Literature Review on the Framework of Investment Finance Essay

Graham and Qadd (1934) states that an investment operation is one which is based upon thorough analysis that guarantees safety of amount invested and gives an adequate return. Operations that do not meet these conditions are speculative. Gordon and Sharpe (2002) differentiate between investment and saving. Investment is restricted to "real" investment as that type that increases national output in the future, while saving is consumption forgone. For Reilly and Brown (2002), investment is the current commitment of money for a time period in order to develop future payments that will reward the investor for the time period the funds are devoted, the rate of inflation, and the degree uncertainty of future payments. Bodie, Kane and Marcus (2003) speak of investment as "the sacrifice of existing resources, something of value now, to benefit from that sacrifice later in terms of benefits". It is the engagement of money or other resources that one have in its possession to some other consistent assets with the expectation of earning some benefits in the future. From an Economist point of view, investment refers to the amount of expenditure on goods and services, which are not used for present consumption but for producing further goods and services. Economists argue that investment is equal to saving in any economy. While we can note a distinction between savings and investment, both terms are regularly used conversely (Hamouda, 2009). The three main characteristics of investment are return, time and risk. The engagement of resources invested now is certain, while the reward upon investment in meant in the future and the degree of uncertainty is uncertain. For instance, government bonds it is the time factor that predominates and the risk element is the principal feature for a common stock (Sharpe and Gordon, 2006).

2.2 Real Investment and Financial Investment

Real investments represent investments in tangible or real assets such as equipment, land or buildings while financial investments deal with securities and contracts written on papers. The material wealth of a society is calculated by the productive capacity of goods and services of the society members. The capacity function of real assets of the economy can be used to manufacture goods and services by using land, buildings and knowledge. Real asset is that component of real investment that determines the productive capacity of any economy. Financial assets are written paper contracts and represent claims on real assets or the revenue generated by them. Financial assets define the proportion of income or wealth among investors while real assets create net income to an economy (Sharpe and Gordon, 2006; Bodie et al, 2002). Real investments that can generate significant income require significant financing. It is obvious that an individual will not be able to own banks, but this individual, have the possibility to invest in the securities of an established firm to perform these fruitful activities. Table 2: Balance of U.S Household For instance, an individual who buys stocks of the Barclays PLC or the Mauritius Commercial Bank is carrying out financial investment in these organisations, which then can execute real investment in buildings, equipment, technology and furniture and fittings. Individuals have the choice of consuming today or investing their wealth today for future consumption. If they prefer to invest today, they will place their present wealth in financial assets through investment in various securities. Investors' returns come from the income generated by the real assets that were funded by the issuance of those securities (Breadley and Myers, 2001). The difference between financial and real assets will be clearly apparent when one looks at the balance sheet of households. For instance, we are going to look at the United State household balance sheet as shown in Table 2 and Table 3 depicting United States national wealth. Source: Flow of Funds Accounts of the United States, Board of Governors of Federal Reserve System, June 2008 Table 3 :Domestic net worth (only with real assets) Assets Billion Non-residential real estate $9,001 Residential real estate $22,070 Equipment and software $3,923 Inventories $1,849 Consumer durables $4,082 Total $40,925 Source: Flow of Funds Accounts of the United States, Board of Governors of Federal Reserve System, June 2008 The largest asset and liability both come from the house owned. The position of deposits is usually maintained for liquidity of consumption and pension reserves are the money or assets invested for future retired life. Equity in non-corporative business may come from the investment in sole proprietorship or partnership companies. For example, a bond that an individual possess as an asset gives him an entitlement on interest income while repayment of principal is a liability for the bond issuing company, where these payments are compulsory. The individual's asset is the bond issuing company's liability. When the balance sheet is totalled, the financial assets nullify the liabilities. Structures, equipment, inventories and land form the National wealth.

