Chapter 1Design of study

OBJECTIVES OF THE STUDY 1. The main objective of this project is to understand what investment is and overview various investment options. 2. To observe the relation between Returns and Risk in investment management. 3. To understand policies to minimize risks and maximize the returns.

LIMITATIONS Time constraintsThe time stipulated for the project is less and thus there are chances that some information might have been left out, however due care is taken to include all information needed.

EXECUTIVE SUMMERYWhen building a portfolio, investors have to choose from a wide range of investment styles. Value investors, trend followers, global-macro or volatility arbitragers, to name just a few, each o er a di erent way of generating returns. Under the reasonable yet controversial assumption that markets do work, any extra return is earned in exchange for a certain degree of risk. Hence, before even measuring it, it is essential to identify and understand that risk in order to analyze the returns from certain strategies. Unfortunately, this is a di cult task, especially in the case of dynamic investment strategies, which are known to generate asymmetric returns. Since it is well established that options can be replicated using dynamic strategies, the approach developed in this study consists in exploring the extent to which an option prole can be associated with a given dynamic strategy. To keep things simple, we focus on strategies running on a single asset. Excluding classical analysis of constant-mix strategies, some of this key ndings are: (1) Many dynamic strategies returns can be broken down into an option prole and some trading impact, (2) Contrarian strategies on a single asset tend to generate frequent limited gains, in exchange for infrequent larger losses, (3) Trend-following strategies on a single asset will perform if the absolute value of the realized Sharpe ratio is above a certain threshold. The shorter-term the investment style, the higher this threshold.

Chapter 2Introduction to Investment management

MEANING OF INVESTMENT
The money we earn is partly spent and the rest saved for meeting future expenses. Instead of keeping the savings idle we may like to use savings in order to get return on it in the future. This is called Investment. Investment is the employment of funds with the aim of achieving additional income or growth in value. The essential quality of an investment is that it involves waiting for a reward. It involves the commitment of resources which have been s a v e d o r p u t a w a y f r o m c u r r e n t c o n s u m p t i o n i n t h e h o p e t h a t s o m e b e n e f i t s w i l l accrue in future. The term Investment does not appear to be as simple as it has been defined. Investment has been further categorized by financial experts and economists.

Why should one invest? One needs to invest to: earn return on our idle resources. generate a specified sum of money for a specific goal in life make a provision for an uncertain future

One of the important reasons why one needs to invest wisely is to meet the cost of Inflation. Inflation is the rate at which the cost of living increases. The cost of living is simply what it costs to buy the goods and services we need to live. Inflation causes money to lose value because it will not buy the same amount of a good or a service in the future as it does now or did in the past. For example, if there was a 6% inflation rate for the next 20 years, a Rs. 100 purchase today would cost Rs. 321 in 20 years. This is why it is important to consider inflation as a factor in any long-term investment strategy. Remember to look at an investment's 'real' rate of return, which is the return after inflation. The aim of investments should be to provide a return above the inflation rate to ensure that the investment does not decrease in value. For example, if the annual inflation rate is 6%, then the investment will need to earn more than 6% to ensure it increases in value. If the after-tax return on our investment is less than the inflation rate, then our assets have actually decreased in value; that is, they won't buy as much today as they did last year.

When to start Investing? The sooner one starts investing the better. By investing early we allow our investments more time to grow, whereby the concept of compounding (as we shall see later) increases our income, by accumulating the principal and the interest or dividend earned on it, year after year.

The three golden rules for all investors are: Invest early Invest regularly Invest for long term and not short term

What care should one take while investing?

Before making any investment, one must ensure to: 1. obtain written documents explaining the investment 2. read and understand such documents 3. verify the legitimacy of the investment 4. find out the costs and benefits associated with the investment 5. assess the risk-return profile of the investment 6. know the liquidity and safety aspects of the investment 7. ascertain if it is appropriate for our specific goals 8. compare these details with other investment opportunities available 9. examine if it fits in with other investments we are considering or we have already made 10. deal only through an authorized intermediary 11. seek all clarifications about the intermediary and the investment 12. explore the options available to we if something were to go wrong, and then, if satisfied, make the investment. These are called the Twelve Important Steps to Investing.

What is meant by Interest? When we borrow money, we are expected to pay for using it this is known as Interest. Interest is an amount charged to the borrower for the privilege of using the lenders money. Interest is usually calculated as a percentage of the principal balance (the amount of money borrowed). The percentage rate may be fixed for the life of the loan, or it may be variable, depending on the terms of the loan.

What factors determine interest rates? When we talk of interest rates, there are different types of interest rates rates that banks offer to their depositors, rates that they lend to their borrowers, the rate at which the Government borrows in the Bond/Government Securities market, rates offered to investors in small savings schemes like NSC, PPF, rates at which companies issue fixed deposits etc. The factors which govern these interest rates are mostly economy related and are commonly referred to as macroeconomic factors. Some of these factors are: Demand for money Level of Government borrowings Supply of money Inflation rate The Reserve Bank of India and the Government policies which determine some of the variables mentioned above

INVESTMENT OPTIONS

One may invest in: Physical assets like real estate, gold/jewellery, commodities etc. and/or Financial assets such as fixed deposits with banks, small saving instruments with post offices, insurance/provident/pension fund etc. or securities market related instruments like shares, bonds, debentures etc.

What are various Short-term financial options available for investment?

