1
Chapter 1: Understanding Investments
CHAPTER OVERVIEW
Chapter 1 is designed to be a standard introductory chapter. As such, its purpose is to
introduce students to the subject of investments, explain what investments is concerned with
from a summary viewpoint, and outline what the remainder of the text will cover. It defines
important terms such as investments, security analysis, portfolio management, expected and
realized rate of return, risk-free rate of return, risk, and risk tolerance.
IT IS IMPORTANT TO NOTE that Chapter 1 discusses some important issues, such as
the expected return-risk tradeoff that governs the investment process, the uncertainty that
dominates investment decisions, the globalization of investments, and the impact of institutional
investors. As such, the chapter sets the tone for the entire text and explains to the reader what
investments is all about. It establishes a basic framework for the course without going into too
much detail at the outset.
Chapter 1 also contains some material that will be of direct interest to students, including
the importance of studying investments (using illustrations of the wealth that can be accumulated
by compounding over long periods of time) and investments as a profession. The CFA
designation is also briefly discussed.
Equally important, Chapter 1 does not cover calculations and statistical concepts, data on
asset returns, and so forth. The authors feel strongly that Chapter 1 is not the place to do this
when most students have little knowledge of what the subject is all about. They are not ready for
this type of important material, and since it will not be used immediately, they will lose sight of
why it was introduced. The authors believe that it is much more effective to introduce the
students thoroughly to what the subject involves.
It is highly desirable for instructors to add their own viewpoints at the outset of the
course, perhaps using recent stories from the popular press to emphasize what investments is
concerned with, why students should be interested in the subject, and so forth. One interesting
and important topic that can be discussed in class is investment fraud. Scams continue day after
day, and many people lose their life savings. Most people will have at least heard of the Ponzi
scheme revealed in late 2008 involving Bernie Madoff. By learning a few basic investing
principles, students will be able to avoid these “scams,” thereby possibly saving themselves or
their family and friends from misfortune.
Chapter 1 also discusses ethics in investing, setting the stage for examples of ethical
issues in other chapters.
, 2
CHAPTER OBJECTIVES
To introduce students to the subject matter of investments from an overall viewpoint,
including terminology.
To explain the basic nature of the investing decision as a tradeoff between expected
return and risk.
To explain that the decision process consists of security analysis and portfolio
management and that external factors affect this decision process. These factors
include uncertainty, the necessity to think of investments in a global context, the
environment involving institutional investors, and the impact of the internet on
investing.
To organize the remainder of the text.
, 3
MAJOR CHAPTER HEADINGS [Contents]
An Overall Perspective on Investing
Just Say NO!
Establishing a Framework for Investing
Some Definitions
[investment; investments; financial and real assets;
marketable securities; portfolio]
A Perspective on Investing
[investing is only one part of overall financial decisions; take a portfolio perspective]
Why Do We Invest?
[to increase monetary wealth]
Take a Portfolio Perspective
The Importance of Studying Investments
The Personal Aspects
[most people make investment decisions; examples of wealth accumulation as a result
of compounding; people will be largely responsible for making investing decisions
affecting their retirement; an understanding of the subject will help students when
reading the popular press]
Investments as a Profession
[various jobs such as security analysts, portfolio managers, stockbrokers, and
financial advisors; financial planners; CFA designation]
Understanding the Investment Decision Process
The Basis of Investment Decisions—Return and Risk
[expected return; realized return; risk; risk-averse investor; risk tolerance; the
Expected Return-Risk Tradeoff; diagram of tradeoff; ex post vs. ex ante; risk-free
rate of return, RF]
Structuring the Decision Process
[a two-step process: security analysis and portfolio management]
Important Considerations in the Investment Decision Process for Today’s Investors
The Great Unknown
, 4
[uncertainty dominates decisions--the future is unknown!]
A Global Perspective
[the importance of foreign markets; the euro; emerging markets]
The Importance of the Internet
[using the internet to invest]
Individual Investors vs. Institutional Investors
[individual investors compete with institutional investors, but individuals are the
beneficiaries of institutional investor activity; Regulation FD; spin-offs]
Ethics in Investing
Organizing the Text
[Background; Realized and Expected Returns and Risk; Bonds; Stocks; Security
Analysis, including both fundamental and technical analysis; Derivative Securities;
Portfolio Theory and Capital Market Theory; the Portfolio Management Process and
Measuring Portfolio Performance]
Chapter 1: Understanding Investments
CHAPTER OVERVIEW
Chapter 1 is designed to be a standard introductory chapter. As such, its purpose is to
introduce students to the subject of investments, explain what investments is concerned with
from a summary viewpoint, and outline what the remainder of the text will cover. It defines
important terms such as investments, security analysis, portfolio management, expected and
realized rate of return, risk-free rate of return, risk, and risk tolerance.
