CHAPTER 1

The Investment Background

WHAT IS AN INVESTMENT?
For most of your life, you will be earning and spending money. Rarely, though, will your curre
nt money income exactly balance with your consumption desires. Sometimes, you may have
more money than you want to spend; at other times, you may want to purchase more than y
ou can afford based on your current income. These imbalances will lead you either to borrow
or to save to
maximize the long-run benefits from your income. When current income exceeds current con
sumption desires, people tend to save the excess. They can do any of several things with th
ese savings. One possibility is to put the money under a mattress or bury it in the backyard u
ntil some future time when consumption desires
exceed current income. When they retrieve their savings from the mattress or backyard, they
have the same amount they saved. Another possibility is that they can give up the immediate
possession of these savings for a future larger amount of money that will be available for fut
ure consumption. This trade-off of
present consumption for a higher level of future consumption is the reason for saving. What
you do with the savings to make them increase over time is investment.

Investment Defined
From our discussion, we can specify a formal definition of an investment. Specifically, an
investment is the current commitment of dollars for a period of time in order to derive future p
ayments that will compensate the investor for
(1) the time the funds are committed,
(2) the expected rate of inflation during this time period, and
(3) the uncertainty of the future payments.
The “investor” can be an individual, a government, a pension fund, or a corporation. Similarly
this definition
includes all types of investments, including investments by corporations in plant and equipm
ent and investments by individuals in stocks, bonds, commodities, or real estate. This text e
mphasizes investments by individual investors. In all cases, the investor is trading a known d
ollar amount today for some expected future stream of payments that will be greater than the
current dollar amount today.
They invest to earn a return from savings due to their deferred consumption.They want a rat
e of return that compensates them for the time period of the investment, the expected rate of
inflation, and the uncertainty of the future cash flows. This return, the investor’s required rate
of return, is discussed throughout this book. A central question of this book is how investors
select investments that will give them their required rates of return.

What is ‘Risk and Return’?

In investing, risk and return are highly correlated. Increased potential returns on investment
usually go hand-in-hand with increased risk. Different types of risks include project-specific ri
sk, industry-specific risk, competitive risk, international risk, and market risk. Return refers to
either gains and losses made from trading a security.
The return on an investment is expressed as a percentage and considered a random variabl
e that takes any value within a given range. Several factors influence the type of returns that
investors can expect from trading in the markets.

Diversification allows investors to reduce the overall risk associated with their portfolio but m
ay limit potential returns. Making investments in only one market sector may, if that sector si
gnificantly outperforms the overall market, generate superior returns, but should the sector d
ecline then you may experience lower returns than could have been achieved with a broadly
diversified portfolio.

How Diversification Reduces or Eliminates Firm-Specific Risk

First, each investment in a diversified portfolio represents only a small percentage of that por
tfolio. Thus, any risk that increases or reduces the value of that particular investment or grou
p of investments will only have a small impact on the overall portfolio.

Second, the effects of firm-specific actions on the prices of individual assets in a portfolio ca
n be either positive or negative for each asset for any period. Thus, in large portfolios, it can
be reasonably argued that positive and negative factors will average out so as not to affect t
he overall risk level of the total portfolio.

DETERMINANTS OF REQUIRED RATES OF RETURN

You will recall that this selection process involves find-
ing securities that provide a rate of return that compensates you for:
(1) the time value of money during the period of investment,
(2) the expected rate of inflation during the period,
and
(3) the risk involved.
The summation of these three components is called the required rate of return. This is the mi
nimum rate of return that you should accept from an investment to compensate you for defer
ring consumption. Because of the importance of the required rate of return to the total
investment selection process, this section contains a discussion of the three components an
d what influences each of them. The analysis and estimation of the required rate of return ar
e complicated by the behavior of
market rates over time. First, a wide range of rates is available for alternative investments at
any
time. Second, the rates of return on specific assets change dramatically over time. Third, the
dif-
ference between the rates available (that is, the spread) on different assets changes over tim
e.

The Real Risk-Free Rate

The real risk-free rate (RRFR) is the basic interest rate, assuming no inflation and no uncer-
tainty about future flows. An investor in an inflation-free economy who knew with certainty
what cash flows he or she would receive at what time would demand the RRFR on an inves
t-
ment. Earlier, we called this the pure time value of money, because the only sacrifice the inv
es-
tor made was deferring the use of the money for a period of time. This RRFR of interest is th
e
price charged for the risk-free exchange between current goods and future goods.

