Ch01-The Investment Setting

Chapter 1
THE INVESTMENT SETTING

Chapter 1 Questions
What is an investment ?
What are the components of the
required rate of return on an
investment?
What key issues should investors
always consider?
What types of investments can one
make?
Chapter 1 Questions
Where do U.S. investors place funds for
investment and savings purposes?
What are some basic investment philosophies
that individual and institutional investors
follow?
Why are ethics and regulations a concern to
all investment professionals?
What are some career paths available for
persons interested in investments?
An investment is the current commitment
of resources for a period of time in the
expectation of receiving future
resources greater than the current
outlay.
Is hiding money in a
mattress or keeping
it in a piggy bank an
investment ?
No! The “safe-
keeping” of money
does not involve any
expected
compensation.
How about baseball
cards or Beanie
Babies? Are they an
investment?
Possibly, but
compensation is highly
uncertain, and some of
the value of ownership
may be “sentimental”
rather than financial in
nature.
Components Of The
Required Rate of Return
In order to part with their money,
investors require compensation for:
 the time resources are committed
 the expected rate of inflation
 the uncertainty of the future payments

Compensation for time:
The real risk-free rate of
interest is the exchange
rate between future
consumption and
present consumption.
This rate of interest can
be thought of as the
“pure” rental rate on
money in the absence
of inflation and risk.
Why is the real risk-free
rate positive?
Borrowers are
willing to pay to be
able to spend more
than their current
resources allow.
Savers need
compensation in
order to give up the
right to consume
today.
Compensation for
expected inflation:
If the future payment will be diminished in
value because of inflation, then
investors will demand an interest rate
higher than the real risk-free interest
rate so that their expected purchasing
power will actually increase.
Compensation for the
time value of money:
The nominal risk-free rate of interest
adjusts the real risk-free rate to reflect
expected inflation over the life of the
investment.
Taking into account these two factors
(time and expected inflation)
compensates investors for the “time
value” of their money.
Compensation for risk-
bearing:
Investors tend to be risk-averse, meaning that
they need sufficient expected additional
compensation in order to bear additional risk.
If the future payment from an investment is
uncertain, investors will demand an interest
rate that exceeds the nominal risk-free rate of
interest to provide a risk premium.
The Required Rate of
Return
The sum of the nominal risk-free
interest rate and the risk premium on an
investment gives that investment’s
required rate of return.
Note that for riskier investments, the risk
premium, and therefore the required
rate of return, will be higher than for
lower risk investments.
Issues That Investors
Should Always Consider
There is a trade-off between risk and
expected return.
Developed financial markets are nearly
efficient.
Focus on after-tax returns, net of
expenses.
Diversify across asset types, industries,
and even countries.
Risk-Return Trade-Off
Because investors tend to be risk averse,
it makes sense that they will only take
on riskier investments if they expect to
earn more than with lower risk
investments.
Market Efficiency
An efficient market is one where …
 Information is quickly and accurately reflected in
asset prices,
So …
 What appears to be “news” is not useful in
predicting future asset prices,
With the result that …
 Investors cannot systematically and consistently
“beat the market” without the aid of either inside
information or loads of luck.
Implications of Market
Efficiency
It’s what is unexpected that moves the
market (the genuinely new information
in news).
We should be skeptical of investment
strategies that claim to be able to beat
the market on a consistent basis.
The Paradox of Market
Efficiency
If markets are
perfectly efficient, it
makes no sense to
seek out superior
investments.
But if nobody seeks
out superior
investments, the
market would not
remain efficient!
Take Taxes and
Expenses Into Account
It’s what you get to keep that counts!
Taxes affect investment decisions
 Some allow for lower or no tax burden
(Municipal bonds)
 Some allow for deferral of tax liability
(IRA’s)
Take Taxes and
Expenses Into Account
Since financial markets are “nearly”
efficient, even large investors generally
do not beat the market, but that does
not mean that they do not generate lots
of expenses in trying to!
 Avoid high expense investments when
possible since they tend to reduce “net”
return without increasing “gross” return.
Diversify, Diversify,
Diversify
Don’t put all of your
eggs in one basket!
Diversification
reduces risk without
necessarily
sacrificing expected
return.
It’s a no-brainer!
What types of
investments can one
make?
Real assets vs. Financial assets
 Tangible assets vs. Claims on assets
Direct vs. Indirect financial investments
 Individual securities vs. “pools” of assets
Derivatives
 Futures, options
Where do U.S.
households invest?
All over the map!
But in recent years, there has been a
shift toward longer term investing
through retirement accounts, mutual
funds, and stocks.
Basic Investment
Philosophies
In forming an investment portfolio, several
questions are paramount:
In what types of securities should I invest?
 Asset Allocation
Within each security type, how do I select which
assets to purchase?
 Security Selection
Finally, how active should I manage my
portfolio?
 Should I be an active or passive investor?
Summarizing the Basic
Strategies
Asset Security
Allocation Selection
Active Market timing Stock picking
Passive Maintain pre- Try to track a
determined well-known
allocation(s) market index
Ethics in Investments
Financial markets are vitally important to a
well-functioning economy.
Trust in information and faith in fairness are
essential.
Codes of ethics for financial professionals
and strict regulations attempt to create such
an environment where financial markets can
efficiently fulfill their economic function.
Jobs in Investments
Sales
 Registered representative of a brokerage firm
 Financial planners
Investment Analysis and Portfolio
Management
 Brokerage firms, banks, money managers, mutual
fund managers, insurance companies
Professional Designations
 Chartered Financial Analyst (CFA)
 Certified Financial Planner (CFP)

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Chapter 1

THE INVESTMENT SETTING

 the uncertainty of the future payments

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