The Investment Setting

Learning Objectives

• Define investment and discuss what it means

to study investments.
• Explain why risk and return are the two
critical components of all investing decisions.
• Outline the two-step investment decision
process.
• Discuss key factors that affect the investment
decision process.
 Investment interpreted
• Investment can be interpreted broadly from three angles
 Economic -commitment of the fund for net addition to the
capital stock of the economy.
 Layman- term investment as any commitment of funds for
a future benefit not necessarily in terms of return.
 Financial- Employment of funds with the objective of
realizing additional income or growth in value of
investment at a future date.
 Investments Defined
• Investment - the process of committing
funds to one or more assets
• The sacrifice of certain present value for
(possibly uncertain) future value
• Two most important features of an
investment are
a) current sacrifice and b) future benefit.
 Investment Objectives
• Primary Objectives
– Safety of principal
– Income/return
– risk
• Secondary Objectives
– Liquidity
– Tax minimization
 Investment Constraints
• Possible constraints for investors include:
– Legal
– Moral / Ethical
– Emotional – including investment knowledge and risk
tolerance
– Basic minimum income to be provided by the portfolio
/return
– Realism – an understanding that some objectives are
unrealistic (e.g., high returns with low risk)
– Age, liquidity
– Other (e.g., illness, pending divorce, etc.)
 Why Study Investments?
• Most individuals make investment
decisions sometime
– Individuals need sound framework for
managing and increasing wealth
• Essential part of a career in the field
– Security analyst, portfolio manager,
investment advisor, financial planner,
Chartered Financial Analyst
 Return
• Any investment involves a current commitment
of funds for some period of time in order to
derive future payments that will compensate
for:
– the time the funds are committed (the real rate of
return)
– the expected rate of inflation (inflation premium)
– uncertainty of future flow of funds (risk premium)
 risk
• Risk is the chance that the actual return
from an investment may differ from its
expected value.
• “Risk is not knowing what you are doing.”
Warren Buffett
 Investment Decisions

• Underlying investment decisions: the

tradeoff between expected return and risk
• Return: expected return is not usually the
same as realized return
• Risk: the possibility that the realized return
will be different than the expected return
The Tradeoff Between ER and
Risk
• Investors manage
risk at a cost – lower
expected returns Stocks
(ER) ER Bonds
• Any level of
expected return and
risk can be attained Risk-free Rate
Risk
 Typical Chart
RT

RELATION RISQUE-RENDEME
RISK- EXPECTED RETURN RELATIONSHIPS
12

High Options/Futures
10 Art objects
Coins and stamps
8
Real estate (commercial)
Common shares
Expected
6 Return Real estate (residential) Rendement

Preferred shares
4
Corporate bonds
Government bonds
2
Treasury bills

0
Low
0 2 4 6
Risk
8 10 12
High
 The Investment Decision
Process
• Two-step process:
– Security analysis
• Necessary to understand security characteristics
and applied to these securities to estimate their
price or value
– Portfolio management
• Selected securities viewed as a single unit
• How and when should it be revised?
• How should portfolio performance be measured?
 INVESTMENT VERSES
SPECULATION:
Investment and speculation are some what different and yet
similar because speculation requires an investment and
investment are at lest some what speculative.
• Investments are usually made with the expectation that a
certain stream of income or a certain price that has existed
will not change in the future. Where as speculation are
usually based on the expectation that some change will
occur in future, there by resulting a return.
 Types of speculator
• A bull buys shares in the expectation of selling
them at a higher price. When there is a bullish
tendency in the market, share prices tend to go
up since the demand for the shares is high.
• A bear sells shares in the expectation of a fall in
price with the intention of buying the shares at a
lower price at a future date. These bearish
tendencies result in a fall in the price of shares.
 Types of investor
• On the basis of groups
• individual investors
• Institutional investor
• On the basis of risk
• Risk seeker
• Risk avoiders
• Risk bearers
Investment Vs Gambling
• What are securities ?
• Types of market
• Financial market
• Forex market
• Primary secondary markets
• Capital and money market
• Equity and debt market
• Spot and derivative market
• Euro market
 Investment categories:
• Real assets: Real assets are tangible material things like
building, automobiles,land, gold etc.
• Financial assets: Financial assets are piece of paper
representing an indirect claim to real assets held by some
one else. These pieces of paper represent debt or equity
commitment in the form of IOUs or stock certificates.
certificates.
• Investments in financial assets consist of –
 Securities (i.e. security forms of) investment
 Non-securities investment
• Commodity assets
Approaches to investment decision
making
• Fundamental approach

• Psychological approach

• Academic approach
Error in investment decision making
A) Improper Evaluation of risk reward ratio
B) Cursory decision making
C) Investment in penny stock
D) Improper diversification
E) Greed and fear
 Investopedia
• http://http://www.investorguide.com
http://www.aaii.com
http://www.economist.com
http://www.online.wsj.com
http://www.forbes.com
http://www.barrons.com
http://fisher.osu.edu/fin/journal/jofsites.htm http://www.ft.com
http://www.fortune.com
http://www.smartmoney.com
http://www.worth.com
http://www.money.cnn.com