CHAPTER 1_Introduction to Investment

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Introduction to Investment

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� Investment can be viewed as sacrificeof present consumption in expectation

for a handsome return to be reaped inthe future.

� Definition : foregoing the presentconsumption in expectation of having a

greater consumption opportunities inthe future.



� Definition : claims that organizations sell in order to

finance their financial needs, usually evidenced by legal

documents.� Example:???

� Advantage: the existence of an efficient market resulting

high liquidity (easy to buy and sell).

� Disadvantage: need to have a full understanding on how

the markets works and must go through broker or remiser

in order to get access into market.



� Defi iti : t i l ass ts/ si al capitals t at generate

income.

� ample:

� dvantage: owning a real asset t at has both investment and

aesthetic val e.

� Disadvantage: lack of the existence of an efficient market to

sell real assets on short notice. Involve paperwork, middlemanand commission to be paid.



ISSUES INVESTOR SPECULATOR GAMBLER

Definition

Process of committing funds

into one or moreassets to obtain

return

Process of committing funds

into one or moreassets and betting

to obtain return

Betting on certainoutcome that

depends on luck

PurposeWay to earn anincome

Income andentertainment

More onentertainment




Time horizonLong run (at leastone year)

Short-termoriented (only a

few days, weeks ormonths)

Very short-timeperiod

Investmentdecision

Make a carefulanalysis

Based on rumors,intuitions or

simple market

analysis

Depend on luck

Risk assume

Low to moderaterisk, therefore low

and moderatereturn

Moderate to highrisk-moderate to

high return

High risk, highreturn




Incomeexpectation

Moderate capitalappreciation

Rapid capitalappreciation

Rapid capitalappreciation

Sources of funds

Prefer use own

money rather thanborrowing fundsthrough financial

institutions

Uses own moneyto buy securities

and sometimesborrows money

from moneybroker or financial

institutions

Usually borrows

money frommoney broker orfinancial

institutions



RISK RISK RETURN RETURN TIME TIME

INVESTMENT INVESTMENT Substantial /Substantial /

LowLowSubstantial /Substantial /

LowLowMedium /Medium /

LongLong

SPECULATION SPECULATION Substantial /Substantial /HighHigh

Substantial /Substantial /HighHigh

Short /Short /MediumMedium

GAMBLING GAMBLING HighHigh HighHigh ShortShort

SAVINGS SAVINGS LowLow LowLow Short/MediumShort/Medium

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� Mainly determined by the investors· personal characteristics such

as age, sex, health, family responsibilities and past experiences.

�

T hese

factors

will

affect

the

investors·

willingness

to

assume

risk.

� Investors invest in any kind of investment program fro two main

goal:

1. Personal goal

2. Financial goal



3 . Res rv r r y: all indiv idual s hould hav s kind of

s av ings r r s rv und to meet any unexpected needs in the

futur .

4. Childr ·s ducation: hildr ·s ducation is tting mor and

mor xpens iv wadays . Inv s tment pr r ams pr v ide the

oppor tunities to s av y r the childr ·s ducation.

5. Pr v iding for r tir t: to pr par r a comfor tabler tir t and to ens ur that we hav s ufficient funds to pay

any dical expenditur s and to liv r tably dur ing

r tir t per iod.



1. Safety ri i l: mai t i i g t he ori gi l val ue of t he

i vest ment d pr t ti g t he pur hasi g power t he funds.

Invest ment r gr m shoul d be r dily mar ket bl d has pri st bility .

2. Assur i me and fi i l i dependence: i vest r s will

have a st bility i me, exampl , i t r st d di vi dend.



3 . Pr t ti i st i l ti : i l ti will r duce a pur hasi

power . T he val ue of money is decr si s ti me goes .

4. Liq ui dit y of port li s: meas ur d by how eas y can s uriti s be

convert d i t s h wit hout l si its pri i pal .

5. P rt li di versi i ti : ¶don·t put your s i bas ket ·. If

port li is pr perl y di versi i d, t he ris k i vol ved can be

s uffi i tl y r duced.



I v st tlicy

I v st talysis

al ati f c riti s

rtf listr cti

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(i) Personal objectives

- insurance protection

- providing a home

- liquidity reserves/reserve for emergency

- large needs before retirement/childrens education

- providing for retirement

(ii) Financial objectives

- safety of principal

- assurance of income

- protection against inflation

- liquidity of portfolios

- portfolio diversification

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� Involves comparing the type of industry and

the kind of security whether fixed or variable.

� To understand the future share price

behavior, the expected return and riskinvolved.

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� Determine the value of the securities base on the presentvalue of future stream of income.

�

Compared to the current market price to determine theattractiveness of the security.

� If value of security is underprice should be bought, helduntil price is right for reselling.

� If value of securities is overprice should be sold.

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� A group of investment with different patterns

of returns over time.

� Requires knowledge about personal and

financial objectives should considering thetiming, selection of investment and allocation

of savings to different investment.

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Financial

Psychological

Management

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� Refers to whether an investor can allocatesome portion of savings for investment

activities.

� More savings to cater for present and futurefinancial requirement, less financialconstraints.