Broadly speaking, savings bank account, money market/liquid funds and fixed deposits with banks may be considered as short-term financial investment options: Savings Bank Account is often the first banking product people use, which offers low interest (4%-5% p.a.), making them only marginally better than fixed deposits. Money Market or Liquid Funds are a specialized form of mutual funds that invest in extremely short-term fixed income instruments and thereby provide easy liquidity. Unlike most mutual funds, money market funds are primarily oriented towards protecting our capital and then, aim to maximize returns. Money market funds usually yield better returns than savings accounts, but lower than bank fixed deposits. Fixed Deposits with Banks are also referred to as term deposits and minimum investment period for bank FDs is 30 days. Fixed Deposits with banks are for investors with low risk appetite, and may be considered for 6-12 months investment period as normally interest on less than 6 months bank FDs is likely to be lower than money market fund returns.
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What are various Long-term financial options available for investment?

Post Office Savings Schemes, Public Provident Fund, Company Fixed Deposits, Bonds and Debentures, Mutual Funds etc. Post Office Savings: Post Office Monthly Income Scheme is a low risk saving instrument, which can be availed through any post office. It provides an interest rate of around 8% per annum, which is paid monthly. Minimum amount, which can be invested, is Rs. 1,000/- and additional investment in multiples of 1,000/-. Maximum amount is Rs. 3,00,000/(if Single) or Rs. 6,00,000/- (if held Jointly) during a year. It has a maturity period of 6 years. Premature withdrawal is permitted if deposit is more than one year old. A deduction of 5% is levied from the principal amount if withdrawn prematurely. Public Provident Fund: A long term savings instrument with a maturity of 15 years and interest payable at 8% per annum compounded annually. A PPF account can be opened through a nationalized bank at anytime during the year and is open all through the year for depositing money. Tax benefits can be availed for the amount invested and interest accrued is tax-free. A withdrawal is permissible every year from the seventh financial year of the date of opening of the account and the amount of withdrawal will be limited to 50% of the balance at credit at the end of the 4th year immediately preceding the year in which the amount is withdrawn or at the end of the preceding year whichever is lower the amount of loan if any. Company Fixed Deposits: These are short-term (six months) to mediumterm (three to five years) borrowings by companies at a fixed rate of interest which is payable monthly, quarterly, semi- annually or annually. They can also be cumulative fixed deposits where the entire principal along with the interest is paid at the end of the loan period. The rate of interest varies between 6-9% per annum for company FDs. The interest received is after deduction of taxes.
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Bonds: It is a fixed income (debt) instrument issued for a period of more than one year with the purpose of raising capital. The central or state government, corporations and similar institutions sell bonds. A bond is generally a promise to repay the principal along with a fixed rate of interest on a specified date, called the Maturity Date. Mutual Funds: These are funds operated by an investment company which raises money from the public and invests in a group of assets (shares, debentures etc.), in accordance with a stated set of objectives. It is a substitute for those who are unable to invest directly in equities or debt because of resource, time or knowledge constraints. Benefits include professional money management, buying in small amounts and diversification. Mutual fund units are issued and redeemed by the Fund Management Company based on the fund's net asset value (NAV), which is determined at the end of each trading session. NAV is calculated as the value of all the shares held by the fund, minus expenses, divided by the number of units issued. Mutual Funds are usually long term investment vehicle though there some categories of mutual funds, such as money market mutual funds which are short term instruments.

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OTHER IMPORTANT TERMS IN INVESMENT MANAGEMENT-

What is meant by a Stock Exchange? The Securities Contract (Regulation) Act, 1956 [SCRA] defines Stock Exchange as anybody of individuals, whether incorporated or not, constituted for the purpose of assisting, regulating or controlling the business of buying, selling or dealing in securities. Stock exchange could be a regional stock exchange whose area of operation/jurisdiction is specified at the time of its recognition or national exchanges, which are permitted to have nationwide trading since inception. NSE was incorporated as a national stock exchange.

What is an Equity/Share? Total equity capital of a company is divided into equal units of small denominations, each called a share. For example, in a company the total equity capital of Rs 2,00,00,000 is divided into 20,00,000 units of Rs 10 each. Each such unit of Rs 10 is called a Share. Thus, the company then is said to have 20,00,000 equity shares of Rs 10 each. The holders of such shares are members of the company and have voting rights.

What is a Debt Instrument? Debt instrument represents a contract whereby one party lends money to another on pre-determined terms with regards to rate and periodicity of interest, repayment of principal amount by the borrower to the lender. In the Indian securities markets, the term bond is used for debt instruments issued by the Central and State governments and public sector organizations and the term debenture is used for instruments issued by private corporate sector.
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What is a Derivative? Derivative is a product whose value is derived from the value of one or more basic variables, called underlying. The underlying asset can be equity, index, foreign exchange (forex), commodity or any other asset. Derivative products initially emerged as hedging devices against fluctuations in commodity prices and commodity-linked derivatives remained the sole form of such products for almost three hundred years. The financial derivatives came into spotlight in post-1970 period due to growing instability in the financial markets. However, since their emergence, these products have become very popular and by 1990s, they accounted for about two- thirds of total transactions in derivative products.

What is a Mutual Fund? A Mutual Fund is a body corporate registered with SEBI (Securities Exchange Board of India) that pools money from individuals/corporate investors and invests the same in a variety of different financial instruments or securities such as equity shares, Government securities, Bonds, debentures etc. Mutual funds can thus be considered as financial intermediaries in the investment business that collect funds from the public and invest on behalf of the investors. Mutual funds issue units to the investors. The appreciation of the portfolio or securities in which the mutual fund has invested the money leads to an appreciation in the value of the units held by investors. The investment objectives outlined by a Mutual Fund in its prospectus are binding on the Mutual Fund scheme. The investment objectives specify the class of securities a Mutual Fund can invest in. Mutual Funds invest in various asset classes like equity, bonds, debentures, commercial paper and government securities. The schemes offered by mutual funds vary from fund to fund. Some are pure equity schemes; others are a mix of equity and bonds. Investors are also given the option of getting dividends, which are declared periodically by the mutual fund, or to participate only in the capital appreciation of the scheme.
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What is an Index? An Index shows how a specified portfolio of share prices is moving in order to give an indication of market trends. It is a basket of securities and the average price movement of the basket of securities indicates the index movement, whether upwards or downwards.

