| INVESTMENT MANAGEMENT 1
1. Content Index
2. Chapter 1
3. Chapter 2
4. Chapter 3
5. Chapter 4
6. Chapter 5
INVESTMENT MANAGEMENT
CONTENT
INTRODUCTION
CHAPTER 1: INTRODUCTION TO INVESTMENT MANAGEMENT
A. Industry Scope
B. Types of Investments
C. Investment Managers and Portfolio Structures
D. Performance Measurement
E. The Investment Management Process
CHAPTER 2: INVESTMENT ENVIRONMENT
A. Investment Avenues and Attributes
B. Investment Decision Making: Approaches
C. Common Errors in Investment Management
D. Investment and Speculation
E. The Securities Market
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| CHAPTER 3: ACTIVE ASSET ALLOCATION 2
1. Content Index
2. Chapter 1
3. Chapter 2
4. Chapter 3
5. Chapter 4
6. Chapter 5
CHAPTER 3: ACTIVE ASSET ALLOCATION
A. Asset Allocation
B. Tactical Asset Allocation
C. Management of Asset Allocation
D. Asset Allocation Process
E. The Portfolio Upgrade
CHAPTER 4: INVESTMENT MANAGEMENT AND TRADING IN THE STOCK MARKET
A. Estimation of the Intrinsic Value of a Stock
B. Margin of Safety
C. The Time Value of Money
D. Investment Management and the First Trade
E. Stock Market Investment Rules and Strategies
F. Investment Management and Stock Market Simulation
G. Risk and Return
H. Market Efficiency
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| CHAPTER 5: ROLE OF OPTIONS AND FUTURES IN INVESTMENT MANAGEMENT 3
1. Content Index
2. Chapter 1
3. Chapter 2
4. Chapter 3
5. Chapter 4
6. Chapter 5
I. Investment Management and Mutual Funds
J. Investment Management and Forex Trading
K. Investment Management and Real Estate
CHAPTER 5: ROLE OF OPTIONS AND FUTURES IN INVESTMENT MANAGEMENT
A. What are Options?
B. Types of Options
C. Option Concepts
D. Investment World and Reflections for the Investment Manager
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| INVESTMENT MANAGEMENT 4
1. Content Index
2. Chapter 1
3. Chapter 2
4. Chapter 3
5. Chapter 4
6. Chapter 5
INVESTMENT MANAGEMENT
INTRODUCTION
Investment management is the professional management of various securities (shares,
bonds etc.) and assets (e.g., real estate), to meet specified investment goals for the benefit of
the investors. Investors may be institutions (insurance companies, pension funds, corporations
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 (not necesarily) whilst 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 wealth management or
portfolio management often within the context of so-called "private banking".
The provision of 'investment management services' includes elements of financial
analysis, asset selection, stock selection, plan implementation and ongoing monitoring of
investments. Investment management is a large and important global industry in its own right
responsible for caretaking of trillions of dollars, euro, pounds and yen. 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 and create billions in revenue.
Fund manager (or investment adviser in the U.S.) refers to both a firm that provides
investment management services and an individual who directs fund management decisions.
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| 1 INTRODUCTION TO INVESTMENT MANAGEMENT 5
1. Content Index
2. Chapter 1
3. Chapter 2
4. Chapter 3
5. Chapter 4
6. Chapter 5
1 INTRODUCTION TO INVESTMENT MANAGEMENT
What is Investment?
Investment or investing is a term with several closely-related meanings in business
management, finance and economics, related to saving or deferring consumption. Investing is
the active redirecting resources from being consumed today so that they may create benefits
in the future; the use of assets to earn income or profit.
An investment is the choice by the individual, after thorough analysis, to place or lend
money in a vehicle (e.g. property, stock securities, and bonds) that has sufficiently low risk and
provides the possibility of generating returns over a period of time. Placing or lending money
in a vehicle that risks the loss of the principal sum or that has not been thoroughly analyzed is,
by definition speculation, not investment.
In the case of investment, rather than store the good produced or its money equivalent,
the investor chooses to use that good either to create a durable consumer or producer good,
or to lend the original saved good to another in exchange for either interest or a share of the
profits.
In the first case, the individual creates durable consumer goods, hoping the services
from the good will make his life better. In the second, the individual becomes an entrepreneur
using the resource to produce goods and services for others in the hope of a profitable sale.
The third case describes a lender, and the fourth describes an investor in a share of the
business.
In each case, the consumer obtains a durable asset or investment, and accounts for
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| 1 INTRODUCTION TO INVESTMENT MANAGEMENT 6
1. Content Index
2. Chapter 1
3. Chapter 2
4. Chapter 3
5. Chapter 4
6. Chapter 5
that asset by recording an equivalent liability. As time passes, and both prices and interest
rates change, the value of the asset and liability also change.
An asset is usually purchased, or equivalently a deposit is made in a bank, in hopes of
getting a future return or interest from it. The word originates in the Latin "vestis", meaning
garment, and refers to the act of putting things (money or other claims to resources) into
others' pockets. The basic meaning of the term being an asset held to have some recurring or
capital gains. It is an asset that is expected to give returns without any work on the asset per
se.
Industry Scope
The business of investment management has several facets, including the employment
of professional fund managers, research (of individual assets and asset classes), dealing,
settlement, marketing, internal auditing, and the preparation of reports for clients. The largest
financial fund managers are firms that exhibit all the complexity their size demands. Apart from
the people who bring in the money (marketers) and the people who direct investment (the fund
managers), there are compliance staff (to ensure accord with legislative and regulatory
constraints), internal auditors of various kinds (to examine internal systems and controls),
financial controllers (to account for the institutions' own money and costs), computer experts,
and "back office" employees (to track and record transactions and fund valuations for up to
thousands of clients per institution).
Key problems of running such businesses: Key problems include:
 revenue is directly linked to market valuations, so a major fall in asset prices causes a
precipitous decline in revenues relative to costs;
 above-average fund performance is difficult to sustain, and clients may not be patient
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| 1 INTRODUCTION TO INVESTMENT MANAGEMENT 7
1. Content Index
2. Chapter 1
3. Chapter 2
4. Chapter 3
5. Chapter 4
6. Chapter 5
during times of poor performance;
 successful fund managers are expensive and may be headhunted by competitors;
 above-average fund performance appears to be dependent on the unique skills of the
fund manager; however, clients are loath to stake their investments on the ability of a
few individuals- they would rather see firm-wide success, attributable to a single
philosophy and internal discipline;
 Analysts who generate above-average returns often become sufficiently wealthy that
they avoid corporate employment in favor of managing their personal portfolios.
The most successful investment firms in the world have probably been those that have
been separated physically and psychologically from banks and insurance companies. That is,
the best performance and also the most dynamic business strategies (in this field) have
generally come from independent investment management firms.
Representing the Owners of Shares
Institutions often control huge shareholdings. In most cases they are acting as fiduciary
agents rather than principals (direct owners). The owners of shares theoretically have great
power to alter the companies they own via the voting rights the shares carry and the
consequent ability to pressure managements, and if necessary out-vote them at annual and
other meetings.
In practice, the ultimate owners of shares often do not exercise the power they
collectively hold (because the owners are many, each with small holdings); financial
institutions (as agents) sometimes do. There is a general belief that shareholders - in this
case, the institutions acting as agents—could and should exercise more active influence over
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| 1 INTRODUCTION TO INVESTMENT MANAGEMENT 8
1. Content Index
2. Chapter 1
3. Chapter 2
4. Chapter 3
5. Chapter 4
6. Chapter 5
the companies in which they hold shares (e.g., to hold managers to account, to ensure Boards
effective functioning). Such action would add a pressure group to those (the regulators and
the Board) overseeing management.
However there is the problem of how the institution should exercise this power. One
way is for the institution to decide, the other is for the institution to poll its beneficiaries.
Assuming that the institution polls, should it then: (i) Vote the entire holding as directed by the
majority of votes cast? (ii) Split the vote (where this is allowed) according to the proportions of
the vote? (iii) Or respect the abstainers and only vote the respondents' holdings?
The price signals generated by large active managers holding or not holding the stock
may contribute to management change. For example, this is the case when a large active
manager sells his position in a company, leading to (possibly) a decline in the stock price, but
more importantly a loss of confidence by the markets in the management of the company, thus
precipitating changes in the management team.
Some institutions have been more vocal and active in pursuing such matters; for
instance, some firms believe that there are investment advantages to accumulating substantial
minority shareholdings (i.e. 10% or more) and putting pressure on management to implement
significant changes in the business. In some cases, institutions with minority holdings work
together to force management change. Perhaps more frequent is the sustained pressure that
large institutions bring to bear on management teams through persuasive discourse and PR.
On the other hand, some of the largest investment managers—such as Barclays Global
Investors and Vanguard—advocate simply owning every company, reducing the incentive to
influence management teams. A reason for this last strategy is that the investment manager
prefers a closer, more open and honest relationship with a company's management team than
would exist if they exercised control; allowing them to make a better investment decision.
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| 1 INTRODUCTION TO INVESTMENT MANAGEMENT 9
1. Content Index
2. Chapter 1
3. Chapter 2
4. Chapter 3
5. Chapter 4
6. Chapter 5
The national context in which shareholder representation considerations are set is
variable and important. The USA is a litigious society and shareholders use the law as a lever
to pressure management teams. In Japan it is traditional for shareholders to be low in the
'pecking order,' which often allows management and labor to ignore the rights of the ultimate
owners. Whereas US firms generally cater to shareholders, Japanese businesses generally
exhibit a stakeholder mentality, in which they seek consensus amongst all interested parties
(against a background of strong unions and labour legislation).
