Nims

In our quest to discover how interest rates affect investment decisions we did a little research. Have you ever stopped to ask yourself what drives the investment decisions of rational investors with a longer time horizon? Well, worry less. Research has shown that majority of these investors generally do not take a keen look at the differences in the market interest rates among countries in making investment decisions.

It has been found out that the factors they do consider in making the investment decisions are good and stable growth prospects, low country risks—including political and economic stability—and a stable exchange rate. This all makes good sense for long-term investors such as pension funds and insurance companies. So why all this talk about how low interest rates in advanced economies are “pushing” investment flows to emerging countries. Additionally, it is in these economies where interest rates are generally higher. Does it really matter what the interest rates are? Let us find out.

Read Also: five Steps of the Investment Process

Interest rate can defined as the proportion of a loan that is charged as interest to the borrower. It can typically be expressed as an annual percentage of the loan outstanding. Interest rates are the single most important variable in determining returns to investors for bonds and fixed-income securities. Let us figure out how Interest Rates affect Investment Decisions.

Read also: Investing Decisions Over Investor Life Cycle

Interest rates and bond prices move in opposite directions. This is to say that, when interest rates go up, bond prices go down and when interest rates go down, bond prices go up. Investors therefore have to need to put this into consideration before investing in bonds. For example, if the market interest rates rise, then the price of the bond with the 3% coupon rate will fall more than that of the bond with the 6% coupon rate. Investors have to therefore purchase bonds in a low-interest rate environment. This means they have to do the vice versa in the case of high interest rates. A bond’s maturity refers to the specific date in the future at which the face value of the bond will be repaid to the investor.

The economic environment in business terms is the environment in which a business operates and it has a great influence upon it. For any successful investment the economic environment has to be studied and fully analysed. A rational investor has to be well versatile when it comes to Market timing. Market Timing is the process of identifying the current state of the economy/market and assessing the likelihood of its continuing on its present course. It is the strategy of making buy or sell decisions of financial assets (often stocks) by attempting to predict future market price movements. The prediction may be based on an outlook of market or economic conditions resulting from technical or fundamental analysis. It is important to note that the investment occurs in an economy and therefore the economic conditions of the state can affect the returns.

There are two Conditions of the Economy that are important in the investment environment.

Recovery or expansion; This is the phase of the business cycle when the economy moves from a trough to a peak. It is a period when the level of business activity surges and gross domestic product (GDP) expands until it reaches a peak. During this phase, the Corporate profits are up and this helps stock prices. This phase is growth-oriented and speculative stocks do well.

Decline or recession; This is the phase of temporary economic decline during which trade and industrial activity are reduced, generally identified by a fall in GDP in two successive quarters. During this phase, the values and returns on common stocks tend to fall.

Read also: Five Steps Of The Investment Process

Different Stages of an Economic/ Market Cycle

A peak is the highest point between the end of an economic expansion and the start of a contraction in a business cycle. The peak of the cycle refers to the last month before several key economic indicators, such as employment and new housing starts, begin to fall. In economics, a trough is a low turning point or a local minimum of a business cycle.

Investing Decisions Over Investor Life Cycle vary as a in accordance with the age bracket. Investors tend to follow different investment philosophies as they move through different stages of the life cycle. Investment decisions are made by investors and investment managers. Investors commonly perform investment analysis by making use of fundamental analysis, technical analysis and gut feel. Investment decisions are often supported by decision tools. The investor life cycle refers to the different stages of investment ownership, from the initial purchase, to the sale of the investment. The most commonly used investor life cycle includes the accumulation phase, the consolidation phase and the spending and gifting phases. These phases if put into ages refer to the youth stage, the Middle-Aged and the Retirement Stage respectively.

1. Youth Stage: accumulation phase

–Twenties and thirties

–Growth-oriented investments

–Higher potential growth; Higher potential risk

–Stress capital gains over current income

• What are some examples of age-appropriate investments?

–Common stocks, options or futures

2. Middle-Aged Consolidation Stage

Include people of aged between 45 to 60

–Family demands & responsibilities become important (education expenses, retirement savings)

–Move toward less risky investments to preserve capital

–Transition to higher-quality securities with lower risk

• What are some examples of age-appropriate investments?

–Low-risk growth and income stocks, preferred stocks, convertible stocks, high-grade bonds

 3. Retirement Stage; gifting phase

A gifting phase is when a person begins planning for or actively begins giving away wealth as part of his or her estate planning. Happens with ages of 60 years and older

–Preservation of capital becomes primary goal

–Highly conservative investment portfolio

–Current income needed to supplement
retirement income

• What are some examples of age appropriate investments?

–Low-risk income stocks and mutual funds, government bonds, quality corporate bonds, bank certificates of deposit

Checkout what you need to know when Investing in Different Market Economic Environments

We are by now well aware that there are five steps in the investment process. We have already covered the first step which is Setting an investment policy covering in the process the need for an investment policy too. In this article, we shall look at the remaining four steps on the investment process.