What is a Depository? A depository is like a bank wherein the deposits are securities (viz. shares, debentures, bonds, government securities, units etc.) in electronic form.

What is Dematerialization? Dematerialization is the process by which physical certificates of an investor are converted to an equivalent number of securities in electronic form and credited to the investors account with his Depository Participant (DP).

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Chapter 3- Investment management and its process

Investment management is the professional asset management of various securities (shares, bonds and other securities) and 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 or exchange-traded funds). The term asset management is often used to refer to the investment management of collective investments, while the more generic fund management may refer to all forms of institutional investment as well as investment management for private investors. Investment managers who specialize in advisory or discretionary management on behalf of (normally wealthy) private investors may often refer to their services as money management or portfolio management often within the context of so-called "private banking". The provision of investment management services includes elements of financial statement analysis, asset selection, stock selection, plan implementation and ongoing monitoring of investments. Coming under the remit of financial services many of the world's largest companies are at least in part investment managers and employ millions of staff. Fund manager refers to both a firm that provides investment management services and an individual who directs fund management decisions.

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5 Steps of Investment Management Process

1- Setting the Investment Objectives:The first and the basic step for investment is that the investor should set his investment objectives. These investment objectives vary from person to person. For example for an individual the objective may be to optimize the rate of return. 2- Establishing Investment Policy:Establishing investment policy refers to the allocation of asset amongst the major allocated assets in the capital market. The range of allocated asset is from equities, debt, fixed income securities, real estate, foreign securities to currencies. Restraint of environment and that of investor should be kept in mind while establishing the investment policy. 3- Selecting the Portfolio Strategy:The portfolio strategy selected should be in accordance and in conformity with the investment objectives and investment policies. If these are not in accordance with each other then the whole investment management process will collapse. 4- Selecting the Assets:The assets to be placed in the portfolio have to be selected by the investor. This is the point where real creation of portfolio will take place after the selection of assets in which to invest by the manager or investor. That asset will be selected which will give best return in available resources and which involves lowest risk. The assets can be shares, stocks, art objects, securities, gold, property etc.

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5- Measuring and Evaluating Performance:In this step the performance of the portfolio will be measured in comparison to the realistic benchmark or the standard set by the investor. Risk and return will be evaluated by the manager. Measuring and evaluating the portfolio will give the feedback to the investor and will in turn help the investor to improve the quality as well as the performance of the portfolio of investment.

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Chapter 4Risk and Return Analysis

Investment RiskWhile investing, we take certain risks. With insured bank investments, such as certificates of deposit (CDs), we face inflation risk, which means that we may not earn enough over time to keep pace with the increasing cost of living. With investments that aren't insured, such as stocks, bonds, and mutual funds, we face the risk that we might lose money, which can happen if the price falls and we sell for less than we paid to buy. Just because we take investment risks doesn't mean we can't exert some control over what happens to the money we invest. In fact, the opposite is true. If we know the types of risks we might face, make choices about those we are willing to take, and understand how to build and balance our portfolio to offset potential problems, we are managing investment risk to our advantage.

Why Take Risks? The question we might have at this point is, "Why would I want to risk losing some or all of my money?" In fact, we might not want to put money at risk that we expect to need in the short termto make the down payment on a home, for example, or pay a tuition bill for next semester, or cover emergency expenses. By taking certain risks with the rest of our money, however, we may earn dividends or interest. In addition, the value of the assets we purchase may increase over the long term. If we prefer to avoid risk and put our money in an FDIC-insured certificate of deposit (CD) at our bank, the most we can earn is the interest that the bank is paying. This may be good enough in some years, say, when interest rates are high or when other investments are falling.
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But on average, and over the long haul, stocks and bonds tend to grow more rapidly, which would make it easier or even possible to reach our savings goals. That's because avoiding investment risk entirely provides no protection against inflation, which decreases the value of our savings over time. On the other hand, if we concentrate on only the riskiest investments, it's entirely possible, even likely, that we will lose money. For many people, it's best to manage risk by building a diversified portfolio that holds several different types of investments. This approach provides the reasonable expectation that at least some of the investments will increase in value over a period of time. So even if the return on other investments is disappointing, our overall results may be positive.

Types of Investment Risk There are many different types of investment risk. The two general types of risk are:

Losing money, which we can identify as investment risk Losing buying poour, which is inflation risk