Types of Investments
The term "investment" is used differently in economics and in finance. Economists refer
to a real investment (such as a machine or a house), while financial economists refer to a
financial asset, such as money that is put into a bank or the market, which may then be used
to buy a real asset.
Business Management
The investment decision (also known as capital budgeting) is one of the fundamental
decisions of business management: Managers determine the investment value of the assets
that a business enterprise has within its control or possession. These assets may be physical
(such as buildings or machinery), intangible (such as patents, software, goodwill), or financial.
Assets are used to produce streams of revenue that often are associated with particular costs
or outflows. All together, the manager must determine whether the net present value of the
investment to the enterprise is positive using the marginal cost of capital that is associated
with the particular area of business.
In terms of financial assets, these are often marketable securities such as a company
stock (an equity investment) or bonds (a debt investment). At times the goal of the investment
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| 1 INTRODUCTION TO INVESTMENT MANAGEMENT 10
1. Content Index
2. Chapter 1
3. Chapter 2
4. Chapter 3
5. Chapter 4
6. Chapter 5
is for producing future cash flows, while at others it may be for purposes of gaining access to
more assets by establishing control or influence over the operation of a second company (the
investee).
Economics
In economics, investment is the production per unit time of goods which are not
consumed but are to be used for future production. Examples include tangibles (such as
building a railroad or factory) and intangibles (such as a year of schooling or on-the-job
training). In measures of national income and output, gross investment (represented by the
variable I) is also a component of Gross domestic product (GDP), given in the formula GDP =
C + I + G + NX, where C is consumption, G is government spending, and NX is net exports.
Thus investment is everything that remains of production after consumption, government
spending, and exports are subtracted.
Both non-residential investment (such as factories) and residential investment (new
houses) combine to make up I. Net investment deducts depreciation from gross investment. It
is the value of the net increase in the capital stock per year.
Investment, as production over a period of time ("per year"), is not capital. The time
dimension of investment makes it a flow. By contrast, capital is a stock, that is, an
accumulation measurable at a point in time (say December 31).
Investment is often modeled as a function of Income and Interest rates, given by the
relation I = f(Y, r). An increase in income encourages higher investment, whereas a higher
interest rate may discourage investment as it becomes more costly to borrow money. Even if a
firm chooses to use its own funds in an investment, the interest rate represents an opportunity
cost of investing those funds rather than lending out that amount of money for interest.
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| 1 INTRODUCTION TO INVESTMENT MANAGEMENT 11
1. Content Index
2. Chapter 1
3. Chapter 2
4. Chapter 3
5. Chapter 4
6. Chapter 5
Finance
In finance, investment is the commitment of funds by buying securities or other
monetary or paper (financial) assets in the money markets or capital markets, or in fairly liquid
real assets, such as gold, real estate, or collectibles. Valuation is the method for assessing
whether a potential investment is worth its price. Returns on investments will follow the risk-
return spectrum.
Types of financial investments include shares, other equity investment, and bonds
(including bonds denominated in foreign currencies). These financial assets are then expected
to provide income or positive future cash flows, and may increase or decrease in value giving
the investor capital gains or losses.
Trades in contingent claims or derivative securities do not necessarily have future
positive expected cash flows, and so are not considered assets, or strictly speaking, securities
or investments. Nevertheless, since their cash flows are closely related to (or derived from)
those of specific securities, they are often studied as or treated as investments.
Investments are often made indirectly through intermediaries, such as banks, mutual
funds, pension funds, insurance companies, collective investment schemes, and investment
clubs. Though their legal and procedural details differ, an intermediary generally makes an
investment using money from many individuals, each of whom receives a claim on the
intermediary.
Within personal finance, money used to purchase shares, put in a collective investment
scheme or used to buy any asset where there is an element of capital risk is deemed an
investment. Saving within personal finance refers to money put aside, normally on a regular
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| 1 INTRODUCTION TO INVESTMENT MANAGEMENT 12
1. Content Index
2. Chapter 1
3. Chapter 2
4. Chapter 3
5. Chapter 4
6. Chapter 5
basis. This distinction is important, as investment risk can cause a capital loss when an
investment is realized, unlike saving(s) where the more limited risk is cash devaluing due to
inflation.
In many instances the terms saving and investment are used interchangeably, which
confuses this distinction. For example many deposit accounts are labeled as investment
accounts by banks for marketing purposes. Whether an asset is a saving(s) or an investment
depends on where the money is invested: if it is cash then it is savings, if its value can
fluctuate then it is investment.
 Real estate: In real estate, investment money is used to purchase property for the
purpose of holding or leasing for income and there is an element of capital risk.
 Residential real estate: The most common form of real estate investment as it
includes property purchased as a primary residence. In many cases the buyer does not
have the full purchase price for a property and must engage a lender such as a bank,
finance company or private lender. Different countries have their individual normal
lending levels, but usually they will fall into the range of 70-90% of the purchase price.
Against other types of real estate, residential real estate is the least risky.
 Commercial real estate: Commercial real estate consists of multifamily apartments,
office buildings, retail space, hotels and motels, warehouses, and other commercial
properties. Due to the higher risk of commercial real estate, loan-to-value ratios allowed
by banks and other lenders are lower and often fall in the range of 50-70%.
Investment Managers and Portfolio Structures
At the heart of the investment management industry are the managers who invest and
divest client investments. A certified company investment advisor should conduct an
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| 1 INTRODUCTION TO INVESTMENT MANAGEMENT 13
1. Content Index
2. Chapter 1
3. Chapter 2
4. Chapter 3
5. Chapter 4
6. Chapter 5
assessment of each client's individual needs and risk profile. The advisor then recommends
appropriate investments.
Asset allocation: The different asset class definitions are widely debated, but four
common divisions are stocks, bonds, real-estate and commodities. The exercise of
allocating funds among these assets (and among individual securities within each asset
class) is what investment management firms are paid for. Asset classes exhibit different
market dynamics, and different interaction effects; thus, the allocation of monies among
asset classes will have a significant effect on the performance of the fund. Some
research suggests that allocation among asset classes has more predictive power than
the choice of individual holdings in determining portfolio return. Arguably, the skill of a
successful investment manager resides in constructing the asset allocation, and
separately the individual holdings, so as to outperform certain benchmarks (e.g., the
peer group of competing funds, bond and stock indices).
Long-term returns: It is important to look at the evidence on the long-term returns to
different assets, and to holding period returns (the returns that accrue on average over
different lengths of investment). For example, over very long holding periods (eg. 10+
years) in most countries, equities have generated higher returns than bonds, and bonds
have generated higher returns than cash. According to financial theory, this is because
equities are riskier (more volatile) than bonds which are themselves more risky than
cash.
Diversification: Against the background of the asset allocation, fund managers consider
the degree of diversification that makes sense for a given client (given its risk
preferences) and construct a list of planned holdings accordingly. The list will indicate
what percentage of the fund should be invested in each particular stock or bond. The
theory of portfolio diversification was originated by Markowitz and effective
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| 1 INTRODUCTION TO INVESTMENT MANAGEMENT 14
1. Content Index
2. Chapter 1
3. Chapter 2
4. Chapter 3
5. Chapter 4
6. Chapter 5
diversification requires management of the correlation between the asset returns and
the liability returns, issues internal to the portfolio (individual holdings volatility), and
cross-correlations between the returns.
Performance Measurement
Fund performance is the acid test of fund management, and in the institutional context
accurate measurement is a necessity. For that purpose, institutions measure the performance
of each fund (and usually for internal purposes components of each fund) under their
management, and performance is also measured by external firms that specialize in
performance measurement. The leading performance measurement firms (e.g. Frank Russell
in the USA) compile aggregate industry data, e.g., showing how funds in general performed
against given indices and peer groups over various time periods.
In a typical case (let us say an equity fund), then the calculation would be made (as far
as the client is concerned) every quarter and would show a percentage change compared with
the prior quarter (e.g., +4.6% total return in US dollars). This figure would be compared with
other similar funds managed within the institution (for purposes of monitoring internal controls),
with performance data for peer group funds, and with relevant indices (where available) or
tailor-made performance benchmarks where appropriate. The specialist performance
measurement firms calculate quartile and decile data and close attention would be paid to the
(percentile) ranking of any fund.
Generally speaking, it is probably appropriate for an investment firm to persuade its
clients to assess performance over longer periods (e.g., 3 to 5 years) to smooth out very short
term fluctuations in performance and the influence of the business cycle. This can be difficult
however and, industry wide, there is a serious preoccupation with short-term numbers and the
effect on the relationship with clients (and resultant business risks for the institutions).
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| 1 INTRODUCTION TO INVESTMENT MANAGEMENT 15
1. Content Index
2. Chapter 1
3. Chapter 2
4. Chapter 3
5. Chapter 4
6. Chapter 5
An enduring problem is whether to measure before-tax or after-tax performance. After-
tax measurement represents the benefit to the investor, but investors' tax positions may vary.
Before-tax measurement can be misleading, especially in regimens that tax realised capital
gains (and not unrealised). It is thus possible that successful active managers (measured
before tax) may produce miserable after-tax results. One possible solution is to report the
after-tax position of some standard taxpayer.
Risk-Adjusted Performance Measurement
Performance measurement should not be reduced to the evaluation of fund returns
alone, but must also integrate other fund elements that would be of interest to investors, such
as the measure of risk taken. Several other aspects are also part of performance
measurement: evaluating if managers have succeeded in reaching their objective, i.e. if their
return was sufficiently high to reward the risks taken; how they compare to their peers; and
finally whether the portfolio management results were due to luck or the manager‘s skill. The
need to answer all these questions has led to the development of more sophisticated
performance measures, many of which originate in modern portfolio theory.
