UNIT 1- Overview of Investment

1.1. Investing versus financing

The term ‘investing” could be associated with the different activities, but the common target in these activities
is to “employ” the money (funds) during the time period seeking to enhance the investor’s wealth. Funds to
be invested come from assets already owned, borrowed money and savings. By foregoing consumption today
and investing their savings, investors expect to enhance their future consumption possibilities by increasing
their wealth. But it is useful to make a distinction between real and financial investments. Real investments
generally involve some kind of tangible asset, such as land, machinery, factories, etc. Financial investments
involve contracts in paper or electronic form such as stocks, bonds, etc. Following the objective as it presented
in the introduction this course deals only with the financial investments because the key theoretical investment
concepts and portfolio theory are based on these investments and allow to analyze investment process and
investment management decision making in the substantially broader context Some information presented in
some chapters of this material developed for the investments course could be familiar for those who have
studied other courses in finance, particularly corporate finance. Corporate finance typically covers such issues
as capital structure, short-term and long-term financing, project analysis, current asset management. Capital
structure addresses the question of what type of long-term financing is the best for the company under current
and forecasted market conditions; project analysis is concerned with the determining whether a project should
be undertaken. Current assets and current liabilities management addresses how to manage the day-by-day
cash flows of the firm. Corporate finance is also concerned with how to allocate the profit of the firm among
shareholders (through the dividend payments), the government (through tax payments) and the firm itself
(through retained earnings). But one of the most important questions for the company is financing. Modern
firms 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 – in financial markets. Corporate
finance area of studies and practice involves the interaction between firms and financial markets and
Investments area of studies and practice involves the interaction between investors and financial markets.
Investments field also differ from the corporate finance in using the relevant methods for research and decision
making.
Investment problems in many cases allow for a quantitative analysis and modeling approach and the
qualitative methods together with quantitative methods are more often used analyzing corporate finance
problems. The other very important difference is, that investment analysis for decision making can be based
on the large data sets available form the financial markets, such as stock returns, thus, the mathematical
statistics methods can be used.
But at the same time both Corporate Finance and Investments are built upon a common set of financial
principles, such as the present value, the future value, the cost of capital). 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 th higher
possible required rate of return on his/ her investments.
Together with the investment the term speculation is frequently used. Speculation can be described as
investment too, but it is related with the short-term investment horizons and usually involves purchasing the
salable securities with the hope that its price will increase rapidly, providing a quick profit. Speculators try to
buy low and to sell high, their primary concern is with anticipating and profiting from market fluctuations.
But as the fluctuations in the financial markets are and become more and more unpredictable speculations are
treated as the investments of highest risk. In contrast, an investment is based upon the analysis and its main
goal is to promise safety of principle sum invested and to earn the satisfactory risk.
There are two types of investors:
_ individual investors;
_ 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. In recent years the process of
institutionalization of investors can be observed. As the main reasons for this can be mentioned the fact, that
institutional investors can achieve economies of scale, demographic pressure on social security, the changing
role of banks.
One of important preconditions for successful investing both for individual and institutional investors is the
favorable investment environment (see section 1.3). Our focus in developing this course is on the management
of individual investors’ portfolios. But the basic principles of investment management are applicable both for
individual and institutional investors.

