Investment by Charles P Jones: Chapter No. 1

Investment: Analysis and Management

By Charles P. Jones

Chapter 1: Understanding Investments

Q 1-1: Define the term investments?

An investment can be defined as the commitment of funds to one or more assets that would be held over some future time period. Investment involves management of investor’s wealth, which is the sum of initially invested amount, current income and present value of all future incomes. Investments can be made both in financial and real assets and both marketable and non-marketable securities.

Q 1-2: Describe the broad two-step process involved in making investment decisions?

Investors can choose from among a wide range of securities in pursuit of their expected returns. Traditionally, investors have analyzed and managed securities using a broad two-step process.

1)      Security analysis

2)      Portfolio management

1)      Security analysis: the first part of the investment decision process involves the valuation and analysis of individual securities. It is necessary to understand the characteristics of various securities and the factors that affect these characteristics. A valuation model is applied to these securities to estimate their price or value. Value is the function of expected return on the security and the risk involved. While conducting valuation process for common stocks, the investors have to deal with the assessment of overall economic condition of the country where the stocks are traded, the industry to which a particular stock belongs and the financial position of the individual company which issued the stock.

2)      Portfolio management: After securities have been evaluated, it becomes easy for an investor to select a portfolio of his choice. A portfolio is a collection of different assets, in which an investor invests his wealth. But buying different stocks is not the end of the story. An investor needs to know when and how to revise or improve the portfolio, while maintaining his risk and return preferences. Portfolio must be managed whether an investor opts for active or passive investment strategy in the market. A passive investment str tegy involves determining the desired investment proportions and assets, making a few occasional changes to portfolio proportion and type of assets. An active investment strategy involves specific investment decisions on a regular basis to change the investment proportion chosen, or the assets in a particular category, based on the belief that it will be profitable to do so. The decision of opting for an active or a passive strategy depends on how efficient the market is. The concept of efficient market will be detailed later.

Q 1-3: Is the study of investments really important to most individuals?

The study of investment is concerned with the economic wellbeing of the people. Every individual has to invest his money in some way so that his wealth may not lose its value. Due to the inflationary trends the economic wealth of the individuals is bound to decline if it is not invested to yield a profit that should at least compensate for the loss in value as a result of inflation.

In the past couple of decades, the retirement benefit fund and pension funds have been invested at an increasing rate in the financial markets through investment companies, which is a form of indirect investing. The working individuals can plan their pension income by investing in the financial markets through investment companies.

The investment activity can range from a simple opening of a Savings Account in a bank, to the more complicated ways of investing in derivative securities. A wide range of other choices of investing in different assets carries various return and risk levels. The investors who are directly investing in the financial markets should have an understanding of investment concepts so that they may be able to devise a strategy to meet their investment objectives. Even those who do not want to invest directly should be familiar with the investment concepts so that they may not lose their wealth by giving it in wrong hands.

The study of investment also enhances the career opportunities for an individual, which can be rewarding both professionally and financially, in investment banking, security trading, security analysis, portfolio management, stockbrokers or financial planners.

Q 1-4: Distinguish between a financial and a real asset?

Real assets are tangible assets which are priced on the basis of their physical characteristics such as gold, silver, cotton or real estate.

In contrast, financial assets are paper, or electronic claims on some issuer, like federal government or corporations. Obviously, these claims do not have any physical characteristics and are priced on the basis of the expected future benefit derived from them. These include certificates of deposits, bonds, shares, treasury bills, and other marketable or non-marketable securities.

Q 1-5: Describe the return and risk trade-off faced by all investors?

Investors wish to earn return on the money that they invest. They must realize that cash has an opportunity cost. By keeping cash idle, one forgoes the opportunity to earn a return. However, while investing, it is important to distinguish between an expected and a realized return. Expected return is the return expected from making an investment, while the realized return is the actual return that the investor would get in the future as a result of investing. The difference between expected and realized return is primarily due to risk. Risk is the chance that the actual return would be different from the expected return. In real life, the actual returns can be lower or higher than the expectations of the investors.

Rational investors are risk averse. A risk-averse investor is the one who will not assume risk unless he expects adequate compensation for assuming risk. However, it is not irrational to assume risk, even large risks, as long as compensation for taking up that risk is expected. Investors cannot reasonably expect to earn larger returns without assuming larger risks.

