Week 3

Question 1

Principles of Investment: Investment objectives

Answer 1

represents the desired outcome in a specified time frame:
people differ in their objectives
people’s objectives can be influenced by many factors (eg. culture, age, attitude to risk)
guiding principle when setting objectives:
understand your client’s needs so you provide investment services they will value and appreciate

Question 2

Principles of Investment: Investment strategies

Answer 2

is the means used to achieve the investment objectives:
investor allocates funds between asset classes; or
purchases products where this decision is made for them

Question 3

Examples of Investment Objectives

Answer 3

Access Income
Capital Growth
Combination of income and capital growth
Speculative
Tax Driven Investments
Philosophical Investing eg/Ethical/Environmental
Educational Reasons- Investment Clubs

Question 4

Principles of investment: Direct vs. Indirect

Answer 4

Direct investment occurs when investors make their own decisions where funds are ultimately placed.
Indirect investment involves investors placing their funds with fund managers.
Direct investment is very popular in Australia.
It is important to appreciate the nature and structure of the relevant markets

Question 5

The choice of asset classes consists of the following:

Answer 5

cash
interest bearing deposits (domestic and international)
shares (domestic and international)
property

Selection into particular investments can be made directly or indirectly
The selection of the appropriate asset class and mix of assets will depend on a number of factors relating to the client’s circumstances

Question 6

Cash & Interest bearing investments (most familiar)

Answer 6

Commercial banks provide both at call deposit accounts and Term Deposit Accounts to all clients.
Subject to PDS, at call deposit accounts allow you to access your funds at any given time.
Term Deposit Accounts are deposits where if you leave your funds in the account for a fixed term you will earn a fixed rate of interest.

Question 7

Asset classes: Cash & Interest bearing investments (most familiar)

current brands include:

Answer 7

Trust account, Cheque account, At Call investment account, Term Deposit Account

Question 8

Asset classes: Non-Cash Payment Services

Answer 8

Online banking (Internet banking & Mobile banking)
Rapid Response telephone banking
BPAY bill paying service
Visa Debit card 
Personal cheques
Regular payments, Direct debit
Customer loyalty schemes

Question 9

Asset Classes: Types of fixed interest investments

Answer 9

Term deposits
Treasury notes and bonds 
Indexed/adjustable rate bonds 
State/semi/local Government bonds 
Corporate bonds
Bank and non-bank bills 
Promissory notes 
Convertible notes and hybrids 
Debentures
Unsecured notes
Fixed interest managed investments

Question 10

Participants in cash and fixed-interest securities

Answer 10

Non ADI- Finance companies
insurance companies
funds managers
private individuals
ordinary businesses
governments

Question 11

Asset Classes: Bonds

Answer 11

Corporate bonds are long-term securities that pay regular interest at fixed rates on face value.

Government and semi-government bonds enjoy very good security ratings.

Trading of securities occurs in the primary market initially and later in the secondary market.

There is an inverse relationship between the price of a bond and interest rates.

The difference between selling price and the face value is the interest, hence bonds can be traded at a discount or at a premium.

Question 12

The Nature of Markets-Fixed Interest

Answer 12

Essential features
Interest rate set at start of loan period
Fixed face value (principal)

All interest rates are based on cash rate which is the interest rate paid on money lent between commercial banks overnight.
Margins added to compensate lenders for increased risk and increased time to maturity.
The cash rate is managed by the RBA by manipulation of the money supply to inject or withdraw funds by buying or selling securities.
Fixed-interest investments can vary from immediate access to up to 20 years.

Question 13

Two types of fixed-interest markets:

Answer 13

Money market (short term) - Discount

Capital market ( long term) - Bonds

Question 14

Risks of Bonds

Answer 14

Credit risk
This is the risk that the issuer may not be able to pay back the money they owe on the bonds they have issued (also called ‘default’ risk).

Interest rate risk
This is the risk that the market value of the bonds will go up and down as interest rates go up and down. For example, if interest rates go up, the market value of corporate bonds will generally go down.

Liquidity risk
This is the risk that you won’t be able to sell your bonds when you want to at the price you want to because there aren’t many buyers for the bonds
.
Prepayment (or early redemption) risk
This is the risk that the issuer will redeem the bonds early if interest rates fall and the market price goes up. If this happens, you will be paid the face value of the bonds (you may have paid more for them or they may be worth more on the secondary market)

Question 15

Example
A security with a face value of $1000 has 180 days to maturity and sells now for $970. What is the discount at which the security is sold and the yield on the investment?

