FIN 604 Introduction and Overview

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FIN 604FIN 604Introduction and OverviewIntroduction and Overview

1. Investor vs. Speculator

2. Participants in the Investment Process

3. Steps in Investing

4. Types of Investors and Investments

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Investor Vs. SpeculatorInvestor Vs. Speculator

InvestorInterested in the L-

R holdingAssume moderate

riskInterested in

dividend, interest income as well as capital gains.

SpeculatorInterested in the S-

R holdingAssume high riskPrimarily interested

in capital gains.High rate of return.

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Investor Vs. SpeculatorInvestor Vs. Speculator

InvestorModerate rate of

return.Decision to buy is

made after careful analysis of the past performance

Use own money

SpeculatorDecision to buy is

based on intuitions, rumor, charts or market analysis.

Usually borrowed money.

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Participants in the Investment ProcessParticipants in the Investment Process

1. Federal, state and Local GovernmentsCapital expenditure, operating needs, etc.“Net demander of funds”?

2. BusinessBoth S- T and L-T financial needs.

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Participants in the Investment ProcessParticipants in the Investment Process

•Capital expenditure, mergers & acquisitions, etc

“Net demander of funds”?

3. HouseholdsBoth S- T and L-T financial needs.Loans. Mortgages, car loans , etc“Net suppliers of funds”?

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Steps in InvestingSteps in Investing Explain Investment

Sacrifice of current consumption for future consumption.

Life Cycle Hypothesis Steps in Investing

1. Meeting Financial Plan Preliminaries2. Establishing Investment Goals3. Evaluating Investment Vehicle4. Selecting Suitable Investment5. Constructing a Diversified Portfolio

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Individual InvestorIndividual InvestorLife CycleLife Cycle

Accumulation phase – early to middle years of working career

Consolidation phase – past midpoint of careers. Earnings greater than expenses

Spending/Gifting phase – begins after retirement

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Individual Investor Life Individual Investor Life CycleCycle

25 35 45 55 65 75

Net Worth

Age

Accumulation Phase

Long-term: Retirement Children’s college

Short-term: House Car

Consolidation Phase

Long-term: Retirement

Short-term:

Vacations

Children’s College

Spending Phase Gifting Phase

Long-term: Estate Planning

Short-term: Lifestyle Needs Gifts

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Financial Plan PreliminariesFinancial Plan Preliminaries

Insurance– Life insurance

Term life insurance - Provides death benefit only. Premium could change every renewal period

Universal and variable life insurance – provide cash value plus death benefit

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Insurance– Health insurance– Disability insurance– Automobile insurance– Home/rental insurance– Liability insurance

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Cash reserve– To meet emergency needs– Includes cash equivalents (liquid

investments)– Equal to six months living expenses

recommended by experts

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Investment ObjectivesInvestment Objectives

Risk ToleranceAbsolute or relative percentage

returnGeneral goals

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Investment ObjectivesInvestment ObjectivesGeneral Goals

Capital preservation– minimize risk of real loss

Capital appreciation– Growth of the portfolio in real terms to meet

future need

Current income– Focus is in generating income rather than capital

gains

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Investment ObjectivesInvestment Objectives

General GoalsTotal return

– Increase portfolio value by capital gains and by reinvesting current income

– Maintain moderate risk exposure

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Investment ConstraintsInvestment Constraints Liquidity needs

– Vary between investors depending upon age, employment, tax status, etc.

Time horizon– Influences liquidity needs and risk tolerance

Tax Consideration– Capital gains Vs. Dividend income– Realized Vs. Unrealized Capital gains– Tax planning Vs. Diversification

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Equivalent Taxable YieldEquivalent Taxable Yield

RateTax Marginal1

Yield MunicipalETY

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Investment ConstraintsInvestment Constraints

Legal and Regulatory Factors – Limitations or penalties on withdrawals– Fiduciary responsibilities -

“prudent man” rule– Investment laws prohibit insider trading

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The Importance The Importance of Asset Allocationof Asset Allocation

An investment strategy is based on four decisions– What asset classes to consider for investment– What normal or policy weights to assign to each

eligible class– Determining the allowable allocation ranges based

on policy weights– What specific securities to purchase for the

portfolio

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The Importance The Importance of Asset Allocationof Asset Allocation

According to research studies, most (85% to 95%) of the overall investment return is due to the first two decisions, not the selection of individual investments

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Returns and Risk of Different Returns and Risk of Different Asset ClassesAsset Classes

Historically, small company stocks have generated the highest returns. But the volatility of returns have been the highest too

Inflation and taxes have a major impact on returns

Returns on Treasury Bills have barely kept pace with inflation

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The Portfolio Management ProcessThe Portfolio Management Process

1. Policy statement - Focus: Investor’s short-term and long-term needs, familiarity with capital market history, and expectations

2. Examine current and project financial, economic, political, and social conditions - Focus: Short-term and intermediate-term expected conditions to use in constructing a specific portfolio

3. Implement the plan by constructing the portfolio - Focus: Meet the investor’s needs at the minimum risk levels

4. Feedback loop: Monitor and update investor needs, environmental conditions, portfolio performance

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1. Policy statement– specifies investment goals and acceptable risk levels– should be reviewed periodically– guides all investment decisions

2. Study current financial and economic conditions and forecast future trends– determine strategies to meet goals– requires monitoring and updating

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3. Construct the portfolio– allocate available funds to minimize

investor’s risks and meet investment goals

– Mutual funds vs. individual stock.

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4. Monitor and update– evaluate portfolio performance– Monitor investor’s needs and market

conditions– revise policy statement as needed– modify investment strategy

accordingly

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Investors and Investments Investors and Investments

Types of Investors

1. Individual Investors

2. Institutional InvestorsTypes of Investments

– Securities or Properties Stocks , bonds vs. real tangible

investment or personal properties.

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Investors and Investments Investors and Investments

– Direct or Indirect Direct: Stocks , bonds, real estate,

coins, paintings, etc ….Indirect: investment made in a

portfolio. Mutual fund.– Debt, equity and Derivative Securities– Domestic Vs. Foreign

FIN 604 Introduction and Overview

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Transcript of FIN 604 Introduction and Overview