Investment Basics
Investment is the act of putting money into a project or something, with an aim of getting gains at the end of a certain period. Investment is different from gambling. There exists a high level of security for the capital and for the returns within an expected period. Speculation and gambling assumes a gain without through analysis and without security of capital or that of return. Therefore, investment involves a thorough analysis of the stocks that people purchase in the stock markets or the financial markets.
A financial market is one in which people trade financial securities that include stocks and bonds. Types of Securities 1. Bond This is a loan which the government or a corporation issues on a long term basis in terms of a negotiable instrument. They are in the form of loan from the buyer to the seller. It is in the form of a promise to pay the loan amount, the principal, plus an interest when it matures. Bonds are of different types, and they include the following: Bearer bonds that belong to the people who hold them and registered bonds where they record the name of the owner.
General obligation bonds are the government bonds that have the backing of the taxing power government that issues them and revenue bonds that whose payment is from specific tax sources and are free of the taxing power of the seller (Remenyi, 1999). Treasury bonds that the government releases to finance long-term financial goals and can mature between 1 to 30 years. Treasury notes are intermediate investment instruments that mature between 2 to 10 years. Treasury bills are short-term securities that mature between 3 months and 1 year. Participating bonds have both a fixed rate of interest and a profit sharing feature.
Convertible bonds are those that one can convert into stocks or shares on their maturity or agreed dates. Zero coupon bonds that come at a discount and pay no interest. Indexed bonds used in inflation periods. They have adjustments for to inflation rates. 2. Equities They are the shares of common stocks that corporations issue and inclue: Common stocks or ordinary shares are those that have the last claim on the corporation’s assets and they represent the chief ownership of a corporation.
Preferred stocks are those stocks that have an assurance to dividends or on the claim on assets in the case of bankruptcy before payment to the common stocks (O’Neil, 2000). 3. Commodities The contract to buy and sell a commodity in the stock markets is a security, for example, in the purchase expensive materials like gold and agricultural products. The investors here deal with the contracts to buy and sell these commodities and they do not deal with these commodities in question. 4.
Derivatives A derivative is contracts, which to parties make stating the payments that a party has to make and the benefits of the payment after a given period. Derivatives can act as a tool of speculation or hedging in the stock exchange market. Investors use financial derivatives for various purposes.First, derivatives ensure leverage. This happens because a minor adjustment in the underlying price of a security can have a significant impact on the value of the derivative. Secondly, when an investor uses a derivative for speculative purposes, he can make a profit if the value of the asset in which he has invested in shifts, in the suitable direction.
When an investor uses a derivative for hedging purposes, he mitigates the risk of adjustments in the value of the asset in the undesirable direction (Damodaran, 2002). The Investment Process Most investors put more emphasis on investment strategies, more than understanding the investment process. An analysis of the investment process will help an investor to make adequate preparations before starting effecting the investment. The first stage of the process understands the investor in terms of his needs and preferences. A portfolio manager views the investor as a client.
Understanding the client is therefore, vital, to know his preferences and risks. Secondly, one should construct the actual portfolio, which involves three sections. Firstly, we need to know how to allocate the portfolio among the various asset categories like equity, real assets, annd income securities. Secondly, an investor has to make a decision on allocation of assets. The investor picks individual assets from each asset category to constitute the portfolio.
The investor will finally execute the portfolio, where they conduct a comparison of the transaction costs and the velocity of transactions. The last section of the investment process is the evaluation of performance. The portfolio managers will examine the targets, which they set at the start of the investment, in comparison with the actual outcomes of the investment (O’Neil, 2000). Considerations in Investment in Bonds. There are factors that an investor should consider when investing in bonds. Active and Passive Management The first is how we manage the portfolio.
When the management of a portfolio is active, components of the portfolio will largely affect investment decisions. If the management is passive, the portfolio will invest mostly in stocks and bonds, employing a buy and hold strategy. Diversification This is where an investor allocates assets in various classifications in an effort to minimize the risk. This could be through considering the bond type or laddering. Bond Swap This is the act of selling a group of bond swaps and consequently buying another, which has the same market value.Rationale for Equities There exists a higher probability of large returns.
The growth of a company implies the growth of its stock. Equities have a high degree of accessibility. Anybody who has capital can access equity. Rationale for Derivatives Derivatives provide security to investors in the form of mitigation from risk of adjustments in the value of the stocks due to the foreign exchange movements. Rationale for Bonds Bonds have an advantage of extremely predictable returns because of their slow and steady nature. Bonds also have better interest rates than the banks.
Rationale for Commodities Investment in commodities poses less risk about the future returns (Damodaran, 2002).
