Understanding Investments

Some Definitions Investments is concerned with the management of an investor’s wealth, which is the sum of current income and present value of all future income. Investments is concerned with the management of an investor’s wealth, which is the sum of current income and present value of all future income. There are many categories for investments: There are many categories for investments: Financial assets : Paper claims on some issuer. Financial assets : Paper claims on some issuer. Real assets : Tangible assets such as gold, real estate. Real assets : Tangible assets such as gold, real estate. Marketable and non-marketable securities. Marketable and non-marketable securities.

Why Do We Invest? We invest to improve our welfare, current and future. We invest to improve our welfare, current and future. By foregoing consumption today and investing the saving, investors expect to enhance their future consumption by increasing their wealth. By foregoing consumption today and investing the saving, investors expect to enhance their future consumption by increasing their wealth. Most individuals must make investment decisions sometimes in their lives. Most individuals must make investment decisions sometimes in their lives.

Over $ 500 billion flowed out of deposit as their rates declined in the early 1990s and this money had to be invested elsewhere. Over $ 500 billion flowed out of deposit as their rates declined in the early 1990s and this money had to be invested elsewhere. We study investment in the hope of earning better return in relation to the risk when we invest. We study investment in the hope of earning better return in relation to the risk when we invest.

Investments As Profession Investment as a profession is very profitable. Investment as a profession is very profitable. A security analyst on Wall Street with few years of experience can earn $ 200,000 annually. A security analyst on Wall Street with few years of experience can earn $ 200,000 annually. All financial firms need investment analysis. All financial firms need investment analysis.

Understanding the Investment Decision Process To pursue higher returns investors must assume larger risks. To pursue higher returns investors must assume larger risks. Trade-off between expected return and risk. Trade-off between expected return and risk. Investment decisions have been divided into two-step process: Investment decisions have been divided into two-step process: Security analysis : involves the valuation of securities. Security analysis : involves the valuation of securities. Portfolio management : involves the management of an investor’s investment selection as a portfolio. Portfolio management : involves the management of an investor’s investment selection as a portfolio.

The Basis of Investment Decisions Return and Risk Return Return Cash has an opportunity cost. By holding cash, you forego the opportunity to earn a return on that cash. Cash has an opportunity cost. By holding cash, you forego the opportunity to earn a return on that cash. In an inflationary environment, the purchasing power of cash diminishes. In an inflationary environment, the purchasing power of cash diminishes. Realized return always differs than expected return. Realized return always differs than expected return. Investor build their decision to invest on the expected return, not the realized one. Investor build their decision to invest on the expected return, not the realized one.

Risk Risk The chance that actual return on the investment will be different from its expected return. The chance that actual return on the investment will be different from its expected return. Actual return is always different from expected return because expected return is calculated based on models. Actual return is always different from expected return because expected return is calculated based on models. Minimization of the risk will result in everyone holding risk-free assets, such as treasury bills. Minimization of the risk will result in everyone holding risk-free assets, such as treasury bills. There are three types of individuals: risk lover, risk neutral and risk averse. The common case is the risk aversion. There are three types of individuals: risk lover, risk neutral and risk averse. The common case is the risk aversion.

The Expected Risk-Return Tradeoff Expected Return Risk RF

If the investors wish to try to earn a larger rate of return, they must be willing to assume a larger risk. If the investors wish to try to earn a larger rate of return, they must be willing to assume a larger risk. In reality, the trade-off between risk and return as shown in the diagram may turn out to be flat or even negative. In reality, the trade-off between risk and return as shown in the diagram may turn out to be flat or even negative. Investors maximize their expected return subject to risk. Investors maximize their expected return subject to risk.

Structuring the Decision Process Investors analyze and manage securities using security analysis and portfolio management. Investors analyze and manage securities using security analysis and portfolio management. Security analysis: Valuation and analysis of individual securities is time-consuming process because: Security analysis: Valuation and analysis of individual securities is time-consuming process because: It is necessary to understand the characteristics of various securities and the factors affecting them. It is necessary to understand the characteristics of various securities and the factors affecting them. We need to apply a valuation model to these securities to estimate their prices. We need to apply a valuation model to these securities to estimate their prices.

Portfolio management has two investment strategies: Portfolio management has two investment strategies: A passive investment strategy: determine the desired investment proportion and assets in a portfolio and maintaining these proportions, making few changes. A passive investment strategy: determine the desired investment proportion and assets in a portfolio and maintaining these proportions, making few changes. An active investment strategy: involves specific decisions to change the investment proportions based on the belief that an investor can profit by doing so. An active investment strategy: involves specific decisions to change the investment proportions based on the belief that an investor can profit by doing so.

Important Consideration in the Investment Decision The great unknown (Uncertainty) The great unknown (Uncertainty) The realized return on an asset with any risk attached to it may be different from what was expected. The realized return on an asset with any risk attached to it may be different from what was expected. All market participants, individual investors, and professionals make errors. They base investment decision solely on the past which leads to errors. All market participants, individual investors, and professionals make errors. They base investment decision solely on the past which leads to errors.

The global investment arena. The global investment arena. Investing in international markets, specially emerging markets, such as Singapore, Egypt, Indonesia and Thailand. Investing in international markets, specially emerging markets, such as Singapore, Egypt, Indonesia and Thailand. Emerging markets have higher return relative to US. Emerging markets have higher return relative to US. International portfolio diversifies the risk between countries. International portfolio diversifies the risk between countries. The rise of the internet. The rise of the internet. All investors can access a wealth of information about investing, trade cheaply and quickly. All investors can access a wealth of information about investing, trade cheaply and quickly.

Institutional investors. Institutional investors. They are the professional investors, such as banks, mutual funds, and insurance companies. They are the professional investors, such as banks, mutual funds, and insurance companies. Some companies disclose important information to institutional investors. They have more access to the data. Some companies disclose important information to institutional investors. They have more access to the data.