Investment Management 2

Part 01 Introduction

Structure

Chapter 01 Introduction

Chapter 02 The Investment Decision

Chapter 03 The Mathematics of Interest

01 Introduction

Learning Objective
♥ Introduce the concept of investment,
discuss the formulation of a strategy and
need to achieve your aim.

Structure
1.1 Purpose of Investment
1.2 Speculation
1.3 Strategy
1.4 Setting Objectives
1.5 Achieving Goals

01 Introduction

Purpose of Investment
“Enable you to realize your needs, your
requirement through saving and investing
your money.”

It requires
use of your skills,
knowledge,
analytical intelligence.

The rewards are great.

01 Introduction

Speculation
♣ Is just a flash. It may provide quick
results. But they are not permanent.
Downslide can destroy family, home and
lives.

Successful investment requires
investment plan,
investment objectives.
Rate of return from investment has to be
more than the rate of inflation.

01 Introduction

Speculation

☻ To achieve investment objectives the
investment plan be devised to take care of

1] nature of your needs,
2] the period within which funds to be
accumulated,
3] the rate at which savings grow and
4] amount that can be regularly saved &
invested.

01 Introduction

Strategy

Now that you know what your objectives
are and the time within which you must
realize it, you must devise a strategy.

The strategy must be well thought out,
clear and coherent and must make provisions
for unanticipated letdowns.

Nothing be left to the chance. All
great entrepreneurs and managers are
strategists first.

01 Introduction

Setting Objectives

☻ It is important to know objectives;
which should be achievable and possible.

Achieving Goals

Review your investments regularly. Look for
new opportunities. Collect data, analyze it
and add profitable investments and get rid
of those with returns below your
expectations.

02 The Investment Decision

Learning Objectives

♣ To explain the investment decision.

Structure

2.1 Determinants of the Investment Decision

2.2 How the Decision Should be Arrived at?


Determinants of the Investment Decision

☺ Basic criteria for investment decision
are Safety, Liquidity & Returns.

Safety

There should be growth, and no erosion, in
the value of the capital invested. Riskier
the investment greater the possibility of
loss.

Public sector bonds or deposits with the
nationalized banks offer safety.

Liquidity
Investments should be capable of
converting into cash with speed. Lack of
liquidity in investments immobilizes
investors’ funds.
Fixed deposits or NSCs freeze money for a
period of time while shares can be converted
into money in a couple of days.
Returns
How much income will the investment
yield? On this is based each investment
decision. For a given degree of safety,
investor seeks to maximize his returns.


How the Decision Should be Arrived at?

The investment decision must be
based on the ability of an individual
to take risk and thus bear a loss or on
whether a steady dependable {though
small in comparison} income is the
priority.



Investments – Risks & Returns Table
Risk Investment Return
No real SB Accounts 3½%
Rural Bonds
Govt. Securities 8%
NSC 8%
Bank FD variable
PPF 8%
Real Estate 30%
not liquid



Practically Debentures
No Bonds
Issued by
good, well
reputed
blue chip 8 to 18%
& public
sector companies




A little Debentures
issued by
other than
blue chip 10 to 15%
public
limited companies




fairly equity shares
risky of blue chip around 20%
companies



risky equity shares around 25%
of other companies

very risky equity shares of > 35%
untried companies

Safe gold, silver & art not
quantifiable


Risk appetite :
Young adults, in 20s, with no
dependents but low investable surplus pursue
growth aggressively as risk taking ability
is high.
Young family, in 30s, with young
children start investing seriously and
continue aggressive wealth creation.
Mature family , in 40s, with school /
college going children pursue low risk safer
investments.


Risk appetite :

Empty nesters, in 50s, with independent
children, divert new surplus to build
retirement corpus & keep reducing portfolio
risk.
Retirees, in 60s, with no surplus for
investment, create regular cash flows from
safe investments. Beating the inflation is
the main concern.

03 The Mathematics of Interest

Learning Objective
☻☻ Understand mathematics of interest.
Structure
3.1 What is interest?
3.2 Real rate of Interest
3.3 Inflation and Risk Premium
3.4 Default Risk & Interest Rate Risk
3.5 Simple & Compound Interest
3.6 Present Value
3.7 Future Value


What is Interest?
♥ Banks pay interest on deposits they
collect from the public and charge interest
on loans that they disburse. The interest
charged is more than that paid so that
earning is there for the banker.
♥ Interest is defined as “ the
compensation paid by the borrower of
capital to the lender, for permitting him
to use his funds”.
Interest rates are determined by the demand
& supply of capital.


Real Rate of Interest
The key determinant of interest is the pure
rate or the real rate of interest.

The real rate of interest is that would
prevail [ in absence of inflation] on a risk
less Government Security.
Real Interest Rate can also be defined as
the rate as measured by our ability to buy
goods and services.


Inflation and Risk Premium
♥ In the real world, however, inflation
exists. Hence the money rate of interest we
earn has to be modified by rate of
inflation to arrive at the pure rate.
♥ If ruling inflation is at 5%, the
money rate of 12% would reflect the real
rate of interest of 7% only.
♥ To ensure that real rate of income is
always maintained investor includes risk
premium in expected income to take care of
difference between actual & expected rate
of inflation.


Default Risk & Interest Rate Risk
The rate of interest is based on risk.
Interest you earn on bank deposit is lower
than that on company deposit as
possibility of bank failing to repay is
also low. Interest charged on loans is
higher as risk of non repayment is also
higher. This is default risk.
Bank may pay 8% interest on a deposit of
two years, but only 7.5% on deposit for
five years. Lower interest on longer term
deposit is due to bank’s belief that there
is a risk that rates would fall in future.


Simple & Compound Interest

If bank pays you simple interest of
10% on your deposit of Rs. 10,000/- for
five years, you earn Rs.1,000/- each year.
And on maturity you would receive a cheque
for Rs. 15,000/-
But if the deposit was at compound
interest, you earn interest on accumulated
interest [not paid to you]. Thus in the
second year you earn interest of Rs.
1,100/- on Rs. 11,000/- and Rs. 1,210/- in
the third year. On maturity you get Rs.
16,105/-.


Present Value

There is time value to money earned
today than a year hence.
Thus if you were to earn Rs. 110/-
one year from now, [assuming 10% interest]
its value today is only Rs. 100/-

This is the principle used in
discounting bills and other amounts due at
a future date.


Future Value

◙ A corollary is what would be the
future value of the present amount say
after five years.
◙ Thus if you want to earn Rs 16,105/-
after five years [assuming 10% interest],
you need to place Rs. 10,000/- with the
bank today.

◙ Annuity is a series of identical
payments made at equally spaced intervals.
Principal & interest payable each year is
calculated to determine annuity.


The End!

Next Part 02, Interest bearing
investments - section 01”

Good Luck!

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Investment Management 2

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