Chapter One: Introduction to Investment Management

1.1 Concept of Investment:

Investment is the employment of funds with the aim of getting return on it. In general terms,
investment means the use of money in the hope of making more money. In finance, investment
means the purchase of a financial product or other item of value with an expectation of favorable
future returns. Investment of hard earned money is a crucial activity of every human being.
Investment is the commitment of funds which have been saved from current consumption with the
hope that some benefits will be received in future. Thus, it is a reward for waiting for money.
Savings of the people are invested in assets depending on their risk and return demands. Investment
refers to the concept of deferred consumption, which involves purchasing an asset, giving a loan
or keeping funds in a bank account with the aim of generating future returns. Various investment
options are available, offering differing risk-reward tradeoffs. An understanding of the core
concepts and a thorough analysis of the options can help an investor create a portfolio that
maximizes returns while minimizing risk exposure.
Two concepts of Investment:
1) Economic Investment: The concept of economic investment means addition to the capital
stock of the society. The capital stock of the society is the goods which are used in the production
of other goods. The term investment implies the formation of new and productive capital in the
form of new construction and producers durable instrument such as plant and machinery.
Inventories and human capital are also included in this concept. Thus, an investment, in economic
terms, means an increase in building, equipment, and inventory.
2) Financial Investment: This is an allocation of monetary resources to assets that are expected
to yield some gain or return over a given period of time. It means an exchange of financial claims
such as shares and bonds, real estate, etc. Financial investment involves contrasts written on pieces
of paper such as shares and debentures. People invest their funds in shares, debentures, fixed
deposits, national saving certificates, life insurance policies; provident fund etc. in their view
investment is a commitment of funds to derive future income in the form of interest, dividends,
rent, premiums, pension benefits and the appreciation of the value of their principal capital. In
primitive economies most investments are of the real variety whereas in a modern economy much
investment is of the financial variety.
The economic and financial concepts of investment are related to each other because investment
is a part of the savings of individuals which flow into the capital market either directly or through
institutions. Thus, investment decisions and financial decisions interact with each other. Financial
decisions are primarily concerned with the sources of money where as investment decisions are
traditionally concerned with uses or budgeting of money.
So from above we know the term investment. The savers become the investors in the following
term and invest in unique assets:
1.2. Investment Alternatives
Sometimes, the term "investment" can be used differently in economics and in finance. Economists
refer to a real asset investment (such as a machine, land, a factory, a house, etc), while financial

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economists refer to a financial asset investment, such as money that is put into a bank or a security,
which may, then, be used to buy (or own) a real asset. Generally, the following are important
investment avenues and alternatives of investment that an investor can choose from.
1. Assets: Assets are things that people own. The two kinds of assets are:

Assets

Real Assets Financial Assets

✪ Determine the productive or ✪ Are Claims on real assets or the income

economic capacity of a society; generated by the real assets;
capacity is a function of the real
✪ Are no more than the sheets of paper or computer
assets of the economy: land,
entries, and they don’t directly contribute to the
building, equipment, machinery,
productive capacity of the economy. e.g. stocks
knowledge, etc can be used to
and bonds
produce goods and services.
✪ Do not have a corresponding ✪ A financial asset carries a corresponding
liabilities associated with them. A liability somewhere. If an investor buys shares of
separate liability may be created to stock, they are an asset to the investor, but show
finance the real asset, though. up on the right-side of the corporation’s balance
sheet.
In general, the material wealth of a society is determined ultimately by the productive capacity of
its economy—the goods and services that can be provided to its members. This productive capacity
is a function of the real assets of the economy: the land, buildings, knowledge, and machines that
are used to produce goods and the workers whose skills are necessary to use those resources.
Together, physical and “human” assets generate the entire spectrum of output produced and
consumed by the society. In contrast to such real assets are financial assets such as stocks or
bonds. These assets, do not represent a society’s wealth. Shares of stock are no more than sheets
of paper or more likely, computer entries, and do not directly contribute to the productive capacity
of the economy. Instead, financial assets contribute to the productive capacity of the economy
indirectly, because they allow for separation of the ownership and management of the firm and
facilitate the transfer of funds to enterprises with attractive investment opportunities. Financial
assets certainly contribute to the wealth of the individuals or firms holding them. This is because
financial assets are claims to the income generated by real assets or claims on income from the
government.
When the real assets used by a firm ultimately generate income, the income is allocated to investors
according to their ownership of the financial assets, or securities, issued by the firm. Bondholders,
for example, are entitled to a flow of income based on the interest rate and par value of the bond.

