Introduction to Investment

Investment is putting money into something with the expectation of profit. The word
originates in the Latin "vestis", meaning garment, and refers to the act of putting
things (money or other claims to resources) into others' pockets.
The term "investment" is used differently in economics and in finance. Economists
refer to a real investment (such as a machine or a house), while financial economists
refer to a financial asset, such as money that is put into a bank or the market, which
may then be used to buy a real asset.

Financial meaning of investment

• Financial investment involves of funds in various assets, such as stock, Bond,
Real Estate, Mortgages etc.
• Investment is the employment of funds with the aim of achieving additional
income or growth in value.
• It involves the commitment of resources which have been saved or put away
from current consumption in the hope some benefits will accrue in future.
• Investment involves long term commitment of funds and waiting for a reward
in the future.
Economic meaning of investment:
Economic investment means the net additions to the capital stock of the society
which consists of goods and services that are used in the production of other goods
and services. Addition to the capital stock means an increase in building, plants,
equipment and inventories over the amount of goods and services that existed

Characteristics of Investment.
1. Risk Factor

Every investment contains certain portion of risk. It is a key feature of investment

which refers to loss of principal, delay in payment of interest and capital etc. Most
investors prefer to invest in less riskier securities.

2. Expectation of Return
Return expectation is the main objective of investment. Investors expect regularity
of high and consistent income for their capital.

3. Safety

Investors expect safety for their capital. They desire certainty of return and
protection of their investment or principal amount.

4. Liquidity

Liquidity means easily sale or convert the capital or investment into cash without
any loss. So, most investors prefer liquid investments.

5. Marketability

It is another feature of investment that they are marketable. It means buying and
selling or transferability of securities in the market.

6. Stability Of Income

Investors invest their capital with high expectation of income. So, return on their
investment should be adequate and stable.
Investment
Introduction to Investment

 Investment is putting money into something with the expectation of profit.

The word originates in the Latin "vestis", meaning garment, and refers to the
act of putting things (money or other claims to resources) into others'
pockets.
 The term "investment" is used differently in economics and in finance.
Economists refer to a real investment (such as a machine or a house), while
financial economists refer to a financial asset, such as money that is put into
a bank or the market, which may then be used to buy a real asset.
Meaning

Financial meaning of investment

 Financial investment involves of funds in various assets, such as stock, Bond, Real
Estate, Mortgages etc.
 Investment is the employment of funds with the aim of achieving additional
income or growth in value.
 It involves the commitment of resources which have been saved or put away from
current consumption in the hope some benefits will accrue in future.
 Investment involves long term commitment of funds and waiting for a reward in
the future.
Economic meaning of investment:
Economic investment means the net additions to the capital stock of the society
which consists of goods and services that are used in the production of other goods
and services. Addition to the capital stock means an increase in building, plants,
equipment and inventories over the amount of goods and services that existed
Characteristics of Investment

 Risk Factor
 Expectation of Return
 Safety
 Liquidity
 Marketability
 Stability of Income
Classification of Investment

The investment activities can be classified into two categories:

• Direct Investing
• Indirect Investing

Direct Investing

Direct investment involves the buying and selling of sureties by investors

themselves. The securities may be capital market securities such as shares,
debentures. Money market instruments such as Treasury Bills, Commercial Bills,
Commercial Papers and Certificates of Deposits etc.

Indirect Investing

Investors may not directly invest and manage the portfolio; rather they buy the units
of funds that hold various types of securities on behalf of investors. The funds are
known as mutual funds or investment companies and the part owners are known as
unit holders. In case indirect investing, the investors let the investment company to
do all the work and make all the decisions (for a fee). The unit-holders have
ownership interest in the assets of the fund or the investment company and are
entitled to a pro-rata share of interest, dividend and capital gains generated. It
involves investing in mutual funds and exchange traded funds.

Shares meaning and Types:

A share is referred to as a unit of ownership which represents an equal proportion of a
company’s capital. A share entitles the shareholders to an equal claim on profit and losses of the
company. There are majorly two kinds of shares i.e. equity shares and preference shares.

Different types of shares

As per section 43 of the Companies Act 2013, the share capital of the company is of two types:

• Preference Share Capital

Preferential shares are preferential in nature. During the liquidation of the company, the
shareholders holding preferential shares are paid out first after settling the debts of the
creditors of the company. Also, preferential shareholders do not have any voting rights.
Various types of preferential shares are seen based on structure, maturity terms, nature of
dividend payment, etc. below are some common types:
 • Equity Share Capital:

Equity Shares are also known as ordinary shares. Equity shares are one of the most
common types of share. These are equal in value and also impart various rights like
voting rights, dividends, etc. to the shareholders. These shares are traded in stock
exchange and are issued at a face value.

Debenture:
A debenture is an instrument used by a lender, such as a bank, when providing capital to
companies and individuals. It enables the lender to secure loan repayments against the
borrower’s assets – even if they default on the payment.
Types of debentures:

• Registered Debentures:
• Bearer Debentures:
• Secured Debentures:
• Unsecured Debentures:
• Redeemable Debentures:
• Non-redeemable Debentures:
• Convertible Debentures:
• Non-convertible Debentures:
Treasury Bills (T-Bills)

Treasury bills or T- Bills are issued by the Reserve Bank of India on behalf of the Central
Government for raising money. They have short term maturities with highest upto one year.
Currently, T- Bills are issued with 3 different maturity periods, which are, 91 days T-Bills, 182
days T- Bills, 1 year T – Bills.

T-Bills are issued at a discount to the face value. At maturity, the investor gets the face value
amount. This difference between the initial value and face value is the return earned by the
investor. They are the safest short term fixed income investments as they are backed by the
Government of India.

2. Commercial Papers

Large companies and businesses issue promissory notes to raise capital to meet short term
business needs, known as Commercial Papers (CPs). These firms have a high credit rating, owing
to which commercial papers are unsecured, with company’s credibility acting as security for the
financial instrument.

Corporates, primary dealers (PDs) and All-India Financial Institutions (FIs) can issue CPs.

CPs have a fixed maturity period ranging from 7 days to 270 days. However, investors can trade
this instrument in the secondary market. They offer relatively higher returns compared to that from
treasury bills.

3. Certificates of Deposits (CD)

CDs are financial assets that are issued by banks and financial institutions. They offer fixed interest
rate on the invested amount. The primary difference between a CD and a Fixed Deposit is that of
the value of principal amount that can be invested. The former is issued for large sums of money
( 1 lakh or in multiples of 1 lakh thereafter).

Because of the restriction on minimum investment amount, CDs are more popular amongst
organizations than individuals who are looking to park their surplus for short term, and earn interest
on the same.

The maturity period of Certificates of Deposits ranges from 7 days to 1 year, if issued by banks.
Other financial institutions can issue a CD with maturity ranging from 1 year to 3 years.

Mutual funds
A mutual fund is a company that pools money from many investors and invests the money in
securities such as stocks, bonds, and short-term debt. The combined holdings of the mutual fund
are known as its portfolio. Investors buy shares in mutual funds.
Types of mutual funds
Types of Mutual Funds based on structure
• Open-Ended Funds: These are funds in which units are open for purchase or redemption
through the year. All purchases/redemption of these fund units are done at prevailing
NAVs. Basically these funds will allow investors to keep invest as long as they want. There
are no limits on how much can be invested in the fund. They also tend to be actively
managed which means that there is a fund manager who picks the places where investments
will be made. These funds also charge a fee which can be higher than passively managed
funds because of the active management. THey are an ideal investment for those who want
investment along with liquidity because they are not bound to any specific maturity
periods. Which means that investors can withdraw their funds at any time they want thus
giving them the liquidity they need.
• Close-Ended Funds: These are funds in which units can be purchased only during the
initial offer period. Units can be redeemed at a specified maturity date. To provide for
liquidity, these schemes are often listed for trade on a stock exchange. Unlike open ended
mutual funds, once the units or stocks are bought, they cannot be sold back to the mutual
fund, instead they need to be sold through the stock market at the prevailing price of the
shares.
• Interval Funds: These are funds that have the features of open-ended and close-ended
funds in that they are opened for repurchase of shares at different intervals during the fund
tenure. The fund management company offers to repurchase units from existing unitholders
during these intervals. If unitholders wish to they can offload shares in favour of the fund.
Types of Mutual Funds based on asset class
• Equity Funds: These are funds that invest in equity stocks/shares of companies. These are
considered high-risk funds but also tend to provide high returns. Equity funds can include
specialty funds like infrastructure, fast moving consumer goods and banking to name a
few. THey are linked to the markets and tend to
• Debt Funds: These are funds that invest in debt instruments e.g. company debentures,
government bonds and other fixed income assets. They are considered safe investments
and provide fixed returns. These funds do not deduct tax at source so if the earning from
the investment is more than Rs. 10,000 then the investor is liable to pay the tax on it
himself.
• Money Market Funds: These are funds that invest in liquid instruments e.g. T-Bills, CPs
etc. They are considered safe investments for those looking to park surplus funds for
immediate but moderate returns. Money markets are also referred to as cash markets and
come with risks in terms of interest risk, reinvestment risk and credit risks.
• Balanced or Hybrid Funds: These are funds that invest in a mix of asset classes. In some
cases, the proportion of equity is higher than debt while in others it is the other way round.
 Risk and returns are balanced out this way. An example of a hybrid fund would be Franklin
India Balanced Fund-DP (G) because in this fund, 65% to 80% of the investment is made
in equities and the remaining 20% to 35% is invested in the debt market. This is so because
the debt markets offer a lower risk than the equity market.
Types of Mutual Funds based on investment objective
• Growth funds: Under these schemes, money is invested primarily in equity stocks with the
purpose of providing capital appreciation. They are considered to be risky funds ideal for
investors with a long-term investment timeline. Since they are risky funds they are also
ideal for those who are looking for higher returns on their investments.
• Income funds: Under these schemes, money is invested primarily in fixed-income
instruments e.g. bonds, debentures etc. with the purpose of providing capital protection and
regular income to investors.
• Liquid funds: Under these schemes, money is invested primarily in short-term or very
short-term instruments e.g. T-Bills, CPs etc. with the purpose of providing liquidity. They
are considered to be low on risk with moderate returns and are ideal for investors with
short-term investment timelines.
• Tax-Saving Funds (ELSS): These are funds that invest primarily in equity shares.
Investments made in these funds qualify for deductions under the Income Tax Act. They
are considered high on risk but also offer high returns if the fund performs well.
• Capital Protection Funds: These are funds where funds are are split between investment
in fixed income instruments and equity markets. This is done to ensure protection of the
principal that has been invested.
• Fixed Maturity Funds: Fixed maturity funds are those in which the assets are invested in
debt and money market instruments where the maturity date is either the same as that of
the fund or earlier than it.
• Pension Funds: Pension funds are mutual funds that are invested in with a really long term
goal in mind. They are primarily meant to provide regular returns around the time that the
investor is ready to retire. The investments in such a fund may be split between equities
and debt markets where equities act as the risky part of the investment providing higher
return and debt markets balance the risk and provide lower but steady returns. The returns
from these funds can be taken in lump sums, as a pension or a combination of the two.
Types of Mutual Funds based on specialty
• Sector Funds: These are funds that invest in a particular sector of the market e.g.
Infrastructure funds invest only in those instruments or companies that relate to the
infrastructure sector. Returns are tied to the performance of the chosen sector. The risk
involved in these schemes depends on the nature of the sector.
• Index Funds: These are funds that invest in instruments that represent a particular index
on an exchange so as to mirror the movement and returns of the index e.g. buying shares
representative of the BSE Sensex.
• Fund of funds: These are funds that invest in other mutual funds and returns depend on
the performance of the target fund. These funds can also be referred to as multi manager
funds. These investments can be considered relatively safe because the funds that investors
invest in actually hold other funds under them thereby adjusting for risk from any one fund.
• Emerging market funds: These are funds where investments are made in developing
countries that show good prospects for the future. They do come with higher risks as a
result of the dynamic political and economic situations prevailing in the country.
• International funds: These are also known as foreign funds and offer investments in
companies located in other parts of the world. These companies could also be located in
emerging economies. The only companies that won’t be invested in will be those located
in the investor’s own country.
• Global funds: These are funds where the investment made by the fund can be in a company
in any part of the world. They are different from international/foreign funds because in
global funds, investments can be made even the investor's own country.
• Real estate funds: These are the funds that invest in companies that operate in the real
estate sectors. These funds can invest in realtors, builders, property management
companies and even in companies providing loans. The investment in the real estate can
be made at any stage, including projects that are in the planning phase, partially completed
and are actually completed.
• Commodity focused stock funds: These funds don’t invest directly in the commodities.
They invest in companies that are working in the commodities market, such as mining
companies or producers of commodities. These funds can, at times, perform the same way
the commodity is as a result of their association with their production.
• Market neutral funds: The reason that these funds are called market neutral is that they
don’t invest in the markets directly. They invest in treasury bills, ETFs and securities and
try to target a fixed and steady growth.
• Inverse/leveraged funds: These are funds that operate unlike traditional mutual funds. The
earnings from these funds happen when the markets fall and when markets do well these
funds tend to go into loss. These are generally meant only for those who are willing to incur
massive losses but at the same time can provide huge returns as well, as a result of the
higher risk they carry.
• Asset allocation funds: The asset allocation fund comes in two variants, the target date
fund and the target allocation funds. In these funds, the portfolio managers can adjust the
allocated assets to achieve results. These funds split the invested amounts and invest it in
various instruments like bonds and equity.
• Gilt Funds: Gilt funds are mutual funds where the funds are invested in government
securities for a long term. Since they are invested in government securities, they are
virtually risk free and can be the ideal investment to those who don’t want to take risks.
• Exchange traded funds: These are funds that are a mix of both open and close ended
mutual funds and are traded on the stock markets. These funds are not actively managed,
they are managed passively and can offer a lot of liquidity. As a result of their being
managed passively, they tend to have lower service charges (entry/exit load) associated
with them.
Factors influencing
on Investment
 Technological changes:
 Competitors’ strategy:.
 Demand forecast
 Outlook of management:
 Fiscal Policy:
 Cash Flows:
 Expected return from the investment:
 Non-economic factors:
The Investment Process

Investment Process

When we speak of investment, I am sure most of you would think of investing in some fixed
deposit or a property or some of you would even buy gold. But there is much more to investing.
An investment is the purchase of an asset with an expectation to receive return or some other
income on that asset in future. The process of investment involves careful study and analysis of
the various classes of assets and the risk-return ratio attached to it.

An investment process is a set of guidelines that govern the behaviour of investors in a way which
allows them to remain faithful to the tenets of their investment strategy, that is the key principles
which they hope to facilitate outperformance.

There are 5 investment process steps that help you in selecting and investing in the best asset class
according to your needs and preferences.

Step 1- Understanding the client

The first and the foremost step of investment process is to understand the client or the investor
his/her needs, his risk taking capacity and his tax status. After getting an insight of the goals and
restraints of the client, it is important to set a benchmark for the client’s portfolio management
process which will help in evaluating the performance and check whether the client’s objectives
are achieved.

Step 2- Asset allocation decision

This step involves decision on how to allocate the investment across different asset classes, i.e.
fixed income securities, equity, real estate etc. It also involves decision of whether to invest in
domestic assets or in foreign assets. The investor will make this decision after considering the
macroeconomic conditions and overall market status.

Step 3- Portfolio strategy selection

Third step in the investment process is to select the proper strategy of portfolio creation. Choosing
the right strategy for portfolio creation is very important as it forms the basis of selecting the assets
that will be added in the portfolio management process. The strategy that conforms to the
investment policies and investment objectives should be selected.

There are two types of portfolio strategy-

1. Active Management
2. Passive Management

Active portfolio management process refers to a strategy where the objective of investing is to
outperform the market return compared to a specific benchmark by either buying securities that
are undervalued or by short selling securities that are overvalued. In this strategy, risk and return
both are high. This strategy is a proactive strategy it requires close attention by the investor or the
fund manager.

Passive portfolio management process refers to the strategy where the purpose is to generate
returns equal to that of the market. It is a reactive strategy as the fund manager or the investor
reacts after the market has responded.

Step 4- Asset selection decision

The investor needs to select the assets to be placed in the portfolio management process in the
fourth step. Within each asset class, there are different sub asset-classes. For example, in equity,
which stocks should be chosen? Within the fixed income securities class, which bonds should be
chosen?

Also, the investment objectives should conform to the investment policies because otherwise the
main purpose of investment management process would become meaningless.

Step 5- Evaluating portfolio performance

This is the final step in the investment process which evaluates the portfolio management
performance. This is an important step as it measures the performance of the investment with
respect to a benchmark, in both absolute and relative terms. The investor would determine whether
his objectives are being achieved or not.

