Fundamentals of Investments and Financial Markets

1. Fundamentals of Investmentsand Financial Markets Gitman - Joenhk Chapter 1

2. The Role and Scope of Investments Gitman-Joehnk Chapter 1

3. Defining Investment • Investment is any asset (paper or real) in which funds can • be placed with the expectation of • preserving or increasing value • earning a positive rate of return • “Expectation” means that the investment has the potential • to preserve or increase value and the potential to earn a • positive return. • Bad investments do exist.

4. Defining Investment:an example • placing funds in a checking account at a bank isnot an • investment under this definition • does not produce income (no interest is paid on checking accts.) • value of the funds will be reduced by inflation • same funds placed in a savings account or even a NOW account • would be an investment under this definition • generates interest income

5. Investment Alternatives • There are a variety of potential investment alternatives • facing any potential investor, including: • short-term alternatives • Treasury and Agency Bills • Commercial paper • money market mutual funds • transactions accounts

6. Investment Alternativescontinued Stocks common preferred Bonds Government Corporate Municipal Mutual Funds Real Estate Tangible Investments

7. Investment Alternativescontinued Limited Partnerships Commodities Derivative Securities options futures zero coupon bonds strips Individuals can invest in any of these alternatives or put together a collection of these in a portfolio

8. Securities vs. Property Securities and Property are two alternative forms that investments can take Securities-investments which represent evidence of debt or ownership or the legal right to acquire or sell an ownership interest share of stock bond Property-investment in either real property (land, buildings) or tangible personal property (gold, art work, antiques)

9. Securities vs. Property Individual investors generally prefer to invest in securities (the major exception being real estate) because the financial sector provides organized mechanisms for buying and selling securities

10. Debt, Equity, & Derivative Securities Debt: funds loaned in exchange for the receipt of interest income and the promised repayment of the loan at a given future date -- bonds, notes, bills Equity: an ongoing ownership interest in a specific business or property --common stock, preferred stock Derivative Securities: securities that are structured to provide characteristics similar to those of an underlying security or asset and that derive their value from the underlying security or asset -- options, futures, swaps

11. Short-Term vs. Long-TermInvesting Short-Term Investments: investments that typically mature within ONE year Long-Term Investments: investments with maturities of longer than a year or with no stated maturity at all.

12. Direct vs. Indirect Investment Direct Investment-- the investor acquires a security or property directly from the issuer/seller of the security or property -investor purchases a share of stock from the company issuing it -investor purchases building from the individual selling it -investor purchases a government bond from the government issuing it

13. Direct vs. Indirect Investment Indirect Investment-- provides an investor with an indirect claim on a security or property purchasing shares in a mutual fund provides the investor with a claim on the investments made by the mutual fund putting funds on deposit at a financial institution provides the investor with a claim on the investments (loans & securities) made by the bank

14. Indirect Investment Indirect investment is generally carried out through the use of Institutional Investors Institutional Investors are investment professionals that are paid to manage the funds placed with them by individual investors. banks insurance companies mutual funds Generally believed to be more sophisticated and to have broader knowledge of the investment process, available investment alternatives and techniques.

15. Rewards for Investing Rewards are received in one of two ways: *current income -interest -dividends *increase in investment’s value between purchase date and date of sale -capital gains These rewards represent compensation paid to the investor for -giving up the use of their funds (opportunity cost to investing) -compensation for taking assuming the risk that expected rewards will not be received

16. Risk Risk--refers to the chance or probability that an undesirable event will occur. For an investment, the undesirable event is that return on the investment will be less than its expected return. This may occur because *some or all of the expected current income is not paid *the value of the investment falls or does not rise as much as expected

17. Risk In general, investors regard investments as having *expected return *return variance-actual returns will deviate from expected returns The broaderthe range of possible outcomes (actual returns) the greater the return variance, the greater the risk associated with the investment. variance is the sum of the squared deviations of the actual outcomes from the mean divided by the number of outcomes, so High Variance is synonymous with High Risk

18. Speculation Speculation: the purchase of investments in which the levels of expected earnings and future value are highly uncertain.

19. Seven Steps In Investing Prior to investing, each investor should establish a set of financial goals that they would like to accomplish with their investment program. Once the goals are established an investment program should be selected that is capable of accomplishing the established goals. The investment program should then be executed as planned. Avoid haphazard, intuitive, seat of the pants investing- evidence indicates reduced performance.

20. Step 1Evaluate Investment Prereq.’s Prior to investing, each potential investor should provide for: *necessities (housing, food, transportation, taxes, clothing, etc.) *minimum cash reserve for emergency purposes *adequate insurance against loss income or property (health, life, property, liability) *retirement planning Only after establishing these prerequisites can you clearly define financial and investment goals

21. Step 2Establish Investment Goals • Investment goals are specific statements of the • timing • size • form • risk • associated with the desired return being sought.

22. Step 2Establish Investment Goals • Common Investment Goals Include: • Accumulation of Funds for Retirement • Enhance Current Income • Save for Major Expenditures • Shelter Income from Taxes

23. Step 2continued • The investment goals that are established should be • consistent with overall financial goals • realistic *investor must have adequate funds available for the investment *an attainable rate of return should be assumed If the available funds and attainable rate of return are not sufficient to achieve the investment goals then the investment program will be unsuccessful.

24. Step 3Adopt a Written Investment Plan For each goal, specify the target date for achievement and the amount of tolerable risk. The more specific you can be in your statement of goals the easier it will be to establish a written investment plan.

25. Step 4Evaluating Investment Alternatives The potential returns and risks associated with investment alternatives must be assessed. This assessment process is referred to as valuation. The basic procedures for valuing investments are discussed in general in GJ-Chapter 4.

