CHAPTER

CHAPTER 1
INVESTMENTS

Learning Objectives
After studying this chapter you should be able to:

• Define investment
• Distinguish between real and financial asset
• Distinguish between institutional and retail investors
• Describe the steps involved in the investment process
• Explain the meaning of asset allocation decision
• Distinguish between active and passive investment policy
• Describe the relationship between risk and return of various investment instruments

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OVERVIEW

Definition of Investment
Financial
Assets
Introduction
Types of Asset
Real Assets

Investment Process Market Participants

Overview

Risk and Return

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1.1 INTRODUCTION
1.1.1 Definition of Investment

Investment means the commitment of current resources with the expectation of receiving a
larger amount of resources in the future. It involves the sacrifice of current money with the
hope of receiving a larger amount in the future. Investment involves both the elements of
risk and time, where the investor forgoes consumption now for a much larger consumption
later. However, the later consumption is not guaranteed, it may or may not be larger in the
future. Thus, there is an element of risk involved in investment: some instruments may
have larger risk than others. Before we look at the various investment instruments available
in the market, we should first distinguish between the types of assets in the economy.

1.1.2 Types of Assets

Investment involves the purchase by an investor of an asset that will generate a certain
amount of return proportional to the amount of risk assumed over a period of time. These
assets can either be classified as real assets or financial assets.

Real assets are those which contribute directly to the productive capacity of an economy.
Assets which are used to produce goods and services of a nation are considered as real
assets. They can either be tangible or intangible. Examples of tangible assets are land,
buildings and machines, while an intangible asset is knowledge. Notice that these are all
used directly to produce goods and services.

Financial assets are claims on real assets or on the income they generate. Examples of
financial assets are stocks and bonds. For investment purpose, an investor can use his funds
either to buy real assets or financial assets. If he decides to buy common stocks, then he
will have financial assets on hand. The company which receive his fund can then use it to
buy real assets such as machines and equipment, and use them to generate profits. Thus,
return to investors come from the income produced by real assets which were financed by
funds obtained from selling financial assets.

Are these financial or real assets?

• A RM100 bill
• A piece of cheque for RM1,000
• Patents
• Corporate bonds

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Types of Financial Assets

There are 3 broad classes of financial assets: equity, fixed income and derivatives. An
equity or a common stock is considered as ownership share in a company. The holder of
common stock is part-owner and is entitled to receive dividends the company may declare.
He is also the last to claim on the company's assets in case of liquidation. The performance
of equity security depends on the success of the firm and the income generated by its real
assets. Due to this, equity investment tend to be quite risky.
A fixed income security promises a certain amount of return on a regular basis. This return
can either be a constant amount or it can vary depending on the terms agreed upon. The
security also has a fixed maturity date when the principal amount will be paid by the issuer
(i.e. the company).

A derivative security is an asset where its value is determined by, or derived from, the
value of another investment vehicle. Examples of derivative securities are options, futures,
swaps and forwards. A derivative security is used to transfer risk to other parties.

1.1.3 Market Participants

Participants in the financial markets can be divided into 3 groups:

i) providers of fund ii) users of fund iii) financial intermediaries

Fund providers are usually the households who, in general, earn more than they can
consume. They are net savers and will purchase securities issued by firms which needed
funds. These are the investors and can be further classsified as either retail or institutional.
Retail investors are individuals while institutional investors are provident and pension
funds, investment companies, insurance companies and banks.

The users of fund are usually business firms and the government. In Malaysia, since the
beginning of the First Malaysia Plan in 1970 until 1993, the government has been the
major user of funds compared to the private sector which comprises of corporations,.
However, with the success of various privatisation and corporatisation plans, the private
sector took over as the major user of funds since 1993.

The government can either act as a lender or a borrower depending on its fiscal policy. It
becomes a lender when its budget is in surplus, that is when total revenues is larger than
total expenditures. However, if the government spends more than its revenues, then it will
be a borrower of funds. The government borrows from the public through the issue of
Treasury bills (TB) and Malaysian Government Securities (MGS).

Financial intermediaries are institutions that bring lenders and borrowers together. Savers
with excess funds will deposit these with financial intermediaries who will then lend them
to fund deficit units. Examples include commercial banks, insurance companies, and

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investment companies. Thus, financial intermediaries can be regarded both as a provider
and as a user of funds.

