Investment Meaning: Investment is the employment of funds with the aim of

getting return on it. In general terms, investment means the use of money in the
hope of making more money. In finance, investment means the purchase of a
financial product or other item of value with an expectation of favorable future returns.

An investment is the current commitment of rupee for a period of time in order to

derive future payments that will compensate the investor for
(1) The time the funds are committed,
(2) The expected rate of inflation, and
(3) The uncertainty of the future payments.

MEANING OF TIME VALUE OF MONEY

The term ‘Time Value of Money (TVM)’ implies that there is a connection between ‘time’
and ‘value of money’.
In other words, time value of money is defined as a concept which states that
purchasing power of money differs with the passage of time. Normally what we do with
money. We either expend or save money. In expenditure, time value of money is
understood with inflation and in savings, it has relevance due to interest rates. In our
daily routine, from our income, we spend, save, borrow or invest money. Here we shall
see how time value of money affects our daily transactions:
SPENDING: Since, inflation is in place, the prices of goods are bound to rise every some
days. With the same amount of money today, we can buy more goods than in what we
can in future. So, spending today has more value in terms of more amounts of goods
compared to future.
SAVING: We save money to ensure future because it is certain that we will have needs
in future but the inflow of money to satisfy those needs is not certain. So, saving money
today has value in future in terms of fulfilling our future necessities.
BORROWING: To fulfil our current needs, we borrow money. For example, to enjoy the
benefits of a car today, you borrow money and repay it slowly in future.
INVESTING: We opt for an investment of our surplus as we know that investing money
will result maximizing the value of our surplus money.
REASONS FOR TIME VALUE OF MONEY
The question arises is “Why money has time value?” Following are the primary reasons
for money changing its value due to a passage of time.
UNCERTAIN FUTURE: One can control its spending, but he has no control over his
income or the inflows. A risk factor is always attached with the inflows. Everyone wants
to avoid that risk and prefer cash receipts now.
INFLATION: In this economic trend, the purchasing power of money is falling. Money
received today is more useful than money received in future.
Time value of money relationships
In any time value of money relationship, there are following components:
A value today called present value (PV),
A value at some future date called future value (FV),
Number of time periods between the PV and FV, referred to as n,
Annual percentage interest rate labeled as r,
Number of compounding periods per year, m,
An annuity payment (only case of annuities), PMT.
CONCEPT OF RETURN AND RISK
There are different motives for investment. The most prominent among all is to earn a
return on investment. However, selecting investments on the basis of return in not
enough. The fact is that most investors invest their funds in more than one security
suggest that there are other factors, besides return, and they must be considered. The
investors not only like return but also dislike risk. So, what is required is:
i. Clear understanding of what risk and return are,
ii. What creates them, and
iii. How can they be measured?
Return: the return is the basic motivating force and the principal reward in the
investment process. The return may be defined in terms of (i) realized return, i.e., the
return which has been earned, and (ii) expected return, i.e., the return which the
investor anticipates to earn over some future investment period. The expected return is
a predicted or estimated return and may or may not occur. The realized returns in the
past allow an investor to estimate cash inflows in terms of dividends, interest, bonus,
capital gains, etc, available to the holder of the investment. The return can be measured
as the total gain or loss to the holder over a given period of time and may be defined as a
percentage return on the initial amount invested. With reference to investment in
equity shares, return is consisting of the dividends and the capital gain or loss at the
time of sale of these shares.
Risk: Risk in investment analysis means that future returns from an investment are
unpredictable. The concept of risk may be defined as the possibility that the actual
return may not be same as expected. In other words, risk refers to the chance that the
actual outcome (return) from an investment will differ from an expected outcome. With
reference to a firm, risk may be defined as the possibility that the actual outcome of a
financial decision may not be same as estimated. The risk may be considered as a
chance of variation in return. Investments having greater chances of variations are
considered more risky than those with lesser chances of variations. Between equity
shares and corporate bonds, the former is riskier than latter. If the corporate bonds are
held till maturity, then the annual interest inflows and maturity repayment are fixed.
However, in case of equity investment, neither the dividend inflow nor the terminal
price is fixed.
Risk should be differentiated with uncertainty: Risk is defined as a situation where the