Answer 15

Discount= % below face value = 30/1000 x 365/180 = 6.08%

Yield= % return from an investment = 30/970 x 365/180 = 6.27%

Question 16

Note : Fixed-term investments appeal to more risk-averse people because:

Answer 16

There are guaranteed interest payments at a given level.

The level of capital remains fixed which means there is a low risk of loss.

Question 17

Asset Classes: Property

Answer 17

In Australia the rate of home ownership is one of the highest in the world.

As an investment, property can offer:
A stable income stream
Capital growth in excess of inflation over the long term.

Participants in the property market include:
Investors as owners
Residential tenants
Commercial tenants
Valuers, brokers and agents

Question 18

Qualities and characteristics of property

Answer 18

solid form of investment
land is scarce
generally illiquid form of investment
returns comprise both income and capital
entry and exit costs may be high
management and maintenance costs can be expensive
high level of gearing possible
taxation advantages
prices less volatile
property market cycles do not necessarily coincide with the share market — can offer diversification.

Question 19

There are number of classes of property:

Answer 19

residential, commercial, industrial and rural

Question 20

property Returns are dependent on

Answer 20

Type of property
Position of property
Continuity of rental stream
Cost of upkeep

Question 21

TAXATION OF PROPERTY

Answer 21

Rental income is assessable income
Legitimate expenses are deductible
Investment in property has both
CGT implications, and
GST implications

Question 22

Asset Classes: Shares or Equity

Answer 22

Represents an interest in / ownership of a firm.
Can share in a company’s successes and failures.
No guarantee of return on capital.
Payment by companies of dividends is optional.
Normally ranks last in event of liquidation.

Question 23

Shares

Answer 23

Shares have historically offered higher returns than other asset classes, over the long term.
They can offer regular income.
They can provide strong capital growth.
Australian shares can offer the added tax benefit of dividend imputation.
Shares offer an investment of with limited liability.

Question 24

Participants in the equities market include

Answer 24

Listed corporations
Investors
Brokers
Hedgers
Speculators
Arbitrageurs

Question 25

Nature of the Equities Market

Answer 25

Bulk of trading occurs on stock exchanges, with the ASX having a monopoly in Australia. Market price is determined by interaction of supply and demand.

Question 26

There are various classes of shares. Ordinary & Preference

Answer 26

Ordinary- most common, share of business, receive dividends | Preference- more like a fixed interest product, return is fixed, but more guaranteed.