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Equity holders or stockholders are entitled to any residual income after bondholders and other
creditors are paid. In this way, the values of financial assets are derived from and depend on the
values of the underlying real assets of the firm. Real assets produce goods and services, whereas
financial assets define the allocation of income or wealth among investors. Individuals can choose
between consuming their current endowments of wealth today and investing for the future. When
they invest for the future, they may choose to hold financial assets. The money a firm receives
when it issues securities (sells them to investors) is used to purchase real assets. Ultimately, then,
the returns on a financial asset come from the income produced by the real assets that are financed
by the issuance of the security. In this way, it is useful to view financial assets as the means by
which individuals hold their claims on real assets in well-developed economies. Most of us cannot
personally own auto plants (a real asset), but we can hold shares of General Motors or Ford (a
financial asset), which provide us with income derived from the production of automobiles.
Real and financial assets are distinguished operationally by the balance sheets of individuals and
firms in the economy. Whereas real assets appear only on the asset side of the balance sheet,
financial assets always appear on both sides of balance sheets. Your financial claim on a firm is
an asset, but the firm’s issuance of that claim is the firm’s liability.
When we aggregate overall balance sheets, financial assets will cancel out, leaving only the sum
of real assets as the net wealth of the aggregate economy.
Another way of distinguishing between financial and real assets is to note that financial assets are
created and destroyed in the ordinary course of doing business. For example, when a loan is paid
off, both the creditor’s claim (a financial asset) and the debtor’s obligation (a financial liability)
cease to exist. In contrast, real assets are destroyed only by accident or by wearing out over time.
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.
 Information about financial assets is often more abundant and less costly to obtain, than
information about physical assets. Information availability shows the real possibility of the
investors to receive the necessary information which could influence their investment decisions
and investment results. Since a big portion of information important for investors in such
financial assets as stocks, bonds is publicly available, the impact of many disclosed factors

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 having influence on value of these securities can be included in the analysis and the decisions
made by investors.
Even if we analyze only financial investment there is a big variety of financial investment vehicles.
The ongoing processes of globalization and integration open wider possibilities for the investors
to invest into new investment vehicles which were unavailable for them some time ago because of
the weak domestic financial systems and limited technologies for investment in global investment
environment. Financial innovations suggest for the investors the new choices of investment but at
the same time make the investment process and investment decisions more complicated, because
even if the investors have a wide range of alternatives to invest they can’t forgot the key rule in
investments: invest only in what you really understand. Thus the investor must understand how
investment vehicles differ from each other and only then to pick those which best match his/her
expectations.
The most important characteristics of investment vehicles on which bases the overall variety of
investment vehicles can be assorted are the return on investment and the risk which is defined as
the uncertainty about the actual return that will be earned on an investment.
Each type of investment vehicles could be characterized by certain level of profitability and risk
because of the specifics of these financial instruments. Though all different types of investment
vehicles can be compared using characteristics of risk and return and the most risky as well as less
risky investment vehicles can be defined. However, the risk and return on investment are close
related and only using both important characteristics, we can really understand the differences in
investment vehicles.
The main types of financial investment vehicles (alternatives) are:
• Short term investment vehicles;
• Fixed-income securities;
• Common stock;
• Speculative investment vehicles;
• Other investment tools.
Short - term investment vehicles are all those which have a maturity of one year or less. Short-
term investment vehicles often are defined as money-market instruments, because they are traded
in the money market which presents the financial market for short term (up to one year of maturity)
marketable financial assets. The risk as well as the return on investments of short-term investment
vehicles usually is lower than for other types of investments. The main short-term investment
vehicles are:
 Certificates of deposit
 Treasury bills
 Commercial paper
 Bankers’ acceptances
 Repurchase agreements
Certificate of deposits (CDs): is debt instrument issued by bank that indicates a specified sum of
money has been deposited at the issuing depository institution. It is a certificate issued by a bank
to a person depositing money for a specified length of time at a specified rate of interest. Certificate
of deposit bears a maturity date and specified interest rate and can be issued in any denomination.

