Tag: Investment Management Osmania University b.com Notes

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.

An investment is essentially an asset that is created with the intention of allowing money to grow. The wealth created can be used for a variety of objectives such as meeting shortages in income, saving up for retirement, or fulfilling certain specific obligations such as repayment of loans, payment of tuition fees, or purchase of other assets.

Investment may generate income for you in two ways. One, if you invest in a saleable asset, you may earn income by way of profit. Second, if Investment is made in a return generating plan, then you will earn an income via accumulation of gains. In this sense, ‘what is investment’ can be understood by saying that investments are all about putting your savings into assets or objects that become worth more than their initial worth or those that will help produce an income with time.

Objectives of Investment

Before you decide to invest your earnings in any one of the many investment plans available in India, it’s essential to understand the reasons behind investing. While the individual objectives of investment may vary from one investor to another, the overall goals of investing money may be any one of the following reasons.

1. To Meet your Financial Goals

Investing can also help you achieve your short-term and long-term financial goals without too much stress or trouble. Some investment options, for instance, come with short lock-in periods and high liquidity. These investments are ideal instruments to park your funds in if you wish to save up for short-term targets like funding home improvements or creating an emergency fund. Other investment options that come with a longer lock-in period are perfect for saving up for long-term goals.

2. To Help Money Grow

Another common objective of investing money is to ensure that it grows into a sizable corpus over time. Capital appreciation is generally a long-term goal that helps people secure their financial future. To make the money you earn grow into wealth, you need to consider investment options that offer a significant return on the initial amount invested. Some of the best investments to achieve growth include real estate, mutual funds, commodities, and equity. The risk associated with these options may be high, but the return is also generally significant.

3. To Minimize the Burden of Tax

Aside from capital growth or preservation, investors also have another compelling incentive to consider certain investments. This motivation comes in the form of tax benefits offered by the Income Tax Act, 1961. Investing in options such as Unit Linked Insurance Plans (ULIPs), Public Provident Fund (PPF), and Equity Linked Savings Schemes (ELSS) can be deducted from your total income. This has the effect of reducing your taxable income, thereby bringing down your tax liability.

4. To Keep Money Safe

Capital preservation is one of the primary reasons people invest their money. Some investments help keep hard-earned money safe from being eroded with time. By parking your funds in these instruments or schemes, you can ensure that you don’t outlive your savings. Fixed deposits, government bonds, and even an ordinary savings account can help keep your money safe. Although the return on investment may be lower here, the objective of capital preservation is easily met.

5. To Earn a Steady Stream of Income

Investments can also help you earn a steady source of secondary (or primary) income. Examples of such investments include fixed deposits that pay out regular interest or stocks of companies that pay investors dividends consistently. Income-generating investments can help you pay for your everyday expenses after you’ve retired. Alternatively, they can also act as excellent sources of supplementary income during your working years by providing you with additional money to meet outlays like college expenses or EMIs.

6. To Save up for Retirement

Saving up for retirement is a necessity. It’s essential to have a retirement fund you can fall back on in your golden years, because you may not be able to continue working forever. Additionally, it would be unfair to depend on your children to support you later in life, particularly if they have children of their own to raise. By investing the money you earn during your working years in the right investment options, you can allow your funds to grow enough to sustain you after you’ve retired.

The word “investment” can be defined in many ways according to different theories and principles. It is a term that can be used in a number of contexts. However, the different meanings of “investment” are more alike than dissimilar. Generally, investment is the application of money for earning more money. Investment also means savings or savings made through delayed consumption. According to economics, investment is the utilization of resources in order to increase income or production output in the future.

An amount deposited into a bank or machinery that is purchased in anticipation of earning income in the long run is both examples of investments. Although there is a general broad definition to the term investment, it carries slightly different meanings to different industrial sectors.

According to economists, investment refers to any physical or tangible asset, for example, a building or machinery and equipment. On the other hand, finance professionals define an investment as money utilized for buying financial assets, for example stocks, bonds, bullion, real properties, and precious items.

According to finance, the practice of investment refers to the buying of a financial product or any valued item with anticipation that positive returns will be received in the future. The most important feature of financial investments is that they carry high market liquidity. The method used for evaluating the value of a financial investment is known as valuation. According to business theories, investment is that activity in which a manufacturer buys a physical asset, for example, stock or production equipment, in expectation that this will help the business to prosper in the long run.

Types of investments

Investments may be classified as financial investments or economic investments. In Finance investment is putting money into something with the expectation of gain that upon thorough analysis has a high degree of security for the principal amount, as well as security of return, within an expected period of time. In contrast putting money into something with an expectation of gain without thorough analysis, without security of principal, and without security of return is speculation or gambling. Investment is related to saving or deferring consumption. Investment is involved in many areas of the economy, such as business management and finance whether for households, firms, or governments.

Economic investments are undertaken with an expectation of increasing the current economy’s capital stock that consists of goods and services. Capital stock is used in the production of other goods and services desired by the society. Investment in this sense implies the expectation of formation of new and productive capital in the form of new constructions, plant and machinery, inventories, and so on. Such investments generate physical assets and also industrial activity. These activities are undertaken by corporate entities that participate in the capital market.

