Investment Decision & Portfolio management


Course Title: Investment
Decisions & Portfolio
Management
 Curse Code : AcFn
 Credit Hr: 2

 Instructor: Nigusu T.
E-mail: [email protected]
Chapter One: The Investment Environment

Chapter outlines:
1.1 Definition of Investment
1.2 Investment alternatives
1.3 Investment objectives
1.4 The Investment process
1.5 Clients of the financial system
1.6 Ongoing trends
1.1 Definition of Investment

 Why do individual/institutions
invest &
 What do you understand by

Investment
 Where does the resource for

investmement comes from?

?
 1.1 Definition of Investment

 Investment is commitment of fund to one or more

assets that is held over for some future time period
with the expectation of future benefits/returns.
 Investment is defined as a sacrifice made
now to obtain a return later. It is current
consumption that is sacrificed
 Funds to be invested may come from assets
already owned, borrowed money, savings or
foregone consumptions.
 By forgoing consumption today and investing the
savings, investors expect to enhance their future
consumption possibilities by increasing their
wealth.
1.1 Definition of Investment

 Investment is a sacrifice of current money or

other resources for future benefits.
 Investment is the employment of funds on assets
with the aim of earning or capital appreciation.
 Investment can be made to
intangible assets like marketable
securities or to real assets like gold,
real estate etc.
 However, more generally investment

refers to investment in financial

assets (indirect investment)
 1.2 INVESTMENT ALTERNATIVES
(Financial assets Vs Real Assets)

Though there are a range of investment

alternatives, they can be classified into
two broad categories:
1. Financial Investments (Financial Assets)
2. Real Investments (Real Assets)
 Financial investment is the purchase of a "paper"
contract
 Financial assets: These are pieces of
paper (or electronic) evidencing claim on
some issuer.
1.2 Investment Alternatives

 Financial assets are paper (or electronic) claims

on some issuer such as the government bonds,
Corporate bonds, stocks, commercial papers e.t.c
 The important financial assets are equity shares,
corporate bonds, government securities, deposit
with banks, mutual fund shares, insurance
policies, and derivative instruments and the like
1.2 Investment Alternatives

 Real assets are represented by tangible assets like

residential house, commercial property, agricultural
farm, gold, precious stones, and art objects.
 As the economy advances, the relative importance
of financial assets tends to increase.
 The two forms of investments are complementary
& not competitive.
 Financial investment can provide finance for real
investment decisions
 Financial investment can guide real investment
decisions.
 The share issue of a firm finances the purchase of capital
 The commitment to a mortgage finances the purchase of
property
1.3 Investment objectives

 What are the objectives of

Investment?
1.3 investment objectives


 The main investment objectives are increasing
the rate of return and reducing risk.
 Other objectives like safety, liquidity and hedge

against inflation can be considered as

subsidiary objectives.
1. Return: investors always expect a good
rate of return from their investments.
 Rate of return could be defined as the total

income the investor receives during the holding

period stated as a percentage of the purchasing
price at the beginning of the holding period.
 The total income could be in the form of annual

income(current yield) and capital appreciation

(capital yield).
1.3 investment objectives

2. Risk: is the probability of actual return becoming less

than the expected return
 It refers to the chance that expected return may not be

achieved in reality
 Sources of Risk:

 Business risk
 Financial risk
 Liquidity risk
 Interest rate risk
 Exchange rate risk
 Market risk
 Inflation risk
 Country risk (political risk)
1.3 investment objectives

 Business risk: Uncertainty of income

flows caused by the nature of a firm’s
business. Sales volatility and operating
leverage determine the level of business
risk.
 Interest rate risk is the risk that arises for bond
owners from fluctuating interest rates. How
much interest rate risk a bond has depends on how
sensitive its price is to interest rate changes in the
market.
 1.3 investment objectives

 Liquidity risk arises due to the uncertainty

introduced by the secondary market for an
investment.
 How long will it take to convert an investment into
cash?
 How certain is the price that will be received?
 Exchange rate risk arises due to the uncertainty
introduced by acquiring securities denominated in
a currency different from that of the investor.
 Changes in exchange rates affect the investors
return when converting an investment back into
the “home” currency.
 1.3 investment objectives

 Market risk is the risk that the value of an investment

will decrease due to moves in market factors. Volatility
frequently refers to the standard deviation of the change in
value of a financial instrument with a specific time horizon
 Inflation risk, also called purchasing power risk, is the
chance that the cash flows from an investment won't be worth
as much in the future because of changes in purchasing power
due to inflation.
 Country risk (also called political risk) refers to the
uncertainty of returns caused by the possibility of a major
change in the political or economic environment in a country.
Individuals who invest in countries that have unstable political-
economic systems must include a country risk-premium when
determining their required rate of return
1.4 The Investment 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
five steps:
1. Framing investment policy/objectives
2. Investment analysis
3. Investment Valuation
4. Portfolio construction
5. Portfolio evaluation
1. Framing Investment Policy

