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Chapter 1

Understanding Investment

Prepared By
Dr. Mohammad Bayezid Ali
Associate Professor and Adjunct Faculty
School of Business
Independent University, Bangladesh

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Chapter Objectives
1. Defining Basic Concepts of Investment and
Portfolio.
2. Identifying the reasons for investment
3. Types of investment
4. Classifying the types of investors
5. Investment and Portfolio Management Process
6. Investment Vs Speculation
7. Speculation Vs Gamble
8. Types of Market Efficiency
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Investment: Basic Concept
The term ‘Investment’ covers a wide range of
activities. For example:
Advancing money to another for interest.
Purchase of 100 ounce of gold for its price appreciation.
Purchase of a piece of land for commercial use.
Purchase of stocks or bonds for getting dividends or interests respectively
etc.
Purchase of currency swap for protection against exchange rate
fluctuation.
Purchase of Treasury Bill for hedging against inflation risk.
Purchase of mutual funds securities for diversifying the risk.
Purchase of insurance plan for the various benefits it promises etc.
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Investment: Basic Concept cont…
Generally investment may be defined as “ a commitment of
funds made in the expectation of some positive rate of return”.
In the financial sense, ‘investment’ is the commitment of a
person’s funds to derive future income in the form of interest,
dividend, premiums, pension benefits or appreciation in the
value of their capital. Purchasing of shares, debentures, post
office savings certificates, insurance policies etc. are all
investment in the financial sense.
More specifically, investment is an attempt to carefully plan,
evaluate and allocate funds to various investment outlets which
offers safety of principal and moderate and continuous return
over a long period of time.
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Reasons for investments:
An individual used to make investment for a variety of reasons.
These are:
1. To Generate Income: People make investment to have
future generation of income in the form of interest from
fixed income securities and/or dividends from variable
income securities.
2. Capital Preservation: People make investment in order to
preserve capital. Investors invest their funds in assets with
the assurance that funds will be available, with possibly no
risk of loss in purchasing power at a future point in time. As
the investors desire the real value of funds invested, the
nominal value must increase at a pace consistent with the
trend of inflation. These types of investment in called
conservative investment.
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Reasons for investments: Cont..
3. Capital Gain: People also make investments so that the
funds will appreciate or grow in value. The objective of such
investment is to increase money at a faster rate than
inflation. Investment with the motive of capital gains should
have risk exposure to get the desired returns. Risk can affect
returns either positively or negatively.
4. To Achieve Financial Efficiency: As future is always uncertain
and investors used to make investment for future earnings,
so every investment decision tries to seek financial
efficiency. Here, financial efficiency implies the ability of the
investors to raise funds from the least costly sources and use
the same funds in any investment projects which offers
maximum return.
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Types of Investment
Broadly investment may be two types:
1. Real Investment: The material wealth of a society is
ultimately determined by the productive capacity of
its economy, i.e. the goods and services its member
can produce. This capacity is a function of real
investment of the economy: investment in land,
buildings, machinery, and knowledge that can be used
to produce goods and services. More specifically, the
resources that can be used to produce goods and
services are real investment.

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Types of Investment cont..
2. Financial Investment: Financial investment
are the means by which individuals hold
their claims on real investment. Investment
in stock, bonds, savings certificate,
insurance plans are different forms of
financial investment.
While real investment generate income to the
economy, financial investment simply define the
allocation of these income or wealth among investors.
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Types of Investors:
Investors may be of three different types:
1. Individual Investors: Individual investors are those who
deploy their funds individually in local market to purchase
different types of securities or deposit their fund into bank
account or to purchase insurance policies. Following are
some general characteristics of individual investors:
 They are large in numbers.
 Their investable resources are few.
 They generally lack the skill to carry out extensive evaluation and
analysis before investing.
 Moreover, they do not have the time and resources to engage in
such analysis. 9
Types of Investors Cont..
2. Institutional Investors: Institutional investors are
organizations with surplus funds to engage in investment
activities. They constitute mutual funds, investment
companies, banking and non-banking companies,
insurance corporations etc. Few commonly observed
characteristics of institutional investors are:
 They have large amount of surplus funds
 they are fewer in number
 They can appoint professional fund managers to carry
out extensive analysis and evaluation of different
investment opportunities.
 They have a better chance of maximizing returns and
minimizing risk. 10
Investment Management Process:
Investment management is a process encompassing many
activities aimed at optimizing the investment of one’s
funds. Five phases can be identified in this process:
1. Security Analysis:
 This step consists of examining the risk-return
characteristics of individual securities. A basic strategy in
security investment is to buy under-priced securities and
sell over-priced securities. Security analysis provides a
mean to identify mispriced securities.
 There are two alternative approaches to security
analysis: fundamental analysis and technical analysis.
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Investment and Portfolio Management Process: Cont..
 Fundamental analysis concentrates on the fundamental factors
affecting the company such as EPS, dividend pay-out ratio, market
competition, market share, quality of management etc. According
to this approach, the share price of a company is determined by
these fundamental factors.
 A fundamental analyst determine the true worth or intrinsic value
of a security based on its fundamental; then compare this value
with the current market price. If the current market price is higher
than intrinsic value, the share is said to be over-priced and vice-
versa. The mispricing of securities provides an opportunity to the
investor to gain some price benefit.
 The fundamental analysis helps to identify fundamentally strong
companies whose shares and worthy to be included in the
investor’s portfolio. 12
Investment and Portfolio Management Process: Cont..

