PRINCIPLES OF INVESTMENT MANAGEMENT

MODULE-I

Introduction

Financial market is a place or a system where financial assets or instruments are created and exchanged
by market participants. Financial markets play a significant role in performing the resource management in an
economy. They help capital creation by acting as a bridge between the savers and the spenders through various
financial instruments like equity, debt or a mix of both. In the process it facilitates price discovery and providing
liquidity for financial assets. In every economic system, some units which may be individuals or institutions are
surplus generating (savers) while others are deficit units (spenders). Savers can either invest or hold their
savings in liquid cash. Holding liquid cash is required to meet transaction or precautionary or speculative needs.
The surplus-generating units could invest in different forms. They could invest in physical assets viz. land and
building, plant and machinery or in precious metal viz. gold and silver, or in financial assets viz. shares and
debentures, units of the Mutual Funds, treasury bills, commercial papers, etc.,

Financial and economic meaning of investment

Investment is the sacrifice of certain product value for the uncertain future return. It is the process of
divesting money in securities. It refers to exchange of money into some tangible assets or wealth. According to
Donald E.Fischer and renaldJ.Jordan” an investment is a commitment of funds made in the expectation of some
positive rate of returns. If the investment is properly undertaken, the return will be commensurable with the risk
the investor assumes”.

Features of an investment

1) It is the process of investing money.

2) Allocation of funds into different financial assets.
3) The process of analysis, decision and selection a is the subject matter of investment management
4) The return of the investment can be classified into: interest or dividend, appreciation odinvestmenti.e
capital gain
5) Expectation of some future rewards
6) Element of risk which is associated with return.
7) Mobilizing the investment needed by the corporate bodies.
8) Investment is different from savings
9) Investment is based on various decision factors, mode or avenue, types of kinds, portfolio or mix,
timing, criteria and grade .. etc.
Difference between investment and savings

Investment is an activity that is entered into by those who have savings. Savings can be defined as the
excess of income over expenditure. But all savers need not be investors. Motive of savings does not distinguish
the investor from a saver. The saver who puts aside money in a box cannot have expectation of excess return
attached to it. However, the saver who opens a bank deposit account expects a return from the bank and hence is

differentiated as an investor. Expectation of return is hence an essential.

Characteristics of investment
 Return
 Risk
 Safety
 Liquidity
 Tax savings
 Inflation
 Period

Objectives of investment
 Minimizing the risk
 Maximizing the return
 Liquidity
 To keep the money in a safe place
 To convert the saving into investments
 To adopt a balanced approach in selection of securities
 To educate and create awareness of the various alternatives for growth
 To utilize the tax incentive schemes offered by the government
 To analyze the features, advantages and availability of investment avenues

Types of investment

Investment may be classified into financial investments and economic investments. In the financial
sense investment is the commitment of funds to derive future income in the form of interest, dividend,
premiums, and pension benefits of appreciation in the value of initial investment. Hence purchase of shares,
debenture, post office saving certificates insurance policies are all financial investments. Such investment
generates financial asserts. These activities are entered into by anyone who desires a return and is willing to
accept the risk from the financial instrument.
Economic investments are entered with an expectation to increase the current economy’s capital stock
that of goods and services. Capital is used in the production of other goods and services desired by the society.
Investment in this sense implies the expectation of formation of new and productive capital in the form of new
constructions, plan, machinery, inventories.Etc. such investments generate physical assets and also industrial
activity. These activities are entered into by the corporate entities that participate in the capital market.
These two types of investments are related and dependent. The money invested in financial investments
is ultimately converted into physical assets. Thus ass investments result in the acquisition of some asset either
financial or physical. In this sense the markets are also closely related t each other. The perfect financial market
hence reflects the progress pattern of the real markets. Since, in reality the financial markets exists only as a
support to the real markets.

