Chapter 1
1.1 Introduction
Simply stated an investment is any vehicle into which funds can be placed with the expectation that they will be preserved or increase in value and/or generate positive returns. The various types of investments can be differentiated based on a number of factors such as whether the investment is a security or property; direct or indirect; debt or equity or options; low or high risk and short or long term.
The investments that represent the evidence of ownership of a business or a liability or even the legal right to acquire or sell an ownership interest in a business are called securities. The most commonly accepted types of securities are stocks, bonds, debentures, and options. Property on the other hand is investments in real property or tangible personal property. This would include land, buildings, and tangible personal property, which include gold, antiques, and art.
A direct investment is one in which an investor directly acquires a claim on a security or property such as investment in equity, bonds or even gold. An indirect investment is an investment made in a portfolio or group of securities or properties such as the purchase of a mutual fund.
Broadly speaking an investment will be either in equity or in debt. An investment in debt implies loan of funds for a certain period in exchange for the receipt of interest at regular intervals of time and the repayment of principal at a particular future date. Investment in equity on the other hands represents a type of ownership of a business or property and is represented by a security showing title to a property. Options also called derivatives simply securities that are backed by an opportunity to buy or sell another security and its value is derived on the basis of the underlying asset.
Finally an investment can be distinguished by its risk nature, i.e. whether it carries higher or lower risk. In that sense the nature of risk would depend on the nature of cash flows, the type of ownership and the potential degree of loss of value of the asset. Equity therefore is considered more risky than debt simply because the returns are not certain and its value is determined by the company fortunes. Similarly, an investment can also be demarcated by the tenure of the investment i.e. whether the investment is of long duration or of short duration.
1.2 Investment Planning
Investment Planning lies at the base of marketing an investment product. Till the time, an appropriate amount of investment planning is not done; finding the right fit of the investment product with the individual would be an impossible task.
Simply understood investment is nothing but postponed consumption . Not all incomes earned are consumed immediately; some of the surplus left over is set aside to be used at various future dates. The moment one is postponing consumption, the concept of time value of money comes into place. Money has time value due to three primary reasons.
a. Present consumption is more preferable to future consumption and therefore
a price must be paid to balance the utility from both
b. The future is uncertain and therefore to compensate for the uncertainty
element of perhaps not receiving the money either totally or partly
c. There will be some inflation present and therefore simply to keep the value of money constant certain inflation adjusted minimum return needs to be built in while factoring in future returns.
Therefore three factors are important that determine the return investors require in
order to forgo current consumption to invest.
a. The time preference for consumption that is measured by the risk free real
rate of return
b. The expected rate of inflation
c. The possible risk that is associated with the investment.
It is therefore not surprising that the required return that an investor would need
would be the sum total of the above three components.
1.2.1 Required return
= risk free real rate + expected inflation + risk premium
The risk free real rate can be reasonably approximated by default free government treasury bills while the expected inflation is a matter of a scanning the economic environment including past figures and future estimates by various formal and informal sources. Though there can not be a total finality on the issue, reasonable consensus estimates can be arrived at over shorter investment horizons. It is the third element of risk premium that is the most difficult to estimate since it varies across from products to products all of which may not remain at the same risk level across different time periods even for the same investment product. Moreover the assessment of risk premium and the returns required to compensate for the same varies from person to person. This represents a challenge to understand the risk- return profile of the client for the financial planner. Only a complete understanding of the same can enable the financial planner to suggest and implement the right proportion of investment products.
An investment product is usually denominated as a security. A security represents a type of ownership of an asset. In other words, a security represents a claim on an asset and any future cash flows the asset may generate. Thus, a security can cover a wide array of assets right from stocks and shares to even real estate.
Each of the various types of securities has a different risk and return profile. In investment analysis, return and risk is represented by specific definitions and is measured in a certain manner.
Return
Chapter- 2
2.1 The rate of return on a security can be calculated as:
In a 5 year period the average yearly return would then be 132/5 = 26.4%
R = (P1 -P0) + D1
-------------
P0
Where
R=therateofreturn
P0=thebeginningprice
P1=theendingprice
D1 or I1 = the dividends received or the interest received depending upon the type
of security
The above is simply the total of the capital appreciation earned and the regular income received over the tenure of the investment horizon divided by the price at which the investment was purchased.
To take an example: - The price of a security on April 1, 2006 was Rs 100. On 31st of March, 2007 the price of the security was Rs 120. In between, the company gave a dividend of Rs 8. In that case, the return can be calculated as
P0=100 P1=120 D1 = 8
R = (120-100) + 8
-----------------
100
=0.28
= 28.0 %
The above formula can be calculated over differing horizon periods which can be as small as a day or over a ten year period as well. However using the above formula for longer durations of time does not necessarily give a clear indication of the actual returns on the security. This is simply because between the beginning and ending prices there may be a lot of volatility and price variations that affect the actual returns on the security. However from the point of view of the actual returns earned by a person who bought a security at a particular time period and then sold it another, the above formulae would clearly indicate the actual returns earned by the investor.
In the example given below the prices of a particular security are given at various dates. If an investor had bought a security in 2002 and sold it in 2007 the returns that he would have got would have equaled the capital appreciation plus the dividends of the various years.
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CFP Investment Planing
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