Investment Analysis

and
Portfolio Management
Chapter One
INTRODUCTION TO
INVESTMENT
‘’Poor people see a dollar as a dollar to trade for

something they want right now. Rich people see every

dollar as a ‘seed’ that can be planted to earn a hundred
more dollars….then replanted to earn a thousand more
dollars’’ (T. Harv Eker, Secrets of Millionaire Mind)
An economist says when people earn money they do one

of two things with it:

o they either consume it or save it.
o A person consumes money by spending it on something

like clothing, food or other.

o A person saves a dollar by somehow putting it aside for

consumption at a later time.

This tradeoff of present consumption for a higher level of

future consumption is the reason for saving.

What you do with the savings to make them increase in

value over time is investment.

WHAT DO YOU KNOW ABOUT INVESTMENTS?

The term ‘investing” could be associated with

the different activities, but the common

target in these activities is to “employ” the
money during the time period seeking to
enhance the investor’s wealth.
Funds to be invested come from assets
already owned /savings , or borrowed money.
An investment is the current commitments of money for a
period of time in order to derive future payments that will
compensate the investor for:
 The time the funds are committed,
 The expected rate of inflation, and
 The uncertainty of the future payments.
Investment involves employment of own funds or
borrowed funds on a real or financial asset for a certain
period of time in anticipation of a return in future.
Investment also involves employment of funds with the

aim of achieving additional income or growth in values.

 Lending money (Interest)
 Purchasing Gold (value appreciation )
 Insurance policy …etc
 Who is an Investor?

When a person has more money than he requires for

current consumption, he would be coined as a potential

investor.
The “investor” can be an individual, a
government, or a corporation.
 Types of Investors

There are two types of investors:

 Individual investors; and
 Institutional investors
 Individual investors are individuals who are investing on their

own. Sometimes individual investors are called retail investors.

 Institutional investors are entities such as investment companies,

commercial banks, insurance companies, pension funds and other

financial institutions.
 Types of Investing

Investors can use direct or indirect types of investing.

Direct investing is realized using financial markets and

Indirect investing involves financial intermediaries.

In direct investing investors buy and sell financial assets

and manage individual investment portfolio themselves.

Their successful investing depends on their understanding

of financial markets, its fluctuations and on their abilities

to analyze and to evaluate the investments and to manage
their investment portfolio.
Takes all the risk
In indirect type of investing investors are buying or

selling financial instruments of financial intermediaries

(financial institutions) which invest large pools of funds
in the financial markets and hold portfolios.
Indirect investing relieves investors from making

decisions about their portfolio.

By pooling the funds of thousands of investors,
those companies can offer them a variety of services, in
addition to diversification, including professional
management of their financial assets and liquidity.
 Investment and Related terms

Investment Vs Saving

Investment Vs Financing

Investment Vs Speculation

Investment Vs Gambling
 Investment Vs Saving

First, Investors are savers, but all savers cannot be good

investors, as investment is a science and an art.
Saving involves putting money away with little, or no risk
A saver knows the future return, and the account is
probably insured by a government agency that protects
depositors against bank failure (NBE).
In the short-run, saving involves few worries.
A dollar saved is not always a commitment for some
specified period.
Investing also involves putting money away, but in

a risky endeavor and uninsured decline in asset

value.
Both saving and investing amount to consumption

shifting through time, not spending a dollar today,

as a result a person is able to spend more lately,
assuming of course, the person saved or invested
wisely.
Investing is risky and rewarding but saving is not.
 Investment Vs Financing

An investment is the current commitments of money and

money to be invested come from assets

already owned /savings, or borrowed money.
By postponing consumption today and
investing their savings, investors expect to
enhance their future consumption
possibilities by increasing their wealth.
Businesses raise money by issuing stocks and

bonds. These securities are traded in the

financial markets and the investors have
possibility to buy or to sell securities issued by
the companies.
Thus, the investors and companies, searching for

financing, realize their interest in the same place

i.e. in financial markets.
And very often investment and financing analysis for

decision making use the same tools, but the interpretation

of the results from this analysis for the investor and for
the financier would be different.
For example, when issuing the securities and selling

them in the market, the company perform valuation

looking for the higher price and for the lower cost of
capital,
…but the investor using valuation search for attractive

securities with the lower price and the higher possible

required rate of return on his/ her investments.
 Investment Vs Speculation

Investors take on calculated risk

The primary difference between investing and

speculating is the amount of risk involved.

Investor expects regular income in the form

of dividend or Interest whereas Speculator

seeks to buy and sell in order to take
advantage of market price fluctuations.
The speculator's primary interest lies in
anticipating and profiting from market
fluctuations.
Investor’s funds commitment is a long term

An investor has a relatively longer planning

horizon.
 Investment Vs Gambling

Gambling is defined as an act of betting on an uncertain

outcome.
The outcome of gambling is largely a matter of luck.

The risk that gamblers assume is highly

disproportionate to that of their expected return.
Results of gambling are known in quick time.
 The results of gambling are random in nature and it is not

correlated with past events.

 Creates new speculative risk that did not exist before

 Socially unproductive, since the winners gain comes at the

expense of the loser

 Investment Alternatives

Broadly, investment can be made in two forms:

I. Investments in real assets: generally involve some kind
of tangible asset, such as land, machinery, factories, etc.
II.Investments in financial assets: involve contracts in
paper or electronic form such as stocks, bonds, etc
 Real Assets

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
consumed by the society.
 Financial Assets

Financial Assets are no more than sheets of paper

or more likely, computer entries, and do not

directly contribute to the productive capacity of
the economy.
Represent the transfer of funds to enterprises with

attractive investment opportunities.

