Introduction to Investment

Investment can be viewed as sacrifice of present consumption in expectation for a handsome return to be reaped in the future. Definition: foregoing the present consumption in expectation of having a greater consumption opportunities in the future.
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Definition: claims that organizations sell in order to finance their financial needs, usually evidenced by legal documents.

Example:??? Advantage: the existence of an efficient market resulting high liquidity (easy to buy and sell).

Disadvantage: need to have a full understanding on how the markets works and must go through broker or remiser in order to get access into market.

Defi iti income.

:t

i l ass ts/

si al capitals t at generate

ample: dvantage: owning a real asset t at has both investment and aesthetic val e. Disadvantage: lack of the existence of an efficient market to sell real assets on short notice. Involve paperwork, middleman and commission to be paid.

ISSUES

INVESTOR

SPECULATOR

GAMBLER

Definition

Process of committing funds into one or more assets to obtain return

Process of committing funds into one or more assets and betting to obtain return

Betting on certain outcome that depends on luck

Purpose

Way to earn an income

Income and entertainment

More on entertainment

ISSUES

INVESTOR

SPECULATOR

GAMBLER

Time horizon

Long run (at least one year)

Short-term oriented (only a Very short-time few days, weeks or period months) Based on rumors, intuitions or simple market analysis Moderate to high risk-moderate to high return

Investment decision

Make a careful analysis

Depend on luck

Risk assume

Low to moderate risk, therefore low and moderate return

High risk, high return

ISSUES

INVESTOR

SPECULATOR

GAMBLER

Income expectation

Moderate capital appreciation

Rapid capital appreciation

Rapid capital appreciation

Sources of funds

Uses own money to buy securities Prefer use own money rather than and sometimes borrows money borrowing funds from money through financial broker or financial institutions institutions

Usually borrows money from money broker or financial institutions

RISK INVESTMENT SPECULATION GAMBLING SAVINGS

Substantial / Low Substantial / High High Low

RETURN
Substantial / Low Substantial / High High Low

TIME
Medium / Long Short / Medium Short Short/Medium

Mainly determined by the investors personal characteristics such as age, sex, health, family responsibilities and past experiences.

These factors will affect the investors willingness to assume risk. Investors invest in any kind of investment program fro two main goal:

1. 2.

Personal goal Financial goal

1.

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1.

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(i)

Personal objectives - insurance protection - providing a home - liquidity reserves/reserve for emergency - large needs before retirement/children s education - providing for retirement

(ii)

Financial objectives - safety of principal - assurance of income - protection against inflation - liquidity of portfolios - portfolio diversification

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Involves comparing the type of industry and the kind of security whether fixed or variable. To understand the future share price behavior, the expected return and risk involved.

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Determine the value of the securities base on the present value of future stream of income. Compared to the current market price to determine the attractiveness of the security. If value of security is underprice until price is right for reselling. should be bought, held

If value of securities is overprice should be sold.

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A group of investment with different patterns of returns over time. Requires knowledge about personal and financial objectives should considering the timing, selection of investment and allocation of savings to different investment.

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Financial Psychological Management

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Refers to whether an investor can allocate some portion of savings for investment activities. More savings to cater for present and future financial requirement, less financial constraints.

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Refers to how well an investor can absorb the consequences of investment decision such as emotions like greed, fear and caution. If investors cannot control their emotion, might end up making wrong and costly investment decision.

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Refers to the lack of expertise in managing the investment activities. Might not have the time or proper knowledge to analyze the investment alternatives.

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RISK Def: uncertainty about the size of future return on a principal amount of money invested. RETURN Def: the future value amount that we are going to get an investment activity. from

RISK & RETURN TRADEOFF Def: Risk and return are positively correlated. Higher rate of return, High risk the investment alternative.

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(1)

Risk Averse - Conservative type. - require an additional expected return to compensate the high risk that involved. - will make sure that they will get a return for each dollar they put in an investment. RiskTaker - Aggressive type. - Willing to accept a large amount of risk for a small increase in the expected return. Risk Neutral - Moderate type. - Would be satisfied if they will get only the principal that they put in the investment.

