SAPM Unit I
SAPM Unit I
INVESTMENT
Investment is the employment of funds with the aim of getting return on it. In general
terms, investment means the use of money in the hope of making more money. In
finance, investment means the purchase of a financial product or other item of value
with an expectation of favourable future returns. Investment of hard earned money is
a crucial activity of every human being. Investment is the commitment of funds which
have been saved from current consumption with the hope that some benefits will be
received in future.
4. Utility:
5. Legality:
⚫ There is no legal restriction on speculation. It is a legally permissible activity
because it is a valuable economic service.
⚫ Gambling, on the other hand, is unsocial, unhealthy and illegal.
INVESTMENT ALTERNATIVES
Investment in any of the alternatives depends on the needs and requirements of the
investor. Corporates and individuals have different needs. Before investing, these
alternatives of investments need to be analyzed in terms of their risk, return, term,
convenience, liquidity etc.
EQUITY SHARES
Equity investments represent ownership in a running company. By ownership, we
mean share in the profits and assets of the company but generally, there are no fixed
returns. It is considered as a risky investment but at the same time, depending upon
situation, it is liquid investments due to the presence of stock markets. There are
equity shares for which there is a regular trading, for those investments liquidity is
more otherwise for stocks have less movement, liquidity is not highly attractive.
Equity shares of companies can be classified as follows:
▪ Blue chip scrip
▪ Growth scrip
▪ Income scrip
▪ Cyclical scrip
▪ Speculative scrip
DEBENTURES OR BONDS
Debentures or bonds are long-term investment options with a fixed stream of cash
flows depending on the quoted rate of interest. They are considered relatively less
risky. An amount of risk involved in debentures or bonds is dependent upon who the
issuer is. For example, if the issue is made by a government, the risk is assumed to
be zero. However, investment in long term debentures or bonds, there are risk in
terms of interest rate risk and price risk. Suppose, a person requires an amount to
fund his child’s education after 5 years. He is investing in a debenture having
maturity period of 8 years, with coupon payment annually. In that case there is a risk
of reinvesting coupon at a lower interest rate from end of year 1 to end of year 5 and
there is a price risk for increase in rate of interest at the end of fifth year, in which
price of security falls. In order to immunize risk, investment can be made as per
duration concept. Following alternatives are available under debentures or bonds:
▪ Government securities
▪ Savings bonds
▪ Public Sector Units bonds
▪ Debentures of private sector companies
▪ Preference shares
MUTUAL FUNDS
Mutual funds are an easy and tension free way of investment and it automatically
diversifies the investments. A mutual fund is an investment only in debt or only in
equity or mix of debts and equity and ratio depending on the scheme. They provide
with benefits such as professional approach, benefits of scale and convenience.
Further investing in mutual fund will have advantage of getting professional
management services, at a lower cost, which otherwise was not possible at all. In
case of open ended mutual fund scheme, mutual fund is giving an assurance to
investor that mutual fund will give support of secondary market. There is an absolute
transparency about investment performance to investors. On real time basis,
investors are informed about performance of investment. In mutual funds also, we
can select among the following types of portfolios:
▪ Equity Schemes
▪ Debt Schemes
▪ Balanced Schemes
▪ Sector Specific Schemes etc.
REAL ESTATE
Every investor has some part of their portfolio invested in real assets. Almost every
individual and corporate investor invest in residential and office buildings
respectively. Apart from these, others include:
▪ Agricultural Land
▪ Semi-Urban Land
▪ Commercial Property
▪ Raw House
▪ Farm House etc
PRECIOUS OBJECTS
Precious objects include gold, silver and other precious stones like the diamond.
Some artistic people invest in art objects like paintings, ancient coins etc.
Derivatives
Derivatives means indirect investments in the assets. The derivatives market is growing
at a tremendous speed. The important benefit of investing in derivatives is that it
leverages the investment, manages the risk and helps in doing speculation. Derivatives
include:
▪ Forwards
▪ Futures
▪ Options
▪ Swaps etc
NON-MARKETABLE SECURITIES
Non-marketable securities are those securities which cannot be liquidated in the
financial markets. Such securities include:
▪ Bank Deposits
▪ Post Office Deposits
▪ Company Deposits
▪ Provident Fund Deposits
Objectives of Investment
The options for investing savings are continually increasing, yet every
investment vehicle can be categorized according to three fundamental
characteristics: safety, income, and growth.
