FINANCIAL INVESTING

You already know about the meaning of finance,now we should know about the meaning of investing.

Investing is putting or parking the efforts on something.

Financial investing is putting or parking the money in financial instruments(tools) such as equity shares, preference shares, debentures , bonds, government T(Treasure)-Bills, commodities, and so on...

Investing in these financial instruments is lucrative (making large profit) as well as exciting 

 for the investors.

Though investing in these financial instruments may be rewarding but it also fraught (anxious, stressful) with risk.

Therefore, investment in these financial instruments requires a good amount of scientific & analytical skills.

An investor should not invest his entire investable financial resources in one financial instrument.

Through Financial investing we can create portfolios of financial instruments.

What is portfolio?

Portfolio  is collection of things, here portfolio means collection of financial instruments

why should we invest in portfolio

One famous saying is their " Do not put all your eggs in one basket".

If you put all your eggs in one basket,if it falls all your eggs will break.

That why we should diversify the things ,

here it is diversifying the financial instruments,

That's why we need a portfolio of financial instruments.

Activities involved in  portfolio creation & portfolio management.

Following three major activities are involved in the formation of an optimal portfolio for an investor :

  * Selection of financial instruments.

   *Creation of all feasible portfolios with the help       of the selected financial instruments.

    *Deciding the weights/proportions of the                different financial instruments in the portfolio.

So that it is an optimal portfolio for the investor according to investor risk appetite.

Let's discuss about the phases of creation & management of portfolio.

Portfolio creation & management is a process and broadly it involves following five phases:

Financial instruments Analysis,

Portfolio Analysis ,

Portfolio Selection,

Portfolio Revision,

Portfolio Evaluation.

Financial instruments Analysis:

Financial instruments  available to investors           are numerous in number & of various types. 

Financial instruments are  generally classified 

on basis of ownership such as:

 Equity shares,

preference shares,

debentures &bonds,

and so on... and in recent times a number

of new financial instruments with innovative 

 features are available in the market such as

  Convertible debentures,

Deep Discount bonds,

  Zero coupon bonds,

Flexi bonds,

Flat rate bonds, 

Global Depository Receipts,

Euro coupon bonds  and so on...

Among the vast group of these financial 

instruments ,an investor has to choose those ones which he considers worthwhile to be inclined in his investment portfolio.

This required a detailed analysis of all financial instruments available for making investments

like

          Fundamental analysis , 

         Technical analysis.

Fundamental analysis  of  financial instruments :

Fundamental analysis concentrates on the fundamental factors affecting the company such as EPS ( Earning per share) , dividend

payout ratio, competition faced by the company,

Market share, quality of management,and so on..

fundamental factors affecting the industry to which company belongs.

Fundamental analysis based on the assumption that the share price depends up on future dividends expected by its shareholders

The present value of future dividends can be calculated by discounting cash flows at an appropriate discount rate to get the  

 intrinsic value of shares.

Fundamental analysts compare intrinsic value with the current market price, if the current market price is lower than intrinsic value,the share is said to be under priced and if the current market price is higher than intrinsic valuet the share is said to be over priced.

These mispricing of shares gives opportunity to investors to  buy and sell shares for profitably.

An intelligent investors  would buy those shares which are under priced & sell those shares which are overpriced.

Thus it can be said that fundamental analysis helps to identify fundamentally strong companies whose shares are worthy to be included  in the investor's portfolio.

Fundamental analysis encompasses (includes):

ECONOMIC ANALYSIS

INDUSTRY ANALYSIS

COMPANY ANALYSIS

In detail discussion on these three analysis can be discussed in another topic of discussion blog as a Integrated portfolios creation based on Fundamental analysis.

These three analyses are the most important analysis to be considered while creating portfolios.  

Technical Analysis of financial instruments :

This Analysis mainly based on s basis of 

Share price movements are systematic and

exhibit certain consistent patterns .

Therefore properly studied past movements

in the prices of shares helps to identify trends and patterns in share prices and efforts are made to predict the future price movements by looking at the patterns of the immediate past.

 Thus It can be said that technical analyst concentrates more on price moments and ignores the fundamentals of the shares.

