Investments, Securities and Portfolio Fundamentals

Introduction

Investment converts present funds into financial or real assets with the expectation of future income, capital appreciation, risk reduction, or some combination of these outcomes. Banks, insurers, pension funds, investment companies and households all invest, but their objectives and constraints differ. A bank may emphasize liquidity and regulatory capital, an insurer must match assets with policy liabilities, and an individual may invest for retirement or education.

An investment decision therefore involves more than selecting the asset with the highest expected return. The investor must consider risk, liquidity, time horizon, taxation, costs, legal restrictions, ethical preferences and capacity to absorb losses. Portfolio management integrates these considerations by evaluating assets collectively rather than in isolation.

Learning Objectives

After studying this chapter, students should be able to:

• distinguish equities, bonds, mutual funds, exchange-traded funds, derivatives and alternative assets;
• apply basic equity and bond valuation techniques;
• calculate investment returns and elementary portfolio risk measures;
• explain how correlation creates diversification benefits;
• interpret the Capital Asset Pricing Model and market efficiency hypotheses;
• assess investment suitability using investor objectives and constraints; and
• recognize regulatory, ethical and technological issues in investment practice.

1. The Investment Landscape

A security is a tradable financial claim. Securities may represent ownership, debt, contractual rights or claims on an underlying asset. They are issued in the primary market and subsequently traded among investors in the secondary market.

Investment assets can be classified as follows:

1.1 Risk, return and liquidity

Expected return is compensation for delaying consumption and accepting uncertainty. Higher expected return generally requires bearing greater risk, but higher risk does not guarantee a higher realized return. Liquidity describes the ability to sell an asset quickly at a price close to its fair value. Cash and actively traded government securities are generally more liquid than private equity, direct property or collectibles.

Investment decisions should distinguish three concepts:

• Risk tolerance: the investor's psychological willingness to accept fluctuations.
• Risk capacity: the investor's financial ability to sustain losses.
• Risk requirement: the return and associated risk needed to meet an objective.

A suitable portfolio cannot exceed the lowest binding risk constraint merely because an investor expresses optimism about markets.

2. Equity Securities

An ordinary or common share represents residual ownership in a company. Shareholders may receive dividends and voting rights, but dividends are not contractual obligations. In liquidation, ordinary shareholders rank after creditors and preference shareholders.

Preference shares usually provide a stated dividend and priority over ordinary shares, but they commonly offer fewer voting rights. Their economic characteristics may resemble both debt and equity.

2.1 Equity returns

For one holding period, the holding-period return is:

where R is the holding-period return, P₀ is the purchase price, P₁ is the ending price and D₁ is cash dividend income received during the period. Prices and dividends must use the same currency and be adjusted consistently for share splits and other corporate actions.

Example. An investor buys a share for $50, receives a $2 dividend and sells it for $52. The return is:

2.2 Dividend discount valuation

The intrinsic value of equity equals the present value of expected future cash flows to shareholders. Under the constant-growth Gordon model:

Here, P₀ is estimated current value per share, D₁ is the dividend expected in the next period, k_e is the required equity return and g is the perpetual dividend growth rate. The model requires k_e > g, assumes dividends grow indefinitely at a constant rate, and is most appropriate for mature, dividend-paying companies. Rates must refer to equal time periods.

If next year's expected dividend is $3, the required return is 10% and perpetual growth is 4%, then:

The result is highly sensitive to small changes in k_e and g. It should not be treated as a precise market-price forecast.

2.3 Relative valuation

The price–earnings ratio is:

A high P/E ratio may indicate strong expected growth, lower perceived risk or overvaluation. Comparisons are most meaningful among firms with similar accounting policies, capital structures and business risks. Relative valuation is not a substitute for examining cash-flow quality and sustainable profitability.

3. Bonds and Fixed-Income Securities

A bond is a debt instrument through which the issuer promises specified payments. Important terms include:

• Face value: principal repayable at maturity.
• Coupon rate: annual coupon as a percentage of face value.
• Maturity: date on which principal becomes due.
• Yield to maturity: discount rate that equates the bond's price with the present value of promised payments, assuming payments occur as scheduled.
• Credit risk: risk that the issuer fails to make promised payments.