Modern portfolio theory established the quantitative link that exists between portfolio
risk and return. The Capital Asset Pricing Model (CAPM) developed by Sharpe (1964)
highlighted the notion of rewarding risk and produced the first performance indicators, be they
risk-adjusted ratios (Sharpe ratio, information ratio) or differential returns compared to
benchmarks (alphas). The Sharpe ratio is the simplest and best known performance measure.
It measures the return of a portfolio in excess of the risk-free rate, compared to the total risk of
the portfolio. This measure is said to be absolute, as it does not refer to any benchmark,
avoiding drawbacks related to a poor choice of benchmark. Meanwhile, it does not allow the
separation of the performance of the market in which the portfolio is invested from that of the
manager. The information ratio is a more general form of the Sharpe ratio in which the risk-
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| 1 INTRODUCTION TO INVESTMENT MANAGEMENT 16
1. Content Index
2. Chapter 1
3. Chapter 2
4. Chapter 3
5. Chapter 4
6. Chapter 5
free asset is replaced by a benchmark portfolio. This measure is relative, as it evaluates
portfolio performance in reference to a benchmark, making the result strongly dependent on
this benchmark choice.
Portfolio alpha is obtained by measuring the difference between the return of the
portfolio and that of a benchmark portfolio. This measure appears to be the only reliable
performance measure to evaluate active management. In fact, we have to distinguish between
normal returns, provided by the fair reward for portfolio exposure to different risks, and
obtained through passive management, from abnormal performance (or out performance) due
to the manager‘s skill, whether through market timing or stock picking. The first component is
related to allocation and style investment choices, which may not be under the sole control of
the manager, and depends on the economic context, while the second component is an
evaluation of the success of the manager‘s decisions. Only the latter, measured by alpha,
allows the evaluation of the manager‘s true performance.
Portfolio normal return may be evaluated using factor models. The first model,
proposed by Jensen (1968), relies on the CAPM and explains portfolio normal returns with the
market index as the only factor. It quickly becomes clear, however, that one factor is not
enough to explain the returns and that other factors have to be considered. Multi-factor
models were developed as an alternative to the CAPM, allowing a better description of
portfolio risks and an accurate evaluation of managers‘ performance. For example, Fama and
French (1993) have highlighted two important factors that characterise a company's risk in
addition to market risk. These factors are the book-to-market ratio and the company's size as
measured by its market capitalisation. Fama and French therefore proposed a three-factor
model to describe portfolio normal returns (Fama-French three-factor model). Carhart (1997)
proposed to add momentum as a fourth factor to allow the persistence of the returns to be
taken into account. Also of interest for performance measurement is Sharpe‘s (1992) style
analysis model, in which factors are style indices. This model allows a custom benchmark for
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| 1 INTRODUCTION TO INVESTMENT MANAGEMENT 17
1. Content Index
2. Chapter 1
3. Chapter 2
4. Chapter 3
5. Chapter 4
6. Chapter 5
each portfolio to be developed, using the linear combination of style indices that best replicate
portfolio style allocation, and leads to an accurate evaluation of portfolio alpha.
The Investment Management Process
The starting point would be an understanding of the investment management process.
Setting the Investment Objective
The first step for the investor is to set the investment objective. Which would vary for
individuals, pension and mutual funds, banks, financial institutions, insurance companies, etc.
For instance the objective for a pension or mutual fund or insurance company maybe to
have a cash flow specification to satisfy liabilities at different dates in the future. These
liabilities would include redemption, dividends or claim settlement payouts.
For a bank it maybe to lock in a minimum interest spread over their cost of funds.
For the individual investor the objective maybe to maximize return on investment - A
more appropriate word would be ‗optimize‘. As the individual would achieve optimum return at
optimum risk. To maximize return would imply the maximization of risk, which would not be
practical or sustainable.
Establishing Investment Policy
Setting policy begins with asset allocation amongst the major asset classes available in
the capital market. Which range from equities, debt, fixed income securities, real estate,
foreign securities to currencies.
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| 1 INTRODUCTION TO INVESTMENT MANAGEMENT 18
1. Content Index
2. Chapter 1
3. Chapter 2
4. Chapter 3
5. Chapter 4
6. Chapter 5
While setting the investment policy the constraints of the environment and that of the
investor have to be kept in perspective.
The environment would include: government rules and regulations (or restrictions);
another would be the operating system of the market place. Individual constraints would
include financial capability, availability of time to undertake the exercise, risk profile and the
level of understanding the investor has of the investment environment.
Selecting the Portfolio Strategy
The portfolio strategy selected would have to be in conformity with both the objectives
and policy guidelines. Any contradiction here would result in a systems break down and
losses.
Let‘s consider a person with a job that keeps him busy for 10-12 hours a day, five days
of the week. On Saturday he helps the family with household chores. On Sunday he takes the
day off and enjoys himself. Now with such a busy life, we cannot expect him to obtain optimal
returns from investments in the equity market. Where is the time for thought, analysis and
action? He would at best be playing a game of Russian roulette.
For a person with such a busy life schedule it would be best to invest in fixed income
securities. These would include RBI bonds, Bank deposits, insurance, etc. The portfolio
strategy selected would have to be in conformity with both the objectives and policy
guidelines. Any contradiction here would result in a systems break down and losses.
Let‘s consider a person with a job that keeps him busy for 10-12 hours a day, five days
of the week. On Saturday he helps the family with household chores. On Sunday he takes the
day off and enjoys himself. Now with such a busy life, we cannot expect him to obtain optimal
returns from investments in the equity market. Where is the time for thought, analysis and
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| 1 INTRODUCTION TO INVESTMENT MANAGEMENT 19
1. Content Index
2. Chapter 1
3. Chapter 2
4. Chapter 3
5. Chapter 4
6. Chapter 5
action? He would at best be playing a game of Russian roulette.
For a person with such a busy life schedule it would be best to invest in fixed income
securities. These would include RBI bonds, Bank deposits, insurance, etc. Where there is a
lower but assured return. However, if this average, hard working and successful person still
wants to invest in the equity market for a relatively higher rate of return. Then he would have
to create the time for the thought, analysis and action required for success in this endeavor.
Portfolio strategies are mainly of two types: Active strategies and Passive strategies.
Active strategies have a higher expectation about the factors that are expected to influence
the performance of the asset class. While Passive strategies involve a minimum expectation
input. The latter would include indexing which would require the investor to replicate the
performance of a particular index. Between these two extremes we have a range of other
strategies which have elements of both active and passive strategies. In the fixed income
segment, structured portfolio strategies have become popular. Here the aim would be to
achieve a predetermined performance in relation to a benchmark. These are frequently used
to fund liabilities.
Selecting the Assets
It is of importance for the investor to select specific assets to be included in the
portfolio. It is here that the investor or manager attempts to construct an optimal or efficient
portfolio. Which would give the expected return for a given level of risk, or the lowest risk for a
given expected return.
The asset classes he can choose from are:
 Equity
 Fixed income securities (which would include RBI bonds and bank deposits)
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| 20
1. Content Index
2. Chapter 1
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4. Chapter 3
5. Chapter 4
6. Chapter 5
 Debt instruments
 Real estate
 Art objects
 Rare stamps
 Currencies
The investor would ideally have all the above in his investment portfolio. This would
then require the investor to rebalance the various components of his overall portfolio from time
to time, depending on his objectives with respect to this portfolio. These objectives may be
time based or asset price based or a combination of both.
Measuring and Evaluating Performance
This step would involve the measuring and evaluating of portfolio performance relative
to a realistic benchmark. We would measure portfolio performance in both absolute and
relative terms, against a predetermined, realistic and achievable benchmark. Further, we
would evaluate the portfolio performance relative to the objective and other predetermined
performance parameters.
The investor or manager would consider two main aspects; namely risk and return. He
would measure and evaluate, whether the returns were worth the risk, or whether the risk was
worth the return. The issue here is, whether the portfolio has achieved commensurate returns,
given the risk exposure of the portfolio
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| 2. INVESTMENT ENVIRONMENT 21
1. Content Index
2. Chapter 1
3. Chapter 2
4. Chapter 3
5. Chapter 4
6. Chapter 5
2. INVESTMENT ENVIRONMENT
To study the investment environment would be of importance to the investor, as it
would also encompass the demand supply match/mismatch.
Let us visualize the world and its economy. There are many countries with their many
economies in this environment. We see the interaction between countries at different stages in
their development. We see the many markets to enable this interaction between the various
countries. Each of these markets has its regulator, the trading platform and its system, its
agents (or brokers), and the participants. Here it is a question of demand and supply of
various commodities, products & services and trading instruments. And the analysis would
encompass the demand-supply match/mismatch.
Among these markets we have the securities market, with its regulator (SEBI), the
trading platform and its systems (stock exchanges), its agents (brokers) and its many
participants (including corporate, financial institutions both domestic and foreign, mutual funds,
insurance companies, banks and individual investors). Here again it is a question of demand
and supply of various commodities, products & services and trading instruments. And the
analysis would encompass the demand-supply match/mismatch.
It would be advisable to note at this stage, that due to the liberalization process
undertaken by India over the last 18 years, we are today in an environment where events that
take place in other parts of the world have a direct or indirect effect on our economy. This
would further affect the specific market and finally would have an effect on the equity market.
Let us visualize a scenario of an industrial slowdown in the U.S. Amongst other things,
this would have a direct bearing (i.e. a reduction) on the demand of steel. To protect its own
domestic steel industry, the U.S. government would temporarily introduce trade barriers on
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| 2. INVESTMENT ENVIRONMENT 22
1. Content Index
2. Chapter 1
3. Chapter 2
4. Chapter 3
5. Chapter 4
6. Chapter 5
steel imports. This in turn would cause a reduced export of steel from India to the U.S.,
causing a temporary over supply of steel in the domestic market. The steel manufacturers
would have to tackle the higher levels of inventory and its associated costs. In the domestic
steel market, even if the demand were constant, the excess supply would cause a reduction in
the price realization per marketable ton of steel. This in turn would directly affect the incomes
and profit margins of the steel manufacturers. Such a situation would temporarily cause a drop
in the share prices of steel stocks in the equity market.