2.3 Behavioral Finance

It is an integral part of investment decision making. In comparison with traditional finance theory. Behavioral finance lays emphasis on irrational behaviour of investors. Factors like cognitive biases, heuristics and mental errors can cause bad investment decisions. It integrates psychological factors with risk-return trade off theory (Mauboussin, 2004). Behavioural finance describe individual investors as unrational investors who are subject to cognitive & psychological biases, who often exhibit risk seeking behaviour and their expectations are biased(Lucey, 2005). The classical decision-making under risk and uncertainty is based on asset integration, risk aversion and rational expectations. Unlike traditional finance theories suggest, investors do not necessarily make rational investment decisions. Cognitive & psychological biases, which influence investment decision making, are heuristics (Representative, overconfidence, availability), regret aversion, cognitive dissonance, anchoring mental accounting and greed & fear (Chandra, 2008).

2.4 Factors affecting Investment Decisions

The selection of investment alternative for the investor are to be considered first to know what are the objectives of investors (Hirt and Block, 2003). Different investors have different investment objectives. Some will be willing to bear significant risk in reaping returns; for other investors, safety is a principal concern. Taking into considerations investor objectives, the most vital question is: Why should we invest at all? (Corrado and Jordan, 2001). We shall consider the following factors as the investment objectives of an investor and the guidance in the selection of the different types of investment. Risk, return and Safety The most vital decision that an investor must deal with is the degree of risk he is prepared to shoulder. Risk tolerance measures the level of risk an investor is willing to accept. Most investors are risk-averse, that is, they will choose the investment with the minimum risk possible (Pellinen et al, 2010). Since higher returns are generally associated with higher risks, the investor must therefore seek equilibrium between return objectives with risk tolerance. Most investors have a difficulty in expressing in any defined way their attitude toward risk. The main reason is that risk is not a simple theory; it cannot be easily defined or measured (Chandra, 2008). Investors who are rational and risk-averse will choose a portfolio made up mostly of short-term debt, securities from the government and major organisations. Conservative investors will normally invest in market fund where the capital of several investors are combined and reinvested in high-yielding investments and short-term investments. Current Income vs. Capital Appreciation If current income is the return objective, the investors' portfolio will contain generating income rather than capital gains. This strategy sometimes suits investors who want to increase their income with income engendered by their portfolio to meet their living expenses. Pensioners may favour this objective for part of their portfolio to be able to generate spendable funds. The investment will usually be in high-yielding mature firms. Capital appreciation is an appropriate objective when the investor wants the portfolio to develop in real terms, through a rise in value to provide the expected return over time to meet some future need. Under this strategy, growth generally occurs through capital gains. It shows an aggressive strategy where investors are prepared to take on risk to meet their aim. It should be noted that there is a balance between growth and income, where it is unlikely to find these two characteristics in one type of investment. Capital Preservation Investors want to minimise their risk of loss, usually in real terms. They strive for maintaining the purchasing power of their investment, that is, the return should not be less than the rate of inflation. This is a strategy for strongly risk-averse investors or when funds are needed in the short-run, such as a down payment on a house. Ease of Management It is a factor worth considering in investment selection such that the time period and effort the investor has to dedicate to his portfolio should define the type of assets he decide to invest in. Liquidity Considerations Liquidity measures the ability to quickly convert an investment into cash at a price close to fair market value. Assets are more liquid if many traders are interested in a standardised product. Treasury bills are highly liquid while real estate and venture capital are not. There is need to consider in the investment plan the liquidity needs of the investor. Tax Factors Different types of investments are taxed differently. Higher tax bracket investors will prefer investment strategies with favourable tax credits or tax shelters while lower tax bracket investors will focus more on pre-tax returns.