For a conventional coupon bond with annual payments, price is:

where P_B is bond price, C is the annual coupon payment, F is face value, y is the annual yield per payment period and n is the number of remaining payments. This formulation assumes annual coupons and a single yield used to discount all cash flows. With semiannual coupons, the coupon and yield must be converted to consistent half-year amounts and periods.

Worked bond valuation

Consider a two-year bond with $1,000 face value, a 6% annual coupon and an 8% required annual yield. The annual coupon is C = 0.06 × 1,000 = $60. Therefore:

The answer is rounded to the nearest cent. Because the coupon rate of 6% is below the required yield of 8%, the bond trades at a discount to face value.

Bond prices and market yields move inversely. The longer the maturity and the lower the coupon, the greater the bond's price sensitivity to a given yield change, other factors being equal. This sensitivity is commonly assessed using duration and convexity. Moreover, quoted yield to maturity is a promised yield, not a guaranteed realized return: default, early sale and reinvestment rates can change the outcome.

4. Mutual Funds and Exchange-Traded Funds

A mutual fund pools money from many investors and invests according to a stated mandate. It may be actively managed or designed to track an index. Investors gain diversification and professional administration but bear management fees and portfolio expenses.

The net asset value per share is:

If a fund has assets of $105 million, liabilities of $5 million and 10 million shares, its NAV is $100\ million ÷ 10\ million = $10 per share.

Open-end mutual fund transactions normally occur at the next calculated NAV, possibly adjusted for permitted charges. An exchange-traded fund, or ETF, trades throughout the day on an exchange. Its market price may be slightly above or below NAV. Authorized participants can create or redeem large blocks of ETF shares, helping align price and NAV.

Passive funds reduce manager-selection risk but still carry market risk, tracking error and concentration risk. A sector ETF, for example, may be inexpensive without being well diversified.

5. Derivatives

A derivative derives its value from an underlying asset, rate, index, commodity, currency or event. Derivatives support hedging, speculation and arbitrage, but leverage can magnify losses.

5.1 Forwards and futures

A forward is a customized over-the-counter agreement to transact later at a price agreed today. A futures contract is standardized, exchange-traded, margined and normally settled daily. Both create obligations for the long and short parties unless the position is closed or otherwise settled.

At maturity, the payoff to a long forward is:

where S_T is the underlying asset's spot price at maturity and K is the contracted delivery price. The formula excludes transaction costs and credit effects.

5.2 Options

A call option gives its holder the right, but not the obligation, to buy an underlying asset at the exercise price. A put gives the right to sell. The holder pays a premium to acquire this right.

European option payoffs at expiration are:

These are gross expiration payoffs, not profits. Profit must also account for the option premium and transaction costs. An option writer can face substantial risk; writing an uncovered call can create theoretically unlimited loss as the underlying price rises.

5.3 Swaps

A swap exchanges specified cash-flow streams. In a plain-vanilla interest-rate swap, one party commonly pays a fixed rate and receives a floating rate on a notional principal, while the other takes the opposite side. The notional amount is normally not exchanged. Banks and companies use swaps to manage interest-rate or currency exposure, subject to counterparty and collateral risks.

6. Alternative Assets

Alternative assets include real estate, commodities, infrastructure, private equity, venture capital, hedge funds, private credit and collectibles. Their return patterns may differ from listed shares and bonds, potentially improving diversification. However, reported correlations can be understated when assets are valued infrequently.

Key limitations include illiquidity, high minimum investment, complex fees, limited transparency, valuation uncertainty and long commitment periods. Commodity investments do not necessarily produce cash income. Private equity performance may depend heavily on manager skill and the timing of cash flows. Direct real estate involves location, maintenance, financing and legal risks. Suitability analysis must therefore go beyond an attractive historical return.

7. Measuring Investment Return and Risk

7.1 Arithmetic and geometric returns

For multiple possible outcomes, expected return is:

where p_i is the probability of outcome i, R_i is its return and the probabilities sum to one.

The arithmetic mean estimates an average one-period return. For realized multiperiod performance, the geometric mean captures compounding:

The formula requires each wealth relative 1+R_t to be nonnegative; a total loss prevents subsequent compounding. For returns of 20% and −10%, cumulative growth is 1.20 × 0.90 = 1.08, so the annual geometric mean is √1.08 - 1 ≈ 3.92%.