1.2. Direct versus indirect investing

Investors can use direct or indirect type of investing. Direct investing is realized using financial markets and
indirect investing involves financial intermediaries.
The primary difference between these two types of investing is that applying direct investing investors buy
and sell financial assets and manage individual investment portfolio themselves. Consequently, investing
directly through financial markets investors take all the risk and 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. Contrary, using 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. As shareholders with the ownership interest in the portfolios managed
by financial institutions (investment companies, pension funds, insurance companies, commercial banks) the
investors are entitled to their share of dividends, interest and capital gains generated and pay their
share of the institution’s expenses and portfolio management fee. The risk for investor using indirect investing
is related more with the credibility of chosen institution and the professionalism of portfolio managers. In
general, indirect investing is more related with the financial institutions which are primarily in the business
of investing in and managing a portfolio of securities (various types of investment funds or investment
companies, private pension funds). 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. Investors can “employ” their funds by performing direct transactions, bypassing both
financial institutions and financial markets (for example, direct lending). But such transactions are very risky,
if a large amount of money is transferred only to one’s hands, following the well known American proverb
“don't put all your eggs in one basket” (Cambridge Idioms Dictionary, 2nd ed. Cambridge University Press
2006). That turns to the necessity to diversify your investments. From the other side, direct transactions in the
businesses are strictly limited by laws avoiding possibility of money laundering. All types of investing
discussed above and their relationship with the alternatives of financing. Companies can obtain necessary
funds directly from the general public (those who have excess money to invest) by the use of the financial
market, issuing and selling their securities. Alternatively, they can obtain funds indirectly from the general
public by using financial intermediaries. And the intermediaries acquire funds by allowing the general public
to maintain such investments as savings accounts,
Certificates of deposit accounts and other similar vehicles.
Characteristics of Investment
The characteristics of investment can be understood in terms of as
- return,
- risk,
- safety,
- liquidity etc.
Return: All investments are characterized by the expectation of a return. In fact, investments are made with
the primary objective of deriving return. The expectation of a return may be from income (yield) as well as
through capital appreciation. Capital appreciation is the difference between the sale price and the purchase
price. The expectation of return from an investment depends upon the nature of investment, maturity period,
market demand and so on.
Risk: Risk is inherent in any investment. Risk may relate to loss of capital, delay in repayment of capital,
nonpayment of return or variability of returns. The risk of an investment is determined by the investments,
maturity period, repayment capacity, nature of return commitment and so on.
Risk and expected return of an investment are related. Theoretically, the higher the risk, higher is the expected
returned. The higher return is a compensation expected by investors for their willingness to bear the higher
risk.
Safety: The safety of investment is identified with the certainty of return of capital without loss of time or
money. Safety is another feature that an investor desires from investments. Every investor expects to get back
the initial capital on maturity without loss and without delay.
Liquidity: An investment that is easily saleable without loss of money or time is said to be liquid. A well
developed secondary market for security increase the liquidity of the investment. An investor tends to prefer
maximization of expected return, minimization of risk, safety of funds and liquidity of investment.

1.3. Investment environment

Investment environment can be defined as the existing investment vehicles in the market available for
investor and the places for transactions with these investment vehicles. Thus further in this subchapter the
main types of investment vehicles and the types of financial markets will be presented and described.

1.3.1. Investment vehicles

As it was presented in 1.1, in this course we are focused to the financial investments that mean the object will
be financial assets and the marketable securities in particular. But even if further in this course only the
investments in financial assets are discussed, for deeper understanding the specifics of financial assets
comparison of some important characteristics of investment in this type of assets with the investment in
physical assets is presented. Investment in financial assets differs from investment in physical assets in
those important aspects:
• Financial assets are divisible, whereas most physical assets are not. An asset is divisible if investor can buy
or sell small portion of it. In case of financial assets it means, that investor, for example, can buy or sell a
small fraction of the whole company as investment object buying or selling a number of common stocks.

• Marketability (or Liquidity) is a characteristic of financial assets that is not shared by physical assets, which
usually have low liquidity. Marketability (or liquidity) 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.
• The planned holding period of financial assets can be much shorter than the holding period of most physical
assets. The holding period for investments is defined as the time between signing a purchasing order for asset
and selling the asset. Investors acquiring physical 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 can be reasonable.
Holding period for investing in financial assets vary in very wide interval and depends on the investor’s goals
and investment strategy.
• Information about financial assets is often more abundant and less costly to obtain, than information about
physical assets. Information availability shows the real possibility of the investors to receive the necessary
information which could influence their investment decisions and investment results. Since a big portion of
information important for investors in such financial assets as stocks, bonds is publicly available, the impact
of many disclosed factors having influence on value of these securities can be included in the analysis and the
decisions made by investors. Even if we analyze only financial investment there is a big variety of financial
investment vehicles. The on going processes of globalization and integration open wider possibilities for the
investors to invest into new investment vehicles which were unavailable for them some time ago because of
the weak domestic financial systems and limited technologies for investment in global investment
environment.
Financial innovations suggest for the investors the new choices of investment but at the same time make the
investment process and investment decisions more complicated, because even if the investors have a wide
range of alternatives to invest they can’t forgot the key rule in investments: invest only in what you really
understand. Thus the investor must understand how investment vehicles differ from each other and only then
to pick those which best match his/her expectations. The most important characteristics of investment vehicles
on which bases the overall variety of investment vehicles can be assorted are the return on investment and the
risk which is defined as the uncertainty about the actual return that will be earned
on an investment (determination and measurement of returns on investments and risks will be examined in
Chapter 2). Each type of investment vehicles could be characterized by certain level of profitability and risk
because of the specifics of these financial instruments. Though all different types of investment vehicles can
be compared using characteristics of risk and return and the most risky as well as less risky investment vehicles
can be defined. However the risk and return on investment are close related and only using both important
characteristics we can really understand the differences in investment vehicles.