Step 2:  Security Analysis

The analysis of various financial instruments is called security analysis. Security analysis helps a financial expert to determine the value of assets in a portfolio. The main objectives is to find mispriced securities. This can be done;

• Using technical analysis; forecasting the direction of prices through the study of past market data, primarily price and volume.
• Using fundamental analysis; evaluating a security that entails attempting to measure its intrinsic value by examining related economic, financial and other qualitative and quantitative factors

One then has to Compare current market price to true market value and Identify undervalued securities as appropriate to constitute an investment portfolio.

Step 3:  Construct a Portfolio

What is a portfolio? A portfolio is a range of investments held by a person or organization. With the results obtained above, the investor then has to identify specific assets and proportion of wealth in which to invest. He or she has to address issues of Selectivity, Timing and Diversification.

Read Also; Suppliers And Demanders Of Funds And The Investment Process

Step 4:  Portfolio Revision

This step involves periodically repeating step 3. Revise the portfolio if necessary. The investor can Increase/decrease existing securities, Delete some securities or Add new securities depending on the circumstances. The sale and purchase of assets in an existing portfolio over a certain period of time to maximize returns and minimize risk is called as Portfolio revision.

Step 5:  Portfolio Performance Evaluation

This step involves periodic determination of portfolio performance with respect to risk and return. Requires appropriate measures of risk and return as well as relevant standards (or benchmarks). Today, we have three sets of performance measurement tools to assist us with our portfolio evaluations. The Treynor, Sharpe and Jensen ratios combine risk and return performance into a single value, but each is slightly different. Which one is best according to you? We shall find out later.

Discover the Investing Decisions Over Investor Life Cycle

As discovered in the previous post,  the first step of the five steps of the investment process in the investment policy. In this step, one has to do the following;

1. –Identify investor’s unique objective
2. –Determine amount of investable wealth
3. –State objectives in terms of risk and return
4. –Identify investment  and legal constraints
5. –Identify potential investment categories

Unique Needs and  Preferences

• Personal preferences such as socially conscious investments could influence investment choice
• Time constraints or lack of expertise for managing the portfolio may require professional management
• Large investment in employer’s stock may require consideration of diversification needs
• Institutional investors needs

Investment Objectives

General Goals

• Capital preservation

–Minimize risk of loss

• Capital appreciation

–Growth of the portfolio in real terms to meet future needs

• Current income

–Focus on generating income rather than capital gains

Investment Constraints

• Liquidity needs

–Varies between investors depending upon age, employment, tax status, etc.

• Time horizon

–Influences liquidity needs and risk tolerance

• Tax concerns

–Capital gains or losses –  taxed differently from income

–Unrealized capital gain – reflect price appreciation of currently held assets that have not yet been sold

–Realized capital gain – when the asset has been sold at a profit

–Trade-off between taxes and diversification – tax consequences of selling company stock for diversification purposes

Legal and Regulatory Factors

• Limitations or penalties on withdrawals (such as from an RBA)
• Investment laws prohibit insider trading

The Need For A Policy Statement; Why have a policy statement?

• Helps investors understand their own needs, objectives, and investment constraints
• Sets standards for evaluating portfolio performance
• Reduces the possibility of inappropriate behavior on the part of the portfolio manager

Constructing A Policy Statement

To effectively construct a policy statement, you have to ask yourself the following key questions and attend to them with due diligence.

• What are the real risks of an adverse financial outcome, especially in the short run?
• What probable emotional reactions will I have to an adverse financial outcome?
• How knowledgeable am I about investments and the financial markets?

• What other capital or income sources do I have? How important is this particular portfolio to my overall financial position?
• What, if any, legal restrictions may affect my investment needs?
• What, if any, unanticipated consequences of interim fluctuations in portfolio value might affect my investment policy?

Checkout the remaining four steps of the investment process.

Types of Investors

Before we fully understand the investment process, we have to know the types of investors taking part in the investment process. To recup, An investor is someone who provides his or her money or resources for an enterprise, such as a corporation, with the expectation of financial or other gain at a later date in time. The main types of investors in the typical investment environment are the individual investors and the institutional investors.

Read also: Types of Investments that form an investment portfolio

• Individual Investors: these are investors who Invest for personal financial goals such as retirement, car or house. They can also be refered to as retail investors. A retail investor is an individual who purchases securities for his or her own personal account rather than for an organization. Retail investors typically trade in much smaller amounts than institutional investors such as mutual funds, pensions, or university endowments.
• Institutional Investors; These are investors who are Paid to manage other people’s money. They usually trade large volumes of securities. Institutional investors are the big guys on the block – the elephants. They’re the pension funds, mutual funds, money managers, insurance companies, investment banks, commercial trusts, endowment funds, hedge funds, and some hedge fund investors.

steps of the Investment Process

The investment process starts with the investor, and his or her needs and preferences. To design the “right” portfolio for an investor, we need to understand how much risk he or she is willing to take, what his or her cash needs might be and the tax status of the investor. With this in mind, there are five conventional steps that are  involved in the investment process. Each of the steps are critical and hence therefore, we will discuss each one of them in details in separate posts in their respective order for you to get an in depth understanding of the investment process.