It probably comes as no surprise that there are several different ways we might lose money on an investment. To manage these risks, we need to know what they are. Most investment risk is described as either systematic or nonsystematic. While those terms seem intimidating, what they refer to is actually straightforward. Systematic Risk Systematic risk is also known as market risk and relates to factors that affect the overall economy or securities markets. Systematic risk affects all companies, regardless of the company's financial condition, management, or capital structure, and, depending on the investment, can involve international as well as domestic factors. Here are some of the most common systematic risks:
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Interest-rate risk describes the risk that the value of a security will go down because of changes in interest rates. For example, when interest rates overall increase, bond issuers must offer higher coupon rates on new bonds in order to attract investors. The consequence is that the prices of existing bonds drop because investors prefer the newer bonds paying the higher rate. On the other hand, there's also interest-rate risk when rates fall because maturing bonds or bonds that are paid off before maturity must be reinvested at a lower yield. Inflation risk describes the risk that increases in the prices of goods and services, and therefore the cost of living, reduce our purchasing poour. Let's say a can of soda increases from $1 to $2. In the past, $2 would have bought two cans of soda, but now $2 can buy only one can, resulting in a decline in the value of our money. Inflation risk and interest rate risk are closely tied, as interest rates generally rise with inflation. Because of this, inflation risk can also reduce the value of our investments. For example, to keep pace with inflation and compensate for the loss of purchasing poour, lenders will demand increased interest rates. This can lead to existing bonds losing value because, as mentioned above, newly issued bonds will offer higher interest rates. Inflation can go in cycles, however. When interest rates are low, new bonds will likely offer lower interest rates.

Currency risk occurs because many world currencies float against each other. If money needs to be converted to a different currency to make an investment, any change in the exchange rate between that currency and ours can increase or reduce our investment return. We are usually only impacted by currency risk if we invest in international securities or funds that invest in international securities. For example, assume that the current exchange rate of the U.S. dollar to British pound is $1=0.53 British pounds. If we invest $1,000 in a mutual fund that invests in the stock of British companies, this will equal 530 pounds ($1,000 x 0.53 pounds = 530 pounds). Six months later, assume the dollar strengthens and the exchange rate becomes $1=0.65 pounds. If the value of the fund does not change, converting the original investment of 530
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pounds into dollars will return only $815 (530 pounds/0.65 pounds = $815). Consequently, while the value of the mutual fund has not changed in the local currency, a change in the exchange rate has devalued the original investment of $1,000 into $815. On the other hand, if the dollar were to weaken, the value of the investment would go up. So if the exchange rate changes to $1=0.43 pounds, the original investment of $1,000 would increase to $1,233 (530 pounds/0.43 pounds = $1,233). As with most risks, currency risk can be managed to a certain extent by allocating only a limited portion of our portfolio to international investments and diversifying this portion across various countries and regions.

Liquidity risk is the risk that we might not be able to buy or sell investments quickly for a price that is close to the true underlying value of the asset. Sometimes we may not be able to sell the investment at all if there are no buyers for it. Liquidity risk is usually higher in over-the-counter markets and small-capitalization stocks. Foreign investments can pose liquidity risks as well. The size of foreign markets, the number of companies listed, and hours of trading may limit our ability to buy or sell a foreign investment. Sociopolitical risk is the possibility that instability or unrest in one or more regions of the world will affect investment markets. Terrorist attacks, war, and pandemics are just examples of events, whether actual or anticipated, that impact investor attitudes toward the market in general and result in system-wide fluctuations in stock prices. Some events, such as the September 11, 2001, attacks on the World Trade Center and the Pentagon, can lead to widescale disruptions of financial markets, further exposing investments to risks. Similarly, if we are investing overseas, problems there may undermine those markets, or a new government in a particular country may restrict investment by non-citizens or nationalize businesses.

Our chief defense against systematic risk, as we'll see, is to build a portfolio that includes investments that react differently to the same economic factors. It's a strategy known as asset allocation. This generally involves investing in both bonds and stocks or the funds that own them, always holding some of each. That's because historical patterns show that when bonds as a groupthough not every bondare providing a strong return, stocks on the whole tend to provide a disappointing return. The reverse is also true.
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Bonds tend to provide strong returns, measured by the combination of change in value and investment earnings, when investor demand for them increases. That demand may be driven by concerns about volatility risk in the stock marketwhat's sometimes described as a flight to safety or by the potential for higher yield that results when interest rates increase, or by both factors occurring at the same time. That is, when investors believe they can benefit from good returns with less risk than they would be exposed to by owning stock, they are willing to pay more than par value to own bonds. In fact, they may sell stock to invest in bonds. The sale of stock combined with limited new buying drives stock prices down, reducing return. In a different phase of the cycle, those same investors might sell off bonds to buy stock, with just the opposite effect on stock and bond prices. If we owned both bonds and stocks in both periods, we would benefit from the strong returns on the asset class that was in greater demand at any one time. We would also be ready when investor sentiment changes and the other asset class provides stronger returns. To manage systematic risk, we can allocate our total investment portfolio so that it includes some stock and some bonds as well as some cash investments.

Non systematic Risk Nonsystematic risk, in contrast to systematic risk, affects a much smaller number of companies or investments and is associated with investing in a particular product, company, or industry sector. Here are some examples of non systematic risk:

Management risk, also known as company risk, refers to the impact that bad management decisions, other internal missteps, or even external situations can have on a company's performance and, as a consequence, on the value of investments in that company. Even if we research a company carefully before investing and it appears to have solid management, there is probably no way to know that a competitor is about to bring a superior product to market. Nor is it easy to anticipate a financial or personal scandal
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that undermines a company's image, its stock price, or the rating of its bonds.

Credit risk, also called default risk, is the possibility that a bond issuer won't pay interest as scheduled or repay the principal at maturity. Credit risk may also be a problem with insurance companies that sell annuity contracts, where our ability to collect the interest and income we expect is dependent on the claimspaying ability of the issuer.

One way to manage nonsystematic risk is to spread our investment dollars around, diversifying our portfolio holdings within each major asset classstock, bonds, and casheither by owning individual securities or mutual funds that invest in those securities. While we're likely to feel the impact of a company that crashes and burns, it should be much less traumatic if that company's stock is just one among several we own.