(2)

(3)

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S stem tic / Extern l / Uncontroll ble / Nondiversified risk RISK Uns stem tic / Intern l / Controll ble / Diversified risk.
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Uncontrollable and external factors affecting the price of securities. Cannot diversified. E.g.: changes in economy, politic & social, business, interest rate, inflation and war. Three sources: i. Purchasing power/inflation risk ii. Market risk iii. Interest rate risk

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When inflation rate increases, the amount of principal and income received will not provide the same purchasing power as its original value. If the price of goods and services rises due to the increase in inflation rate (rising cost of production & excess demand), the investor actually losing the purchasing power. Affects investor who buy long-term fixed income securities and who holds surplus funds in the bank.

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Invest in common shares as they tend to increase in value over time. Good hedge against inflation. Diversify by buying real estates, precious metals such as gold, art objects & other valuable commodities. Tend to increase in value at the same rate or higher than rate of inflation. Invest in short-term securities such as short-term shortshortbonds because short maturity allows investors to make necessary adjustments. Less affected by the increase in interest rate.

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Possibility of loss due to fluctuations in stock price. The decrease in value of the principal invested caused by changes in prices of securities due to tangible and intangible events. Such as political, sociological and economic factors. Psychological factors such as rumors, speeches by important people.

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Investing in growing firm and financially sound because price of shares potentially will increase in the long run. Study and carefully examine the past security price behavior. E.g. Stocks with growth patterns in the past will continue to do so in the future provided there is no change in the company s expectation of its product and market. Buy securities at the right time. Price low BUY Price high SELL

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Fluctuation of interest rate that will affect the future market values & size of future income. Loss of the principal value because of the change in the interest rate paid on newly issued securities. When interest rate rises, lower the stock prices less demand from buyers.

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Invest in short-term securities to minimize the effect of fluctuation in interest rate. The closer the bond to its maturity date, the more certain will be the price. Invest at different time on securities with different maturity periods.

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Controllable and internal factors affecting a particular industry. Can diversified. E.g.: labor strike and mismanagement. Two sources: i. Business risk ii. Financial risk

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Relate to the efficiency of the management in handling the business (internal) and how it responds to factors outside its control (external) such as business cycle. Affect the general operation of the company such as increase in operating cost, reducing the operating profit.

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Invest in leading companies in the industry or smaller firms with low earning record that shows signs of improvement.

Diversify by buying securities from different companies of different industries.

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Refers to the method through which the company plans its financial structure. Company that borrows to finance its operation carries high financial risk because it has to bear high interest expense which affect low net profit resulting low earning per share (EPS). The more debt the company has, the riskier it is for shareholders.
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Investing in firms that use more equity financing than debt financing.

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TOTAL RISK

SYSTEMATIC RISK

UNSYSTEMATIC RISK

1. Due to common factor. 2. Affects return on all securities. 3. Cannot be protected against through diversification. 4. Sources: a) Purchasing power/inflation risk b) Market risk c) Interest rate risk

1. Due to unique factor. 2. Affects return on one security. 3. Can be protected against through diversification. 4. Sources: a) Business risk b) Financial risk

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Investment is defined as making a current commitment of funds in order to enjoy a higher level of consumption in the future. Investing and speculating are different mainly because investors expect not more than a fair return for the risk that they undertake whereas speculators assume high risk with an intention to make quick profit through rapid increase in the price of the securities.

A well-informed investor with well-defined investment objectives and full understanding of financial constraints has a greater chance of making a successful investment decision.

Risk and return is positively correlated, the higher the risk the higher the return and vice-versa. An investors attitude toward risk can be explained by 3 terms: risk averse, risk taker and risk neutral.
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Two types of risk: systematic and unsystematic risk. Sources of systematic risk: purchasing power/inflation risk, market risk and interest rate risk. Purchasing power risk can be avoided by: including more variable-income securities in the investment portfolio, holding more short-term securities and investing more in real assets. Market risk can be avoided by: avoiding securities with volatile price movement, following the principal of buy low sell high and not being panic easily when the price of securities go down. Interest rate risk can be avoided by: choosing short-term fixed-income securities, buying securities with different maturity period and holding securities until maturity.
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The sources of unsystematic risk are: business risk and financial risk. Business risk can be avoided into choosing to invest in firms with good management team and diversifying the investment portfolio.

Financial risk can be avoided by investing in firms that use more equity financing than debt financing.

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