2.5 Major differences in Investment Cultures around the Globe

Culture comprises of beliefs and values that religious, ethnics and social groups hand on from generation to generation. Individuals have less control over their culture than other social capital (Becker, 1996). They cannot change their race, ethnicity, or family history, with some difficulties arousing that they can move to another country or change religion. Trust is one facet of culture, the levels of trust differ from countries to countries; it is quite high in China and they are particularly high in Norway, Finland, and Sweden. They are quite low in France and Italy and lower in Mexico and the West Indies (Statman, 2009). Guiso at al (2006) institute that levels of trust persevere among immigrants to the United States, and quite high levels of trust among immigrants are connected with quite high levels of trust in their countries of origin. Does cultural background affect financial attitudes? This is an essential question for financial advisors whose clients originate from different cultures. If we take Japan as example, decision-making is slower because they tend to seek authorisation of everyone in the group, particularly the elders. Japan is a high context culture, where less is expressed overtly and more is understood. For a person originating from a low context culture, sometimes it is challenging to understand what is the real definition. You need billions to penetrate the Japanese market; this is what makes it the last resort for investors. Despite Japanese has larger disposable income, they still find it hard to find investment opportunities (Ghimire, 2006). In Zimbabwe, where inflation rate is high, the government encourages the population to invest in securities rather than saving their income. Their investment culture has changed towards militating against the current hyper inflationary situation and the presence of resources in starting up and running their own business (The Herald, 2007). Uganda is populated by 30 million people and has around three million bank accounts, confirming that a major part of the population does not possess a formal saving structure. Mr Charles Ocici, Executive Director of the Enterprise Uganda, stated: 'it's not always easy for an individual to save for future investment', hence if they are put in a group it's easier to gather a fair amount of money for future investments where individual savings return less potential capital (Ladu, 2010). Johnson (2006) promulgates that Jamaica's investment culture is defined in terms of size, skill, bureaucracy and corruption. Coming to Chinese and American Investment Culture, Chinese households witnesses a high percentage of net worth in investments and they may experience fluctuations in wealth larger than they are able to cope, which could pave the way to stress or absurd financial behaviours. The difference between the two investment cultures lies in the collectivism of Chinese culture versus the self-centred nature of American culture. The Chinese are risk attracted because even though the asset is highly risky and offers a high probability of low return, there is still a guarantee of family or friend's solidarity and support even in case of bankruptcy. The Americans on the other side of the coin are risk averse because they do not benefit from the same support. Family and friends are rarely present for help in case of high loss and bankruptcyA and that is the cultural safety net. Financial advisers must know that people are different and even people who were born in any country have diverse preferences and those preferences may be found in family history, in personality or in culture. People carry on with their culture even for several years after they establish in a new country (Statman, 2009). New Zealand has witness a fall in household saving and a rise in household wealth, as they are tempted to invest in residential property due to rises in house prices. It should be noted that the household saving rate has been among the lowest and investment in wealth is at much lower levels than the United States or Australia. Wealth is more unevenly distributed than income as well as financial skills. People who possess high financial knowledge have higher education, higher income and higher wealth and these people represent only 15 % of the population (Burns and Dwyer, 2007). Studies demonstrate the consumers' inability to ascertain the quality of investments and they are faced with lots of information. Others will turn up with 'rules of thumb' on how to progress. Consumer interviews suggest that advice from family members and friends are regarded as an important factor for investment decisions. A small proportion of people will have recourse to professional financial advisors. Lower taxes on managed funds, changes in the regulatory framework of the financial sector, educational measures to increase financial literacy are some factors that affect the investment culture in a particular country. A new trend has been observed; people tend to see education a reliable investment with much greater return. For instance, when Sweden denationalised its social security scheme, the Swedish population who had invested their own pensions chose more costly and less diversified funds (Burns and Dwyer, 2007, adapted from Stewart, 2005). The intricacy of the market and investment products, the costs of swapping products has set up demand-side restrictions that alleviate competition in the investment market (Burns and Dwyer, 2007, adapted from Grimes, 2005). Information about investment products has contributed to a low-trust environment, where