CHAPTER THREE

INVESTMENT PROCESS AND

ALTERNATIVES
 3.1. Concept of Investment
 An investment is the current commitment of money or other resources in the
expectation of reaping future benefits that will compensate the investor for
(1) The time the funds are committed,
(2) The expected rate of inflation, and
(3) The uncertainty of the future payments.

For example, an individual might purchase shares of stock anticipating that the future
proceeds from the shares will justify both the time that the money is tied up as well as
the risk of the investment.
 Two type of investment
1) Economic Investment: undertaken with an expectation of increasing the current
economy’s capital stock that consists of goods and services.
 The capital stock of the society is the goods which are used in the production of

other goods.
 The term investment implies the formation of new and productive capital in the

form of new construction and producers durable instrument such as plant and
machinery.
 Inventories and human capital are also included in this concept.
 Thus, an investment, in economic terms, means an increase in building, equipment,
and inventory.
 Cont…
2) Financial Investment: It is the commitment on financial asset.
 It means an exchange of financial claims such as shares, bonds, debentures, fixed

deposits, national saving certificates, life insurance policies, provident fund etc.
 Here, investment can be defined as a commitment of funds to derive future income

in the form of
 interest, dividends, premiums, pension benefits and the appreciation of the value of their
principal capital.
 Cont…
 In primitive economies most investments are of the real variety whereas in a
modern economy much investment is of the financial variety.
 Elements of Investments
a) Return: Investors buy or sell financial instruments in order to earn return on
them.
 The return on investment is the reward to the investors.

 The return includes both current income and capital gain, which arises by the

increase or decrease of the security price or real asset price.

 The expectation of return from an investment depends upon the nature of

investment, maturity period, market demand, and so on.

 Cont…
b) Risk: Risk may relate to loss of capital, delay in repayment of capital, nonpayment
of interest, or variability of returns.
 The risk of an investment is determined by the investment’s maturity period,

repayment capacity, nature of return commitment, and so on.

 Risk and return are inseparable.

 Theoretically, the higher the risk, higher is the expected return. The higher return is

a compensation expected by investors for their willingness to bear the higher risk.
 The investment process should be considered in terms of both risk and return.
 Cont…
c) Safety: identified with the certainty of return of capital without loss of money or
time.
 Investment safety is gauged through the reputation established by the borrower of

funds.
 A highly reputed and successful corporate entity assures the investors of their initial

capital.
d) Time: time is an important factor in investment.
 Time period depends on the attitude of the investor who follows a ‘buy and hold’

policy.
 As time moves on, analysis believes that conditions may change and investors may

revaluate expected returns and risk for each investment.

 Cont…
e) Liquidity: it is also important factor to be considered while making an investment.
 It refers to the ability of an investment to be converted into cash, when required.

 The investor wants his money back any time.

 Therefore, the investment should provide liquidity to the investor.

 A well-developed secondary market for securities increases the liquidity of the

instruments traded therein.

 Cont…
f) Tax Saving: The investors often get the benefit of tax exemption from the
investments.
 There are certain investments which provide tax exemption to the investor.

 The tax saving investments increases the return on investment.

 Therefore, the investors should also think of saving income tax and invest money in

order to maximize the return on investment.

 Forms of investment
1. Shares
 It implies, a share in a company or you own part of the company, including its

assets.
 You are also entitled to a share of the profits.

 In addition, people also invest in shares to make money from changes in the

share price.
 Share prices, which are available in secondary market, are quoted on the stock

market.
 Its price is not set by an authority or organization.
 Instead, it represents the amount that someone is prepared to pay for that share.
 Cont…
 The price you see quoted is, typically, the last price that was paid for that
share by an investor.
 Owning certain types of shares means you can also have a say in how that
company is run.
 Shareholders are entitled to vote on certain decisions at the company’s annual
general meeting.
 Cont…
2. Fixed income securities (bonds)
 A fixed income security is a type of loan.

 It has a repayment date and charges interest.

 They are used by governments or companies to raise money.

 They are often just called bonds, but

 UK government bonds are also known as gilt-edged securities or gilts, and

 bonds issued by companies are known as corporate bonds.
 Bonds usually pay regular interest and are repaid in full on the repayment
date.
 Cont…
3. Property
 It’s been a very profitable type of investment over the last 10 years

 However, direct property investment can be quite risky and hard to cash in if

the property market falls.

 Fund managers also invest in property.

