Investment Analysis & Portfolio Management

CHAPTER ONE
INTRODUCTION TO INVESTMENT
Contents:
What is investment
Economic Investment Vs Financial Investment
Investment Vs speculation
Investment Vs Gambling
 The Investment Process
Investment avenues/alternatives
Investment companies
Security market
Approaches to Investment Decision Making
Common Errors In Investment Management
Qualities for Successful Investing

1
 The investment environment
Introduction
For most of your life, you will be earning and spending
money.
 Rarely, though, your current money income exactly balance
with your consumption desires.
Sometimes, you may have more money than you want to
spend; at other times, you may want to purchase more than
you can afford.
These imbalances will lead you either to borrow or to
save/invest to maximize the long-run benefits from your
income.

2
 What is Investment
Investment is the employment of funds on assets with
aim of earning income or capital appreciation.
Investment is putting money into something with the
expectation of profit.
More specifically, investment is the commitment of
money or capital to the purchase of financial instruments
or other assets so as to gain profitable returns in the
form of interest, income (dividends), or appreciation
(capital gains) of the value of the instrument.
It is related to saving or deferring consumption.

3
 Cont…
In general, investment is the current commitment of
dollar/birr 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.

Investment is involved in many areas of the economy, such

as households, firms, or government.
The “investor” can be an individual, a government, a pension
fund, or a corporation.

4
Cont..
 Types of investors
 Investors can be classified in to two broad categories; these are
individual investors and institutional investors.
 Individual investors are individuals who are investing on their
own. Sometimes individual investors are called retail investors.
 Institutional investors are entities such as investment companies,
commercial banks, insurance companies, pension funds and other
financial institutions.
 Investors can be classified on the basis of their risk bearing
capacity.
 Investors in the financial market have different attitudes towards
risk and hence varying levels of risk-bearing capacity.

5
 Cont…
 Some investors are risk averse, while some may have an affinity
for risk.
 The risk bearing capacity of an investor is a function of personal,
economic, environmental, and situational factors such as income,
family size, expenditure pattern, and age.
 Thus, investor can be classified as risk seekers, risk avoiders, or
risk bearers.
 A risk seeker is capable of assuming a higher risk while a risk
avoider choose instruments that do not show much variation in
returns.
 Risk bearers fall in between these two categories. They assume
moderate levels of risk.

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 TYPES OF INVESTMENT
 ECONOMIC INVESTMENT AND FINANCIAL INVESTMENT

 When a person invests his funds for the acquisition of some

physical assets, say a building or equipment, such types of
investments are called economic investments.
 Economic investment can be defined as the investment that
contributes to the net additions to the capital stock of society.
 Capital stock refers to the goods and service that are used in the
production of other goods and services.
 Hence, in short, it can be said that economic investments help
create physical assets directly.

7
 Cont..
 When a person invests his funds for the acquisition of some
financial assets like shares, bonds, insurance policies, mutual fund
units etc, and such investments are known as financial
investments.
 Financial investments also help in creating physical assets, but
indirectly.
 Hence, economic investment and financial investment are inter-
related.
 Increase in financial investment leads to increase in capital stock.
 When an investor invests in a financial asset, he indirectly invests
in an underlying physical asset, since the financial investments are
ultimately used in creation of physical assets.

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 CHARACTERISTICS OF INVESTMENT
 Return: All investments are characterized by the expectation of a
return.
 In fact, investments are made with the primary objective of deriving a
return.
 The expectation of a return may be from income (yield) as well as
through capital appreciation.
 Capital appreciation is the difference between the sale price and the
purchase price of the investment.
 Risk: Risk is inherent in any investment. Risk may relate to loss of
capital, delay in repayment of capital, non-payment of interest, or
variability of returns.
 The risk of an investment is determined by the investment’s maturity
period repayment capacity, nature of return commitment, and so on.
 The longer the maturity period, greater is the risk.
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 Cont…
 Safety: The safety of investment is identified with the certainty
of return of capital without loss of money or time.
 Safety is another feature that an investor desires from
investments.
 Every investor expects to get back the initial capital on maturity
without loss and without delay.
 Liquidity: An investment that is easily saleable or marketable
without loss of money and without loss of time is said to
possess the characteristic of liquidity.

