British Columbia Institute of Technology Security Fundamentals W, SEAN CLEARY + CHARLES P. FMGT 4620©2013 John Wiley & Sons Canada, Ltd. Cleary: Investments: Analysis and Management, Third Canadian Edition (ISBN: 9780470157596). Copyright ©2009 by John Wiley & Sons Canada, Ltd All rights reserved. No part of this work covered by the copyright herein may be reproduced, transmitted, or used in any form or by any means—graphic, electronic or mechanical —without the prior written permission of the publisher. Any request for photocopying, recording, taping, or inclusion in information storage and retrieval systems of any part of this book shall be directed to The Canadian Copyright Licensing Agency (Access Copy- right), For an Access Copyright licence, visit www.accesscopyright.ca or call toll-free, 1-800-893-5777. Care has been taken to trace ownership of copyright material contained in this text. The Publishers will gladly receive any information that will enable them to rectify any erroneous reference or credit line in subsequent editions. CHAPTER UNDERSTANDING INVESTMENTS Marketing Manager: Anita Osborne Custom Project Editor: Sara Tinteri Production Coordinator: Lynda Jess } hapter 1 provides the foundation for the study of investments by analyzing what investing is all about. The crt caly important trade-off between expected return and risk is explained, and the major issues that every investor ‘ust deal within making investment decisions are analyzed. An organizational structure forthe entre texts provided. Printed and bound in the United States of America . } Learning Objectives j After reading this chapter, you should be able to 1. Define investment and discuss what it means to study investments. 2. Explain why risk and return are the two critical components of all investing decisions. 8. Outline the two-step investment decision process. W ILEY 4, Discuss key factors that affect the investment decision process. John Wiley & Sons Canada, Ltd 6045 Freemont Blvd. Mississauga, Ontario LSR 433, Visit our website at: www.wiley.ca ear eeeeeeeeeereerererreeeerreamammmcanasmmaamtmmmmmaaaaCHAPTER ONE * Understanding Investments CHAPTER PREVIEW This chapter lays the foundation forthe study of investments. You wil learn what an investment is and why itis important to study the investment process, We introduce the concept ofa trade-off between expected return and risk—the bass forall investment decistons—and outline the two-step investment decision process of secunty analysis and porfotio management, Finally, we discuss some ofthe key fac tors that affect the investment decision process such as plobal markeis and institutional investors. THE PURPOSE OF THIS TEXTBOOK The objective of this text isto help you understand the investments fied as it is currently under stood, discussed, and practised so that you can make sound investment decisions that will enhance your economic were, Key concepts are presented to provide an appreciation of the theory and prac> tice of investments, Alter reading this text, you will be able to intelligently answer questions such as the folowing + The SSSPITSX Composite Index, which is the major Canadian stock index measuring stock per formance on the Toronto Stock Exchange (TSX), fell 604.99 points (or 4.75 percent) on January 21, 2008, which combined with previous losses that week to produce an 11.4 percent decline for the TSX for that week’ trading, The next day (January 22, 2008), the Index increased 509 points (or 4.2 percent), What causes this type of extreme volatility? With volatility such as this, should Investors avoid common stocks altogether, particularly for retirement plans? ‘The average return on Canadian equity mutual funds was 15.0 percent for the five-year period ending December 31, 2007." This is below the 18.4 percent return achieved over this period by the S&P/TSX Total Return Index. Why is this? In 2007, the average returns earned on Canadian Emerging Market and Global Equity mutual funds were 18.9 percent and -3.2 percent respectively, while the average return for Canadian eq- ity funds was 5.5 percent, Should Canadian investors be participating in developed ancV/or emerg- ing global equity markets? Ifo, what investment options are available to them and how much wealth should they allocate to such investments? Isit possible to have earned 30 percent or more investing in low-risk Treasury bills in a single year? In January of 2008, the French bank Société Générale announced losses of €4.9 billion, or $7.14 billion (US), resulting from the fraudulent actions of a single futures trader who implemented a series of unauthorized trades that spiraled out of control. Given that such potential losses can be caused by futures trading, how ist that investors use these instruments to actualy reduce or con- rol sk? + What isthe historical average annual rate of return on common stocks and what can an investor reasonably expect to earn from stocks in the Future? Both descriptive and quantitative materials on investing are readily available in a variety of forms. Some ofthis material is very enlightening, much of itis entertaining but debatable