possibility of happening or non-happening of an event can be quantified and measured:
while uncertainty is defined as a situation where this possibility cannot be measured.
Thus, risk is a situation when probabilities can be assigned to an event on the basis of
facts and figures available regarding the decision. Uncertainty, on the other hand, is a
situation where either the facts and figures are not available, or the probabilities cannot
be assigned.
Types of Risk:
Systematic Risk: It refers to that portion of variability in return which is caused by the
factors affecting all the firms. It refers to fluctuation in return due to general factors in
the market such as money supply, inflation, economic recessions, interest rate policy of
the government, political factors, credit policy, tax reforms, etc. these are the factors
which affect almost all firms. The effect of these factors is to cause the prices of all
securities to move together. This part of risk arises because every security has a built in
tendency to move in line with fluctuations in the market. No investor can avoid or
eliminate this risk, whatever precautions or diversification may be resorted to. The
systematic risk is also called the non-diversifiable risk or general risk.
Types of Systematic Risk:
1. Market Risk: market prices of investments, particularly equity shares may
fluctuate widely within a short span of time even though the earnings of the
company are not changing. The reasons for this change in prices may be varied.
Due to one factor or the other, investors’ attitude may change towards equities
resulting in the change in market price. Change in market price causes the return
from investment to very. This is known as market risk. The market risk refers to
variability in return due to change in market price of investment. Market risk
 appears because of reaction of investors to different events. There are different
social, economic, political and firm specific events which affect the market price
of equity shares. Market psychology is another factor affecting market prices. In
bull phases, market prices of all shares tend to increase while in bear phases, the
prices tend to decline. In such situations, the market prices are pushed beyond
far out of line with the fundamental value.
2. Interest-rate Risk: interest rates on risk free securities and general interest rate
level are related to each other. If the risk free rate of interest rises or falls, the
rate of interest on the other bond securities also rises or falls. The interest rate
risk refers to the variability in return caused by the change in level of interest
rates. Such interest rate risk usually appears through the change in market price
of fixed income securities, i.e., bonds and debentures. Security (bond and
debentures) prices have an inverse relationship with the level of interest rates.
When the interest rate rises, the prices of existing securities fall and vice-versa.
3. Purchasing power or Inflation Risk: The inflation risk refers to the uncertainty
of purchasing power of cash flows to be received out of investment. It shows the
impact of inflation or deflation on the investment. The inflation risk is related to
interest rate risk because as inflation increases, the interest rates also tend to
increase. The reason being that the investor wants an additional premium for
inflation risk (resulting from decrease in purchasing power). Thus, there is an
increase in interest rate. Investment involves a postponement in present
consumption. If an investor makes an investment, he forgoes the opportunity to
buy some goods or services during the investment period. If, during this period,
the prices of goods and services go up, the investor losses in terms of purchasing
power. The inflation risk arises because of uncertainty of purchasing power of
the amount to be received from investment in future.
Unsystematic Risk: The unsystematic risk represents the fluctuation in return from an
investment due to factors which are specific to the particular firm and not the market as
a whole. These factors are largely independent of the factors affecting market in general.
Since these factors are unique to a particular firm, these must be examined separately
for each firm and for each industry. These factors may also be called firm-specific as
these affect one firm without affecting the other firms. For example, a fluctuation in
price of crude oil will affect the fortune of petroleum companies but not the textile
manufacturing companies. As the unsystematic risk results from random events that
tend to be unique to an industry or a firm, this risk is random in nature. Unsystematic
risk is also called specific risk or diversifiable risk.
Types of Unsystematic Risk:
1. Business Risk: Business risk refers to the variability in incomes of the
firms and expected dividend there from, resulting from the operating
condition in which the firms have to operate. For example, if the earning
or dividends from a company are expected to increase say, by 6%,
however, the actual increase is 10% or 12 %. The variation in actual
earnings than the expected earnings refers to business risk.
Some industries have higher business risk than others. So, the securities
of higher business risk firms are more risky than the securities of other
firms which have lesser business risk.

