INVESTMENT ENVIRONMENT

INTRODUCTION OF INVESTMENT ENVIRONMENT

To study the investment environment would be of importance to the investor, as it would also encompass the demand supply match and mismatch. Let us visualize the world and its economy. There are many countries with their many economies in this environment. We see the interaction between countries at different stages in their development. We see the many markets to enable this interaction between the various countries. Each of these markets has its regulator, the trading platform and its system, its agents (or brokers), and the participants. Here it is a question of demand and supply of various commodities, products & services and trading instruments. And the analysis would encompass the demand-supply match/mismatch. In this global environment, we have India with its economy and its own many markets. Among these markets we have the securities market, with its regulator (SEBI), the trading platform and its systems (stock exchanges), its agents (brokers) and its many participants (including corporate, financial institutions both domestic and foreign, mutual funds, insurance companies, banks and individual investors). Here again it is a question of demand and supply of various commodities, products & services and trading instruments. And the analysis would encompass the demand-supply match and mismatch. It would be advisable to note at this stage, that due to the liberalization process undertaken by India over the last 18 years, we are today in an environment where events that take place in other parts of the world have a direct or indirect effect on our economy. This would further effect the specific market and finally would have an effect on the equity market.

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Let us visualize a scenario of an industrial slowdown in the U.S. Amongst other things, this would have a direct bearing (i.e. a reduction) on the demand of steel. To protect its own domestic steel industry, the U.S. government would temporarily introduce trade barriers on steel imports. This in turn would cause a reduced export of steel from India to the U.S., causing a temporary over supply of steel in the domestic market. The steel manufacturers would have to tackle the higher levels of inventory and its associated costs. In the domestic steel market, even if the demand were constant, the excess supply would cause a reduction in the price realization per marketable ton of steel. This in turn would directly effect the incomes and profit margins of the steel manufacturers. Such a situation would temporarily cause a drop in the share prices of steel stocks in the equity market. This example is to describe to you how logical the sequence of events is and what the end result would be. However, this sequence does take a long duration of time to unfold, sometimes may even take years.

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SETTING THE INVESTMENT OBJECTIVE

The first step for the investor is to set the investment objective. Which would vary for individuals, pension and mutual funds, banks, financial institutions, insurance companies, etc? For instance the objective for a pension or mutual fund or insurance company maybe to have a cash flow specification to satisfy liabilities at different dates in the future. These liabilities would include redemption, dividends or claim settlement payouts. For a bank it maybe to lock in a minimum interest spread over their cost of funds. For the individual investor the objective maybe to maximize return on investment. A more appropriate word would be 'optimize'. As the individual would achieve optimum return at optimum risk. To maximize return would imply the maximization of risk, which would not be practical or sustainable. It would be quite in order to present a sample investment objective for further analysis and modification to suit the requirements of individual investors. The objective would revolve around aspects of income generation, growth of the investment capital, stability and implementation. Sample Investment Objective: Income:

In the year 20XX-XX, I need an income of (state the amount here). In the year 20XX-XX, I need an income of (state the amount here).

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Growth:

In the year 20XX-XX, I need an investment capital growth of (state the amount here). In the year 20XX-XX, I need an investment capital growth of (state the amount here).

Stability:

Maintain a reduced factor of risk to achieve an optimum level of return.

Implementation:

Risk control tools to reduce risk exposure at all times. Money management tools to ensure better flow of funds between the various asset classes. Document all transactions for future analysis, income review and taxation purposes.

At the time of the documentation and setting of the investment objective, the investor would be called upon to conduct a SWOT analysis to get a better perspective of his present financial condition and the strengths, weaknesses, opportunities and threats he is faced with. Aspects to consider would be as listed below: Sample SWOT Analysis: Strengths:

Whether he is living in own home/house. Whether he owns office space (may even be generating rental income). Whether the investment knowledge base is available. Whether the investment system, management process, and platform are available. Whether the investment capital is available.
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Others; list them.

Weaknesses:

Level of risk tolerance; would be a weakness if it is high. Level of money management skills. Whether there is enough income generation through present investments. Whether there is a current expenses overrun. Others; list them.

Opportunities:

Whether there is potential for growth. Others; list them.

Threats:

Inflation risk. Interest rate risk. Conduct and actions of the peer group and extended family which may cause financial damage or harm. Others; list them.

Of course, the investor is welcome to list other strengths, weaknesses, opportunities and threats he may be faced with or even expects to be faced with sometime in the future. The purpose here would be to reinforce and/or increase the strengths and opportunities while restricting and/or reducing the weaknesses and threats. The next step would be for the investor to document his risk tolerance. A sample would be as stated below: Sample Risk Tolerance Review: I have been through the stock market crash of 20XX-XX. Amongst the reasons for coming out relatively unscathed is that I did not sell any stock

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positions. However, during the up-move I sold stock positions at a reduced level of profit and also at break even points. This has resulted in a reduced level of income generation and investment capital growth; causing an erosion of the investment capital on account of current expenses and contingency provisioning. Having learnt good lessons over the years, I have concluded that it would be prudent to reduce the risk tolerance levels from high to medium. This would require me to follow the investment systems and processes already known and adopt a more disciplined manner of addressing the stock market. Thereafter, it would be quite in order to state the investment time horizon. It would be prudent to restrict the time horizon to one year at a time; along with a periodic performance review during and at the end of the investment time horizon. This would be for the primary purpose of improving performance over the subsequent years. Sample Investment Time Horizon: The present investment time horizon is for a period of one year; which is January 20XX to December 20XX. This would see me go through four quarters; which are January March, April June, July September and October December. Last but not the least, the investor must state and document the matters that would require his attention in the future. Some such matters are listed below: Matters for attention in the future:

Build human capital and knowledge base. Life and disability insurance. Investment in real estate (residential and office space). Children education and resource allocation. Financial security for the family. Savings for retirement. Wealth creation.

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Charitable activity. Others; list them.

As a word of caution and a disclaimer of sorts, the investor must appreciate that the above documented sample investment objective, is but a sample. The investor would be required to document his own investment objective; and subsequently analyze and appreciate whether he has been able to achieve such investment objectives. It would be fair to say that the setting of, monitoring; and subsequent analysis and revalidation of the investment objective against real time investment results is a dynamic process.

