U U N IT

1
The Investment Process

“Investing money is the process of committing resources in a strategic way to

accomplish a specific objective.” - Alan Gotthardt, The Eternity Portfolio

Unit Overview

In this Unit, you will be introduced to the basic concept of investing. This Unit
explains why persons invest, and how they measure the associated risks and
returns. It is important to gain an understanding of how these factors are measured
in order to fully appreciate how investments work.

This Unit will first define the term investment and discuss the types of investment
instruments that are present in the financial market. This will lead into a discussion
of the methodologies applied to measuring returns and the types of risks facing
investors. Finally, the Unit will close with an introduction of how investors decide
on an investment.

Unit 1 Learning Objectives

By the end of this Unit, you will be able to:

1. Comprehend the meaning of the term “investment.”

2. Describe how investors measure the rate of risk and return.

3. Discuss the relationship between risk and return.

4. Discuss why the savings and borrowing patterns of individuals differ by age.

This Unit is divided into three sessions as follows:

Session 1.1: An Overview of the Investment Process

Session 1.2: Risk and Return

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 Readings and Resources

Required Reading
Reilly, F. K., & Brown, K. C. (2012). Chapter 1: The Investment Setting. In F. K.
Reilly, & K. C. Brown, Investment Analysis and Portfolio Management (pp.
3-32). South-Western Cengage Learning.

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 SSession 1.1

An Overview of the Investment Process

Introduction
How often are you faced by considering something you wish to purchase, but
cannot afford it? A trip you wish to experience, but lack the financial resources?
Does your current income exceed your consumption needs? Would you be more
willing to take a bank loan to meet these needs, or forgo your immediate desires
for a higher level of future consumption? This Unit will introduce the concept of
“making your money work for you” through investments.

What is an Investment?
Meet Mike, a 25-year-old graduate who just landed his first job out of graduate
school, which pays $500 monthly. Mike currently lives at home and uses public
transportation. He has made a list of things that he wishes to purchase within the
first year of employment, but realises that his disposable income, after student
loan repayment, transportation costs and household contributions, leaves $150
making his dreams impossible.

Essentially, Mike has three options:

1. Borrow the money, and use his disposable income for repayment.

2. Save his disposable income until he has accumulated enough wealth.

3. Invest his savings.

 

An investment is a current commitment of money for a period of time, in order to

derive future payments that will compensate for:

– The time the funds are committed

– The expected rate of inflation

– Uncertainty of future flow of funds

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 Saving/Investment
Saving/Investment: sacrificing immediate possession of savings for a larger
amount of money that will be available for future consumption.

Types of Investments
Mike has three basic types of investments available at his disposal:

Reasons for Investments

The situations still beg the question: Why invest and not borrow? The main reasons
are:

1. Pure Rate of Interest

– It is the exchange rate between future consumption (future dollars) and present
consumption (current dollars). Market forces determine this rate.

– Example: If you can exchange $100 today for $104 next year, this rate is 4%

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 2. Pure Time Value of Money

– The fact that people are willing to pay more for the money borrowed and
lenders desire to receive a surplus on their savings (money invested), gives
rise to the value of time, referred to as the pure time value of money.

– Example: Investing $100 today at a 10% interest rate, will be worth $110 in
1 year, hence, once invested, money available now is worth more than the
same amount in the future.

3. Other Factors Affecting Investment Value

– Inflation: If the future payment will be diminished in value because of

inflation, then the investor will demand an interest rate higher than the
pure time value of money, to also cover the expected inflation expense e.g.
an investor purchasing securities in Jamaican dollars will request a higher
interest rate to compensate for the risk of lost value.

– Uncertainty: If the future payment from the investment is not certain, the
investor will demand an interest rate that exceeds the pure time value
of money, plus the inflation rate, to provide a risk premium to cover the
investment risk Pure Time Value of Money.

