1. THE INVESTMENT SETTING
Chapter 1
THE INVESTMENT SETTING

2. Chapter 1 Questions What is an investment ?
What are the components of the required rate of return on an investment?
What key issues should investors always consider?
What types of investments can we make?
Where do investors place funds for investment and savings purposes?
What are some basic investment philosophies that individual and institutional investors follow?
Why are ethics and regulations a concern to all investment professionals?
What are some career paths available for persons interested in investments?

3. What is an investment ?
An investment is the current commitment of resources for a period of time in the expectation of receiving future resources that will compensate the investor for:
the time resources are committed
the expected rate of inflation
the uncertainty of future payments

4. What is an investment ?
Is hiding money in a mattress or keeping it in a piggy bank an investment ?
No! The “safe-keeping” of money does not involve any expected compensation.

5. What is an investment ?
How about baseball cards? Are they an investment?
Possibly, but compensation is highly uncertain, and some of the value of ownership may be “sentimental” rather than financial in nature.

6. Components Of The Required Rate of Return
In order to defer consumption, investors need compensation from three sources
the pure or real interest rate (Real risk free rate )
inflation protection
risk

7. The real interest rate : Compensation for time
The real risk-free rate of interest is the exchange rate between future consumption and present consumption.
This rate of interest can be thought of as the “pure” rental rate on money in the absence of inflation and risk.
Question: if some one want to borrow
100 $ for a year form you, how much do you want received after a year? Suppose there is no inflation, no risk.

8. Why is the real risk-free rate positive?
Borrowers are willing to pay to be able to spend more than their current resources allow.
Savers need compensation in order to give up the right to consume today.

9. Inflation Protection
If the future payment will be diminished in value because of inflation, then investors will demand an interest rate higher than the real risk-free interest rate so that their expected purchasing power will actually increase.

10. example 1970-2001年，美国平均通货膨胀率5％ 中国
全国居民消费价格总水平比上年上涨
2004年3.9% 2003年1.2% 2002年0.8% 2001年0.7% 2000年0.4% 1999年1.4%
1998年0.8%

12. Use the former example,
If you expected the inflation rate is 2% in the come year, how much do you want to be paid after a year?

13. Combining the Real Rate and Expected Inflation
The nominal risk-free rate of interest adjusts the real risk-free rate to reflect expected inflation over the life of the investment.
Taking into account these two factors (time and expected inflation) compensates investors for the “time value” of their money.

14. Compensation for Risk-bearing
Investors tend to be risk-averse, meaning that they need sufficient expected additional compensation in order to bear additional risk.
If the future payment from an investment is uncertain, investors will demand an interest rate that exceeds the nominal risk-free rate of interest to provide a risk premium.
Use the same example,
If there is some risk in the investment, and you need 3% risk premium, then how much do you want be paid?

15. The Required Rate of Return
The sum of the nominal risk-free interest rate and the risk premium on an investment gives that investment’s required rate of return.
Note that for riskier investments, the risk premium, and therefore the required rate of return, will be higher than for lower risk investments.

16. Issues That Investors Should Always Consider
There is a trade-off between risk and expected return.
Developed financial markets are nearly efficient.
Focus on after-tax returns, net of expenses.
Diversify across asset types, industries, and even countries.

17. Risk-Return Trade-Off
Because investors tend to be risk averse, it makes sense that they will only take on riskier investments if they expect to earn more than with lower risk investments.

18. Market Efficiency An efficient market is one where … So …
Information is quickly and accurately reflected in asset prices,
So …
What appears to be “news” is not useful in predicting future asset prices,
With the result that …
Investors cannot systematically and consistently “beat the market” without the aid of either inside information or loads of luck.

19. Implications of Market Efficiency
It’s what is unexpected that moves the market (the genuinely new information in news).
We should be skeptical of investment strategies that claim to be able to beat the market on a consistent basis.

20. The Paradox of Market Efficiency
If markets are perfectly efficient, it makes no sense to seek out superior investments.
But if nobody seeks out superior investments, the market would not remain efficient!

21. Take Taxes and Expenses Into Account
It’s what you get to keep that counts!
Taxes affect investment decisions
Some allow for lower or no tax burden (Municipal bonds)
Some allow for deferral of tax liability (IRA’s)
Lets look an example:
Mary and John each invest $2,000 for 25 years in a mutual fund account that earns over time an average annual 10 percent return on a pre-tax basis. After income and capital gains tax, an investor’s annual return could be only 8%. Mary’s money is invested in tax-defferred IRA; John invested in the fund through a taxable account. How much do they get actually after 25 years.

22. Take Taxes and Expenses Into Account
Since financial markets are “nearly” efficient, even large investors generally do not beat the market, but that does not mean that they do not generate lots of expenses in trying to!
Avoid high expense investments when possible since they tend to reduce “net” return without increasing “gross” return.

23. Diversify, Diversify, Diversify
Don’t put all of your eggs in one basket!
Diversification reduces risk without necessarily sacrificing expected return.
It’s a no-brainer!

25. The Financial Environment: Market Participants
Households: net savers (investors)
Federal Government: net borrower
Businesses: issuers of investment securities such as stocks and bonds

26. The Financial Environment: Types of Investments
Real assets vs. Financial assets
Tangible assets vs. Claims on assets
Direct vs. Indirect financial investments
Individual securities vs. “pools” of assets
Derivatives
Futures, options

27. The Financial Environment: Primary and Secondary Markets
When issuers of securities raise money through selling new securities, often with the assistance of investment bankers or financial intermediaries, these are primary market transactions
Investors trade among themselves in secondary markets, often with the assistance of brokers or dealers

28. Basic Investment Philosophies
In forming an investment portfolio, several questions are paramount:
In what types of securities should I invest?
Asset Allocation
Within each security type, how do I select which assets to purchase?
Security Selection
Finally, how active should I manage my portfolio?
Should I be an active or passive investor?

29. Summarizing the Basic Strategies
Asset Allocation
Security Selection
Active
Market timing
Stock picking
Passive
Maintain pre-determined allocation(s)
Try to track a well-known market index

30. Ethics in Investments
Financial markets are vitally important to a well-functioning economy.
Trust in information and faith in fairness are essential.
Codes of ethics for financial professionals and strict regulations attempt to create such an environment where financial markets can efficiently fulfill their economic function.

31. Jobs in Investments Registered Representative of a Brokerage Firm
Investment Analysis
Portfolio Management
Financial Planning
Corporations
Professional Designations
Chartered Financial Analyst (CFA)
Certified Financial Planner (CFP)