 Hello and welcome to the session. This is Professor Farhad in the session we would look at the investment process and the concept of risk versus return. This topic is covered in essentials of investment course, undergraduate or graduate level, CPA exam, as well as the CFA exam. As always, I would like to remind you to connect with me on LinkedIn if you haven't done so. YouTube is where you would need to subscribe. I have 1,700 plus accounting, auditing, tax, finance, as well as Excel tutorial. If you like my lectures, please like them, share them, put them in playlists. Subscribe to my YouTube channel. If they help you, it means they might help other people connect with me on Instagram. On my website, farhadlectures.com, you will find additional resources to supplement your accounting as well as your finance education, especially if you are studying for the CPA exam. I strongly suggest you check out my website. So let's talk about the concept of investing. So when you invest, do you think you invest in one thing or many things? Simply put, do you put your eggs in one basket or do you spread your eggs out? And the answer is obviously you want to diversify. You want to invest in many different investments. So simply put, you will create a portfolio so you don't put all your eggs in one basket. And what is a portfolio? A portfolio is a collection of investment assets. What are we talking about here? For example, this is a portfolio that consists of bonds, stocks, and cash. And this is, it's one-third, one-third, one-third, but this is what we have here. So when we talk about portfolio, we have to understand two concepts. One is called asset allocation. The other one is security collection. So what is asset allocation? Asset allocation is when you choose among broad asset classes like this. For example, here we are choosing one-third in stocks, one-third in bonds, and one-third in cash, which is when I keep one-third in cash. This is our overall asset allocation. For example, 33.33% stock, stocks 33.33 bonds, and we're going to keep 33.33% in cash. That's the asset allocation. Now, obviously it doesn't have to be this way. We could add mutual bonds, we can add commodity. This is a sample asset allocation. Now, once we have the asset allocation, let's talk about stocks now. Now we need to go into security selection. What is security selection? For example, in stocks, we have to figure out the different types of stocks we want to invest in. For example, this 33% of stocks will have to choose individual stocks. Do we want to invest in software companies? Do we want to invest in social media like Facebook, Twitter? Do we want to invest in retailers? Do we want to invest in large tax, small tax, medium-sized companies, international, real estate, so on and so forth? Same thing with bonds. We could also, we have security selection for bonds. So this is, so asset allocation is looking at the overall picture. Security selection is looking to invest in a specific stock. Now what we do over time, for example here, if stocks went up in value, what's going to happen? They're going to ear up the percentage of our portfolio. Therefore, we rebalance the portfolio as necessary. And within stocks, if we invested within that 33%, 10% in tax, we want to make sure if this percentage increased, we need to sell our gains, maybe move them to cash or move them to bonds to rebalance as needed. But this is what security selection is. Now how do we conduct our security selection? We have two approach. We have the top-down approach and we have the bottom-up approach. Let's look at the top-down approach because basically in a sense, we were talking about the top-down approach is where we have asset allocation first. We determine what's our asset allocation. Then it's followed by security analysis. Then we look at specific stocks that we want to invest in. This would require a lot of research from our end because we are saying, this is what we want our portfolio to look like from a macro perspective, like 50% stocks, 50% bond, or 70%, 30%. Or 30% stocks, 30% bond, 40% international or whatever we are looking at at asset allocation. Here we are, we might be more diversified because we are trying to invest in different classes of stocks and in different industries. This is the idea of a top-down approach. A bottom-up approach is a little bit different and this is where most individual people uses when they invest themselves as they select securities based mainly on price attractiveness. So if we think the price is right, we buy the stock. We don't care in which industry, we don't care what is our asset allocation. Now let me go back to the asset allocation page and this, you need to be familiar with this asset allocation before I move on. Why? Because when you invest in your 401K, so if you have a 401K plan at your company, most likely they send you a menu of investments and this is what they break it down for you. For example, if you want to invest 40% in stocks, then within stocks they would say, you know, you could break down your investments into various categories. For example, a person like me, I practically have 99% of my investments still in stocks and equity, but breaking down into different industries in different capsizes. But the point is investors when they do it themselves, they choose on price attractiveness. So here you don't have no class asset proportions. You don't care about how much is invested in real estate versus stack versus retailers. You don't care about this. In other words, you may not be well diversified statistically speaking because the stocks are more sensitive to the issue in company firms condition. Why? Because you are selecting one stock. And generally speaking, when an industry is doing well, it's not gonna rely on one single company. It's gonna rely on many companies. And if you keep on selecting those price securities based on price attractiveness, you might be concentrated in one specific industry without knowing why because they're all attractive stocks. So that's the concern. So just make sure you know the difference between top-down approach versus bottom-up approach. Now we need to understand the concept of risk and return. And the concept, I believe it's intuitive. I'll give you two options. Let's assume you have some money today and I'll give you two options. You could invest in a safe investments or you could invest in a risky investment. What could be a safe investment? You could give your money to the US government and buy treasury bonds. That's a safe investment. Or you can invest in a startup. Some company that's, you know, it's a drone. It's creating drones, okay? So if you have money, if you have let's assume you have $100,000 today, if you invest money in government, in the government, in US treasury bond, you may not, first of all, they're not gonna offer you high return. Why? Because you're gonna have this money later. Let's assume you're investing for 30 years. The risk of that money being there is practically risk-free. You're gonna have your principal plus some interest. Okay, now, so you might be, you might be okay with a 3% over all return over 30 