Chapter

one

Investments:
Background and
Issues

Real Versus Financial Assets

Essential nature of investment
Reduce current consumption in hopes of
greater future consumption

Real Assets
Used to produce goods and services:

Property, plant & equipment, human capital,

etc.

Financial Assets
Claims on real assets or claims on asset
income

Overview
Real investments and financial
investments are linked

The share issue of a firm finances the purchase

of capital
The commitment to a mortgage finances the
purchase of property

Financial investment can provide finance

for real investment decisions

Financial investment can guide real

investment decisions

Many ways to categorize financial

securities

Major Classes of Financial

Assets or Securities
Debt
o Money market instruments
Bank certificates of deposit, T-bills, commercial paper,
etc.

o Bonds
o Preferred stock
Common stock
o Ownership stake in the entity, residual cash flow
Derivative securities
o A contract whose value is derived from some
underlying market condition.

Gains and Losses

Some investments can
be very successful.

10,000 invested in

September 2001 in
Lastminute.com would
have been worth
134,143 in August
2003

$10,000 invested in

August 1998 in
Cephalon would have
been worth $107,096 in
September 2003 (and
$180,000 in 2007)

And Losses
Losses in value can be

even more spectacular

$10,000 invested in

September 2000 in
Palm Inc. would have
been reduced to $91 by
April 2003

A holding in July 2000

of 15 million in Exeter
Equity Growth Fund
would have been worth
72,463 in August 2003
(the share price fell
from 103.50 to 0.50)

Variability

Variability
The essentially feature of stock prices is
unpredictable variability

Even when averaged into an index this

variability is apparent

Portfolio management is about coping with the

variability

Investment analysis is about underlying longerterm trends

The same principles apply to both

Investment process: the

decision about which
securities, and how much of
each
Financial theory: the factors
that determine the rewards
from investment (and the
risks).

Allocation of Risk
o Investors can choose a desired risk
level
Bonds versus stock of a given company
Bank CD versus company bond
Tradeoff between risk and return?

1.4 The Investment

Process
oAsset allocation
Choosing the percentage of funds in asset
classes
60%
Stocks
30%
Bonds
6%
Alternative Assets
4%
Money market
securities

oSecurity selection & analysis

Choosing specific securities w/in an asset

class

1.5 Markets Are Competitive

o

Risk-return trade-off:

o Assets with higher expected returns have

higher risk.
Average Annual
Return
Stocks

About 12%

Minimum
(1931)

Maximum
(1933)

-46%

55%

o Bonds have a much lower average rate of

return (under 6%) and have not lost more
than 13% of their value in any one year.

Efficient Markets
o Market efficiency:
o Securities should be neither

underpriced nor overpriced on

average
o Security prices should reflect all

information available to investors

o Whether we believe markets are

efficient affects our choice of

appropriate investment management
style.

Active vs. Passive

Management
Active Management (inefficient markets)
Finding undervalued securities
Timing the market
Passive Management (efficient markets)
No attempt to find undervalued securities
No attempt to time
Holding a diversified portfolio:

Indexing

1.6 The Players

The Players

Business Firms net borrowers

Households net savers
Governments can be both borrowers
and savers

Financial Intermediaries Connectors

of borrowers and lenders
o Commercial Banks
Traditional line of business: Make loans funded by
deposits

o Investment companies
o Insurance companies
o Pension funds

The Players Cont.

Investment Bankers
o Firms that specialize in primary market
transactions

o Primary market:
A market where newly issued securities are

offered to the public.

The investment banker typically underwrites the
issue.

o Secondary market
A market where pre-existing securities are traded
among investors.