An investor can take any position on an expected risk-return spectrum. The expected return should be large enough to compensate for taking up additional risks. However, there is no guarantee that the expected additional returns would actually be realized. Although all rational investors prefer high returns and avoid high risks, they should not expect to earn a high return without assuming high level of risk. By avoiding risk, what they get is a mere nominal return on their investment

Q 1-7: “A risk-averse investor will not assume risk”. Do you agree or disagree with the statement?

A risk-averse investor is the one who avoids risk, but that does not mean that he would not take risk at all. In fact, if an adequate return is offered to compensate for the risk assumed, an investor would be willing to assume risk. So one can only partially agree with the statement—a risk-averse will not assume risk unless he is inadequately compensated for it. If there is no compensation, he will not assume risk.

Q 1-8: Summarize the basic nature of investment decision in one sentence.

Underlying the investment decision is the trade-off between expected return and risk.

Q 1-9: Distinguish between the expected return and the realized return?

Expected return is the return expected by the investors over some future holding period. Realized return is the actual return earned on an investment.

Q 1-10: Define risk. How many specific types can you think of?

Risk is the chance that the actual return on investment will be different from its expected return. There are two broad categories of risk.

1.                  Systematic risk

2.                  Non-systematic risk

Q 1-11: What other constraints besides risk do investors face?

Risk is the primary constraint that holds back the investors from maximizing returns. However, investors face numerous other constraints, as they make their investment decisions. Investors, when analyzing securities, have to conduct thorough analysis to value the security. They need to know the characteristics of the security, the financial position of the company which has issued the security, the conditions of the sector to which the company belongs and also the overall economic conditions. Without conducting such an analysis, the investor would only be dependent on the personal hunches, suggestions from friends and recommendations from brokers—all of them can prove to be lethal to the financial health of the investor.

Investors also need to consider whether the market is efficient or not so that they may strategize accordingly. They need to know how well their portfolios are performing. Although the evaluation tools to measure portfolio performance are inexact, but they do provide us enough information to make a decision about portfolio management.

Q 1-12: Are all rational investors risk-averse? Do they have the same degree of risk aversion?

Rational investors prefer certainty to uncertainty. Risk is an outcome of uncertainty and rational investors avoid assuming risk. On the other hand, assuming high risk can also result in high rewards. Since a risk-averse investor is the one who does not wish to assume risk unless he is compensated by an adequate return, we can say that all rational investors are risk averse.

However, not all the risk-averse investors have the same priorities while choosing risk-free or risky assets in the portfolio. A risk-averse investor may try to minimize his risk for as given level of return, while another risk-averse investor may attempt to maximize his return for a given level of risk, so the approach towards risk and return as well as the risk return preferences for both the investors may not be the same.

Moreover, the amount of invested funds and the psychological disposition of the investor may also influence the level of risk he would like to assume for a given level of return. Since the economic concept of diminishing marginal utility fits as well to money, the more units of money one has, the less one cares about having additional units.

Q 1-13: What is meant by an investor’s risk tolerance? What role does this concept play in investor decision making?

While making investment decisions, investors usually set for themselves the burden of risk that they are willing to take. In other words, they decide about the amount of risk that they are willing to tolerate. Investors do not minimize their risk since minimizing risk could result in additional costs, which in effect would decrease their returns. Investors therefore decide about the amount of risk that the investors will be willing to take. For that level of risk that they are willing to tolerate, the investors maximize their return.

Q 1-14: What external factors affect the decision process? Which do you think is the most important?

There are certain external factors in the financial environment, which have affected the decision process of all investors.

Uncertainty

The first and the paramount factor that every investor comes into grips with is uncertainty. Investors buy various financial assets and expect return on their investment, which may or may not be realized. At best estimates can be imprecise; at worst they can be completely wrong. It is because no matter how informed and careful investors may be, they are liable to make mistakes since the future ahead is uncertain. Investors use the past data to estimate expected returns and risks. They frequently modify the data to incorporate what they believe is likely to happen. It is important to understand that investment decisions based on past data can lead to errors. To ensure success an investor needs to think in terms of a forecast of what they believe is likely to happen. Although the future is uncertain, it is manageable and a thorough understanding of the basic principles of investment will allow investors to intelligently cope with uncertainty.

Global Environment

Investing can be thought of in a global context now. Although foreign investment was made possible some years ago, most of the investors did not have the opportunity of investing globally. by investing around the world and around the clock, the investors cannot only increase their returns but also reduce the risks by diversifying their portfolio across markets all over the world.

