Chapter Three

3. Introduction to investment
3.1. What is Investment?

An investment is a commitment of fund to one or more assets that is held over for some future
time period with the expectation of future better benefits/returns. Investment is a sacrifice of
current money or other resources for future benefits. Funds to be invested may come from assets
already owned and borrowed money. And also an investment is the employment of funds on
assets with the aim of earning or capital appreciation. And it can be made to intangible assets like
marketable securities or to real assets like gold, real estate etc.
An investment is an asset or item acquired with the goal of generating income or appreciation. In
an economic sense, an investment is the purchase of goods that are not consumed today but are
used in the future to create wealth. In finance, an investment is a monetary asset purchased with
the idea that the asset will provide income in the future or will later be sold at a higher price for a
profit. An investment always concerns the outlay of some asset today (time, money, effort, etc.)
in hopes of a greater payoff in the future than what was originally put in. Investing is putting
money to work to start or expand a project - or to purchase an asset or interest - where those
funds are then put to work, with the goal to income and increased value over time. The term
"investment" can refer to any mechanism used for generating future income. In the financial
sense, this includes the purchase of bonds, stocks or real estate property among several others.
Additionally, a constructed building or other facility used to produce goods can be seen as an
investment. The production of goods required to produce other goods may also be seen as
investing.

Economic growth can be encouraged through the use of sound investments at the business level.
When a company constructs or acquires a new piece of production equipment in order to raise
the total output of goods within the facility, the increased production can cause the nation’s gross
domestic product (GDP) to rise. This allows the economy to grow through increased
production based on the previous equipment investment.
Investment is a commitments of fund to one or more assets that is held over for some future time
period with the expectation of future better benefits/returns. Investment is a sacrifice of current

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money or other resources for future benefits. Funds to be invested may come from assets already
owned and borrowed money.
Investment is an exchange of financial claims such as stock and bonds for money. They are
expected to yield returns and experience capital growth over the period of time.

 When investing, present consumption is sacrificed to get a return in the future.

 The sacrifice takes place now and is certain. The return is expected in the future and
tends to be uncertain (form certainty to uncertainty)
 This uncertainty of investment indicates the inherent existence of risk. The risk
 Risk refers to the variability/fluctuation of rate of return how much do individual
outcomes deviate from expected value

3.2. Investment Alternatives

Though there are a range of investment alternatives, they can be classified into two broad
categories:
1. Investment on Financial Assets (Financial investment)

Financial assets are paper (or electronic) claims on some issuers such as the government bonds,
corporate bonds, stocks, commercial papers e.t.c.. Financial investment is the purchase of a
"financial paper" contract The important financial assets are equity shares, corporate bonds,
government securities, deposit with banks, mutual fund shares, insurance policies, and derivative
instruments and the like

2. Investments on Real Assets

Real assets are represented by tangible assets like house, commercial property, agricultural farm,
gold, precious stones, and other physical objects. As the economy advances, the relative
importance of financial assets tends to increase. Financial investment can provide finance for real
investment decisions
3.3. Investment Companies

Investment companies are financial intermediaries that collect funds from individual investors
and invest those funds in a potentially wide range of securities or other assets. Pooling of assets

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is the key idea behind investment companies. Each investor has a claim to the portfolio
established by the investment company in proportion to the amount invested. These companies
thus provide a mechanism for small investors to “team up” to obtain the benefits of large scale
investing.

Investment companies perform several important functions for their investors:

1. Record keeping and administration. Investment companies issue periodic status
reports,
keeping track of capital gains distributions, dividends, investments, and redemptions, and
they may reinvest dividend and interest income for shareholders.
2. Diversification. By pooling their money, investment companies enable
investors to hold fractional shares of many different securities. They can act as large
investors even if any individual shareholder cannot.
3. Professional management. Investment companies can support full-time staffs of
security
analysts and portfolio managers who attempt to achieve superior investment results for
their investors.
4. Lower transaction costs. Because they trade large blocks of securities, investment
companies can achieve substantial savings on brokerage fees and commissions.
While all investment companies pool the assets of individual investors, they also need to divide
claims to those assets among those investors. Investors buy shares in investment companies, and
ownership is proportional to the number of shares purchased. The value of each share is called
the net asset value, or N A V. Net asset value equals assets minus liabilities expressed on a per-
share basis:

Net asset value = Market value of assets minus liabilities/Shares outstanding

Consider an investment company that manages a portfolio of securities worth $120 million.
Suppose the company owes $4 million to its investment advisers and owes another $1 million for
rent, wages due, and miscellaneous expenses. The fund has 5 million shares.

Then ; Net asset value = $120 million - $5 million = $23 per share
5million shares
3.4. Types of Investment Companies

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Investment companies are classified as either unit investment trusts or managed investment
companies. The portfolios of unit investment trusts are essentially fixed and thus are called
“unmanaged.” In contrast, managed companies are so named because securities in their
investment portfolios continually are bought and sold: The portfolios are managed. Managed
companies are further classified as either closed-end or open-end. Open-end companies are what
we commonly call mutual funds.