Factors Influencing the Nominal Risk-Free Rate (NRFR)

Earlier, we observed that an investor would be willing to forgo current consumption in order t
o increase future consumption at a rate of exchange called the risk-free rate of interest. This
rate of exchange was measured in real terms because we assume that investors want to incr
ease the consumption of actual goods and services rather than consuming the same amount
that had come to cost more money. Therefore, when we discuss rates of interest, we need to
differentiate between real rates of interest that adjust for changes in the general price
level, as opposed to nominal rates of interest that are stated in money terms. That is, nomina
l rates of interest that prevail in the market are determined by real rates of interest, plus facto
rs that will affect the nominal rate of interest, such as the expected rate of inflation and the m
onetary environment. It is important to understand these factors. Notably, the variables that d
etermine the RRFR change only gradually because we are concerned
with long-run real growth. Therefore, you might expect the required rate on a risk-free invest
ment
to be quite stable over time.

Conditions in the Capital Market

You will recall from prior courses in economics and fi- nance that the purpose of capital mark
ets is to bring together investors who want to invest savings with companies or governments
who need capital to expand or to finance budget deficits.The cost of funds at any time (the in
terest rate) is the price that equates the current supply and demand for capital. Beyond this l
ong-run equilibrium, change in the relative ease or tightness in
the capital market is a short-run phenomenon caused by a temporary disequilibrium in the su
pply and demand of capital.

Expected Rate of Inflation Previously, it was noted that if investors expected the price lev
el
to increase (an increase in the inflation rate) during the investment period, they would requir
e
the rate of return to include compensation for the expected rate of inflation.

The Common Effect All the factors discussed thus far regarding the required rate of return
affect all investments equally. Whether the investment is in stocks, bonds, real estate, or ma-
chine tools, if the expected rate of inflation increases from 2 percent to 6 percent, the inves-
tor’s required rate of return for all investments should increase by 4 percent.

Risk Premium
A risk-free investment was defined as one for which the investor is certain of the amount and
timing of the expected returns. The returns from most investments do not fit this pattern. An i
nvestor typically is not completely certain of the income to be received or when it will be rece
ived. Investments can range in uncertainty from basically risk-free securities, such as T-bills,
to highly speculative investments, such as the common stock of small companies engaged i
n
high-risk enterprises. Most investors require higher rates of return on investments if they per
ceive that there is
any uncertainty about the expected rate of return. This increase in the required rate of return
over the NRFR is the risk premium (RP). Although the required risk premium represents a co
mposite of all uncertainty, it is possible to consider several fundamental sources of uncertain
ty. In this section, we identify and discuss briefly the major sources of uncertainty, including:

Business risk is the uncertainty of income flows caused by the nature of a firm’s business.
The less certain the income flows of the firm, the less certain the income flows to the investo
r. Therefore, the investor will demand a risk premium that is based on the uncertainty caused
by the basic business of the firm. As an example, a retail food company would typically expe
rience stable sales and earnings growth over time and would have low business risk compar
ed to a firm in the auto or airline industry, where sales and earnings fluctuate substantially ov
er the business cycle, implying high business risk.

Financial risk is the uncertainty introduced by the method by which the firm finances its inve
stments. If a firm uses only common stock to finance investments, it incurs only business risk
If a firm borrows money to finance investments, it must pay fixed financing charges (in the fo
rm of interest to creditors) prior to providing income to the common stockholders, so the unc
ertainty of returns to the equity investor increases. This increase in uncertainty because of fix
ed-cost financing is called financial risk or financial leverage, and it causes an increase in th
e stock’s risk premium.

Liquidity risk is the uncertainty introduced by the secondary market for an investment. Whe
n an investor acquires an asset, he or she expects that the investment will mature (as with a
bond) or that it will be salable to someone else. In either case, the investor expects to
be able to convert the security into cash and use the proceeds for current consumption or ot
her investments. The more difficult it is to make this conversion to cash, the greater the liquid
ity risk.

Exchange rate risk is the uncertainty of returns to an investor who acquires securities de-
nominated in a currency different from his or her own. The likelihood of incurring this risk is
becoming greater as investors buy and sell assets around the worldBefore you invest in an a
sset fund, what do you need to consider?
your budget
the asset manager's performance
what type of investor you are, as opposed to only assets
within their own countries.

Country risk, also called political risk, is the uncertainty of returns caused by the possibility
of a major change in the political or economic environment of a country.