7.2 Variance and standard deviation

For a probability distribution, return variance is:

Standard deviation is σ = √σ². It is expressed in the same return units as the observations. Standard deviation treats gains and losses relative to the mean symmetrically and may not fully describe assets with skewed returns or extreme tail risk.

Other risk measures include downside deviation, maximum drawdown, value at risk and expected shortfall. Each relies on assumptions and should be interpreted alongside liquidity, leverage and scenario analysis.

8. Portfolio Risk, Return and Diversification

A portfolio's expected return is the weighted average of component expected returns:

where w_i is the proportion invested in asset i. For a fully invested long-only portfolio, weights are nonnegative and sum to one.

For a two-asset portfolio, variance is:

Here, ρ_AB is the correlation coefficient, ranging from −1 to +1. The formula assumes finite variances and that weights and return observations use consistent periods.

Example. A portfolio invests 60% in Asset A and 40% in Asset B. Expected returns are 10% and 5%; standard deviations are 18% and 8%; correlation is 0.20.

The portfolio's standard deviation is below the weighted average of individual standard deviations, 0.60(18%) + 0.40(8%) = 14%, because correlation is below +1.

Figure: Correlation below +1 bends the opportunity set leftward, allowing lower risk for some target returns.

Diversification reduces unsystematic risk, which is specific to firms or industries. It cannot eliminate systematic risk, such as broad recession or market-wide repricing. Correlations can also rise during crises, weakening diversification when it is most needed.

9. Systematic Risk and the Capital Asset Pricing Model

Beta measures an asset's sensitivity to market returns:

A beta above one indicates greater historical sensitivity than the market; a negative beta indicates movement in the opposite direction on average. Beta depends on the selected market proxy and estimation period.

The Capital Asset Pricing Model states:

where R_f is the risk-free rate and E(R_M)-R_f is the market risk premium. Rates must use consistent horizons and nominal or real terms. The model assumes, among other conditions, mean–variance investors, frictionless markets, homogeneous expectations and borrowing or lending at the risk-free rate. These assumptions are restrictive, so CAPM is better viewed as a benchmark for required return than an exact predictor.

10. Market Efficiency and Investor Behaviour

The Efficient Market Hypothesis proposes that prices incorporate information:

• Weak-form efficiency: prices reflect past prices and trading data.
• Semi-strong-form efficiency: prices reflect all publicly available information.
• Strong-form efficiency: prices reflect public and private information.

Strong-form efficiency is inconsistent with the practical value of material non-public information and with laws prohibiting insider trading. Semi-strong efficiency implies that consistently earning abnormal risk-adjusted returns from public information is difficult after costs, not that prices are always correct.

Behavioural finance identifies departures from fully rational decision-making. Overconfidence may cause excessive trading; loss aversion can make investors hold losing assets too long; anchoring causes undue reliance on an initial value; and herding can amplify market movements. Market anomalies may also reflect risk, data mining, transaction costs or institutional constraints rather than pure inefficiency.

11. Investor Suitability and Portfolio Construction

A disciplined process begins with an investment policy statement. It should document:

1. return objectives;
2. risk tolerance and capacity;
3. time horizon;
4. liquidity needs;
5. tax circumstances;
6. legal and regulatory constraints;
7. ethical or sustainability preferences; and
8. strategic asset allocation and rebalancing rules.

Asset allocation should precede security selection. Strategic weights establish long-term exposures, while tactical allocation permits limited temporary deviations. Rebalancing restores target risk by selling relatively overweight assets and buying underweight assets. Calendar rebalancing occurs at set intervals; threshold rebalancing occurs when weights move outside specified bands.

Suitability is not identical to product eligibility. A client may legally qualify for a complex product that is nevertheless inappropriate for the client's objectives, knowledge, liquidity needs or loss capacity.

12. Illustrative Case: Building a Suitable Portfolio

Background

This fictional case concerns Maya, aged 38, who has $250,000 available after maintaining a separate emergency reserve. She seeks to fund a long-term objective in seven years. Her income is stable, she has no high-interest debt and describes her risk tolerance as moderate.

Problem

Maya proposes investing the entire amount in a technology ETF because the sector recently outperformed. Such concentration conflicts with her moderate risk profile and fixed time horizon. A severe decline near the goal date could jeopardize the objective.

