Chapter 12

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Chapter 12

  1. 1. Chapter 12 Introduction to Investment Planning
  2. 2. Establishing Financial Goals <ul><li>Typical Financial Goals </li></ul><ul><li>Common Investment Goals </li></ul><ul><ul><li>Capital accumulation </li></ul></ul><ul><ul><li>Preservation of capital </li></ul></ul><ul><ul><li>Maximizing returns </li></ul></ul><ul><ul><li>Minimizing risk </li></ul></ul><ul><li>Budgeting </li></ul><ul><li>Methods of Increasing Savings </li></ul>
  3. 3. Investment Risks <ul><li>Systematic Risks </li></ul><ul><ul><ul><li>Market risk </li></ul></ul></ul><ul><ul><ul><li>Interest rate risk </li></ul></ul></ul><ul><ul><ul><li>Purchasing power risk </li></ul></ul></ul><ul><ul><ul><li>Foreign currency (exchange rate) risk </li></ul></ul></ul><ul><ul><ul><li>Reinvestment risk </li></ul></ul></ul><ul><li>Unsystematic Risks </li></ul><ul><ul><ul><li>Business risk </li></ul></ul></ul><ul><ul><ul><li>Financial risk </li></ul></ul></ul><ul><ul><ul><li>Default risk </li></ul></ul></ul><ul><ul><ul><li>Country (or regulation) risk </li></ul></ul></ul>
  4. 4. Investment Risks (cont’d) <ul><li>Risk and Return </li></ul><ul><ul><li>There is a direct relationship between risk and return. As the level of risk increases, the expected return increases, and as the level of risk decreases, the expected return decreases. </li></ul></ul><ul><li>Liquidity vs. Marketability </li></ul>
  5. 5. Investment Choices <ul><li>Lending investments </li></ul><ul><ul><li>Default risk </li></ul></ul><ul><ul><li>Interest rate risk </li></ul></ul><ul><li>Ownership investments in business </li></ul><ul><li>Ownership investments in real estate </li></ul><ul><ul><li>Cash flow </li></ul></ul><ul><ul><li>Depreciation deduction </li></ul></ul><ul><ul><li>Low correlation with other assets </li></ul></ul>
  6. 6. Investment Choice (cont.) <ul><li>Derivatives </li></ul><ul><ul><li>Options </li></ul></ul><ul><ul><ul><li>Puts </li></ul></ul></ul><ul><ul><ul><li>Calls </li></ul></ul></ul><ul><ul><li>Futures </li></ul></ul><ul><li>Direct vs. Indirect Investing </li></ul>
  7. 7. Measures of Risk <ul><li>Beta – a measure of systematic risk derived from regression analysis </li></ul><ul><li>Standard Deviation – measures total volatility (systematic and unsystematic risk) </li></ul><ul><li>Semivariance – measures downside volatility </li></ul>
  8. 8. Measures of Return <ul><li>Holding period return </li></ul><ul><li>Arithmetic mean </li></ul><ul><li>Geometric mean </li></ul><ul><li>Internal rate of return </li></ul><ul><li>Real rate of return </li></ul>
  9. 9. Holding Period Return <ul><li>HPR = EI – BI +/- Cashflows </li></ul><ul><li>BI </li></ul><ul><li>EI = Ending Value of Investment </li></ul><ul><li>BI = Beginning Value of Investment </li></ul>
  10. 10. Arithmetic Mean AM = HPR 1 + HPR 2 + HPR 3 + HPR t n HPR t = Return for period t n = Number of periods
  11. 11. Geometric Mean GM is interest rate when solving: PV = -100 FV = 100 (1+R 1 ) (1+R 2 ) (1+R 3 ) (1+R n ) N = n R n = Return for period n n = Number of periods
  12. 12. Internal Rate of Return PV = Present Value CF n = Cash flow for period n n = Number of cash flows k = IRR PV CF 1 1 k + ( ) 1 CF 2 1 k + ( ) 2 ¼ + CF n 1 k + ( + ) n + =
  13. 13. Real Rate of Return Real return 1 R n + ( ) 1 I + ( ) 1 – = R n = Nominal rate of return I = Inflation rate
  14. 14. Modern Portfolio Theory <ul><li>Modern portfolio theory is the concept that describes the diversification process among a portfolio’s asset classes </li></ul>
  15. 15. The Efficient Frontier
  16. 16. Markowitz’s Three Rules <ul><li>Same return – choose lower risk. </li></ul><ul><li>Same risk – choose higher return. </li></ul><ul><li>Choose higher return with lower risk. </li></ul>
  17. 17. Modern Portfolio Theory (cont’d) <ul><li>The following are the foundation for most of the asset allocation (mean-variance optimization) software packages used by financial planners: </li></ul><ul><ul><li>Standard Deviation of a Multi-Asset Portfolio </li></ul></ul><ul><ul><li>Expected Return of the Portfolio </li></ul></ul>
  18. 18. Correlation Coefficient <ul><li>R = +1.0 perfect positive correlation </li></ul><ul><li>R = -1.0 perfect negative correlation </li></ul><ul><li>R = 0 no correlation </li></ul><ul><li>R 2 = Coefficient of determination </li></ul>
  19. 19. Investment Strategies and Theories <ul><li>Efficient Market Hypothesis </li></ul><ul><li>Active vs. Passive Investing </li></ul><ul><li>Indexing </li></ul><ul><li>Timing the Market </li></ul>

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