Chapter
1
Investments:
Introduction
Bodie, Kane, and Marcus
Essentials of Investments
12th Edition
Investments – Learning Objectives
• What is an investment?
• Describe the function of financial markets
• Relationship between risk and return
• Identify major steps in portfolio construction
• Introduce the concept of efficient markets
• Investment valuation
Copyright © 2019 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education.
2
Assets, Liabilities, Net Worth
• Real Assets = Land, Buildings, Equipment
• Financial Assets = Investments
• Liabilities = Mortgages, Loans
• Net Worth = Assets - Liabilities
Copyright © 2019 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education.
3
Table 1.1 Balance Sheet, U.S. Households, 2019
Copyright © 2019 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education.
4
What is an investment?
• Definition of Investment: Current commitment
of money or other resources (risk) with
expectation of future benefit (return).
• Types of Investments
• Debt
• Bonds, Money Market Accts, Savings
• Equity
• Common stock, Preferred stock
• Derivatives
• Options, Futures, Swaps
Copyright © 2019 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education.
5
1.3 Financial Markets and the Economy
Financial markets are used to
• Allocate capital
• Matching of buyers and sellers
• Setting security prices
• Allocate risk
• Risk takers
• Risk averse investors
Copyright © 2019 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education.
6
1.3 Financial Markets and the Economy
• Risk Allocation
• Concept of Risk and Return
• In general, earning greater returns requires
taking greater risk
• Investors seeking greater returns are generally
required to take greater risk
• Investors only willing to accept lower risk, must
generally accept lower returns
Copyright © 2019 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education.
7
1.4 The Investment Process
• Asset Allocation (Asset classes)
• Huge effect on expected return
• Often first step of investment strategy
• Based on investor’s “appetite” for risk
• Allocates percentage of invested dollars to
various types or classes of assets
• “Top-down” portfolio construction begins with
asset allocation
Copyright © 2019 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education.
8
1.4 The Investment Process
• Example portfolio allocations:
10%
Equity
30%
60%
25%
25%
Bonds
Cash
50%
Copyright © 2019 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education.
9
1.4 The Investment Process
• Security Selection
• Picking specific securities within asset class
• Security analysis
• Analysis of security value
• Fundamental analysis
• Technical analysis
• “Bottom-up” portfolio construction involves
security selection
Copyright © 2019 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education.
10
Efficient Markets
• Risk Return Trade-off
• How much risk are you willing to take?
• How is risk measured?
• What affects risk?
• Diversification
• Other factors
• How much return is required?
• How do you know how much you’ll earn on an
investment?
Copyright © 2019 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education.
11
Efficient Markets
• If markets were perfectly efficient:
• All information would be immediately available to
investors and reflected in security prices
• Securities would be efficiently priced:
• Not over-priced
• Not under-priced
• Real markets are rarely, if ever, perfectly efficient
• Your belief in the level of market efficiency should
influence your investment style
• Active portfolio management
• Passive portfolio management
Copyright © 2019 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education.
12
Efficient Markets
Markets are…
Security Selection:
Asset Allocation
Active
Management
Passive
Management
Inefficient
Efficient
Actively Seek
Undervalued
Stocks
No Attempt to Find
Undervalued
Securities
Market Timing
No Attempt to
Time Market
Copyright © 2019 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education.
13
1.6 Financial Market Economics
Price of Capital
Who Demands Capital?
Sellers/Borrowers
Who Supplies Capital?
Buyers/Lenders
Quantity of Capital
Copyright © 2019 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education.
14
1.6 The Players
• Business Firms (generally borrowers)
• Can be lenders
• Households (generally lenders/net savers)
• Often borrowers
• Intermediaries (connectors of borrowers
and lenders)
• Commercial Banks
• Investment Managers
• Insurance Companies
• Pension Funds
Copyright © 2019 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education.
15
1.6 The Players: Some others
• Investment Banks
•
•
•
•
Originally created as result of Great Depression
Primary market for securities
Secondary market for securities
Industry significantly altered as result of 2008-09
Financial Crisis
• Venture Capital and Private Equity
• Venture capitalists – generally provide equity
investment to finance new firms
• Private equity – generally make investments in
privately-held companies
Copyright © 2019 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education.
16
1.6 The Players: New Guys
• Direct Public Offerings
• Offering of shares directly to investors without going
through an underwriter
• Spotify
• Slack
• Electronic Trading Platforms
• E-Trade
• Schwab
• Robinhood
• Crypto-exchanges
• Binance
• Coinbase
Copyright © 2019 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education.
17