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Chapter 1

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) Stocks
• Any level of expected ER
return and risk can be Bonds
attained

Risk-free Rate
Risk
“Typical” Chart
RT

RELATION RISQUE-RENDEME
RISK- EXPECTED RETURN RELATIONSHIPS
12

High Options/Futures
10 Art objects
Coins and stamps
8
Real estate (commercial)
Common shares
Expected
6 Return Real estate (residential) Rendement

Preferred shares
4
Corporate bonds
Government bonds
2
Treasury bills

0
Low
0 2 4 6
Risk
8 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
 Portfolio management
• Selected securities viewed as a single unit
• How and when should it be revised?
• How should portfolio performance be measured?
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?