INVESTMENTS: Analysis and Management Second Canadian Edition INVESTMENTS: Analysis and Management Second Canadian Edition W. Sean Cleary Charles P. Jones

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.

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

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

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 Investment Decisions

Investors manage risk at a cost – lower expected returns (ER) Any level of expected return and risk can be attained Risk ER Risk-free Rate Bonds Stocks The Tradeoff Between ER and Risk

“Typical” Chart

Two-step process:  Security analysis Necessary to understand security characteristics and applied to these securities to estimate their price or value  Portfolio management Selected securities viewed as a single unit How and when should it be revised? How should portfolio performance be measured? The Investment Decision 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 new information? Factors Affecting the Process

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 Corporate Governance

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