that will ultimately cancel flights. This means your portfolio will experience a noticeable drop in value.

You can counterbalance these stocks with a few railway stocks, so only part of your portfolio will be affected. In fact, there is a very good chance that these stock prices will rise, as passengers look for alternative modes of transportation.

You could diversify even further because of the risks associated with these companies. That’s because anything that affects travel will hurt both industries. Statisticians may say that rail and air stocks have a strong correlation. This means you should diversify across the board different industries as well as different types of companies. The more uncorrelated your stocks are, the better.

Be sure to diversify among different asset classes, too. Different assets such as bonds and stocks don’t react the same way to adverse events. A combination of asset classes like stocks and bonds will reduce your portfolio’s sensitivity to market swings because they move in opposite directions. So if you diversify, unpleasant movements in one will be offset by positive results in another.

And don’t forget location, location, location. Look for opportunities beyond your own geographical borders. After all, volatility in the United States may not affect stocks and bonds in Europe, so investing in that part of the world may minimize and offset the risks of investing at home.

Purpose of portfolio diversification

 The fundamental purpose of portfolio diversification is to minimize the risk on your investments; specifically unsystematic risk.

Unsystematic risk also known as specific risk is risk that is related to a specific company or market segment. By diversifying your portfolio, this is the risk you hope to cut. This way, all your investments would not be uniformly affected in the same way by market events.

Portfolio diversification is of the core tenets of investing and is crucial for better risk management. There are many benefits of diversification. However, it must be done with caution. Here’s how you can effectively diversify your portfolio:

Spread out your investments

Investing in equities is good but that doesn’t mean you should put all your wealth in a single stock or a single sector. The same applies to your investments in other options like Fixed Deposits, Mutual Funds or gold too.

For instance, you might invest in six stocks. But if the whole market suddenly takes a tumble, you could have a problem. This problem is compounded if the stocks belonged to the same sector like manufacturing. This is because any news item or information that affects the performance of one manufacturing stock could as well affect the other stocks in some way or other.

So, even if you choose the same asset, you can diversify by investing in different sectors and industries. There are so many different industries and sectors to explore with exciting opportunities like pharmaceuticals, Information Technology (IT), consumer goods, mining, aeronautics, energy and so on.

Explore other investment avenues

You could also add other investment options and assets to your portfolio. Mutual funds, bonds, real estate and pension plans are other investments you can consider. Also, make sure that the securities vary in risk and follow different market trends. 

It has been generally observed that the bond and equity markets have contrasting movements. So, by investing in both these avenues, you can offset any negative results in one market by positive movements in the other. This way, you can ensure that you are not in a lose-lose situation.

Consider Index or Bond Funds

A sound diversification strategy, adding Index or bond funds to the mix provides your portfolio with the much-needed stability. Also, investing in Index funds is highly cost-effective as the charges are quite low compared to actively managed funds.

At the same time, investing in bond funds hedges your portfolio from market volatility and uncertainty and prevents gains from being wiped out during market volatility.

Keep Building Your Portfolio

This is another portfolio diversification strategy. You need to keep building your portfolio by investing in different asset classes, spreading across equities, debt and fixed-return instruments. Adopting this approach helps you better ride volatility.

Also, if you are investing in mutual funds, adopting the SIP route is advisable as it helps you stay invested across market cycles and gain from the concept of rupee cost averaging.

Know When to Get Out

Portfolio diversification also entails knowing the time when you must exit your investments. If the asset class you have been investing hasn’t performed up to the mark for a long period and if there have been any changes in its fundamental structure that don’t align with your goals and risk appetite, then you must exit.

Also, note that if you have invested in any market-linked instrument, then don’t exit following short-term volatility.

Keep an Eye on Commissions

This is another crucial thing to watch out for. If you are taking services of a professional, check out the fees you are paying in lieu of the services availed.

This is essential because commissions can ultimately take a toll on the end returns. A high commission can eat away into your gains.

Pros and Cons of Diversification

Now that you know the different portfolio diversification strategies let’s look at its advantages and disadvantages.

Advantages of Diversification

Makes Your Portfolio Better Shock-Proof

This is one of the major benefits of diversification. A well-diversified portfolio can better absorb the shocks during a market downturn. The risk is well-spread out when you invest in different asset classes.

