Investments: Analysis
and Behavior
Chapter 1- Introduction
©2008 McGraw-Hill/Irwin
Learning Objectives





Learn the power of building wealth through investing
over time.
Understand the nature and performance of financial
assets.
Identify common objectives of investors.
Practice obtaining important financial information.
Become acquainted with job opportunities in the financial
services sector.
1-2
0
1
2
3
4
5
J an-0
J an-0
J an-0
J an-0
J an-0
J an-0
Oc t- 0
5
9
J an-9
Net New Cash Flow into Equity Mutual Funds ($ billions)
40
20
1200
1100
0
1000
-20
-60
S&P 500 Index Value
80
1600
1500
60
1400
1300
900
800
-40
700
600
1-3
Buy High, Sell Low?!

It is obvious that investors should buy low and
sell high in order to build wealth over time.


So why do investors frequently buy high and sell
low?
The investment process involves analytical
analysis of investment alternatives that are
filtered through a decision process that is
fraught with psychological biases.

To be a successful investor, you should be able to
use the analytical tools and control your emotions
and psychological biases!
1-4
Building Wealth
Recipe for success:
Start with some cash…
Earn a high rate of return…
Add lots of time…

How important are time and return?
1-5
Table 1.1
Compound Interest Leads to Amazing Growth
Over a 24-year period, a 9% return leads to twice the wealth of 6% returns, and 12% returns
almost quadruple the wealth generated by a 6% return.
Look What $10,000 Turns into
Number
With an Investment Return of:
of Years
6%
9%
12%
1
$10,600
$10,900
$11,200
2
11,236
11,881
12,544
3
11,910
12,950
14,049
4
12,625
14,116
15,735
6
14,185
16,771
19,738
8
15,938
19,926
24,760
12
20,122
28,127
38,960
16
25,404
39,703
61,304
20
32,071
56,044
96,463
24
40,489
79,111
151,786
28
51,117
111,671
238,839
32
64,534
157,633
375,817
36
81,473
222,512
591,356
40
102,857
314,094
930,510
(Note: Annual compounding is assumed.)
1-6
Asset Classes

Cash Reserves
 i.e.,
short-term money market instruments
 U.S. Treasury bills, Savings deposits, CDs
 Commercial Paper

Bonds
 Debt
obligations over one year
 Treasury Notes, Treasury Bonds, Municipal Bonds
 Corporate Bonds

Stocks
 Common
stock is ownership of a public corporation
1-7
Historical Returns of Stocks and Bonds

Stocks have earned an average return of
around 12% per year for the past 50
years.
 Depending

what index is used.
Long-term Treasury bonds have earned
around 6% per year.
 50%/50%
allocation to stocks/bonds would
average around 9%

But there is a lot of volatility!
1-8
Year
Stocks
Treasury
Treasury
(S&P 500)
Bonds
Bills
1970
4.0%
12.11%
6.5%
1990
-3.2%
6.18%
7.5%
1971
14.3%
13.23%
4.3%
1991
30.6%
19.30%
5.4%
1972
19.0%
5.69%
4.1%
1992
7.7%
8.05%
3.5%
1973
-14.7%
-1.11%
7.0%
1993
10.0%
18.24%
3.0%
1974
-26.5%
4.35%
7.9%
1994
1.3%
-7.77%
4.3%
1975
37.2%
9.20%
5.8%
1995
37.4%
31.67%
5.5%
1976
23.8%
16.75%
5.0%
1996
23.1%
-0.93%
5.0%
1977
-7.2%
-0.69%
5.3%
1997
33.4%
15.08%
5.1%
1978
6.6%
-1.18%
7.2%
1998
28.6%
13.52%
4.8%
1979
18.4%
-1.23%
10.0%
1999
21.0%
-8.74%
4.7%
1980
32.4%
-3.95%
11.5%
2000
-9.1%
20.11%
5.9%
1981
-4.9%
1.86%
14.0%
2001
-11.9%
4.56%
3.5%
1982
21.4%
40.36%
10.7%
2002
-22.1%
17.17%
1.6%
1983
22.5%
0.65%
8.6%
2003
28.7%
2.06%
1.0%
1984
6.3%
15.48%
9.6%
2004
10.9%
7.70%
1.4%
1985
32.2%
30.97%
7.5%
2005
4.9%
3.05%
3.1%
1986
18.5%
24.53%
6.0%
1987
5.2%
-2.71%
5.8%
1988
16.8%
9.67%
6.7%
Average
13.3%
6.4%
4.9%
1989
31.5%
18.11%
8.1%
Median
15.4%
3.6%
4.7%
1-9
Figure 1.3 Building Wealth by Investing in Stocks, Bonds and Treasury Bills (1950-present)
$6,000,000
Stocks:
$5,514,912
$5,000,000
Dollars
$4,000,000
$3,000,000
$2,000,000
$1,000,000
Bonds:
$249,020
T -bills:
$146,715
$0
1950
1955
1960
1965
1970
1975
1980
1985
1990
1995
2000
2005
Years
Data source: Council of Economic Advisors, Economic Report of the President, February 2006, and Lehman Brothers.
Start with $10,000 in each asset.
1-10
Investment Objectives