CHAPTER 2
The Asset Allocation Decision
Asset allocation is the process of deciding how to distribute an investor’s wealth among diff
erent countries and asset classes for investment purposes. An asset class is comprised of s
ecurities that have similar characteristics, attributes, and risk/return relation-
ships. A broad asset class, such as “bonds,” can be divided into smaller asset classes, such
as Treasury bonds, corporate bonds, and high-yield bonds. We will see that, in the long run,
the highest compounded returns will most likely accrue to those investors with larger exposu
res to risky assets. We will also see that although there are no shortcuts or guarantees to inv
estment
success, maintaining a reasonable and disciplined approach to investing will increase the lik
elihood of investment success over time.

The asset allocation decision is not an isolated choice; rather, it is a component of a structur
ed four-step portfolio management process that we present in this chapter.
As we will see, the first step in the process is to develop an investment policy statement, or p
lan, that will guide all future decisions. Much of an asset allocation strategy
depends on the investor’s policy statement, which includes the investor’s goals or objectives,
constraints, and investment guidelines.

What we mean by an “investor” can range from an individual account to trustees overseeing
a corporation’s multibillion-dollar pension fund, a university endowment,
or an insurance company portfolio. Regardless of who the investor is or how simple or compl
ex the investment needs, he or she should develop a policy statement beforemaking long-ter
m investment decisions. Although most of our examples will be in the context of an individual
investor, the concepts we introduce here—investment objectives, constraints, benchmarks, a
nd so on—apply to any investor, individual or institu-
tion. We’ll review historical data to show the importance of the asset allocation decision and
discuss the need for investor education, an important issue for companies who offer retireme
nt or savings plans to their employees.

INDIVIDUAL INVESTOR LIFE CYCLE

Financial plans and investment needs are as different as each individual. Investment needs
change over a person’s life cycle. How individuals structure their financial plan should be rel
ated to their age, financial status, future plans, risk aversion characteristics, and needs.

The Preliminaries
Before embarking on an investment program, we need to make sure other needs are satisfie
d. No serious investment plan should be started until a potential investor has adequate inco
me to cover living expenses and has a safety net should the unexpected occur.

Insurance Life insurance should be a component of any financial plan. Life insurance protec
ts loved ones against financial hardship should death occur before our financial goals are me
t. The death benefit paid by the insurance company can help pay medical bills and funeral ex
penses and provide cash that family members can use to maintain their lifestyle, retire debt,
or invest for future needs (for example, children’s education, spouse retirement). Therefore,
one of the first steps in developing a financial plan is to purchase adequate life insurance co
verage. Insurance can also serve more immediate purposes, including being a means to me
et long-
term goals, such as retirement planning. On reaching retirement age, you can receive the ca
sh or surrender value of your life insurance policy and use the proceeds to supplement your
retirement lifestyle or for estate planning purposes. Insurance coverage also provides protect
ion against other uncertainties. Health insurance
helps to pay medical bills. Disability insurance provides continuing income should you beco
me unable to work. Automobile and home (or rental) insurance provides protection against a
ccidents and damage to cars or residences.

Cash Reserve Emergencies, job layoffs, and unforeseen expenses happen, and good inves
tment opportunities emerge. It is important to have a cash reserve to help meet these occasi
ons. In addition to providing a safety cushion, a cash reserve reduces the likelihood of being
forced to sell investments at inopportune times to cover unexpected expenses. Most experts
recommend a cash reserve equal to about six months’ living expenses. Calling it a “cash” re
serve does not mean the funds should be in cash; rather, the funds should be in investments
you can easily convert to cash with little chance of a loss in value. Money market or short-ter
m
bond mutual funds and bank accounts are appropriate vehicles for the cash reserve. Similar
to the financial plan, an investor’s insurance and cash reserve needs will change over his or
her life. The need for disability insurance declines when a person retires. In contrast, other in
surance, such as supplemental Medicare coverage or long-term-care insurance, may becom
e more important.

Investment Strategies over an Investor’s Lifetime

Assuming the basic insurance and cash reserve needs are met, individuals can start a serio
us investment program with their savings. Because of changes in their net worth and risk tol
erance, individuals’ investment strategies will change over their lifetime. In the following secti
ons, we review various phases in the investment life cycle. Although each individual’s needs
and preferences are different, some general traits affect most investors over the life cycle.

Accumulation Phase Individuals in the early-to-middle years of their working careers are in
the accumulation phase. As the name implies, these individuals are attempting to accumulat
e assets to satisfy fairly immediate needs (for example, a down payment for a house) or long
er-term goals (children’s college education, retirement). Typically, their net worth is small, an
d debt from car loans or their own past college loans may be heavy. As a result of their typic
ally long investment time horizon and their future earning ability, individuals in the accumulati
on phase are willing to make relatively high-risk investments in the hopes of making above-a
verage nominal returns over time.