Also, non-performance of one asset class is made up for by a different asset class. Simply put, with a well-diversified portfolio, you can contain the losses in a better manner.

Better Weather Market Cycles

Every economy goes through a cycle. During a cycle, markets move up, become stagnant, comes down and goes up again. With portfolio diversification, you can better weather market cycles and gain from its bullish run.

Also, following a crash when markets move up, it helps you gain from the rally. This is not the case, however, with a non-diversified portfolio that’s concentrated towards one asset class.

Enhance Risk-Adjusted Returns

This is another significant benefit of portfolio diversification. When two portfolios yield the same returns, a diversified one will take lesser risk than a concentrated one. The latter will be more volatile than the former.

Hence, for better risk-adjusted returns, it’s vital to have a diversified portfolio investing across asset classes.

Leverage Growth Opportunities Present in Other Sectors

When you invest across different assets in different sectors, you can leverage the growth opportunity present in them. For instance, of late gold has given spectacular returns and those having an exposure to the yellow metal have made quite significant gains.

Markets often see a cycle when one sector outperforms the other, and only when you have the exposure to this sector, you can take its advantage.

Provides Stability and Peace of Mind

Another significant advantage of diversification strategy is that it gives your portfolio the much-needed stability and peace of mind as you know, it can better combat a downturn. With a more predictable return, it cuts out the emotional quotient from investments, essential for achieving the desired goal.

Disadvantages of Diversification

Go Overboard

Sometimes in the name of portfolio diversification, investors tend to go overboard and end up investing in too many assets that they don’t even require.

For instance, often investors end up investing in too many equity funds holding the same stocks. This makes the portfolio bloated and dilutes returns.

Tax Complications

This is another major disadvantage of diversification. The tax structure differs across asset classes, and buying and selling them can lead to major complications. For example, taxation structure of equity mutual funds are different from debt funds. Similarly, income from bank FDs is taxed differently from that of real estate.

Hence, you need to be aware of the various tax structure while investing in different asset classes.

Risk of Investing in an Unknown Asset

Sometimes, in the name of diversification, you can end up investing in an asset that’s unknown to you. You may get caught off guard if investing in that asset isn’t legal in the country. Also, investing in an unknown asset may result in losing capital in the long run, which brings down returns of your overall portfolio.

Can Make Investments Complicated

 When you diversify too much, it can complicate investments. Before proceeding, you need to understand the structure and working of the asset class, and this can be a task too much.

On the other hand, when you invest in only a few asset classes, complications tend to be on the lower side.

Missed Windfalls

Another disadvantage of portfolio diversification is that if a single sector witnesses a spike, you can miss out on leveraging complete gains from it.

Often in the past, investors have regretted that only a small percentage of their holdings have made profits. Having said that, it’s pretty difficult to predict as to when that will happen to an asset class.

Traditional Portfolio theory is one of the subjective analysis but it has provided positive results to many some people who have invested keeping in mind the individual securities. Through this traditional theory, investors have been getting the maximum return at the minimum risk.

On the other hand, modern portfolio theory emphasizes on maximizing of return through a combination of securities. It discusses the relationship between different securities and then draws inter-relationships of risks between them.  This theory states that by combining a low risk security with the one with higher risk will ultimately result in a success by investor in making choice of investment.

Traditional portfolio analysis has been of a very subjective nature but it has provided success to some persons who have made their investments by making analysis of individual securities through evaluation of return and risk conditions in each security.

In fact, the investor has been able to get the maximum return at the minimum risk or achieve his return position at that indifferent curve which states his risk condition. The normal method of calculating the return on an individual security was by finding out the amount of dividends that have been given by the company, the price earning ratios, the common holding period and by an estimation of the market value of the shares.

The modern portfolio theory believes in the maximization of return through a combination of securities. The modern portfolio theory discusses the relationship between different securities and then draws inter-relationships of risks between them.

It is not necessary to achieve success, only by trying to get all securities of minimum risk. The theory states that by combining a security of low risk with another security of high risk, success can be achieved by an investor in making a choice of investment outlets.

Traditional theory was based on the fact that risk could be measured on each individual security through the process of finding out the standard deviation and that security should be chosen where the deviation was the lowest. Greater variability and higher deviations showed more risk than those securities which had lower variation.