Question 27

Advantages Shares

Answer 27

``` May provide income. May provide capital growth. May be tax effective. Generally liquid. Can provide diversification benefits. ```

Question 28

Disadvantages Shares

Answer 28

Involves risk. Income and cash flow are not assured. Ranks behind all creditors in event of liquidation.

Question 29

Business risk

Answer 29

the risk that a company may not be well run resulting in poor outcomes for shareholders in terms of income and capital growth.

Question 30

Credit risk

Answer 30

the risk that a company may not be able to meet its financial commitments (e.g. OneTel, Enron).

Question 31

Reputation risk

Answer 31

where a major incident involving a company causes a loss of faith by the market, devaluing its shares.

Question 32

Market risk

Answer 32

loss of confidence in the sector or overall market can have a drop in share value.

Question 33

Political risk

Answer 33

stability of the present or future Government policies can affect the capability of companies to perform.

Question 34

Liquidity risk

Answer 34

the shareholder may be unable to find a buyer at the desired price.

Question 35

Inflation risk

Answer 35

increases in overheads, costs and margins could adversely affect company performance and shareholder outcomes.

Question 36

Income risk

Answer 36

there is no certainty of dividend payments.

Question 37

Information risk

Answer 37

Information risk | a case of poor/lack of information can cause a wrong investment decision or is incorrectly interpreted.

Question 38

Fundamental Analysis

Answer 38

Fundamental analysis uses objective measures to analyse a company’s current financial position. It involves studying three main factors in an attempt to determining the best time to invest:

Question 39

Fundamental analysis uses objective measures to analyse a company’s current financial position. It involves studying three main factors in an attempt to determining the best time to invest:

Answer 39

1. Firm specific factors ,(i.e. its performance, level of debt, dividends, management, future direction, asset base and competitive advantage). 2. Industry wide factors,– (quotas, tariffs ). 3. Economy wide factors , (unemployment, inflation, movements in interest rates, exchange rates, )

Question 40

Fundamental Analysis can be usually divided into 2 levels:

Answer 40

bottom up approach focuses on the firm level predominantly and then moves towards analysing the economy level (use of ratios) top-down approach looks predominantly at general economic trends before moving towards analysing the firm level

Question 41

Fundamental Analysis: Common ratios

Answer 41

Earnings per share (EPS) Price / Earnings ratio (P/E ratio)

Question 42

Earnings per share (EPS)

Answer 42

provides an indication of company profitability calculated as: Operating profit after tax divided by No. of ordinary shares

Question 43

Price / Earnings ratio (P/E ratio)

Answer 43

shows how much the market is prepared to pay for shares in relation to reported profits calculated as: Current market price divided by EPS

Question 44

Dividends per share (DPS)

Answer 44

provides an indication of company profitability and payout of dividends calculated as: Dividends to ord. shareholders divided by No. of ordinary shares

Question 45

Dividend yield ( DY)

Answer 45

relates the dividends paid to the current market price provides an insight into the return on investment calculated as: DPS Divided by Market price

Question 46

Value investment characterised by:

Answer 46

finding undervalued shares (low P/E ratio) Shares may have high dividend yield Considers some shares to be overvalued Waits for market to correctly price the shares

Question 47

Growth investment characterised by:

Answer 47

select shares which exhibit high growth (high P/E ratio) | Shares may have low dividend yield

Question 48

Contrarian or “picking the dogs”

Answer 48

Contrarians believe that investors tend to overreact to recent news causing the price to vary from its fair value Fads may also cause investors to overreact Price variations will correct themselves By going against the trend, contrarians hope to profit when investors realise they have oversold out-of-favour companies Ratios to consider Low P/E ratios, high dividend yield , low ratio of price / net tangible assets

Question 49

Technical analysis

Answer 49

Attempts to predict future share prices by studying past behaviour of markets as a guide to their possible behaviour Analysts believe that investors are moved by market psychology ie herd mentality enables some sort of predictability in movements

Question 50

Tools for technical analysis include the following:

Answer 50

charting historical prices and volume trend and cycle studies investor sentiment - behavioural studies looking at technical indicators (moving averages,momentum oscillators

Question 51

Investment approaches

Answer 51

Buy and hold Timing the market Dollar cost averaging

Question 52

Dollar cost averaging

Answer 52

Is a strategy of investing fixed amounts at regular intervals regardless of market trends Avoids the need to pick the highs and lows of the market Smooths out the average cost of an investment because the fixed amount of money buys more units of the investment when the price is low and less when the price is high Provides a saving discipline

Question 53

Investment Consideration

Answer 53

Whatever be the choice of assets classes, there are a number of factors that investors must take into consideration. Client objectives whether it’s financial or lifestyle is your prime focus

Question 54

Investment Consideration 1. Liquidity

Answer 54

how easily the asset can be converted into cash to pay short term debts the greater the liquidity, the lower the yield

Question 55

Investment Consideration 2. Investment horizon

Answer 55

the selection of investments must be tailored to the investor’s time frames generally investors with a longer time frame can usually accept greater risk / volatility as a trade-off for higher returns investors with a short time frame will be concerned with protection of capital what sort of asset allocation would be required for a 2 year time horizon as compared to a 7 year time horizon?

Question 56

3. Taxation

Answer 56

each investment has its own taxation attributes and impact upon the investor’s tax position need to ascertain how important tax is in constructing a portfolio

Question 57

4. Diversification

Answer 57

achieving optimal return for the given level of risk diversification is insurance it reduces risk, BUT AT A COST

Question 58

5. Transaction costs

Answer 58

entry, exit, broker fees, estate agents, solicitors, accountants

Question 59

6. Timing

Answer 59

``` how important is it to time the market? consider efficient market hypothesis Strategies to eliminate timing problems long term investing dollar cost averaging ```

Question 60

7. Return

Answer 60

need to determine the reason for investing major role of financial planners task is to find right balance between income and growth. Will need to consider taxation also choice between investing in assets that yield regular income and those that have better potential for capital gain or combination of both income only income and growth growth only

Question 61

8. Risk analysis

Answer 61

What is risk analysis a framework for understanding risk, comparing the risks of different investments, and analysing the relationship between risk and return Principle of risk - reward trade-off generally, investors seek the best return from investments with the lowest level of risk Different investors have different risk profiles and it is important to know the level of risk the investor is willing to accept an investors tolerance to risk can be measured to an extent by risk tolerance Establish efficient frontier