1 Security Analysis and Portfolio Management

 Basic Concept of Investments

Investment involves making of a sacrifice in the present with the hope of deriving future benefits.
Two most important features of an investment are current sacrifice and future benefit.
Investment is the sacrifice of certain present values for the uncertain future reward. It involves
numerous decision such as type, mix, amount, timing, grade etc, of investment the decision
making has to be continues as well as investment may be defined as an activity that commits
funds in any financial/physical form in the present with an expectation of receiving additional
return in the future. The expectation brings with it a probability that the quantum of return may
vary from a minimum to a maximum. This possibility of variation in the actual return is known as
investment risk. Thus every investment involves a return and risk. Investment has many meaning
and facets. However, investment can be interpreted broadly from three angles –
 Economic investment includes the commitment of the fund for net addition to the capital
stock of the economy. The net additions to the capital stock means an increase in building
equipment or inventories over the amount of equivalent goods that existed, say, one year
ago at the same time.
 Layman uses of the term investment as any commitment of funds for a future benefit not
necessarily in terms of return. For example a commitment of money to buy a new car is
certainly an investment from an individual point of view.
 Financial investment is the commitment of funds for a future return, thus investment may
be understood as an activity that commits funds in any financial or physical form in the
presence of an expectation of receiving additional return in future.
In the present context of portfolio management, the investment is considered to be
financial investment, which imply employment of funds with the objective of realizing additional
income or growth in value of investment at a future date. Investing encompasses very
conservative position as well as speculation the field of investment involves the study of
investment process. Investment is concerned with the management of an investors’ wealth
which is the sum of current income and the present value of all future incomes. In this text
investment refers to financial assets. Financial investments are commitments of funds to derive
income in form of interest, dividend premium, pension benefits or appreciation in the value of
initial investment. Hence the purchase of shares, debentures post office savings certificates and
insurance policies all are financial investments. Such investment generates financial assets. These
activities are undertaken by anyone who desires a return, and is willing to accept the risk from
the financial instruments.

 Investment v/s Trading v/s Speculation

 Investing looks primarily at fundamentals, which tend to be long-term drivers of stock
prices. The long-term investor waits out the short term volatility as long as the bullish
outlook and the general uptrend are intact. The good part is that investing involves fewer

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2 Security Analysis and Portfolio Management

transaction costs and usually lower taxes. The bad part is that sometimes the stock can
correct (go down temporarily) or have periods of flat performance, which the long-term
investor has to tolerate.
 In trading, much more activity takes place during a range of a few days, weeks, or months.
Traders may dump losers immediately and cash out winners to lock in some profit before
the next dip in price. Trading can mean more costs due to frequent commissions and
short-term taxable gains. For trading, the fundamentals are either not a factor or at best
a secondary or minor factor because short-term movements in a stock price are more
geared to momentum and sentiment.
 Speculating is a form of “financial gambling.” As a speculator, you’re not investing but
making an educated guess about which way the stock price will go. Speculating is typically
associated with a short-term time frame, but it can also be long-term.

Key Differences between Investment and Speculation

The basic difference between investment and speculation are mentioned in the points given
below:
 Investment refers to the purchase of an asset with the hope of getting returns. The term
speculation denotes an act of conducting a risky financial transaction, in the hope of
substantial profit.
 In investment, the decisions are taken on the basis of fundamental analysis, i.e.
performance of the company. On the other hand, in speculation decisions are based on
hearsay, technical charts, and market psychology.
 Investments are held for at least one year. Hence, it has a longer time horizon than
speculation, where speculators hold assets for short term only.
 The quantity of risk is moderate in investment and high in case of speculation.
 The investors, expect profit from the change in the value of the asset. As opposed to
speculators who expect profit from the change in the prices, due to demand and supply
forces.
 An investor expects the modest rate of return on the investment. On the contrary, a
speculator expects higher profits from the speculation in exchange for the risk borne by
him.
 The investor uses his own funds for investment purposes. Conversely, speculator uses
borrowed capital for speculation.
 In speculation, the stability of income is absent it is uncertain and erratic which is not in
the case of investment.
 The psychological attitude of investors is conservative and cautious. In contrast,
speculators are daring and careless.