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 OBJECTIVES OF INVESTMENT
 Savings kept as cash do not result in an incremental return.
 Hence, savings are invested in assets with the desired risk-return
characteristics.
 The main objective of an investment process is to minimize risk
while simultaneously maximizing the expected returns from the
investment and assuring safety and liquidity of the invested assets.
 Investors look for growth/increase in current wealth through
investment opportunities.
 Investors desire to earn as large returns as possible but with the
minimum of risk.
 Risk can also be stated as the probability that the actual return
realized from an investment may be different from the expected
return.

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 INVESTMENT Vs SPECULATION
Both investment and speculation are somewhat interrelated.
 It is said that speculation requires investment and investments
are to some extent speculative.
 Speculation is the purchase or sale of anything in the hope of
profit from anticipated changes in price.

 Both investment and speculation aim at realizing income and

capital appreciation.
 Yet, differences exist in terms of expectation, risk and period
of time.

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 Cont..
Investment Speculation
 The investor invest for long  The peculator invest for
term gain purpose. short term gain purpose.
 The investor holds securities  The speculator holds
for long period. securities very short
period say 1 or 2 days
 Risk is less as compare to
speculation.  Risk is high.

 The rate of return is less as  Rate of return is more

compare to speculation.  It involve buying and selling

of securities.

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 Investment Vs Gambling
 As against investment and speculation, gambling is unplanned.
A gamble is usually a very short term investment in a game
or chance.
 It is an act of creating artificial and unnecessary risks for
expected increased return.
 Gambling is undertaken just for trill and excitement. There is
no risk and return trade off in the gambling and the negative
outcomes are expected.
 But in the investment there is an analysis of risk and return.
 In short, gambling involves acceptance of extraordinary risks
even without a thorough knowledge about them for
pecuniary gains.
 Horse racing, playing cards, lottery etc., are some typical
examples of gambling

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 THE INVESTMENT MANAGEMENT PROCESS
 The investment process involves a series of activities leading to
the purchase of securities or other investment alternatives.
 The investment process can be divided into the following stages.

Investment Investment Investment PORTFOLIO PORTFOLIO

objective Policy Analysis CONSTRUCTION EVALUATION

•Valuation •Diversification
•Objectives •Asset •Fundamental •Selection &
•Appraisal
•Risk allocation analysis Allocation
•Revision
•Return •Constraints •Technical •Efficient
analysis portfolio

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 Cont..
 Step 1: Setting Investment Objectives
 The first step in the investment management process, setting
investment objectives, begins with a thorough analysis of the
investment objectives of the entity whose funds are being
managed.
 These entities can be classified as individual investors and
institutional investors. Within each of these broad classification is
a wide range of investment objectives.
 The objectives of an individual investor may be to accumulate
funds to purchase a home or other major acquisitions, to have
sufficient funds to be able to retire at a specified age, or to
accumulate funds to pay for college tuition for children

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 Cont..
 Hence, investment objectives should be stated in
terms of both risk and return.
 Step 2: Establishing an Investment Policy
 Setting policy begins with the asset allocation
decision.
 That is, a decision must be made as to how the
funds to be invested should be distributed
among the major classes of assets/investments.