The main types of financial investment vehicles are:

• Short term investment vehicles;
• Fixed-income securities;
• Common stock;

• Speculative investment vehicles;

• Other investment tools.
Short - term investment vehicles are all those which have a maturity of one year or less. Short term investment
vehicles often are defined as money-market instruments, because they are traded in the money market which
presents the financial market for short term (up to one year of maturity) marketable financial assets. 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.
Certificate of deposit is debt instrument issued by bank that indicates a specified sum of money has been
deposited at the issuing depository institution. Certificate of deposit bears a maturity date and specified interest
rate and can be issued in any denomination. Most certificates of deposit cannot be traded and they incur
penalties for early withdrawal. For large money-market investors financial institutions allow their large-
denomination certificates of deposits to be traded as negotiable certificates of deposits.
Treasury bills (also called T-bills) are securities representing financial obligations of the government.
Treasury bills have maturities of less than one year. They have the unique feature of being issued at a discount
from their nominal value and the difference between nominal value and discount price is the only sum which
is paid at the maturity for these short term securities because the interest is not paid in cash, only accrued. The
other important feature of T-bills is that they are treated as risk-free securities ignoring inflation and default
of a government, which was rare in developed countries, the T-bill will pay the fixed stated yield with
certainty. But, of course, the yield on T-bills changes over time influenced by changes in overall
macroeconomic situation. T-bills are issued on an auction basis. The issuer accepts competitive bids and
allocates bills to those offering the highest prices. Noncompetitive bid is an offer to purchase the bills at a
price that equals the average of the competitive bids. Bills can be traded before the maturity, while their market
price is subject to change with changes in the rate of interest. But because of the early maturity
dates of T-bills large interest changes are needed to move T-bills prices very far. Bills are thus regarded as
high liquid assets.
Commercial paper is a name for short-term unsecured promissory notes issued by corporation. Commercial
paper is a means of short-term borrowing by large corporations. Large, well-established corporations have
found that borrowing directly from investors through commercial paper is cheaper than relying solely on bank
loans. Commercial paper is issued either directly from the firm to the investor or through an

