Defining Investment:

An investment is the current commitment of money or other resources in the expectation of

obtaining future benefits. For example, an individual might purchase shares of stock anticipating
that the future proceeds from the shares will justify both the time that her money is tied up as
well as the risk of the investment. The time you will spend studying this module also is an
investment. You are missing either current leisure or the income you could be earning at a job in
the expectation that your future career will be sufficiently enhanced to justify this commitment of
time and effort. While these two investments differ in many ways, they share one key attribute
that is central to all investments: You sacrifice something of value now, expecting to benefit
from that sacrifice later.

In this module, we will focus on investments in securities such as stocks, bonds, or options and
futures contracts, but much of what we discuss will be useful in the analysis of any type of
investment.

INVESTMENT ALTERNATIVES

Assets: Assets are things that people own. The two kinds of assets are financial assets and real
assets. The distinction between these terms is easiest to see from an accounting viewpoint.

A financial asset carries a corresponding liability somewhere. If an investor buys shares of

stock, they are an asset to the investor but show up on the right side of the corporation’s balance
sheet. A financial asset, therefore, is on the left-hand side of the owner’s balance sheet and the
right-hand side of the issuer’s balance sheet.

A real asset does not have a corresponding liability associated with it, although one might be
created to finance the real asset.

Real Assets vs. Financial Assets

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
the real assets of the economy: the land, buildings, machines, and knowledge that can be used to
produce goods and services.

In contrast to such real assets are financial assets, such as stocks and bonds. Such securities are
no more than sheets of paper or, more likely, computer entries and do not contribute directly to
the productive capacity of the economy. Instead, these assets are the means by which individuals
in well-developed economies hold their claims on real assets. Financial assets are claims to the
income generated by real assets (or claims on income from the government).

If we cannot own our own auto plant (a real asset), we can still buy shares in ABC Company
(financial assets) and, thereby, share in the income derived from the production of automobiles.

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 companies, the firms use the money so raised to pay for real assets, such as plant,
equipment, technology, or inventory. So investors’ returns on securities ultimately come from
the income produced by the real assets that were financed by the issuance of those securities.

Household wealth includes financial assets such as bank accounts, corporate stock, or bonds.
However, these securities, which are financial assets of households, are liabilities of the issuers
of the securities. For example, a bond that you treat as an asset because it gives you a claim on
interest income and repayment of principal from ABC company is a liability of ABC company,
which is obligated to make these payments to you. Your asset is ABC’s liability.

We will focus almost exclusively on financial assets. But you shouldn’t lose sight of the fact that
the successes or failures of the financial assets we choose to purchase ultimately depend on the
performance of the underlying real assets.

Financial assets have a corresponding liability but real assets do not.

Securities:

A security is a legal document that shows an ownership interest. Securities have historically
been associated with financial assets such as stocks and bonds, but in recent years have also been
used with real assets. Securitization is the process of converting an asset or collection of assets
into a more marketable forum.

Security Groupings:

Securities are placed in one of three categories: equity securities, fixed income securities, or
derivative assets.
1) Equity Securities:

The most important equity security is common stock. Stock represents ownership interest in a
corporation. Equity securities may pay dividends from the company’s earnings, although the
company has no legal obligation to do so. Most companies do pay dividends, and most
companies try to increase these dividends on a regular basis.

2) Fixed Income Securities:

A fixed income security usually provides a known cash flow with no growth in the income
stream. Bonds are the most important fixed income securities. A bond is a legal obligation to
repay a loan’s principal and interest, but carries no obligation to pay more than this. Interest is
the cost of borrowing money. Although accountants classify preferred stock as an equity
security, the investment characteristics of preferred stock are more like those of a fixed income
security. Most preferred stocks pay a fixed annual dividend that does not change overtime
consequently. An investment manager will usually lump preferred shares with bonds rather than
with common stocks.

Conversely, a convertible bond is a debt security paying a fixed interest rate. It has the added
feature of being convertible into shares of common stocks by the bond holders. If the terms of
the conversion feature are not particularly attractive at a given moment, the bonds behave like a
bond and are classified as fixed income securities. On the other hand, rising stock prices make
the bond act more like the underlying stock, in which case the bond might be classified as an
equity security.

The point is that one cannot generalize and group all stock issues as equity securities and all
bonds as fixed income securities. Their investment characteristics determine how they are
treated.

For investment purposes, preferred stock is considered a fixed income security.

