Owais Husain PhD.



CHAPTER -1------------------------------------------------------------------------------------Meaning and Definition of Investment – Individual Investor life cycle – Clients ofInvestment Environment - the Investment process – Forms of investment------------------------------------------------------------------------------------INTRODUCTION OF INVESTMENT:An economist says when people earn a dollar; they do one of two things with it: they either consume it or save it. A person consumes a dollar by spending it on something like a car, clothing, or food. People also consume some of their money involuntarily because they must pay tax; a person saves a dollar by somehow putting it aside for consumption at a later time.A distinction can be made between saving and investing. Saving involves putting money away with little, if any, risk saving dollars. Putting money in a bank certificate of deposit or a passbook account is saving. A saver knows the future return, and the account is probably insured by the Federal deposit Insurance Corporation (FDIC), a government agency that protects depositors against bank failure. In the short-run, saving involves few worries.Investing also involves putting money away, but in a risky endeavor. Buying shares of stock in a New York Stock Exchange listed company is investing. If an investor choose to let a broker hold the shares and just send an account statement each month, his or her investment is protected against theft, loss, or brokerage firm failure by the Securities Investor Protection Corporation (SIPC), but not against a decline in value. Depending on the particular stock purchased and other holdings, an investor may have plenty to worry about.Both saving and investing amount to consumption shifting through time. By not spending a dollar today, a person is able to spend more lately, assuming of course, the person saved or invested wisely.Investing is risky but saving is not.INVESTMENT ALTERNATIVES:Assets:Assets are things that people own. The two kinds of assets are financial assets and real assets. The distinction between these terms is easiest to see from an accounting viewpoint.A financial asset carries a corresponding liability somewhere. If an investor buys shares of stock, they are an asset to the investor but show up on the right side of the corporation’s balance sheet. A financial asset, therefore, is on the left-hand side of the owner’s balance sheet and the right-hand side of the issuer’s balance sheet.A real asset does not have a corresponding liability associated with it, although one might be created to finance the real asset.Financial assets have a corresponding liability but real assets do not.Securities:A security is a legal document that shows an ownership interest. Securities have historically been associated with financial assets such as stocks and bonds, but in recent years have also been used with real assets. Securitization is the process of converting an asset or collection of assets into a more marketable forum.Security Groupings:Securities are placed in one of three categories: equity securities, fixed income securities, or derivative assets.1) Equity Securities:The most important equity security is common stock. Stock represents ownership interest in a corporation. Equity securities may pay dividends from the company’s earnings, although the company has no legal obligation to do so. Most companies do pay dividends, and most companies try to increase these dividends on a regular basis.2) Fixed Income Securities:A fixed income security usually provides a known cash flow with no growth in the income stream. Bonds are the most important fixed income securities. A bond is a legal obligation to repay a loan’s principal and interest, but carries no obligation to pay more than this. Interest is the cost of borrowing money. Although accountants classify preferred stock as an equity security, the investment characteristics of preferred stock are more like those of a fixed income security. Most preferred stocks pay a fixed annual dividend that does not change overtime consequently. An investment manager will usually lump preferred shares with bonds rather than with common stocks.Conversely, a convertible bond is a debt security paying a fixed interest rate. It has the added feature of being convertible into shares of common stocks by the bond holders. If the terms of the conversion feature are not particularly attractive at a given moment, the bonds behave like a bond and are classified as fixed income securities. On the other hand, rising stock prices make the bond act more like the underlying stock, in which case the bond might be classified as an equity security.The point is that one cannot generalize and group all stock issues as equity securities and all bonds as fixed income securities. Their investment characteristics determine how they are treated.For investment purposes, preferred stock is considered a fixed income security.3) Derivative Assets:Derivative assts have received a great deal of attention in the 1990s. A derivative asset is probably impossible to define universally. In general, the value of such an asset derives from the value of some other asset or the relationship between several other assets. Future and options contracts are the most familiar derivative assets. These building blocks of risk management programs are used by all large investment houses and commercial banks.The three broad categories of securities are equities, fixed income securities, and derivative asset.THREE REASONS FOR INVESTING:People choose to invest to enhancement their income, to earn gains, and to experience the excitement of the investment process.1) Income:Some people invest in order to provide or supplement their income. Investments provide income through the payment of dividends or interest.2) 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.3) 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. If an active investor makes frequent trades