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 Cont…
 In the development of an investment policy, the
following factors must be considered:

 Client constraints ( such as liquidity needs, time

horizon, unique needs and preferences)
 Regulatory constraints
 Tax and accounting issues

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Cont…
 Step 3: Analysis of Investment Alternatives
 This step involves examining several relevant types of investment
alternatives.
 Most frequently two forms of analysis are used: technical analysis
and fundamental analysis.
 Technical analysis involves the analysis of market prices in an
attempt to predict future price movements for the particular
financial asset traded on the market.
 This analysis examines the trends of historical prices and is based
on the assumption that these trends or patterns repeat
themselves in the future.
 Fundamental analysis in its simplest form is focused on the
evaluation of intrinsic value of the financial asset.
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 Cont…
 This valuation is based on the assumption that intrinsic value is the
present value of future flows from particular investment.
 Step 4: Selecting the Specific Assets (Portfolio
Construction)
 Once you have decided on the classes of assets in which you will
invest and how much you will invest in each, you will be ready to
select the specific assets to include in your portfolio.
 In this phase of the investment management process that the
investor attempts to construct an efficient portfolio.
 Step 5: Measuring and Evaluating Performance (Portfolio
evaluation)
 This step involves measuring the performance of the portfolio and
then evaluating that performance relative to some benchmark.
 In this step the investment portfolio may be revised.

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 Investment alternatives/Avenues
 Investment in any of the alternatives depends on the needs
and requirements of the investor.
 Corporate and individuals have different needs. Before
investing, these alternatives of investments need to be
analyzed in terms of their risk, return, term, convenience,
liquidity etc.
 Equity Shares:
Equity investments represent ownership in a running company.
By ownership, we mean share in the profits and assets of the
company but generally, there are no fixed returns. It is
considered as a risky investment but at the same time, they
are most liquid investments due to presence of stock markets.

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 Cont…
 Debentures or Bonds:
 Debentures or bonds are long term investment options with a fixed
stream of cash flows depending on the quoted rate of interest.
 They are considered relatively less risky. Amount of risk involved in
debentures or bonds is dependent upon who the issuer is. For
example, if the issuer is government, the risk is assumed to be zero.
Following alternatives are available under debentures or bonds:
 Government securities
 Savings bonds
 Public Sector Units bonds
 Debentures of private sector companies
 Preference shares

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Cont…
 Money Market Instruments:
 Money market instruments are just like the debentures but the
time period is very less. It is generally less than 1 year. Corporate
entities can utilize their idle working capital by investing in money
market instruments. Some of the money market instruments are
 Treasury Bills
 Commercial Paper

 Certificate of Deposits

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Cont…
 Mutual Funds:
 Mutual funds are an easy and tension free way of investment
and it automatically diversifies the investments.
 Mutual fund is an investment mix of debts and equity and ratio
depending on the scheme.
 They provide with benefits such as professional approach,
benefits of scale and convenience. In mutual funds also, we can
select among the following types of portfolios:
◦ Equity Schemes
◦ Debt Schemes
◦ Balanced Schemes
◦ Sector Specific Schemes etc.

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Cont…
 Life Insurance:
 Life insurances are one of the important parts of investment
portfolios.
 Life insurance is an investment for security of life.
 The main objective of other investment avenues is to earn
return but the primary objective of life insurance is to secure
our families against unfortunate event of our death.
 It is popular in individuals. Other kinds of general insurances are
useful for corporate.

 There are different types of insurances which are as follows:

◦ Endowment Insurance Policy
◦ Money Back Policy
◦ Whole Life Policy
◦ Term Insurance Policy

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 Cont…
 Real Estate:
 Every investor has some part of their portfolio invested in real
assets.
 Almost every individual and corporate investor invests in
residential and office buildings respectively. Apart from these,
others include:
◦ Agricultural Land
◦ Semi-Urban Land
◦ Commercial Property
◦ Raw House
◦ Farm House etc

