The investor has various alternative avenues of investment for his savings to flow in accordance with his preferences. Savings flow into investment for a return, but savings kept as cash are barren and do not earn anything.
Savings are invested in assets depending on their risk and return characteristics. Any rational investor knows that money is losing its value by the extent of the rise in prices. If the investment does not earn as much as the rise in prices or inflation, the real rate of return is negative. Thus, if inflation is at an average annual rate of 5%, then the return should be 5% or above to induce savings to flow into investment.
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If an investment is made in short-term deposits with banks or in securities of Government, then the rate of interest is around 5-7%. As the risk of loss of money is almost negligible in such cases, the rate can be called a risk free return. All investments involve some risk or uncertainty. The objective of investor is to minimize the risk involved in investment and maximize the return.
Features of Investment
The following are the features of Investment Programme:
- Safety of Principal
- Adequate Liquidity and Collateral Value
- Stability of Income
- Capital Growth
- Tax Benefits
- Purchasing Power Stability
Safety of Principal
The safety sought in investment is not absolute or complete; it rather implies protection against loss under reasonably likely conditions or variations. It calls for a careful review of economic and industry trends before deciding the types and/or timing of investments. Thus, it recognizes that errors are unavoidable for which extensive diversification is suggested as an antidote.
Adequate diversification means an assortment of investment commitments in different ways. Those who are not familiar with the aggressive-defensive approach nevertheless often carry out the theory of hedging against inflation-deflation.
Diversification may be geographical, wherever possible, because regional or local storms, floods, droughts, etc. can cause extensive real estate damage. Vertical and horizontal diversification can also opt for the same.
- Vertical diversification occurs when securities of various companies engaged in different phases of production form raw material to finished goods are held in the portfolio.
- On the other hand, horizontal diversification is the holding by an investor in various companies all of which carry on activity is the secure stage of production.
Another way to diversify security is to classify them according to bonds and shares and reclassify them according to types of bonds and types of shares. Again, they can also be classified according to the issuers, according to the dividend or interest income dates, according to the products which are made by the firm represented by the securities.
But over-diversification is undesirable. By limiting investments to a few issues, the investor has an excellent opportunity to maintain a knowledge of the circumstances corresponding each issue. Probably the simplest and most effective diversification is accomplished by holding different media at the same time having a reasonable concentration in each.
Adequate Liquidity and Collateral Value
An investment is a liquid asset if it can be converted into cash without delay at full market value in any quantity. For an investment to be liquid it must be reversible, or marketable. The difference between reversibility and marketability is that reversibility is the process whereby the transaction is reversed or terminated while marketability involves the sale of the investment in the market for cash.
To meet emergencies, every investor must have a sound portfolio to be sure of the additional funds which may be needed for the business opportunities. Whether money-raising is; to be done by sale or by borrowing it will be easier if the portfolio contains a planned proportion of high-grade and readily saleable investment.
Stability of Income
Stability of income must be looked at in different ways just as was a security of principal. An investor must consider the stability of monetary income and stability of purchasing power of income. However, emphasis upon income, stability may not always be consistent with other investment principles. If monetary income stability is stressed, capital growth and diversification will be limited.
Capital appreciation has today become an important principle. Recognizing the connection between corporation and industry growth and very large capital appreciation, investors and their advisors constantly are seeking “growth stocks.” It is exceedingly difficult to make a successful choice. The ideal “growth stock” is the right issue in the right industry, bought at the right time.
To plan an investment programme without regard to one’s tax status may be costly to the investor. There are really two problems involved here, one concerned with the amount of income paid by the investment and the other with the burden of income taxes upon that income.
When investors’ income is small, they are anxious to have maximum cash returns on their investment and are prone to take excessive risk. On the other hand, investors who are not pressed for cash income often find that income taxes deplete certain types of investment income less than others, thus affecting their choices.
Purchasing Power Stability
Since an investment nearly always involves the commitment of current funds with the objective of receiving greater amounts of future funds, the purchasing power of the future fund should be considered by the investor. For maintaining purchasing power stability, investors should carefully study, the degree of price level inflation they expect, the possibilities of gain and loss in the investment available to them, and the limitations imposed by personal and family consideration.
To be safe from social (disorder, government confiscation or unacceptable levels of taxation, a property must be concealable and leave no record of income received from its use or sale. Gold and precious stones have long been esteemed for these purposes because they combine high value with small bulk and are readily transferable.