An Overview of The Investment Process

AN OVERVIEW OF THE
INVESTMENT PROCESS
ACF317
March 25, 2024 Mr. T.H. Shongwe

Learning objectives – answer
following questions
Why do individuals invest?
What is an investment?
How do investors measure the rate
of return on an investment?
How do investors measure the risk
related to alternative investments?

Learning objectives – answer
following questions
What factors contribute to the rates
of return that investors require on
alternative investments?
What macroeconomic and
microeconomics factors contribute to
changes in the required rates of
return?

In life income may be more than your
consumption desires.
When current income exceeds
consumption desires, there is two
options:
People can save their extra income.
People can also invest the extra
savings to have more money for
future consumption.
The trade off of present consumption
for a higher level of future
consumption is the reason for
saving.
Investment is to make the savings to
increase over time.

If people want to consume more
than their income at present they
have to borrow and must be willing
to pay more than they borrowed in
the future.
The rate of exchange between future
consumption and current
consumption is the pure rate of
interest.
The desire for people to pay more for
borrowed funds and the desire to
receive a surplus on their savings
give rise to an interest rate referred
to as the pure time value of
money/ RRFR.

This interest rate is established in
the capital market by comparing the
supply of capital (savings) to be
invested and the demand for excess
consumption (borrowing) at a given
time.
For example, if you exchange E100
of certain income today for E104
next year.
Then the pure rate of exchange on a
risk free investment (that is the time
value of money) is said to be 4%
which is (E104/E100)-1
The investor who gives up E100
today expects to consume E104 in
the future assuming the that the
general price level remains the
same.
If the investor expects prices to
increase, they will require a higher
rate of return to compensate for the
higher prices.
Suppose the investor who gave up
the E100 expected a rise in prices of
2% during the period of investment,
the investor would require E106 in
the future.
A 6% nominal risk free rate would be
required instead of 4%.
Furthermore, if the future payment is
not certain, the investor will demand
an interest rate that exceeds the risk
free interest rate.
The uncertainty of the payments
from an investment is the
investment risk.
The additional return that is added to
the nominal risk free rate is called
the risk premium.
Suppose in our previous example the
investor would require more than the
E106 one year from today to
compensate for uncertainty.

Suppose the required amount is
E110 more than E106, then E4 (4%
would be considered a risk premium.

Definition of investment
Investment is the current
commitment of emalangeni for a
period of time in order to derive future
payments for the investor for:
The time the funds are committed.
The expected rate of inflation during
the period.
The uncertainty of the future
payments (future cash flows)
The investor can be an individual, a
government or pension fund or a
corporation.
This defn includes all types of
investments by corporations in plant
and equipment and investments by
individuals in stocks, bonds,
commodities or real estate.

Our main focus will be investments
by individual investors.
In summary people invest to earn a
return from savings due to their
deferred consumption

This return, the investor’s required
rate of return will be our focus
throughout this course.
A central question to ask is how do
investors select investments that will
give them their required rate of
return?
We will focus on financial assets such
as bonds and stocks.
Measurement of return and risk
How do you choose among
alternative investments assets?
The selection process requires that
you estimate and evaluate the
expected risk return trade offs for
the alternative investments
available.

You must understand how to
measure the rate of return and the
risk involved in an investments
accurately.
We shall consider historical measures
of return and risk and expected rates
of return and risk.

Historical results are often used by
investors when attempting to
estimate the expected rates of return
and risk for an asset class.
The first measure is the historical
rate of return on an individual
investment over the time period the
investment is held (holding period).

Next we shall consider how to
measure the average historical rate
of return for an individual investment
over a number of time periods.
We then consider the average rate of
return for a portfolio of investments.

