Basics of Finance and Investment
Finance and investment are the most commonly used keywords in the day-to-day affairs of people from all walks of life. There had been no talk among the common men in society about Investment and finance in the earlier time. But, the dimensions of investment have improved over the years and naturally, it has invited the attraction of people with even small means. Keeping this in view the present essay is an attempt to discuss the fundamentals of investment and finance. The essay takes a descriptive approach where the basics of investment and finance such as risk and return, inter-relationship between them are discussed.
Investment management is essentially dealing with the management of assets such as real estate and other long-term and short-term securities like equities, bonds and debentures with an aim to achieve specified investment objectives. The services of investment management are done mainly to meet the needs of various investors such as individuals, financial institutions, companies and insurance firms. The reasons that forced for adopting such an approach include the presence of large number of financial products which are complex in nature, high volatility and prone to change on regulatory requirements. Though every investor applies the concept of investment management as a decision-making tool to a certain level but it is the investor managers (also known as fund managers) who are much more specialized in dealing with how the money pooled from various investors must be effectively invested in various instruments and at what time they have to be sold in the market in order to achieve the predetermined objectives.
Unlike investment management, financial management is regarded as one of the specialized functions of ‘General Management’ which deals with the management of finance function. Finance means the money, cash or fund with which the business operations are to be carried out. This is the reason that makes finance as the ‘life blood of a business. Therefore, it is necessary to manage finance efficiently and effectively. The management of finance has become a wide area of knowledge and new insights and theories are being evolved every time to enrich financial management literature. Thus financial management deals with the management of financial activities such as procurement and effective utilization of funds to accomplish common objectives of an organization. With the help of financial management an organization can ensure its adequate and regular supply of funds at a reasonable cost and moreover they can have effective utilization of funds.
Basics of Finance and Investment
The term ‘finance’ refers to money, cash, or fund that is used by an enterprise to carry out its business operations. Finance is required at all levels of activity right from its inception and up to the stage when its product has started to flow in the market. Financial management can help in a better way to have proper planning, administration and control of the finance required by an organization. Thus, financial management functions revolve around a number of activities such as planning, organizing, directing and controlling of financial activities that is, procurement and utilization of funds of an enterprise. Financial management can be defined in many ways.
Investment refers to any asset or item that is acquired now with the anticipation that it will generate positive income in future. For instance, purchase of an asset or depositing funds in the banks with the hope that it will generate returns in future. Investing in different assets and securities involves large amount of risks for an investor. In fact, the development of the investment as it is seen today is mainly attributed to this unique feature of investment. It enables an investor to create an investment portfolio that can maximize returns by minimizing exposures to risk. Investment management through an investment manager who is specialized in this field suggests an investor where, when and how to invest their funds in the assets or securities. Investment management is also referred to as money management, portfolio management and fund management. Thus investment management simply refers to the management of funds belonging to different investors (such as individuals, firms, pension funds, financial institutions, etc) in order to achieve their specified individual objectives.
Types of Investment
Before an investor starts to invest he must have thorough knowledge about various types of investments existing in the market, as each investment is entirely different from one another in terms of its features, benefits, demerits etc. Gitman and Joehnk observe that there are number investments that can make the life of the investors even much easier down the road; some of them are as follows (Gitman, 2008):
Cash investments: Savings bank accounts, certificates of deposits, and treasury bills are included in these investments. This type of investment generally pays a low rate of return and is an option for risk during periods of inflation.
Debt securities: These investments pay returns for fixed periods and capital appreciations are possible during its maturity. That is why these securities are referred to as safer and risk-free tools for investment than compared to equities. But their returns are lower compared to equities.
Stocks: These are also called equities. The purchase of such securities of a particular company makes an investor be the part-owner of that company. As a result, he can share the fruits (profits) earned by the company. But these investments are much volatile and riskier.
Mutual funds: These are essentially a collection of stocks and bonds where the professional manager helps an investor to select a particular type of securities for investment so that the investor need not bother about the evaluation of the investment. The different types of mutual funds may be stock, bond and index-based mutual funds.
Derivatives: These are the financial instruments that derive their value from underlying assets such as stocks, equity, bonds, commodities etc. The common types of derivatives are forwards, futures, options and swaps. These derivatives help the investors to minimize risk of loss resulting from the changes in the value of underlying assets.
Commodities: This type of investment helps investors those who are dealing with agricultural and industrial commodities. And the commodities must be standardized, basic, raw and an unprocessed one. These investments involve high risk as well as high return.
Real estate: This kind of investment is comprised of residential and commercial properties. These involve long term commitment of money and fetch earnings/return via periodical rental or lease earnings and also from capital appreciation in the long run.
