Beforeinvestors engage in any investment venture, investors usuallyundertake thoroughresearch in order to understanding and study theinvestment environment. This step is an essential process thatprovides investors with the experience necessary to address theprevailing problems during the investment period (Organization forEconomic Co-operation and Development, 2001). Investment takesdifferent meaning, but in finance investment refers to the process ofbuying an item or asset that is expected to be sold at a higher priceor to generate income in the future.
Foran efficient operation of the investment projects several key aspectsof investment environment need to be evaluated. The leadingcomponents of the investment environment include the business risks,market barriers, dispute resolution, regulatory and legal system,corruption, labour issues, political violence and intellectualproperty rights among other factors surrounding the investmentventures .(Organization for Economic Co-operation and Development,2001).
Thesefactors provide a regulatory framework that influences the initiationand performance of different investment projects. Government modifiesthis environment to favor investments and normally act as the majorplayer. The government is mandated to put in place stable,predictable and clear mechanisms and structures to facilitate thesmooth running of investment projects. This environment is usuallyappropriate for the operation of long-term investments projects thatcan have duration of decades or many years of operation. For instanceinvestors that are interested in major renewable energy investmentsproject will require favorable policies and legislations regardingthe energy-targets and emissions level.
Financialinstruments are key documents either virtual or real that forms apart of a legal agreement with a monetary value attached. Currentlythere are three categories of financial instruments, this includeequity based, the debt based and foreign exchange instruments. Equitybased financial instrument involves the individual or cooperateownership of assets, debt based financial instrument comprise a loangiven by the investor to an asset owner while the foreign exchangeinstrument include such services as foreign exchange contracts andspot cover. These instruments offer capital that can be traded easilywith different unique structures and characteristics. Thesecategories of financial instruments give the investors effectiveoperation of different investments ventures.
HowSecurities are traded
Mutualfund is a special and unique investment vehicle that brings togetherdifferent investors to a joint investment venture. Several investorscontribute their savings to a common pool with an objective to gaintogether financial benefits. This money is then invested in differentforms of securities which include bonds, money markets instruments,stocks and other related assets (Sheimo, 2000). The income generatedfrom the investments and the capital gained through assetsappreciation is then shared equally among the shareholders accordingto the amount of units owned by each investor.
Thesemutual funds are coordinated by managers who are specialized tomanage money flow they oversee the investment of the fund capitaland ensure it generates capital and income gains for the investors.The portfolio of this mutual fund is properly maintained andstructured in accordance with the stated investment objectives. Thistype of investment is the most effective for the average investorswith little capital to run their own investment projects. Instead ofinvesting in a single investment project this type of investmentprovides investors with an opportunity to own professionally managedand diversified categories of securities at considerable lower cost.
Mutualfunds offer several benefits especially to small investors. Apartfrom enabling the small investors with an opportunity to accessmultiple securities, mutual fund also allows the investors to shareproportionately the loss or gain of the fund. In addition, this kindof investment is transparent, flexible, offers choice of schemes tothe shareholders, well regulated, offers tax benefits and convenientadministration (Sheimo, 2000).
Introductionto risk, return, and historical record
Inthe process of undertaking the investments ventures, investors in thecapital market usually grapples with the reality of expected returns.Returns refer to the losses or gains expected from a given securityover a stipulated period of time, normally expressed as a percentage.The investors expected returns from securities are determined byseveral factors, these are uncertainties that make investmentsreturns unpredictable (Grinold at al. 2000).
Themajor factor influencing investments returns is risk. Risk is theprobability that a given investment possible return will be differentfrom the actual expected return. It refers to the possibility oflosing part or all of the original investment. Using risk factor,Portfolios are categorized into two: risk-free portfolio and riskyportfolio.
Wheninvestors are developing a portfolio, they have a choice to make withregard to its composition. They have to decide how much to invest ina risk-free portfolio and risky portfolio. Risky portfolio comprisesassets such as long-term bonds and stocks, and normally its expectedreturns are high. Risk-free portfolio on the other hand refers tosafe assets which include short term treasury bills. For investors,making up asset allocation for each portfolios pose a problem, withwhich investors solve by crafting a risk-return tradeoff for eachportfolio.
