1. Introduction to Investments (Chapter 1)
MB 72

2. Outline What is meant by “Investment”? Why do individuals invest?
Measuring Risk and Return
Sources of Risk
Relationship between Risk and Return

3. Meaning of Investments
Commitment of money that is expected to generate additional money
Current commitment of dollars for a period of time to desire future payments that will compensate the investor for
The time the funds are committed
The expected rate of inflation, and
The uncertainty of the future payments
The investor can can be an individual, a government, and/or a corporation

4. Why do individuals invest?
To achieve a higher level of consumption in the future by forgoing consumption today
To improve our welfare in the future
Investments help us achieve tradeoff between current consumption and future consumption

5. Why Study Investments? The Personal Aspects Investment as a Profession
To earn better returns in relation to the risk we assume when we invest
Knowledge of investments help investors understand the relationship between risk and return
Investment as a Profession
To become a licensed broker (series 7 exam), to become CFA/CFP/CMA, knowledge of investments is needed

6. Basis of Investment Decisions
Basic element of all investment decisions: trade-off between expected return and risk
Expected return is not usually the same as realized return

7. Measuring Return on Investments
Measures of Actual Return/Historical Return/Realized Return
Holding Period Return (HPR)
Total Holding Period Return
Annualized HPR = [HPR]1/n, where n is the number of years investment is held
Holding Period Yield = HPR - 1 n
Mean Rate of Return = HPYi/n
i=1
Geometric Mean = [HPR1HPR2 … HPRn]1/n – 1
Which measure gives us a better estimate of the wealth effect of an investment?

8. Expected Return
A weighted average of each possible outcome, where weights represent the probability of each possible outcome
Multiply each possible outcome by its probability and add them up n
E(Ri) =  Pi  Ri
i=1

9. Risk of Expected Returns
Risk is defined as the chance that the actual return on an investment will differ from its expected return—variability of returns
Risk is measured by standard deviation of expected returns
Standard deviation () is given by [variance]1/2 n
Variance =  Pt [Rt – E(R)]2
t=1
Where Pt represents probability of each possible outcome; Rt represents each possible return; E{R} represents expected return.

10. 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

11. Making Investment Decisions on the Basis of Expected Return and Risk
Investors should choose dominant assets
Dominant Assets—assets that promise higher expected return at any selected level of risk or assets that promise minimum risk of all assets at any selected level of expected return.
Example of Dominant Assets

12. Example Assets Expected Return Risk M 10% 10% B 5% 10% C 5% 20%
Which of these assets is dominant over others? Which of these assets is not being dominated by any other asset?

13. Return M A E
15% M
10% T C B 5% T
RISK 5%
10% % % % %

14. A, M, and T are dominant investments
Which one would you choose and Why?

15. The Investment Decision Process
Two-step process:
Security analysis and valuation
Necessary to understand security characteristics
Portfolio management
Selected securities viewed as a single unit
How efficient are financial markets in processing new information?
How and when should it be revised?
How should portfolio performance be measured?

16. 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 or reduce risk
Quick adjustments needed to a changing environment
The Internet and investment opportunities
Institutional investors important

17. Sources of Risk Interest Rate Risk Purchasing Power Risk
Bull-Bear Market Risk
Default Risk
Liquidity Risk
Callability Risk
Convertibility Risk
Political Risk