You are on page 1of 12



Understanding Investments

Chapter 1 is designed to be a standard introductory chapter. As such, its purpose is to introduce students to the subject of Investments, explain what this topic is concerned with from a summary viewpoint, and outline what the remainder of the text will cover. It defines important terms such as investments, se"#rit$ ana%$sis, p&rt'&%i& management, e(pe"ted and rea%i)ed rate &' ret#rn, ris*+'ree rate &' ret#rn, and ris*. IT I I!"#$TA%T T# %#T& T'AT Chapter 1 discusses some important issues, such as the expected return((ris) tradeoff that governs the investment process, the uncertainty that dominates investment decisions, the globali*ation of investments, the impact of institutional investors, and the basic idea behind the &fficient !ar)et 'ypothesis. As such, the chapter is important in setting the tone for the entire text and in explaining to the reader what Investments is all about. It establishes a basic framewor) for the course without going into too much detail at the outset. Chapter 1 also contains some material that will be of direct interest to students, including the importance of studying investments +using illustrations of the wealth that can be accumulated by compounding over long periods of time, and investments as a profession. The C-A designation is discussed, and the Appendix contains a more detailed description of the C-A program. &.ually important, Chapter 1 does not cover calculations and statistical concepts, data on asset returns, and so forth, either in the chapter or an appendix. The author feels strongly that Chapter 1 is not the place to do this when students in most cases have no real idea what the subject is all about. They are not ready for this type of important material, and since it will not be used immediately they will lose sight of why it was introduced. The author believes that it is much more effective to introduce the students thoroughly to what the subject 1

involves without getting into technical details at the very beginning of the course. It is highly desirable for instructors to add their own viewpoints at the outset of the course, perhaps using recent stories from the popular press to emphasi*e what investments is concerned with, why students should be interested in the subject, and so forth. CHAPTER OB,ECTI E

To introduce students to the subject matter of Investments from an overall viewpoint, including terminology. To explain the basic nature of the investing decision as a tradeoff between e(pe"ted ret#rn and ris*. To explain that the decision process consists of se"#rit$ ana%$sis and p&rt'&%i& management and that external factors affect this decision process. These factors include uncertainty, the necessity to thin) of investments in a global context, the environment involving institutional investors, and the impact of the internet on investing. To organi*e the remainder of the text.

/A,OR CHAPTER HEADING- 0C&ntents1 The Nat#re &' Investments

ome /efinitions 0investment1 investments1 financial and real assets1 mar)etable securities1 portfolio2 A "erspective on Investing in -inancial Assets 0investing is only one part of overall financial decisions2 3hy /o 3e Invest4 0to increase monetary wealth2

The Imp&rtan"e &' -t#d$ing Investments

The "ersonal Aspects 0most people ma)e some type of investment decisions1 examples of wealth accumulation as a result of compounding1 how an understanding of the subject will help students when reading the popular press2 Investments as a "rofession 0various jobs, salary ranges1 Chartered -inancial Analyst designation2

Understanding the Investment De"isi&n Pr&"ess

The 5asis 0expected investor1 tradeoff1

of Investment /ecisions return1 reali*ed return1 ris)1 ris)(averse the &xpected($eturn(($is) Tradeoff1 diagram of ex post vs. ex ante1 ris)(free rate of return, $-2

tructuring the /ecision "rocess 0a two(step process6 security analysis and portfolio management1 passive and active investment strategies1 the &fficient !ar)et 'ypothesis2

Imp&rtant C&nsiderati&ns in the Investment De"isi&n Pr&"ess '&r T&da$2s Invest&rs

The 7reat 8n)nown 0uncertainty dominates decisions((the future is un)nown92 The 7lobal Investments Arena 0the importance of foreign mar)ets1 the &uro1 emerging mar)ets2 The %ew &conomy vs. The #ld &conomy 0&%d e"&n&m$ stoc)s are the traditional service, consumer and financial companies1 ne3 e"&n&m$ stoc)s have a focus on technology, e(commerce, etc. In most cases the latter have little or no earnings, and certainly don:t pay dividends in virtually all cases2 The $ise of the Internet 0using the internet to invest1 the impact of the sharp mar)et decline in ;<<<(;<<12 Institutional Investors 0individual investors compete with institutional investors, but individuals are the beneficiaries of institutional investor activity, such as pension funds1 the issue of mar)et efficiency2

Organi)ing the Te(t 05ac)ground1 $eali*ed and &xpected $eturns and $is)1 5onds1 toc)s1 ecurity Analysis, including both fundamental and technical analysis1 /erivative ecurities1 "ortfolio Theory and Capital !ar)et Theory1 the "ortfolio !anagement "rocess and !easuring "ortfolio "erformance2 Appendi( 1+A The Chartered 4inan"ia% Ana%$st Pr&gram

0a description of the C-A program2 POINT- TO NOTE ABOUT CHAPTER 1

Ta5%es and 4ig#res There is only one figure in Chapter 1, but it is crucial because it the basis of investing decisions((indeed, it is the basis of all finance decisions. It shows the expected return(( ris) tradeoff available to investors. This diagram may be desirable to use as a transparency because it can be used to generate much useful discussion, including6 %#T&6 T'I T'& =A T. The The The The The upward(sloping tradeoff that dominates Investments. role of $-, the ris)(free rate of return. importance of ris) in all discussions of investing. different types of financial assets available. distinction between reali*ed and expected return.

