Introduction to Investments (Chapter

1)

MB 72

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 return—variability 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=1Where Pt represents probability of each possible outcome; Rt

represents each possible return; E{R} represents expected return.

Investors manage risk at a cost - lower expected returns (ER)

Any level of expected return and risk can be attained

Risk

ER

Risk-free Rate

Bonds

Stocks

The Tradeoff Between ER and Risk

Making Investment Decisions on the Basis of Expected Return and Risk

Investors should choose dominant assets Dominant Assets—assets 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 Expected Return Risk

M 10% 10%

B 5% 10%

C 5% 20%

A 15% 20%

E 15% 30%

T 5% 5%

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

5%

10%

15%

5% 10% 15% 20% 25% 30%

T B C

A E

RISK

Return

T

M

M

A, M, and T are dominant investments Which one would you choose and Why?

Two-step process: Security analysis and valuation

Necessary to understand security characteristics Portfolio management

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?

The Investment Decision 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

Factors Affecting the Process

Sources of Risk

Interest Rate Risk Purchasing Power Risk Bull-Bear Market Risk Default Risk Liquidity Risk Callability Risk Convertibility Risk Political Risk