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Investments: Background and Issues

1.1 Investment and Assets​

1) Investment​

Investment: The current commitment of resources in the expectation of receiving greater resources in the future.

2) Real and Financial Assets​

Real Assets: Assets that produce goods and services and create economic wealth.

Examples include land, buildings, equipment, and knowledge.

Financial Assets: Claims on real assets or on the income generated by them.

Examples include stocks, bonds, and bank deposits.

Core Relationship: Real assets create wealth, while financial assets determine how that wealth is distributed among investors.

1.2 Types of Financial Assets​

1) Fixed-Income Securities​

Fixed-Income Security: A security that promises fixed or formula-based payments.

The investor lends money to the issuer and receives interest and principal payments.

2) Equity​

Equity: An ownership share in a corporation.

Equity investors receive residual income after the corporation pays its other obligations.

3) Derivative Securities​

Derivative Security: A security whose value depends on the value of an underlying asset.

Options and futures are representative derivative securities.

1.3 Functions of Financial Markets​

1) Capital Allocation​

Capital Allocation: The process of directing financial resources toward productive investments.

Financial markets transfer funds from savers to businesses and governments that need capital.

2) Consumption Timing​

Consumption Timing: The use of borrowing and saving to shift consumption between present and future periods.

3) Risk Allocation​

Risk Allocation: The distribution of financial risk among investors with different levels of risk tolerance.

4) Separation of Ownership and Management​

Separation of Ownership and Management: A corporate structure in which shareholders own the corporation while managers control its operations.

Agency Problem: A conflict that occurs when managers pursue their own interests instead of shareholders’ interests.

1.4 Portfolio Construction​

1) Portfolio​

Portfolio: A collection of financial assets held by an investor.

2) Asset Allocation​

Asset Allocation: The decision of how to divide a portfolio among broad asset classes.

Examples include stocks, bonds, and money market instruments.

3) Security Selection​

Security Selection: The decision of which individual securities to hold within each asset class.

Core Order: Portfolio construction generally begins with asset allocation and then proceeds to security selection.

1.5 Risk, Return, and Market Efficiency​

1) Risk-Return Trade-off​

Risk-Return Trade-off: The principle that investments offering higher expected returns generally expose investors to greater risk.

Expected Return: The return an investor anticipates before making an investment.

Actual Return: The return that is actually realized after the investment period.

Core Principle: Actual return may differ substantially from expected return because investment outcomes are uncertain.

2) Market Efficiency​

Informationally Efficient Market: A market in which security prices reflect available information.

Competition among investors makes it difficult to consistently identify clearly mispriced securities.

3) Investment Strategies​

Passive Management: A strategy that attempts to match market performance without searching for mispriced securities.

Active Management: A strategy that attempts to outperform the market through security analysis or market timing.

Security Analysis: The evaluation of securities to determine whether their market prices differ from their estimated values.

1.6 Financial Market Participants​

1) Financial Intermediaries​

Financial Intermediary: An institution that pools investor funds and invests or lends them on investors’ behalf.

Banks, insurance companies, pension funds, and investment companies are financial intermediaries.

Economies of Scale: Cost advantages obtained by performing financial activities on a large scale.

Financial intermediaries can gather information, diversify investments, and monitor portfolios more efficiently than individual investors.

2) Investment Companies​

Investment Company: A financial intermediary that pools money from investors and invests it in a portfolio of securities.

3) Investment Banking​

Investment Banker: A financial specialist who helps corporations and governments issue and sell new securities.

Primary Market: The market in which newly issued securities are sold to investors.

Secondary Market: The market in which existing securities are traded among investors.

4) Private Capital​

Venture Capital: Financing provided to young companies with high growth potential.

Private Equity: Ownership investment in companies whose shares are not publicly traded.

1.7 Financial Crisis and Systemic Risk​

1) Securitization​

Securitization: The process of pooling loans and converting them into tradable securities.

Securitization transfers loan-related cash flows and risks from lenders to investors.

2) Systemic Risk​

Systemic Risk: The risk that a problem in one institution or market will spread and disrupt the entire financial system.

Counterparty Risk: The risk that the other party to a financial contract will fail to meet its obligations.

Leverage: The use of borrowed money to increase the size of an investment position.

High leverage increases both potential returns and potential losses.

Liquidity: The ability to sell an asset quickly without significantly reducing its price.

3) Controlling Systemic Risk​

Transparency: The availability of information that allows investors to evaluate institutions and counterparties.

Capital Requirement: A rule requiring financial institutions to maintain enough capital to absorb potential losses.

Frequent Settlement: The regular realization of gains and losses to prevent unpaid losses from accumulating.

Core Lesson: Systemic risk is reduced through transparency, sufficient capital, frequent settlement, proper risk-taking incentives, and unbiased credit analysis.

Summary​

  • Real assets create economic wealth, while financial assets represent claims on that wealth.
  • Financial assets are classified into fixed-income securities, equity, and derivatives.
  • Financial markets allocate capital, adjust consumption timing, and distribute risk.
  • Portfolio construction begins with asset allocation and proceeds to security selection.
  • Higher expected returns generally require investors to accept greater risk.
  • In an efficient market, security prices reflect available information.
  • Financial intermediaries connect savers and borrowers while reducing information and transaction costs.
  • The primary market sells newly issued securities, while the secondary market trades existing securities.
  • Securitization converts pooled loans into tradable securities.
  • Excessive leverage, insufficient transparency, and counterparty risk can lead to systemic risk.