Investment Defined and Its Process PDF

UNIT I. INVESTMENT DEFINED AND ITS PROCESS ========================================== Overview -------- In this unit you will be able to learn more about investments and realize the importance of investment process. The investment expectation brings with it a probability that the quantum of return...

UNIT I. INVESTMENT DEFINED AND ITS PROCESS ========================================== Overview -------- In this unit you will be able to learn more about investments and realize the importance of investment process. The investment expectation brings with it a probability that the quantum of return may vary from a minimum to a maximum. Thus we all aware every investment involves a return and risk. Through this unit you will be able to understand the investment processes, benefits and also the investment risk. Learning Objectives ------------------- At the end of the unit, the students should be able to: 1. Define investment; 2. Identify the types of investment; 3. Differentiate investment from speculation; 4. Analyze the different characteristics of investments; and 5. Familiarize with return on investment formula. Introduction ------------ An **investment** is an asset or item acquired with the goal of generating income or appreciation. Appreciation refers to an increase in the value of an asset over time. When an individual purchases a good as an investment, the intent is not to consume the good but rather to use it in the future to create wealth. An investment always concerns the outlay of some asset today---time, money, or effort---in hopes of a greater payoff in the future than what was originally put in. Investment involves making of a sacrifice in the present with the hope of deriving future benefits. Two most important features of an investment are current sacrifice and future benefit. Investment is the sacrifice of certain present values for the uncertain future reward. It involves numerous decision such as type, mix, amount, timing, grade etc, of investment the decision making has to be continues as well as investment may be defined as an activity that commits funds in any financial/physical form in the present with an expectation of receiving additional return in the future. However, investment can be interpreted broadly from three angles -- - economic,  layman, - financial. **Economic investment** includes the commitment of the fund for net addition to the capital stock of the economy. The net additions to the capital stock means an increase in building equipment or inventories over the amount of equivalent goods that existed, say, one year ago at the same time. **The layman** uses of the term investment as any commitment of funds for a future benefit not necessarily in terms of return. For example a commitment of money to buy a new car is certainly an investment from an individual point of view. **Financial investment** is the commitment of funds for a future return, thus investment may be understood as an activity that commits funds in any financial or physical form in the presence of an expectation of receiving additional return in future. Lesson Proper ------------- I. TYPES OF INVESTMENT ---------------------- Investing intimidates a lot of people. There are numerous options, and it can be hard to figure out which investments are right for your portfolio. This guide walks you through 10 of the most common types of investment and explains why you may want to consider including them in your portfolio. If you're serious about investing, it might make sense to find a financial advisor to guide you. 1. Stocks --------- Stocks, also known as shares or equities, may be the most well-known and simple type of investment. When you buy stock, you're buying an ownership stake in a publicly traded company. Many of the biggest companies in the country --- think General Motors, Apple and Facebook --- are publicly traded, meaning you can buy stock in them. When you buy a stock, you're hoping that the price will go up so you can then sell it for a profit. The risk, of course, is that the price of the stock could go down, in which case you'd lose money. Brokers sell stocks to investors. You can either opt for an online brokerage firm or work face-to-face with a broker. 2. Bonds -------- When you buy a bond, you're essentially lending money to an entity. Generally, this is a business or a government entity. Companies issue corporate bonds, whereas local governments issue municipal bonds. The U.S. Treasury issues Treasury bonds, notes and bills, all of which are debt instruments that investors buy. While the money is being lent, the lender gets interest payments. After the bond matures --- that is, you've held it for the contractually determined amount of time --- you get your principal back. The rate of return for bonds is typically much lower than it is for stocks, but bonds also tend to be lower risk. There is some risk involved, of course. The company you buy a bond from could fold, or the government could default. Treasury bonds, notes and bills, however, are considered very safe investments. 3. Mutual Funds --------------- A mutual fund is a pool of many investors' money that is invested broadly in a number of companies. Mutual funds can be actively managed or passively managed. An actively managed fund has a fund manager who picks securities in which to put investors' money. Fund managers often try to beat a designated market index by choosing investments that will outperform such an index. A passively managed fund, also known as an index fund, simply tracks a major stock market index like the Dow Jones Industrial Average or the S&P 500. Mutual funds can invest in a broad array of securities: equities, bonds, commodities, currencies and derivatives. 4. Exchange-Traded Funds ------------------------ Exchange-traded funds (ETFs) are similar to mutual funds in that they are a collection of investments that tracks a market index. Unlike mutual funds, which are purchased through a fund company, shares of ETFs are bought and sold on the stock markets. Their price fluctuates throughout the trading day, whereas mutual funds' value is simply the net asset value of your investments, which is calculated at the end of each trading session. 