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 we 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?

What is an investment ? An investment is the current commitment of resources for a period of time in the expectation of receiving future resources that will compensate the investor for: the time resources are committed the expected rate of inflation the uncertainty of future payments

What is an investment ? 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.

What is an investment ? How about baseball cards? 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 defer consumption, investors need compensation from three sources the pure or real interest rate inflation protection risk

The real interest rate : 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.

Inflation Protection 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.

Combining the Real Rate and Expected Inflation 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 … So … 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!

The Financial Environment: Types of Investments 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.

The Financial Environment: Market Participants Households: net savers (investors) Federal Government: net borrower Businesses: issuers of investment securities such as stocks and bonds

The Financial Environment: Primary and Secondary Markets When issuers of securities raise money through selling new securities, often with the assistance of investment bankers or financial intermediaries, these are primary market transactions Investors trade among themselves in secondary markets, often with the assistance of brokers or dealers

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 Allocation Security Selection Active Market timing Stock picking Passive Maintain pre-determined allocation(s) Try to track a well-known 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.

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