Page 8 - DCOM507_STOCK_MARKET_OPERATIONS

Unit 1: Basics of Investment

Thus, government securities would be seen as risk-free investments because the probability of Notes
actual return diverging from expected return is zero. In the case of debentures, say of a company
like TELCO or GRASIM, again the probability of the actual return being different from the
expected return would be very little because the chance of the company defaulting on stipulated
interest and principal repayments is quite low. You would obviously put equity shares in the
category of ‘high risk’ investment for the simple reason that the actual return has a great chance
of differing from the expected return over the holding period of the investor which may range
from one day to a year or more.
Investment decisions are premised on an important assumption that investors are rational and
hence prefer certainty. They are risk averse which implies that they would be unwilling to take
risk just for the sake of risk. They would assume risk only if an adequate compensation is
forthcoming. And the dictum of ‘rationality’ combined with the attitude of ‘risk aversion’ imparts
to investment their basic nature. The question to be answered is: how best to enlarge returns
with a given level of risk? Or how best to reduce risk for a given level of return? Obviously,
there would be several different levels of risk and different associated expectations of return.

Notes The basic investment decision would be a trade-off between risk and return.
Self Assessment

Fill in the blanks:
1. .................................... is the process of meeting your life goals through the proper
management of your finances.

2. .................................... decisions are premised on an important assumption that investors
are rational and hence prefer certainty.
3. ...................................., is the probability that the actual return on an investment will be
different from its expected return.

1.2 The Investment Process

After understanding the concept of investment and the nature of the investment decision you
might now like to know as to how does an investor go about the task or business of investing?
How much to invest at any moment? And when to make or unmake the investment? These
questions essentially relate to the investment process which is briefly outlined in this section.
A typical investment decision undergoes a five step procedure which, in turn, forms the basis of
the investment process. These steps are:
1. Determine the investment objectives and policy
2. Undertake security analysis
3. Construct a portfolio

4. Review the portfolio
5. Evaluate the performance of the portfolio
You may note at the very outset that this five-step procedure is relevant not only for an individual
who is on the threshold of taking his own investment decisions but also for individuals and
institutions who have to aid and work out investment decisions for others i.e., for their clients.

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