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THE INVESTMENT MANAGEMENT PROCESS

The starting point would be an understanding of the investment management process. This process has 5 steps: SETTING THE INVESTMENT OBJECTIVE: The first step for the investor is to set the investment objective. Which would vary for individuals, pension and mutual funds, banks, financial institutions, insurance companies, etc? For instance the objective for a pension or mutual fund or insurance company maybe to have a cash flow specification to satisfy liabilities at different dates in the future. These liabilities would include redemption, dividends or claim settlement payouts. For a bank it maybe to lock in a minimum interest spread over their cost of funds. For the individual investor the objective maybe to maximize return on investment. A more appropriate word would be 'optimize'. As the individual would achieve optimum return at optimum risk. To maximize return would imply the maximization of risk, which would not be practical or sustainable. ESTABLISHING INVESTMENT POLICY: Establishing or setting investment policy begins with asset allocation amongst the major asset classes available in the capital market. Which range from equities, debt, fixed income securities, real estate, foreign securities to currencies. This may also be understood as the establishing of investment policy begins with the allocation of the financial resource amongst the major asset classes available in the capital market. Which range from equities, debt, fixed income securities, real estate, foreign securities and currencies, commodities, amongst others.

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SELECTING THE PORTFOLIO STRATEGY: The portfolio strategy selected would have to be in conformity with both the investment objective and investment policy guidelines. Any contradiction here would result in a systems break down and losses. Portfolio strategies are mainly of two types; which are active portfolio strategies and passive portfolio strategies. Portfolio strategies are mainly of two types; which are active portfolio strategies and passive portfolio strategies. Active strategies have a higher expectation about the factors that are expected to influence the performance of the asset classes. While passive strategies involve a minimum expectation input. SELECTING THE ASSETS: It is of importance for the investor to select specific assets to be included in the portfolio. It is here that the investor or manager attempts to construct an optimal or efficient portfolio. Which would give the expected return for a given level of risk, or the lowest risk for a given expected return. MEASURING AND EVALUATING PERFORMANCE: This step would involve the measuring and evaluating of portfolio performance relative to a realistic benchmark. We would measure portfolio performance in both absolute and relative terms, against a predetermined, realistic and achievable benchmark. Further, we would evaluate the portfolio performance relative to the objective and other predetermined performance parameters. The investor or manager would consider two main aspects; namely risk and return. He would measure and evaluate, whether the returns were worth the risk, or whether the risk was worth the return. The issue here is, whether the portfolio has achieved commensurate returns, given the risk exposure of the portfolio. Ladies and gentlemen, let us assure you that the 5 steps of the investment management process are applicable to anyone wanting to invest. Of course, you would find a further discussion on each of these steps on the webpages linked through from the titles of the 5 steps listed above.
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Different Types of Investors According to him, there are two main types of investors: Average Investors and Professional Investors. Average investors buy packaged securities such as mutual funds, treasury bills, or real-estate-investment trusts. Professional investors are more aggressivethey create investment opportunities or get in on the ground floor of new offerings, build businesses and marketing networks, assemble groups of financiers to fund deals too large for them to undertake alone, and pick the companies with the most promise for initial public offerings of stock.

There are five different types of professional investors:

The Accredited Investor: As defined by Robert Kiyosaki, accredited investors are individual investor that earns at least $200,000 in annual income ($300,000 for a couple) and/or has a net worth of $1 million. An accredited investor has access to many lucrative investments that, because of their risk may be legally off-limits to people of lesser income. Although usually financially educated, accredited investors are not necessarily fully literate. They may be content with security and comfort rather than wealth, and may rely on advisors to develop and implement their financial plans.

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The Qualified Investor: This investor is well versed in either fundamental or technical investing and so there are two types of qualified investors the fundamental investor and technical investor. Fundamental investing requires the ability to assess a companys potential by reviewing financial statements, tracking the industry the company represents, and calculating how changes in interest rates and the economy as a whole could affect profitability. The fundamental investor uses financial ratios, which youll learn all about later, to assess the strength of a company he or she is considering as an investment. Technical investing is differentit is based on knowledge of the sales history of a companys stock, the mood of the market in general, and techniques such as short selling and options. The fundamental investor is typically an S in the CASHFLOW Quadrant because he or she will usually operate alone in evaluating stocks, either through examining fundamentals or using technical analysis in evaluating potential investments. Unlike a fundamental investor, a technical investor (often a stock trader) does not necessarily look for well-run, profitable corporations. If people are rushing to invest in a certain type of industry, say dot-com companies, the technical investor may jump on the bandwagon, regardless of whether these companies are showing earnings, let alone profits. Technical investing is thus more speculative than fundamental, but it can yield greater rewards. Regardless of investment style, qualified investors know how to make, or at least preserve, money in an up or down market. The Sophisticated Investor: The goal of this investor is to build wealth by developing a foundation of assets that can generate high cash returns with minimum payment of taxes. Armed with the three Eseducation, experience, and excess cashthe sophisticated investor takes advantage of tax, corporate, and securities laws to protect capital and maximize earnings. When operating from the B
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quadrant, the investor can choose the best structure or entity through which to create assets. This entity provides some degree of control over the investment and also serves as a firewall between personal and business finances in the event of a lawsuit. Sophisticated investors exercise control over the timing of taxes and the character of their income. They know, for example, to defer paying taxes on capital gains from real estate by rolling over profits to more expensive property. They look at economic downturn as an opportunity to pay bargain basement prices for quality securities, and they create deals instead of simply waiting for the right one to come along. Sophisticated investors take risks but abhor gambling, hate losing but are not afraid to, are financially intelligent yet rely on experts to teach them more, own little in their names yet command great wealth. Although they become partners in real-estate ventures and large shareholders in corporations, they lack one essential strength: management control over their assets. The Inside Investor: Building or owning a profitable business is the primary goal of this investor. Whether as an officer of a corporation or owner of a majority of its shares of stock, the inside investor exercises some degree of management control. By running business systems from the inside, he or she learns how to analyze them from the outside and thereby becomes a sophisticated investor as well. Although inside investors have financial intelligence, they do not necessarily have financial resources and thus may not meet the definition of an accredited investor. If inside investors mind their own business and succeed, however, they can become not only accredited investors but ultimate investors as well. The Ultimate Investor: The goal of the ultimate investor is to own a business that is so successful that shares are sold to the public. Making an initial public offering (IPO) is expensive and full of risks, yet it allows business owners to cash in on the
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equity they have built up in the company, while also raising money to pay down debt and fund expansions. The ultimate investor is one who has mastered every rule and enjoys playing the game for its own sake. Which type of investor do you belong? As for me, I am not even a professional investor. I am just an average investor. But with the continuous learnings that I feed my mind, I hope to become a professional investor someday and be able to reach the ultimate investor status.

