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Lecture 1

Lecture 1. Understanding Investment Investment decision process. Some Definitions. Investment: An investment is the current commitment of money or other resources in the expectation of reaping future benefits (Kane, Bodie and Marcus 2005 ). Definitions.

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Lecture 1

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  1. Lecture 1 Understanding Investment Investment decision process

  2. Some Definitions • Investment: An investment is the current commitment of money or other resources in the expectation of reaping future benefits (Kane, Bodie and Marcus 2005)

  3. Definitions • Generally, “investments” refers to financial assets and in particular to marketable securities • Financial assets are paper or electronic claims on some issuer, such as the government or a company • Marketable securities financial assets that are easily and cheaply tradable in organized markets • Real assets are tangible assets such as gold, silver, diamonds, real estate,

  4. Why to 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

  5. If we do not invest, then? • If we do not invest, we can’t earn anything on cash • Second, the purchasing power of cash diminishes in inflation • This means that if savers 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

  6. But investment has problems • Investment has the following three problems: • 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

  7. Compensation to investors • Due to the three problems, investors will not invest until they are compensated for these problems • Required rate of return = compensation for (sacrifice , inflation, risk) • RRR= opportunity cost + risk premium

  8. Understanding the investment decision process • The basis of all investment decisions is to earn return and assume risk • By investing, investors expect to earn a return (expected return)

  9. Expected 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 has 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

  10. The expected risk-return trade-off

  11. The expected risk-return trade-off • The expected risk-return is depicted in the graph • The line from RFR 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

  12. 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

  13. Steps in the decision process • Traditionally, the investment decision process has been structured using two-steps: • Security analysis • Portfolio management

  14. Security Analysis • Security analysis: this is the first part of investment decision process • It involves the analysis and valuation of individual securities • To analyze securities, it is important to understand the characteristics of the various securities and the factors that affect them • Then valuation model is applied to find out their value or price

  15. Security Analysis • Value of a security is a function of estimated future earnings from the security and the risk attached • For securities valuation, investors must deal with economy, industry or the individual company • Both the expected return and risk must be estimated keeping in view the economic, market or company related factors

  16. Portfolio Management • The second major component of the decision processes is portfolio management • After securities have been analyzed and valued, portfolio of selected securities is made • Once a portfolio is made, it is managed with the passage of time • For management, there can be two approaches

  17. Portfolio Management • Approaches to portfolio management: • A. Passive investment strategy • B. Active investment strategy In Passive Strategy, investors make few changes in the portfolio so that transactions costs, time and search costs are minimum In Active Strategy, investors believe that they can earn better returns by actively making changes in the portfolio

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