Chapter 1Chapter 1

THE INVESTMENT SETTINGTHE INVESTMENT SETTING

Chapter 1 QuestionsChapter 1 Questions

•• What is an investment ?What is an investment ?•• What are the components of the What are the components of the

required rate of return on an required rate of return on an investment?investment?

•• What key issues should investors What key issues should investors always consider?always consider?

•• What types of investments can we What types of investments can we make?make?

Chapter 1 QuestionsChapter 1 Questions

•• Where do U.S. investors place funds for Where do U.S. investors place funds for investment and savings purposes?investment and savings purposes?

•• What are some basic investment What are some basic investment philosophies that individual and institutional philosophies that individual and institutional investors follow?investors follow?

•• Why are ethics and regulations a concern to Why are ethics and regulations a concern to all investment professionals?all investment professionals?

•• What are some career paths available for What are some career paths available for persons interested in investments? persons interested in investments?

What is an investment ?What is an investment ?

•• An investment is the current An investment is the current commitment of resources for a period of commitment of resources for a period of time in the expectation of receiving time in the expectation of receiving future resources that will compensate future resources that will compensate the investor for:the investor for:–– the time resources are committedthe time resources are committed–– the expected rate of inflationthe expected rate of inflation–– the uncertainty of future paymentsthe uncertainty of future payments

What is an investment ?What is an investment ?

Is hiding money in a Is hiding money in a mattress or keeping mattress or keeping it in a piggy bank an it in a piggy bank an investment ? investment ?

No! The No! The ““safesafe-- keepingkeeping”” of money of money does not involve any does not involve any expected expected compensation.compensation.

What is an investment ?What is an investment ?

•• How about baseball How about baseball cards? Are they an cards? Are they an investment?investment?

•• Possibly, but Possibly, but compensation is highly compensation is highly uncertain, and some of uncertain, and some of the value of ownership the value of ownership may be may be ““sentimentalsentimental”” rather than financial in rather than financial in nature.nature.

Components Of The Required Components Of The Required Rate of ReturnRate of Return

•• In order to defer consumption, investors In order to defer consumption, investors need compensation from three sourcesneed compensation from three sources–– the pure or real interest ratethe pure or real interest rate–– inflation protectioninflation protection–– riskrisk

The real interest rate : The real interest rate : Compensation for timeCompensation for time

•• The real riskThe real risk--free rate of free rate of interest is the exchange interest is the exchange rate between future rate between future consumption and consumption and present consumption. present consumption.

•• This rate of interest can This rate of interest can be thought of as the be thought of as the ““purepure”” rental rate on rental rate on money in the absence money in the absence of inflation and risk.of inflation and risk.

Why is the real riskWhy is the real risk--free rate free rate positive?positive?

•• Borrowers are Borrowers are willing to pay to be willing to pay to be able to spend more able to spend more than their current than their current resources allow.resources allow.

•• Savers need Savers need compensation in compensation in order to give up the order to give up the right to consume right to consume today.today.

Inflation ProtectionInflation Protection

If the future payment will be diminished in If the future payment will be diminished in value because of inflation, then value because of inflation, then investors will demand an interest rate investors will demand an interest rate higher than the real riskhigher than the real risk--free interest free interest rate so that their expected purchasing rate so that their expected purchasing power will actually increase.power will actually increase.

Combining the Real Rate and Combining the Real Rate and Expected InflationExpected Inflation

•• The nominal riskThe nominal risk--free rate of interest free rate of interest adjusts the real riskadjusts the real risk--free rate to reflect free rate to reflect expected inflation over the life of the expected inflation over the life of the investment.investment.

•• Taking into account these two factors Taking into account these two factors (time and expected inflation) (time and expected inflation) compensates investors for the compensates investors for the ““time time valuevalue”” of their money.of their money.

Compensation for RiskCompensation for Risk-- bearingbearing

•• Investors tend to be riskInvestors tend to be risk--averse, meaning averse, meaning that they need sufficient expected additional that they need sufficient expected additional compensation in order to bear additional risk.compensation in order to bear additional risk.

•• If the future payment from an investment is If the future payment from an investment is uncertain, investors will demand an interest uncertain, investors will demand an interest rate that exceeds the nominal riskrate that exceeds the nominal risk--free rate of free rate of interest to provide a risk premium.interest to provide a risk premium.

The Required Rate of ReturnThe Required Rate of Return

•• The sum of the nominal riskThe sum of the nominal risk--free free interest rate and the risk premium on an interest rate and the risk premium on an investment gives that investmentinvestment gives that investment’’s s required rate of return.required rate of return.

•• Note that for riskier investments, the Note that for riskier investments, the risk premium, and therefore the risk premium, and therefore the required rate of return, will be higher required rate of return, will be higher than for lower risk investments.than for lower risk investments.

Issues That Investors Should Issues That Investors Should Always ConsiderAlways Consider

•• There is a tradeThere is a trade--off between risk and off between risk and expected return.expected return.

•• Developed financial markets are nearly Developed financial markets are nearly efficient.efficient.

•• Focus on afterFocus on after--tax returns, net of tax returns, net of expenses.expenses.

•• Diversify across asset types, industries, Diversify across asset types, industries, and even countries.and even countries.

