Understanding
Investments
Source: 'Investments; Analysis & Management' 1
9e, by Charles P. Jones
Preliminary Concepts
‘Investment’ is the current commitment of
funds (i.e., money) or other resources to
one or more assets over some future time
period in the expectation of reaping future
benefits.
“Investments” refers to the study of the
investment process.
Source: 'Investments; Analysis & Management' 2
9e, by Charles P. Jones
Preliminary Concepts
According to this definition we can say that
Investment is the process of purchasing
assets with the purpose to store value
(wealth) and also to increase it.
Assets have value because of the future
benefits they offer.
Source: 'Investments; Analysis & Management' 3
9e, by Charles P. Jones
Preliminary Concepts
‘Value’ is what something is worth; the
present value of all future benefits.
‘Valuation’ is the process of determining
the current worth of all its future benefits.
Valuation of some assets is relatively easy
as the determination of benefits
associated to them are (almost) certain,
but is complicated for some other assets.
Source: 'Investments; Analysis & Management' 4
9e, by Charles P. Jones
Preliminary Concepts
Valuation is a subjective process. Mr. A
may consider an asset X undervalued and
will try to acquire it, whereas, on the other
hand Mr. B considers asset X to be
overvalued and will try to sell it.
Source: 'Investments; Analysis & Management' 5
9e, by Charles P. Jones
Preliminary Concepts
‘Financial assets’ are paper or electronic
claims on some issuer (a deficient unit), such
as the government or a company.
‘Real assets’ are tangible assets such as
gold, silver, diamonds, real estate, etc.
Source: 'Investments; Analysis & Management' 6
9e, by Charles P. Jones
Preliminary Concepts
Financial assets also have ‘marketability’
& ‘liquidity’.
‘Marketability’ means the ease of buying or
selling an asset.
‘Liquidity’ means the ability of an asset to
convert to cash without loss of value.
Source: 'Investments; Analysis & Management' 7
9e, by Charles P. Jones
Preliminary Concepts
‘Marketable securities’ are financial assets
easily and cheaply tradable in organized
markets.
NB: Our emphasis in this course will be upon investments made in
marketable securities but the same principles apply to all other
Investments.
Source: 'Investments; Analysis & Management' 8
9e, by Charles P. Jones
Why invest?
Investment increases future consumption
possibilities;
◦ By foregoing consumption today and investing the
savings, investors expect to increase their future
consumption possibilities by increasing their
wealth. This increase in wealth is termed ‘Return’.
Source: 'Investments; Analysis & Management' 9
9e, by Charles P. Jones
Why invest?
Firstly, if we do not invest, we will not earn
anything on cash.
Secondly, the purchasing power of cash
diminishes as a result of inflation.
If savers (surplus units) do not invest their
savings, they will not only lose possible
return on their savings, but will also lose
value of their money due to inflation.
Source: 'Investments; Analysis & Management' 10
9e, by Charles P. Jones
Return
Return may be earned in two ways.
Increase in the value of an asset called
‘capital gain’ (CG)
Flow of money (value) or its equivalent
produced by an asset ‘income’.
Source: 'Investments; Analysis & Management' 11
9e, by Charles P. Jones
Return
The total return therefore is given by
following formula;
TR = Terminal Value – Initial Value
Initial Value
Or
TR = Income + CG
Initial Value
Source: 'Investments; Analysis & Management' 12
9e, by Charles P. Jones
Concerns of an Investor
An investor has to look out for the following;
A. Sacrifice; While investing, investor delay
their current consumption (delaying consumption
is kind of sacrifice)
B. Inflation; Investment loses value in periods
of inflation.
C. Risk; Giving your money to someone else
involves risk.
Source: 'Investments; Analysis & Management' 13
9e, by Charles P. Jones
Compensation for Investors
Due to the three problems, investors will
not invest until compensated.
Rate of Return Required by an Investor =
Compensation (for sacrifice, inflation, risk)
RRR= opportunity cost + risk premium +
inflation premium
NB: There may be other premiums but we will leave this discussion
for later classes.