 The investors before proceeding into investment, they

should formulate the policy for the systematic
functioning (as an individual or institutional investor)
 Investment policy basically includes setting up
investment objectives.
 the essential ingredients of the policy are related with
1. The investible funds (source and amount of funds)
2. Investment objectives
3. knowledge of investment alternatives and market
(choice of an asset)
1. Investment Policy

1. Investible funds: the fund may be generated

through savings or from borrowings. If the funds are
borrowed, the investor has to be very much careful in
the selection of investment alternatives. The return
should be higher than the interest expense charged on
borrowings.
2. Objectives: Investment objectives should be stated
in terms of both risk and return. The objectives are
framed on the premises of the :
 Required rate of return (For example, the investment
policy may define that the target of the investment
average return should be 15 % and should avoid more
than 10 % losses)
 Need for regularity of income (the nature of the
instrument matters)
 1. Investment Policy

3. Knowledge:
 The investment alternatives range from

security to real estate.

 The risk and return, advantage and

disadvantage associated with investment

alternatives differ each other.
 Investment in equity is high yielding but has

more risk than fixed income securities.

 Knowledge of stock market structure,

function and cost is also very important.

2. Investment(Security)
Analysis
 This step involves examining several relevant types of
investment vehicles and the individual vehicles inside
these groups.
 For example, if the common stock was identified as
investment vehicle relevant for investor, the analysis will
be concentrated to the common stock as an investment.
 The purpose of such analysis and evaluation is to identify
those investment vehicles that currently appear to be
mispriced (under or overpriced)
 There are many different approaches how to make such
analysis. Most frequently two forms of analysis are used:
Technical analysis and Fundamental analysis.
2. Investment(Security)
Analysis
Technical analysis

Involves the examination of past prices for
trends.
 Involves the analysis of past 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.
 2. Investment(Security)
Analysis
 Fundamental analysis:
 Involves analysis of true value based on
future expected returns.
 In its simplest form it focuses on the evaluation
of intrinsic value of the financial asset.
 This valuation is based on the assumption that
intrinsic value is the present value of future flows
from particular investment.
 By comparison of the intrinsic value and market
value of the financial assets those which are
under priced or overpriced can be identified.
 2. Investment(Security)
Analysis
 The securities to be bought have to be
scrutinized through market, industry and
company analysis.
1. Market Analysis: the stock market mirrors the
general economic scenario.
 The growth in GDP and Inflation are reflected in the
stock prices.
 The recession in the economy results in a bear market.

 The stock markets may be fluctuating in the short run

but in the long run they may move in trends.
 The investor can fix entry and exit points through
security analysis.
2. Investment(Security)
Analysis
2. Industry analysis: the industries that
contribute to the output of the major
segments of the economy vary in their
growth rate and their overall contribution to
the economic activity.
 Some industries grow faster than GDP and
are expected to continue in their growth.
 The economic significance and the growth
potential of the industry have to be
analyzed.
2. Investment(Security)
Analysis
3. Company analysis: the purpose of
company analysis is to help the investors to
make better decisions.
 The company’s earnings, profitability,
operating efficiency, capital structure and
management have to be screened.
 These factors have direct bearing on the stock
prices and on the return of the investors.
 Appreciation of the stock value is a function of
the performance of the company.
3. Investment valuation
 The valuation helps the investor to
determine the return and risk expected
from an investment.
 The intrinsic value of the share is
measured through the book value of the
share and price earning ratio, or some
discounting techniques.
 The real worth of the shares is compared
with the market price and then the
investment decisions are made.
4. Portfolio construction
 Portfolio is a combination of securities.
 The portfolio is constructed in such a manner
to meet the investor’s goals and objectives.
 The investor should decide how best to reach
the goals with the securities available.
 The investor tries to attain maximum return
with minimum risk.
 Towards this end one need to diversifies his
portfolio and allocates funds on selected
securities among the securities.
4. Portfolio construction
1. Diversification: In any investment the main objective
of diversification is the reduction of the risk.
 A diversified portfolio is comparatively less risky than

holding a single portfolio (this goes with the saying

of “don’t put all yr eggs in one basket” or “ don’t
put all your money in one pocket”)
 There are several ways to diversify the portfolio.

A. Debt and equity diversification:

 Debt(assured return but limited capital appreciation);
 Equity securities( provide income and capital gain but with
the flavor of uncertainty.
 The investor needs to decide on the mix of the capital
structure
4. Portfolio construction
B. Industry Diversification: industries’
growth and their reaction to government policies
differ from each other.
• Banking industry shares may provide regular
returns but with limited capital appreciation.
C. Company diversification: securities from
different companies are purchased to reduce risk.
 Based on the diversification level, industry and
company analysis the securities have to be
selected.
 funds are allocated for the selected companies.
5. Portfolio evaluation
 The portfolio has to be managed
efficiently.
 This is the last step in investment
management process
 It involves determining periodically how
the portfolio performed, in terms of not
only the return earned, but also the
risk of the portfolio.
 For evaluation of portfolio performance
appropriate measures of return and risk
and benchmarks are needed.
 5. Portfolio evaluation
 A benchmark is the performance of
predetermined set of assets, obtained for
comparison purposes. The benchmark
may be a popular index of appropriate
assets – stock index, bond index.
 The benchmarks are widely used by
institutional investors for evaluating the
performance of their portfolios.
 The efficient management calls for
evaluation of the portfolio.
 5. Portfolio
evaluation
This process consists of portfolio appraisal and
revision.
A). Appraisal: the return and risk performance of
the security vary from time to time.
the variability in returns of the securities is
measured and compared.
the developments in the economy, industry
and relevant companies from which the stocks
are bought have to be appraised.
the appraisal warns the loss and steps can be
taken to avoid such losses.
 5. Portfolio evaluation
B) Revision:
 Revision depends on the results of the