 They won’t often buy properties directly, although they might do depending on the
nature of their investment fund.
 More often they will invest in companies that manage properties.
 They might also invest in other funds that specialize in property investing,
known as real-estate investment trusts.
 Cont…
4. Commodities
 A commodity is a natural resource that can be processed and sold.
 Commodities that are tracked in the markets include agricultural goods,
metals, energy and minerals, among others.
 There are two general categories of commodities:
 Soft commodities are typically grown, whereas
 hard commodities are usually mined or extracted.
 Cont…
 There are several ways to consider investing in commodities.
 One way is to purchase varying amounts of physical raw commodities.
 This isn’t the most favorable option for institutional investors,
 The other one is to invest through the use of futures contracts.
 A future contract is an agreement between two parties to exchange, at some
fixed future date, a given quantity of a commodity for a price defined when
the contract is finalized.
 Cont…
 Another way to gain exposure to commodities is through mixed equity and
futures investment funds.
 These funds usually invest in a variety of commodities as well as commodity-
related businesses.
 For instance, a fund could own equity shares in companies involved in storage,
machinery or distribution while also holding future contracts in wood, coffee and
iron.
 Cont…
5. Liquidity funds (cash)
 Most investment funds have an allocation to cash, but this doesn’t mean that

the manager is keeping piles of fifty pound notes in his or her drawer.
 What cash actually means in this context is closer to the types of fixed-interest

savings.
 These types of investment are also known as money market or liquidity funds.

 These are called liquidity funds because they are very easy to convert to cash

when the fund manager needs it.

 They carry very little investment risk, as they always pay a set amount, but

they can be subject to inflation risk.

 Cont…
6. Private Credit
 Private credit is a type of loan.
 Unlike gilts and bonds, which are bought and sold via public stock markets, private
credit is negotiated directly between the investor and the borrower.
 While the word ‘private’ refers to the type of investment, the borrower doesn’t have
to be a private company.
 Loans can be raised by private companies, public companies, corporate groups,
subsidiaries of companies, or even entities that are specifically set up to finance
projects like building shopping centers, apartment buildings or wind farms, or
developing new technologies like artificial intelligence (AI) or blockchain.
 Objectives of investment
 To Keep Money Safe
 To Help Money Grow
 To Earn a Steady Stream of Income
 To Minimize the Burden of Tax
 To Save up for Retirement
 To Meet your Financial Goals
 Types of Investors
 On the basis of their risk bearing capacity:
 Risk averse: chooses instruments that do not show much variation in returns.
 Risk seeker: is capable of assuming a higher risk

 Risk bearers fall in between these two categories.

 They assume moderate levels of risk.
 The risk bearing capacity of an investor is a function of
 personal, economic, environmental, and situational factors such as income, family
size, expenditure pattern, and age.
 A person with a higher income is assumed to have a higher risk-bearing
capacity.
 Cont…
 On the basis of groups as individuals or institutions:
 Individual investors
 Institutional investors
 Individual investors operate alongside institutional investors in the investment
market.
 They are large in number, but in terms of value of investment they are
comparatively smaller.
 Cont…
 Institutional investors are organizations with surplus funds beyond immediate
business needs or organizations whose business objective is investment.
 Mutual funds, investment companies, banking and non-banking companies,
insurance corporations, and so on are examples.
 They are fewer in number compared to individual investors, their resources are much
larger.
 They engage professional fund managers to carry out extensive analysis.