4. The Notion of Required Rate of Return

– The minimum rate of return an investor requires on an investment, including

the pure rate of return.

– to receive a rate of return different from the required rate of return, which
is called expected rate of return. What would occur if these two rates of
returns are not the same?

– Example: Investors considering purchasing stock in a start-up company

will demand a higher rate of return due to the risk associated. A start-up
company lacks the track record of an established business, therefore the
investor is not guaranteed any return. An investor will demand a return
based on his evaluation of the investment and market conditions.

At this point, Mike now knows why he should invest, and what he should expect
from his investment. He’s now faced with the challenge of determining what return
will compensate for the time period he has to sacrifice his current consumption,
the rate of inflation and the uncertainty of the future cash flows. This is referred to
as his required rate of return.

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 ACTIVITY 1.1
Please read pages 3-5 of the text on the investment setting. Discuss the
overall purpose people have for investing.

Session Summary

This introduction into the challenges that would lead to an individual’s interest in
Investments is the point at which the remainder of the Unit will derive. So long as
consumption desires outweigh income, investing will be an option to individuals.

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 SSession 1.2

Risk and Return

Introduction
In order for Mike to make a sound investment decision, he needs to evaluate his
available options and their associated risk-return trade-offs. Therefore, he must
first understand how to measure the rate of return, and how to measure the
risk involved in a given investment. This Session will examine the methods of
quantifying return and risk.

The following video provides an introduction to the concepts of Risk and Return.
After watching this video, you should understand the compromise between risks
and return when investing.

Play Video
Introduction to Risk and Return

https://www.youtube.com/watch?v=xAWxKk9tUME

Rates of Return
Rates of return measure the profitability of financial assets in percentage figures
rather than dollar amounts to allow for comparison of various assets. This value
indicates the additional revenue the investor can expect from purchasing given
investment assets.

Can you tell which is more profitable?

• Earning $200 on Scotiabank stock

Or
• Earning $100 on Sagicor stock?

If you had invested $1000 in BNS and $200 in Sagicor then Sagicor was more
profitable. For comparing profitability, absolute dollar value is meaningless and
% figures are more appropriate.

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 Rates of return can be calculated in more than one way. Different methods can
yield different results. Investment managers who are rated on their performance
have an incentive to use those methods which make them look best. Therefore,
Mike must fully understand how to apply these measures.

Simple Rate of Return

EMV - BMV + 1
R=
BMV

Where R is the rate of return, EMV is the market value of the investment asset at
the end of the holding period, BMV is the value at the beginning of the period and
I is any interest or dividend received during the holding period.

Example:

Assume you purchased 200 shares of stock at the beginning of the year for $100 per
share. At the end of the year you receive an $8 cash dividend per share. The stock
is trading at the end of the year @ $110 per share. What is the rate of return?

EMV= $110 x 200 shares BMV= $100 x 200 shares

$22,000 $20,000

R= $110-$100+$8

$100

Answer: 18%

10% (additional $10) is derived from the increased price of the stock, known as
capital gain and an 8% ($8 dividend) is the return on the share given as a dividend
the dividend yield.

The simple rate of return is useful but has an important limitation. It does not
accurately account for the timing of cash flows (eg. dividends), that are received
during the evaluation period. For this, we turn to the historical rate of return.

Historical Rate of Return

To effectively evaluate alternative investments with different prices or lives, their

historical rate of return must be assessed.

The return on an investment, is concerned with the change in wealth resulting

from the change in wealth over the period that the investment is held (Holding

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 Period). This change in wealth can be either due to cash inflows, such as interest
or dividends, or caused by a change in the price of the asset (positive or negative).

The Return over the Holding Period is calculated:

Ending Value of Investment

HPR =
Beginning Value of Investment

The HPR value will always be zero or greater – it can never be a negative value.