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Most certificates of deposit cannot be traded and they incur penalties for early withdrawal. For
large money-market investors financial institutions allow their large-denomination certificates of
deposits to be traded as negotiable certificates of deposits.
Treasury bills:(also called T-bills) are securities representing financial obligations of the
government. Treasury bills have maturities of less than one year. They have the unique feature of
being issued at a discount from their nominal value and the difference between nominal value and
discount price is the only sum which is paid at the maturity for these short term securities because
the interest is not paid in cash, only accrued. The other important feature of T-bills is that they are
treated as risk-free securities ignoring inflation and default of a government, which was rare in
developed countries, the T-bill will pay the fixed stated yield with certainty. But, of course, the
yield on T-bills changes over time influenced by changes in overall macroeconomic situation. T-
bills are issued on an auction basis. The issuer accepts competitive bids and allocates bills to those
offering the highest prices. Noncompetitive bid is an offer to purchase the bills at a price that
equals the average of the competitive bids. Bills can be traded before the maturity, while their
market price is subject to change with changes in the rate of interest. But because of the early
maturity dates of T-bills large interest changes are needed to move T-bills prices very far. Bills are
thus regarded as high liquid assets.
Commercial paper (CP):is a name for short-term unsecured promissory notes issued by
corporation. Commercial paper is a means of short-term borrowing by large corporations. Large,
well-established corporations have found that borrowing directly from investors through
commercial paper is cheaper than relying solely on bank loans. Commercial paper is issued either
directly from the firm to the investor or through an intermediary. Commercial paper, like T-bills
is issued at a discount. The most common maturity range of commercial paper is 30 to 60 days or
less. Commercial paper is riskier than T-bills, because there is a larger risk that a corporation will
default. Also, commercial paper is not easily bought and sold after it is issued, because the issues
are relatively small compared with T-bills and hence their market is not liquid.
Banker‘s acceptances: are the vehicles created to facilitate commercial trade transactions. These
vehicles are called bankers acceptances because a bank accepts the responsibility to repay a loan
to the holder of the vehicle in case the debtor fails to perform. Banker‘s acceptances are short-term
fixed-income securities that are created by non-financial firm whose payment is guaranteed by a
bank. This short-term loan contract typically has a higher interest rate than similar short –term
securities to compensate for the default risk. Since bankers’ acceptances are not standardized, there
is no active trading of these securities.
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. Basically, a repo is a collectivized short-term loan, where collateral is a security. The
collateral in a repo may be a Treasury security, other money-market security. The difference
between the purchase price and the sale price is the interest cost of the loan, from which repo rate
can be calculated. Because of concern about default risk, the length of maturity of repo is usually
very short. If the agreement is for a loan of funds for one day, it is called overnight repo; if the
term of the agreement is for more than one day, it is called a term repo. A reverse repo is the

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opposite of a repo. In this transaction a corporation buys the securities with an agreement to sell
them at a specified price and time. Using repos helps to increase the liquidity in the money market.
Fixed-income securities
Fixed-income securities are those which return is fixed, up to some redemption date or indefinitely.
The fixed amounts may be stated in money terms or indexed to some measure of the price level.
This type of financial investments is presented by two different groups of securities:
 Long-term debt securities
 Preferred stocks.
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. The buyer
(investor) of these securities is lending money to the issuer, who undertake obligation periodically
to pay interest on this loan and repay the principal at a stated maturity date. Long-term debt
securities are traded in the capital markets. From the investor’s point of view these securities can
be treated as a “safe” asset. However, in reality the safety of investment in fixed –income securities
is strongly related with the default risk of an issuer. The major representatives of long-term debt
securities are bonds, but today there are a big variety of different kinds of bonds, which differ not
only by the different issuers (governments, municipals, companies, agencies, etc.), but by different
schemes of interest payments which is a result of bringing financial innovations to the long-term
debt securities market. As demand for borrowing the funds from the capital markets is growing
the long-term debt securities today are prevailing in the global markets. And it is really become
the challenge for investor to pick long-term debt securities relevant to his/her investment
expectations, including the safety of investment.
Preferred stocks: Is 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. Though, this security provides for the investor the flow
of income very similar to that of the bond, the main difference between preferred stocks and bonds
is that for preferred stock the flows are forever, if the stock is not callable. The preferred
stockholders are paid after the debt securities holders but before the common stock holders in terms
of priorities in payments of income and in case of liquidation of the company. If the issuer fails to
pay the dividend in any year, the unpaid dividends will have to be paid if the issue is cumulative.
If preferred stock is issued as noncumulative, dividends for the years with losses do not have to be
paid. Usually same rights to vote in general meetings for preferred stockholders are suspended.
Because of having the features attributed for both equity and fixed-income securities preferred
stocks is known as hybrid security. In recent years the preferred stocks with option of convertibility
to common stock are proliferating.
The common stock: is the other type of investment vehicles which is one of the most popular
among investors with long-term horizon of their investments. Common stock represents the
ownership interest of corporations or the equity of the stockholders. Holders of common stock are
entitled to attend and vote at a general meeting of shareholders, to receive declared dividends and
to receive their share of the residual assets, if any, if the corporation is bankrupt. The issuers of the
common stock are the companies which seek to receive funds in the market and though are “going
public”.