intermediary. Commercial paper, like T-bills is issued at a discount. The most common maturity range of
commercial paper is 30 to 60 days or less. Commercial paper is riskier than T-bills, because there is a larger
risk that a corporation will default. Also, commercial paper is not easily bought and sold after it is issued,
because the issues are relatively small compared with T-bills and hence their market is not liquid.
Banker‘s acceptances are the vehicles created to facilitate commercial trade transactions. These vehicles are
called bankers acceptances because a bank accepts the responsibility to repay a loan to the holder of the
vehicle in case the debtor fails to perform. Banker‘s acceptances are short-term fixed-income securities that
are created by non-financial firm whose payment is guaranteed by a bank. This short-term loan
contract typically has a higher interest rate than similar short –term securities to compensate for the default
risk. Since bankers’ acceptances are not standardized, there is no active trading of these securities.
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. Basically, a repo is a
collectivized short-term loan, where collateral is a security. The collateral in a repo may be a Treasury security,
other money-market security. The difference between the purchase price and the sale price is
the interest cost of the loan, from which repo rate can be calculated. Because of concern about default risk,
the length of maturity of repo is usually very short. If the agreement is for a loan of funds for one day, it is
called overnight repo; if the term of the agreement is for more than one day, it is called a term repo. A reverse
repo is the opposite of a repo. In this transaction a corporation buys the securities with an agreement to sell
them at a specified price and time. Using repos helps to increase the liquidity in the money market.
Our focus in this course further will be not investment in short-term vehicles but it is useful for investor to
know that short term investment vehicles provide the possibility for temporary investing of money/ fund and
investors use these instruments managing their investment portfolio.
Fixed-income securities are those which return is fixed, up to some redemption date or indefinitely. The fixed
amounts may be stated in money terms or indexed to some measure of the price level. This type of financial
investments is presented by two different groups of securities:
• Long-term debt securities
• Preferred stocks.
Long-term debt securities can be described as long-term debt instruments representing the issuer’s contractual
obligation. Long term securities have maturity longer than 1 year. The buyer (investor) of these securities is
landing money to the issuer, who undertake obligation periodically to pay interest on this loan and repay the
principal at a stated maturity date. Long-term debt securities are traded in the capital
markets. From the investor’s point of view these securities can be treated as a “safe” asset. But in reality the
safety of investment in fixed –income securities is strongly related with the default risk of an issuer. The major
representatives of long-term debt securities are bonds, but today there are a big variety of different kinds of
bonds, which differ not only by the different issuers (governments, municipals, companies, agencies, etc.),
but by different schemes of interest payments which is a result of bringing financial innovations to the long-
term debt securities market. As demand for borrowing the funds from the capital markets is growing the long-
term debt securities today are prevailing in the global markets. And it is really become the challenge for
investor to pick long-term debt securities relevant to his/ her investment expectations, including the safety of
investment.
Preferred stocks are equity security, which has infinitive life and pay dividends. But preferred stock is
attributed to the type of fixed-income securities, because the dividend for preferred stock is fixed in amount
and known in advance.
Though, this security provides for the investor the flow of income very similar to that of the bond. The main
difference between preferred stocks and bonds is that for preferred stock the flows are for ever, if the stock is
not callable. The preferred stockholders are paid after the debt securities holders but before the common stock
holders in terms of priorities in payments of income and in case of liquidation of the company. If the issuer
fails to pay the dividend in any year, the unpaid dividends will have to be paid if the issue is cumulative. If
preferred stock is issued as noncumulative, dividends for the years with losses do not have to be paid. Usually
same rights to vote in general meetings for preferred stockholders are suspended. Because of having the
features attributed for both equity and fixed-income securities preferred stocks is known as hybrid security.
A most preferred stock is issued as noncumulative and callable. In recent years the preferred stocks with
option of convertibility to common stock are proliferating.
The common stock is the other type of investment vehicles which is one of most popular among investors
with long-term horizon of their investments. Common stock represents the ownership interest of corporations
or the equity of the stock holders. Holders of common stock are entitled to attend and vote at a general meeting
of shareholders, to receive declared dividends and to receive their share of the residual
assets, if any, if the corporation is bankrupt. The issuers of the common stock are the companies which seek
to receive funds in the market and though are “going public”. The issuing common stocks and selling them in
the market enables the company to raise additional equity capital more easily when using other alternative
sources. Thus many companies are issuing their common stocks which are traded in financial markets and
investors have wide possibilities for choosing this type of securities for the investment.
Speculative investment vehicles following the term “speculation” could be defined as investments with a high
risk and high investment return. Using these investment vehicles speculators try to buy low and to sell high,
their primary concern is with anticipating and profiting from the expected market fluctuations. The
only gain from such investments is the positive difference between selling and purchasing prices. Of course,
using short-term investment strategies investors can use for speculations other investment vehicles, such as
common stock, but here we try to accentuate the specific types of investments which are more risky than other
investment vehicles because of their nature related with more uncertainty about the changes influencing the
their price in the future.

Speculative investment vehicles could be presented by these different vehicles:

• Options;
• Futures;
• Commodities, traded on the exchange (coffee, grain metals, other
commodities);