Conclusion

After all the above points have been followed, the investor needs to keep monitoring the portfolio
management performance at an appropriate interval. If the investor finds that any asset is not
performing well, he/she should’ve balance’ the portfolio. Re balancing means adding or removing
(or better call it adjusting) some assets from the portfolio to maintain the target level. Re balancing
helps the investor to maintain his/her level of risk and return.
Types of investment risk

1. Market risk

The risk of investments declining in value because of economic developments or other events that
affect the entire market. The main types of market risk are equity risk, interest rate risk and
currency risk.

• Equity risk – applies to an investment in shares. The market price of shares varies all the
time depending on demand and supply. Equity risk is the risk of loss because of a drop in
the market price of shares.
• Interest rate risk – applies to debt investments such as bonds. It is the risk of losing money
because of a change in the interest rate. For example, if the interest rate goes up, the market
value of bonds will drop.
• Currency risk – applies when you own foreign investments. It is the risk of losing money
because of a movement in the exchange rate. For example, if the U.S. dollar becomes less
valuable relative to the Canadian dollar, your U.S. stocks will be worth less in Canadian
dollars.

2. Liquidity risk

The risk of being unable to sell your investment at a fair price and get your money out when you
want to. To sell the investment, you may need to accept a lower price. In some cases, such as
exempt market investments, it may not be possible to sell the investment at all.

3. Concentration risk

The risk of loss because your money is concentrated in 1 investment or type of investment. When
you diversify your investments, you spread the risk over different types of investments, industries
and geographic locations.

4. Credit risk

The risk that the government entity or company that issued the bond will run into financial
difficulties and won’t be able to pay the interest or repay the principal at maturity. Credit risk
applies to debt investments such as bonds. You can evaluate credit risk by looking at the credit
rating of the bond. For example, long-term Canadian government bonds have a credit rating of
AAA, which indicates the lowest possible credit risk.

5. Reinvestment risk

The risk of loss from reinvesting principal or income at a lower interest rate. Suppose you buy a
bond paying 5%. Reinvestment risk will affect you if interest rates drop and you have to reinvest
the regular interest payments at 4%. Reinvestment risk will also apply if the bond matures and you
have to reinvest the principal at less than 5%. Reinvestment risk will not apply if you intend to
spend the regular interest payments or the principal at maturity.
6. Inflation risk

The risk of a loss in your purchasing power because the value of your investments does not keep
up with inflation. Inflation erodes the purchasing power of money over time – the same amount of
money will buy fewer goods and services. Inflation risk is particularly relevant if you own cash or
debt investments like bonds. Shares offer some protection against inflation because most
companies can increase the prices they charge to their customers. Share prices should therefore
rise in line with inflation. Real estate also offers some protection because landlords can increase
rents over time.

7. Horizon risk

The risk that your investment horizon may be shortened because of an unforeseen event, for
example, the loss of your job. This may force you to sell investments that you were expecting to
hold for the long term. If you must sell at a time when the markets are down, you may lose money.

8. Longevity risk

The risk of outliving your savings. This risk is particularly relevant for people who are retired, or
are nearing retirement.

9. Foreign investment risk

The risk of loss when investing in foreign countries. When you buy foreign investments, for
example, the shares of companies in emerging markets, you face risks that do not exist in Canada,
for example, the risk of nationalization.
Difference between Investment and speculation

Basis for Comparison Investment Speculation

Speculation is an act of
The purchase of an asset with
conducting a risky financial
Meaning the hope of getting returns is
transaction, in the hope of
called investment.
substantial profit.

Fundamental factors, i.e. Hearsay, technical charts and

Basis for decision
performance of the company. market psychology.

Time horizon Longer term Short term

Risk involved Moderate risk High risk

Intent to profit Changes in value Changes in prices

Expected rate of return Modest rate of return High rate of return

A speculator uses borrowed

Funds An investor uses his own funds.
funds.

Income Stable Uncertain and Erratic

Behavior of participants Conservative and Cautious Daring and Careless

Difference between Speculation and Gambling

Profile of the Investor
An investor´s profile is determined by an individual´s preference in investment decisions, shaped
by the individual’s capacity to deal with risk in order to obtain a higher return. There are three
basic investor profiles: the conservative, the moderate, and the aggressive.

The definition of the profiles is associated with the “Tripod of Investments” that are essential
factors used in the evaluation of an investment which is liquidity, security, and profitability.

Liquidity is related to the availability of money, or to the “rescue” of the investor´s money;
Security is related to risks; And Profitability is related to the possible return, the gains.

These factors are used by investors during their decision-making process, and a significant detail
is that these factors may not be present in an investment in a remarkable way, which leads the
investor to have to give up some factor.

Your preferences, your choices and the factors you choose to prioritize will define your investor´s
profile.

*When it is time to invest, what are you willing to give up? * Which factor do you prioritize most?
*Do you have emotional tolerance for losses? *Or do you get desperate for losing any amount?
*Would you like to have your money available for withdrawal at any time? *Or do you feel
comfortable waiting 30+ days? What is your tolerance for risks? *Are you interested in investing
short term or long term?

The Three Basic Investor Profiles

1. The Conservative
The conservative investor prioritizes security and liquidity much more than profitability. Thus, the
conservative has zero tolerance for losses and risks which naturally leads him or her to give up on
a larger return that comes with higher-risk investments. This profile likes to have its investments
deposited in applications without much volatility so that he or she can leave them there and rest.
This does not mean that he or she does not monitor them, but rather that there is no reason for very
strong emotions like the stock market for example. In the case of riskier applications, the
conservative profile appreciates rescue power, or immediate liquidity, and would not be able to
tolerate 15 or 30 days waiting while watching their precious investments declining. This profile is
in search of, or comfortable with, short to medium term investments ranging from 0- 5 years.

Usually, new investors who are just getting started will easily fit this profile and overtime after
acquiring more experience their profile may change.

• Investment Portfolio: At least 80% applied to Fixed Income and little or nothing in Variable
Income.

2. The Moderate
The moderate investor has one foot in the conservative and another in the aggressive profile,
making it safe to say that this is a more balanced profile. This profile has greater tolerance for risks
than the conservative but not as much as the aggressive; it is willing to give up a little more on
liquidity and security to obtain the desired returns. This profile is in search of, or comfortable with,
medium to long term investments from 5 to 10 years.

• Investment Portfolio: 60–65% applied to Fixed Income and the rest in Variable Income
and Funds

Ps: It would be natural to believe this is the best profile, but truth be told, the best profile for you
is your own. There is not one profile better than the other. Keep that in mind ;)

3. The Aggressive
The aggressive investor prioritizes profitability above all factors and has great tolerance for risks.
This is usually a savvy investor with more money, and so he or she is willing to give up on
immediate liquidity tending to be more flexible with greater tolerance for losses because he or she
understands that higher profits will come in the long run. This profile is in search of, or comfortable
with, long term investments of 10+ years.
Types of Investors

The needs of investment clients vary widely but we can group investors into two broad categories –
individual investors and institutional investors. Different investors will have varying investment
time horizons, tolerance for portfolio risk, income needs and liquidity needs.

Individual Investors
Individual investors may be investing for short-term or long-term goals. A short-term goal may be
their children’s education or the purchase of a house. Longer-term goals center on providing
income for retirement. These differing goals mean some investors are focused on capital growth
and look for those investments with a potential for capital appreciation while retirees will want
income-producing assets. The structuring of a portfolio for an investor will also be dependent on
their financial circumstances like home-ownership, employment prospects, and other financial
obligations.

Institutional Investors
There are many different types of institutional investors. By size, institutional assets make up a
major portion of investment market participation. Pension funds, endowments, charities, banks,
insurance companies, investment funds and Sovereign Wealth Funds (SWF) are all classified as
institutional investors. These institutional investors also have differing financial objectives.

Endowments and Foundations

The typical objective of an endowment or foundation is to maintain the real (inflation-adjusted)

capital value of the fund in perpetuity as well as generate income to provide financial support for
their beneficiaries.

Banks

Banks hold deposits and make loans which can lead to excess reserves – this is where the bank
holds more deposits than it has extended loans. Banks can invest these reserves which typically
have to be held in conservative and liquid assets like fixed-income and money market instruments.
The objective of the bank is to earn a rate of return in excess to the rate of interest it pays on its
deposits.

Insurance Companies

Insurance companies receive premiums from the insurance policies they write. They need to invest
these premiums to ensure there are sufficient funds available to pay for insurance claims when
these arise. As such, their investments are also often conservative in nature and cognizant of the
investment time frame over which claims may arise.

Investment Companies
Investment companies manage mutual funds which are pooled investment vehicles. Mutual funds
are seen as an efficient way for individual investors to gain access to a diversified portfolio and
benefit from the skills of a professional investment manager. Mutual funds are managed according
to the limits and restrictions of their investment mandates.

Sovereign Wealth Funds

SWFs are government-owned investment funds. Some operate with the objective of investing the
revenues from the natural resources of the country (i.e. oil) for the benefit of future generations of
citizens while others manage the assets of the state.
Investor Life Cycle

Individual investor life cycle indicates the investment behavior of investor over the different age
of their life. The investment decision is based on the age, financial condition, future plans and risk
characteristics of an individual.

Investor mainly invests in getting a return which can compensate the sacrifice of present for more
future earnings and security. As a financial plan investor can adopt different insurance policies or
reserve cash for future. Although investor has to take risk of reserving cash or investing the cash
they are ready to take some risk according to their risk-taking behavior.

Four Phases of Individual Investor Life Cycle

An investor passes through four different phases in life

• Accumulation Phase
• Consolidation Phase
• Spending Phase
• Gifting Phase

Accumulation Phase

Investor early or middle to their career tries to accumulate fund so that individual can have money
to spend in the later phase of their life. Some people accumulate the fund to buy house, car or other
important assets and some people accumulate for their children’s education cost, life peaceful life
after retirement.

Funds invested in the early phase of life gives an investor a huge amount of fund which is
compounding over the years

Consolidation Phase

Consolidation phase is the midpoint of their career, in this phase, they earn more, spends more and
pay off all their debts. In this phase moderately high risk taken by the investor but for capital
reservation some investor prefer lower risk investor. Individual invest in the capital market and
investment securities.

Spending Phase

This phase starts when an individual retires from the job. Their overall portfolio is to be less risky
than the consolidation phase; they prefer low risky investment or risk-free investment. People
prefer fixed income securities like a bond, debenture, treasury bills etc. In this phase, they need
some risky investor if they have extra money so that future inflation can be adjusted.

Gifting Phase

If individuals believe that they have enough extra funds to meet their current and future expenses
then they go for gifting money to their friends, family members or establish charitable trusts. These
can reduce their income taxes and they also keep some fun for future uncertainties.

Over the different phase, investor behaves differently and invest in their preferred sector according
to their risk-taking behavior.
Common Mistakes in Investments

Mistake No. 1: Not having clear investment goals

For most people, this isn’t an issue – their goal with investing is to have a stable income in
retirement to supplement their Social Security. This is about as easy as can be, with both employee
sponsored and individual plans within easy reach of pretty much everyone. Most retirement plans
make working toward that goal really, really easy by offering target-date retirement funds.

Where this gets tricky is when people are investing for reasons besides retirement. If you’re not
investing toward retirement, you need to figure out exactly why you’re investing, how far off that
goal is, and how much risk you can tolerate along the way.

Mistake No. 2: Failing to diversify enough

Diversification in investments simply means having your money spread across a lot of different
things. Ideally, you’re spreading your investment money across completely different types of
assets – cash, bonds, stocks, real estate, maybe even things like precious metals or collectibles.

The reasoning is easy – just because one of those things drops in value doesn’t mean that the others
will, so if you have your money spread across all of those things, you won’t suffer if, say, the stock
market takes a dive.

Some things even work in reverse: For example, historically, bonds do well when stocks take a
dive and vice versa. The problem is that most people don’t diversify very much, especially when
it comes to the things that are most important, like retirement savings.

Mistake No. 3: Focusing on the wrong kind of performance

The stock market can jump or drop multiple percentage points in a single day, and that can be a
really bumpy ride for some people. If you have 100,000 in the stock market and it drops 4% in a
day, you’ve just lost 4,000. That’s enough to make some people panic.

The thing is, if you’re invested in the stock market, the short term shouldn’t matter at all to you.
What matters is the long term, and over the long term, the stock market has a fairly steady (although
bumpy) upward trend. If you push the panic button because of one down day, or one down week,
or even one down year, you’re going to end up hurting yourself big time.

Mistake No. 4: Buying high and selling low

Many people’s instincts tell them to buy stocks after a day or a week where they’ve done really
well. Stocks have gone up 10% in the last quarter, they must be hot, I should buy in! Unfortunately,
that’s buying high.

On the other hand, people often instinctively sell when an investment drops rapidly. They see
losses over the last month or quarter and they get scared and panic. That’s selling low.
Buying high and selling low are strategies that are going to fail you over and over again. A much
better approach: Ignore the lows and highs, buy a little bit each week or each month, and then sell
when you need to.

Mistake No. 5: Trading too much and too often

Some people get really into the “game” of playing around with their investments. They’ll react to
the news that they hear and move their investments around all the time. The problem when you do
that is that you tend to generate lots of transaction fees as well as lots of tax implications.

Many brokerages charge you every time you buy or sell an investment, which can add up extremely
quickly if you’re buying and selling too often. Those transaction fees chew up and swallow your
gains quite quickly.

Beyond that, it can quickly turn your tax situation into a mess, with a mix of short- and long-term
capital gains and losses that could result in a painful tax bill, too. You’re almost always better off
making a diversified plan and sticking with it right off the bat.

Mistake No. 6: Paying too much in fees and commissions

Different brokerages charge different fees when you buy and sell investments. Not only that,
commission-based financial planners like to get their piece of the pie, too. If you’re using a high
commission planner and also investing in something that has high transaction charges, your money
is going down the drain.

You’re far better off figuring out how to do these things yourself and finding investment
opportunities that come with little or no transaction fees. I use Vanguard for almost all of my
investments and if you invest directly with them and buy their funds, there are no transaction fees
or commissions at all.

Mistake No. 7: Focusing too much on taxes

People often focus intensely on the tax consequences of their investment decisions, often to their
own detriment. Yes, making a move to help you pay lower taxes can be a good thing, but the taxes
a person pays on investment gains are often insignificant compared to having a good investment
strategy for your goals.

If an opportunity comes up that can help you lower your taxes without losing investment gains,
you should by all means take advantage of it, but if you’re making investment choices primarily
to avoid paying a few dollars to Uncle Sam, like putting your money in a 401(k) with terrible
options instead of a Roth IRA with great options so you pay fewer taxes this year, you’re almost
always guaranteeing yourself a worse outcome.

Mistake No. 8 : Not knowing the true performance of your investments

It’s great if some of your investments are doing really well, but that doesn’t mean that things are
good overall. Your success isn’t judged on your best investment, nor is your failure based on your
worst. What matters is that you know how everything is doing and that you keep them in balance
by tweaking your contributions.

Mistake No. 9 : Reacting to the media

The media always loves to hype things. The media also loves to hit that panic button hard.

One day, they’ll work to convince you that you need this or that investment because it’s the hottest
thing in town. The next, they’ll tell you that everything is falling apart and the sky is falling.

Usually, neither one is true. The media simply knows that hype and fear are the things that attract
viewers and readers. Be calm and measured – don’t fall for the media hype cycle, especially when
it comes to your investments.

Mistake No. 10 : Working with the wrong advisor

Just as there is in any profession, there are good financial advisors and bad financial advisors out
there. There are a few tell-tale signs of bad advisors, however.

One sure sign of a questionable advisor is that they’re not asking you a lot of questions – a good
advisor wants to know who you are and what your reasons for investing are. Another sign is that
they can’t explain why you would want to invest in a particular investment.

In general, I look for fee-based financial advisors, meaning that they don’t make their money from
commissions on particular investments (because doing so would give them incentive to push you
into those investments whether they’re right for you or not).

Mistake No. 11: Letting emotions get in the way

The worst investment decision is one based on emotions, and those emotions can come from a lot
of places. They can come from fear about the future. They can come from anger or sadness
regarding your key life relationships. They can come from irrational exuberance about how well
things are going at the moment.

The best investment plan is one that’s considered with minimal emotion and one that you stick to
throughout those emotional highs and lows.

Mistake No. 12: Forgetting about inflation

Inflation is a real thing. Prices continue to go up and up and up and if you don’t account for that
down the road, you’re going to find yourself in a real pickle eventually.

Don’t make your target number match what you would need today. Include inflation in the
equation. Assume that prices are going to go up (at least) 3% per year and thus you’re going to
need that much more to live on in retirement. Yes, it makes the hill a lot bigger, but you’re better
off shooting for the right number.