Safety
There is truth to the axiom that there is no such thing as a completely safe and
secure investment. However, we can get close to ultimate safety for our
investment funds through the purchase of government-issued securities in
stable economic systems or through the purchase of corporate bonds issued
by large, stable companies. Such securities are arguably the best means of
preserving principal while receiving a specified rate of return.
Income
The safest investments are those likely to have the lowest rate of income
return or yield. Investors must inevitably sacrifice a degree of safety if they
want to increase their yields. As yield increases, so does the risk.
To increase their rate of investment return and take on risk above that of
money market instruments or government bonds, investors may choose to
purchase corporate bonds or preferred shares with lower investment ratings.
Investment grade bonds rated at A or AA are slightly riskier than AAA bonds but
typically also offer a higher income return than AAA bonds. Similarly, BBB-rated
bonds carry medium risk, but they offer less potential income than junk bonds,
which offer the highest potential bond yields available but at the highest possible
risk. Junk bonds are the most likely to default.
Most investors, even the most conservative-minded ones, want some level of
income generation in their portfolios, even if it is just to keep up with the
economy's rate of inflation. But maximizing income return can be an
overarching principle for a portfolio, particularly for individuals who require a
fixed sum from their portfolio every month. A retired person who requires a
certain amount of money every month is well served by holding reasonably
safe assets that provide funds over and above other income-generating
assets, such as pension plans.
Capital Growth
This discussion has thus far been concerned only with safety and yield as
investment objectives and has not considered the potential of other assets to
provide a rate of return from an increase in value, often referred to as a capital
gain.
Capital gains are entirely different from yield in that they are only realized
when the security is sold for a price that is higher than the price at which it
was originally purchased. Selling at a lower price is referred to as a capital
loss. Therefore, investors seeking capital gains are likely not those who need
a fixed, ongoing source of investment returns from their portfolio, but rather
those who seek the possibility of longer-term growth.
Capital growth is most closely associated with the purchase of common stock,
particularly growth securities, which offer low yields but a considerable
opportunity for an increase in value. For this reason, common stock ranks
among the most speculative of investments as the return depends on what will
happen in an unpredictable future. Blue-chip stocks can potentially offer the
best of all worlds by possessing reasonable safety, modest income, and
potential for capital growth generated by long-term increases in corporate
revenues and earnings as the company matures. Common stock is rarely able
to provide the safety and income generation of government bonds.
Secondary Objectives
Tax Minimization: An investor may pursue certain investments to leverage tax
minimization as part of their investment strategy. A highly paid executive, for
example, may seek investments with favourable tax treatment to lessen his or her
overall income tax burden. Making contributions to an IRA or another
tax-sheltered retirement plan, such as a 401(k), can be an effective tax
minimization strategy.
Types of Investment
1. Financial Investment
❖ Cash
❖ Bank deposits
❖ Pension plans
❖ Provident Funds
❖ Insurance policies
2. Physical Investment
❖ Land & Buildings, Flats, Metals like Gold, etc,
3. Marketable investment
❖ Shares, bonds, Mutual funds, Govt. Securities, etc.,
Growth investments
These are more suitable for long term investors that are willing and able to withstand
market ups and downs.
Shares
Shares are considered a growth investment as they can help grow the value of your
original investment over the medium to long term.
If you own shares, you may also receive income from dividends, which are effectively a
portion of a company’s profit paid out to its shareholders.
Of course, the value of shares may also fall below the price you pay for them. Prices can
be volatile from day to day and shares are generally best suited to long term investors,
who are comfortable withstanding these ups and downs.
Also known as equities, shares have historically delivered higher returns than other
assets, shares are considered one of the riskiest types of investment.
Property
Property is also considered as a growth investment because the price of houses and
other properties can rise substantially over a medium to long term period.
However, just like shares, property can also fall in value and carries the risk of losses.
It is possible to invest directly by buying a property but also indirectly, through a property
investment fund.
Defensive investments
These are more focused on consistently generating income, rather than growth, and are
considered lower risk than growth investments.
Cash
Cash investments include everyday bank accounts, high interest savings accounts and
term deposits.
They typically carry the lowest potential returns of all the investment types.