Measures of historical rates of
return
When evaluating alternative
investments for inclusion in your
portfolio, you will be comparing
investments with different prices or
lives.
For example you might compare a
$10 stock that pays no dividends to
a stock selling for $150 that pays a
dividend of $5.
return
To properly evaluate these two
investments, you must accurately
compare their historical rates of
returns.
Therefore in investment we are
concerned with deferring current
consumption to add to our wealth to
be able to consume more in the
future.
return
Therefore when we talk about the
return on an investment, we are
concerned with the change in wealth
resulting from this investment.
This change in wealth can either be
due to cash inflows such as interest
and dividends or caused by a change
in the price of the asset (positive or
negative).
return
Suppose for example you invest
$200 at the beginning of the year
and get back $220 at the end of the
year.
The period during which you hold the
investment is called the holding
period.
What is your return for this period?
return
The return for the period during
which you hold the investment is
called the holding period return.
The holding period return (HPR)=
Ending value of investment/
Beginning value of investment.
Holding period return
=$220/$200=1,10
return
This HPR value will be zero or
greater – that is it can never be a
negative value.
A value greater than 1.0 reflects an
increase in your wealth. It means
you received a positive return during
the period.

return
A value less than 1.0 means that you
suffered a decline in wealth which
means you had a negative return
during the period.
A holding period return of zero
indicates that you lost all your
money invested in an asset.

return
Although the Holding Period return
helps us to express the change in the
value of an investment, investors
generally prefer to evaluate returns
in percentage terms on an annual
basis.
Percentage makes it easier to
compare investments that have
markedly different characteristics.
return
The first step in converting an
Holding period return (HPR) to an
annual percentage rate is to derive a
percentage return, referred to as the
holding period yield (HPY).
The holding period yield is equal to
Holding period return (HPR) minus 1.
HPY= HPR-1=1.10-1=0.10=10%.
return
To derive an annual holding period
yield, you compute an annual HPR and
subtract 1.
Annual HPR is found by:
Annual Holding period return= HPR1/n
where:
n= is the number of years the
investment is held

return
Consider an investment that cost $250
and is worth $350 after being held for
two years:
Holding period return= $350/$250
HPR=1.40
Annual Holding period return=1.40
return= 1/2
Annual Holding period return=1.1832

Annual Holding period yield=1.1832-
1=0.1832= 18.32%
return
If you experience a decline in your
wealth value, the computation is as
follows:
HPR= Ending value/ Beginning value
HPR=$400/$500
HPR=0.80
Holding period yield (HPY)=0.80-1
HPY =-0,20=-20%
return
A multiple year loss over two years
would be computed as follows:
HPR = $750/$1000=0.75
Annual HPR=(0.75)
HPR= 1/n
Annual HPR=(0.75)
HPR= 1/2
Annual HPR=0.866
Annual HPY =0.866-1=-0.134=-13.4%
NB: Assumes that $750 is ending value.
return
In contrast, consider an investment
of $100 held for only 6 months that
earned a return of $12.
HPR= $112/$100=1.12
Annual HPR=1.121/0.5
Annual HPR=1.122
Annual HPR=1.2544
HPY=1.2544-1= 0.2544=25.44%
Computing mean historical
returns
Having calculated the HPY for a single
investment for a single year, we want to
consider mean rates of return for a
single investment and for a portfolio of
investments.
Over a number of years, a single
investments will likely give high rates of
return during some years and low rates
of return, or possible negative rates of
return during other years.
returns
Your analysis must consider each of
these returns but you also want a
summary figure that indicates this
investment’s typical experience or
the rate of return you would expect if
you owned this investment over an
extended period of time.

returns
You derive such a summary figure by
computing the mean annual rate of
return (its HPY) for this investment
over some period of time.
Alternatively you might want to
evaluate a portfolio of investments
that might include similar investments
(i.e. for all bonds or shares or a
combination of investments.
returns
In this instance you would calculate
the mean rate of return for this
portfolio of investments for an
individual year or for a number of
years.

Single investment
Given a set of annual rates of return
(HPYs) for an individual investment,
there are two summary measures of
return of performance.
The first is the Arithmetic mean (AM)
of return.
Arithmetic mean (AM)= ∑HPY
N
Single investment
Where:
∑HPY= the sum of annual holding
period yields
N: The number of years the HPYs
was earned.
An alternative computation (second)
is the Geometric mean (GM) return.