 The alternative approach to security analysis is


technical analysis. Here the technical analyst believes
that share price movements are systematic and exhibit
certain consistent patterns. They studies past price
movement to identify trends and patterns. They then
try to predict the future price movements. The current
market price is compared with the future predicted
price to determine the extent of mispricing.
 Technical analysis is an approach which concentrates
on price movements and ignores the fundamentals of
the shares
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Investment and Portfolio Management Process: Cont..
 A more recent approach to security analysis is the efficient
market hypothesis (EMH). According to this school of thought,
financial market is efficient in pricing securities. The efficient
market hypothesis holds that market prices instantaneously and
fully reflect all relevant available information. It means that the
market prices of securities will always equal their intrinsic
values.
 As a result, the fundamental analysis which tries to identify
mispriced securities is said to be futile exercise.
 The EMH also holds that share price movement are random and
not systematic. Consequently, technical analysis which tries to
study price movements and identify pattern in them is of little
use. 14
Investment and Portfolio Management Process: Cont..
2. Portfolio Analysis:
 The term ‘Portfolio’ means a combined investment in
different securities in order to maximize return or to
diversify the risk. Security analysis provides the investor
with a set of desirable securities.
 From this set of desirable securities, an indefinitely
large number of portfolios can be constructed by
choosing different sets of securities and also by varying
the proportion of investment in each security.
 The basic objective of this phase is to identify the
range of possible portfolios that can be constructed
from a given set of desirable securities and calculating
their return and risk for further analysis.
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Investment and Portfolio Management Process: Cont..
3. Portfolio Selection:
 Portfolio analysis provides the input for the next phase
in portfolio management which is portfolio selection.
The goal of portfolio construction is to generate a
portfolio that provides the highest returns at a given
level of risks.
 A portfolio having this characteristic is known as an
efficient portfolio from which the optimal portfolio has
to be selected for investment.
 Harry Markowitz’s portfolio theory provides both the
conceptual framework and the analytical tools for
determining the optimal portfolio in a disciplined and
objective way..
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Investment and Portfolio Management Process: Cont..
4. Portfolio Revision:
 Having constructed the optimal portfolio, the investor has
to constantly monitor the portfolio to ensure that it
continues to be optimal.
 As the economy and financial markets are dynamic,
changes takes place almost every moment. As the time
passes, optimal portfolios may turn into less efficient
portfolio and that’s why investors have to revise their
portfolio in the light of the developments and changes in the
market.
 This revision leads to purchase some new securities and to
sell some of the existing securities from the portfolio. The
mix of securities and their proportion in the portfolio
changes as a result of revision.
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Investment and Portfolio Management Process: Cont..
5. Portfolio Evaluation:
 The objective of constructing a portfolio and revising it
periodically is to earn maximum returns with minimum risk.
Portfolio evaluation is the process which is concerned with
assessing the performance of the portfolio over a selected
period of time in terms of risk and return.
 This involves quantitative measurement of actual return
realized and the risk born by the portfolio over the period of
investment. This evaluation also provides a mechanism for
identifying weakness in the investment process and for
improving these deficient areas. It also provides necessary
feedback for designing a better portfolio next time.
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Investment Vs Speculation:
1. Investment can be defined as the systematic and carefully
planned allocation of funds with the expectation to receive a
positive rate of return. Speculation can be defined as the
deliberate or aggressive commitment of funds in different
project which offer very high rate of return.
2. Investors invest their surplus funds for a relatively long period
of time whereas speculators invest their funds for a relatively
short period of time.
3. Investors seek to generate a satisfactory return from their
investment by taking on an average or below average risk. On
the other hand, speculators seeking to make abnormally high
returns by taking high risk.
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Investment Vs Speculation:
4. The investors give emphasis upon the principal of
conservatism for the safety of their principal. On the
other hand, speculation does not give such emphasis.
5. Investors focus on income (such as dividend or interest)
on the amount invested in taking their investment
decision. Whereas speculators focus on price
appreciation on the amount invested in their speculative
decision.
6. It is possible to get insurance facility for every safe
investment but it is not possible for speculation.

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Gambling
Gambling is fundamentally different from speculation and
investment in the following respect:
Gambling consists in taking high risks not only for high
returns but also for thrill and excitement. Typical examples
of gambling are horse race, card games, lotteries, etc.
Gambling is unplanned and nonscientific, without the
knowledge of the nature of the risk involved. It is
surrounded by uncertainty and is based on tips and rumors.
Gambling does not involve a bet on an economic activity .
In gambling artificial and unnecessary risks are created for
increasing the returns.

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An Example
• Assume that dollar-denominated T-bills in the United
States and pound denominated bills in the United
Kingdom offer equal yields to maturity. Both are short
term assets, and both are free of default risk. Neither
offer investor a risk premium. However, a U.S. investor
who holds U.K. bills is subjected to exchange rate risk.
• Is the U.S. investor engaging in speculation or
gambling?

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Direct Investment Vs Indirect Investment
1. In case of direct investment, investor directly trades
(purchase and sell) securities from the securities market.
Whereas in indirect investment different investment
banks trades securities on behalf of their clients.
2. In direct investment, investors are called active investor
whereas in indirect investment, investors are called
dormant investor.
3. In direct investment, investor enjoy the whole earnings
from their investment. In indirect investment, investor get
the earnings which has been given by investment
companies.
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Direct Investment Vs Indirect Investment
4. Risk level is high in direct investment whereas risk
level is low in indirect investment.
5. Fund management in direct investment is
comparatively less efficient, whereas fund
management is efficient in indirect investment.
6. Scope of investment in less in direct investment
whereas scope of investment is large for indirect
investment.

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Types of Market Efficiency
Allocational Efficiency: A market is said to be
allocationally efficient when it ensures and promotes the
allocation of resources to the highest value uses.
Informationally Efficient: A market in which asset prices
reflect new information quickly and rationally.
Operationally Efficient: A market is said to have
operational efficiency when it has relatively low
transaction costs.

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End of Chapter 1

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