Module 1 Chapter 4

Introduction

Understanding saving, investment, risk, and return is

fundamental to making informed personal finance and

investment decisions.

Saving involves setting aside a portion of income for future

needs, ranging from emergencies to long-term purchases,

building a financial stability and a safety net.

Investment, in other side, is the allocation of saved funds into

assets like stocks, bonds, or real estate, with the goal of

generating returns over time. This balance between saving and

investing is essential for long-term wealth accumulation and

financial security.

Risk and return are fundamental factors to consider in investing.

Risk refers to the potential loss of invested funds due to various

factors, such as market volatility, while return signifies the gains

(or losses) from an investment over a specific period. Generally,

higher returns come with higher risks, underscoring the

importance of understanding this relationship when

constructing a diversified portfolio tailored to personal goals, risk

tolerance, and investment horizon.

Overview of Saving and Investment

In the course of managing finances, individuals encounter periods of excess
income or needs that exceed income. During times of surplus, one may
choose to save—setting aside funds for future use. Savings can serve as a
buffer for unexpected events, like emergencies, or be accumulated to meet
long-term goals, such as buying a house or funding education. Effective
saving enables people to manage risks, plan for life events, and build assets
over time.

On the other hand, investment is about purchasing assets not for

immediate consumption but for future wealth creation. Investments can
range from stocks and bonds to tangible assets like real estate, each
presenting a unique balance of risk and potential return. Investing involves
committing funds with an expectation of future financial gain,
compensating for the time funds are invested, expected inflation, and the
risk involved.

Key Distinctions:

• Saving: Setting aside funds safely for future spending.

• Investment: Committing funds to potentially riskier assets for future
returns.

Overview of Saving and Investment

In the course of managing finances, individuals encounter periods of excess
income or needs that exceed income. During times of surplus, one may
choose to save—setting aside funds for future use. Savings can serve as a
buffer for unexpected events, like emergencies, or be accumulated to meet
long-term goals, such as buying a house or funding education. Effective
saving enables people to manage risks, plan for life events, and build assets
over time.
On the other hand, investment is about purchasing assets not for
immediate consumption but for future wealth creation. Investments can
range from stocks and bonds to tangible assets like real estate, each
presenting a unique balance of risk and potential return. Investing involves
committing funds with an expectation of future financial gain,
compensating for the time funds are invested, expected inflation, and the
risk involved.

Investment Saving

• Investing is when you use your

money (or capital) to:
• Saving involves
o buy an asset that you
simply setting
expect to
money aside for
o generate an acceptable
future spending
return
• It is putting your money
• Investment funds are obtained
into the safest places
from assets already owned,
• Safer
borrowed money, and savings
• Can involve more risk

Key Distinctions:

• Saving: Setting aside funds safely for future spending.

• Investment: Committing funds to potentially riskier assets for future
returns.

Types of Investments
Under the Ethiopian Capital Market Proclamation No. 1248/2021, Art. 2/35,
Investment refers to:
 1. securities publicly offered,
2. securities listed on a foreign securities exchange or facility,
3. ownership interests and/or units in a collective investment scheme
approved under this Proclamation,
4. funds intended for the purchase of such securities, units or other
instruments; or
5. any other instruments declared to be investments for this
Proclamation by a directive of the Authority.

Generally speaking, there are different classes of investment alternatives,

and here below are the most common ones.

Investment Saving

• Investing is when you use your

money (or capital) to:
• Saving involves
o buy an asset that you
simply setting
expect to
money aside for
o generate an acceptable
future spending
return
• It is putting your money
• Investment funds are obtained
into the safest places
from assets already owned,
• Safer
borrowed money, and savings
• Can involve more risk

1 Cash and Commodities

These are typically low-risk investments ideal for risk-averse individuals.

• Gold: A historically significant investment whose value is influenced

by scarcity and external factors.
• Bank Products and CDs: These include savings accounts, money
market accounts, and certificates of deposit (CDs), offering safer
returns.
• Cryptocurrency: Digital currencies like Bitcoin, known for volatility
and high risk.
2 Bonds and Stocks
Bonds are relatively low risk, with options including government and
corporate bonds.

• Government Bonds: Backed by the government, making them

almost risk-free.
• Corporate Bonds: Slightly riskier as they depend on the issuing
corporation’s stability.
• Mortgage-Backed Securities: Investments backed by a pool of
mortgages, providing monthly interest and principal payments.

• Stocks represent shares of ownership in a company, allowing

investors to participate in its growth and success. When individuals
purchase stocks, they acquire a claim on a portion of the company’s
assets and earnings, with the potential for dividends as a return on
investment. The value of stocks can fluctuate based on various factors,
including the company’s performance, market trends, and economic
conditions. Investing in stocks can offer significant financial rewards,
but it also carries risks, as stock prices can be volatile and can decline
due to market downturns or poor company performance. As a result,
many investors view stocks as a key component of diversified
investment portfolios, aiming to balance risk and achieve long-term
growth.