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INVESTMENT AVENUES

There are a large number of investment instruments available today. To make our lives easier we would classify or group them under 4 main types of investment avenues. We shall name and briefly describe them. 1.Financial securities: These investment instruments are freely tradable and negotiable. These would include equity shares, preference shares, convertible debentures, non-convertible debentures, public sector bonds, savings certificates, gilt-edged securities and money market securities. 2. Non-securitized financial securities: These investment instruments are not tradable, transferable nor negotiable. And would include bank deposits, post office deposits, company fixed deposits, provident fund schemes, national savings schemes and life insurance. 3. Mutual fund schemes: If an investor does not directly want to invest in the markets, he/she could buy units/shares in a mutual fund scheme. These schemes are mainly growth (or equity) oriented, income (or debt) oriented or balanced (i.e. both growth and debt) schemes. 4. Real assets: Real assets are physical investments, which would include real estate, gold & silver, precious stones, rare coins & stamps and art objects. Before choosing the avenue for investment the investor would probably want to evaluate and compare them. This would also help him in creating a well diversified portfolio, which is both maintainable and manageable.

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INVESTMENT ATTRIBUTES To enable the evaluation and a reasonable comparison of various investment avenues, the investor should study the following attributes: 1. Rate of return 2. Risk 3. Marketability 4. Taxes 5. Convenience Each of these attributes of investment avenues is briefly described and explained below. 1. Rate of return: The rate of return on any investment comprises of 2 parts, namely the annual income and the capital gain or loss. To simplify it further look below: Rate of return = Annual income + (Ending price - Beginning price) / Beginning price The rate of return on various investment avenues would vary widely. 2. Risk: The risk of an investment refers to the variability of the rate of return. To explain further, it is the deviation of the outcome of an investment from its expected value. A further study can be done with the help of variance, standard deviation and beta. 3. Marketability: It is desirable that an investment instrument be marketable, the higher the marketability the better it is for the investor. An investment instrument is considered to be highly marketable when: It can be transacted quickly.

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The transaction cost (including brokerage and other charges) is low. The price change between 2 transactions is negligible. Shares of large, well-established companies in the equity market are highly marketable. While shares of small and unknown companies have low marketability. To gauge the marketability of other financial instruments like provident fund (which in itself is non-marketable). Then we would consider other factors like, can we make a substantial withdrawal without much penalty, or can we take a loan against the accumulated balance at an interest rate not much higher than our earning rate of interest on the provident fund account. 4. Taxes: Some of our investments would provide us with tax benefits while other would not. This would also be kept in mind when choosing the investment avenue. Tax benefits are mainly of 3 types: Initial tax benefits. This is the tax gain at the time of making the investment, like life insurance. Continuing tax benefit. Is the tax benefit gained on the periodic return from the investment, such as dividends. Terminal tax benefit. This is the tax relief the investor gains when he liquidates the investment. For example, a withdrawal from a provident fund account is not taxable. 5. Convenience: Here we are talking about the ease with which an investment can be made and managed. The degree of convenience would vary from one investment instrument to the other.

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COMPARISON OF INVESTMENT AVENUES Rate of Rate of return return Risk Marketability Tax Benefit Conveni Annual Income Capital Appreciation Financial Securities Equity Non-convertible Debentures Financial securities (Non-securitized) Bank deposits Provident fund Life insurance Mutual funds Growth/equity Income/debt Real assets Real estate Gold/silver Low Nil High Average Low Low Limited Nil Average Average Low High High Low High Low High High Yes Yes High High Low Nil Nil Nil High High Low Nil Nil High Average Average Yes Yes Yes High High High Low High High Low High Low High Average Yes Nil High High

Average

Average

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INVESTMENT DECISION MAKING: APPROACHES As investors we would have diverse investment strategies with the primary aim to achieve superior performance, which would also mean a higher rate of return on our investments. All investment strategies can be broadly classified under 4 approaches, which are explained below. Fundamental approach: In this approach the investor is concerned with the intrinsic value of the investment instrument. Given below are the basic rules followed by the fundamental investor. There is an intrinsic value of a security, which in turn is dependent on the underlying economic factors. This intrinsic value can be ascertained by an in-depth analysis of the fundamental or economic factors related to an economy, industry and company. At any point in time, many securities have current market prices, which are different from their intrinsic values. However, sometime in the future the current market price would become the same as its intrinsic value. We as fundamental investors can achieve superior results by buying undervalued securities and selling overvalued securities. Psychological approach: The psychological investor would base his investment decision on the premise that stock prices are guided by emotions and not reason. This would imply that the stock prices are influenced by the prevalent mood of the investors. This mood would swing and oscillate between the two extremes of 'greed' and 'fear'. When 'greed' has the lead stock prices tend to achieve dizzy heights. And when 'fear' takes over stock prices get depressed to lower than lower levels. As psychic values seem to be more important than intrinsic values, it is suggested that it would be more profitable to analyze investor behaviour as the market is swept by optimism and pessimism. Which seem to alternate one after the other. This approach is also called 'Castle-in-the-air' theory. In
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this approach the investor uses some tools of technical analysis, with a view to study the internal market data, towards developing trading rules to make profits. In technical analysis the basic premise is that price movement of stocks have certain persistent and recurring patterns, which can be derived from market trading data. Technical analysts use many tools like bar charts, point and figure charts, moving average analysis, market breadth analysis amongst others. Academic approach: Over the years, the academics have studied many aspects of the securities market and have developed advanced methods of analysis. The basic rules are: The stock markets are efficient and react rationally and fast to the information flow over time. So, the current market price would reflect its intrinsic value at all times. This would mean "Current market price = Intrinsic value". Stock prices behave in a random fashion and successive price changes are independent of each other. Thus, present price behavior can not predict future price behavior. In the securities market there is a positive and linear relationship between risk and return. That is the expected return from a security has a linear relationship with the systemic or non-diversifiable risk of the market. Eclectic approach: This approach draws upon all the 3 approaches discussed above. The basic rules of this approach are: 1. Fundamental analysis would help us in establishing standards and benchmarks. 2. Technical analysis would help us gauge the current investor mood and the relative strength of demand and supply.

