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Chapter One
Introduction to Investment

1.1 Types of Assets

Conducive economic environment attracts investment, which in turn influences the
development of the economy. One of the essential criteria for the assessment of economic
development is the quality and quantity of assets in a nation at a specific time. According to the
IFRS definition, asset is a present economic resource controlled by the entity as a result of past
events. Therefore, in this section discuss the types of assets. In general, there are two broad types
of assets: (1) real assets, (2) financial assets.
1) Real Assets: Real assets comprise the physical and intangible items available to a society.
Example, land, machinery, building, automobiles and bullions are physical assets. Physical
assets can be classified into fixed assets and current assets, based on the length of their life.
Intangible assets also result in a positive or negative contribution to the owner, but are
different in that they do not have a physical shape or form. Intangible assets are goodwill,
patents, copyrights, and royalties.
2) Financial Assets: Financial assets refer to pieces of paper having an indirect claim to real
assets held by some others (stock certificates). The current or future value of financial
instruments depends on the current or future return expectations from these financial assets.
Their dependence on real assets requires the financial assets to be valued differently.
Therefore, all financial assets in an economy represent a real asset either in the present
context or in the context of the future. The major component of the financial assets is cash,
also called money. Some examples of financial assets besides cash are deposits, debt
instruments, shares, and foreign currency reserves. Financial assets have specific properties
that distinguish them from physical and intangible assets. These properties are monetary
value, divisibility, convertibility, reversibility, liquidity, and cash flow.

1.2 What is an Investment?

Investment is the current commitment of dollars for a period of time in order to derive
future payments that will compensate the investor for (1) the time the funds are committed, (2)
the expected rate of inflation, and (3) the uncertainty of the future payments. Therefore,
investment is the current commitment of money or other resources in the expectation of reaping
future benefits. For example, an individual might purchase shares of stock anticipating that the
future proceeds from the shares will justify both the time that her money is tied up as well as the
risk of the investment. 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. It is the sacrifice of certain present values for the uncertain future reward.
Therefore, it can be defined as an activity that commits funds in any financial/real form in the
present with an expectation of receiving additional return in the future. Investment decision

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making involves numerous decisions such as type, mix, amount, timing, grade, etc. and the
decision making has to be continues.
In the present context of investment analysis and portfolio management, the investment is
considered to be financial investment, which implies employment of funds in shares, debentures,
post office savings, and insurance policies, foreign currency, etc. with the objective of realizing
additional income or growth in value of investment at a future date. Financial investments are
commitments of funds to derive income in form of interest, dividend, pension benefits or
appreciation in the value of initial investment. Hence the purchase of shares, debentures, post
office savings, and insurance policies are financial investments. These activities are undertaken
by anyone who desires a return, and is willing to accept the risk from the financial instruments.

1.3 Investment vs. Speculation

Investment and speculation both involve the purchase of assets such as shares and
securities, with an expectation of return. However, investment can be distinguished from
speculation by risk bearing capacity, return expectations, and duration of trade. The capacity to
bear risk distinguishes an investor from a speculator. An investor prefers low risk investments,
whereas a speculator is prepared to take higher risks for higher returns. Speculation focuses more
on returns than safety, thereby encouraging frequent trading without any intention of owning the
investment. The speculator's motive is to achieve profits through price change, that is, capital
gains are more important than the direct income from an investment. Thus, speculation is
associated with buying low and selling high with the hope of making large capital gains.
Investors are careful while selecting securities for trading. Investments, in most instances, expect
an income in addition to the capital gains that may accrue when the securities are traded in the
market. Investment is long term in nature. An investor commits funds for a longer period in the
expectation of holding period gains. However, a speculator trades frequently; hence, the holding
period of securities is very short.
The identification 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 on 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. In any stock
exchange, there are two main categories of speculators called the bulls and bears. A bull buys
shares in the expectation of selling them at a higher price. When there is a bullish tendency in the
market, share prices tend to go up since the demand for the shares is high. A bear sells shares in
the expectation of a fall in price with the intention of buying the shares at a lower price at a
future date. These bearish tendencies result in a fall in the price of shares. A share market needs
both investment and speculative activities. Speculative activity adds to the market liquidity. A
wider distribution of shareholders makes it necessary for a market to exist.

