FIN 352 Investments (Sp 2024)
Instructor: Dr. Chang
Chapter 1 Introduction to Investments
Lecture Outline (Week 1)
Investments?
1. How can investors build wealth over time?
2. The investment process involves analytical analysis of investment alternatives.
(a) Do your due diligence and use the analytical tools.
(b) Control your emotions and psychological biases.
3. The investment process consists of two broad tasks:
(a) Security (micro) analysis.
(b) Market (macro) analysis.
Investments as a profession
Exhibit 1-1 (p. 7): Professional Designations held by financial advisors and planners
1. Investment bankers and traders
2. Security analysts and portfolio managers
3. Stockbrokers and financial advisors
Financial Assets vs. Real Assets
1. Financial assets:
(a) Financial claims on the issuers of the securities
(b) Marketable securities are financial assets that are easily and cheaply tradable in organized
markets.
(c) What are three categories of securities?
(1) Equity securities
(2) Debt securities
(3) Derivative securities
2. Real assets:
(a) Tangible, physical assets
(b) Examples such as gold, silver, diamonds, art, and real estate.
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The Basis of Investment Decisions
1. Return on investment
2. Risk involved with this investment
Return 101
1. The rate of return (Ri) is what you earn on an investment over a time period.
(a) The return is usually stated in percentage terms.
(b) The rate of return on an asset over a period is also known as (a.k.a.) total return (TR) or holding
period return (HPR).
(c) The return can represent growth in wealth and purchasing power.
2. The quantitative measure of return consists of two components:
(a) The income component of a return arises from income that an investor receives from the asset
while he or she owns it.
e.g.,
(1) What is the term that describes an income component from stock investments?
(2) What is the term that describes an income component from bond investments?
(3) What is the term that describes an income component from real estate investments?
(b) The capital appreciation component of a return arises from a change in the price of the asset over
the holding period.
(1) Capital gain is often used to mean realized capital gain. An unrealized capital gain is an
investment that hasn't been sold yet but would result in a profit if sold.
(2) If the price of the security rises above what we paid for, we have a capital _______________.
(3) If the price of the security drops below what we paid for, we have a capital _______________.
3. Equation:
Dollar gains
Cash flow+Capital Appreciation CF1 +(P1 −P0 )
CF1 +∆P
CF1
∆P
Ri =
=
=
=
=
+
P
Initial Price
P
P
P
P
0
(a)
(b)
(c)
(d)
0
0
0
0
Ri = the holding period return over the period
CF1 = the cash flow from the dividend (or the cash received from the investment)
P1 = the price of the asset at a later point in time
P0 = the price of the asset at time zero
4. Assume you bought one stock at $10 (P0) and sold at $13 (P0) in a year. You also received a $1
dividend on this stock. What is your return on this investment?
5. Two types of returns:
(a) Actual return (AR)
(b) Expected return (ER)
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Actual Return (AR)
1. Realized/actual return on an investment for some previous period of time.
2. The AR is also known as the ex post return. Note that ex post means “___________ the fact” or
when it is known what has occurred.
3. The realized return on any risky asset will often differ from what was expected—sometimes
quite dramatically.
4. A standard disclaimer for investments: “Past performance does NOT guarantee future
results.”
Expected Return on Security = E(Ri)
1. The anticipated rate of return on an investment for some future period of time.
(a) The rate of return expected by investors over some future holding period.
(b) The expected return is also known as the ex ante return. Note that ex ante means “________ the
fact.”
2. The expected return is a weighted average of the possible returns from an investment, where
each of these returns is weighted by the probability that it will occur.
(a) The single most likely outcome from a particular probability distribution
(b) Expected value = most likely value = mean = an average of the possible returns from an
investment
Risk 101
1. Risk serves as a measure of how certain you are that you will receive a particular return.
(a) Assets that generate very certain returns are considered ____________-risk.
(b) Assets that generate very uncertain returns are considered ____________-risk.
(c) The more uncertain the return from an asset, therefore the _________ risky.
(d) If you have two choices: investment in stocks and putting in savings account, which is
considered low-risk?
