Chapter 1
Understanding
Investments
Learning Objectives
• Define investment and discuss what it means to
study investments.
• Explain why risk and return are the two critical
components of all investing decisions.
• Outline the two-step investment decision process.
• Discuss key factors that affect the investment
decision process.
Investments Defined
• Investments is the study of the process of
committing funds to one or more assets (The
sacrifice of certain present value for possibly
uncertain future value)
 Emphasis on holding financial assets and
marketable securities
 Concepts also apply to real assets
 Foreign financial assets should not be ignored
Types of Assets
A financial asset is a paper or electronic
claim on an issuer such as a corporation or
the federal or provincial government.
Examples of financial assets include
stocks, government bonds, and corporate
bonds.
A real asset is a tangible physical asset.
Examples of real assets include gold, silver,
gems, art, coins, and real estate.
Investment Objectives
• Primary Objectives
 Safety of principal
 Income (e.g. dividends)
 Growth of capital (e.g. capital gains)
• Secondary Objectives
 Liquidity (the ease with which assets can be
converted into cash with little risk of loss of
principal) & Marketability (the ease with which an
asset maybe bought and sold)
 Tax minimization
Investment Constraints
• Possible constraints for investors include:
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Legal constraints
Taxes
Transaction Costs
Moral / Ethical
Emotional – including investment knowledge and risk
tolerance
Income requirements (basic minimum income to be
provided by the portfolio)
Diversification Requirements
Realism – an understanding that some objectives are
unrealistic (e.g., high returns with low risk)
Other (e.g., illness, pending divorce, etc.)
Primary and Secondary Objectives
• Objectives and constraints must be related to the
three primary investment objectives of safety,
income, and growth, and to the secondary
objectives of liquidity and tax minimization.

The importance of safety relates to: risk, market
timing, inflation, return, and emotion
 The importance of income relates to: taxation, return,
risk, inflation, and basic minimum income
 The importance of growth relates to: taxation, risk,
return, market timing, and emotional considerations
Primary and Secondary Objectives
(cont.)
• There are three main constraints that could have
an impact on the design of an investment policy
1- the level and stability of current and future
income and financial obligations of an investor
2- an investor’s level of investment knowledge
3- an investor’s tolerance for risk
Sources of Risk
• Total Risk = Unsystematic Risk + Systematic Risk
Unsystematic Risk (diversifiable risk): depends on the
factors that are unique to the specific asset (e.g.
business risk)
Systematic Risk (nondiversifiable risk): depends on
factors that affect the returns on all comparable
investments (e.g. interest rate risk, reinvestment rate
risk, exchange rate risk, & purchasing power risk)
Why Study Investments?
• Most individuals make investment decisions
sometime
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Individuals need sound framework for
managing and increasing wealth
• Essential part of a career in the field

Security analyst, portfolio manager, investment
advisor, financial planner, Chartered Financial
Analyst
Why Study Investments? (cont.)
• The study of investments is important to most
individuals because almost everyone has wealth
of some kind and will be faced with investment
decisions at some point in their lives. One
important area where many individuals may
make important investing decisions is retirement
plans, particularly their Registered Retirement
Savings Plan (RRSP).
• Investments, in the final analysis, is simply a
risk-return tradeoff. In order to have a chance to
earn a return above that of a risk-free asset,
investors must take risk. The larger the return
expected, the greater the risk that must be taken
Investment Decisions
• Underlying investment decisions: the tradeoff
between expected return and risk
• Return: expected return is not usually the same as
realized return
Expected return is the anticipated return by investors
for a future time period
Realized return is the actual return on an investment
for a previous period of time
• Risk: the possibility that the realized return will be
different than the expected return
The Tradeoff Between ER and Risk
• Investors manage risk at a
cost – lower expected
returns (ER)
• Any level of expected
return and risk can be
attained
• An investor would expect to
earn the risk-free rate of
return when he or she
invests in a risk-free asset
(such as a Treasury bill)
Stocks
ER
Bonds
Risk-free Rate
Risk
“Typical” Chart
RT
RELATION
RISQUE-RENDEME
RISK- EXPECTED RETURN RELATIONSHIPS
12
Options/Futures
High
Art objects
10
Coins and stamps
Real estate (commercial)
8
Common shares
6
Expected
Return
Rendement
Real estate (residential)
Preferred shares
4
Corporate bonds
Government bonds
2
Treasury bills
0
0
Low
2
4
6
Risk
8
10
12
High
Risk-Expected Return
Relationships
• Required rates of return differ as the risk of an
investment varies. Government of Canada bonds
are less risky than corporate bonds, and therefore
have a lower required rate of return
The Investment Decision Process
• Two-step process:

