MF0010

Q.1 Frame the investment process for a person of your age group.
Answer: It is rare to find investors investing their entire savings in a single security. Instead, they tend to invest in a group of securities. Such a group of securities is called a portfolio. Most financial experts stress that in order to minimize risk; an investor should hold a well-balanced investment portfolio. The investment process describes how an investor must go about making. Decisions with regard to what securities to invest in while constructing a portfolio, how extensive the investment should be, and when the investment should be made. This is a procedure involving the following five steps: Set investment policy Perform security analysis Construct a portfolio Revise the portfolio Evaluate the performance of portfolio

1. Setting Investment Policy This initial step determines the investors objectives and the amount of his investable wealth. Since there is a positive relationship between risk and return, the investment objectives should be stated in terms of both risk and return. This step concludes with the asset allocation decision: identification of the potential categories of financial assets for consideration in the portfolio that the investor is going to construct. Asset allocation involves dividing an investment portfolio among different asset categories, such as stocks, bonds and cash. The asset allocation that works best for an investor at any given point in his life depends largely on his time horizon and his ability to tolerate risk.

Time Horizon The time horizon is the expected number of months, years, or decades that an investor will be investing his money to achieve a particular financial goal. An investor with a longer time horizon may feel more comfortable with a riskier or more volatile investment because he can ride out the slow economic cycles and the inevitable ups and downs of the markets. By contrast, an investor who is saving for his teen-aged daughters college education would be less likely to take a large risk because he has a shorter time horizon.

Risk Tolerance Risk tolerance is an investors ability and willingness to lose some or all of his original investment in exchange for greater potential returns. An aggressive investor, or one with a high-risk tolerance, is more likely to risk losing money in order to get better results. A conservative investor, or one with a low-risk tolerance, tends to favour investments that will preserve his or her original investment. The conservative investors keep a bird in the hand, while aggressive investors seek two in the bush. While setting the investment policy, the investor also selects the portfolio management style (active vs. passive management).

Active Management is the process of managing investment portfolios by attempting to time the market and/or select undervalued? stocks to buy and overvalued? stocks to sell, based upon research, investigation and analysis.

Passive Management is the process of managing investment portfolios by trying to match the performance of an index (such as a stock market index) or asset class of securities as closely as possible, by holding all or a representative sample of the securities in the index or asset class. This portfolio management style does not use market timing or stock selection strategies.

2. Performing Security Analysis This step is the security selection decision: Within each asset type, identified in the asset allocation decision, how does an investor select which securities to purchase. Security analysis involves examining a number of individual securities within the broad categories of financial assets identified in the previous step. One purpose of this exercise is to identify those securities that currently appear to be mispriced. Security analysis is done either using Fundamental or Technical analysis (both have been discussed in subsequent units).

Fundamental analysis is a method used to evaluate the worth of a security by studying the financial data of the issuer. It scrutinizes the issuers income and expenses, assets and liabilities, management, and position in its industry. In other words, it focuses on the basics? of the business.

Technical analysis is a method used to evaluate the worth of a security by studying market statistics. Unlike fundamental analysis, technical analysis disregards an issuers financial statements. Instead, it relies upon market trends to ascertain investor sentiment to predict how a security will perform.

3. Portfolio Construction

This step identifies those specific assets in which to invest, as well as determining the proportion of the investors wealth to put into each one. Here selectivity, timing and diversification issues are addressed. Selectivity refers to security analysis and focuses on price movements of individual securities. Timing involves forecasting of price movement of stocks relative to price movements of fixed income securities (such as bonds). Diversification aims at constructing a portfolio in such a way that the investors risk is minimized. The following table summarizes how the portfolio is constructed for an active and a passive investor.

4. Portfolio Revision This step is the repetition of the three previous steps, as objectives might change and previously held portfolio might not be the optimal one.

5. Portfolio performance evaluation This step involves determining periodically how the portfolio has performed over some time period (returns earned vs. risks incurred).

Q.2 From the website of BSE India, explain how the BSE Sensex is calculated.
Answer: SENSEX: Sensex is the stock market index for BSE. It was first compiled in 1986. It is made of 30 stocks representing a sample of large, liquid and representative companies. The base year of SENSEX is 1978-79 and the base value is 100.

