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Investment systemsThere are basically three concepts of investment, a) economic investment, i.e. an economists definition of investment; b) investment in a more general or extended sense, which is used by the man on the street, and c) the sense in which a finance manager is very much interested, namely, financial investment.
Financial investment systems is a form of this general or extended sense of the term. It means an exchange of financial claims like stocks, bonds, etc. The term financial investment is often used by investors to differentiate between the pseudo-investment concept of the consumer and the real investment of the businessman.
Portfolio of Marketable Securities / Temporary Investments
There are two basic reasons for holding investments in the corporate portfolio of marketable securities:
a) They serve as a substitute for cash balances
b) They are used as temporary investment for surplus cash-flows arising either during seasonal operations or out of sale of long term securities.
Some firms hold portfolios of marketable investment systems in lieu of larger cash balances, liquidating part of the portfolio to increase the cash account when cash outflows exceed inflows. In such situations, the marketable securities could be a substitute for transaction balances, precautionary balances, or speculative balances, or all three. In most cases, the securities are held primarily for precautionary purposes most firms prefer to rely on bank credit to meet temporary transactions or speculative needs, but to hold some liquid assets to guard against a possible shortage of bank credit. Thus such temporary investments occur for one of three reasons:
a) Seasonal or cyclical operations
b) To meet known financial requirements
c) Immediately following the sale of term-securities.
The cash forecast may indicate whether excess cash available is temporary or not. If it is found that excess liquidity will be only temporary, the cash should then even if a substantial part of idle cash is invested even though for a short period, the interest earned thereon is significant. Failure on the part of the investment systems to invest idle cash not only deprives the firm of a reasonable income but also be an injustice and failure in serving the interest of the shareholders. On the other hand, if the cash forecast indicates that the excess cash is temporary and not caused by only seasonal variation and the same need not be used in the business, then it should be invested in productive assets.
Process of Investment Management
Investment management is the process by which money is managed. The process involves:
a) Collection of information with regard to the proposed investments.
b) Analysis of that information
c) Establishment of the investment policy that is to be followed
d) Decision making process as to investments
e) Appropriate back-up for administrative arrangements
f) Measurement of the investment performance achieved
The first objective of an investment team is to collect as much relevant information as possible about potential investments with regard to fixed interest securities; this tends to be a relatively simple exercise in that the basic fats are set out in the initial prospectus. Of more immediate relevance are up to date market prices, current yields, and supply and demand reports. Economics play a major part in investment decision making, and in particular in the area of Government Securities Market. Consequently, investment systems Managers must be aware of the latest economic developments and forecasts.
The collection of information in equity type investments such as ordinary shares and properties is a more difficult task, as the range of possible investments is immense and not two are similar. Most of the larger investment management teams employ a number of security analysis, but even if they do, the vast majority of teams rely on the analysis work carried out by stock-brokers, with the investment manager analyzing the competing stock-brokers output.
The second relates to analysis of the information which has been collected. Generally speaking the investment analysts duty is to assimilate the information and to produce recommendations for consideration. Obviously there is a reliance on the information supplied by stockbrokers and statistical services, and in addition there is the analysts own output.
The establishment of correct investment policy for a fund is perhaps the most important aspect of investment management. The investment policy to be followed must be laid down by the proprietors of the fund, but quite often the investment manager by the nature of his training is well placed to assist in the formation of such policy. In fact the quality of an investment management team can often be judged by their grasp of the fundamentals in this area. The point here is that the objectives of investors vary, and different investors require different investments with different attributes.
The investment policy of a fund must be such that the liabilities of the fund must be met as they are. Furthermore, they must be met at the minimum cost. In order to achieve this, investment managers must maximize the return on the investments, but the risk factor must not be exceeded. Thus the investment policy must recognize the risk factor and establish the appropriate level of risk to be accorded to the fund.
Having collected the information, analyzed it and produced recommendations, established policy and risk levels, one arrives at the decision making process. While this is clearly seen to be the point on which the fate of the fund will depend, it will be appreciated that, if the earlier foundation parts of the investments management process are carried out correctly, the actual decision on buying and selling is relatively easy to make. Consider the process under which, for example, investment policy has indicated that the fund needs more ordinary shares to meet its long term liabilities, that an analysis of the portfolio reveals that no oil shares are held, that this is considered too high risk from a lack of industrial diversification point of view, and that the analyst is recommending an investment in Bharat Petroleum. Under such circumstances, the management decision is straight forward.
One then comes to the administrative arrangement contract notes, valuations, meetings, dividend collection and tax reclamation, safe keeping of securities and nominee company services. Generally speaking, these arrangements present little difficulty to the investment manager, who is probably backed by sophisticated computer programs to handle the investment function. Clients will usually find that these arrangements can be tailored to his individual needs.
In one sense the measurement of investment performance is the last stage of the investment management process. An investor who pays someone to manage a portfolio in the hope of achieving superior performance has every right to insist on knowing what sort of performance is actually achieved. Such performance can be used to alter the constraints placed on the manager, the objective stated for the account or the amount of money allocated to the manager. Perhaps more important by measuring performance a client can forcefully communicate his interests to an investment manager and perhaps influence the way in which the portfolio is managed.
Valuation of Marketable Securities
The marketable securities may be valued under the following three criteria:
a) Valuation at cost
Investments in securities have traditionally been carried at cost and no gain or loss recognized until the securities were sold. One of the basic concepts of financial accounting is that the gains shall not be recognized until they are realized and the usual test of realization is the sale of asset in question. In current practice the market value of marketable securities is disclosed a separate note in the balance sheet.
b) Valuation at the lower of cost or Market Price
Though valuation of securities at cost is generally accepted, the accounting theory also treats as acceptable the lower of cost or market price method. The objective of this method of valuation is to give effect to market declines without recognizing market increases, and the result is a more conservative valuation of investments in the balance sheet.
c) Valuation at Market Price
An increasing number of financial accountants also argue that investments in marketable securities should be valued at current market price regardless of whether this price is above or below cost. However, it is not a current practice to value security investments at market value.
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