Chapter 1 - Introduction to Investments Flashcards
What is the definition of capital markets (financial markets, stock exchanges)
Channel for the exchange of funds between lenders and borrowers, buyers and sellers
Where buyers and sellers compete for the best prices - driven by supply and demand
In markets generally the higher the risk being taken by an investor - the higher the expected return to compensate for risk
Two main types of financial instruments:
- equity - shares, part ownership - return of capital value increase and dividends
- bonds - debt instrument - return in the form of coupon and capital back at maturity
What is an equity and what is achieved through equity investment?
Equity is part ownership in a business - investing funds into a count in return for a share in the company
Rights of shareholders governed by the company’s articles
Over the long term investors would expect to dividends payable from the company’s profits - if business is successful, would expect the price of shares to increase - resulting in a capita, gain if these were sold
Risk of shares
Volatile - no guaranteed returns, all depends on the performance of the company and general market conditions
No guarantee return on winding up either - ordinary shareholders are the last to share in assets in the event of a dissolution - bond holders even come first
What is a bond and what is the long terms attraction of bonds ?
A bond is a debt instrument - provides a steady income stream (known as the coupon) during its life and capital repayment at maturity of the bond
Risks of bonds
Risk of default - based on credit rating - can affect likelihood of payment - investor usually compensated for any risk of default with a higher coupon
Interest rate risk - affects longer terms bonds - as interest rates move this may affect the price of bonds and therefore the overall yield
Inflation risk - general movement in prices and can impact on the value of the bond (erode value of capital) and coupon
Liquidity risk - the possibility that there won’t be a market (willing buyers of a bond)
What is diversification?
Not putting all your eggs in one basket - spreading the risk in a portfolio
Done through ensuring that portfolio is invested across different asset classes - further diversification can be achieved through diversification within asset classes, investing in shares of different and uncorrelated companies and a mix of corporate bonds and gov bonds for example
Care needs to be taken - max number of investments should be 30 - too many investments and the cost of running portfolio could outweigh the benefits to be achieve
Systematic risk cannot be diversified away
Definition of risk
All investments involve some element of risk - risk refers to the degree of uncertainty inherent in investment - the possibility hat returns will not be achieved or even capital lost completely
Different types of risk
Volatility risk - fluctuations in stock price impacted on by factors outside an investors control, inflation, interest rate changes and general market conditions. Share price valuations not an exact science and driven by mixture of supply and demand and general market conditions as well as performance of company (driven by the performance of management)
Systematic risk - general inherent risk of the market - this cannot be diversified away as it is due to factors outside of investors control
Unsystematic - risk specific to investments and which can be diversified away through careful investment selection
What factors should be considered in relation to a investor when making an investment decision?
Investors personal financial circumstances - cash requirements, assets to be investment in context of overall wealth
Attitude to risk - differs for investors, how much risk are they willing to take on - generally the younger investor tends to be less risk averse
Personal assessment of the merits of bond and securities markets
Expectation of interest rate movements
Assessment of the overall health of the economy
Investors should always seek professions, advice prior to making investment decisions
Rebalancing
over time the balance of a portfolio will change as some investments will perform better than others over time - this can skew the portfolio holdings to be out of alignment with original goals set
To rebalance a portfolio - investor can sell investments where holdings are overweight and use funds to buy investments in the underweight asset classes
Cost constraints and possible tax consequences from buying and selling assets should always be considered
