2: Financial Markets: Goals, Limitations & Definitions

• Investment in Financial Markets: A Practical Guide - Definitions
• Course goals and limitations will be discussed

Investment Goals

• Accumulating wealth is a primary goal
  • Goal is to maximize returns
• Considering volatility/loss probability is another goal
  • Goal is to minimize risk
• Accumulating wealth can facilitate large purchases, such as real estate and contribute to retirement funds
• Accumulating wealth can satisfy Bequeathment motives, i.e. for kids
• Other relevant factors when using savings include
  • Liquidity buffer
  • Emotional value, i.e. owning a home
  • Having fun "gambling" on the stock market

Limitations

• Real estate is omitted
• Cryptocurrencies are omitted
• Many other mixed forms and special cases are omitted
  • Including conditionally convertible bonds, P2P-credits etc.

Definitions: Basic Terminology & Asset Classes

• Definitions reviewed include:
  • Principal
  • Default of payment
  • Bankruptcy
  • Gross Returns
  • Net Returns
  • Fees

Fees

• Key types of fees include
  • Brokerage fees paid periodically to broker
  • Commission Fees paid to broker for each trade
  • Bid-Ask Spread is the difference in money paid by buyer and money received by seller, levied by trading platform
  • Fund-Fee is paid to fund for managing portfolio, measured in Total Expense Ratio (short TER)

Asset Classes

• Assets classes covered are:
  • Real estate
  • Savings accounts
  • Bonds
  • Individual stocks
  • Market portfolio
  • Stock funds
  • Other investment vehicles

Real Estate

• Real estate includes land, flats, and houses
• Investors can earn money renting the assets
• Asset prices vary over time, leading to potential speculative losses or gains from buying and selling
• By living in real estate, monetary gains can be made from not having to pay rent

Savings Accounts

• Banks lend money to others from savings accounts
• Fixed interest payments are received for money invested
• Invested capital is insured in Austria up to €100,000 ("deposit protection system”)
• Savings accounts are very secure but yield relatively low returns

Bonds

• Bonds are typically issued by governments or large companies and count as debt capital
• Money is lent to institutions for a predetermined period receiving fixed interest payments in return
• Ratings agencies can assess the probability of default
  • S&P, Moody's and Fitch
• There is a potential to lose capital if the issuer files for bankruptcy
• Higher risk is usually accompanied by higher interest payments
• Bonds are traded on the financial markets, making them more liquid

Individual Stocks

• When buying shares, you become co-owner of the company
• Typically associated rights come with participation in the management
• Participation in the financial success of the company is another benefit
• The value of shares will likely decrease in losses
• In cases of losses this is financial loss for co-owner/investor
• Dividend payments are received in cases of profits, depending on the size of the profits
• There is full exposure to losses from bankruptcy
• There is a possibility to lose principal from investment
• Shares are tradable on financial markets, boosting their liquidity and leading to losses or gains when selling the shares

The Market Portfolio

• The market portfolio is when investors invest indiscriminately in all companies in the given market proportionate to the company's size
• However, discrimination is possible based on which market is considered
• Common distinctions include:
  • Nations/Regions
  • Size
  • Industries
• A radical, all-encompassing „World-Market Portfolio“ is practically impossible to achieve, since companies need to be publicly listed on the stock market and many/most countries do not have an organized public stock market
• The MSCI ACWI All Cap-Index is closest to an all-encompassing market portfolio
  • Stands for MSCI All Countries World Index All Capitlizations
  • Considers 99% of all investable assets from developed and emerging markets covering all sizes of listed companies
• A portfolio that rebuilds exactly the MSCI ACWI All Cap-Index will have returns driven by the value development of companies in the world,
• Market participation can be described as passive, as there is no attempt to actively pick and choose better companies
• Investors can single out specific markets within their market portfolio, such as the U.S. Market
  • Examples are the MSCI USA All Cap Index and includes 99% of all US-listed companies based on market weight
  • Investing according to this index would still be considered a passive investment, since companies are indiscriminately included within the market focus of the U.S.
• Indexes can be understood as "shopping lists" with different foci
  • S&P 500: price-weighted 500 largest US-listed companies (country and size)
  • Russell 2000: Of the 3000 largest US-listed companies, the 2000 smallest (country and size)
  • NASDAQ-100: 100 largest non-financial US-Nasdaq-listed companies (country, sector and size)
  • Nikkei 225: price-weighted 225 large Japan-listed companies (country and size)
  • MSCI World: all large- and mid-cap companies from 23 developed markets (regions and size)
  • MSCI Emerging Markets: all large- and mid-cap companies from 24 emerging markets (regions and size)
• Market portfolios often include an „active" aspect by choosing which market to represent by regional, industry, size (etc.) criteria
• Strategies which then indiscrimately include all relevant companies in the targeted market are called passive portfolios

Stock Funds

• Compiling a “basket” of different kinds of individual shares are called stock funds
• The overall performance of investments in funds depends on the performance of the constituent parts
• Key types of stock funds are:
  • Passively managed funds(typically called „Exchange Traded Funds“, or ETFs)
  • Actively managed funds (typically called „mutual funds“)
• The basket of the passive funds equals the constituent stocks of the index
• The service of the fund involves saving investors time and manually replicating the index
• Fees for passive funds tend to be low
• Active funds aim to outperform the market
• The basket’ of individual stocks (or other securities) are purposefully chosen to achieve abnormal returns at given risk levels
• Active funds require sizeable resources for research, infrastructure and human capital so fees tend to be high
• Funds must beat markets (consistently) more than the increase in fees to be reasonable attractive for investors

Other Investment Vehicles

• There are many possibilities to invest savings, including:
  • Commodities (i.e. gold, wheat, water)
  • Derivatives (i.e. options, futures)
  • Currencies (i.e. dollar, euro, crypto)
• These asset classes will be the end of the next chapter.
• Households ultimately decide how to invest their savings
• Can mean sinking all their savings into one kind of asset or any mixture of assets mentioned
• The course will attempt to serve as an information basis for decisions