Investment Alternatives
Investment Alternatives are classified into two categories that are:
Financial assets
These are paper or electronic claim on some issues such as the government or a corporate body. (Equity shares,
corporate debt….etc.)
Real assets
Tangible assets like residential house, gold….. Etc.
Non-marketable financial assets
1) Bank deposits (Saving bank a/c, term deposits….etc.)
2) Post office savings account (4% interest p.a, Tax free interest)
3) Post office time deposits (interest rate 8.20 – 8.5%, interest calculated on quarterly Basis, eligible for
tax deduction under 80C)
4) Post Office Monthly Income Scheme (POMIS)
5) KisanVikasPatra (KVP) (this scheme was not offered w.e.f dec,2011)
6) National Saving Certificate (8.5% for 5yrs, 8.9% for 10 yrs, TD u/s 80c)
7) Company deposits (deposits or saving schemes are offered by the companies)
8) Employee provident fund scheme(8.8%, TD u/s 80c, loan facility avail after 3rd Year)
9) Public provident fund scheme (8.8%, TD u/s 80c, loan facility avail after 3rd year)

Marketable financial assets

1) Money market instruments (facilitate for short-term financial requirement normally less than 1 year)
a. Treasury bills (issued at discount rate and redeemed at par rate, 91,…364 days)
b. Certificate of deposits (Deposit certificate bearing interest rate for stipulated period of time)
c. Commercial papers (promissory note issued by the companies for mobilizing fund based on
the promise)
d. Repos (repossession agreements)
2) Bonds or debentures
a. Government securities (gilt fund- highly secured govt funds)
b. Saving bonds (specific period assured to pay the stipulated interest rate)
c. Private sector debentures
d. Public sector undertaking bonds
e. Preference shares (hybrid shares, having characteristics of debt and equity)
3) Equity shares (ownership shares, high risk and return associated , voting rights )
4) Mutual funds (it is the vehicle for collecting investment from the investors and pool it in to the various
investment avenues)
a. Equity scheme(investment in various company’s’ equity shares)
b. Debt scheme(investment in various company’s debentures)
c. Hybrid scheme (investment in various company’ debentures and equity shares )
5) Financial derivatives (derive the future value of underlying financial assets)
a. Futures (Execute the contract of buy/sell the underlying value in future at given price)
b. Options (option to the investor to execute or not execute the contract of buying/selling)
6) Life insurance(assurance for uncertainty about the human life and provide investment opportunity)
a. Endowment assurance (pure endowment(maturity benefit: after completion of contract period
– sum assures + vested bonus) + term insurance(provide only on the death of life assured
during the period of the contract )
b. Money back plan (proceed is the portion of sum assured may divided into equal parts based on
the contract term and it will provided on some periodical interval at the end of the maturity
will get vested bonus. It generate the cash flow to the investor during the contract term)
c. Whole life assurance (pure endowment + unlimited insurance (term not be defined , but the
premium paid only certain period of time)
d. Unit linked plan (investment benefit + insurance coverage)
e. Term assurance
f. Immediate annuity (pension benefits starts immediately after the lump sum payment)
g. Deferred annuity (pension benefits start some period of time in future but premium paid
periodically or lump sum)
h. Riders (Additional benefits offered along with the existing plan for the extra risk of the life
insured e.g. Accidental death benefit rider, total and permanent disability rider, term rider,
critical illness rider…etc.)
7) Real assets
a. Real estate (investing in land or building id the pert of the real estate)
b. Precious metals (investment made in gold, platinum…etc.)
c. Precious stone (investment mad in diamond, etc.)
d. Art objects and collectibles (some valuable collections like art by the famous artist in the
world, the products used by the kings, some luxuries products that are having appreciated
value in future)
 Choice and Evaluation of various investment avenues
Return Risk Marketability/ Tax convenience
Liquidity shelter
Current Capital
yield appreciation

Equity shares Low High High Fairly high High High

Non- High Negligible Low Average Nil High

convertible
debentures
Equity shares Low High High High High Very High

Debt Moderate Low Low High No tax on Very High

dividend
Bank deposits Moderate Nil Negligibl High Low Very High
e
PPF Nil Moderate Nil Avg 80 C Very High