The modern theory is of the view that by diversification risk can be reduced. Diversification can be made by the investor either by having a large number of shares of companies in different regions, in different industries, or those producing different types of product lines.

Diversification is important but the modern theory states that there cannot be only diversification to achieve the maximum return. The securities have to be evaluated and thus diversified to some limited extent within which the maximum achievement can be sought by the investor. The theory of diversification was based on the research work by Harry Markowitz.

Markowitz is of the view that a portfolio should be analysed depending upon:

(a) The attitude of the investor towards risk and return; and

(b) The quantification of risk

Thus, traditional theory and modern theory are both framed under the constraints of risk and return, the former analysing individual securities and the latter believing in the perspective of combination of securities.

Traditional theory believes that the market is inefficient and the fundamental analyst can take advantage of the situation. By analysing internal financial statements of the company, he can make superior profits through higher returns. The technical analyst believed in the market behaviour and past trends to forecast the future of the securities. These analyses were mainly under the risk and return criteria of single security analysis.

Modern portfolio theory, as brought out by Markowitz and Sharpe, is the combination of the securities to get the most efficient portfolio. Combination of securities can be made in many ways. Markowitz developed the theory of diversification through scientific reasoning and method.

Market index refers to a portfolio of securities that represent a particular section of the stock market. The securities that are part of a particular index often come with certain characteristics.

A market index measures the value of a portfolio of holdings with specific market characteristics. Each index has its own methodology which is calculated and maintained by the index provider. Index methodologies will typically be weighted by either price or market cap. A wide variety of investors use market indexes for following the financial markets and managing their investment portfolios. Indexes are deeply entrenched in the investment management business with funds using them as benchmarks for performance comparisons and managers using them as the basis for creating investable index funds.

Uses of Market Indexes

People from many walks of life use and are affected by market indexes. Economists and statisticians use stock-market indexes to study long-term growth patterns in the economy, to analyze and forecast business-cycle patterns, and to relate stock indexes to other time- series measures of economic activity.

Investors, both individual and institutional, use the market index as a benchmark against which to evaluate the performance of their own or institutional portfolios. The answer to the question, “Did you beat the market?” has important ramifications for all types of investors.

Market technicians in many cases base their decisions to buy and sell on the patterns that appear in the time series of the market indexes. The final use of the market index is in portfolio analysis.

In discussions of the market model and systematic it will be evident that the relevant riskiness of a security is determined by the relationship between that security’s return and the return on the market.

Among economists and statisticians one of the major uses of stock-market indexes is to use them as a leading economic indicator. Judging by how long they have been employed, leading indicators of economic activity must be considered in a forecasting success.

Unlike econometric modeling, the leading economic indicator approach to forecasting does not require assumptions about what causes economic behaviour. Instead, it relies on statistically detecting patterns among economic variables that can be used to forecast turning points in economic activity.

Real World Examples

Some of the market’s leading indexes include:

• S&P 500
• Dow Jones Industrial Average
• Nasdaq Composite
• S&P 100
• Russell 1000
• S&P MidCap 400
• Russell Midcap
• Russell 2000
• S&P 600
• S. Aggregate Bond Market
• Global Aggregate Bond Market

A stock index, or stock market index, is an index that measures a stock market, or a subset of the stock market, that helps investors compare current price levels with past prices to calculate market performance. It is computed from the prices of selected stocks (typically a weighted arithmetic mean).

An index is a statistical measure that represents the value of a batch of stocks. Investors use this measure like a barometer to track the overall progress of the market (or a segment of it).

There are various methods for calculating the stock market index. In this post, we will discuss some of the major methods to calculate stock market index

1. Full Market Capitalization method

In this method, to determine the scrips weighted in the index, the number of shares outstanding is multiplied by the market price of companies shares. The share with the highest market capitalization would have a higher weighted in the index and would be most influential in the index.  In the end, Market capitalization of all companies will be added and it will be the final value of that index.

The number of shares outstanding means the total number of shares currently held by all its shareholders, including shares held by institutional investors and restricted shares owned by the company’s officers and insiders. S&P 500 index in the USA uses this method.

