The investment Process

The investment process involves a series of activities leading to the purchase of securities or other Investment alternatives. The investment process can be divided into five stages-

             I) Framing of Investment policy

             ii) Investment Analysis

             iii) Valuation

             iv) Portfolio Construction

             v) Portfolio Evaluation

1. Investment Policy

The government or the investor before proceeding into Investment formulates the policy for the systematic functioning. The essential ingredients of the policy are the investible funds, objectives and the knowledge about the investment alternatives and market.

Investible funds: The entire Investment procedure revolves around the availability of investible funds. The funds may be generated through savings or from borrowings. If the funds are borrowed, the investor has to be extra careful in the selection of Investment alternatives. The return should be higher than the interest he/she pays. Mutual funds invest their owners money in Securities.

Objectives: The objectives are framed on the premises of the required rate of return, need for regularity of income, risk perception and the need for liquidity. The risk taker's objective is to earn high rate of return in the form of capital appreciation, whereas the primary objective of the risk averse is the safety of the principal 

Knowledge: The knowledge about the investment alternatives and markets plays a key role in the policy formulation. The alternatives range from security to real estate. The risk and return associated with Investment alternatives differ from each other. Investment in equity is high yielding but has more risk than the fixed income securities. The tax sheltered schemes offer tax benefits to the Investors.

The investor should be aware of the stock market structure and the functions of the Brokers. The mode of operation varies among BSE, NSE, and OTCEI. Brokerage charges are also different. The knowledge about the stock exchanges enables him to trade the stock intelligently.

2. Security Analysis

After formulating the investment policy, the securities to be bought have to be scrutinized through the market, industry and company analysis.

Market analysis: The stock market mirrors the general economic scenario. The growth in gross domestic product and inflation are reflected in the stock prices. The recession in the economy results in a bear market. The stock prices may be fluctuating in the short run but in long run they will be trending. The investor can fix his entry and exit points through technical analysis.

Industry analysis: The industries that contribute to the output of the major segments of the economy vary in their growth rates and their overall contribution to economic activity. Some industries grow faster than the GDP and are expected to continue in their growth. For example, the information technology industry has experienced higher growth rate than the GDP in 1998. The economic significance and the growth potential of the industry have to be analysed.

3. Valuation:

The valuation help the investor to determines the return and risk expected from an investment in the common stock. The intrinsic value of the share is measured through the book value of the share and price earning ratio. Simple discounting models also can be adopted to value the shares. The stock market analysts have developed many advanced models to value the shares. The real worth of the share is compared with the market price and then the investment decisions are made.

Future value: Future value of the securities could be estimated by using a simple  statistical techniques like trend analysis. The analysis of the historical behaviour of the price enables the investor to predict the future value.

 

4. Construction of portfolio:

A portfolio is a combination of securities. The portfolio is constructed in such a manner to meet the Investor's goals and objectives. The investor should decide how best to reach the goals with the securities available. The Investors try to attain maximum return with minimum risk. Towards this end he/she diversifies his portfolio and allocates funds among securities.

Diversification: The main objective of diversification is the reduction of risk in the loss of capital and income. A diversification portfolio is comparatively less risky than holding a single portfolio. There are several ways to diversify the portfolio.

Debt and equity diversification: Debt instruments provide assured return with limited capital appreciation. Common stocks provide income and capital gain but with the flavour of uncertainty. Both Debt instruments and equity are combined to compliment each other.

Industry diversification: Industries growth and reaction to government policies differ from each other. Banking industry shares may provide regular returns but with limited capital appreciation. The information technology stock yields high return and capital appreciation but their growth potential after the year 2002 is not predictable. Thus, industry diversification is needed and it reduces risk.

Company diversification: Securities from different companies are purchased to reduce risk. Technical Analysts suggest the Investors to buy securities based on the price movement. Fundamental analysts suggest the selection of Financially sound and Investor friendly companies.

Selection: Based on the diversification level, industry and company analyses the securities have to be selected. Funds are allocated for the selected securities. Selection of securities and the allocation of funds, seals the construction of portfolio.

5. Portfolio evaluation: 

The portfolio has to be managed efficiently. The efficient management calls for evaluation of the portfolio. This process consists of portfolio appraisal and revision.

Appraisal: The return and risk performance of the security vary from time to time. The variability in returns of the securities is measured and compared. The developments in the economy, industry and relevant companies from which the stocks are bought have to be appraised. The appraisal warns the loss and steps can be taken to avoid such loses.

Revision: Revision depends on the results of the appraisal. The low yielding securities with high risk are replaced with high yielding securities with low risk factor. To keep the return at a particular level necessitates the investor to revise the components of the portfolio periodically.

Reference: Security Analysis and Portfolio Management by Punithavathy Pandian