This example is to describe to you how logical the sequence of events is and what the
end result would be. However, this sequence does take a long duration of time to unfold,
sometimes may even take years
Investment Avenues and Attributes
Investment Avenues
There are a large number of investment instruments available today. To make our lives
easier we would classify or group them under 4 main types of investment avenues. We shall
name and briefly describe them.
 Financial securities: These investment instruments are freely tradable and negotiable.
These would include equity shares, preference shares, convertible debentures, non-
convertible debentures, public sector bonds, savings certificates, gilt-edged securities
and money market securities.
 Non-securitized financial securities: These investment instruments are not tradable,
transferable nor negotiable. And would include bank deposits, post office deposits,
company fixed deposits, provident fund schemes, national savings schemes and life
insurance.
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| 2. INVESTMENT ENVIRONMENT 23
1. Content Index
2. Chapter 1
3. Chapter 2
4. Chapter 3
5. Chapter 4
6. Chapter 5
 Mutual fund schemes: If an investor does not directly want to invest in the markets,
he/she could buy units/shares in a mutual fund scheme. These schemes are mainly
growth (or equity) oriented, income (or debt) oriented or balanced (i.e. both growth and
debt) schemes.
 Real assets: Real assets are physical investments, which would include real estate,
gold & silver, precious stones, rare coins & stamps and art objects.
Before choosing the avenue for investment the investor would probably want to
evaluate and compare them. This would also help him in creating a well diversified portfolio,
which is both maintainable and manageable.
Investment Attributes
To enable the evaluation and a reasonable comparison of various investment avenues,
the investor should study the following attributes:
RATE OF RETURN
The rate of return on any investment comprises of 2 parts, namely the annual income
and the capital gain or loss. To simplify it further look below:
Rate of return = Annual income + (Ending price - Beginning price) / Beginning price
The rate of return on various investment avenues would vary widely.
 Risk: The risk of an investment refers to the variability of the rate of return. To explain
further, it is the deviation of the outcome of an investment from its expected value. A
further study can be done with the help of variance, standard deviation and beta.
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| 2. INVESTMENT ENVIRONMENT 24
1. Content Index
2. Chapter 1
3. Chapter 2
4. Chapter 3
5. Chapter 4
6. Chapter 5
 Marketability: It is desirable that an investment instrument be marketable, the higher the
marketability the better it is for the investor. An investment instrument is considered to be
highly marketable when:
 It can be transacted quickly.
 The transaction cost (including brokerage and other charges) is low.
 The price change between 2 transactions is negligible.
 Shares of large, well-established companies in the equity market are highly marketable.
While shares of small and unknown companies have low marketability.
To gauge the marketability of other financial instruments like provident fund (which in
itself is non-marketable). Then we would consider other factors like, can we make a
substantial withdrawal without much penalty, or can we take a loan against the accumulated
balance at an interest rate not much higher than our earning rate of interest on the provident
fund account.
Taxes: Some of our investments would provide us with tax benefits while other would not.
This would also be kept in mind when choosing the investment avenue. Tax benefits are
mainly of 3 types:
 Initial tax benefits. This is the tax gain at the time of making the investment, like life
insurance.
 Continuing tax benefit. Is the tax benefit gained on the periodic return from the
investment, such as dividends.
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| 2. INVESTMENT ENVIRONMENT 25
1. Content Index
2. Chapter 1
3. Chapter 2
4. Chapter 3
5. Chapter 4
6. Chapter 5
 Terminal tax benefit. This is the tax relief the investor gains when he liquidates the
investment. For example, a withdrawal from a provident fund account is not taxable.
 Convenience: Here we are talking about the ease with which an investment can be made
and managed. The degree of convenience would vary from one investment instrument to
the other.
Investment Decision Making: Approaches
As investors we would have diverse investment strategies with the primary aim to
achieve superior performance, which would also mean a higher rate of return on our
investments. All investment strategies can be broadly classified under 4 approaches, which
are explained below.
Fundamental Approach
In this approach the investor is concerned with the intrinsic value of the investment
instrument. Given below are the basic rules followed by the fundamental investor.
There is an intrinsic value of a security, which in turn is dependent on the underlying
economic factors. This intrinsic value can be ascertained by an in-depth analysis of the
fundamental or economic factors related to an economy, industry and company.
At any point in time, many securities have current market prices, which are different
from their intrinsic values. However, sometime in the future the current market price would
become the same as its intrinsic value. We as fundamental investors can achieve superior
results by buying undervalued securities and selling overvalued securities.
Psychological Approach
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| 2. INVESTMENT ENVIRONMENT 26
1. Content Index
2. Chapter 1
3. Chapter 2
4. Chapter 3
5. Chapter 4
6. Chapter 5
The psychological investor would base his investment decision on the premise that
stock prices are guided by emotions and not reason. This would imply that the stock prices are
influenced by the prevalent mood of the investors. This mood would swing and oscillate
between the two extremes of ―greed‖ and ―fear‖. When ―greed‖ has the lead stock prices tend
to achieve dizzy heights. And when ―fear‖ takes over stock prices get depressed to lower than
lower levels.
As psychic values seem to be more important than intrinsic values, it is suggested that
it would be more profitable to analyze investor behaviour as the market is swept by optimism
and pessimism. Which seem to alternate one after the other? This approach is also called
―Castle-in-the-air‖ theory. In this approach the investor uses some tools of technical analysis,
with a view to study the internal market data, towards developing trading rules to make profits.
In technical analysis the basic premise is that price movement of stocks has certain
persistent and recurring patterns, which can be derived from market trading data. Technical
analysts use many tools like bar charts, point and figure charts, moving average analysis, and
market breadth analysis amongst others.
Academic Approach
Over the years, the academics have studied many aspects of the securities market and
have developed advanced methods of analysis. The basic rules are:
The stock markets are efficient and react rationally and fast to the information flow over
time. So, the current market price would reflect its intrinsic value at all times. This would mean
"Current market price = Intrinsic value".
Stock prices behave in a random fashion and successive price changes are
independent of each other. Thus, present price behaviour can not predict future price
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| 2. INVESTMENT ENVIRONMENT 27
1. Content Index
2. Chapter 1
3. Chapter 2
4. Chapter 3
5. Chapter 4
6. Chapter 5
behaviour.
In the securities market there is a positive and linear relationship between risk and
return. That is the expected return from a security has a linear relationship with the systemic or
non-diversifiable risk of the market.
Eclectic Approach
This approach draws upon all the 3 approaches discussed above. The basic rules of
this approach are:
Fundamental analysis would help us in establishing standards and benchmarks.
Technical analysis would help us gauge the current investor mood and the relative strength of
demand and supply. The market is neither well ordered nor speculative. The market has
imperfections, but reacts reasonably well to the flow of information. Although some securities
would be mispriced, there is a positive correlation between risk and return.
Common Errors in Investment Management
In any endeavor we undertake, we are sometimes right and make correct decisions and
sometimes we are wrong and prone to errors. We are prone to these errors, when we do not
have a correct perspective of the environment or lack a correct assessment of the current
situation in the environment.
We would have to watch out for these errors to reduce the probability of losses. For
instance, it would be very difficult and an error to be in a buy or hold position if the market is in
a bearish mode. Similarly, it would be difficult and an error to be in a sell or short position if
the market is in a bullish trend. It would be advisable, correct and profitable to trade with the
trend and not against it.
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| 2. INVESTMENT ENVIRONMENT 28
1. Content Index
2. Chapter 1
3. Chapter 2
4. Chapter 3
5. Chapter 4
6. Chapter 5
Still investors of all hues and levels of experience are prone to errors. Some of these
errors are listed and described below:
Goals beyond Rational Expectation
Here the investor probably thinks that he owns the company lock, stock and barrel. Or
that the market owes him his profits for having exposed himself to the market risks. Or the
investor may have a targeted expected rate of return beyond what the market would be able to
give him consistently over time.
On the other hand, unrealistic goals could also be a result of unjustified claims made by
a company going for a new issue. Or misplaced expectations due to exceptionally good past
performance of the investment instrument or a mutual fund or a portfolio manager. Or
promises not kept by tipsters, market operators and fly by night operators.
An Investment Policy Not Clearly Defined
This would also include an unclear view on risk. Here, the investor would be prone to
greed and fear as the market goes up and down, respectively. This vacillation would cause the
investor much loss and pain.
Seat of the Pant Decision Making
Investors without even realizing it base their decisions on incomplete information. Some
of the thoughts of the investor would be:
 Come on! I know what is going on in the market, and there isn‘t any time to do a
detailed analysis. I don‘t want an opportunity loss if I delay.
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| 2. INVESTMENT ENVIRONMENT 29
1. Content Index
2. Chapter 1
3. Chapter 2
4. Chapter 3
5. Chapter 4
6. Chapter 5
 All that hard work is strictly for the mediocre. I know I am right.
 He is my guru and can‘t be wrong.
We must clarify at the beginning whether we are doing an investment exercise or are
we indulging in ego satisfaction. If it is investment then do the analysis as the markets and the
investment instruments will still be there tomorrow. On the other hand, if it is ego satisfaction,
then may the Gods bless you, as other would profit from your market actions.
Another situation could cause the investor a loss of balance. As the market goes up
and continues going up, the investor tends to set aside all thoughts on the various investment
risks and follows the investing public. Here, the investor is being greedy, and sooner or later
would pay the price for this error of judgment.
