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Commentary

Basic criteria for portfolio management of stocks, bonds

By Abu Ahmed Guest Columnist
Portfolio management, fn general a tricky matter, Is more so when It concerns financial assets like stocks, bonds etc. People hold assets for their future and those assets may breed additional income or may decay in value.
In the primitive days people used to hold land and precious metals like gold and silver as assets. Later, with the advent of exchange and commerce economies people started to hold commodities. Holding of paper assets like stocks and bonds arc the latest inclusion In the portfolio of a modern man.
Behind the asset holding, whether it Is land, gold, commodity or stock and bond'there is only one motive, and that Is profit earning. As the holding of assets of any type is for the purpose of earning an income, the holding can be termed as Investment in the modern economic sense.
Investment comes from surplus income or from borrowed fund. The investor is to see whether he Is receiving a reasonable income from an investment no matter whether the money is from his self-source or from borrowing.
Portfolio management, in this sense, has become wider to include almost every type of assets and also has become complicated. But there are always some people who want to compartmentalise the investment, i.e. they prefer one type of investment over the other. For example, a person who wants to earn his income from Investment in land and houses normally does not invest in financial assets like stocks and bonds. Of course, there are overlappings also.
Despite overlappings investment choice now-a-days is a matter of specialisation and needs skill in the process of decision making. Of all the Investments, investment in financial assets is much more Intricate and complex.
No branch of economic science has developed so much during the last two decades as the one regarding investment tn financial assets. Starting with Markowitz’s Risk-Return theory and ending up with the Sharpe s Capital Assets Pricing Model, all sophisticated analyses were devoted to investment analyses of financial assets. The use of computer along with the application of advanced mathematics and statistics has given a fillip to the basic decision making process in investment. Now, the brokerage firms of the West regularly publish and also sell researched-out results on investment decision.
But though, the investment decision has attained so much of sophistication, ’the basic -tools which were developed much earlier than the elements of modern portfolio theory still remain in use. The basic tools are the present value and internal rate of return concepts. These are widely used by the decision makers to know the present value of an asset compared to the receivable future incomes.
Both the tools offer the investors the same-result. The present value concept uses a discount rate’ for the receivable future Income to know the present net worth of an asset, whereas, the internal rate of return concept equates the future receivable Incomes with the
present outlay at a given rate.
The basic rule is, If the net present value Is positive a particular investment is worth to be undertaken, if the net present value is negative, the investment decision Is to be rejected. But here the controversy centres around the discount rate to be used in discounting the future receivable Incomes from an investment act.
The agreement among the financial analysts is that the discount factor must cover the opportunity cost of investable fund and also the risk factor. That Is. the discount factor must be greater than the market rate of interest which is the borrowing price of money.
The accounting science has given the decision makers some other extra tools. These are : the price-earning ratio of a financial asset, its book value, and above all. the yield rate to investment. These criteria are used to know whether an asset like stock or bond Is overvalued- or undervalued in the market. The market price is not necessarily to be a right price.
Market price is determined by many factors other than the above mentioned economic factors. Of the other factors, the human factor is important. The market price may be a manipulated price by people if the scope for manipulation exists. Investor is to sec the price at which he is buying a stock and compare the earning it would generate. If the stock offers higher prospect the price-earning ratio of it will be higher.
Price-earning ratio is to be seen In the light of stock s book value, prospect, and dividend policy.’ Normally, a price-earning ratio between 10 and 12 is said to be not that much risky in stock investment.
Book value, as it represents the share capital and reserve money over the stock outstanding, can also be considered as a good guide to investment decision. A stock being sold much above the book value can be thought to be a risky stock. Above all. investor is to be always on guard to see how much his invested money is bringing him in the form of dividend. Dividend must reflect the opportunity cost of his invested money, otherwise, by Investing in . stock or bond he is simply losing money.
An Investor is also to sec whether the financial asset he is buying has an easy marketability at a later stage. An asset may bring good return. but If it finds difficulty in marketing Itself the investor should think twice before buying such an asset. No investor holds an asset perpetually. He might have to sell it sometimes to meet his liquidity needs, and if at that time he can not sell it easily, the holding of such an asset is not desirable.
Profitability, marketability and the liquidity are the three other criteria to be added to the above book-based criteria for investment decision in financial assets like stoc ks and bonds.
However, a competitive financial market can ease many ol the problems an investor normally faces. But if a financial market remains hostage to vested interests the ordinary investors keep away from It and the slogan of achieving a market economy remains in paper only-