HPR > 1 - Increased wealth

HPR = 1 - No appreciation of wealth

HPR < 1 - Diminished wealth

As mentioned previously, the conversion of returns to a percentage is a more

effective method of comparing returns among alternative investment options.
Hence, investors will find it more effective to evaluate returns in percentage terms
on an annual basis in order to compare alternative investments.

HPR expressed as an annual percentage is referred to as the Holding Period Yield

(HPY) i.e. the investment’s annual rate of return.

Annual HPY is annual HPR minus 1.

Annual HPR = HPR1/n

HPY = Annual HPR - 1 = HPR1/n -1
where n = number of years of the investment.

# Begin Beginning Ending Ending Market Wtd

Stock Shares Price Mkt. Value Price Mkt. Value HPR HPY Wt. HPY
A 100,000 $10. $1,000,000. $12. $1,200,000. 1.20 20% 0.05 0.010
B 200,000 $20. $4,000,000. $21. $4,200,000. 1.05 5% 0.20 0.010
C 500,000 $30. $15,000,000 $33. $16,500,000. 1.10 10% 0.75 0.075
Total $20,000,000. $21,900,000. 0.095

HPR = $21,900,000. = 1.095

$20,000,000.

HPY = 1.095 – 1 = 0.095

=
9.5%

The next step to calculating the rate of return of an investment, is to account for
all the years the investment is held (particularly if the investment is held for an

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 extended period). To do this, the mean HPV by either using the arithmetic mean
(AM) or the geometric mean (GM).

Given a set of HPVs;

AM = Σ HPY / n

Where, Σ= the sum of, and n = the number of years

Or
GM = [π HPY] 1/n -1
where, π = product of, and n= the number of years

Please see the example in the following learning activity.

Comparison of AM and GM

– When rates of return are the same for all years, the AM and the GM will be
equal.
– When rates of return are not the same for all years, the AM will always be
higher than the GM.
– While the AM is best used as an “expected value” for an individual year, while
the GM is the best measure of an asset’s long-term performance.

ACTIVITY 1.2
Calculating the Return on an Investment
Suppose you invested $100 three years ago. At the end of Year 1, the
investment was worth $115, at the end of Year 2, it was worth $138, and
it is worth $110.40 today (at the end of Year 3). Calculate AM and the GM
over a three-year period for an investment.

Answer:
Step 1: Calculate HPR for each Year:

Ending Value of Investment

HPR =
Beginning Value of Investment

HPR 1 = (115/100) = 1.15

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 HPR 2 = (138/115) = 1.20

HPR 3 = (110.4/138) = 0.80

Step 2: Calculate the HPY for each Year:

HPY 1: 1.15-1 = 0.15

HPY 2= 1.20-1 =0.2

HPY 3 = 0.80-1= -0.20

Step 3: Calculate AM and GM

AM=[(0.15)+(0.20)+(-0.20)] / 3

= 0.15/3

= 5%

GM=[(1.15) x (1.20) x (0.80)]1/3 – 1

= (1.104)1/3 -1=1.03353 -1

= 3.353%

Risk
Risk refers to the uncertainty of an investment; therefore the measure of risk should
reflect the degree of the uncertainty.

• The risk of expected return reflects the degree of uncertainty that actual return
will be different from the expect return. E.g. Any equity investment carries the
associated risk to market volatility; this means that the expected appreciation
or dividend payment can likely vary from the actual return.
• The common measures of risk are based on the variance of rates of return
distribution of an investment. E.g.

The Real Risk Free Rate (RRFR)

The real risk free rate is the return on an investment with zero risk. This is a
theoretical tool used to compare available investments; it is the minimum return
an investor can expect for any investment. This tool carries the following features:

– Assumes no inflation.
– Assumes no uncertainty about future cash flows.