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3. The market is neither well ordered nor speculative. The market has imperfections, but reacts reasonably well to the flow of information. Although some securities would be mispriced, there is a positive correlation between risk and return.

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COMMON ERRORS IN INVESTMENT MANAGEMENT

In any endeavor we undertake, we are sometimes right and make correct decisions and sometimes we are wrong and prone to errors. We are prone to these errors, when we do not have a correct perspective of the environment or lack a correct assessment of the current situation in the environment. We would have to watch out for these errors to reduce the probability of losses. For instance, it would be very difficult and an error to be in a buy or hold position if the market is in a bearish mode. Similarly, it would be difficult and an error to be in a sell or short position if the market is in a bullish trend. It would be advisable, correct and profitable to trade with the trend and not against it. Still investors of all hues and levels of experience are prone to errors. Some of these errors are listed and described below: Goals beyond rational expectation: Here the investor probably thinks that he owns the company lock, stock and barrel. Or that the market owes him his profits for having exposed himself to the market risks. Or the investor may have a targeted expected rate of return beyond what the market would be able to give him consistently over time. On the other hand, unrealistic goals could also be a result of unjustified claims made by a company going for a new issue. Or misplaced expectations due to exceptionally good past performance of the investment instrument or a mutual fund or a portfolio manager. Or promises not kept by tipsters, market operators and fly by night operators. An investment policy not clearly defined: This would also include an unclear view on risk. Here, the investor would be prone to greed and fear as the
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market goes up and down, respectively. This vacillation would cause the investor much loss and pain. Seat of the pant decision making: Investors without even realizing it base their decisions on incomplete information. Some of the thoughts of the investor would be: Come on! I know what is going on in the market, and there isn't any time to do a detailed analysis. I don't want an opportunity loss if I delay. All that hard work is strictly for the mediocre. I know I am right. He is my guru and can't be wrong. We must clarify at the beginning whether we are doing an investment exercise or are we indulging in ego satisfaction. If it is investment then do the analysis as the markets and the investment instruments will still be there tomorrow. On the other hand, if it is ego satisfaction, then may the Gods bless you, as other would profit from your market actions. Another situation could cause the investor a loss of balance. As the market goes up and continues going up, the investor tends to set aside all thoughts on the various investment risks and follows the investing public. Here, the investor is being greedy, and sooner or later would pay the price for this error of judgment. Stock switching: In this situation, the investor is selling one stock and at the same time buying another stock. This is interesting, as here the investor expects that the first stock would go down in value, while the second stock would go up. This is unique and is rarely successful. Two scenarios require our attention: It maybe the right time to sell the first stock, but it may not be the right time to buy the second stock, as that too maybe on its way down.

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It maybe the right time to buy the second stock, but it may not be the right time to sell the first stock, as it may still have some upside left. The love for a cheap stock: A cheap stock is a very attractive proposition for any investor, as he is able to buy large quantities of the same. Investors find it easier to buy 1,000 shares of a INR 10.00 stock, and find it difficult to buy 100 shares of a INR 100.00 stock. The total investment amount is the same in both cases. In certain situations, when a stock price moves down, investors start buying and continue to buy larger quantities of the same stock. The investor here is averaging his price down. But, he does not have a guarantee that in the foreseeable future the price trend of this stock would reverse and go above his average purchase price. Averaging can be dangerous. Over-diversification: Is a situation, when an investor has a large number of names in his portfolio, maybe 50 or 60 or even more. Let's be practical, it is like owning an index and more. Therefore the investor's portfolio performance would be about the same as the index or marginally above or below it depending on the names in the portfolio. Secondly, managing and monitoring would become a Herculean task. The investor would get a false sense of safety in numbers. Decision-making would become slow and ineffective. If the market goes down due to a systemic risk factor, all the stocks including the best would move down in price. And the investor would not know what to sell, at what price to sell and when to sell. Ideally, a portfolio should consist of 10-15 well-researched stocks. In any case as individual investors we are not institutions, nor do we have the requisite staffing to effectively monitor and manage a larger number of stocks. Under-diversification: Is a situation in which an investor has only 1-2 stocks in his portfolio. This maybe due to a situation of over-confidence in the

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expected performance of these stocks. Or maybe the result of plain complacency. This is not a good portfolio strategy, as the investor has exposed himself to all market risks to a larger extent due to a lack of diversification. We must always remember that we diversify our portfolio to minimize the systemic or non-diversifiable risks. In any case, this high level of risk exposure is not really necessary if we view ourselves as long term investors. The lure of known companies: Investors are tempted to buy shares of companies that they know and are familiar with. However, the investor should keep in mind, that his knowing a company is not correlated to the returns he expects to derive from his investments in its stock. Wrong attitude towards profits and losses: An average investor due to ego and pride does not want to recognize or admit that he may have made a mistake. Let's look at two situations: An investor buys a stock, and soon thereafter its price goes down. Instead of applying a stop loss and getting out of the stock, the investor holds the stock in expectation of a rebound or trend reversal. However, the price continues moving down with a potential of a further decline. Now, the investor is holding the stock at a 30%-40% loss. Here, the investor wants to postpone the booking of this substantial loss and the acknowledgement of having made a mistake. When the stock price does move up, the investor is ready and waiting to sell this stock at or marginally above his purchase price, even if the stock is expected to move up into a higher trading range. Here the investor sells to gain the relief of not having incurred a substantial loss and also he does not have to acknowledge his mistake at the start of this investment. Both these situations are loaded towards the reinforcement of losses and not profits.

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INVESTMENT AND SPECULATION There is a very thin and blurred line between investing and speculating (or gambling). To have a clearer understanding of this, we would differentiate between the two. There is a tendency for investors to be speculative when the markets are bullish and buoyant. However, for long term and profitable survival in the markets we must try and control this urge to speculate. After all, we are here to learn and apply investment management and not speculation management. To be part of the speculative herd in a bull market situation has been the waterloo of many participants in the financial markets across the globe. This participant maybe an individual investor, a NBFC, a financial institution, a pension fund, a bank, or a brokerage. Some are responsible corporate citizens while others are not.

Investor Planning horizon

Speculator

Very short, holding period a few Relatively long, holding period days or weeks. of at least 1 year. Moderate, rarely high risk. Normal to assume high risk.

Risk disposition

Return expectation Moderate returns at limited risk.

High return at high risk exposure.