Consider investment with the
following data - illustration

Single investment
Arithmetic mean (AM)=
0.15)+(0.20)+(-0.20)}/3= 0.15/3
= 0.05
= 5%

Single investment
Geometric mean (GM)= [(1.15) X
(1.20) X (0.80)]1/3-1
= (1.104) 1/3-1
= 1.03353-1
= 0.03353
= 3.353%

Single investments
Investors are typically concerned with
long term performance when
comparing alternative investments.
Geometric mean is considered a
superior measure of the long term
mean rate of return because it indicates
the compound annual rate of return
based on the ending value of the
investment versus its beginning value.
Although the arithmetic average
provides a good indication of the
expected rate of return for an
investment during a future individual
year, it is biased upward if you are
attempting to measure an asset’s
long term performance.
This is obvious for a volatile security.

Example
YEAR BEGINNING VALUE ENDING VALE HPR HPY

1 50 100 2 1
2 100
March 25, 2024
50 0.5 -50
Mr. T.H. Shongwe
Example
AM={(1.00)+(-0.50)}/2=0.25=25%
The investment brought no change in
wealth and therefore no return, yet
the AM rate of return is computed to
be 25%.

Example
The GM rate of return would be
= (2.00x0.50)1/2-1
= (1.00)1/2-1
= 1-1=0%
The answer of 0% rate of return
accurately measures the fact that
there was no change in wealth from
this investment over the 2 year
period.
When rates of return are the same
for all years, the GM and AM will be
the same.
If the rates of return vary over the
years, the GM will always be lower
than the AM.
The diff. b/n the two mean values
depend on the yr to yr changes in
rates of return.
The AM is best used as an expected
value for an individual year, whilst
the GM is the best measure of long
term performance as it measures the
compound annual rate of return for
the asset being measured.

COMPUTATION OF HOLDING PERIOD YIELD FOR A PORTFOLIO
BEGINNING ENDING
NO. OF BEGIN. MARKET ENDIN. MARKET Market WEIGHTED
INVEST. SHARES PRICE VALUE PRICE VALUE HPR HPY Weight HPY
A 100 000 10 1 000 000 12 1 200 000 1,20 20% 0,05 0,01
B 200 000 20 4 000 000 21 4 200 000 1,05 5% 0,2 0,01
C 500 000 30 15 000 000 33 16 500 000 1,10 10% 0,75 0,075
Total 20 000 000 21 900 000 0,095
A portfolio of investments
A portfolio of investments: The mean
historical rate of return (HPY) for a
portfolio is measured as the overall
percentage change in the value of the
original portfolio.
Ending market value 21 900 000
Beginning market value 20 000 000
=1.095 is the HPR. HPY=1.095-1
=9.5%
Alternatively, the mean historical return
for a portfolio is measured as the
weighted average of the HPYs for the
individual investments in the portfolio.
The weights used in computing the
averages are the relative beginning
market values for each investment.
This is referred to as dollar weighted or
value weighted mean rate of return.
The analysis of historical
performance is useful.
Selecting investments for your
portfolio requires a prediction of the
rates of return you expect to prevail.
The next section focus on how you
derive the estimates of expected
rates of return.
There is normally a great deal of
uncertainty regarding these future
expectations and we therefore show
how this uncertainty is measured
which is referred to as the risk of an
investment.

Calculating expected rates of
return
Risk is the uncertainty that an
investment will earn its expected rate
of return.
An investor who is evaluating a future
investment alternative expects a
certain rate of return.
The investor could say he is expecting
that the investment will earn a rate of
return of say 10%.
return
This is the investor’s most likely
estimate also referred to as a point
estimate.
The investor could specify a larger
range of possible returns from an
investment which reflects the
investor’s uncertainty regarding what
the actual return will be.

return
Therefore, a larger range of possible
returns implies that the investment is
riskier.
An investor determines how certain the
expected rate of return on an investment
is by analysing estimates of possible
returns.
To do this, the investor assigns
probability values to all possible returns.
return
The probability values range from
zero which suggest no change of the
return to one which indicates
complete certainty that the
investment will provide the specified
rate of return.