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3 Security Analysis and Portfolio Management

The identification of these distinctions of these distinctions helps to define the role of the
investor and the speculator in the market. The investor can be said to be interested in a good
rate of return of a consistent basis over a relatively longer duration. For this purpose the investor
computes the real worth of the security before investing in it. The speculator seeks very large
returns from the market quickly. For a speculator, market expectations and price movements are
the main factors influencing a buy or sell decision. Speculation, thus, is more risky than
investment. In any stock exchange, there are two main categories of speculators called the bulls
and bears. A bull buys shares in the expectation of selling them at a higher price. When there is
a bullish tendency in the market, share prices tend to go up since the demand for the shares is
high. A bear sells shares in the expectation of a fall in price with the intention of buying the shares
at a lower price at a future date. These bearish tendencies result in a fall in the price of shares. A
share market needs both investment and speculative activities. Speculative activity adds to the
market liquidity. A wider distribution of shareholders makes it necessary for a market to exist.

 Various Avenues and Investments Alternative

Investment generally involves commitment of funds in two types of assets:
1. Real assets: Real assets are tangible material things like building, automobiles, land, gold
etc.
2. Financial assets: Financial assets are piece of paper representing an indirect claim to real
assets held by someone else. These pieces of paper represent debt or equity commitment
in the form of IOUs or stock certificates. Investments in financial assets consist of
a. Security forms of investment: The term ‘securities’ used in the broadest sense,
consists of those papers which are quoted and are transferable. Therefore,
context, security forms of investments include Equity shares, preference shares,
debentures, government bonds, Units of UTI and other Mutual Funds, and equity
shares and bonds of Public Sector Undertakings (PSUs).
b. Non-securities investment: Non-security forms of investments include all those
investments, which are not quoted in any stock market and are not freely
marketable. viz., bank deposits, corporate deposits, post office deposits, National
Savings and other small savings certificates and schemes, provident funds, and
insurance policies. Another popular investment in physical assets such as Gold,
Silver, Diamonds, Real estate, Antiques etc. Indian investors have always
considered the physical assets to be very attractive investments. There are a large
number of investment avenues for savers in India. Some of them are marketable
and liquid, while others are non-marketable, some of them are highly risky while
some others are almost risk less. Investment avenues can be broadly categorized
under the following heads: -

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Investment Avenues
1. Equity Shares: Equity investments represent ownership in a running company. By
ownership, we mean share in the profits and assets of the company but generally, there
are no fixed returns. It is considered as a risky investment but at the same time, they are
most liquid investments due to the presence of stock markets. Equity shares of companies
can be classified as follows:
a. Blue-chip stocks: These are stocks of high quality, financially strong companies
which are usually the leaders in their industry. They are stable and matured
companies. They pay good dividends regularly and the market price of the shares
does not fluctuate widely. Examples are stocks of Colgate, HLL, Infosys, Reliance.
b. Income Stocks: A company that pays a large dividend relative to the market price
is called an income stock. They are also called defensive stocks. Drug, food and
public utility industry shares are regarded as income stocks. Prices of income
stocks are not as volatile as growth stocks.
c. Cyclical Stocks: Cyclical stocks are companies whose earnings fluctuate with the
business cycle. Cyclical stocks generally belong to infrastructure or capital goods
industries such as general engineering, auto, cement, paper, construction etc.
Their share prices also rise and fall in tandem with the trade cycles.
d. Defensive Stocks: They are issued by companies that are resistant to the economic
cycles, and may even profit from them. When consumers and businesses cut back
spending, a few other businesses profit, either because they offer a way to cut
costs, or because they have the lowest prices. E.g. FMCG, Pharma
e. Growth Stocks: Growth stocks are companies whose earnings per share is grows
faster than the economy and at a rate higher than that of an average firm in the
same industry. Often, the earnings are ploughed back with a view to use them for
financing growth. They invest in research and development and diversify with an
aggressive marketing policy. They are evidenced by high and strong EPS.
f. Speculative Stocks: They are the stocks of companies that have little or no
earnings, or widely varying earnings, but hold great potential for appreciation
because they are tapping into a new market, are operating under new
management, or are developing a potentially very lucrative product that could
cause the stock price to zoom upward if the company is successful.

Sometimes stocks are categorized by their market capitalization, or market cap.

