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.
Inter-temporal Choices
• Utility of consumption
• Savings –foregone consumption, the
difference between current income and
current consumption
• Borrowing
• Demand and Supply determines the
equilibrium price
Investments Defined
• Investment - the process of committing
funds to one or more assets
• The sacrifice of certain present value for
(possibly uncertain) future value
• MGT3040?
Investment Objectives
• Primary Objectives
 Safety of principal
 Income
 Growth of capital
• Secondary Objectives
 Liquidity
 Tax minimization
Investment Constraints
• Possible constraints for investors include:
– Legal
– Moral / Ethical
– Emotional – including investment knowledge and
risk tolerance
– Basic minimum income to be provided by the
portfolio
– 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
Why Study Investments?
• Most individuals make investment
decisions sometime
– 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
Investment Decisions
• Underlying investment decisions: the
tradeoff between expected return and risk
• Return: expected return is not usually the
same as realized return
• 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
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
The Investment Decision
Process
• Two-step process:
–
Security analysis
•
–
Necessary to understand security characteristics
and applied to these securities to estimate their
price or value
Portfolio management
•
•
•
Selected securities viewed as a single unit
How and when should it be revised?
How should portfolio performance be measured?
Factors Affecting the Process
• Uncertainty in ex post returns dominates decision
process
–
Future unknown and must be estimated
• Foreign financial assets – opportunity to enhance return
and/or reduce risk
• Investors must cope with a new investing environment
• Internet changes investments environment
• Institutional investors are important
• How efficient are financial markets in processing new
information?
Factors Affecting the Process
• Uncertainty in ex post returns dominates decision
process
–
Future unknown and must be estimated
• Foreign financial assets – opportunity to enhance
return and/or reduce risk
• Investors must now cope with a changed investing
environment
• Internet changes investments environment
• Institutional investors are important
• How efficient are financial markets in processing
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
• Disclosure requirements
• The effectiveness of existing regulatory
bodies
Appendix 1-A: The Chartered
Financial Analyst® (CFA®)
Program
• Individuals who are interested in the
investment area should consider seeking
a CFA designation
– Level I emphasizes tools and inputs
– Level II emphasizes asset valuation
– Level III emphasizes portfolio management
• For more information:
www.cfainstitute.org
Appendix 1-B:
Professional Educational Alternatives
• Canadian Securities Institute (CSI)
– The CSI offers the Canadian Securities Course
(CSC), which is a mandatory requirement for
individuals who wish to become licensed to sell
financial securities in Canada and to register to sell
mutual funds
• CFA Institute (formerly Association for
Investment Management and Research (AIMR))
– The CFA institute administers the Chartered
Financial Analyst ® curriculum and examination
program
Appendix 1-B:
Professional Educational
Alternatives
• Financial planners
– The Financial Planners Standards Council
(FPSC) developed a set of minimum
standards regarding education, experience,
and ethical and moral conduct for financial
planners