CHAPTER 1 – INTRODUCTION TO INVESTMENT AND PORTFOLIO MANAGEMENT

Types of Assets commodities. It They include

1. Real assets unique feature is that investments such as
o Assets used to produce goods and services. they have intrinsic stocks and bonds. The
o Physical or tangible assets that have value, value by themselves major feature if
due to their substance and properties. and don’t rely on financial assets is that
o Real assets include precious metal, exchanges to have it has some economic
commodities, real estate, agricultural land and value. value that is easily
oil. realized. However, by
o Real assets are appropriate for inclusion in itself, it has lesser
most diversified portfolios. intrinsic value.
o Their proportion is dependent on investor’s Real assets are less More liquid and
risk tolerance and preferences. liquid since real assets location-dependent,
o Reason is real assets have a relatively low are difficult to trade, whereas financial
correlation with financial assets, such as and they don’t have a assets are more
stocks and bonds. competitive and mobile, making them
2. Financial assets efficient exchange. independent of their
o Financial assets are claims on real assets or location.
the income generated by real assets. The similarities between real financial assets
o Financial assets value is derived from a are that their valuation depends on their cash
contractual claim on an underlying asset, flow generation potential.
which may be real or intangible – meaning Table 1 – Differences and Similarities of Real Assets
that if we cannot our own auto plant (real9 and Financial Assets
asset)., we can still buy shares in Ford/Toyota
(financial assets) and thereby share in the Definition of Security
income derived from the production of An investment instrument (other than an insurance
automobiles. policy or fixed annuity) issued by a corporation,
o For example, commodities and property are government, or other organization which offers
real assets, but commodity futures and real evidence of debt or equity.
estate investment trusts constitute financial
assets whose value depend on the underlying Major Classes of Financial Assets/Security
real assets. 1. Debt
o Types of financial assets: o An amount of money borrowed by one party
- Certificate of deposit (CD) from another. Many corporations or
- Bonds individuals use debt as a method for making
- Stocks large purchases that they could not afford
- Cash or cash equivalent under normal circumstances.
- Derivatives o A debt arrangement gives the borrowing party
- Bank deposits permission to borrow money under the
- Loans and receivables condition that it is to be paid back at a later
o The success or failure of the financial assets date, usually with interest.
depends on the performance of the o Money market debt instruments - Bank
underlying real assets. certificates of deposit (CD, T-bills, commercial
3. Differences and similarities of real assets and paper
financial assets: o Capital market debt instruments – bonds and
Real Assets Financial Assets debentures
Real assets are real Financial assets 2. Common stock
estate, infrastructure include stocks, bonds o A security that represents ownership in a
and commodities. and cash. corporation.
Real assets are value- Financial assets are o On a company’s balance sheet, the amount of
driven physical assets highly liquid assets the funds contributed by the owners (the
that a company owns. that are either in cash stockholders) plus the retained earnings (or
They include buildings, or can be fast losses). Also referred to as shareholders’
land, motor cars or converted to cash. equity.
CHAPTER 1 – INTRODUCTION TO INVESTMENT AND PORTFOLIO MANAGEMENT
o Holders of common stock exercise control by
electing a board of directors and voting on
corporate policy.
o Common stockholders are on the bottom of
the priority ladder for ownership structure.
o In the event of liquidation, common
shareholders have rights to a company’s
assets only after bondholders, preferred
shareholders and other debtholders have
been paid in full.
3. Preferred Stock
o A class of ownership in a corporation that has
a higher claim on its assets and earning than
common stock.
o Preferred shares generally have a dividend
that must be paid out before dividends to
common shareholders and the shares usually
do not carry voting rights.
4. Derivative securities
o A derivative is a security with a price that is
dependent upon or derived from one or more
underlying assets. The most common
underlying assets include stocks, bonds,
commodities, currencies, interest rates and
market indexes.
o The derivative itself is a contract between two
or more parties based upon the asset or
assets.
o Its value is determined by fluctuations in the
underlying asset.
o For example, options, futures and swap.
What Is an Investment?
1. The current commitment or purchase of a
financial product (or other resources0 with an
expectation of favorable future returns.
2. Investment means the use of money in the hope
of making more money.
3. Therefore, investors have to reduced current
consumption and planned for later consumption.
4. Investors have to come up with financial plan that
outline the investment goals, their risk tolerance
and saving targets.
Financial Planning
1. A comprehensive evaluation of an investor’s
