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.

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

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?

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

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.)

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

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

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

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

Typical Chart
RT

RISK- EXPECTED RETURN RELATIONSHIPS

12

RELATION

RISQUE-RENDEME

High
10

Options/Futures Art objects Coins and stamps

Real estate (commercial) Common shares Real estate (residential) Preferred shares Corporate bonds Government bonds
Rendement

Expected Return 6
4

Treasury bills

0 0 Low 2 4 6

Risk

10

12

High

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 Selected securities viewed as a single unit How and when should it be revised? How should portfolio performance be measured?

Portfolio management

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?

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

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

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

Appendix 1-B: Professional 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

Appendix 1-B: Professional 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