INVESTMENT MANAGEMENT



Investment management comprises a broad spectrum of topics ranging from the workings of capital markets, to valuation of financial securities, to the construction of portfolios of assets to meet the objectives of investors. Investment itself can be considered any activity that requires the commitment of current wealth to some set of specified assets for the purpose of enhancing future wealth. These assets can be either real (e.g., gold, art, real estate) or financial (e.g., stocks, bonds). The enhancement of future wealth can be derived from appreciation in the value of the asset itself, referred to as capital gains, or as income provided to the owner of the asset.

There are well-developed financial markets around the world that have evolved to assist in the transfer of funds from investors to individuals and organizations who have a need for capital. These markets can be divided into primary and secondary categories. Primary markets capture the initial transfer of funds from investors to those with viable projects requiring additional cash. For example, a corporation may sell stock to the public in order to raise needed funds for an expansion of productive capacity, or to undertake new initiatives in new markets. This type of transaction is typically mediated by an investment banker who will assist the corporation in the sale of its securities. Other than the fee charged by the investment banker, the corporation actually receives the cash generated from the stock sale. The investor receives shares of stock representing partial ownership of the firm.

Secondary markets are resale markets where financial securities are traded among investors. Although corporations receive no additional cash flow from the purchase or sale of their securities in secondary markets, these markets provide the important ingredient of liquidity to investors. Liquidity refers to the ability to quickly exchange assets and cash at reasonable prices. The New York Stock Exchange (NYSE) is the largest example of a secondary market in the world. On the floor of the NYSE, traders exchange shares of corporations after agreeing on the proper price. Other major stock exchanges in the world are located in Tokyo, London, Frankfurt, Toronto, Paris, and in most other developed economies. In addition, there are significant markets that have no physical location. The over-the-counter (OTC) market in the United States, is one such example. This market is really a computer network of dealers who maintain inventories of various securities and serve as market makers. Dealers post prices at which they would be willing to purchase additional securities (the bid price) and prices at which they would be willing to sell securities that they hold (the ask price).

Investors who want to buy or sell financial assets typically engage the services of a broker. The broker transmits orders to buy or sell to the trading floor of the appropriate exchange or views price quotes provided by dealers and executes the order at the best available price. Investors can submit either market orders or limit orders. A market order is an instruction to buy or sell at the current market price. A limit order carries conditions that must be met before the transaction can be carried out. These conditions relate to the price level of the security and the time period during which the order remains valid.

Additionally, investors can hold a long position in a security, by purchasing a quantity and holding it, or a short position, by borrowing securities and selling them. While the motivation behind the long position is clear—the investor expects the value of the security to increase or expects it to provide income in the future—the motivation for short selling requires further explanation. By borrowing securities now, selling them at the current price, and agreeing to replace them at a later date, the investor is clearly forecasting a decrease in price. If the price does decline, then the investor can purchase securities at this lower price, repay the loan that is denominated in securities, not money, and profit from the decline. If the price rises after the initial sale, however, the investor will sustain a loss when the shares are eventually purchased and replaced. Brokers will assist in this transaction by locating shares that can be borrowed and sold.

Brokers will also lend funds to investors for the purchase of shares. This is called margin trading. Current regulations in the United States allow an investor to borrow up to 50 percent of the value of securities purchased. Note that the investor's profits are amplified since only a fraction of the purchase was financed with personal funds. Likewise, losses will accumulate at a more rapid rate if the value of the securities purchased declines. If the drop in value is considerable, the investor will be contacted by the broker and instructed to provide additional cash in order to secure the position. This is referred to as a margin call.

