Understanding
Investments
CHAPTER 1
Objectives
To understand the investments field as currently practiced
To help you make investment decisions that will enhance your economic
welfare
To create realistic expectations about the outcome of investment
decisions
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What is investments
Investment: The commitment of funds to one or more assets that will be held
over some future period
Investments is the study of process of committing funds to one or more assets
Investments is concerned with the management of an investor’s wealth, which
is the sum of current income and the present value of all future income
Financial assets and Real assets
Financial assets are paper (or electronic) claims on some issuer, such as the
federal government or a corporation
Certificates of deposits
Bonds
Stocks
Or funds
Real assets: real assets are tangible, physical assets such as gold, silver,
diamonds, art, and real estate
Marketable securities
Securities? Fungible, negotiable financial instrument that holds some type of
monetary value
Marketable securities are financial assets that are easily and cheaply tradable in
organized Markets
What are examples of marketable securities?
Examples of non marketable securities?
U.S. savings bonds,
Why there is a need to invest?
Bob video!
Investors seek to manage their wealth effectively, obtaining the most from it while protecting it
from inflation, taxes, and other factors.
What do you require for investment?
Funds to be invested come from assets already owned, borrowed money, and savings or
foregone consumption.
By foregoing consumption today and investing the savings, investors expect to enhance their
future consumption possibilities by increasing their wealth.
TAKE A PORTFOLIO PERSPECTIVE
Investors invest in an “optimal combination”
Optimal combination is important because our wealth, which we hold in the
form of various assets, should be evaluated and managed as a unified whole
Wealth should be evaluated and managed within the context of a portfolio,
which consists of the asset holdings of an investor.
Like a combination of bonds and stocks
Why Study Investments
Most individuals make investment decisions sometime
◦ Need sound framework for managing and increasing wealth
Essential part of a career in the field
◦ Security analyst, portfolio manager, registered representative, Certified
Financial Planner, stock brokers and financial advisors
Understanding the investment decision
process (Risk and Return)
The reason for investing to generate Return
Cash as the opportunity cost of forgone return
Inflation diminishes the purchasing power
Expected Return vs. Realized Return
Expected Return: The anticipated return for some future period
Realized return: The actual return over some past period
Investors invest for the future—for the returns they expect to earn—but when the investing
period is over, they are left with their realized returns.
Expected Return is not usually the same as realized return
Risk
Risk: The possibility that the realized return will be different than the expected
return
Investors are Risk-Averse!
It is easy to say that investors dislike risk, but more precisely, we should say that
investors are risk-averse
A risk-averse investor will not
assume risk simply for its own sake a
incur any given level of risk unless there is an expectation of adequate
compensation for having done so.
Investor’s Risk Tolerance
Investors deal with risk by choosing the amount of risk they are willing to incur—
that is, they decide their risk tolerance.
Can we say that investors, in general, will choose to minimize their risks?
The expected Risk Return Tradeoff
This tradeoff always slopes upward, because the vertical axis is expected return,
and rational investors will not assume more risk unless they expect to be
compensated.
Ex Post vs. Ex Ante
Risk-return tradeoff depicted in Figure is ex ante, meaning “before the fact.”
Ex post means “after the fact”
For a given period, the tradeoff may turn out to be flat or even negative.
Structuring the decision process
Two step Process
1) Security Analysis - valuation and analysis of individual securities
Value is a function of the expected future returns on a security and the risk
attached.
2) 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?
Other considerations
Foreign financial assets: opportunity to enhance return or reduce risk
The Internet and investment opportunities
Regulation of Fair Disclosure (FD)
Ethical Practices