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Financial Investments
Introduction to Investments
Objectives
What is an investment?
What is the difference between real assets and
financial assets?
What are different types of financial assets?
What is a financial market and what is its role in
an economy?
What does typical investment process look like?
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Objectives
Are financial markets competitive?
Who are the main participants in financial
markets?
What are some of the questions that can be
studied in an investment course?
What are some of the considerations in investment
decisions?
Introduction to Investments
Investment
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Investment
Investing is the current commitment of money or
other resources with the expectation of reaping
future benefits.
For instance, an individual might purchase shares
of common stock with an anticipation that future
proceeds from the shares will justify both the time
that her money is tied up in the investment as well
as the risk of investment.
Investment
It is important to highlight that the value of
investment (and the income it generates) may fall
or rise and investor may get less than what she
invested.
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Investment
An important question to ask is: What motivates
a person or an organization to invest their
money in risky assets, rather than spending
their money immediately?
Investment
The most common answer is savings the desire
to pass money from the present into the future.
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Investment
People and organizations anticipate future cash
needs, and expect that their earnings in the future
will not meet those needs. Consequently, they
invest today to meet their future needs.
Investment, therefore, helps us achieve a tradeoff
between current consumption and future
consumption.
Investment
Another motivation is the desire to increase
wealth. Sometimes, the desire to become wealthy
can make us take big risks. For instance, many
investors buy a lottery ticket with a hope of
becoming very wealthy.
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Introduction to Investments
Real Assets and Financial Assets
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Patents
Lease obligations
Customer goodwill
College education
$5 bill
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Introduction to Investments
Types of Financial Assets
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Futures
Forward
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Introduction to Investments
Financial Market and its Role in an
Economy
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Provision of Information
Consumption Timing
Allocation of Risk
Separation of Ownership and Management
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Bonds
Risk-free Asset
Risk
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Introduction to Investments
Investment Process
Investment Process
The Process
The process governing investment consists of the
following elements:
Asset Allocation: It involves allocation of an
investment across broad asset classes.
Security Selection: It is the choice of specific securities
within each asset classes.
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Investment Process
The Process
Once the portfolio is established, it is updated or
rebalanced by doing the following:
Selling existing securities and using the proceeds to buy
new securities.
By investing additional funds to increase the overall size
of the portfolio.
By selling securities to decrease the size of the portfolio.
Investment Process
Investment Philosophies
Generally, there are two philosophies that govern
the portfolio construction:
Top-Down Portfolio
Bottom-Up Portfolio
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Investment Process
Investment Philosophies: Top-Down Process
Top-down portfolio construction starts with
asset allocation. For example, an individual who
currently holds all of his money in a bank account
would first decide what proportion of the overall
portfolio ought to be moved into stocks, bonds,
and so on. In this way, the broad features of the
portfolio are established.
Investment Process
Investment Philosophies: Top-Down Process
After this, a top-down investor turns to the
decision of the particular securities to be held in
each asset class. This process involves significant
effort in security analysis.
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Investment Process
Investment Philosophies: Bottom-Up Process
In bottom-up process, the portfolio is
constructed from the securities that seem
attractively priced without as much concern for
the resultant asset allocation.
Investment Process
Investment Philosophies: Bottom-Up Process
Such a technique can result in unintended bets on
one or another sector of the economy. For
example, it might turn out that the portfolio ends
up with a very heavy representation of firms in
one industry, from one part of the country, or with
exposure to one source of uncertainty.
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Investment Process
Investment Philosophies: Bottom-Up Process
An important feature of bottom-up strategy is that
it focuses on the assets that seem to offer the most
attractive investment opportunities.
Introduction to Investments
Financial Markets and
Competitiveness
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Introduction to Investments
Main Participants of Financial
Markets
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Firms
Households
Governments
Intermediaries
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Introduction to Investments
Some Introductory Questions
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Introduction to Investments
Important Considerations in
Investment Decisions
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Important Considerations
Unknowns
You have to understand that being wrong is a part
of the process (Peter Bernstein Prominent
Investment Expert).
Important Considerations
Unknowns
All investors must realize that there is uncertainty
present in investment process. Investors buy
various financial assets, expecting to earn various
returns over some future holding period. These
returns may never be realized.
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Important Considerations
Unknowns
The best an investor can do is to make the most
informed risk and return estimates and act on
them with the condition that he will be prepared
for new circumstances.