The Bombay Stock Exchange SENSEX (acronym of Sensitive Index)

more commonly referred to as SENSEX or BSE 30 is a free-float market capitalization-weighted index of 30 well-established and financially sound companies listed on Bombay Stock Exchange. The 30 component companies which are some of the largest and most actively traded stocks, are representative of various industrial sectors of the Indian economy. Published since January 1, 1986, the SENSEX is regarded as the pulse of the domestic stock markets in India. The base value of the SENSEX is taken as 100 on April 1, 1979, and its base year as 1978-79. On 25 July, 2001 BSE launched DOLLEX-30, a dollar-linked version of SENSEX. As of 21 April 2011, the market capitalisation of SENSEX was about 29,733 billion (US$660 billion) (42.34% of market capitalization of BSE), while its free-float market capitalization was 15,690 billion (US$348 billion).

The Bombay Stock Exchange (BSE) regularly reviews and modifies its composition to be sure it reflects current market conditions. The index is calculated based on a free float capitalization methoda variation of the market capitalisation method. Instead of using a companys outstanding shares it uses its float, or shares that are readily available for trading. The free-float method, therefore, does not include restricted stocks, such as those held by promoters, government and strategic investors. Initially, the index was calculated based on the full market capitalization method. However this was shifted to the free float method with effect from September 1, 2003. Globally, the free float market capitalization is regarded as the industry best practice. As per free float capitalization methodology, the level of index at any point of time reflects the free float market value of 30 component stocks relative to a base period. The market capitalization of a company is determined by multiplying the price of its stock by the number of shares issued by the company. This market capitalization is multiplied by a free float factor to determine the free float market capitalization. Free float factor is also referred as adjustment factor. Free float factor represent the percentage of shares that are readily available for trading. The calculation of SENSEX involves dividing the free float market capitalization of 30 companies in the index by a number called index divisor.The divisor is the only link to original base period value of the SENSEX. It keeps the index comparable over time and is the adjustment point for all index adjustments arising out of corporate actions, replacement of scrips, etc. The index has increased by over ten times from June 1990 to the present. Using information from April 1979 onwards, the long-run rate of return on the BSE SENSEX works out to be 18.6% per annum, which translates to roughly 9% per annum after compensating for inflation. Following is the list of the component companies of SENSEX as on Feb 26, 2010. Code Name Sector Adj. Factor Housing Related Weight in Index(%) 0.55 3.26 0.35 3 1.02 1.5 0.77

500410 ACC

500103 BHEL Capital Goods 0.35 532454 Bharti Airtel Telecom

532868 DLF Universal Limited Housing related 0.25 500300 Grasim Industries 500010 HDFC Finance 0.90 500180 HDFC Bank Diversified 5.21 5.03 0.75

Finance 0.85

500182 Hero Honda Motors Ltd.

Transport Equipments 0.50

1.43 1.75

500440 Hindalco Industries Ltd. Metal,Metal Products & Mining 0.7 500696 Hindustan Lever Limited FMCG 0.50 2.08

532174 ICICI Bank

Finance 1.00

7.86 10.26

500209 Infosys Information Technology0.85 500875 ITC Limited FMCG 0.70 4.99

532532 Jaiprakash Associates 500510 Larsen & Toubro

Housing Related Capital Goods 0.90

0.55 6.85

1.25

500520 Mahindra & Mahindra Limited Transport Equipments 0.75 532500 Maruti Suzuki Transport Equipments 0.50 532541? NIIT Technologies 2.03 2.03 1.71

1.71

Information Technology0.15

2.03

532555 NTPC Power 0.15 500304? NIIT

Information Technology0.15 0.20 3.87 Telecom 0.50 1.19 4.57

500312 ONGC Oil & Gas

532712 Reliance Communications 500325 Reliance Industries

0.35 12.94

0.92

Oil & Gas

500390 Reliance Infrastructure Power 0.65 500112 State Bank of India 500900 Sterlite Industries Finance 0.45

Metal, Metal Products, and Mining 0.40 1.03

0.45

2.39

524715 Sun Pharmaceutical Industries Healthcare 532540 Tata Consultancy Services 500570 Tata Motors 500400 Tata Power 500470 Tata Steel

Information Technology0.25 1.66

3.61

Transport Equipments 0.55 Power 0.70 1.63

Metal, Metal Products & Mining 1.61

0.70

2.88

507685 Wipro Information Technology0.20