Chapter 1 THE INVESTMENT SETTING 1.2 Investments Chapter 1 Chapter 1 Questions What is an investment ? What are the components of the required rate of

Chapter 1Chapter 1

THE INVESTMENT SETTING

1.2Investments Chapter 1

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 we make? Where do 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 that will compensate the investor for:the time resources are committedthe expected rate of inflationthe uncertainty of future payments



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.



How about baseball cards? 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 Return

In order to defer consumption, investors need compensation from three sourcesthe pure or real interest rate (Real risk free rate )inflation protectionrisk


The real interest rate : 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.

Question: if some one want to borrow 100 $ for a year form you, how much do you want received after a year? Suppose there is no inflation, no 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.


Inflation Protection

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.


example

1970-2001年，美国平均通货膨胀率 5％中国

全国居民消费价格总水平比上年上涨

2004 年 3.9% 2003 年 1.2% 2002 年 0.8% 2001 年 0.7% 2000 年 0.4% 1999 年 1.4% 1998 年 0.8%



Use the former example, If you expected the inflation rate is 2% in the come

year, how much do you want to be paid after a year?


Combining the Real Rate and Expected Inflation 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.

Use the same example, If there is some risk in the investment, and you need 3% risk

premium, then how much do you want be paid?


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 Consider There 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-Off

Because 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 Efficiency

An 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 decisions

Some allow for lower or no tax burden (Municipal bonds)

Some allow for deferral of tax liability (IRA’s)

Lets look an example:Mary and John each invest $2,000 for 25 years in a mutual fund account that earns over time an average annual 10 percent return on a pre-tax basis. After income and capital gains tax, an investor’s annual return could be only 8%. Mary’s money is invested in tax-defferred IRA; John invested in the fund through a taxable account. How much do they get actually after 25 years.


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!


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The Financial Environment: Market Participants

Households: net savers (investors) Federal Government: net borrower Businesses: issuers of investment securities such

as stocks and bonds


The Financial Environment: Types of Investments

Real assets vs. Financial assetsTangible assets vs. Claims on assets

Direct vs. Indirect financial investmentsIndividual securities vs. “pools” of assets

DerivativesFutures, options


The Financial Environment: Primary and Secondary Markets

When issuers of securities raise money through selling new securities, often with the assistance of investment bankers or financial intermediaries, these are primary market transactions

Investors trade among themselves in secondary markets, often with the assistance of brokers or dealers


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 Investments

Financial 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 Investments

Registered Representative of a Brokerage Firm Investment Analysis Portfolio Management Financial Planning Corporations Professional Designations

Chartered Financial Analyst (CFA)Certified Financial Planner (CFP)

Documents

Chapter 1 THE INVESTMENT SETTING 1.2 Investments Chapter 1 Chapter 1 Questions What is an investment ? What are the components of the required rate of