Chapter 12: Introduction to Investment Planning Chapter 12 Introduction to Investment Planning.

Chapter 12: Introduction to Investment Planning

Chapter 12

Introduction to Investment Planning


2005 Kaplan Financial

2

Establishing Financial Goals

Typical Financial Goals Common Investment Goals

Capital accumulation Preservation of capital Maximizing returns Minimizing risk

Budgeting Methods of Increasing Savings



3

Investment Risks Systematic Risks

Market risk Interest rate risk Purchasing power risk Foreign currency (exchange rate) risk Reinvestment risk

Unsystematic Risks Business risk Financial risk Default risk Country (or regulation) risk



4

Investment Risks (cont’d)

Risk and Return There is a direct relationship between

risk and return. As the level of risk increases, the expected return increases, and as the level of risk decreases, the expected return decreases.

Liquidity vs. Marketability



5

Investment Choices

Lending investments Default risk Interest rate risk

Ownership investments in business Ownership investments in real

estate Cash flow Depreciation deduction Low correlation with other assets



6

Investment Choice (cont.)

Derivatives Options

Puts Calls

Futures Direct vs. Indirect Investing



7

Measures of Risk

Beta – a measure of systematic risk derived from regression analysis

Standard Deviation – measures total volatility (systematic and unsystematic risk)

Semivariance – measures downside volatility



8

Measures of Return

Holding period return Arithmetic mean Geometric mean Internal rate of return Real rate of return



9

Holding Period Return

HPR = EI – BI +/- Cashflows BIEI = Ending Value of InvestmentBI = Beginning Value of Investment



10

Arithmetic Mean

AM =

HPR1 + HPR2 + HPR3+ HPRt n

HPRt = Return for period t

n = Number of periods



11

Geometric Mean

GM is interest rate when solving:

PV = -100FV = 100 (1+R1) (1+R2) (1+R3) (1+Rn)N = n

Rn = Return for period n

n = Number of periods



12

Internal Rate of Return

PV CF

1

1 k+

( ) 1

CF2

1 k+

( ) 2¼ + CF n

1 k+ ( + )n

+=

PV = Present ValueCFn = Cash flow for period n

n = Number of cash flowsk = IRR



13

Real Rate of Return

Real return 1 R n

+

( )

1 I

+

( )1–=

Rn = Nominal rate of return

I = Inflation rate



14

Modern Portfolio Theory

Modern portfolio theory is the concept that describes the diversification process among a portfolio’s asset classes



15

The Efficient Frontier

ExpectedReturn

Risk

BD

CA

EfficientFrontier



16

Markowitz’s Three Rules

1. Same return – choose lower risk.2. Same risk – choose higher return.3. Choose higher return with lower

risk.



17

Modern Portfolio Theory (cont’d)

The following are the foundation for most of the asset allocation (mean-variance optimization) software packages used by financial planners: Standard Deviation of a Multi-Asset

Portfolio Expected Return of the Portfolio



18

Correlation Coefficient

R = +1.0 perfect positive correlationR = -1.0 perfect negative correlationR = 0 no correlation

R2 = Coefficient of determination



19

Investment Strategies and Theories

Efficient Market Hypothesis Active vs. Passive Investing Indexing Timing the Market

Chapter 12: Introduction to Investment Planning Chapter 12 Introduction to Investment Planning.

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