We wrote the first edition of this textbook almost two decades ago. The intervening years have been a period of rapid, profound, and ongoing change in the investments industry. This is due in part to an abundance of newly designed securities, in part to the creation of new trading strategies that would have been impossible without concurrent advances in computer technology, and in part to rapid advances in the theory of investments that have come out of the academic community. In no other field, perhaps, is the transmission of theory to real-world practice as rapid as is now commonplace in the financial industry. These developments place new burdens on practitioners and teachers of investments far beyond what was required only a short while ago. Of necessity, our text has evolved along with financial markets.

Investments, Eighth Edition, is intended primarily as a textbook for courses in investment analysis. Our guiding principle has been to present the material in a framework that is organized by a central core of consistent fundamental principles. We make every attempt to strip away unnecessary mathematical and technical detail, and we have concentrated on providing the intuition that may guide students and practitioners as they confront new ideas and challenges in their professional lives.

This text will introduce you to major issues currently of concern to all investors. It can give you the skills to conduct a sophisticated assessment of current issues and debates covered by both the popular media as well as more-specialized finance journals. Whether you plan to become an investment professional, or simply a sophisticated individual investor, you will find these skills essential.

Our primary goal is to present material of practical value, but all three of us are active researchers in the science of financial economics and find virtually all of the material in this book to be of great intellectual interest. Fortunately, we think, there is no contradiction in the field of investments between the pursuit of truth and the pursuit of money. Quite the opposite. The capital asset pricing model, the arbitrage pricing model, the efficient markets hypothesis, the option-pricing model, and the other centerpieces of modern financial research are as much intellectually satisfying subjects of scientific inquiry as they are of immense practical importance for the sophisticated investor.

In our effort to link theory to practice, we also have attempted to make our approach consistent with that of the CFA Institute. In addition to fostering research in finance, the CFA Institute administers an education and certification program to candidates seeking the designation of Chartered Financial Analyst (CFA). The CFA curriculum represents the consensus of a committee of distinguished scholars and practitioners regarding the core of knowledge required by the investment professional. This text also is used in many certification programs for the Financial Planning Association and by the Society of Actuaries.

There are many features of this text that make it consistent with and relevant to the CFA curriculum. Questions from past CFA exams appear at the end of nearly every chapter, and, for students who will be taking the exam, those same questions and the exam from which they’ve been taken, are listed at the end of the book. Chapter 3 includes excerpts from the “Code of Ethics and Standards of Professional Conduct” of the CFA Institute. Chapter 28, which discusses investors and the investment process, presents the CFA Institute’s framework for systematically relating investor objectives and constraints to ultimate investment policy.

In the Eighth Edition, we have further extended our systematic collection of Excel spreadsheets that give tools to explore concepts more deeply than was previously possible. These spreadsheets are available on the Web site for this text (www.mhhe.com/bkm), and provide a taste of the sophisticated analytic tools available to professional investors.

UNDERLYING PHILOSOPHY

In the Eighth Edition, we address many of the changes in the investment environment.

At the same time, many basic principles remain important. We believe that attention to these few important principles can simplify the study of otherwise difficult material and that fundamental principles should organize and motivate all study. These principles are crucial to understanding the securities already traded in financial markets and in understanding new securities that will be introduced in the future. For this reason, we have made this book thematic, meaning we never offer rules of thumb without reference to the central tenets of the modern approach to finance.

The common theme unifying this book is that security markets are nearly efficient, meaning most securities are usually priced appropriately given their risk and return attributes. There are few free lunches found in markets as competitive as the financial market. This simple observation is, nevertheless, remarkably powerful in its implications for the design of investment strategies; as a result, our discussions of strategy are always guided by the implications of the efficient markets hypothesis. While the degree of market efficiency is, and always will be, a matter of debate (and in fact, in this edition, we devote a full chapter to the behavioral challenge to the efficient market hypothesis), we hope our discussions throughout the book convey a good dose of healthy criticism concerning much conventional wisdom.

Distinctive Themes

Investments is organized around several important themes:

1. The central theme is the near-informational-efficiency of well-developed security markets, such as those in the United States, and the general awareness that competitive markets do not offer “free lunches” to participants.
    
   A second theme is the risk–return trade-off. This too is a no-free-lunch notion, holding that in competitive security markets, higher expected returns come only at a price: the need to bear greater investment risk. However, this notion leaves several questions unanswered. How should one measure the risk of an asset? What should be the quantitative trade-off between risk (properly measured) and expected return? The approach we present to these issues is known as modern portfolio theory, which is another organizing principle of this book. Modern portfolio theory focuses on the techniques and implications of efficient diversification, and we devote considerable attention to the effect of diversification on portfolio risk as well as the implications of efficient diversification for the proper measurement of risk and the risk–return relationship.
    
2. This text places greater emphasis on asset allocation than most of its competitors. We prefer this emphasis for two important reasons. First, it corresponds to the procedure that most individuals actually follow. Typically, you start with all of your money in a bank account, only then considering how much to invest in something riskier that might offer a higher expected return. The logical step at this point is to consider other risky asset classes, such as stock, bonds, or real estate. This is an asset allocation decision. Second, in most cases, the asset allocation choice is far more important in determining overall investment performance than is the set of security selection decisions. Asset allocation is the primary determinant of the risk–return profile of the investment portfolio, and so it deserves primary attention in a study of investment policy.
    