Investorsnormally study the past behavior of the global market in order topredict the possible returns in the future. According to a researchconducted ( Grinold at al. 2000)concerning the global stock marketfrom twentieth century to the beginning of the twenty first century,indicates that the United States became dominant in the globalmarket. This was made possible by her large investments in human andphysical capital, higher productivity and improved technologicaladvancement. But of utmost importance was her less involvement in theworld wars compared with the United Kingdom which took considerabletime to recover its losses. While this historical records can behelpful, on the other hand it does not accurately predicts the futuredue to many factors existing at each stage of time.
Efficientmarket hypothesis (EMH) is a market theory that was developed from aPh.D. dissertation by Eugene Fama in 1960’s (Timmermann at al.2002). It stipulates that beating the market is impossible owing tothe fact that the prices are already part and indicates all theessential information. That means at certain period of time providedthe market is liquid, the prices of securities fully reflect all theinformation available. EMH are categorized into different degrees,that is strong, semi-strong and weak, all of which deal with theincorporation of non-public information in prices in the market.
Thistheory hangs on the fact that provided there is a great deal ofmarket efficiency and the retailing market prices indicates allinformation, any effort to surpass the market performance arebasically a game of probability and not based on skill. Weak degreeof efficient market hypothesis takes into account the fact that thepresent stock prices fully contain all the present information of thesecurity market (Timmermann at al. 2002). It disputes the fact thatthe volume data and past prices do not have any relationship withregard to the future direction of security prices. In summary, ithighlights that the extra returns cannot be obtained by technicalanalysis.
Thesemi-strong aspect of EMH put into consideration the fact that thepresent stock prices vary rapidly according to all new informationreleased to the public. This type of efficient market hypothesisdisputes the belief that the security prices have considered theavailable market and non-market information by the public. Insummary, this hypothesis highlights that the extra returns cannot begained by the normal fundamental analysis.
Andlastly, the strong type of EMH put into consideration the fact thatthe present stock prices fully mirrors all the private and publicinformation. It highlights that the non- market, market andinformation within is incorporated into security prices, and furthershows that there is no single individual with access to themonopolistic essential information (Timmermann at al. 2002). Thistype of theory assumes that the market is perfect and gives a summarythat the extra returns are quite difficult to consistently achieve.
Termstructure of interest rates
Termstructure of interests’ rates which can also be referred to as theyield curve is very essential parameter in any economy. The termstructure highlights the market participants’ expectationsconcerning the changes of the interest rates in the future as well asthe evaluation of the aspects of monetary policy (Baker & Martin,2011). Often it is expected that money lenders attach a higher ratesof interest when long-term loan is taken by a corporate or anindividual, this is so because there is a greater risk linked withthe long-term loan hence increased interest rate acts ascompensation. On the contrary the short term loan has a lowerinterest rate.
Corporationstrading on securities ought to invest and attract an adequatefinancing for its investments projects. For an efficient running ofthe corporations, the corporation must carefully choose theappropriate option to fund its investments (Baker & Martin,2011). The managers should understand the best strategies to employin order to increase the firms’ value for the benefit of theshareholders. To obtain the objectives of the firm the corporateinvestments must receive appropriate financing.
Thefinancial sources are basically the capital sourced by the firm’sassets and the capital obtained from the external sources. Usuallythe external sources are obtained through issuing new equity anddebt. For firms to operate normally the firms must choose the rightform of financing, the option that result in the maximum capitalvalue (Baker & Martin, 2011). It very risky for the firm tofinance its projects using debt, this will result to increasedliabilities that the firm must shoulder. Equity financing on theother hand offers a less risky option that is in line with the cashflow focus, but it is often associated with the dilution of the sharecontrol, earnings and ownership. This downside of equity financingcan escalate the hurdle rate and hence increase the risk in cashflow.
Behavioralfinance is a recent emerging new field in finance that helps explainsthe reason behind the irrational financial decisions made by marketparticipants (Goldberg & Nitzsch, 2001). This involves theoccasions when psychology and emotion dictate our decision makingprocess in financial matters, and in effect contribute tounpredictable choices. For instance an individual will purely bemotivated by emotion to buy a lottery tickets to win a jackpot whenin reality the odds for winning is too small.