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Issuing of common stocks and selling them in the market enables the company to raise additional
equity capital more easily when using other alternative sources. Thus, many companies are issuing
their common stocks which are traded in financial markets and investors have wide possibilities
for choosing this type of securities for the investment.
A corporation is controlled by a board of directors elected by the shareholders. The board, which
meets only a few times each year, selects managers who run the corporation on a day- to-day basis.
Managers have the authority to make most business decisions without the board’s approval. The
board’s mandate is to oversee management to ensure that it acts in the best interests of
shareholders. Thus, management usually has considerable discretion to run the firm as it sees fit,
without daily oversight from the equity holders who actually own the firm.
Speculative investment vehicles following the term “speculation” could be defined as investments
with a high risk and high investment return. Using these investment vehicles speculators try to buy
low and to sell high, their primary concern is with anticipating and profiting from the expected
market fluctuations. The only gain from such investments is the positive difference between selling
and purchasing prices. Of course, using short-term investment strategies investors can use for
speculations other investment vehicles, such as common stock, but here we try to accentuate the
specific types of investments which are riskier than other investment vehicles because of their
nature related with more uncertainty about the changes influencing their price in the future.
Speculative investment vehicles include:
 Options;
 Futures;
 Commodities traded on the exchange (coffee, grain metals, and other commodities);
Options: are the derivative financial instruments. An options contract gives the owner of the
contract the right, but not the obligation, to buy or to sell a financial asset at a specified price from
or to another party. The buyer of the contract must pay a fee (option price) for the seller. There is
a big uncertainty about if the buyer of the option will take the advantage of it and what option price
would be relevant, as it depends not only on demand and supply in the options market, but on the
changes in the other market where the financial asset included in the option contract are traded.
Though, the option is a risky financial instrument for those investors who use it for speculations
instead of hedging.
Futures: are the other types of derivatives. A future contract is an agreement between two parties
than they agree to transact with the respect to some financial asset at a predetermined price at a
specified future date. One party agree to buy the financial asset, the other agrees to sell the financial
asset. It is very important, that in futures contract case both parties are obligated to perform and
neither party charges the fee.
There are two types of people who deal with options (and futures) contracts: speculators and
hedgers. Speculators buy and sell futures for the sole purpose of making a profit by closing out
their positions at a price that is better than the initial price. Such people neither produce nor use
the asset in the ordinary course of business. In contrary, hedgers buy and sell futures to offset an
otherwise risky position in the market.