Relies on hearsay, tips and market Basis for decisions Fundamental factors, careful psychology. evaluation of proposed investment.
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With regard to the differentiation between investors and speculators listed above it would be opportune to elaborate on these points of reference. We would first explain the investor's position and mindset; thereafter, we would explain the speculator's views in this regard. Planning horizon: The investor would be willing to buy and hold stock positions for long periods of time and probably well beyond the 1 year listed above. This would mostly be the result of the investor having prepared himself both financial as well as psychologically for the inevitable changes in the prices of the stocks held in his stock portfolio. His intention would be to benefit from the advances in the value of his stocks at various levels of the market; in other words it is highly probable that most of his stock positions would turn out to be multi-baggers by the time he sells them. In a sense he would buy these stocks at prices which offer a fair discount over value to him; in other words he would be "buying low and selling high". Even if his intent were to indulge the short term on occasion, it would be with the full knowledge that he is now speculating. The speculator on the other hand is seeking immediate gratification. Thus, he would trade within the day while buying some stocks and selling them later at the rise of a few points and selling other stocks and buying them back after a fall of a few points. Usually, the speculators would be in moment to moment contact with the trade desk of their broker. They are of the view that the life cycle of the earning capacity and capability of the selected stocks and their underlying enterprise can be replicated within the span of a trading day. This is also called day trading. The speculators may indulge margin trading and on occasion even the futures & options segment of the stock market to leverage their meagre financial resources. Risk disposition: The investor would at all times seek a discount to the intrinsic value of the stocks he would buy subsequently for capital gains sometime in the future. For instance, he would seek stocks priced at levels at or below their book value per share; of course, the earnings per share would be at reasonable levels and maintainable into the future and the price earning
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multiplier would be at a lower level when compared with other similar stocks. Thus, the investor would need to wait while the stock price gains to levels at or above its book value per share and sell the stock at a reasonable profit. This price range may on occasion be the first point of profit; and depending on the future performance and outlook of the underlying enterprise the investor may find occasion to buy the stock again at higher price levels (including after a downward price correction from the recent higher price levels) and subsequently sell them at even higher levels. In this fashion and style the investor would be able to considerably reduce his risk exposure. The speculator would be willing to take on a higher level of risk in expectation of a higher return in the short term. As his holding period is very short he is able to take on larger stock positions probably on margin. But given the short duration of his holding period he is unable to mitigate the risk in any fashion and style and the moment to moment stock price during the day (or a few days or weeks) would guide the decision to sell the stock at the gain of a few points during the day or a few percentage points during the week. On the flip side, if the stock price were to move against the speculator's position he would need to quickly sell it to minimize the loss. It would be the stock price which would rule the trading decisions. Return expectation: The investor as already listed above would expect moderate returns from his stock market investments as he would be limiting his risk exposure to acceptable and reduced levels. However, the discerning investor with many years of experience would be able to compound his investment capital at a reasonable rate over the years of his investment time horizon. On average such compounding would be at 16% to 18% annualized and on occasion may be at levels of 50% and even more. The speculator on the other hand would adopt a higher level of risk exposure in the expectation of a higher return in the short term. As such decisions are mostly based on the daily price volume data pertaining to the stocks selected for trading, they would not take into account the unsystemic risk associated with these stocks or the systemic risks associated with the stock market in

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general. If the speculator is right he has gains to be had, and if he is wrong he would have to book the loss and move on to the next trade. On most occasions it would be a zero sum game, as he would win some and also lose some. Basis for decisions: The investor would consider the fundamental factors easily found in the balance sheet, profit & loss account and cash flow statements of the underlying enterprise. This study would revolve around the profit after tax which is also the earnings per share, dividends paid, and the present premium over earnings afforded by the current market price which is also called the price earnings multiplier. This study on most occasions would also expand into an understanding of the products and services of the enterprise, its plant locations, its markets and its relative position in such markets. To complete this study would require the investor to also gain knowledge of the management and an understanding of their management style. This evaluation of the stock would be in the lines of enabling part minority ownership in such enterprise for the investor. The speculator would give little regard to an evaluation of the fundamentals underlying a stock. His trading decisions would be based mostly on tips, grapevine news and hearsay. It would indeed be market psychology at play as its the present price trend that is being addressed. His decision would be mostly based on the here and now with little or no regard to the future prospects of the underlying enterprise. It would surprise most to learn that in today's time and age the speculators usually call themselves short-term investors, probably in an attempt to bring recognition and dignity to their trade and craft. Indeed this would blur the distinction between investors and speculators even further; as the investors would now be the long-term investors while the speculators would be the short-term investors.

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What is the Difference Between Gambling and Investment What is the difference between gambling and investing? In order to differentiate between the two, we should start by defining them. Comparisons are often made between the two activities, but Ive never seen the terms explicitly defined. If youre sufficiently motivated, I encourage you to try to define the terms gambling and investing before you continue reading this essay you may surprise yourself. What definitions did you come up with? Are investing and gambling mutually exclusive, or is there an area of overlap? And are the boundaries clearly delineated, or is there a gray area in the middle? Lets see what the dictionary says. Heres what the Random House dictionary on my bookshelf says:

Gamble: To play at any game of chance for stakes. To stake or risk money, or anything of value, on the outcome of something involving chance. Invest: To put money to use, by purchase or expenditure, in something offering profitable returns. Both seem reasonable upon cursory review, but a closer look reveals that theyre not terribly helpful. The definition for gambling could apply just as well to investing, and vice-versa. The Dictionary.com web site says:

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Gamble: To bet on an uncertain outcome, as of a contest. To take a risk in the hope of gaining an advantage or a benefit. Invest: To commit money or capital in order to gain a financial return. Again, the distinction isnt clear. In investing, are you not betting on an uncertain outcome? Are you not taking a risk in the hope of gaining an advantage or benefit? In gambling, are you not committing money? Are you not doing it in order to gain a financial return?