/IA7$A! I $&=&>A%T #% T'& -I$ T /A? #- C=A , A%/ IT I A 7##/ 3A? T# TA$T T'& C#8$ &, A%/ T# &%/ IT.

Table 1(1 shows wealth accumulations possible from an I$A( type investment. It typically generates considerable student interest to see the ending wealth that can be produced by compounding over time. This type of example can be related to @<1 +), plans, which are .uic)ly becoming of primary importance to many people. B&(ed Inserts 5ox 1(; is a good example of why Investments is a difficult subject. It highlights some predictions by the investing community, which did not wor) too well. This 5ox Insert is ta)en from a regular feature of Smart Money, and offers a good opportunity to start informing students about the popular press maga*ines and newspapers available to investors. 5ox 1(; is a discussion of spinoffs. The discussion indicates that spinoffs do well over a period of one to three years, unli)e many I"#s. !ost importantly, individual investor can invest in spinoffs as well as, or better than, institutional investors. In other words, this is an opportunity for individual investors to compete effectively in the investing arena. "rofessional managers often dump spinoffs because they do not fit in with what they are currently doing. Analysts 5

often ignore them. Thus, this can be an opportunity for individual investors.

AN-!ER- TO END+O4+CHAPTER 6UE-TION1+1. Investments is the study of the investment process. An investment is defined as the commitment of funds to one or more assets to be held over some future time period. Traditionally, the investment decision process has been divided into security analysis and portfolio management. A -e"#rit$ ana%$sis involves the analysis and valuation of individual securities1 that is, estimating value, a difficult job at best. A P&rt'&%i& management utili*es the results of security analysis to construct portfolios. As explained in "art II, this is important because a portfolio ta)en as a whole is not e.ual to the sum of its parts. 1+8. The study of investments is important to many individuals because almost everyone has wealth of some )ind and will be faced with investment decisions sometime in their lives. #ne important area where many individuals can ma)e important investing decisions is that of retirement plans, particularly @<1 +), plans. In addition, individuals often have some say in their retirement programs, such as allocation decisions to cash e.uivalents, bonds, and stoc)s. The dramatic stoc) mar)et gains of 1BBC,1BBD, 1BBE, and 1BBF illustrate almost better than anything else the importance of studying investments. Investors who were persuaded in the past to go heavily, or all, in stoc)s have reaped tremendous gains in their retirement assets as well as in their taxable accounts. 1+9. A 'inan"ia% asset is a piece of paper evidencing some type of financial claim on an issuer, whether private +corporations, or public +governments,. A rea% asset, on the other hand, is a tangible asset such as gold coins, diamonds, or land.



Investments, in the final analysis, is simply a ris)(return tradeoff. In order to have a chance to earn a return above that of a ris)(free asset, investors must ta)e ris). The larger the return expected, the greater the ris) that must be ta)en. The ris)(return tradeoff faced by investors ma)ing investment decisions has the following characteristics6 The ris)(return tradeoff is upward sloping because investment decisions involve expected returns +vertical axis, versus ris) +hori*ontal axis,. The vertical intercept of this tradeoff is RF, the ris) free rate of return available to all investors.


An investor would expect to earn the ris)(free rate of return +$-, when he or she invests in a ris)(free asset and is, therefore, at the *ero ris) point on the hori*ontal axis in -igure 1(1. 4a%se. $is)(averse investors assume ris) if they expect to be ade.uately compensated for it. The basic nature of the investment decision for all investors is the upward(sloping tradeoff between expected return and ris) that must be dealt with each time an investment decision is made. E(pe"ted ret#rn is the anticipated return for some future time period, whereas rea%i)ed ret#rn is the actual return over some past period. In general, the term ris* as used in investments refers to adverse circumstances affecting the investor:s position. $is) can be defined in several different ways. Ris* is defined here as the chance that the actual return on an investment will differ from its expected return. 5eginning students will probably thin) of default ris) and purchasing power ris) very .uic)ly. ome may be aware of interest rate risk and market risk without fully understanding these concepts +which

1+<. 1+=.



will be explained in later chapters,. #ther ris)s include political risk and liquidity risk. tudents may also remember financial risk and business risk from their managerial finance course. 1+11. Although ris) is the most important constraint, investors face other constraints. These include6 1+17. legal constraints taxes transaction costs income re.uirements exchange listing +or lac) thereof, diversification re.uirements