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 Cont…
 Precious Objects:
 Precious objects include gold, silver and other precious stones
like diamond. Some artistic people invest in art objects like
paintings, ancient coins etc.
 Financial Derivatives:
 Derivatives means indirect investments in the assets.
Derivatives market is growing at a tremendous speed.
 The important benefit of investing through derivatives is that
it leverages the investment, manages the risk and helps in
doing speculation. Derivatives include:
◦ Forwards
◦ Futures
◦ Options
◦ Swaps etc
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 Investment Companies
 DEFINITION: a financial intermediary that collect funds from
individual investors and invest those funds in a potentially wide range
of securities or other assets.
◦ investors receive certain rights/share in exchange.
 A corporation or trust engaged in the business of investing the
pooled capital of investors in financial securities.
 An investment company is a company whose main business is
holding securities of other companies purely for investment
purposes.
 The investment company invests money on behalf of its
shareholders who in turn share in the profits and losses.
 These companies thus provide a mechanism for small
investors to “team up” to obtain the benefits of large-scale
investing.
 “It works on the principle of „small drops of water make a big
ocean”
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 Cont…
 They make a profit by buying and selling shares, property and other
assets.
 An investment manager(portfolio manager) decides what assets to buy
in order to build a diverse, managed portfolio.
◦ Advantages of investment companies to the
Individual Investor
 Economies of scale
 higher volume purchases,
 lower commission rate
 provides diversification
 Professional management
 Each investment company uses professional management expertise.
 Way to spread your risk (risk diversification)
 Each investment company owns shares in a range of investments(diversified
portfolio)
 A chance to invest small amounts
• You can invest small lump sum amounts or even invest monthly.
 Protection
 As the establishment and operation of MFs are guided and regulated by
regulatory body, the investors get reasonable protection
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How do mutual funds work?
 Different parties form an institution (investment company=
Mutual Fund).
 Public puts pool of money in the company against its shares
(by buying units of the fund).
 Company(the fund) hires professional (fund mgr) to run the
fund.
 Fund Mgr manages the money.
 Benefits/losses shared among investors based on their holding
(no of units or shares owned).

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 Types of Investment Companies

 Open end Mutual funds (legally known as open-end

companies);

 Closed-end mutual funds (legally known as closed-end

companies);

 UITs (legally known as unit investment trusts).

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 Cont..
 Open-end Mutual Fund
 Free entry and Withdrawal
◦ New investors can join the funds at any time
 Redeemable" (when investors want to sell their
shares, they sell them back to the fund).
 The fund manager buys and sells units constantly on
demand by investors-
◦ it is always open for the investors to sell or buy
their share units at NAV.

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 Cont…
• Closed-end Mutual Fund
• The amount of the fund and its duration are determined in
advance. After the new issue, the number of shares remain
constant , no sale or purchase of fund shares are made by the
fund company.
• Once the subscription reaches the pre-determined level, the
entry of investors is closed.
• Are not redeemable.
• when closed-end mutual fund investors want to sell their
shares, they generally sell them to other investors on the
secondary market, at a price determined by the market.
 Unit investment trust
◦ Money pooled from many investors is invested in portfolio
fixed for life of fund.
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Cont..
 In addition, there are variations within each type of Investment
Company, such as stock funds, bond funds, money market funds,
index funds, interval funds, and exchange-traded funds (ETFs).
 Money market Mutual Funds
 Hold cash reserves, or short-term debt instruments issued by
the government, corporations, or financial institutions,
treasury bills, and bank CDs.
 Bond Funds:
• Bond Funds invest in debt instrument issued by corporations or
government agencies
 Stock (Equity) funds- are funds that make equity
investments.
 Hybrid Funds: Hybrid funds combine stock and bonds into
one fund.

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 Financial Markets and Instruments
 A Financial market is a market where financial
assets are traded.
 Financial market can be classified based on the
following different bases:
 By the maturity of the claim :
 Money market
 Capital market
 By the type of financial claim
 Debt Market and
 Equity market

35
Cont…
 By origin of securities
 Primary Market
 Secondary Market
 By organizational structure of market
 Auction market E.g. New York stock exchange
 Over the counter trading E.g. NASDAQ
 Other Market
 commodity market
 derivative market,
 foreign exchange market
 insurance market.