Financial investments and economic investments are, however, related and dependent. The money invested in financial investments is ultimately converted into physical assets. Thus, all investments result in the acquisition of some asset, either financial or physical. In this sense, markets are also closely related to each other. Hence, the perfect financial market should reflect the progress pattern of the real market since, in reality, financial markets exist only as a support to the real market.

Nature of investment

The features of economic and financial investments can be summarized as return, risk, safety, and liquidity.

Return

All investments are characterized by the expectation of a return. In fact, investments are made with the primary objective of deriving a return.

The return may be received in the form of yield plus capital appreciation.

The difference between the sale price and the purchase price is capital appreciation.

The dividend or interest received from the investment is theyield.

The return from an investment depends upon the nature of the investment, the maturity period and a host of other factors.

Return = Capital Gain + Yield (interest, dividend etc.)

2. Risk

Risk refers to the loss of principal amount of an investment. It is one of the major characteristics of an investment.

The risk depends on the following factors:

The investment maturity period is longer; in this case, investor will take larger risk.

Government or Semi Government bodies are issuing securities which have less risk.

In the case of the debt instrument or fixed deposit, the risk of above investment is less due to their secured and fixed interest payable on them. For instance debentures.

In the case of ownership instrument like equity or preference shares, the risk is more due to their unsecured nature and variability of their return and ownership character.

The risk of degree of variability of returns is more in the case of ownership capital compare to debt capital.

The tax provisions would influence the return of risk.

3. Safety:

Safety refers to the protection of investor principal amount and expected rate of return.

Safety is also one of the essential and crucial elements of investment. Investor prefers safety about his capital. Capital is the certainty of return without loss of money or it will take time to retain it. If investor prefers less risk securities, he chooses Government bonds. In the case, investor prefers high rate of return investor will choose private Securities and Safety of these securities is low.

4. Liquidity:

Liquidity refers to an investment ready to convert into cash position. In other words, it is available immediately in cash form. Liquidity means that investment is easily realizable, saleable or marketable. When the liquidity is high, then the return may be low. For example, UTI units. An investor generally prefers liquidity for his investments, safety of funds through a minimum risk and maximization of return from an investment.

 Four main investment objectives cover how you accomplish most financial goals. These investment objectives are important because certain products and strategies work for one objective, but may produce poor results for another objective. It is quite likely you will use several of these investment objectives simultaneously to accomplish different objectives without any conflict. Let’s examine these objectives and see how they differ.

Capital Appreciation

Capital appreciation is concerned with long-term growth. This strategy is most familiar in retirement plans where investments work for many years inside a qualified plan. However, investing for capital appreciation is not limited to qualified retirement accounts. If this is your objective, you are planning to hold the stocks for many years. You are content to let them grow within your portfolio, reinvesting dividends to purchase more shares. A typical strategy employs making regular purchases. You are not very concerned with day-to-day fluctuations, but keep a close eye on the fundamentals of the company for changes that could affect long-term growth.

Current Income

If your objective is current income, you are most likely interested in stocks that pay a consistent and high dividend. You may also include some top-quality real estate investment trusts (REITs) and highly-rated bonds. All of these products produce current income on a regular basis. Many people who pursue a strategy of current income are retired and use the income for living expenses. Other people take advantage of a lump sum of capital to create an income stream that never touches the principal, yet provides cash for certain current needs (college, for example).

Capital Preservation

Capital preservation is a strategy you often associate with elderly people who want to make sure they don’t outlive their money. Retired on nearly retired people often use this strategy to hold on the detention has. For this investor, safety is extremely important even to the extent of giving up return for security. The logic for this safety is clear. If they lose their money through foolish investment and are retired, it is unlike they will get a chance to replace it. Investors who use capital preservation tend to invest in bank CDs, U.S. Treasury issues and savings accounts.

Speculation

The speculator is not a true investor, but a trader who enjoys jumping into and out of stocks as if they were bad shoes. Speculators or traders are interested in quick profits and used advanced trading techniques like shorting stocks, trading on the margin, options and other special equipment. They have no love for the companies they trade and, in fact may not know much about them at all other than the stock is volatile and ripe for a quick profit. Speculators keep their eyes open for a quick profit situation and hope to trade in and out without much thought about the underlying companies. Many people try speculating in the stock market with the misguided goal of getting rich. It doesn’t work that way. If you want to try your hand, make sure you are using money you can afford to lose. It’s easy to get addicted, so make sure you understand the real possibilities of losing your investment.

The secondary objectives are tax minimization and Marketability or liquidity.

Tax Minimization:

An investor may pursue certain investments in order to adopt tax minimization as part of his or her investment strategy. A highly-paid executive, for example, may want to seek investments with favorable tax treatment in order to lessen his or her overall income tax burden. Making contributions to an IRA or other tax-sheltered retirement plan can be an effective tax minimization strategy.

Marketability/Liquidity:

Many of the investments we have discussed are reasonably illiquid, which means they cannot be immediately sold and easily converted into cash. Achieving a degree of liquidity, however, requires the sacrifice of a certain level of income or potential for capital gains.

Common stock is often considered the most liquid of investments, since it can usually be sold within a day or two of the decision to sell. Bonds can also be fairly marketable, but some bonds are highly illiquid, or non-tradable, possessing a fixed term. Similarly, money market instruments may only be redeemable at the precise date at which the fixed term ends. If an investor seeks liquidity, money market assets and non-tradable bonds aren’t likely to be held in his or her portfolio.