Mistake No. 13: Neglecting to start or continue

Many people avoid retirement savings because of a fear of complexity or a desire to maximize
their paychecks today. Some people choose to discontinue their retirement savings because they
feel pressured by today’s financial needs. The worst mistake you can make when saving for
retirement is not starting at all; the second worst mistake is stopping your savings and not restarting
it.

Mistake No. 14: Not controlling what you can

You can’t personally change the ups and downs of the economy, but you can change your own
day-to-day behavior. You can choose to spend less on unnecessary things, which gives you more
money to invest toward the future.

The key is finding a good balance, and many people believe in a balance that is tilted too hard
toward the present and away from their future needs.
Non Marketable Financial Assets

These assets represent personal transactions between the investor and the issuer.
For example, when you open a savings bank account at a bank you deal with the bank
personally. In contrast when you buy equity shares in the stock market you do not know
who the seller is and you do not care.

A. Bank Deposits: An individual needs to open a bank account and deposit money in order
to open a bank deposit. There are various kinds of bank accounts: current accounts,
savings account and fixed deposit account. While a deposit in a current account does not
earn any interest, deposits in other kinds of bank accounts earn interest. The important
features of bank deposits are as follows:
a. Deposits in scheduled banks are very safe because of the regulations of the Reserve
Bank of India and the guarantee provided by the Deposit Insurance Corporation, which
guarantees deposits up to Rs. 5,00,000 per depositor of a bank.
b. There is a ceiling on the interest rate payable on deposits in the savings account.
c. The interest rate on fixed deposits varies with the term of the deposit. In general, it is
lower for fixed deposits of shorter term and higher for fixed deposits of longer term.
d. If the deposit is less than 90 days, the interest is paid on maturity; otherwise it is paid
quarterly.
e. Bank deposits enjoy exceptionally high liquidity. They can be enchased prematurely
by incurring a small penalty.
f. Loans can be raised against bank deposits
g. Most banks calculate interest on the minimum deposit between the 10th and the last
date of the month. So the best way maximize returns on your savings account is to
treat it like a current account between the 1st and the 10th and a fixed deposit for the
rest of the month.

The advantages of bank deposits are:

a. Assured rate of return: Banks publish the fixed deposit rate of interest on their website
and in bank branches which makes it easy for a customer to ascertain how much return
he or she will get. Banks also have a fixed deposit interest calculator on their websites
where a customer can calculate the interest he or she will receive on investing a
particular sum of money for a particular period of time.
b. Tax threshold for interest: Banks are not mandated to deduct tax on any interest until it
crosses Rs. 40,000. This provides comfort to small deposit holders.
c. Flexible tenure: The tenure for a fixed deposit is flexible and depends on the deposit
holder. Each bank has their own minimum tenure rules. However, the final decision
can be taken by the deposit holder. It is also possible to decide whether to redeem the
fixed deposit at an early stage or to extend it for the same period of time.
d. Easy liquidation: It is relatively easy to liquidate a fixed deposit. For FDs booked
online, they can be liquidated online via net banking as well. Otherwise, most bank
branches have a form to liquidate the FD.
e. Loans against fixed deposit: An FD is a dependable instrument to keep in case of
financial emergencies. Taking a loan against a fixed deposit is very easy. You can take
a loan up to 95% of the fixed deposit amount depending on the bank. This makes it a
dependable investment.

The disadvantages of bank deposits are:

a. Reducing interest rates: Even though fixed deposits have a lot of advantages, the
interest rates do not move in line with inflation. This means in some cases, they may
actually earn less than the inflation rate. The interest rates for fixed deposits have been
falling in recent times which has reduced the attractiveness of this investment.
b. Locked in funds: Fixed deposits lock in your funds for a fixed duration. These funds
are not available for you to use unless you withdraw the funds prematurely. Fixed
deposits are not at all liquid and cannot be converted into cash easily.
c. Penalties on withdrawal: Banks charge penalty to the depositors who withdraw their
fixed deposits prematurely. This penalty is in the form of a reduced rate of interest.
d. No tax benefit: The interest earned on fixed deposit is added to the taxable income of
the deposit holder. There is no deduction on any interest earned. However, senior
citizens get a deduction up to Rs. 50,000 on interest.
e. Fixed interest rate: The rate of interest on a fixed deposit remains the same for the
entire duration of the fixed deposit. Even if the rates increase, the bank does not pay
additional interest to the deposit holder.
Post Office Deposits

It is similar to fixed deposits in commercial banks. Their features are:

a. The interest rates on Post Office Deposits are in general slightly higher than those on
bank deposits.
b. The interest is calculated half yearly and paid annually.
c. No withdrawal is permitted for up to six months.
d. After six months, withdrawals are permitted. However, on withdrawals made between
six months and one year, no interest is payable. On withdrawal after one year, but
before the term of deposit, interest is paid for the period the deposit has been held,
subject to a penal deduction of 2 percent.
e. A Post Office Deposits account can be pledged
f. Post Office Time Deposit Scheme provides guaranteed return on investment
g. 5 Year Time Deposits qualify for tax deduction under Section 80C of the Income Tax
Act
h. Even minors aged 10 years and above can operate the account by themselves
i. Nomination facility is available
j. The investments are quite flexible and be made with an amount as low as Rs. 200 and
with no maximum investment limit
k. Accounts can easily be transferred from one post office to another
l. Premature withdrawal of deposits is allowed
m. POTD investments are considered safer than FDs as the principal amount invested
and the interest earned are backed by the government.
n. There is no cap on the maximum number of accounts that can be opened in any post
office

A. National Savings Certificate (NSC)

It is issued at post offices. The National Saving Certificate offers the following
features:
a. It comes in denomination of Rs 100, Rs 500, Rs 1,000 , Rs 5,000 and Rs 10,000
b. It has a term of 6 years. Over this period Rs 100 becomes Rs 160.1. Hence the
compound rate of return works out to 8.16 percent
c. Investment in NSC can be deducted before computing the taxable income under
Section 80C.
d. There is no tax deduction at source
e. It can be pledged as collateral for raising loans.

The advantages are:

a. The interest earned is virtually tax exempted barring for last year.
b. Invested amount is tax exempted under section 80C of Income Tax Act.
c. One can make investments starting from Rs 100 and there is no upper limit on the
invested amount.
d. Interest earned is compounded, resulting in higher returns.
e. NSC can also be taken on behalf of a minor.
f. NSC can be used as collateral for securing loans from banks.
g. Low-risk investment option with Government backing.
h. Highest return rate amongst other fixed rate investment options.
i. Easy investment option as they are available at all post offices.

The disadvantages are:

a. It does not offer a reinvestment option. Hence, a new certificate should be bought every
time.
b. The interest rate offered is fixed and hence may not offer real returns if they fall below
inflation.
c. The proposed e-mode for purchase is still not available at many post-offices and national
banks.
d. Long Tenure of 6 Years
e. Cannot redeem the National Savings Certificate before its maturity period except in some
cases like death, forfeiture by pledgee etc.
Employee Provident Fund Scheme:

It is a scheme for providing a monetary benefit to all salaried individuals after

their retirement. The process is monitored by the Employee Provident Fund Organisation
of India (EPFO). Any organization that has more than 20 employees must register with
the EPFO.
An amount is deducted from the monthly salary of employees and is put into the
EPF account. The amount collected in the EPF account is provided to the employees after
they retire.
Both the employee and the organization contribute 12% of basic remuneration
into the EPF account. The employee can contribute additional amount if he or she wishes
to do so. The employee will receive a fixed level of 8.5% interest on this amount based
on the rules set by the EPFO. The interest is accumulated and not paid annually to the
employee annually. The total amount with the interest is tax exempted. Moreover, the
amount is free from getting attached in case of a court order. The employees are eligible
to get loans against the provident fund balance.
All individuals earning a salary of Rs. 15,000 and above have to register under the
EPF scheme. An employee can withdraw the entire amount from the account after
retirement or after leaving the organization. In case of death, the nominee or legal heir
can withdraw this EPF amount.

The advantages are:

a. Capital appreciation: The PF online scheme offers a pre-fixed interest on the deposit held
with the EPF India. Additionally, rewards extended at maturity further ensure growth in
the employees’ funds and accelerate capital appreciation.
b. Corpus for Retirement: In the long run, the sum deposited towards the employee
provident fund helps to build a healthy retirement corpus. Such a corpus would extend a
sense of financial security and independence to them after retirement.
c. Emergency Corpus: Uncertainties are a part of life. Therefore, being financially prepared
to face such unwarranted situations is the best an individual can do deal with exigencies.
An EPF fund acts as an emergency corpus when an individual requires emergency funds.
d. Tax-saving: Under Section 80C of the Indian Income Tax Act, en employee’s
contribution towards their PF account is deemed eligible for tax exemption. Moreover,
earnings generated through EPF scheme are exempted from taxes. Such exemption can
be availed up to a limit of Rs. 1.5 Lakh. The tax benefits applicable to the Employees
Provident Fund scheme ensure higher earnings to the members. It further improves
savings and an individual’s purchasing power in the long-term.
e. Easy premature withdrawal: Individuals can withdraw funds from their PF account to
meet their specific requirements like pursuing higher education, constructing a house,
bearing wedding expenses or for availing medical treatment.
 The disadvantages are:
a. It is not available to self-employed or retired individuals
b. The EPF contribution is rigid and fixed at 12% of salary and DA from the employer and
employee.
c. Withdrawal before 5 years from account opening of EPF is taxable. In the modern
economy, many people cannot keep a job in an EPF-registered company for 5 years.
d. If you move jobs from large to small companies or become self-employed, you cannot
contribute to the EPF. In such a case, the EPF will stop earning interest after 3 years from
your exit from the EPF-registered employer. Your money will lie idle in the EPF account
e. The EPF rate may not match the long term returns of Mutual Funds or National Pension
System (NPS)
 Money market instruments

Debt instruments which have a maturity period of less than one year are called as
money market instruments. They are highly liquid and negligible risk. It is dominated by
banks, government, financial institutions and corporate. Individuals rarely participate in
such market.

The different money market instruments are as follows:

a. Treasury Bills: Treasury bills are money market instruments issued by the Government
of India as a promissory note with guaranteed repayment at a later date. Funds collected
through such tools are typically used to meet short term requirements of the government.
At present, the Government of India issues four types of treasury bills, namely, 14-day,
91-day, 182-day and 364-day. It is available for a minimum amount of Rs. 25,000 and in
multiples of Rs. 25,000. They do not carry an explicit interest rate. Instead, they are sold
at a discount and redeemed at par. Though the yield on Treasury bills is somewhat low,
they have appeal for the following reasons:
i. They can be transacted readily and there is a very active secondary market for
them
ii. Treasury bills have no credit risk and negligible price risk.

The advantages of treasury bills are:

I. Risk-free: Such schemes are issued by the RBI and are backed by the central government.
Such tools act as a liability to the Indian government as they need to be repaid within the
stipulated date. Hence, individuals enjoy comprehensive security on the total funds
invested as they are backed by the highest authority in the country, and have to be paid
even during an economic crisis.
II. Liquidity: A government treasury bill is issued as a short-term fundraising tool for the
government and has the highest maturity period of 364 days. Individuals looking to
generate short term gains through secure investments can choose to park their funds in
such securities. Also, it can be resold in the secondary market, thereby allowing
individuals to convert their holding into cash during emergencies.
III. Non-competitive bidding: Treasury bills are auctioned by the RBI every week through
non-competitive bidding, thereby allowing retail and small-scale investors to partake in
such bids without having to quote the yield rate or price. It increases the exposure of
amateur investors to the government securities market, thereby creating higher cash flows
to the capital market.

The disadvantages of treasury bills are:

I. Low returns: The primary disadvantage of government treasury securities is that they are
known to generate relatively lower returns when compared to standard stock market
 investment tools. Treasury bills are zero-coupon securities, issued at a discount to
investors. Hence, total returns generated by such instruments remain constant through the
tenure of bond, irrespective of economic conditions and business cycle fluctuations.
II. Taxation: Short term capital gain (STCG) realised on these bills is subject to STCG tax at
rates applicable as per the income tax slab of an investor. Nonetheless, one major
advantage is that retail investors are not required to pay any tax deducted at source (TDS)
upon redemption of these bonds, thereby reducing the hassles of claiming back the same
through income tax returns if he/she does not fall under the taxable income bracket.
 Certificates of Deposits (CDs): It is a fixed-income financial instrument governed under
the Reserve Bank and India (RBI) issued in a dematerialized form. Banks and financial
institutions are the major issuers of CDs. The principal investors in CDs are banks, financial
institutions, corporates, and mutual funds. CDs are issued in bearer or registered form. They
generally have a maturity of 3 months to 1 year CDs carry a certain interest rate. The
features of CDs are:

i. Banks are normally willing to tailor the denominations and maturities to suit the
needs of the investors
ii. CDs generally offer a higher rate of interest than Treasury bills or term deposits
iii. CDs can be issued in India for a minimum deposit of ₹1 lakh and in subsequent
multiples of it.
iv. Similar to dematerialized securities, CDs in dematerialized forms are transferable
through means of endorsement or delivery.
v. There is no lock-in required for a CD.
vi. One cannot issue a loan against a CD.
vii. A certificate of deposit is fully taxable under the Income Tax Act.
viii. A CD cannot be publicly traded.
ix. Banks are not permitted to buy back a CD before its maturity.

The advantages of Certificates of Deposits are:

i. Security: A certificate of deposit or FD is not going to eat up your capital due to market
volatility. It is a completely secure financial instrument with an assured sum at maturity,
similar to traditional insurance. The money you put into your CD will continue to
predictably increase and there is no risk of any loss. It is a very secure short to mid-term
investment.
ii. High-Interest Rate: This benefit is what attracts most investors towards a CD. They offer
larger rates of interest which can go as high as 7.8% on the lump sum deposited than
traditional savings accounts whose interest rates average around 4%.
iii. Flexibility: You can opt for monthly payouts, annual payouts, or a lump sum withdrawal
of your CD at maturity. You can pick the duration and price you want to invest, although
it has to fit certain parameters set by the bank. Tailoring the CD to your needs helps you
get the most from it.
iv. Low to Minimum Maintenance Costs: When it comes to the market there are always
brokerage costs for the delivery, buying and selling of shares. There are usually no
additional costs associated with a CD. You only pay what you invest with some banks.
Commercial Paper: It is an unsecured, short period debt tool issued by a company, usually for
the finance and inventories and temporary liabilities. These papers are like a promissory note
allotted at a huge cost and exchangeable between Financial Institutions.

Most of the commercial paper investors are from the banking sector, individuals,
corporate and incorporated companies, Non-Resident Indians (NRIs) and Foreign
Institutional Investors (FIIs), etc. However, FII can only invest according to the limit
outlined by the Securities and Exchange Board of India (SEBI).

In India, commercial paper is a short-term unsecured promissory note issued by the

Primary Dealers (PDs) and Financial Institutions (FIs) for a short period of 7 days to 364
days.

The features of Commercial Paper are:

i. It is a negotiable instrument
ii. It is subscribed at a discount rate and can be issued in an interest-bearing
application as well.
iii. The issuer guarantees the buyer to pay a fixed amount in future in terms of liquid
cash and not as fixed assets.
iv. A company can directly issue the paper to investors, or it can be done through
banks/dealer banks.
v. It is an unsecured instrument and is not backed by an assets

The advantages of Commercial Paper are:

i. Contributes Funds – It contributes extra funds as the cost of the paper to the
issuing company is cheaper than the loans of the commercial bank.
ii. Flexible – It has a high liquidity value and flexible maturity range giving it extra
flexibility.
iii. Reliable – It is highly reliable and does not have any limiting condition.
iv. Save Money – On commercial paper, companies can save extra cash and earn a
good return.
v. Lasting Source of Funds– Maturity range can be customised according to the
firm’s requirement, and matured papers can be paid by selling the new
commercial paper.

Disadvantages of commercial papers:

 i. Only financially secure and highly rated organizations can raise money through
commercial papers. New and moderately rated organizations are not in a position
to raise funds by this method.
ii. Commercial paper is an odd method of financing. As such if a firm is not in a
position to redeem its paper due to financial difficulties, extending the duration of
commercial paper is not possible. By issuing commercial paper, the credit
available from the banks may get reduced.
iii. Issue of commercial paper is very closely regulated by the RBI guidelines.
iv. New companies cannot issue commercial papers.