5. Certificates of Deposit -------------------------- A certificate of deposit (CD) is a very low-risk investment. You give a bank a certain amount of money for a predetermined amount of time. When that time period is over, you get your principal back, plus a predetermined amount of interest. The longer the loan period, the higher your interest rate. 6. Retirement Plans ------------------- Retirement plans are life insurance products designed to act as investment plans to allocate a part of your savings to accumulate over a period and provide financial security after retirement. Retirement pension plans help you invest your earnings over the years and create a fund which you can withdraw as a whole or in parts during your retirement years. Further, with dual benefits of protection with investment, these plans are ideal for covering your financial needs in the golden years of your life. Given the high cost of living and rising inflation, retirement planning has become more necessary. 7. Options ---------- An option is a somewhat more complicated way to buy a stock. When you buy an option, you're purchasing the ability to buy or sell an asset at a certain price at a given time. There are two types of options: call options, for buying assets, and put options, for selling options. The risk of an option is that the stock will decrease in value. If the stock decreases from its initial price, you lose your money. Options are an advanced investing technique, and retail should exercise caution before using them. 8. Annuities ------------ Many people use annuities as part of their retirement savings plan. When you buy an annuity, you purchase an insurance policy and, in return, you get periodic payments. Annuities come in numerous varieties. They may last until death or only for a predetermined period of time. The may require periodic premium payments or just one upfront payment. They may be linked partially to the stock market or they may simply be an insurance policy with no direct link to the markets. Payments may be immediate or deferred to a specified date. 9. Cryptocurrencies ------------------- These are fairly new investment option. Bitcoin is the most famous cryptocurrency, but there are countless others, such as Binance, Litecoin and Ethereum. Cryptocurrencies are digital currencies that don't have any government backing. You can buy and sell them on cryptocurrency exchanges. Some retailers will even let you make purchases with them. 10. Commodities --------------- Commodities are physical products that you can invest in. They are common in futures markets where producers and commercial buyers -- in other words, professionals -- seek to hedge their financial stake in the commodities. Retail investors should make sure they thoroughly understand futures before investing in them. Partly, that's because commodities investing runs the risk that the price of a commodity will move sharply and abruptly in either direction due to sudden events. For instance, political actions can greatly change the value of something like oil, while weather can impact the value of agricultural products. There are four main types of commodities: - Metals -- this includes precious metals like gold and silver and industrial metals like copper - Agricultural -- this includes wheat, corn and soybeans; - Livestock and meat -- this includes pork bellies and feeder cattle; and  Energy -- this includes crude oil, petroleum products and natural gas II. INVESTMENT VERSUS SPECULATION --------------------------------- Often investment is understood as a synonym of speculation. Investment and speculation are somewhat different and yet similar because speculation requires an investment and investment are at least somewhat speculative. Probably the best way to make a distinction between investment and speculation is by considering the role of expectation. Investments are usually made with the expectation that a certain stream of income or a certain price that has existed will not change in the future. Whereas speculation are usually based on the expectation that some change will occur in future, there by resulting a return. +-----------------+-----------------+-----------------+-----------------+ | | | | | +-----------------+-----------------+-----------------+-----------------+ | | | | | +-----------------+-----------------+-----------------+-----------------+ | | | Usually by | | | | | outright | | +-----------------+-----------------+-----------------+-----------------+ | | | | | +-----------------+-----------------+-----------------+-----------------+ | | | | | +-----------------+-----------------+-----------------+-----------------+ | | | | | +-----------------+-----------------+-----------------+-----------------+ | | | | | +-----------------+-----------------+-----------------+-----------------+ | | **of** | | Cautious and | | | | | conservative | +-----------------+-----------------+-----------------+-----------------+ | | | | | +-----------------+-----------------+-----------------+-----------------+ Thus an expected change is the basis for speculation but not for investment. An investment also can be distinguished from speculation by the time horizon of the investor and often by the risk return characteristic of investment. A true investor is interested in a good and consistent rate of return for a long period of time. In contrast, the speculator seeks opportunities promising very large return earned within a short period of time due to changing environment. Speculation involves a higher level of risk and a more uncertain expectation of returns, which is not necessarily the case with investment. The identification of these distinctions of these distinctions helps to define the role of the investor and the speculator in the market. The investor can be said to be interested in a good rate of return of a consistent basis over a relatively longer duration. For this purpose the investor computes the real worth of the security before investing in it. The speculator seeks very large returns from the market quickly. For a speculator, market expectations and price movements are the main factors influencing a buy or sell decision. Speculation, thus, is more risky than investment. III. INVESTMENT PROCESS ----------------------- When we speak of investment, I am sure most of you would think of investing in some fixed deposit or a property or some of you would even buy gold. But there is much more to investing. An investment is the purchase of an asset with an expectation to receive return or