Investments: Analysis and Management, Second Canadian Edition

1
Chapter 1
Understanding Investments
2
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.

3
Inter-temporal Choices

• Utility of consumption
• Savings foregone consumption, the difference
  between current income and current consumption
• Borrowing
• Demand and Supply determines the equilibrium price

4
Investments Defined

• Investment - the process of committing funds to
  one or more assets
• The sacrifice of certain present value for
  (possibly uncertain) future value
• MGT3040?

5
Investment Objectives

• Primary Objectives
• Safety of principal
• Income
• Growth of capital
• Secondary Objectives
• Liquidity
• Tax minimization

6
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.)

7
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

8
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

9
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

10
The Tradeoff Between ER and Risk

• Investors manage risk at a cost lower expected
  returns (ER)
• Any level of expected return and risk can be
  attained

Stocks
ER
Bonds
Risk-free Rate
Risk
11
Typical Chart
12
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?

13
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 cope with a new investing
  environment
• Internet changes investments environment
• Institutional investors are important
• How efficient are financial markets in processing
  new information?

14
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?

15
Corporate Governance

• 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
• Disclosure requirements
• The effectiveness of existing regulatory bodies

16
Appendix 1-A The Chartered Financial Analyst
(CFA) Program

• Individuals who are interested in the investment
  area should consider seeking a CFA designation
• Level I emphasizes tools and inputs
• Level II emphasizes asset valuation
• Level III emphasizes portfolio management
• For more information www.cfainstitute.org

17
Appendix 1-BProfessional Educational
Alternatives

• Canadian Securities Institute (CSI)
• The CSI offers the Canadian Securities Course
  (CSC), which is a mandatory requirement for
  individuals who wish to become licensed to sell
  financial securities in Canada and to register to
  sell mutual funds
• CFA Institute (formerly Association for
  Investment Management and Research (AIMR))
• The CFA institute administers the Chartered
  Financial Analyst curriculum and examination
  program

18
Appendix 1-BProfessional Educational
Alternatives

• Financial planners
• The Financial Planners Standards Council (FPSC)
  developed a set of minimum standards regarding
  education, experience, and ethical and moral
  conduct for financial planners