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Understanding Investments

Learning Objectives
Define investment and discuss what it means to

study investments.
Explain why risk and return are the two critical

components of all investing decisions.


Outline the two-step investment decision process. Discuss key factors that affect the investment

decision process.

Investments Defined
Investments is the study of the process of

committing funds to one or more assets


Emphasis on holding financial assets and marketable

securities Concepts also apply to real assets Foreign financial assets should not be ignored

Investment Objectives
Primary Objectives

Safety of principal Income Growth of capital


Secondary Objectives

Liquidity Tax minimization

Investment Constraints
Possible constraints for investors include:
Legal Moral / Ethical Emotional including investment knowledge and risk

tolerance Basic minimum income to be provided by the portfolio Realism an understanding that some objectives are unrealistic (e.g., high returns with low risk) Other (e.g., illness, pending divorce, etc.)

Primary and Secondary Objectives


Objectives and constraints must be related to the

three primary investment objectives of safety, income, and growth, and to the secondary objectives of liquidity and tax minimization.
The importance of safety relates to: risk, market timing,

inflation, return, and emotion The importance of income relates to: taxation, return, risk, inflation, and basic minimum income The importance of growth relates to: taxation, risk, return, market timing, and emotional considerations

Why Study Investments?


Most individuals make investment decisions

sometime
Individuals need sound framework for managing and

increasing wealth
Essential part of a career in the field
Security analyst, portfolio manager, investment

advisor, financial planner, Chartered Financial Analyst

Investment Decisions
Underlying investment decisions: the tradeoff between

expected return and risk Return: expected return is not usually the same as realized return Risk: the possibility that the realized return will be different than the expected return

The Tradeoff Between ER and Risk


Investors manage risk at

a cost lower expected returns (ER) Any level of expected return and risk can be attained

Stocks

ER

Bonds

Risk-free Rate Risk

Typical Chart
RT

RISK- EXPECTED RETURN RELATIONSHIPS


12

RELATION

RISQUE-RENDEME

High
10

Options/Futures Art objects Coins and stamps

Real estate (commercial) Common shares Real estate (residential) Preferred shares Corporate bonds Government bonds
Rendement

Expected Return 6
4

Treasury bills

0 0 Low 2 4 6

Risk

10

12

High

The Investment Decision Process


Two-step process:

Security analysis

Necessary to understand security characteristics and applied to these securities to estimate their price or value Selected securities viewed as a single unit How and when should it be revised? How should portfolio performance be measured?

Portfolio management

Factors Affecting the Process


Uncertainty in ex post returns dominates decision

process

Future unknown and must be estimated

Foreign financial assets opportunity to enhance

return and/or reduce risk Investors must now cope with a changed investing environment Internet changes investments environment Institutional investors are important How efficient are financial markets in processing new information?

Corporate Governance
Main issues: The accountability of the Board of Directors and Management A re-examination of accounting and auditing practices Management compensation arrangements such as executive stock option plans Disclosure requirements The effectiveness of existing regulatory bodies