Besides the above types of investments there are also short term investments and long term investments which is the classification based on the time horizon of investment. These are discusses below:
Long term investments: These are the investments that are held by investors (may be an individual or company) for more than one year. This includes stocks, bonds, real estate and cash. These long term investments have the capacity to earn small amounts of money but over a long period of time. As a result they have high degree of stability and can be considered as a less risky investment option than short term investments. They are highly suitable for making savings as well as retirement fund grow. One of the main defects of such investment is that there is a chance of charging penalties and fines to those investors who are either withdrawing or selling their stocks or bonds before its maturity period.
Short term investments: On other hand short term investments are the investments that are hold by the investors for less than one year which may be a few weeks to a few months. This includes short term loans. Such investments have enough potential for quicker growth and are much more controllable than long term investments as the maturity period is less.
Risk and Return
Risk in simple words is the possibility to get loss. In other words it is the anticipation or expectation that, some adverse event may occur. According to Keith Redhead (2003), the main feature of risk is that the amount or quantity of the risk cannot be seen in advance. The person or organization who takes the risk is rewarded well. With regard to investment, the more risk involved in a project, higher the return. The word risk is commonly used in the business world.
The term return in this context refers to the return on the investment or in other words returns for taking or bearing risk.
Inter-relationship between risk and return
When one is taking the case of any individual or organizations who achieved great position, it is clear that he might have taken high risk. The causes for the general risks include some unforeseen events like natural calamities including floods, earth quakes…etc, thefts, fire, accidents…etc. The causes of risks that are specifically associated are inflation, recession, government policies…etc. The risk involved in investment shares can be expressed in such a way that, the genuine investors are not ready to take higher risk. Genuine investors mean investors who invest in shares or securities for a long period and they are interested in only the annual return (dividend or interest) of their investment. Opposing this argument, Pilbeam opines that the investors who are ready to take the risk and not interested in long term investment (Pilbeam, 2005). They buy shares or other securities only with the intention of selling it to others as and when prices are high. They are ready to anticipate and bear any amount of risk.
Investment decision is a challenging task for the management team of any kind of organization. It is evident from the success or failure of different organizations that there are one or more decisions in the success or failure. While taking investment decisions whole or some of factors like internal rate of return (IRR), net present value, payback period, accounting rate of return and profitability index…etc are to be considered. Sometimes new ideas might be seen as a failure in the short run but it can give better return in the long run. Therefore while making investment decision the long run return should be given much preference and they are to be made into action first. The managers also have to consider different other factors like the nature of the organization, cash flow and feasibility…etc.
In the context of investment appraisal, risk refers to the business risk of an investment, which increases with the variability of expected returns. There are different views on the relationship between risk and return. Some experts view that the relationship between risk and return is a positive relationship. In other words when the amount of risk is high, higher would be the return and when the amount of risk is low, lower would be the return. Majority of people supports this opinion. The amount of uncertainty involved in the risk gives a positive nature to the relationship between risk and return (Arnold, 2004).
The following chart shows that there exists a positive relationship between risk and return.
At the same time some experts are of the opinion that the relationship between risk and return is negative. That is when the amount of risk is high lower would be the return and when the amount of risk is low higher would be the return. Also some others opine that there exists a curvilinear relationship between risk and return. That is the relationship between risk and return is relative. In other words it may be positive or sometimes it may be negative.
It is seen that, the OTC derivatives have made improvements in the financial risk management practices, thus reducing the financial risk associated with it. It is held that, derivatives are risk managing instruments rather than risk creating instruments. Institutions and investors use derivatives as hedging instruments to reduce risk like foreign exchange risk, interest rate risk etc. Derivatives are regarded as zero sum game as it offers gain with reduced risk (Kohn, 2005). Derivatives help to transfer the price risk to another party who is willing to take it. In case, if the hedging is uncertain for the given assets, we can use derivatives. This can be explained with an example, if an investor owns foreign stocks expecting a dividend, he has to face the exchange rate risk and the amount of dividend paid. In this case, he can enter into a future contract to hedge the risk.
Arnold, G. (2004). The Financial Times Guide to Investing, The Definitive Companion to Investment and the Financial Markets. New York: FT Prentice Hall.
Financial Concepts: Risk Return Trade off. (No Date). Investopedea. [Online]. Web.
Gitman, L. J. and Joehnk, M.D. (2008). Fundamentals of Investing. 10th Edition, Chester CT: Pearson Education Inc
Kohn, M. (2004). Financial Institutions & Markets. 2nd Edition. Oxford University Press
Pilbeam, K. (2005). Finance and Financial Markets, 2nd Edition, London: Macmillan Business Press
Redhead, Keith (2003). Introducing investments: A Personal Finance Approach. Princeton NJ: FT Prentice Hall