While they offer no chance of capital growth, they can deliver regular income and can
play an important role in protecting wealth and reducing risk in an investment portfolio.
Fixed interest
The best known type of fixed interest investments are bonds, which are essentially when
governments or companies borrow money from investors and pay them a rate of interest
in return.
Bonds are also considered as a defensive investment, because they generally offer
lower potential returns and lower levels of risk than shares or property.
They can also be sold relatively quickly, like cash, although it’s important to note that
they are not without the risk of capital losses.
INVESTMENT PROCESS
1. Investment Policy:
The first stage determines and involves personal financial affairs and objectives
before making investments. It may also be called preparation of the investment
policy stage.
The investor has to see that he should be able to create an emergency fund, an
element of liquidity and quick convertibility of securities into cash. This stage may,
therefore; be considered appropriate for identifying investment assets and
considering the various features of investments.
2. Investment Analysis:
When an individual has arranged a logical order of the types of investments that he
requires on his portfolio, the next step is to analyse the securities available for
investment. He must make a comparative analysis of the type of industry, kind of
security and fixed vs. variable securities. The primary concerns at this stage would
be to form beliefs regarding future behaviour or prices and stocks, the expected
returns and associated risk.
3. Valuation of Securities:
The third step is perhaps the most important consideration of the valuation of
investments. Investment value, in general, is taken to be the present worth to the
owners of future benefits from investments. The investor has to bear in mind the
value of these investments.
An appropriate set of weights have to be applied with the use of forecasted benefits
to estimate the value of the investment assets. Comparison of the value with the
current market price of the asset allows a determination of the relative attractiveness
of the asset. Each asset must be valued on its individual merit. Finally, the portfolio
should be constructed.
4. Portfolio Construction:
Under features of an investment programme, portfolio construction requires a
knowledge of the different aspects of securities. These are briefly recapitulated here,
consisting of safety and growth of principal, liquidity of assets after taking into
account the stage involving investment timing, selection of investment, and allocation
of savings to different investments and feedback of portfolio. While evaluating
securities, the investor should realize that investments are made under conditions of
uncertainty. These cannot be a magic formula which will always work. The investor
should be concerned with concepts and applications that will satisfy his investment
objectives and constantly evaluate the performance of his investments. If need be,
the investor may consider switching over to alternate proposals.
5. Portfolio Evaluation
This is the last step of the investment process. The securities included in the portfolio
may not perform as predicted or may not satisfy the investing objectives. Therefore,
an investor should make periodic evaluation of the performance of the portfolio
against the investment objectives. Some securities in the portfolio which stood
attractive may no longer be so attractive. Thus, investors should delete such
securities from the portfolio and add new ones that are attractive. Thus evaluating
and revising is an ongoing process.
The typical object of investment is to make current income from investments in the form
of dividends and interest income. The investments should earn reasonable and expected rate
of return on investments. Certain investments like bank deposits, public deposits, debentures,
bonds etc. will carry a fixed rate of return payable periodically.
Another form of return is in the form of capital appreciation. This element of return is
the difference between the purchase price and the price at which the asset can be sold, it
can be a capital gain or capital loss arising due to change in the price of the investment.
The rate of return of a particular investment is calculated as follows:
The above formula is used for calculation of annual return of an investment in shares. In the
above formula, D1/P0 represents dividend yield and (P1 – P0)/P0 represents capital gain or loss.
Problem 1:
Mr. Ravi has purchased 100 shares of Rs.10 each of Radheshyam Ltd. in 2013 at Rs.78 per
share. The company has declared a dividend @ 40% for the year 2015-16. The market price
of share as at 1-4-2015 was Rs.104 and on 31-3-2016 was Rs.128. Calculate the annual return
on the investment for the year 2015-16.
Solution:
The rate of return can also be calculated for a period more than one year. The average rate of
return represents the average of annual rates of return over a period of years.
The formula used for calculation of average rate of return is given below:
Problem 2:
The average market prices and dividend per share of High-Tech Securities Ltd. for the
past 6 years are given below:
Calculate the average rate of return of High Tech Securities Ltd. Shares for past 6 years.
