Francis & IbbotsonChapter 1: The Investment Setting1 Chapter 1 The Investment Setting

Francis & IbbotsonChapter 1: The Investment Setting 2 What is Investing?  Criteria used to determine whether an investment of money is investing or something else, including: –Is it short-term or long-term? –Is it productive or unproductive? –Is it legal or illegal? –Is it rational or irrational?

Francis & IbbotsonChapter 1: The Investment Setting 3 Gambling vs. Speculating  Gambling occurs when –Outcome is determined very quickly (a roll of the dice, for instance) –A source of entertainment –Outcome is not based on an economic endeavor, but, rather, random outcomes –Creates risk without expectation of economic benefit  Speculation occurs when –An asset is purchased with hope that price will rise rapidly, leading to quick profit –Not based on random outcomes Example: Buying an IPO of a stock on the first day hoping to sell it in several days at a higher price

Francis & IbbotsonChapter 1: The Investment Setting 4 Assets of Choice  Major asset classes include –Primary securities such as common and preferred stock, government bonds, corporate bonds, Treasury bills, commercial paper –Derived instruments such as mutual funds, put and call options, forward and futures contracts –Physical assets such as houses, land, buildings, diamonds, gold

Francis & IbbotsonChapter 1: The Investment Setting 5 Other Issues  Large international corporations have their securities traded somewhere in the world 24 hours a day  While other areas—such as China and Africa — have a larger population than the U.S., the U.S. has the highest Gross National Product (GNP) [a measure of a nation’s income] –However, when allocating a country’s GNP across the country’s population, the U.S. ranks 6 th But after adjusting for each country’s cost of living, the U.S. ranks 2 nd behind Luxembourg

Francis & IbbotsonChapter 1: The Investment Setting 6 The World’s Equity Capital  World’s equity capital is concentrated in North America, western and central Europe and the Pacific Rim (mostly Japan) Because market prices are rather volatile, this situation can change rapidly. For instance, from Japan’s stock market was worth more than the U.S. stock market.

Francis & IbbotsonChapter 1: The Investment Setting 7 The World’s Bond Market

Francis & IbbotsonChapter 1: The Investment Setting 8 The World’s Bond Market

Francis & IbbotsonChapter 1: The Investment Setting 9 World’s Real & Human Capital  Value of world’s real assets > financial assets  World’s human capital greatly exceeds combined world’s real and financial capital –Income from human capital is  80% of the world’s income –Human capital represents the stock of ideas and information possessed by humans For instance, the capital contained within a tool doesn’t come from the tool itself, but from the knowledge of how to build and use the tool

Francis & IbbotsonChapter 1: The Investment Setting 10 The U.S. Financial Markets Residential real estate is one of the larger investments made by U.S. citizens. However, this may change in the future.

Francis & IbbotsonChapter 1: The Investment Setting 11 U.S. Equity Investors  Individual investors –Over 50 million in the U.S. –Typically own only a few stocks with aggregate value of  $15,000 –Have a small impact on U.S. equities market –Mostly amateurs who ‘play the market’  Institutional investors –Include pension funds, mutual funds, life insurance companies, commercial bank trust departments, etc. –In 1998 controlled  60% of market value of U.S. equities with individual investors controlling remainder –Households own much of the money managed by institutional investors –Frequently buy shares in blocks of 10,000 or more Block trades account for  51% of volume on NYSE

Francis & IbbotsonChapter 1: The Investment Setting 12 U.S. Market for Bonds

Francis & IbbotsonChapter 1: The Investment Setting 13 The Bottom Line  In determining whether a gamble, a speculation or an investment has occurred, it is useful to examine the length of the holding period  Even though there are millions of individual investors, their impact on the U.S. equities market is small  Institutional investors (such as pension funds, insurance companies, mutual funds) have a much greater impact on the U.S. markets

Francis & IbbotsonChapter 1: The Investment Setting 14 Appendix: Opportunities and Salaries in Investments Investment Counsel. FirmBank Security Broker/ Dealer Insurance Company Mutual Fund Mgmt. Co. Plan Sponsor/ Endow./ Foundat. Pension Consult. Firm 1999 Median Salary $113,150$90,000 $107,000$110,000$92,750$80, Median Bonus $50,000$30,000$85,000$35,000$70,000$11,000$12, Median Non-Cash Compensation $9,000$10,000$8,000$5,000$20,000$200$2,000 Median Total Compensation $185,000$128,000$185,000$150,000$196,000$104,200$95, th Percentile$682,265$365,111$757,108$430,769$814,603$294,412$256,250