M.

COM-FC 311 Unit-I Lesson-4

INVESTMENT/SPECULATION/GAMBLING
STRUCTURE

4.1 Introduction

4.2 Objectives

4.3 Process of Investment Decisions

4.4 Difference between Investment and Speculation

4.5 Difference between Investment and Gambling

4.6 Investment/ Speculation/ Gambling

4.7 Investment and Arbitrage

4.8 Summary

4.9 Glossary

4.10 Self Assessment Questions

4.11 Lesson End Exercises

4.12 Suggested Readings

4.13 References

4.1 INTRODUCTION

An organized view of the investment process involves analyzing the basic

nature of investment decisions and organizing the activities in the decision
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 process.

Investment process is governed by the two important facets of investment

they are risk and return. Therefore, these two basic parameters should be
considered which are of critical importance to all investors and the trade off
that exists between expected return and risk. The investment management
process refers to the process an investor takes to aid him in meeting his
investment goals. Certain steps need to be considered while engaging in
investment activity, namely, creating a policy statement, choosing the asset
mix, developing an investment strategy, selecting the securities, portfolio
execution, portfolio revision and performance evaluation.

Though every investment involves an element of risk, yet investment cannot

be equated with speculation; because speculation is considered to be just a
guess and is not based on any scientific basis. Speculation is about taking up
the business risk in the hope of achieving short-term gain. It essentially
involves buying and selling activities with the expectation of making a profit
from price fluctuations.

On the other hand, gambling involves high risk with an expectation of high
returns. Gambling relies on tips, rumours and hunches and it is therefore,
considered as unplanned, unscientific and uncalculated risk. In gambling,
the outcome is largely a matter of luck, no rational economic reason can be
given for it. This is in contrast to what we can say about genuine investments.
Unlike investors and speculators, the gamblers are risk lovers in the sense
that the risk they assume is quite disproportionate to the expected reward.

4.2 OBJECTIVES

After going through this lesson, you will be able to:

l Know about investment process.

l Differentiate between speculation and investment.

l Differentiate between gambling and investment.

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4.3 PROCESS OF INVESTMENT DECISIONS

The investment process involves a series of activities leading to the purchase

of securities or other investment alternatives. The investment process can be
divided into five stages:

i) Framing of the investment policy

ii) Security analysis

iii) Valuation

iv) Portfolio construction

v) Portfolio evaluation

1) Framing of the Investment Policy

For systematic functioning, the government or investor, formulates the

investment policy before proceeding to invest. The essential ingredients of
the policy are investible funds, objectives and knowledge about investment
alternatives and the market.

Investment Process

Investment Analysis Valuation Portfolio Portfolio

Policy Construction Evaluation

Investible funds Market Intrinsic value Diversification Appraisal

Objectives Industry Future value Selection and Revision
Knowledge Company allocation

Figure: 4.1 Stages of the Investment Process

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a) Investible funds: The entire investment procedure revolves around
the availability of investible funds. Funds may be generated through savings
or from borrowings. If the funds are borrowed, the investor has to be extra
careful in the selection of investment alternatives. He must make sure that
the returns are higher than the interest he pays. Mutual funds invest their
stockholders' money in securities.

b) Objectives: The objectives are framed on the premises of the required

rate of return, need for regular income, risk perception and the need for
liquidity. The risk taker's objective is to earn a high rate of return in the form
of capital appreciation, whereas the primary objective of the risk-averse is
the safety of principal.

c) Knowledge: The knowledge about investment alternatives and

markets plays a key role in policy formulation. Investment alternatives range
from security to real estate. The risk and return associated with investment
alternatives differ from each other. Investment in equity is high-yielding but
faces more risk than fixed income securities. Tax sheltered schemes offer
tax benefits to the investors.

The investor should be aware of the stock market structure and functions of
the brokers. The modes of operation are different in the Bombay Stock
Exchange (BSE), National Stock Exchange (NSE), Over-the-Counter
Exchange of India (OTCEI). Brokerage charges are also different.
Knowledge about stock exchanges enables an investor to trade the stock
intelligently.

