Chapter One: - Introduction to Investment
This chapter is introductory and contains important institutional material focusing on the
investment environment.
1.1. What is investment
When current income exceeds current consumption desires, people tend to save the excess. They
can do any of several things with these savings. One possibility is to put the money under a
mattress or bury it in the backyard until some future time when consumption desires exceed
current income. When they retrieve their savings from the mattress or backyard, they have the
same amount they saved. Another possibility is that they can give up the immediate possession
of these savings for a future larger amount of money that will be available for future
consumption. This tradeoff of present consumption for a higher level of future consumption is
the reason for saving. What you do with the savings to make them increase over time is
investment Those who give up immediate possession of savings (that is, defer consumption)
expect to receive in the future a greater amount than they gave up. Conversely, those who
consume more than their current income (that is, borrow) must be willing to pay back in the
future more than they borrowed. The rate of exchange between future consumption (future
dollars) and current consumption (current dollars) is the pure rate of interest. Both people’s
willingness to pay this difference for borrowed funds and their desire to receive a surplus on their
savings give rise to an interest rate referred to as the pure time value of money. This interest rate
is established in the capital market by a comparison of the supply of excess income available
(savings) to be invested and the demand for excess consumption (borrowing) at a given time. If
you can exchange $100 of certain income today for $104 of certain income one year from today,
then the pure rate of exchange on a risk-free investment (that is, the time value of money) is said
to be 4 percent (104/100 – 1). The investor who gives up $100 today expects to consume $104 of
goods and services in the future. This assumes that the general price level in the economy stays
the same. For instance in US the price stability has rarely been the case during the past several
decades when inflation rates have varied from 1.1 percent in 1986 to 13.3 percent in 1979, with
an average of about 5.4 percent a year from 1970 to 2001. If investors expect a change in prices,
they will require a higher rate of return to compensate for it. For example, if an investor expects
a rise in prices (that is, he or she expects inflation) at the rate of 2 percent during the period of
investment, he or she will increase the required interest rate by 2 percent. In our example, the
investor would require $106 in the future to defer the $100 of consumption during an inflationary
period (a 6 percent nominal, risk-free interest rate will be required instead of 4 percent). 6
Further, if the future payment from the investment is not certain, the investor will demand an
interest rate that exceeds the pure time value of money plus the inflation rate. The uncertainty of
the payments from an investment is the investment risk. The additional return added to the
nominal, risk-free interest rate is called a risk premium. In our previous example, the investor
would require more than $106 one year from today to compensate for the uncertainty. As an
example, if the required amount were $110, $4, or 4 percent, would be considered a risk
premium.
From our discussion, we can specify a formal definition of investment. Specifically, an
investment is the current commitment of dollars for a period of time in order to derive future
payments that will compensate the investor for
i. the time the funds are committed,
ii. ii. the expected rate of inflation, and
iii. The uncertainty of the future payments.
The “investor” can be an individual, a government, a pension fund, or a corporation. Similarly,
this definition includes all types of investments, including investments by corporations in plant
and equipment and investments by individuals in stocks, bonds, commodities, or real estate. The
investor is trading a known dollar amount today for some expected future stream of payments
that will be greater than the current outlay. Why people invest and what they want from their
investments. They invest to earn a return from savings due to their deferred consumption. They
want a rate of return that compensates them for the time, the expected rate of inflation, and the
uncertainty of the return. This return, the investor’s required rate of return, is discussed
throughout this course. A central question of this course is how investors select investments that
will give them their required rates of return.
The rewards or returns from an investment can be received in form of current income or
increased value to your asset. For example, if you invest money in a bank’s savings account, you
will receive current income in the form of periodic interest payments. On the other hand, if you
buy a piece of land or building, this investment will give you increased value in future over and
above what you spent in buying. It is a simple logic. Landed property (land and building)
appreciates in value as the area where the property is located urbanizes or develops.
“In very simple words, when an individual, a company, any institution or a group of these park
money to earn yield in future it is called investment.”
Characteristics of Investment:
All investments are characterized by certain features; few among them are mentioned below:
1. Return: Investors buy or sell financial instruments in order to earn return on them. The
return on investment is the reward to the investors. The return includes both current
income and capital gain or losses, which arises by the increase or decrease of the security
price.
2. Risk: Risk is the chance of loss due to variability of returns on an investment. In case of
every investment, there is a chance of loss. It may be loss of interest, dividend or
principal amount of investment. However, risk and return are inseparable. Return is a
precise statistical term and it is measurable. But the risk is not precise statistical term.
However, the risk can be quantified. The investment process should be considered in
terms of both risk and return.
3. Safety of funds: The safety of investment is identified with the certainty of return of capital
without loss of money or time. The selected investment avenue should be under the legal and
regulatory frame work. If it is not under the legal frame work. It is difficult to represent the
grievances if any approval of the law itself adds a flavor of safety.
