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Chapter 1

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.

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Chapter 1

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  1. Chapter 1 Understanding Investments

  2. 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.

  3. Inter-temporal Choices • Utility of consumption • Savings –foregone consumption, the difference between current income and current consumption • Borrowing • Demand and Supply determines the equilibrium price

  4. Investments Defined • Investment - the process of committing funds to one or more assets • The sacrifice of certain present value for (possibly uncertain) future value • MGT3040?

  5. Investment Objectives • Primary Objectives • Safety of principal • Income • Growth of capital • Secondary Objectives • Liquidity • Tax minimization

  6. 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.)

  7. 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

  8. 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

  9. Investment Decisions • 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

  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. Typical Chart

  12. The Investment Decision Process • 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?

  13. 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 and/or reduce risk • Investors must cope with a new investing environment • Internet changes investments environment • Institutional investors are important • How efficient are financial markets in processing new information?

  14. 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 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?

  15. Corporate Governance 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

  16. Appendix 1-A: The Chartered Financial Analyst® (CFA®) Program • Individuals who are interested in the investment area should consider seeking a CFA designation • Level I emphasizes tools and inputs • Level II emphasizes asset valuation • Level III emphasizes portfolio management • For more information: www.cfainstitute.org

  17. Appendix 1-B:Professional Educational Alternatives • Canadian Securities Institute (CSI) • The CSI offers the Canadian Securities Course (CSC), which is a mandatory requirement for individuals who wish to become licensed to sell financial securities in Canada and to register to sell mutual funds • CFA Institute(formerly Association for Investment Management and Research (AIMR)) • The CFA institute administers the Chartered Financial Analyst ® curriculum and examination program

  18. Appendix 1-B:Professional Educational Alternatives • Financial planners • The Financial Planners Standards Council (FPSC) developed a set of minimum standards regarding education, experience, and ethical and moral conduct for financial planners

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