Introduction to Investment

Prof. ZHU Yingzi

SEM, Tsinghua University
 Overview
• Essence of Investments
• Role of financial assets in the economy: Real vs.
financial assets
• Economic roles of financial markets
• Financial market friction: agency problem
• Financial market Participants
• Competitive financial markets
• Risk–return trade-off
• Market efficiency
• Investment processes
 What is Investment?
• Investment connects:
Households → Financial Markets → Firms →
Production → Income
 Real vs Financial Assets
• Real assets create wealth
– Physical assets(the land, buildings, machines)
– Intangible assets (Patents, copyrights, brand,
trademarks, and intellectual property)
• Financial assets allocate wealth
– claims to the income generated by real assets (or
claims on income from the government)
– Facilitate investors’ need for different risk level
and maturity
 What is Investment
• For households, investment is
– the current commitment of money or other
resources in assets for future benefits
– We focus on investments in financial assets
– but the principles can be applied to any type of
investment
• Q: Suppose you are given $50,000, how would
you invest?
 Balance Sheet for Household

1-6
 Financial Assets
• Fixed income securities or debt
• Promise either a fixed stream of income or a stream of
income determined by a specified formula
• Common stock or equity
• Represent an ownership share in the corporation
• Derivative securities
• Provide payoffs that are determined by the prices of
other assets
• Investment in currency
• Futures or forward
• Investment in real assets through commodity
futures
 Aggregated Balance Sheet
Where are the financial assets?

1-8
 Real Assets vs. Financial Assets –
what’s the main difference?
• Financial assets are aggregated out and total
balance sheet for country consists of only real
assets
– financial assets of households are liabilities of the issuers
of the securities
• Financial assets are more liquid than real assets
– Liquidity refers to the speed and the ease with which
investors can realize the cash value of an investment.
– Illiquid assets (e.g. real estate) can be hard to sell quickly,
and a quick sale may require a substantial discount
• Financial assets are more volatile in valuation, while
real assets are more stable in valuation
 Other Types of Investment

• Cryptocurrency
• Are they real or financial assets?
 Financial Markets and the Economy
• The Informational Role
– Capital flows to companies with best prospects (or appear to
have the best prospect at the time)
– If a company has poor prospect, investors will bid down the
stock price and the company will have to downsize
• Consumption Timing
– Use securities to store wealth and transfer consumption
to the future
• Allocation of Risk
– Investors can select securities consistent with their tastes
for risk
– the firms that need to raise capital as security can be sold
for the best possible price
Financial Markets and the Economy
• Separation of Ownership and Management
• When firms becomes large, separation of ownership and
management is inevitable
• Financial markets makes the separation possible
• Common stocks represent the ownership of the firm, one
share one vote
• Shareholders elect board of directors to hire and supervise
the management of the firm
• Important decisions such as mergers and acquisitions are
subject to shareholders votes
Separation of Ownership and Management

• Why Separation Happens

– As firms grow, capital requirements exceed what
founders can provide
– Ownership becomes dispersed among many
investors
– Professional managers run the firm on behalf of
shareholders
 Role of Financial Markets

• Financial markets enable firms to raise capital

from many investors
– Investors receive shares representing ownership
claims.
• Common stock typically carries:
– Residual cash flow rights
– Voting rights (often one share, one vote)
 Agency problems
• Principal-Agent Problem （Agency problems）
– Once ownership and management separate:

– Managers (the agent) may not always act in

shareholders’ (the principal) best interests.
– managers pursue their own interests instead of
maximizing firm's value
 Examples of agency problems
• Managerial "Empire-Building" (Growing the
Company for Personal Gain)
• Risk-Taking Behavior: Managers invest in
high-risk projects that could result in large
rewards or losses
• Managers make short-term cost cuts (e.g.,
layoffs) to boost immediate profits and meet
bonus targets
• managers avoid risky but profitable projects
 Examples of agency problems

• Accounting Scandals
• Claim an expense to be an investment
• overstate profits
• use financial tools to move debt off balance sheet
• claimed to have deposit in bank account that turned
out not to exist
How to mitigate Agency problems
• Mechanisms to mitigate agency problems:
– Tie managers' income to the success of the
firm (stock options)
– Monitoring from the board of directors
– Monitoring from the large outside investors
and security analysts
– Takeover threat
 Governance Structure
• Governance Structure
– Shareholders elect Board of Directors
– Board hires and monitors Management
• Major corporate actions (e.g., mergers,
acquisitions) require shareholder approval.
 Sarbanes-Oxley Act
Sarbanes-Oxley Act（Public Company Accounting Reform
and Investor Protection Act of 2002）