Market Capitalization = Stock Price × Number of Stocks Outstanding
a. The large-cap stocks consists of the blue-chip, income, defensive, and cyclical
stocks, since large companies have little potential for growth. Capital gains can be
earned, however, by buying these stocks at the bottom of a business cycle and

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5 Security Analysis and Portfolio Management

selling them as the economy reaches full speed. Large-cap stocks have the best
price stability and the least risk.
b. Mid-cap stocks are composed of most of the categories listed here, since their
market caps range from the top of the small-cap market to the bottom of the
large-cap market. They have consistent profit growth and stability, and low levels
of debt, but are smaller in size than the large-cap blue-chips.
c. Small-cap stocks are small companies that have the greatest potential for growth
— hence, most of these stocks are growth or speculative stocks. Small-cap stocks
tend to do better than other stocks at the beginning of an economic expansion,
unless their growth is constrained by the availability of credit, since they rely more
on bank financing than larger companies that can sell bonds directly to the market.
2. Debentures or Bonds: Debentures or bonds are long term investment options with a fixed
stream of cash flows depending on the quoted rate of interest. They are considered
relatively less risky. An amount of risk involved in debentures or bonds is dependent upon
who the issuer is. For example, if the issuer is government, the risk is assumed to be zero.
Following alternatives are available under debentures or bonds:
a. Government securities
b. Savings bonds
c. Public Sector Units bonds
d. Debentures of private sector companies
e. Preference shares: Preference shares refer to a form of shares that lie in between
pure equity and debt. They have the characteristic of ownership rights while
retaining the privilege of a consistent return on investment. The claims of these
holders carry higher priority than that of ordinary shareholders but lower than
that of debt holders. These are issued to the general public only after a public issue
of ordinary shares.
3. Money Market Instruments: Money market instruments are just like the debentures but
the time period is very less. It is generally less than 1 year. Corporate entities can utilize
their idle working capital by investing in money market instruments. Some of the money
market instruments are
a. Treasury Bills
b. Commercial Paper
c. Certificate of Deposits
4. Mutual Funds: Mutual funds are an easy and tension free way of investment and it
automatically diversifies the investments. A mutual fund is an investment mix of debts
and equity and ratio depending on the scheme. They provide with benefits such as
professional approach, benefits of scale and convenience. In mutual funds also, we can
select among the following types of portfolios:

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6 Security Analysis and Portfolio Management

a. Equity Schemes
b. Debt Schemes
c. Balanced Schemes
d. Sector Specific Schemes etc.
5. Life Insurance and General Insurance: They are one of the important parts of good
investment portfolios. Life insurance is an investment for the security of life. The main
objective of other investment avenues is to earn a return but the primary objective of life
insurance is to secure our families against unfortunate event of our death. It is popular in
individuals. Other kinds of general insurances are useful for corporates. There are
different types of insurances which are as follows:
a. Endowment Insurance Policy
b. Money Back Policy
c. Whole Life Policy
d. Term Insurance Policy
e. General Insurance for any kind of assets.
6. Real Estate: Every investor has some part of their portfolio invested in real assets. Almost
every individual and corporate investor invest in residential and office buildings
respectively. Apart from these, others include:
a. Agricultural Land
b. Semi-Urban Land
c. Commercial Property
d. Raw House
e. Farm House etc
7. Precious Objects: Precious objects include gold, silver and other precious stones like the
diamond. Some artistic people invest in art objects like paintings, ancient coins etc.
8. Derivatives: Derivatives means indirect investments in the assets. The derivatives market
is growing at a tremendous speed. The important benefit of investing in derivatives is that
it leverages the investment, manages the risk and helps in doing speculation. Derivatives
include:
a. Forwards
b. Futures
c. Options
d. Swaps etc
9. Non-Marketable Securities: Non-marketable securities are those securities which cannot
be liquidated in the financial markets. Such securities include:
a. Bank Deposits
b. Post Office Deposits
c. Company Deposits

