Investment Analysis

Real vs. Financial Assets

Real assets: physical, hard

Financial assets: paper, liabilities

• including bonds, stocks, derivatives, currency (liability of the central bank)
• think Wall Street
• The value of financial assets decreases with the increase of the value of real assets.

Taxonomy

The terminology "investment assets" and "investment classes" indicate the same thing.

1. Stocks
2. Bonds
3. Real estate
4. Commodities
5. Currencies

Gold and silver can act both as commodities and currencies. During inflationary periods, the switch from behaving like classical commodities to classical currencies, and during deflation ship periods that change from behaving as currencies to behaving as commodities.

Markets are where different investment assets are traded. Money markets: a market in money market instruments, i.e., short-term instruments (<1 year maturity) Capital markets: a market in long-term instruments (>1 year maturity) Bond market: fixed income market Stock market: equity market, a.k.a., credit market or debt market

Instrument: Default risk: the risk that there will be non-payment, or non-satisfaction, of an obligation when it is due. Derivative: a financial instrument whose value is based on, or derived from, another instrument (the base).

• E.g. An option is the derivative of a stock (which is in turn the base of the option).

Types of analysis: fundamental, portfolio, technical, cyclical

Financial Markets and the Economy (Purposes of financial markets)

1. Allocation of resources, i.e., financial intermediation
2. Allocation of risk
3. Timing of consumption: if there is an excess of funds this month and next month, rather than save the cash, it can be invested in some sort of instrument
4. Separation of ownership and management (stock owners, or holders, own a corporation, while management runs it)

• This leads to agency problems: information problems; principal (owner)/agent (management) problems arise because of asymmetric information

Corporate Governments: a subject which studies how to mitigate principal-agent problems by creating proper incentives, monitoring and control of management

• An investor should avoid companies with management which is not operating with the company's profit in mind, unless they have a mind to short the company.

Forensic accounting: a field of accounting which does not make an analysis but instead ties to see how the CEO and accountant tried to cheat with their own books. (It is common for companies to circumvent accounting laws, and it has been said that accountants are hired based on their skills to manipulate accounting books.)

IPO: initial public offering

Investment Process

1. Portfolio: a collection, or set, of assets (financial or real)
2. Asset allocation: how a portfolio is split between the five asset classes

• This is primarily determined by the macroeconomic environment, such as whether the environment is inflationary, deflationary, or has stable inflation, or whether there is a booming, weakening, or stagflationary economy.

1. Portfolio construction, to which their are two approaches

• Top-down: It is first decided what fraction of the portfolio is to be invested where (characteristics of where: country, industry, investment class (gold is diversified by where it is bought and stored))
• Bottom-up: A company is chosen and evaluated for suitability of investment. This approach risks inappropriate asset allocation and there fore potential overexposure in some characteristic, such as geographical are, country, or investment class

1. Markets are competitive (competitive financial markets)

• Tradeoff between return and risk: a higher return will carry a higher price, i.e., a higher risk
• Markets are efficient

Investment strategy/style

• Active: deliberately selecting vehicles with the hope that they will effectively outperform the market. Note: If a market is efficient, economists claim that it is impossible to beat the market, and therefore only a passive investment strategy is rational; the active strategy implies that the market is not efficient.
• Passive: buy a fairly large and diversified index, and hold it. The decision-making is over how to allocate risk, or how much risk will be taken, e.g., 50% risky and 50% risk free.

Resources

• [1] Introductory lecture by Professor Krassimir Petrov on Investment Analysis covering Chapter 1 from Bodie, Kane, Marcus "Essentials of Investments"