years. But if you're gonna take this $100,000 and invest in a startup, that it's really practically brand new, what's gonna happen is this. There's a risk that this startup may not exist when you retire. So what's gonna happen? You might wanna take your chances. You can if you want to. But you're gonna ask for a higher return. You might ask for 20 or 25% return on your money if you want to invest in a startup. So what does that mean? Simply put, the riskier the investment. If you're investing in the riskier investments, then you require a higher rate of return. So the riskier is the investments, the higher is the return. And hopefully this makes sense, okay? So what are you doing when you make an investment? Whether you invest in treasury bond, US government, whether you invest in this startup drone company I'm starting, which is I'm not, but the point is giving you an example. All what you're doing is you're delaying your consumption. In other words, you are not consuming the money now. You're investing the money for later. And what you're doing is you are making a commitment. Another commitment, you are kind of basically getting a promise about the cash flow into the future. But that cash flow would have uncertainty. With the US government, there's practically no uncertainty. The US government will be here 30 years from now. But this startup company, I really don't know. So what's gonna happen? If you want to invest in the startup, you're gonna have to request or require a higher rate of return. So invest in US government, it's safe. Invest in stocks or simply a startup company, it's riskier. So the higher the risk of the asset, the higher is the required rate of return. Hopefully this makes sense. So there's a positive relationship. There's a positive correlation between the two. Higher risk, the higher the return. And this is what happened when you invest, okay? Now we need to understand the concept of efficient market. What is efficient market? What's the concept of efficient market? Efficient markets simply state in one way or another that the stock price reflect all available information. And we'll discuss this later, this concept. Simply put, when you buy a stock, it's fairly priced. Why? Because all the information is known. You have a competitive market. You have analysts, you have professional investors. You have amateurs. And everyone is aware of this information and reflecting the information in the stock price. Simply put, you cannot beat the market. The price that you buy is a fair price. It's not undervalued, it's not overvalued. And the price is quickly adjusted. And if there's new information, the stock price would quickly adjust. So the question here is how comfortable are you when you invest in this efficient market hypothesis? How comfortable are you? Because if you are comfortable with this, if you think the price is fair, if you think the price of the securities reflect all available information, then guess what? Then the stock, any stock you buy, it's not overpriced or it's not underpriced because the stock reflect all available information. And here we're talking in theory in a perfect market. If you don't believe that's the case, if you don't believe in the efficient market theory, then you have the opportunity to find advantage over other investors by doing what? By finding underpriced or undervalued investments. Now, how do you do so? Well, you conduct research and that's costly. So the point is, do you believe in market efficiency? And if you do so, well, you really should not be looking for stocks just buying the market and just, because if all the stocks are fairly priced, then the market is fairly priced. But how do we invest when we invest? We have two ways to invest when we invest. We have a passive management approach and an active management approach. Let's take a look at the passive management. Here we purchased highly diversified portfolio, okay? And nowadays it's very easy to buy a highly diversified portfolio. You have those exchange traded funds. For example, you can buy the S&P 500. The S&P 500 include all the 500 in the S&P. So you buy that ETF and you are highly diversified before either needed to buy a mutual fund or worst is you have to find an advisor or a financial analyst who would buy different stocks from different industry to have you diversified. You don't have to do this anymore. Now it can be easily done. So you can buy a passive investment. You don't make any attempt to time the market. Maybe you'll buy it in pieces, but you're not looking to time the market, okay? You're not taking any time to invest, to invest in research, no time consuming. You believe everything is, nothing is undervalued. Nothing is overvalued. All the stock prices are properly valued. So no attempt to find undervalued. Here you assume efficient market, just what we talked about when you are passive investor, you are assuming efficient market. You don't worry about doing research. And this strategy is called buy and hold and wouldn't buff it, believe it or not, as a fan. He always advise regular investors, look, buy an ETF that represent the S&P 500 that you don't have to worry about anything. You can wait 30 years and you're gonna be fine. This is if you believe in this, this is you are a passive investor. Active investments is a little bit different. Now you are looking for mispriced securities. Securities either undervalued or overvalued. If they're overvalued, you can short them and we'll talk about shorting stocks later on. So you are looking to find an opportunity to make more profit, more return than the market, okay? And also you are timing your entry. So you're looking when the market drops, or you think this is the best time to enter the market. Here you are assuming inefficient market of prices of securities. So you are actively managing your portfolio. That's costly and difficult. That's not easy at all. But those are the two strategies that you could use. Now, in my opinion, I mean, this is just a personal preference. For my 401K, for my retirement, I believe in passive. For my trading, I'm very active. But again, I am more than investor. I am basically, I'm a trader. And I don't usually trade individual stocks. I trade the market overall. But that's a different story. But the point is, I also believe in what Warren Buffett says. Look, if you're gonna invest in your 401K, buy a mutual fund to represent a large, large swath in the market. S&P 500 is a good investment. Or S&P 500 and QQQ, which is the NASDAQ 100. So, or find an ETF that represents the Dow and just buy if you believe in the US, if you believe in the market, just in the long run, we're gonna be here. We're gonna be prosperous so you buy them and you just don't forget about it. That's all what you do. In the next session, we'll look at the players in the financial market. As always, I would like to remind you to, like my lectures, share them, put them in playlists. If they benefit you, they may benefit other people. And always check out my website, farhatlectures.com. If we are still experiencing this coronavirus, stay safe. That's the most important thing and study hard.