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7 Security Analysis and Portfolio Management

d. Provident Fund Deposits

 Investment Process
Criteria of evaluation of Investment
1. Return: All investments are characterized by the expectation of a return. In fact,
investments are made with the primary objective of deriving return. The expectation of a
return may be from income (yield) as well as through capital appreciation. Capital
appreciation is the difference between the sale price and the purchase price. The
expectation of return from an investment depends upon the nature of investment,
maturity period, market demand and so on.
2. Risk: Risk is inherent in any investment. Risk may relate to loss of capital, delay in
repayment of capital, nonpayment of return or variability of returns. The risk of an
investment is determined by the investments, maturity period, repayment capacity,
nature of return commitment and so on.
3. Marketability: A measure of the ability of a security to be bought and sold. If there is an
active marketplace for a security, it has good marketability. Marketability is similar to
liquidity, except that liquidity implies that the value of the security is preserved, whereas
marketability simply indicates that the security can be bought and sold easily, thus
reducing the impact on cost.
4. Tax Benefits: Some investments provide tax benefits. There are of three kinds
a. Initial Tax Benefit: Tax relief enjoyed at the time of making the investment. E.g.
80C
b. Continuing Tax Benefit: Tax shield with periodic returns from investment. E.g.
Dividend Income
c. Terminal Tax Benefit: Relief from taxation when investment is realized or
liquidated. E.g. Withdrawal from PPF.
5. Convenience: The ease with which investment can be made and looked after.

Investment process is governed by the two important facets of investment they are risk, return
and their trade off. Risk and expected return of an investment are related. Theoretically, the
higher the risk, higher is the expected returned. The higher return is a compensation expected
by investors for their willingness to bear the higher risk. Although numerous separate decisions
must be made, for organizational purposes, this decision process has traditionally been divided
into a two-step process: security analysis and portfolio management. Security analysis involves
the valuation of securities, whereas portfolio management involves the management of an
investor’s investment selections as a portfolio (package of assets), with its own unique
characteristics.

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8 Security Analysis and Portfolio Management

Classification of Financial Markets

It can be classified in various ways as follows
1. Nature of claim
a. Debt Market (Fixed Claim, Interest)
b. Equity Market (Residual Claim Divident)
2. Maturity of Claim
a. Money Market (Short term)
b. Capital Market (Long Term)
3. Seasoning of Claim
a. Primary Market (New)
b. Secondary Market (Outstanding)
4. Timing of Delivery
a. Spot Market (Cash, Immediate)
b. Forward / Future Market (Future)
5. Organizational Structure
a. Exchange Traded Market (Standard)
b. Over the Counter Market (Customised)

 4 Important Functions of Financial Market

1. Financial market gives strength to economy by making finance available at the right
place: Mobilization of Savings and their Channelization into more Productive Uses:
Financial market gives impetus to the savings of the people. This market takes the
uselessly lying finance in the form of cash to places where it is really needed. Many
financial instruments are made available for transferring finance from one side to the
other side. The investors can invest in any of these instruments according to their wish.
2. Facilitates Price Discovery: The price of any goods or services is determined by the forces
of demand and supply. Like goods and services, the investors also try to discover the price
of their securities. The financial market is helpful to the investors in giving them proper
price.
3. Provides Liquidity to Financial Assets: This is a market where the buyers and the sellers
of all the securities are available all the times. This is the reason that it provides liquidity
to securities. It means that the investors can invest their money, whenever they desire,
in securities through the medium of financial market. They can also convert their
investment into money whenever they so desire.
4. Reduces the Cost of Transactions: Various types of information are needed while buying
and selling securities. Much time and money is spent in obtaining the same. The financial
market makes available every type of information without spending any money. In this
way, the financial market reduces the cost of transactions.

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9 Security Analysis and Portfolio Management