The size of the issue of the commercial papers is limited to the extent that the liquidity available
at a particular time should be in excess of the required working capital of the company
Fixed income securities: It refers to those instruments that offer a fixed interest income on
the investment. The maturity amount that one will get post maturity of the securities is
known in advance. Because of this, risk-averse investors prefer fixed income securities over
market-linked securities; these securities are apt for such people who want to earn steady
returns as well. Moreover, some of the fixed income securities like government bonds are
backed by the government which ensures minimal chances of default.

A. Government bonds: They are debt securities issued by the Indian central government or
state governments. Issuance of such bonds occur when the issuing body (Central or State
governments) faces a liquidity crisis and requires funds for the purpose of infrastructure
development. Government bond in India is essentially a contract between the issuer and
the investor, wherein the issuer guarantees interest earnings on the face value of bonds
held by investors along with repayment of the principal value on a stipulated date.
Government Bonds India ,fall under the broad category of government securities (G-Sec)
and are primarily long term investment tools issued for periods ranging from 5 to 40
years. Initially, most G-Secs were issued for the purpose of large investors, such as
companies and commercial banks. However, eventually, GOI made government
securities available to smaller investors such as individual investors, co-operative banks,
etc.

The advantages of investing in Government Bonds are:

a. Sovereign Guarantee: Government Bonds enjoy a premium status with respect to
the stability of funds and promise of assured returns. As G-Secs are a form of a
formal declaration of Government’s debt obligation, it implies the issuing
governmental body’s liability to repay as per the stipulated terms.
b. Inflation-adjusted: Balances held in Inflation-Indexed Bonds are adjusted against
increasing average price level. Other than that, the principal amount invested in
Capital Indexed Bonds is also adjusted against inflation. This feature provides an
edge to investors as they are less susceptible to be financially undermined as
investing in such funds increase the real value of the deposited funds.
c. Regular source of income: As per RBI regulations, interest earnings accrued on
Government Bonds are supposed to be disbursed every six months to such debt
holders. It provides investors with an opportunity to earn regular income by
investing their idle funds.
d. Liquidity: One can buy and sell government bonds like equity instruments. The
liquidity in these bonds is as adequate as banks and financial institutions.
e. Portfolio Diversification: Investment in government bonds makes a well-
diversified portfolio for the investor. It mitigates the risk of the overall portfolio
since government bonds are risk-free investments.
 The disadvantages of Investing in Government Bonds are:

a. Low Income: Other than 7.75% GOI Savings Bond, interest earnings on other
types of bonds are relatively lower.

b. Loss of relevancy: As Government Bonds are long-term investment options with

maturity tenure ranging from 5 – 40 years, it can lose relevancy over time. It
means such bonds value loses relevance in the face of inflation.
 Equity shares: It is a long-term financing source for any company. These shares are issued
to the general public and are non-redeemable in nature. Investors in such shares hold the right
to vote, share profits and claim assets of a company.

The features of equity shares are:

a. Most types of equity shares include voting rights to an investor, allowing him/her to
choose individuals responsible to run the business. Electing efficient managers allows a
company to increase its annual turnover, thereby increasing investors’ average dividend
income.
b. Equity shareholders are eligible to realize additional profits generated by a company in a
fiscal year. This increases the total wealth of individual investors having a considerable
investment in equity shares of a company.
c. Even though equity shares are not repaid until a business closes down, equity shares
already issued can be traded in the secondary capital market. Thus, investors can
withdraw funds from a company upon their discretion. This ensures massive wealth
creation through capital appreciation of such shares.

The advantages of equity shares are:

a. High Income: Equity share market is an ideal segment of the capital market responsible
for the remarkable income of investors. Wealth creation not only works through capital
appreciation of such securities but also high dividend earnings received by individuals.
b. Hedge against Inflation: Investment in profitable equity shares increases the standard of
living of individuals through asset value appreciation. Money invested in equity shares
offer manifold returns, higher than the rate of erosion of an individual’s purchasing
power due to inflation. Thus, the real value of investments tends to rise over time.
c. Portfolio Diversification: Investors having a low aptitude for risk tend to stick with debt
instruments, as it is less volatile. However, stock and bond market fluctuations are
inversely related when it comes to aggregate demand. Thus, when the bond market is
underperforming, risk-averse investors can profit from investment in best equity shares
through stock market investments.
d. Equity shares are liquid in nature and can be sold easily in the capital market.
e. The equity shareholders not only get the benefit of dividend but they also get the benefit
of price appreciation in the value of their investment.

The disadvantages of equity shares are:

Equity share market tends to be the most volatile segment in a stock market, profoundly
affected by minor fluctuations. Returns on equity investments are paid out after all other
obligations of a company have been met. During market downturn, production cycle of a
business is affected, thereby reducing profits generated by a business. This lower share of profit
is used up to meet all existing liabilities before funds are disbursed to as equity investment
returns. Thus equity markets tend to be adversely affected during market downturn. Market
fluctuations are a part of the business cycle, which has associated highs and lows as per the
prevailing socio-economic scenario of a country. Even if equity shares demonstrate lower returns
at a certain point of time, it is bound to pick up when the economy recovers.
Mutual fund

A mutual fund is an investment instrument which pools in money from different investors
and invests the collected corpus in a set of different asset classes such as equity, debt, gold,
foreign securities etc. Mutual funds enable investors to create diversified investment portfolios
with investments as low as Rs. 500. A mutual fund is managed by a fund manager who is an
expert carrying vast experience in the investment industry. They are regulated by capital markets
regulator SEBI (Securities and Exchange Board of India) and AMFI (Association of Mutual
Funds in India).
The advantages of mutual funds are:
a. Portfolio Diversification: Mutual Funds diversifies investments by investing in different asset
classes. As an individual investor, one cannot afford to invest in variety of sectors. Therefore,
mutual fund offers diversification and exposure to multiple sectors through minimal
investment.
b. Professional Management: Mutual Funds are managed by qualified experienced
professionals who works towards fulfillment of investment objective of the fund.
c. Affordability: You can start your investment in Mutual Fund systematic investment plan with
a minimum investment of as low as Rs. 500.
d. Liquidity: Open ended Mutual Funds can be redeemed totally or partially at the present
value.
e. Transparency: Mutual Funds Performance is easily available on their own website as well the
performance is reviewed and published by esteemed publications and rating agencies.
f. Rupee Cost Averaging: Regular investing irrespective of the market trends help average
investment cost over a period of time. One can get higher number of units when the markets
are falling. Similarly, if the markets are rising, the overall value of the portfolio increases.
g. Consistent Savings: Helps make periodical and consistent investments. Adds financial
discipline into your life through regular investing.
h. Choice of Investment: There is a wide range of mutual funds schemes available to meet
individual goals. It also offers flexibility in the mode of investments.

The disadvantages of mutual funds are:

a. Costs: Some mutual funds have a high cost associated with them. Mutual funds charge for
managing the funds, fund managers salary, distribution costs, etc. Depending on the fund,
these charges can be significant. When opting out from mutual fund, exit load might be
charged as an extra cost. Exit loads are applicable if investments are sold within a specified
duration. Passively managed funds like index funds or ETFs (Exchange Traded Funds) have
lower expense ratios than actively managed funds. This is because passively managed funds
track the underlying index and do not require a fund manager to take active investment calls.
b. Dilution: Diversification has an averaging effect on investments. While diversification saves
from suffering any major losses, it also prevents from making any major gains.
c. Fluctuating returns: Mutual funds do not offer fixed guaranteed returns. Even the value of the
mutual fund scheme might depreciate. It entails a wide range of price fluctuations.
Professional management of a fund by a team of experts does not insulate from bad
performance of a fund scheme.
d. No Control: All types of mutual funds are managed by fund managers. In many cases, the
fund manager may be supported by a team of analysts. All major decisions concerning the
fund are taken by the fund manager.
e. Diversification: Diversification is often cited as one of the main advantages of a mutual fund.
However, there is always the risk of over diversification, which may increase the operating
cost of a fund, demands greater due diligence and dilutes the relative advantages of
diversification.
f. Fund Evaluation: Many investors may find it difficult to extensively research and evaluate
the value of different funds. A mutual fund's net asset value (NAV) provides investors the
value of a fund's portfolio. However, investors have to study various parameters such as
sharpe ratio and standard deviation among others to ascertain how one fund has fared
compared to another which can be complicated to some extent.
g. Past performance: Ratings and advertisements issued by companies are only an indicator of
the past performance of a fund. It is important to note that robust past performance of a fund
is not a guarantee of a similar performance in the future. As an investor, one should analyse
the investment philosophy, transparency, ethics, compliance and overall performance of a
fund house across different phases in the market over a period of time. Ratings can be taken
as a reference point.
h. CAGR: The performance of a mutual fund vis-a-vis the compounded annualised growth rate
(CAGR) neither provides investors adequate information about the amount of risk facing a
mutual fund nor the process of investment involved. It is therefore, only one of the indicators
to gauge the performance of a fund but is far from being comprehensive.
Types of mutual funds

a. Based on Asset Class

i. Equity Funds: Equity funds primarily invest in stocks, and hence go by the name
of stock funds as well. They invest the money pooled in from various investors
from diverse backgrounds into shares/stocks of different companies. The gains and
losses associated with these funds depend solely on how the invested shares
perform (price-hikes or price-drops) in the stock market. Also, equity funds have
the potential to generate significant returns over a period. Hence, the risk
associated with these funds also tends to be comparatively higher.

ii. Debt Funds: Debt funds invest primarily in fixed-income securities such as bonds,
securities and treasury bills. They invest in various fixed income instruments such
as Fixed Maturity Plans (FMPs), Gilt Funds, Liquid Funds, Short-Term Plans,
Long-Term Bonds and Monthly Income Plans, among others. Since the
investments come with a fixed interest rate and maturity date, it can be a great
option for passive investors looking for regular income (interest and capital
appreciation) with minimal risks.

iii. Money Market Funds: Investors trade stocks in the stock market. In the same way,
investors also invest in the money market, also known as capital market or cash
market. The government runs it in association with banks, financial institutions and
other corporations by issuing money market securities like bonds, T-bills, dated
securities and certificates of deposits, among others. The fund manager invests and
disburses regular dividends in return. Opting for a short-term plan (not more than
13 months) can lower the risk of investment considerably on such funds.

iv. Hybrid Funds: As the name suggests, hybrid funds (Balanced Funds) is an
optimum mix of bonds and stocks, thereby bridging the gap between equity funds
and debt funds. The ratio can either be variable or fixed. In short, it takes the best
of two mutual funds by distributing, say, 60% of assets in stocks and the rest in
bonds or vice versa. Hybrid funds are suitable for investors looking to take more
risks for ‘debt plus returns’ benefit rather than sticking to lower but steady income
schemes.

b. Based on Structure
i. Open-Ended Funds: Open-ended funds do not have any particular constraint such
as a specific period or the number of units which can be traded. These funds allow
investors to trade funds at their convenience and exit when required at the
prevailing NAV (Net Asset Value). This is the sole reason why the unit capital
continually changes with new entries and exits. An open-ended fund can also
 decide to stop taking in new investors if they do not want to (or cannot manage
significant funds).

ii. Closed-Ended Funds: In closed-ended funds, the unit capital to invest is pre-
defined. The fund company cannot sell more than the agreed number of units.
Some funds also come with a New Fund Offer (NFO) period; wherein there is a
deadline to buy units. NFOs comes with a pre-defined maturity tenure with fund
managers open to any fund size. Hence, SEBI has mandated that investors be given
the option to either repurchase option or list the funds on stock exchanges to exit
the schemes.

iii. Interval Funds: Interval funds have traits of both open-ended and closed-ended
funds. These funds are open for purchase or redemption only during specific
intervals (decided by the fund house) and closed the rest of the time. Also, no
transactions will be permitted for at least two years. These funds are suitable for
investors looking to save a lump sum amount for a short-term financial goal, say,
in 3-12 months.

c. Based on Investment Goals

i. Growth Funds: Growth funds usually allocate a considerable portion in shares and
growth sectors, suitable for investors who have a surplus of idle money to be
distributed in riskier plans (albeit with possibly high returns) or are positive about
the scheme.

ii. Income Funds: Income funds belong to the family of debt mutual funds that
distribute their money in a mix of bonds, certificate of deposits and securities
among others. It has historically earned investors better returns than deposits. They
are best suited for risk-averse investors with a 2-3 years perspective.

iii. Liquid Funds: Like income funds, liquid funds also belong to the debt fund
category as they invest in debt instruments and money market with a tenure of up
to 91 days. The maximum sum allowed to invest is Rs 10 lakh. A highlighting
feature that differentiates liquid funds from other debt funds is the way the Net
Asset Value is calculated. The NAV of liquid funds is calculated for 365 days
(including Sundays) while for others, only business days are considered.

iv. Tax-Saving Funds: ELSS or Equity Linked Saving Scheme, over the years, have
climbed up the ranks among all categories of investors. Not only do they offer the
benefit of wealth maximisation while allowing you to save on taxes, but they also
come with the lowest lock-in period of only three years. Investing predominantly
 in equity (and related products), they are known to generate non-taxed returns in
the range 14-16%. These funds are best-suited for salaried investors with a long-
term investment horizon.

v. Aggressive Growth Funds: Slightly on the riskier side when choosing where to
invest in, the Aggressive Growth Fund is designed to make steep monetary gains.
Though susceptible to market volatility, one can decide on the fund as per the beta
(the tool to gauge the fund’s movement in comparison with the market). Example,
if the market shows a beta of 1, an aggressive growth fund will reflect a higher
beta, say, 1.10 or above.

vi. Capital Protection Funds: If protecting the principal is the priority, Capital
Protection Funds serves the purpose while earning relatively smaller returns (12%
at best). The fund manager invests a portion of the money in bonds or Certificates
of Deposits and the rest towards equities. Though the probability of incurring any
loss is quite low, it is advised to stay invested for at least three years (closed-
ended) to safeguard your money, and also the returns are taxable.

vii. Fixed Maturity Funds: Many investors choose to invest towards the of the FY ends
to take advantage of triple indexation, thereby bringing down tax burden. If
uncomfortable with the debt market trends and related risks, Fixed Maturity Plans
(FMP) – which invest in bonds, securities, money market etc. – present a great
opportunity. As a close-ended plan, FMP functions on a fixed maturity period,
which could range from one month to five years (like FDs). The fund manager
ensures that the money is allocated to an investment with the same tenure, to reap
accrual interest at the time of FMP maturity.

viii. Pension Funds: Putting away a portion of your income in a chosen pension fund to
accrue over a long period to secure you and your family’s financial future after
retiring from regular employment can take care of most contingencies (like a
medical emergency or children’s wedding). Relying solely on savings to get
through your golden years is not recommended as savings (no matter how big) get
used up. EPF is an example, but there are many lucrative schemes offered by
banks, insurance firms etc.

d. Based on Risk:
i. Very Low-Risk Funds: Liquid funds and ultra-short-term funds (one month to one
year) are known for its low risk, and understandably their returns are also low (6%
at best). Investors choose this to fulfil their short-term financial goals and to keep
their money safe through these funds.
 ii. Low-Risk Funds: In the event of rupee depreciation or unexpected national crisis,
investors are unsure about investing in riskier funds. In such cases, fund managers
recommend putting money in either one or a combination of liquid, ultra short-
term or arbitrage funds. Returns could be 6-8%, but the investors are free to switch
when valuations become more stable.

iii. Medium-risk Funds: Here, the risk factor is of medium level as the fund manager
invests a portion in debt and the rest in equity funds. The NAV is not that volatile,
and the average returns could be 9-12%.

iv. High-Risk Funds: Suitable for investors with no risk aversion and aiming for huge
returns in the form of interest and dividends, high-risk mutual funds need active
fund management. Regular performance reviews are mandatory as they are
susceptible to market volatility. You can expect 15% returns, though most high-
risk funds generally provide up to 20% returns.

e. Specialized Mutual Funds

i. Sector Funds: Sector funds invest solely in one specific sector, theme-based
mutual funds. As these funds invest only in specific sectors with only a few stocks,
the risk factor is on the higher side. It also delivers great returns. Some areas of
banking, IT and pharma have witnessed huge and consistent growth in the recent
past and are predicted to be promising in future as well.

ii. Index Funds: Suited best for passive investors, index funds put money in an index.
A fund manager does not manage it. An index fund identifies stocks and their
corresponding ratio in the market index and put the money in similar proportion in
similar stocks. Even if they cannot outdo the market (which is the reason why they
are not popular in India), they play it safe by mimicking the index performance.

iii. Funds of Funds: A diversified mutual fund investment portfolio offers a slew of
benefits, and ‘Funds of Funds’ also known as multi-manager mutual funds are
made to exploit this to the tilt – by putting their money in diverse fund categories.
In short, buying one fund that invests in many funds rather than investing in
several achieves diversification while keeping the cost down at the same time.