Options are the derivative financial instruments. An options contract gives the owner of the contract the right,
but not the obligation, to buy or to sell a financial asset at a specified price from or to another party. The buyer
of the contract must pay a fee (option price) for the seller. There is a big uncertainty about if the buyer of the
option will take the advantage of it and what option price would be relevant, as it depends not
only on demand and supply in the options market, but on the changes in the other market where the financial
asset included in the option contract are traded. Though, the option is a risky financial instrument for those
investors who use it for speculations instead of hedging.
Futures are the other type of derivatives. A future contract is an agreement between two parties than they
agree tom transact with the respect to some financial asset at a predetermined price at a specified future date.
One party agree to buy the financial asset, the other agrees to sell the financial asset. It is very important, that
in futures contract case both parties are obligated to perform and neither party charges the fee. There are two
types of people who deal with options (and futures) contracts: speculators and hedgers. Speculators buy and
sell futures for the sole purpose of making a profit by closing out their positions at a price that is better than
the initial price. Such people neither produce nor use the asset in the ordinary course of business. In contrary,
hedgers buy and sell futures to offset an otherwise risky position in the
market. Transactions using derivatives instruments are not limited to financial assets. There are derivatives,
involving different commodities (coffee, grain, precious metals, and other commodities). But in this course
the target is on derivatives where underlying asset is a financial asset.

Other investment tools:

• Various types of investment funds;

• Investment life insurance;

• Pension funds;
• Hedge funds.
Investment companies/ investment funds. They receive money from investors with the common objective of
pooling the funds and then investing them in securities according to a stated set of investment objectives. Two
types of funds:
• open-end funds (mutual funds) ,
• closed-end funds (trusts).
Open-end funds have no pre-determined amount of stocks outstanding and they can buy back or issue new
shares at any point. Price of the share is not determined by demand, but by an estimate of the current market
value of the fund’s net assets per share (NAV) and a commission.
Closed-end funds are publicly traded investment companies that have issued a specified number of shares and
can only issue additional shares through a new public issue. Pricing of closed-end funds is different from the
pricing of open-end funds: the market price can differ from the NAV.

Insurance Companies are in the business of assuming the risks of adverse events (such as fires, accidents,
etc.) in exchange for a flow of insurance premiums. Insurance companies are investing the accumulated funds
in securities (treasury bonds, corporate stocks and bonds), real estate. Three types of Insurance Companies:
life insurance; non-life insurance (also known as property-casualty insurance) and reinsurance.
During recent years investment life insurance became very popular investment alternative for individual
investors, because this hybrid investment product allows to buy the life insurance policy together with
possibility to invest accumulated life insurance payments or lump sum for a long time selecting investment
program relevant to investor‘s future expectations.
Pension Funds are an asset pools that accumulates over an employee’s working years and pays retirement
benefits during the employee’s nonworking years. Pension funds are investing the funds according to a stated
set of investment objectives in securities (treasury bonds, corporate stocks and bonds), real estate.
Hedge funds are unregulated private investment partnerships, limited to institutions and high-net-worth
individuals, which seek to exploit various market opportunities and thereby to earn larger returns than are
ordinarily available. They require a substantial initial investment from investors and usually have some
restrictions on how quickly investor can withdraw their funds. Hedge funds take concentrated speculative
positions and can be very risky. It could be noted that originally, the term “hedge” made some sense when
applied to these funds. They would by combining different types of investments, including derivatives, try to
hedge risk while seeking higher return. But today the word “hedge’ is misapplied to these funds because they
generally take an aggressive strategies investing in stock, bond and other financial markets around the world
and their level of risk is high.
1.3.2. Financial markets

Financial markets are the other important component of investment environment.

Financial markets are designed to allow corporations and governments to raise new funds and to allow
investors to execute their buying and selling orders. In financial markets funds are channeled from those with
the surplus, who buy securities, to those, with shortage, who issue new securities or sell existing securities. A
financial market can be seen as a set of arrangements that allows trading among its participants. Financial
market provides three important economic functions (Frank J. Fabozzi, 1999):
1. Financial market determines the prices of assets traded through the interactions between buyers and sellers;
2. Financial market provides a liquidity of the financial assets;
3. Financial market reduces the cost of transactions by reducing explicit costs, such as money spent to
advertise the desire to buy or to sell a financial asset.
Financial markets could be classified on the bases of those characteristics:

• Sequence of transactions for selling and buying securities;

• Term of circulation of financial assets traded in the market;
• Economic nature of securities, traded in the market;
• From the perspective of a given country.
By sequence of transactions for selling and buying securities:

_ Primary market
_ Secondary market
All securities are first traded in the primary market, and the secondary market provides liquidity for these
securities.
Primary market is where corporate and government entities can raise capital and where the first transactions
with the new issued securities are performed. If a company’s share is traded in the primary market for the first
time this is referred to as an initial public offering (IPO).
Investment banks play an important role in the primary market:
• Usually handle issues in the primary market;
• Among other things, act as underwriter of a new issue, guaranteeing the proceeds to the issuer.

