A' Understand Investments

1
Introduction

• A. Understand Investments
• B. Understand the Investment Process
• C. Understand differences between financial and
  real assets in the economy
• D. Understand types of financial markets and
  trends in those markets

2
Chapter 1

• Toolbox
• Investments - Background and Issues

3
A. Understand Investments

• What is an Investment?
• Current commitment of money or other resources in
  the expectation of reaping future benefits.
• What is Sacrifice?
• Current commitment of money or other resources in
  the expectation of reaping future benefits.
• Is there a difference?
• Interestingly, in the church we interchange the
  two.

4
Investments (continued)

• Are there priorities of Investments?
• What are your most important investments?
• Your family

5
Investments (continued)

• What are your other key investments?
• Education and Skills
• Knowledge and Friendships
• Food Storage and Emergency Funds
• Financial Investments
• Do not be too narrow in your view of investments

6
Investments (continued)

• What investments will we be working with in this
  class?
• Generally financial investments
• Stocks (equities), bonds, options, futures, etc,
  (with reference to other important investments as
  well)
• Will the analysis skills we will be learning be
  useful for other investments as well?
• Yes, they can be used in analyzing any type of
  investment, whether its a dental or medical
  office practice, a small business, a department
  of a larger business, or even a home.

7
Questions?

• Do we understand investments?

8
B. Understand the Investment Process

• Not as simple as it seems
• Theres a whole industry set up to help you
  establish a framework
• Association for Investment Management and
  Research (which sponsors the CFA program)
• Its a process of determining your current
  financial state, your objectives, constraints,
  policy, investing, and then monitoring your
  investments with the intent of reaching specific
  goals

9
The Investment Process (continued)

• Four major steps
• 1. Specifying Objectives
• What are your (realistic) risk and return
  expectations?
• What kind of return do you need?
• What amount of risk can you handle?

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The Investment Process (continued)

• 2. Specifying Constraints
• What are your individual circumstances that will
  impact portfolio construction?
• Taxes
• Liquidity
• Time horizon
• Regulations
• Unique needs

11
The Investment Process (continued)

• 3. Formulating Policies
• What group of asset classes can be invested in to
  meet your objectives and constraints, and how
  should they be invested?
• Allowable asset classes stocks, bonds, money
  funds, international, real estate, etc.
• How will you invest your assets
• Active or passive (market efficiency)
• Top-down or bottom-up
• Individual stocks or mutual funds

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The Investment Process (continued)

• Make the Asset Allocation Decision based on
  current and long-term market expectations
• Set your acceptable asset classes and your
  percentage in each asset class
• Begin to invest the assets
• Begin security selection

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The Investment Process (continued)

• 4. Monitoring and Updating the Portfolio
• Monitor portfolio performance to ensure it meets
  your goals and objectives
• Monitor asset allocation based on market
  expectations
• Modify and change the portfolio as necessary to
  meet your objects and to take into account
  changes in market expectations, investor
  constraints, and current conditions

14
Questions?

• Do we understand the investment process?

15
Problem 1-15

• What are some advantages and disadvantages of
  top-down versus bottom-up investing styles?

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Answer 1-15

• Under top-down investment strategy, you focus on
  the asset allocation or broad composition of the
  entire portfolio, which is the greatest
  determinant of your performance. It is also a
  natural way to establish a portfolio with a risk
  level appropriate for you. The disadvantage is
  that you could give up potential high returns
  from individual securities that may be
  attractive.
• Under bottom-up investing, you try to benefit
  from finding undervalued securities. The
  disadvantage is that you tend to overlook the
  overall composition of your portfolio, which may
  result in a non-diversified portfolio. It also
  tends to require more active management, hence
  higher costs.

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C. Understand the differences between Financial
and Real Assets in the Economy

• The wealth of a society is determined by the
  productive capacity of the economy
• The productive capacity is a function of the
  real assets in the economy
• Real Assets
• Assets used to produce goods and services, e.g.,
  land, machines, buildings, and knowledge
• Financial Assets
• Claims on real assets which only define ownership
  of income streams, e.g., stocks, bonds, warrants,
  etc.

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Financial and Real Assets

• If we cannot own our auto plant (a real asset),
  we can still buy shares in GM or Toyota
  (financial assets) and, thereby, share in the
  income derived from the production of
  automobiles.
• When investors buy these securities from
  companies, the firm use the money so raised to
  pay for real assets, such as plant, equipment,
  technology, or inventory.
• So investors returns on securities ultimately
  come from the income produced by the real assets
  that were financed by the issuance of those
  securities.