Stock Switching
In this situation, the investor is selling one stock and at the same time buying another
stock. This is interesting, as here the investor expects that the first stock would go down in
value, while the second stock would go up. This is unique and is rarely successful.
Two scenarios require our attention:
 It maybe the right time to sell the first stock, but it may not be the right time to buy the
second stock, as that too maybe on its way down.
 It maybe the right time to buy the second stock, but it may not be the right time to sell
the first stock, as it may still have some upside left.
The Love for a Cheap Stock
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| 2. INVESTMENT ENVIRONMENT 30
1. Content Index
2. Chapter 1
3. Chapter 2
4. Chapter 3
5. Chapter 4
6. Chapter 5
A cheap stock is a very attractive proposition for any investor, as he is able to buy large
quantities of the same. Investors find it easier to buy 1,000 shares of a INR 10.00 stock, and
find it difficult to buy 100 shares of a INR 100.00 stock. The total investment amount is the
same in both cases.
In certain situations, when a stock price moves down, investors start buying and
continue to buy larger quantities of the same stock. The investor here is averaging his price
down. But, he does not have a guarantee that in the foreseeable future the price trend of this
stock would reverse and go above his average purchase price. Averaging can be dangerous.
Over-diversification
Is a situation, when an investor has a large number of names in his portfolio, maybe 50
or 60 or even more. Let‘s be practical, it is like owning an index and more. Therefore the
investor‘s portfolio performance would be about the same as the index or marginally above or
below it depending on the names in the portfolio.
Secondly, managing and monitoring would become a Herculean task. The investor
would get a false sense of safety in numbers. Decision-making would become slow and
ineffective. If the market goes down due to a systemic risk factor, all the stocks including the
best would move down in price. And the investor would not know what to sell, at what price to
sell and when to sell.
Ideally, a portfolio should consist of 10-15 well-researched stocks. In any case as
individual investors we are not institutions, nor do we have the requisite staffing to effectively
monitor and manage a larger number of stocks.
Under-diversification
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| 2. INVESTMENT ENVIRONMENT 31
1. Content Index
2. Chapter 1
3. Chapter 2
4. Chapter 3
5. Chapter 4
6. Chapter 5
Is a situation in which an investor has only 1-2 stocks in his portfolio. This maybe due to
a situation of over-confidence in the expected performance of these stocks. Or maybe the
result of plain complacency.
This is not a good portfolio strategy, as the investor has exposed himself to all market
risks to a larger extent due to a lack of diversification. We must always remember that we
diversify our portfolio to minimize the systemic or non-diversifiable risks. In any case, this high
level of risk exposure is not really necessary if we view ourselves as long term investors.
The Lure of Known Companies
Investors are tempted to buy shares of companies that they know and are familiar with.
However, the investor should keep in mind, that his knowing a company is not correlated to
the returns he expects to derive from his investments in its stock.
Wrong attitude towards profits and losses
An average investor due to ego and pride does not want to recognize or admit that he
may have made a mistake. Let‘s look at two situations:
 An investor buys a stock, and soon thereafter its price goes down. Instead of applying a
stop loss and getting out of the stock, the investor holds the stock in expectation of a
rebound or trend reversal. However, the price continues moving down with a potential
of a further decline. Now, the investor is holding the stock at a 30%-40% loss. Here, the
investor wants to postpone the booking of this substantial loss and the
acknowledgement of having made a mistake.
 When the stock price does move up, the investor is ready and waiting to sell this stock
at or marginally above his purchase price, even if the stock is expected to move up into
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| 2. INVESTMENT ENVIRONMENT 32
1. Content Index
2. Chapter 1
3. Chapter 2
4. Chapter 3
5. Chapter 4
6. Chapter 5
a higher trading range. Here the investor sells to gain the relief of not having incurred a
substantial loss and also he does not have to acknowledge his mistake at the start of
this investment.
Both these situations are loaded towards the reinforcement of losses and not profits.
Investment and Speculation
There is a very thin and blurred line between investing and speculating (or gambling).
To have a clearer understanding of this, we would differentiate between the two.
There is a tendency for investors to be speculative when the markets are bullish and
buoyant. However, for long term and profitable survival in the markets we must try and control
this urge to speculate. After all, we are here to learn and apply investment management and
not speculation management.
To be part of the speculative herd in a bull market situation has been the waterloo of
many participants in the financial markets across the globe. This participant maybe an
individual investor, a NBFC, a financial institution, a pension fund, a bank, or a brokerage.
Some are responsible corporate citizens while others are not.
Investment Wisdom: One Liner
Listed below are wisdom one liners which would give an investor an insight to what he
or she is up against:
 The market is a discounting machine.
 A cynic knows the price of everything and the value of nothing.
 Investment management is 10% inspiration and 90% perspiration.
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| 2. INVESTMENT ENVIRONMENT 33
1. Content Index
2. Chapter 1
3. Chapter 2
4. Chapter 3
5. Chapter 4
6. Chapter 5
 To err is human, to hedge divine.
 No stock is good or bad, it is the price that makes it so.
 No price is too high for a bull or too low for a bear.
 Somebody is wrong every time a trade is made.
 Ride the winners and sell the losers.
 You never understand a stock unless you are long or short in it.
 Be long term but watch the ticks.
 Never throw good money after bad.
 To achieve superior performance, you have to differ from the majority.
 Two things cause stocks to move – the expected and the unexpected.
 No tree grows to the sky.
 A pie doesn‘t grow through its slices.
 Never confuse brilliance with a bull market.
 Successful investment managers have brains, nerves and luck.
 All generalizations are false, including this one.
 The market makes mountains out of molehills.
 Investigate, then invest.
 The memory of people in the stock market is very short.
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| 2. INVESTMENT ENVIRONMENT 34
1. Content Index
2. Chapter 1
3. Chapter 2
4. Chapter 3
5. Chapter 4
6. Chapter 5
 Open-mindedness and independent thinking will pay big dividends in the stock market.
 It is only a step from the sublime to the ridiculous.
 It is only a step from common stock investment to common stock speculation.
 The market is a pendulum that swings back and forth through the median line of
rationality.
 The only way to beat the market is to discover and exploit other investors‘ mistakes.
 No investment manager can perform successfully in all kinds of markets. There is no
man for all seasons.
 Better is one fore-thought than two after.
 The greatest of all gifts is the power to estimate things at their true worth.
 Shallow men believe in luck, wise and strong men in cause and effect.
The Securities Market
The term securities markets enclose a number of markets in which securities can be
bought and sold. These securities markets can be classified into four types of markets:
 Primary market: Corporate entities offer new issues to the investing public through the
issue of equity shares. After the initial issue, the securities are subsequently shifted to the
secondary market, where the can be traded.
 Secondary market: Have securities of corporate entities that are already outstanding and
owned by investors. These securities can be traded (i.e. bought and sold) in the secondary
market.
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| 2. INVESTMENT ENVIRONMENT 35
1. Content Index
2. Chapter 1
3. Chapter 2
4. Chapter 3
5. Chapter 4
6. Chapter 5
 Money market: Enables trading of securities with maturity of one year or less.
 Capital market: Securities with a maturity period of more than one year are traded in the
capital market.
The existence of these markets is advantageous to both the issuer of the security and
the investor. The ―issuers‖, i.e. business entities and government need to raise funds or capital
at competitive rates for productive and improvement activities, respectively. The markets allow
the transfer of funds from the surplus to the deficit sectors both efficiently and at low cost.
The investors also benefit, as they are able to invest their excess funds or savings
through the market in the expectation of a future return on their investments. The investors are
also able to trade (i.e. buy and sell) these securities through the markets.
The Broker
As investors we are not able to deal with the market directly. It would be like entering
and trying to find our way through an unending maze. The markets on their part, are too large,
to attend to every single investor directly. This would be a Herculean task and a management
nightmare for it. So, the markets introduce and authorize the middleman to act on its behalf.
This middleman is also called the ―Broker‖.
To reinforce this point, consider the following:
 We want an insurance policy; we would deal with the insurance company‘s agent.
 We want to buy a car or motor cycle or scooter; we would deal with the dealer of the
automobile manufacturer.
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| 2. INVESTMENT ENVIRONMENT 36
1. Content Index
2. Chapter 1
3. Chapter 2
4. Chapter 3
5. Chapter 4
6. Chapter 5
 We want to buy a pair of trousers or shirt or a dress, we would go to the retail store
which sells these products. The retail store would be the representatives of Raymond
Ltd. or Reliance or Bombay Dyeing.
 We want to buy the shares of a company traded in the NSE or BSE. We would have to
deal with the broker of these exchanges.
Agents, dealers, representatives and brokers mean the same thing, and they perform
the same function. Which is that of a middleman. They do this function as they would be
receiving commissions in return for the services they provide.
For instance, whether an investor buys or sells a stock in the stock exchange the
middleman or broker would receive a commission either ways. Which is a percentage of the
value traded by the investor.
For investors it is very important to choose a broker correctly. Also that the broker is
able to provide the services that the investor requires.
In this selection of a broker, the investor would be well advised to consider the following:
 Is the brokerage well established and known in the market?
 Is the representative of the brokerage house able to attend to him or is he overloaded
with too many accounts?
 Does the brokerage have a research department? How many qualified professionals do
they have on their staff?
There are many other questions, which may be asked and answered. The main aim
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| 3. ACTIVE ASSET ALLOCATION 37
1. Content Index
2. Chapter 1
3. Chapter 2
4. Chapter 3
5. Chapter 4
6. Chapter 5
here is whether the broker we are proposing to deal with meets all our requirements or not.
