Overview of Investment Concepts

• Time Value of Money

  • Importance of understanding that money has different values at different times.

• Interest Rates

  • Role in investment decisions.

• Economic Value

  • Measurement of worth in financial terms.

• Decision Rules

  • Frameworks guiding investment decisions.

• Cash Flows

  • Differentiation among various cash flow types.

• Risk

  • Central to investment considerations; uncertainties linked with future outcomes.

Introduction to Opportunity Cost

• Opportunity Cost Concept

  • Definition: The cost of forgoing the next best alternative when making a decision.

  • Importance in investment decision making: Understanding the trade-offs involved.

Risk Fundamentals

• Risk-Free Rate and Risk Premium

  • Definitions:

  • Risk-Free Rate: The theoretical return on an investment with zero risk, often represented by government securities like treasury bills.

  • Risk Premium: The additional return expected for taking on additional risk above the risk-free rate.

  • Role of Risk in Investment:

  • Investors accept risks for potential higher returns.

  • Variability in returns introduces challenges in forecasting.

Understanding Diversification

• Concept of Diversification

  • Definition: The practice of spreading investments across various assets to reduce risk.

  • Limitations of Diversification:

  • Not all diversifications effectively reduce risk.

Frequency and Probability Distributions

• Frequency Distributions

  • Historical analysis of asset returns: Understanding past performance helps in predicting future trends.

  • Importance: Understanding how often certain returns have occurred historically and variability in performance.

• Current Example - S&P 500 Returns

  • Common returns such as 15% and rare returns like 40% listed.

• Probability Distributions

  • Predict future performance based on historical data.

  • Provides potential outcome estimations for investment performance.

Historical Asset Performance Examples

• Investment Variability

  • Example of $1 invested in various securities:

  • Small company stocks over decades yielding substantial returns (e.g., $33,000 at an annual return rate of 16.06%).

  • Long-term U.S. Government bonds yielding relatively safer returns ($133 from a $1 investment at a 6% return).

  • Short-term treasury securities providing minimal gains ($21 for a $1 investment at 3%).

Expected Returns and Variance in Investments

• Expected Return Calculation

  • Measure of predicted performance of investment considering likelihoods of various outcomes (e.g., stocks).

  • Initial example: Calculating expected returns from stocks with varying potential rates of return.

• Understanding Variance

  • Definition: Variance measures how far returns deviate from the expected return, indicating investment risk.

  • Formula for variance explained: Squared probabilities weighted by deviations from expected returns.

• Standard Deviation

  • Measurement of risk in terms of returns, translating variance into usable context.

Portfolio Probability Distributions

• Definition of Portfolio

  • Combination of multiple assets intended to optimize risk and returns.

• Expected Portfolio Return Calculation

  • Weighted average of expected returns of individual assets in the portfolio.

• Variance of Portfolio Returns

  • Combination of individual asset variances coupled with the covariance between asset returns, affecting total portfolio risk.

  • Example discussing two assets with dependent returns.

Insight on Covariance and Investment Decisions

• Covariance

  • Definition: A measure of how two investment returns move in relation to each other.

  • Implications on risk: Understanding how investments react together is crucial in minimizing risk through diversification.

Application and Practical Examples

• Example of Travel Agency Investment

  • Case studying the return variability of Whistle Travel dependent on economic cycles.

• Counter-cyclical Investments

  • Introduction of a counter-cyclical asset (Backyard Splash) demonstrating different performance in varying economic conditions.

• Importance of choosing assets in a portfolio that are imperfectly correlated for effective risk management.

Conclusion and Next Steps

• Summary of Key Ideas

  • Importance of understanding risk, diversification, and how past performance influences future decisions.

  • Essential need for incorporating both frequency and probability distributions in investment strategies.

• Preparation for Next Lesson

  • Future learning to build on risk insights and practical application of the discussed concepts.