Other Investment Risks The investment decisions we makeand sometimes those we avoid makingcan expose we to certain risks that can impede our progress toward meeting our investment goals. For example, buying and selling investments in our accounts too frequently, perhaps in an attempt to take advantage of short-term gains or avoid short-term losses, can increase our trading costs. The money we spend on trading reduces the balance in our account or eats into the amount we have to invest. If we decide to invest in something that's receiving a lot of media attention, we may be increasing the possibility that we're buying at the market peak, setting up for future losses. Or, if we sell in a sudden market downturn, it can mean not only locking in our losses but also missing out on future gains. We can also increase our investment risk if we don't monitor the performance of our portfolio and make appropriate changes. For example, we should be aware of investments that have failed to live up to our expectations, and shed them when we determine that they are unlikely to improve, using the money from that sale for another investment.

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Concept of Returns on investment

RETURNS: A major purpose of investment is to set a return of i n c o m e o n t h e f u n d s invested. On a bond an investor expects to receive interest. On a stock, dividends may be anticipated. The investor may expect capital gains from some investments and rental income from house property.

Factors affecting returns on investmentThe rate of return on an investment asset is the income and capital appreciation over a measurement period divided by the cost of acquisition, expressed as a percentage. Assets include stocks, bonds, real estate and mutual funds. The rates of return depend on several factors, such as the portfolio composition and macroeconomic conditions, and determine the extent to which investors can meet their financial objectives. 1) Asset MixThe asset mix of an investment portfolio determines its overall return. There is a risk-return tradeoff with every asset -- the higher the risk, the higher the volatility and return potential. For example, stocks are generally riskier and more volatile than bonds, but the rates of return on stocks have exceeded those of bonds over the long term. An investment portfolio fully invested in stocks is likely to suffer in a down economy and during periods of high market volatility. On the other hand, a conservative portfolio invested mainly in high-quality bonds is likely to have lower but more predictable and stable returns. 2) FundamentalsThe strategic and operational fundamentals of the underlying businesses affect investment returns. Strategy involves positioning a company to take advantage of opportunities and responding effectively to competitive threats. Operational execution involves managing costs, expanding into new markets and continually innovating to stay ahead of the competition.
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Companies that consistently meet sales and profit expectations generally see their stock prices outperform market averages. Conversely, companies that lose market share and miss earnings expectations underperform the market. 3) EconomyMacroeconomic conditions affect investment rates of return. A growing economy means that more people have jobs, which means they spend more. For businesses, this leads to increases in sales, profits and investments in new employees and equipment. However, rapid economic growth can lead to higher interest rates. This makes credit more expensive, thus dampening consumer spending and business investments. Economic slowdowns lead to low employment, which usually means lower profits and stock prices. The resulting weakness in the stock markets could improve bond prices as investors move funds to the relative safety of bonds. 4) OtherFiscal policy, regulations and political stability also affect investment rates of return. Large fiscal deficits reduce government flexibility and may result in higher borrowing costs for businesses. An arduous regulatory approval process can hamper business investments in the resource and energy sectors. Political stability creates investor and business confidence because there is more visibility into possible investment returns. Investors tend to avoid countries that change governments frequently or have civil strife.

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Relationship between risk and returns in investment

Risk and return are directly related. The greater the risk of the investment, the greater the potential return from that investment. Conversely, with very safe, low-risk investments, the return will likely be low. The basic principle is this: To be willing to accept the risk that an investment could do poorly, investors must be compensated with the potential for greater return.

Measuring Portfolio Risks One of the concepts used in risk and return calculations is standard deviation which measures the dispersion of actual returns around the expected return of an investment. Since standard deviation is the square root of the variance, this is another crucial concept to know. The variance is calculated by weighting each possible dispersion by its relative probability (take the difference between the actual return and the expected return, then square the number). The standard deviation of an investment's expected return is considered a basic measure of risk. If two potential investments had the same expected return, the one with the lower standard deviation would be considered to have less potential risk. Risk Measures There are three other risk measures used to predict volatility and return:

Alpha - this measures stock price volatility based on the specific characteristics of the particular security. As with beta, the higher the number, the higher the risk. Sharpe ratio- this is a more complex measure that uses the standard deviation of a stock or portfolio to measure volatility. This calculation measures the incremental reward of assuming incremental risk. The larger the Sharpe ratio, the greater the potential return. The formula is: Sharpe Ratio = (total return minus
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the risk-free rate of return) divided by the standard deviation of the portfolio.

Beta - this measures stock price volatility based solely on general market movements. Typically, the market as a whole is assigned a beta of 1.0. So, a stock or a portfolio with a beta higher than 1.0 is predicted to have a higher risk and, potentially, a higher return than the market. Conversely, if a stock (or fund) had a beta of .85, this would indicate that if the market increased by 10%, this stock (or fund) would likely return only 8.5%. However, if the market dropped 10%, this stock would likely drop only 8.5%.