Investing is a good thing, gambling is a bad thing. I think it would be hard to argue with the claim that investing is, on the balance, a good thing. Investing is widely regarded as the engine that drives capitalism. It tends to put money in the hands of those with the most promising and productive uses for it, and drives the economy gradually upward. Investors arent merely betting on which companies will succeed, theyre providing the capital those companies need to accomplish their goals. The U.S.s leadership position in technology is largely due to investments by venture capital firms, angel investors and technophilic individual investors. Similarly, you can change the world in a small way by investing in companies you believe in, such as socially or environmentally conscious firms and mutual funds, or biotech companies that are working on diseases that might affect you or someone close to you. Gambling, on the other hand, is not so clearly making a positive contribution. Gambling does tend to help local economies, but also usually brings with it well-documented unpleasant side effects. Ill leave it up to the reader to decide whether gambling is, on the balance, a plus or a minus. Looking to the financial markets, one could make the case that people who gamble in this realm do serve a function, by adding to the markets depth, liquidity, transparency, and efficiency. But thats of relatively minor value, and those gamblers probably capture most of that value for themselves. On the other hand, they often increase the volatility of the markets, which is on

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the balance usually a negative (although it does afford savvy investors opportunities for larger profits). As Warren Buffett has said, Wall Street likes to characterize the proliferation of frenzied financial games as a sophisticated, prosocial activity, facilitating the fine-tuning of a complex economy. But the truth is otherwise: Short-term transactions frequently act as an invisible foot, kicking society in the shins. The questions of whether gambling is morally wrong and how strictly it should be regulated are important but are well beyond the scope of this essay, and so Ill mention them only in passing. Governments generally frown on gambling (unless, of course, theyre getting the lions share of the profits, such as with state lotteries). Many religions frown on gambling (but they dont seem to mind church bingo). I have no problem with a person being morally opposed to gambling, as long as that person knows exactly what he/she means by gambling. I should hasten to add that not all types of investing are productive. Buying and holding results in a positive contribution to the economy, but buying and selling quickly, the way day traders do, results in no net contribution. For the purposes of the current investigation, we could either reclassify investingtype activities that arent productive as gambling, or we could consider these to be exceptions to the rule. I lean toward the latter interpretation. In investing, the odds are in your favor; in gambling, the odds are against you. Peter Lynch has said that An investment is simply a gamble in which youve managed to tilt the odds in your favor. But that position is too simplistic. There are plenty of investments where the odds are against you: futures, options, and commodities trading (where you get hurt on commissions and the bid/ask spread), frequent stock trading (for the same reason), and selling short (since the market goes up rather than down in the long run), to name just a few examples. Similarly, while for
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most types of gambling the odds are against you, it is possible for the odds to be in your favor. I spent one summer during college working in Arizona, and I drove up to Nevada most weekends to play blackjack. By counting cards, I was able to obtain a small but predictable advantage over the house, about 1.5% per betting unit on average. (I havent returned since then, for several reasons: its not intellectually challenging; while card counting is not illegal, Vegas casinos can make you leave if they suspect you of doing it; and Ive found it easier and more enjoyable to make money in stocks than in blackjack.) Expert poker players can also make money at casinos, because their competition is other players rather than the house, and as long as the house takes its cut it doesnt care how the rest of the money is redistributed among the players. There are additional problems with this attempted characterization of gambling as a losing bet and investing as a winning bet. It implies that a given activity switches from gambling to investing (or vice versa) as soon as the odds swing past the breakeven point. Similarly, if two players are participating in an activity in which one has an advantage over the other, it would mean that one person is gambling and the other is investing. That would imply that institutions which get in on IPOs at the offering price would be investors, and the little folks that those institutions immediately flip the shares to for a profit would be gamblers. Furthermore, while its possible to calculate exact odds for some casino games, this is rarely the case on Wall Street. How can you know for sure whether the odds are for or against you if you decide to buy a particular stock today? What about venture capital investments, you say? Arent the odds stacked against them? Yes, the majority of venture capital investments result in loss, often a total loss of the amount invested. However, venture funds typically yield higher returns than stocks because a small percentage of the firms investments are home runs, more than making up for complete losses on other investments. So while venture capital might seem like gambling in that the odds are against the VC firms on any given bet, on average the expected payoff is positive, so the odds in the long run are actually in their favor.

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Gambling can be addictive and destructive, but investing cant. Compulsive gambling has been correctly identified as a problem, and organizations like Gamblers Anonymous are helping people cope with the problem. No similar problem is generally thought to exist in investing. There is no Investors Anonymous, and no one talks about compulsive investors. But while there isnt yet widespread acknowledgement of investing addiction, there will be soon. Marvin Steinberg, executive director of the Connecticut Council on Compulsive Gambling, recently said this about investing addiction: We dont know the true extent of the problem because hardly anyone identifies it as a gambling problem they see it as a financial problem or an investing problem. Many online investors who claim to be buy-and-hold investors check their portfolios on a daily or hourly basis, and jump in and out of stocks more often than they realize. Active trading can be expensive, both in terms of the commissions and bid/ask spreads and in terms of emotional fatigue. Also, some people invest more aggressively than they should, which is virtually identical to gamblers who bet more money than they can afford to lose. This page provides a list of questions to help a person determine if he/she might be a compulsive gambler. Replace the word gambler with investor for each question and the questionnaire is equally useful, but for a different purpose. Investing is saving for specific goals, such as retirement, while gambling isnt. Many people regard investing as a planned strategy of wealth-building for specific future goals. And this is certainly true of some types of investing. But this is largely a by-product of having the odds in ones favor. If you have the edge (whether in blackjack or in equities), time and the laws of probability are a powerful combination. Gambling would work just as well as investing for financial event planning if gambling games were in your favor.

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Investors are risk-averse, while gamblers are risk-seekers. Risk-taking is intrinsic to both gambling and investing. There are a few investments that dont entail risk, such as fixed annuities and government bonds held to maturity, but even those have inflation risk. The major difference between the two groups seems to be the participants relative willingness to accept risk. Investors tend to avoid risk unless adequately compensated for taking it, but gamblers dont. To put it another way, investors take only the risks they should take, while gamblers also take some risks they shouldnt take. Would you rather have $50 or a 50/50 chance at $100? If you take the $50, youre an investor. If you go for all or nothing, youre a gambler. Would you rather put your money under your mattress or in an extremely volatile stock that could go bankrupt or could double in value? The question is slightly different, but the answer is equally instructive. If you expect to double your money quickly, whatever youre doing is probably gambling, even if it happens on Wall Street rather than in Las Vegas. However, this characterization of gamblers as risk-takers applies only to non-professional gamblers, people who visit Atlantic City for a weekend for entertainment purposes. Professional gamblers who have managed to tip the odds in their favor behave more like investors, shying away from risk unless the reward is sufficient to justify taking the chance. In fact, one could make the argument that investors generally take on more risk than professional gamblers, because of the uncertainly inherent in the financial markets. As I mentioned before, its difficult for investors to calculate how much of an advantage they have, but the odds of a given gambling strategy can be known either precisely or at least approximately. Investing is a continuous process; gambling is an immediate event or series of events. This rule does seem to hold in most cases. Investing is a continuous process of deployment of capital in search of continually increasing net worth. As a result, delayed gratification is implied. Gambling is a specific act or series of acts, centered around immediate gratification. In this respect, day trading

