Chapter 11

1. Chapter 11 Investments Basics

2. Learning Objectives • Set your goals and be ready to invest. • Calculate interest rates and real rates of return. • Manage risk in your investments. • Allocate your assets in the manner that is best for you. • Understand how difficult it is to beat the market.

3. Introduction • Your investing goals should be to protect your money and make a profit • It is important to understand investing from a common sense perspective • A solid grounding in investing knowledge will help you reach your financial goals and avoid pitfalls

4. Before You Invest • Decide what your investing goals are • How much can you set aside to meet those goals? • Know the difference between investing and speculating

5. Investing Versus Speculating • Investment —an asset that generates a return (an increase in the value of the asset or an increase in money (profit) when the asset is sold) • Income return – a return received directly from the company or organization, usually in the form of dividends or interest payments • Dividend – a payment made by a company to its shareholders, usually as a distribution of profits

6. Investing Versus Speculating • Speculation—buying an asset whose value depends solely on supply and demand • Example: baseball cards are worth more in the future only if someone is willing to pay more • Derivative securities —value derived from value of other assets • Option —right of the owner of the option to buy or sell an asset, usually stock, at a specified price

7. Investing versus Speculating • With investing, the value of an asset is determined by what return it earns, not by supply and demand • Investments have intrinsic value because they produce wealth and income • Investing is much less risky than speculating

8. Setting Investment Goals When making your financial plan: • Write down your goals and prioritize them. • Attach costs to them. • Figure out when the money for those goals will be needed. • Periodically reevaluate your goals.

9. Setting Investment Goals • Formalize goals: • Short-term – within 1 year • Intermediate-term – 1-10 years • Long-term – over 10 years • Goals should be realistic: • Consequences, if not accomplished? • Am I willing to make financial sacrifices? • How much money is needed? • When do I need the money?

10. Financial Reality Check Before you start investing: • Have a grip on your financial affairs • Make sure you’re living within your means • Have adequate insurance • Keep emergency funds

11. Starting Your Investment Program • Pay yourself first • Make investing automatic • Take advantage of Uncle Sam and your employer • Windfalls • Make 2 months a year investment months

12. Fitting Taxes Into Investing • Marginal tax rate: the tax rate on your last dollar of income • The higher your marginal tax rate, the more attractive tax-free investments are • Compare investment returns on an after-tax basis

13. Fitting Taxes Into Investing • Tax Deferred Investments – 401(k)s and IRAs • The money you invest now is tax-sheltered • The amount you invest reduces your taxable income • You don’t pay taxes on investments or profits for many years—until you take the money out at retirement • With taxes, capital gains and dividend income are better than ordinary income • They are taxed at a lower 15% rate

14. Investment Choices – Two Types • Lending Investments —savings accounts and bonds, which are debt instruments issued by corporations andthe government • Ownership Investments —preferred stocks and common stocks, which represent ownership in a corporation, along with income-producing real estate

15. Lending Investments • Maturity date • Par Value or Principal • Coupon interest rate • Know ahead of time what return will be • If issuer goes bankrupt, bondholder can lose entire investment

16. Ownership Investments • Real estate —your home, rental apartments and investments in income-producing property • Illiquid-hard to sell off • Stock —fractional ownership in a corporation • Owner or equity holder —owns stock • Dividend —a payment by a corporation to its shareholders

17. The Returns from Investing • You can receive a return (profit) from: • Capital gain or loss —gain (or loss) when you sell the capital asset • Income return —any payments you receive directly from the company or organization in which you’ve invested • Interest on bonds • Dividends on stocks

18. Formula for Rate of Return (ending value of investment – beginning value) + income return beginning value of investment Example: You buy a stock for $10,000. You get $100 in dividends every year for the next five years. At the end of five years you sell the stock for $12,000. What is your rate of return? ($12,000 - $10,000) + $500 $10,000 $2,500 = 25% $10,000

19. Practice Rate of Return: You buy a stock for $15,000. A year later you sell it for $17,000. What is your rate of return? ($17,000 - $15,000) / $15,000 = $2,000/$15,000 =.133 or 13.3% Be sure to move the decimal two places to the right

20. Practice Rate of Return You buy a stock for $25,000. You hold the stock for 20 years. During that 20 years you receive a total of $5,000 in dividends. After 20 years, you sell the stock for $60,000. What is your rate of return? ($60,000 - $25,000) + $5,000 $25,000 ($35,000 + $5,000) / $25,000 = 1.60 or 160%

21. Market Interest Rates • Investors need to understand interest rates • Interest rates affect the value of stocks, bonds, and real estate • Interest rates also determine earnings on savings and are closely tied to inflation

22. Nominal and Real Rates of Return • Nominal (or quoted) rate of return —the rate of return earned on an investment, without any adjustment for inflation • Real rate of return —the current or nominal rate of return minus the inflation rate • Example: If you earn 8% on an investment while the inflation rate is 3%, your real rate of return is 8% - 3% = 5%