4. Tax benefits: The investor who invests their money in shares and securities which will reduce
the investor’s income tax burden.
5. Capital growth: Every investor seeks maximum capital growth and implies making risky
investment with considerable investment analysis and management. Example – equity shared and
the growth shared.
6. Liquidity i.e. nearness to money: Liquidity refers to the ability of an investment to be
converted into cash as and when required or 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.
If a portion of the investment could be converted into cash without much loss of time. It would
help the investor meet the emergencies.
7. Stability income: It refers to constant return from an investment.
8. Diversification: The idea is to create a portfolio that includes multiple investments in order
to reduce risk.
Example – invest 10.000 in to 10 different companies.
9. Marketability: An investment is highly marketable or liquid if:
It can be transacted quickly
The transaction cost is low
The price change between two successive transactions
The above are the objectives of every investor to increase their wealth.
Objectives of Investment:
An investor has various alternative avenues of investment for his savings to flow. Thus,
objectives of an investor can be stated as:
Maximization of return
Minimization of risk
Hedge against inflation
1.2. Investment Alternatives
Investment consists of two alternatives:
• Security & Non-Security Forms of Investment or Marketable & Non-Marketable Investment
Security Forms of Investment
Security forms of investment include the following:
Corporate Bonds/Debenture:-Convertible& Non-Convertible
Public Sector Bonds:- Taxable & Tax Free
Preference Shares
Equity Shares:- New Issue, Rights Issue,& Bonus Issue
Non-Security Forms of Investment (nontransferable)
Non-security forms of investment as outlined below:
National Savings Scheme
National Savings Certificates
Provident Funds:- Statutory Provident Fund, Recognized Provident Fund, Unrecognized
Provident Fund & Public Provident Fund
Corporate fixed deposits:- Public Sector& Private Sector
Life insurance policies
Investment vs. Speculation
Investment and speculation both involve the purchase of assets such as shares and securities,
with an expectation of return. However, investment can be distinguished from speculation by
risk bearing capacity, return expectations, and duration of trade. The capacity to bear risk
distinguishes an investor from a speculator. An investor prefers low risk investments, whereas a
speculator is prepared to take higher risks for higher returns. Speculation focuses more on returns
than safety, thereby encouraging frequent trading without any intention of owning the
investment. The speculator’s motive is to achieve profits through price change, that is, capital
gains are more important than the direct income from an investment. Thus, speculation is
associated with buying low and selling high with the hope of making large capital gains.
Investors are careful while selecting securities for trading. Investments, in most instances, expect
an income in addition to the capital gains that may accrue when the securities are traded in the
market. Investment is long term in nature. An investor commits funds for a longer period in the
expectation of holding period gains. However, a speculator trades frequently; hence, the holding
period of securities is very short.
Investment Vs Gambling
Investment has also to be distinguished from gambling. Typical examples of gambling are horse
races, card games, lotteries, etc. Gambling consists in taking high risks not only for high returns,
but also for thrill and excitement. Gambling is unplanned and non -scientific, without knowledge
of the nature of the risk involved. It is surrounded by uncertainty and is based on tips and rumors.
In gambling artificial and unnecessary risks are created for increasing the returns. Investment is
an attempt to carefully plan, evaluate and allocate funds to various investment outlets which
offer safety of principal and moderate and continuous return over a long period of time.
Gambling is quite the opposite of investment.
13..Investment Companies
Generally, an "investment company" is a company (corporation, business trust, partnership, or
Limited Liability Company) that issues securities and is primarily engaged in the business of
investing in securities.
An investment company invests the money it receives from investors on a collective basis, and
each investor shares in the profits and losses in proportion to the investor's interest in the
investment company. The performance of the investment company will be based on (but it won't
be identical to) the performance of the securities and other assets that the investment company
owns.
Generally investment companies categorized into three basic types:
Mutual funds (legally known as open-end companies);
Closed-end funds (legally known as closed-end companies);
UITs (legally known as unit investment trusts).
Mutual Funds:- A
A mutual fund is a type of Investment Company that pools money from many investors and
invests the money in stocks, bonds, money-market instruments, other securities, or even cash.
Here are some characteristics of mutual funds:
Investors purchase shares in the mutual fund from the fund itself, or through a broker for the
fund, and cannot purchase the shares from other investors on a secondary market, such as the
New York Stock Exchange or Nasdaq Stock Market. The price that investors pay for mutual
fund shares is the funds approximate net asset value (NAV) per share plus any fees that the
fund may charge at purchase, such as sales charges, also known as sales loads.
Mutual fund shares are "redeemable." This means that when mutual fund investors want to sell
their fund shares, they sell them back to the fund, or to a broker acting for the fund, at their
current NAV per share, minus any fees the fund may charge, such as deferred sales loads or
redemption fees.
