CHAPTER ONE

INTRODUCTION TO INVESTMENT
1.1 Investment defined
In finance, an investment is a monetary asset purchased with the idea that the asset will provide
income in the future or appreciate and be sold at a higher price. In other words, an investment is
the commitment of money or capital to purchase financial instruments or other assets in order to
gain profitable return in the form of interest, income, or appreciation of the value of the
instrument. In financial sense, investment includes the purchase of bonds, stocks, short-term
financial assets or real estate property. Beside these, in economics discipline, an investment is
defined as the purchase of goods that are not consumed today but used in the future to create
wealth.

In general, an investment is the current commitment of money or other resources in the

expectation of obtaining future benefits. For example, an individual might purchase shares
anticipating that the future proceeds from the shares will justify both the time that his/her money
is tied up as well as the risk of the investment.

Investment vs. Speculation

There is often some confusion between the terms investment, speculation and gambling. This
confusion is often linked with investment made in the stock market.

John Maynard Keynes, described investment as “the activity of forecasting the prospective yield
of assets over their life time”. In contrast, speculation means “the activity of forecasting the
psychology of the market”. Speculation has come to mean different things to different people.
However, its original meaning is to reflect or speculate without a factual basis.

A speculator can be defined as someone that seeks to buy and sell in order to take advantage of
market price fluctuations. An investor is someone who holds on the securities that provide a
good income or capital gain by virtue of them being based on something of real and increasing
value.

The most realistic distinction between the investor and the speculator is found in their attitude
toward market movements. The speculator's primary interest lies in anticipating and profiting
from market fluctuations. The investor's primary interest lies in acquiring and holding suitable
securities at suitable prices.

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Investment vs. Gambling
Many beginner investors often confused about the differences between investing and gambling.
 Gambling is defined as, an act putting money at risk by betting on an uncertain outcome
with the hope that you might win money. In other words, gambling is an act of taking the
risk of losing money in the expectation of a desired result.
 Investing means committing money in order to earn a financial return.
The definitions seem to indicate a higher element of chance or randomness in gambling, while
investing appears to be more rational.

It could be argued that buying a stock based on a “hot tip” is essentially the same as placing
money on a casino which is considered as gambling. “Hot-tip” investors throw their money at
any random investment, but “real” investor does not throw his money at any random investment.

For Example: Assume that there are playing card games, like poker, that demand skill.
However, you cannot choose the cards dealt out to you. In investing, you can choose your
investment. This is the fundamental difference between investing vs. gambling

In general, what does "real" investing mean? The essence of true investing is buying into
companies behind the stock and not just the stock itself. This means that you carefully research
the fundamentals of the company, buy it at a good price, and hold it for a meaningful period
(typically a few years, unless the reasons you bought the stock in the first place are not valid
anymore).

"Buy and hold", a doctrine recommended by the majority of investors, means you buy
something with the intention of holding it as long as possible. The analysis is done on the basis
that the business being bought is to be held for quite some time, and there is more of a focus on
valuation and the business operations of the company than the price action in the market.

Buying stocks based on "hot tips", trading frequently by following the fluctuation of the market,
and holding on to certain stocks based on pure sentiment (emotion) is not investing. It's
speculation.

INVESTMENT OBJECTIVES

i) INCOME: Investors who seek investments primarily focused on the continued receipt of
current income, while recognizing and accepting market and issuer risks inherent in
investments of this type. Investors in the category are usually seeking income above the
market average, but carry higher risks and can be more volatile than the general market.

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ii) GROWTH: Investors who seek investments primarily focused on achieving high capital
appreciation with little emphasis on the generation of current income. Investors using this
approach expect to have higher-than-average increases in revenues and returns and accept a
higher risk.

iii) SPECULATION: This investment approach seeks maximum gain and accepts maximum
risks. Investors who seek investments focused on speculation seek the highest gains without
regard to holding period and accept the potential of the entire loss of their principal in return
for the potential gain.

iv) GROWTH & INCOME: For investors who seek both higher returns from capital
appreciation and some current income by investing the portfolio primarily in growth equities
which produce little or no current income and in income producing investment of all grades,
while recognizing and accepting the increased risks associated with investment of this type.
Investors accept some risk and greater volatility than the “income” objective in this category.

Characteristics of Investment
The sophisticated nature of investing means that a lot goes into making an investment decision.
Since there is much at stake, an investor should consider the basic attributes of investments when
deciding on a suitable option.

