FM 42: Investment and

Portfolio Management
Lesson 1: Investment
Environment
 Investment has Different
Meaning:

 Investment: any vehicle into which funds can

be placed with the expectation that it will
generate positive income and/or that its value
will be preserved or increased
 Return: the reward for owning an investment
 Current income
 Increase in value
 Investment has Different
Meaning:

Investment involves employment of funds with the aim

of achieving additional income or growth in values.
Lending money to another [interest]
Purchasing of gold[value appreciation]
Purchase of insurance plan[promised future benefits]
The essential quality of an investment is that it involves
waiting for a reward.
Investment has Different Meaning:

 Investment may be defined

as………………. “ a commitment of
funds made in the expectation of some
positive rate of return” OR it can be
defined as……………….. “ a sacrifice of
current money or other resources for
future benefits”.
Investment has Different Meaning:

 Commitment of money that is expected to

generate additional money
 Current commitment of money for a period of
time to desire future payments that will
compensate the investor for
 The time the funds are committed
 The expected rate of inflation, and
 The uncertainty of the future payments
 The investor can be an individual, a government,
and/or a corporation
 Investment Decisions
 Underlying investment decisions: the
tradeoff between expected return and
risk
 Expected return is not usually the same as
realized return
 Risk: the possibility that the realized
return will be different than the
expected return
Characteristics of Investment

All investments are characterized by

certain features.
Returns
Risks
Safety
Liquidity
Characteristics of Investment

Returns depend upon nature of the investment, the

maturity period, host of other factors.

Received return in the form of Yield[dividend or

interest] + capital appreciation[difference between
sales price and purchase price]
 Characteristics of
Investment

Should I try to avoid the

Risk is inherent in any investment. risk, share the risk, accept
the
Risk and return of an investment are related. risk, or reduce the risk?
“the higher the risk, the higher is the return” .
Risks may be
Loss of capital
Delay in repayment
Non-payment of interest
Variability in returns
 Characteristics of Investment
Safety.
Every investor expects to get back his
capital on maturity without loss and
without delay. Safety is another feature
which an investor desires for his
investments.
Safety implies the certainty of
return of capital without loss of
money or time.
 Financial Meaning of Investment –
commitment of a person’s funds to derive
future income or appreciation in the value of
their capital.

Economic Meaning of Investment –

net addition to the economy’s capital stock
which consists of goods and services that are
used in the production of other goods and
services.
 Types of Investments

 Securities or Property
 Securities: stocks, bonds, options
 Real Property: land, buildings
 Tangible Personal Property: gold,
artwork, antiques
 Direct or Indirect
 Direct: investor directly acquires a claim
 Indirect: investor owns an interest in a
professionally managed collection of securities or
properties
Real Assets Versus Financial Assets

 Real Assets
 Determine the productive capacity and net income of
the economy
 Examples: Land, buildings, machines, knowledge used
to produce goods and services
 Financial Assets
 Claims on real assets
 Types of Investments

 Debt, Equity or Derivative Securities

 Debt: investor lends funds in exchange for
interest income and repayment of loan in
future (bonds)
 Equity: represents ongoing ownership in a
business or property (common stocks)
 Derivative Securities: neither debt nor
equity; derive value from an underlying
asset (options)
 Types of Investments

 Short-Term or Long-Term
 Short-Term: mature within one year
 Long-Term: maturities of longer than a year
 Low Risk or High Risk
 Risk: chance that actual investment returns
will differ from those expected
Forms of Investment

Savings Account. This is lending to the bank cash deposits that

can be withdrawn anytime.
Time deposit. This is lending to the bank for a fixed length of
period. It earns interest higher than savings accounts do.
Special Savings Deposit (Premium Savings Account). This earns a
rate higher than that on the ordinary time deposit.
Trust Investments. These are a pooling of investors’ money as
evidenced by certificates issued by trustee banks who are
authorized to invest the money.
Treasury bills (T-bills). These are short-term promissory notes
issued by the national government.
 Forms of Investment
Commercial Papers. These are interest bearing promissory
notes issued by big firms and are considered a low-risk from
marketable securities. Most of these are asset-backed
securities.
Mutual Funds. These are a pooling of investors’ money by a
stock corporation that issues redeemable shares of stock.
Bonds. These are interest bearing certificates of
indebtedness issued by an organization.
Shares of Stocks. These are shares of in the ownership of
corporate entities and are evidenced by stock certificates.
 Forms of Investment
Derivatives. These are financial instruments the value of
which is derived from the value of other assets.
Option. This refers to the right but not the
obligation to buy or sell something at a specified
price and at a specified date or period of time.
Futures contracts (Futures). These are forward type
contracts wherein buyer and seller are
committed to trade a given asset at a set price on a
fixed date.
 Forms of Investment
Real Estate. This refers to real property (land and
buildings).
Precious Stones and Metals. Precious stones generally
refers to diamonds, because they appreciate in value due
to their rarity. Precious metals are platinum, gold and
silver.
Other Forms of Investment. Other forms of investment
may be works of art and other collectibles.
 Investable cash refers to the amount of money that an
organization or individual can afford to keep in some forms
of investment for a definite length period without
hampering his day-to-day operations.

