Investment Mechanism

Investment Mechanism

Investment is the employment of funds on assets with the aim of earning income or capital appreciation. Investment has two attributes namely time and risk. Present consumption is sacrificed to get a return in the future. The sacrifice that has to be borne is certain but the return in the future may be uncertain. This attribute of investment indicates the risk factor. The risk is undertaken with a view to reap some return from the investment.

Investment Mechanism include - Security Analysis, the Computer and Investment Analysis, and portfolio management. Let us see all this step in brief.

1. Security Analysis: Traditional Investment Analysis, when applied to securities, emphasizes the projection of prices and dividends. That is, the potential price of a firm's common stock and the future dividend stream are forecast, then discounted back to the present. This intrinsic value is then compared with the security's current Market price (after adjusting for taxes and commissions). If the current Market price is below the intrinsic value, a purchase is recommended. Conversely, if the current market price is above the intrinsic value, a sale is recommended.

Although modern security Analysis is deeply rooted in the fundamental concepts just outlined, the emphasis has shifted. The more modern approach to common stock stock analysis emphasizes return and risk estimates rather than mere price and dividend estimates. The return and risk estimates, of course, are dependent on the share price and the accompanying dividend stream.

Any forecast of securities must necessarily consider the prospects of the economy. The economic setting greatly influences the prospects of certain industries, as well as the psychological outlook of the investment public. Among industries the impact of the economy will differ, and thus it is incumbent on the analyst to be thoroughly informed about any industry peculiarities. 

2. The computer and Investment Analysis: Earlier most of the techniques of security Analysis can be applied manually by a limited number of personnel using desk calculators, but this process is feasible only for analysing a small number of securities. For a large number, the use of a computer becomes a necessity. However, today Investors can make use of home computers or micro computers for limited numbers of securities.

Computers can absorb many thousands of pieces of information and can make use of them as the computer program instructs. The analyst informs a programmer as to the given inputs, the required operations, and the desired format of the output. The required calculations, which might take days to perform manually, can be done by the computer in seconds. This kind of quick turnaround is invaluable to the analyst.

The computer also assists in other valuable ways. First, the analyst can vary his assumptions, resubmit the data, and observe what difference arise as a result of the changed assumptions. Second, alternative constructs can be tested on data of various companies merely by applying "canned" (already-existing) programs to data have been collected and are stored at the computer center. The results of these various constructs can be compared - often within minutes after they have been conceived. This allows the analyst to follow through immediately with various thought processes without interrupting them for several days while the data are being compiled and processed.

These advantages are realised not only by the largest research organisation; individuals can lease limited amounts of time on computers, and various data banks as well, for a reasonable cost. The implication is not that all small Investors can (or should) run out and lease computer time for mere premises a day. It does mean, however, that an individual Investor with the necessary know - how and a portfolio of above-average size can avail himself of more sophisticated research techniques and systems.

3. Portfolio Management: We have already seen that modern security Analysis differs in emphasis from traditional security Analysis. The former emphasizes risk and return estimates; the latter emphasizes the calculation of an intrinsic value. Portfolio management is also characterized by an old and a new way of solving the portfolio problem.

Portfolios are combinations of assets. In this text, portfolio planning called for the selection of those securities that best fit the personal needs and desires of the Investor. For example, a young, aggressive, single adult would would be advised to buy stocks in newer, dynamic, rapidly growing firms. A retired widow would be advised to buy stocks and bonds in old-line, established, stable firms, such as utilities.

Modern portfolio theory suggests that the traditional approach to portfolio analysis, selection and management may well yield less than optimum results- that a more scientific approach is needed, based on estimates of risk and return of the portfolio and the attitudes of the Investor toward a risk-return trade-off stemming from the analysis of the individual securities.

The return of the portfolio is nothing more than the weighted average of the returns of the individual stocks. The weights are based on the percentage composition of the portfolio. The total risk of the portfolio is more complex. Here we need oy point out that securities when combined may have a greater or lesser risk than the sum of their component risks. This fact arises from the degree to which the returns of individual securities move together or interact.

Reference: Security Analysis and Portfolio Management by Punithavathy Pandian

Security Analysis and Portfolio Management by Donald E. Fischer and Ronald J. Jordan