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resembles gambling: the participant gets in, the price moves up or down, and he/she gets out, usually in a matter of minutes. The same could be said of buying with the belief that a stock is about to jump, or buying IPO shares with the intention of flipping them in a few hours or days, or buying options which are close to expiration. On the other hand, buying in the belief that a stocks price will eventually reflect its value, with the plan of holding as long as it takes for this to happen, is more like investing. Investing is the ownership of something tangible; gambling isnt. The latter half of the statement is certainly true, but the former half is only sometimes true. Some investments involve the ownership of something tangible, but many dont. For example, derivatives are investments derived from other investments. An option is a derivative that gives the owner the right to buy or sell a specific amount of a given security at a specified price during a specified period of time. Options are generally classified as investing rather than gambling, and rightly so, but they do not represent ownership of anything tangible. However, when you realize that an option is essentially a bet that a given security will or wont be above a certain price on or by a certain date, it starts to feel more like gambling thaAn even more strict definition of investing would require that it involves the purchase of an asset which either produces a stream of income or can be made to produce a stream of income. But this definition would eliminate such assets as collectibles, stamps, art, and gold, which have no intrinsic value. I dont think it makes sense to exclude them simply on this basis. We might choose not to consider them investments because of their poor long-term performance, but we shouldnt choose not to consider them investments simply because they wont ever produce a stream of income. Investing is based on skill and requires the use of a system based on research, while gambling is based on luck and emotions. A lot of so-called investors dont do nearly as much research as they should. Many buy on tips or rumors, or based on some analysts price target, without doing their own exhaustive research. It feels right to call such behavior gambling. Similarly, investors who are making decisions based on emotions
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(especially greed and fear), rather than remaining emotionally detached and sticking with their strategy, are to some extent gambling. On the other side of the coin, some gamblers do serious research, often paying hundreds of dollars a month for real time data on what the current lines are (for example, on http://www.scoresandodds.com or http://www.vegasinsider.com). Professional sports investors devote 12 hours a day, every day, to handicapping sports. They read dozens of newspapers, subscribe to line services, maintain inside contacts, and have years of experience, usually on both sides of the betting counter. These professionals keep their emotions away from the decision-making process. Once they have a system that works for them, they dont second-guess it, focusing on longterm profits instead of day-to-day performance. Also, they concentrate on the areas in which they achieve maximum results. Many professionals bet only on one sport, which bears more than a superficial resemblance to Warren Buffetts idea of staying within ones circle of competence.

While investing and gambling probably initially appear to be worlds apart, the above attempts at differentiation revealed that the actual differences are smaller than the perceived differences, and that there is a significant gray area in the middle. Based on the above characterizations, it is clear that the appropriate classification isnt wholly dependent on the activity, but also on the way in which the activity is conducted. Theres a big difference between buying a stock after thoroughly researching it and buying a stock by hitting it on a dartboard. This is true even if the same stock happens to be chosen. Similarly, theres a big difference between buying exotic derivatives to hedge against an existing risk or position and buying the same derivatives because you saw a web site touting them. As a final example, theres a big difference between buying a government bond in order to collect the interest it earns and buying the same bond in the belief that interest rates are about to drop and the bonds value will skyrocket. One interesting thing to note is the pattern of exceptions to the attempted characterizations. Most of the exceptions were people who were doing
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investing-related things but werent behaving like investors, or people who were doing gambling-related things but werent behaving like gamblers. Of the four groups, recreational investors, professional investors, recreational gamblers, professional gamblers, there are more similarities between the two recreational groups and between the two professional groups than between the two investing groups and between the two gambling groups. Specifically, those who use a rigorous system, do research, tilt the odds in their favor, treat it as a business rather than as entertainment, avoid addiction, and keep their emotions in check tend to behaving like investors, and those who dont tend to be behaving like gamblers. It might not be such a stretch to call professional gamblers investors and recreational investors gamblers.

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INVESTMENT WISDOM

Listed below are wisdom one liners which would give an investor an insight to what he or she is up against:
o o o o o o o o o o o o

The market is a discounting machine. A cynic knows the price of everything and the value of nothing. Investment management is 10% inspiration and 90% perspiration. To err is human, to hedge divine. No stock is good or bad, it is the price that makes it so. No price is too high for a bull or too low for a bear. Somebody is wrong every time a trade is made. Ride the winners and sell the losers. You never understand a stock unless you are long or short in it. Be long term but watch the ticks. Never throw good money after bad. To achieve superior performance, you have to differ from the majority. Two things cause stocks to move, the expected and the unexpected. No tree grows to the sky. A pie doesn't grow through its slices. Never confuse brilliance with a bull market. Successful investment managers have brains, nerves and luck. All generalizations are false, including this one. The market makes mountains out of molehills. Investigate, then invest. The memory of people in the stock market is very short. Open-mindedness and independent thinking will pay big dividends in the stock market. It is only a step from the sublime to the ridiculous. It is only a step from common stock investment to common stock speculation.

o o o o o o o o o o

o o

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o

o o

The market is a pendulum that swings back and forth through the median line of rationality. The only way to beat the market is to discover and exploit other investors' mistakes. No investment manager can perform successfully in all kinds of markets. There is no man for all seasons. Better is one forethought than two after. The greatest of all gifts is the power to estimate things at their true worth. Shallow men believe in luck, wise and strong men in cause and effect.