iv. Emerging market Funds: To invest in developing markets is considered a risky bet,
and it has undergone negative returns too. India, in itself, is a dynamic and
emerging market where investors earn high returns from the domestic stock
market. Like all markets, they are also prone to market fluctuations. Also, from a
 longer-term perspective, emerging economies are expected to contribute to the
majority of global growth in the following decades.

v. International/ Foreign Funds: Favoured by investors looking to spread their

investment to other countries, foreign mutual funds can get investors good returns
even when the Indian Stock Markets perform well. An investor can employ a
hybrid approach (say, 60% in domestic equities and the rest in overseas funds) or a
feeder approach (getting local funds to place them in foreign stocks) or a theme-
based allocation (e.g., gold mining).

vi. Global Funds: Aside from the same lexical meaning, global funds are quite
different from International Funds. While a global fund chiefly invests in markets
worldwide, it also includes investment in your home country. The International
Funds concentrate solely on foreign markets. Diverse and universal in approach,
global funds can be quite risky to owing to different policies, market and currency
variations, though it does work as a break against inflation and long-term returns
have been historically high.

vii. Real Estate Funds: Despite the real estate boom in India, many investors are still
hesitant to invest in such projects due to its multiple risks. Real estate fund can be
a perfect alternative as the investor will be an indirect participant by putting their
money in established real estate companies/trusts rather than projects. A long-term
investment negates risks and legal hassles when it comes to purchasing a property
as well as provide liquidity to some extent.

viii. Commodity-focused Stock Funds: These funds are ideal for investors with
sufficient risk-appetite and looking to diversify their portfolio. Commodity-
focused stock funds give a chance to dabble in multiple and diverse trades.
Returns, however, may not be periodic and are either based on the performance of
the stock company or the commodity itself. Gold is the only commodity in which
mutual funds can invest directly in India. The rest purchase fund units or shares
from commodity businesses.

ix. Market Neutral Funds: For investors seeking protection from unfavourable market
tendencies while sustaining good returns, market-neutral funds meet the purpose
(like a hedge fund). With better risk-adaptability, these funds give high returns
where even small investors can outstrip the market without stretching the portfolio
limits.
 x. Inverse/Leveraged Funds: While a regular index fund moves in tandem with the
benchmark index, the returns of an inverse index fund shift in the opposite
direction. It is nothing but selling your shares when the stock goes down, only to
repurchase them at an even lesser cost (to hold until the price goes up again).

xi. Asset Allocation Funds: Combining debt, equity and even gold in an optimum
ratio, this is a greatly flexible fund. Based on a pre-set formula or fund manager’s
inferences based on the current market trends, asset allocation funds can regulate
the equity-debt distribution. It is almost like hybrid funds but requires great
expertise in choosing and allocation of the bonds and stocks from the fund
manager.

xii. Exchange-traded Funds: It belongs to the index funds family and is bought and
sold on exchanges. Exchange-traded Funds have unlocked a new world of
investment prospects, enabling investors to gain extensive exposure to stock
markets abroad as well as specialized sectors. An ETF is like a mutual fund that
can be traded in real-time at a price that may rise or fall many times in a day.
Life insurance:

Life Insurance can be defined as a contract between an insurance policy holder

and an insurance company, where the insurer promises to pay a sum of money in
exchange for a premium, upon the death of an insured person or after a set period. The
insured pays premiums for a specific term and in return it secures the insured’s future by
paying a lump sum amount in case of an unfortunate event. However, in some policies,
an amount called Maturity Benefit will be paid at the end of the policy term.

The features of life insurance are:

a. Waiver of premium: This feature pays the premium of a policy if you become seriously
ill or disabled.
b. Accelerated death benefit: This feature allows you to receive cash advances against the
death benefit of your policy if you're diagnosed with a terminal illness. Many people with
this benefit use the money to help pay for treatment and other expenses when they have
only a short time to live.
c. Guaranteed purchase option: With this feature, you can purchase coverage at designated
future dates or life events without proving you're in good health.
d. Long-term care riders. Some life products include this option, which allows you to use
the benefits of your policy to pay for long-term care in exchange for a reduced life
benefit.
e. Spouse or child term riders: Life policies with this feature allow you to purchase term
life insurance for your spouse or dependent child, up to age 26. This option can be a
more affordable way to purchase coverage if you can't afford separate policies.
f. Cash value plans: This type of policy pays out upon your death and also accumulates
value during your lifetime. You can use the cash value as a tax-sheltered investment, as a
fund from which you can borrow and use to pay the policy premiums later.
g. Mortgage protection: This feature, typically found on term life policies, will pay your
mortgage if you die.
h. Cash withdrawals and loans: Many universal and whole life policies allow you to
withdraw or borrow money, using the cash value of the policy as collateral. Interest rates
tend to be relatively low. You can also use the cash value of your life policy to pay your
premiums if you need or want to stop paying premiums for a period of time. You must
pay back the loan or your beneficiaries will receive a reduced death benefit.
i. Survivor support services: Some life policies offer services that provide objective
financial and legal assistance to beneficiaries.
j. Employee assistance programs: This feature makes resources available to you for
problems that can affect your personal and professional life. Resources are usually free
and help address issues such as substance abuse, stress, marital problems, legal concerns
and major life events.
 The advantages of life insurance are:
a. Risk Coverage: Insurance provides risk coverage to the insured family in form of
monetary compensation in lieu of premium paid.

b. Difference plans for different uses: Insurance companies offer a different type of plan to
the insured depending on his need for insurance. More benefits come with the more
premium.

c. Cover for Health Expenses: These policies also cover hospitalization expenses and
critical illness treatment.

d. Promotes Savings/ Helps in Wealth creation: Insurance policies also come with the
saving plan i.e. they invest your money in profitable ventures.

e. Guaranteed Income: Insurance policies come with the guaranteed sum assured amount
which is payable on happening of the event.

f. Loan Facility: Insurance companies provide the option to the insured that they can
borrow a certain sum of amount. This option is available on selected policies only.

g. Tax Benefits: Insurance premium is tax deductible under section 80C of the income tax
Act, 1961.

The disadvantages of life insurance are:

a. The premium for life insurance steeply increases with advancing age and hence insurance
needs at higher ages cannot be economically met.
b. At older ages, say beyond 65 or 70 it becomes difficult to buy life insurance as most
companies do not offer it beyond these ages. Even in cases where life insurance is offered
at ages beyond this, several conditions, disadvantageous to the insured, are attached.
c. Life insurance will not serve the purpose to save money for a specific need such as
education of child, marriage, old age provision like retirement needs etc.
d. It will also not help to provide for income or capital needs of a family while the insured is
living.
e. No surrender values or loans are available.
f. Life insurance cannot provide a hedge against inflation as they are without profit plans.
Types of life insurance policies:

a. Term insurance plan: Term insurance plan are those plan that is purchased for a
fixed period of time, say 10, 20 or 30 years. As these policies don’t carry any cash
value their policies do not carry any maturity benefits, hence their policies are
cheaper as compared to other policies. This policy turns beneficial only on the
occurrence of the event.

b. Endowment policy: The only difference between the term insurance plan and the
endowment policy is that endowment policy comes with the extra benefit that the
policyholder will receive a lump sum amount in case if he survives until the date
of maturity. Rest details of term policy are same and also applicable to an
endowment policy.

c. Unit Linked Insurance Plan: These plans offer policyholder to build wealth in
addition to life security. Premium paid into this policy is bifurcated into two parts,
one for the purpose of Life insurance and another for the purpose of building
wealth. This plan offers to partially withdraw the amount.

d. Money Back Policy: In a money back plan, the insured person gets a percentage
of sum assured at regular intervals, instead of getting the lump sum amount at the
end of the term. It is an endowment plan with the benefit of liquidity. This policy
is suitable for risk-averse individuals who wish to save through an insurance plan
and also maintain liquidity throughout. In case of death of the insured person, the
nominee gets the entire sum assured and the survival benefits are not deducted.

e. Whole Life Policy: Unlike other policies which expire at the end of a specified
period of time, this policy extends up to the whole life of the insured. This policy
also provides the survival benefit to the insured. In this type of policy, the
policyholder has an option to partially withdraw the sum insured. Policyholder
also has the option to borrow sum against the policy.

f. Annuity/ Pension Plan: Under this policy, the amount collected in the form of a
premium is accumulated as assets and distributed to the policyholder in form of
income by way of annuity or lump sum depending on the instruction of insured.
Real estate

The term “real estate” is defined as land and any buildings or structures on it. It is also
referred to as realty. It covers residential housing, commercial offices, trading spaces
such as theatres, hotels and restaurants, retail outlets, industrial buildings such as
factories and government buildings. Real estate involves the purchase, sale, and
development of land, residential and non-residential buildings.

The advantages of real estate are:

a. Allows Diversification of Asset: Real estate provides is diversification of asset.
Growth in value of real estate portfolio bears little relationship with other asset
classes. It is common to find that, when stock market is doing bad, then real estate
will perform well. In a situation where an economic boom is at its end, real estate
property would still yield good returns.
b. Instantaneous Dual Income: Like stocks, real estate also provides possibility of
dual income. Stocks provides short term income in form of dividend. Likewise,
Real estate provides rental income in short term. In long term, both stocks and
real estate provides capital appreciation. Stock can provide faster appreciation.
However, Real estate provides slower but steadier capital appreciation in long
term.
c. Inflation Hedge: A combination of rental income and value appreciation certainly
beats inflation. There is no other investment which can beat inflation as
consistently as real estate property.
d. Saves from Income Tax: If investment in real estate is made availing home loan,
then tax benefits can be claimed.
e. Competitive Risk-Adjusted Returns: Unlike stocks and bonds which are volatile
assets and are closely affected by multiple external factors beyond control
(external factors include interest rates, inflation, government policy, and
regulation), Real Estate is a more stable and tangible asset and gives better control
thereby allowing to generate additional passive cash income. Time-consuming
process and large transactions safeguard real estate investments from sudden
shocks and provide controlled and stable returns.
f. Highly Tangible Asset: Unlike stocks and bonds (except secured bonds), a
property is backed up by a tangible asset which is, land. A stock can slump to
zero; the issuer of the bond might default but, land can never reduce to zero.

The disadvantages of real estate are:

a. Capital gain tax is applicable: On sale of property at higher price capital gain tax
is applicable. When property is sold within 3 years of purchase short term capital
gain tax will be applicable as per ones income slab. But when property is sold
after 3 years of purchase, long term capital gain tax of flat 20% is applicable.
b. High need of capital: The biggest disadvantages of real estate investment is high
capital requirement. Because of high capital requirement, buying and selling of
property is laborious.
c. High Cost of maintenance: Real estate also involves high management costs as
compared to other investments. The owner of the property not only has to
maintain the internals of the property but must also pay the maintenance charges
payable to the society. This makes a real estate property more costly.
d. Real estate property is very illiquid. A large sum of money gets locked which is
not so easy to redeem.
e. To keep earning rental income, it is not so easy to find suitable tenants time an
again.
f. When market condition is not so good, market price of real estate property may
also go down (temporarily).
 Precious objects:

It is divided as follows:
A. Precious metals: Precious metals are metals that are rare and have a high
economic value, due to various factors, including their scarcity, use in industrial
processes, and role throughout history as a store of value. The most popular precious
metals with investors are gold, platinum, and silver.
The advantages are: Historically, they have been good hedges against inflation.
Also, they are highly liquid with very low trading commissions. Investment in gold and
silver, however, has no tax advantage associated with them. They are highly liquid and
are aesthetically attractive. Moreover, they are durable, easy to own anonymously, to
subdivide into small piece that are valuable and easy to authenticate.
The disadvantages are: They do not provide regular current income, There is no
tax advantage associated with them, There may be a possibility of being cheated and
Gold and silver have not kept up with inflation in recent times.

B. Collectibles: It include rare coins, works of art, antiques, Chinese ceramics,

paintings and other items that appeal to collectors and investors. Each of these items
offers the knowledgeable collector/ investor both pleasure and the opportunity for profit.
It does not provide regular income, and may be difficult to sell quickly.

a. Art Objects and antiques: Objects which possess aesthetic appeal because their
production requires skill, taste, creativity talent and imagination may be referred to
as art objects. According to this definition, paintings, sculptures, etchings may be
regarded as art objects. Some of these objects due to their historical importance are
classified as antiques. The value of an art object is a function of its aesthetic appeal,
rarity, reputation of the creator, physical conditions and fashion.

The advantages of art objects are:

i. Art works hardly depreciate in value. In fact, art prices are known to appreciate over a
period of time.
ii. Since art prices do not depend on other possible components of a portfolio, they act as a
cushion when other markets are not doing well.
iii. It is a good method for diversification.
iv. It beats inflation since it gains capital value above the average rate of inflation.
v. No Market Fluctuations. Stock market corrections, volatility, and other financial
fluctuations are nonexistent in the art world.

The disadvantages of art objects are:

i. Not anyone can invest in art. It requires a certain level of knowledge and expertise.
ii. The fact that it depends largely on public tastes and other external factors, make it a fairly
speculative investment.
iii. Art cannot be resold quickly for a profit.
iv. It needs a high level of maintenance, storage as well as security.
v. There’s no guarantee it will appreciate. The art world is a very fickle environment. New
or established artists can quickly fall out of favor as quickly as they rose.
 SECURITY ANALYSIS -INTRODUCTION

Security analysis is the analysis of tradable financial instruments called securities. It deals with
finding the proper value of individual securities (i.e., stocks and bonds). These are usually classified
into debt securities, equities, or some hybrid of the two.

A prospective investor as well as an existing shareholder is interested more in knowing “What the
price should be” or what is the real worth of a share. So that a ‘buy’ or ‘sell’ decision can be
made. In a bid to answer this question and predict share price, the following three approaches
to security valuation have evolved over the years.
 Fundamental Analysis :
 Technical Analysis :
 Efficient Market Hypothesis (EMH)
 FUNDAMENTAL ANALYSIS
Fundamental analysis is based on the premise that in the long run true or fair value of an equity
share is equal to its intrinsic value. The intrinsic value of an asset is the present value of all
expected future cash inflows (or earnings) from that asset. In case of an equity share it will be
equal to the present value all expected future earnings (in the form of dividend, capital gain
etc.) from that share because equity shares have infinite life. The expected earnings from an
equity share depend upon a variety of economy wide, industry wide and company specific
factors.

Therefore fundamental analysis involves in-depth analysis of all possible factors having a
bearing on company’s profitability and future prospects and hence on share price (theoretical
or fair price). Fundamental analysts forecast, among other things, future level of the economy’s
GDP, future sales and earnings of a large number of industries and earnings of a large number
of companies. Eventually such forecasts are converted to estimate the expected cash inflows
from the shares of these companies.

There can be two approaches to fundamental analysis –

Top down approach and Bottom up approach.

Top down approach : with this approach the financial analysts are first involved in making
forecasts for the economy, then for the industries and finally for the companies. The industry
forecasts are based on the forecasts of the economy. Further a company’s forecasts are based
on the forecasts of the economy as well as the concerned industry.

Bottom up approach: In case of bottom up approach, fundamental analysts forecast the

prospects of the companies first, then for the industries 135 FUNDAMENTAL ANALYSIS
Para 4.2 and in the last forecast for the economy. Such bottom up forecasting may unknowingly
involve inconsistent assumptions. Forecasts of the economy is of no use if it is done after
company forecasts because ultimately it is the expected cash inflows from the company’s share
that will be used in finding out the intrinsic value of a share.
Company analysis:
In company analysis analysts consider the basic financial variables for the estimation of the
intrinsic value of the company. These variables contain sales, profit margin, tax rate,
depreciation, asset utilization, sources of financing and other factors. The conduction of further
analysis of company include the competitive position of the company in the industry,
technological changes, management, labor relations, foreign competition and so on.

How to do the Company Analysis

Company analysis actually provides the indication of the estimated value & potential of the
company along with the comprehension of its financial variables. Common stock can be valued
by the investors by using dividend discount model. Similarly earnings multiplier model can be
used for estimation of intrinsic value for a short run. Intrinsic value is the relation between
price per share and estimated earnings per share (EPS).

The Financial variables

Major financial data about company is obtained from its financial statements while doing the
process of company analysis. Following are included in the category of financial statements.

• Balance Sheet
• Income Statement
• Cash Flow Statement

The Balance Sheet

The balance sheet represents the Portfolio of assets and liabilities & owner’s equity of a
company at particular point of time. The accounting conventions dictate the amounts at which
items are carried on the balance sheets. Cash is the real dollar amount while marketable
securities can be at market value or cost. Assets and stockholders equity are based on the book
value. The careful analysis of the balance sheet of a company is important for the investors.
The investors want to know those companies which are really profitable and are different from
the ones which pump up their performance by taking too much debt whose recovery is a big
issue. Balance sheet is really important to analyze while doing company analysis for making
investment.