Approaches to Investment Decision Making

We have seen above that stock market is thronged by investors pursuing diverse investment
strategies. These may be subsumed under four broad approaches:
1. Fundamental Approach: The basic tenets of the fundamental approach, which is perhaps
most commonly advocated by investment professionals, are as follows:
a. There is an intrinsic value of a security and this depends upon underlying
economic (fundamental) factors. The intrinsic value can be established by a
penetrating analysis of the fundamental factors relating to the company, industry,
and economy.
b. At any given point of time, there are some securities for which the prevailing
market price would differ from the intrinsic value. Sooner or later, of course, the
market price would fall in line with the intrinsic value.
c. Superior returns can be earned by buying under-valued securities (securities
whose intrinsic value exceeds the market price) and selling over-valued securities
(securities whose intrinsic value is less than the market price).
2. Psychological Approach: The psychological approach is based on the premise that stock
prices are guided by emotion, rather than reason. Stock prices are believed to be
influenced by the psychological mood of the investors. When greed and euphoria sweep
the market, prices rise to dizzy heights. On the other hand, when fear and despair envelop
the market, prices fall to abysmally low levels. Since psychic values appear to be more
important than intrinsic values, the psychological approach suggests that it is more
profitable to analyse how investors tend to behave as the market is swept by waves of
optimism and pessimism which seem to alternate. Those who subscribe to the
psychological approach generally use some form of technical analysis which is concerned
with a study of internal market data, with a view to developing trading rules aimed at
profit-making. The basic premise of technical analysis is that there are certain persistent
and recurring patterns of price movements, which can be discerned by analysing market
data. Technical analysts use a variety of tools like bar chart, point and figure chart, moving
average analysis, breadth of market analysis, etc.
3. Academic Approach: Over the last five decades or so, the academic community has
studied various aspects of the capital market, particularly in the advanced countries, with
the help of fairly sophisticated methods of investigation. While there are many
unresolved issues and controversies stemming from studies pointing in different
directions, there appears to be substantial support for the following tenets. Stock markets
are reasonably efficient in reacting quickly and rationally to the flow of information.
Hence, stock prices reflect intrinsic value fairly well. Put differently: Market price =
Intrinsic value. Stock price behaviour corresponds to a random walk. This means that
successive price changes are independent. As a result, past price behaviour cannot be

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10 Security Analysis and Portfolio Management

used to predict future price behaviour. In the capital market, there is a positive
relationship between risk and return. More specifically, the expected return from a
security is linearly related to its systematic risk. Stock price behaviour corresponds to a
random walk. This means that successive price changes are independent. As a result, past
price behaviour cannot be used to predict future price behaviour. In the capital market,
there is a positive relationship between risk and return. More specifically, the expected
return from a security is linearly related to its systematic risk
4. Eclectic Approach: The eclectic approach draws on all the three different approaches
discussed above. The basic premises of the eclectic approach are as follows:
 Fundamental analysis is helpful in establishing basic standards and benchmarks.
However, since there are uncertainties associated with fundamental analysis,
exclusive reliance on fundamental analysis should be avoided. Equally important,
excessive refinement and complexity in fundamental analysis must be viewed
with caution.
 Technical analysis is useful in broadly gauging the prevailing mood of investors and
the relative strengths of supply and demand forces. However, since the mood of
investors can vary unpredictably excessive reliance on technical indicators can be
hazardous. More important, complicated technical systems should ordinarily be
regarded as suspect because they often represent figments of imagination rather
than tools of proven usefulness.
 The market is neither as well ordered as the academic approach suggests, nor as
speculative as the psychological approach indicates. While it is characterised by
some inefficiencies and imperfections, it seems to react reasonably efficiently and
rationally to the flow of information. Likewise, despite many instances of
mispriced securities, there appears to be a fairly strong correlation between risk
and return.
The operational implications of the eclectic approach are as follows:
a. Conduct fundamental analysis to establish certain value ‘anchors’.
b. Do technical analysis to assess the state of the market psychology.
c. Combine fundamental and technical analyses to determine which securities are
worth buying, worth holding, and worth disposing of.
d. Respect market prices and do not show excessive zeal in ‘beating the market’.
Accept the fact that the search for a higher level of return often necessitates the
assumption of a higher level of risk.

 Return
For most investors, however, the prime interest in investments is largely to earn a return on their
money. People want to maximize expected returns subject to their tolerance for risk. Return is

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11 Security Analysis and Portfolio Management

the principal reward in the investment process, and it provides the basis to investors in comparing
alternative investments. Measuring historical returns allows investors to assess how well they
have done, and it plays a part in the estimation of future, unknown returns.
 Realised Return is after the fact return that was earned (or could have been earned).
Realised Return is history.
 Expected return is the return from an asset that investors anticipate they will earn over
some future period. It is a predicted return, and it may or may not occur.

Return of an investment consists of 2 components.