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THE BROKER

As investors we are not able to deal with the market directly. It would be like entering and trying to find our way through an unending maze. The markets on their part, are too large, to attend to every single investor directly. This would be a Herculean task and a management nightmare for it. So, the markets introduce and authorize the middleman to act on its behalf. This middleman is also called the Broker. To reinforce this point, consider the following: 1. We want an insurance policy, we would deal with the insurance company's agent. 2. We want to buy a car or motor cycle or scooter, we would deal with the dealer of the automobile manufacturer. 3. We want to buy a pair of trousers or shirt or a dress, we would go to the retail store which sells these products. The retail store would be the representatives of various fashion brands. 4. We want to buy the shares of a company traded in the NSE or BSE. We would have to deal with the many stock brokers of these exchanges. Agents, dealers, representatives and brokers mean the same thing, and they perform the same function. Which is that of a middleman. They do this function as they would be receiving commissions in return for the services they provide. For instance, whether an investor buys or sells a stock in the stock exchange the middleman or broker would receive a commission either ways. Which is a percentage of the value traded by the investor. The same (that is, the broker's commission or charges and fees) would also be applicable to

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transactions the investors may undertake in the futures and options segment of the stock market as well as ETFs (or equity traded funds). For investors it is very important to choose a broker correctly. Also that the broker is able to provide the services that the investor requires. In this selection of a broker, the investor would be well advised to consider the following: 1. Is the brokerage well established and known in the market? 2. Is the representative of the brokerage house able to attend to him or is he overloaded with too many accounts? 3. Does the brokerage have a research department. How many qualified professionals do they have on their staff? There are many other questions, which may be asked and answered. The main aim here is whether the broker we are proposing to deal with, meets all our requirements or not. In more recent years, this brokerage function of the stock markets as well as other financial markets has been engaged by the leading banks through their brokerage subsidiaries. This has indeed brought all market services (including the trading platform and advisory services) and back office support to the retail investors at very cost effective fees and charges. Some of the banks and their subsidiaries would be the SBI, HDFC Bank, Kotak Mahindra Bank, ICICI Bank, amongst other leading banks. Ideally, an investor may contact these banks with regard to stock market services (including the trading platform, advisory services and brokerage function) required by them. Similar questions as listed above would again be asked to enable the selection of the best fit bank and its subsidiary for the efficient management of an investor's financial resources (including the investment capital he or she may have available for the task of investment and its management).

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INVESTMENT MANAGEMENT AND TRADING IN THE STOCK MARKET

We realize that this area of our field of endeavor is a serious matter for any investor of the stock market, so it is best to start with the basics. We expect that, the investor has an understanding of the various aspects of investment management. Now, we would be introducing the aspect of 'trading'. Trading is basically buying and selling a financial instrument, like a stock quoted in the stock market. And making a profit from the transaction. That is the investor's selling price is more than the cost price. To get things into perspective, the stock market does not go straight up or straight down. It moves in steps. Depending on the information flow it may move forward (or up) or move back (or down). With research, we have concluded that a step is 6.25% of a base price. That is, if the base price of a stock is 100.00, then one step is 6.25. This base price is the fair value of a stock at that point in time. The stock market over a period of time would show the following conditions or phases: Bull phase. Where the equities traded in the stock market are taking at least 2 steps forward with one step back. This may extend to 6 steps forward to 2 steps back. In further extreme conditions there would be no top to the stock market. Bear phase. Where the equities traded in the stock market take 2 steps back for every one step forward. This may extend to 6 steps back to 2 steps

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forward. In further extreme conditions there would be no bottom to the stock market. Consolidation phase. Where the stocks traded in the stock market have reached an equilibrium level and are taking one step forward for every one step back. However, the various participants of the stock market are awaiting some news to take the price up or down depending on the nature of the news. That is whether the news is as per expectation, better than expectation or not as per expectation and what effect it has on the valuation of the stock in question. Thereafter we can expect a further move in the price levels. Distribution phase. Where the stocks traded in the stock market have achieved high price levels maybe their yearly highs. It is here that the strong hands (knowledgeable investors) are selling equities to the weak hands (not so knowledgeable investors). After the selling is over and done with, we may safely expect a down move in price levels. That is, prices would move down and back to their fair values or below it. Let's face it, which knowledgeable investor would buy stocks when he knows that there is no margin of safety available in the transaction. Please remember, whichever phase the market may exist in, it is taking one step at a time. However, depending on the nature of the stage the market may take more than one step in a day. This would cause happiness to investors if the net outcome is positive and sadness if the net outcome is negative. We have provided links to various webpages of our website which would be relevant to this aspect of investment management. It is expected that the investors after read these webpages listed below would have a better understanding of the stock markets, the preparation they must do before engaging it in a better than amateur fashion. It may also be understood that, in spite of all the knowledge and wisdom the investors may gain with regard to investment management at the various stages of their learning curve, the stock markets would still do what they must do; so, caution would be advisable at all the various stages of the investment program the investors may implement from time to time.
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Conclusions So whats my resolution to this definition conundrum? Well, the purpose of words is to communicate concepts. So it doesnt really matter what definitions you use, as long as you and But with that said, it would be beneficial if everyone could agree on what the terms mean, so we dont nee d to make our definitions explicit every time we want to use them. To this end, I offer the following definitions, which are built from the various characterizations in the above section: Investing: Any activity in which money is put at risk for the purpose of making a profit, and which is characterized by some or most of the following (in approximately descending order of importance): sufficient research has been conducted; the odds are favorable; the behavior is risk-averse; a systematic approach is being taken; emotions such as greed and fear play no role; the activity is ongoing and done as part of a long-term plan; the activity is not motivated solely by entertainment or compulsion; ownership of something tangible is involved; a net positive economic effect results. The person(s) youre communicating with are clear about what is meant by those words. And even more importantly, as long as you know what youre doing, investing or gambling, before you do it. Gambling Any activity in which money is put at risk for the purpose of making a profit, and which is characterized by some or most of the following (in approximately descending order of importance): little or no research has been conducted; the odds are unfavorable; the behavior is risk-seeking; an unsystematic approach is being taken; emotions such as greed and fear play a role; the activity is a discrete event or series of discrete events not done as part of a long-term plan; the activity is significantly motivated by

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entertainment or compulsion; ownership of something tangible is not involved; no net economic effect results. Speculating I would prefer to avoid this term entirely, but if necessary I would define it as: Are you disappointed that I didnt crystallize the essence of gambling and investing into a single distinguishing feature? Did I merely sidestep the ambiguity, and sweep the gray areas and the important exceptions under the rug? I dont think so. The taxonomy doesnt have to be completely distinct in order to be useful, nor does it need to be just a single feature. And just because some of the characterizations had exceptions doesnt mean they should be thrown out entirely. Nearly everyone agrees that the concept of chair is a useful one, even though its difficult to define exactly what the necessary and sufficient characteristics of a chair are.

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