Investment Management and its Process

Description
concepts of investment considerations like return, risk, legal and regulatory factors, time horizon of investment, asset allocation, security selection, hurdle rate

Investment Management
Expectations Vs The Promise
• We shall focus on investors not the
traders (speculators).

• Market is a difficult place to make money.

• Course is not going to give you tips to earn
super-normal profits.
What is Investment?
What is an Investment
Today
Tomorrow
Certain
Uncertain
Time and Risk and return
are important attributes
of “Investment”
An investor trades a known rupee
amount today for some expected
(but risky) future stream of
payments that will be greater than
the current outlay (return).
Return is a compensation for:
•Time
•Inflation
•Uncertainty.

Risk for Comp.
Inflation for Comp.
aiting Comp.for w ) E(R
i
+
+
=
Investment may be in real assets or in
financial assets
What is a Real Asset
• Real assets represent the society’s
wealth.
• The productive capacity of an economy
is the function of real asset
• Real Assets may be:
– Tangible
– Intangible

What is Financial Asset
• Financial Assets do not represent society’s
wealth.
• One person’s financial assets are other
person’s liability.

Then, why do we
need financial assets
in the economy?
• Separation ‘earning” and
‘consumption’
• Separation of ownership and
management
• Efficient Allocation of Capital
• Allocation of risk
Financial
Assets
Equity
Claims
(Equity
Shares)
Creditor
Claims
(Bonds)
Hybrid
Claims
(Preferred
Stocks)

Derivative
s
(Claims on
other Financial
Assets)
Indirect
Investing
(mutual Funds)
Process of Investment Management
Margaret Wheeler
The Investment Objectives
• Why does Margaret need to invest?
• How does her motives differ from those of
Henry Sr.?
• What was the investment portfolio of
Henry Sr.
• How was it suitable for his objectives?
• Is it still suitable for Margaret?
Investment Considerations
• Return
– Regular Income Vs Capital Appreciation
• Safety / Risk
– What factors affect our risk taking attitude?
• Liquidity
• Tax Factors
• Ease of Management
• Legal and Regulatory Factors
• Unique Needs and Preference



...Considerations
• What is more important for Margaret:
– Capital Appreciation or Regular Income
• How much risk she is likely to take?
• How tax considerations will affect her
choice?
• How the ease to manage will affect her
investment behaviour?
The Time Horizon of
Investment
• How long I want to be invested
• How frequently I want to evaluate the
performance of my portfolio/ or want to
revise the portfolio.

• What is the investment horizon for
Margaret?

– The challenges before the institutional
investors
Set your Investment Objectives,
Time Horizon and Risk Tolerance
Major Asset Allocation
Asset/Security Selection
Executing
Performance Review and
Revising the Portfolio
Asset Allocation
• Allocation among two Major Asset Types :
What factors affect them?
• Fixed Income Securities : How Fixed is
your income?
• Equity Investment : Is it always a risky
proportion?
• Strategic Vs Tactical Asset Allocation.

Security Selection
• Stocks have their peculiar Characteristics
– Growth vs Value
– Cyclic vs Defensive.

– What kind of stocks are more suitable for
Margaret?
• Security Selection in context to portfolio
investment.
Market Timing
• Is it a suitable time to invest?
Important Concepts Revisited
Time Value of Money
P
Money
Today
F
Money
in
Future
0 1 2 3 . . . . . . . . t-1 t
Compoundi
ng
t
r P F ) 1 ( + =
2000
10 Years
Rate of interest = 8%
F=2000*(1.08)^10
=2000*2.1589
=4318
Future Value of a Single Sum
5%,
8%
10%
15%,
0
2
4
6
8
10
12
14
16
18
1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16 17 18 19 20
A
m
o
u
n
t

R
s
.

Future Value of Rs. 1
0 1 2 3 . . . . . . . . t-1 t
Discounting
P = 5000/(1.08^10)
= 5000*0.4632
= 2316
10 Years
Rate of discounting = 8%
F=5000
Present Value of a Single Sum
t
r
F
P
) 1 ( +
=
Factors affecting Hurdle Rate
• Preference of present consumption over
future consumption
• Effect of inflation
• Effect of risk
0%
5%,
8%
10%,
15%
0
0.2
0.4
0.6
0.8
1
1.2
0 1 2 3 4 5 6 7 8 9 10
A
m
o
u
n
t

R
s
.

Present Value of Rs. 1
0 1 2 3 . . . t-1 t
Future Value of an Annuity
Year
Amount
deposited at end
of the year
Stayed
invested for
(years)
Future value at
the end
1 100 4 136.05
2 100 3 125.97
3 100 2 116.64
4 100 1 108.00
5 100 0 100.00
Total 586.66
Future Value of an Annuity of Rs. 100 for 5
years at the rate of interest of 8%
1 2
) 1 ( ........ ) 1 ( ) 1 (
÷
+ + + + + =
t
r A r A r A A FVA
1 2
) 1 ( ........ ) 1 ( ) 1 (
÷
+ + + + + =
t
r A r A r A A FVA
t t
r A r A r A r A r FVA ) 1 ( ) 1 ( ........ ) 1 ( ) 1 ( ) 1 (
1 2
+ + + + + + = +
÷
( ) 1 ) 1 ( ) ( ÷ + =
t
r A r FVA
r
r
A FVA
t
) 1 ) 1 ((
.
÷ +
=
0 1 2 3 . . n
Present Value of an Annuity
(
(
(
(
¸
(

