Investment and Portfolio Management, Chapter 1 Introduction to Investment

CHAPTER ONE

INVESTMENT

1.1. Meaning of investment

Investment is foregoing the present consumption in expectation of having greater consumption

opportunities in the future. It is current commitment of dollars/Birr for a period of time in order

to derive future payments that will compensate the investor for (1) the time the funds are

committed, (2) the expected rate of inflation, and (3) the uncertainty of the future payments.

Investor can be an individual, a government, a pension fund, or a corporation. Similarly, this

definition includes all types of investments, including investments by corporations in plant and

equipment and investments by individuals in stocks, bonds, commodities, or real estate. In all

cases, the investor is trading a known dollar/birr amount today for some expected future stream of

payments that will be greater than the current outlay.

Investors can be individual investors; or Institutional investors. Individual investors are those

investors who are investing on their own. Sometimes individual investors are called retail

investors. Institutional investors are entities such as investment companies, commercial banks,

insurance companies, pension funds and other financial institutions.

1.2. Reasons for Investing: (Why people invest?)

People choose to invest to supplement their income, to earn gains, and to experience the

excitement of the investment process.

Income: Some people invest in order to provide or supplement their income. Investments

provide income through the payment of dividends or interest.

Appreciation: Other individuals, especially those in their peak working years, may be more

interested in seeing the value of their investments grow rather than in receiving any income

from investment. Appreciation is an increase in the value of an investment.

Excitement: Investing is frequently someone’s hobby. Investing is not inherently an end in

itself; it is a means to an end. Ultimately, the investment objective involves improved financial

standing.

1.3. Investment Goals

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Investment and Portfolio Management, Chapter 1 Introduction to Investment

Investment goals are the financial objectives you wish to achieve by investing in any of a wide

range of investment vehicles. Common investment goals are as follows.

(a) Enhancing current income: means choosing investment vehicles that regularly pay dividends

and interest that can provide all or some of the money needed to meet living expenses. This is

a common goal of retired persons and sometimes an important part of a normal family

budget.

(b) Saving for major expenditures includes money set aside for such things as the down payment

on a home, college tuition, and even an expensive vacation. The amount of money needed

and the time period over which one can save will determine the amount set aside and,

frequently, the investment vehicle employed.

(c) Accumulate retirement funds: it is the single most important reason for investing. The amount

that must be set aside is determined by the level of expected expenditures, expected income

from social security and other sources, and the amount of interest expected to be earned on

savings.

(d) Sheltering income from taxes involves taking advantage of certain tax provisions that permit

reduction of the income reported to the government or direct reductions in taxes. Investments

in certain assets, such as real estate, may be attractive due to their tax advantages.

1.4. Steps to Investment

The seven steps in investing are as follows:

1. Meeting Investment Prerequisites: Providing for necessities of life, adequate protection

against losses, and setting retirement goals.

2. Establishing Investment Goals: Investment goals are the financial objectives that one wishes

to achieve by investing mentioned above.

3. Adopting an Investment Plan: An investment plan is a written document describing how

funds will be invested. The more specific your investment goal, the easier it will be to

establish an investment plan consistent with your goals.

4. Evaluating Investment Vehicles: In this step, the measures of risk and return are used to

estimate the perceived worth of an investment vehicle. This process is called valuation.

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5. Selecting Suitable Investments: This step involves careful selection of investment vehicles

that are consistent with established goals and offer acceptable levels of return, risk, and

value.

6. Constructing a Diversified Portfolio: Diversification is the concept of forming a portfolio

using different investment vehicles to reduce risk and increase return. This concept is central

to constructing an effective portfolio.

7. Managing the Portfolio: Portfolio management involves monitoring the portfolio and

restructuring it as dictated by the actual behavior of the investments.

1.5. Investment Constraints

1. Financial Constraints: refer to whether an investor can allocate some portion of savings for

investment activities. If an investor has more than enough savings to cater for present and

future financial requirements, than they would have less financial constraints.

2. Psychological Constraints: refers to how well an investor can absorb the consequences of an

investment decision. Emotions like greed, fear, caution and hope will be a vital part in any

investment decision. If investors cannot control their emotion, they might end up wrong and

costly investment decision.

3. Management Constraint: refers to the lack of expertise in managing the investment activities.

Investors might not have the time or proper knowledge to analyze the investment

alternatives.

1.6. Investment, Speculation and gambling compared

Investment: Foregoing the present consumption in expectation of having greater consumption

opportunities in the future.

Speculation: Aim high ‘gain or heavy loss; Higher level of risk and more uncertain expected

returns.

Gambling: Gambling at 'out of proportion gain or total loss.' Depend more on luck and chances.
Differences between Investment and Speculation
Investment Speculation
1. Risk and Return

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Earning a good return for an appropriate Willing to take high risk in exchange for a high
level of risk return by buying very volatile stocks.
2. Time Horizon
Hold securities for a longer period of time. Interested in seeking opportunities over a short
At least 1 year period of time. Few days, weeks or months.
3. Performance
Interested in a company with a consistent Interested in a less consistent performance along
performance with some abnormal and extremely return on risk.
4. Motivation
Investor is more concerned with dividend Speculators are more concerned with rapid short
payments & com long term growth prospect term price appreciation.
5. Decisions and Funds to buy
Careful & thorough fundamental analysis in Speculators will buy securities using borrowed
terms of past performance and future funds and choose securities mostly based on
prospects. Normally use their own money intuition and rumors spread in the market.
to buy securities
Differences between Investment and Gambling
Investment Gambling
1. Purpose
A way of earning an income Is a form of entertainment
2. Time Horizon
Hold securities for a longer period of time. A gamble is over when a dice is rolled or a card is
At least 1 year turned. Short period of time
3. Need for Analysis
An investor rely on careful analysis of the Depends on luck
market to reduce the risk in investing
4. Risk and Return
The return in investment will commensurate In gambling, a gambler takes on the risk that is
with the risk that the investor assumes. Also greater than the commensurate expected return.
have risk but on average the return is Gambling has high risk and the players’ return on
positive. average is negative

1.7. Investment environment

Investment environment can be defined as the existing investment vehicles in the market

available for investor and the places for transactions with these investment vehicles.