Secondary market - where previously issued securities are traded among investors. Generally, individual
investors do not have access to secondary markets. They use security brokers to act as intermediaries for them.
The broker delivers an orders received form investors in securities to a market place, where these orders are
executed. Finally, clearing and settlement processes ensure that both sides to these transactions honor their
commitment. Types of brokers:
• Discount broker, who executes only trades in the secondary market;

• Full service broker, who provides a wide range of additional services to clients (ex., advice to buy or sell);
• Online broker is a brokerage firm that allows investors to execute trades electronically using Internet.
Types of secondary market places:
• Organized security exchanges;
• Over-the-counter markets;

• Alternative trading system.

By term of circulation of financial assets traded in the market:
_ Money market;
_ Capital market
Money market - in which only short-term financial instruments are traded.

Capital market - in which only long-term financial instruments are traded.

The capital markets allow firms, governments to finance spending in excess of their current incomes.

1.4. Investment management process

Investment management process is the process of managing money or funds. The investment management
process describes how an investor should go about making decisions.
Investment management process can be disclosed by five-step procedure, which includes following stages:
1. Setting of investment policy.
2. Analysis and evaluation of investment vehicles.
3. Formation of diversified investment portfolio.

4. Portfolio revision
5. Measurement and evaluation of portfolio performance.
Setting of investment policy is the first and very important step in investment management process. Investment
policy 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. The investment horizon is the period of
time for investments.
Projected time horizon may be short, long or even indefinite. Setting of investment objectives for individual
investors is based on the assessment of their current and future financial objectives. The required rate of return
for investment depends on what sum today can be invested and how much investor needs to have at the end
of the investment horizon. Wishing to earn higher income on his / her investments investor must assess the
level of risk he /she should take and to decide if it is relevant for him or not. The investment policy can include
the tax status of the 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. From the section 1.3.1 we could see that various
financial assets by nature may be more or less risky and in general their ability to earn returns differs from
one type to the other. As an example, for the investor with low tolerance of risk common stock will be not
appropriate type of investment.
Analysis and evaluation of investment vehicles. 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. This step involves examining several relevant types of investment
vehicles and the individual vehicles inside these groups. For example, if the common
stock was identified as investment vehicle relevant for investor, the analysis will be concentrated to the
common stock as an investment. The one purpose of such analysis and evaluation is to identify those
investment vehicles that currently appear to be mispriced. There are many different approaches how to make
such analysis. 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. Fundamental analysis will be examined in Chapter 4.
This step involves identifying those specific financial assets in which to invest and determining the
proportions of these financial assets in the investment portfolio.
Formation of diversified investment portfolio is the next step in investment management process. Investment
portfolio is the set of investment vehicles, formed by the investor seeking to realize its’ defined investment
objectives. 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 relative to fixed-income securities in general. Diversification involves forming the investor’s portfolio
for decreasing or limiting risk of investment. 2 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.
Investment management theory is focused on issues of objective portfolio diversification and professional
investors follow settled investment objectives then constructing and managing their portfolios.

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. Investor should form the new
portfolio by selling some assets in his portfolio and buying the others that are not currently held. It could be
the other reasons for revising a given portfolio: over time the prices of the assets change, meaning that some
assets that were attractive at one time may be no longer be so. Thus investor should sell one asset ant buy the
other more attractive in this time according to his/ her evaluation. The decisions to perform changes in revising
portfolio depend, upon other things, in the transaction costs incurred in making these changes. For institutional
investors portfolio revision is continuing and very important part of their activity. But individual investor
managing portfolio must perform portfolio revision periodically as well. Periodic reevaluation of the
investment objectives and portfolios based on them is necessary, because financial markets change, tax laws
and security regulations change, and other events alter stated investment goals.
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. It is important to point out that investment management process is continuing
process influenced by changes in investment environment and changes in investor’s attitudes as well. Market
globalization offers investors new possibilities, but at the same time investment management become more
and more complicated with growing uncertainty.