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 – Influenced by time preference for consumption of income and investment
opportunities in the economy

RRFR=[(1+NRFR) / (1+ Rate of Inflation)] - 1

Nominal Risk-Free Rate (NRFR)

This is an additional analytical tool that accounts for inflationary expectations. It
considers:
– Conditions in the capital market

– Expected rate of inflation

NRFR=(1+RRFR) x (1+ Rate of Inflation) - 1

Types of Risk

The Main Types of Risk Associated

with Investing are:

3 Exchange Rate Risk Political Risk 4

– Political risk is the uncertainty of
–Uncertainty of return is introduced by returns caused by the possibility of a
acquiring securities denominated in a major change in the political or
currency different from that of the economic environment in a country.
investor.
– Individuals who invest in
– Changes in exchange rates countries that have unstable
affect the investors’ return political-economic systems must
when converting an include a country risk-premium
investment back into the when determining their required
“home” currency. rate of return

Business Risk Financial Risk 2

1 (aka Unsystematic Risk) – Uncertainty caused
by the use of debt financing
– Uncertainty of income flows
caused by the nature of a firm’s – Borrowing requires fixed
business payments which must be paid
ahead of payments to
– Sales volatility and operating stockholders.
leverage determine the level of
business risk. – The use of debt increases
uncertainty of stockholder
income and causes an increase in
the stock’s risk premium.

INVESTMENTS

Types of Risks Associated with Investing

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 Play Video
The types of risk are further explained in the following video
Investment types of risk: https://www.youtube.com/watch?v=mp8u__O_-k4

The Relationship between Risk and Return

The relationship between risk and return can be illustrated on the Security Market
Line (SML). The SML illustrates the risk-return combinations available for all risky
assets. Investors will select investments consistent with their risk preferences.

The Relationship between Risk and Return

Movement along the SML

When the risk changes, the expected return will also change, moving along the
SML.

Risk premium: RPI = E(Ri) - NRFR

Changes in the Slope of the SML

– When there is a change in the attitude of investors toward risk, the slope of the
SML will also change.

– If investors become more risk averse, then the SML will have a steeper slope,
indicating a higher risk premium, RPi, for the same risk level.

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 Changes in Market Condition or Inflation
– A change in the RRFR or the expected rate of inflation will cause a parallel shift
in the SML.

– When nominal risk-free rate increases, the SML will shift up, implying a higher
rate of return while still having the same risk premium.

Play Video
The SML is further explained in the following videos:

• Investment Risk and Return - https://www.youtube.com/watch?v=bLI9-

5txwtg

• Security Market Line - https://www.youtube.com/watch?v=R3oAOCR2S5I

Session Summary

The relationship between the risks and returns of any investor will determine the
quality of the investment decision. The balance between risk and return is the most
important task that investors can make. In the next Unit, we will explore the other
practical variables that affect the investor’s risk and return.

ACTIVITY 1.3
Discuss why you would expect the savings and borrowing patterns of
individuals to differ by age.

Uit 1 Summary

Unit 1 has provided the foundation on which the remainder of this course will be
built. Understanding why individuals invest, and how they use their savings to
build returns is at the core of why we examine every other aspect in this course.

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 References
CollegeForFinPlan CollegeForFinPlan. (2014, January 21). Investments
Types of Risk. [Video file]. Retrieved from https://www.youtube.com/
watch?v=mp8u__O_-k4

DSP BlackRock Mutual Fund. (2011, August 3). Investment Risk and Return .
[Online Video]. Retrieved from https://www.youtube.com/watch?v=bLI9-
5txwtg

Kanjohvideo. (2009, June 12). Introduction to Risk and Return. [Online Video].
Retrieved from https://www.youtube.com/watch?v=xAWxKk9tUME

Moy, Ronald. (2013, October 30).. Security Market Line . [Online Video]. Retrieved
from https://www.youtube.com/watch?v=R3oAOCR2S5I

Reilly, F. K., & Brown, K. C. (2012). Chapter 1: The Investment Setting. In F. K.

Reilly, & K. C. Brown, Investment Analysis and Portfolio Management (pp. 3-32).
South-Western Cengage Learning.

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