3. ACTIVE ASSET ALLOCATION
Asset Allocation
Active asset allocation would be of importance to the investor with respect to decisions
regarding where exactly to deploy his resources and in what proportion.
Active asset allocation has attracted a lot of interest from investors in recent times. But
asset allocation also means different things to different people; therefore it would be
appropriate to define the use and application of various terms in this regard. While, long term
asset allocation would establish a policy mix consistent with the long term portfolio objectives;
tactical asset allocation would add value while opportunistically responding to changing
patterns of risk and reward, which would enable a buy low, sell high stance on the part of the
investor; and portfolio insurance would of course protect against unexpected performance
while allowing a sell low, buy high on the part of the investor.
Asset allocation or active asset allocation is of interest to all investors. But, what does it
mean? To make matters easy for ourselves, asset allocation is exactly what it states ―asset
allocation‖.
Let‘s say our total savings and reserves are INR 1, 00,000.00. This amount is an asset
to start with, or what we can call our asset base. From this asset base we would be employing
funds for investment in various financial instruments and securities.
Before we deploy or employ our funds or asset base into financial instruments, we as
investors would have to plan on what percentage of our total asset base we would invest in
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| 3. ACTIVE ASSET ALLOCATION 38
1. Content Index
2. Chapter 1
3. Chapter 2
4. Chapter 3
5. Chapter 4
6. Chapter 5
―equity, debt and cash‖ or in other words ―stocks, bonds and cash‖ or ―growth, income and
cash‖. Notice here that different words carry the same meaning.
“Equity = Stock = Growth”. “Debt = Bond = Income”. And “Cash = Cash = Cash”.
Asset allocation is the process of evaluation and planning what proportion of our asset
base would be invested in equity, debt and cash (i.e. various financial instruments and
securities) to fulfill the needs of our investment plan. And when done actively is called active
asset allocation. Here there would be a trade-off between our ―aversion to risk‖ and the ―need
for performance‖.
There are three distinct classes of asset allocation. Namely;
Long Term Asset Allocation
Long term asset allocation is also called "policy asset allocation" or "strategic asset
allocation". Here the investor is concerned with the evaluation of the needs of the investment
plan. And also an assessment of the appropriate asset mix, which would best meet the
requirements of the plan. Basically, the investor is looking for the best compromise between
need for stability and a need for performance. And further, to find a best fit asset mix to
accomplish this in the long term.
To summarize, with long term asset allocation the investor‘s objective is to shape the
risk profile of a portfolio to meet the long-term needs of the investment plan. Here the investor
needs to balance the "aversion to risk" with "the need for performance or return". This is a
passive management process.
Active Asset Allocation
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| 3. ACTIVE ASSET ALLOCATION 39
1. Content Index
2. Chapter 1
3. Chapter 2
4. Chapter 3
5. Chapter 4
6. Chapter 5
Active asset allocation is also called "tactical asset allocation" or "dynamic asset
allocation". Here the investor‘s aim is to improve portfolio performance by responding to
opportunities arising from the changing patterns of the securities market. In short, the investor
would be changing the asset mix of the portfolio to accomplish this, with funds flowing from
one asset class to another within the portfolio.
The investor‘s objective in tactical asset allocation would be to shift the asset mix of the
portfolio from time to time, to respond to the changing patterns of opportunity in the market.
This is obviously an active management process, and implies a "buy low, sell high" strategy.
Portfolio Insurance
Portfolio insurance is also an active asset allocation strategy. Here the investor‘s aim in
not to respond to the opportunities in the market, but to obtain protection against adverse
market action. The synthetic put is the best example of implementing portfolio insurance.
The objective of portfolio insurance is to protect against unacceptable portfolio
performance or adverse market action. Further it can also be used to reshape the distribution
of a portfolio (i.e. to change its asset mix) and its likely return. This is a "sell low, buy high"
strategy.
Our discussion would now center on the management of tactical asset allocation. As
even passive investors have to adopt it from time to time.
Tactical Asset Allocation
Tactical asset allocation can be compared with sector rotation. But, instead of rotating
among the economic sectors in the equity market, we would be rotating among the asset
classes in the securities market. These asset classes are mainly stocks (equity), bonds (debt)
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| 3. ACTIVE ASSET ALLOCATION 40
1. Content Index
2. Chapter 1
3. Chapter 2
4. Chapter 3
5. Chapter 4
6. Chapter 5
and cash. The strategy involves a disciplined and quantitative structure to measure available
returns.
Here the strategy is designed to exploit the shifts in the relative attractiveness of these
asset classes. It also provides the discipline and confidence to take a contrarian position.
Further, there is a tendency to buy the ―out of favor‖ asset classes.
After due deliberation, the most appropriate asset allocation process would entail a
study of the condition of disequilibrium in the market, with respect to the asset under study for
investment. To be followed up with a measure of this imbalance and its resulting effect on the
economics with regard to whether the market can sustain a return to an equilibrium condition.
The investor would also have to give due regard to market sentiment at present and market
sentiment expected in the future. And also the timing of the market, with respect to when it
would move in time.
Therefore, in this process the investor would, firstly require a highly disciplined plan.
And secondly, he would be able to undertake contrarian action. With the objective of
enhancing the profitability of the transaction initiated by him.
Management of Asset Allocation
Long term asset allocation is established on the basis of careful analysis. There is a
careful weighing of the trade-off between risk and return keeping the long-term objective of the
investment plan in perspective. Here the short-term adjustments are handled through cash
flows rather than through a formal analysis. This ad-hocism could result in errors.
Tactical asset allocation provides the structure and a disciplined framework to prevent
such errors. In tactical asset allocation the investor could also use futures to enable short-term
adjustments in the portfolio at very low transaction cost.
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| 3. ACTIVE ASSET ALLOCATION 41
1. Content Index
2. Chapter 1
3. Chapter 2
4. Chapter 3
5. Chapter 4
6. Chapter 5
A question comes to mind: ―Are we able to add value to the portfolio by changing its
asset mix?‖ The answer is ―Yes‖. Consider the following:
If in the equity market, one stock becomes undervalued relative to a second stock.
Then money would flow from the second stock to the first, to bring it up and back to its fair
value.
This flow of money ensures that the securities do not stray very far from their fair value
over time and evaluation or price. We must note here that this flow of money has taken place
within an asset class.
However, such flow from one asset class to another are fewer and far between. As for
such money flows to occur a change would be required in the long-term asset allocation of the
portfolio. Which would further require a change in the over all long-term investment plan and
objectives. Some flows do occur between the asset classes, but they are gradual and
moderate. This is also to explain that if money flows did not occur among the asset classes,
then the markets would sway away from their fair value.
By observing the above we realize that asset allocation itself represents the greatest
opportunity to enhance portfolio performance in the securities market.
Asset Allocation Process
The asset allocation process would require a disciplined structure based on three
assumptions:
 The securities market indicates the rate of returns available in the various asset
classes. The investor knows the yield on cash. He knows the yield to maturity on long
term bonds. And he knows the P/E ratios of stocks in the equity market (which give him
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| 3. ACTIVE ASSET ALLOCATION 42
1. Content Index
2. Chapter 1
3. Chapter 2
4. Chapter 3
5. Chapter 4
6. Chapter 5
an idea on the long-term returns available in the stock market).
 There is a normal relationship among these implied returns.
 The securities market correct disequilibrium conditions when they occur. For instance, if
the equity market strays away from their normal relationship with fixed income
securities. Then the forces of the securities market (through a money flow from fixed
income securities to the equity market) will pull them back in line; i.e. back to their
normal relationship.
It is important to note at this point:
 Firstly, opportunities lie in markets, which have swayed from their normal relationships
or their equilibrium.
 Secondly, opportunities also lie in the economic conditions, which can sustain a return
to equilibrium. This tendency of the markets to return to their equilibrium is the profit
mechanism of any asset allocation strategy. Further, it is also important to assess the
market sentiment, with respect to whether the market would move now or later.
So, tactical asset allocation processes; firstly, share a disciplined structure, secondly
are contrarian in nature and thirdly enhance portfolio performance substantially.
Let‘s say we have a portfolio value of INR 1, 00,000.00, which can give us a return of
10% per annum over the next 10 years. Here our initial value would become INR 2, 59,000.00
by the end of the 10 year period.
Next, let‘s say we apply a simple rebalancing technique. This would require us to
rebalance the parts of the portfolio back to their normal levels every month. If stocks go down,
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| 3. ACTIVE ASSET ALLOCATION 43
1. Content Index
2. Chapter 1
3. Chapter 2
4. Chapter 3
5. Chapter 4
6. Chapter 5
we buy more to bring it back to its normal value level. If bonds go up, we sell a part of our
bond exposure to bring it back to its normal level. Historically, this passive strategy has added
30 basis points per annum to returns over the long term. So, our return in this situation would
be 10.3% per annum over a period of 10 years. By which our initial investment would become
INR 2, 67,000.00 at the end of 10 years. Thereby adding INR 8,000.00 to our return.
Further, let‘s say we introduce a 20% active asset allocation range. This would add an
additional 1% per annum to our annual return; i.e. a return of 11.3%. In this situation our initial
investment would become INR 2, 92,000.00 at the end of 10 years. This would be an
additional return of INR 25,000.00 at the end of 10 years.
The Portfolio Upgrade
With discipline we can implement the asset allocation process. This process can be
carried out with or without the use of futures. The use of futures would be undertaken mainly
to reduce the transaction cost to accomplish the change over required in the portfolio. Further,
any tool which can help reduce the transaction cost is welcome, including buying a brokerage.
A portfolio comprises of two types or categories of stocks; namely the ―buy candidates‖
and the ―hold candidates‖. A buy candidate is an attractive stock worth having in the portfolio.