Income Statement

In Company analysis process Investors frequently use income statement to evaluate the current
performance of management and forecasting of the future profitability of the company. The
flows for certain period (one year) are represented by the income statement.

The investors are more interested for the After-tax net income item of the income statement
which is divided by the number of common shares outstanding to ascertain the earnings per
share. The success of the company is viewed from the earnings from its continuing operations
and these earnings are mostly reported as earnings in the financial press. Nonrecurring income
is kept separate from the continuing income.

The Cash Flow Statement

The cash flow statement is the third financial statement of the company which includes the
items of the balance sheet and income statement as well as other ones. It provides the picture
of the travelling of the cash in and out of the company. There are three part of cash flow
statement which are

• Cash from operating activities

• Cash from investing activities
• Cash from financing activities

The quality of earnings is examined by the investors with the help of cash flow statement. For
example if inventories are increasing more quickly than sales this indicate serious problem by
likely softening of the demand. Similarly cutting back of capital expenditures by a company
indicate problem. Moreover it is also problematic if the accounts receivables increase more
quickly than the sales which shows the poor recovery of the debts by the company.
Industry Analysis
Industry analysis is a market assessment tool used by businesses and analysts to understand
the competitive dynamics of an industry. It helps them get a sense of what is happening in an
industry, e.g., demand-supply statistics, degree of competition within the industry, state of
competition of the industry with other emerging industries, future prospects of the industry
taking into account technological changes, credit system within the industry, and the
influence of external factors on the industry.

Types of industry analysis

• Competitive Forces Model (Porter’s 5 Forces)

• SWOT Analysis

1 Competitive Forces Model (Porter’s 5 Forces)

One of the most famous models ever developed for industry analysis, famously known as
Porter’s 5 Forces, was introduced by Michael Porter in his 1980 book “Competitive Strategy:
Techniques for Analyzing Industries and Competitors.”

According to Porter, analysis of the five forces gives an accurate impression of the industry
and makes analysis easier. In our Corporate & Business Strategy course, we cover these five
forces and an additional force — power of complementary good/service providers.

Competitive Forces Model

1. Intensity of industry rivalry

The number of participants in the industry and their respective market shares are a direct
representation of the competitiveness of the industry. These are directly affected by all the
factors mentioned above. Lack of differentiation in products tends to add to the intensity of
competition. High exit costs such as high fixed assets, government restrictions, labor unions,
etc. also make the competitors fight the battle a little harder.

2. Threat of potential entrants

This indicates the ease with which new firms can enter the market of a particular industry. If it
is easy to enter an industry, companies face the constant risk of new competitors. If the entry
is difficult, whichever company enjoys little competitive advantage reaps the benefits for a
longer period. Also, under difficult entry circumstances, companies face a constant set of
competitors.

3. Bargaining power of suppliers

This refers to the bargaining power of suppliers. If the industry relies on a small number of
suppliers, they enjoy a considerable amount of bargaining power. This can particularly affect
small businesses because it directly influences the quality and the price of the final product.
4. Bargaining power of buyers

The complete opposite happens when the bargaining power lies with the customers. If
consumers/buyers enjoy market power, they are in a position to negotiate lower prices, better
quality, or additional services and discounts. This is the case in an industry with more
competitors but with a single buyer constituting a large share of the industry’s sales.

5. Threat of substitute goods/services

The industry is always competing with another industry producing a similar substitute product.
Hence, all firms in an industry have potential competitors from other industries. This takes a
toll on their profitability because they are unable to charge exorbitant prices. Substitutes can
take two forms – products with the same function/quality but lesser price, or products of the
same price but of better quality or providing more utility.

2. SWOT Analysis

SWOT Analysis stands for Strengths, Weaknesses, Opportunities, and Threats. It can be a
great way of summarizing various industry forces and determining their implications for the
business in question.

Industry analysis enables a company to develop a competitive strategy that best defends against
the competitive forces or influences them in its favour. The key to developing a competitive
strategy is to understand the sources of the competitive forces.
 ECONOMIC ANALYSIS
In business, economic analysis allows to incorporate elements from the economic environment
such as inflation, interest rates, exchange rates and GDP growth into the corporate planning.
Every organization is an open system that impact and is impacted by the external context. This
means that a proper assessment of economic variables facilitates the identification of
opportunities and threats that could affect the company’s performance.
Economic Analysis Factors
Savings and investment:
Growth of an economy requires proper amount of investments which in turn is dependent upon
amount of domestic savings. The amount of savings is favorably related to investment in a
country. The level of investment in the economy and the proportion of investment in capital
market is major area of concern for investment analysts. The level of investment in the
economy is equal to: Domestic savings + inflow of foreign capital - investment made abroad.
Stock market is an important channel to mobilize savings, from the individuals who have
excess of it, to the individual or corporate, who have deficit of it. Savings are distributed over
various assets like equity shares, bonds, small savings schemes, bank deposits, mutual fund
units, real estates, bullion etc. The demand for corporate securities has an important bearing on
stock prices movements. Greater the allocation of equity in investment, favorable impact it
have on stock prices.
Price level and Inflation:
The inflation rate is defined as the rate of change in the price level. Most economies face
positive rates of inflation year after year. The price level, in turn, is measured by a price index,
which measures the level of prices of goods and services at given time. The numbers of items
included in a price index vary depending on the objective of the index. Usually three kinds of
price indexes, having particular advantages and uses are periodically reported by government
sources. The first index is called the consumer price index (CPI), which measures the average
retail prices paid by consumers for goods and services bought by them. A couple of thousand
items, typically bought by an average household, are included in this index.

Agriculture and monsoons:

Agriculture is directly and indirectly linked with the industries. Hence increase or decrease in
agricultural production has a significant impact on the industrial production and corporate
performance. Companies using agricultural raw materials as inputs or supplying inputs to
agriculture are directly affected by change in agriculture production. For example- Sugar,
Cotton, Textile and Food processing industries depend upon agriculture for raw material.
Fertilizer and insecticides industries are supplying inputs to agriculture. A good monsoon leads
to higher demand for inputs and results in bumper crops. This would lead to buoyancy in stock
market. If the monsoon is bad, agriculture production suffers and cast a shadow on the share
market.
Government budget and deficit:
Government plays an important role in the growth of any economy. The government prepares
a central budget which provides complete information on revenue, expenditure and deficit of
the government for a given period. Government revenue come from various direct and indirect
taxes and government made expenditure on various developmental activities. The excess of
expenditure over revenue leads to budget deficit. For financing the deficit the government goes
for external and internal borrowings. Thus, the deficit budget may lead to high rate of inflation
and adversely affects the cost of production and surplus budget may results in deflation. Hence,
balanced budget is highly favorable to the stock market.
The tax structure:
The business community eagerly awaits the government announcements regarding the tax
policy in March every year. The type of tax exemption has impact on the profitability of the
industries. Concession and incentives given to certain industry encourages investment in that
industry and have favorable impact on stock market.
Balance of payment, forex reserves and exchange rate:
Balance of payment is the record of all the receipts and payment of a country with the rest of
the world. This difference in receipt and payment may be surplus or deficit. Balance of payment
is a measure of strength of rupee on external account. The surplus balance of payment augments
forex reserves of the country and has a favorable impact on the exchange rates; on the other
hand if deficit increases, the forex reserve depletes and has an adverse impact on the exchange
rates. The industries involved in export and import are considerably affected by changes in
foreign exchange rates. The volatility in foreign exchange rates affects the investment of
foreign institutional investors in Indian Stock Market. Thus, favorable balance of payment
renders favorable impact on stock market.
Infrastructural facilities and arrangements:

Infrastructure facilities and arrangements play an important role in growth of industry and
agriculture sector. A wide network of communication system, regular supply or power, a well
developed transportation system (railways, transportation, road network, inland waterways,
port facilities, air links and telecommunication system) boost the industrial production and
improves the growth of the economy. Banking and financial sector should be sound enough to
provide adequate support to industry and agriculture. The government has liberalized its policy
regarding the communication, transport and power sector for foreign investment. Thus, good
infrastructure facilities affect the stock market favorable.
Demographic factors:

The demographic data details about the population by age, occupation, literacy and geographic
location. These factors are studied to forecast the demand for the consumer goods. The data
related to population indicates the availability of work force. The cheap labor force in India has
encouraged many multinationals to start their ventures. Population, by providing labor and
demand for products, affects the industry and stock market.
Technical analysis :
Technical Analysis can be defined as an art and science of forecasting future prices based on
an examination of the past price movements. Technical analysis is not astrology for predicting
prices. Technical analysis is based on analyzing current demand-supply of commodities,
stocks, indices, futures or any tradable instrument. Technical analysis involve putting stock
information like prices, volumes and open interest on a chart and applying various
patterns and indicators to it in order to assess the future price movements.

The time frame in which technical analysis is applied may range from intraday (1-
minute, 5-minutes, 10-minutes, 15-minutes, 30-minutes or hourly), daily, weekly or monthly
price data to many years.

Technical Analysis: The basic assumptions

The field of technical analysis is based on three assumptions:

• The market discounts everything.

• Price moves in trends.
• History tends to repeat itself.

1. The market discounts everything

Technical analysis is criticized for considering only prices and ignoring the fundamental
analysis of the company, economy etc. Technical analysis assumes that, at any given time, a
stock’s price reflects everything that has or could affect the company - including fundamental
factors. The market is driven by mass psychology and pulses with the fl ow of human
emotions. Emotions may respond rapidly to extreme events, but normally change gradually
over time. It is believed that the company’s fundamentals, along with broader economic
factors and market psychology, are all priced into the stock, removing the need to actually
consider these factors separately. This only leaves the analysis of price movement, which
technical theory views as a product of the supply and demand for a particular stock in the
market.

2. Price moves in trends

Trade with the trend” is the basic logic behind technical analysis. Once a trend has
been established, the future price movement is more likely to be in the same direction as the
trend than to be against it. Technical analysts frame strategies based on this assumption only.

3. History tends to repeat itself

People have been using charts and patterns for several decades to demonstrate patterns in price
movements that often repeat themselves. The repetitive nature of price movements is
attributed to market psychology; in other words, market participants tend to provide a
consistent reaction to similar market stimuli over time. Technical analysis uses chart patterns
to analyze market movements and understand trends.
Technical analysis charts:
Technical analysis of charts aims to identify patterns and market trends by utilising differing forms
of technical chart types and other chart functions. Interpreting charts can be intimidating for novice
traders, so understanding basic technical analysis is essential. This article reveals popular types of
technical analysis charts used in forex trading, outlining the foundations and uses of these chart
types

There are three main types of technical analysis charts: candlestick, bar, and line charts. They are
all created using the same price data but display the data in different ways. As a result, they involve
different types of technical analysis to help traders make informed decisions across forex, stocks,
indices and commodities markets.

Line Charts

A line chart typically displays closing prices and nothing else. Each closing price is linked to the
previous closing price to make a continuous line that is easy to follow.

This type of chart is often used for television, newspapers and many web articles because it is
simple and easy to digest. It provides less information than candlestick or bar charts but it is better
for viewing at a glance for a simplistic market view.

Another advantage of the line chart is that it can assist in managing the emotions of trading by
selecting a neutral colour, like the blue chart depicted above. This is because the line chart
eliminates ‘choppy’ movements in different colours as seen in the bar and candlestick charts.

Expert tip: Due to the line chart illustrating only closed prices, more experienced traders will
consider a line chart to map out the daily closing prices or for situations when the analyst wants to
inspect the sub-waves without the noise.
Bar (HLOC) Charts

A bar chart displays the high, low, open and closing (HLOC) prices for each period designated for
the bar. The vertical line is created by the high and low price for the bar. The dash to the left of the
bar was the opening price and the dash to the right signals the closing price.

Being able to identify whether a bar closes up (green) or down (red), indicates to the trader the
market sentiment (bullish/bearish) for that period.

The similarities between this chart type and a candlestick chart are visible when they are viewed
side by side, but a bar chart is better for a cleaner market view. By removing the bolded colour
from the chart, traders can view market trends with an uncomplicated outlook.
Candlestick Charts

A candlestick chart displays the high, low, open and closing (HLOC) prices for each period
designated for the candle. The “body” of each candlestick represents the opening and closing prices
while the candle “wicks” display the high and low prices for each period.

The colour of each candle depends on the applied settings, but most charting packages will use
green and red as the default colours. The green candles reflect that price closed higher than where
it opened (often called a bullish candle), and every candle that is red means the price closed lower
than where it opened (often called a bearish candle).

The candlestick chart is by far the most popular type of chart used in forex technical analysis as it
provides the trader with more information while remaining easy to view at a glance.
Dow Theory- Meaning and Use
Dow Theory (Dow Jones Theory) is a trading approach developed by Charles Dow. Dow
Theory is the basis of technical analysis of financial markets. The basic idea of Dow Theory
is that market price action reflects all available information and the market price movement is
comprised of three main trends.
The Dow Theory primarily helps traders identify market trends with greater accuracy, so they
can take advantage of potential price action points. It also helps traders act with caution and
not move against the market trends. And above all, the Dow Theory stresses on the
importance of the closing price as a good indicator of the general sentiment of the market.
This is because throughout any trading day, trades can happen all over the place. But as the
closing bell draws nearer, most market participants will want to conform with the trend.
Accordingly, the closing price of a stock is determined, depending on how the traders react as
the trading day draws to a close. This can give you a great deal of insight into where the
market is heading collectively. With these inputs, you can even develop Dow Jones trading
strategies that help you make well-informed trading decisions.
Basic Tenets of Dow Theory
a. The Averages Discount Everything.: Every knowable factor that may possibly affect both
demand and supply is reflected in the market price.
b. The Market Has Three Trends: According to Dow an uptrend is consistently rising peaks
and troughs. And a downtrend is consistently rising lowering peaks and troughs. Dow
believed that laws of action and reaction apply to the markets just as they do to the physical
universe, meaning that each significant movement is followed by a certain pullback. Dow
considered a trend to have three parts:
• Primary (compared to tide, reaching further and further inland until the ultimate point
is reached).
• Secondary (compared to waves and representing corrections in the primary trend,
normally retracing between one-third and two-thirds of the previous trend movement
and most frequently about half of the previous move)
• Minor (ripples) (fluctuations in the secondary trend).
c. Major Trends Have Three Phases: Dow mainly paid attention to the primary (major) trends
in which he distinguished three phases:
• Accumulation phase – the most astute investors are entering the market feeling the
change in the current market direction.
• Public participation phase – a majority of technicians begin to join in as the price is
rapidly advancing.
• Distribution phase – a new direction is now commonly recognized and well hiked;
economic news are all confirming which all ends up in increasing speculative volume
and wide public's participation.
d. The Averages Must Confirm Each Other: Dow used to say that unless both Industrial and
Rail Averages exceed a previous peak, there is no confirmation of inception or continuation
of a bull market. Signals did no have to occur simultaneously, but the quicker one followed
another – the stronger the confirmation was.
e. Volume Must Confirm the Trend: Volume increases or diminishes according to whether
the price is moving in direction of a trend or in reverse. Dow considered volume a secondary
indicator. His buy or sell signals were based on closing prices.
f. A Trend Is Assumed to Be Contiunous Until Definite Signals of Its Reversal: The overall
technical approach in market analysis is based upon the idea that trends continue in motion
until there is an external force causing it to change its direction - just like any other physical
objects. And of course there are reversal signals to be looking for.