 Current Return: The principal component of return is the periodic income on the
investment, either in the form of interest or dividends.
 Capital Return: The second component is the change in the price of the asset— commonly
called the capital gain or loss. This element of return is the difference between the
purchase price and the price at which the asset can be or is sold. The price change may
bring a gain or a loss as it may be in any side.
Total Return = Current Return + Capital Return

 Measuring Return
1. Measuring Historical Return: The total return is an acceptable measure of return for a
specified period of time. The total return on an investment for a given period is
Cash Payment + (Ending Price – Beginning Price)
Beginning Price

2. Relative Return: It is a measure of the return of an investment portfolio relative to a

theoretical passive reference portfolio or benchmark. On adding 1.0 to each return (r),
we shall get a return relative. If the return for a period is 10 percent (.10), then the return
relative is 1.10. The investor has received Rs. 1.10 relative to each Rs. 1 invested. If the
return for a period is –15 percent (-.15) then the return relative is .85 (1-.15). Return
relatives are used in calculating geometric average returns because negative total returns
cannot be used in the math.
Relative Return = 1 + Total Return in decimals

3. Average Return: The total return is an acceptable measure of return for a specified period
of time. But we also need statistics to describe a series of returns. For example, investing
in a particular stock for ten years or a different stock in each of ten years could result in
10 total returns, which must be described mathematically. There are two generally used
methods of calculating the average return, namely, the arithmetic mean and geometric
mean

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12 Security Analysis and Portfolio Management

4. Arithmetic Mean: The arithmetic average return is appropriate as a measure of the

central tendency of a number of returns calculated for a particular time, such as a year.
∑𝒏𝒊=𝟏 𝐑𝐢
̅
𝐑=
𝐧

Where 𝑅̅ is arithmetic mean, Ri is value of the total return (i = 1, ... n) and n is the number of
total returns.

5. Geometric Mean: The geometric average return measures compound, cumulative

returns over time. It is used in investments to reflect the realized change in wealth over
multiple periods. The geometric average is defined as the nth root of the product resulting
from multiplying a series of returns.
̅ = [(𝟏 + 𝑹𝟏 )( 𝟏 + 𝑹𝟐 ) + … + (𝟏 + 𝑹𝒏 )] 𝟏/𝒏 − 𝟏
𝐑
Where 𝑅̅ is geometric mean, Ri is value of the total return (i = 1, ... n) and n is the number of
total returns.

6. Real Return: A real rate of return is the annual percentage return realized on an
investment, which is adjusted for changes in prices due to inflation or other external
effects. This method expresses the nominal rate of return in real terms, which keeps
the purchasing power of a given level of capital constant over time. Adjusting the nominal
return to compensate for factors such as inflation allows you to determine how much of
your nominal return is actually real return
𝟏 + 𝑵𝒐𝒎𝒊𝒏𝒂𝒍 𝑹𝒆𝒕𝒖𝒓𝒏
Real Return = -1
𝟏+𝐈𝐧𝐟𝐥𝐚𝐭𝐢𝐨𝐧 𝐑𝐞𝐭𝐮𝐫𝐧

 Arithmetic Mean v/s Geometric Mean

The arithmetic mean is the simplest calculation to determine the average return. The average return on
an asset, observed over a long period of time, is often used as the expected return for future years.
Although the future return is unknown and cannot be predicted with great accuracy, the historical average
return is as good a guess as any of what the return will be in the future. The geometric mean is a bit more
complicated. It uses compounding to determine the mean return. Geometric mean is slightly lower than
the arithmetic mean. This is the case when the returns are changing through time. The greater the
volatility the greater the difference will be between arithmetic and geometric averages. If the
annual rate of return on the asset has no volatility, then the geometric mean and arithmetic mean will be
equal. The geometric mean is also used in the calculation for the cumulative average growth rate (CAGR).
CAGR assumes that an asset, cash flow, or some other random variable grows at a constant rate of return
compounded over a sample period of time.