2. Risk is defined as the uncertainty regarding the variability of returns associated with a given
asset.
(a) Risk is inherent in an investment, and uncertainty always surrounds investing decisions.
(b) The more uncertain the return from an asset, the higher the variability, and therefore the greater
the risk will be associated with this asset.
3. Risk is the chance that the actual return (or outcome) is different from the expected return (or
outcome). Specifically, most investors are concerned that the actual outcome will be less than
the expected outcome.
(a) As a result, risk is the chance that an expected return may not be realized.
(b) Risk represents the quantifiable likelihood of loss or less-than-expected return.
(c) Although investors may receive their expected returns on risky securities on a long-run average
basis, they often fail to do so on a short-run basis. It is a fact of investing life that realized
returns often differ from expected returns.
4. The wider the range of possible returns that can occur, the higher the risk.
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FIN 352 Figure 6-1 (p. 152) Graph of Spread in Returns for Major Asset Classes for the Period 1926-2014
5. Please answer the following questions:
FIN 352 Figure 6-1 (p. 152) Graph of Spread in Returns for Major Asset Classes for the Period 1926-2014.
(a) Which type of securities is expected to offer the highest return?
(b) Which type of securities is subject to the highest risk?
(c) Check your knowledge:
(1) What is the long-term average return for the S&P 500 index?
(2) What was the return in 2022 and 2023, respectively?
Year
Average Return
(100 years)
2022
2023
Return
(3) What is the year-to-date (YTD) return this year?
Sources:
Historical Average Stock Market Returns for S&P 500 (5-year to 150-year averages) - Trade
That Swing, https://tradethatswing.com/average-historical-stock-market-returns-for-sp-500-5-year-up-to-150-yearaverages/#:~:text=The%20average%20yearly%20return%20of%20the%20S%26P%20500,average%20stock%20market%20r
eturn%20%28including%20dividends%29%20is%206.99%25.
-
“Visualizing 150 Years of S&P 500 Returns” at https://www.visualcapitalist.com/150-yearsof-sp-500-historical-returns/
-
https://www.google.com/finance/
(d) Stocks offer higher return potential, along with more volatility, while bonds have less upside but
provide interest payments.
6. Useful quotes about risk:
o
“When we take a risk, we are betting on an outcome that will result from a decision we have
made, though we do not know for certain what the outcome will be.” Peter L. Berstein, Against
the Gods: The Remarkable Story of Risk.
o
“Risk is a fact of life, but it’s also the cornerstone of human progress.”
Trade-off between Expected Return and Risk 101
1. The rate of return that investors require for an investment depends on the risk associated with
that investment.
FIN 352: Table 6.6 (p. 156) Annual total returns for major assets for 85 years
(a) Long-term bonds are expected to pay _______ interest rates than Treasury bills or money market
funds.
(b) Stocks are expected to provide _______ returns than bonds.
2. The greater the risk, the higher the return investors require a compensation for bearing that
risk.
(a) Because investors are aware of higher risk, they demand compensation in the form of
_____________ expected return.
(b) Investors should be willing to purchase a particular asset if the expected return is adequate to
compensate for the risk, but they must understand that their expectation about the asset’s return
may not materialize.
3. Any level of expected return and risk can be attained.
FIN 352 Figure 1.1 (p.11) The expected return-risk trade-off available to investors.
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(a) The tradeoff always slopes upward because rational investors will not assume more risk unless
they expect to be compensated.
(b) The required return increases for an increase in risk.
(c) The risk-free rate of return (Rf) is the return on a riskless asset, often proxied by the rate of return
on Treasury securities.
(d) Are there costs of minimizing the risk?
Two-Step Process of Investment Decisions
1. Valuation and analysis of individual securities
2. Portfolio management
(a) Construct a portfolio with stocks, bonds, and other assets.
(b) Revise the portfolio on a continuous basis.
[The END of the first chapter!]
Picture yourself sitting in a pleasant classroom.
Visualize yourself learning financial knowledge that helps your career and your personal finance.
The spring always passes too quickly, but every July holds the promise of a fresh start.
Let’s enjoy learning investments in this summer session.
Cheers,
Dr. Chang
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