INVESTMENTS

Analysis and Management

 

Charles P. Jones, Ph.D., CFA

CH.01 : Understanding
Investments
DOSEN : ROFINUS LEKI, SE, MM
N O . C O N TA C T : 0 8 1 9 5 4 4 5 8 9 9 9
 ESTABLISHING A FRAMEWORK FOR INVESTING
SOME DEFINITIONS
The term investing can cover a wide range of activities. It often refers to investing money in certificates of deposit, bonds, common stocks,
or mutual funds. More knowledgeable investors would include other “paper” assets, such as warrants, puts and calls, futures contracts, and
convertible securities, as well as tangible assets, such as gold, real estate, and collectibles. Investing encompasses very conservative positions as
well as aggressive speculation. Whether your perspective is that of a college graduate starting out in the workplace or that of a senior citizen
concerned with finances after retirement, investing decisions are critically important to most people sometime in their life. An investment can be
defined as the commitment of funds to one or more assets that will be held over some future time period. Investments is concerned with the
management of an investor’s wealth, which is the sum of current income and the present value of all 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.

Financial Assets and Marketable Securities

The term investments refers in general to financial assets and in particular to marketable securities. Financial assets are paper (or electronic)
claims on some issuer, such as the federal government or a corporation; on the other hand, real assets are tangible, physical assets such as gold,
silver, diamonds, art, and real estate. Marketable securities are financial assets that are easily and cheaply tradable in organized markets.
Technically, the word investments includes both financial and real assets, and both marketable and nonmarketable assets. Because of the vast
scope of investment opportunities available to investors, our primary emphasis is on marketable securities; however, the basic principles and
techniques discussed in this text are applicable to real assets.
 A Perspective on Investing
WHY DO WE INVEST ?
We invest to make money. Although everyone would agree with this statement, we need to be more precise.
We invest to improve our welfare, which for our purposes can be defined as monetary wealth, both current
and future. We assume that investors are interested only in the monetary benefits to be obtained from
investing, as opposed to such factors as the psychic income to be derived from impressing one’s friends with
one’s financial prowess. Funds to be invested come from assets already owned, borrowed money, and savings
or foregone consumption. By foregoing consumption today and investing the savings, investors expect to
enhance their future consumption possibilities by increasing their wealth. Don’t underestimate the amount of
money many individuals can accumulate. A 2004 survey found that more than 8 million U.S. households had
a net worth of more than $1 million (excluding their primary residence). That represented a one-third increase
over 2003 alone and amounted to 7 percent of all U.S. households. Much of this success was attributed to
ownership of stocks and bonds. Of course, things can change. Americans’ net worth declined a record 18
percent in 2008. Investors also seek to manage their wealth effectively, obtaining the most from it while
protecting it from inflation, taxes, and other factors. To accomplish both objectives, people invest.
 A Perspective on Investing

TAKE A PORTFOLIO PERSPECTIVE

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 assets. The idea of an “optimal combination”
is important because our wealth, which we hold in the form of various assets, should be evaluated and
managed as a unified whole. Wealth should be evaluated and managed within the context of a portfolio, which
consists of the asset holdings of an investor. For example, if you own four stocks and three mutual funds, that
is your portfolio. If your parents own 23 stocks, some municipal bonds, and some CDs, that is their portfolio
of financial assets.
The Importance of Studying Investments
The Personal Aspects
It is important to remember that all individuals have wealth of some kind; if nothing else, this
wealth may consist of the value of their services in the marketplace. Most individuals must make
investment decisions sometime in their lives. For example, many employees today must decide
whether their retirement funds are to be invested in stocks or bonds or some other alternative. And
many people try to build some wealth during their working years by investing.

