Investment Attributes
Since there is much at stake in an investment decision, an investor should consider the basic attributes of investments when deciding on a suitable option. At least four investment attributes are integral to sound decisions in this sphere: Safety : Although the degree of risk varies across investment types, all investments bear risk. Therefore, it is important to determine how much risk is involved in an investment. The average performance of an investment normally provides a good indicator. However, past performance is merely a guide to future performance - not a guarantee. Some investments, like variable annuities, may have a safety net while others expose the investor to comprehensive losses in the event of failure. Investors should also consider whether they could manage the safety risk associated with an investment financially and psychologically. ♦
Rate of return: Investments (growth options) generally provide higher rates of return compared to other asset classes - cash and income options. The rate of return compensates for the level of risk involved. Therefore, higher risk investments should necessarily bear higher rates of return to attract investors. It is important not to be preoccupied with the rate of return without assessing its relation to safety. ♦
Liquidity: A liquid investment is one you can easily convert to cash or cash equivalents. In other words, a liquid investment is tradable- there are ample buyers and sellers on the mar ket for a liquid li quid investment. An example of a liquid investment is currency trading. When you trade currencies, there is always someone willing to buy when you want to sell and vice versa. With other investments, like stock options, you may hold an ill iquid asset at various points in your i nvestment horizon. ♦
Duration: The duration of an investment-, particularly how long it may take to generate a healthy rate of return- is a vital consideration for an investor. The investment horizon should match the period that your funds must be invested for or how long it would take to generate a desired return. ♦
Investment Objectives: 1. 2. 3. 4. 5. 6.
Capital Appreciation Current yield Reduce risk Hold the company Create a portfolio Speculation
Investment vs. Gambling : Gambling is a very short term investment in a game. Time horizon is shortest. Results are determined by the roll of dice or turn of a card. Entertainment is primary, Earning income is secondary. Employs artificial risks while investment involves commercial risk. No risk-return trade-off; Negative outcomes are expected. Financial analysis does not reduce the risk proportion involved in gambling Approaches to Investment Decision Making 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. Superior returns can be earned by buying under-valued securities (securities whose intrinsic value exceeds the market price) and selling over-valued securities (securities whose intrinsic value is less than the market price). Psychological approach: 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 have 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, 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 behavior can not predict future price behavior. In the capital market, there is a positive relationship between risk and return. More specifically, the expected return from a security is linearly related to its systematic risk. Stock price behaviour corresponds to a random walk. This means that successive price changes are independent. As a result, past price behaviour cannot be used to predict future price behaviour. In the capital market, there is a positive relationship between risk and return. More specifically, the expected return from a security is linearly related to its systematic risk.
Eclectic Approach The eclectic approach draws on all the three different approaches discussed above. The basic premises of the eclectic approach are as follows: ·
Fundamental analysis is helpful in establishing basic standards and benchmarks. However, since there are uncertainties associated with fundamental a nalysis, exclusive reliance on fundamental analysis should be avoided. Equally important, excessive refinement and complexity in fundamental analysis must be viewed with caution.
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Technical analysis is useful in broadly gauging the prevailing mood of investors and the relative strengths of supply and demand forces. However, since the mood of investors can vary unpredictably excessive reliance on technical indicators can be hazardous. More important, complicated technical systems should ordinarily be regarded as suspect because they often represent figments of imagination rather than tools of proven usefulness.
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The market is neither as well ordered as the academic approach suggests, nor as speculative as the psychological approach indicates. While it is characterised by some inefficiencies and imperfections, it seems to react reasonably efficiently and rationally to the flow of information. Likewise, despite many instances of mispriced securities, there appears to be a fairly strong correlation between risk and return.
Do technical analysis to assess the state of the market psychology. Combine fundamental and technical analyses to determine which securities are worth buying, worth holding, and worth disposing of. Respect market prices and do not show excessive zeal in ‘beating the market’. Accept the fact that the search for a higher level of return often necessitates the assumption of a higher level of risk.