Why are you investing?
 Retirement,

down payment, vacation, …
Investment objectives are important.
 Matching
goal characteristics with investment
characteristics.
 Risk, return, time
1-11
Long-term Investing

Retirement plans from employers

Defined Benefit plans

Employer promise to pay a fixed
retirement income.
 Formula driven.
 Employer does all the work and
makes decisions

Defined Contribution plans

You save (tax deferred) from
paycheck.
 Employers may contribute too.
 You make all the decisions
 Benefit depends on contributions and
investment return.
1-12
The Long-term Payoff to Regular Investing
Can Be Huge
Young investors can accumulate significant wealth through regular investing of modest amounts. The
longer you wait to start investing, however, the greater the cost to building significant wealth.
Wealth Created With an
Amount Invested
Number
Investment Return of:
per Year
of Years
6%
9%
12%
Young Investor
$300
40
$46,429
$101,365
$230,127
$1,200
40
185,714
405,459
920,510
$2,000
40
309,524
675,765
1,534,183
$6,000
40
928,572
2,027,295
4,602,549
$12,000
40
1,857,144
4,054,589
9,205,097
$300
20
11,036
15,348
21,616
$1,200
20
44,143
61,392
86,463
$2,000
20
73,571
102,320
144,105
$6,000
20
220,714
306,961
432,315
$12,000
20
441,427
613,921
864,629
Middle-age Investor
1-13
Key Investment Concepts

A portfolio



Risk



Diversified (hopefully!) collection of
stocks, bonds and other assets.
Individual investments are often
evaluated on how they change the
characteristics of the portfolio.
Chance of economic loss.
Sometimes measured as a variation
in return.
Expected Return


Anticipated gain of a specific period
of time.
Often evaluated as compensation for
taking certain types of risks.
1-14
Efficient Market Hypothesis

Idea that every security at every point in
time is fairly priced.
 Implication

is that prices are unpredictable
Controversial
 Market
bubbles
 Most professional investors don’t beat the
market
 Investment superstars
 Hard to predict the direction of stock prices
1-15
Investment management performance

At any point in time, many
investment managers are
beating the market for the
month, quarter or year. A
couple years later, most of
these managers are no
longer performing so well.


Regression to the mean
Superstar exceptions



Warren Buffett
Peter Lynch
Sir John Templeton
1-16
Valuing Assets – future value

Future Value
Future value = Present sum × (1 + Interest rate)t
The future value of a $5,000 investment earning
8% interest over a period of 15 years is
future value = $5,000 × (1 + 0.08)15 = $15,861
N
15
I/Y
8
PV
-5,000
PMT FV
0
|
CPT FV = $15,860.85
1-17
Valuing Assets – present value

Future sum
Present Value
Present value = 1  Interest rate t
The present value of a $15,860 to be received
in 15 years with an 8% rate of return is
$15,860
present value = 1  0.0815 = $5,000
N
15
I/Y
8
PV
PMT FV
|
0
15,860
CPT PV = -$5,000
1-18
Valuing Assets – payments
Future value = Payment  1  interest
rate  - 1
interest rate
t
t


1

interest
rate
-1
Present value = Payment 
t
interest rate  1  interest rate 
Over the next 30 years, an employee contributes
$3,000 per year to an investment expected to earn 9%
per year. After 30 years, the employee will have:
future value =
N
30
I/Y
9
30