On the other hand, a hold candidate is a stock which in not attractive enough to be a buy
candidate, but not unattractive enough to justify the transaction cost of selling it. Thus, a
portfolio would comprise of stocks, which are buy candidates (i.e. very attractive) and hold
candidates (mildly attractive).
Active asset allocation and its process force an investor to improve the quality of his
portfolio within asset classes. Consider the following.
Let‘s say an asset allocation decision requires a shift from bonds or cash into stocks.
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| 3. ACTIVE ASSET ALLOCATION 44
1. Content Index
2. Chapter 1
3. Chapter 2
4. Chapter 3
5. Chapter 4
6. Chapter 5
Then the investor most likely would buy the more attractive stocks or the buy candidates. On
the other hand, if an asset allocation decision requires a shift out of stocks. Then the investor
is more likely to sell the lesser attractive stocks or the hold candidates. And would continue to
hold the buy candidates in his portfolio.
In either situation, there is an ongoing process of upgrading the portfolio, with attractive
stocks or the buy candidates comprising it. The same process is true for the other asset
classes, as the aim here is to increase returns or improve performance of the portfolio.
Using Futures in Asset Allocation: Advantages & Disadvantages
Transaction costs are the main hindrance to the active or tactical asset allocation
process. The transaction cost has to be paid for whether the investor is buying or selling to
accomplish a shift in the asset mix of his portfolio.
The investor can do the same buying (calling) and selling (putting) through futures to
accomplish the same changes in the asset mix of his portfolio. With the added advantage of
not necessarily changing the underlying assets in his portfolio. But, to accomplish this he
would have to create a cash reserve within the portfolio to provide for the margins he would
have to pay on the futures trades. So, in a sense he would be incurring an opportunity loss on
the funds not deployed in stocks or bonds. And, further would have to provide for and
compensate the portfolio for this opportunity loss.
Futures may be and are used from time to time to accomplish shifts in the portfolio
composition. The advantages are:
 Minimum transaction cost.
 High liquidity and fast execution.
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| 45
1. Content Index
2. Chapter 1
3. Chapter 2
4. Chapter 3
5. Chapter 4
6. Chapter 5
 One day settlement and simultaneous trades.
 Does not disrupt the management of the underlying assets.
 Potential of favorable mis-pricing.
However, there are also disadvantages in the use of futures:
 Potential of unfavorable mis-pricing.
 Large quantum of back office work required, to record all transactions on a daily basis.
A cash reserve is required to pay for margins on futures. So, to provide for this a part of
the stock or bond holding is liquidated. Here, we have an opportunity loss on these funds, and
would have to be provided for.
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| 4. INVESTMENT MANAGEMENT AND TRADING IN 46
1. Content Index
2. Chapter 1
3. Chapter 2
4. Chapter 3
5. Chapter 4
6. Chapter 5
4. INVESTMENT MANAGEMENT AND TRADING IN
THE STOCK MARKET
Trading is basically buying and selling a financial instrument, like a stock quoted in the
stock market. And making a profit from the transaction. That is the investor‘s selling price is
more than the cost price.
To get things into perspective, the stock market does not go straight up or straight
down. It moves in steps. Depending on the information flow it may move forward (or up) or
move back (or down).
The stock market over a period of time would show the following conditions or phases:
 Bull phase: Where the equities traded in the stock market are taking at least 2 steps
forward with one step back. This may extend to 6 steps forward to 2 steps back. In
further extreme conditions there would be no top to the stock market.
 Bear phase: Where the equities traded in the stock market take 2 steps back for every
one step forward. This may extend to 6 steps back to 2 steps forward. In further
extreme conditions there would be no bottom to the stock market.
 Consolidation phase: Where the stocks traded in the stock market have reached an
equilibrium level and are taking one step forward for every one step back. However, the
various participants of the stock market are awaiting some news to take the price up or
down depending on the nature of the news. That is whether the news is as per
expectation, better than expectation or not as per expectation and what effect it has on
the valuation of the stock in question. Thereafter we can expect a further move in the
price levels.
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| THE STOCK MARKET 47
1. Content Index
2. Chapter 1
3. Chapter 2
4. Chapter 3
5. Chapter 4
6. Chapter 5
 Distribution phase: Where the stocks traded in the stock market have achieved high
price levels maybe their yearly highs. It is here that the strong hands (knowledgeable
investors) are selling equities to the weak hands (not so knowledgeable investors).
After the selling is over and done with, we may safely expect a down move in price
levels. That is, prices would move down and back to their fair values or below it. Let‘s
face it, which knowledgeable investor would buy stocks when he knows that there is no
margin of safety available in the transaction.
Please remember, whichever phase the market may exist in, it is taking one step at a
time. However, depending on the nature of the stage the market may take more than one step
in a day. This would cause happiness to investors if the net outcome is positive and sadness if
the net outcome is negative.
Estimation of the Intrinsic Value of a Stock
The procedure commonly used by investment analysts to estimate the intrinsic value of
a stock traded in the stock market consists of the following steps:
 Estimate the expected earnings per share of the stock.
 Establish a price earning multiplier (or P/E ratio).
 Develop a value anchor and a value range.
However, we consider it appropriate to advise you the investor at this stage itself, that
there are three main obstacles in the way of successful fundamental analysis. Namely:
 Inadequate and/or incorrect financial data pertaining to the stock under study.
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| THE STOCK MARKET 48
1. Content Index
2. Chapter 1
3. Chapter 2
4. Chapter 3
5. Chapter 4
6. Chapter 5
 Future uncertainties.
 Irrational stock market behaviour.
Estimate the expected earnings per share:
Assess how the underlying company has performed in the past, how it is doing at
present how it is likely expected to perform in the future. This leads the investment analyst to
estimate the future expected earnings per share (EPS) of the stock under study. The reader
must understand that this EPS is an educated guess about the future earning capacity and
profit generating ability of the company.
A good estimate would be based on a careful projection of the revenues and costs;
starting a few from a few years in the past up to the present and then projecting it into the
future.
The reason for using cash flow per share is, that the depreciation charge is merely an
accounting adjustment devoid of any real expenditure on the part of the company. We
managed companies maintain plant and machinery in excellent condition through periodic
repairs and overhauls. The related expenses are reflected in the manufacturing cost. Thus, we
can ignore the book depreciation charges. However, this may not be valid for all companies,
and we would have to look into the specific circumstances of a company to ascertain what
adjustment would be appropriate.
Establishing a price earning ratio:
The price earning (P/E) ratio reflects the price investors are willing to pay per INR of
earnings per share (EPS). It essentially reflects the market's summary valuation of a
company's prospects. The price earning (P/E) ratio maybe derived from the:
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| THE STOCK MARKET 49
1. Content Index
2. Chapter 1
3. Chapter 2
4. Chapter 3
5. Chapter 4
6. Chapter 5
 Constant growth dividend model;
 Cross-section analysis; or
 Historical analysis.
We shall now explain each of the above in greater detail:
Constant growth dividend model: In this model the price earning ratio is derived from
the formula given below. And we shall explain the parts of the formula.
Price earning ratio = (Dividend payout ratio) / (Required return on equity - Expected
growth rate in dividend) Where,
Dividend payout ratio. Most companies are serious about their dividend commitments.
Thus, once dividends are set at a certain level they are not reduced unless there is no
alternative. Further, dividends are not increased unless it is clear and certain that a higher
level of dividend can be sustained. By which we may conclude, that dividends adjust with a lag
to earnings.
Keeping the above formula in view, if the dividend payout ratio increases, the
numerator increases, which has a favorable effect on the price-earning multiplier. However,
this also has the effect of lowering the expected growth rate of dividends in the denominator,
which has an effect of decreasing the price-earning multiplier. In most cases, these two effects
are likely to balance out.
Required return on equity. Is a function of the risk-free rate of return and a risk
premium. According to the Capital asset pricing model;
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| THE STOCK MARKET 50
1. Content Index
2. Chapter 1
3. Chapter 2
4. Chapter 3
5. Chapter 4
6. Chapter 5
Required return on equity = Risk free return + (Beta of equity X Expected market risk
premium)
Expected growth rate in dividend. The expected growth rate in dividend is calculated
with the formula given below:
Expected growth rate in dividend = Retention ratio X Return on equity
Cross section analysis: In this analysis, we look at price earning (P/E) ratios of similar
companies in the industry; and then take a view on what is a reasonable price earning ratio for
the company under study.
You can also conduct a cross section regression analysis, where the price earning ratio
is regressed on several fundamental variables. For instance, the following formula maybe
applied:
Price-earning ratio = A1 + A2 Growth rate in earning + A2 Dividend payout ratio + A3
Variability of earning + A4 Company size
Based on the estimated coefficients of such cross section regression analysis, the
price-earning ratio for the company under study maybe derived.
Historical Analysis
We can look up the historical price-earning ratio of the company and take a view on a
reasonable present day price-earning ratio; that is after taking into account the changes in the
capital market and the evolving competition.
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| THE STOCK MARKET 51
1. Content Index
2. Chapter 1
3. Chapter 2
4. Chapter 3
5. Chapter 4
6. Chapter 5
Margin of Safety
The central concern of all investors in their investment policy is to always ensure a
"margin of safety" in their transactions in financial instruments. These financial instruments
would include various asset classes, whether equity, debt and/or real estate amongst others.
The selection of the asset class for investment would depend on the individual investors
personal preferences.
To follow a policy of buying low and selling high, in itself ensures a fair margin of safety
for the investor. And in certain respects makes it unnecessary for the investor to accurately
estimate the future. For instance, stock prices are associated with the enterprise's earning
power. Thus, the margin of safety lies in the earnings over expenses, which in most cases
would be a positive figure. There have been occasions in the equity markets, when stock
prices have dropped to levels which offer the investor a margin of safety equal to or larger
than offered by a debt instrument.