3) Derivative Assets:

A derivative asset is probably impossible to define universally. In general, the value of such an
asset derives from the value of some other asset or the relationship between several other assets.

Future and options contracts are the most familiar derivative assets. These building blocks of risk
management programs are used by all large investment houses and commercial banks.
The three broad categories of securities are equities, fixed income securities, and derivative
asset.

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.
Functions of Investment Companies
Investment companies perform several important functions for their investors:
i) 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.
ii) 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.
iii) 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.
iv) Lower transaction costs. Because they trade large blocks of securities, investment companies
can achieve substantial savings on brokerage fees and commissions.
While all investment companies pool the assets of individual investors, they also need to divide
claims to those assets among those investors. Investors buy shares in investment companies, and
ownership is proportional to the number of shares purchased. The value of each share is called
the net asset value, or NAV. Net asset value equals assets minus liabilities expressed on a per-
share basis:
Market value of assets minus liabilities
Net asset value=
Shares Outstandng
Consider a mutual fund that manages a portfolio of securities worth $120 million. Suppose the
fund owes $4 million to its investment advisers and owes another $1 million for rent, wages due,
and miscellaneous expenses. The fund has 5 million shareholders. Then:
$ 120 million−$ 5 million
Net asset value= =¿$23 per share
5 million shares
Types of Investment Companies
In the United States, investment companies are classified by the Investment Company Act of
1940 as either unit investment trusts or managed investment companies. The portfolios of unit
investment trusts are essentially fixed and thus are called “unmanaged.” In contrast, managed
companies are so named because securities in their investment portfolios continually are bought
and sold: The portfolios are managed. Managed companies are further classified as either closed-
end or open-end. Open-end companies are what we commonly call mutual funds.
Unit Investment Trusts
Unit investment trusts are pools of money invested in a portfolio that is fixed for the life of the
fund. To form a unit investment trust, a sponsor, typically a brokerage firm, buys a portfolio of
securities which are deposited into a trust. It then sells to the public shares, or “units,” in the
trust, called redeemable trust certificates. All income and payments of principal from the
portfolio are paid out by the fund’s trustees (a bank or trust company) to the shareholders.
There is little active management of a unit investment trust because once established, the
portfolio composition is fixed; hence these trusts are referred to as unmanaged. Trusts tend to
invest in relatively uniform types of assets; for example, one trust may invest in municipal
bonds, another in corporate bonds. The uniformity of the portfolio is consistent with the lack
of active management. The trusts provide investors a vehicle to purchase a pool of one particular
type of asset, which can be included in an overall portfolio as desired. The lack of active
management of the portfolio implies that management fees can be lower than those of managed
funds.
Sponsors of unit investment trusts earn their profit by selling shares in the trust at a premium
to the cost of acquiring the underlying assets. For example, a trust that has purchased $5
million of assets may sell 5,000 shares to the public at a price of $1,030 per share, which
(assuming
the trust has no liabilities) represents a 3% premium over the net asset value of the securities
held by the trust. The 3% premium is the trustee’s fee for establishing the trust.
Investors who wish to liquidate their holdings of a unit investment trust may sell the shares
back to the trustee for net asset value. The trustees can either sell enough securities from the
asset portfolio to obtain the cash necessary to pay the investor, or they may instead sell the
shares to a new investor (again at a slight premium to net asset value).
Managed Investment Companies
There are two types of managed companies: closed-end and open-end. In both cases, the fund’s
board of directors, which is elected by shareholders, hires a management company to manage the
portfolio for an annual fee that typically ranges from .2% to 1.5% of assets. In many cases the
management company is the firm that organized the fund. For example, Fidelity Management
and Research Corporation sponsors many Fidelity mutual funds and is responsible for managing
the portfolios. It assesses a management fee on each Fidelity fund. In other cases, a mutual fund
will hire an outside portfolio manager. For example, Vanguard has hired Wellington
Management as the investment adviser for its Wellington Fund. Most management companies
have contracts to manage several funds.
Open-end funds stand ready to redeem or issue shares at their net asset value (although both
purchases and redemptions may involve sales charges). When investors in open-end funds wish
to “cash out” their shares, they sell them back to the fund at NAV. In contrast, closed-end funds
do not redeem or issue shares. Investors in closed-end funds who wish to cash out must sell their
shares to other investors. Shares of closed-end funds are traded on organized exchanges and can
be purchased through brokers just like other common stock; their prices therefore can differ from
NAV.