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CHAPTER 14 principles of investment

INVESTING AND SAVING

Saving: money that you did not spend; money left over after your consumption

Investing: using the savings that you have and putting it in investments to earn a rate of return

BASIC CHARACTERISTICS OF AN INVESTMENT

Important characteristics – return, risk, liquidity, marketability, term (short term, long term),

management, tax considerations, divisibility

Income return: periodic cash flow that the investor receives

Capital gain return: generated when you sell it for a price higher than what you paid for it

Total return: income return plus the capital gain return

Rate of return (holding period return)

R or (HPR) = P1 – P0 + D / P0

P0 = price at the beginning of the holding period

P1 = price at the end of the holding period

D = income return (interest or dividend) during the holding period

Realized rate of return: rate of return that actual occurred in a past period

Expected rate of return: return that is expected to happen in the future

E(r) = E(P1) – P0 + E(D) / P0

P0 = price today, or at the beginning of the period

E(D) = expected income during the period

INVESTMENT RISKS

Risk is the uncertainty about the rate of return that you will earn from an investment

Variability: one way of measuring risk in an investment’s rate of return

o Investments with more variability in their rate of return are riskier than investments with less

variability because the larger of the variability, the higher probability of getting a rate of return

lower than the expected rate of return

Beta: measures the co-movement of the stock’s return with the stock market’s return

o Measures the risk of the investment relative to the risk of the market

o The higher the beta, the more sensitive the stock is to moves in the market

Total risk: standard deviation of its rate of return

o Measures the total variability or volatility of an investment

Objective probability distribution: formed by measuring objective historical data to find the rate of

return of a stock (mean and standard deviation)

Subjective probability distribution: formed by writing down one’s perception of all the possible rates of

return of the investment and then assigning probabilities to them

E(r) = ∑Piri

S.D. = [∑Pi [ri – E(r)]2]1/2

Risk-free asset: no variability in the rate and the standard deviation is zero

Inflation risk: does not guarantee the purchasing power of your money

Default risk: risk of losing part or all of the future cash flow that the investor expects to get when making

the investment initially

Interest rate risk: risk that is caused by the changes in the level of market interest rates, which affect the

values of all assets

Liquidity risk: risk of not being able to cash your investment in time of need

Reinvestment risk: risk associated with the uncertainty of not knowing at what rates of return your

money can be reinvested in the future