Apart from bringing fund-deficit and fund-surplus units together, another function
provided by financial intermediaries is that of investment banking. Frequently, companies
may need to obtain large amount of funds direct from the public. This involves issues of
securities, either in the form of debt or equity. The service of a merchant banker is required
for this purpose. The banker is directly involved in floating new securities to the public
besides providing advice and underwriting services. When a banker underwrites an issue, it
means that any shares not bought by investors will be bought by the banker. The
underwriting function ensures that the corporation receives the total amount of funds it
wants to raise.

Why is the role of financial intermediation important in an

economy?

1.2 INVESTMENT PROCESS

Before we can start our journey into the investment world, we need to get a bird's eye view
of the investment process. It is important to see the whole process first so that we will get a
better understanding of how later chapters are inter-related.

The investment process involves five basic steps:

i) setting investment objectives

ii) establishing investment policy
iii) selecting a portfolio strategy
iv) selecting the assets
v) measuring and evaluating performances.

i) Setting investment objectives

Objectives are goals that investors want to achieve in their investments. The objectives
of the investor must be clearly defined such as the type of return, his investment

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horizon and the amount of risk that can be tolerated. Some investors may want safety
of principal, stable income and low risk while others may be more interested in high
return and can undertake high risks. These objectives must be reasonable and
attainable. Some objectives are impossible, for example, wanting high return and
safety of principle.

ii) Establishing Investment Policy

The investment policy is a written document which states the asset allocation decision
and the constraints of the investor in satisfying the investment objectives. Asset
allocation decision involves determining the proportion of funds to be invested in
major asset classes, that is, stocks, bonds and real assets. Some investors face
constraints that will affect their asset allocation decision. For example, life insurance
companies can only invest about 10% of their portfolio in the stock market.

iii) Selecting a Portfolio strategy

In this third step of the investment process, the investor has to decide on the type of
investment strategy he wants to adopt. This strategy can either be active or passive.

An active strategy is one in which the investor or investment manager actively

manages the investments by changing the proportions of assets in the portfolio. The
investor is always searching for new information in an attempt to identify undervalued
securities. Undervalued securities are securities whose current market price are lower
than its expected price or intrinsic value. A point to remember in active strategy is that
frequent trading of securities do occur which may diminish the amount of returns after
considering transaction costs.

A passive strategy is one in which investors invest in a well-diversified portfolio

without trying to find mispriced securities. Some investors believe this is a better
strategy as time is not wasted in trying to "beat the market" and transaction costs will
be minimised.

iv) Selecting Assets

This is the part which involves selecting individual companies or securities within each
asset class for the investor's portfolio. Security analysis is required for this. Most
common is fundamental analysis which requires analysis of the economy, industry and
company's financial position. Security valuation follows with the intention of
identifying mispriced securities that will provide investors with a higher level of
return.

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v) Monitoring and Evaluating Performance

In this step, the return on the portfolio is measured and compared against a benchmark.
This benchmark can be the return on any broad-based index like the Kuala Lumpur
Composite Index or the EMAS Index.

If an investor thinks the market is efficient in assimilating all

information into share prices, which strategy (active or passive) is
better?

1.3 RISK AND RETURN

In this last section of the chapter, we need to mention briefly the concept of risk and return. In
general, there is a positive relationship between risk and return. Investments with high risk tend
to give high expected return and vice versa. For those with low risk, the return will also be low.
The diagram below illustrates this relationship for various instruments available in the market:

Return

Speculative stocks

“Blue-chip” stocks
Unit Trusts
Bonds

MGS

T bills

Risk
Fig. 1.1 Risk-return relationship for different investment alternatives

From the diagram, we can see that instruments regarded as risk free (example Treasury Bills)
have very low return. While those which are very risky tend to be on the higher end of the
spectrum and give high returns.

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We will cover more of these in later chapters.

Why wouldn't all investors go for instruments that will give high returns?

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Conclusion

In this chapter, the concept of investment is initially introduced. This is followed by the
different types of assets available, that is real assets and financial assets. The type of
financial market participants is explained next. Section 1.2 describes the investment
process which comprises of five different steps. Each of these steps is explained in more
detail under their individual headings. Finally, the chapter concludes with a description of
the risk and return relationship.

DISCUSSION QUESTIONS
1. Define the term investments

2. Distinguish between a real asset and a financial asset.

3. Describe the participants in a financial market

4. Describe the five steps in the investment process

5. Differentiate between active and passive investment strategy

6. Describe the risk return relationship.

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