3 Money Market Instruments

Money market instruments are short-term financial instruments that are
used to manage liquidity and raise funds in the financial markets. They
typically provide a safe and liquid investment option for investors looking to
park their funds for a short duration, usually less than one year. Common
types of money market instruments include treasury bills, commercial
paper, certificates of deposit, and repurchase agreements. These
instruments are characterized by their low risk, as they are often issued or
backed by governments and highly rated financial institutions. The stability
they offer makes them particularly attractive for conservative investors or
institutions seeking to preserve capital while earning a modest return.
The money market plays a critical role in the overall financial system,
facilitating the efficient allocation of capital and helping companies and
governments meet their short-term funding needs. Through the trading of
these instruments, entities can manage their short-term cash flow
requirements, while investors can benefit from higher yields compared to
traditional savings accounts. Additionally, money market instruments are
often used as a benchmark for evaluating other investments, as their yields
reflect the prevailing interest rates in the economy. Overall, money market
instruments serve as a vital component of the financial landscape, enabling
liquidity and stability for both borrowers and lenders.
4 Investment Funds
Funds pool resources from multiple investors and diversify across different
assets.

• Mutual Funds: Managed funds combining stocks and bonds, offering

diversification and lower risk.
• Index Funds: Passively managed funds that track market indices,
reflecting broader market trends.
• Exchange-Traded Funds (ETFs): Similar to index funds but traded on
the stock market.

5 Real Assets
Investing in real assets includes:

• Businesses: Small businesses or startups.

• Farming: Agricultural ventures, given Ethiopia’s economy is
agriculture-based.
• Real Estate: Property investment, a stable and tangible asset class.

Types of Risks
In finance, risk refers to the chance that actual outcomes will differ from
expected ones. Specifically, risk in investments represents the possibility
that actual returns will vary from expected returns, encompassing both the
potential for gains and losses. This variability can be measured by using
standard deviation, variance and coefficient of variation. Investment risk
implies that there is a chance of losing some, or even all, of the initial
investment.

1 Attitudes Towards Risk

Investors’ decisions are heavily influenced by their risk attitudes, which can
be classified as follows:

• Risk-Indifferent (Risk-Neutral): These investors are unconcerned

with increased risk and do not require a corresponding increase in
 return. They focus on potential returns without needing
compensation for added risk.
• Risk-Averse: Such investors prefer lower risk and require higher
returns to compensate for any increased risk. They prioritize
preserving capital and are often conservative in their investment
approach.
• Risk-Seeking: These investors are willing to accept lower returns in
exchange for higher risk. They enjoy risk and are more inclined toward
speculative investments.

Most investors are risk-averse, accepting increased risk only if it comes with
a proportional rise in expected return. Risk aversion doesn’t imply avoidance
of all risk but reflects a preference for less risk over more risk, assuming other
factors are equal.
2 Systematic and Unsystematic Risk
When investing, the total risk of an asset or portfolio can be broken down
into two components:

1. Systematic Risk: This is the portion of risk that affects the entire
market and cannot be diversified away. It includes factors like interest
rates, inflation, and economic cycles.
2. Unsystematic Risk: This risk is specific to an individual company or
industry. Through diversification—holding various assets across
sectors and asset classes—investors can mitigate unsystematic risk,
although they cannot eliminate systematic risk.

In other words, diversification reduces risk by spreading investments across

multiple assets. However, no matter how well-diversified a portfolio is,
systematic risk remains, as it is inherent to the overall market environment.
Total risk=Systematic risk + Unsystematic risk

Relationship Between Risk and Return

The risk-return trade-off is fundamental in finance: it suggests that the
potential for higher returns comes with greater risk. If an investor desires
higher returns, they must be prepared to accept higher levels of uncertainty
or potential losses. Lower-risk investments generally yield lower returns,
while higher-risk investments offer the possibility of greater gains but also
come with increased volatility and the potential for loss.
The Capital Asset Pricing Model (CAPM) formalizes this relationship,
suggesting a linear and positive correlation between expected return and
systematic risk, represented by the formula:
Expected Return (Ri)=Rf+βi(Rm−Rf) Expected Return (Ri)=Rf+βi(Rm−Rf)
Where:

• Ri = Expected return of the investment

• Rf = Risk-free rate
• βi = Beta, or the measure of an asset’s systematic risk relative to the
market
• Rm = Expected market return

CAPM illustrates that riskier assets should provide higher returns to

compensate investors for taking on additional risk.