but only breaks even in the process, only the stockbroker will benefit materially.Investing is not an end in itself; it is a means to an end.THE ACADEMICS STUDY OF INVESTMENTS:Some things about the markets and investor behavior are clear. Many other things remain a puzzle. One objective of any investments course should be to distinguish between what we do and don’t know. Let’s look briefly at the two types of market research in which both professors and Wall Street professionals engage: theoretical and empirical research.One objective of any investment course should be to distinguish between what we do and don’t know.Theoretical Research:Theoretical research builds mathematical models and proposes pricing relationships rather than studying actual market data. Arbitrage is the presence of a risk less profit. Much of theoretical research is the study of arbitrage relationships.Similarly, dividends must be paid from the firm’s checkbook, and once the checks are sent, the firms total assets decline. With reduced assets, the firm is worth less and the stock price declines. Both these points can be demonstrated with theoretical models, but that does not mean people will believe them.Arbitrage is a presence of a risk less profit.Empirical Research:Empirical research uses actual market data rather than mathematical models. Financial theory might suggest a relationship that should hold, and research might then the hypothesis using real numbers. Relatively arbitrary accounting decisions within the firms should not affect the value of the firm. The theoretical underpinnings of firm value show that if management could increase the value of the firm by a simple management action all rational management teams would do so. An empirical research project might be to investigate all stock splits over the past 60 months and see if the evidence is consistent with the “no change in firm value” thesis.The financial press is particularly interested in empirical research, especially research dealing with anomalies. An anomaly (unusual) is an observed result that defies explanation within the known theoretical framework.DEFINITION OF INVESTMENT:A standard definition is that investment is “the sacrifice of current consumption in order to obtain increased consumption at a later date”. A formal definition for investment is “the current commitment of dollars 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.Individual Investor Life Cycle:As we know each investor has difference phases of their life cycle. In different phases of life cycle investors needs, wants and desires are different. These phases of life cycle are categorized as: Net Worth Accumulation phase Consolidation phase Spending phase Gifting PhaseLong term:RetirementChildren’s college needs Long term:Retirement Long term:Estate planning Long term: No requirementShort term:HousecarShort term:Vacations Children’s higher education needs Short term:Lifestyle needs Short term: Gifts, Charity 25 35 45 55 65 75 Age of Investor Accumulation Phase:Accumulation phase is known as individuals earlier to middle working careers phase. It is approximately 15 to 20 years of early to middle career. In this phase individuals scarifies most of their earnings to mange future requirements (e.i down payments and further installments of their short term needs). Most of the time their net worth is small and debts are heavy. For managing of their debts individual is always ready for high-risk investments. Consolidation Phase:Consolidation phase is known as middle to retirement phase of individuals working career in investor’s life cycle. This phase is long approximately 20 to 30 years. In this phase most of the investor paid their debts possibly have to pay their children’s higher education fees. In this phase mostly earning are more than their expenditures and individual is concerned about their retirement planning, so individuals invest their excess earning in real estate investment. As individual do not want to take high-risk. Spending Phase:Spending phase starts from individual’s retirements. In this phase expenditures only for maintaining social status and individual is concerned about capital preservation, at the same time, they must balance their desire to preserve the nominal value of their savings with the need to protect themselves against a decline in the real value of their savings due to inflation. Although their overall portfolio may be less risky than in the consolidation phase, they still need some risky growth investments, such as common stock, for inflation protection. Gifting Phase:Gifting phase is similar to spending phase. In this phase individuals relies that they have sufficient receiving’s and assets to cover their expenditures. Individuals are using these excess assets to provide financial assistance to their own relatives and do charity for poor’s.CLIENTS OF INVESTMENT ENVIRONMENTThe major clients that place demands on the financial system are classified into three groups – household sector, corporate sector and government sector.Household sector:Households constantly make economic decisions concerning such activities as work, job training, retirement planning and savings versus consumption. Most households are potentially interested in a wide array of assets and the assets that are attractive can vary considerably depending on the household’s economic situation. Even a limited consideration of taxes and risk preferences can lead to widely varying asset demands and this demand for variety is, as we shall see, a driving force behind financial innovation. Taxes lead to varying asset demands because people in different tax brackets transform before-tax income to after-tax income at different rates, for example high-tax bracket investors naturally will seek tax free securities compared with low-tax bracket investors who want primarily higher yielding taxable securities. Risk considerations also create demand for a diverse set of investment alternatives. At an obvious