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Introduction to Investments (Chapter 1) MB 72 Outline What is meant by “Investment”? Why do individuals invest? Measuring Risk and Return Sources of Risk Relationship between Risk and Return Meaning of Investments 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 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? 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? The Personal Aspects 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 To become a licensed broker (series 7 exam), to become CFA/CFP/CMA, knowledge of investments is needed Basis of Investment Decisions Basic element of all investment decisions: trade-off between expected return and risk Expected return is not usually the same as realized return Measuring Return on Investments Measures of Actual Return/Historical Return/Realized Return Holding Period Return (HPR) 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 = [HPR1HPR2 … HPRn]1/n – 1 Which measure gives us a better estimate of the wealth effect of an investment? Expected Return 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. 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 Making Investment Decisions on the Basis of Expected Return and Risk 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% A, M, and T are dominant investments Which one would you choose and Why? The Investment Decision Process Two-step process: Security analysis and valuation Necessary to understand security characteristics Portfolio management 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 Uncertainty in ex post returns dominates decision process 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 Interest Rate Risk Purchasing Power Risk Bull-Bear Market Risk Default Risk Liquidity Risk Callability Risk Convertibility Risk Political Risk