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Summary Investment Management 254
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- Stellenbosch University (SUN)
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Chapter 1: Background and IssuesAn investment is the current commitment of money or other resources in the expectation of
reaping future benefits.
1. REAL ASSETS VERSUS FINANCIAL ASSETS
The material wealth of a society is ultimately determined by the productive capacity of its economy,
that is, the goods and services its members can create. This capacity is a function of the real assets of
the economy: the land, buildings, equipment, and knowledge that can be used to produce goods and
services.
In contrast to such real assets are financial assets such as stocks and bonds. Such securities are no
more than sheets of paper or, more likely, computer entries and do not directly contribute to the
productive capacity of the economy. Financial assets are claims to the income generated by real
assets (or claims on income from the government).
While real assets generate net income to the economy, financial assets simply define the allocation
of income or wealth among investors.
2. FINANCIAL ASSETS
It is common to distinguish among three broad types of financial assets: debt, equity, and
derivatives. Fixed-income or debt securities promise either a fixed stream of income or a stream of
income that is determined according to a specified formula. For example, a corporate bond typically
would promise that the bondholder will receive a fixed amount of interest each year. Other so-called
floating-rate bonds promise payments that depend on current interest rates.
The money market refers to fixed-income securities that are short term, highly marketable, and
generally of very low risk. Examples of money market securities are U.S. Treasury bills or bank
certificates of deposit (CDs). In contrast, the fixed-income capital market includes long-term
securities such as Treasury bonds, as well as bonds issued by federal agencies, state and local
municipalities, and corporations. These bonds range from very safe in terms of default risk
Unlike debt securities, common stock, or equity, in a firm represents an ownership share in the
corporation. Equity holders are not promised any particular payment. They receive any dividends the
firm may pay and have prorated ownership in the real assets of the firm. If the firm is successful, the
value of equity will increase; if not, it will decrease. The performance of equity investments,
,therefore, is tied directly to the success of the firm and its real assets. For this reason, equity
investments tend to be riskier than investments in debt securities.
Finally, derivative securities such as options and futures contracts provide payoffs that are
determined by the prices of other assets such as bond or stock prices. Derivative securities are so
named because their values derive from the prices of other assets.
3. FINANCIAL MARKETS AND THE ECONOMY
The Informational Role of Financial Markets
Stock prices reflect investors' collective assessment of a firm's current performance and future
prospects. When the market is more optimistic about the firm, its share price will rise. That higher
price makes it easier for the firm to raise capital and therefore encourages investment. In this
manner, stock prices play a major role in the allocation of capital in market economies, directing
capital to the firms and applications with the greatest perceived potential.
Consumption Timing
One way is to “store” your wealth in financial assets. In high-earnings periods, you can invest your
savings in financial assets such as stocks and bonds. In low-earnings periods, you can sell these
assets to provide funds for your consumption needs. By so doing, you can “shift” your consumption
over the course of your lifetime, thereby allocating your consumption to periods that provide the
greatest satisfaction. Thus, financial markets allow individuals to separate decisions concerning
current consumption from constraints that otherwise would be imposed by current earnings.
Allocation of Risk
Financial markets and the diverse financial instruments traded in those markets allow investors with
the greatest taste for risk to bear that risk, while other, less risk-tolerant individuals can, to a greater
extent, stay on the side lines.
Capital markets allow the risk that is inherent to all investments to be borne by the investors most
willing to bear that risk.
This allocation of risk also benefits the firms that need to raise capital to finance their investments.
When investors are able to select security types with the risk-return characteristics that best suit
their preferences, each security can be sold for the best possible price. This facilitates the process of
building the economy's stock of real assets.
,Separation of Ownership and Management
This structure means that the owners and managers of the firm are different parties. This gives the
firm a stability that the owner-managed firm cannot achieve. For example, if some stockholders
decide they no longer wish to hold shares in the firm, they can sell their shares to other investors,
with no impact on the management of the firm. Thus, financial assets and the ability to buy and sell
those assets in the financial markets allow for easy separation of ownership and management.
Agency problems because managers, who are hired as agents of the shareholders, may pursue their
own interests instead.
Several mechanisms have evolved to mitigate potential agency problems. First, compensation plans
tie the income of managers to the success of the firm. A major part of the total compensation of top
executives is typically in the form of shares or stock options, which means that the managers will not
do well unless the stock price increases, benefiting shareholders. Second, while boards of directors
have sometimes been portrayed as defenders of top management, they can, and in recent years
increasingly have, forced out management teams that are underperforming. Third, outsiders such as
security analysts and large institutional investors such as mutual funds or pension funds monitor the
firm closely and make the life of poor performers at the least uncomfortable.
Finally, bad performers are subject to the threat of takeover. If the board of directors is lax in
monitoring management, unhappy shareholders in principle can elect a different board. They can do
this by launching a proxy contest in which they seek to obtain enough proxies (i.e., rights to vote the
shares of other shareholders) to take control of the firm and vote in another board.
4. THE INVESTMENT PROCESS
An investor's portfolio is simply his collection of investment assets. Once the portfolio is established,
it is updated or “rebalanced” by selling existing securities and using the proceeds to buy new
securities, by investing additional funds to increase the overall size of the portfolio, or by selling
securities to decrease the size of the portfolio.
The asset allocation decision is the choice among these broad asset classes, while the security
selection decision is the choice of which particular securities to hold within each asset class.
“Top-down” portfolio construction starts with asset allocation. For example, an individual who
currently holds all of his money in a bank account would first decide what proportion of the overall
portfolio ought to be moved into stocks, bonds, and so on. In this way, the broad features of the
portfolio are established.
, A top-down investor first makes this and other crucial asset allocation decisions before turning to
the decision of the particular securities to be held in each asset class.
Security analysis involves the valuation of particular securities that might be included in the
portfolio.
In contrast to top-down portfolio management is the “bottom-up” strategy. In this process, the
portfolio is constructed from the securities that seem attractively priced without as much concern
for the resultant asset allocation. Such a technique can result in unintended bets on one or another
sector of the economy. However, a bottom-up strategy does focus the portfolio on the assets that
seem to offer the most attractive investment opportunities.
5. MARKETS ARE COMPETITIVE
The Risk-Return Trade-Off
Naturally, if all else could be held equal, investors would prefer investments with the highest
expected return. However, the no-free-lunch rule tells us that all else cannot be held equal. If you
want higher expected returns, you will have to pay a price in terms of accepting higher investment
risk. If higher expected return can be achieved without bearing extra risk, there will be a rush to buy
the high-return assets, with the result that their prices will be driven up.
Similarly, if returns were independent of risk, there would be a rush to sell high-risk assets. Their
prices would fall (improving their expected future rates of return) until they eventually were
attractive enough to be included again in investor portfolios. We conclude that there should be
a risk-return trade-off in the securities markets, with higher-risk assets priced to offer higher
expected returns than lower-risk assets.
Diversification means that many assets are held in the portfolio so that the exposure to any
particular asset is limited.
Efficient Markets
Another implication of the no-free-lunch proposition is that we should rarely expect to find bargains
in the security markets.
One interesting implication of this “efficient market hypothesis” concerns the choice between active
and passive investment-management strategies.
Passive management calls for holding highly diversified portfolios without spending effort or other
resources attempting to improve investment performance through security analysis.
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