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1.4 Investment vs. Gambling

Investment can also to be distinguished from gambling. Examples of gambling are horse
race, card games, lotteries, and so on. Gambling involves high risk not only for high returns but
also for the associated excitement. Gambling is unplanned and unscientific, without the
knowledge of the nature of the risk involved. It is surrounded by uncertainty and a gambling
decision is taken on unfounded market tips and rumors. In gambling, artificial and unnecessary
risks are created for increasing the returns. Investment is an attempt to carefully plan, evaluate,
and allocate funds to various investment outlets that offer safety of principal and expected
returns over a long period of time. Hence, gambling is quite the opposite of investment even
though the stock market has been euphemistically referred to as a "gambling den".

1.5 Classification of Investors

Investors can be classified in to two broad categories; these are individual investors and
institutional investors.
a. Institutional investors: are entities such as investment companies, commercial banks,
insurance companies, pension funds and other financial institutions. In recent years the
process of institutionalization of investors can be observed as the main reasons for this
can be mentioned the fact that institutional investors can achieve economies of scale,
demographic pressure on social security, the changing role of banks.
b. Individual investors: are individuals who are investing on their own. Sometimes
individual investors are called retail investors. Individual investors invest to earn a return
from savings due to their deferred consumption. They want a rate of return that
compensates them for the time, the expected rate of inflation, and the uncertainty of the
return. This course emphasizes investments by individual investors.

An investor can invest directly in securities or indirectly. Direct investing involves the
purchase of securities. In this case, the investor controls the purchase and sale of each security in
their portfolio. Indirect investing can be undertaken by purchasing the shares of an investment
company. An investment company sells shares in itself to raise funds to purchase a portfolio of
securities. The motivation for doing this is that the pooling of funds allows advantage to be taken
of diversification and of savings in transaction costs. Many investment companies operate in line
with a stated policy objective, for example on the types of securities that will be purchased and
the nature of the fund management. Indirect investing involves investing in mutual funds, closed
end funds, or exchange traded funds. In this case, the investor does not control the composition
of the fund’s investment; the investor only controls whether to buy or sell the shares of the fund.

1.6 Investment Avenues (Alternatives)

Investors choose different investment avenues to invest their money in order to achieve
their objectives. The following are some types of investment alternatives:
1. Bank deposits
2. Post office savings

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3. Pension/Provident Funds
4. Company fixed deposits
5. Corporate Bonds/Debentures
6. Government securities/bonds
7. Stocks/Equity Shares
8. Life insurance
9. Mutual fund schemes
10. Ornaments/Bullion (Gold and Silver)
11. Real Estate
12. Chit Funds

1.7 Characteristics Investment

The features of economic and financial investments can be summarized as return,
risk, safety, and liquidity.

Return: all investments are characterized by the expectation of a return. In fact, investments are
made with the primary objective of deriving a return. The return may be received in the form of
dividend yield plus capital appreciation. The difference between the sale price and the purchase
price is capital appreciation. The dividend or interest received from the investment is the yield.
Different types of investments promise different rates of return. The expectation of return from
an investment depends upon the nature of investment, maturity period, market demand, and so
on. Investment in high growth potential sectors would certainly increase such expectations. The
longer the maturity period, the longer is the duration for which the investor parts with the value
of the investment. Hence, the investor would expect a higher return from such investments.

Risk: risk is inherent in any investment. This risk may relate to loss of capital, delay in
repayment of capital, non-payment of interest, or variability of return. While investments in
government securities and bank deposits are risk free, other investment vehicles are more risky.
The risk of an investment depends on:
 The maturity period:- the longer the maturity period, the larger is the risk
 The credit worthiness of the borrower:- the lower the credit worthiness of the borrower,
the larger is the risk.
 The nature of investment:- investment in equity securities like equity shares carry higher
risk compared to in debt instruments like bonds or debentures.
Safety: the safety of investment implies the certainty of return with out of the loss of money or
time. Safety is another feature which an investor desires for his investment. Every investor
expects to get back his capital on maturity without loss and without delay
Liquidity: an investment which is easily marketable without loss of money and time is said to
have liquidity.
Generally an investor prefers liquidity for his investments, safety of his funds, a
good return with a minimum risk or minimization of risk and maximization of return.