Full Market Capitalization = No. of shares outstanding * Market Price of one share

2. Free Float Market Capitalization method

Free Float is the percentage of shares available in the market for trading. It excludes restricted shares held by the government in the form of strategic investment, shares held by companies officers and insiders, shares locked under employee stock option plan etc. Companies in the index are provided with the free float factors based on its percentage of shares in free float. Free float ranges from 0.05 to 1.0 Value of index through this method is calculated using following steps-

• Free float market Capitalization using the formula = Total number of free float shares * Market price of each share * Free float factor
• Add Market capitalization of all the companies in the index calculated through step 1.
• Calculate the index value with the help of following formula.

Index Value = (Current Free Float Market Capitalization of index / Base Free Float Market Capitalization of index) * Base Index Value

Free float market capitalization method is used by both BSE and NSE

3. Modified Capitalization Weighted

This method seeks to reduce the effect of largest stock in the index which would otherwise dominate the value of the index. This method sets a limit on percentage weight of the largest stock in the group of stocks. NASDAQ 100 uses this method.

4. Price weighted Index

In price-weighted index calculation method,   each stock influences the index in proportion to its price per share. The value of the index is calculated by adding the prices of each stock in the index and dividing them by the total number of stocks. Stocks with a higher price are given more weight which has a greater influence on the performance of the index. Dow Johns Industrial Average uses this method.

5. Equal Weighing

In this method, percentage weight of every stock in the index is equal. so, all the stocks have equal influence on the index value. Kansas City Board of Trade (KCBT) uses this method.

The value of money does not remain constant over time. It rises or falls and is inversely related to the changes in the price level. A rise in the price level means a fall in the value of money and a fall in the price level means a rise in the value of money. Thus, changes in the value of money are reflected by the changes in the general level of prices over a period of time. Changes in the general level of prices can be measured by a statistical device known as ‘index number.’

Index number is a technique of measuring changes in a variable or group of variables with respect to time, geographical location or other characteristics. There can be various types of index numbers, but, in the present context, we are concerned with price index numbers, which measures changes in the general price level (or in the value of money) over a period of time.

Price index number indicates the average of changes in the prices of representative commodities at one time in comparison with that at some other time taken as the base period. According to L.V. Lester, “An index number of prices is a figure showing the height of average prices at one time relative to their height at some other time which is taken as the base period.”

Features of Index Numbers:

(i) Index numbers are a special type of average. Whereas mean, median and mode measure the absolute changes and are used to compare only those series which are expressed in the same units, the technique of index numbers is used to measure the relative changes in the level of a phenomenon where the measurement of absolute change is not possible and the series are expressed in different types of items.

(ii) Index numbers are meant to study the changes in the effects of such factors which cannot be measured directly. For example, the general price level is an imaginary concept and is not capable of direct measurement. But, through the technique of index numbers, it is possible to have an idea of relative changes in the general level of prices by measuring relative changes in the price level of different commodities.

(iii) The technique of index numbers measures changes in one variable or group of related variables. For example, one variable can be the price of wheat, and group of variables can be the price of sugar, the price of milk and the price of rice.

(iv) The technique of index numbers is used to compare the levels of a phenomenon on a certain date with its level on some previous date (e.g., the price level in 1980 as compared to that in 1960 taken as the base year) or the levels of a phenomenon at different places on the same date (e.g., the price level in India in 1980 in comparison with that in other countries in 1980).

Uses:

• Index numbers are used in the fields of commerce, meteorology, labour, industry, etc.
• Index numbers measure fluctuations during intervals of time, group differences of geographical position of degree, etc.
• They are used to compare the total variations in the prices of different commodities in which the unit of measurements differs with time and price, etc.
• They measure the purchasing power of money.
• They are helpful in forecasting future economic trends.
• They are used in studying the difference between the comparable categories of animals, people or items.
• Index numbers of industrial production are used to measure the changes in the level of industrial production in the country.
• Index numbers of import prices and export prices are used to measure the changes in the trade of a country.
• Index numbers are used to measure seasonal variations and cyclical variations in a time series.

A collection of index numbers for different years, locations, etc., is sometimes called an index series.

• Simple Index Number: A simple index number is a number that measures a relative change in a single variable with respect to a base.
• Composite Index Number: A composite index number is a number that measures an average relative changes in a group of relative variables with respect to a base.

Types of Index Numbers

The following types of index numbers are usually used: price index numbers and quantity index numbers.

• Price Index Numbers: Price index numbers measure the relative changes in the price of a commodity between two periods. Prices can be either retail or wholesale.
• Quantity Index Numbers: These index numbers are considered to measure changes in the physical quantity of goods produced, consumed or sold for an item or a group of items.