26. Step 5Selecting Suitable Investments The specific investment alternatives selected will significantly affect the success of the investment program in achieving the established goals. Selecting an investment alternative that maximizes expected return may not be consistent with the goals established. An investor may be interested in current income or reducing tax liability, maintaining liquidity, avoiding excessive risk, etc. many of which may conflict with maximizing return.

27. Step 6Construct a Diversified Portfolio The investment process involves selecting a number of alternative investment vehicles. The performance (risk and return) on the selected group of investment vehicles is likely to differ substantially from the performance of individual investment vehicles making up the group. The investor should evaluate the performance of the group or portfolio of investment vehicles to ensure that its risk-return characteristics are consistent with investment goals.

28. Step 7Managing the Portfolio After constructing the investment portfolio, the investor must constantly monitor the performance of the portfolio to ensure that actual performance is consistent with expected performance. If not, the investor will need to make changes to the investment portfolio. This may involve selling some investment vehicles and purchasing others.

29. Step 7Managing the Portfolio Portfolio Management involves monitoring the portfolio and restructuring it as dictated by the actual behavior of the investments in the portfolio and the goals established.

30. Investing Over the Life Cycle Young Investors, ages 20-45, tend to prefer growth oriented investments that stress capital gains rather than income. These investors have little investable funds, and capital gains are seen as the quickest way to build up investment capital.

31. Retirement years, ages 60 and up, preservation of capital and current income become the principal concerns. High quality stocks and bonds and money market instruments are used. The investor’s objective is to live as comfortably as possible from their investment income.

32. Middle age investors, ages 45-60, prefer to consolidate their investments as family demands and responsibilities changes. During this stage growth oriented securities are still utilized. However, investing becomes less speculative. Quality-growth vehicles are employed, and more attention is given to current income. Foundation for retirement is being set.

33. General Market Conditions Bull Markets - favorable markets, normally associated with: rising stock prices investor optimism economic expansion government stimulus Bear Markets - unfavorable markets, normally associated with: falling stock prices investor pessimism economic slowdown government restraint

34. General Market Conditions In general, investors experience higher returns on common stock during bull markets since most securities are bullish in bullish markets most securities are bearish in bearish markets Market Conditions are hard to predict and can generally be identified only after the fact.

35. Investing in Different Economic Markets Four stages of the economic/financial market cycle are: recovery - strengthening of the economy after a recession expansion - continued strength and optimism about economic growth decline - slowing down of the economy after an expansion which may have been moving too quickly recession - economy contracts and pessimism develops

36. Stocks and equity related securities (like mutual funds and convertible bonds) are highly responsive to the economic cycle. During recovery and expansion, stock prices generally rise. Stock prices begin to fall as decline approaches. Growth-oriented and speculative stocks tend to do especially well in an expanding market.

37. Bonds and other fixed-income securities are sensitive to movements in interest rate changes. Bond prices move in the opposite direction of interest rate changes. Thus when interest are expected to rise, bond prices would fall and bonds would not be a good place to hold investment funds. Interest rates generally shift with the economic cycle. Rates generally rise during a normal expansion and fall during the later stages of decline and in recession.

38. Real estate and other tangible investments are responsive to rates of inflation more than anything else. As the consumer price index begins to rise, the returns on real estate and tangibles also start to rise. However, as inflation subsides, so does the value of these investments.

39. Investing over the Business/Economic Cycle Recession: Monetary Indicators short-term interest rates falling/low long-term interest rates falling/low Fed’s bias toward further easing short-term rates far below long-term rates Economic Indicators GDP contracting leading economic indicators declining inflation flat or declining manufacturing low and falling

40. Investing over the Business/Economic Cycle Recession (cont.) Sentiment deflation worries financial ads emphasize safety headlines emphasize layoffs consumer confidence falling/low Hot Stocks consumer staples (food, tobacco) utilities (fas, water, electric) energy large-company stocks outperform

41. Investing over the Business/Economic Cycle Early Recovery: Monetary Indicators short-term interest rates flat long-term interest rates flat Fed stops easing difference between short and long-term interest rates decreasing Economic Indicators GDP shows modest positive gains leading economic indicators begin to rise inflation remains low/flat manufacturing begins rising

42. Investing over the Business/Economic Cycle Early Recovery (cont.) Sentiment earnings worries still common financial ads emphasize safety income investments are popular consumer expectations begin rising Hot Stocks consumer cyclicals (autos, retailers) technology (software, computers) industrials (factory and equipment) small companies tend to outperform

43. Investing over the Business/Economic Cycle Mid-Cycle (Expansion): Monetary Indicators short-term rates remain flat long-term rates begin rising Fed adopts a neutral stance difference between short and long-term interest rates begins widening Economic Indicators leading indicators up factory capacity rising hourly wages begin rising manufacturing strong

44. Investing over the Business/Economic Cycle Mid-Cycle (cont.) Sentiment inflation worries begin to rise financial ads emphasize gains sector funds become popular consumer confidence rising Hot Stocks technology consumer cyclicals basic materials larger companies start to outperform

45. Investing over the Business/Economic Cycle Late Cycle (Peak): Monetary Indicators short-term rates begin rising long-term rates rising Fed begins tightening short-term interest rates rise above long-term interest rates (inverted yield curve) Economic Indicators leading indicators begin to decline factory capacity above 90% hourly wages rising manufacturing begins slowing

46. Investing over the Business/Economic Cycle Late Cycle (cont.) Sentiment momentum stocks are popular financial ads emphasize capital gains word ‘boom’ is frequently in the headlines consumer expectations begin falling Hot Stocks energy technology basic materials large companies outperform