Dow only took in consideration closing prices. Averages had to close higher than a previous
peak or lower than a previous trough to be significant. Intraday penetrations did not count.

g. All news is discounted in the stock market: Prices know it all. All possible information and
expectations are factored into prices beforehand.
Efficient Market Hypothesis- Meaning
The Efficient Market Hypothesis (EMH) essentially says that all known information about
investment securities, such as stocks, is already factored into the prices of those securities.
Therefore, assuming this is true, no amount of analysis can give an investor an edge over
other investors, collectively known as "the market."
EMH does not require that investors be rational; it says that individual investors will act
randomly, but as a whole, the market is always "right." In simple terms, "efficient" implies
"normal." For example, an unusual reaction to unusual information is normal. If a crowd
suddenly starts running in one direction, it's normal for you to run in that direction as well,
even if there isn't a rational reason for doing so.
Efficient Market Hypothesis- Assumptions
The efficient market hypothesis only holds if the following assumptions are met:
• All market participants have equal access to historical data on stock prices, and both
public and private information is available. This condition proves that no arbitrage
opportunity is available. Thus, none of the investors has an advantage over the others
in making investment decisions.
• The efficient market hypothesis only holds if investors are rational, i.e., investors are
risk averse. To put it simply, if there are two investments of the same return but of
different risk, a rational investor will always prefer the one with lower risk.
• It is impossible to beat the market in the long run, which means that it is impossible in
the long term to consistently receive returns higher than the market average.
• Stock prices change randomly, i.e., trends or patterns in the past do not allow
someone to forecast their movements in the future. Therefore, the efficient market
hypothesis makes both technical and fundamental analysis completely useless.
Proponents of EMH
After EMH was published by Fama in the 1960s, it remained extremely popular in both
economic and business studies – and most research seemed to back up the assumptions made
by EMH.
Even today, there are still arguments in favour of EMH, including:
• The outperformance of passive funds: The increasing popularity of passive investing
through mutual funds and ETFs is often cited as evidence that people still support EMH.
In theory, if EMH is incorrect and markets are inefficient, then active funds should gain
higher returns than passive funds. However, this often isn’t the case over a long time
period. A study by Morningstar found that over the ten-year period ending June 2019,
just 23% of active funds surpassed the average returns of their passive counterpart.1
Proponents of EMH cite this study, and others like it, as evidence that markets are
efficient and that over the longer-term, EMH holds up. However, an argument has been
made that if passive investing grows too much, it could have an adverse impact on the
efficiency of markets. As active investors support research, trading and market
monitoring, all of which is vital for well-functioning markets. For a truly efficient
market, there needs to be a mix of both passive and active participants. While active
 investors are considered ‘informed’ – in that they have collected all the information
available in order to exploit market inefficiencies – they are still dependant on other
‘uninformed’ traders to take the other side of their trade. But if people opt out of this
risk by trading financial markets passively, then there will be fewer opportunities in
theory. It remains to be seen whether regulatory bodies will take action on the growing
imbalance between active and passive funds in order to maintain market efficiency. The
Financial Conduct Authority (FCA) has previously said that it would consider corporate
governance of how many shares can be owned by passive funds in order to encourage
active investing.
• The presence of arbitrage opportunities: Another argument in favour of EMH is the
presence of arbitragers. These are individuals who buy an asset from one marketplace
and sell the same asset in another to take advantage of price differences. Arbitragers
will look out for an asset whose price is out of line with expectations and bring it back
to its true value – capitalising on the market move as it happens. If we use a long
position as an example, these arbitragers would identify stocks that are trading below
their true value, in order to ‘buy low and sell high’. It is these traders who drive the
asset toward its fundamental value. This is the strategy that underpins the EMH theory,
as it relies on individuals to ensure that market prices reflect the available information
accurately.

Critics of EMH
Over the years, many criticisms of EMH have emerged. We’ve taken a look at just a few of the
popular arguments against the theory, which include:
• Market bubbles and crashes: Speculative bubbles occur when an asset’s price increases
beyond its fair value to the extent that, when the market correction occurs, prices fall
rapidly and a financial crash takes place. According to the efficient market hypothesis,
market bubbles and financial crashes should not occur. In fact, the theory would argue
they cannot exist as an asset’s price is always accurate. For example, Fama actually
argued that the 2008 financial crisis was a result of an impending recession rather than
a credit bubble. He argued that it cannot have been a speculative bubble, as this would
be predictable rather than just seen in hindsight. However, many critiques of Fama’s
explanation point out that the credit bubble was predictable, as evidenced by those who
bet against the credit default option market and made millions. When a financial bubble
occurs, it does not mean that there is no consensus about the price of an asset, it just
means that the consensus is wrong. In the case of the 2008 financial crash, the market
participants were ignoring vital market information in order to keep boosting the credit
options market. This prospect goes against everything that EMH stands for.
• Market anomalies: Market anomalies describe a situation in which there is a difference
between a share price’s trajectory as set out by EMH, and its actual behaviour. In
practice, efficient markets are near impossible to maintain, and the presence of
anomalies is a symptom of this. Market anomalies occur for different reasons, at
different times and have different effects. But they all prove that markets are not always
efficient, and that individuals do not always act rationally. If markets were truly rational
then calendar anomalies such as the January effect, would not exist – because they have
 no true explanation behind them, other than that people believe they will happen. In
some respects, they are a self-fulfilling prophecy. And if the market price contained all
available information then post-earnings-announcement drift would not have such a
hold over the market. This anomaly in particular contradicts EMH theory, as it describes
the phenomena of pricing continuing to move in the direction of an earnings surprise.
If EMH were accurate, then new information would be priced in immediately, however
this anomaly shows that markets can be slower to adjust.
• Behavioural economics: The introduction of the field of behavioural economics has
also been used to criticise EMH. The idea that market participants are, on the whole,
rational has increasingly come into question as we learn more and more about the
psychology of trading. Behavioural economics also goes some way to explaining the
market anomalies described above. Social pressures can cause individuals to make
irrational decisions, which can cause traders to make errors and take on a larger amount
of risk than they otherwise would. Especially the phenomena of herding, which
describes individuals ‘jumping on the bandwagon’, is evidence that not all decisions
are rational and based on information. Even factors such as a trader or investor’s
personality traits or emotions can have a significant impact on how they behave and the
way they interact with the market.
• Investors have beaten the market: There are investors who have consistently beaten the
average market. Of course, the most famous is Warren Buffett – his company Berkshire
Hathaway outperformed the S&P index 73% of the time between 2008 and 2018.
Buffett does not believe the EMH himself and has been a vocal critic of the passive
approach to investing. Instead Buffett takes a value investing approach, which seeks to
identify undervalued stocks through fundamental analysis. Buffett does concede that
EMH is a persuasive enough argument that it is understandable why many investors
choose index funds and ETFs. Buffett himself has never invested in an index fund.
Types of Market Forms
There are three forms of EMH: weak, semi-strong, and strong:
• Weak Form EMH: Suggests that all past information is priced into securities.
Fundamental analysis of securities can provide an investor with information to produce
returns above market averages in the short term, but there are no "patterns" that exist.
Therefore, fundamental analysis does not provide long-term advantage and technical
analysis will not work.
• Semi-Strong Form EMH: Implies that neither fundamental analysis nor technical
analysis can provide an advantage for an investor and that new information is instantly
priced in to securities.
• Strong Form EMH. Says that all information, both public and private, is priced into
stocks and that no investor can gain advantage over the market as a whole. Strong Form
EMH does not say some investors or money managers are incapable of capturing
abnormally high returns because that there are always outliers included in the averages.
EMH does not say that no investors can outperform the market; it says that there are outliers
that can beat the market averages; however, there are also outliers that dramatically lose to the
market. The majority is closer to the median. Those who "win" are lucky and those who "lose"
are unlucky.
Benefits of an efficient market
• Saves Time: Once you are aware that stock markets are efficient than you do not need
to spend too much in analyzing the balance sheet, profit and loss accounts, and technical
charts of stocks as according to this theory they are of no use and one cannot make an
abnormal return by taking the decision on the basis of these tools. In simple words just
like in speculation you place bets on your gut feeling in the same way according to this
theory you should buy or sell stocks according to a gut feeling which requires no
research and analysis.
• Save Money of Innocent Investors: The first and foremost advantage of the efficient
market hypothesis is that it helps in saving money of innocent people who try to enter
into the stock market thinking that they can earn huge money by following the advice
of technical analyst or fundamental analyst as in the case of stock markets small retail
investors come into the stock market at the end of bull markets and end up buying stocks
at inflated levels only to sell them in huge losses. In simple words, the efficient market
hypothesis makes it clear that the stock market should be viewed as a speculative game
and not a place where one can earn a consistent abnormal return by buying undervalued
stocks and selling overvalued stock.
• Neutralizes Self Made Experts: Another benefit of this theory is that once you know
that the stock market is efficient and reflects the true value of stocks that you will not
get into the trap of buying blindly any stock on the basis of the recommendation of self-
made experts who keep giving advice regarding stocks on various social media
platforms as the majority of people end up burning their pocket by investing in the
stocks on the basis of the recommendation of self-made experts.

Limitations of an efficient market

• Markets are Irrational: The first and foremost disadvantage of the efficient market
hypothesis is that while this theory argues that markets are efficient but history is filled
with examples where stock markets become irrational due to panic and stocks were
available at throwaway prices and people made a lot of money by buying stocks at
throwaway prices. Hence the argument that market timing can do nothing fails due to
the irrational nature of stock markets and an individual can make money by buying
undervalued stocks during the market crash and selling overvalued stocks during
market exuberance.
• Fundamental and Technical Analysis Works: The argument that fundamental analysis
and technical analysis are a waste of time is also not correct because just chances of
accidents happening due to the bad driver are more as compared to a good driver in the
same way while there can bad fundamental analyst or technical analyst but saying that
fundamental and technical analysis is of no use is not the right thing to say as there are
many people who have to earn consistent above normal return following fundamental
analysis and technical analysis.
• Stock Markets is not Gambling: The argument that stock markets is nothing but
speculation is flawed as in the case of gambling one places bets on the basis of his or
her gut feeling but when it comes to stock markets one takes risks but it is not only on
the basis of gut feeling but other factors like the financial position of the company,
market trend, technical trends, economic and stocks specific news and so on. In simple
words risks taken in stock markets are calculated ones as opposed to gambling which
is nothing but pure speculation.
Meaning of Portfolio management
The art and science of making decisions about investment mix and policy, matching
investments to objectives, asset allocation for individuals and institutions, and balancing risk
against performance.
Portfolio management is all about strengths, weaknesses, opportunities and threats in the
choice of debt vs. equity, domestic vs. international, growth vs. safety, and many other
tradeoffs encountered in the attempt to maximize return at a given appetite for risk.
Portfolio management is the professional asset management of various securities (shares,
bonds and other securities) and other assets (e.g., real estate) in order to meet specified
investment goals for the benefit of the investors. Investors may be institutions (insurance
companies, pension funds, corporations, charities, educational establishments etc.) or private
investors (both directly via investment contracts and more commonly via collective
investment schemes e.g. mutual funds.
Scope of Portfolio management
Portfolio management is a continuous process. It is a dynamic activity. The following are the
basic operations of a portfolio management.
• Monitoring the performance of portfolio by incorporating the latest market conditions.
• Identification of the investor’s objective, constraints and preferences.
• Making an evaluation of portfolio income (comparison with targets and achievement).
• Making revision in the portfolio.
• Implementation of the strategies in tune with investment objectives.
Nature of Portfolio management
• Stable Current Return: Once investment safety is guaranteed, the portfolio should yield
a steady current income. The current returns should at least match the opportunity cost
of the funds of the investor. What we are referring to here current income by way of
interest of dividends, not capital gains.
• Marketability: A good portfolio consists of investment, which can be marketed without
difficulty. If there are too many unlisted or inactive shares in your portfolio, you will
face problems in encasing them, and switching from one investment to another. It is
desirable to invest in companies listed on major stock exchanges, which are actively
traded.
• Tax Planning: Since taxation is an important variable in total planning, a good portfolio
should enable its owner to enjoy a favorable tax shelter. The portfolio should be
developed considering not only income tax, but capital gains tax, and gift tax, as well.
What a good portfolio aims at is tax planning, not tax evasion or tax avoidance.
• Appreciation in the value of capital: A good portfolio should appreciate in value in
order to protect the investor from any erosion in purchasing power due to inflation. In
other words, a balanced portfolio must consist of certain investments, which tend to
appreciate in real value after adjusting for inflation.
• Liquidity: The portfolio should ensure that there are enough funds available at short
notice to take care of the investor’s liquidity requirements. It is desirable to keep a line
 of credit from a bank for use in case it becomes necessary to participate in right issues,
or for any other personal needs.
• Safety of the investment: The first important objective of a portfolio, no matter who
owns it, is to ensure that the investment is absolutely safe. Other considerations like
income, growth, etc., only come into the picture after the safety of your investment is
ensured.
Markowitz theory
Before the development of Markowitz theory, combination of securities was made through
“simple diversification”. The layman could make superior returns on his investments by
making a random diversification in his investments.
A portfolio consisting of securities of a large number will always bring a superior return than
a portfolio consisting of ten securities because the portfolio is ten times more diversified.
The simple diversification would be able to reduce unsystematic or diversifiable risk. In
securities, both diversifiable and un-diversifiable risks are present and an investor can expect
75% risk to be diversifiable and 25% to be un-diversifiable.
Simple diversification at random would be able to bring down the diversifiable risk if about 10
to 15 securities are purchased. Unsystematic risk was supposed to be independent in each
security. Many research studies were made on diversification of securities. It was found that
10 to 15 securities in a portfolio would bring adequate returns. Too much diversification would
also not yield the expected return.
Some experts have suggested that diversification at random does not bring the expected return
results. Diversification should, therefore, be related to industries which are not related to each
other. Many industries are correlated with each other in such a way that if the stock of ‘X’
increases in price the stock of ‘Y’ also increases and vice versa.
By looking at the trends, industries should be selected in such a way that they are unrelated to
each other. A person having on his portfolio about 8 to 10 securities will reduce his risk but if
he has too many securities as described above it would not lead to any gain.
If systematic risk is reduced by simple diversification, research studies have shown that an
investor should spread his investments but he should not spread himself in so many investments
that it leads to “superfluous diversification”. When an investor has too many assets on his
portfolio he will have many problems. These problems relate to inadequate return.
It is very difficult for the investor to measure the return on each of the investments that he has
purchased. Consequently, he will find that the return he expects on the investments will not be
up to his expectations by over- diversifying.
The investor will also find it impossible to manage the assets on his portfolio because the
management of a larger number of assets requires knowledge of the liquidity of each
investment, return; the tax liability and this will become impossible without specialized
knowledge.
An investor will also find it both difficult and expensive to look after a large number of
investments. This will also have the effect of cutting into the profits or the return factor on the
investments.
If the investor plans to switch over investments by selling those which are unprofitable and
purchasing those which will be offering him a high rate of return, he will involve himself in
high transaction costs and more money will be spent in managing superfluous diversification.
The research studies have shown that random diversification will not lead to superior returns
unless it is scientifically predicted. Markowitz theory is also based on diversification. He
believes in asset correlation and in combining assets in a manner to lower risk.

Assumptions
(1) The market is efficient and all investors have in their knowledge all the facts about the stock
market and so an investor can continuously make superior returns either by predicting past
behaviour of stocks through technical analysis or by fundamental analysis of internal company
management or by finding out the intrinsic value of shares. Thus, all investors are in equal
category.
(2) All investors before making any investments have a common goal. This is the avoidance of
risk because they are risk averse.
(3) All investors would like to earn the maximum rate of return that they can achieve from their
investments.
(4) The investors base their decisions on the expected rate of return of an investment. The
expected rate of return can be found out by finding out the purchase price of a security dividend
by the income per year and by adding annual capital gains. It is also necessary to know the
standard deviation of the rate of return expected by an investor and the rate of return which is
being offered on the investment. The rate of return and standard deviation are important
parameters for finding out whether the investment is worthwhile for a person. Markowitz
brought out the theory that it was a useful insight to find out how the security returns are
correlated to each other. By combining the assets in such a way that they give the lowest risk
maximum returns could be brought out by the investor. From the above, it is clear that every
investor assumes that while making an investment he will combine his investments in such a
way that he gets a maximum return and is surrounded by minimum risk.
(5) The investor assumes that greater or larger the return that he achieves on his investments,
the higher the risk factor surrounds him. On the contrary, when risks are low the return can also
be expected to be low.
(6) The investor can reduce his risk if he adds investment to his portfolio.
(7) An investor should be able to get higher return for each level of risk “by determining the
efficient set of securities”.
Pros and Cons of Markowitz theory
Pros Explained
No timing the market: Most investors want to maximize their returns for minimal risk but don't
have the time, knowledge, or emotional distance to be successful at market timing.
Suitable for average investor: An average investor can benefit from applying MPT or
incorporating its key ideas to achieve a balanced portfolio that is set up for long-term growth.
Decreases risk in investing: Spreading your investments across assets that aren't positively
correlated protects you from changes in the market.
 Cons Explained
Not based on modern data: The concepts of risk, reward, and correlation that underlie MPT are
derived from historical data. This data may not be applicable to new circumstances in the
market.
Standardized assumptions: MPT functions bases on a standardized set of assumptions about
market behavior. These assumptions may not bear out in a constantly changing financial
climate.
Problem 1: Stocks L and M have yielded the following returns for past 2 years.
Years Stock L Stock M
(Returns) (Returns)
2014 12% 14%
2015 18% 12%
a. What is the expected return on portfolio made up of 60% of Stock L and 40% of Stock M
b. Find out the standard deviation of each stock

Problem 2: The expected rate of returns and possibilities of their occurrence for Alpha Co.
and Beta Co. stocks are given below:
Possibility of occurrence Returns of Alpha Co. stock Returns of Beta Co. stock
0.05 -2 -3
0.20 9 6
0.50 12 11
0.20 15 14
0.05 26 19

a. Find out the expected rate of return for Alpha Co. and Beta Co. stocks
b. If an investor invests equally in both the stocks what would be the return?
c. If the proportion is changed to 25% and 75% and then 75% and 25% what would be the
expected rate of return?