current and future financial sate by using
currently known variables to predict future cash
flows, asset values and withdrawal plans.
2. A good financial plan can alert an investor to
changes that must be made to ensure a smooth
transition through life’s financial phases such as
decreasing spending or changing asset allocation.
3. Financial plans should also be fluid, with
occasional updates when financial changes occur.
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Daily risk Asset
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Daily return Global macro
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Figure 1 - Financial Planning Process
Investment Portfolio
1. Portfolio is a collection of investment assets
(securities) owned by the same individual or
organization.
2. A grouping of financial assets such as stocks,
bonds and cash equivalents. It is also called as a
basket of assets that can hold stocks, bonds, cash
and more.
3. Investors aim for a return by mixing these
securities in a way that reflects their risk tolerance
and financial goals.
4. Portfolios are held directly by investors and/or
managed by financial professionals.
Portfolio Investment Process
Investors make three types of decisions in
constructing their portfolios:
1. Asset allocation
o A portfolio strategy that involves setting
target allocations for various asset classes,
and periodically rebalancing the portfolio back
to the original allocations when they deviate
significantly from the initial settings due to
differing returns from various assets.
o The allocations depend on a number of
factors such as the investor’s risk tolerance,
time horizon and investment objectives.
o Example:
- 55 years old En Zakaria who has a
conservative approach to investing and is
five years away from retirement, may
CHAPTER 1 – INTRODUCTION TO INVESTMENT AND PORTFOLIO MANAGEMENT
have an asset allocation of 40% equities,
40% fixed income and 20% cash.
- Assume En Zakaria has a RM500,000
portfolio and rebalances his portfolio
annually. The dollar amounts allocated to
the various asset classes at the time of
setting the allocations would therefore be
– equities RM200,000, fixed income
RM200,000 and cash RM100,000.
2. Security selection
o Process used to determine which securities
will be included within an asset class in a
portfolio. Certain factors, such as risk and
return, are taken into consideration when
selecting the security.
o The goal of security selection is to increase
one’s chances of making a profit on all
investments in the portfolio and hedge
against losses.
o Example:
- Equity – common stocks and preferred
stocks
- Fixed income – bonds
- Cash – money market funds, bank
accounts and certificates of deposit
3. Security analysis
o The analysis of various tradable financial
instruments. Security analysis helps to
determine the value of assets in a portfolio.
o Security analysis is a method which helps to
determine the value of various assets and also
find out the effect of various market
fluctuations on the value of securities
o Security analysis is broadly classified into
three categories:
- Fundamental analysis
- Technique analysis
- Quantitative analysis
Three Categories of Security Analysis
1. Fundamental analysis
o Fundamental analysts’ study anything that
can affect the security’s value, from
macroeconomic factors such as the state of
the economy and industry conditions to
microeconomic factors like the effectiveness
of the company’s management. Examples
include financial statements, current interest
rates, competitor’s products and financial
market.
o All stocks analysis tries to determine whether
a security is correctly valued within the
broader market. The end goal is to arrive at a
number that an investor can compare with a
security’s current price in order to see
whether the security is undervalued or
overvalued.
2. Technical analysis
o A method of evaluating securities by analyzing
statistics generated by market activity, such as
past prices and volume. Technical analysts do
not attempt to measure a security’s intrinsic
value, but instead use charts or other tools to
identify patterns to predict future price
movements.
o Technical analysis can be used on a timeframe
of weeks, days or even minutes. Technical
analysis is used for a trade whereby traders
buy assets they believe they can sell to
somebody else at a greater price.
3. Quantitative analysis
o A business or financial analysis technique that
seeks to understand behavior by using
complex mathematical and statistical
modelling, measurement and research.
o By assigning a numerical value to variables,
quantitative analysts try to replicate reality
mathematically.
o Quantitative analysis can be done for
performance evaluation or valuation of a
financial instrument. It can also be used to
predict real world events such as changes in a
share price.
Implications of Competitive Markets
1. Risk-return tradeoff
o There will almost always be risk associated
with the investment. Higher risk is associated
with greater probability of higher return and
lower risk with a greater probability of smaller
return.
o For investors, the risk-return tradeoff is one of
the essential components of each investment
decision as well as in the assessment of
portfolios as a whole.
o In investments, the term ‘risk’ is often