LI Nil Moderate Nil Avg 80 C Very High

Residential Moderate Moderate Negligibl Low High Fair

house e
Gold & silver Nil Moderate Avg High Nil Avg

Approaches to the investment decision making

• Fundamental approach
• Intrinsic value of security depends upon the underlying economic factors. Factors related to
company, industry and economy. Buy- undervalued (IV > MP), Sell overvalued (IV<MP)
• Psychological approach
• Stock prices are guided by emotions rather than reasons. Castles-in- air theory used technical
analysis. Study internal market data. Chart, moving avg….
• Academic approach
• Stock market reaction based on information. Past price behavior cannot use for future.
Positive relationship with risk and return.
• Eclectic approach (Assorted Approach)
FA established & benchmarks. TA relative strength of supply &demand. AA reacts reasonably efficient
with flow of information

Characteristics and Objectives of Investment Management

Characteristics of investment

The features of economic and financial investments can be summarized as return, risk, safety, and liquidity.
 1. Return

 All investments are characterized by the expectation of a return. In fact, investments are made with
the primary objective of deriving a return.
 The return may be received in the form of yield plus capital appreciation.
 The difference between the sale price and the purchase price is capital appreciation.
 The dividend or interest received from the investment is theyield.
 The return from an investment depends upon the nature of the investment, the maturity period and a
host of other factors.

Return = Capital Gain + Yield (interest, dividend etc.)

2. Risk

Risk refers to the loss of principal amount of an investment. It is one of the major characteristics of an
investment.

The risk depends on the following factors:

 The investment maturity period is longer; in this case, investor will take larger risk.
 Government or Semi Government bodies are issuing securities which have less risk.
 In the case of the debt instrument or fixed deposit, the risk of above investment is less due to their
secured and fixed interest payable on them. For instance debentures.
 In the case of ownership instrument like equity or preference shares, the risk is more due to their
unsecured nature and variability of their return and ownership character.
 The risk of degree of variability of returns is more in the case of ownership capital compare to debt
capital.
 The tax provisions would influence the return of risk.

Safety:

Safety refers to the protection of investor principal amount and expected rate of return.

 Safety is also one of the essential and crucial elements of investment. Investor prefers safety about his
capital. Capital is the certainty of return without loss of money or it will take time to retain it. If investor
prefers less risk securities, he chooses Government bonds. In the case, investor prefers high rate of return
investor will choose private Securities and Safety of these securities is low.

Liquidity:

Liquidity refers to an investment ready to convert into cash position. In other words, it is available immediately
in cash form. Liquidity means that investment is easily realizable, saleable or marketable. When the liquidity is
high, then the return may be low. For example, UTI units. An investor generally prefers liquidity for his
investments, safety of funds through a minimum risk and maximization of return from an investment.

Risk & Return concepts

Risk
• Variation of return of income
• Risk can be quantified and measured
• Risk is the difference between expected return and actual return.
Types of risk
• External risks are uncontrollable and broadly affect the investment- Systematic risk (undiversified)
market risk.
 • Internal environment of the firm or particular industry and is controllable to certain extend. –
Unsystematic risk (diversified) unique risk.
• Total risk = unique risk + Market risk

Sources of risks
• market risk
• Earning power of corporate sector. Price of securities tends to fluctuate. Major causes appear
to change in consumer sentiment.
• Interest rate risk
• Interest rate goes up, market price of fixed income securities will fall & vice versa.
• Business risk
• Emerging new technologies, changes in consumer preference and changes in government
policies…etc. poor business performance affects the interest of equity holders.
• Inflation risk
• Currency risk
Measuring historical risk
• Variance and standard deviation
• Beta
• Arithmetic mean- An arithmetic average is the sum of a series of numbers divided by the count of that series of
numbers.
• Geometric mean- it takes into account the compounding that occurs from period to period

Return
• Reward for undertaking investment.
• Total return =current return + capital return
• R=C+(Pc-PB)/PB

Types of risk: 

 Systematic Risk - Systematic risk influences a large number of assets. A significant political event, for
example, could affect several of the assets in your portfolio. It is virtually impossible to protect
yourself against this type of risk. 