level, differences in risk tolerance create demand for assets with a variety of risk-return combinations. Individuals also have particular hedging requirements that contribute to diverse investment demands. Risk motives also lead to demand for ways that investors can easily diversify their portfolios and even out their risk exposure.Corporate sector:Whereas household financial decisions are considered with how to invest money, businesses typically need to raise money to finance their investments in real assets: plant, equipment, technological know-how and so forth. Businesses issuing securities to the public have several objectives. First, they want to get the best possible price for the securities. Second, they want to market the issues to the public at the lowest possible cost. the complexities of securities issuance have been the catalyst for creation of an investment banking industry to cater to business ernment sector:Like business, governments often need to finance their expenditures by borrowing. Unlike businesses, governments cannot sell equity shares; they are restricted to borrowing to raise funds when tax revenues are not sufficient to cover expenditures. Governments have a special advantage in borrowing money because their taxing power makes them very creditworthy and therefore able to borrow at the lowest rates.THE INVESTMENT PROCESSThe investment process is description of the steps that an investor should take to construct and manage their portfolio. These proceed from the initial task of identifying investment objectives through to the continuing revision of the portfolio in order to best attain those objectives.The steps in this process are:a. Determine Objectives:Investment policy has to be guided by a set of objectives. Before investment can be undertaken, a clear idea of the purpose of the investment must be obtained. The purpose will vary between investors. Some may be concerned only with preserving their current wealth. Others may see investment as a means of enhancing wealth. What primarily drives objectives is the attitude towards taking on risk. Some investors may wish to eliminate risk as much as is possible, while others may be focused almost entirely on return and be willing to accept significant risks.b. Choose Value:The second decision concerns the amount to be invested. This decision can be considered a separate one or it can be subsumed in the allocation decision between assets (what is not invested must either be held in some other form which, by definition, is an investment in its own right or else it must be consumed).c. Conduct Security Analysis:Security analysis is the study of the returns and risks of securities. This is undertaken to determine in which classes of assets investments will be placed and to determine which particular securities should be purchased within a class. Many investors find it simpler to remain with the more basic assets such as stocks and fixed income securities rather than venture into complex instruments such as derivatives. Once the class of assets has been determined, the next step is to analyze the chosen set of securities to identify relevant characteristics of the assets such as their expected returns and risks. This information will be required for any informed attempt at portfolio construction. Another reason for analyzing securities is to attempt to find those that are currently mispriced. For example, a security that is under-priced for the returns it seems to offer is an attractive asset to purchase. Similarly, one that is overpriced should be sold. Whether there are any assets are under priced depends on the degree of efficiency of the market. More is said on this issue later. Such analysis can be undertaken using two alternative approaches:? Technical analysis: This is the examination of past prices for predictable trends. Technical analysis employs a variety of methods in an attempt to find patterns of price behavior that repeat through time. If there is such repetition (and this is a disputed issue), then the most beneficial times to buy or sell can be identified.? Fundamental analysis: The basis of fundamental analysis is that the true value of a security has to be based on the future returns it will yield. The analysis allows for temporary movements away from this relationship but requires it to hold in the long-rum. Fundamental analysts study the details of company activities to makes predictions of future profitability since this determines dividends and hence returns.d. Portfolio Construction:Portfolio construction follows from security analysis. It is the determination of the precise quantity to purchase of each of the chosen securities. A factor that is important to consider is the extent of diversification. Diversifying a portfolio across many assets may reduce risk but it involves increased transactions costs and increases the effort required to manage the portfolio.e. Evaluation:Portfolio evaluation involves the assessment of the performance of the chosen portfolio. To do this it is necessary to have some yardstick for comparison since a meaningful comparison is only achieved by comparing the return on the portfolio with that on other portfolios with similar risk characteristics.f. Revision:Portfolio revision involves the application of all the previous steps. Objectives may change, as may the level of funds available for investment. Further analysis of assets may alter the assessment of risks and returns and new assets may become available. Portfolio revision is therefore the continuing reapplication of the steps in the investment process.Questions:Why do people invest?How to Save?, How to Invest?, Where to Invest?What is the meaning of Investment? How to monitor the investments?What are the investment alternatives?What steps should an investor follow to make an investment?What is an indirect investment alternative?Gifting phase falls in the age group of 65 + why?. ................
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