 Risk
Risk is explained theoretically as the fluctuation in returns from a security. A security that yields
consistent returns over a period of time is termed as risk less security or risk free security. The
risk free interest rate is the interest rate on the risk free and default free securities. Return

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13 Security Analysis and Portfolio Management

expected by an investor from a particular security depends upon the market rate of return and
risk associated with a particular security. When the secondary market does not respond to
rational expectations, the risk component of such markets are relatively high and most investors
fail to recognize the real risk involved in the investment process. Risk aversion is the criteria
commonly associated with many small investors in the secondary market. Risk averse investors
prefer to lock up their funds in securities that would rather give them back their investment with
small returns than those securities that yield high returns on an average but are subject to wild
fluctuations. Risk is defined as the uncertainty about the actual return that will earn on an
investment. When one invest, expects some particular return, but there is a risk that he ends up
with a different return when he terminates the investment. The more the difference between
the expected and the actual the more is the risk. It is not sensible to talk about the investment
returns without talking about the risk, because the investment decision involves a trade-off
between the two, return and risk.

 Factors influence risk

Traditionally, investors have talked about several factors causing risk such as business failure,
market fluctuations, change in the interest rate inflation in the economy, fluctuations in exchange
rates changes in the political situation etc. Based on the factors affecting the risk the risk can be
understood in following manners:
1. Interest rate risk: The variability in a security return resulting from changes in the level of
interest rates is referred to as interest rate risk. Such changes generally affect securities
inversely, that is other things being equal, security price move inversely to interest rate.
2. Market risk: The variability in returns resulting from fluctuations in overall market that is,
the agree get stock market is referred to as market risk. Market risk includes a wide range
of factors exogenous to securities themselves, like recession, wars, structural changes in
the economy, and changes in consumer preference. The risk of going down with the
market movement is known as market risk.
3. Inflation risk: Inflation in the economy also influences the risk inherent in investment. It
may also result in the return from investment not matching the rate of increase in general
price level (inflation). The change in the inflation rate also changes the consumption
pattern and hence investment return carries an additional risk. This risk is related to
interest rate risk, since interest rate generally rises as inflation increases, because lenders
demands additional inflation premium to compensate for the loss of purchasing power.
4. Business risk: The changes that take place in an industry and the environment causes risk
for the company in earning the operational revenue creates business risk. When a
company fails to earn through its operations due to changes in the business situations
leading to erosion of capital, there by faces the business risk.
5. Financial risk: The use of debt financing by the company to finance a larger proportion of
assets causes larger variability in returns to the investors in the faces of different business

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14 Security Analysis and Portfolio Management

situation. During prosperity the investors get higher return than the average return the
company earns, but during distress investors faces possibility of vary low return or in the
worst case erosion of capital which causes the financial risk. The larger the proportion of
assets finance by debt (as opposed to equity) the larger the variability of returns thus
lager the financial risk.
6. Liquidity risk: An investment that can be bought or sold quickly without significant price
concession is considered to be liquid. The more uncertainty about the time element and
the price concession the greater the liquidity risk. The liquidity risk is the risk associated
with the particular secondary market in which a security trades.
7. Exchange rate risk: The change in the exchange rate causes a change in the value of
foreign holdings, foreign trade, and the profitability of the firms, there by returns to the
investors. The exchange rate risk is applicable mainly to the companies who operate
oversees. The exchange rate risk is nothing but the variability in the return on security
caused by currencies fluctuation.
8. Political risk: Political risk also referred, as country risk is the risk caused due to change in
government policies that affects business prospects there by return to the investors.
Policy changes in the tax structure, concession and levy of duty to products, relaxation or
tightening of foreign trade relations etc. carry a risk component that changes the return
pattern of the business.

 Types of Risk
Modern investment analysis categorizes the traditional variability in returns into two general
types: those that are pervasive in nature, such as market risk or interest rate risk, and those that
are specific to a particular security issue, such as business or financial risk. Therefore, we must
consider these two categories of total risk. Dividing total risk in to its two components, a general
(market) component and a specific (issue ) component, we have systematic risk and unsystematic
risk which are additive:
Total risk = general risk + specific risk
= market risk + issuer risk
= systematic risk + non systematic risk

 Systematic risk: Variability in a securities total return that is directly associated with
overall moment in the general market or economy is called as systematic risk. This risk
cannot be avoided or eliminated by diversifying the investment. Normally diversification
eliminates a part of the total risk the left over after diversification is the non-diversifiable
portion of the total risk or market risk. Virtually all securities have some systematic risk
because systematic risk directly encompasses the interest rate, market and inflation risk.
The investor cannot escape this part of the risk, because no matter how well he or she
diversifies, the risk of the overall market cannot be avoided. If the stock market declines

