Investment Models Securities and Investments

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Why Use Investment Models? All investors expect to earn money on their investments. All investors wish they could predict the future so they would know which investments will earn the greatest returns. Investors could close their eyes and pick investments randomly, but that could be very risky. All investors want to eliminate as much risk as possible. Investment models provide tools for selecting investments. 3 Copyright © Texas Education Agency, All rights reserved.

Measures of Risk  Beta - a measure of volatility of a company’s stock compared to the entire industry  Variance – the calculation of the measurement of risk involved, can be reduced through diversification 4 Copyright © Texas Education Agency, All rights reserved.

Capital Asset Pricing Model (CAPM) Used for pricing risky securities Formula includes a return for a risk-free security in addition to a premium which accounts for the additional risk Example: If an expected rate of return for a lower-risk security is 2% with a beta of 2 (industry average) and the projected return for the particular market is 8%, the selected stock should generate a 14% return (2% + 2(8%-2%)) 5 Copyright © Texas Education Agency, All rights reserved.

Capital Asset Pricing Model (CAPM) – cont.  Uses beta as an indicator-compares a stock’s performance to the market as a whole o >1 can mean the particular stock is more volatile than the market as a whole o <1 can indicate slower movement than the market  Contains risk that cannot be eliminated through diversification  Also contains risk that can be reduced through diversifying 6 Copyright © Texas Education Agency, All rights reserved.

Modern Portfolio Theory Assumes inherent market risk but attempts to reduce risk through diversification The diversification can raise returns due to the balancing of risky and less-risky investments The risk of one stock or investment is higher than a combination of different types of investments or stock in different companies. 7 Copyright © Texas Education Agency, All rights reserved.

Arbitrage Pricing Theory Stephen Ross created this theory in 1976 Assumes that the asset in question may not be priced accurately Studies the investment itself as opposed to the entire market 8 Copyright © Texas Education Agency, All rights reserved.

Venture Capital  Venture capital is money invested in a business, usually a new or small business with a high potential for growth.  Businesses financed with venture capital are usually extremely risky.  The investors are considered part owners.  These owners can create their own ‘fund’ 9 Copyright © Texas Education Agency, All rights reserved.

Venture Capital (continued)  These funds are more risky than mutual funds because the companies being funded are risky themselves, being new and growth-oriented.  Investors contribute at different times, starting with ‘seed’ or startup money  Then they contribute for marketing or other purposes as the company grows.  Eventually their stake in the company is sold.  The performance measurement for the fund is basically the internal rate of return of the money invested in the fund 10 Copyright © Texas Education Agency, All rights reserved.

Formal Assessments  Asset Allocation Scenarios Assignment #1 – Given the following three scenarios, create a pie chart for each displaying your recommendation for investment in different types of securities based upon the needs presented in each scenario. You may use spreadsheet software to create the pie charts or create them on posterboard, clearly displaying each scenario, clearly-labeled investments and percentages, and a paragraph summarizing your rationale for each scenario’s asset allocation. Following are the scenarios: 1) John is in his twenties, moderate income, single, very little in the way of assets, does not mind taking risks, 2) Mary has only a few years until she retires, has a high value of assets (house, cars, money to invest), but prefers safer (less risky) investments, 3) Ben is in his 40s, has a small amount of assets (car, electronics), and prefers a good balance between risky and conservative investments. Your pie charts will address percentages for cash, bonds, mutual funds, and stocks of large-, mid-, and small-cap companies. 11 Copyright © Texas Education Agency, All rights reserved.

Formal Assessments (continued) Asset Allocation Timeline Assignment #2 – In pairs students are to create a timeline for every ten years of life, from 20 to 60. They will add the different levels of risk tolerance for what they believe is typical for each time period. Then they will provide a short-term and long-term financial goal for each period on the timeline. They should include a graphic or some sort of visual for each of the goals listed. Then they will provide one investment for each of the time periods that is appropriate for the time period and financial goals. They may do this on a word processing document or on flipchart paper. Investment Strategy Brochure Assignment #3 – Students will create a six- panel brochure in a word processing program from the point-of-view of someone who is instructing another student about the different pricing models. The student should include sections about beta and what it means, major points about the different models, including who created the models, pros and cons for each model, and a section about what the student has learned about risk so far. Examples of each model can also be included. This assignment will require Internet research to increase understanding. The brochure should look professional when completed. 12 Copyright © Texas Education Agency, All rights reserved.