¸

|
.
|

\
|
+
÷
=
r
r
A PVA
t
1
1
1
.
0
2
4
6
8
10
12
1 6 11 16 21 26 31 36 41 46
PV of an Annuity of Rs 1 for 50 years at 10% rate of
discounting
Present Value of a Perpetuity
r
A
PVA=
·
+
+
+
+
+
= ......... ..........
) 1 ( ) 1 ( ) 1 (
3 2
r
A
r
A
r
A
PVA
Future Value of a Sum
With multiple compounding within a year
tm
m
r
P F ) 1 ( + =
Where m is the compounding frequency with in a
year and r is annual rate of interest
Continuous compounding
rt
Pe F =
Continuous Rate of Return
r
Pe F =
P F r ln ln ÷ =
Return
What Constitutes Return
What you get
• Dividend / Interest
• Reinvestment Income
• Capital appreciation
• Tax Considerations
What is your cost
• Investment (money)
• Time
Return for a period
1
1
÷
÷
÷
=
t
t t
t
P
P P
R
assuming that the compounding is
discrete
assuming that the compounding is continuous
) ln( ) ln(
1 ÷
÷ =
t t t
P P R
(one may include any other cash flow that may arise during the period.)
Return on Infosys Tech.
• Price on 16 June2009 Rs 1721.10
• Price on 17 June 2010 Rs 2747.45
• Dividend per Share
– October 15, 2009 Rs. 10.00

– Returns 60.21%
– Returns (precisely) 60.22%
Returns and Tax
• Returns are affected by tax.
• In India dividend is not taxed in the hand
of an Investors,( but companies pay dividend distribution tax @ 15
%)
• On short term (less than 12 months)
capital gain 10% tax is payable. (without STT tax
according to income-tax slab)
• No tax is payable on long-term capital
gain. (without STT tax 10% without indexation, 20% with indexation )

Computation of Holding Period Returns
An Investor made the following transitions:
6 April 2009 Bought 200 stocks of Wipro@ Rs. 269
26 March 2010 Sold 50 stocks @ Rs 698
15 June 2010 Bonus Shares 2:3
17 June 2010 Sold all stocks @ Rs 406.
Dividend:
29 June 2009 Rs 4.00
15 June 2010 Rs 6.00
Compute the equivalent Rate of return (before tax
and after tax). Tax on short term capital gain is 10%;
long-term capital gains and dividend income are
exempted.
Date Transaction
Gross
Cash-
flow
Tax
Net Cash-
flow
6-Mar-09 Buy -53800 -53800
29-Jun-09 Dividend 800 800
26-Mar-10 Sell 34900 2145 32755
15-Jun-10 Dividend 900 900
17-Jun-10 Sell 101500 101500
Return 114%
We do not make decisions for
the past!
• Decisions are always made for future on
the basis of expectations.
Expected Return
Current Price Future Price Prob. Return
130 8% 30%
120 30% 20%
110 25% 10%
100 100 15% 0%
90 12% -10%
80 8% -20%
70 2% -30%
Expected Return 7.50%
How do we form expectations regarding
the future
• One possible way- on the basis of the past
behaviour of the variable.
• But future may be very different from the
past.
• We may consider other factors ( economy,
industry etc.) which may affect future
returns

Future is always uncertain !
• This introduce an element of Risk in our
decision.
Risk
What is Risk?
The chance that the actual
return from an investment
would differ from its expected
return is referred as risk.
Statistically it is quantified as the Standard
Deviation (or Variance) of the expected
returns
µ
o
SQRT of mean
square deviation
Why should we worry about
positive deviations!!!
Expected Return and Risk
Current Price Future Price Prob. Return
130 8% 30%
120 30% 20%
110 25% 10%
100 100 15% 0%
90 12% -10%
80 8% -20%
70 2% -30%
Expected Return 7.50%
Standard Deviation 14.92%
How to estimate RISK and RETURN from
the past data?
• The mean of the return can be taken as a
proxy for the Expected Return.
• The standard deviation (or variance) of
the past data can be taken as a proxy of
the risk.

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HUL
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Tata Steel
Average =3.37%
SD = 15.89%
Average =0.94%
SD = 9.03%
Risk-Return Trade-off
• Investors are rational and prefer less risky
investments to riskier. (They are Risk
Averse)
• Some investors are ready to take even
higher risk but only with the expectation of
higher return.(Risk Premium)


Risk
R
i
s
k

P
r
e
m
i
u
m
Risk-free
returns
Govt Bonds
Corporate Bonds
Unsecured Loans
Preference Shares
Equity Shares
Realized Rate of Return on Different Investments in US
(% Returns)

1926-
2005 30s 40s 50s 60s 70s 80s 90s 2000s
Large
Companies 10.4 -0.1 9.2 19.4 7.8 5.9 17.5 18.2 -5.3
Small
Companies 12.6 1.4 20.7 16.9 15.5 11.5 15.8 15.1 13.3
Corporate
Bonds 5.9 6.9 2.7 1.0 1.7 6.2 13 8.4 11.2
Government
Bonds 5.5 4.9 3.2 -0.1 1.4 5.5 12.6 8.8 10.8
Infltaion 3.0 -2.0 5.4 2.2 2.5 7.4 5.1 2.9 2.3

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