Chapter 1 - The Investment Environment Flashcards
What is the difference between real assets and financial assets?
Real assets of the economy are: Land, buildings machines and knowledge that can be used to produce goods and services.
Financial assets such as stocks and bonds are the means by which individuals hold their claims on real assets. These are claims to the income generated by real assets.
Real assets generate income to the economy, financial assets simply define the allocation of wealth
Why might equity investments be riskier than debt securities?
Because the equity of common stock is tied directly to the success of the firm
What is the informational role of financial markets?
Stock prices reflect investors collective assessment of a firm’s current performance and future prospects. Optimism makes share prices rise. The higher the price the easier it is for firms to raise capital. Problems: hot stocks e.g. dot com bubble
What is the difference between asset allocation and security selection?
The choice amongst board asset classes while security selection is the choice of which particular securities to hold within each asset class.
Asset allocation includes the decision of how much of one’s portfolio should be held in safe assets such as bank accounts or money market securities vs risky assets.
Is saving safe investing?
Saving means you do not spend all of your current income and therefore can add to your portfolio. You may choose to invest your savings into safe assets, risky assets or a combination of both.
What is top-down portfolio construction?
This starts with asset allocation. An individual with money in the bank will first decide what proportion should be in stocks, bonds etc. The asset allocation decision is made first before security selection.
What is security analysis?
The valuation of particular securities that might be included in the portfolio
What is bottom up portfolio construction?
Securities are selected based on what seems to be attractively priced without much concern for resultant asset allocation. Such techniques can result in unintended bets on one or another sector in the economy.
What is passive management?
Calls for holding highly diversified portfolios without spending effort or other resources attempting to improve investment performance through security analysis.
What is active management?
The attempt to improve performance either by identifying misplaced securities or by timing the performance of broad asset classes - eg increasing ones commitment to stocks when one is bullish on the stock market.
Implications of Efficient market hypothesis
If markets are efficient and prices reflect all relevant information perhaps it is better to follow passive strategies instead of spending resources in a futile attempt to outguess your competitors in the financial markets.
Without ongoing security analysis however, prices would eventually depart from “correct” values, creating incentives for experts to move in.
Therefore, only near efficiency may be observed and profits may exist for especially diligent and creative investors.
The Players: What are firms?
Firms are net demanders of capital. They raise capital now and pay for investments in plant and equipment. The income generated by those real assets provide the returns to investors who purchase the securities issued by the firm.
The Players: What are households?
Households typically are net suppliers of capital. They purchase securities issued by firms that need to raise funds.
The Players: What are governments?
Both borrowers and lenders depending on the relationship between tax revenue and expenditures.
The Players: What are financial intermediaries?
These financial institutions stand between firms and the ultimate owner of the security. Governments and securities usually sell to these institutions which then distribute securities. They bring suppliers of capital together with demanders of capital.