Problem 3: Stocks X and Y displays the following returns over the past 3 years
Years X (Returns) Y (Returns)
2010 14% 12%
2011 17% 19%
2012 20% 18%

a. What is the expected return on a portfolio made up of 40% of X and 60% of Y

b. What is the Standard Deviation of each stock?
Problem 4: Stocks A and B have yielded the following.
Years Stock A Stock B
(Returns) (Returns)
2014 20% 25%
2015 33% 40%
a. What is the expected return on a portfolio made up of 50% of Stock A and 50% of Stock B
b. Find out the standard deviation of each stock
c. What is the covariance and co-efficient of correlation between stocks A and B
d. What is the portfolio risk of a portfolio made up of 50% of Stock A and 50% of Stock B

Problem 5: Stocks X and Y displayed the following returns over the past 3 years:
Years Stock X Stock Y
2010 16% 13%
2011 18% 21%
2012 22% 19%
a. What is the expected return on a portfolio made up of 40% of X and 60% of Y?
b. What is the Standard Deviation of each stock?
c. Determine the correlation of co-efficient and covariance of X and Y
d. What is the portfolio risk of a portfolio made up of 40% of X and 60% of Y

Problem 6: A Financial analyst is analyzing two investment alternatives Stock Y and Z, the
estimated rates of returns and their chances of occurrences are given below

Possibility of occurrence (prob) Return on Y stocks Return on Z stocks

0.20 22 5
0.60 14 15
0.20 -4 25
a. Determine expected rate of return and standard deviation of stocks Y and Z
b. Is Y comparatively riskless?
c. If the financial analyst wishes to invest half in Y and half in Z would it reduce the risk?
CAPM Theory- Meaning
The capital asset pricing model is a formula that can be used to calculate an asset’s expected
return versus its systematic risk. An asset’s expected return refers to the loss or profit that you
anticipate based on its anticipated or known rate of return. The capital market line is a tangent
line and represents asset and investment mixtures that provide an optimal combination of risk
and returns.
You figure out the expected return of an asset by multiplying the potential outcomes by the
chances that they will occur. Finally, you total your results. The systematic risk is the risk that
is unpredictable and that is intrinsic to the whole market instead of a specific industry or stock.
The CAPM gives investors a simple calculation that they can use to get a rough estimate of the
return that they might expect from an investment versus the risk of the outlay of capital. The
capital asset pricing model helps you to understand the importance of diversification. Investors
who follow the CAPM model choose assets that fall on the capital market line by lending or
borrowing at the risk-free rate.

CAPM Theory- Assumptions

1. Risk-averse investors: The investors are basically risk averse and diversification is necessary
to reduce their risks.
2. Maximising the utility of terminal wealth: An investor aims at maximizing the utility of his
wealth rather than the wealth or return. The term ‘Utility’ describes the differences in individual
preferences. Each increment of wealth is enjoyed less than the last as each increment is less
important in satisfying the basic needs of the individual. Thus, the diminishing marginal utility
is most applicable to wealth. There are also other forms of utility functions. Some investors
showing a preference for larger risks are those who have increasing marginal utility for wealth.
In such cases, each increase in wealth prompts the individual to acquire more wealth. For a
risk-neutral investor, each increment in wealth is equally attractive. In other words, each
increment would have the same utility for him.
3. Choice on the basis of risk and return: Investors make investment decisions on the basis of
risk and return. Risk and return are measured by the variance and the mean of the portfolio
returns. CAPM assumes that the rational investors put away their diversifiable risk, namely,
unsystematic risk. But only the systematic risk remains which varies with the Beta of the
security. Some investors use the beta only to measure the risk while other investors use both
beta and variance of returns as the sources of reward. As individuals have varying perceptions
towards risk and reward, CAPM gives a series of efficient frontlines.
4. Similar expectations of risk and return: All investors have similar expectations of risk and
return. In other words, all investors’ estimates of risk and return are the same. When the
expectations of the investors differ, the estimates of mean and variance lead to different
forecasts. As a result, there will be innumerable efficient frontiers and the efficient portfolio
of each will be different from that of the others. Varying preferences also imply that the price
of an asset will be different for different investors.
5. Identical time horizon: The CAPM is based on the assumption that all investors have
identical time horizon. The core of this assumption is that investors buy all the assets in their
portfolios at one point of time and sell them at some undefined but common point in future.
This assumption further implies that investors form portfolios to achieve wealth at a single
common terminal rate.
This single common horizon enables one to construct a single period model. This assumption
is highly unrealistic as investors are short-term speculators. Further, the horizon is chosen on
the basis of the characteristics of an asset. So investors have different time horizons and their
estimates of stock value vary even when the estimated earnings remain constant. Instead of
single period model, investors generally adopt continuous time models as if they make a series
of reinvestments.
6. Free access to all available information: One of the important assumptions of the CAPM is
that investors have free access to all the available information at no cost. Supposing some
investors alone are able to have access to special information which is not readily available to
all, then the markets would not be regarded efficient. In other words, if the available
information has not reached all, it will be difficult to draw a common efficient frontier line.
7. There is risk-free asset and there is no restriction on borrowing and lending at the risk free
rate: This is a very important assumption of the CAPM. The risk free asset is essential to
simplify the complex pairwise covariance of Markowitz’s theory. The risk free asset makes the
curved efficient frontier of MPT to the linear efficient frontier of the CAPM simple. As a result,
the investors will not concentrate on the characteristics of individual assets. By adding a portion
of risk-free assets to the portfolio and borrowing the additional funds needed at a risk free rate,
the risk is either decreased or increased.
8. There are no taxes and transaction costs: According to Roll, there must be either a risk free
asset or a portfolio of short sold securities. Then only the capital Market Line (CML) will be
straight. When there are no risk free assets, the investor could not create a proxy risk free asset.
As a result, the capital market line would not be linear and the direct linear relationship between
risk and return would not exist.
9. Total availability of assets is fixed and assets are marketable and divisible: This assumption
holds the view that the total asset quantity is fixed and all assets are marketable. However,
models have been developed to include unmarketable assets which are more complex than the
basic CAPM.

CAPM Theory- Advantages

• It considers only systematic risk, reflecting a reality in which most investors have
diversified portfolios from which unsystematic risk has been essentially eliminated.
• It is a theoretically-derived relationship between required return and systematic risk
which has been subject to frequent empirical research and testing.
• It is generally seen as a much better method of calculating the cost of equity than the
dividend growth model (DGM) in that it explicitly considers a company’s level of
systematic risk relative to the stock market as a whole.
 • It is clearly superior to the WACC in providing discount rates for use in investment
appraisal.

CAPM Theory- Disadvantages

• Assigning values to CAPM variables: To use the CAPM, values need to be assigned to
the risk-free rate of return, the return on the market, or the equity risk premium (ERP),
and the equity beta. The yield on short-term government debt, which is used as a
substitute for the risk-free rate of return, is not fixed but changes regularly with
changing economic circumstances. A short-term average value can be used to smooth
out this volatility. Finding a value for the equity risk premium (ERP) is more difficult.
The return on a stock market is the sum of the average capital gain and the average
dividend yield. In the short term, a stock market can provide a negative rather than a
positive return if the effect of falling share prices outweighs the dividend yield. It is
therefore usual to use a long-term average value for the ERP, taken from empirical
research, but it has been found that the ERP is not stable over time. In the UK, an ERP
value of between 3.5% and 4.8% is currently seen as reasonable. However, uncertainty
about the ERP value introduces uncertainty into the calculated value for the required
return. Beta values are now calculated and published regularly for all stock exchange-
listed companies. The problem here is that uncertainty arises in the value of the
expected return because the value of beta is not constant, but changes over time.

• Using the CAPM in investment appraisal: Problems can arise in using the CAPM to
calculate a project-specific discount rate. For example, one common difficulty is
finding suitable proxy betas, since proxy companies very rarely undertake only one
business activity. The proxy beta for a proposed investment project must be
disentangled from the company’s equity beta. One way to do this is to treat the equity
beta as a portfolio beta (βp), an average of the betas of several different areas of proxy
company activity, weighted by the relative share of the proxy company market value
arising from each activity.
Problems on CAPM

1) Security J has a beta of 0.75 while Security K has beta of 1.45. Calculate the respected
rate of return for these securities assuming that the risk free rate of return is 5 % expected
return on the market is 14 %

2) The following data are available

Securities Estimated return Beta ( B)
A 30 % 2
B 25 % 1.5
C 20 % 1.0
D 11.5 % 0.8
E 10 % 0.5

Market index (returns) = 15 %

Government security returns= 7 %

Which of the above securities are undervalued?

Capital Market Line- Meaning
The Capital Market Line is a graphical representation of all the portfolios that optimally
combine risk and return. CML is a theoretical concept that gives optimal combinations of a
risk-free asset and the market portfolio. The CML is superior to Efficient Frontier in the sense
that it combines the risky assets with the risk-free asset.

• The slope of the Capital Market Line(CML) is the Sharpe Ratio of the market
portfolio.
• The efficient frontier represents combinations of risky assets.
• If we draw a line from the risk-free rate of return, which is tangential to the efficient
frontier, we get the Capital Market Line. The point of tangency is the most efficient
portfolio.
• Moving up the CML will increase the risk of the portfolio, and moving down will
decrease the risk. Subsequently, the return expectation will also increase or decrease,
respectively.

All investors will choose the same market portfolio, given a specific mix of assets and the
associated risk with them.
Capital Market Line- Formula

The Capital Market Line (CML) formula can be written as follows:

ERp = Rf + SDp * (ERm – Rf) /SDm

where,

• Expected Return of Portfolio

• Risk-Free Rate
• Standard Deviation of Portfolio
• Expected Return of the Market
• Standard Deviation of Market

Assumptions of Capital Market Line

The key problem of capital market line in real markets conditions is that CML is based on the
same assumptions as capital asset pricing model CAPM).
• There are taxes and transaction costs, which can significantly differ for various
investors.
• It is supposed that any investor can ether lend or borrow unlimited amount at risk-free
rate. In real market conditions investors can lend at lower rate than borrow, that brings
to bend of CML like on figure below.
• Real markets don’t have strong form of efficiency, so investors have unequal to
information.
• Not all investors are rational and risk-averse.
• Standard deviation isn’t the only risk measurement, because real markets are subject
to inflation risk, reinvestment risk, currency risk etc.
• There are no risk-free assets.

Security Market Line- Meaning

The security market line (SML) is the graphical representation of the Capital Asset Pricing
Model (CAPM) and gives the expected return of the market at different levels of systematic or
market risk. It is also called ‘characteristic line’ where the x-axis represents beta or the risk of
the assets, and the y-axis represents the expected return.
Security Market Line - Formula
The Equation is as follows:
SML: E(Ri) = Rf + βi [E(RM) – Rf]
In the above security market line formula:
E(Ri) is the expected return on the security
Rf is the risk-free rate and represents the y-intercept of the SML
βi is a non-diversifiable or systematic risk. It is the most crucial factor in SML. We will discuss
this in detail in this article.
E(RM) is expected to return on market portfolio M.
E(RM) – Rf is known as Market Risk Premium

Security Market Line- Characteristics

• SML is a good representation of investment opportunity cost, which provides a
combination of the risk-free asset and the market portfolio.
• Zero-beta security or zero-beta portfolio has an expected return on the portfolio,
which is equal to the risk-free rate.
• The slope of the Security Market Line is determined by market risk premium, which
is: (E(RM) – Rf). Higher the market risk premium steeper the slope and vice-versa
• All the assets which are correctly priced are represented on SML.
• The assets above the SML are undervalued as they give the higher expected return for
a given amount of risk.
 • The assets which are below the SML are overvalued as they have lower expected
returns for the same amount of risk.

Security Market Line- Assumptions

Since the security market line is a graphical representation of the capital asset pricing model
(CAPM), the assumptions for CAPM also hold for SML. Most commonly, CAPM is a one-
factor model that is only based on the level of systematic risk a security is exposed to.
The larger the level of systematic risk, the larger the expected return for the security is – more
risk equals more reward. It is a linear relationship and explains why the security market line is
a straight line. However, very broad assumptions need to be made for a one-factor model to be
upheld. Below are some SML assumptions:
• All market participants are price takers and cannot affect the price of a security.
• The investment horizon for all investors is the same.
• There are no short sales.
• There are no taxes or transaction costs.
• There is only one risk-free asset.
• There are multiple risky assets.
• All market participants are rational.

Security Market Line- Disadvantages

• The risk-free rate is the yield of short-term government securities. However, the risk-
free rate can change with time and can have even shorter-term duration, thus causing
volatility
• The market return is the long-term return from a market index that includes both
capital and dividend payments. The market return could be negative, which is
generally countered by using long-term returns.
• Market returns are calculated from past performance, which cannot be taken for
granted in the future.
• The slope of SML, i.e., market risk premium and the beta coefficient, can vary with
time. There can be macroeconomic changes like GDP growth, inflation, interest rates,
unemployment, etc. which can change the SML.
• The significant input of SML is the beta coefficient; however, predicting accurate beta
for the model is difficult. Thus, the reliability of expected returns from SML is
questionable if proper assumptions for calculating beta are not considered.
Sharpe’s model- Meaning
Markowitz Model had serious practical limitations due to the rigours involved in compiling
the expected returns, standard deviation, variance, covariance of each security to every other
security in the portfolio. Sharpe Model has simplified this process by relating the return in a
security to a single Market index. Firstly, this will theoretically reflect all well traded
securities in the market. Secondly, it will reduce and simplify the work involved in compiling
elaborate matrices of variances as between individual securities.
If thus the market index is used as a surrogate for other individual securities in the portfolio,
the relation of any individual security with the Market index can be represented in a
Regression line or characteristic line. This is drawn below, with the excess return on the
security on the y-axis and excess return on the Market Portfolio on the x-axis.
The equation of the characteristic line is Ri – Rf = a + βim (Rm – Rf) + ei
Ri is the holding period return on security i
Rf is the riskless rate of interest
Alpha is the vertical intercept on y-axis representing the return on the security when only
unsystematic risk is considered and systematic risk is measured by Beta. ci is the residual
component, not captured by the above variables.

The sharpe equation is as follows:

Rj = αj + βj + ej
• Where αj is some constant, say risk free return
• βj is the Beta which is a risk measure of the market called systematic risk
• ej is the value or return on the stock index.
 • ej is the residual factor which cannot be specified.

Sharpe’s model- Assumptions

The calculation of Sharpe ratio pivots on the assumption that returns are normally distributed,
but in real market scenarios, the distribution might suffer from kurtosis and fatter tails, which
decreases the relevance of its use.
Sharpe ratio cannot differentiate between intermittent and consecutive losses as the risk
measure is independent of the order of various data points. Thus, while it is good for long
term analysis, it might be counterproductive if we decide on a portfolio which has a
significant share of stocks which are losing value in the past few trading periods.
Another notable drawback of Sharpe ratio is that it cannot distinguish between upside and
downside and focuses on volatility but not its direction. The ratio would penalize a system
which exhibited sporadic sharp increases in equity, even if equity retracements were small.
As with most parameters, Sharpe ratios is backwards-looking and accounts for historical
returns and volatility. The decisions based on the ratio assume future performance will be
similar to the past.
It can be manipulated by individuals to present their best side. If the three-year Sharpe ratio
of a portfolio does not present an interesting proposition, the fund manager could, in theory,
calculate a 5 year time period knowing that the portfolio had performed well before.
Sharpe Theory Problem 1:
Securities Weightage αi βi Residual
Variance
σ2
1 0.2 2 1.2 320
2 0.3 1.7 0.8 450
3 0.1 -0.8 1.6 270
4 0.4 1.2 1.3 180

Calculate the return and risk of the portfolio under the single index model if the return on market
index is 16.4% and the standard deviation of return on market index is 14%

Sharpe Theory Problem 2: Consider a portfolio of 6 securities with the following characteristics
Securities Weightage αi βiResidual
Variance
σ2
1 0.10 -0.28 0.91 23
2 0.15 -0.76 0.87 60
3 0.20 2.52 1.17 52
4 0.10 0.16 0.97 86
5 0.25 1.55 1.07 67
6 0.20 0.47 0.86 82
Assuming return on Market Index to be 14.5% and the S.D. of returns on market index to be 16%,
calculate portfolio return and risk under single index model.