appraisal.
the low yielding securities with high risk
are replaced with high yielding securities
with low risk factor.
 To keep the return at a particular level

necessitates the investor to revise the

components of the portfolio periodically.
1.6 Clients of the Financial
System
 The major clients that place demands on the
financial system could be categorized into :
1. the household sector
2. the business sector
3. the government sector
1. The Household sector
households constantly make economic decisions
concerning activities such as saving versus
consumption.. Essentially, we need to analyze
what types of financial assets house holds desire
to hold.
1.6 Clients of the Financial
System
 Most households are potentially
interested in a wide array of assets, and
the assets that are attractive can vary
considerably depending on the
household’s economic condition, taxes
and risk preferences. There are financial
assets that less or totally tax exempted.
 Thus, the different demand of
households for various types of
investment vehicles is a driving force
behind financial innovation.
1.6 Clients of the Financial
System
2. The Business Sector:
 whereas household financial decisions are

primarily concerned with how to invest

money, businesses typically need to raise
money to finance their investments in real
assets: plant, equipment, technological
knowhow, and so forth.
 business can raise money using by

borrowing either from banks or directly from

households by issuing bonds or stocks.
1.6 Clients of the Financial
System
3. The government sector
 like business, government often need to finance their

expenditures by borrowing (issuing T-bills and T-bonds)

 Unlike businesses, governments cannot sell equity

securities; they are restricted to borrowing to raise funds

when tax revenues are not sufficient to cover
expenditures.
 they also can print money, of course, but this source of

funds is limited by its inflationary implications.

 Government have a special advantage in borrowing

money because their taxing power makes them very

creditworthy and, therefore, able to borrow at the lowest
cost rates and the default risk is perceived to be zero.
1.6 Clients of the Financial System

 When enough clients demand a service

and are willing to pay for it, it is likely
that the system needs to develop the
new product/service and charge for
that service.
 Assessment of unfulfilled demand (gap) is a
mechanism that leads to the diversity of
financial intermediation, investment
banking, financial innovation and derivatives
financial instruments, financial institutions
and markets.
1.6 Clients of the Financial
System
Financial Intermediation
 In most cases the financial problem of
households is how best to invest their funds.
 Direct investment in businesses by households
is naturally difficult.
 Thus, financial intermediaries like mutual funds,
banks, investment companies, insurance
companies or credit unions evolve to bring the
two sectors together.
1.6 Clients of the Financial
System
 financial intermediaries are distinguished from
other businesses in that both their assets and
liabilities are overwhelmingly financial.
 Intermediaries are middlemen, simply moving
funds from one sector to another, that is, they
mobilize household(small savers/investors)
savings to lend it to the business sector for
investment. i.e, they channel household
savings to the business sector. This process
is called intermediation or transfer
process.
1.6 Clients of the Financial
System
Advantages of intermediaries
1. They are able to mobilize more savings from
households
2. They are able to lend considerable sums to
large borrowers.
3. By lending to many borrowers, intermediaries
achieve significant diversification(can accept
loans that individually might be risky).
4. Build expertise through the volume of business
they do.
1.6 Clients of the Financial
System
Investment Banking/underwriters
 they pool together and manage the money of

many investors.
 many investment companies offer mutual funds

which are profitable to the small investors which

otherwise is difficult to achieve by their own.
 just as economies of scale and specialization

create profit opportunities for financial

intermediaries, so too do these economies
create niches for firms that perform
specialized services of business.
1.6 Clients of the Financial
System
 Usually, firms raise much of their capital by selling
securities such as stocks and bonds to the public.
 firms do not do these activities frequently.
 thus, it is good to get such services from
investment banking firms that specialize in such
activities which can able to offer such services at a
cost below that of running an in-house security
issuance division.
 Investment bankers advise the issuing firm the
securities issued, market conditions, appropriate
interest rates, and so forth.
 Underwrite the security for issuers.
1.6 Clients of the Financial
System
Financial Innovation and Derivatives
 The investment diversity desired by households is far

greater than most financial institutions have to satisfy.

 Most firms find it simpler to issue “plain” securities,

leaving exotic variants to others who specialize in

financial markets.
 This, of course, create a profit opportunity for

innovative security design and repackaging that

investment bankers are only too happy to fill it.
 As the investment banking industry becomes ever

sophisticated, security creation and customization

become more prevalent.
End of Chapter-one