Investing in Stock Market Notes
Topic 1: Meaning and Features of Investment and Speculation
Difference between Investment and Speculation
Table of Contents
Meaning of Investment
Investment of hard earned money is a crucial activity of every human being. In general terms, Investment means employment of surplus funds in any asset with the aim of getting return, as interest, dividend or appreciation in value of assets. The word investment originates from the Latin word “vestis” which means garment, and refers to the act of putting money or other resources into other’s pocket.
Investment is simply the commitment of funds which have been saved from current consumption with the hope that some benefits will be received in future. Thus, it is a reward for waiting for money. Savings of the people are invested in assets depending on their risk and return demands.
There are two concepts of the term “investment” – Economic investment and financial investment.
Economist refers investment as employment of funds in real investment i.e., investment in land, building, tools, equipment’s or other physical assets. Economic investment means the net addition to the capital stock of society which consists of goods and services that are used in the production of other goods and services. Addition to the capital stock means an increase in land, building, tools, equipment’s or other physical assets over the amount of goods and services that existed.
In finance, investment means the purchase of a financial product or other item of value with an expectation of favorable future returns. Financial products include stock, bond, real estate, mortgages etc. As per this concept, the investors are called the supplier of capital and in their view investment is a commitment to a person’s funds to derive future income in the form of interest, dividend, rent, premium etc.
For financial investor it is not important whether money is invested for a productive use or for the purchase of secondhand instruments such as existing shares and stocks listed on the stock exchange. Most investments are considered to be transfers of financial assets from one person to another.
Features of an Ideal Investment
While investing their money, the investors must have some definite ideas regarding the features their investments must process. These features must be consistent with the objectives, preferences and constraints of the investors. These investments must also offer optimum facilities and advantages to investors as for as the circumstances permit. The investors, generally, form their investment policies on the basis of the following features:
1) Safety: Safety is one of the most important features that an investor desires from investments. Every investor expects to get back the initial capital on maturity without loss and without delay. Investment safety is gauged through the reputation established by the borrower of funds. A highly reputed and successful corporate entity assures the investors of their initial capital.
2) Liquidity: A liquid investment is that which can be converted into cash immediately at full market value in any quantity whatsoever. Every investor must ensure a minimum liquidity in his investments. To ensure liquidity, the investor should keep a part of his total investments in the form of readily saleable securities. Marketable securities, gold and very short term Investments are highly liquid but real estate, insurance policy, pension fund, fixed time securities etc. cannot ensure immediate liquidity.
3) Regularity and Stability of Income: Regularity of income at a stable and consistent rate is essential in any investment programme. However, the stability of income is not consistent with the other investment principles. Monetary stability limits the scope for capital growth and diversification.
4) Stability of Purchasing Power: Investors should balance their investment programmes to fight against any purchasing power instability. Any rational investor knows that money is losing its value by the extent of the rise in prices. If money lent cannot earn as much as rise in prices or inflation, the real rate of return is negative.
5) Capital Appreciation: Capital appreciation has become a very important principle in the present day’s volatile markets. The investors should try and forecast which securities will appreciate in future. It is an exceedingly difficult job and should be done thoughtfully in a scientific manner and not in the way of speculation or gambling.
6) Tax Benefits: Every investor must plan his investment programme keeping in mind his tax status. Investors should be concerned about the returns on the investments as well as the burden of taxes upon such returns. Real returns are returns after taxes. The investors should plan their investments in such a way that the tax liability is minimum.
7) Legality: Legal aspect of investments must also be kept in mind. Illegal securities pose many problems for the investors. Investors should be aware of the various level provisions relating to the purchase of investments. The safest way is to invest in the securities issued by the UTI, the LIC or Post Office National Saving Certificates. These securities are legal beyond doubt and help the investor in avoiding many problems.
8) Concealability: Sometimes, the investor has to invest in securities which can be concealed and leave no record of income received from them. Concealability is required to be safe from social disorders, government confiscation or unacceptable levels of taxations. Gems, precious stones etc. have been used for this purpose since ages because they combine high value with small bulk and are readily transferable.
9) Tangibility: Most of investors prefer to keep a part of their money invested in tangible securities like building, machinery, land etc. Tangible property does not yield an income, but they are used for personal and business purpose and also give the investor a feeling and satisfaction of possession of such assets.