At least four investment attributes are integral to sound decisions in this sphere:

1) Safety 3) Liquidity

2) Rate of return 4) Duration

(1) Safety: - Although the degree of risk varies across investment types, all investments bear
risk. Therefore, it is important to determine how much risk is involved in a selected option.
The average performance of an investment normally provides a good indicator. However,
past performance is merely a guide to future performance – not a guarantee. Some
instruments, like variable annuities, may have a safety net while others expose the investor to
comprehensive losses in the event of failure. Investors should also consider whether they
could manage the associated safety risk – financially and psychologically.
(2) Rate of return: - Investments generally provide higher rates of return compared to other asset
classes, such as cash and income options. The rate of return compensates for the level of risk
involved. Therefore, higher risks should necessarily bear higher rates of return to attract

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 investors. It is important not to be preoccupied with the rate of return without assessing its
relation to safety.
(3) Liquidity: - This refers to how easily you can convert to cash or cash equivalents. In other
words, a liquid investment is tradable – there are sufficient buyers and sellers on the market
when it is liquid. An example of this is currency trading. When you trade currencies, there is
always someone willing to buy when you want to sell and vice versa. With other
investments, like stock options, you may hold an illiquid asset at various points in your
horizon.
(4) Duration: - Investments typically have a longer horizon than cash and income options. Their
duration, particularly how long it may take to generate a healthy rate of return, is a vital
consideration for an investor. The investment horizon should match the period that your
funds must be invested for or how long it would take to generate a desired return.

A good investment has a good risk-return trade-off and provides a good return-duration trade-off
as well. Given that there are several risks that an investment faces, it is important to use these
attributes to assess the suitability of an option. A good investment is one that suits your
investment objectives. To do that, it must have a combination of attributes that satisfy you.

Investment Avenues

There are a large number of investment instruments available today. To make our lives easier we
would classify or group them under 4 main types of investment avenues. We shall name and
briefly describe them.

1) Financial securities: These investment instruments are freely tradable and negotiable. These
would include equity shares, preference shares, convertible debentures, non-convertible
debentures, public sector bonds, savings certificates, gilt-edged securities and money market
securities.
2) Non-securitized financial securities: These investment instruments are not tradable,
transferable nor negotiable. And would include bank deposits, company fixed deposits,
provident fund schemes, national savings schemes and life insurance.
3) Mutual fund schemes: If an investor does not directly want to invest in the markets, he/she
could buy units/shares in a mutual fund scheme. These schemes are mainly growth (or equity)
oriented, income (or debt) oriented or balanced (i.e. both growth and debt) schemes.
4) Real assets: Real assets are physical investments, which would include real estate, gold &
silver, precious stones, rare coins & stamps and art objects.

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Before choosing the avenue for investment the investor would probably want to evaluate and
compare them. This would also help him in creating a well diversified portfolio, which is both
maintainable and manageable.

1.2 Investment alternatives

Investing in various types of assets is an interesting activity that attracts people from all walks of
life irrespective of their occupation, economic status, education and family background. When a
person has more money than he requires for current consumption, he would be coined as a
potential investor. The investor who is having extra cash could invest it in securities or in any
other assets like gold or real estate or could simply deposit it in his bank account. The companies
that have extra income may like to invest their money in the extension of the existing firm or
undertake a new venture. All of these activities in a broader sense mean investment.
The investors have an alternative to invest in two types of investments. These alternatives are:
 Real assets
 Financial assets
1. Real assets
Real assets are physical or tangible assets that have value, due to their substance and properties.
Real assets include precious metals, commodities, real estate, agricultural land, buildings,
equipment and knowledge that can be used to produce goods and services.

2. Financial assets
In contrast to real assets, financial assets such as stocks and bonds, which are no more than
sheets of paper or, more likely, computer entries and don’t contribute directly to the productive
capacity of the economy. Instead, these assets are the means by which individuals hold their
claims on real assets. Financial assets are claims to the income generated by real assets (or
claims on income from the government). While real assets generate net income to the economy,
financial assets simply define the allocation of income or wealth among investors.
Investment in financial assets differs from investment in real assets in those important aspects:
 Financial assets are divisible, whereas most real assets are not. An asset is divisible if
an investor can buy or sell a small portion of it. In case of financial assets it means, that
investor, for example, can buy or sell a small fraction of the whole company as an
investment object is buying or selling a number of common stocks.
 Marketability (or Liquidity) is a characteristic of financial assets that is not shared by real
assets, which usually have low liquidity. Marketability (or liquidity) reflects the

