Investment
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Introduction
Investment is a branch of finance dealing with the management of individual or organizational funds to generate future income. The primary processes involved in investment involve setting of investment goals, the establishment of an investment policy, selection of an investment strategy, selection of specific assets, and measurement and evaluation of investment performance (Drake & Fabozzi, 2013).
The first step is the thorough analysis of what an entity wants to achieve and the establishment of policy guidelines that are in line with the set objectives. The policies should adhere to legal constraints, tax restrictions, and the business or individual’s imposed investment constraints. The major concern of the task is the distribution of funds among the major asset classes known as portfolio. The manager should then come up with a portfolio strategy that is consistent with investment policy guidelines and objectives. The next steps involved selection of financial assets to include in the portfolio. The last step allows investors to obtain answers to questions like what adjustments were made to counter the risks involved and how the reported returns were achieved.
Financial instruments can be described as the claim that an investor has on the issuer. There are three types of financial instruments; these are equity, debt, and derivative securities.
Debt
Debt and is a type financial instrument where the issuer agrees to pay the investor the borrowed amount and an agreed interest that are fixed contractually. The debt instrument may be a fixed amount or as a percentage of the initial value of the debt. The debt may be in the form of loans, bonds or notes. Debt is also known as a fixed income instrument because the issuer cannot get more than the agreed amount in the contract.
Equity
An equity instrument is a situation where the issuers pay the investors a certain percentage of the acquired earnings after the business’s creditors have been paid. Examples of equity include common stock, which is the ownership interest in a company and partnership shares that is the ownership interest in a company. Any disbursement of a corporation’s earnings is known as dividends.
Financial Derivatives
These are instruments whose values are based on other securities and are not worth anything by themselves. There are thousands of financial derivatives, although the most common ones are options, futures and swaps (Smith, 2014). Options are agreements between the investors and issuers to sell securities at a given price. Futures work on the same principles as options, but the underlying securities are different. The traditional use of futures was to purchase the rights to buy or sell a commodity, although they can also be used to purchase financial securities too. Swaps allow investors to exchange their securities’ benefits with each other based on their preferences.
Framework for Analyzing Income and Derivative Securities
Investors trade financial instruments in a financial market that provide three major economic functions. The functions are price discovery, liquidity, and reduced transaction costs. Price discovery means that the interactions of participants in the financial markets determine the traded assets. It determines the required returns that the investors demand to buy financial securities and consequently how the funds available from the lenders can be distributed amongst the borrowers. Liquidity is the presence of willing buyers and sellers in the market ready to trade that is an important aspect when circumstances force investors to sell a financial instrument or a derivative security. Reduced transaction costs are realized when two entities are willing to trade a financial security. The transaction cost can be classified as either search cost or cost information. Search cost can further be subdivided into explicit and implicit costs. An explicit cost is a cost associated with advertising the sale or purchase of securities while implicit cost is the value of time spent in finding a counterparty. Information cost is the expense incurred in evaluating a financial instrument’s investment attributes. In an efficient market, the prices reflect the aggregate information common to all market players, hence investors know what risks or returns to expect from issuers financial instruments.
Understanding and taking into account the risk involved in any chosen asset is critical to investors regardless of the selected investment strategy. The risk can either be classified as systematic or non-systematic risks. Unsystematic risks are described as the generation of risk factors that are specific to a certain stock or share. Unsystematic risks occur due to such things as poor management and changes in regulation. Systematic risks affect the whole financial system and are responsible for upwards or downwards shifts in the market index.
Risk Reduction via Diversification
This is a type of risk reduction through the investment of obtained funds in a large number of different companies’ stocks. The diversification of funds results in the reduction of risks since the returns from the investments do not move in the same direction. Financial intermediaries perform economic diversification functions by transforming risky assets into less risky ones. Although individual investors can perform diversification on their own, they cannot do it at the same efficiency as the financial intermediaries. Investors with small investment sums find it difficult to diversify because of lack of funds to buy different companies’ stocks (Holder and Combes, 2015).
The use of cost-effective diversification through the purchase of financial assets of a financial intermediary can significantly reduce risk. However, the method can be used to minimize systematic risks and the benefit observed in having shares in 35 or more companies’ shares in different sectors to minimize non-systematic risk has little to no benefit.
Different Investors and their Investment Processes
Investment companies manage funds for different investment entities and charge some fees for their services. The fees may be tied to the amount managed for the client or the performance of the managed assets.
Regulated Investment Companies generate capital through the public sale of shares and invest the money in various portfolios of securities. There are three types of Regulated Investment Companies namely open-end funds, closed-end funds, and Unit Investment Trusts.
Exchange traded funds are similar to open-end funds but trades like stock in an exchange market. An investment advisor performs the role of maintaining the portfolio such as the index returns are accurate.
Investment banks are highly leveraged and play a major role in investment activities through such ways as raising funds through public offering, securities trade, mergers and acquisitions, security finance and merchant banking.
Conclusion
The invest processes consist of five processes that need proper understanding and planning. There are three financial instruments that the issuers and investor’s deal with depending on their preferences. Financial markets are used to provide a level playing field for both lenders and borrowers and analyze the value of incomes and securities. There are different risks associated with investments with mostly diversification being used to mitigate the risks, although the method is not foolproof. There are different investment companies that provide investment opportunities for both individuals and organizations, each using different investment methods.
References
Drake, P. P., & Fabozzi, F. J. (2013). An Introduction for Financial Markets, Business Finance, and Portfolio Management
Holder and Combes. (2015). Investment risk assessment, management & analysis. Retrieved March 1, 2016, from Holder and Combes, https://www.holderandcombes.co.uk/our-services/investments/risk/
Smith, K. (2014). What are Financial Derivatives – Common Derivatives Trading Examples. The Wall Street Journal
