ch01-the investment setting

8/8/2019 Ch01-The Investment Setting

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Chapter 1

THE INVESTMENT SETTING


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Chapter 1 QuestionsWhat is an investment ?

Whatarethe components ofthe

requiredrate ofreturn onaninvestment?

What key issues should investors

always consider?Whattypes of investments can onemake?


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Chapter 1 QuestionsWheredo U.S. investors place funds forinvestmentand savings purposes?

Whatare some basic investmentphilosophies that individualand institutionalinvestors follow?

Whyareethics andregulations a concernto

all investmentprofessionals?Whatare some careerpaths available forpersons interested in investments?


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What is an investment ?

An investment is the current commitment

ofresources foraperiod oftime inthe

expectation ofreceiving future

resources greaterthanthe current

outlay.


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Is hidingmoney ina

mattress orkeeping

it inapiggy bank aninvestment ?

No! The safe-

keeping ofmoney

does not involveanyexpected

compensation.


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Howabout baseballcards orBeanieBabies? Aretheyan

investment?Possibly, butcompensation is highlyuncertain,and some ofthevalue of ownershipmay be sentimentalratherthan financial innature.


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Components Of The

Required Rate of ReturnIn orderto partwiththeirmoney,

investors require compensation for:

thetimeresources are committed

theexpectedrate of inflation

theuncertainty ofthe futurepayments


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Compensation for time:Therealrisk-freerate of

interest is theexchange

rate between futureconsumptionand

present consumption.

This rate of interest can

bethought ofas the

purerentalrate onmoney intheabsence

of inflationandrisk.


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Why is the real risk-free

rate positive?Borrowers arewillingto payto be

ableto spendmorethantheircurrentresources allow.

Savers need

compensation inorderto giveuptherightto consumetoday.


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Compensation for

expected inflation:Ifthe futurepaymentwill bediminished in

value because of inflation,then

investors willdemandan interestrate

higherthantherealrisk-free interest

rate so thattheirexpectedpurchasing

powerwillactually increase.


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Compensation for the

time value of money:Thenominalrisk-freerate of interest

adjusts therealrisk-freerateto reflect

expected inflation overthelife ofthe

investment.

Taking into accountthesetwo factors

(timeandexpected inflation)compensates investors forthe time

value oftheirmoney.


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Compensation for risk-

bearing:Investors tendto berisk-averse,meaningthat

theyneed sufficientexpectedadditional

compensation in orderto bearadditionalrisk.Ifthe futurepayment froman investment is

uncertain, investors willdemandan interest

ratethatexceeds thenominalrisk-freerate of

interestto providearisk premium.


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The Required Rate of

ReturnThe sum ofthenominalrisk-free

interestrateandtherisk premium onan

investmentgives that investmentsrequiredrate ofreturn.

Notethat forriskier investments,therisk

premium,andthereforetherequiredrate ofreturn,will behigherthan for

lowerrisk investments.


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Issues That Investors

Should Always ConsiderThere is atrade-off betweenrisk andexpectedreturn.

Developed financialmarkets arenearlyefficient.

Focus onafter-taxreturns,net of

expenses.Diversifyacross assettypes, industries,andeven countries.


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Risk-Return Trade-OffBecause investors tendto berisk averse,

itmakes sensethattheywill onlytake

onriskier investments iftheyexpecttoearnmorethanwithlowerrisk

investments.


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Market Efficiency

Anefficientmarket is onewhere Information is quicklyandaccuratelyreflected in

assetprices,So Whatappears to be news is notuseful in

predicting futureassetprices,

Withtheresultthat Investors cannot systematicallyand consistently

beatthemarketwithouttheaid ofeither insideinformation orloads ofluck.


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Implications ofMarket

EfficiencyIts what is unexpectedthatmoves the

market (thegenuinelynew information

innews).

We should be skeptical of investment

strategies that claimto beableto beat

themarket ona consistent basis.


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The Paradox ofMarket

EfficiencyIfmarkets areperfectlyefficient, it

makes no sensetoseek out superiorinvestments.

But ifnobody seeksout superiorinvestments,themarketwouldnotremainefficient!


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Take Taxes and

Expenses Into AccountIts whatyougetto keepthat counts!

Taxes affect investmentdecisions

Someallow forlowerorno tax burden

(Municipal bonds)

Someallow fordeferral oftaxliability

(IRAs)


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Take Taxes and

Expenses Into AccountSince financialmarkets are nearly

efficient,evenlarge investors generally

do not beatthemarket, butthatdoesnotmeanthattheydo notgeneratelots

ofexpenses intryingto!

Avoidhighexpense investments whenpossible sincetheytendto reduce net

returnwithout increasing grossreturn.


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Diversify, Diversify,

DiversifyDontputall ofyour

eggs in one basket!

Diversificationreduces risk without

necessarily

sacrificingexpected

return.

Its ano-brainer!


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What types of

investments can onemake?Realassets vs. Financialassets

Tangibleassets vs. Claims onassets

Directvs. Indirect financial investments

Individual securities vs. pools ofassets

Derivatives

Futures, options


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Where do U.S.

households invest?All overthemap!

But inrecentyears,therehas beena

shifttowardlongerterm investing

throughretirementaccounts,mutual

funds,and stocks.


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asic Investment

PhilosophiesIn formingan investmentportfolio, several

questions areparamount:

Inwhattypes of securities should I invest? AssetAllocation

Withineach securitytype,howdo I selectwhichassets to purchase?

Security SelectionFinally,howactive should I managemyportfolio? Should I beanactive orpassive investor?


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Summarizing the Basic

StrategiesAsset

Allocation

Security

Selection

Active Markettiming Stock picking

Passive Maintainpre-

determined

allocation(s)

Tryto track a

well-known

market index


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Ethics inInvestments

Financialmarkets arevitally importantto a

well-functioningeconomy.

Trust in informationand faith in fairness areessential.

Codes ofethics for financialprofessionals

and strictregulations attemptto create such

anenvironmentwhere financialmarkets can

efficiently fulfilltheireconomic function.


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Jobs in

Investments

Sales Registeredrepresentative ofa brokerage firm

FinancialplannersInvestmentAnalysis and PortfolioManagement Brokerage firms, banks,moneymanagers,mutual

fundmanagers, insurance companies

Professional Designations Chartered FinancialAnalyst (CFA)

Certified Financial Planner (CFP)

ch01-the investment setting

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