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Chapter 1. THE INVESTMENT SETTING. Chapter 1 Questions. What is an investment ? What are the components of the required rate of return on an investment? What key issues should investors always consider? What types of investments can one make?. Chapter 1 Questions. - PowerPoint PPT Presentation
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Chapter 1
THE INVESTMENT SETTING
Chapter 1 QuestionsWhat is an investment ?What are the components of the required rate of return on an investment?What key issues should investors always consider?What types of investments can one make?
Chapter 1 QuestionsWhere do U.S. investors place funds for investment and savings purposes?What are some basic investment philosophies that individual and institutional investors follow?Why are ethics and regulations a concern to all investment professionals?What are some career paths available for persons interested in investments?
What is an investment ?An investment is the current commitment
of resources for a period of time in the expectation of receiving future resources greater than the current outlay.
What is an investment ?Is hiding money in a
mattress or keeping it in a piggy bank an investment ?
No! The “safe-keeping” of money does not involve any expected compensation.
What is an investment ?How about baseball cards or Beanie Babies? Are they an investment?Possibly, but compensation is highly uncertain, and some of the value of ownership may be “sentimental” rather than financial in nature.
Components Of The Required Rate of ReturnIn order to part with their money, investors require compensation for: the time resources are committed the expected rate of inflation the uncertainty of the future payments
Compensation for time:The real risk-free rate of interest is the exchange rate between future consumption and present consumption. This rate of interest can be thought of as the “pure” rental rate on money in the absence of inflation and risk.
Why is the real risk-free rate positive?
Borrowers are willing to pay to be able to spend more than their current resources allow.Savers need compensation in order to give up the right to consume today.
Compensation for expected inflation:
If the future payment will be diminished in value because of inflation, then investors will demand an interest rate higher than the real risk-free interest rate so that their expected purchasing power will actually increase.
Compensation for the time value of money:
The nominal risk-free rate of interest adjusts the real risk-free rate to reflect expected inflation over the life of the investment.Taking into account these two factors (time and expected inflation) compensates investors for the “time value” of their money.
Compensation for risk-bearing:
Investors tend to be risk-averse, meaning that they need sufficient expected additional compensation in order to bear additional risk.If the future payment from an investment is uncertain, investors will demand an interest rate that exceeds the nominal risk-free rate of interest to provide a risk premium.
The Required Rate of Return
The sum of the nominal risk-free interest rate and the risk premium on an investment gives that investment’s required rate of return.Note that for riskier investments, the risk premium, and therefore the required rate of return, will be higher than for lower risk investments.
Issues That Investors Should Always ConsiderThere is a trade-off between risk and expected return.Developed financial markets are nearly efficient.Focus on after-tax returns, net of expenses.Diversify across asset types, industries, and even countries.
Risk-Return Trade-OffBecause investors tend to be risk averse,
it makes sense that they will only take on riskier investments if they expect to earn more than with lower risk investments.
Market EfficiencyAn efficient market is one where … Information is quickly and accurately reflected in
asset prices,So … What appears to be “news” is not useful in
predicting future asset prices,With the result that … Investors cannot systematically and consistently
“beat the market” without the aid of either inside information or loads of luck.
Implications of Market Efficiency
It’s what is unexpected that moves the market (the genuinely new information in news).We should be skeptical of investment strategies that claim to be able to beat the market on a consistent basis.
The Paradox of Market Efficiency
If markets are perfectly efficient, it makes no sense to seek out superior investments.But if nobody seeks out superior investments, the market would not remain efficient!
Take Taxes and Expenses Into Account
It’s what you get to keep that counts!Taxes affect investment decisionsSome allow for lower or no tax burden
(Municipal bonds)Some allow for deferral of tax liability
(IRA’s)
Take Taxes and Expenses Into Account
Since financial markets are “nearly” efficient, even large investors generally do not beat the market, but that does not mean that they do not generate lots of expenses in trying to!Avoid high expense investments when
possible since they tend to reduce “net” return without increasing “gross” return.
Diversify, Diversify, Diversify
Don’t put all of your eggs in one basket!Diversification reduces risk without necessarily sacrificing expected return.It’s a no-brainer!
What types of investments can one make?
Real assets vs. Financial assetsTangible assets vs. Claims on assets
Direct vs. Indirect financial investments Individual securities vs. “pools” of assets
DerivativesFutures, options
Where do U.S. households invest?
All over the map!But in recent years, there has been a shift toward longer term investing through retirement accounts, mutual funds, and stocks.
Basic Investment Philosophies
In forming an investment portfolio, several questions are paramount:In what types of securities should I invest? Asset Allocation
Within each security type, how do I select which assets to purchase? Security Selection
Finally, how active should I manage my portfolio? Should I be an active or passive investor?
Summarizing the Basic Strategies
Asset Allocation
Security Selection
Active Market timing Stock picking
Passive Maintain pre-determined allocation(s)
Try to track a well-known market index
Ethics in InvestmentsFinancial markets are vitally important to a well-functioning economy.Trust in information and faith in fairness are essential.Codes of ethics for financial professionals and strict regulations attempt to create such an environment where financial markets can efficiently fulfill their economic function.
Jobs in InvestmentsSales Registered representative of a brokerage firm Financial planners
Investment Analysis and Portfolio Management Brokerage firms, banks, money managers, mutual
fund managers, insurance companiesProfessional Designations Chartered Financial Analyst (CFA) Certified Financial Planner (CFP)