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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)