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.

Structure1.1 Purpose of Investment1.2 Speculation1.3 Strategy1.4 Setting Objectives1.5 Achieving Goals

01 Introduction

Purpose of Investment

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

It requiresuse 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 requiresinvestment 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 BondsGovt. Securities 8%NSC 8%Bank FD variablePPF 8%Real Estate 30%

not liquid





Practically DebenturesNo Bonds

Issued by good, well reputed blue chip 8 to 18%& public sector companies





A little Debenturesissued by other than blue chip 10 to 15%public

limited companies


How the Decision Should be Arrived at?Investments – Risks & Returns Table


fairly equity sharesrisky of blue chip around 20%

companies


How the Decision Should be Arrived at?Investments – Risks & Returns Table


risky equity shares around 25%of other companies

very risky equity shares of > 35%untried companies

Safe gold, silver & art notquantifiable



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.

Structure3.1 What is interest?3.2 Real rate of Interest3.3 Inflation and Risk Premium3.4 Default Risk & Interest Rate Risk3.5 Simple & Compound Interest3.6 Present Value3.7 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