Difficulty: ★★★ | High-yield focus: Define investment, distinguish investment from speculation and gambling, and outline the steps of the investment process. Key exam mastery: Formulate an institutional Investment Policy Statement (IPS) specifying return objectives, risk constraints, liquidity needs, and time horizons.
Part 1: Core Concepts (2 Marks)
Academic Definition of Investment
According to Frank K. Reilly and Keith C. Brown (★), “An investment is the current commitment of dollars for a period of time in order to derive future payments that will compensate the investor for (1) the time the funds are committed, (2) the expected rate of inflation during this time frame, and (3) the uncertainty (risk) of the future payments.”
The Efficient Market Hypothesis (EMH - Eugene Fama, 1970)
A market is informational efficient if security prices at all times fully and instantly reflect all available relevant information:
- Weak-Form Efficiency: Stock prices fully reflect all historical price and trading volume data. Implication: Technical analysis cannot generate abnormal returns.
- Semi-Strong Form Efficiency: Stock prices reflect all publicly available information (financial statements, news, earnings, macroeconomic announcements). Implication: Fundamental analysis cannot generate abnormal returns.
- Strong-Form Efficiency: Stock prices reflect all public AND private insider information. Implication: Even corporate insiders cannot earn abnormal profits.
Part 2: Structural Frameworks (10 Marks)
1. The Five-Stage Investment Process
THE SYSTEMATIC INVESTMENT LIFECYCLE
- SETTING INVESTMENT POLICY (IPS)
- Define risk tolerance, return goals, time horizon,
- liquidity needs, tax status, and legal constraints
- ASSET ANALYSIS & VALUATION
- Fundamental analysis (macro, industry, firm DDM/DCF)
- Technical analysis and pricing misalignments
- PORTFOLIO CONSTRUCTION & ASSET ALLOCATION
- Markowitz mean-variance optimization across assets
- Selecting optimal risky portfolio along CAL
- PORTFOLIO REVISION & REBALANCING
- Periodically adjusting weights as asset prices shift
- PORTFOLIO PERFORMANCE EVALUATION
- Benchmarking returns (Sharpe, Treynor, Jensen Alpha)
Part 3: Distinction Tables
| Basis of Comparison | Real Assets | Financial Assets |
|---|---|---|
| Fundamental Nature | Physical, tangible assets that have productive capacity | Legal contractual claims on the income generated by real assets |
| Economic Role | Generate real goods, services, and physical societal output | Allocate and distribute the income and risk produced by real assets |
| Balance Sheet Impact | Appears strictly on the Asset side of the balance sheet | Appears as an Asset on buyer’s balance sheet and Liability/Equity on issuer’s |
| Examples | Factories, land, heavy equipment, inventory, intellectual patents | Common stock, corporate bonds, bank certificates of deposit, derivatives |
Part 4: Worked Problems & Exam Traps
Market Efficiency Archetype: Testing EMH Forms
Scenario: A stock analyst in Kathmandu claims:
- Claim A: “By examining past 200-day moving average chart patterns on NEPSE, I can consistently beat the market by 15%.”
- Claim B: “By reading corporate annual reports the minute they are published, I can consistently earn abnormal profits.” Evaluate these claims against the Efficient Market Hypothesis.
Empirical Evaluation:
- If Claim A is proven true, it disproves Weak-Form Market Efficiency.
- If Claim B is proven true, it indicates that NEPSE is not even Semi-Strong Form Efficient (common in emerging markets with slow information dissemination).
- If NEPSE is semi-strong efficient, all published earnings are reflected in share prices in milliseconds, rendering public report reading incapable of generating abnormal returns without taking excess risk.
Exam Trap: Beating the market by taking on astronomical risk does NOT disprove the EMH! Abnormal returns (Jensen’s Alpha) must be evaluated strictly on a risk-adjusted basis.
Students lose marks here because they describe investment merely as saving money in bank fixed deposits, failing to analyze the real rate of return adjusted for inflation and risk tolerance.