1.6.1. Investment vehicles

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An investment vehicle is simply an investment product that is offered to investors that provide

the chance for investors to earn a return, or profit, on the product purchased.

The main types of financial investment vehicles are:

(a) Short term investment vehicles;

(b) Fixed-income securities;

(c) Common stock;

(d) Speculative investment vehicles;

(e) Other investment tools.

(a) Short - term investment vehicles are all those which have a maturity of one year or less. Short

term investment vehicles often are defined as money-market instruments, because they are

traded in the money market which presents the financial market for short term (up to one

year of maturity) marketable financial assets. The risk as well as the return on investments of

short-term investment vehicles usually is lower than for other types of investments. The main

short term investment vehicles are:

Certificate of deposit is debt instrument issued by bank that indicates a specified sum of

money has been deposited at the issuing depository institution.

Treasury bills (also called T-bills) are securities representing financial obligations of the

government. Treasury bills have maturities of less than one year.

Commercial paper is a name for short-term unsecured promissory notes issued by

corporation. Commercial paper is a means of short-term borrowing by large corporations.

Bankers acceptances are the vehicles created to facilitate commercial trade transactions.

These vehicles are called bankers acceptances because a bank accepts the responsibility to

repay a loan to the holder of the vehicle in case the debtor fails to perform.

Repurchase agreement (often referred to as a repo) is the sale of security with a

commitment by the seller to buy the security back from the purchaser at a specified price

at a designated future date.

(b) Fixed-income securities are those which return is fixed, up to some redemption date or

indefinitely. The fixed amounts may be stated in money terms or indexed to some measure of

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the price level. This type of financial investments is presented by two different groups of

securities:

• Long-term debt securities

• Preferred stocks.

Long-term debt securities can be described as long-term debt instruments representing the

issuer’s contractual obligation. Long term securities have maturity longer than 1 year.

Preferred stocks are equity security, which has infinitive life and pay dividends. But preferred

stock is attributed to the type of fixed-income securities, because the dividend for preferred stock

is fixed in amount and known in advance.

(c) The common stock is the other type of investment vehicles which is one of most popular

among investors with long-term horizon of their investments. Common stock represents the

ownership interest of corporations or the equity of the stock holders. Holders of common

stock are entitled to attend and vote at a general meeting of shareholders, to receive declared

dividends and to receive their share of the residual assets, if any, if the corporation is

bankrupt.

(d) Speculative investment vehicles the term “speculation” could be defined as investments with

a high risk and high investment return. Using these investment vehicles speculators try to

buy low and to sell high, their primary concern is with anticipating and profiting from the

expected market fluctuations. The only gain from such investments is the positive difference

between selling and purchasing prices.

1.6.2. Financial markets
Financial markets are the other important component of investment environment. Financial
markets are designed to allow corporations and governments to raise new funds and to allow
investors to execute their buying and selling orders. In financial markets funds are channeled
from those with the surplus, who buy securities, to those, with shortage, who issue new
securities or sell existing securities. A financial market can be seen as a set of arrangements that
allows trading among its participants.

1.8. Investment companies

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Investment companies pool funds from various investors and invest the accumulated funds in

various financial instruments or other assets. The profits and losses from the investment (after

repaying the management expenses) are distributed to the investors in the funds in proportion to

the investment amount. Each investment company is run by an asset management company who

simultaneously operate various funds within the investment company. Each fund is managed by

a fund manager who is responsible for management of the portfolio. Investment companies are

referred by different names in different countries, such as mutual funds, investment funds,

managed funds or simply funds.

They receive money from investors with the common objective of pooling the funds and then

investing them in securities according to a stated set of investment objectives.

Functions of investment companies

1. Record keeping and administration. Investment companies issue periodic status reports,

keeping track of capital gains distributions, dividends, investments, and redemption, and

they may reinvest dividend and interest income for shareholders.

2. Diversification and divisibility. By pooling their money, investment companies enable

investors to hold fractional shares of many different securities. They can act as large investors

even if any individual shareholder cannot.

3. Professional management. Most, but not all, investment companies have full-time staffs of

security analysts and portfolio managers who attempt to achieve superior investment results

for their investors.

4. Lower transaction costs. Because they trade large blocks of securities, investment companies

can achieve substantial savings on brokerage fees and commissions. While all investment

companies pool the assets of individual investors, they also need to divide claims to those

assets among those investors. Investors buy shares in investment companies, and ownership

is proportional to the number of shares purchased. The value of each share is called the net

asset value, or NAV.

There are two types of investment companies/Investment funds:

(a) Open-End Funds: Have no pre-determined amount of stocks outstanding and they can buy

back or issue new shares at any point. Price of the share is not determined by demand, but by
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an estimate of the current market value of the fund’s net assets value (NAV) and a

commission.

(b) Closed-End Funds: Are publicly traded investment companies that have issued a specified

number of shares and can only issue additional shares through a new public issue. Pricing of

closed-end funds is different from the pricing of open-end funds: the market price can differ

from the NAV.