because of the ‘many controversies in investments, and some of it is simply worthless. This text seeks to cover what ‘is particularly useful and relevant for today investment climate. I olfers some ideas about what you can reasonably expect to accomplish by using what you learn and therefore what you can tealist- cally expect to achieve as an investor in today’ investment world, Many investors have unrealistic expectations, which ultimately lead to disappointment or worse Learning to avoid the many pitfalls awaiting you as an investor by clearly understanding what ‘you can reasonably expect from investing your money may be the single most important benefit 0 ‘aveglabefand com, May 12,2008, j \ nn THE NATURE OF INVESTMENTS be derived from this text. For example, would you entrust your money to someone offering, 36 per- cent annual return on riskless US government Treasury securities? Some 600 investors did and lost approximately $10 milion to former Sunday schoolteacher. Intelligent investors lear to say no and to avoid many of the mistakes that can thus he prevented THE NATURE OF INVESTMENTS Some Definitions The term investing can cover a wide range of activities. It ofien refers to putting money in GICs, bonds, ‘common stocks, or mutual funds. More knowledgeable investors would include other paper assets, such as income trusts, warrants, puts and call, futures contracts, and convertible securities, as well a tang ble assets, such as gold, real estate, and collectibles. Investing can range from very conservative 10 ag- _gessive speculation. Whether you are a university graduate starting out in the workplace or a senior citizen concemed with how to get by in retirement, investing decisions wil be very important to you {An investment can be defined as the commitment of funcls to one or more assets that will bbe held over some future time period. The field of investments, therefore, involves the study of the investment process. The study of investments is concerned with the management of an investor's ‘wealth, which isthe sur of current income and the present value of ll future income. (This is why present value and compound interest concepts have an important role in the investment process.) Although the field of investments encompasses many aspects, it can be thought of in terms of two primary functions: analysis and management Inthistex, the term investments relers in general to financial assets and in panicularto marketable securities, Financial assets are paper (or electronic) claims on some issuer suchas the federal or provin- cial government ora corporation; on the ether hand, real assets are tangible physical assets such as pre- cious metals (gold, silver), gems (diamonds), art, and real estate. Marketable securities are financial assets that ae easily and cheaply traded in organized markets, Technically, investments inelude bath f- nancial and real assets, and both marketable and non-marketable assets. Because ofthe vast scope of n= Yestment opportunities available to investors, our primary emphasis is on marketable securities: however, the basic principles and techniques discussed in this text are applicable 1 ral assets as wel Even when we limit our discussion primarily to financial asses, iis dificult to keep up with the proliferation of new products, One such product that was relatively unimportant a few years ago is exchange-traded funds (ETFs) (discussed in Chapter 3), Real-World Returns 1-1 reers to the Fe- cent growth of ETFS, Investing as Part of Personal Financial Planning The investment of funds in various assets is only par ofthe overall financial decision making and plan- ning that most individuals must do, Before investing, each individual should develop a financial plan that should include the decision on whether to purchase @ house, a major investment for most individ- uals In adlition, decisions must be made about insurance of various types—Hfe, health, disabily, and protection of business and property. Finally, the plan should provide for emengency reserve funds? Thistext astmes that investors have established their overall financial plan and are now interested in managing and enhancing their wealth by investing in an optimal combination of financial asses, The idea of an “optimal combination” is important because our wealth, which we hold in the form of var us assets, should be evaluated and managed! asa unified whole, Wealth should be evaluated and man- aged within the context of portfolio, which is made up of the asset holdings of an investor. "Hersnal nance dens of tis type are discussed in personal finance ests Define investment and discuss wha it means to ‘study investments. Investment The commitment of funds tw one oF move assets that ‘will beheld oversome Future tie pid. Investments The study ofthe investment proses Financial Assets Paper or electronic claims ‘on some issuer such a the federal oF provincial gow ernment ora comporation, Real Assets Physical assets such as gol or teal exate Marketable Securities Finacial assets that are cesily and cheaply traded in organized markets Portfolio “The seeurites held by an hnwestor taken a6. unit.