10) Adequate Diversification: Adequate diversification means distribution of surplus in various investment alternatives available in adequate percentage. Diversification may be geographical, vertical or horizontal. Geographical diversification means investment of difference countries. Vertical diversification means investment in securities of various companies engaged in different phases of production from raw material to finished goods. Horizontal diversification means investment in various companies all of which carry on activity in the same stage of production.
Objectives of Investment in Securities
Any investment decision will be influenced by three objectives – security, liquidity and yield which is called investment triangle. A best investment decision will be one, which has the best possible compromise between these three objectives. The major objectives of investment in securities are as follows:
1. Income: The major objective of every investment is to earn income in the form of dividend, yield or interest. Suitable securities are those whose prices are relatively stable but still pay reasonable dividends or interest, such as blue chip companies. The investment should earn reasonable and expected return on the investments.
2. Liquidity: The liquidity of investments is another consideration to be kept in mind by the investor. Before making the investment, the investor should consider the degree of liquidity required. Certain securities are capable of being sold in the readily available market and some securities may not be so liquid. The investors generally prefer securities which ensure liquidity and marketability.
3. Yield on investment: The returns expected from securities may be of two types:
a)Periodic Cash Receipts: Cash dividends are payable as and when the board of directors of the company decides to distribute the after tax earnings of the company to the shareholders. In case of debentures, bonds, bank deposits etc. the coupon rate is payable at the end of each specified period?
b)Capital Gain: The second component of return is the change in the price of investment called the capital gain or loss. This element of return is the difference between the purchase price and the price at which the asset can be or is sold.
The combination of periodic cash receipts and capital gain made on investments constitute the total return on particular investment.
A part from these objectives, some additional objectives of investment are listed below:
4. Safety and Security of Funds: Another important consideration in making investments is that the funds so invested should be safe and secure. The investment should be capable for redemption as and when due.
5. Risk: The level of risk depends on the object of investment. An investor who expects greater return should be prepared to take greater risk. By careful planning and periodical review of the market situation, the investor can minimize his risk on the investments.
6. Capital Appreciation: The other important objective of investments is appreciation in the capital invested over a period of time. Capital appreciation can be achieved in the following three ways:
a)Conservative Growth: Investors who seek to achieve conservative growth seek to build an investment portfolio that will make money over the long term by capital appreciation known as wealth building over time.
b)Aggressive Growth: Investors who seek to achieve short term and long term capital gains opt for aggressive growth in stocks.
c)Speculation: An investor with speculation as an objective wants to maximize returns by buying and selling shares and securities so often solely to make profit from short term price fluctuations.
7. Tax minimization: An investor may pursue certain investment in order to adopt tax minimization as part of his or her investment strategy. A highly paid executive, for example, may want to seek investments with Favourable tax treatment in order to lessen his or her overall tax burden.
The investor should also keep in mind considerations like the extent of inflation, diversification of portfolios, degree of risk and risk coverage, growth rate etc.
Speculation and its Features
Meaning of Speculation
Speculation is an act of conducting any short term financial transaction in which there is a substantial chance of risk of losing money but also holds the expectation of significant gain in shorter period. Speculative investment can be defined as “The employment of funds to acquire assets for shorter duration of time to take advantage of fluctuations in prices of underlying assets”. Short term investment in stock market on the basis of news and rumors is the perfect example of speculation.
Features of Speculation:
1) It is short term in nature.
2) Speculation is mainly made on the basis of news or rumors.
3) Speculations to made huge profits are made only in marketable securities.
4) Speculators are very high risk takers.
5) Market risks involved in speculation.
Difference between Investment and Speculation
Own funds are invested to create wealth.
Own funds or borrowed funds are invested for short term to earn higher income.
Investments are mainly for long term period.
Speculations are short term in nature.
Fundamental analysis is the main basis of investment.
News or rumors in the market is the main basis of speculation.
Risk in case of investment is moderate.
Risk is high in case of speculation.
Reasonable return expected in case of investment in longer period.
Returns can be very high in case of speculation.
6. Income stability
Return in long term is stable.
Return in case of speculation is uncertain and unstable.
7. Asset class
Investment can be made in physical assets, financial assets and securities.
Speculation is mainly made in marketable securities.
Investors are normally cautious and conservatives.
Speculators are high risk takers
9. Nature of risk
There are two types of risks in investment – Systematic and unsystematic.
In speculation there is mainly market risk.
These notes are useful for the Students of Gauhati University in study of their subject: Investing in Stock Market.