Investment Models
Securities and Investments
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Why Use Investment Models?
All investors expect to earn money on their
investments.
All investors wish they could predict the future so
they would know which investments will earn the
greatest returns.
Investors could close their eyes and pick
investments randomly, but that could be very
risky.
All investors want to eliminate as much risk as
possible.
Investment models provide tools for selecting
investments.
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Measures of Risk
Beta
- a measure of volatility of a company’s
stock compared to the entire industry
Variance – the calculation of the measurement
of risk involved, can be reduced through
diversification
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Capital Asset Pricing Model (CAPM)
Used for pricing risky
securities
Formula includes a
return for a risk-free
security in addition to
a premium which
accounts for the
additional risk
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Example: If an
expected rate of return
for a lower-risk
security is 2% with a
beta of 2 (industry
average) and the
projected return for
the particular market
is 8%, the selected
stock should generate
a 14% return (2% +
2(8%-2%))
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Capital Asset Pricing Model (CAPM) – cont.
Uses
beta as an indicator-compares a stock’s
performance to the market as a whole
o >1
can mean the particular stock is more volatile than
the market as a whole
o <1 can indicate slower movement than the market
Contains
risk that cannot be eliminated through
diversification
Also contains risk that can be reduced through
diversifying
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Modern Portfolio Theory
Assumes inherent market risk but attempts to reduce risk
through diversification
The diversification can raise returns due to the balancing
of risky and less-risky investments
The risk of one stock or investment is higher than a
combination of different types of investments or stock in
different companies.
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Arbitrage Pricing Theory
Stephen Ross created this
theory in 1976
Assumes that the asset in
question may not be priced
accurately
Studies the investment itself as
opposed to the entire market
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Venture Capital
Venture
capital is money invested in a
business, usually a new or small business with a
high potential for growth.
Businesses financed with venture capital are
usually extremely risky.
The investors are considered part owners.
These owners can create
their own ‘fund’
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Venture Capital (continued)
These
funds are more risky than mutual funds because the
companies being funded are risky themselves, being new and
growth-oriented.
Investors contribute at different times, starting with ‘seed’ or
startup money
Then they contribute for marketing or other purposes as the
company grows.
Eventually their stake in the
company is sold.
The
performance measurement for the
fund is basically the internal rate of return of the money
invested in the fund
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Formal Assessments
Asset
Allocation Scenarios Assignment #1 – Given the following
three scenarios, create a pie chart for each displaying your
recommendation for investment in different types of securities based
upon the needs presented in each scenario. You may use spreadsheet
software to create the pie charts or create them on posterboard,
clearly displaying each scenario, clearly-labeled investments and
percentages, and a paragraph summarizing your rationale for each
scenario’s asset allocation. Following are the scenarios: 1) John is in
his twenties, moderate income, single, very little in the way of assets,
does not mind taking risks, 2) Mary has only a few years until she
retires, has a high value of assets (house, cars, money to invest), but
prefers safer (less risky) investments, 3) Ben is in his 40s, has a small
amount of assets (car, electronics), and prefers a good balance
between risky and conservative investments. Your pie charts will
address percentages for cash, bonds, mutual funds, and stocks of
large-, mid-, and small-cap companies.
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Formal Assessments (continued)
Asset Allocation Timeline Assignment #2 – In pairs students are to create a
timeline for every ten years of life, from 20 to 60. They will add the different
levels of risk tolerance for what they believe is typical for each time period.
Then they will provide a short-term and long-term financial goal for each
period on the timeline. They should include a graphic or some sort of visual
for each of the goals listed. Then they will provide one investment for each of
the time periods that is appropriate for the time period and financial goals.
They may do this on a word processing document or on flipchart paper.
Investment Strategy Brochure Assignment #3 – Students will create a sixpanel brochure in a word processing program from the point-of-view of
someone who is instructing another student about the different pricing
models. The student should include sections about beta and what it means,
major points about the different models, including who created the models,
pros and cons for each model, and a section about what the student has
learned about risk so far. Examples of each model can also be included. This
assignment will require Internet research to increase understanding. The
brochure should look professional when completed.
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