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.
 Practice obtaining important financial information.
 Become acquainted with job opportunities in the financial
services sector.

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 Net New Cash Flow into Equity Mutual Funds ($ billions)

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Oct- 0
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S&P 500 Index Value

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!

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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?

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Table 1.1 Compound Interest Leads to Amazing Growth
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.
Look What $10,000 Turns into
Number With an Investment Return of:
of Years 6% 9% 12%
1 $10,600 $10,900 $11,200
2 11,236 11,881 12,544
3 11,910 12,950 14,049
4 12,625 14,116 15,735
6 14,185 16,771 19,738
8 15,938 19,926 24,760
12 20,122 28,127 38,960
16 25,404 39,703 61,304
20 32,071 56,044 96,463
24 40,489 79,111 151,786
28 51,117 111,671 238,839
32 64,534 157,633 375,817
36 81,473 222,512 591,356
40 102,857 314,094 930,510
(Note: Annual compounding is assumed.) 1-6
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

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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!

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 Stocks Treasury Treasury
Year (S&P 500) Bonds Bills
1970 4.0% 12.11% 6.5% 1990 -3.2% 6.18% 7.5%
1971 14.3% 13.23% 4.3% 1991 30.6% 19.30% 5.4%
1972 19.0% 5.69% 4.1% 1992 7.7% 8.05% 3.5%
1973 -14.7% -1.11% 7.0% 1993 10.0% 18.24% 3.0%
1974 -26.5% 4.35% 7.9% 1994 1.3% -7.77% 4.3%
1975 37.2% 9.20% 5.8% 1995 37.4% 31.67% 5.5%
1976 23.8% 16.75% 5.0% 1996 23.1% -0.93% 5.0%
1977 -7.2% -0.69% 5.3% 1997 33.4% 15.08% 5.1%
1978 6.6% -1.18% 7.2% 1998 28.6% 13.52% 4.8%
1979 18.4% -1.23% 10.0% 1999 21.0% -8.74% 4.7%
1980 32.4% -3.95% 11.5% 2000 -9.1% 20.11% 5.9%
1981 -4.9% 1.86% 14.0% 2001 -11.9% 4.56% 3.5%
1982 21.4% 40.36% 10.7% 2002 -22.1% 17.17% 1.6%
1983 22.5% 0.65% 8.6% 2003 28.7% 2.06% 1.0%
1984 6.3% 15.48% 9.6% 2004 10.9% 7.70% 1.4%
1985 32.2% 30.97% 7.5% 2005 4.9% 3.05% 3.1%
1986 18.5% 24.53% 6.0%
1987 5.2% -2.71% 5.8%
1988 16.8% 9.67% 6.7% Average 13.3% 6.4% 4.9%
1989 31.5% 18.11% 8.1%
Median 15.4% 3.6% 4.7%
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 Figure 1.3 Building Wealth by Investing in Stocks, Bonds and Treasury Bills (1950-present)

$6,000,000

Stocks:
$5,514,912
$5,000,000

$4,000,000
Dollars

$3,000,000

$2,000,000

T -bills:
$1,000,000
Bonds: $146,715
$249,020

$0
1950 1955 1960 1965 1970 1975 1980 1985 1990 1995 2000 2005
Ye ars
Data source: Council of Economic Advisors, Economic Report of the President, February 2006, and Lehman Brothers.

Start with $10,000 in each asset. 1-10

Investment Objectives

 Why are you investing?

 Retirement, down payment, vacation, …
 Investment objectives are important.
 Matching goal characteristics with investment
characteristics.
 Risk, return, time

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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.

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 The Long-term Payoff to Regular Investing
Can Be Huge

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.