Mutual funds generally sell their shares on a continuous basis, although some funds will stop
selling when, for example, they reach a certain level of assets under management.
The investment portfolios of mutual funds typically are managed by separate entities known as
"investment advisers" that are registered with the SEC. In addition, mutual funds themselves
are registered with the SEC and subject to SEC regulation.
There are many varieties of mutual funds, including index funds, stock funds, bond funds, and
money market funds. Each may have a different investment objective and strategy and a different
investment portfolio. Different mutual funds may also be subject to different risks, volatility, and
fees and expenses. Fees reduce returns on fund investments and are an important factor that
investors should consider when buying mutual fund shares.
Closed-End Fund
A "closed-end fund," legally known as a "closed-end company," is one of three basic types of
Investment Company.
Closed-end funds generally do not continuously offer their shares for sale. Rather, they sell a
fixed number of shares at one time (in an initial public offering), after which the shares typically
trade on a secondary market, such as the New York Stock Exchange or the Nasdaq Stock Market.
The price of closed-end fund shares that trade on a secondary market after their initial public
offering is determined by the market and may be greater or less than the shares net asset value
(NAV).
Closed-end fund shares generally are not redeemable. That is, a closed-end fund is not required
to buy its shares back from investors upon request. Some closed-end funds, commonly referred
to as interval funds, offer to repurchase their shares at specified intervals.
Like mutual fund the investment portfolios of closed-end funds generally are managed by
separate entities known as "investment advisers" that are registered with the SEC.
Closed-end funds are permitted to invest in a greater amount of "illiquid" securities than are
mutual funds. (An "illiquid" security generally is considered to be a security that cannot be sold
within seven days at the approximate price used by the fund in determining NAV.) Because of
this feature, funds that seek to invest in markets where the securities tend to be more illiquid are
typically organized as closed-end funds.
Unit Investment Trusts (Uits)
A"unit investment trust," commonly referred to as a "UIT," is one of three basic types of
investment company.
A UIT typically issues redeemable securities (or "units"), like a mutual fund, which means that
the UIT will buy back an investors "units," at the investors request, at their approximate net
asset value (or NAV) .
A UIT typically will make a one-time "public offering" of only a specific, fixed number of units
(like closed-end funds). Many UIT sponsors, however, will maintain a secondary market, which
allows owners of UIT units to sell them back to the sponsors and allows other investors to buy
UIT units from the sponsors. A UIT will have a termination date (a date when the UIT will
terminate and dissolve) that is established when the UIT is created (although some may terminate
more than fifty years after they are created). In the case of a UIT investing in bonds, for example,
the termination date may be determined by the maturity date of the bond investments. When a
UIT terminates, any remaining investment portfolio securities are sold and the proceeds are paid
to the investors.
A UIT does not actively trade its investment portfolio. That is, a UIT buys a relatively fixed
portfolio of securities (for example, five, ten, or twenty specific stocks or bonds), and holds them
with little or no change for the life of the UIT. Because the investment portfolio of a UIT
generally is fixed, investors know more or less what they are investing in for the duration of their
investment. Investors will find the portfolio securities held by the UIT listed in its prospectus.
A UIT does not have a board of directors, corporate officers, or an investment adviser to render
advice during the life of the trust.
In addition, to their characteristics 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).
1.4. Securities market
The market in which securities are issued, purchased by investors, and subsequently transferred
among investors is called the securities market. Or The place where the exchange of securities
like stocks and bonds occurs by considering the demand and supply as the basis of trade is
known as the securities market. These markets regulate the cost and are open to both types of
buyers and sellers: professionals and non-professionals. The securities markets are responsible
for providing a regulated body for the systematic flow of capital i.e. equity and debt from
investors to businesses in the financial market sector. Securities markets in fiscal terms are
represented as IOUs which means ‘I owe you and more importantly this market deals with
financial assets. The central or state government, business firms, and the corporate sector are
responsible for issuing the securities and the public sector undertakings also issue the same.
These issued securities provide financial support for investments and expenditures. These
markets play a vital role as a platform that allocates savings to investments. Securities markets
are very capable and have a lot of potential as they can channel the savings of government,
households, and business firms to provide funds for capital needs concerning a business
enterprise.
TYPES OF SECURITIES MARKETS
Securities markets can be categorized into two segments namely primary market and secondary
market.
Primary market: It deals with the public trading of new securities through investment
brokers. In this market, the person who issues the securities is granted them to proceed
with the transaction. Security is sold once in the primary market i.e. when the corporation
issues it. Equity and debt both have a market where they are first issued.
Secondary market: rest of the transaction happens in this market. The securities which
have already been issued are bought, traded, and sold here. The absolute transaction of
securities takes place. The actual trade of securities is done in the secondary market.
By term of circulation of financial assets traded in the market: Money Vs Capital
Markets;
Money market: in which only short-term financial instruments are traded.