Asset Allocation In simple terms, asset allocation refers to the balance between growthoriented and income-oriented investments in a portfolio. This allows the investor to take advantage of the risk/reward tradeoff and benefit from both growth and income. Here are the basic steps to asset allocation: 1. Choosing which asset classes to include (stocks, bonds, money market, real estate, precious metals, etc.) 2. Selecting the ideal percentage (the target) to allocate to each asset class 3. Identifying an acceptable range within that target 4. Diversifying within each asset class Risk Tolerance The client's risk tolerance is the single most important factor in choosing an asset allocation. At times, there may be a distinct difference between the risk tolerance of a client and his/her spouse, so care must be taken to get agreement on how to proceed. Also, risk tolerance may change over time, so it's important to revisit the topic periodically. Time Horizon Clearly, the time horizon for each of the client's goals will affect the asset allocation mix. Take the example of a client with a very aggressive risk tolerance. The recommended allocation to stocks will be much higher for the client's retirement portfolio than for the money being set aside for the college fund of the client's 13-year-old child.
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Chapter 5Accessing and managing the risk

It's one thing to know that there are risks in investing. But how do we figure out ahead of time what those risks might be, which ones we are willing to take, and which ones may never be worth taking? There are three basic steps to assessing risk:

Understanding the risk posed by certain categories of investments Determining the kind of risk we are comfortable taking Evaluating specific investments

We can follow this path on our own or with the help of one or more investment professionals, including stockbrokers, registered investment advisers, and financial planners with expertise in these areas.

Step 1: Determining the Risk of an Asset Class The first step in assessing investment risk is to understand the types of risk a particular category or group of investmentscalled an asset class might expose we to. For example, stock, bonds, and cash are considered separate asset classes because each of them puts our money to work in different ways. As a result, each asset class poses particular risks that may not be characteristic of the other classes. If we understand what those risks are, we can generally take steps to offset those risks.

StockBecause shares of stock don't have a fixed value but reflect changing investor demand, one of the greatest risks we face when we invest in stock is volatility, or significant price changes in relatively rapid succession. In fact, in some cases, we must be prepared for stock prices to move from hour to hour and even from minute to minute. However, over longer periods, the short-term fluctuations tend to smooth out to show a gradual increase, a gradual decrease, or a basically flat stock price.
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For example, if a stock we bought for $25 a share dropped $5 in price in the following week because of disappointing news about a new product, we suffered a 20% loss. If we had purchased 200 shares at a cost of $5,000, our investment would now be worth just $4,000. If we sold at that pointand there might have been good reason to do sowe would have lost $1,000, plus whatever transaction fees we paid. While some gains or losses of value seem logical, others may not, as may be the case when a company announces increased earnings and its stock price drops. If we have researched the investment before we made it and believe that the company is strong, we might hold on to the stock. In that case, we might be rewarded down the road if the investment then increases in value and perhaps pays dividends as well. While positive results aren't guaranteed, we can learn to anticipate when patience is likely to pay off.

BondsBonds have a fixed valueusually $1,000 per bondor what is known as par or face value. If we hold a bond until maturity, we will get that amount back, plus the interest the bond earns, unless the issuer of the bond defaults, or fails to pay. In addition to the risk of default, we also face potential market risk if we sell bonds before maturity. For example, if the price of the bonds in the secondary marketor what other investors will pay to buy themis less than par, and we sell the bonds at that point, we may realize a loss on the sale. The market value of bonds may decrease if there's a rise in interest rates between the time the bonds were issued and their maturity dates. In that case, demand for older bonds paying lower rates decreases. If we sell, we must settle for the price we can get and potentially take that loss. Market prices can also fall below par if the bonds are downgraded by an independent rating agency because of problems with the company's finances. Some bonds have a provision that allows the issuer to "call" the bond and repay the face value of the bond to we before its maturity. Often there is a set "call date," after which a bond issuer can pay off the bond. With these bonds, we might not receive the bond's original coupon rate for the bond's entire term. Once the call date has been reached, the stream of a callable bond's interest payments is uncertain, and any appreciation in the market value of the bond may not rise above the call price. These risks are part of
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call risk. Similar to when a homeowner seeks to refinance a mortgage at a lower rate to save money when loan rates decline, a bond issuer often calls a bond after interest rates drop, allowing the issuer to sell new bonds paying lower interest ratesthus saving the issuer money. The bond's principal is repaid early, but the investor is left unable to find a similar bond with as attractive a yield. This is known as reinvestment risk.

CashThe primary risk we face with cash investments, including U.S. Treasury bills and money market mutual funds, is losing ground to inflation. In addition, we should be aware that money in money market funds usually is not insured. While such funds have rarely resulted in investor losses, the potential is always there.

Other asset classes, including real estate, pose their own risks, while investment products, such as annuities or mutual funds that invest in a specific asset class, tend to share the risks of that class. That means that the risk we face with a stock mutual fund is very much like the risk we face with individual stock, although most mutual funds are diversified, which helps to offset nonsystematic risk.

Step 2: Selecting Risk The second step is to determine the kinds of risk we are comfortable taking at a particular point in time. Since it's rarely possible to avoid investment risk entirely, the goal of this step is to determine the level of risk that is appropriate for we and our situation. Our decision will be driven in large part by:

Our age Our goals and our timeline for meeting them Our financial responsibilities Our other financial resources

Age is one of the most important issues in managing investment risk. In general, the more investment risk we can afford to take. The reason is simple: We have more time to make up for any losses we might suffer in the short term.
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We can use recent history to illustrate the validity of this point. Suppose two people, one 30 and the other 60, had been similarly invested in October 2007 in portfolios overloaded with stocks. By March 2009, both would almost certainly have lost substantial amounts of money. But while the person has perhaps 35 years to recover and accumulate investment assets, the older person may be forced to delay retirement. On the other hand, having a long time to recover from losses doesn't mean we can ignore the importance of managing risk and choosing investments carefully and selling them when appropriate. The more stock and stock fundsboth mutual funds and exchange traded fundswe might consider buying. But stock in a poorly run company, a company with massive debt and noncompetitive products, or a company whose stock is wildly overpriced, probably isn't a good investment from a riskmanagement perspective, no matter how old we are. As we get closer to retirement, managing investment risk generally means moving at least some of our assets out of more volatile stock and stock funds into income-producing equities and bonds. Determine what percentage of our assets we want to transfer, and when. That way we won't have more exposure to a potential downturn than we've prepared for. The consensus, though, is to include at least some investments with growth potential (and therefore greater risk to principal) after we retire since we'll need more money if we live longer than expected. Without growth potential, we're vulnerable to inflation. Keep in mind that our attitude toward investment risk mayand probably shouldchange over time. If we are the primary source of support for a number of people, we may be willing to take less investment risk than we did when we were responsible for just our self. In contrast, the larger our investment base, the more willing we may be to take added risk with a portion of our total portfolio. In a worst-case scenario, we could manage without the money we lost. And if our calculated risk pays off, we may have even more financial security than we had before. Many people also find that the more clearly they understand how investments work, the more comfortable they feel about taking risk.

