Page 268 - DCOM504_SECURITY_ANALYSIS_AND_PORTFOLIO_MANAGEMENT

Unit 10: Portfolio Analysis

Notes
We have learnt earlier how savings transform to 'Risk Capital'. We have taken a hard look
at equity risks and figured out that khel risky hai.
But did you know that 'risk' owes its origin to the Italian word, "risicare", that literally
means 'to dare?' Risk as a verb is used to imply "taking the chance." In other words, as Peter
Bernstein observes in the introduction to his magnum opus Against the Gods,
"... risk is a choice rather than a fate. The actions we dare to take, which depend on how free
we are to make choices, are what the story of risk is all about. And that story helps define
what it means to be a human being..."
If 'risk' is all about choices, it is time to know how to factor this in our investment
decisions.
Let us learn how these choices are made from the actions of Mr. Savvy Investor. Needless
to say, he is the smart guy who makes the smartest choices when it comes to investing.
Mr. Savvy Investor has 1,00,000 to invest. He has two investment options.
The first option is a government bond that pays an interest of 5% per annum for the next
three years.
The second option is investing in a particular stock. A leading analyst expects this stock to
go up by just 2% in the first year as the company is still expanding its capacity. But he
expects the stock to gain 28% in the next two years.
Mr. Savvy Investor fishes out his pocket calculator and gets down to business.
The bond option is fairly easy to calculate. His 1,00,000 investment would be worth
1,30,000 in three years. In other words, it would fetch him a return of 30% in three years.
He works out the returns for the second option.
His investment would be worth 1,02,000 at the end of the first year. A gain of 28% over
the next two years means that his investment would be worth 1,30,560, thanks to the
'power of compounding. his 2% gain in the first year will earn a return too. In the end, he
would earn a 30.56% return in three years.
Two investment options with almost the same returns in three years. Which option does
Mr. Savvy Investor choose?
Our Mr. Savvy Investor chooses to invest in the government bond.
It is easy to figure out why Mr. Savvy Investor has chosen the bond option.
Though investing in the stock meant marginally higher returns, there were lots of
uncertainties. Remember, investment in the stock is based on expectations, expectations
of a leading analyst, in this case. On the other hand, the government bond gives a fixed
return with no question of a default.
What if the analyst got it all wrong? For all you know, a competitor might increase
capacities and kill the market in the second year. Hence, the expected 28% appreciation
might actually turn out to be a decline! As Murphy's law states "if anything can go wrong,
it will go wrong."
Hence, Mr. Savvy Investor does not even bat an eyelid while deciding to invest in the
government bond.

Let us now add a twist to the second investment option and see if it makes a difference to
Mr. Savvy Investor's choice.
Contd...

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