Retirement Decisions
Estimates suggest that more than 40 percent of households headed by someone between 47
and 62 will be unable to replace half their pre-retirement income when they cease working. Even
more worrisome, many will have retirement income below the poverty line. A major revolution in
personal finance is to provide employees with self-directed retirement plans (defined contribution
plans rather than defined benefit plans). Whereas traditional defined-benefit retirement plans
guarantee retirees an amount of money each month, the new emphasis on self-directed retirement
plans means that you will have to choose among stock funds, bond funds, guaranteed investment
contracts, and other alternatives.
The Importance of Studying Investments
Building Wealth Over Your Lifetime
A careful study of investment analysis and portfolio management principles can provide a sound
framework for both managing and increasing wealth. Furthermore, a sound study of this subject
matter will allow you to obtain maximum value from the many articles on investing that appear
daily in newspapers and magazines, which in turn will increase your chances of reaching your
financial goals. Popular press articles cover many important topics, such as the following examples
:
1. Financial assets available to investors
2. Should a mutual fund investor use a financial advisor?
3. Compounding effects and terminal wealth
4. Realized returns vs. expected returns
5. How to compare taxable bonds to municipal(tax-exempt) bonds
6. Index funds and ETFs
7. How diversification works to reduce risk
8. The asset allocation decision
9. Active vs. passive investing

All of these issues are covered in the text, and learning about them will make you a much
smarter investor
 Understanding The Investment Decision
Process
Common stocks have produced, on average, significantly larger returns over the years than savings accounts or bonds. Should not all investors invest in
common stocks and realize these larger returns? The answer to this question is : To pursue higher returns, investors must assume larger risks. Underlying all
investment decisions is the tradeoff between expected return and risk.

THE BASIS OF INVESTMENT DECISIONS—RETURN AND RISK

Return Why invest? Stated in simplest terms, investors wish to earn a return on their money. Cash has an opportunity cost: By holding cash, you forego
the opportunity to earn a return on that cash. Furthermore, in an inflationary environment, the purchasing power of cash diminishes, with high rates of
inflation (such as that in the early 1980s) bringing a relatively rapid decline in purchasing power. Investors buy, hold, and sell financial assets to earn returns
on them. Within the spectrum of financial assets, why do some people buy common stocks
instead of safely depositing their money in an insured savings account or a U.S. savings bond with a guaranteed minimum return? The answer is that they are
trying to earn returns larger than those available from such safer (and lower-yielding) assets. They know they are taking a greater risk of losing some of their
money by buying common stocks, but they expect to earn a greater return.

Expected Return vs. Realized Return

In investments, it is critical to distinguish between an expected return (the anticipated return for some future period) and a realized return (the actual
return over some past period). Investors invest for the future—for the returns they expect to earn—but when the investing period is over, they are left with
their realized returns. What investors actually earn from their holdings may turn out to be more or less than what they expected to earn when they initiated
the investment. This point is the essence of the investment process: Investors should always consider the risk involved in investing. Properly stated, investors
seek to maximize their returns from investing, subject to the risk they are willing to incur. Therefore, we must consider the other side of the coin from return,
which is risk
 Understanding The Investment Decision
Process
Risk
There are different types, and therefore different definitions, of risk. Risk is defined here as the uncertainty about the actual return that will be earned on
an investment. When we invest, we may do so on the basis of an expected return, but there is a risk that what we in fact end up with when we terminate the
investment—the actual (realized) return—will be different.

Investors Are Risk-Averse

It is easy to say that investors dislike risk, but more precisely, we should say that investors are risk-averse. A risk-averse investor is one who will not
assume risk simply for its own sake and will not incur any given level of risk unless there is an expectation of adequate compensation for having done so.
Note carefully that it is not irrational to assume risk, even very large risk, as long as we expect to be compensated for it. Investors cannot reasonably expect
to earn larger returns without assuming larger risks. Furthermore, it is possible that some investors, perhaps unwittingly, act in a manner that is too risk-
averse, thereby severely diminishing the final wealth they will accumulate over a long period of time.