 Institutional investors and individual investors combine to make the investment

market dynamic.
 Investment Vs Speculation
 Both involve the purchase of assets such as shares and securities, with an
expectation of return.
 However, investment can be distinguished from speculation by risk bearing
capacity, return expectations, and duration of trade.
 A share market needs both investment and speculative activities.
 Speculative activity adds to the market liquidity
 Cont…
Speculator
 prepared to take higher risks for higher returns.
 Focuses more on returns than safety, thereby
encouraging frequent trading without any intention
of owning the investment.
 motive is to achieve profits through price changes,
 capital gains are more important than the direct
income from an investment.
 trades frequently; hence, the holding period of
securities is very short.
 seeks very large returns from the market quickly.
 Market expectations and price movements are the
main factors influencing a buy or sell decision.
 It is more risky than investment.
Investor
 prefers low risk investments,
 are careful while selecting securities for
trading.
 expect an income in addition to the capital
gains.
 Investment is long term in nature.
 An investor commits funds for a longer
period in the expectation of holding period
gains.
 interested in a good rate of return on a
consistent basis over a relatively longer
duration.
 computes the real worth of the security
before investing in it.
 Investment Vs Gambling
 Examples of gambling are horse race, card games, lotteries, and so on.
 Gambling involves high risk not only for high returns but also for the
associated excitement.
 Gambling is unplanned and unscientific, without the knowledge of the nature
of the risk involved.
 It is surrounded by uncertainty and a gambling decision is taken on unfounded
market tips and rumors.
 In gambling, artificial and unnecessary risks are created for increasing the
returns.
 Cont…
 Investment is an attempt to carefully plan, evaluate, and allocate funds to
various investment outlets that offer safety of principal and expected returns
over a long period of time.
 Hence, gambling is quite the opposite of investment even though the stock
market has been euphemistically referred to as a “gambling den”.
 Speculator Vs Gambling
 They are differentiated on the basis of their approach to trading and
expectations.
 Speculation is a calculated move with an expectation to reap huge profits from
the market.
 A speculator is able to bear losses but would not tolerate continuous losses if
not compensated by gains.
 Gambling, is betting and reckless trading.
 A gambler could lose all capital in the trading process, based on his emotions.
 Hedging
 Risk reduction is known as hedging.
 Any investment activity inherently has an element of risk.
 By using derivative instruments, investors try to minimize risk.
 Thus, the risk reduction practices of investors using derivative instruments are
called as hedging activities.
 Investment Process
 Goal Setting: a formal assessment of your needs, goals, tolerance for risk and
timeframe.
 Portfolio Construction: divided into two primary parts: asset allocation and
investment selection.
 Asset allocation determines how your investment assets are allocated across the
different investment classes defined broadly as equities, fixed income securities,
money market instruments, and real assets.
 It is also framed in terms of investments in domestic securities vs international assets.
 Investment selection is the step where the stocks, bonds and real assets that make up
the equity, fixed income and real asset component are selected for your portfolio.
 Cont…
 Implementation: Executing your plan.
 Execute through the purchase and sale of assets or securities, resulting in your
investment portfolio.
 Portfolio Monitoring and Evaluation: The care and maintenance of your
portfolio over time.
 Any changes in your objectives, risk tolerance, income, net worth or liquidity needs
or changes that take place in your life, like marriage or divorce, the birth of a child or
death of a spouse will require your investment plan to be updated accordingly.
 The process involves constant monitoring of the economy and capital markets while
continually researching and analyzing investment opportunities.
 Cont…
 Investment managers utilize a variety of techniques and styles in the portfolio
construction and management process based on
 their individual investment philosophies, objectives, experience and beliefs about the
financial markets.
 These may include:
 Active portfolio management –The investment manager is paid to select individual
investments, like stocks or bonds to construct a portfolio.
 Passive investment management –Typically found in index funds or certain
Exchange Traded Funds (ETFs), simply tracks an index (like the S&P 500) or a
basket of companies.
 Cont…
 Technical analysis –is the study of how securities prices behave over time.
 The goal is to use this information to drive profits while minimizing losses.

 The emphasis in technical analysis is to take advantage of opportunities to profit

from trading, not to buy and hold securities over an indefinite time period like a
buy and hold strategy.
 Fundamental analysis – it focuses on the qualitative aspects of the companies
selected for investment.
 Concentration vs diversification – Diversification is the process of spreading
investment assets across multiple investments and/or investment classes in an effort
to reduce the risk associated with any one investment or asset class.
 Cont…
 A concentrated investment strategy typically invests in a single investment idea
and/or a smaller basket of investments.
 Warren Buffett, the legendary leader of Berkshire Hathaway, has long been an advocate of
concentrated equity portfolios, believing that they offer the opportunity for better risk-adjusted
returns.
 Like Warren Buffet, John Maynard Keynes, the influential British economist, was a staunch
supporter of concentration. “As time goes on, I get more and more convinced that the right
method in investment is to put fairly large sums into enterprises which one thinks one knows
something about and in the management of which one thoroughly believes,” Keynes said.
 However, it’s important for investors to understand that no single strategy can
eliminate investment risk, and that all investments and investment strategies are
subject to loss.
 Cont…
 Buy/sell discipline – Nowhere does emotion play a bigger role than in
portfolio buy and sell decisions.
 That is why it’s often difficult for investors to sell a once-prized holding that
is underperforming or no longer provides any benefit to the portfolio.
 However, emotional decision-making is eliminated when a strong buy/sell
discipline is in place and adhered to by a professional portfolio manager who
is able to maintain an objective approach.
 If the holding no longer meets specified criteria, it’s sold to make room for
new holdings that better meet the investment parameters
End of the chapter!