1  0.09  - 1
$3000 
0.09
PV
PMT FV
0
-3000 |
CPT PV = $408,923
= $408,923
1-19
Compound Frequency

Mortgages and auto loans use monthly
payments and compounding
 Dividends
paid quarterly
 Bonds pay semi-annually

Adjust the number of periods and rate
What is the future value of a $1,000 investment 3 years from
now if it receives a 9% annual return compounded (A) annually,
(B) quarterly, and (C) continuously?
Solution:
(A) Future value = $1,000 X (1 + 0.09)3 = $1,295
(B) Future value = $1,000 X (1 + 0.0225)12 = $1,306
(C) Future value = $1,000 X e0.09x3 = $1,310
1-20
Behavior is important too

Incentives
 Stockbroker
and
commissions
 Mutual fund incentives

Psychology
 The
higher the degree of uncertainty
in a decision, the more emotions and
psychological biases are used to
help make the decision.
1-21
Getting information - Newspapers
Barron’s
http://www.barrons.com/
Biting market commentary once a
week, portfolio analysis and
databank.
Investor’s Business Daily
http://www.investors.com/default.asp
Founder William O’Neal dispenses
stock picking, charting, and
momentum strategies. Big on
investor education.
The Wall Street Journal
http://online.wsj.com/home/us
The daily paper when it comes to
financial news and
information. Print subscribers
get interactive access at a
bargain price.
USA Today
http://www.usatoday.com/money/front.
htm
Don’t underestimate “McPaper’s”
Money Section when it comes
to business, economic, and
financial news. It’s terrific!
1-22
Getting information - Magazines
Business Week
http://businessweek.com/index.html
Timely business news and analysis,
useful business school, career and
small business information.
The Economist
http://www.economist.com/
Offers analysis and opinion on the
business and political events of
the week.
Forbes
http://forbes.com/
Terrific commentary on economics
and financial markets from an allstar stable of regular columnists.
Fortune
http://www.fortune.com/fortune
Famous for Fortune 500 company list.
Interesting advice on career
development.
Kiplinger's Personal Finance
http://www.kiplinger.com
Provides practical guidance on saving,
investing, planning for
retirement, and major purchases.
Money
http://money.cnn.com/
Interesting market commentary,
company and mutual fund
analysis aimed at novice
investors.
Smart Money
http://www.smartmoney.com/
Serves the need for personal finance
information for affluent,
sophisticated, professional, and
managerial Americans.
1-23
Getting information - Online
CBS MarketWatch
http://cbs.marketwatch.com
Focused on financial news and
information. Individual investors
can find news, commentary,
advice, and stock price
information.
The Motley Fool
www.fool.com
An online forum designed to "educate,
amuse and enrich investors." A
constant stream of witty
investment advice on active
message boards.
MSN Money
http://moneycentral.msn.com/home.asp
Investing highlights for customized
portfolios, market reports, mutual
fund directory, retirement and
personal finance.
TheStreet.com
www.thestreet.com
A full menu of stock analysis, market
commentary, and biting satire.
U.S. Securities and Exchange
Commission
http://www.sec.gov/
This is the place to find free access to
official SEC filings by individual
companies, obrain information
about individual brokers, or file a
complaint about shady business
practices
Yahoo! Finance
http://finance.yahoo.com/
A terrific web site with U.S. markets,
world markets, quotes, financial
news, and data.
1-24
Investment Industry Jobs


Jobs






Brokers
Traders
Portfolio managers
Financial planners
Investment bankers
Security analysts
Working at









Commercial banks
Savings and credit unions
Securities firms
Investment banks
Companies
Credit rating agencies
Mutual funds
Life insurance companies
Securities exchanges
1-25
Objectives of the course and text




Develop a clear understanding of the many useful
and practical implications of financial theory.
Understand how the incentives of various market
participants influence investor decisions and also
highlight the impact of a person’s own psychology.
Acquire a framework for understanding the returns
on all financial assets, including stocks, bonds and
financial derivatives.
Gain familiarity with the institutions and language of
Wall Street so as to facilitate the development of an
effective personal investment strategy.
1-26