 Liquidity buffer refers to the amount of cash an entity or

individual must have to take care of unexpected cash
requirements.
 Diversification as applied to investments refers to
spreading investable funds to different investment
items.
 Overdiversification is the extreme spreading of the
investable funds to so many items of investments.
Although it minimizes exposure to risk in each item of
investment, it may bring forth the following
disadvantages:
1. Inability of investor to keep track of developments in
each item of investment.
2. Increased transaction costs.
3. Minimized earnings from the more profitable items of
investment.
Factors in Allocating
Investable Funds

1. Investor’s Cash needs. This refers to the investor’s cash

requirements for monthly operations and planned changes
therein as reflected in his cash budget.
2. Risk Preference or Tolerance. This refers to the degree of risk
that an investor can be comfortable with or his appetite for risk.
3. Financial Limitations. An investor with so many financial
obligations, limited earnings or with limited resources would
prefer to play it safe by putting his money in fixed income and
low-risk financial instruments. On the other hand, an investor
with more than sufficient earnings, adequate savings and other
financial resources would allocate his investable funds to
different forms of investments.
 Factors in Allocating Investable
Funds

4. Time horizon.
short-term- one year or less
long-term- more than three years
medium- one to three years
5. Laddered Investing. This refers to timing investment
maturities at staggered dates to jibe with expected or
planned cash outlays.
6. Market timing. This refers to buying and selling items
of investment when it is advisable to do so.
 Offensive and Defensive
Investments

 Offensive investment is aggressive for it entails more

risks but bigger rewards.

 Defensive investment entails less risks but smaller

rewards. In most cases, it brings in fixed amount of
income or gain upon sale can be predetermined.
 Portfolio Manager is the person or office given the
authority to make decisions regarding the investments
of an individual or entity.

Expert Opinions

 Financial markets are the venues for buying and selling

financial instruments.
 Money markets instruments are those that are often referred to as
near-cash items and include short-term, marketable, low-risk debt
securities.
 Capital markets, the financial instruments dealt with are the longer
and riskier securities .
Suppliers and Demanders of Funds

 Government
 Federal, state and local projects & operations
 Typically net demanders of funds
 Business
 Investments in production of goods and services
 Typically net demanders of funds
 Individuals
 Some need for loans (house, auto)
 Typically net suppliers of funds
 Figure 1.1
The Investment Process
 Types of Investors
 Individual Investors
 Invest for personal financial goals
(retirement, house)
 Institutional Investors
 Paid to manage other people’s money
 Trade large volumes of securities
 Include: banks, life insurance companies,
mutual funds and pension funds
 Steps in Investing
 Step 1: Meeting Investment Prerequisites
a. Adequately provide for necessities of life, including
funds for meeting emergency cash needs
b. Adequate protection against losses from death,
illness and disability
 Step 2: Establishing Investment Goals
Examples include:
a. Accumulating retirement funds
b. Enhancing current income
c. Saving for major expenditures
d. Sheltering income from taxes
 Steps in Investing
 Step 3: Adopting an Investment Plan
a. Develop a written investment plan
b. Specify target date and risk tolerance for each
goal
 Step 4: Evaluating Investment Vehicles
a. Assess potential return and risk
 Step 5: Selecting Suitable Investments
a. Research and gather information on
specific investments
b. Make investment selections
 Steps in Investing
 Step 6: Constructing a Diversified Portfolio
a. Use portfolio comprised of different investments
b. Diversification can increase returns or decrease
risks
 Step 7: Managing the Portfolio
a. Compare actual behavior with expected
performance
b. Take corrective action when needed
The Role of Short-Term Vehicles

 Liquidity: the ability of an investment to be

converted into cash quickly and with little or
no loss in value
 Primary use is for emergency cash reserve or
to save for a specific short-term
financial goal
The Advantages and Disadvantages
of Short-Term Vehicles

 Advantages
 High liquidity
 Low risks of default
 Disadvantages
 Low levels of return
 Loss of potential purchasing power
from inflation
 Investment Suitability

 Short-Term Vehicles are used for:

 Savings
 Emphasis on safety and security instead
of high yield
 Investment
 Yield is often as important as safety
 Used as component of diversified portfolio
 Used as temporary outlet waiting for attractive
permanent investments
Common investing Mistakes
 Failure to make financial plan for the future. This refers to
failing to understand one’s overall financial situation and how
wise investments fit in.
 Miscalculating risk tolerance. Risk tolerance varies
depending on one’s source of income, personality, lifestyle,
financial goals and investment time frame.
 Failure to keep sufficient contingency funds. This refers to
the failure to set aside sufficient amount of money for
emergency needs so that an investor is apt to sell a long-term
investment when prices are down.
 Jumping on the bandwagon. In a layman’s language,
this refers to the joining the crowd wherever it goes.
 Inability to have leverage. This refers to putting too
many eggs in one basket or maintaining only one
form of investment so that the investor is apt to
suffer significant loss if something goes wrong with it.
Common investing mistakes
 Overdiversification. This refers to spreading investable
funds to so many items of investment resulting in
minimum gains because the investor is unable to keep
track of developments that affect each of them and to
earn more on the more profitable investment items.
 Erroneous timing of the market. This refers to buying
when it is time to sell and selling when it is time to buy.
 Failure to keep a long-term perspective. This refers to
failure to look forward to a number of years in the
future by merely buying and selling at small margins.
 Inability to cut losses. This refers to the inability to
sell at a loss when prices are going down.