A. Unit Investment Trusts

Unit investment trusts are pools of money invested in a portfolio that is fixed for the life of the
fund. To form a unit investment trust, a sponsor, typically a brokerage firm, buys a portfolio of
securities which are deposited into a trust. It then sells to the public shares, or “units,” in the
trust, called redeemable trust certificates. All income and payments of principal from the
portfolio are paid out by the fund’s trustees (a bank or trust company) to the shareholders.

There is little active management of a unit investment trust because once established, the
portfolio composition is fixed; hence these trusts are referred to as unmanaged. Trusts tend to
invest in relatively uniform types of assets; for example, one trust may invest in municipal
bonds, another in corporate bonds. The uniformity of the portfolio is consistent with the lack of
active management.

The lack of active management of the portfolio implies that management fees can be lower than
those of managed funds.

Sponsors of unit investment trusts earn their profit by selling shares in the trust at a premium to
the cost of acquiring the underlying assets. For example, a trust that has purchased $5 million of
assets may sell 5,000 shares to the public at a price of $1,030 per share, which (assuming the
trust has no liabilities) represents a 3% premium over the net asset value of the securities held by
the trust. The 3% premium is the trustee’s fee for establishing the trust.

3.4.1. Managed Investment Companies

There are two types of managed companies: closed-end and open-end. In both cases, the fund’s
board of directors, which is elected by shareholders, hires a management company to manage the
portfolio for an annual fee that typically ranges from 0.2% to 1.5% of assets. In many cases the

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management company is the firm that organized the fund. For example, Fidelity Management
and Research Corporation sponsors many Fidelity mutual funds and is responsible for managing
the portfolios. It assesses a management fee on each Fidelity fund.

In other cases, a mutual fund will hire an outside portfolio manager. For example, Vanguard has
hired Wellington Management as the investment adviser for its Wellington Fund. Most
management companies have contracts to manage several funds.

1. Open-end funds stand ready to redeem or issue shares at their net asset value
(although both purchases and redemptions may involve sales charges). When
investors in open-end funds wish to “cash out” their shares, they sell them back to the
fund at NAV.
2. In contrast, closed-end funds do not redeem or issue shares. Investors in closed-end
funds who wish to cash out must sell their shares to other investors. Shares of closed-
end funds are traded on organized exchanges and can be purchased through brokers
just like other common stock; their prices therefore can differ from NAV.

3.5. Risk and return on investment

Return is the total gain or loss experienced on an investment over a given period of time.
Investment return is what you get back on an investment you make. Ideally, the return will be
positive, your initial investment or principal will remain in intact, and you will end up with more
than you invested. But because investing typically involves risk—especially if you invest in
securities such as stocks, bonds, or mutual funds that invest in stocks and bonds—your returns
can be negative, and you may wind up with less money than you initially invested.
For example, let’s say you buy a stock for $30 a share and sell it for $35 a share. Your return is
$5 a share minus any commission or other fees you paid when you bought and sold the stock. If
the stock had paid a dividend of $1 per share while you owned it, your total return would be a
gain of $6 a share before expenses.
Compare a return of $5 per share on a $30 investment with a return of $5 per share on a $60
investment. In both cases, your dollar return is the same. But your rate of return, which you
figure by dividing the gain by the amount you invest, is different.

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The yield on an investment is the amount of money you collect in interest or dividends,
calculated as a percentage of either the current price of the investment or the price you paid to
buy it.
Risk can be defined as the chance or possibility of loss. In financial terms it can be defined as the
degree of uncertainty regarding the rate of return on and/or the principal value of an investment.
Part of becoming a good investor is understanding the types of risks you will face. On the other
hand, you will need to know how much financial risk you can afford in order to reach your goals.
3.5.1. Types of risk
There are three types of risks you need to become aware of:
1. Market Risk
2. Inflation Risk
3. Liquidity Risk
1. Market risk is the risk that the value of your investment will decrease due to moves in market
factors. The four standard market risk factors include:
a. Equity risk
b. Interest rate risk
c. Currency risk
d. Commodity risk
2. Inflation risk is the risk that the interest you're earning may fall below the inflation rate.
3. Liquidity risk is defined as the ease with which an investor can convert an investment to cash
without negative impact on either capital or return.
 The best way to reduce risks is by diversifying your investments. Simply
stated, don’t put all of your eggs into one basket. Diversification can be
defined as: An investment strategy that can reduce market risk by combining a
variety of investments
3.5.2. Risk return relationship

If you have a financial goal with a long time horizon, you are likely to make more money by
carefully investing in asset categories with greater risk, like stocks or bonds, rather than
restricting your investments to assets with less risk, like cash equivalents. On the other hand,
investing solely in cash investments may be appropriate for short-term financial goals

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• The reward for taking on risk is the potential for a greater investment return.

• “No pain, no gain" - those words come close to summing up the relationship between risk
and reward.

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