Understanding Investments

Theories and Strategies

Nikiforos T. Laopodis

• Publisher: Routledge
• Year: 2012
• ISBN:
  9781136255137
• Edition: 1
• Topic: Business
• Subtopic: Business General
• Index: Business

The author's main goal in writing Understanding Investments is to present the classic theories and strategies in the field of finance in a new, intuitive, and practical way.This text offers context and grounding information to students trulylooking, as the title indicates, to understand investments.

This textbook brings a number of innovative features to the field:

1. Presentation of material from the economics point of view, stressing the interpretation of concepts, rather than their mere memorization and mechanical application.

2. Shorter, more streamlinedchapters, so instructors and students won't be distracted by superfluous detail, and can instead focus on the most relevant issues.

3. Fewer chapters than in current textbooks, so instructors can comfortably cover all material within a semester.

4. Boxes with 'International Focus' vignettes, discussions 'Applying Economic Analysis' to relevant topics, and featured 'Lessons from our Times', allowing students to gain a deeper understanding of the material and its relevant context and applications.

5. Sections in each chapter discussing different investment strategies and their pros and cons.

6. Questions that solicit students'critical thinking skills and problems that require their quantitative expertise to address real-life problems - rather than rote, mechanical questions that merely require regurgitation.

Part I

INVESTMENT BASICS

What is an investment and why do people invest? Investment is the sacrifice of your resources (time, money, and effort) today for the expectation of earning more resources tomorrow. What can you do with your money? Spend it, save some of it, or invest it? If you choose the latter, where are you going to invest it? There are many investment alternatives (like stocks and bonds), and the amount of information on each of them is staggering. What is your goal in investing? What are your constraints and risks? Once you have defined these, what is the next step? Are you going to do the investing on your own, or are you going to hire a professional money manager? These are some of the questions that you need to address as a (novice) investor, and we will deal with them in this part of this textbook. In the remaining chapters, we will have more to say about the field of investments in general, the strategies that you can apply to achieve your goals, and the risks involved in investing.

Chapter 1 examines the general investment framework by defining investments and the various investment alternatives available in the market. It also presents the objectives and constraints of individual and institutional investors and the roles of the various financial intermediaries that assist you in investing. Chapter 2 lays out the investment process (that is, the two main steps that you need to take before investing) and presents some very basic and simple investment strategies. Finally, Chapter 3 discusses in detail the basic elements of investments: risk and return. This chapter also addresses the objective of investing, which is the maximization of your expected return, and its constraint, which is (subject to) risk.

We end with a cautionary word. This textbook cannot make investment decisions for you! It can only assist you in making informed decisions by providing you with valuable information so that you can apply it to your particular investment situation.

1

THE INVESTMENT FRAMEWORK

CHAPTER OBJECTIVES

After studying this chapter, you should be able to

• See what investment is and distinguish between real and financial assets
• Know the various classes of securities
• Understand the roles of the financial markets and financial intermediaries
• Know your investment objectives and constraints
• Evaluate the role of financial information on investment alternatives
• Understand some of the issues that arise in financial markets, such as agency theory, asymmetric information, and ethical investment behavior

INTRODUCTION

This chapter deals with the general economic and financial environment in which market participants make investment decisions. Specifically, it discusses the securities an investor can invest in as well as the financial markets that facilitate the trading of securities among investors. In this respect, the functions of financial markets and financial intermediaries are explored. The chapter also discusses the objectives and constraints of investors, individual and institutional alike, and concludes with some issues that arise within financial markets. These include problems encountered by market participants while engaging in mutual trades of securities and the occurrences of unethical investment behavior in the marketplace. We end the chapter with the significance of learning and practicing investments.

THE GENERAL FINANCIAL AND ECONOMIC ENVIRONMENT

Definition of Investments

To understand investments in general terms, let us start with a basic question. Why did you come to college? Surely you could do other things with your money and time, such as work, travel, and so on. But because you chose to go to college means that you have some expectations for the future (after you graduate). Perhaps you expect to earn a higher salary or to achieve a higher standard of living, or both. Therefore you sacrifice money and other resources today for (hopefully) more money (or wealth) tomorrow. In a broad sense, this sacrifice you currently make for future returns is called investment. Stated differently, you are investing in your future tomorrow by going to college today.