Analysis and approach

After assessing capacity, liquidity and preferences, an adviser proposes the following illustrative strategic allocation:

The portfolio's assumed expected return is:

This is an assumption-based planning estimate, not a guaranteed return. Fees, taxes and inflation would reduce the return available to meet the goal. The adviser also recommends annual review, rebalancing bands and gradual reduction of equity exposure as the spending date approaches.

A stress scenario assumes equities fall 25%, bonds rise 3%, cash earns 3% and listed alternatives fall 12%. The approximate portfolio return is:

The portfolio would decline from $250,000 to approximately $218,750. The scenario demonstrates that diversification reduces concentration but does not prevent loss.

Outcome and learning points

Maya accepts the diversified plan rather than the concentrated ETF position. The decision aligns the portfolio with her goal, horizon and loss capacity. The case shows that suitability requires quantified scenarios, realistic assumptions, cost awareness and ongoing review—not merely selecting high-return products.

13. Governance, Ethics and Regulation

Investment professionals owe duties defined by applicable law, regulation and contract. Core principles include fair dealing, competence, confidentiality, clear disclosure, appropriate product governance and management of conflicts of interest. Common regulatory concerns include insider trading, market manipulation, misleading performance claims, unsuitable advice, mis-selling and inadequate custody of client assets.

Fees and incentives deserve particular attention. A product may offer an intermediary higher compensation while a lower-cost product better serves the client. Such conflicts should be avoided where possible and otherwise disclosed and controlled. Historical returns must not be presented as guaranteed future results. Sustainability claims should be supported by transparent criteria to prevent greenwashing.

14. Technology, AI and Contemporary Developments

Electronic trading, fractional shares, robo-advice and low-cost index funds have broadened market access. Artificial intelligence can process news, estimate risk, detect fraud and personalize portfolio recommendations. However, models may reproduce biased data, overfit historical patterns or fail during structural market changes. Human oversight, data governance, explainability, cybersecurity and model validation remain essential.

Contemporary developments also include tokenized securities, digital-asset investment products, direct indexing and increasing use of environmental, social and governance data. Innovation does not remove traditional requirements for valuation, custody, liquidity assessment and investor protection.

15. Limitations and Professional Best Practices

Valuation models depend on uncertain forecasts. Historical correlations, volatilities and betas can change. Reported alternative-asset values may be stale, while tail events are often underrepresented in short data samples. Taxes, spreads, fees and market impact can turn an attractive gross return into a poor net outcome.

Professional best practice therefore includes:

• defining objectives before selecting securities;
• using consistent data, time periods and currency units;
• diversifying across genuine economic risk drivers;
• stress-testing adverse scenarios;
• evaluating returns net of fees, taxes and inflation where relevant;
• documenting assumptions and conflicts;
• rebalancing under a predetermined policy; and
• reviewing suitability after major changes in markets or client circumstances.

Chapter Summary

Investment assets differ in their contractual rights, return sources, liquidity and risks. Equities provide residual ownership, while bonds promise contractual payments subject to credit risk. Mutual funds and ETFs pool investments; derivatives transfer or transform risk; and alternative assets may provide differentiated exposure but often involve illiquidity and complexity.

Valuation rests on discounting expected cash flows at a rate appropriate to their risk. Portfolio analysis demonstrates that expected return is a weighted average, whereas risk depends on variances and correlations. Diversification reduces asset-specific risk but cannot eliminate market-wide risk. CAPM links required return to systematic risk, while market-efficiency theory examines how information enters prices. Ultimately, portfolio decisions must be governed by investor suitability, disciplined asset allocation, ethical conduct, cost control and continuing review.

Key Terms

Alternative asset: An investment outside traditional listed equities, bonds and cash.

Beta: A measure of an asset's sensitivity to market returns.

Bond: A security representing a contractual debt claim against an issuer.

Capital Asset Pricing Model: A model relating expected return to systematic risk measured by beta.

Correlation: A standardized measure of how two variables move together.

Derivative: A contract whose value depends on an underlying asset or variable.

Diversification: Combining assets to reduce concentration and asset-specific risk.

Efficient Market Hypothesis: The proposition that security prices incorporate specified categories of information.

Equity: A residual ownership interest in an entity.

Exchange-traded fund: A pooled investment vehicle whose shares trade on an exchange.

Geometric return: The constant periodic return that reproduces compounded wealth growth.

Liquidity: The ability to trade an asset quickly without a substantial price concession.

Mutual fund: A professionally administered pool of investor funds.