36
 Cont…
 The Money Market
◦ A market where short-term maturity securities are
bought and sold.
◦ highly marketable securities are traded such as
Treasury bills, Certificate of deposit, Commercial
paper, bankers’ acceptances, federal funds, Repos and
Reverses, Euro dollars etc.
 Capital Market
◦ A market where long term maturity securities are
bought and sold such as Bonds, equity shares,
convertible and non convertible preference shares.
◦ Finance the long-term investments.

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 Cont…
 The Bond Market
◦ A market for long-term borrowing instruments such as Treasury
notes and bonds, corporate bonds, municipal bonds, mortgage
securities, and federal agency debt.
◦ It is also known as fixed income capital market
 Stock Market or Equity Market
◦ A stock market or equity market is a public entity for the trading of
company stock (shares) at an agreed price.
◦ Securities are listed on a stock exchange
 Equity Securities
o Common Stock
◦ Common stocks, also known as equity securities or equities,
represent ownership shares in a corporation.
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Cont…
◦ residual claim and limited liability features
o Preferred Stock
◦ Preferred stock has features similar to both equity
and debt.
How Securities are Traded
 How Firms Issue Securities
◦ When firms need to raise capital, they may choose to sell (or
float) new securities.
◦ Securities are marketed to the public by investment bankers
in what is called the primary market.
◦ Purchase and sale of already issued securities among private
investors takes place in the secondary market.
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Cont…
 There are two types of primary market issues of
common stock.
 Initial public offerings, or IPOs, are stocks issued by
a formerly privately owned company selling stock to
the public for the first time.
 Seasoned equity issues are new shares offered by
firms that already have stock outstanding.
◦ An example would be General Electric, which is a large,
well-regarded firm that has had public stock trading on
the NYSE for over 50 years.
◦ If General Electric decided that it needed new capital, it
could sell additional shares of its common stock to the
public at a price very close to the current price of the
firm’s stock.

40
 Cont…
 Public offering
◦ Which is an issue of stock or bonds sold to the general
investing public.
 Private placement
◦ Which is an issue that is sold to a few wealthy or institutional
investors.

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Investment Bankers and Underwriting
 Investment bankers are specialists in issuing
securities.
 Public offerings of both stocks and bonds typically
are marketed by investment bankers.
 The function of buying the securities from the
issuer is called underwriting.
 Investment bankers perform one of more of the
following three functions.
◦ Advising the issuer on the terms and the timing of the
offering.
◦ Formulating the method used to issue the securities.
◦ Pricing the new securities.
◦ Selling the new securities to the public.

42
Cont…
 In public offering, the securities may be
underwritten on
◦ a firm commitment basis or
◦ best effort, and the securities may be offered to the
public at large.
I. Firm Commitment underwriting
 Here the investment bankers act as principal,
purchasing the securities from the issuer at one price
and seeking to place them with the public investors at
a slightly higher price.

43
Cont…
 Here the investment bank guarantees the
issuing body a price for newly issued securities
by buying the whole issue at a fixed price from
the issuer (the bid price).
 The investment bank then seeks to resell
securities to suppliers of funds (investors) at a
higher price (the offer price).
 As a result, the investment bank takes a risk
that it may not be able to resell the securities
to investors at higher prices.
 If IB could not sell the securities, it incurs a loss.

44
Cont..
II. Public offering-Best-efforts offering
 The investment bank does not guarantee a price to
the issuer ( as with a firm commitment offering) and
acts more as a placing or distribution agent on a fess
basis related to its success in placing the issue.
 IB agrees only to use its expertise to sell the securities;
it does not buy the entire securities from the issuer.
 The investment bank incurs no risk of mispricing the
securities since it seeks to sell the securities at the
price it can get in the market.
 In return the investment bank receives a fee
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 Where Securities are Traded
 Purchase and sale of already-issued securities
take place in the secondary markets, which
consist of

(1) national and local securities exchanges,

(2) the over-the-counter market, and
(3) direct trading between two parties.