Ex-Ante

Ex-ante refers to future events, such as the potential returns of a particular security, or the returns of a company. Transcribed from Latin, it means “before the event.”

Ex-ante is a Latin word that means “before the event,” and it is the estimated return that investors can expect to earn from an investment or the earnings that a company can expect to earn at the end of a specific period. In simple terms, it is the prediction of an event before it actually happens, and the actual outcome is uncertain. By making the prediction of the outcome, the obtained ex-ante value can then be compared to the actual performance when it happens.

Much of the analysis conducted in the markets is ex-ante, focusing on the impacts of long-term cash flows, earnings and revenue. While this type of ex-ante analysis focuses on company fundamentals, it often relates back to asset prices. For example, buy-side analysts often use fundamental factors to determine a price target for a stock, then compare the predicted result to actual performance.

For example, when preparing a merger of two competitors, analysts can predict the expected synergies that will emerge from such a transaction before it actually happens. The synergies may be in terms of changes in the share price, as well as the estimated earnings of the combined entity. The prediction can happen before the merger happens or immediately after the merger happens, but there is uncertainty about the possible effects of the transaction.

Working

Ex-ante is the prediction of an event before it happens, or before the participants become aware of the event. The prediction may involve individual products of a business, a business unit, or the entire business entity. The predicted outcome serves as a basis for comparing the prediction to the actual results (ex-post).

For example, the Federal Reserve makes ex-ante predictions on expected inflation to decide whether to raise or lower interest rates. The prediction is not based on actual data, since the event will occur in the future, and does not know with certainty how the economic performance will be.

For example, if the Fed raises interest rates, we can only know if the decision was right or wrong when the predicted outcome happens. If the increased interest rates and global recession pushed the economy into inflation, it might mean that raising the interest rates was a wrong decision. However, if the economy is still stable and performing above board three to five years later, it means that the Fed’s decision to raise interest rates was appropriate and timely.

Ex-Post

Ex-post is a Latin word that means “after the event,” and it is the opposite of the Latin word “ex-ante.” Investment companies use the concept to forecast the expected returns of a security based on the actual or historical returns earned by the security. Unlike ex-ante, which is based on estimated returns, ex-post represents the actual results attained by the company, which is the return earned by the company’s investors.

The use of historical returns has customarily been the most well-known approach to forecast the probability of incurring a loss on investment on any given day. Ex-post is the opposite of ex-ante, which means “before the event.”

Investors can use the ex-post data to get the actual performance of a security, without including any forecasts or projections that may be affected by market shocks. The ex-post value of a security can be obtained by deducting the price paid by investors from the current market price of the security.

Working

The ex-post value of an asset can be calculated by taking the starting and ending values during a specific period, usually less than a year, and then taking into account the asset value growth or declines, as well as earned income from the asset. The beginning value is the market price of the asset at that time or the price that investors paid for the asset if the purchase occurred within the measurement period. The ending value is the current market price of the asset or the price that potential investors would pay to acquire the asset today.

The value obtained can then be used to analyze investment price fluctuations or earnings, and predict the expected returns of a security or investment. The ex-post value (actual returns based on historical returns) can then be compared to the predicted returns to determine the accuracy of the risk assessment methods used. For example, when measuring the returns of a security from October 1 to December 31, calculate the difference between the starting value on October 1 and the ending value on December 31.

The typical object of investment is to make current income from investments in the form of dividends and interest income. The investments should earn reasonable and expected rate of return on investments. Certain investments like bank deposits, public deposits, debentures, bonds etc. will carry a fixed rate of return payable periodically.

In case of investments in shares of companies, the periodical payments in the form of dividends are not assured, but it may ensure higher returns than fixed income investments. But the investments in equity shares of companies carry higher risk than fixed income instruments.

Another form of return is in the form of capital appreciation. This element of return is the difference between the purchase price and the price at which the asset can be sold, it can be a capital gain or capital loss arising due to change in the price of the investment.

