Here are the key points to remember in this chapter

» The Investment decision making process has two components:

1. Investment options - Its risks and returns

2. Investor's own circumstances and needs and his positioning in his lifetime while making investments.

» Investment can be defined as a current commitment of funds in expectation of earning a greater amount from it in the future.

» The higher the uncertainty of future payments, or higher the investment risk, the higher would be the return sought by an investor.

» The longer the time period for which the funds are committed, the higher will be the return expectations.

» The required rate of return or the expected rate of return by an investor has three components:

   E(R) = Time value of Money + Expected Inflation + Risk Premium

» In an inflation-free economy, for zero-risk investments, an investor would require the real risk free rate i.e.

    E (R) = Real Risk-Free Rate (RRFR) = Time value of Money

» For zero-risk investments, in an inflationary economy, an investor would require the nominal risk-free rate i.e.

    E (R) = Nominal Risk-Free Rate (NRFR) = Time value of Money + Inflation

OR

    Nominal Risk-Free Rate (NRFR) = Real Risk-Free Rate (RRFR) + Inflation

» The Nominal Risk-Free Rate (NRFR) of return can be understood as the required return by an investor for his investments in zero-risk investment avenues.

» The Nominal Risk-Free Rate of return (NRFR), apart from Real Risk-Free Rate, depends on:

1. Rate of inflation in the economy

2. Monetary environment

» In an equation form, NRFR can be expressed as:

    NRFR = (1+RRFR) x (1+Expected Rate of Inflation) - 1

» The increase in the expected return over the NRFR is the risk premium.

   E(R) = NRFR + Risk Premium

» In Investments, risks that are uncontrollable, external and broad in their effect are called systematic risk.

» In Investments, risks that are controllable and internal sources of risk, which are peculiar to the companies and/or industries, are called the sources of unsystematic risk.

» Variance and Standard Deviation are often used as measures of risk (uncertainty) in the portfolio theory.

» The expected return would change due to the following reasons:

1. Change in the risk premium attached to a specific investment

2. Change in the market risk premium

3. Change in growth rate in the economy, money market conditions or the expected inflation.

» Any investment decision making process will necessarily entail two aspects:

1. The investment vehicle in which investment is to be made

2. Its suitability to the investor.

» An investor's objective's can be expressed in terms of his/her expectations of risk and return.

» Risk tolerance of a person would depend on the following things:

1. His psychological makeup.

2. His current financial status and income expectations

3. His family circumstances

4. His age

» Capital preservation means that the investors want to minimize the risk of loss, usually in real terms.

» Capital appreciation means that the investors want their investment portfolio to grow in real terms over-time.

» Current Income means that the investors want their investment portfolio to focus on generating income rather than capital gains.

» Total return means the investors want their investment portfolio to increase by both capital gains and reinvesting current income.

» Investment constraints would include liquidity needs, investment time horizon, tax factors, legal and regulatory constraints and other factors specific to each individual investor's own needs and requirements.

» The After-tax Return on a taxable investment would be:

    After-tax Return = Pre-tax Return (1-Marginal Tax Rate)

» Stating investment policy is the first step in creating an investment portfolio for an investor.

» The investment portfolio management process works in the following flow:

1. Investment policy statement

2. Financial & economic forecasts

3. Constructing the investment portfolio

4. Monitoring and updating investment portfolio and investment needs.

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