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Transactions using derivatives instruments are not limited to financial assets. There are derivatives,
involving different commodities (coffee, grain, precious metals, and other commodities). But in
this course the target is on derivatives where underlying asset is a financial asset.
Other investment tools:
 Various types of investment funds;
 Investment life insurance;
 Pension funds;
 Hedge funds.
 Real estates
1.3. 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 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 the following important functions for their investors:
1. 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.
2. 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.
3. 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.
4. Lower transaction costs. Because they trade large blocks of securities, investment companies
can achieve substantial savings on brokerage fees and commissions.
1.4. Definition of Investment Risk:
Investment risk can be defined as the probability or likelihood of occurrence of losses relative to
the expected return on any particular investment.
Stating simply, it is a measure of the level of uncertainty of achieving the returns as per the
expectations of the investor. It is the extent of unexpected results to be realized.
Risk is an important component in assessment of the prospects of an investment. Most investors
while making an investment consider less risk as favorable. The lesser the investment risk, more
lucrative is the investment. However, the thumb rule is the higher the risk, the better the return.
1.5. Types of Investment Risks:
Interest Rate Risk: Interest rate risk is the possibility that a fixed-rate debt instrument will decline
in value as a result of a rise in interest rates. Whenever investors buy securities that offer a fixed
rate of return, they are exposing themselves to interest rate risk. This is true for bonds and also for
preferred stocks.
Business Risk: Business risk is the measure of risk associated with a particular security. It is also
known as unsystematic risk and refers to the risk associated with a specific issuer of a security.

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Generally speaking, all businesses in the same industry have similar types of business risk. But
used more specifically, business risk refers to the possibility that the issuer of a stock or a bond
may go bankrupt or be unable to pay the interest or principal in the case of bonds. A common way
to avoid unsystematic risk is to diversify - that is, to buy mutual funds, which hold the securities
of many different companies.
Credit Risk: This refers to the possibility that a particular bond issuer will not be able to make
expected interest rate payments and/or principal repayment. Typically, the higher the credit risk,
the higher the interest rate on the bond.
Taxability Risk: This applies to municipal bond offerings, and refers to the risk that a security
that was issued with tax-exempt status could potentially lose that status prior to maturity. Since
municipal bonds carry a lower interest rate than fully taxable bonds, the bond holders would end
up with a lower after-tax yield than originally planned.

Call Risk: Call risk is specific to bond issues and refers to the possibility that a debt security will
be called prior to maturity. Call risk usually goes hand in hand with reinvestment risk, discussed
below, because the bondholder must find an investment that provides the same level of income for
equal risk. Call risk is most prevalent when interest rates are falling, as companies trying to save
money will usually redeem bond issues with higher coupons and replace them on the bond market
with issues with lower interest rates. In a declining interest rate environment, the investor is usually
forced to take on more risk in order to replace the same income stream.
Inflationary Risk: Also known as purchasing power risk, inflationary risk is the chance that the
value of an asset or income will be eroded as inflation shrinks the value of a country's currency.
Put another way, it is the risk that future inflation will cause the purchasing power of cash flow
from an investment to decline. The best way to fight this type of risk is through appreciable
investments, such as stocks or convertible bonds, which have a growth component that stays ahead
of inflation over the long term.
Liquidity Risk: Liquidity risk refers to the possibility that an investor may not be able to buy or
sell an investment as and when desired or in sufficient quantities because opportunities are limited.
A good example of liquidity risk is selling real estate. In most cases, it will be difficult to sell a
property at any given moment should the need arise, unlike government securities or blue chip
stocks.
Market Risk: Market risk, also called systematic risk, is a risk that will affect all securities in the
same manner. In other words, it is caused by some factor that cannot be controlled by
diversification. This is an important point to consider when you are recommending mutual funds,
which are appealing to investors in large part because they are a quick way to diversify. You must
always ask yourself what kind of diversification your client needs.
Reinvestment Risk: In a declining interest rate environment, bondholders who have bonds coming
due or being called face the difficult task of investing the proceeds in bond issues with equal or
greater interest rates than the redeemed bonds. As a result, they are often forced to purchase
securities that do not provide the same level of income, unless they take on more credit or market
risk and buy bonds with lower credit ratings. This situation is known as reinvestment risk: it is the