return
The probabilities represent subjective
estimates based on historical
performance of the investment or
similar investments modified by the
investor’s expectations for the future.
An investor for example may know that
about 30% of the time that the rate of
return on the investment is 10%

return
Using this information, along with
future expectations regarding the
economy, one can derive an estimate
of what might happen in the future.
The expected rate of return from an
investment is defined as:

return

return
Suppose a case wherein the investor
is absolutely certain of a return of
5%.
Perfect certainty allows only one
possible return and the probability of
receiving that return is 1.0.
Few investments provide certain
returns and would be considered risk
free investments.
return
In the case of perfect certainty there
is only one value for PiRi.
E(Ri) =(Pi)(Ri)
=(1.0)(0.05)=5%

return
In an alternative scenario suppose an
investor believed an investment could
provide several different rates of return
depending on different possible
economic conditions.
The investor might estimate
probabilities for each of these economic
scenarios based on past experience and
current outlook as below:
return

return
The computation of the expected rate of return
[E(Ri)] is as follows:
E(Ri)=[0.15x0.20]+ [0.15x-0.20] +[0.70x0.10]
= 0.07
= 7%

return
Obviously the investor is less certain
about the expected return from this
investment than about the return
from the prior investment with its
single possible return.
The investment is uncertain about
the expected rate of return.

return
When investors are faced with a
choice between the risky investment
and the certain (risk free)
investment, the investor would select
the certain alternative.
This expectation is based on the
belief that most investors are risk
averse.

return
Risk averse means that everything
else remaining the same, they will
select the investment that offers
greater certainty (i.e. less risk).

Measuring the risk of expected
rates of return
We have shown that we can calculate
the expected rate of return and
evaluate the uncertainty, or risk, of
an investment by identifying the
range of possible returns from that
investment and assigning each
possible return a weight based on
the probability that it will occur.

The use of statistical measures
allows us to measure the dispersion
of returns.
The statistical measures allows one
to compare the return and risk
measures for alternative investments
directly.

Two possible measures of risk
(uncertainty) have received support
in theoretical work in portfolio
theory:
The variance and standard deviation
of the estimated distribution of
expected returns.

Variance (σ2) is a measure of the
dispersion of a set of data points
around their mean value.
Portfolio variance is a
measurement of how the aggregate
actual returns of a set of securities
making up a portfolio fluctuate over
time. It is a measure of a portfolio’s
volatility.
The variance of a portfolio’s return is
a function of two variables:
– The first is a variance of each asset in
the portfolio.
– The second is how each of those assets
moves in relation to one another – that
is, their covariance to one another.

Covariance is a measure of the
degree to which returns on two risky
assets move in relation to each other
/tandem.
A positive covariance means that the
returns move together.

A positive covariance means that
assets generally move in the same
direction.
Negative covariance means that
assets generally move in opposite
directions or inversely.
Covariance is used in portfolio theory
to determine what assets to include
in the portfolio.
Variance: the larger the variance for
an expected rate of return, the
greater the dispersion of expected
returns and the greater the
uncertainty.
The variance for the perfect –
certainty (risk free) example would
be:

A standard deviation is an indicator
of investment’s risk because it shows
how stable its earnings are.
A high standard deviation indicates
high risk because it shows that the
earnings are highly unstable and
volatile.
Standard deviation measures the risk
of individual stocks.
Standard deviation can be defined in two
ways:
It is a measure of the dispersion of a set
of data from its mean. The more spread
apart the data, the higher the standard
deviation.
In finance, a standard deviation is
applied to the annual rate of return to an
investment to measure the investment’s
volatility.
A standard deviation is used by
investors to gauge the amount of
expected volatility on a security.

A relative measure of risk: in
some cases, an unadjusted variance
or standard deviation can be
misleading.

If conditions for two or more
investment alternatives are not
similar – that is, if there are major
differences in the expected rates of
return – it is necessary to use a
measure of relative variability to
indicate risk per unit of expected
return.

A widely used relative measure of
risk is the coefficient of variation
(CV), calculated as follows:
Coefficient of variation (cv)=
Standard deviation of returns
Expected rate of return
= σi
E (R)
The CV for the preceding example
would be:
CV=0.11874/0.07000
CV=1.696
This measure of relative variability
and risk is used by financial analysts
to compare alternative investments
with widely different rates of return
and standard deviation of returns.
Investments A Investments B
Expected return 0,07 0,12
Standard deviation 0,05 0,07
By comparing the standard deviations of
Invest. A and Invest. B, investment B
appears to be riskier because it has a high
standard deviation of 7% versus 5% for
Invest. A.
In contract the CV figures show that
Invest. B has less relative variability or
lower risk per unit of expected return
because it has a substantially higher
expected rate of return:
CVa= 0.05 =0.714
0.07
CVb = 0.07 =0.583

0.12

Risk measures for historical
returns
To measure the risk for historical
rates of returns, we use the same
measures as for expected returns
(variance and standard deviation)
except that we consider the historical
holding yields (HPYs) as follows:

returns

returns
The standard deviation is the square
root of the variance.
Both the variance and standard
deviation indicate how much the
individual HPYs over time deviated
from the expected value of the
series.