2) Security Analysis

Securities to be bought are scrutinized through market, industry and company

analyses after the formulation of investment policy.

a) Market analysis: The stock market mirrors the general economic

scenario. The growth in gross domestic product and inflation is reflected in
stock prices. Recession in the economy results in a bear market. Stock

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prices may fluctuate in the short- run but in the long-run, they move in trends,
i.e. either upwards or downwards. The investor can fix his entry and exit
points through technical analysis.

b) Industry analysis: Industries that contribute to the output of major

segments of the economy vary in their growth rates overall contribution to
economic activity. Some industries grow faster than the GDP and are expected
to continue in their growth. For example, the information technology industry
has experienced a higher growth rate than the GDP in 1998. The economic
significance and the growth potential of the industry have to be analysed.

c) Company analysis: The purpose of company analysis is to help the

investors make better decisions. The company's earnings, profitability,
operating efficiency, capital structure and management have to be screened.
These factors have a direct bearing on stock prices and investor's returns.
The appreciation of stock value is a function of the performance of the
company. A company with a high product market share is able to create
wealth for investors in the form of capital appreciation.

3) Valuation

Valuation helps the investor determine the return and risk expected from an
investment in common stock. The intrinsic value of the share is measured
through the book value of the share and price earning ratio. Simple
discounting models also can be adopted to value the shares. Stock market
analysts have developed many advanced models to value shares. The real
worth of the share is compared with the market price, and investment
decisions are then made.

Future value The future value of securities can be estimated by using a

simple statistical technique like trend analysis. The analysis of the historical
behavior of price enables the investor to predict the future value.

4) Construction Portfolio

A portfolio is a combination of securities. It is constructed in a manner so as

to meet the investor's goals and objectives. The investor should decide how
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best to reach the goals with the securities available. The investor tries to
attain maximum return with minimum risk. Towards this end, he diversifies
his portfolio and allocated funds among the securities.

a) Diversification: The main objective of diversification is the reduction

of risk in the form of loss of capital and income. A diversified portfolio is
comparatively less risky than holding a single portfolio. Several modes are
available to diversify a portfolio.

i) Debt and equity diversification: Debt instruments provide assured

returns with limited capital appreciation. Common stocks provide income
and capital gain but with a flavor of uncertainty. Both debt instrument and
equity are combined to complement each other.

ii) Industry diversification: Industries' growth and their reaction to

government policies differ from each other. Banking industry shares may
provide regular returns but with limited capital appreciation. Information
technology stocks yield higher returns and capital appreciation, but their
growth potential in the post-global crisis years was unpredictable. Thus,
industry diversification is needed, and it reduces the risk.

iii) Company diversification: Securities from different companies are

purchased to reduce the risk. Technical analysts suggest that investors buy
securities based on price movement. Fundamental analysts suggest the
selection of financially sound and investor-friendly companies

b) Selection: Securities have to be selected based on the level of

diversification, industry and company analyses. Funds are allocated for
selected securities. Selection of securities and the allocation of funds seal
the construction of portfolio.

5) Portfolio Evaluation

A portfolio has to be managed effectively. Efficient management calls for

evaluation of the portfolio. This process consists of portfolio appraisal and
revision.

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 a) Appraisal: The return and risk performance of security varies from
time to time. The variability in returns of securities is measured and compared.
Developments in the economy, industry and relevant companies from which
stocks are bought have to be appraised. The appraisal warns of the loss and
steps can be taken to avoid such losses.

b) Revision: It depends on the results of the appraisal. Low-yielding

securities with high risk are replaced with high-yielding securities with low
risk factor. The investor periodically revises the components of the portfolio
to keep the return at a level.

4.4 DIFFERENCE BETWEEN INVESTMENT AND SPECULATION

"Speculation is an activity, quite contrary to its literal meaning, in which a

person assumes high risks, often without regard for the safety of their invested
principal, to achieve large capital gains." The time span in which the gain is
sought to be made is usually very short.

Investment involves putting money into an asset which is not necessarily

marketable in order to enjoy a series of returns. The investor sacrifices some
money today in anticipation of a financial return in future. He indulges in a bit
of speculation. There is an element of speculation involved in all investment
decisions. However, it does not mean that all investments are speculative by
nature. Genuine investments are carefully thought out decisions. On the other
hand, speculative investment, are not carefully thought out decisions. They
are based on tips, and rumors.

Speculation has a special meaning when talking about money. The person
who speculates is called a speculator. A speculator does not buy goods to
own them, but to sell them later. The reason is that speculator wants to earn
profit from the changes of market prices. One tries to buy the goods when
they are cheap and to sell them when they are expensive.

Speculation includes the buying, holding, selling and short selling of stocks,
bonds, commodities, currencies, real estate collectibles, derivatives or any

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 valuable financial instrument. It is the opposite of buying because one wants
to use them for daily life or to get income from them (as dividends or interest).

