Chapter 1 and Notes: Lecture 2 Slides 15-34

Question 1

How do you measure investment return?

Answer 1

1. Total Dollar Return - measured in dollars that accounts for all cash flows and capital gains/losses
2. Total Percent Return - measured as a percentage that accounts for all cash flows and capital gains/losses

Question 2

What measurement of investment return is more important and why?

Answer 2

Total Percent Return

Because measures of this return allows us to compare investment alternatives

Question 3

How do you measure risk?

Answer 3

There are many ways, all of them imperfect. One popular measure is standard deviation.

Question 4

What is standard deviation?

Answer 4

Standard deviation measures the volatility of an investment.

In any given year, there is about a ⅔ chance that the return of an investment will be within one standard deviation of the historical average return (average return plus or minus one standard deviation)

The higher the standard deviation, the more volatile the investment

The greater the variance from the norm

Question 5

What are equity securities? What does the investor get? What is the risk?

Answer 5

Equity Securities – a.k.a. Common Stocks
Represents ownership in a corporation
Investors receive…
Dividends – optional payments to shareholders
Capital Gains – shares increase in value
Limited Liability
Moderate-risk to high-risk to speculative-risk
“Volatility” – euphemism for “I lost a whole lotta’ money!”
Historically best returns over time
8% to 12% (8% to 10%)
Should be considered a long-term investment

Question 6

What are fixed income securities? What does the investor get? What is the risk?

Answer 6

Fixed-Income Securities – a.k.a. Bonds
Long-term loans to
Corporations (Corporate bonds)
State and local governments (Municipal bonds)
Federal government (Treasury bonds)
Bond investors lend their money to the bond issuers (corporation, state or local municipality, Treasury)
The bond investors then receive interest and a promise that the loan will be repaid when due
Historically much less riskier than stocks but…
Also less reward – 2-5% (govt/mun) to 4-6% (corp)
Good intermediate-term / long-term investment

Question 7

What are short term investments? What does the investor get? What is the risk?

Answer 7

Short-term Investments
a.k.a. “Cash” “Short-term vehicles”
Normally up to 1 year (1 to 3 years)
Usually guaranteed (or pretty darned close)
Liquid (many let you simply write a check!)
Very low risk of losing principal
Hence, very low reward
1% to 3% over time (currently less than 1%)
“A place to park your money”
Also used for holding an “emergency fund”

Question 8

Discuss some examples of short term investments.

Answer 8

Short-term Investments – Examples
Deposit accounts at financial institutions
Passbook savings accounts at banks, share accounts at credit unions
Series EE or I savings bonds
U.S. Treasury bills (T-bills)
Certificates of Deposit (CDs)
Money market accounts
Money market mutual funds
Commercial paper (Corporate IOUs)
Banker’s acceptance notes (Bank IOUs)

Question 9

What are mutual funds? What does the investor get? What is the risk?

Answer 9

Mutual Funds
a.k.a. Investment companies
A company that pools investors’ money and invests in a diversified portfolio of securities
Investors get…
Diversification
Mutual funds can purchase hundreds of securities
Professional money management
Very popular form of investment
Range from low-risk to speculative-risk

Question 10

Discuss the process of mutual funds.

Answer 10

The little persons give $50-100 a month to the professional money managers. There are millions of little persons giving money every month creating a huge pool of money. There are billions of dollars in these pools. Then the money managers buy stock mutual funds, bond mutual funds, and money market mutual funds creating various types of mutual funds such as balanced mutual funds owning stocks and bonds.

Approximately 50% of
American households own mutual funds

Question 11

What is a hybrid investment?

Answer 11

A hybrid investments is a combination of stocks and bonds.
Preferred Stock
Represents ownership in corporation, but…
Dividends are not considered optional
Convertible Securities
A bond or preferred stock that can be converted into common stock
Hybrid investments are designed to offer the stability of fixed-income investments (bonds) with the opportunity for capital growth of equity investments (stocks)

Question 12

What is the difference between common and preferred stock?

Answer 12

In preferred stock the dividend is not optional.

Question 13

Discuss other popular investments.

Answer 13

Real estate
Examples: residential, commercial, raw land, Real Estate Investment Trusts (REITs)
Tangible assets
Examples: precious metals, jewels, art, collectibles
Tax-advantaged investments
Examples: oil and gas limited partnerships, low-income housing projects

Question 14

What are derivative assets?

Answer 14

Speculative securities that derive their value from an underlying security or asset
Options – a.k.a. Options Contracts
Calls and puts
Futures – a.k.a. Futures Contracts
Commodities
Stock indexes
Many in the financial world do not categorize these as investments

Question 15

What are the big four financial options, investments, and alternatives?

Answer 15

1. Equities – a.k.a. Stocks
   You are an owner
2. Fixed-Income Securities – a.k.a. Bonds
   You are a loaner
3. Short-term Securities – a.k.a. “Cash”
   Your principal is safe (often guaranteed)
4. Mutual Funds – a.k.a. Investment Companies
   Your investments are managed on your behalf

Question 16

What are investment companies that pool investors’ money and invest in a diversified portfolio of securities? Investors get diversification and professional money management.

Answer 16

Mutual Funds

Question 17

What type of investment represents ownership in a corporation? Investors receive dividends and capital gains (or capital losses).

Answer 17

Common Stocks

Question 18

What are investments with very little risk, and correspondingly, very little return? Often used as a place to “park your money” or for an emergency fund of 3 to 6 months income.

Answer 18

Short Term Securities

Question 19

What are fixed-income securities that represent loans to corporations, municipalities (state & local governments & agencies), and the Federal government? Investors receive interest and a promise to repay the loan.

Answer 19

Bonds

Question 20

What are securities designed to offer the stability of fixed-income investments with the opportunity for capital growth of equity investments? Examples include preferred stock and convertible bonds.

Answer 20

Hybrid Securities

Question 21

What are speculative securities that derive their value from an underlying security or asset? Examples include options contracts and futures contracts.

Answer 21

Derivatives

Question 22

What are reasonable long-term expectations of returns from the following investments?
Stocks 
Bonds 
Short Term Securities 
Mutual Funds 
Hybrid Securities 
Derivatives

Answer 22

Stocks 8%-12% (10%)
Bonds 2%-6%
Short Term Securities 1%-3%
Mutual Funds ?
Hybrid Securities ?
Derivatives -?

Question 23

Describe the following to someone with no investing experience.

1. Stocks
2. Bonds
3. Short-Term Securities
4. Mutual Funds
5. Hybrid Securities
6. Derivatives

Answer 23

1.
2.
3.
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6.