After you read this chapter, you should be able to answer the following questions:
Why do individuals invest?
What is an investment?
How do investors measure the rate of return on an investment?
How do investors measure the risk related to alternative investments?
What factors contribute to the rates of return that investors require on alternative investments?
What macroeconomic and microeconomic factors contribute to changes in the required rates of return for investments?
This initial chapter discusses several topics basic to the subsequent chapters. We begin by defining the term investment and discussing the returns and risks related to investments. This leads to a presentation of how to measure the expected and historical rates of returns for an individual asset or a portfolio of assets. In addition, we consider how to measure risk not only for an individual investment but also for an investment that is part of a portfolio.
The third section of the chapter discusses the factors that determine the required rate of return for an individual investment. The factors discussed are those that contribute to an asset's total risk. Because most investors have a portfolio of investments, it is necessary to consider how to measure the risk of an asset when it is a part of a large portfolio of assets. The risk that prevails when an asset is part of a diversified portfolio is referred to as its systematic risk.
The final section deals with what causes changes in an asset's required rate of return over time. Notably, changes occur because of both macroeconomic events that affect all investment assets and microeconomic events that affect the specific asset.
1.1 WHAT IS AN INVESTMENT
For most of your life, you will be earning and spending money. Rarely, though, will your current money income exactly balance with your consumption desires. Sometimes, you may have more money than you want to spend; at other times, you may want to purchase more than you can afford...