Determinants of required rates
of return
The selection process for an
investment portfolio involves finding
securities that provide a rate of
return that compensates the investor
for:
The time value of money during the
investment period.
The expected rate of inflation during
the period
of return
The risks involved.
The summation of these 3
components is called the required
rate of return.
The required rate of return is the
minimum rate of return that you
should accept from an investment to
compensate you for deferring
consumption.
of return
We shall focus on the 3 components
of the required rate of return and
what influences them.
The real risk free rate of interest
(RRFR): Is the basic interest rate
assuming no inflation. This is also
called the pure time value of money.
The only sacrifice investor makes is
deferring consumption.
of return
This rate is influenced by how much
consumers want to consume by
deferring consumption now-
subjective factor.
This rate is also influenced by the set
of investment opportunities available
in the economy. Investment
opportunities are determined by the
long run real growth rate.
of return.
When there is a lot of investment
opportunities, the investor will ask
for a high required rate of return.
A positive relationship exists b/n real
growth rate in the economy and the
real risk free rate.

of return.
The nominal risk free rate
(NRFR)
The RRFR of interest was measured
in real terms because we assume
that investors want to increase the
consumption of actual goods and
services rather than consuming the
same amount that had come to cost
more money.
of return.
Nominal risk free rate of interest
(NRFR) that prevail in the market
are determined by RRFR of interest
plus factors that will affect the
nominal rate of interest, such as the
expected rate of inflation and
monetary environment.

of return.
Investors view Treasury bills as a
prime example of a default free
investment coz the govt has
unlimited ability to derive income
from taxes or to create money from
which to pay interest.
Therefore one could expect rates on
T-bills to change gradually.

of return.
As noted, two other factors influence
the nominal risk free rate:
The relative or tightness in the capital
markets.
The expected rate of inflation.
Capital markets bring together investors
who want to invest savings with
companies or govt who need capital to
expand or finance budget deficit.
of return.
The cost of funds at any time
(interest rate) is the price that
equates the current supply and
demand for capital.
Disequilibrium in the capital market
could be caused by an unexpected
change in monetary policy or fiscal
policy.

of return.
Change is short lived becoz the
higher or lower interest rates will
affect capital supply and demand.
As an example, an increase in the
govt deficit caused by an increase in
govt spending will increase demand
for capital and increase interest
rates.

of return.
In turn the increase in interest rates
will cause an increase in savings and
a decrease in the demand for capital
by corporations or individuals.
This changes in the market
conditions should bring rates back to
long run equilibrium, which is based
on the long run growth rate of the
economy.
of return.
It was noted that when investors
expect prices to increase they would
require the rate of return to include
compensation for inflation.
NRFR=[(1+RRFR)X(1+ Expected
Inflation rate)]-1
Rearrange the equation as follows:
RRFR=[(1+NRFR)/(1+Rate of
inflation)]-1
of return.
The factors discussed so far affects
all investments equally i.e.
investments in stocks, bonds, real
estate or machine tools.

Risk premium
Most investors require higher rates
of return on investments if they
perceive that there is uncertainty
about the expected rate of return.
This increase in the required rate of
return over the NRFR is the risk
premium.
The risk premium represent a
composite of uncertainty.
Risk premium
Fundamental sources of all
uncertainty affecting the risk
premium include the following:
Business risk
Financial risk (leverage)
Liquidity risk
Exchange rate risk
Country (political risk)
Factors affecting the risk
premium
Business risk: is the uncertainty of
income flows caused by the nature of
a firm’s business.
The less certain a firm is about the
income flows, the less certain the
income flows to the investor.
The investor will demand a required
return that is high as a result of the
business risk for the firm.
Financial risk: uncertainty caused
by firm’s choice of financing its
investments.
If firm uses common stock to finance
its investments, it incurs business
risk.

