Chapter- One

Introduction to investment

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 Meaning of investment
• Investment is foregoing the present consumption in
expectation of having greater consumption
opportunities in the future.
• It is current commitment of Birr 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.
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Investors can be individual investors; or Institutional investors.

Individual investors are those investors who are investing on their

own.

Sometimes individual investors are called retail investors.

Institutional investors are entities such as investment companies,

commercial banks, insurance companies, pension funds and other
financial institutions.

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Reasons for Investing: (Why people invest?)
Income: Some people invest in order to provide or supplement their
income. Investments provide income through the payment of
dividends or interest.
Appreciation: Other individuals, especially those in their peak
working years, may be more interested in seeing the value of their
investments grow rather than in receiving any income from
investment.
Appreciation is an increase in the value of an investment.
Excitement: Investing is frequently someone’s hobby.

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 Investment Goals
Enhancing current income: means choosing investment vehicles
that regularly pay dividends and interest that can provide all or some
of the money needed to meet living expenses.
Saving for major expenditures includes money set aside for such
things as the down payment on a home, college tuition, and even an
expensive vacation.
Accumulate retirement funds: it is the single most important reason
for investing.
Sheltering income from taxes involves taking advantage of certain
tax provisions that permit reduction of the income reported to the
government or direct reductions in taxes. 5
 Steps to Investment
• The seven steps in investing are as follows:
1. Meeting Investment Prerequisites: Providing for necessities of
life, adequate protection against losses, and setting retirement goals.
2. Establishing Investment Goals: Investment goals are the financial
objectives that one wishes to achieve by investing mentioned above.
3. Adopting an Investment Plan: An investment plan is a written
document describing how funds will be invested.

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4. Evaluating Investment Vehicles: In this step, the measures of risk
and return are used to estimate the perceived worth of an investment
vehicle. This process is called valuation.
5. Selecting Suitable Investments: This step involves careful
selection of investment vehicles that are consistent with
established goals & offer acceptable levels of return, risk, &
value.
6. Constructing a Diversified Portfolio: Diversification is the
concept of forming a portfolio using different investment vehicles to
reduce risk and increase return.
7. Managing the Portfolio: Portfolio management involves
monitoring the portfolio and restructuring it as dictated by the actual
behavior of the investments. 7
 Investment Constraints
Financial Constraints: refer to whether an investor can allocate
some portion of savings for investment activities.

Psychological Constraints: refers to how well an investor can

absorb the consequences of an investment decision.

Management Constraint: refers to the lack of expertise in managing

the investment activities.

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 Investment, Speculation and gambling compared
• Investment: Foregoing the present consumption in
expectation of having greater consumption
opportunities in the future.
• Speculation: Aim high ‘gain or heavy loss; Higher
level of risk and more uncertain expected returns.
• Gambling: Gambling at 'out of proportion gain or total
loss.' Depend more on luck and chances.

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 Investment Speculation
1. Risk and Return
Good return for an appropriate level of risk Willing to take high risk in exchange for a high return

2. Time Horizon
Longer period of time. At least 1 year Short period of time. Few days, weeks or months.

3. Performance
Interested in a company with a consistent Interested in a less consistent performance along with
performance some abnormal and extremely return on risk.
4. Motivation
Concerned with dividend payments & long Concerned with rapid short term price appreciation.
term growth prospect
5. Decisions and Funds to buy
Careful & thorough fundamental analysis in Speculators will buy securities using borrowed funds
terms of past performance and future prospects. and choose securities mostly based on intuition and
Normally use their own money to buy rumors spread in the market.
securities

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 Investment Gambling
1. Purpose
A way of earning an income Is a form of entertainment
2. Time Horizon
Long period of time. At least 1 year Short period of time

3. Need for Analysis

Rely on careful analysis of the Depends on luck
market to reduce the risk

4. Risk and Return

Have risk but on average the Gambling has high risk and the
return is positive. players’ return on average is negative

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 Investment environment
• It is the existing investment vehicles in the market available for investor and
the places for transactions with these investment vehicles.
• Investment vehicles: is an investment product that is offered to investors
that provide the chance for investors to earn a return, or profit, on the
product purchased.
• The main types of financial investment vehicles are:
– Short term investment vehicles;
– Fixed-income securities;
– Common stock;
– Speculative investment vehicles
– Other investment tools
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1. Short - term investment vehicles
– They have a maturity of one year or less.
– They are often defined as money-market instruments
The main short term investment vehicles are:
Certificate of deposit is debt instrument issued by bank that indicates a specified sum of
money has been deposited at the depository institution.
Treasury bills (T-bills) are securities representing financial obligations of the government.
They have maturities of less than one year.
Commercial paper is a name for short-term unsecured promissory notes issued by
corporation. It is a means of short-term borrowing by large corporations.
Bankers acceptances are the vehicles created to facilitate commercial trade transactions. A
bank accepts the responsibility to repay a loan to the holder of the vehicle in case the debtor
fails to perform.
Repurchase agreement (often referred to as a repo) is the sale of security with a
commitment by the seller to buy the security back from the purchaser at a specified price at a
designated future date. 13
2. Fixed-income securities
• Are those which return is fixed, up to some redemption date or
indefinitely. This type of financial investments is presented by two
different groups of securities:
• Long-term debt securities can be described as long-term debt
instruments representing the issuer’s contractual obligation. Long term
securities have maturity longer than 1 year.
• Preferred stocks are equity security, which has infinitive life and
pay dividends. But preferred stock is attributed to the type of fixed-
income securities, because the dividend for preferred stock is fixed in
amount and known in advance.

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3. The common stock
• Represents the ownership interest of corporations or the equity of the
stock holders.
4. Speculative investment vehicles
• It is an investments with a high risk and high investment return.
• The only gain from such investments is the positive difference
between selling and purchasing prices.

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Financial markets
They are the other important component of investment environment. In
financial markets funds are channeled from those with the surplus, who
buy securities, to those, with shortage, who issue new securities or sell
existing securities.
Investment companies
Investment companies pool funds from various investors and invest the
accumulated funds in various financial instruments or other assets. The
profits and losses from the investment (after repaying the management
expenses) are distributed to the investors in the funds in proportion to
the investment amount.

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Functions of investment companies
• Record keeping and administration. Investment companies issue
periodic status reports.
• Diversification and divisibility. 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.
• Professional management. Most, but not all, investment companies have
full-time staffs of security analysts and portfolio managers who attempt
to achieve superior investment results for their investors.
• Lower transaction costs. Because they trade large blocks of securities,
investment companies can achieve substantial savings on brokerage fees
and commissions.
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There are two types of investment companies/Investment funds:
• Open-End Funds: Have no pre-determined amount of stocks
outstanding and they can buy back or issue new shares at any point.
Price of the share is not determined by demand, but by an estimate of
the current market value of the fund’s net assets value (NAV) and a
commission.
• Closed-End Funds: Are publicly traded investment companies that
have issued a specified number of shares and can only issue
additional shares through a new public issue.

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 END OF
CHAPTER ONE

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