Solution:
Working Notes:
× 100 = 4.74%
1.8
38
2010-2011- Dividend Yield =
The concept of risk is more difficult to quantify. Statistically we can express risk in terms of
standard deviation of return. For example, in case of gilt edged security or government bonds,
the risk is nil since the return does not vary – it is fixed. But strictly speaking if we
consider inflation and calculate real rate of return (inflation adjusted) we find that even
government bonds have some amount of risk since the rate of inflation may vary.
Return from unsecured fixed deposits appear to have zero variability and hence zero risk. But
there is a risk of default of interest as well as the principal. In such case the rate of return can
be negative. Hence, this investment has high risk though apparently it carries zero risk. For
other investments like shares, business etc., where the rate of return is not fixed, there may be
a schedule of return with associated probability for each rate of return.
The mean of the probable returns gives the expected rate of return and the standard
deviation or variance which is square of standard deviation measures risk. Higher the range
of the probable return, higher the standard deviation and hence higher the risk. A risk averse
investor will look for return where the range is low. Hence, low standard deviation means
low risk.
The returns of Investment ‘A’ show more variability than Investment ‘B’. In view of the
variability of returns, Investment ‘A’ is more risky, even though both the investments are
having the same mean returns. The following illustrations explains the quantification of risk
in terms of standard deviation.
Problem 3:
The rate of return of equity shares of Karan Steels Ltd. for past six years are given
below:
Solution:
Calculation of Average Rate of Return (R̅ ):
So far our analysis of risk-return was confined to single assets held in isolation. In real world, we
rarely find investors putting their entire wealth into single asset or investment. Instead they build
portfolio of investments and hence risk-return analysis is extended in context of portfolio.
A portfolio is composed of two or more securities. Each portfolio has risk-return characteristics of
its own. A portfolio comprising securities that yield a maximum return for given level of risk or
minimum risk for given level of return is termed as ‘efficient portfolio’. In their Endeavour to
strike a golden mean between risk and return the traditional portfolio managers diversified funds
over securities of large number of companies of different industry groups.
However, this was done on intuitive basis with no knowledge of the magnitude of risk reduction
gained. Since the 1950s, however, a systematic body of knowledge has been built up which
quantifies the expected return and riskiness of the portfolio. These studies have collectively come
to be known as ‘portfolio theory’.
i. Portfolio Return:
The expected return of a portfolio represents weighted average of the expected returns on the
securities comprising that portfolio with weights being the proportion of total funds invested in
each security (the total of weights must be 100).
Unlike the expected return on a portfolio which is simply the weighted average of the expected
returns on the individual assets in the portfolio, the portfolio risk, σp is not the simple, weighted
average of the standard deviations of the individual assets in the portfolios.
It is for this fact that consideration of a weighted average of individual security deviations
amounts to ignoring the relationship, or covariance that exists between the returns on securities. In
fact, the overall risk of the portfolio includes the interactive risk of asset in relation to the others,
measured by the covariance of returns. Covariance is a statistical measure of the degree to which
two variables (securities’ returns) move together. Thus, covariance depends on the correlation
between returns on the securities in the portfolio.
2. Find the deviation of possible returns from the expected return for each security
3. Find the sum of the product of each deviation of returns of two securities and respective
probability.
The formula for determining the covariance of returns of two securities is:
Let us explain the computation of covariance of returns on two securities with the help of
the following illustration:
So far as the nature of relationship between the returns of securities A and B is concerned, there
may be three possibilities, viz., positive covariance, negative covariance and zero covariance.
Positive covariance shows that on an average the two variables move together.
A’s and B’s returns could be above their average returns at the same time or they could be below
their average returns at the same time. This signifies that as the proportion of high return and high
risk assets is increased, higher returns on portfolio come with higher risk.
Negative covariance suggests that, on an average, the two variables move in opposite direction. It
means A’s returns could be above its average returns while B’s return could be below its average
returns and vice-versa. This implies that it is possible to combine the two securities A and B in a
manner that will eliminate all risk.
Zero covariance means that the two variables do not move together either in positive or negative
direction. In other words, returns on the two securities are not related at all. Such situation does
not exist in real world. Covariance may be non-zero due to randomness and negative and positive
terms may not cancel each other.
In the above example, covariance between returns on A and B is negative i.e., -38.6. This suggests
that the two returns are negatively related.