The investment process steps are;

1. –Set investment policy
2. –Perform security analysis
3. –Construct a portfolio
4. –Revise the portfolio
5. –Evaluate performance

Be on the know, read on.

Just before we look at the suppliers and demanders of funds, it is in order that we familiarise ourselves with the environment in which these suppliers and demanders of funds exist. They do exist in the financial markets. Financial markets are forums in which suppliers of funds and demanders of funds can transact business directly. A primary market is the one which “new” securities are sold. The secondary markets can be viewed as “pre owned” securities market. Fianacial institutions such as banks actively participate in the financial markets as both suppliers and demanders of funds.

Suppliers and Demanders of Funds

Key participants or rather suppliers and demanders of funds in the financial markets are individuals, businesses, and government.  firms and government

• Government

Governments are typically net demanders of funds. They typically borrow more than they save. This is because of the need to finance State and local projects & operations.

• Business

Business firms are are also net demanders of funds. They typically borrow more than they save. The borrowing can be attributed to Investments in production of goods and services.

• Individuals

Individuals as a group are the net suppliers of funds for financial institutions (They save more than borrow). Some are neede of loans to finance house, auto, among others. The individuals are therefore Typically the net suppliers of funds

The investment Process

The investment process involves the financial institutions (banks, savings and loans, savings banks, credit unions, insurance companies, pension funds) actively participate in the financial markets as both suppliers and demanders of funds.

The financial markets (Money and capital markets) act as forums in which suppliers of funds and demanders of funds can transact business directly

Then we have the suppliers and demanders of funds whose roles are well covered above. We will discuss in details the process in our consequent articles. Let us now look at the types of investors.

The components on an investment portfolio are determined by the types of investment the investor wishes to invest in. having learnt about the basic terminologies in the investment environment, I believe we are on the same page to look at the various types of investments.

Types of investments

1. Securities or Property: 

Securities include stocks(shares), bonds, options whereas Real Property: land, buildings, machinery. The tangible Personal Property which includes gold, artwork, antiques, etc are also included in this category.

2. Direct or Indirect

With the direct investment, the investor directly acquires a claim on a financial asset say for example stock. On the other hand, with the Indirect investment, the investor owns an interest in a professionally managed collection of securities or properties.

    3. Debt, Equity or Derivative Securities

–Debt: investor lends funds in exchange for interest income and repayment of loan in future (bonds)

–Equity: represents ongoing ownership in a business or property (common stocks)

–Derivative Securities: neither debt nor equity; derive value from an underlying asset (options)

    4. Low Risk or High Risk

–Risk is the chance that actual investment returns will differ from those expected. with this in mind, there can therefore be a high risk investment and a low risk investment basically differentiated by how likely the deviation from expected returns is likely to unfold.

    5. Short-Term or Long-Term

This type looks at the time to maturity of a given investment. Owing to this fact, Short-Term investments mature within one year while Long-Term investments have maturities of longer than a year.

6. Domestic or Foreign

This type is on the basis of the geographical jurisdiction in which the investment is undertaken. Domestic investment is where a citizen invests in a company or securities within his own country of origin or citizenship Kenyan whereas Foreign investment is the opposite of the above where an investor invests across boundaries in the securities or company in a foreign country.

Those are the various types of investments. Let’s now look at the Suppliers and Demanders of Funds in the Investment environment.

Any rational financial enthusiast must have encountered these Investment terminologies (Return, securities, securities market, etc) in the various investment environments. But what exactly is investment? Before we dive deep into the definitions, this article is aimed at acquainting us with the basic terminologies of investment to help us get started on the right foot.

• Investment is any vehicle into which funds can be placed with the expectation that it will generate positive income and/or that its value will be preserved or increased. Investment means the sacrifice of current cash for future cash. It involves time and risk. In an economic sense, an investment can be described as the purchase of goods that are not consumed today but are used in the future to create wealth. In finance, an investment is a monetary asset purchased with the idea that the asset will provide income in the future or appreciate and be sold at a higher price.
• portfolio is a grouping of financial assets such as stocks, bonds and cash equivalents, as well as their mutual, exchange-traded and closed-fund counterparts. Portfolios are held directly by investors and/or managed by financial professionals.
• Risk: chance that actual investment returns will differ from those expected
• Return can basically be described as the reward an investor gets for for owning an investment. can be in the form of current income or Increase in value.
• Investor:  an investor is someone who provides money or financial resources for an enterprise, such as a corporation, with the expectation of financial or other gain.

Investment environment

  It encompasses the kind of marketable securities that exists and where and how they are bought and sold.

• Investment process;  This is concerned with how an investor should proceed in making decisions about what marketable securities to invest in, how extensive the investment should be, and when the investment should be made.

• Securities;  This is a legal representation of the right to receive prospective future benefits under stated conditions.

• Security markets; This is a meeting place for buyers and sellers. It is a part of the financial market where securities are traded between subjects of the economy, on the basis of demand and supply.

With these basic terminologies, all is set to look at the different types of investments.