Consolidation Phase Individuals in the consolidation phase are typically past the midpoint o
f their careers, have paid off much or all of their outstanding debts, and perhaps have paid, o
r have the assets to pay, their children’s college bills. Earnings exceed expenses, so the exc
ess can be invested to provide for future retirement or estate planning needs.

Spending Phase The spending phase typically begins when individuals retire. Living expens
es are covered by social security income and income from prior investments, including empl
oyer pension plans. Because their earning years have concluded (although some retirees ta
ke part-time positions or do consulting work), they are very conscious of protecting their capit
al. At the same time, they must balance their desire to preserve the nominal value of their sa
vings with the need to protect themselves against a decline in the real value of their savings
due to inflation.

Gifting Phase The gifting phase is similar to, and may be concurrent with, the spending pha
se. In this stage, individuals may believe they have sufficient income and assets to cover thei
r current and future expenses while maintaining a reserve for uncertainties. In such a case, e
xcess assets can be used to provide financial assistance to relatives or friends, to establish c
haritable trusts, or to fund trusts as an estate planning tool to minimize estate taxes.

Life Cycle Investment Goals

During an individual’s investment life cycle, he or she will have a variety of financial goals. N
ear-term, high-priority goals are shorter-term financial objectives that individuals set to fun
d purchases that are personally important to them, such as accumulating funds to make a ho
use down payment, buy a new car, or take a trip. Parents with teenage children may have a
near-term, high-priority goal to accumulate funds to help pay college expenses. Because of t
he emotional importance of these goals and their short time horizon, high-risk investments ar
e not usually considered suitable for achieving them.
Long-term, high-priority goals typically include some form of financial independence, such
as the ability to retire at a certain age. Because of their long-term nature, higher-risk investm
ents can be used to help meet these objectives.
Lower-priority goals are just that—it might be nice to meet these objectives, but it is not crit
ical.
Examples include the ability to purchase a new car every few years, redecorate the home wit
h expensive furnishings, or take a long, luxurious vacation. A well-developed policy statemen
t considers these diverse goals over an investor’s lifetime. The following sections detail the p
rocess for constructing an investment policy, creating a portfolio that is consistent with the po
licy and the environment, managing the portfolio, and monitoring its performance relative to it
s goals and objectives over time.

Investment Objectives
The investor’s objectives are his or her investment goals expressed in terms of both risk and
returns. The relationship between risk and returns requires that goals not be expressed only
in terms of returns. Expressing goals only in terms of returns can lead to inappropriate invest
ment practices by the portfolio manager, such as the use of high-risk investment strategies o
r account “churning,” which involves moving quickly in and out of investments in an attempt t
o buy low and sell high.
For example, a person may have a stated return goal such as “double my investment in five
years.” Before such a statement becomes part of the policy statement, the client must beco
me fully informed of investment risks associated with such a goal, including the possibility of
loss. A careful analysis of the client’s risk tolerance should precede any discussion of return
objectives.
It makes little sense for a person who is risk averse to have his/her funds invested in high-ris
k assets. Investment firms survey clients to gauge their risk tolerance. Sometimes investmen
t magazines or books contain tests that individuals can take to help them evaluate their risk t
olerance.
Risk tolerance is more than a function of an individual’s psychological makeup; it is affected
by other factors, including a person’s current insurance coverage and cash reserves. Risk tol
erance is also affected by an individual’s family situation (for example, marital status
and the number and ages of children) and by his or her age.

Capital preservation means that investors want to minimize their risk of loss, usually in real
terms: They seek to maintain the purchasing power of their investment. In other words, the r
eturn needs to be no less than the rate of inflation. Generally, this is a strategy for strongly ri
sk-averse investors or for funds needed in the short run, such as for next year’s tuition paym
ent or a down payment on a house.
Capital appreciation is an appropriate objective when the investors want the portfolio to gro
w in real terms over time to meet some future need. Under this strategy, growth mainly occur
s through capital gains. This is an aggressive strategy for investors willing to take on risk to
meet their objective. Generally, longer-term investors seeking to build a retirement or college
education fund may have this goal.
When current income is the return objective, the investors want the portfolio to concentrate
on
generating income rather than capital gains. This strategy sometimes suits investors who wa
nt to supplement their earnings with income generated by their portfolio to meet their living e
xpenses. Retirees may favor this objective for part of their portfolio to help generate spendab
le funds. The objective for the total return strategy is similar to that of capital appreciation; n
amely, the investors want the portfolio to grow over time to meet a future need. Whereas the
capital appreciation strategy seeks to do this primarily through capital gains, the total return s
trategy seeks to increase portfolio value by both capital gains and reinvesting current income.
Because the total return strategy has both income and capital gains components, its risk ex
posure lies between that of the current income and capital appreciation strategies.

