Investors are concerned with holding an optimal portfolio. Identify the reasons why investors seek stocks as an investment vehicle. Further explain the importance of financial statements. How does an efficient market affect investors? Appraise how cultural differences affect the way business transactions are considered. Explain the choices an investor can make. How will the portfolio choices differ for a conservative investor? What about an aggressive investor? Which type of investor would you most likely identify with? Moderate or hybrid is not an option.
Sample Answer
Investors seek stocks for an optimal portfolio primarily for the potential for superior long-term returns and capital appreciation, which helps to outpace inflation. An investor's portfolio choices, specifically the allocation between higher-risk stocks and lower-risk bonds/cash, are fundamentally dictated by their risk tolerance, which separates them into aggressive or conservative styles.
Why Investors Seek Stocks as an Investment Vehicle
Investors favor stocks (equities) because they represent partial ownership in a company, offering two main pathways to wealth creation:
Capital Appreciation (Growth): This is the primary driver. If the company is successful, its value increases, and the stock price rises. Selling the stock at a higher price than the purchase price provides a capital gain. Over the long term, stocks have historically provided the highest average returns compared to bonds or cash.
Income (Dividends): Many established companies share a portion of their profits with shareholders through periodic cash payments called dividends, providing a steady income stream that can be taken as cash or reinvested to buy more shares (compounding).
Inflation Hedge: Since stocks represent real assets and future earnings, their value tends to rise with the general price level, offering better protection against inflation than fixed-income assets.
Liquidity: Stocks are generally easy to buy and sell quickly on a major exchange, offering high liquidity compared to less liquid assets like real estate.
Importance of Financial Statements
Financial statements are essential because they provide the objective, standardized data necessary for fundamental analysis—the process of determining a company's true intrinsic value.
| Statement | Information Provided to Investors |
| Balance Sheet | The company's financial health at a single point in time. It shows what a company owns (Assets), owes (Liabilities), and the residual claim of the owners (Shareholders' Equity). Used to assess solvency and debt levels. |
| Income Statement | The company's profitability over a period. It details Revenues, Expenses, Gains, and Losses to arrive at Net Income. Used to calculate key ratios like Earnings Per Share (EPS) and profit margins. |
| Cash Flow Statement | The company's ability to generate actual cash. It tracks cash inflows and outflows from Operating, Investing, and Financing activities. Used to assess liquidity and the quality of earnings (as net income can be manipulated, but cash flow is harder to fake). |
Export to SheetsIn short, financial statements allow an investor to gauge the company's past performance, current financial stability, and future profit potential before committing capital.
How an Efficient Market Affects Investors
The Efficient Market Hypothesis (EMH) asserts that an asset's price reflects all publicly available information instantly and accurately. Its main effect on investors is profound:
Discourages Active Management: In an efficient market (specifically the semi-strong form), no one can consistently achieve returns higher than the overall market by analyzing public information. Any new information (e.g., a good earnings report) is immediately incorporated into the stock price.
Promotes Passive Investing: The best strategy becomes a passive approach, such as investing in low-cost, diversified index funds (which mirror the market). This is because attempts to "beat the market" through stock-picking incur transaction costs and may not yield better results.
Return is Tied to Risk: The only way to achieve higher expected returns in an efficient market is by taking on greater risk. The market is expected to compensate investors only for the risk they assume, not for superior analysis.