This definition of investment involves several elements worthy of special mention. First, you are spending time and money (or resources in general). Your resources are scarce and thus valuable. Investments deal with the efficient management of your money (or financial wealth) today in hopes of receiving more money (or returns) in the future. This brings us to the next element of investment: uncertainty of the future. In other words, the fact that you can have only an expectation for higher returns in the future means that you are faced with risk. But why do people invest? Can’t they just keep their money in the form of cash and stash it under their mattresses or bury it in their backyards? Well, you recall from economics that cash has an opportunity cost. Opportunity cost is defined as the value of an activity that must be given up in order to engage in another activity.

Another insight from economics is that income is either consumed, saved, or both. Saving means sacrificing consumption today for (the expectation of) greater consumption in the future. Investing also involves a similar sacrifice, as already discussed. However, there is a fundamental difference between saving and investment. Saving does not entail risk (or at most very little), but investment does. For example, if you put your money in a bank account like a certificate of deposit, you incur no risk of losing your money because your savings up to $250,000 (at the time of writing) is insured by the federal government (the Federal Deposit Insurance Corporation, or FDIC). But if you invest in the stock market, you are faced with significant risk that you may lose all your invested capital. In general, investment assets carry various amounts of risk ranging from no risk to very high risk.

The General Investment Environment

In general terms, the investment environment refers to the various investment assets (or instruments) that individuals and institutions can buy and sell as well as the markets in which these assets are traded. The assets can be grouped into two major categories: real assets and financial assets. Real assets are tangible and can be used to produce a good or a service. Examples of real assets are machinery, factories, and land. Financial assets are intangible (or electronic entries) and represent claims on the revenues generated from real assets or claims created by the government. Unlike real assets, financial assets do not produce a good or a service but indirectly help the production of real assets. Examples of financial assets are the stocks or bonds that you own or a security offered by the government. Table 1.1 shows the latest data (second quarter of 2010) on the balance sheets of households and nonprofit organizations in the United States. As you see, the financial assets of households and nonprofit organizations include not only stocks and bonds but also items like bank accounts, pension funds, and life insurance funds.

How do financial assets help with the production of real assets? Well, if we buy shares of a car company (in the primary market where securities are issued by the company and not from another investor), the company uses the money to expand its productive capacity and sell more cars so it can pay us back from the revenues generated from

Table 1.1 Selected Balance Sheet Items of US Households and Organizations, 2010Q2

Assets	Billions of $	Liabilities and Net Worth	Billions of $
Real Assets	28,543.5	Credit market instruments	13,418.5
Real estate	23,675.2	Home mortgages	10,150.4
Equipment owned by nonprofits	282.8	Consumer credit	2,403.7
Consumer durables	4,585.5	Bank and other loans	351.2
Financial Assets	43,737.6
Deposits	7,559.1
Money market shares	1,109.5
Credit market instruments	4,329.6
Treasury sec’s	10,63.6
Agency and GSE sec’s	23.6
Municipal sec’s	1,033.3
Corporate and foreign bonds	2,033.1
Mortgages	96.4
Corporate equities	6,767.6
Mutual fund shares	4,056.2
Life insurance reserves	1,266.6
Pension fund reserves	11,653.8
Other	2,745.2
Total Assets	53,504.1	Net Worth	53,504.1

Source: Federal Reserve System, Board of Governors, Flow of Funds Accounts of the United States. Amounts outstanding end of period, not seasonally adjusted. Assets and liabilities sides do not add up because of omitted items.

selling its cars. Similarly, if we buy a govern...

Table of contents

• Cover
• Half Title
• Full Title
• Copyright
• Dedication
• Contents
• List of Illustrations
• Preface
• Part I INVESTMENT BASICS
• Part II FINANCIAL MARKETS, INTERMEDIARIES, AND INSTRUMENTS
• Part III PORTFOLIO THEORY
• Part IV EQUITY PORTFOLIO MANAGEMENT
• Part V DEBT SECURITIES
• Part VI DERIVATIVE MARKETS AND INSTRUMENTS
• Appendix
• Index