Speculation should not be considered purely a form of gambling, as

speculators do make an informed decision before choosing to acquire the
additional risks. Additionally, speculation cannot be categorized as a
traditional investment because the acquired risk is higher than average. More
sophisticated investors will also use a hedging strategy in combination with
their speculative investment in order to limit potential losses.

Table: 4.1 Difference between Investor and Speculator

Investor Speculator
Time horizon Plans for a longer time horizon. His Plans for a very short period. His
holding period may be from one year holding period varies from few days to
to few years. months.
Risk Assumes moderate risk. Willing to undertake high risk.
Return Likes to have moderate rate of return Like to have high returns for assuming
associated with limited risk. high risk.
Decision Considers fundamental factors and Considers inside information.
evaluates the performance of the
company regularly.
Funds Uses his own funds and avoids Uses borrowed funds to supplement his
borrowed funds. personal resources.

4.5 DIFFERENCE BETWEEN INVESTMENT AND GAMBLING

The term gambling dates back to antiquity. Most dictionaries refer to 'gamble'
as an act involving an element of risk. In particular, a gamble involves taking
on risk without demanding compensation in the form of increased expected
return. Gambling exhibit some or all of the following characteristics:

i) Gambling is a typical, chronic and repetitive experience

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 ii) Gambling absorbs all other interests

iii) The gambling displays persistent optimism without winning

iv) The gambler never stops without winning

v) The gambler eventually risks more than he or she can afford

vi) The gambler seeks and enjoys a strange thrill from gambling, a
combination of pleasure and pain.

A gamble is usually a very short-term investment in a game or chance.

Gambling is different from speculation and investment. First, the time horizon
involved in gambling is shorter than in speculation and investment. The results
are determined by the roll of a dice or the turn of a card. Secondly, people
gamble to entertain themselves. Earning an income from gambling is a
secondary factor. Thirdly, the risk, taken in gambling is different from that of
investment. Gambling enjoys artificial risks, whereas commercial risks are
present in investment activity. Risk and return trade-off is not found in
gambling and negative outcomes are expected. On the other hand, during
investment, the analysis of risk and return is carried out, as a result of which
positive returns are expected by investors. Finally, financial analysis does
not reduce the risk proportion involved in gambling.

Investment is a study of employment of funds for the purpose of a return to

the investor. It is of long-term horizon and it has to be planned through a
proper process of evaluation. The investment process consists of different
stages such as preparing an investment policy, making investment analysis,
valuation of securities, portfolio construction and review.

4.6 INVESTMENT/SPECULATION/GAMBLING

Investment is well grounded and carefully planned speculation whereas it is

an ostrich-like form of involuntary and unconscious speculation at its worst.
There are no set rules for permanently establishing which securities are
investment and which are speculations. Only constant examination and

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vigilance, against a background of knowledge, can enable us to decrease
the risks which are inherent in all forms of ownership. Speculation is not the
same as gambling and the two should never be confused. The difference
between speculation and gambling is that in gambling artificial and unnecessary
risks are created whereas in speculation the risks already exist and the
question is simple who shall bear them.

Gambling is a far cry from the carefully planned research and scientific
procedure which underlies the best speculative practice. The gambler plays
rumours, tips, hunches and other unreliable intuitions which should not play
any but a negative role in the trained speculator's process. Speculation is a
reasoned anticipation of future conditions. It does not rely upon hearsay or
labels. It attempts to organize the relevant knowledge as a support for
judgments. It is as legitimate and moral as any other form of risk-taking
business activity.

In fact, the whole fabric of our society revolves around speculation. Those
who write and speak most forcibly against speculation are usually guilty of
failing to define their terms. Mere risk assumption is not gambling so long as
the size of the risk is known, risk taking is speculating. Gambling has to do
with acceptance of risks (1) for their own sake, (2) for the object of pecuniary
gains, (3) without knowledge of the exact nature of the risk.

The distinctions between investment, speculation and gambling give us a

basic idea of their nature, purpose and role. The basic differentiations
between investment, speculation and gambling are:

I) Investor preferably buys to procure an annual return under conditions

of safety, whereas speculators and gamblers buy for appreciation.

II) The investor presumably buys high degree securities whereas

speculators and gamblers buy low grade securities.

III) The investor holds securities for the longest period of time and the
speculator holds it for a short period of time. The holding period of

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 gamblers can be measured in seconds.