There are a variety of financial assets for the investor to consider. Shares of common stock, often referred to as equity, represent a claim of ownership of the firm's future earnings. Common stockholders are the legal owners of a corporation and typically carry voting rights regarding matters of corporate governance. The shares have value if the firm is expected to generate significant future cash flows that will be sufficient to cover expenses and allow for a profit that can be distributed to shareholders. These future cash flows to shareholders can take the form of dividends, direct cash payments, or capital gains. Capital gains represent the change in the value of the shares themselves. This value will change as investors reassess the ability of the firm to generate future cash flows for shareholders. Closely related to common stock is a second category, preferred stock. This stock pays a dividend that is either fixed or varies with some indicator of interest rates. The term "preferred" refers to the fact that dividends must be paid to this class of shareholders before any dividend payments are made to common shareholders. While it is also considered equity, and its holders are also considered owners of the firm, preferred shareholders can vote on matters of corporate governance in only very limited circumstances.

A second category of financial assets is represented by debt. Debtholders are creditors of the firm, not owners. Therefore, an investment in a firm's debt is inherently less risky than an investment in its equity. All obligations to debtholders must be met before any payments can be made to preferred or common shareholders. Debt is often classified by the life of the liability it entails. At the shortest end of the maturity spectrum are highly liquid corporate and government obligations that must be paid within one year. Highly creditworthy corporations may issue commercial paper. Commercial paper carries a stated par, or face value, which represents the amount that the corporation agrees to repay when the obligation matures. This asset is sold at a discount, or for less than its face value. The return to the investor is the difference between this initial discount price and the face value. Similar instruments, called U.S. Treasury bills, are issued by the U.S. Department of the Treasury and by governmental units of other foreign nations. Notes are medium-term obligations that typically have a life of more than one year and less than five years. Notes also have a face value and usually provide periodic payments of interest at a rate expressed as a percentage of the face value.

Bonds are the most prominent securities in the debt category. They include any obligation with a life of more than five years. Bonds are commonly issued for 20-year periods. There are, however, many examples of 30-year bonds and a U.S. corporation, Disney, has issued bonds with a 100-year life. Regardless of longevity, bonds are similar to notes in that they make periodic payments of interest to holders. These payments are referred to as coupon payments and are typically expressed as a percentage of the bond's face value. For example, a 20-year bond with an 8 percent coupon rate and a $1,000 face value would make payments of $80 per year. Most coupon bonds commonly divide this interest payment into semiannual installments. There are many types of bonds that differ from the fixed rate coupon bond just described. Floating-rate bonds have no fixed coupon rate. Instead, interest payments are adjusted to move with some broader indicator of interest rates. Zero coupon bonds pay no interest whatsoever. They are sold at some fraction of their face value and, unless resold, will generate no cash inflow until they mature. Convertible bonds are typically coupon paying bonds that also provide the holder with the option of exchanging the bond for a specified number of shares of common stock. This option can be very valuable if the firm's stock price rises significantly.

Another class of financial assets is represented by derivative securities. These are securities whose value is directly tied to the value of another asset. One prominent example is the stock option. Options are traded securities that allow the holder to purchase or sell a specified quantity of shares of an individual stock for a predetermined price, called the strike or exercise price, during a specified period. The holder of a call option may purchase stock at the exercise price. Therefore, the call option becomes more valuable as the value of the stock itself increases. Conversely, the holder of a put option has the right to sell stock at the exercise price and will profit if the stock's value falls. A second prominent category of derivative securities is the futures contract. In a futures contract, the buyer agrees to take delivery of a specified commodity or financial instrument at a specified time and price. Therefore, the buyer profits if the value of the commodity rises above this price. The seller has incurred a loss since there is an obligation to deliver the commodity for a price that is lower than the current market price. The situation is reversed, however, if the value of the commodity falls below the price specified in the futures contract. In this case, the seller profits and the buyer loses. Futures contracts are used to hedge, or transfer, risk associated with the underlying commodity of the contract; they are used by speculators to take risky positions regarding the future price movements of the commodities themselves. Futures contracts are available on many agricultural commodities (e.g., corn, wheat, soybeans, cattle), industrial commodities (e.g., crude oil, copper), precious metals (e.g., gold, silver, platinum), interest rate sensitive securities (e.g., U.S. Treasury notes, bonds, and bills), foreign currencies, and a variety of market indexes.

