Basics of Investment

(Part-I)
Prepared by:
Md. Thasinul Abedin
MBA (AIS, DU), BBA (AIS,DU)
Lecturer, Department of Accounting
Faculty of Business Administration
University of Chittagong
What is Investment?
An investment is the current commitment of dollars (deferring
consumption) for a period of time in order to derive future
payments that will compensate the investors:
1. The time the funds are committed;
2. The expected rate of inflation during this time period;
3. The risk of future payments.
What is Investment? (cont…)
 Compensation for the time : Individuals give up the immediate
possession of savings (defer consumption) for future larger
amount of money that will be available for future consumption.
For example, the individual who gives up $100 today expects to
consume $104 of goods and services in future. Here, the rate of
exchange between present consumption and future consumption
is 4% which is known as compensation for the time or the pure
time value of money.
What is Investment? (cont…)
 Compensation for the Expected Rate of Inflation: If the price
level of an economy remains stable, then investors will be
satisfied with only the pure time value of money. However, the
price level increases over the time and investors demand
compensation for the increase.
For example due to increase in price level, investors deferring $100
consumption today demand $106 instead of $104. The extra 2%
apart from the 4%-pure time value of money is known as
compensation for expected rate of inflation.
What is Investment? (cont…)
 Compensation for the Risk: If the future payment from the
investment is not certain, the investors demand some
compensation apart from the compensation for the time and
compensation for the expected rate of return. The uncertainty of
payments from investment is known as investment risk.
For example due to uncertainty of payments from an investment,
investors deferring $100 consumption today demand $108 instead
of $106. The extra 2% apart from the 4%-pure time value of
money and 2%-compensation for expected rate of inflation is
known as compensation for the risk.
What is Investment? (cont…)
Therefore, Investment can be defined as current commitment of
money in the expectation of future benefits (Compensation for
time, inflation, and risk).
Note:
 Pure time value of money is only the compensation for the time.
 Actual time value of money is the compensation for the time,
inflation, and risk.
Asset Allocation Decision
Investment in Assets and Asset Classes
 It is basically the Asset Allocation Decision.
 Usually investors choose to invest in either real assets or
financial assets or both.
 The material wealth of a society is ultimately determined by the
productive capacity of its economy, that is, the goods and services
its members can create. This capacity is a function of real assets
of the economy: land, buildings, machines, and knowledge etc.
that can be used to produce goods and services.
Investment in Assets and Asset Classes (cont…)
 In contrast to real assets are the financial assets: stocks, bonds etc.
Such assets are no more than sheets or papers or computer entries
and do not contribute directly to the productive capacity of the
economy.
 Financial assets are the means by which individuals hold their
claims on real assets. More specifically , financial assets are claims
to the income generated by the real assets.
 For example, If we cannot own our own auto plant (real asset), we
can still buy the stocks in General Motors or Toyota (financial
asset) and thereby share in the income derived from the production
of automobiles.
Investment in Assets and Asset Classes (cont…)
 While real assets generate net income to the economy, financial
assets simply define the allocation of income or wealth among
investors.
 Individuals can choose between consuming their wealth today or
investing for the future.
 If they choose to invest, they may place their wealth in financial
assets by purchasing various securities.
 When investors buy these securities from firms, firms use the
money raised to pay for real assets (plant, equipment, technology,
and inventory).
Investment in Assets and Asset Classes (cont…)
 So investors’ returns on securities ultimately come from the
income produced by the real assets.
 The investors may invest in similar real assets at a time or similar
financial assets at a time.
 Securities held by the investors having similar characteristics,
attributes, and risk/return relationships make an asset class.
 A broad asset class such as bonds can be divided into smaller
asset classes such as Treasury Bonds, Corporate Bonds, and High
Yield Bonds.
Investment Strategies over an Investor’s Lifetime
 Investment needs change over a person’s life cycle. How
individual structure their financial plan should be related to age,
financial status, future plans, risk tolerance, and needs.
 Due to changes in age, net worth, risk tolerance, financial status,
and future plan, investment strategies will change over an
investor’s lifetime.
 Although each individual’s needs and preferences are different,
some general traits affect most investors over the life cycle.
Investors’ Life Cycle
 The four life cycle phases (common for all):
1. Accumulation Phase
2. Consolidation Phase
3. Spending Phase
4. Gifting Phase
Accumulation Phase
 Early to Middle years of working careers.
 Individuals attempt to accumulate assets to satisfy fairly
immediate needs (for example a down payment for a house) or
longer term goals (for example, children’s college education and
retirement).
 Net worth is small and debt from car loans or past college loans
may be heavy.
 As a result of typically long investment time horizon and future
earnings ability, individuals in accumulation phase are willing to
make relatively high-risk investments in the hopes of making
above average abnormal returns over time.
Accumulation Phase (cont…)
 Funds invested in early life cycle phases, with returns
compounding over time, will reap significant financial benefits
during later phases.
Consolidation Phase
 Individuals have just passed the mid point of their careers.
 Have paid off much or all of their debts.
 Perhaps have paid off or have assets to pay their children’s
college bills.
 Earnings exceed expenses. So the excess can be invested to
provide for future retirement.
 Since the typical time horizon is still like accumulation phase, so
moderately high risk investments are attractive .
Consolidation Phase (cont…)
 Because individuals in this phase are concerned about capital
preservation, they do not want to take abnormally high risks that may
put their current nest egg in jeopardy.
Spending Phase
 Typically begins when an individual retires.
 Living expenses are covered by the social security income and income
from prior investments including employer pension plans.
 Because individuals’ earning years have concluded, they are very
conscious about protecting their capital.
 At the same time, individuals must balance their desire to preserve the
nominal value of their savings with the needs to protect themselves
against a decline in real value of their savings due to inflation.
Spending Phase (cont….)
 Although individuals’ portfolio may be less risky than that of in
consolidation phase, individuals still need some risky growth
investments, such as common stocks for inflation protection.
Gifting Phase
• Similar to and may be concurrent with the spending phase. In this
stage individuals may believe they have sufficient income and
assets to cover their current and future expenses while
maintaining a reserve for uncertainties.
• In such cases, excess assets can be used to provide financial
assistance to relatives or friends, to establish charitable trusts or to
fund trusts as an estate planning tool to minimize estate taxes.
 Spending Phase
Accumulation Consolidation Phase
Gifting Phase
Phase
Long-term:
Long-term:
Long-term:
Retirement
Retirement Estate Planning
Children’s college Short-term: Short-term:
Short-term: Vacations
Lifestyle Needs
House Children’s College
Gifts
Car

25 35 45 55 65 75
Life Cycle Investment Goals
 Near-term, High-priority goals
 Long-term, High-priority goals
 Lower priority goals
Life Cycle Investment Goals (cont….)
 Near-term, high-priority goals: Short term financial objectives
that individuals set to fund purchases that are personally
important to them, such as accumulating funds to make a house
down payment, buy a new car, or take a trip.
 Long-term, high-priority goals: Typically include some form of
financial independence, such as the ability to retire at a certain
age. Because of their long term nature, higher risk investments
can be used to help meet these objectives.
Life Cycle Investment Goals (cont…)
Lower-priority needs: Include the ability to purchase a new car every
few years, redecorate the home with expensive furnishings, or take a
long luxurious vacation.