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1.8 Investment Companies

Investment companies are firms that pool and manage the money/fund of many
investors, also arise out of economies of scale. The problem with most of the households
is that the household portfolios are not large enough to be spread among a wide variety
of securities. It is very expensive in terms of brokerage fees and research costs to
purchase one or two shares of many different firms. Investment companies such as
mutual funds have the advantage of large-scale trading and portfolio management,
while participating investors are assigned a prorated share of the total funds according to
the size of their investment. This system gives small investors advantages they are willing
to pay for via a management fee to the mutual fund operator. Investment companies also
can design portfolios specifically for large investors with particular goals. Mutual funds
are sold in the retail market, and their investment philosophies are differentiated mainly
by strategies that are likely to attract a large number of clients. Economies of scale also
explain the proliferation of analytic services available to investors. Newsletters,
databases, and brokerage house research services all engage in research to be sold to a
large client base. This setup arises naturally. Investors clearly want information, but with
small portfolios to manage, they do not find it economical to personally gather all of it.
Hence, a profit opportunity emerges: A firm can perform this service for many clients
and charge for it.

1.9 Security Markets

Security market, also called financial markets, is a market where funds are transferred from
people who have an excess of available funds to people who have a shortage. It is a mechanism
that allows people to easily buy and sell (trade) financial securities (such as stocks and bonds).
There are different types of security markets:
1. Money Markets
Money market instruments include short-term, marketable, liquid, low-risk debt
securities. Money market instruments sometimes are called cash equivalents, or just cash
for short. The money market is a subsector of the debt market. It consists of very short-
term debt securities that are highly marketable. Many of these securities trade in large
denominations and so are out of the reach of individual investors.
Money market mutual funds are mutual funds that pool the resources of many
investors and purchase a wide variety of money market securities on their behalf. This
market is easily accessible to small investors.
Treasury bills (T-bills) or just bills for short are the most marketable of all money
market instruments. T-bills represent the simplest form of borrowing. The government
raises money by selling bills to the public. Investors buy the bills at a discount from the
stated maturity value. At the bill’s maturity, the holder receives from the government a
payment equal to the face value of the bill. The difference between the purchase price and
the ultimate maturity value represents the investor’s earnings. T-bills with initial

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maturities of 28, 91, and 182 days are issued weekly. Sales are conducted by an auction
where investors can submit competitive or noncompetitive bids.
A certificate of deposit (CD) is a time deposit with a bank. Time deposits may
not be withdrawn on demand. The bank pays interest and principal to the depositor only
at the end of the fixed term of the CD. CDs issued in denominations larger than $100,000
are usually negotiable, however; that is, they can be sold to another investor if the owner
needs to cash in the certificate before its maturity date. Short-term CDs are highly
marketable, although the market significantly thins out for maturities of three months or
more.
Large, well-known companies often issue their own short-term unsecured debt
notes directly to the public, rather than borrowing from banks. These notes are called
commercial paper (CP). Sometimes, CP is backed by a bank line of credit, which gives
the borrower access to cash that can be used if needed to pay off the paper at maturity.
CP maturities range up to 270 days; longer maturities require registration with the
Securities and Exchange Commission (SEC) and so are almost never issued. CP most
commonly is issued with maturities of less than one or two months in denominations of
multiples of $100,000. Therefore, small investors can invest in commercial paper only
indirectly, through money market mutual funds. CP is considered to be a fairly safe asset,
given that a firm’s condition presumably can be monitored and predicted over a term as
short as one month.
A bankers’ acceptance starts as an order to a bank by a bank’s customer to pay a
sum of money at a future date, typically within six months. At this stage, it is like a
postdated check. When the bank endorses the order for payment as “accepted,” it
assumes responsibility for ultimate payment to the holder of the acceptance. At this point,
the acceptance may be traded in secondary markets much like any other claim on the
bank. Bankers’ acceptances are considered very safe assets, as they allow traders to
substitute the bank’s credit standing for their own. They are used widely in foreign trade
where the creditworthiness of one trader is unknown to the trading partner. Acceptances
sell at a discount from the face value of the payment order, just as T-bills sell at a
discount from par value.