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 feasibility of converting of the asset into cash quickly and without affecting its price
significantly. Most of financial assets are easy to buy or to sell in the financial markets.
 The planned holding period of financial assets can be much shorter than the holding
period of most real assets. The holding period for investments is defined as the time
between signing a purchase order for asset and selling the asset. Investors acquiring a
physical asset usually plan to hold it for a long period, but investing in financial assets,
such as securities, even for some months or a year can be reasonable. The holding period
for investing in financial assets vary in very wide intervals and depends on the investor’s
goals and investment strategy.
 Information about financial assets is often more abundant and less costly to obtain, than
information about real assets. Information availability shows the real possibility of the
investors to receive the necessary information which could influence their investment
decisions and investment results. Since a big portion of information important for
investors in such financial assets as stocks, bonds is publicly available, the impact of
many disclosed factors having an influence on the value of these securities can be
included in the analysis and the decisions made by investors.

1.3 Investment companies

Investment companies are financial intermediaries that collect funds from individual investors
and invest those funds in a potentially wide range of securities or other assets. Pooling of assets
is the key idea behind investment companies. Each investor has a claim to the portfolio
established by the investment company in proportion to the amount invested. These companies
thus provide a mechanism for small investors to “team up” to obtain the benefits of large-scale
investing.
Investment companies perform several important functions for their investors:
 Recordkeeping and administration. Investment companies issue periodic status reports,
keeping track of capital gains distributions, dividends, investments, and redemptions, and
they may reinvest dividend and interest income for shareholders.
 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.

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  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.
 Lower transaction costs. Because they trade large blocks of securities, investment
companies can achieve substantial savings on brokerage fees and commissions.

1.4 Security market

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.
Investment in securities represents either a debt or an equity interest. Debt represents funds
borrowed in exchange for payment of interest expense and the promise that the loan will be
repaid at a given future date. Bonds and commercial papers are example of debt securities.
Equity represents a current ownership interest in a specific business or property. Typically, an
investor obtains an equity interest in a business by buying securities collectively known as stocks
(i.e., common, preferred and convertible preferred).
Securities markets are organized to help bring buyers and sellers together, so that both parties to
the transaction will be satisfied that a fair transaction price, close to the true equilibrium price,
has been arranged. Basically, it is in the capital market, called the stock market, where an
investor can buy and sell stocks. This market consists of the primary market or secondary
market, depending on whether the securities were sold by the company itself or by an existing
shareholder(s).

a) Primary market
In the primary market, new shares are issued and sold to the investing public for the first time. It
is where capital is actually raised by the company selling stock directly to investors, typically
through an initial public offering. For instance, if X-Corporation decides to sell a new stock to
raise equity funds, it will be a primary market transaction. Since it is the first time the company
has sold stock to the public, it is called an initial public offering (IPO). The proceeds of the sale
go to X-Corporation, the issuing company. Investors who have subscribed to the IPO provide the
company with the necessary funds to continue its operation and expansion, and become part
owners of the company.

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An underwriter or investment banker assists the issuer of a new security in setting the offering
price and in marketing the securities to the public. The investment banker serves as a middleman
in the transfer of funds between the company in need of capital and the public, and facilitates the
issuance of shares.

b) Secondary market
The secondary market is where securities can be bought and sold after they have been issued to
the public in the primary market. Thus, if you decide to buy existing shares of X-Corporation,
you cannot buy them directly from the issuing company anymore since they have all been sold to
the investing public during the initial public offering.
So, how can you avail of X-Corporation shares when the Initial Public Offering (IPO) has been
completed? Investors can only buy these shares from existing shareholders who are willing to
sell their shares. When they do so, it is a secondary market transaction. The proceeds from this
transaction do not go to the issuing corporation; instead they go to the investor who sold his
shares.
The secondary market is where the original shareholders sell their shares to other investors. An
investor can only make a profit when he can sell his shares at a price higher than the purchase
price. This market gives a continuous reflection of the value of securities (prices) at some point
in time according to the best available information. Secondary markets include the stock
exchange and the over-the-counter (OTC) market. The investor also has a choice, of which type
of securities to invest in depending on such considerations like cost, rate of return, risk involved
and taxes to be paid.

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