Regardless of the assets chosen as investments, the investor must always consider the duality of risk and return associated with each. Rate of return refers to the percentage of wealth appreciation or depreciation associated with a particular investment. Rate of return can be considered in a historical or an expectational sense. That is, it can be measured for some prior period or it can be forecast for some upcoming period. Risk refers to the cloud of uncertainty surrounding the expected future return. It is common in investment analysis to use measures of historical return, such as an arithmetic average over multiple periods, and historical risk, such as statistical variance or standard deviation, to serve as a proxy for expected future returns and risk. But this is just a convenient starting point and investment analysis commonly modifies the forecast drawn from historical data to reflect more relevant information derived from a broader array of sources. So, it is the future risk and return that truly matters and it is reasonable to assume that as investors compare various alternatives, they will prefer higher expected returns and lower expected risk.

Analysis of individual investment alternatives is carried out in a variety of ways. One interesting dichotomy is the distinction between fundamental and technical analysis. Fundamental analysis is an attempt to build a model of security value by careful scrutiny of the characteristics of the firm (or government) that has issued the security. Such an assessment will draw upon financial statements of a corporation and other pertinent sources of information regarding the firm's activities. The assessment will also rely upon judgments made regarding the prospects of the industry in which the firm resides and on the outlook for the economy in general. The objective is to forecast the future cash flows that will be available to the various security holders in the firm and to subsequently assess whether these expected cash flows will be sufficient to compensate the investor for the associated risk. Clearly, there is no one methodology for fundamental analysis even though there is a common objective.

Technical analysis attempts to forecast future security values by exploiting patterns in past security prices, and in the relationship between prices and other relevant variables. This technique requires careful identification and exploitation of trends that provide an unambiguous clue regarding future price movements. Technical analysts do not rely on information regarding financial characteristics of the firm itself, but instead examine both psychological and institutional determinants of supply and demand of the firm's stock. As with fundamental analysis, there is no one mode of technical analysis.

Acting as an umbrella over these two modes of investment analysis is the idea of market efficiency. A market is considered efficient if security prices fully reflect all available information. Furthermore, new and relevant information will be rapidly incorporated into the price. If there are many fundamental analysts searching for relevant information that can be used to value a security, then financial markets should be informationally efficient. On the other hand, if markets are imperfect and investors exhibit irrational behavior (e.g., systematically overreacting to bad news or exhibiting "herd" behavior), then markets will not be efficient. The question is really one concerning the level of efficiency. There are many studies that have scrutinized the predictive ability of past stock prices and other historical relationships. By and large, these studies have found no significant "memory," or forecasting ability using such data. Other studies have indicated that an unanticipated disclosure of information relevant to the future cash flow stream of the firm evokes a rapid and complete adjustment to a new price level for the firm's securities. There are small, yet undeniable, examples that suggest financial markets are not perfectly efficient and that investors sometimes act on information that should have no economic consequence. It is reasonable, however, to say that financial markets in most developed economies exhibit a high degree of informational efficiency.

The large body of research on market efficiency has generated a relatively new specialty called quantitative investment management. This style of management generates models using both fundamental and technical data. The objective is to rank securities based on expected future performance and to assess the risk of any portfolio resulting from such a ranking.

Given well-functioning global security markets, a broad array of securities, and many sources of information for assessing alternatives, investors are presented with the difficult choice of what combination of securities to hold. The first step in addressing this fundamental problem requires an examination of investment objectives. A clarification of investment objectives and other relevant information regarding the investor's specific situation will lead to effective screening of investment alternatives, proper portfolio construction, and ultimately, a suitable set of investments for the investor. Investment objectives can be described in a number of ways. One useful scale is based upon risk and return.