The above discussion leads us to conclude that the riskiness of a portfolio depends much more on
the paired security covariance than on the riskiness (standard deviations) of the separate security
holdings. This means that a combination of individually risky securities could still comprise a
moderate-to-low-risk portfolio as long as securities do not move in lock step with each other. In
brief, low covariance’s lead to low portfolio risk.
iii. Diversification:
Diversification is venerable rule of investment which suggests “Don’t put all your eggs in one
basket”, spreading risk across a number of securities.
Diversification may take the form of unit, industry, maturity, geography, type of security and
management. Through diversification of investments, an investor can reduce investment risks.
Investment of funds, say, Rs. 1 lakh evenly among as many as 20 different securities is more
diversified than if the same amount is deployed evenly across 7 securities. This sort of security
diversification is naive in the sense that it does not factor in the covariance between security
returns.
The portfolio comprising 20 securities could represent stocks of one industry only and have
returns which are positively correlated and high portfolio returns variability. On the other hand,
the 7-stock portfolio might represent a number of different industries where returns might show
low correlation and, hence, low portfolio returns variability.
Meaningful diversification is one which involves holding of stocks of more than one industry so
that risks of losses occurring in one industry are counterbalanced by gains from the other industry.
Investing in global financial markets can achieve greater diversification than investing in
securities from a single country. This is for the fact that the economic cycles of different countries
hardly synchronize and as such a weak economy in one country may be offset by a strong
economy in another.
Fig. 5.2 portrays meaningful diversification. It may be noted from the figure that the returns
overtime for Security X are cyclical in that they move in tandem with the economic fluctuations.
In case of Security Y returns are moderately counter cyclical. Thus, the returns for these two
securities are negatively correlated.
If equal amounts are invested in both securities, the dispersion of returns, up, on the portfolio of
investments will be less because some of each individual security’s variability is offsetting. Thus,
the gains of diversification of investment portfolio, in the form of risk minimization, can be
derived if the securities are not perfectly and positively correlated.
Thus, the variance of returns on a portfolio moving in inverse direction can minimize portfolio
risk. However, it is not possible to reduce portfolio risk to zero by increasing the number of
securities in the portfolio. According to the research studies, when we begin with a single stock,
the risk of the portfolio is the standard deviation of that one stock.
As the number of securities selected randomly held in the portfolio increase, the total risk of the
portfolio is reduced, though at a decreasing rate. Thus, degree of portfolio risk can be
reduced to a large extent with a relatively moderate amount of diversification, say 15-20
randomly selected securities in equal-rupee amounts.
Portfolio risk comprises systematic risk and unsystematic risk. Systematic risk is also known as
non- diversifiable risk which arises because of the forces that affect the overall market, such, as
changes in the nation’s economy, fiscal policy of the Government, monetary policy of the Central
bank, change in the world energy situation etc.
Such types of risks affect securities overall and hence, cannot be diversified away. Even if an
investor holds well diversified portfolio, he is exposed to this type of risk which is affecting the
overall market. This is why, non-diversifiable or unsystematic risk is also termed as market risk
which remains after diversification.
Another risk component is unsystematic risk. It is also known as diversifiable risk caused by such
random events as law suits, strikes, successful and unsuccessful marketing programmes, winning
or losing a major contract and other events that are unique to a particular firm.
Unsystematic risk can be eliminated through diversification because these events are random,
their effects on individual securities in a portfolio cancel out each other. Thus, not all of the risks
involved in holding a security are relevant because part of the risk can be diversified away. What
is relevant for investors is systematic risk which is unavoidable and they would like to be
compensated for bearing it. However, they should not expect the market to provide any extra
compensation for bearing the avoidable risk, as is contended in the Capital Asset Pricing Model.
Figure 5.3 displays two components of portfolio risk and their relationship to portfolio size.
Illustrative Problems:
1. An investor has two investment options before him. Portfolio A offers risk-free expected
return of 10%. Portfolio B offers an expected return of 20% and has standard deviation of
10%. His risk aversion index is 5. Which investment portfolio the investor should choose?
Solution:
You are required to calculate the risk and return for a portfolio comprising 60% invested in
the stock of Company X and 40% invested in the stock of Company Y.
Solution:
(ii) 0p = [(.6)2 (1.0)(.05)2 + 2(.6) (.4) (-35) (.05) (.04) + (.4)2 (1.0) (.04)2)]1/2
= [.00082)1/2 = 2.86%