Investment analysis
Before making any investment, one has to be clear as to what is the objective of the investment. Investment analysis can be with a long term objective to earn regular income from the same, it can be medium term for any specific occasion like children education, marriage or it can be short term for speculative gains.
Similarly investments can be made in equity market, fixed income instruments, debt-equity related instruments. If the investment is being made in fixed income instruments like time deposits, government bonds, then there is not much analysis that can be done except to ensure that the return is comparable with the market rates, as these investments are considered to be risk free investments. If the investment is being done in debt related instruments like debentures, ADRs or in equity of companies then an analysis has to be done in terms of industry preference, company preference. In determining the company or the industry for Investment analysis , a lot of study has to be carried out and it will be advisable to get professional consultancy rather than making uninformed individual decisions. The other option would be to go for mutual funds which are managed by knowledgeable fund managers. However, in either of the options certain basic study can be always done by the investor itself, like the past performance, dividend payout ratio, management.
Diversification
Diversification can be defined as the act or practice of investing in variety of securities, so that a failure in or an economic slump affecting one of them will not be disastrous to the entire portfolio. In other words while investing, it is not only important to invest in a variety of securities but it is also important to ensure that failure in one of them does not affect the entire portfolio. Most of us ensure that we invest in a variety of securities but do not ensure to have a diversified portfolio. Portfolios should have securities which move in opposite direction at most of the times. This will enable to have balanced returns over a period of time aligned to our financial goal rather than have erratic changes in the portfolio on either side, gains or losses. If all your investments are generating gains, then at some point of time during a downward cycle or due to negative news, all the Investment analysis will start making losses.
The best example is during the technology bubble, all the stocks fell at the same time and people having exposure to only technology stocks made huge losses and burnt there fingers very badly, as compared to those who had a diversified portfolio. There are statistically proven method to find out if securities or asset class will rise or fall together. One of the methods is correlation and if the correlation between the securities is positive, it will all rise together and if the correlation is negative, then it means that when one rises, the other will fall. A well diversified portfolio is one which has negative correlation among the securities. Amongst the asset classes, normally the debt and equity has negative correlation. This means that when the returns from debt related instruments rise, the value of the equity comes down and vice versa. Thus to conclude diversification strategy is to reduce portfolio risk.
Asset Allocation
Asset allocation means when you are investing your surplus money, how to allocate the same to various type of asset classes. An asset class as discussed above consists of equity, debt, debt and equity and time deposits. Based on the age of an individual and the capacity to take risk, we can identify the ideal asset class for each age group.
Age of the individual Equity Debt Time Deposits
In the 20s 80 10 5
In the 30s 70 20 10
In the 40s 60 25 15
In the 50s 50 30 20
Although the above is stated on more generic terms, the asset allocation will depend on the ability of the individual to take risks, higher the risk, higher the returns and vice versa. It is assumed that at a young age, the responsibilities are less and the appetite for risks is higher and therefore a higher percentage is allocated for equity and a smaller percentage for debt related instruments. As the age increases, the responsibilities also increase and the appetite for risk reduces due to variety of reasons like health issues, previous experience, you become wiser and so on. It should also be noted that within the asset class as well you need to have diversification. This means that if you are investing in equity, then you should ensure that you classify a few different industries and then follow the principles discussed above to minimize risk. The same applies to debt related instruments as well; however it is easier to decide on a debt instrument. To conclude behavioral economics has useful implication for investors. Success can be achieved only by Investment analysis with a sound mind and analysis rather than investing based on emotional judgments.
Return on Investment
Return on investment is the return that you make on your capital investments. There are different methods to calculate the return on investments and in this article we will discuss the main methods.
Accounting rate of return:
This is the return that we are used to calculate. In this case you determine your profits or income on the investment over an accounting period and find out the return of investment. You may consider deducting the brokerage expense and any other incidental expense from the profits to determine the return. This is the most common method to determine the return on investment. However it should be noted here that, account rate of return calculates the absolute return and does not consider the time value of money. So to the extent of depreciation in the value of money, accounting rate of return will not give you the correct yield on the investments.
Net Present Value Method (NPV)
Calculation of net present value of future income can be related to the understanding of the compounded rate of interest or the general formula of compounding. Suppose a sum of 100 dollars is invested for a period of one year at a rate of interest of 10 percent per annum. The investment at the end of one year will be equal to 110 dollars. It can also be stated that 110 dollars in one years time is worth of 100 dollars today. Thus NPV method of calculating return on investment will help to determine the actual yield on investment after considering the time value of money. Therefore it is advised that when you analyze the return on investment, you should do the workings on NPV method.
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