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15 Security Analysis and Portfolio Management

sharply, most stock will be adversely affected, if it rises strongly, most stocks will
appreciate in value. Clearly mark risk is critical to all investors.
 Non-systematic risk: Variability in a security total return not related to overall market
variability is called unsystematic (non market) risk. This risk is unique to a particular
security and is associated with such factors as business, and financial risk, as well as
liquidity risk. Although all securities tend to have some non-systematic risk, it is generally
connected with common stocks.

Measuring Historical Risk

Risk can be measured with an absolute measure of dispersion, or variability. The most commonly
used measure of dispersion over some period of years is the standard deviation, which measures
the deviation of each observation from the arithmetic mean of the observations and is a reliable
measure of variability, because all the information in a sample is used. The standard deviation is
a measure of the total risk of an asset or a portfolio. It captures the total variability in the assets
or portfolio’s return, whatever the source(s) of that variability. The standard deviation is the
square root of variance. The historical standard deviation can be calculated for individual
securities or portfolio of securities using Total Returns for some specified period of time. This ex
post value is useful in evaluating the total risk for a particular historical period and in estimating
the total risk that is expected to prevail over some future period.
 Variance is a measurement of the spread between numbers in a data set. The variance
measures how far each number in the set is from the mean. Variance is one of the key
parameters in asset allocation. Along with correlation, variance of asset returns helps
investors to develop optimal portfolios by optimizing the return-volatility trade-off in
investment portfolios. Risk or volatility is often expressed as a standard deviation rather
than variance because the former is more easily interpreted.
 Standard deviation is a measure of the dispersion of a set of data from its mean.

̅ )𝟐
∑𝒏𝒊=𝟏(𝐑 𝒊 − 𝑹
𝝈𝟐 =
𝒏−𝟏

𝒏
𝟐 ̅ )〗𝟐 𝒑𝒊 )
𝝈 = (∑(𝐑 𝒊 〖− 𝑹
𝒊=𝟏

𝝈 = √𝝈𝟐
𝜎 2 = Variance of Return
𝜎 = Standard Deviation of return
𝑅̅ is arithmetic mean
Ri is value of the total return

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16 Security Analysis and Portfolio Management

n is no of periods

 Risk Aversion and Required Return

The relationship of a person’s certainty equivalent to the expected monetary value of a risk
investment defines his attitude towards risk. If certainty equivalent is less than the expected
value person is risk averse, If certainty equivalent is equal to the expected value the person is risk
neutral and if the certainty equivalent is more than the value the person is risk loving. In general
investors are risk averse, this means that risky investment must offer higher expected returns
than less risky investments to induce people to invest in them.
A risk premium is the return in excess of the risk-free rate of return an investment is expected to
yield; an asset's risk premium is a form of compensation for investors who tolerate the extra risk,
compared to that of a risk-free asset, in a given investment. Risk premium may be calculated
between 2 classes of security that differ in their risk level.
 Equity Risk Premium = Return on Equity Stock and Risk Free Rate
 Bond Horizon Premium = Return on Long Term Government Bonds and Return on
Treasury Bill
 Bond Default Premium = Return on Long Term Corporate Bond and Long Term
Government Bond

 Normal Distribution and Standard Deviation

A normal distribution is a very important statistical data distribution pattern occurring in many
natural phenomena. Random
variation conforms to a particular
probability distribution known as the
normal distribution, which is the
most commonly observed probability
distribution. Fifty percent of the
distribution lies to the left of the
mean and fifty percent lies to the
right of the mean. It appears that
stock returns at least over short term
horizon are approximately normally
distributed. The following features of
normal distribution may be noted:

 It is completely characterized by just 2 parameters expected return and standard

deviation of return.
 A bell shaped distribution, it is perfectly symmetric around the expected return.

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17 Security Analysis and Portfolio Management

 The probabilities for values lying with certain bands are as follows
Band Probability
± One Standard Deviation 68.3%
± Two Standard Deviation 95.4%
± Three Standard Deviation 99.7%

MMS Finance Faculty: Natasha A Vasanji