The rate of return of a particular investment is calculated as follows:

Annual Rate of Return:

The annual rate of return of a particular investment can be calculated as follows:

R = {D1+(P1-P0)}/P0

Were,

R = Annual rate of return of a share

D1 = Dividend paid at the end of the year

P0 = Market price of share at the beginning of the year

P1 = Market price of share at the end of the year

The above formula is used for calculation of annual return of an investment in shares. In the above formula, D1/P0 represents dividend yield and (P1 – P0)/P0 represents capital gain or loss.

Average Rate of Return:

The rate of return can also be calculated for a period more than one year. The average rate of return represents the average of annual rates of return over a period of years.

The formula used for calculation of average rate of return is given below:

R̅ = 1/n (R1+R2+…. +Rn)

Where, R̅ = Average rate of return

R1, R2 …..Rn = Annual rate of return in period 1, 2,…..

n = Total number of periods

Risk on Single Asset:

The concept of risk is more difficult to quantify. Statistically we can express risk in terms of standard deviation of return. For example, in case of gilt edged security or government bonds, the risk is nil since the return does not vary – it is fixed. But strictly speaking if we consider inflation and calculate real rate of return (inflation adjusted) we find that even government bonds have some amount of risk since the rate of inflation may vary.

Return from unsecured fixed deposits appear to have zero variability and hence zero risk. But there is a risk of default of interest as well as the principal. In such case the rate of return can be negative. Hence, this investment has high risk though apparently it carries zero risk. For other investments like shares, business etc., where the rate of return is not fixed, there may be a schedule of return with associated probability for each rate of return.

The mean of the probable returns gives the expected rate of return and the standard deviation or variance which is square of standard deviation measures risk. Higher the range of the probable return, higher the standard deviation and hence higher the risk. A risk averse investor will look for return where the range is low. Hence, low standard deviation means low risk.

The problem in portfolio management is to minimize the standard deviation without sacrificing expected rate of return. This is possible by diversification. Risk is measured in terms of variability of returns. If Investment ‘A’ and Investment ‘B’ whose mean rate of return is same as shown in figure 3.9.

Variability of Return

The returns of Investment ‘A’ show more variability than Investment ‘B’. In view of the variability of returns, Investment ‘A’ is riskier, even though both the investments are having the same mean returns.

Risk is the probability that actual results will differ from expected results. In the Capital Asset Pricing Model (CAPM), risk is defined as the volatility of returns. The concept of “risk and return” is that riskier assets should have higher expected returns to compensate investors for the higher volatility and increased risk.

1. Reputation Risk

There has always been the risk that an unhappy customer, product failure, negative press or lawsuit can adversely impact a company’s brand reputation. However, social media has amplified the speed and scope of reputation risk. Just one negative tweet or bad review can decrease your customer following and cause revenue to plummet.

To prepare for this risk, leverage reputation management strategies to regularly monitor what others are saying about the company online and offline. Be ready to respond to those comments and help address any concerns immediately. Keep quality top of mind to avoid lawsuits and product failures that can also damage your company’s reputation.

2. Operational Risk

This business risk can happen internally, externally or involve a combination of factors. Something could unexpectedly happen that causes you to lose business continuity.

That unexpected event could be a natural disaster or fire that damages or destroys your physical business. Or, it might involve a server outage caused by technical problems, people, or power cut. Many operational risks are also people-related. An employee might make mistakes that cost time and money.

Whether it’s a people or process failure, these operational risks can adversely impact your business in terms of money, time and reputation. Address each of these potential operational risks through training and a business continuity plan. Both tactics provide a way to think about what could go wrong and establish a backup system or proactive measures to ensure operations aren’t affected.

3. Economic Risk

The economy is constantly changing as the markets fluctuate. Some positive changes are good for the economy, which lead to booming purchase environments, while negative events can reduce sales. It’s important to watch changes and trends to potentially identify and plan for an economic downturn.

To counteract economic risk, save as much money as possible to maintain a steady cash flow. Also, operate with a lean budget with low overhead through all economic cycles as part of your business plan.

4. Compliance Risk

Business owners face an abundance of laws and regulations to comply with. For example, recent data protection and payment processing compliance could impact how you handle certain aspects of your operation. Staying well versed in applicable laws from federal agencies like the Occupational Safety and Health Administration (OSHA) or the Environmental Protection Agency (EPA) as well as state and local agencies can help minimize compliance risks.

5. Competition (or Comfort) Risk

While a business may be aware that there is always some competition in their industry, it’s easy to miss out on what businesses are offering that may appeal to your customers.