expressed as ‘volatility’ or variations in
returns. The greater the volatility the more
rises and falls are recorded by an individual
asset class the measurement of fluctuation in
the market values of various asset classes as
they rise and fall over time.
o A return, also known as a financial return, in
its simplest terms, is the money made or list
on an investment over some period of time.
CHAPTER 1 – INTRODUCTION TO INVESTMENT AND PORTFOLIO MANAGEMENT
o In investing, risk and return are highly
correlated. Increased potential returns on
investment usually go hand-in-hand with
increased risk – call as tradeoff.
o For investors, the risk-return tradeoff is one of
the essential components of each investment
decision as well as in the assessment of
portfolios as a whole.
Figure 2 – Risk Return Tradeoff
o At the foundation of this assessment, the
consideration of the risk and the reward of an
investment can be determined whether taking
action makes sense or not.
o At the portfolio level, the risk-return trade-off
can include assessments on the concentration
or the diversity of holdings and whether the
mix presents too much risk or a lower than
desired potential for returns.
o Diversification means that many assets are
held in the portfolio so that the exposure to
any particular asset is limited.
2. Efficient market hypothesis
o This hypothesis stated that financial markets
process all relevant information about
securities quickly and efficiently. For example,
the security price usually reflects all the
information available to investors concerning
the value of the security. Therefore, securities
should be neither underpriced nor overpriced.
o The implications of this hypothesis concern
the choice between passive and active
investment management strategies.
o Passive management call for holding highly
diversified portfolios without attempting to
identify mispriced securities.
o Active management is the attempt to identify
mispriced securities or to forecast broad
market trends.
o If markets are efficient and prices reflect all
relevant information perhaps it is better to
follow passive strategies. However, even in
environments as competitive as the financial
markets, we may observe only near-efficiency
and profit opportunities may exist especially
for diligent and creative investors.
The Players
Three major players in the financial markets:
1. Firms are net borrowers. They raise capital to pay
for investments in plant and equipment and the
income generated by the real assets provide the
returns to investors who purchase the firm’s
securities.
2. Households typically are net savers whereby they
purchase securities issued by firms that need to
raise funds.
3. Governments can be borrowers and lenders
depending on the relationship between tax
revenue and government expenditures. Malaysian
government has run budget deficits and therefore
the government has had to borrow funds to cover
its budget deficit. Issuance of government debt
securities is the major way that the government
borrow funds from the public.
Financial Intermediaries
1. Financial intermediaries are institutions that bring
borrowers and lenders together. They include
banks, investment companies and insurance
companies. Financial intermediaries are
distinguished from other business because their
assets and liabilities are overwhelmingly financial
(very small amount of real assets).
2. Intermediaries simply move funds from one sector
to another, for example channel household
savings to the business sector.
3. Institutions that connect borrowers and lenders
by accepting funds from lenders and loaning funds
to borrowers. For example, commercial banks,
investment companies, insurance companies and
credit unions.
Figure 3 – Financial Market and The Economy
4. Advantages of financial intermediaries:
o By pooling the resources of many small
investors, they are able to lend considerable
sum to large borrowers.
CHAPTER 1 – INTRODUCTION TO INVESTMENT AND PORTFOLIO MANAGEMENT

o By lending to many borrowers, intermediaries

achieve significant diversification so they can
accept loans that individually might be too
risky.
o Economies of scale. Financial intermediaries
are able to spread large amount od brokerage
fees, research cost and analytic services
among the many clients.
o Secondary securities sold by financial
intermediaries are easy to buy hold and sell.
The information cost and transaction cost
involved are very low. Banks run branches in
all urban areas and several semi-urban and
rural areas. The deposits they sell are
standardized and information about them
easily available.

Investment Bankers
1. Investment bankers are firms specializing in the
sale of new securities to the public. The
investment banking firm handles the marketing of
the security in the primary market where the new
issues of securities are offered to the public.
2. The investment bankers will suffer along with
investors if the securities it underwrites are
marketed to the public with overly optimistic or
exaggerated claims.
3. The investment banker’s effectiveness and ability
to command future business depend on the
reputation it has established over time.
4. Example – Merrill Lynch, Goldman, Sachs,
Citigroup Malaysia, CIMB Investment Bank Bhd,
Kenanga Investment Bank Bhd, Affin Hwang
Investment Bank Bhd