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Step 3: Evaluating Specific Investments The third step is evaluating specific investments that we are considering within an asset class. There are tools we can use to evaluate the risk of a particular investmenta process that makes a lot of sense to follow both before we make a new purchase and as part of a regular reassessment of our portfolio. It's important to remember that part of managing investment risk is not only deciding what to buy and when to buy it, but also what to sell and when to sell it. For stocks and bonds, the place to start is with information about the issuer, since the value of the investment is directly linked to the strength of the companyor in the case of certain bonds, the government or government agencybehind them.

Company DocumentsEach public company must register its securities with the Securities and Exchange Commission (SEC) and provide updated information on a periodic basis. ,The annual report on Form 10-K contains audited financial statements as well as a wealth of detailed information about the company, the people who run it, the risks of investing in the company, and much more. Companies also submit to the SEC three additional quarterly reports called 10-Qs and interim reports on Form 8-K. We can access these company filings using the SEC's EDGAR database. While they aren't always exciting reading, SEC filings can be a treasure trove of information about a company. When we're reading a company's financial statements, don't skip over the footnotes. They often contain red flags that can alert we to pending lawsuits, regulatory investigations, or other issues that could have a negative impact on the company's bottom line. The company's prospectus, especially the risk factors section, is another reliable tool to help we evaluate the investment risk of a newly issued stock, an individual mutual fund or exchange-traded fund, or a REIT (real estate investment trust). The investment company offering the mutual fund, ETF, or REIT must update its prospectus every year, including an evaluation of the level of risk we are taking by owning that particular investment. We'll also want to look at how the fund, ETF, or REIT has done in the past, especially if it has been around long enough to have weathered a
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full economic cycle of market ups and downswhich might be as long as 10 years. Keep in mind, however, that past results cannot predict future performance. Also verify that mutual fund managers have not changed. In actively managed funds, it is the managers' picks that determine returns and the level of risk the fund assumes. Past returns would not reflect a new managers performance.

Rating ServicesIt's important to check what one or more of the independent rating services has to say about specific corporate and municipal bonds that we may own or may be considering. Each of the rating companiesincluding A.M. Best Company, Inc.; Dominion Bond Rating Service Ltd. (also known as DBRS Ltd.); Egan-Jones Rating Company; Fitch, Inc.; Japan Credit Rating Agency, Ltd.; LACE Financial Corp.; Moodys Investors Service; Rating and Investment Information, Inc.; Realpoint, LLC (which focuses on commercial mortgage-backed securities); and Standard & Poors Ratings Servicesevaluates the issuing company a little differently, but all of them are focused on the issuer's ability to meet its financial obligations. The higher the letter grade a rating company assigns, the lower the risk we are taking. But remember that ratings aren't perfect and can't tell we whether or not our investment will go up or down in value. Also remember that managing investment risk doesn't mean avoiding risk altogether. There might be times when we include a lower-rated bond or bond fund in our portfolio to take advantage of the higher yield it can provide. Research companies also rate or rank stocks and mutual funds based on specific sets of criteria. Brokerage firms that sell investments similarly provide their assessments of the probable performance of specific equity investments. Before we rely on ratings to select our investments, learn about the methodologies and criteria the research company uses in its ratings. We might find some research companies' methods more useful than others'.

Take a Broad View While the past performance of an investment never guarantees what will happen in the future, it is still an important tool. For example, a historical perspective can alert we to the kinds of losses we should be prepared for
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an awareness that's essential to managing our risk. A sense of the past can also tell we which asset class or classes have provided the strongest return over time and what their average returns are. Another way to assess investment risk is to stay tuned to what's happening in the world around we. For example, investment professionals who learn that a company is being investigated by its regulator may decide it's time to unload any of its securities that their clients own or that they hold in their own accounts. Similarly, political turmoil in a particular area of the world might increase the risk of investing in that region. While we don't want to overreact, we don't want to take more risk than we are comfortable with.

Investing to Minimize Risk While some investors assume a high level of risk by going for the gold or looking for winnersmost people are interested in minimizing risk while realizing a satisfactory return. If that's our approach, we might consider two basic investment strategies: asset allocation and diversification.