Increase in uncertainty because of
fixed cost financing is called financial
risk or financial leverage.
Liquidity risk: uncertainty
introduced by the secondary market
for an investment.
The greater the uncertainty over
converting the investment to cash
the greater the liquidity risk.
Sometimes there is great difficulty in
selling an asset and there can be great
variation in the price to be received for
an asset and this increases liquidity
risk.
Liquidity risk can be a significant factor
when investments are held in foreign
markets and this depends on the
country where the investments is held.
Exchange rate risk: is the risk of
uncertainty of returns to an investor
who acquires securities denominated
in a currency different from his or
her own.
The likelihood of incurring this risk is
becoming greater as investors buy
and sell assets around the world.

The more volatile the exchange rate
b/n two countries, the less certain
you would be regarding the
exchange rate and the greater the
likelihood of demanding a higher risk
premium.

Country risk or political risk: is the
uncertainty of returns caused by the
possibility of a major change in the
political or economic environment of
a country.
The U.S.A is considered to have the
smallest country risk in the world
because it has the most stable
political and economic environment.
People who invest in countries that
have unstable political or economic
systems must add a country risk
premium when determining their
required rates of return.
When investing globally, individuals
must consider these additional
uncertainties.

Risk premium and portfolio
theory
All rational, profit maximising
investors want to hold a completely
diversified market portfolio of risky
assets, and they borrow or lend to
arrive at a risk level that is
consistent with their risk
preferences.

The relevant risk measure for an
individual asset is its
comovement with the market
portfolio.
This comovement, which is
measured by an asset’s
covariance with the market
portfolio, is referred to as an
asset’ systematic risk.
Systematic risk is the portion of
an individual asset’s total
variance that is attributable to
the variability of the total market
portfolio.

Unsystematic risk: refers to risk of
individual assets or variance that is
unrelated to the market portfolio (the
asset’s non market variance) that is
due to the asset’s unique features.
Unsystematic risk is considered
unimportant because it can be
eliminated in a large diversified
portfolio.
Fundamental risk versus
systematic risk
A number of studies have examined
the relationship between the market
measure of risk (systematic risk and
accounting variables used to
measure the fundamental risk factors
such as business risk, financial risk,
and liquidity risk.

The authors of these studies have
concluded that a significant
relationship exists between the
market measure of risk (systematic
risk) and the fundamental measures
of risk.
Therefore, the two measures of risk
can be complementary.

This consistency seems reasonable
because one might expect the
market measures of risk to reflect
the fundamental risk characteristics
of the asset.

Relationship between risk and
return
The security market line (SML)
shows that investors increase their
required rates of return as perceived
risk (uncertainty) increases.
The line that reflects the
combinations of risk and return
available on alternative investments
is referred to as the security market
line (SML).
The SML reflects the risk return
combinations available for all risky
assets in the capital market at a
given time.
Investors would select investments
that are consistent with their risk
preferences.

Some would consider only low risk
investments whereas others
welcome high risk investments.

Movements along the SML
Investors place alternative
investments somewhere along the
SML based on their perceptions of
the risk of the investments.
If an investment’s risk changes due
to a change in one of its fundamental
risk sources (Business risk, financial
risk, etc) it will move along the SML.

Any change in an asset that affects
its fundamental risk factors or its
market risk (that is, its beta) will
cause the asset to move along the
SML.

Changes in the slope of the
SML.
The slope of the SML indicates the
return per unit of risk required by all
investors.
Assuming a straight line, it is
possible to select any point on the
SML and compute a risk premium
for an asset through the equation:
Rpi=E(Ri)-NRFR
RPi=Risk premium for asset i.
E(Ri)=The expected return for asset
i.
NRFR= The nominal return on a risk
free asset.

Changes in the capital market
conditions or expected inflation
When there are changes in any of
the following factors:
Expected real growth in the economy
Capital market conditions
The expected rate of inflation
For example a growth in the real
growth rate will lead to a parallel
shift upward.

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AN OVERVIEW OF THE

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Annual Holding period return=1.1832

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YEAR BEGINNING VALUE ENDING VALE HPR HPY

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E(Ri)=[0.15x0.20]+ [0.15x-0.20] +[0.70x0.10]

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CVb = 0.07 =0.583

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