1. Interest rate risk

Interest-rate risk arises due to variability in the interest rates from time to time. It particularly affects debt
securities as they carry the fixed rate of interest.
A)Price risk arises due to the possibility that the price of the shares, commodity, investment, etc. may decline or
fall in the future.
B)Reinvestment rate risk results from fact that the interest or dividend earned from an investment can't be
reinvested with the same rate of return as it was acquiring earlier.
2. Market risk
Market risk is associated with consistent fluctuations seen in the trading price of any particular shares or
securities. That is, it arises due to rise or fall in the trading price of listed shares or securities in the stock market.
A) Absolute risk is without any content. For e.g., if a coin is tossed, there is fifty percentage chance of getting a
head and vice-versa.
B) Relative risk is the assessment or evaluation of risk at different levels of business functions. For e.g. a
relative-risk from a foreign exchange fluctuation may be higher if the maximum sales accounted by an
organization are of export sales.
C) Directional risks are those risks where the loss arises from an exposure to the particular assets of a market.
For e.g. an investor holding some shares experience a loss when the market price of those shares falls down.
D) Non-Directional risk arises where the method of trading is not consistently followed by the trader. For e.g.
the dealer will buy and sell the share simultaneously to mitigate the risk
Sin offsetting positions in two related but non-identical markets.
F) Volatility risk is of a change in the price of securities as a result of changes in the volatility of a risk-factor.
For e.g. it applies to the portfolios of derivative instruments, where the volatility of its underlying is a major
influence of prices.
3. Purchasing power or inflationary risk
Purchasing power risk is also known as inflation risk. It is so, since it emanates (originates) from the fact that it
affects a purchasing power adversely. It is not desirable to invest in securities during an inflationary period.
A) Demand inflation risk arises due to increase in price, which result from an excess of demand over
supply. It occurs when supply fails to cope with the demand and hence cannot expand anymore. In
other words, demand inflation occurs when production factors are under maximum utilization.
B) Cost inflation risk arises due to sustained increase in the prices of goods and services. It is actually
caused by higher production cost. A high cost of production inflates the final price of finished goods
consumed by people.

 Unsystematic Risk - Unsystematic risk is sometimes referred to as "specific risk". This kind of risk
affects a very small number of assets. An example is news that affects a specific stock such as a sudden
strike by employees. Diversification is the only way to protect yourself from unsystematic risk.
Now that we've determined the fundamental types of risk, let's look at more specific types of risk,
particularly when we talk about stocks and bonds. 

1. Credit or Default Risk - Credit risk is the risk that a company or individual will be unable to pay the
contractual interest or principal on its debt obligations. This type of risk is of particular concern to investors
who hold bonds in their portfolios. Government bonds, especially those issued by the federal government,
have the least amount of default risk and the lowest returns, while corporate bonds tend to have the highest
amount of default risk but also higher interest rates. Bonds with a lower chance of default are considered to
be investment grade, while bonds with higher chances are considered to be junk bonds. Bond rating
services, such as Moody's, allows investors to determine which bonds are investment-grade, and which
bonds are junk.

2. Country Risk - Country risk refers to the risk that a country won't be able to honor its financial
commitments. When a country defaults on its obligations, this can harm the performance of all other
financial instruments in that country as well as other countries it has relations with. Country risk
applies to stocks, bonds, mutual funds, options and futures that are issued within a particular country.
This type of risk is most often seen in emerging markets or countries that have a severe deficit.

3.Foreign-Exchange Risk - When investing in foreign countries you must consider the fact that currency
exchange rates can change the price of the asset as well. Foreign-exchange risk applies to all financial
instruments that are in a currency other than your domestic currency. As an example, if you are a resident of
America and invest in some Canadian stock in Canadian dollars, even if the share value appreciates, you may
lose money if the Canadian dollar depreciates in relation to the American dollar. 

4.Political Risk - Political risk represents the financial risk that a country's government will suddenly
change its policies. This is a major reason why developing countries lack foreign investment. 

5.Business or liquidity risk

Business risk is also known as liquidity risk. It is so, since it emanates (originates) from the sale and purchase of
securities affected by business cycles, technological changes, etc.
A) Asset liquidity risk is due to losses arising from an inability to sell or pledge assets at, or near, their
carrying value when needed. For e.g. assets sold at a lesser value than their book value.
 B) Funding liquidity risk exists for not having an access to the sufficient-funds to make a payment on
time. For e.g. when commitments made to customers are not fulfilled as discussed in the SLA (service
level agreements).

