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 (The sacrifice of certain present value for possibly uncertain future value)  Emphasis on holding financial assets and marketable securities  Concepts also apply to real assets  Foreign financial assets should not be ignored

Types of Assets A financial asset is a paper or electronic claim on an issuer such as a corporation or the federal or provincial government. Examples of financial assets include stocks, government bonds, and corporate bonds. A real asset is a tangible physical asset. Examples of real assets include gold, silver, gems, art, coins, and real estate.

Investment Objectives Primary Objectives  Safety of principal  Income (e.g. dividends)  Growth of capital (e.g. capital gains) Secondary Objectives  Liquidity (the ease with which assets can be converted into cash with little risk of loss of principal) & Marketability (the ease with which an asset maybe bought and sold)  Tax minimization

Investment Constraints Possible constraints for investors include:  Legal constraints  Taxes  Transaction Costs  Moral / Ethical  Emotional – including investment knowledge and risk tolerance  Income requirements (basic minimum income to be provided by the portfolio)  Diversification Requirements  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

Primary and Secondary Objectives (cont.) There are three main constraints that could have an impact on the design of an investment policy 1- the level and stability of current and future income and financial obligations of an investor 2- an investor’s level of investment knowledge 3- an investor’s tolerance for risk

Sources of Risk Total Risk = Unsystematic Risk + Systematic Risk Unsystematic Risk (diversifiable risk): depends on the factors that are unique to the specific asset (e.g. business risk) Systematic Risk (nondiversifiable risk): depends on factors that affect the returns on all comparable investments (e.g. interest rate risk, reinvestment rate risk, exchange rate risk, & purchasing power risk)

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

Why Study Investments? (cont.) The study of investments is important to most individuals because almost everyone has wealth of some kind and will be faced with investment decisions at some point in their lives. One important area where many individuals may make important investing decisions is retirement plans, particularly their Registered Retirement Savings Plan (RRSP). Investments, in the final analysis, is simply a risk-return tradeoff. In order to have a chance to earn a return above that of a risk-free asset, investors must take risk. The larger the return expected, the greater the risk that must be taken

Underlying investment decisions: the tradeoff between expected return and risk Return: expected return is not usually the same as realized return Expected return is the anticipated return by investors for a future time period Realized return is the actual return on an investment for a previous period of time Risk: the possibility that the realized return will be different than the expected return Investment Decisions

Investors manage risk at a cost – lower expected returns (ER) Any level of expected return and risk can be attained An investor would expect to earn the risk-free rate of return when he or she invests in a risk-free asset (such as a Treasury bill) Risk ER Risk-free Rate Bonds Stocks The Tradeoff Between ER and Risk

“Typical” Chart

Risk-Expected Return Relationships Required rates of return differ as the risk of an investment varies. Government of Canada bonds are less risky than corporate bonds, and therefore have a lower required rate of return

Two-step process:  Security analysis The first step in the investment decision process, involves the analysis and valuation of individual securities Necessary to understand security characteristics and applied to these securities to estimate their price or value  Portfolio management The second step, involves managing a group of assets (a portfolio), as a unit Selected securities viewed as a single unit The Investment Decision Process

Active and Passive Investment Strategies An active investment strategy involves identifying and investing in securities that the investor believes are underpriced. An investor would concentrate on identifying and purchasing these securities in an attempt to outperform the market. A passive investment strategy is based on the belief that most securities are fairly priced. With this strategy, an investor would attempt to construct a portfolio that mirrors the market index and would concentrate instead on reducing transaction costs and taxes.

1- Uncertainty 2- The investing environment (institutional investors vs. individual investors) 3- The globalization of the investing process 4- The issue of market efficiency External Factors Affecting the Decision Process

Uncertainty The most important factor investors must deal with is uncertainty. Uncertainty dominates investments, and always will, since the realized return on a risky asset will almost always be different (sometimes quite different), from the expected return.

Institutional Investors Institutional investors consist of banks, pension funds, investment companies, insurance companies, and bank trust departments. These investors manage huge portfolios of securities. Institutional investors own and manage portfolios of securities. They affect the investments environment (and therefore individual investors), through their actions in the marketplace and by buying and selling securities in large dollar amounts. However, although they appear to have several advantages over individuals (research departments, expertise, etc.), reasonably informed individuals should be able to perform as well as institutions, on average, over time. This relates to the issue of market efficiency.

Market Efficiency Efficient markets are ones in which the prices of securities quickly and correctly reflect information about securities. In such a market, the prices of securities do not depart for long from their justified economic values. An efficient market is significant to investors because it will affect their behaviour. Quite a few actions, such as performing the same security analysis as everyone else, are of no value in an efficient market. Technical analysis is ruled out, as is standard fundamental analysis.

Foreign Financial Assets Investors should be concerned with global investing for several important reasons: 1- more opportunities are now available to investors in the form of mutual funds and closed-end funds investing in foreign stocks and bonds 2- the returns may be better in foreign markets at a particular point in time than in the Canadian markets 3- by investing in foreign securities, investors may be able to reduce the risk of their portfolios 4- many Canadian companies are increasingly affected by conditions abroad

Ex ante and Ex post Ex ante: meaning before the fact, it refers to an investor’s expectation of higher returns from assets with higher risk before the investment is actually made. Ex post: meaning after the fact or when it is known what has occurred, refers to the actual return realized for the risk taken.

The Effect of the Internet Internet technology has: 1- Revolutionized the flow of investment information 2- Dramatically lowered commission rates for individual investors 3- Allowed investors to trade with software on their own personal computer 4- Led to intense competition among on-line discount brokerage firms for investor business

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 (ESOPs) Disclosure requirements The effectiveness of existing regulatory bodies Corporate Governance