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Charles P. Jones, Investments: Analysis and Management,

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Title: 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

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