Investment Objective: 25-Year-Old What is an appropriate investment objective for our typi
cal 25-year-old investor? Assume he holds a steady job, is a valued employee, has adequat
e insurance coverage, and has enough money in the bank to provide a cash reserve. Let’s al
so assume that his current long-term, high-priority investment goal is to build a retirement fu
nd. Depending on his risk preferences, he can select a strategy carrying moderate to high a
mounts of risk because the income stream from his job will probably grow over time. Further,
given his young age and income growth potential, a low-risk strategy, such as capital preser
vation or current income, is inappropriate for his retirement fund goal; a total return or capital
appreciation objective would be most appropriate. Here’s a possible objective statement:
●
Investment Objective: 65-Year-Old Assume our typical 65-year-old investor likewise has a
dequate insurance coverage and a cash reserve. Let’s also assume she is retiring this year.
This individual will want less risk exposure than the 25-year-old investor because her earnin
g power from employment will soon be ending; she will not be able to recover any investmen
t losses by saving more out of her paycheck. Depending on her income from social security
and a pension plan, she may need some current income from her retirement portfolio to mee
t living expenses. Given that she can be expected to live an average of another 20 years, sh
e will need protection against inflation. A risk-averse investor will choose a combination of cu
rrent income and capital preservation strategy; a more risk-tolerant investor will choose a co
mbination of current income and total return in an attempt to have principal growth outpace i
nflation.

THE IMPORTANCE OF ASSET ALLOCATION

A major reason why investors develop policy statements is to provide guidance for an overall
investment strategy. Though a policy statement does not indicate which specific securities to
purchase and when they should be sold, it should provide guidelines as to the asset classes
to include and a range of percents of the investor’s funds to invest in each class. How the inv
es tor divides funds into different asset classes is the process of asset allocation. Rather tha
n provide strict percentages, asset allocation is usually expressed in ranges. This allows the
investment manager some freedom, based on his or her reading of capital market trends, to i
nvest toward the upper or lower end of the ranges.

ASSESSMENT

1. Define Investing
A. Saving in a way to earn food money
B. Saving in a way to earn income
C. Saving in a way to earn car money
2. Define Risk
A. You cliff diving and not seeing the ground
B. You driving 5 over the speed limit
C. Degree of uncertainty on how likely you'll make that income
3. Define Money Market
A. A type of checking account that doesn't require a minimum.
B. A type of savings account that has a required minimum.
C. a type of market account that doesn't require a minimum.
4. Every good investment plan starts with:
A. an interest in making money in addition to your salary
B. an appointment with a Certified Financial Planner
C. a clear statement of financial goals
5. Think carefully about this one. Some investors will accept high-risk investments and some
investors prefer low-risk investments. What term best describes that situation?
A. Risk aversion
B. Risk return tradeoff
C. Risk tolerance
D. Rate of return
6. Most investors are risk averse, meaning:
A. they will not take any investment risk.
B. they do not care about risk..
C. They seek the thrill of risk.
D. they will take risk only with higher expected returns.
7. Investment risk is most appropriately understood as
A. a chance that an investment will suffer a loss.
 B. a range of possible returns from an investment.
C. not recovering all funds placed in an investment.
8. Inflation risk is most critical with respect to
A. real estate.
B. common stocks.
C. government and corporate bonds.
9. Financial risk is risk associated with
A. the use of considerable debt in a company's financing arrangement.
B. volatile conditions in the stock market.
C. financial changes in the overall economy
10. Before you invest in an asset fund, what do you need to consider?
A. your budget
B. the asset manager's performance
C. what type of investor you are
11. What do you want from your investments?
A. I don't want to lose money, even if that means lower or no gains.

B. I want income now. Ok with a little up and down in investment, but not too much.

C. I want income now and some potential for growth. Ok with short-term volatility.

D. I don’t need money soon. Looking for growth, so some volatility is okay.

E. I'm looking for maximum growth in the long run, and I expect volatility.
12. Explain what is Capital preservation?
13. Explain what is Capital appreciation?

200+ words essay;

Does Investment and Insurance difference? What is the difference of Investment and Insura
nce?