Investor’s Risk Tolerance

Investors deal with risk by choosing (implicitly or explicitly) the amount of risk they are willing to incur—that is, they decide their risk tolerance. Some
investors choose to incur high levels of risk with the expectation of high levels of return. Other investors are unwilling to assume much risk, and they should
not typically expect to earn large returns. The reason is that there are costs to minimizing the risk, specifically a lower expected return. Taken to its logical
conclusion, the minimization of risk would result in everyone holding risk-free assets such as savings accounts and Treasury bills. The intelligent way to
think about return and risk is this : Investors decide on their risk tolerance—how much risk they are willing to assume when investing. They then seek to
maximize their returns subject to this risk tolerance constraint and any other constraints that might apply (for example,taxes).Of course, investors’ risk
tolerance changes as conditions (real or perceived) change. In today’s world, with all the instant communications available to most people, this can happen
quickly.
 Understanding The Investment Decision
Process
The Expected Risk-Return Tradeoff
Within the realm of financial assets, investors can achieve virtually any position on an expected return-risk spectrum such as that depicted in Figure 1-1.
The line RF to B is the assumed tradeoff between expected return and risk that exists for all investors interested in financial assets. This tradeoff always
slopes upward, because the vertical axis is expected return, and rational investors will not assume more risk unless they expect to be compensated. The
expected return should be large enough to compensate for assuming the additional risk; however, there is no guarantee that the additional returns will be
realized.
Obviously, Figure 1-1 depicts broad categories. Within a particular category, such as common stocks, a wide range of expected return and risk
opportunities exists at any time.
The important point in Figure 1-1 is the tradeoff between expected return and risk that should prevail in a rational environment. Investors unwilling to
assume risk must be satisfied with the risk-free rate of return, RF. If they wish to try to earn a larger rate of return, they must be willing to assume a larger
risk as represented by moving up the expected return-risk tradeoff into the wide range of financial assets available to investors. In effect, investors have
different risk tolerances, and, therefore, they should have differing return expectations
 Understanding The Investment Decision
Process
Ex Post vs. Ex Ante
Always remember that the risk-return tradeoff depicted in Figure 1-1 is ex ante, meaning “before the fact.” That is, before the investment is actually
made, the investor expects higher returns from assets that have a higher risk. This is the only sensible expectation for risk-averse investors, who are assumed
to constitute the majority of all investors.
Ex post means “after the fact” or when it is known what has occurred. For a given period of time, such as a month or a year or even several years, the
tradeoff may turn out to be flat oreven negative.
 Checking Your Understanding

1. Historically, stocks on average have

3. Investors should always seek to maximize
outperformed other asset classes such as bonds.
their returns from investing. Agree or
Should all intelligent investors own stocks?
disagree

4. The following is a correct statement: “The

2. Rational investors always attempt to
tradeoff between return and risk can be, and has
minimize their risks. Agree or disagree, and
been, both upward-sloping and downward-
explain your reasoning.
sloping.” How is this possible?
Structuring the Decision Process
Security Analysis
The first part of the investment decision process involves the valuation and analysis of individual
securities, which is referred to as Security Analysis. The valuation of securities is a time-
consuming and difficult job. First of all, it is necessary to understand the characteristics of the
various securities and the factors that affect them. Second, a valuation model is applied to these
securities to estimate their price, or value. Value is a function of the expected future returns on a
security and the risk attached. Both of these parameters must be estimated and then brought
together in a model. Despite the difficulties, some type of security analysis is performed by most
investors serious about their portfolios. Unless this is done, one has to rely on personal hunches,
suggestions from friends, and recommendations from brokers—all dangerous to one’s financial
health.

