Fundamental of Investing

‘Investing is defined as the act of committing money or          capital in an endeavour with the expectation of obtaining additional income or profit’ – Investopedia.

The phases involved in investing are:

a)     Setting investment objectives

b)    Establishing an investment policy

c)     Selecting a portfolio strategy

d)    Constructing a portfolio

e)     Evaluating performance

Setting investment objectives

Investors are generally of two kinds: (a) individual investors, and (b) institutional investors. The latter includes organisations as pension funds, depository institutions, insurance companies, regulated investment companies, endowments and foundations, and treasury departments of corporations, government agencies etc.

In general the institutional investors are categorised on the basis of the liabilities to be met specifically or not. Those who have to meet specified liabilities are known as “liability-driven objectives” and those not are known as “non-liability-driven objectives”.

Establishing an investment policy

This step begins with the asset allocation process. Here generally the asset is referred to as the cash with the investor. For appropriate and return maximising decision, the investor needs to know the different asset classes and also the risk-return characteristics of all the assets.

Three factors to be considered for the activity are: (a) client constraints, (b) regulatory constraints, and, (c) accounting and tax issues.

Assets have also been defined on various bases. They are:

·         Traditional asset class – Domestic common stocks, foreign common stocks, domestic bonds, foreign bonds, cash equivalents, and real estate

·         Domestic common stock – large capitalisation stocks, mid-cap stocks, small-cap stocks, growth stocks, value stocks

·         Domestic bonds – Domestic government bonds, investment grade corporate bonds, high-yield corporate bonds, municipal bonds, mortgage backed securities, asset backed securities

·         Foreign common stocks – developed market foreign stocks, emerging market foreign stocks, developed market foreign bonds, emerging market foreign bonds

·         Alternate asset classes – hedge funds, private equity, venture capital, managed funds

The asset classes are drawn as per the amount of significance the kind of asset gains and is based upon the risks, return, features, and the underling principal/objective the asset serves.

Thought investing in assets seem to be an attractive proposition, every asset in this world comes with a risk. The underlying principle here is that the return is the appropriate reflection of the risks which the instrument carries. Thus, higher the risk greater is the return.

You might hear a term called risk-free return at various places. Though, the term has gained prominence and has come to mean the rate of return provided by the government bonds, in actual, even the government bonds carry some risks, which would be outlined in the article related to “bonds”.

Some of the associated risks have been outlined below.

Risks in investing

·         Total risk – this is the total risk which is carried by the investor. It includes all the factors which are either related to the market in which it trades or the instrument itself. This risk is measures with the help of the statistical element, the variance of the return. Variance in essence measures the dispersion of the return about its expected returns. Though this seems to be plausible, there are a number of critiques for the concept. Firstly, variance calculates the dispersion on both sides of the expected return. Any investor would prefer to have the positive dispersion, i.e. more return than expected, this instead the total risk should be measured with the semi-variance or only on the downward side; also if the probability distribution is not symmetrical suitable changes in the calculations of the risk has to be made as the variance method, assumes the risk to have normal distribution in nature.

·         Systematic vs. unsystematic risk – systematic risk refers to the undiversifiable risk/market risk. This is the minimum risk which the portfolio would carry on the condition of being diversified completely. Unsystematic risk is also called diversifiable risk, unique risk, residual risk, idiosyncratic risk, or company-specific risk. Measures are used for quantifying this. Beta measures the sensitivity of an asset’s return to changes in the market returns. R-squared/coefficient of determination is the ratio of the amount of systematic risk relative to the total risk.

·         Interest rate risk – a number of asset prices are dependent upon the interest rate prevalent in the market. As the interest rate increases/decreases the price at which the asset can be sold changes. Thus, based upon the interest rate, it might be that the investor has had to sell the instrument at a price which is lower than the price at which it was bought and this amounts to a capital loss. This kind of risk is known as the interest rate risk. Alternatively it is also called the market risk.

·         Inflation or purchasing power risk - Inflation risk or purchasing power risk arises because of the variation in the value of an asset’s cash flows due to inflation, as measured in terms of purchasing power. The purchasing power which an asset aids in increasing is calculated after adjusting for the inflation. For example, if the return in 12% and the inflation is 8%, then the purchasing power increment is only 4%.