Regardless of how careful and informed investors
are, the future is uncertain, and mistakes will be
made.
Important Considerations
Unknowns
Although future is uncertain, but it is still
manageable. Thorough understanding of basic
principles of investing will allow investors to cope
with this uncertainty.
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Important Considerations
Global Investment Arena
Samsung Electronics from South Korea was the
Worlds most profitable firm in 2004. It suggests
that investors must think globally while investing.
However, surprisingly investors do not pay enough
attention to global investments. Investors tend to
have local bias (home bias) in their investments.
Increased profitability of global firms highlight the
importance of foreign investment.
Important Considerations
Global Investment Arena
Furthermore, investors should also be aware that
foreign investors can significantly effect local stock
markets. Clark and Berko (1997) document
positive relationship between foreign equity
purchases in Mexico and stock market returns.
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Important Considerations
Importance of Internet
Internet has changed the investment environment
in a way that it has the ability to provide huge
amount of information instantaneously. Investors
can gain real time quotes throughout the day and
can track their portfolios.
Internet has also allowed investors to trade
instantly using their online brokerage accounts.
Important Considerations
Institutional Investors
Institutional investors are the most sophisticated
investors. They have highly skillful and have
greater resources. Therefore, they can identify
profitable investment opportunities within the
stock markets.
NOTE: Institutional investors consist of banks, pension
funds, mutual funds, and insurance companies.
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Introduction to Investments
Problems
Problem 1
Question
A risk averse investor will not assume risk. Do
you agree or disagree with this statement.
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Problem 1
Answer
Disagree.
Risk-averse investors will assume risk if they
expect to be adequately compensated for it.
NOTE: Risk aversion means that you dislike risk it
does not mean that you will not take risk.
Problem 2
Question
Define risk. How many specific types of risks can
you think of?
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Problem 2
Answer
Risk is defined as the chance that the actual return
on an investment will differ from its expected
return. Some important risks are:
Default Risk
Liquidity Risk
Political Risk
Interest Rate Risk
Market Risk
Problem 3
Question
Are all rational investors risk averse?
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Problem 3
Answer
All rational investors are risk averse because it is
not rational when investing to assume risk unless
one expects to be compensated for doing so.
Problem 4
Question
Do all investors have the same degree of risk
aversion?
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Problem 4
Answer
All investors do not have the same degree of risk
aversion. They are risk averse to varying degrees,
requiring different risk premiums in order to
invest.
Introduction to Investments
Practice Questions
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Practice Questions
Question 1
You see an advertisement for a book that claims to
show how you can make $1 million with no risk
and with no money down. Will you buy the book?
Practice Questions
Question 2
ADA Corporation is a start-up computer software
development firm. It currently owns computer
equipment worth $30000 and has cash on hand of
$20000 contributed by ADA Corporations owners.
For each of the following transactions, identify the
real and/or financial assets that trade hands.
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Practice Questions
Question 2
ADA Corporation takes out a bank loan. It receives
$50000 in cash and signs a note promising to pay
back the loan over three years.
ADA Corporation uses the cash from the bank plus
$20000 of its own funds to finance the
development of new financial planning software.
Practice Questions
Question 2
ADA Corporation sells the software product to
Microsoft, which will market it to the public under
the Microsoft name. ADA Corporation accepts
payment in the form of 1500 shares of Microsoft
stock.
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Practice Questions
Question 3
Although we stated that real assets comprise the
true productive capacity of an economy, it is hard
to conceive of a modern economy without welldeveloped financial markets and security types.
How would the productive capacity of any
economy be affected if there were no markets in
which one could trade financial assets?
Practice Questions
Question 4
Historically, the average rate of return on
investments in large stocks has outpaced that on
investments in government securities. Why, then,
does anyone invest in government securities?
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Practice Questions
Question 5
What are some advantages and disadvantages of
top-down versus bottom-up investing styles?
Introduction to Investments
References
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References
Bodie, Z., Kane, A., and Marcus, A.J., (2013).
Chapter 1 (Sections 1.1, 1.2, 1.3, 1.4, 1.5, 1.6):
Essentials of Investments. 9th Edition, McGrawHill/Irwin.
References
Clark, J. and Berko, E., (1997). Foreign Investment
Fluctuations and Emerging Market Stock Returns:
The Case of Mexico. Staff Report No. 24, Federal
Reserve Bank of New York.
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