Source: 'Investments; Analysis & Management' 14
9e, by Charles P. Jones
Return & Risk
The basis of all investment decisions is to
earn return. By investing, investors
expect to earn a return (we will call it
‘expected return’).
Source: 'Investments; Analysis & Management' 15
9e, by Charles P. Jones
Return and Risk
Realized returns (actual return) might be more or
less than the expected return.
The chance that the actual return on an investment
will be different from the expected return is called
risk.
This way T-Bills have no risk as the expected return
and actual return are the same.
But actual returns on common stock have greater
chances of deviating from expected return and
hence have high risk.
Source: 'Investments; Analysis & Management' 16
9e, by Charles P. Jones
Risk-Return Tradeoff
Source: 'Investments; Analysis & Management' 17
9e, by Charles P. Jones
Risk-Return Tradeoff
The line from RFR to point B shows risk-return
combinations.
It shows that at zero level of risk, investor can
earn risk free rate (RFR) which is equal to the rate
on T-bills.
To earn a little higher return than the risk free rate,
investors can invest in corporate bonds, but the
investors will have to take some risk as well.
Source: 'Investments; Analysis & Management' 18
9e, by Charles P. Jones
Ex-Ante and Ex-Post Risk-Return
To earn even higher return than on corporate
bonds, investor can invest in common stocks,
but the risk is also high.
The risk return trade-off depicted in the graph
in ex-ante i.e. before the fact or before the
investment is made.
Ex post (after fact or actual) trade-off may be
positive, flat or even negative.
Source: 'Investments; Analysis & Management' 19
9e, by Charles P. Jones
The Investment Process
An investor will be looking to invest in
several marketable securities and thus
he/she will be concerned with the returns
from all investments.
All the assets of one investor taking as
one unit is termed his/her ‘Portfolio’.
Source: 'Investments; Analysis & Management' 20
9e, by Charles P. Jones
The Investment Process
The investment process describes how an
investor should go about making decisions
with regard to;
What marketable securities to invest in,
How extensive the investments should be,
When the investment should be made.
Source: 'Investments; Analysis & Management' 21
9e, by Charles P. Jones
The Investment Process
The following five steps will form the basis
for investment process;
Set Investment Policy
Perform Security Analysis
Construct a Portfolio
Revise the Portfolio
Evaluate the Performance of Portfolio
Source: 'Investments; Analysis & Management' 22
9e, by Charles P. Jones
The Investment Process
‘Investment Policy’
Determines the investor’s objectives, the
amount of invest-able wealth, and tax-status
of the investor.
Objectives must be stated in terms of both
Risk & Return.
Concludes with identification of potential
categories of assets for inclusion in portfolio.
Source: 'Investments; Analysis & Management' 23
9e, by Charles P. Jones
The Investment Process
‘Security Analysis’
With broad categories of assets being
identified previously, individual securities are
examined/analyzed with the purpose to
outline the ‘under-priced’.
Source: 'Investments; Analysis & Management' 24
9e, by Charles P. Jones
The Investment Process
Portfolio Construction
Picking individual securities in which to
invest, as well as deciding upon the
proportion of invest-able wealth to be
allocated to each one.
Issues of selectivity (micro forecasting),
timing ( macro forecasting), and diversification
(to minimize risks) are addressed.
Source: 'Investments; Analysis & Management' 25
9e, by Charles P. Jones
The Investment Process
Portfolio Revision
Repeating the first 3 steps as a result of;
Revision in the investment objectives of investor,
Changes in prices of securities.
This step will also depend upon;
Transaction costs associated with revision,
Perceived improvement in the performance of
portfolio due to revision.
Source: 'Investments; Analysis & Management' 26
9e, by Charles P. Jones
The Investment Process
Portfolio Performance Evaluation
Determining periodically how the portfolio
performed.
Performance may be judged relatively or
absolutely.
Source: 'Investments; Analysis & Management' 27
9e, by Charles P. Jones