Net asset value: A fund's assets less liabilities per outstanding share.

Risk capacity: An investor's financial ability to absorb losses.

Risk tolerance: An investor's psychological willingness to accept uncertainty and loss.

Systematic risk: Market-wide risk that cannot be eliminated through broad diversification.

Unsystematic risk: Firm-specific or sector-specific risk that diversification can reduce.

Yield to maturity: The discount rate equating a bond's price with the present value of its promised payments.

Review Questions

Short Answer Questions

1. Distinguish an ordinary share from a bond.
2. Why does a conventional bond's price generally fall when its required yield rises?
3. What is the difference between an ETF's market price and its NAV?
4. Distinguish risk tolerance from risk capacity.
5. What types of risk can and cannot be reduced through diversification?

Long Answer Questions

1. Compare equities, bonds, mutual funds, ETFs, derivatives and alternative assets in terms of claims, returns, liquidity and risk.
2. Explain the assumptions, uses and limitations of the Gordon growth model.
3. Discuss portfolio diversification using variance, covariance and correlation.
4. Critically evaluate the three forms of the Efficient Market Hypothesis.
5. Explain how an investment policy statement supports suitable portfolio management.

Analytical / Application Questions

1. A three-year, $1,000 bond pays an annual coupon of 5%. Calculate its value at a 7% annual required yield and interpret whether it trades at a premium or discount.
2. Construct a suitability assessment for a retired investor with limited income, a short horizon and low loss capacity.
3. Evaluate whether adding an illiquid private equity fund to a diversified portfolio is appropriate when the investor expects substantial withdrawals within two years.

Multiple Choice Questions with Answers

Question 1

Which statement best describes an ordinary equity shareholder's claim?

A. A guaranteed claim to annual dividends

B. A residual ownership claim after creditors are paid

C. A contractual claim to repayment at maturity

D. A right to receive a fixed market return

Correct Answer: B. A residual ownership claim after creditors are paid

Question 2

A two-year bond has a $1,000 face value, pays a 6% annual coupon and has an 8% annual required yield. What is its price, rounded to the nearest cent?

A. $964.33

B. $1,000.00

C. $1,035.67

D. $925.93

Correct Answer: A. $964.33

Question 3

Under the Gordon growth model, what is the value of a share with an expected next dividend of $3, a required return of 10% and perpetual growth of 4%?

A. $30

B. $42

C. $50

D. $75

Correct Answer: C. $50

Question 4

A mutual fund has assets of $105 million, liabilities of $5 million and 10 million shares outstanding. What is its NAV per share?

A. $5

B. $10

C. $10.50

D. $11

Correct Answer: B. $10

Question 5

Which feature most clearly distinguishes a futures contract from an option held by a buyer?

A. A futures position generally creates an obligation, while an option holder has a right without an obligation to exercise

B. A futures contract cannot be used for hedging

C. An option requires no premium or other cost

D. An option always produces a positive profit

Correct Answer: A. A futures position generally creates an obligation, while an option holder has a right without an obligation to exercise

Question 6

Holding asset weights and individual standard deviations constant, which correlation generally produces the greatest diversification benefit?

A. +1.0

B. +0.8

C. 0.0

D. −1.0

Correct Answer: D. −1.0

Question 7

A portfolio invests 60% in an asset with an expected return of 10% and 40% in an asset with an expected return of 5%. What is the portfolio's expected return?

A. 6%

B. 7%

C. 8%

D. 9%

Correct Answer: C. 8%

Question 8

Under semi-strong-form market efficiency, security prices reflect:

A. Only historical prices

B. All publicly available information

C. Only material non-public information

D. No accounting information

Correct Answer: B. All publicly available information

Question 9

Which action best demonstrates investor suitability?

A. Recommending the product that pays the adviser the highest commission

B. Selecting the asset with the highest previous-year return

C. Matching portfolio risk with the investor's objectives, horizon, liquidity needs and loss capacity

D. Using the same model portfolio for every investor of the same age

Correct Answer: C. Matching portfolio risk with the investor's objectives, horizon, liquidity needs and loss capacity

Question 10

An investment earns 20% in year one and loses 10% in year two. What is its approximate annual geometric mean return?

A. 3.92%

B. 5.00%

C. 8.00%

D. 10.00%

Correct Answer: A. 3.92%