Investments: Background and Issues

1.1 Real versus Financial Assets

• Nature of Investment:
  • Reducing current consumption to allow for greater future consumption.
• Real Assets:
  • Include physical assets, such as property, plants, and equipment.
  • Human capital also falls under this category.
  • Represent the productive capacity of the economy.
• Financial Assets:
  • Claims on real assets or the income generated by real assets.

1.1 Financial Assets = Financial Liabilities

• Financial assets and liabilities must balance each other.
• When all balance sheets are aggregated, only real assets remain.
• Domestic Net Worth = Sum of real assets.
• Financial assets are claims owned, while financial liabilities are obligations issued.

1.2 Financial Assets Asset Classes

• Common Stock:
  • Represents an ownership stake in an entity.
  • Entitles the holder to residual cash flow.
• Fixed Income Securities:
  • Include money market instruments, bonds, and preferred stock.
• Derivative Securities:
  • Contracts whose value is derived from underlying market conditions.

1.3 Financial Markets and the Economy

• Informational Role of Financial Markets:
  • Do market prices accurately reflect the fair value estimate of a security's expected future risky cash flows?
  • Can we depend on markets to allocate capital to its best uses?
  • What other mechanisms exist to allocate capital, and what are their advantages/disadvantages?
• Risk Allocation:
  • Investors can select their desired risk level.
  • Examples include choosing between bonds and stocks or between bank CDs and company bonds.
  • Is there always a risk/expected return trade-off?

1.4 The Investment Process: Asset Allocation

• Asset Allocation:
  • Primary determinant of a portfolio's return.
  • Involves determining the percentage of the fund allocated to different asset classes (e.g., equity, bonds, bills).
  • Example allocation: 60% Equity, 30% Bonds, 10% Bills or 25% Equity, 50% Bonds, 25% Bills.
  • Top-Down Investment Strategies start with Asset Allocation

1.4 The Investment Process: Security Selection

• Security Selection:
  • Involves choosing specific securities within each asset class.
• Security Analysis:
  • Analysis of the value of specific securities.
  • Bottom-Up Investment Strategies start with Security Selection

1.5 Markets Are Competitive

• Risk-Return Trade-Off:
  • Assets with higher expected returns entail higher risk.
  • Stock portfolios may lose money in 1 of 4 years on average.
  • Bonds tend to have lower average rates of return (under 6%).
  • Bonds have not lost more than 13% of their value in any single year.
  • Stocks:
    • Average Annual Return: About 12%.
    • Minimum (1931): -46%.
    • Maximum (1933): 55%.
• Measuring Risk:
  • How do we quantify risk?
• Diversification:
  • How does diversification impact risk?

1.5 Markets Are Competitive

• Efficient Markets:
  • Securities should be neither underpriced nor overpriced on average.
  • Prices should reflect all information available to investors.
• Belief in Market Efficiency Impacts Investment-Management Style

1.5 Markets Are Competitive

• Active Management:
  • Belief that markets are inefficient
  • Involves actively seeking undervalued stocks through security selection.
  • Market timing is used for asset allocation.
• Passive Management:
  • Belief that markets are efficient
  • No attempt to find undervalued securities.
  • No attempt to time the market.

1.6 The Players

• Business Firms:
  • Net borrowers.
• Households:
  • Net savers.
• Governments:
  • Can be both borrowers and savers.
• Financial Intermediaries:
  • Connectors of borrowers and lenders.
  • Examples: Commercial banks, investment companies, insurance companies, pension funds, hedge funds.
• Investment Bankers:
  • Firms specializing in primary market transactions.
  • Primary Market: Newly issued securities offered to the public.
  • Investment bankers typically underwrite the issue.
  • Secondary Market: Preexisting securities traded among investors.
• Commercial and investment banks' functions and organizations separated by law 1933-1999
• Post-1999: Large investment banks independent from commercial banks.
• Large commercial banks increased investment-banking activities, pressuring investment banks’ profit margins.
• September 2008: Mortgage-market collapse.
• Major investment banks bankrupt; purchased/reorganized.
• Investment banks may become commercial banks
  • Obtain deposit funding
  • Have access to government assistance
• Major banks now under stricter commercial bank regulations
• Venture Capital:
  • Investment to finance new firms.
• Private Equity:
  • Investments in companies not traded on a stock exchange.

1.7 The Financial Crisis of 2008

• Changes in Housing Finance:
  • Low interest rates and a stable economy created a housing market boom.
  • This drove investors to seek higher-yield investments.
  • 1970s: Fannie Mae and Freddie Mac bundled mortgage loans into tradable pools (securitization).
  • Subprime Loans:
    • Loans above 80% of home value.
    • No underwriting criteria.
    • Higher default risk.
• Mortgage Derivatives:
  • CDOs (Collateralized Debt Obligations):
    • Consolidated default risk of loans onto one class of investor.
    • Divided payment into tranches.
  • Ratings agencies were paid by issuers and pressured to give high ratings.
• Credit Default Swaps (CDS):
  • Insurance contract against the default of borrowers.
  • Issuers ramped up risk to unsupportable levels.
  • AIG sold $400$ billion in CDS contracts.
• Systemic Risk:
  • Risk of breakdown in the financial system, with spillover effects from one market into others.
  • Banks were highly leveraged, and assets were less liquid.
  • Formal exchange trading was replaced by over-the-counter markets, lacking margin for insolvency protection.
• The Shoe Drops:
  • September 7, 2008: Fannie Mae and Freddie Mac were put into conservatorship.
  • Lehman Brothers and Merrill Lynch verged on bankruptcy.
  • September 17: The government lent $85$ billion to AIG.
  • A money market panic froze the short-term financing market.
• Dodd-Frank Reform Act:
  • Called for stricter rules for bank capital, liquidity, and risk management.
  • Mandated increased transparency.
  • Clarified the regulatory system.
  • Volcker Rule: Limited banks’ ability to trade for their own account.

1.8 Text Outline

• Part One: Introduction to Financial Markets, Securities, and Trading Methods.
• Part Two: Modern Portfolio Theory.
• Part Three: Debt Securities.
• Part Four: Equity Security Analysis.
• Part Five: Derivative Markets.
• Part Six: Active Investment Management Strategies: Performance Evaluation, Global Investing, Taxes, and the Investment Process.