light should be spread on investment products, fees, charges, and terminologies. Across the globe, investment decisions are taken, but there are some factors that an investor should consider like considering risks and making adequate comparison against the possible returns to be realised from the investment and the investment that provides the optimal value is chosen. We have also random an unsystematic investors. The investment climate depends on a large number of factors that can be gathered into three main categories: macroeconomic conditions, physical infrastructure and institutions. Foreign investors select an explicit location based on the investment type and the expected profitability. The foundation for making investments is determined by the definite features of the favoured location: disposal of cheap skilled labour, market size and volatility, existence of natural resources, nearness to the home country or admittance to good financial and physical infrastructure (UNECE, 2004). People also prefer safer investment like property, treasury bills, and investment in foreign currency and trading. The reluctance of people towards investment is just because they prefer to put in a bank to keep it safe. Moreover, with the uncertainty linked with how quick they can get their investment back on bonds make people reluctant to invest. Another factor that shape investment decisions is the familiarity of the financial institution and the investment type. People are more attracted towards safer investment where they are absolutely familiar with and invest in an institution that they already know. It is also to be noted that some investors prefer their intuition to any systematic methods for their decisions. The source of information for investment decisions would include recommendation by friend, newspapers, leaflet or books, financial skills or a financial agent. The objective of investment would vary form keeping investment safe, making more money, employer actions or a friend's advice (Boye, 2005). Studies have shown that men investment has been higher than women's for social and various demographic reasons. Women tend to be more risk averse than men in general. Individual investment choices on lifestyle and demographic attributes (Warren et al. (1990) and Rajarajan (2000), adapted from Dash, 2010). For making long-term investment, institutional investors need to analyse environmental, social and governance information. Racial differences on investment behaviour are investigated below. The way how black household invest in risky asset ownership would differ from white households. According to Wall Street Journal, the affluent Blacks are less involved in stock market than whites thus benefiting less from market gains. The reasons behind less interest on behalf of Black on the stock market arise from risk tolerance, investment choice, or a cultural difference. The investment behaviour can be viewed in different cases. In the case of individual investor, there is a large difference between Blacks and Whites in wealth accumulation over the life cycle, possibly leaving Black families less prepared for retirement. For financial consultants, lack of understanding between financial planners and Black clients may deter Blacks from ever seeking the advice of financial advisors (Gutter et al, 1999). Investors vary in risk tolerance and it is an important factor. Too little risk tolerance may leave investors with little superannuation income as they retreat from uncertain investments with high estimated returns. Too much risk tolerance might also leave investors with slight superannuation income as they spend their savings in gambles (Hoffman, 2007). In Mauritius, investment is viewed in a different angle, where the preferred investment vehicle is 95.9 % for bank savings and deposits for safety reasons while 7.14 % have invested in SIT and the stock market. 69 % of potential investors are ardent to invest on the stock market subject to disposal of funds and predictions of benefits being good. 10 % expressed hesitation to invest in risky sectors and the rest were reluctant and showed confidence in the banking system for safety reasons. The main reason why there is little investment by Mauritian is the lack of adequate information, no proper financial education. Other factors would include income tax reasons, unprepared for downturns, the saving rate and the agreement, which is too bulky to read that discourages investment (FSC, 2002).

2.3 Conclusion

Investment can be termed as deferred consumption. When an investor is confronted towards an investment decision, he will in a first instance analyse, what is his risk tolerance, what is the investment return and when will the investment yield to maturity. This is a general notion for everyone, but investors attitude vary from country to country or even continent to continent. Different investors have different preferences and needs. A deeper analysis shows that there are differences between male and female investors, uneducated and educated investors, young and older investors. It should be noted that knowledge of the relation between culture and financial attitudes helps financial advisors to improve services to their clients. Besides culture, the financial instrument used helps to define the investment culture and where people who are relatively savers see their savings as an investment. Friends have a major say, as they tend to influence the investor decision thus derouting from its own objective. A poor saving culture may not essentially explain a poor investment culture.

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