Risk Management: Techniques for Managing Investment Risk

Managing investment risk is crucial for protecting capital and maximizing
returns. Several techniques help investors align their risk exposure with
their overall financial goals:

1. Diversification: Spreading investments across various asset classes

(stocks, bonds, real estate) helps reduce exposure to any single asset’s
volatility. This strategy minimizes unsystematic risk.
2. Asset Allocation: Determining the appropriate mix of asset classes
based on risk tolerance and investment horizon ensures a balanced
portfolio.
3. Rebalancing: Periodically adjusting asset allocations to maintain a
desired risk level allows investors to stay aligned with their long-term
strategies.
4. Dollar-Cost Averaging: Investing a fixed amount regularly, regardless
of market conditions, minimizes the impact of volatility.
5. Hedging: Using derivatives like options or futures, investors can
protect their investments against adverse price movements,
particularly in foreign exchange or commodity markets.

Ethics in Financial Markets

Ethics are essential for maintaining trust and integrity in financial markets.
They guide the behaviour of individuals and institutions in financial
transactions, promoting fairness, transparency, accountability, and
integrity. Ethical behaviour enhances investor confidence, reduces fraud,
and fosters a responsible financial environment where all participants
benefit.
Key Ethical Principles Include:

• Fairness: Ensures equal access to information, preventing unfair

advantage.
• Transparency: Involves accurate and open disclosure of information,
enabling informed decision-making.
• Accountability: Implies compliance with laws and regulations, with a
focus on sound risk management.
• Integrity: Involves maintaining honesty and truthfulness in financial
dealings.
• Confidentiality: Protects sensitive information from unauthorized
disclosure, promoting ethical information-sharing practices.
• Fiduciary Responsibility: Compels financial advisors to act in the best
interests of their clients.
• Professional Competence and Due Care: Ensures that financial
professionals have the skills and knowledge necessary to avoid
negligence and make well-informed decisions.

By following these principles, financial market participants help ensure a

stable, efficient, and fair financial system, supporting sustainable economic
growth and benefiting both individual investors and the broader global
economy.

Key Points Summary

• Saving vs. Investment: Saving offers financial security, while

investing helps build wealth over time.
• Balancing Strategies: A combination of saving and investing
supports long-term goals.
• Risk and Return: The higher the risk, the greater the potential for
return—and vice versa.
• Risk Tolerance: Varies among investors, shaping individual
investment choices.
• Types of Investments: Include cash, commodities, bonds, investment
funds, and real assets.
• Systematic vs. Unsystematic Risk: Only unsystematic risk can be
reduced by diversification.

Ethics in Finance: Emphasize trust, transparency, accountability, and

integrity in financial markets.

Quiz
1. According to the Ethiopia Capital Market Proclamation, which of the
following is considered an investment?
a) A standard savings account
b) Purchasing household goods
 c) Shares in a collective investment scheme sanctioned under the proclamation
d) None of the options listed

2. What does the term "risk tolerance" mean?

a) The highest amount an investor is willing to lose without concern
b) The overall willingness and ability of an investor to accept risk
c) The necessity of maintaining a diversified portfolio
d) The capacity to completely evade any investment risk

3. The practice of requiring higher returns to compensate for taking more risk
is characteristic of which attitude toward risk?
a) Risk indifferent
b) Risk seeking
c) Risk averse
d) Risk neutral

4. What is the main goal of saving?

a) To engage in high-risk investments
b) To build funds for emergencies and future needs
c) To secure maximum returns on investment
d) To transfer funds between accounts

5. In investment risk management, which approach aims to reduce exposure

by investing in various asset classes?
a) Hedging
b) Diversification
c) Liquidation
d) Insuring

6. Which of the following is NOT considered a key ethical principle in financial

markets?
a) Fairness
b) Transparency
c) Manipulation
d) Accountability

7. Which statement best describes the relationship between risk and return?
a) Higher returns are always associated with lower risk
b) There is no relationship between risk and return
c) Greater potential returns usually come with higher levels of risk
d) Risk and return have no bearing on investment choices

8. Which of the following risk is associated with factors affecting the entire market,
such as economic downturns?
a) Unsystematic risk
b) Systematic risk
c) Specific risk
d) Default risk

9. In what way do saving and investing differ?

a) Saving carries more risk than investing.
b) Investing involves placing funds in assets expected to generate returns,
while saving focuses on setting money aside for future use
c) Saving guarantees returns, but investing does not
 d) Only wealthy individuals engage in investing, while saving is a universal
practice

10. What is the consequences of a lack of ethics in financial markets?

a) Increased confidence and trust from investors
b) Enhanced market participation
c) Increased volatility and susceptibility to fraud
d) Decreased regulations