Portfolio Management
The second major component of the decision process is portfolio management. After securities
have been evaluated, a portfolio should be constructed. Concepts on why and how to build a
portfolio are well known. Much of the work in this area is in the form of mathematical and
statistical models, which have had a profound effect on the study of investments in this country in
the last 30 years. Having built a portfolio, the astute investor must consider how and when to
revise it. And, of course, portfolios must be managed on a continuing basis. Finally, all investors
are interested in how well their portfolio performs. This is the bottom line of the investment
process. Measuring portfolio performance is an inexact procedure, even today, and needs to be
carefully considered.
 Important Considerations In The Investment
Decision Process for Today’s Investors
THE GREAT UNKNOWN
The first, and paramount, factor that all investors must come to grips with is uncertainty. Investors buy various financial
assets, expecting to earn various returns over some future holding period. These returns, with few exceptions, may never be
realized. The simple fact that dominates investing, although many investors never seem to appreciate it fully, is that the realized
return on any risky asset will often differ from what was expected—sometimes quite dramatically. At best, estimates are
imprecise; at worst, they are completely wrong. The best one can do is make the most informed return and risk estimates
possible, act on them, and be prepared for shifting circumstances. Regardless of how careful and informed investors are, the
future is uncertain, and mistakes will be made. Although the future is uncertain, it is manageable, and a thorough understanding
of the basic principles of investing will allow investors to cope intelligently.

A GLOBAL PERSPECTIVE
Now more than ever, investors must think of investments in a global context. The investing environment has changed
dramatically as the world’s economies have become more integrated. The United States no longer accounts for a majority of
stock market capitalization globally, as it did in the past. U.S. stocks now account for considerably less than half of the world’s
total stock market capitalization. A global marketplace of round-the-clock investing opportunities is emerging. Approximately
two-thirds of U.S. investors now own the securities of foreign companies. Why should today’s investors be actively interested in
international investing? We should first note that European and Asian companies have adopted a more shareholder friendly
attitude in recent years. From an investing standpoint, the real importance of adding foreign securities is that investors can
achieve beneficial risk reduction if some foreign markets move differently than do U.S. markets. For example, when U.S. stocks
are doing poorly, some foreign stocks may be doing well, which would help offset the poor U.S. performance.
 Important Considerations In The Investment
Decision Process for Today’s Investors
THE IMPORTANCE OF THE INTERNET
Now, all investors can access a wealth of information about investing, trade cheaply and quickly in their brokerage accounts,
obtain real-time quotes throughout the day, and track their portfolios. This is a true revolution—the Internet has democratized the
flow of investment information. Any investor, at home, at work, or on vacation, can download an incredible array of information,
trade comments with other investors, do security analysis, manage portfolios, check company filings with government agencies,
and carry out numerous other activities not thought possible for a small investor only a few years ago. While some of these
information sources and/or services carry a fee, most of it is free.

INDIVIDUAL INVESTORS VS. INSTITUTIONAL INVESTORS

There are two broad categories of investors: individual investors and institutional investors. The latter group, consisting of
bank trust departments, pension funds, mutual funds, insurance companies, and so forth, includes the professional money
managers, who are often publicized in the popular press. Institutional investors have a dual relationship with individual investors.
On the one hand, individuals are the indirect beneficiaries of institutional investor actions, because they own or benefit from
these institutions’ portfolios. On a daily basis, however, they are “competing” with these institutions in the sense that both are
managing portfolios of securities and attempting to do well financially by buying and selling securities. Institutional investors are
indeed the “professional” investors, with vast resources at their command. Individual investors are now on a more competitive
basis with institutional investors, given the information they can access from the Internet. We should expect the market to be
more efficient today relative to the past, because information is even more quickly and freely available. All intelligent investors
who seek to do well when investing must ultimately come to grips with the issue of market efficiency.
 Important Considerations In The Investment
Decision Process for Today’s Investors