Wealth Created With an

Amount Invested Number Investment Return of:
per Year of Years 6% 9% 12%
Young Investor
$300 40 $46,429 $101,365 $230,127
$1,200 40 185,714 405,459 920,510
$2,000 40 309,524 675,765 1,534,183
$6,000 40 928,572 2,027,295 4,602,549
$12,000 40 1,857,144 4,054,589 9,205,097

Middle-age Investor
$300 20 11,036 15,348 21,616
$1,200 20 44,143 61,392 86,463
$2,000 20 73,571 102,320 144,105
$6,000 20 220,714 306,961 432,315
$12,000 20 441,427 613,921 864,629
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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.

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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

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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

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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

N I/Y PV PMT FV
15 8 -5,000 0 |
CPT FV = $15,860.85
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 Valuing Assets – present value

 Present Value Future sum

Present value = 1  Interest rate  t

The present value of a $15,860 to be received

in 15 years with an 8% rate of return is
$15,860
present value = 1  0.08 15 = $5,000

N I/Y PV PMT FV
15 8 | 0 15,860
CPT PV = -$5,000
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Valuing Assets – payments
Future value = Payment 
 1  interest rate  - 1
t

interest rate
Present value =
Payment 
 1  interest rate - 1
t

interest rate  1  interest rate

t

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 =
$3000 
 1  0.09 =- 1$408,923
30

0.09
N I/Y PV PMT FV
30 9 0 -3000 |
CPT PV = $408,923
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Compound Frequency
 Mortgages and auto loans use monthly
payments and compounding
 Dividendspaid 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

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 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.
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Getting information - Newspapers

Barron’s http://www.barrons.com/ Biting market commentary once a

week, portfolio analysis and
databank.

Investor’s Business Daily http://www.investors.com/default.asp Founder William O’Neal

The Wall Street Journal http://online.wsj.com/home/us
USA Today http://www.usatoday.com/money/front.
htm
dispenses stock picking,
charting, and momentum
strategies. Big on investor
education.
The daily paper when it comes to
financial news and
information. Print
subscribers get interactive
access at a bargain price.
Don’t underestimate “McPaper’s”
Money Section when it comes
to business, economic, and
financial news. It’s terrific!

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 Getting information - Magazines
Business Week http://businessweek.com/index.html Timely business news and analysis,
useful business school, career
and small business information.

The Economist http://www.economist.com/ Offers analysis and opinion on the

business and political events of
the week.
Forbes http://forbes.com/ Terrific commentary on economics
and financial markets from an
all-star stable of regular
columnists.
Fortune http://www.fortune.com/fortune Famous for Fortune 500 company list.
Interesting advice on career
development.
Kiplinger's Personal Finance http://www.kiplinger.com Provides practical guidance on saving,
investing, planning for
retirement, and major purchases.
Money http://money.cnn.com/ Interesting market commentary,
company and mutual fund
analysis aimed at novice
investors.

Smart Money http://www.smartmoney.com/ Serves the need for personal finance

information for affluent,
sophisticated, professional, and
managerial Americans. 1-23
 Getting information - Online
CBS MarketWatch http://cbs.marketwatch.com Focused on financial news and
information. Individual investors
can find news, commentary,
advice, and stock price
information.
The Motley Fool www.fool.com An online forum designed to
"educate, amuse and enrich
investors." A constant stream
of witty investment advice on
active message boards.
MSN Money http://moneycentral.msn.com/home.asp Investing highlights for customized
portfolios, market reports, mutual
fund directory, retirement and
personal finance.
TheStreet.com www.thestreet.com A full menu of stock analysis, market
commentary, and biting satire.

U.S. Securities and Exchange http://www.sec.gov/ This is the place to find free access to
Commission official SEC filings by individual
companies, obrain information
about individual brokers, or file a
complaint about shady business
practices
Yahoo! Finance http://finance.yahoo.com/ A terrific web site with U.S. markets,
world markets, quotes, financial
news, and data. 1-24
Investment Industry Jobs
 Working at
 Commercial banks
 Jobs  Savings and credit unions
 Brokers  Securities firms
 Traders  Investment banks
 Portfolio managers
 Companies
 Credit rating agencies
 Financial planners  Mutual funds
 Investment bankers  Life insurance companies
 Security analysts  Securities exchanges

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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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