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� Refers to how well an investor can absorb the

consequences of investment decision such as

emotions like greed, fear and caution.

� If investors cannot control their emotion,might end up making wrong and costly

investment decision.

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� Refers to the lack of expertise in managing theinvestment activities.

� Might not have the time or proper knowledgeto analyze the investment alternatives.

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RISK

Def: uncertainty about the size of future return on a principal amount of money invested.

RETURN

Def: the future value amount that we are going to get froman investment activity.

RISK

&RETURN

TRADEO

FF Def: Risk and return are positively correlated.Higher rate of return, High risk the investment alternative.

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(1) Risk Averse-- Conservative type.- require an additional expected return to compensate the high

risk that involved.- will make sure that they will get a return for each dollar they put in

an investment.

(2) Risk T aker -- Aggressive type.- Willing to accept a large amount of risk for a small increase in

the expected return.

(3) Risk N eutral -- Moderate type.- Would be satisfied if they will get only the principal that they put inthe investment.

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RISK

S stem tic /Extern l /

Uncontroll ble /Nondiversified risk

Uns stem tic /

Intern l /Controll ble /

Diversified risk.



� Uncontrollable and external factors affecting theprice of securities.

� Cannot diversified.� E.g.: changes in economy, politic & social, business,

interest rate, inflation and war.� Three sources:

i. Purchasing power/inflation risk

ii. Market riskiii. Interest rate risk

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� When inflation rate increases, the amount of principal and income received will not provide thesame purchasing power as its original value.

� If the price of goods and services rises due to theincrease in inflation rate (rising cost of production &excess demand), the investor actually losing thepurchasing power.

�

Affects investor who buy long-term fixed incomesecurities and who holds surplus funds in the bank.

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� Possibility of loss due to fluctuations in stock price.� The decrease in value of the principal invested

caused by changes in prices of securities due to

tangible and intangible events.� Such as political, sociological and economic factors.

Psychological factors such as rumors, speeches byimportant people.

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� Investing in growing firm and financially sound because priceof shares potentially will increase in the long run.

� Study and carefully examine the past security price behavior.

E.g. Stocks with growth patterns in the past will continue todo so in the future provided there is no change in thecompanys expectation of its product and market.

� Buy securities at the right time.

Price low BUY Price high SELL

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� Fluctuation of interest rate that will affect thefuture market values & size of future income.

� Loss of the principal value because of thechange in the interest rate paid on newlyissued securities.

� When interest rate rises, lower the stockprices ² less demand from buyers.

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� Invest in short-term securities to minimize

the effect of fluctuation in interest rate. The

closer the bond to its maturity date, the morecertain will be the price.

� Invest at different time on securities with

different maturity periods.

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� Controllable and internal factors affecting a

particular industry.

� Can diversified.� E.g.: labor strike and mismanagement.

� Tw o sources:i. Business risk

ii. Financial risk

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� Relate to the efficiency of the management in

handling the business (internal) and how it

responds to factors outside its control(external) such as business cycle.

� Affect the general operation of the companysuch as increase in operating cost, reducing

the operating profit.

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� Invest in leading companies in the industry or

smaller firms with low earning record thatshows signs of improvement.

� Diversify by buying securities from different

companies of different industries.

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� Refers to the method through which thecompany plans its financial structure.

�

Company that borrows to finance itsoperation carries high financial risk because ithas to bear high interest expense which affectlow net profit resulting low earning per share

(EPS).� The more debt the company has, the riskier it

is for shareholders.

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� Investing in firms that use more equityfinancing than debt financing.

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TOTAL RISK

SYSTEMATIC RISK UNSYSTEMATIC RISK

1. Due to common factor.2. Affects return on all securities.3. Cannot be protected against through

diversification.4. Sources:

a) Purchasing power/inflation riskb) Market riskc) Interest rate risk

1. Due to unique factor.2. Affects return on one security.3. Can be protected against through

diversification.4. Sources:

a) Business riskb) Financial risk



� Investment is defined as making a current commitment of funds in order to enjoy a

higher level of consumption in the future.

� Investing and speculating are different mainly because investors expect not more

than a fair return for the risk that they undertake whereas speculators assume high

risk with an intention to make quick profit through rapid increase in the price of

the securities.

� A well-informed investor with well-defined investment objectives and full

understanding of financial constraints has a greater chance of making a successful

investment decision.� Risk and return is positively correlated, the higher the risk the higher the return

and vice-versa.

� An investor·s attitude toward risk can be explained by 3 terms: risk averse, risk

taker and risk neutral.

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� Two types of risk: systematic and unsystematic risk.

� Sources of systematic risk: purchasing power/inflation risk, market risk and

interest rate risk.

�

Purchasing power risk can be avoided by: including more variable-incomesecurities in the investment portfolio, holding more short-term securities and

investing more in real assets.

� Market risk can be avoided by: avoiding securities with volatile price movement,

following the principal of buy low sell high and not being panic easily when the

price of securities go down.

� Interest rate risk can be avoided by: choosing short-term fixed-income securities,

buying securities with different maturity period and holding securities until

maturity.

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CHAPTER 1_Introduction to Investment

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