RiskRisk--Return TradeReturn Trade--OffOff

Because investors tend to be risk averse, Because investors tend to be risk averse, it makes sense that they will only take it makes sense that they will only take on riskier investments if they expect to on riskier investments if they expect to earn more than with lower risk earn more than with lower risk investments. investments.

Market EfficiencyMarket Efficiency

•• An efficient market is one where An efficient market is one where ……–– Information is quickly and accurately reflected in Information is quickly and accurately reflected in

asset prices,asset prices,•• So So ……

–– What appears to be What appears to be ““newsnews”” is not useful in is not useful in predicting future asset prices,predicting future asset prices,

•• With the result that With the result that ……–– Investors cannot systematically and consistently Investors cannot systematically and consistently

““beat the marketbeat the market”” without the aid of either inside without the aid of either inside information or loads of luck.information or loads of luck.

Implications of Market Implications of Market EfficiencyEfficiency

•• ItIt’’s what is unexpected that moves the s what is unexpected that moves the market (the genuinely market (the genuinely newnew information information in in newsnews).).

•• We should be skeptical of investment We should be skeptical of investment strategies that claim to be able to beat strategies that claim to be able to beat the market on a consistent basis.the market on a consistent basis.

The Paradox of Market The Paradox of Market EfficiencyEfficiency

•• If markets are If markets are perfectly efficient, it perfectly efficient, it makes no sense to makes no sense to seek out superior seek out superior investments.investments.

•• But if nobody seeks But if nobody seeks out superior out superior investments, the investments, the market would not market would not remain efficient!remain efficient!

Take Taxes and Expenses Into Take Taxes and Expenses Into AccountAccount

•• ItIt’’s what you get to keep that counts!s what you get to keep that counts!•• Taxes affect investment decisionsTaxes affect investment decisions

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

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

Take Taxes and Expenses Into Take Taxes and Expenses Into AccountAccount

•• Since financial markets are Since financial markets are ““nearlynearly”” efficient, even large investors generally efficient, even large investors generally do not beat the market, but that does do not beat the market, but that does not mean that they do not generate lots not mean that they do not generate lots of expenses in trying to!of expenses in trying to!–– Avoid high expense investments when Avoid high expense investments when

possible since they tend to reduce possible since they tend to reduce ““netnet”” return without increasing return without increasing ““grossgross”” return.return.

Diversify, Diversify, DiversifyDiversify, Diversify, Diversify

•• DonDon’’t put all of your t put all of your eggs in one basket!eggs in one basket!

•• Diversification Diversification reduces risk without reduces risk without necessarily necessarily sacrificing expected sacrificing expected return.return.

•• ItIt’’s a nos a no--brainerbrainer!!

The Financial Environment: The Financial Environment: Types of InvestmentsTypes of Investments

•• Real assets vs. Financial assetsReal assets vs. Financial assets–– Tangible assets vs. Claims on assetsTangible assets vs. Claims on assets

•• Direct vs. Indirect financial investmentsDirect vs. Indirect financial investments–– Individual securities vs. Individual securities vs. ““poolspools”” of assetsof assets

•• DerivativesDerivatives–– Futures, optionsFutures, options

Where do U.S. households Where do U.S. households invest?invest?

•• All over the map!All over the map!•• But in recent years, there has been a But in recent years, there has been a

shift toward longer term investing shift toward longer term investing through retirement accounts, mutual through retirement accounts, mutual funds, and stocks.funds, and stocks.

The Financial Environment: The Financial Environment: Market ParticipantsMarket Participants

•• Households: net savers (investors)Households: net savers (investors)•• Federal Government: net borrowerFederal Government: net borrower•• Businesses: issuers of investment Businesses: issuers of investment

securities such as stocks and bondssecurities such as stocks and bonds

The Financial Environment: The Financial Environment: Primary and Secondary Primary and Secondary

MarketsMarkets•• When issuers of securities raise money When issuers of securities raise money

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

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

Basic Investment PhilosophiesBasic Investment Philosophies

In forming an investment portfolio, several In forming an investment portfolio, several questions are paramount:questions are paramount:

•• In what types of securities should I invest?In what types of securities should I invest?–– Asset AllocationAsset Allocation

•• Within each security type, how do I select Within each security type, how do I select which assets to purchase?which assets to purchase?–– Security SelectionSecurity Selection

•• Finally, how active should I manage my Finally, how active should I manage my portfolio?portfolio?–– Should I be an active or passive investor?Should I be an active or passive investor?

Summarizing the Basic Summarizing the Basic StrategiesStrategies

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 InvestmentsEthics in Investments

•• Financial markets are vitally important to a Financial markets are vitally important to a wellwell--functioning economy.functioning economy.

•• Trust in information and faith in fairness are Trust in information and faith in fairness are essential.essential.

•• Codes of ethics for financial professionals Codes of ethics for financial professionals and strict regulations attempt to create such and strict regulations attempt to create such an environment where financial markets can an environment where financial markets can efficiently fulfill their economic function.efficiently fulfill their economic function.

Jobs in InvestmentsJobs in Investments

•• Registered Representative of a Brokerage Registered Representative of a Brokerage FirmFirm

•• Investment Analysis Investment Analysis •• Portfolio ManagementPortfolio Management•• Financial PlanningFinancial Planning•• CorporationsCorporations•• Professional DesignationsProfessional Designations

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