All rational investors are ris) averse because it is not rational when investing to assume ris) unless one expects to be compensated for doing so. All investors do not have the same degree of ris) aversion. They are ris) averse to varying degrees, re.uiring different ris) premiums in order to invest. The external factors affecting the decision process +1, uncertainty the investing environment +institutional investors vs individual investors, the globali*ation of the investing process the rise of the internet

1+18. are6 1

+;, +G, +@,

The m&st imp&rtant 'a"t&r is #n"ertaint$, the paramount factor with which all investors must deal. 8ncertainty dominates investments, and always will. 1+19. Instit#ti&na% invest&rs include ban) trust departments, pension funds, mutual funds +investment companies,, insurance companies, and so forth. 5asically, these financial institutions own and manage portfolios of securities on behalf of various clienteles. They affect the investments environment +and therefore individual investors, through their actions in the mar)etplace, buying and selling

securities in large dollar amounts. 'owever, although they appear to have several advantages over individuals +research departments, expertise, etc.,, reasonably informed individuals should be able to perform as well as institutions, on average, over time. This relates to the issue of mar)et efficiency. 1.1:. An e''i"ient mar*et is one in which the prices of securities .uic)ly and +on balance, correctly reflect information about securities. In such a mar)et, the prices of securities do not depart for long from their justified economic values. 1+1;. An efficient mar)et is significant to investors because it will affect their behavior. Huite a few actions, such as performing the same security analysis as everyone else, are of no value in an efficient mar)et. Technical analysis is ruled out, as is standard fundamental analysis. "ortfolio management is also affected, with fewer actions justified than would be the case if the mar)et is not efficient. $e.uired rates of return differ as the ris) of an investment varies. Treasury bonds are less ris)y than corporates, and therefore have a lower re.uired rate of return. Investors should be concerned with international investing for several important reasons. -irst, more opportunities are now available to investors in the form of mutual funds and closed(end funds investing in foreign stoc)s and bonds. econd, the returns may be better in foreign mar)ets at a particular point in time than in the 8. . mar)ets. Third, by investing in foreign securities, investors may be able to reduce the ris) of their portfolios. -ourth, many 8. . companies are increasingly affected by conditions abroad((for example, Coca Cola derives most of its revenue and profits from foreign operations. 8. . companies clearly are significantly affected by foreign competitors. The exchange rate +currency ris), is an important part of all decisions to invest internationally. As



discussed later in the text, currency ris) affects investment returns, both positively and negatively. The creation of the &uro presents new opportunities and challenges for investors. This is a significant change for &uropean financial mar)ets, and it is too early to tell what will happen as a result of these changes. 1.1>. The I#ld &conomyJ refers to the traditional manufacturing, service, and financial companies, many of which are very large corporations such as I5!, &xxon, and !errill =ynch. These companies typically show positive earnings, and many pay dividends. They can be analy*ed using the standard financial analysis techni.ues such as ratio analysis, "K& ratios, and so forth. The I%ew &conomyJ refers to the e(commerce and technology(driven companies such as Cisco, &(5ay, Ama*on, and so forth. !ost of these companies have shown little or no earnings, and certainly don:t pay dividends. It is difficult to analy*e these companies using the traditional methodsLif they have no earnings, for example, they can:t have a meaningful "K& ratio. A significant number of these new companies failed in ;<<<(;<<1.

-O/E RECO//ENDATION- !HEN DI-CU--ING CHAPTER 1: 1. The expected return(ris) tradeoff is fundamental to any understanding of Investments. 3hile it seems to be a straightforward concept, I find that students have problems with it. These problems revolve around understanding the ex(post tradeoff +what did happen, vs. the ex(ante tradeoff +what is expected to happen,. I draw the following relationships to show the various tradeoffs.

a,. The e(pe"ted trade&'' +illustrated in the text, which is always upward slopingLrational investors must expect to receive a larger return if they are to assume more ris). This is the basis of decision(ma)ing when investing. b,. The sh&rter+term e(+p&st trade&'', which can be downward sloping. ;<<<(;<<1 offers the perfect example. The mar)et is down sharply, and therefore T(bills returned more than stoc)s. The tradeoff slopes downward. c,. The %&ng+term @9?A :?A <? $earB e(+p&st trade&'', as illustrated by the Ibbotson data. This tradeoff better slope upward if what is taught in Investments is to ma)e sense. And, of course, it does. toc)s have returned more than bonds, which have returned more than T(bills, over very long periods of time. ;. The decline in the economy and in the stoc) mar)et in ;<<<(;<<1 is a good illustration of ris), predicting the future using the recent past, and why understanding the basics of Investments is important. 8p through part of ;<<<, we heard a lot about day traders, and that we were now in a new environment where the old standards of valuation such as profitability were much less important. ince then, of course, many of the high(flyers have crashed andKor gone out of business. There now is a renewed appreciation of the importance of being profitable.