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risk that falling interest rates will lead to a decline in cash flow from an investment when its
principal and interest payments are reinvested at lower rates.
Social/Political / legislative Risk: Risk associated with the possibility of nationalization,
unfavorable government action or social changes resulting in a loss of value is called social
or political risk. Because the U.S. Congress has the power to change laws affecting securities, any
ruling that results in adverse consequences is also known as legislative risk.
Currency/Exchange Rate Risk : Currency or exchange rate risk is a form of risk that arises from
the change in price of one currency against another. The constant fluctuations in the foreign
currency in which an investment is denominated vis-à-vis one's home currency may add risk to the
value of a security.
Understandably, currency risk is greater for shorter term investments, which do not have time to
level off like longer term foreign investments.
1.6. Major Characteristics of Investments:
Certain features characterize all investments. The following are the main characteristics of
investments:
1.Return: All investments are characterized by the expectation of a return. In fact, investments
are made with the primary objective of deriving a return. The return may be received in the form
of yield plus capital appreciation. The difference between the sale price & the purchase price is
capital appreciation. The dividend or interest received from the investment is the yield. Different
types of investments promise different rates of return. The return from an investment depends upon
the nature of investment, the maturity period & a host of other factors.
2.Risk: Risk is inherent in any investment. The risk may relate to loss of capital, delay in
repayment of capital, nonpayment of interest, or variability of returns. While some investments
like government securities & bank deposits are almost risk less, others are more risky. The risk of
an investment depends on the following factors.
 The longer the maturity period, the longer is the risk.
 The lower the credit worthiness of the borrower, the higher is the risk.
The risk varies with the nature of investment. Investments in ownership securities like equity
shares carry higher risk compared to investments in debt instrument like debentures & bonds.
3. Safety: The safety of an investment implies the certainty of return of capital without loss of
money or time. Safety is another features which an investors desire for his investments. Every
investor expects to get back his capital on maturity without loss & without delay.
4. Liquidity: An investment, which is easily saleable, or marketable without loss of money &
without loss of time is said to possess liquidity. Some investments like company deposits, bank
deposits, P.O. deposits, NSC, NSS etc. are not marketable. Some investment instrument like
preference shares & debentures are marketable, but there are no buyers in many cases & hence
their liquidity is negligible. Equity shares of companies listed on stock exchanges are easily
marketable through the stock exchanges.
An investor generally prefers liquidity for his investment, safety of his funds, a good return with
minimum risk or minimization of risk & maximization of return.

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1.7. What is 'Investment Management’?
Investment management is a phrase that refers to the buying and selling of investments within a
portfolio, and can also include banking and budgeting duties, as well as taxes. The term most often
refers to portfolio management and the trading of securities to achieve a specific investment
objective.
1.8. Objectives of Investment Management:
The objective of portfolio management is to invest in securities is securities in such a way that one
maximizes one’s returns and minimizes risks in order to achieve one’s investment objective.
A good portfolio should have multiple objectives and achieve a sound balance among them. Any
one objective should not be given undue importance at the cost of others.
1.9. Investment Management Process:
The investment process involves a series of activities leading to the purchase of securities or other
investment alternatives. The investment management process describes how an investor should go
about making decisions.
Investment management process can be disclosed by the following main procedures
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. An investor, before processing in to investment, formulates the policy for the systematic
functioning of an investment. The essential ingredients of the policy are:
Availability of investible funds: the fund may be generated through savings or from borrowings. If
the funds are borrowed, the investor has to be extra careful in the selection of alternative
investments. The return should be higher than the interest he pays.
Objectives: the objectives are framed on the premises of the required rate of return, need for
regularity of income, risk perception and the need for liquidity. 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. The risk takers objective is to earn high rate of return in the form of
capital appreciation, whereas the primary objective of the risk averse is the safety of the principal.
Knowledge: the knowledge about the investment alternatives and markets play a key role in the
policy formulation. The investments range from security to real estate. The risk and return
associated with investment alternatives differ from each other. The investor should be aware of the
stock market structure, the functions of the brokers.
The investment policy should also state other important constrains which could influence the
investment management. Constrains can include any liquidity needs for the investor, projected
investment horizon, as well as other unique needs and preferences of investor. The investment

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horizon is the period of time for investments. Projected time horizon may be short, long or even
indefinite.
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.
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 underpriced or over-priced 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.
Two techniques of diversification:
 Random diversification, when several available financial assets are put to the portfolio at random;
 Objective diversification when financial assets are selected to the portfolio following investment
objectives and using appropriate techniques for analysis and evaluation of each financial asset.
A diversified portfolio is comparatively less risky than holding a single portfolio. There are several ways
to diversify a portfolio.
 Debt and equity diversification
 Industry diversification

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  Company diversification
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
and 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
reevaluation 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 portfolios.
It is important to point out that investment management process is continuing process influenced by changes
in investment environment and changes in investor’s attitudes as well. Market globalization offers investors
new possibilities, but at the same time investment management become more and more complicated with
growing uncertainty.

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