6. Operational risk
Operational risks are the business process risks failing due to human errors. This risk will change from industry
to industry. It occurs due to breakdowns in the internal procedures, people, policies and systems.
A) Model risk is involved in using various models to value financial securities. It is due to probability of
loss resulting from the weaknesses in the financial-model used in assessing and managing a risk.
B) People risk arises when people do not follow the organization’s procedures, practices and/or rules. That
is, they deviate from their expected behavior.
C) Legal risk arises when parties are not lawfully competent to enter an agreement among them.
Furthermore, this relates to the regulatory-risk, where a transaction could conflict with a government
policy or particular legislation (law) might be amended in the future with retrospective effect.

Difference between systematic and unsystematic risk

The systematic risk is a result of external and uncontrollable variables, which are not industry or security
specific and affects the entire market leading to the fluctuation in prices of all the securities.

Unsystematic risk refers to the risk which emerges out of controlled and known variables that are industry or
security specific.

Systematic risk cannot be eliminated by diversification of portfolio, whereas the diversification proves helpful in
avoiding unsystematic risk.

BASIS FOR COMPARISONSYSTEMATIC RISKUNSYSTEMATIC

Basis Systematic Unsystematic

Meaning Systematic risk refers to the hazard which is Unsystematic risk refers to the risk
associated with the market or market segment as associated with a particular security,
a whole company or industry.
Nature uncontrollable Controllable
Factors External Internal
Affects Large number of securities in the market Only particular company
Types Interest risk, market risk and purchasing power Business risk and financial risk
risk
Protection Asset allocation Portfolio diversification

'Risk-Return Trade-off'
Higher risk is associated with greater probability of higher return and lower risk with a greater probability of
smaller return. This trade off which an investor faces between risk and return while considering
investment decisions is called the risk return trade off.

Risk and return are opposing concepts in the financial world, and the tradeoff between them could be thought of
as the “ability-to-sleep-at-night test.” Depending upon factors like your age, income, and investment goals, you
may be willing to take significant financial risks in your investments, or you may prefer to keep things much
safer. It’s crucial that an investor decide how much risk to take on while still remaining comfortable with his or
her investments. For investors, the basic definition of “risk” is the chance that an investment’s actual return will
be different from what was expected. One can measure risk in statistics by standard deviation. Because of risk,
you have the possibility of losing a portion (or even all) of a potential investment. “Return,” on the other hand,
is the gains or losses one brings in as a result of an investment.
Generally speaking, at low levels of risk, potential returns tend to be low as well. High levels of risk are
typically associated with high potential returns. A risky investment means that you’re more likely to lose
everything; but, on the other hand, the amount you could bring in is higher. The tradeoff between risk and
return, then, is the balance between the lowest possible risk and the highest possible return. We can see a visual
representation of this association in the chart below, in which a higher standard deviation means a higher level
of risk, as well as a higher potential return.

It’s crucial to keep in mind that higher risk does NOT equal greater return. The risk/return tradeoff only
indicates that higher risk levels are associated with the possibility of higher returns, but nothing is guaranteed.
At the same time, higher risk also means higher potential losses on an investment. On the safe side of the
spectrum, the risk-free rate of return is represented by the return on U.S. Government Securities, as their chance
of default is essentially zero. Thus, if the risk-free rate is 6% at any given time, for instance, this means that
investors can earn 6% per year on their assets, essentially without risking anything.

While a 6% return might sound good, it pales compared to returns of many popular investment vehicles. If index
funds average about 12% per year over the long run, why would someone prefer to invest in U.S. Government
Securities? One explanation is that index funds, while safe compared to most investment vehicles, are still
associated with some level of risk. An index fund which represents the entire market carries risk, and thus, the
return for any given index fund may be -5% for one year, 25% for the following year, etc. The risk to the
investor, particularly on a shorter timescale, is higher, as is volatility. Comparing index funds to government
securities, we call the addition return the risk premium, which in our example is 6% (12%-6%).

One of the biggest decisions for any investor is selecting the appropriate level of risk. Risk tolerance differs
depending on an individual investor’s current circumstances and future goals, and other factors as well.

Portfolio Risk and Return

Most investors do not hold stocks in isolation. Instead, they choose to hold a portfolio of several stocks. When
this is the case, a portion of an individual stock's risk can be eliminated, i.e., diversified away. This principle is
presented on the Diversification page. First, the computation of the expected return, variance, and standard
deviation of a portfolio must be illustrated.