ETHICS IN INVESTING
Today, perhaps more than ever, investors need to stop and think about ethical issues as they apply to investing. Recent
corporate scandals involving Enron, WorldCom, HealthSouth, and so forth were prominently in the news as executives from
these firms went on trial, charged with possible fraud in connection with the companies’ financial activities. Other recent
negative headlines involving ethical issues include the conflicts of interest with security analysts and the role of some mutual
funds in providing a few investors with unfair trading advantages. Financial markets depend on integrity in the process, whether
it be from CEOs, brokers, stock exchange employees, security analysts, managers of mutual funds, or so forth. If investors lose
confidence in the overall honesty of the investing environment, financial markets could be severely damaged, and this in turn
could adversely impact the capital formation process which is so vital to the success of the U.S. economy.
Because of the overall importance of ethics in the investing process, we will examine some ethical issues in various chapters. In
some cases, as in the next example, we will not provide a clear answer to the issue raised. In other examples we will offer some
guidance on the issue. This is consistent with the real-life nature of ethical issues, which, while extremely important, is not
always easy to address in the process of deciding on the correct course of action.
 SUMMARY
An investment is the commitment of funds to one or
Expected return and risk are directly related; the greater
more assets that will be held over some future period.
(smaller) the expected return, the greater (smaller) the
The field of investments involves the study of the
risk.
investment process.

Investors seek to maximize expected returns subject to

The investment opportunities considered in this text
constraints, primarily risk. Risk is defined as the
consist primarily of a wide array of financial assets
chance that the actual return on an investment will
(primarily marketable securities), which are financial
differ from its expected return.
claims on some issuer.

The basic element of all investment decisions is the

Rational investors are risk-averse, meaning that they
tradeoff between expected return and risk. Financial
are unwilling to assume risk unless they expect to be
assets are arrayed along an upward-sloping expected
adequately compensated. The study of Investments is
return-risk tradeoff, with the risk-free rate of return as
based on the premise that investors act rationally.
the vertical axis intercept.
 SUMMARY
Investors deal with risk by choosing (implicitly or
Security analysis is concerned with the valuation of
explicitly) the amount of risk they are willing to incur
securities. Valuation, in turn, is a function of expected
—that is, they decide their risk tolerance.
return and risk.

The basic element of all investment decisions is the Portfolio management encompasses building an
tradeoff between expected return and risk. Financial optimal portfolio for an investor. Considerations
assets are arrayed along an upward-sloping expected include initial portfolio construction, revision, and the
return-risk tradeoff, with the risk-free rate of return as evaluation of portfolio performance.
the vertical axis intercept.

Major factors affecting the decision process include

For organizational purposes, the investment decision uncertainty in investment decisions, the global nature
process has traditionally been divided into two broad of investing, the increasing importance of the Internet,
steps: security analysis and portfolio management. the role of institutional investors in the marketplace,
and ethical issues in investing.
 QUESTIONS
• Define the term “investments.”
• Describe the broad two-step process involved in making investment decisions.
• Is the study of investments really important to most individuals ?
• Distinguish between a financial asset and a real asset.
• Carefully describe the risk-return tradeoff faced by all investors.
• “A risk-averse investor will not assume risk.” Agree or disagree with this statement, and explain your reasoning.
• Summarize the basic nature of the investment decision in one sentence.
• Distinguish between expected return and realized return.
• Define risk. How many specific types can you think of ?
• What other constraints besides risk do investors face ?
• Are all rational investors risk-averse? Do they all have the same degree of risk-aversion?
• What is meant by an investor’s risk tolerance? What role does this concept play in investor decision making ?
• What external factors affect the decision process ? Which do you think is the most important ?
• What are institutional investors ? How are individual investors likely to be affected by institutional investors ?
• Why should the rate of return demanded by investors be different for a corporate bond and a Treasury bond ?
• Discuss three reasons why U.S. investors should consider international investing. Do you think the exchange rate value of the dollar will have a
significant effect on the decision to invest internationally ?
• What should the long-run ex ante tradeoff between expected return and risk look like in a graph ? What about the long-run ex-post tradeoff ?
• Rational investors always attempt to minimize their risks! Agree or disagree, and explain your reasoning.
• Investors should always seek to maximize their returns from investing. Agree or disagree.