In this case, the business risk involves a company leader becoming so comfortable with their success and the status quo that they don’t look for ways to pivot or make continual improvements. Increasing competition combined with an unwillingness to change may result in a loss of customers.

Enterprise risk management means a company must continually reassess their performance, refine their strategy, and maintain strong, interactive relationships with their audience and customers. Additionally, it’s important to keep an eye on the competition by regularly researching how they use online and social media channels.

6. Security and Fraud Risk

As more customers use online and mobile channels to share personal data, there are also greater opportunities for hacking. News stories about data breaches, identity theft and payment fraud illustrate how this type of risk is growing for businesses.

Not only does this risk impact trust and reputation, but a company is also financially liable for any data breaches or fraud. To achieve effective enterprise risk management, focus on security solutions, fraud detection tools and employee and customer education about how to detect any potential issues.

7. Financial Risk

This business risk may involve credit extended to customers or your own company’s debt load. Interest rate fluctuations can also be a threat.

Making adjustments to your business plan will help you avoid harming cash flow or creating an unexpected loss. Keep debt to a minimum and create a plan that will start lowering that debt load as soon as possible. If you rely on all your income from one or two clients, your financial risk could be significant if one or both no longer use your services. Start marketing your services to diversify your base so the loss of one won’t devastate your bottom line.

Business risk refers to a threat to the company’s ability to achieve its financial goals. In business, risk means that a company’s or an organization’s plans may not turn out as originally planned or that it may not meet its target or achieve its goals.

Such risks cannot always be blamed on the owner of the company, as risk can be influenced by various external factors, which may include rising prices of raw materials for production, growing competition, or changes or additions to existing government regulations.

Factors responsible for causing risks in investment

1. Demand and supply forces

In securities market, the role played by the demand and supply forces is very vital. When they cannot be properly predicted, then the security prices will show wide variations. Fluctuations in prices make the securities risky.

2. Maturity period

If investments have a longer maturity period, then they will invite more risks because of the duration of the investment.

3. Security

Investment may be secured or unsecured. If the investment is secured by collateral securities, then the risk will be less.

4. Unsatisfactory credit worthiness of the issuer

Generally, the securities of Government and semi-government bodies are having a high degree of credit worthiness. But securities issued by the companies in the private sector do not command much credit worthiness. In situations where the credit worthiness of the issuer is not satisfactory, risks are bound to arise.

5. Selection of the highly risky investment instruments

There is different nature of investments such as corporate shares or bonds, chit funds, Nidhis, Benefit funds, etc. These investments are considered to be highly risky as they relate to the unorganized sector. But some instruments like bank deposits, post office certificates like National saving certificates, Kisan Vikas Patras, etc, are less risky. Because these instruments ensure certainty of payment of interest and principal.

6. Incorrect decision taken with regard to investment

In investments, what to buy and sell are the main decisions to be made. The decision to buy or sell depends upon the estimation of the fair intrinsic value of the shares, over valuation or under valuation of the share and also a number of other factors. Any mistake committed while making an investment decision, therefore, causes considerable risk in investment.

7. Failure to judge the correct timing of investment

The most important factor in the investment programme is the timing of purchase or sale of securities. The prices of stock fluctuate with each stock having its own cycle of fluctuations. If the investor is able to forecast these price changes, he is in a position to make a higher profit.

In boom periods, the prices of stock rise and during depression they fall. An analysis of the price behavior of the individual scrip will help to locate the buy and sell points.

8. Amount of investment

Investing a huge amount in a particular security is quite risky. The higher the amount invested in any security, more will be the risk. On the other hand, judicious mix of investments in small quantities may be ideal.

9. Nature of Business

Selection of a risky industry for investment is only inviting the trouble. As any business is prone to ups and downs, its prosperity should not be taken for granted. Any unfavorable trend in the industry will affect the company also.

10. Terms of lending

Terms of lending such as periodicity of servicing, redemption periods, etc., are the factors which cause risk in the investment concerned.

11. National and international factors

In the days of sophisticated means of communication, even the changes taking place in foreign markets influence the markets of other parts of world. Similarly, changes in conditions within the country are quickly reflected in security prices. So, national and international factors cause risk in investment.