Once again, we will be using the probability distribution for the returns on stocks A and B.

State Probability Return on Return on

 Stock A Stock B
1 20% 5% 50%
2 30% 10% 30%
3 30% 15% 10%
3 20% 20% -10%

From the Expected Return and Measures of Risk pages we know that the expected return on Stock A is 12.5%,
the expected return on Stock B is 20%, the variance on Stock A is .00263, the variance on Stock B is .04200, the
standard deviation on Stock S is 5.12%, and the standard deviation on Stock B is 20.49%.

Portfolio Expected Return

The Expected Return on a Portfolio is computed as the weighted average of the expected returns on the stocks
which comprise the portfolio. The weights reflect the proportion of the portfolio invested in the stocks. This can
be expressed as follows:

where

 E[Rp] = the expected return on the portfolio,

 N = the number of stocks in the portfolio,
 wi = the proportion of the portfolio invested in stock i, and
 E[Ri] = the expected return on stock i.

For a portfolio consisting of two assets, the above equation can be expressed as

Expected Return on a Portfolio of Stocks A and B

Note: E[RA] = 12.5% and E[RB] = 20%

Portfolio consisting of 50% Stock A and 50% Stock B

Portfolio consisting of 75% Stock A and 25% Stock B

Portfolio Variance and Standard Deviation

The variance/standard deviation of a portfolio reflects not only the variance/standard deviation of the stocks that
make up the portfolio but also how the returns on the stocks which comprise the portfolio vary together. Two
measures of how the returns on a pair of stocks vary together are the covariance and the correlation coefficient.

The Covariance between the returns on two stocks can be calculated using the following equation:
where

 s12 = the covariance between the returns on stocks 1 and 2,

 N = the number of states,
 pi = the probability of state i,
 R1i = the return on stock 1 in state i,
 E[R1] = the expected return on stock 1,
 R2i = the return on stock 2 in state i, and
 E[R2] = the expected return on stock 2.

The Correlation Coefficient between the returns on two stocks can be calculated using the following equation:

where

 r12 = the correlation coefficient between the returns on stocks 1 and 2,

 s12 = the covariance between the returns on stocks 1 and 2,
 s1 = the standard deviation on stock 1, and
 s2 = the standard deviation on stock 2.

Covariance and Correlation Coefficent between the Returns on Stocks A and B

Note: E[RA] = 12.5%, E[RB] = 20%, sA = 5.12%, and sB = 20.49%.

Using either the correlation coefficient or the covariance, the Variance on a Two-Asset Portfolio can be
calculated as follows:

The standard deviation on the porfolio equals the positive square root of the the variance.

Measuring Risk
Alpha

Alpha is a measure of an investment's performance on a risk-adjusted basis. It takes the volatility (price risk) of
a security or fund portfolio and compares its risk-adjusted performance to a benchmark index. The excess return
of the investment relative to the return of the benchmark index is its alpha.
Beta

Beta, also known as the beta coefficient, is a measure of the volatility, or systematic risk, of a security or a
portfolio in comparison to the market as a whole. Beta is calculated using regression analysis, and you can think
of it as the tendency of an investment's return to respond to swings in the market. By definition, the market has a
beta of 1 Individual security and portfolio values are measured according to how they deviate from the market.
R-Squared

R-Squared is a statistical measure that represents the percentage of a fund portfolio's or security's movements
that can be explained by movements in a benchmark index. For fixed-income securities and their corresponding
mutual funds, the benchmark is the U.S. Treasury Bill and likewise, with equities and equity funds, the
benchmark is the S&P 500 Index.
Standard Deviation

Standard deviation measures the dispersion of data from its mean. In plain English, the more that data is spread
apart, the higher the difference is from the norm. In finance, standard deviation is applied to the annual rate of
return of an investment to measure its volatility (risk). A volatile stock would have a high standard deviation.
With mutual funds, the standard deviation tells us how much the return on a fund is deviating from the expected
returns based on its historical performance.
Interrelationship of Bond Market and Stock market

The Market Push and Pull

Commodities, bonds, stocks and currencies interact. As commodity prices rise, the cost of goods is pushed up.
This increasing price action is inflationary, and interest rates also rise to reflect the inflation. Since the
relationship between interest rates and bond prices is inverse, bond prices fall as interest rates rise.