2. Financial Risk: It refers to the degree of leverage or degree of debt

financing used by a firm in the capital structure. Higher the degree of debt
financing, the greater is the degree of financial risk. The presence of
interest payment brings more variability in the earning available for
equity shares. This is also known as financial leverage. A firm having
lesser or no risk financing has lesser or no financial risk.
Measurement of risk: No investor can predict with certainty whether the income from
an investment increase or decrease or by how much. Statistical measures can be used to
make precise measurement of risk about the estimated returns, to gauge the extent to
which the expected return and actual return are likely to differ.

The expected return, standard deviation and variance of outcomes can be computed
as:

Variance is
Where,
R = expected return
σ2 = variance of expected return
σ = standard deviation of expected return
P = Probability
O = Outcome
n = total number of different outcomes

Beta Coefficient: there is another measure of risk known as β which measures the risk
of one security/portfolio in relation to market risk. The market risk is represented by
fluctuation in the market benchmark, i.e., market index, e.g., SENSEX. Shares whose β
factor is more than 1 are considered less risky. It may be noted that β is a measure of
systematic risk which cannot be diversified away.
The total risk of an investment consists of two components: diversifiable (unsystematic)
risk and non diversifiable (systematic) risk.
The relationship between total risk, diversifiable risk, and non diversifiable risk can be
expressed by the following equation:

Total risk = Diversifiable risk + Non Diversifiable risk

CHARACTERISTICS OF GOOD INVESTMENT

a. Objective fulfillment

∑ An investment should fulfill the objective of the savers. Every individual

has a definite objective in making an investment. When the investment
objective is contrasted with the uncertainty involved with investments,
the fulfillment of the objectives through the chosen investment avenue
could become complex.

b. Safety

∑ The first and foremost concern of any ordinary investor is that his
investment should be safe. That is he should get back the principal at the
end of the maturity period of the investment. There is no absolute safety
 in any investment, except probably with investment in government
securities or such instruments where the repayment of interest and
principal is guaranteed by the government.

c. Return

∑ The return from any investment is expectedly consistent with the extent
of risk assumed by the investor. Risk and return go together. Higher the
risk, higher the chances of getting higher return. An investment in a low
risk - high safety investment such as investment in government securities
will obviously get the investor only low returns.

d. Liquidity

∑ Given a choice, investors would prefer a liquid investment than a higher

return investment. Because the investment climate and market conditions
may change or investor may be confronted by an urgent unforeseen
commitment for which he might need funds, and if he can dispose of his
investment without suffering unduly in terms of loss of returns, he would
prefer the liquid investment.

e. Hedge against inflation

∑ The purchasing power of money deteriorates heavily in a country which

is not efficient or not well endowed, in relation to another country.
Investors, who save for the long term, look for hedge against inflation so
that their investments are not unduly eroded; rather they look for a capital
gain which neutralizes the erosion in purchasing power and still gives a
return.

f. Concealabilty

∑ If not from the taxman, investors would like to keep their investments
rather confidential from their own kith and kin so that the investments
made for their old age/ uncertain future does not become a hunting
ground for their own lives. Safeguarding of financial instruments
representing the investments may be easier than investment made in real
estate. Moreover, the real estate may be prone to encroachment and other
such hazards.

h. Tax shield
 Investment decisions are highly influenced by the tax system in the
country. Investors look for front-end tax incentives while making an
investment and also rear-end tax reliefs while reaping the benefit of their
investments. As against tax incentives and reliefs, if investors were to pay
taxes on the income earned from investments, they look for higher return
in such investments so that their after tax income is comparable to the
pre-tax equivalent level with some other income which is free of tax, but
is more risky.
DEFINITION OF INVESTMENT OBJECTIVES
Investment objectives are related to what the client wants to achieve with the
portfolio of investments. Objectives define the purpose of setting the portfolio.
Generally, the objectives are concerned with return and risk considerations. These
two objectives are interdependent as the risk objective defines how high the client
can place the return objective.

