Chapter 01 1 Investment

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INVESTMENTS

BACKGROUND AND ISSUES

What is an investment ?

What are the components of the requiredrate of return on an investment?

What key issues should investors alwaysconsider?

What types of investments can we make?

Where do investors place funds for investment andsavings purposes?

What are some basic investment philosophies thatindividual and institutional investors follow?

Why are ethics and regulations a concern to allinvestment professionals?

What are some career paths available for personsinterested in investments?

An investment is the current commitment ofresources for a period of time in the

expectation of receiving future resources thatwill compensate the investor for:

the time resources are committed

the expected rate of inflation

the uncertainty of future payments

Is hiding money in a mattress or keeping it in

a piggy bank an investment ?

No! The safe-keeping of money does notinvolve any expected compensation.

In order to defer consumption, investors

need compensation from three sources

the pure or real interest rate

inflation protection

risk


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The real risk-free rate ofinterest is the exchange rate

between future consumptionand present consumption.

This rate of interest can bethought of as the pure rentalrate on money in the absenceof inflation and risk.

Borrowers are willing to pay to

be able to spend more than theircurrent resources allow.

Savers need compensation inorder to give up the right toconsume today.

If the future payment will be diminished in

value because of inflation, then investors willdemand an interest rate higher than the real

risk-free interest rate so that their expectedpurchasing power will actually increase.

The nominal risk-free rate of interest adjuststhe real risk-free rate to reflect expected

inflation over the life of the investment.

Taking into account these two factors (timeand expected inflation) compensates

investors for the time value of their money.

Investors tend to be risk-averse, meaning

that they need sufficient expected additional

compensation in order to bear additional risk.

If the future payment from an investment is

uncertain, investors will demand an interest

rate that exceeds the nominal risk-free rateof interest to provide a risk premium.

The sum of the nominal risk-free interest rate

and the risk premium on an investment gives

that investments required rate of return.

Note that for riskier investments, the risk

premium, and therefore the required rate of

return, will be higher than for lower riskinvestments.


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There is a trade-off between risk andexpected return.

Developed financial markets are nearlyefficient.

Focus on after-tax returns, net of expenses.

Diversify across asset types, industries, andeven countries.

Because investors tend to be risk

averse, it makes sense that they willonly take on riskier investments ifthey expect to earn more than with

lower risk investments.

An efficient market is one where Information is quickly and accurately reflected in asset

prices,

So What appears to be news is not useful in predicting

future asset prices,

With the result that Investors cannot systematically and consistently beat

the market without the aid of either inside information orloads of luck.

Its what is unexpected that moves themarket (the genuinely new informationin news).

We should be skeptical of investmentstrategies that claim to be able to beat

the market on a consistent basis.

If markets are

perfectly efficient, itmakes no sense toseek out superiorinvestments.

But if nobody seeksout superiorinvestments, themarket would not

Its what you get to keep that counts!

Taxes affect investment decisions

Some allow for lower or no tax burden(Municipal bonds)

Some allow for deferral of tax liability(IRAs)


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Since financial markets are nearly efficient,even large investors generally do not beat

the market, but that does not mean that theydo not generate lots of expenses in trying to!

Avoid high expense investments when possiblesince they tend to reduce net return withoutincreasing gross return.

Dont put all of your eggs inone basket!

Diversification reduces riskwithout necessarily

sacrificing expected return.

Its a no-brainer!

Real assets vs. Financial assets

Tangible assets vs. Claims on assets

Direct vs. Indirect financial investments

Individual securities vs. pools of assets

Derivatives

Futures, options

Households: net savers (investors)

Federal Government: net borrower

Businesses: issuers of investment securitiessuch as stocks and bonds

When issuers of securities raise money

through selling new securities, often with theassistance of investment bankers or financialintermediaries, these are primary market

transactions

Investors trade among themselves insecondary markets, often with the assistance

of brokers or dealers

In forming an investment portfolio, several

questions are paramount: In what types of securities should I invest?

Asset Allocation

Within each security type, how do I selectwhich assets to purchase?

Security Selection

Finally, how active should I manage myportfolio?

Should I be an active or passive investor?


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Asset Allocation Security Selection

Active Market timing Stock picking

Passive Maintain pre-

determined

allocation(s)

Try to track a well-

known market

index

Financial markets are vitally important to awell-functioning economy.

Trust in information and faith in fairness areessential.

Codes of ethics for financial professionalsand strict regulations attempt to create suchan environment where financial markets canefficiently fulfill their economic function.

Registered Representative of aBrokerage Firm

Investment Analysis

Portfolio Management

Financial Planning

Corporations

Professional Designations

Chartered Financial Analyst (CFA)

Certified Financial Planner (CFP)

Chapter 01 1 Investment

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