Essential features of an Investment Programme

1. Safety of principal
Safety of funds invested is one of the essential ingredients of a good investment programme. Safety of principal
signifies protection against any possible loss under the changing conditions. Safety of principal can be achieved
through a careful review of economic and industrial trends before choosing the type of investment. It is clear
that no one can make a forecast of future economic conditions with utmost precision. To safeguard against
certain errors that may creep in while making an investment decision, extensive diversification is suggested.
The main objective of diversification is the reduction of risk in the loss of capital and income. A diversified
portfolio is less risky than holding a single portfolio.
Diversification refers to an assorted approach to investment commitments. Diversification may be of two types,
namely,
Vertical diversification; and
Horizontal diversification.
Under vertical diversification, securities of various companies engaged in different stages of production (from
raw material to finished products) are chosen for investment.
On the contrary, horizontal diversification means making investment in those securities of the companies that
are engaged in the same stage of production.
Apart from the above classification, securities may be classified into bonds and shares which may in turn be
reclassified according to their types. Further, securities can also be classified according to due date of interest,
etc. However, the simplest diversification is holding different types of securities with reasonable concentration
in each.
2. Liquidity and Collateral value
A liquid investment is one which can be converted into cash immediately without monetary loss. Liquid
investments help investors meet emergencies. Stocks are easily marketable only when they provide adequate
return through dividends and capital appreciation. Portfolio of liquid investmentsenables the investors to raise
funds through the sale of liquid securities or borrowing by offering them as collateral security. The investor
invests in high grade and readily saleable investments in order to ensure their liquidity and collateral value.
3. Stable income
Investors invest their funds in such assets that provide stable income. Regularity of income is consistent with a
good investment programme. The income should not only be stable but also adequate as well.
4. Capital growth
One of the important principles of investment is capital appreciation. A company flourishes when the industry to
which it belongs is sound. So, the investors, by recognizing the connection between industry growth and capital
appreciation should invest in growth stocks. In short, right issue in the right industry should be bought at the
right time.
5. Tax implications
While planning an investment programme, the tax implications related to it must be seriously considered. In
particular, the amount of income an investment provides and the burden of income tax on that income should be
given a serious thought. Investors in small income brackets intend to maximize the cash returns on their
investments and hence they are hesitant to take excessive risks. On the contrary, investors who are not particular
about cash income do not consider tax implications seriously.
6. Stability of Purchasing Power
Investment is the employment of funds with the objective of earning income or capital appreciation. In other
words, current funds are sacrificed with the aim of receiving larger amounts of future funds. So, the investor
should consider the purchasing power of future funds. In order to maintain the stability of purchasing power, the
investor should analyze the expected price level inflation and the possibilities of gains and losses in the
investment available to them.
7. Legality
The investor should invest only in such assets which are approved by law. Illegal securities will land the
investor in trouble. Apart from being satisfied with the legality of investment, the investor should be free from
management of securities. In case of investments in Unit Trust of India and mutual funds of Life Insurance
Corporation, the management of funds is left to the care of a competent body. It will diversify the pooled funds
according to the principles of safety, liquidity and stability.

Principle of dominance
The dominance principle states: Among investments with the same rate of return, the one
with the least risk is most desirable. In addition, given a group of investments with the same
level of risk, the one with the highest return is most desirable.

The Dominance Principle of Investing. When selecting investments for your portfolio,

