Charles P. Jones, Investments: Analysis and Management,

1
UnderstandingInvestments

• Chapter 1
• Charles P. Jones, Investments Analysis and
  Management,
• Ninth Edition, John Wiley Sons
• Prepared by
• G.D. Koppenhaver, Iowa State University
• Additional Information by Axel Grossmann

2
Objectives

• To understand the investments field as currently
  practiced
• To help you make investment decisions that will
  enhance your economic welfare
• To create realistic expectations about the
  outcome of investment decision
• Learn Investments as a profession
• For private us

3
Questions

• Should you avoid stocks due to the decline of
  major indexes in 2000 to 2001?
• Should you invest in international and emerging
  markets?
• Two-thirds of all affluent Americans use
  financial advisers, why?
• Was the average annual rate of return higher for
  stocks or Treasury?

4
Questions

• Stocks have historical provided a higher average
  annual rate of return than saving accounts. Why
  would you invest in other securities such as CDs?
• If someone offers you a 36 return on a riskless
  security, would you entrust your money to him?

5
Investments Defined

• Investments is the study of the process of
  committing funds to one or more assets
• Emphasis on holding financial assets and
  marketable securities
• Concepts also apply to real assets
• Foreign financial assets should not be ignored
• e.g. CDs, common stocks, mutual funds, gold, real
  estate.
• Conservative investment strategies
• Aggressive investment strategies

6
Investments Defined

• Financial assets
• Pieces of paper (or electronic) evidencing a
  claim on some issuer
• Real Assets
• Physical assets, such as gold or real estate
• Marketable Securities
• Financial assets that are easily and cheaply
  traded in organized exchanges
• Portfolio
• The securities help by an investor taken as unit

7
Why Study Investments?

• Personal Aspect
• Most individuals make investment decisions
  sometime (e.g. individual retirement account IRA)
• Investing is only one part of overall financial
  decisions
• Need sound framework for managing and increasing
  wealth
• Invest 1200 each year for 40 years
• At 0 48,000
• At 5 144,959
• At 15 2,134,908

8
Why Study Investments?

• Essential part of a career in the field
• Security analyst
• Portfolio manager
• Registered representative
• Financial Planner
• Certified Financial Planner
• Investment Field
• Chartered Financial Analyst

9
The Basis of Investment Decisions

• Stocks have historical provided a higher average
  annual rate of return than saving accounts.
• Why would you invest in other securities such as
  CDs?

10
The Basis of Investment Decisions

• Underlying investment decisions
• The tradeoff between expected return and risk
• Expected return is not usually the same as
  realized return
• Risk
• The possibility that the realized return will be
  different than the expected return
• Risk-Aversion

11
The Basis of Investment Decisions

• Return
• Opportunity cost of cash?
• Forego the opportunity to earn a return on your
  cash
• Inflation will lower the purchasing power on your
  cash
• Expected Return
• The anticipated return for some future period
• Realized Return
• Actual return on an investment

12
The Basis of Investment Decisions

• Risk
• The uncertainty about the actual return that will
  be earned on an investment.
• Risk that the actual return is less than the
  expected return.
• Risk that the actual return will cause a loss.
• Examples
• Return on U.S. Treasury Bill has practically no
  risk
• Return on a corporate bond has some risk
• Return on common stock has substantial risk

13
The Basis of Investment Decisions

• Risk-Averse Investors
• A risk-averse investor is one who will not incur
  any given level of risk unless there is an
  expectation of adequate compensation for having
  done so.
• High level of risk expectation of high return
• No risk risk-free rate of return
• Direct relationship between risk and expected
  return.
• Expected return-risk trade-off

14
The Tradeoff Between Expected Return and Risk

• Investors manage risk at a cost - lower expected
  returns (ER)
• Any level of expected return and risk can be
  attained
• Risk-Free rate of Return
• Often proxied by the return on Treasury
  securities.
• The trade-off is defined as an upward sloping
  line

15
The Tradeoff Between Expected Return and Risk
16
The Investment Decision Process

• Two-step process
• Security analysis and valuation
• Professional security analysts are employed by
  institutional investors
• Necessary to understand security characteristics
• Estimating expected return and risk
• Estimating fundamental value based on current
  information (based on earnings, dividend, risk
  etc)
• If actual market price departs from estimated
  economic value, investors will act
• Buy undervalued stocks
• Sell overvalued stocks

17
The Investment Decision Process

• Two-step process
• Portfolio management
• Selected securities based on evaluation
• Passive Investment strategy (mutual funds,
  indexing, few changes)
• Assumes markets are efficient
• Active investment strategy (frequent changes to
  the investment proportions)
• Assumes that one can make extra profit (beat the
  market)
• How efficient are financial markets in processing
  new information?
• How and when should it be revised?
• How should portfolio performance be measured?

18
Factors Affecting the Process

• Uncertainty in ex post returns dominates decision
  process
• Future unknown and must be estimated
• The past may or may not repeat itself
• The Global Investment Arena
• Less than 20 of all firms are listed in the U.S.
• Only half of the worlds market capitalization
  comes from the U.S.
• Only 6 of U.S. mutual fund money invested abroad

19
Factors Affecting the Process

• The Global Investment Arena
• Foreign financial assets opportunity to enhance
  return or reduce risk
• Western European Markets (well developed)
• Emerging Markets
• Markets of less developed countries,
  characterized by high risks and potentially large
  returns
• Currency risk
• Strong dollar, lower returns from foreign
  investments
• EMU and the Euro

20
Factors Affecting the Process

• Quick adjustments needed to a changing
  environment
• Old Economy traditional companies
• E.g. Ford, GE, Proctor Gamble
• New Economy new technology
• E.g. Cisco, Yahoo, etc
• The Internet and investment opportunities
• Has democratized the flow of investment
  information
• Institutional investors important

21
Factors Affecting the Process

• Institutional investors important
• individual investors compete with institutional
  investors
• Mutual Funds
• Investment companies
• Life Insurance companies
• individuals are also the beneficiaries of
  institutional investor activity, such as pension
  funds
• Regulation FD
• Regulates communications between public companies
  and investment professionals
• Information must be disclosed to everyone at the
  same time

Professional money managers smart money