some other income on that asset in future. The process of investment involves careful study and analysis of the various classes of assets and the risk-return ratio attached to it. An investment process is a set of guidelines that govern the behavior of investors in a way which allows them to remain faithful to the tenets of their investment strategy, that is the key principles which they hope to facilitate out-performance. There are 5 investment process steps that help you in selecting and investing in the best asset class according to your needs and preferences. Step 1- Understanding the client -------------------------------- The first and the foremost step of investment process is to understand the client or the investor his/her needs, his risk taking capacity and his tax status. After getting an insight of the goals and restraints of the client, it is important to set a benchmark for the client's portfolio management process which will help in evaluating the performance and check whether the client's objectives are achieved. Step 2- Asset allocation decision --------------------------------- This step involves decision on how to allocate the investment across different asset classes, i.e. fixed income securities, equity, real estate etc. It also involves decision of whether to invest in domestic assets or in foreign assets. The investor will make this decision after considering the macroeconomic conditions and overall market status. Step 3- Portfolio strategy selection ------------------------------------ Third step in the investment process is to select the proper strategy of portfolio creation. Choosing the right strategy for portfolio creation is very important as it forms the basis of selecting the assets that will be added in the portfolio management process. The strategy that conforms to the investment policies and investment objectives should be selected. There are two types of portfolio strategy. - **Active Management** - **Passive Management** ***Active portfolio management*** process refers to a strategy where the objective of investing is to outperform the market return compared to a specific benchmark by either buying securities that are undervalued or by short selling securities that are overvalued. In this strategy, risk and return both are high. This strategy is a proactive strategy it requires close attention by the investor or the fund manager. ***Passive portfolio management*** process refers to the strategy where the purpose is to generate returns equal to that of the market. It is a reactive strategy as the fund manager or the investor reacts after the market has responded. Step 4- Asset selection decision -------------------------------- The investor needs to select the assets to be placed in the portfolio management process in the fourth step. Within each asset class, there are different sub asset-classes. For example, in equity, which stocks should be chosen? Within the fixed income securities class, which bonds should be chosen? Also, the investment objectives should conform to the investment policies because otherwise the main purpose of investment management process would become meaningless. Step 5- Evaluating portfolio performance ---------------------------------------- This is the final step in the investment process which evaluates the portfolio management performance. This is an important step as it measures the performance of the investment with respect to a benchmark, in both absolute and relative terms. The investor would determine whether his objectives are being achieved or not. IV. CHARACTERISTICS OF INVESTMENT --------------------------------- The characteristics of investment can be understood in terms of the following: 1. **Return:** All investments are characterized by the expectation of a return. In fact, investments are made with the primary objective of deriving return. The expectation of a return may be from income (yield) as well as through capital appreciation. Capital appreciation is the difference between the sale price and the purchase price. The expectation of return from an investment depends upon the nature of investment, maturity period, market demand and so on. 2. **Risk:** Risk is inherent in any investment. Risk may relate to loss of capital, delay in repayment of capital, nonpayment of return or variability of returns. The risk of an investment is determined by the investments, maturity period, repayment capacity, nature of return commitment and so on. - **Factors influence risk**: Traditionally, investors have talked about several factors causing risk such as business failure, market fluctuations, change in the interest rate inflation in the economy, fluctuations in exchange rates changes in the political situation etc. - **Interest rate risk**: The variability in a security return resulting from changes in the level of interest rates is referred to as interest rate risk. - **Market risk**: The variability in returns resulting from fluctuations in overall market that is, the agree get stock market is referred to as market risk. - **Inflation risk**: Inflation in the economy also influences the risk inherent in investment. It may also result in the return from investment not matching the rate of increase in general price level (inflation). - - - - - 3. **Safety:** The safety of investment is identified with the certainty of return of capital without loss of time or money. Safety is another feature that an investor desires from investments. Every investor expects to get back the initial capital on maturity without loss and without delay. 