Gambling is artificial and unnecessary risk created for increased expected

returns. The difference between investment and gambling is very clear. From
the above discussion, it is established that investment is an attempt to carefully
plan, evaluate and allocate funds in various investment outlets which offers
safety of principal, moderate and continuous returns and long-term
commitment.

4.7 INVESTMENT AND ARBITRAGE

Investment is planned commitment of funds from a person's savings into

different outlets with the expectation of safe, stable and fair return. Arbitrage
is the mechanism of minimizing risk through hedging and taking advantage of
price differences in different markets. An arbitrage transaction is the
simultaneous purchase of the same or similar security in two different markets.
Short-term gains can be expected through such transactions. An investor
can also be an arbitrageur if he buys and sells securities in more than one
stock exchange to take advantage of the price differentials in such exchanges.
Derivatives introduced in the Indian market have a great potential for arbitrage
transactions. Arbitrage transactions help in enhancing efficiency and liquidity
in the stock market and in increasing the volume of trade. Hedgers,
speculators and arbitrageurs can minimize risks and make profits through
the arbitrage process.

4.8 SUMMARY

The investment process involves a series of activities leading to the purchase

of securities or other investment alternatives. The investment process can be
divided into five stages: i) Framing of the investment policy ii) Security analysis
iii) Valuation iv) Portfolio construction v) Portfolio evaluation.

For systematic functioning, the government or investor, formulates the

investment policy before proceeding to invest. The essential ingredients of
the policy are investible funds, objectives and knowledge about investment

76
 alternatives and the market. Thereafter, securities to be bought are scrutinized
through market, industry and company analyses after the formulation of
investment policy. The investor shall undertake fundamental analysis and
technical analysis to select 'stock' related securities. In case on 'bond' related
securities, he shall consider yield-to-maturity, credit rating, term-to-maturity,
tax shelter, liquidity etc. A portfolio has to be managed effectively. Efficient
management calls for evaluation of the portfolio. This process consists of
portfolio appraisal and revision.

The distinctions between investment, speculation and gambling give us a

basic idea of their nature, purpose and role. Investor preferably buys to
procure an annual return under conditions of safety, whereas speculators
and gamblers buy for appreciation. Further, the investor presumably buys
high degree securities whereas speculators and gamblers buy low grade
securities.

4.9 GLOSSARY

l Security Analysis: Security analysis is essentially an analysis of the

fundamental value of a share and its forecast for the future through
the calculation of its intrinsic worth of the share.

l Diversification: Diversification means holding of an assortment of

securities by investor rather than a limited number of securities.

l Speculation: It is an activity in which a person assumes high risks,

often without regard for the safety of their invested principal, to
achieve large capital gains.

l Gambling: It is artificial and unnecessary risk created for increased

expected returns.

l Arbitrage: An arbitrage transaction is the simultaneous purchase of

the same or similar security in two different markets.

4.10 SELF ASSESSMENT QUESTIONS

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1. State whether the following statements are True (T) or False (F).

a) Investments are concerned with risk and return.

b) Investments involve long-term commitments.

c) Speculation brings about stable return for long-term period of time.

d) Speculation is considered with review and analysis and investments

with capital gain.

e) Investments are based on portfolio construction, valuation,

identification and analysis..

Answers: a) True b) True c) False d) False e True.

2. Multiple Choice Questions

a) Investment means ____________.

I) commitment of funds for future income

II) net additions to economy capital stock

III) short-term commitment of funds

IV) capital gain

b) Speculation can be distinguished from investment in the following way:

I) Investment is high risk & speculation is low risk.

II) Investment is for short-term period & speculation covers

long-term period.

III) Investment is based on planning of funds for safety,

liquidity, profitability & speculation on haunches and
benefits.

IV) Investment is your own funds & speculation consists of

other people's funds.

c) A gambler is one who makes

78planned investment and ____________.
 I) believes in low risk

II) considers high risk and high profits

III) expects other people to plan his resources in one best

security

IV) buying government securities with safety of return

Answers: a. (I), b. (III), c. (II).

3. What do you mean by security analysis?

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4.11 LESSON END EXERCISES

1. Distinguish between investment, speculation and gambling. What is the

usefulness of a sound investment plan?

2. Investment and speculation are somewhat different and yet similar in certain
respects. Explain.

3. "The investment process involves a series of activities." Discuss.

4.12 SUGGESTED READINGS

1. Sourain Harry, Investment Management, Prentice Hall of India.

2. Maheshwari Yogesh, Investment Management, Prentice Hall of India.

3. Chandra Prasanna, Investment Analysis and Portfolio Management, McGraw

Hill.

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