Investments: Background

Investments: Background

Course Information

  • Course Name: FINC 335 Investments
  • Instructor: An Qin
  • Institution: Loyola University Chicago
  • Semester: Spring 2026

Agenda

  1. Investments: Background
  2. Definitions
  3. Financial Assets
  4. Financial Markets
  5. Players in the Market
  6. Risk and Return
  7. Market Efficiency; Active and Passive Management

Investment Overview

  • Investment Definition:
    • The commitment of resources in the expectation of deriving greater resources in the future.
  • Savings Definition:
    • Savings = Income – Consumption, emphasizing that savings and investment are not the same concept.
Questions for Consideration
  • Can you be an investor and not a saver?
  • Can you be a saver and not an investor?

Examples of Investments

  • Buying one share of Google stock.
  • Purchasing a factory.
  • Obtaining a college education.
  • Attending this lecture can also be considered an investment.

Real vs. Financial Assets

  • Real Assets:
    • Represent tangible assets used to produce goods and services, such as factories, land, and education.
  • Financial Assets:
    • Claims on real assets or income generated from them. Types include:
    1. Debt Securities: Pay specified cash flows over a specified period.
    2. Equity Securities: Ownership share in a firm.
    3. Derivative Securities: Payoffs depend on the performance of underlying securities.
    • Trading: All types of these assets are traded in financial markets, such as the New York Stock Exchange (NYSE).
Real or Financial?
  • **Examples:
    • Stock (Financial Asset)
    • Patent (Financial Asset)
    • A $5 bill (Financial Asset)
    • MBA degree at LUC (Real Asset)
    • Land (Real Asset)
    • Leases (Financial Asset)
    • Machines (Real Asset)
    • Knowledge (Real Asset)
      **

Role of Financial Markets

  • Informational Role:
    • Encourages the allocation of capital to firms with the best economic prospects.
  • Consumption Timing:
    • Financial markets assist individuals in timing consumption and storing wealth.
  • Risk Allocation:
    • Acknowledges the risk-return trade-off; there is no ‘free lunch’ in investing.
  • Separation of Ownership and Management:
    • This separation facilitates capital-intensive industries but introduces agency problems or conflicts of interest.
Income & Lifetime Consumption
  • Financial assets allow investors to shift their income through time, realizing income in the present and future.

Players in the Market

  1. Businesses (Firms):
    • Invest in the production of goods and services; typically net demanders of funds (net borrowers).
  2. Individuals (Households):
    • Often need for loans (e.g., for homes or vehicles); typically net suppliers of funds (net savers).
  3. Government:
    • Engages in federal, state, and local projects and operations; typically net demanders of funds (borrowers or lenders).

Intermediation in Financial Markets

  • Intermediaries connect the demanders and suppliers of capital. Types include:
    • Banks
    • Investment Companies
    • Insurance Companies
    • Credit Unions
Differences Between Intermediaries
  • Investment Banks:
    • Raise capital, provide advice, assist in mergers and acquisitions (M&A), conduct research, and engage in sales and trading.
  • Commercial Banks:
    • Accept deposits, lend money, and hold securities.
  • Rationale for Intermediation:
    • Pooled resources, diversification, monitoring, and achieving economies of scale.

Risk and Return Trade-off

  • Key Concept: There is no free lunch in investing; typically, higher returns are associated with higher risk.
  • Reference Data Source:
    • Stock market returns from Professor Kenneth R. French's data library website.
    • Annual rates of return for 1-month T-bills sourced similarly.

Quiz Question

  • Given the low average return on treasury bills, why would anyone invest in them?
Risk Appetite
  • Investors generally dislike risk, however, some choose to engage in activities that involve risk, such as paying for skydiving experiences.
  • Comparison of two assets for the same price of $40:
    • Asset A Costs:
    • Price: $50 with Heads/Tails outcomes.
    • Asset B Costs:
    • Price: $100 with Heads/Tails outcomes.

Market Efficiency

  • Definition: The degree to which asset prices reflect all public and private information.
    • Forms of Market Efficiency:
    1. Weak Form
    2. Semi-Strong Form
    3. Strong Form
    • Controversy: While financial markets are highly competitive, debates on efficiency persist (examples include the dot-com bubble, the housing bubble, and emerging student debt bubble).
  • Behavioral Explanations: Have anecdotal explanatory power concerning market inefficiencies.

Quiz Question

  • If you see an advertisement for a book that claims to help you make $1 million with no risk and no money down, would you buy the book? Why?

Investment Process

  • Components:
    1. Asset Allocation & Security Selection:
    • Asset Allocation: Allocating an investment portfolio across asset classes (e.g., stocks, bonds, derivatives).
    • Security Selection: Choosing specific securities within each asset class.
    1. Investment Approaches:
    • Top-down Process: Asset allocation first, followed by security selection.
    • Bottom-up Process: Security selection first, leading to asset allocation.
Investment Management Strategies
  1. Active Management:
    • Pursued in inefficient markets; involves searching for undervalued securities and trying to time the market.
  2. Passive Management:
    • No attempts to find undervalued securities or time the market; focuses on holding an efficient portfolio.