Represent claims on the income generated by real

assets
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
Bondholders, for example, are entitled to a flow of

income based on the interest rate and par value of

the bond. Equity holders or stockholders are
entitled to any residual income.
 Balance Sheet Comparison
A financial asset can be defined as any asset held by an

economic unit that is also recorded as a liability or

claim on some other economic unit.

So, for the whole Economy

Volume of financial
Volume of liabilities
assets created for
lenders = issued by borrowers
 For the balance sheet of any economic unit.
Total assets = Total liabilities + Net worth
Where,
TA = Total Financial assets + Total Real assets
 For the whole economy.
Total Financial assets = Total liabilities
 So, for the economy as a whole,
Total real assets = Total net worth(Accum. savings)
Therefore, 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.
 Investments in Financial Assets

In this course our focus will be on the financial asset

investments.
Investment in financial assets differs from investment in real assets in those

important aspects:

a. Divisible -- Financial assets are divisible, whereas most real assets are not. An

asset is divisible if investor can buy or sell small portion of it as required.

b. Marketability--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.

c. The holding period for investments Investors acquiring real 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

Note:- Holding period for investments depends on the investor’s goals and
investment strategy.
e. Information availability-- Information about financial
assets is often more abundant and less costly to obtain,
than information about physical assets.
 Securities/Financial Assets

A security is a legal document that shows an ownership

interest or a legal claim against the asset of the firm.
Securities can be: Equity securities, Debt securities, or
Derivative Securities.
1. Equity securities --the most important equity security is
common stock. which is one of most popular investment
vehicles with long-term investment horizon. Popular
among investors.
Represents real ownership
2. Debt securities – represents a claim on a
borrowed amount and periodic interest.

Can be: Fixed income and short– term securities

a. Fixed income securities—are those whose

return is fixed, up to some redemption date or
indefinitely. Includes:
 Long-term debt securities
 Preferred stocks
Long-term debt securities—security
usually provides a known cash flow with no
growth in the income stream.
The major representatives of long-term debt
securities are bonds.
 Preferred stocks

 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.
 For investment purposes, preferred stock is considered a

fixed income security, if it is none participatory.

 Short - term debt securities – are also called short-

term investment vehicles.

 Are all those which have a maturity of one year or less

 are defined as money-market instruments

 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
 Certificates of deposit—is debt instrument issued by

the bank that indicates a specified sum of money has

been deposited at the issuing depository institution.
 Commercial paper is a name for short-term
unsecured promissory notes issued by corporation.
 Banker’s acceptances are short-term fixed-income

securities that are created by non-financial firm whose

payment is guaranteed by a bank.
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.
 -

3. Derivative Assets—are contractual assets that

drive their value from other underlying assets.
Are also called Speculative investment vehicles

Participants expect profiting from the market

fluctuations.

These instruments include futures contracts, forward

contracts, option contracts, swap agreements.
 Security Markets

Major Functions of Financial Market

Financial markets facilitate the transfer of savings from

surplus to deficit units.

It provides liquidity to financial assets

A Financial market provides a pricing information

It helps to save money, time and efforts of both buyers

and sellers
1. Classification by type of financial claim:
• Equity (Stock) market
• Debt market
2. Classification by maturity of claim:

− Money Market- which provide short term debt financing

and investment.

− Capital Market- the market for debt and equity

instruments with a maturity of greater than one year
3.Classification by origin:
− Primary Market- markets dealing with financial claim that are newly
issued.
− Secondary Market- markets dealing with previously issued financial
claims.
4. Classification by organizational structure.
• Exchange market- physical location where transactions are carried
out on a trading center. Example, New York Stock exchange, AMX
• Over-the-counter markets—OTC -decentralized dealer networks,
smaller companies, non-standardized quantities can be traded, no
exchange fee, no listing requirement.
Other Classifications:
• Commodity markets- which facilitate the trading of
commodities (such as ECX of Ethiopia).
• Foreign exchange markets- which facilitate the trading of
foreign exchange.
• Derivatives markets- which provide instruments for the
management of financial risk.
 Investment Management Process

 The investment management process describes

how an investor should go about making decisions.
Which includes the following stages:

1. Setting of investment policy.

 Is the first and very important step
 Includes setting of investment objectives
 The investment policy should have the specific
objectives regarding the investment return
requirement and risk tolerance of the investor.
For example, the investment policy may define

that the target of the investment average return

should be 15 % and should avoid more than 10 %
losses.
Identifying investor’s tolerance for risk is the

most important objective, because it is obvious

that every investor would like to earn the highest
return possible.
But because there is a positive relationship

between risk and return, it is not appropriate

for an investor to set his/ her investment
objectives as just “to make a lot of money”.
Investment objectives should be stated in
terms of both risk and return
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.
This stage of investment management
concludes with the identification of the
potential categories of financial assets for
inclusion in the investment portfolio.
The identification of the potential categories

is based on the investment objectives, amount

of investable funds, investment horizon, and
tax status of the investor.
2. Analysis and evaluation of investment
vehicles

o 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.
 Most frequently two forms of analysis are used:
technical analysis and fundamental analysis.
 Technical analysis involves the analysis of market

prices in an attempt to predict future price movements

for the particular financial asset traded on the market.
This analysis examines the trends of historical prices
and is based on the assumption that these trends or
patterns repeat themselves in the future.
Fundamental analysis in its simplest form is

focused on the evaluation of intrinsic value of the

financial asset. This valuation is based on the
assumption that intrinsic value is the present
value of future flows from particular investment.
By comparison of the intrinsic value and market
value of the financial assets those which are under
priced or overpriced can be identified.
3. Formation of diversified investment portfolio.

 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.

 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.
 4. 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.
 5. 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.
End of Chapter One