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 1. Trading on the Exchange Market
 A stock exchange is an entity which provides
"trading" facilities for stock brokers and traders, to
trade stocks and other securities.
 It is an organized market for the sale and purchase of
securities.
 An exchange provides a facility for its members to
trade securities, and only members of the exchange
may trade there.
 To be able to trade a security on a certain stock
exchange, it has to be listed there.

47
Cont…
 Listing requirements are the set of conditions
imposed by stock exchange upon companies that
want to be listed on that exchange, such as
Minimum number of shares outstanding,
Minimum market capitalization, and
 minimum annual income.
 The stock can be exchanged either on national
exchange, like New York Stock Exchange (NYSE) or
Regional exchanges, like the Chicago Stock Exchange.

48
Cont…
 The national exchange -list a stock only if the firm
meets certain criteria of size and stability.
E.g. New York Stock Exchange (NYSE)
 Regional exchanges- trading shares of local firms
that do not meet the listing requirements of the
national exchanges.
E.g. Chicago Stock Exchange

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The role of stock exchanges in the economy
Stock exchanges have multiple roles in the economy.
Such as;
◦ Raising capital for businesses
◦ Mobilizing savings for investment
◦ Facilitating company growth
◦ Profit sharing
◦ Corporate governance
◦ Creating investment opportunities for small investors
◦ Government capital-raising for development projects
◦ Barometer of the economy

50
 Stock Market Participants
 Commission Broker: works for a company with a
seat on the exchange.
 Floor Broker: are independent members of the
exchange who own their own seats and handle work
for commission brokers when those brokers have too
many orders to handle.
 Registered (floor) Trader: trades only for his or her
own private account.
 Specialist: market maker; specializes in certain types
of stocks (industries). The specialists central to the
trading process. Specialists maintain a market in one
or more listed securities.

51
 [Link] on the OTC Market
 OTC is a stock exchange where securities transactions are made
via telephone and computer rather than on the floor of an
exchange.
 Trades on the OTC market are negotiated directly through
dealers.
 Each dealer maintains an inventory of selected securities.
 Dealers sell from their inventories at asked prices and buy for
them at bid prices.
 The bid price is that at which a dealer is willing to purchase a
security; the ask price is that at which the dealer will sell a
security
 Stocks are traded in the OTC market because the company is
small, making it unable to meet exchange listing requirements.
 OTC market is not a formal exchange. It is also known as
"unlisted stock".

52
3. Insider Trading
 Insider Trading is the trading in a security (buying or
selling a stock) based on material information that is
not available to the general public.
 It is prohibited by the US Securities and Exchange
Commission (SEC) because it is unfair and would
destroy the securities markets by destroying investor
confidence.
 It is illegal for anyone to transact in securities to
profit from inside information, that is, private
information held by officers, directors, or major
stockholders that has not yet been disclosed to the
public.

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APPROACHES TO INVESTMENT DECISION MAKING

• There are four approaches for investment decision

making
 Fundamental Approach
 Psychological Approach
 Academic Approach
 Eclectic Approach

54
COMMON ERRORS IN INVESTMENT MANAGEMENT

 Inadequate comprehension of return and risk

 Vaguely formulated investment policy
 Naïve extrapolation of the past
 Cursory decision making
 Untimely entries and exits
 High costs
 Over diversification and under diversification
 Wrong attitude towards losses and profits

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QUALITIES FOR SUCCESSFUL INVESTING

• The game of investment, as any other game, requires

certain qualities and virtues on the part of the
investors, to be successful in the long run.
 Contrary thinking
 Patience
 Composure
 Flexibility and openness
 Decisiveness

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

THE END!!!

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