Security analysis
•
•
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The first step in the investment decision process,
involves the analysis and valuation of individual
securities
Necessary to understand security characteristics
and applied to these securities to estimate their
price or value
Portfolio management
•
•
The second step, involves managing a group
of assets (a portfolio), as a unit
Selected securities viewed as a single unit
Active and Passive Investment
Strategies
An active investment strategy involves identifying and
investing in securities that the investor believes are
underpriced. An investor would concentrate on
identifying and purchasing these securities in an
attempt to outperform the market.
•
A passive investment strategy is based on the
belief that most securities are fairly priced. With
this strategy, an investor would attempt to construct
a portfolio that mirrors the market index and would
concentrate instead on reducing transaction costs
and taxes.
External Factors Affecting the Decision
Process
1- Uncertainty
2- The investing environment (institutional
investors vs. individual investors)
3- The globalization of the investing process
4- The issue of market efficiency
Uncertainty
• The most important factor investors must deal with
is uncertainty. Uncertainty dominates investments,
and always will, since the realized return on a risky
asset will almost always be different (sometimes
quite different), from the expected return.
Institutional Investors
• Institutional investors consist of banks, pension funds,
investment companies, insurance companies, and bank
trust departments. These investors manage huge portfolios
of securities.
• Institutional investors own and manage portfolios of
securities. They affect the investments environment (and
therefore individual investors), through their actions in the
marketplace and by buying and selling securities in large
dollar amounts. However, although they appear to have
several advantages over individuals (research departments,
expertise, etc.), reasonably informed individuals should be
able to perform as well as institutions, on average, over
time. This relates to the issue of market efficiency.
Market Efficiency
• Efficient markets are ones in which the prices of
securities quickly and correctly reflect information
about securities. In such a market, the prices of
securities do not depart for long from their justified
economic values.
• An efficient market is significant to investors
because it will affect their behaviour. Quite a few
actions, such as performing the same security
analysis as everyone else, are of no value in an
efficient market. Technical analysis is ruled out, as
is standard fundamental analysis.
Foreign Financial Assets
• Investors should be concerned with global
investing for several important reasons:
1- more opportunities are now available to investors in the
form of mutual funds and closed-end funds investing in
foreign stocks and bonds
2- the returns may be better in foreign markets at a particular
point in time than in the Canadian markets
3- by investing in foreign securities, investors may be able to
reduce the risk of their portfolios
4- many Canadian companies are increasingly affected by
conditions abroad
Ex ante and Ex post
• Ex ante: meaning before the fact, it refers to an
investor’s expectation of higher returns from
assets with higher risk before the investment is
actually made.
• Ex post: meaning after the fact or when it is
known what has occurred, refers to the actual
return realized for the risk taken.
The Effect of the Internet
• Internet technology has:
1- Revolutionized the flow of investment information
2- Dramatically lowered commission rates for
individual investors
3- Allowed investors to trade with software on their
own personal computer
4- Led to intense competition among on-line
discount brokerage firms for investor business
Corporate Governance
Main issues:
• The accountability of the Board of Directors and
Management
• A re-examination of accounting and auditing
practices
• Management compensation arrangements such as
executive stock option plans (ESOPs)
• Disclosure requirements
• The effectiveness of existing regulatory bodies