4. **Liquidity:** An investment that is easily saleable without loss of money or time is said to be liquid. A well-developed secondary market for security increase the liquidity of the investment. An investor tends to prefer maximization of expected return, minimization of risk, safety of funds and liquidity of investment. V. RETURN ON INVESTMENT (ROI) ----------------------------- Return on investment (ROI) is a financial ratio used to calculate the benefit an investor will receive in relation to their investment cost. It is most commonly measured as net income divided by the original capital cost of the investment. The higher the ratio, the greater the benefit earned. ROI Formula ----------- There are several versions of the ROI formula. The two most commonly used are shown below: ROI = Net Income / Cost of Investment x100 *or* ROI = Investment Gain / Investment Base x100 Let us consider the problem. A person makes an Initial Investment of 50000 and the his return amount (Earnings) is 80000. Substituting the values in the formula, ROI = ((80000 - 50000) / 50000)) × 100 = (30000 / 50000) x 100 = 60 % Therefore, the person has 60 % ROI on his investment. Supplemental Readings/Videos ---------------------------- - What is investment? - Types of Investment https://www.youtube.com/watch?v=R7qaVo7NXKE References ---------- - https://www.investopedia.com/terms/i/investment.asp - https://www.easycalculation.com/mortgage/roi-examples.php - https://www.investmentpedia.org/steps-of-investment-process Assessing Learning ------------------ Name:[\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_] Date:[\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_] Section: [ ] Score:[\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_] ACTIVITY 1 ---------- 1. Define Investment. What are the types of investments? **\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_ \_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_ \_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_ \_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_** 2. Enumerate and Explain the Characteristics of Investment \_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_ \_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_ \_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_ \_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_ \_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_ -------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------- 3. What is ROI? Provide 2 instances and solve it. 4. Discuss and elaborate well the investment process. UNIT II. INVESTMENT OBJECTIVES AND CONSTRAINTS ============================================== Overview -------- In this unit you will be able to understand the investment objective and constraints of any financial policy statement such as risk, returns and willingness of the investors. Investment guidelines provide a general road map for investing money at different stages of your financial life cycle. These guidelines should integrate all of your financial goals to give you a complete financial perspective. Learning Objectives ------------------- At the end of the unit, the students should be able to: 1. Define investment objectives and constraints; 2. Explain the Life Cycle Investing theory; 3. Enumerate the different types of investors; 4. Analyze pension plan, insurance and endowment plan;and 5. Start their personal plan and investment. Introduction ------------ Investment objectives and constraints are the cornerstones of any investment policy statement. A financial advisor/portfolio manager needs to formally document these before commencing the portfolio management. Any asset class that is included in the portfolio has to be chosen only after a thorough understanding of the investment objective and constraints. Following are various types of objectives and constraints to be considered and several steps to correctly determine these objectives. *(www.efinancemanagement.com)* Lesson Proper ------------- I. DEFINITION OF INVESTMENT OBJECTIVES -------------------------------------- Investment objectives are related to what the client wants to achieve with the portfolio of investments. Objectives define the purpose of setting the portfolio. Generally, the objectives are concerned with return and risk considerations. These two objectives are interdependent as the risk objective defines how high the client can place the return objective. Risk Objective -------------- Risk objectives are the factors that are associated with both the willingness and the ability of the investor to take the risk. When the ability to accept all types of risks and willingness is combined, it is termed as risk tolerance. When the investor is unable and unwilling to take the risk, it indicates risk aversion. The following steps are undertaken to determine risk objective: 1. **Specify Measure of Risk**: Measurement of risk is the most important issue in portfolio management. Risk either measured in absolute or relative terms. Absolute risk measurement will include a specific level of variance or standard deviation of total return. Relative risk measurement will include a specific tracking risk. 2. **Investor's Willingness**: Individual investors' willingness to take risk is different from institutional investors. For individual investors, willingness is determined by psychological or behavioral factors. 3. **Investor's Ability**: The ability of an investor to take risk is dependent on financial and practical factors that bound the amount of risk taken by the investor. An investor's short term horizon will negatively affect his ability. Similarly, if the investor's obligation and spending are less than his portfolio, he clearly has more ability. Return Objective ---------------- The following steps are required to determine the return objective of the investor: 1. **Specify Measure of Return:** A measure of return needs to be specified. It can be specified in an absolute term or a relative term. It can also be specified in nominal or real terms. Nominal returns are not adjusted for inflation, whereas real returns are. One may also distinguish pre-tax returns from post-tax returns. 2. **Desired Return:** A return desired by the investor needs to be determined. The desired return indicates how much return is expected by the investor. E.g. higher or lower than average returns. 3. **Required Return:** A return required by the investor also needs to be determined. A required return indicates the return which needs to be achieved at the minimum for the investor. 4. **Specific Return Objectives:** The investor's specific return objectives also need to be determined so that they are consistent with his risk objectives. An investor having a high return objective needs to have a portfolio with a high level of expected risk. II. DEFINITION OF INVESTMENT CONSTRAINTS ---------------------------------------- Investment constraints are the factors that restrict or limit the investment options available to an investor. The constraints can be either internal or external constraints. Internal constraints are generated by the investor himself while external constraints are generated by an outside entity, like a governmental agency.