What is an investment?
- Commit money, other resources in expectation of realizing future benefits
- Sacrifice something of value now because you expect to benefit later from that value
- Specifically investments as they relate to financial assets
Real Assets vs. Financial Assets
- Real assets: used to produce goods and services (i.e. land, buildings, machines)
- Financial assets: claims to income generated by real assets (i.e. stocks, bonds)
Types of Financial Assets
- Debt (fixed income, bonds)
- Equities
- Derivatives
Financial Markets
- Capital allocation to firms with best perceived prospects
- Shift consumption timing and store/grow wealth (i.e. put money away today (saving), or take money from the future and put it into today’s time (borrowing))
- PV of money (take money from future and estimate its worth today)
Agency Problems
Manager (CEOs, CFOs, exec. board of corporations etc.) vs. shareholders (own stock in company etc.)
- Need transparency for financial markets to do their job properly (i.e. managers cannot just act out of their own self-interest, maximize their incomes etc.)
MITIGATION:
- Compensation plans tie the income of managers to the success of the firm
- Monitoring from board of directors
- Monitoring by large investors and security analysts
- Threat of takeover for poor performances
Investment Process
Portfolio: collection of investment assets
Asset allocation: choice among broad asset classes (stocks, bonds, real estate, commodities, derivatives, etc.)
- What class are you buying and at what percentage?
Security selection: choice of which securities to hold within each asset class
- If you’re buying bonds, are you buying corporate or treasury bonds? 5-yr, 10 yr? Stocks, what types of stocks?
Security analysis: valuating particular securities that might be included in the portfolio
“Top-down” approach: asset allocation followed by determination of particular securities (based on macro events, world changes, future predictions, which assets should we invest in?)
“Bottom-up” approach: more specific and detailed, investment based on attractively priced securities without as much concern for asset allocation (take advantage of undervalued things)
Efficient Market Hypothesis
Efficient market hypothesis: because markets process all information about securities quickly, so security prices reflect all information available at all times.
Neither underpriced or overpriced securities should exist.
Risk/Return Tradeoff
- Risk/return tradeoff: assets expected to be higher risk are generally priced to offer higher expected returns than assets that are lower risk
Most investors are “risk adverse” (avoid risk) - Actual or realized returns almost always are different than expected returns for risky securities
Financial Intermediaries
- Intermediaries bring together suppliers of capital (investors) and demanders of capital (corporations and government, primarily)
They pool resources, achieve diversification, and economies of scale
Examples include investment companies, banks, insurance companies, credit unions - Banks raise funds by borrowing (taking deposits). They lend that money to other borrowers at a higher interest rate. This is a major source of bank profits.
- Banks pay higher interest rates to those who borrow their money, than to those who they lend their money to
Passive vs. Active Management
- Passive management: we assume the market is efficient. Hold a highly diversified portfolio, don’t waste the time and effort trying to improve investment returns by identifying mispriced securities
- Active management: attempt to improve performance by finding mispriced securities or timing performance of broad asset classes
Investment Bankers, Venture Capital, Private Equity
- Investment bankers specialize in sale of new securities to the public (primary market), typically by underwriting the issue and advising the company on the issuance
- Primary market: new issues of securities are sold to investors
- Secondary market: investors trade previously issued securities amongst themselves (where we invest)
- Venture capital: money invested to finance a new, not yet publicly traded company
Very high risk - Private equity: investments in companies not publicly traded on the stock market
Very high risk
Fintech
-Application of technology to financial markets
-Allows individuals/investors to interact directly with each other without typical financial intermediaries. A source of financial disintermediation
-Examples include the use of distributed ledgers such as blockchain with cryptocurrencies, peer-to-peer lending, crowdfunding, digital wallets and peer-to-peer payment systems
