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Investments: Analysis and Behavior

Investments: Analysis and Behavior. Chapter 1- Introduction. ©2008 McGraw-Hill/Irwin. Learning Objectives. Learn the power of building wealth through investing over time. Understand the nature and performance of financial assets. Identify common objectives of investors.

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Investments: Analysis and Behavior

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  1. Investments: Analysis and Behavior Chapter 1- Introduction ©2008 McGraw-Hill/Irwin

  2. Learning Objectives • Learn the power of building wealth through investing over time. • Understand the nature and performance of financial assets. • Identify common objectives of investors. • Practice obtaining important financial information. • Become acquainted with job opportunities in the financial services sector.

  3. Buy High, Sell Low?! • It is obvious that investors should buy low and sell high in order to build wealth over time. • So why do investors frequently buy high and sell low? • The investment process involves analytical analysis of investment alternatives that are filtered through a decision process that is fraught with psychological biases. • To be a successful investor, you should be able to use the analytical tools and control your emotions and psychological biases!

  4. Building Wealth • Recipe for success: Start with some cash… Earn a high rate of return… Add lots of time… How important are time and return?

  5. Over a 24-year period, a 9% return leads to twice the wealth of 6% returns, and 12% returns almost quadruple the wealth generated by a 6% return.

  6. Asset Classes • Cash Reserves • i.e., short-term money market instruments • U.S. Treasury bills, Savings deposits, CDs • Commercial Paper • Bonds • Debt obligations over one year • Treasury Notes, Treasury Bonds, Municipal Bonds • Corporate Bonds • Stocks • Common stock is ownership of a public corporation

  7. Historical Returns of Stocks and Bonds • Stocks have earned an average return of around 12% per year for the past 50 years. • Depending what index is used. • Long-term Treasury bonds have earned around 6% per year. • 50%/50% allocation to stocks/bonds would average around 9% • But there is a lot of volatility!

  8. Start with $10,000 in each asset.

  9. Investment Objectives • Why are you investing? • Retirement, down payment, vacation, … • Investment objectives are important. • Matching goal characteristics with investment characteristics. • Risk, return, time

  10. Long-term Investing • Retirement plans from employers • Defined Benefit plans • Employer promise to pay a fixed retirement income. • Formula driven. • Employer does all the work and makes decisions • Defined Contribution plans • You save (tax deferred) from paycheck. • Employers may contribute too. • You make all the decisions • Benefit depends on contributions and investment return.

  11. Young investors can accumulate significant wealth through regular investing of modest amounts. The longer you wait to start investing, however, the greater the cost to building significant wealth.

  12. Key Investment Concepts • A portfolio • Diversified (hopefully!) collection of stocks, bonds and other assets. • Individual investments are often evaluated on how they change the characteristics of the portfolio. • Risk • Chance of economic loss. • Sometimes measured as a variation in return. • Expected Return • Anticipated gain of a specific period of time. • Often evaluated as compensation for taking certain types of risks.

  13. Efficient Market Hypothesis • Idea that every security at every point in time is fairly priced. • Implication is that prices are unpredictable • Controversial • Market bubbles • Most professional investors don’t beat the market • Investment superstars • Hard to predict the direction of stock prices

  14. Investment management performance • At any point in time, many investment managers are beating the market for the month, quarter or year. A couple years later, most of these managers are no longer performing so well. • Regression to the mean • Superstar exceptions • Warren Buffett • Peter Lynch • Sir John Templeton

  15. Valuing Assets – future value • Future Value Future value = Present sum × (1 + Interest rate)t The future value of a $5,000 investment earning 8% interest over a period of 15 years is future value = $5,000 × (1 + 0.08)15 = $15,861 NI/YPVPMTFV 15 8 -5,000 0 | CPT FV = $15,860.85

  16. Valuing Assets – present value • Present Value Present value = The present value of a $15,860 to be received in 15 years with an 8% rate of return is present value = = $5,000 NI/YPVPMTFV 15 8 | 0 15,860 CPT PV = -$5,000

  17. Valuing Assets – payments Future value = Present value = Over the next 30 years, an employee contributes $3,000 per year to an investment expected to earn 9% per year. After 30 years, the employee will have: future value = = $408,923 NI/YPVPMTFV 30 9 0 -3000 | CPT PV = $408,923

  18. Compound Frequency • Mortgages and auto loans use monthly payments and compounding • Dividends paid quarterly • Bonds pay semi-annually • Adjust the number of periods and rate What is the future value of a $1,000 investment 3 years from now if it receives a 9% annual return compounded (A) annually, (B) quarterly, and (C) continuously? Solution: (A) Future value = $1,000 X (1 + 0.09)3 = $1,295 (B) Future value = $1,000 X (1 + 0.0225)12 = $1,306 (C) Future value = $1,000 X e0.09x3 = $1,310

  19. Behavior is important too • Incentives • Stockbroker and commissions • Mutual fund incentives • Psychology • The higher the degree of uncertainty in a decision, the more emotions and psychological biases are used to help make the decision.

  20. Getting information - Newspapers

  21. Getting information - Magazines

  22. Getting information - Online

  23. Investment Industry Jobs • Working at • Commercial banks • Savings and credit unions • Securities firms • Investment banks • Companies • Credit rating agencies • Mutual funds • Life insurance companies • Securities exchanges • Jobs • Brokers • Traders • Portfolio managers • Financial planners • Investment bankers • Security analysts

  24. Objectives of the course and text • Develop a clear understanding of the many useful and practical implications of financial theory. • Understand how the incentives of various market participants influence investor decisions and also highlight the impact of a person’s own psychology. • Acquire a framework for understanding the returns on all financial assets, including stocks, bonds and financial derivatives. • Gain familiarity with the institutions and language of Wall Street so as to facilitate the development of an effective personal investment strategy.

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