VESTMENT OBJECTIVES
The investment objectives are mainly of two types:
RISK OBJECTIVE
Risk objectives are the factors that are associated with both the willingness and the
ability of the investor to take the risk. When the ability to accept all types of risks and
willingness is combined, it is termed as risk tolerance. When the investor is unable
and unwilling to take the risk, it indicates risk aversion.
The following steps are undertaken to determine risk objective:
1. Specify Measure of Risk: Measurement of risk is the most important issue in portfolio
management. Risk either measured in absolute or relative terms. Absolute risk
measurement will include a specific level of variance or standard deviation of total return.
Relative risk measurement will include a specific tracking risk.
2. Investor’s Willingness: Individual investors’ willingness to take risk is different from
institutional investors. For individual investors, willingness is determined by psychological or
behavioral factors. Spending needs, long-term obligations or wealth targets, financial
strength, and liabilities are examples of factors that determine the willingness to take the risk
by an investor.
3. Investor’s Ability: The ability of an investor to take risk is dependent on financial and
practical factors that bound the amount of risk taken by the investor. An investor’s short-term
horizon will negatively affect his ability. Similarly, if the investor’s obligation and spending are
less than his portfolio, he clearly has more ability.
RETURN OBJECTIVE
The following steps are required to determine the return objective of the investor:

1. Specify Measure of Return: A measure of return needs to be specified. It can be

specified in an absolute term or a relative term. It can also be specified in nominal or
real terms. Nominal returns are not adjusted for inflation, whereas real returns are.
One may also distinguish pre-tax returns from post-tax returns.
2. Desired Return: A return desired by the investor needs to be determined. The
desired return indicates how much return is expected by the investor. E.g. higher or
lower than average returns.
3. Required Return: A return required by the investor also needs to be determined. A
required return indicates the return which needs to be achieved at the minimum for
the investor.
4. Specific Return Objectives: The investor’s specific return objectives also need to be
determined so that they are consistent with his risk objectives. An investor having a
high return objective needs to have a portfolio with a high level of expected risk.
DEFINITION OF INVESTMENT CONSTRAINTS
Investment constraints are the factors that restrict or limit the investment options available to
an investor. The constraints can be either internal or external constraints. Internal constraints
are generated by the investor himself while external constraints are generated by an outside
entity, like a governmental agency.

TYPES OF INVESTMENT CONSTRAINTS:

The following are the types of investment constraints:
LIQUIDITY
Such constraints are associated with cash outflows expected and required at a specific time in
future and are generally in excess of income available. Moreover, prudent investors will want
to keep aside some money for unexpected cash requirements. The financial advisor needs to
keep liquidity constraints in mind while considering an asset’s ability to be converted into
cash without impacting the portfolio value significantly.
TIME HORIZON
These constraints are related to the time periods over which returns are expected from
portfolio to meet specific needs in the future. An investor may have to pay for college
education for children or needs the money after his retirement. Such constraints are important
to determine the proportion of investments in long-term and short-term asset classes.

TAX

hese constraints depend on when, how and if returns of different types are taxed.
For an individual investor, realized gains and income generated by his portfolio are
taxable. The tax environment needs to be kept in mind while drafting the policy
statement. Often, capital gains and investment income are subjected to differential
tax treatments.

LEGAL AND REGULATORY

Such constraints are mostly externally generated and may affect only institutional
investors. These constraints usually specify which asset classes are not permitted
for investments or dictate any limitations on asset allocations to certain investment
classes. A trust portfolio for individual investors may have to follow substantial
regulatory and legal constraints.

UNIQUE CIRCUMSTANCES
Such constraints are mostly internally generated and signify investor’s special
concerns. Some individuals and philanthropic organizations may not invest in
companies selling alcohol, tobacco or even defense products. Such concerns and
any special circumstance restricting the investor’s investments should be well
considered while formulating investment policy statement.