Investment

Investment refers to the acquisition of the asset, in the expectation of generating income. In a wider sense, it refers to the sacrifice of present money or other resources for the benefits that will arise in future. The two main element of investment is time and risk

Nowadays, there is a range of investment options available in the market as you can deposit money in the bank account, or you can acquire property, or purchase shares of the company, or invest your money in government bonds or contribute in the funds like EPF or PPF.

Investments are majorly divided into two categories i.e. fixed income investment and variable income investment. In fixed income investment there is a pre-specified rate of return like bonds, preference shares, provident fund and fixed deposits while in variable income investment, the return is not fixed like equity shares or property.

Speculation

Speculation is a trading activity that involves engaging in a risky financial transaction, in expectation of making enormous profits, from fluctuations in the market value of financial assets. In speculation, there is a high risk of losing maximum or all initial outlay, but it is offset by the probability of significant profit. Although, the risk is taken by speculators is properly analysed and calculated.

Speculation ca be seen in markets where the high fluctuations in the price of securities such as the market for stocks, bonds, derivatives, currency, commodity futures, etc.

An Investment is an asset acquired with the intent of generating income or appreciation in the future, whereas Speculation is a financial transaction that has a substantial risk of losing all value, but with the expectation of a significant gain.

Investors and traders take on calculated risk as they attempt to profit from transactions they make in the markets. The level of risk undertaken in the transactions is the main difference between investing and speculating.

Whenever a person spends money with the expectation that the endeavor will return a profit, they are investing. In this scenario, the undertaking bases the decision on a reasonable judgment made after a thorough investigation of the soundness that the endeavor has a good probability of success.

But what if the same person spends money on an undertaking that shows a high probability of failure? In this case, they are speculating. The success or failure depends primarily on chance, or on uncontrollable (external) forces or events.

The primary difference between investing and speculating is the amount of risk undertaken. High-risk speculation is typically akin to gambling, whereas lower-risk investing uses a basis of fundamentals and analysis.

As per Benjamin Graham, an American economist, and professional investor, investment is an activity, which upon complete analysis assures the safety of the amount invested and adequate return. Conversely, speculation is an activity which does not satisfy these requirements.

The basic distinguishing point amidst these two is that income in the investment is consistent, but in the case of speculation is inconsistent. So this article makes an attempt to clear the differences between investment and speculation.

Investment vs Speculation: They can be compared on the basis of 4 major criteria’s they are:

• Time Horizon
• Risk Levels
• Decision Criteria
• Investors Attitude

1. Time Horizon

Investment are generally held for a long term this may range from 2-5 years or more than that whereas speculation is held for a very short time span this is basically less than a year.

2. Risk Levels

The amount of risk is relatively moderate in investment when compared with speculation. Speculation generally involves greater risk than investing like options, futures, financial derivatives and similar financial instruments. Speculators ofter tent to be looking for a larger and quicker payout than long-term investors. Both involve risk but as the things move fast in speculations it is riskier than investing.

3. Decision Criteria

Investors tend to have a more basic fundamental approach whereas speculators, on the other hand, focus more on trends, market or investors psychology, they usually focus on these factors for a booking a quick profit.

4. Investors Attitude

Investors mostly have cautious and conservative considering their risk appetite, they know their capability and invest as per the risk that they can absorb, in case of speculator they are more aggressive with a high-risk appetite.

Differences

1. Investment refers to the purchase of an asset with the hope of getting returns. The term speculation denotes an act of conducting a risky financial transaction, in the hope of substantial profit.
2. In investment, the decisions are taken on the basis of fundamental analysis, i.e. performance of the company. On the other hand, in speculation decisions are based on hearsay, technical charts, and market psychology.
3. The quantity of risk is moderate in investment and high in case of speculation.
4. Investments are held for at least one year. Hence, it has a longer time horizon than speculation, where speculators hold assets for short term only.
5. The investors, expect profit from the change in the value of the asset. As opposed to speculators who expect profit from the change in the prices, due to demand and supply forces.
6. An investor expects the modest rate of return on the investment. On the contrary, a speculator expects higher profits from the speculation in exchange for the risk borne by him.
7. The investor uses his own funds for investment purposes. Conversely, speculator uses borrowed capital for speculation.
8. In speculation, the stability of income is absent it is uncertain and erratic which is not in the case of investment.
9. The psychological attitude of investors is conservative and cautious. In contrast, speculators are daring and careless.