Investors who are well read in the ways of the equity market take full advantage of such
opportunities. Opportunities offering a reasonable margin of safety occur during bear market
conditions. However, holding stocks during prolonged bear markets is an exercise in
frustration for the investor, as stock prices are seemingly going nowhere. There are other
market situations like a deep correction during an ongoing bull run or the occurrence of a
selling climax, which offer a fair margin of safety to the investors. These opportunities are used
by investors to indulge in stock picking to the extent of their available financial resources.
The investor may apply the rules of technical analysis in addition to fundamental tools,
to substantiate the buy and sell decisions. And on occasion play the momentum game as
timing would be of the essence.
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| THE STOCK MARKET 52
1. Content Index
2. Chapter 1
3. Chapter 2
4. Chapter 3
5. Chapter 4
6. Chapter 5
In these situations when stock prices drop to unreasonably low levels, we find that all is
well with the underlying enterprise. However, environmental circumstances and/or adverse
market action give the investor opportunities to purchase stocks with a fair margin of safety on
more than one occasion during the pendency of their investment time horizon.
Let's look at a few numbers to analyze and understand this concept of the margin of
safety. Let us say that the fair value of a stock of ABC Ltd is INR 100.00 given its present level
of earnings and a fair discounting of this earning. Now, we can safely say that at a price level
below INR 100.00, this stock would be undervalued or under-priced, thereby giving the
investor an opportunity to buy this stock with a certain margin of safety.
Now, when the price of the same stock moves up to INR 100.00 and beyond, then
inflation has occurred in the stock price and the margin of safety is no longer available to the
investor. Thus, a reasonable investor would be a seller when the stock price is at INR 100.00
or above. That is at prices over and above its fair value.
In addition to the above, the investor would have to keep in perspective future earnings
and future earnings growth estimates. As these add the dimension of the premium which
investors are willing to pay over and above the fair value of the stock to be a part of this
estimated expected growth rate. All is well if these expectations are met by quarterly results,
but if there is a short fall then the stock is punished for this lack of performance.
Putting it short and straight, we have a margin of safety when there is fear in the market
and everyone is running for the exit door. It is here, that the investor is able to get high quality
stocks at undervalued prices. On the other hand, when greed predominates (when everyone
is buying), we can reasonably say that there is no margin of safety available to the investor. As
stock prices are at unreasonably high levels and are disconnected from a reasonable estimate
of their earnings and future expected earnings. Further, even the penny stocks are showing
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| THE STOCK MARKET 53
1. Content Index
2. Chapter 1
3. Chapter 2
4. Chapter 3
5. Chapter 4
6. Chapter 5
signs of becoming multi-baggers.
Investors must always pay heed to this concept of the "margin of safety", for their
financial wellbeing in the long run.
The Time Value of Money
As investors it is of some importance and interest for us to have an understanding of
the time value of money. And to appreciate the reasons why a unit of money (let us say the
Indian Rupee) today has more value than it would have a year or two later.
You would appreciate that in addition to consuming this money in the present, the
investor may consider applying this money through the various investment avenues and
instruments available to him to enable a positive return to him sometime in the future. In
addition, the influence of inflation would reduce the purchasing power of this unit of money
with the passage of time.
To put the above in perspective, the investor would invest his money along with the
accompanying exposure to risk in the expectation of a positive return in the future, which may
be a few months or a year later. A part of this return on investment would provide for the
reduction in the value of the unit of money during the investment period.
For purposes of comparison amongst the various investment avenues and their
accompanying instruments and factors of risk, the investor would be obliged to either
"compound" to ascertain a future value of the money applied or invested today; or he would
"discount" a future money amount to its present day value. The former is usually applied in an
upward trending market, while the latter in a downward trending market and a combination of
the two may be applied in a sideways trending market.
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| THE STOCK MARKET 54
1. Content Index
2. Chapter 1
3. Chapter 2
4. Chapter 3
5. Chapter 4
6. Chapter 5
A time line may be applied when the cash flows occur at different points over time.
Further, these cash flows may be both positive or negative which would signify a cash inflow
and a cash outflow, respectively. It would also be appropriate for the investor to differentiate
between compound interest and simple interest; as in the former the income, profit and/or
interest earned after a period of time is reinvested along with the initial investment into the
future; while in the case of the latter the income, profit and/or interest is not reinvested but
consumed at the point of cash inflow or thereafter. The investor would realize that over a
period of time his return on investment would be much higher if he were to be able to
compound his investment along with the income he is able to generate through his
investments.
The interested investors would further seek the formulae for the future value of a single
amount, for the concept of the doubling period by applying the rule of 72 and ascertaining the
growth rate.
Now, the concept and process of discounting is the inverse of compounding; the
formula for which may be obtained by appropriately adjusting the same for the purpose. Here
the investor is seeking to discover the present value of a monetary amount to be received in
the future. Discounting may be done for a single amount as well as for a cash flow stream over
a period of time.
An investor would undertake this exercise to assess his present position as well as
what lies ahead in the future for him, given the various mathematical tools he may chose to
apply to ascertain the same. This would also help the investor discover a monetary amount he
would be required to save annually or over a period of time to meet cash outflow requirements
pertaining to purchases (like house, car and other consumer durables) and also their interest
cost he would be obliged to provide for in the future. This would lead the investor to create a
sinking fund to provide for these constant and periodic cash outflows in the present and in the
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| THE STOCK MARKET 55
1. Content Index
2. Chapter 1
3. Chapter 2
4. Chapter 3
5. Chapter 4
6. Chapter 5
future. However, the present cash outflows would not be required to be discounted as they
would occur in the present.
The concept of the time value of money may also be utilized towards ascertaining a
loan amount an investor is able to take, while assessing the affordability of the monthly
installments. On the other hand, he may also apply these mathematical tools to determine a
loan amortization amount and the periodicity of its repayment, while also finding the
appropriate accompanying interest rate. In addition to this, the investor may also utilize these
mathematical tools to ascertain the present value of a growth annuity or a perpetuity; and also
be able to differentiate between a stated interest rate versus an effective interest rate.
An understanding of the time value of money would give the investor an insight as to
what he is really up against when he invests the financial resources he may have under
management in the various investment avenues and financial instruments he may have
access to and chose to invest in.
Investment Management and the First Trade
We expect that, you have read the various pages of our website and have reached the
stage of requiring an understanding of a trade and its rules. Before we go into the rules of
trading, it would be imperative for you (the investor) to understand what a trade is.
Most people across the globe believe, that:
 When they purchase equity shares of a chosen company or enterprise from the stock
markets, they have traded.
 When others are holding equity shares of a chosen company or enterprise which they
have purchased earlier from the stock market, they have traded.
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| THE STOCK MARKET 56
1. Content Index
2. Chapter 1
3. Chapter 2
4. Chapter 3
5. Chapter 4
6. Chapter 5
 And, when others sell equity shares of a chosen company or enterprise in the stock
market (which of course they have purchased earlier), they too have traded.
Take a step back, and look at the sequence: buying, holding and selling. You would
realize that these are the three parts of the same composite trade.
To elaborate, when we purchase a stock or equity shares of a company or enterprise
from the stock exchange (or market), we have only initiated a trade. While we are holding the
stock or equity shares in our portfolio, we are expected and required to manage this trade to
enable the realization of optimum profits. Further, when we sell a stock or equity shares of a
company or enterprise in the stock market, we are expected to realize a profit. However, in
certain circumstances we may be required to minimize a loss (which may be the result of
adverse market action, causing the stock or equity share to perform contrary to our
expectation).
This brings us to the realization that from the time we initiate a trade (with its purchase)
to the time we finally close this trade (with its sale), there is a period of time which separates
the two events. This interval of time may be as short as a few hours of a trading day, a few
days or as long as a few months to a few years. Depending on the holding period, the
management of the trade becomes of primary importance. In fact, it is in the correct
management of the trade (during its holding period) that an investor makes a profit.
We would like to bring to your attention here, that depending on the length of the
holding period we would also be required to bring into the equation the time value of money.
We shall elaborate on this at a later stage.
At this stage it would be suffice for you (the investor) to understand that the rules of
trading would pertain to the 3 distinct parts of a trade (which are buy, hold and sell) and would
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| THE STOCK MARKET 57
1. Content Index
2. Chapter 1
3. Chapter 2
4. Chapter 3
5. Chapter 4
6. Chapter 5
be segregated accordingly.
Investment Management and the First Position
A position in a stock or financial instrument is built over a period of time, while
purchasing the same stock over various price levels. However, to begin with we would initiate
a position only when we have a confirmation of oversold levels and that there is a reasonable
margin of safety available to us.
We expect that, you have understood the various aspects of the first trade. However,
before we proceed to the rules of trading, it would be appropriate to have an understanding of
how to build a position in a particular stock or financial instrument.
Let's say we have INR 3, 00,000/= in our equity trading account. Given our initial
requirement to diversify our risk exposure over more than one stock, we would apportion this
initial capital into 10 equal risk segments. Each of these risk segments would be a position in a
stock. Thus, we have allocated INR 30,000/= per position.
Please note, that we may change this allocation to a larger amount depending on
market action and news flow with regard to that particular stock. However, we must realize
that we do this at the expense of increased risk exposure; as the stock (or stocks) may not
perform as expected.
Let us explain this with an example. We have observed a stock (XYZ Ltd.) with good
fundamentals and reasonable growth projections. It has a reasonable EPS and P/E. However,
due to adverse market action, this stock has given an oversold price level confirmation.
Further, its price is quoting near its 52 week low. When we check current news flow with
regard to this stock, there is nothing alarming. In fact, they are taking action to expand
capacity to meet future export demand for their products.
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