the dominance principle of investing is something that you must know. ... In addition, given a group of
investments with the same level of risk, the one with the highest return is most desirable
The most common case where this principle comes into play is when selecting investments in an employer
based retirement plan like a 401k, 403b, or 457 plan.  Usually, these plans will have multiple investment options
in any given investment category.  As an example, a 401k plan might have five large cap stock funds in its
lineup with each having similar long-term returns.  To make things easy, let's consider a lineup of imaginary
funds as follows:
Investment Name     Return     Std. Dev.  
Large Cap Fund A 10% 19%
Large Cap Fund B 10% 17%
Large Cap Fund C 10% 21%
Large Cap Fund D 10% 36%
Large Cap Fund E 10% 28%
All of the funds have the same return for the given time period.  However, the standard deviation (a measure of
risk) varies widely from 17% up to 36%.  What this means is that while the rates of return are the same, the risk
level of Large Cap Fund B is less than half that of Large Cap Fund D.  Using the dominance principle, the most
desirable fund in this lineup is Large Cap Fund B.
Though this has been an important hypothetical exercise, using this principle in the real world can help you
maintain an investment portfolio that keeps a lid on risk.  Often, when markets get hot, investors can be sucked
into purchasing high risk funds by looking only at recent returns while ignoring risk altogether.  Invariably, the
market drops later and high risk funds demonstrate why they're so risky - they suffer much larger losses than
their less risky counterparts.

CARDINAL PRINCIPLES OF INVESTMENT

1. Embrace an Investing Strategy
It’s important to know what kind of investor you are and adhere to the principles of your investing strategies. 
Value, contrarian, growth at a reasonable price, growth, or momentum
.
 
2. Invest With a Margin of Safety
If you buy an asset for less than its real value you have a margin of safety.  The best plan to lower risk is to buy
investments at a price that is lower than the real or intrinsic value.
A low price means greater upside appreciation if conditions are favorable. At the same time, a low price
provides a margin of safety if circumstances are not ideal. Always plan on less than ideal conditions, something
usually goes wrong.
 
3. Asset Allocation is #1
divide the portfolio among different asset categories, will be the biggest determinant of the investment returns.
For overvalued asset categories will experience poor long term returns. It’s important to overweight asset
categories that are bargain priced and underweight or avoid asset categories that are expensive.
 
4. Diversification is Vital
Investment diversification in small numbers provides enormous benefits. In other words, five investments is
much better than two, ten investments is better than five.  However, the marginal benefits of adding additional
investments decreases as the numbers get larger until the costs become greater than the benefits.
Both under diversification and over diversification are common mistakes made in portfolio management. Most
studies show optimization occurs somewhere between 15 and 30 individual investments.
5. Invest For the Long Term
Short term investing is one of the biggest downfalls of current investing strategies. The truly great investors
realize if you buy an investment at a favorable price it may take time for the market to recognize its true value.
Long term investing is one of the most important investing principles because short term trading usually leads to
poor long term performance. This is common because many investors let fear and greed cause them to make bad
decisions. The long term will take care of itself if you make wise investment decisions.
 
6. Keep Expenses Low
Most investors don’t realize how much difference high expenses make to their portfolio. Take a look at the what
happens to your returns with a 1% higher expense ratio;
Assume:
-$100,000 lump sum investment for 30 years.
-6.5% real rate of return less 0.4% expense ratio for self directed investor.
-6.5% real rate of return less 1.4% expense ratio for investor with high fees.
=Real Rate of Return of 6.1% for self directed portfolio grows to $590,829
=Real Rate of Return of 5.1% for investor with high fees grows to $444,715
The Difference is over $146,000!!!
In other words, over a 30 year period, an increase in expenses of 1% can cost your portfolio more than
the original principal!
 
7. Using Compounding
Compounding or exponential growth (they mean the same thing) is a powerful financial concept. Understand
how it works for you and why dividend growth compounding multiplies the value of compounding.
It’s equally important to understand the devastation of reverse compounding. The more of your portfolio you
lose the harder it is to make it back because you lose your principal.  A 10% loss only requires an 11% gain to
get back to break-even. However, a 50% loss requires a 100% gain to get back to break-even.

8. Employ Risk Control Strategies

Because it is so important to not lose your principal you must employ risk control strategies. Portfolio volatility
is an investment return killer. If you don’t control risk you will suffer greatly in bear markets. Avoiding large
portfolio drawdowns should be one of your preeminent investing principles.
 
9. Anticipate Market Volatility and Make it Your Friend
Despise portfolio volatility but embrace market volatility. You can control portfolio volatility but you cannot
control the inevitable volatility of investment markets.
Therefore, you should be prepared to take advantage of investment opportunities. At the same time, you need to
be cognizant of overvalued assets and be willing to move to cash when conditions are unfavorable.