Introduction to Investments (Chapter 1)

Introduction to Investments (Chapter 1) MB 72

Outline • What is meant by “Investment”? • Why do individuals invest? • Measuring Risk and Return • Sources of Risk • Relationship between Risk and Return

Meaning of Investments • Commitment of money that is expected to generate additional money • Current commitment of dollars for a period of time to desire future payments that will compensate the investor for • The time the funds are committed • The expected rate of inflation, and • The uncertainty of the future payments • The investor can can be an individual, a government, and/or a corporation

Why do individuals invest? • To achieve a higher level of consumption in the future by forgoing consumption today • To improve our welfare in the future • Investments help us achieve tradeoff between current consumption and future consumption

Why Study Investments? • The Personal Aspects • To earn better returns in relation to the risk we assume when we invest • Knowledge of investments help investors understand the relationship between risk and return • Investment as a Profession • To become a licensed broker (series 7 exam), to become CFA/CFP/CMA, knowledge of investments is needed

Basis of Investment Decisions • Basic element of all investment decisions: trade-off between expected return and risk • Expected return is not usually the same as realized return

Measuring Return on Investments • Measures of Actual Return/Historical Return/Realized Return • Holding Period Return (HPR) • Total Holding Period Return • Annualized HPR = [HPR]1/n, where n is the number of years investment is held • Holding Period Yield = HPR - 1 n • Mean Rate of Return = HPYi/n i=1 • Geometric Mean = [HPR1HPR2 … HPRn]1/n – 1 • Which measure gives us a better estimate of the wealth effect of an investment?

Expected Return • A weighted average of each possible outcome, where weights represent the probability of each possible outcome • Multiply each possible outcome by its probability and add them up n • E(Ri) =  Pi  Ri i=1

Risk of Expected Returns • Risk is defined as the chance that the actual return on an investment will differ from its expected return—variability of returns • Risk is measured by standard deviation of expected returns • Standard deviation () is given by [variance]1/2 n • Variance =  Pt [Rt – E(R)]2 t=1 Where Pt represents probability of each possible outcome; Rt represents each possible return; E{R} represents expected return.

The Tradeoff Between ER and Risk • Investors manage risk at a cost - lower expected returns (ER) • Any level of expected return and risk can be attained Stocks ER Bonds Risk-free Rate Risk

Making Investment Decisions on the Basis of Expected Return and Risk • Investors should choose dominant assets • Dominant Assets—assets that promise higher expected return at any selected level of risk or assets that promise minimum risk of all assets at any selected level of expected return. • Example of Dominant Assets

Example Assets Expected Return Risk M 10% 10% B 5% 10% C 5% 20% A 15% 20% E 15% 30% T 5% 5% Which of these assets is dominant over others? Which of these assets is not being dominated by any other asset?

M Return A E 15% M 10% T C B 5% T RISK 5% 10% 15% 20% 25% 30%

A, M, and T are dominant investments • Which one would you choose and Why?

The Investment Decision Process • Two-step process: • Security analysis and valuation • Necessary to understand security characteristics • Portfolio management • Selected securities viewed as a single unit • How efficient are financial markets in processing new information? • How and when should it be revised? • How should portfolio performance be measured?

Factors Affecting the Process • Uncertainty in ex post returns dominates decision process • Future unknown and must be estimated • Foreign financial assets: opportunity to enhance return or reduce risk • Quick adjustments needed to a changing environment • The Internet and investment opportunities • Institutional investors important

Sources of Risk • Interest Rate Risk • Purchasing Power Risk • Bull-Bear Market Risk • Default Risk • Liquidity Risk • Callability Risk • Convertibility Risk • Political Risk

Introduction to Investments (Chapter 1)