Old Economy vs. New Economy

The third factor is the changing investment environment. The tools and techniques that were applicable to the old economic system do not deem fit to the new economic system. In the new economic conditions, the priorities of the investors have changed. Profit-hunt is replaced by growth expectations and high prices of some securities these days may not be for immediate returns, but for the expectations of growth of the company. For instance, share of Amazon.com is being traded at $500 plus, although the company has not declared dividends as yet.

Development in Information Technology

The fourth factor is the development in information technology. The modern information technology has brought about a revolution in the financial sector. The investors of today are more informed and the markets witness cu-throat buying and selling everyday. This increased information has also helped the financial markets to grow as rapidly as Jack’s beanstalks!

Institutional investors

Another important factor is the increasing role of institutional investors in financial markets, Usually, the institutional investors, consisting of mutual funds, investment banks and companies, etc., trade in bulk quantities and influence the market. They also have a better access to information since they have infrastructure to conduct extensive research. These institutions have a dual relationship with the individual investors. On one hand, individual investors who opt for indirect investing are beneficiaries of actions of individual investors; on the other, the individual investors are competing with institutional investors in attempting to do well financially by buying and selling securities.

Q 1-15: What are institutional investors? How are individual investors likely to be affected by institutional investors?

Institutional investors include pension funds, investment companies, investment banks and all such organizations, which manage large portfolio of securities through public funds. Individuals are indirect beneficiaries of institutional investor actions, because they own, or benefit from these institutions’ portfolio. On a daily basis, they are also competing with these institutions in the sense that both are managing portfolios of securities and are attempting to do well financially.

Institutional investors are treated differently from individual investors because some companies disclose important information selectively to some institutional investors. The institutional investors can trade in the ‘after-market’ (negotiated trade conducted electronically among institutions), following exchange closing. Despite these advantages an individual investor can earn a fair return from his investment by his skills, insight and luck.

Individual investors can exploit a ‘spin-off’, which is a division of a company that is turned into a separate publicly held company. The institutional investor, on the other hand, would not prefer to invest in spin offs or in newly established companies, unless the institution is underwriting the issue. Institutional investors are advised to defer purchases of spin-offs until they have been trading for a few weeks since the institutional buying and selling in the early weeks can bring high volatility to the price of the new spin-off company stock.

Q 1-16: Why should the required rate of return be different for a corporate bond and a Treasury bond?

Corporate bonds are issued by corporations, which issue bonds in a bid to raise funds for expansion purpose. These bonds are considered to be risky owing to the chances of default by the corporation. Treasury bonds are issued by US Government Treasury Department, and despite their long maturities, they are considered less risky as US government default is less probable. Due to the higher risk involved in corporate bonds, the return has to be high accordingly.

Q 1-18: Discuss some reasons why investors should be concerned with the international investing? Do you think that the exchange rate value of dollar will have nay effect on the decision to invest internationally?

A global marketplace of round-the-clock investing opportunities is emerging. Investors’ concern with the international market owes to the fact that the revenue base of the multi-national companies could be abroad and they would need to know how well these companies are performing in their homeland and other exchanges. Investors should be aware of the capital flows from abroad into domestic financial markets. These investments from abroad can significantly influence the market performance. Another reason can be the high rates of return by some market abroad. Adding foreign securities allows the investor to achieve beneficial risk reduction through diversification of portfolio.

Q 1-19: What is meant by the distinction between the old economy and the new economy?

New challenges are facing investors as a result of changes in the economic environment. In the past, there was a one large financial market, with securities ranging from trading minnows to corporate mammoths, from shaky companies to stable and successful ones, from local to multinational firms. However, the changing economic investment environment, the old rules and analysis procedures do not deem fit to the new system. Old economy refers to the traditional ‘smokestack’ companies and traditional services, consumer and financial companies. They produce goods and services, sell them, show a profit and reward their stockholders fairly consistently. These companies may have a lengthy history of success, but they are not exciting for the investors in the present economic order.

On the other hand, the new technology related stocks have produced nothing but losses in the beginning, however, a firm like Amazon.com which had not been earning any profits compelled the investors to pay as much as $500 for its scrip. Despite the new trends, a sharp decline in the prices of technology shares makes one believe that the old valuation model is still relevant and useful to the investors.