Capital market: in which only long-term financial instruments are traded.
From the perspective of a given country financial markets are: Internal or national market;
External or international market. The internal market can be split into two fractions: domestic
market and foreign market. Domestic market is where the securities issued by domestic issuers
(companies, Government) are traded. A country’s foreign market is where the securities issued
by foreign entities are traded. The external market also is called the international market includes
the securities which are issued at the same time to the investors in several countries and they are
issued outside the jurisdiction of any single country (for example, offshore market)
1.6. What Is an Order?
An order consists of instructions to a broker or brokerage firm to purchase or sell a security on an
investor's behalf. An order is the fundamental trading unit of a securities market. Orders are
typically placed over the phone or online through a trading platform, although orders may
increasingly be placed through automated trading systems and algorithms. When an order is
placed, it follows a process of order execution.
Orders broadly fall into different categories, which allow investors to place restrictions on their
orders affecting the price and time at which the order can be executed. These conditional
order instructions can dictate a particular price level (limit) at which the order must be executed,
for how long the order can remain in force, or whether an order is triggered or canceled based on
another order, among other things.
Types of Orders
The most common types of orders are market orders, limit orders, and stop-loss orders.
A market order is an order to buy or sell a security immediately. This type of order guarantees
that the order will be executed, but does not guarantee the execution price. A market order
generally will execute at or near the current bid (for a sell order) or ask (for a buy order) price.
However, it is important for investors to remember that the last-traded price is not necessarily the
price at which a market order will be executed.
Example: An investor places a market order to buy 1000 shares of XYZ stock when the
best offer price is $3.00 per share. If other orders are executed first, the investor’s market
order may be executed at a higher price.
In addition, a fast-moving market may cause parts of a large market order to execute at different
prices.
Example: An investor places a market order to buy 1000 shares of XYZ stock at $3.00
per share. In a fast-moving market the order could have 500 shares execute at $3.00 per
share and the other 500 shares execute at a higher price.
A limit order is an order to buy or sell a security at a specific price or better. A buy limit order
can only be executed at the limit price or lower, and a sell limit order can only be executed at the
limit price or higher. Example: An investor wants to purchase shares of ABC stock for no more
than $10. The investor could submit a limit order for this amount and this order will only execute
if the price of ABC stock is $10 or lower.
Example: An investor wants to purchase shares of ABC stock for no more than $10. The
investor could submit a limit order for this amount and this order will only execute if the price of
ABC stock is $10 or lower.
A limit order is not guaranteed to execute. A limit order can only be filled if the stock’s market
price reaches the limit price. While limit orders do not guarantee execution, they do help ensure
that an investor does not pay more than a pre-determined price for a stock.
A stop order, also referred to as a stop-loss order is an order to buy or sell a stock once the price
of the stock reaches the specified price, known as the stop price. When the stop price is reached,
a stop order becomes a market order.
A buy stop order is entered at a stop price above the current market price. Investors generally
use a buy stop order to limit a loss or protect a profit on a stock that they have sold short. A sell
stop order is entered at a stop price below the current market price. Investors generally use a sell
stop order to limit a loss or protect a profit on a stock they own.
Stop-Limit Order
A stop-limit order is an order to buy or sell a stock that combines the features of a stop order and
a limit order. Once the stop price is reached, a stop-limit order becomes a limit order that will be
executed at a specified price (or better). The benefit of a stop-limit order is that the investor can
control the price at which the order can be executed.
Before using a stop-limit order, investors should consider the following:
As with all limit orders, a stop-limit order may not be executed if the stock’s price moves
away from the specified limit price, which may occur in a fast-moving market.
The stop price and the limit price for a stop-limit order do not have to be the same price.
For example, a sell stop limit order with a stop price of $3.00 may have a limit price of
$2.50. Such an order would become an active limit order if market prices reach $3.00,
however the order can only be executed at a price of $2.50 or better.
Investors should carefully select the stop and limit prices they use for a stop-limit order
since short-term market fluctuations in a stock’s price can activate a stop-limit order.
As with stop orders, different trading venues and firms may have different standards for
determining whether the stop price of a stop-limit order has been reached. Some use only
last-sale prices to trigger a stop-limit order, while others use quotation prices. Investors
should check with their brokerage firms to determine which standard would be used for
stop-limit orders.
Trailing Stop Order
A trailing stop order is a stop or stop limit order in which the stop price is not a specific price.
Instead, the stop price is either a defined percentage or dollar amount, above or below the current
market price of the security (“trailing stop price”). As the price of the security moves in a
favorable direction the trailing stop price adjusts or “trails” the market price of the security by
the specified amount. However, if the security’s price moves in an unfavorable direction the
trailing stop price remains fixed, and the order will be triggered if the security’s price reaches the
trailing stop price.