IT IS IMPORTANT TO NOTE that Chapter 1 discusses some important issues, such as
the expected return-risk tradeoff that governs the investment process, the uncertainty that
dominates investment decisions, the globalization of investments, and the impact of institutional
investors. As such, the chapter sets the tone for the entire text and explains to the reader what
investments is all about. It establishes a basic framework for the course without going into too
much detail at the outset.
Chapter 1 also contains some material that will be of direct interest to students, including
the importance of studying investments (using illustrations of the wealth that can be accumulated
by compounding over long periods of time) and investments as a profession. The CFA
designation is also briefly discussed.
Equally important, Chapter 1 does not cover calculations and statistical concepts, data on
asset returns, and so forth. The authors feel strongly that Chapter 1 is not the place to do this
when most students have little knowledge of what the subject is all about. They are not ready for
this type of important material, and since it will not be used immediately, they will lose sight of
why it was introduced. The authors believe that it is much more effective to introduce the
students thoroughly to what the subject involves.
It is highly desirable for instructors to add their own viewpoints at the outset of the
course, perhaps using recent stories from the popular press to emphasize what investments is
concerned with, why students should be interested in the subject, and so forth. One interesting
and important topic that can be discussed in class is investment fraud. Scams continue day after
day, and many people lose their life savings. Most people will have at least heard of the Ponzi
scheme revealed in late 2008 involving Bernie Madoff. By learning a few basic investing
principles, students will be able to avoid these “scams,” thereby possibly saving themselves or
their family and friends from misfortune.
Chapter 1 also discusses ethics in investing, setting the stage for examples of ethical
issues in other chapters.
, 2
CHAPTER OBJECTIVES
To introduce students to the subject matter of investments from an overall viewpoint,
including terminology.
To explain the basic nature of the investing decision as a tradeoff between expected
return and risk.
To explain that the decision process consists of security analysis and portfolio
management and that external factors affect this decision process. These factors
include uncertainty, the necessity to think of investments in a global context, the
environment involving institutional investors, and the impact of the internet on
investing.
To organize the remainder of the text.
, 3
MAJOR CHAPTER HEADINGS [Contents]
An Overall Perspective on Investing
Just Say NO!
Establishing a Framework for Investing
Some Definitions
[investment; investments; financial and real assets;
marketable securities; portfolio]
A Perspective on Investing
[investing is only one part of overall financial decisions; take a portfolio perspective]
Why Do We Invest?
[to increase monetary wealth]
Take a Portfolio Perspective
The Importance of Studying Investments
The Personal Aspects
[most people make investment decisions; examples of wealth accumulation as a result
of compounding; people will be largely responsible for making investing decisions
affecting their retirement; an understanding of the subject will help students when
reading the popular press]
Investments as a Profession
[various jobs such as security analysts, portfolio managers, stockbrokers, and
financial advisors; financial planners; CFA designation]
Understanding the Investment Decision Process
The Basis of Investment Decisions—Return and Risk
[expected return; realized return; risk; risk-averse investor; risk tolerance; the
Expected Return-Risk Tradeoff; diagram of tradeoff; ex post vs. ex ante; risk-free
rate of return, RF]
Structuring the Decision Process
[a two-step process: security analysis and portfolio management]
Important Considerations in the Investment Decision Process for Today’s Investors
The Great Unknown
, 4
[uncertainty dominates decisions--the future is unknown!]
A Global Perspective
[the importance of foreign markets; the euro; emerging markets]
The Importance of the Internet
[using the internet to invest]
Individual Investors vs. Institutional Investors
[individual investors compete with institutional investors, but individuals are the
beneficiaries of institutional investor activity; Regulation FD; spin-offs]
Ethics in Investing
Organizing the Text
[Background; Realized and Expected Returns and Risk; Bonds; Stocks; Security
Analysis, including both fundamental and technical analysis; Derivative Securities;
Portfolio Theory and Capital Market Theory; the Portfolio Management Process and
Measuring Portfolio Performance]