Investmentsolely involves the process of decision making after a carefulanalysis of data and evaluation of uncertainty and risk. Thesedecisions are largely influenced by the behavior of an individual orinstitution. From technical analysis it is seen that the market hasits own life controlled by the sentiments which can be illustrated byprice footprints (Goldberg & Nitzsch,2001). These sentimentscomprise the collective psychology of investors in the market, whichultimately contributes to the uncertain decisions in the market. Thisis evident when price patterns are analyzed on the graph to indicatethe prevailing market conditions, which will in essence helps toindicate the possible outcome in the future.
Investmentdiversification is a concept that investors adopts to increase thelevel of returns and minimize the level of risk. It refers to thedevelopment of a portfolio that comprise multiple or differentinvestments. When an investor only owns stock issued from onecompany, the investor may totally lose the investment if the companysuffers stocks downturn. Therefore, putting the investments indifferent companies will lower the possible risk to the givenportfolio (Markowitz, 2008).
Beforean investor decide the appropriate company to invest, the initialstep always involves the analysis of the company’s financialstatements. Financial statements are the financial records thatprovide financial position and activities of a particular business.The major financial statements are income statement and balancesheet (Markowitz, 2008). Balance sheet is a type of financialstatement that is given by a company quarterly, and indicates thecompany’s liabilities, shareholder’s equity and assets at givenperiod of time. This information helps the investors understand howthe company makes money, and whether the company is able to repay itsbills or debts. Income statement on the other hand, evaluates thecompany’s financial performance for a given period of time. Itprovides a summaryof the company’s expenses and revenues forboth the non-operating and operating activities. In addition, itindicates the net loss or profit made over a given accounting periodof time mainly quarterly or yearly (Markowitz, 2008). This financialrecord helps investors learn more about the company’s revenues andexpenses, an indication of the company daily operation. With thisinformation, the investors can understand the solvency state ofcompanies and hence make informed decisions.
Theconcept of the option markets highlights the potential of theinvestors’ to engage in irrational decision during theirinvestments ventures. These behavioral aspects of both individual andinstitutions investors contribute significantly to the choice ofinvestment projects which ultimately influence its financialstability. For instance, an investor choice of portfolio isinfluenced by both his/her cognitive and emotional state. When itcomes to investment allocation, the investor may choose to allocatemore resources on risky portfolio compared to risky-free portfoliosolely based on its high rate of returns. This will in turn influencethe performance of the portfolio with a high chance of poorperformance given that it is highly risky venture.
Inaddition, the choice of investment projects undertaken by theinvestors are dictated by the lay down accepted ethical conducts. Aninvestor will easily purchase an investment from credible issuers whomeet their ethical standards. The right criteria of practices andactions considered ethical must first be establish by the investors.Therefore, ethical standard influences the choice of investmentprojects undertaken and its performance.
Baker,H. K., & Martin, G. S. (2011). Capital structure & corporatefinancing decisions: Theory, evidence, and practice. Hoboken, N.J:John Wiley & Sons.
Goldberg,J., & Nitzsch, R. . (2001). Behavioral finance. New York: JohnWiley.
Grinold,R. C., & Kahn, R. N. (2000). Active portfolio management: Aquantitative approach for providing superior returns and controllingrisk. New York: McGraw-Hill.
Markowitz,H. M. (2008). Portfolio selection: Efficient diversification ofinvestments. Malden, MA: Blackwell.
Organizationfor Economic Co-operation and Development. (2001). The investmentenvironment in the Russian Federation: Laws, policies andinstitutions. Paris, France: Organisation for Economic Co-operationand Development.
Sheimo,M. D. (2000). Mutual fund rules: 50 essential axioms to explain andexamine mutual fund investing. New York, N.Y: McGraw-Hill.
Timmermann,A., Granger, C. W. J., & Centre for Economic Policy Research(Great Britain). (2002). Efficient market hypothesis and forecasting.London: Centre for Economic Policy Research.