Introduction to
Investments (Chapter
1)
MB 72
Outline
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What is meant by “Investment”?
Why do individuals invest?
Measuring Risk and Return
Sources of Risk
Relationship between Risk and Return
Meaning of Investments
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Commitment of money that is expected to generate
additional money
Current commitment of dollars for a period of time to
desire future payments that will compensate the
investor for
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The time the funds are committed
The expected rate of inflation, and
The uncertainty of the future payments
The investor can can be an individual, a
government, and/or a corporation
Why do individuals invest?
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To achieve a higher level of consumption in
the future by forgoing consumption today
To improve our welfare in the future
Investments help us achieve tradeoff
between current consumption and future
consumption
Why Study Investments?
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The Personal Aspects
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To earn better returns in relation to the risk we assume
when we invest
Knowledge of investments help investors understand the
relationship between risk and return
Investment as a Profession
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To become a licensed broker (series 7 exam), to become
CFA/CFP/CMA, knowledge of investments is needed
Basis of Investment Decisions
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Basic element of all investment decisions:
trade-off between expected return and risk
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Expected return is not usually the same as
realized return
Measuring Return on
Investments
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Measures of Actual Return/Historical
Return/Realized Return
Holding Period Return (HPR)
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Total Holding Period Return
Annualized HPR = [HPR]1/n, where n is the number of
years investment is held
Holding Period Yield = HPR - 1
n
Mean Rate of Return = HPYi/n
i=1
Geometric Mean = [HPR1HPR2 … HPRn]1/n – 1
Which measure gives us a better estimate of the wealth
effect of an investment?
Expected Return
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A weighted average of each possible
outcome, where weights represent the
probability of each possible outcome
Multiply each possible outcome by its
probability and add them up
n
E(Ri) =  Pi  Ri
i=1
Risk of Expected Returns
Risk is defined as the chance that the actual return on an
investment will differ from its expected return—variability of
returns
 Risk is measured by standard deviation of expected returns
 Standard deviation () is given by [variance]1/2
n
 Variance =  Pt [Rt – E(R)]2
t=1
Where Pt represents probability of each possible outcome; Rt
represents each possible return; E{R} represents expected
return.
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The Tradeoff Between
ER and Risk
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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
Making Investment Decisions on the
Basis of Expected Return and Risk
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Investors should choose dominant assets
Dominant Assets—assets that promise higher
expected return at any selected level of risk
or assets that promise minimum risk of all
assets at any selected level of expected
return.
Example of Dominant Assets
Example
Assets
M
B
C
A
E
T
Expected Return
10%
5%
5%
15%
15%
5%
Risk
10%
10%
20%
20%
30%
5%
Which of these assets is dominant over others? Which of these assets is not being
dominated by any other asset?
M
Return
A
15%
M
10%
5%
E
T
T
C
B
RISK
5%
10%
15%
20%
25%
30%
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A, M, and T are dominant investments
Which one would you choose and Why?
The Investment Decision Process
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Two-step process:
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Security analysis and valuation
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Necessary to understand security characteristics
Portfolio management
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Selected securities viewed as a single unit
How efficient are financial markets in processing new
information?
How and when should it be revised?
How should portfolio performance be measured?
Factors Affecting the Process
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Uncertainty in ex post returns dominates
decision process
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Future unknown and must be estimated
Foreign financial assets: opportunity to
enhance return or reduce risk
Quick adjustments needed to a changing
environment
The Internet and investment opportunities
Institutional investors important
Sources of Risk
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Interest Rate Risk
Purchasing Power Risk
Bull-Bear Market Risk
Default Risk
Liquidity Risk
Callability Risk
Convertibility Risk
Political Risk