Consider the following broad categories of investment objectives ranging from low to high risk: (1) preservation of capital, (2) growth and income, (3) capital appreciation, and (4) aggressive growth. The first category, preservation of capital, would consider only the highest-quality, lowest risk, investment alternatives. Primary consideration is given to avoidance of loss, not to an increase in wealth. This objective could be met by holding Treasury bills, commercial paper, and other short-term, low-risk instruments. The second category, growth and income, would screen to find a set of securities that also have low risk, but which are expected to provide a reasonable level of current income. This would suggest a significant component of stocks paying a high dividend and coupon-paying bonds. In addition, the growth component of this objective may be met by holding a proportion of securities in industries that are expected to exhibit moderate growth over some upcoming period. Capital appreciation refers to an objective where current income is a minor consideration at best. Common stock (and possibly convertible bonds) in companies expected to exhibit average and above-average growth would be appropriate to include. On the high-risk, high-expected-return end of the spectrum is the aggressive growth objective. Here, an investor would screen out all but those firms expected to generate above-average growth. This port-folio may include stocks of relatively small companies in new industries, bonds from firms that are considered moderate to high credit risks, and derivative securities such as options.

In addition to these simple objectives, the investor's portfolio may be influenced by other characteristics. For example, an institutional investor managing a pension fund will have different concerns than an individual investor designing his or her own personal retirement plan. Other investors will want the portfolio to address their other sources of income, or lack thereof, tax status, age, need to provide for dependents, level of sophistication regarding investment alternatives, and many other attributes. These attributes and attitudes regarding risk will immediately exclude some investment alternatives and implicitly suggest others.

At this point, many investors—individual and institutional—will look toward mutual funds to provide them with a proper package of appropriate investments. Mutual funds are companies that hold portfolios of securities and sell shares in the portfolios that they hold. There are nearly as many mutual funds in the United States as there are publicly listed stocks. Mutual funds can be categorized by risk-return objective or by the subset of securities they hold. For example, there are many funds in each of the four categories previously described. In addition, there are sector funds (specializing in individual industries), country funds (specializing in the securities of an individual country), global funds, bond funds, real estate development funds, funds holding tax-exempt securities, and many others. Such categorization is often referred to as a fund's "style." Managers of these funds charge a fee, but relieve investors of the need to scrutinize individual investments.

After settling on an investment objective and screening the vast number of investment alternatives to a manageable number, there is still a major consideration that remains. Portfolio management theory indicates that an investor can reduce overall exposure to risk by holding a group of securities selected from a diverse set of industries or countries. This diversification of risk occurs because any individual security is subject to unique sources of risk. The unique sources of risk in one security, however, are distinct from the unique sources of risk in another security. This means that when the securities are held together, they tend to stabilize one another since unique surprises from one source are not compounded by similar surprises from another source. This lack of correlation among sources of risk for individual securities means that the investor can minimize, even eliminate, the risk unique to individual securities, by holding a large number of diverse securities. This set could span a number of different industries or regions of the world. This does not eliminate all risk for the investor, however. There is still risk that results from factors common to all securities in the sample. For example, all securities are subject to the risk of changes in overall economic conditions. An investor who wished to reduce risk further could choose securities that have lower sensitivity to such changes.

SEE ALSO : Investment Analysis

[ Paul Bolster ]

FURTHER READING:

Bodie, Zvi, Alex Kane, and Alan J. Marcus. Investments. 4th ed. Boston: Irwin/McGraw-Hill, 1999.

Fabozzi, Frank J., and Franco Modigliani. Capital Markets: Institutions and Instruments. 2nd ed. Upper Saddle River, NJ: Prentice Hall, 1996.

Sharpe, William F. "Asset Allocation: Management Style and Performance Measurement." Journal of Portfolio Management 18, no. 2 (winter 1992): 7 + .



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joseph mukasa
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Jun 1, 2012 @ 7:07 am
What if someone has a viable project that can generate wealth but he has no capital to start the idea can he get assistance from investment management forum.

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