Using Asset Allocation When we allocate our assets, we decideusually on a percentage basis what portion of our total portfolio to invest in different asset classes, usually stock, bonds, and cash or cash equivalents. We can make these investments either directly by purchasing individual securities or indirectly by choosing funds that invest in those securities. As we build a more extensive portfolio, we may also include other asset classes, such as real estate, which can also help to spread out our investment risk and so moderate it. Asset allocation is a useful tool in managing systematic risk because different categories of investments respond to changing economic and political conditions in different ways. By including different asset classes in our portfolio, we increase the probability that some of our investments will provide satisfactory returns even if others are flat or losing value. Put another way, we're reducing the risk of major losses that can result from
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over-emphasizing a single asset class, however resilient we might expect that class to be. For example, in periods of strong corporate earnings and relative stability, many investors choose to own stock or stock mutual funds. The effect of this demand is to drive stock prices up, increasing their total return, which is the sum of the dividends they pay plus any change in value. If investors find the money to invest in stock by selling some of their bond holdings or by simply not putting any new money into bonds, then bond prices will tend to fall because there is a greater supply of bonds than of investors competing for them. Falling prices reduce the bonds' total return. In contrast, in periods of rising interest rates and economic uncertainty, many investors prefer to own bonds or keep a substantial percentage of their portfolio in cash. That can depress the total return that stock provides while increasing the return from bonds. While we can recognize historical patterns that seem to indicate a strong period for a particular asset class or classes, the length and intensity of these cyclical patterns are not predictable. That's why it's important to have money in multiple asset classes at all times. We can always adjust our portfolio allocation if economic signs seem to favor one asset class over another. Financial services companies make adjustments to the asset mix they recommend for portfolios on a regular basis, based on their assessment of the current market environment. For example, a firm might suggest that we increase our cash allocation by a certain percentage and reduce our equity holdings by a similar percentage in a period of rising interest rates and increasing international tension. Companies frequently display their recommended portfolio mix as a pie chart, showing the percentage allocated to each asset class. Modifying our asset allocation modestly from time to time is not the same thing as market timing, which typically involves making frequent shifts in our portfolio holdings in anticipation of which way the markets will turn. Because no one knows what will happen, this technique rarely produces positive long-term results.

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Using Diversification When we diversify, we divide the money we've allocated to a particular asset class, such as stocks, among various categories of investments that belong to that asset class. These smaller groups are called subclasses. For example, within the stock category we might choose subclasses based on different market capitalizations: some large companies or funds that invest in large companies, some mid-sized companies or funds that invest in them, and some small companies or funds that invest in them. We might also include securities issued by companies that represent different sectors of the economy, such as technology companies, manufacturing companies, pharmaceutical companies, and utility companies. Similarly, if we're buying bonds, we might choose bonds from different issuersthe federal government, state and local governments, and corporationsas well as those with different terms and different credit ratings. Diversification, with its emphasis on variety, allows we to manage nonsystematic risk by tapping into the potential strength of different subclasses, which, like the larger asset classes, tend to do better in some periods than in others. For example, there are times when the performance of small company stock outpaces the performance of larger, more stable companies. And there are times when small company stock falters. Similarly, there are periods when intermediate-term bondsU.S. Treasury notes are a good exampleprovide a stronger return than shortor long-term bonds from the same issuer. Rather than trying to determine which bonds to buy at which time, there are different strategies we can use. For example, we can buy bonds with different terms, or maturity dates. This approach, called a barbell strategy, involves investing roughly equivalent amounts in short-term and long-term bonds, weighting our portfolio at either end. That way, we can limit risk by having at least a portion of our total bond portfolio in whichever of those two subclasses is providing the stronger return. Alternatively, we can buy bonds with the same term but different maturity dates. Using this strategy, called laddering, we invest roughly equivalent amounts in a series of fixed-income securities that mature in a rolling pattern, perhaps every two years. Instead of investing $15,000 in
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one note that will mature in 10 years, we invest $3,000 in a note maturing in two years, another $3,000 in a note maturing in four years, and so on. This approach helps we manage risk in two ways:

If rates drop just before the first note matures, we'll have to invest only $3,000 at the new lower rate rather than the full $15,000. If rates behave in traditional fashion, they will typically go up again at some point in the ten-year span covered by our ladder. If we need money in the short term for either a planned or unplanned expense, we could use the amount of the maturing bond to meet that need without having to sell a larger bond in the secondary market.

Measuring Risk We can't measure risk by putting it on a scale or lining it up against a yardstick. One way to put the risk of a particular investment into context called the risk premium in the case of stock or the default premium in the case of bondsis to evaluate its return in relation to the return on a risk-free investment. Is there actually a risk-free investment? The one that comes closest is the 13-week U.S. Treasury bill, also referred to as the 91-day bill. This investment serves as a benchmark for evaluating the risk of investing in stock for two reasons:

The shortness of the term, which significantly reduces reinvestment risk. The backing of the U.S. government, which virtually eliminates default, or credit risk

The long-term Treasury bond is the risk-free standard for measuring the default risk posed by a corporate bond. While both are vulnerable to inflation and market risk, the Treasury bond is considered free of default risk.

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Conclusion

The investor, while making investment has to face various types of risks associated with those transactions. He has to understand and manage the risks properly to maximize his returns. A clear perception of risk is necessary to have control over them. Risk is a potential loss a portfolio is likely to suffer. As most losses proceed from ignorance, they could be avoided by understanding them properly. Risk management aims at understanding and identifying the risks an investor has to face. Future return is an expected return and may or may not be actually realized. Risk management measures the probabilities that may arise in particular investment. It can show the strengths and weaknesses of the investment.

The emphasis of risk management is increasing with globalization and economic liberalization process altering the way risks are perceived. The competitive market scenario and progressive opening up of economy leading to global linkages point to multiplicity of risk and risk management. The investors now have to explicitly identify and deal with all the risk components, as investors have to be accountable to themselves in terms of risk-return implications of their behavior.

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BIBLIOGRAPHY Investing management- by Puthi Singh Security analysis and portfolio management- by Punthvathy Pandiyam NSEindia.com Investopedia.com Glossary.reuters.com Capitalmarket.com Answers.com

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