• Tighten the rules of corporate governance

• requires corporations to have more independent
directors.
• requires the firm's CFO to personally vouch for the firm's
accounting statements.
• prohibits auditing firms from providing other services to
clients.
 Participants in Financial Markets
• Demanders of capital – Firms
• Net borrowers of fund: raise capital to pay for
investments in plant and equipment
• income generated by those real assets provides the
returns to investors
• Suppliers of capital – Households
• Invest in the securities issued by firms or governments
• Governments
– Can be both borrowers or lenders
 Participants in Financial Markets
• Financial Intermediaries:
financial institutions who
stand between the
security issuer (the firm)
and the ultimate owner
of the security (the
individual investor)
• Commercial Banks
• Investment
Companies
• Insurance companies
Balance Sheet of Commercial Banks
Balance Sheet to Non-financial firm
 Investment Company
Investment companies:
• Mutual funds (共同基金）
– pool and manage the money of many investors
– Issue shares to investors
– charge a fixed percentage of assets under
management
– economies of scale: large-scale trading and portfolio
management
– for small investors
• Trust
– for large investors
 Investment Company
• hedge funds
– also pool and invest the money of many clients
– open only to institutional investors such as pension
funds, endowment funds, or wealthy individuals
– more likely to pursue complex and higher-risk
strategies
– typically keep a portion of trading profits as part of
their fees
 Venture Capital and Private Equity
• venture capital (VC, 风险投资）
– Investments in start-up companies: invest in them in
return for an ownership stake in the firm
– Source: venture capital funds, wealthy individuals
known as angel investors, and institutions such as
pension funds
– Venture capital investors commonly take an active
role in the management of a start-up firm
• Private equity(PE)
– also invest in distressed firms, or merger & acquisition
for restructuring firms
 Investment Bank
• Not a financial intermediary
• Advice on how to price new securities (stocks ,
bonds)
• Sell newly issued securities to public in the
primary market
• Investors trade previously issued securities
among themselves in the secondary markets
 Participants in Financial Markets:
Investors
• Investors prefer investments with the highest
expected return
• If higher expected return can be achieved without
bearing extra risk, there will be a rush to buy the
high-return assets, prices will be driven up
• the price will continue to rise until expected return
is no more than commensurate with risk ==>
investor can only get a “fair” return relative to the
asset’s risk, but no more.
• if returns were independent of risk, there would be
a rush to sell high-risk assets and their prices would
fall.
 Markets Are Competitive

• Competitive market:
• Financial markets are highly competitive
• Thousands of intelligent and well-backed analysts
constantly search securities markets for the bargains.
• This competition means that we should expect to
find few obvious bargains
• If you want higher expected returns, you will have
to pay a price by accepting higher risk
 Risk-Return Trade-off
• Investment in a competitive market:
• Risk-Return Trade-Off
• How to measure risk?
• How to measure expected return?
• Diversification
• Only “free lunch” in town
• Topic for modern portfolio theory
 Efficient Markets Hypothesis
• Efficient Markets Hypothesis（EMH）
– Prices fully and immediately reflect all available
information
– Economic logic: competition
 The Grossman–Stiglitz Paradox
(1980, AER)
• The Information Problem
– Information is costly.
– Investors must be compensated for acquiring information.
– If prices fully reflect all information:
• Informed investors earn zero profit.
• No one gathers information
– Without information gathering:
• Prices cannot be efficient.
• Conclusion: Perfect informational efficiency is
impossible.
Markets must be inefficient enough to reward
information acquisition.
 EMH Implications to Investment

• Passive Management
• Holding a highly diversified portfolio
• Active Management
• Security analysis
• Timing the market
• Active management may earn returns before fees
— but competition erodes them.
 Investment Process
• Portfolio:
– collection of investment assets
• Asset classes
– stocks, bonds, real estate, commodities,…
• The asset allocation
– Investment choice among broad asset classes
• The security selection
– Investment choice of which particular securities to
hold within each asset class
– Security analysis: the valuation of particular securities
 Investment Process

• “Top-down” approach
• First step: Asset allocation
• Second step: security selection
• “Bottom-up” approach
• Investment based solely on security selection
• Disadvantage: may result in unintended heavy weight of
a portfolio in only one or another sector of the economy
• Advantage: focus the portfolio on the assets that seem to
offer the most attractive investment opportunities
 Summary
• Essence of Investments
• Real vs. financial assets
• Economic roles of financial markets
• Financial market friction: agency problem
• Financial market Participants
• Competitive financial markets
• Risk–return trade-off
• Market efficiency
• Investment processes