In order to construct well diversified portfolios so that unsystematic risk can be eliminated or substantial mitigated, for that,

Investors have to select financial instruments

across diversified industries sectors which should not have a strong positive correlation among themselves.

Portfolio Analysis:

Once the financial instruments for investments

have been identified the next step is to combine

these to form suitable portfolios.

Each such portfolio has its own specific risk and return characteristics which are not just the aggregates of the characteristics of individual financial instruments constituting it.

The return and risk of each portfolios can be computed mathematically based on the risk return profiles for the constituent financial instruments and their pairwise correlations

among them.

From any chosen set of financial instruments

an indefinitely large number of portfolios can be constructed by varying the fraction of the total

investable financial resources allocated to each one of them.

All  such portfolios that can be constructed out of the set of chosen financial instruments are termed  as feasible portfolios.  

Portfolio Selection   :

The financial goal of investor is to identify the

Efficient portfolios out of the whole set of feasible portfolios mentioned above.

An efficient portfolios has the highest return among the all feasible portfolios having the identical risk and has the lowest risk among the all feasible portfolios having  the identical return.

An efficient portfolio can be selected based on the portfolios theories such as traditional theory, modern theory also known as Harry Markowitz's portfolio theory, and also based on capital asset pricing model (CAPM)  and Capital Market Line (CML) , financial instruments market line (FML),  and so on......

Portfolio Revision:

Once the optimal portfolio has beenconstructed,

it becomes necessary for the investor to constantly monitor the portfolio to ensure that it doesn't lose it optimally.

Since the economy and financial markets are dynamic in nature, changes take place  in these variables almost on a daily basis and financial instruments which were once attractive may cease to bee so with passage of time.

New financial instruments with expectations of high return and low risk may emerge. In light of these developments in the market ,the investor now has to revise the portfolio.

This revision leads to addition (purchase) of some new financial instruments and deletion (sale) of some of the existing financial instruments from the portfolio.

The nature of financial instruments and their proportion in the portfolio changes as a result of the revision.

This portfolio revision may also be necessitated by some investor related changes such as availability of additional funds for investments , change in risk appetite ,need of cash for other alternatives uses and so on..

portfolio revision is not a causal process to be taken lightly and needs to be carried out with care , scientifically and objectively so as to ensure the optimality of the revised portfolios.

Hence in the entire process of portfolios creation and management,portfolio Revision is as important as portfolio Analysis and portfolio selection.

Portfolio Evaluation :

The process is concerned with assessing the performance of the portfolio over a selected period of time in terms of risk and return and it involves quantitative measurement of risk borne  by the portfolio and actual return realized over the period of Investment.

The objective of constructing a portfolio and revising it periodically is to maintain its optimal risk return characteristics.

Various types of alternative measures  of performance evaluation have been developed for use by investors and portfolios  creators & manager.

Following three ratios are used to evaluate the

portfolio:

Sharpe Ratio:

Sharpe Ratio measures the risk premium per unit of Total risk for a financial instrument.

Formula{mathematical(number,quantities)

relation} as follows

Return of portfolio (Rp)   -    Risk free return (Rf)

       Standard deviation of portfolio ( S.Dp)

Treynor Ratio:  

This ratio  is  same as Sharpe ratio with only difference that it measures the risk premium per unit of systematic  risk 

Return of portfolio (Rp) -Risk free return (Rf)

         Systematic risk of  portfolio ( Bp )

Jensen Alpha:

This Alpha is the difference between a portfolio actual return and those that could have been made on a benchmark portfolio with same risk that is beta

                                                                                                                                       ALPHA=

Return of portfolio  (Rp)  -  Expected Return  ( Er)

                Expected Return  =             

Risk free return+Beta Portfolio(Return of market-

                                                                  Risk free return)

It measures the ability of active management to increase returns above those that are purely a reward  for bearing market risk.

It will only produce meaningful results as long as apples are compared to apples. In other words

 if it is used to compare two portfolios which have similar beats.

There are so many concepts related to portfolio management such as:

Portfolios Theories,

Formulation of portfolio strategy,

Portfolio Rebalancing,

Asset allocation strategies ,

Fixed  Income portfolios,

Alternative investment strategies,

in the context of portfolio management.

For detailed discussion of the above  topics , you can refer to related blogs in the coming days.