·         Credit risk – it is the risk which the issuer of an instrument would fail to meet the cash flow obligations. The credit risk, also known as default risk, can be determined by the ratings given to the issuer by the various rating agencies as licensed by the government. Credit ratings are significant as they give the probability of the lender not receiving the investment back on due dates. Due to this risk being carried by the investor, a premium is given on the risk. This premium is known as the credit spread. This again inherently leads to a credit spread risk which refers to issuer not being able to meet the cash flow obligations due to an increase in the credit spread. Referring to credit risk, the ratings can stay as they have been previously or may lead to an upgrade or downgrade, where upgrade would mean that the ratings have been increased and consequently the investor is carrying less risk and vice-versa for downgrade.

·         Liquidity risk – it is the risk that the investor would have to sell the asset below its true value where the true value is indicated by a recent transaction. The greater the bid-ask spread greater is the liquidity risk. Bid rate refers to the rate at which an investor is ready to purchase an asset and the ask rate is the rate at which an investor is ready to sell the asset.

·         Exchange rate or currency risk - An asset whose payments are not in the domestic currency of the investor has unknown cash flows in the domestic currency. The cash flows in the investor’s domestic currency are dependent on the exchange rate at the time the payments are received from the asset. The risk of receiving less of the domestic currency than is expected at the time of purchase when an asset makes payments in a currency other than the investor’s domestic currency is called exchange rate risk or currency risk.

·         Volatility risk – this risk arises from the expected changes in the volatility of the asset consequently affecting the prices.

·         Risk risk – this is the risk which arises out of the fact that the risk carried by the asset is not known to the investor. Thus, this sums up the risk which the investor carries for not having clear and complete information on the kinds of risks which the financial instrument exposes it to.

Risks for bonds

·         Interest rate risk – the risk that the price of a bond or bond portfolio will decline when interest rate increase. The factors considered are: (a) bonds coupon rate, (b) bonds maturity, and (c) level if interest rates. Lower the coupon rate, longer the maturity, and lower the levels of interest rates greater the sensitivity of the bond price. Concept of duration for the bonds.

·         Call/prepayment risk – this risk arises from the fact that a number of debt instruments have the call provision, (which means that the issuer can recall the debt prior to its maturity date). This exposes the investor to the interest rate risk, reinvestment risk amongst others, as the issuer would exercise the call provision when the interest rates in the market fall, leading to investor having cash to be invested but now at a lower interest rate.

·         Reinvestment risk – variability in the reinvestment rate of a given strategy because of changes in the market interest rates is called reinvestment risk. This arises from the fact that the interim cash flows (between the period of issuing and the maturity date), would have to be reinvested at a lower interest rate.

Selecting a portfolio strategy

·         Active portfolio strategy – in this strategy the investor actively adjusts the portfolio to represent the objectives which were defined in the first step.

·         Passive portfolio strategy – here the portfolio is initially designed as per the objectives decided in first step and the portfolio is held to maturity without any changes.

Constructing the portfolio

·         Efficient portfolio is the one that provides the greatest expected return for a given level of risk, or equivalently, the lowest risk for a given expected return.

·         Constructing an indexed portfolio – this allows the investor to follow the index in which the instruments are traded. As it is seen that historically, the investment manager has not been able to consistently produce excess returns over the market, some investors prefer to follow the index, especially for long term. Thus the portfolio is constructed whereby the shares of the individual assets represent the index.

·         Constructing an active portfolio – this strategy refers to the active portfolio management, where using various tools like fundamental and technical analysis, the investor constantly adjusts the portfolio for maximising the returns over the risks carried.

·         Techniques for selecting securities in an active strategy – some of the techniques which have been used widespread for selecting securities in an active strategy are, discounted cash flow methods (dividend discount models, internal rate of return, yield to maturity, yield to call, yield to worst, cash flow yield), capital asset pricing models, multi-factor asset pricing models

Evaluating performance

The performance of the portfolio can be judged as per the criteria which has been set by the individual or at the institutional level. There are various ratios, and methods of calculating the returns (which would be discussed in another article) which can be used for evaluating the performance.