INTRODUCTION TO INVESTMENT

Security analysis is a pre-requisite for making investments. In the present day financial markets,
investment has become complicated. Investment may be defined as an activity that commits
funds in any financial/physical form in the present with an expectation of receiving additional
return in the future.

Types of investments

Investments may be classified as financial investments or economic investments. In the financial

sense, investment is the commitment of funds to derive future income in the form of interest,
dividend, premium, pension benefits, or appreciation in the value of the initial investment.
Economic investments are undertaken with an expectation of increasing the current economy’s
capital stock that consists of goods and services.

Objectives

The main objective of an investment process is to minimize risk while simultaneously

maximizing the expected returns from the investment and assuring safety and liquidity of the
invested assets.

REAL VS. FINANCIAL ASSETS

Investment in financial assets differs from investment in physical assets in those important
aspects:

 Financial assets are divisible, whereas most physical assets are not. An asset is divisible if
investor can buy or sell small portion of it. In case of financial assets, it means, that investor, for
example, can buy or sell a small fraction of the whole company as investment object buying or
selling a number of common stocks.

 Marketability (or Liquidity) is a characteristic of financial assets that is not shared by physical
assets, which usually have low liquidity. Marketability (or liquidity) reflects the feasibility of
converting of the asset into cash quickly and without affecting its price significantly. Most of
financial assets are easy to buy or to sell in the financial markets.
 The planned holding period of financial assets can be much shorter than the holding period of
most physical assets. The holding period for investments is defined as the time between signing a
purchasing order for asset and selling the asset. Investors acquiring physical asset usually plan to
hold it for a long period, but investing in financial assets, such as securities, even for some
months or a year can be reasonable. Holding period for investing in financial assets vary in very
wide interval and depends on the investor’s goals and investment strategy.

INVESTMENT DECISION PROCESS

Investment management process is the process of managing money or funds. The investment
management process describes how an investor should go about making decisions. Investment
management process can be disclosed by five-step procedure, which includes following stages:

1. Setting of investment policy.

2. Analysis and evaluation of investment vehicles.
3. Formation of diversified investment portfolio.
4. Portfolio revision
5. Measurement and evaluation of portfolio performance.

Setting of investment policy is the first and very important step in investment management
process. Investment policy includes setting of investment objectives. The investment policy
should have the specific objectives regarding the investment return requirement and risk
tolerance of the investor. For example, the investment policy may define that the target of the
investment average return should be 15 % and should avoid more than 10 % losses. Identifying
investor’s tolerance for risk is the most important objective, because it is obvious that every
investor would like to earn the highest return possible. But because there is a positive
relationship between risk and return, it is not appropriate for an investor to set his/ her
investment objectives as just “to make a lot of money”. Investment objectives should be stated
in terms of both risk and return. Setting of investment objectives for individual investors is
based on the assessment of their current and future financial objectives. The required rate of
return for investment depends on what sum today can be invested and how much investor needs
to have at the end of the investment horizon. Wishing to earn higher income on his / her
investments investor must assess the level of risk he /she should take and to decide if it is
relevant for him or not. The investment policy can include the tax status of the investor. This
stage of investment management concludes with the identification of the potential categories of
financial assets for inclusion in the investment portfolio. The identification of the potential
categories is based on the investment objectives, amount of investable funds, investment horizon
and tax status of the investor.

Analysis and evaluation of investment vehicles. When the investment policy is set up,
investor’s objectives defined and the potential categories of financial assets for inclusion in the
investment portfolio identified, the available investment types can be analyzed. This step
involves examining several relevant types of investment vehicles and the individual vehicles
inside these groups. For example, if the common stock was identified as investment vehicle
relevant for investor, the analysis will be concentrated to the common stock as an investment.
The one purpose of such analysis and evaluation is to identify those investment vehicles that
currently appear to be mispriced. There are many different approaches how to make such
analysis. Most frequently two forms of analysis are used: technical analysis and fundamental
analysis.

Technical analysis involves the analysis of market prices in an attempt to predict future price
movements for the particular financial asset traded on the market. This analysis examines the
trends of historical prices and is based on the assumption that these trends or patterns repeat
themselves in the future. Fundamental analysis in its simplest form is focused on the evaluation
of intrinsic value of the financial asset. This valuation is based on the assumption that intrinsic
value is the present value of future flows from particular investment. By comparison of the
intrinsic value and market value of the financial assets those which are under priced or
overpriced can be identified.

This step involves identifying those specific financial assets in which to invest and determining
the proportions of these financial assets in the investment portfolio. Formation of diversified
investment portfolio is the next step in investment management process. Investment portfolio is
the set of investment vehicles, formed by the investor seeking to realize its’ defined investment
objectives. In the stage of portfolio formation the issues of selectivity, timing and diversification
need to be addressed by the investor. Selectivity refers to micro forecasting and focuses on
forecasting price movements of individual assets. Timing involves macro forecasting of price
movements of particular type of financial asset relative to fixed-income securities in general.
Diversification involves forming the investor’s portfolio for decreasing or limiting risk of
investment. 2 techniques of diversification:

1. random diversification, when several available financial assets are put to the portfolio at
random;

2. objective diversification when financial assets are selected to the portfolio . Investment
management theory is focused on issues of objective portfolio diversification and professional
investors follow settled investment objectives then constructing and managing their portfolios.

Portfolio revision. This step of the investment management process concerns the periodic
revision of the three previous stages. This is necessary, because over time investor with long-
term investment horizon may change his / her investment objectives and this, in turn means that
currently held investor’s portfolio may no longer be optimal and even contradict with the new
settled investment objectives. Investor should form the new portfolio by selling some assets in
his portfolio and buying the others that are not currently held. It could be the other reasons for
revising a given portfolio: over time the prices of the assets change, meaning that some assets
that were attractive at one time may be no longer be so. Thus investor should sell one asset ant
buy the other more attractive in this time according to his/ her evaluation. The decisions to
perform changes in revising portfolio depend, upon other things, in the transaction costs incurred
in making these changes. For institutional investors portfolio revision is continuing and very
important part of their activity. But individual investor managing portfolio must perform
portfolio revision periodically as well. Periodic re-evaluation of the investment objectives and
portfolios based on them is necessary, because financial markets change, tax laws and security
regulations change, and other events alter stated investment goals.

Measurement and evaluation of portfolio performance. This the last step in investment
management process involves determining periodically how the portfolio performed, in terms of
not only the return earned, but also the risk of the portfolio. For evaluation of portfolio
performance appropriate measures of return and risk and benchmarks are needed. A benchmark
is the performance of predetermined set of assets, obtained for comparison purposes. The
benchmark may be a popular index of appropriate assets – stock index, bond index. The
benchmarks are widely used by institutional investors evaluating the performance of their
portfolio