23. Historical Interest Rates • Nominal interest rates on bonds have dropped somewhat over the past 20 years • As inflation slowed, investors demanded a lower rate on money they lent, which resulted in a drop in nominal interest rates • Real rate of return can even be negative • In 2011, the nominal rate on Treasury bills was .30% and inflation was 1.63%, resulting in a real rate of return of .3% - 1.63% =-1.33%

24. Figure 11.1 Interest and Inflation Rates, 1988–2010

25. How Interest Rates Affect Returns on Other Investments • When interest rates go up, investors demand a higher return on other investments • Risk on stocks is higher than on bonds, so investors demand a higher return on stocks • If the bond rates are higher than stock returns, no one would invest in stocks

26. Risk is related to potential return The more risk you assume, the greater the potential reward—but also the greater possibility of losing your money. You must eliminate risk without affecting potential return Balance amount of risk with amount of return needed A Look at Risk-Return Trade-Offs

27. Historical Levels of Risk and Return • Investments that produce higher returns have higher levels of risk associated with them.

28. Sources of Risk in theRisk-Return Trade-Off • Interest rate risk • Inflation risk • Business risk • Financial risk • Liquidity risk • Market risk • Political and regulatory risk • Exchange rate risk • Call risk

29. Diversification • Diversification is the elimination of risk by investing in different assets • Allows extreme good and bad returns to cancel each other out • Diversification reduces risk without affecting the expected return • See example on page 380-381 (sunglasses and umbrellas)

30. Diversifying Risk Away • Portfolio —a group of investments held by an individual • Systematic or Market-Related or Nondiversifiable Risk —portion of a security’s risk or variability that cannot be eliminated through diversification • Unsystematic or Firm-Specific or Company-Unique Risk or Diversifiable Risk —risk or variability that can be eliminated with diversification

31. Figure 11.3 The Reduction of Risk as the Number of Stocks in the Portfolio Increases

32. Understanding Your Tolerance for Risk • Need to recognize your tolerance for risk and invest accordingly • Take one of many risk-tolerance tests (page 383 for example) • Review your past actions to determine how much risk you take in your life

33. Figure 11.4 Risk Tolerance Quiz

34. The Time Dimension of Investing and Asset Allocation • As the length of the investment horizon increases (the younger you are), you can afford to invest in riskier assets • If investment horizon is longer, will probably end up with a lot more if you invest in some risky assets

35. Meeting Your Investment Goals and the Time Dimension of Risk • With any long-term investment, there will be bad years and good years • With time, dispersion (variability) of returns in these years converges toward the average • What kinds of assets should you invest in? • Investment in bonds will give less uncertainty over time but will give smaller ultimate value than investing in riskier assets like stocks

36. Figure 11.5 Reduction of Risk over Time, 1950–2010

37. Asset Allocation • Asset allocation is how you divide your money among stocks, bonds, and other investments • Common stocks are more appropriate for the long-term horizon • Asset allocation is the most important investing task that is not a one-time decision • You should continue to allocate your investments throughout your life

38. TABLE 11.1 Factors Impacting Your Asset Allocation Decision

39. Asset Allocation and the Early Years—A Time of Wealth Accumulation (Through Age 54) • Investment horizon is quite long, investors should place majority of savings into common stocks. • 80% common stocks and 20% in bonds quite common.

40. Figure 11.6 Risk and Return to Benchmark Asset Allocation Breakdown Duringthe Early Years

41. Asset Allocation and Approaching Retirement—The Golden Years (Ages 55 to 64) • Preserve level of wealth and allow it to grow • Start moving some of retirement portfolio into bonds • Maintain a diversified portfolio • Own 60% stocks and 40% bonds

42. Figure 11.7 Risk and Return to Benchmark Asset Allocation Breakdown Approaching Retirement—The Golden Years

43. Asset Allocation and the Retirement Years (Over Age 65) • Spending more than saving • Income is the primary consideration, capital appreciation secondary • Keep your money safe with diversification away from stocks • Own 40% stocks, 40% bonds, 20% T-bills. Later own 20% common, 60% bonds, and 20% T-bills

44. Figure 11.8 Risk and Return to Benchmark Asset Allocation Breakdown DuringRetirement Years

45. Figure 11.9 Risk and Return to Benchmark Asset Allocation Breakdown Duringthe Late Retirement Years

46. What You Should Know About Efficient Markets • Efficient market —a market in which information about the stock is reflected in the stock price. • The more efficient the market, the faster prices react to new information • If the stock market were truly efficient, then there would be no benefit from stock analysts

47. Beating the Market • Half the time you should outperform the market, and half the time you should underperform • Difficult for “superstars” of investing to pick underpriced stocks and time the market • Keep your plan and invest for the long term. If you try to time the market, you just as likely to miss an upswing as you are to avoid an downswing

48. Checklist 11.1

49. Thinking Back to Principle 9: Mind Games and Your Money • Overconfidence • Disposition Effect • House Money Effect • Loss then Risk Aversion Effect • Herd Behavior

50. Summary • Decide on goals and how much to set aside then develop an investment plan • Interest rates are important in determining value of an investment and are tied to the rate of inflation • There are different sources of risk associated with investments