3. This text offers a much broader and deeper treatment of futures, options, and other derivative security markets than most investments texts. These markets have become both crucial and integral to the financial universe and are the major sources of innovation in that universe. Your only choice is to become conversant in these markets—whether you are to be a finance professional or simply a sophisticated individual investor.

NEW IN THE EIGHTH EDITION

The following is a guide to changes in the Eighth Edition. This is not an exhaustive road map, but instead is meant to provide an overview of substantial additions and changes to coverage from the last edition of the text.

Chapter 3 How Securities are Traded
This chapter has been largely rewritten to reflect the ongoing transformation of trading practices, the growing dominance of electronic trading, the accelerating consolidation of securities markets, and continuing regulatory reform, in particular the response to the Sarbanes-Oxley Act.

Chapter 7 Optimal Risky Portfolios
This chapter contains additional material on the “art” of selecting reasonable parameter values for portfolio construction, and a discussion of what can go wrong when inputs are derived solely from recent historical experience.

Chapter 9 The Capital Asset Pricing Model
We introduce new material generalizing the intuition of the simple CAPM to more sophisticated treatments of risk, for example, consumption risk. We have also updated the material on liquidity and asset pricing throughout the set of chapters dealing with portfolio theory.

Chapter 11 The Efficient Market Hypothesis
We critically evaluate recent suggestions for “fundamental indexing” as a response to market errors in security valuation. We show that these strategies are nothing more than variations on the value-tilted portfolio strategies discussed earlier in the chapter.

Chapter 13 Empirical Evidence on Security Returns
We add considerable new material on the interpretation of risk premiums. For example, we examine new evidence on the relation between the Fama-French risk factors and more fundamental measures of security risk.

Chapter 14 Bond Prices and Yields
The chapter has new material explaining collateralized debt obligations (CDOs) as well as the role of credit rating agencies in the recent credit market crisis.

Chapter 19 Financial Statement Analysis
The chapter has been updated to address current issues in fair value accounting. It also contains additional discussion of the proper interpretation of market-to-book ratios.

Chapter 20 Options Markets
We have added a discussion of options backdating to this chapter.

Chapter 23 Futures, Swaps, and Risk Management
We have added new material on credit default swaps to this chapter. We show how these securities are constructed, and how they are used to transfer credit risk.

Chapter 26 Hedge Funds
This new chapter covers various hedge fund strategies; market-neutral investing and portable alpha; performance evaluation for hedge funds with changing risk exposures; selection bias in hedge fund performance; tail risk in hedge fund portfolios; and hedge fund fees.

Chapter 28 Investment Policy and the Framework of the CFA Institute
This chapter has been updated to reflect the CFA Institute’s expanded rubric for constructing a statement of investment policy.

ORGANIZATION AND CONTENT

The text is composed of seven sections that are fairly independent and may be studied in a variety of sequences. Because there is enough material in the book for a two-semester course, clearly a one-semester course will require the instructor to decide which parts to include.

Part One is introductory and contains important institutional material focusing on the financial environment. We discuss the major players in the financial markets, provide an overview of the types of securities traded in those markets, and explain how and where securities are traded. We also discuss in depth mutual funds and other investment companies, which have become an increasingly important means of investing for individual investors.

The material presented in Part One should make it possible for instructors to assign term projects early in the course. These projects might require the student to analyze in detail a particular group of securities. Many instructors like to involve their students in some sort of investment game and the material in these chapters will facilitate this process.

Parts Two and Three contain the core of modern portfolio theory. Chapter 5 is a general discussion of risk and return, making the general point that historical returns on broad asset classes are consistent with a risk–return trade-off, and examining the distribution of stock returns. We focus more closely in Chapter 6 on how to describe investors’ risk preferences and how they bear on asset allocation. In the next two chapters, we turn to portfolio optimization (Chapter 7) and its implementation using index models (Chapter 8).

After our treatment of modern portfolio theory in Part Two, we investigate in Part Three the implications of that theory for the equilibrium structure of expected rates of return on risky assets. Chapter 9 treats the capital asset pricing model and Chapter 10 covers multifactor descriptions of risk and the arbitrage pricing theory. Chapter 11 covers the efficient market hypothesis, including its rationale as well as evidence that supports the hypothesis and challenges it. Chapter 12 is devoted to the behavioral critique of market rationality. Finally, we conclude Part Three with Chapter 13 on empirical evidence on security pricing. This chapter contains evidence concerning the risk–return relationship, as well as liquidity effects on asset pricing.

Part Four is the first of three parts on security valuation. This Part treats fixed-income securities—bond pricing (Chapter 14), term structure relationships (Chapter 15), and interest-rate risk management (Chapter 16). Parts Five and Six deal with equity securities and derivative securities. For a course emphasizing security analysis and excluding portfolio theory, one may proceed directly from Part One to Part Four with no loss in continuity.

Finally, Part Seven considers several topics important for portfolio managers, including performance evaluation, international diversification, active management, and practical issues in the process of portfolio management. This Part also contains a new chapter on hedge funds.