Introduction to Investments (Chapter 1)

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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 = [HPR1HPR2 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 returnvariability 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 Assetsassets 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 M B C A E T Expected Return 10% 5% 5% 15% 15% 5% Risk 10% 10% 20% 20% 30% 5%

Which of these assets is dominant over others? Which of these assets is not being dominated by any other asset?

Return

15%
10% 5% T T 5% M B
10% 15%

C RISK
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 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?

Portfolio management

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