2. Bond Markets
The bond market is composed of longer-term borrowing or debt instruments than
those that trade in the money market. This market includes treasury notes and bonds,
corporate bonds, municipal bonds, mortgage securities, and federal agency debt. These
instruments are sometimes said to comprise the fixed-income capital market, because
most of them promise either a fixed stream of income or stream of income that is
determined according to a specified formula. In practice, these formulas can result in a
flow of income that is far from fixed. Therefore, the term “fixed income” is probably not
fully appropriate. It is simpler and more straightforward to call these securities either debt
instruments or bonds.

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3. Equity Markets
A corporation is controlled by a board of directors elected by the shareholders.
The members of the board are elected at the annual meeting. Shareholders who do not
attend the annual meeting can vote by proxy, empowering another party to vote in their
name. The board, which meets only a few times each year, selects managers who run the
corporation on a day-to-day basis. Managers have the authority to make most business
decisions without the board’s approval. The board’s mandate is to oversee management
to ensure that it acts in the best interests of shareholders. Management usually solicits the
proxies of shareholders and normally gets a vast majority of these proxy votes. Thus,
management usually has considerable discretion to run the firm as it sees fit, without
daily oversight from the equity holders who actually own the firm. Common stocks, also
known as equity securities, or equities, represent ownership shares in a corporation. Each
share of common stock entitles its owners to one vote on any matters of corporate
governance put to a vote at the corporation’s annual meeting and to a share in the
financial benefits of ownership (e.g., the right to any dividends that the corporation may
choose to distribute).
Characteristics of Common Stock: The two most important characteristics of common stock as
an investment are its residual claim and its limited liability features. Residual claim means
stockholders are the last in line of all those who have a claim on the assets and income of the
corporation. In a liquidation of the firm’s assets, the shareholders have claim to what is left after
paying all other claimants, such as the tax authorities, employees, suppliers, bondholders, and
other creditors. In a going concern, shareholders have claim to the part of operating income left
after interest and income taxes have been paid. Management either can pay this residual as cash
dividends to shareholders or reinvest it in the business to increase the value of the shares.
Limited liability means that the most shareholders can lose in event of the failure of the
corporation is their original investment. Shareholders are not like owners of unincorporated
businesses, whose creditors can lay claim to the personal assets of the owner—such as houses,
cars, and furniture. In the event of the firm’s bankruptcy, corporate stockholders at worst have
worthless stock. They are not personally liable for the firm’s obligations: Their liability is
limited.
Preferred stock: Have features similar to both equity and debt. Like a bond, it promises to pay
to its holder a fixed stream of income each year. In this sense, preferred stock is similar to an
infinite-maturity bond, that is, a perpetuity. It also resembles a bond in that it does not give the
holder voting power regarding the firm’s management. Preferred stock is an equity investment,
however. The firm retains discretion to make the dividend payments to the preferred
stockholders: It has no contractual obligation to pay those dividends. Instead, preferred dividends
are usually cumulative; that is, unpaid dividends cumulate and must be paid in full before any
dividends may be paid to holders of common stock.
In contrast, the firm does have a contractual obligation to make the interest payments on the debt.
Failure to make these payments sets off corporate bankruptcy proceedings. Preferred stock also
differs from bonds in terms of its tax treatment for the firm. Because preferred stock payments

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are treated as dividends rather than as interest on debt, they are not tax-deductible expenses for
the firm. This disadvantage is largely offset by the fact that corporations may exclude 70% of
dividends received from domestic corporations in the computation of their taxable income.
Preferred stocks, therefore, make desirable fixed-income investments for some corporations.
Even though preferred stock ranks after bonds in terms of the priority of its claim to the assets of
the firm in the event of corporate bankruptcy, preferred stock often sells at lower yields than
corporate bonds. Presumably this reflects the value of the dividend exclusion, for risk
considerations alone indicate that preferred stock ought to offer higher yields than bonds.
Individual investors, who cannot use the 70% exclusion, generally will find preferred stock
yields unattractive relative to those on other available assets. Corporations issue preferred stock
in variations similar to those of corporate bonds. Preferred stock can be callable by the issuing
firm, in which case it is said to be redeemable. It also can be convertible into common stock at
some specified conversion ratio. A relatively recent innovation in the market is adjustable-rate
preferred stock, which, like adjustable-rate mortgages, ties the dividend rate to current market
interest rates.

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