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Financial and Real Assets (continued)

• What are the three purposes of financial assets?
• 1. Consumption timing
• Shift consumption to the most optimal time period
  
• 2. Allocation of Risk
• Shift risk to those most willing to bear it (at
  the expectation of higher return)
• 3. Separation of Ownership and Management
• Separates functions and allows for large firms to
  be managed professionally (hopefully)

20
Agency Problem

• Do managers really attempt to maximize firm
  value?
• To mitigate potential agency problem
• Compensation plans tie the income of managers to
  the success of the firm.
• BOD force out management teams that are
  underperforming.
• Outsiders monitor the firm closely.
• Bad performers are subject to the threat of
  takeover.

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Financial and Real Assets (continued)

• Major Classes of Financial Assets or Securities
• Debt
• Money market instruments
• Bonds
• Equity
• Common stock
• Preferred stock
• Derivative securities

22
Questions

• Do you understand the difference between real and
  financial assets?

23
Question 1-1

• Suppose you discover a treasure chest of 10
  billion in cash.
• A. Is this a real or financial asset?
• B. Is society any richer for the discovery?
• C. Are you wealthier?
• D. Can you reconcile your answers to (b) and
  (c)? Is anyone worse off as a result?

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Answer 1-1

• A. Cash is a financial asset because it is a
  liability of the government.
• B. No. The cash does not directly add to the
  productive capacity of the economy.
• C. Yes.
• D. Society as a whole, since taxpayers as a
  whole will have to make up for the liability.

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The Financial Systems
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D. Understand the 4 Types of Financial Markets
and Trends in those markets

• 1. Direct Search Markets
• Buyers/sellers seek each other out
• Example Classified ads
• 2. Brokered Markets
• Brokers offer search services
• Example Primary market, large block
• 3. Dealer Markets
• Dealers specialize in specific assets
• Example OTC
• 4. Auction Markets
• Traders converge on a single place
• Example NYSE

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Trends (continued)

• Four major trends
• 1. Globalization
• 2. Securitization
• 3. Financial Engineering
• 4. Information and computer networks
• The Future?

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Trends (continued)

• 1. Globalization
• International and Global Markets continue
  developing to meet needs
• Managing foreign exchange becoming critical to
  returns
• Diversification becomes even more important
• Instruments and vehicles continue to develop to
  meet global needs
• Information and analysis improves

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Trends (continued)

• 2. Securitization and Credit Enhancement
• Offers opportunities for investors and
  originators
• Requires changes in financial institutions and
  regulation
• Seeks improvement in information capabilities and
  requirements
• Encourages credit enhancement and its role in
  capital formation

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Trends (continued)

• 3. Financial Engineering
• Allows repackaging of services of financial
  intermediaries to meet a specific need or
  objective
• Encourages bundling and unbundling of cash flows
  to meet investor needs for cash flow timing
• Examples strips, CMOs, dual purpose funds,
  principal/interest splits

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Trends (continued)

• 4. Computer Networks
• The Internet and other advances in computer
  networking are transforming many sectors of the
  economy.
• Online trading connects a customer directly to a
  brokerage firm.
• The internet has also allowed vast amounts of
  information to be made cheaply and widely
  available to the public.
• Electronic communication networks that allow
  direct trading among investors have exploded in
  recent years.

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Trends (continued)

• The Future
• Globalization continues and offers more
  opportunities for all
• Securitization continues to develop, and
  increases dramatically in the Emerging Markets
  (less developed countries)
• Continued development of derivatives and exotics
  will meet investor needs
• Greater integration of investments corporate
  finance will lead to greater need for good
  financial analysis

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Questions?

• Do you understand the main financial markets and
  trends?

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Problem 1-9

• Why would you expect securitization to take place
  only in highly developed capital markets and
  countries, and not yet in many emerging markets
  such as Russia, Iran, and Pakistan?

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Answer 1-9

• Securitization requires access to a large number
  of potential investors. To attract them the
  capital market needs
• A safe system of business laws and low
  probability of confiscatory taxation/regulation
• A well developed investment banking industry
• A well developed system of brokerage and
  financial transactions
• A well developed media, particularly financial
  reporting
• These functions are found in, and need, a well
  developed capital market.

36
Review of Learning Objectives

• Do you feel comfortable with
• A. Investments?
• B. The Investment Process?
• C. The differences in financial and real assets
  in the economy?
• D. The types of financial markets and trends in
  those markets?
• Questions?