1. 1 Building Portfolios with Stocks, Bonds, and Mutual Funds Financial & Retirement Planning Jay Taparia, CFA Managing Director, Sanskar Investments, Inc. Lecturer of Finance, University of Illinois @ Chicago

2. 2 The Client Is A Human Being & Is Capable Of Having… Emotion attached to wealth… Emotion attached to wealth… Goals (if…) that are ST, MT or LT Goals (if…) that are ST, MT or LT A limited life span… A limited life span… Uncertainty about the future… Uncertainty about the future… Irrationality associated with decision-making… Irrationality associated with decision-making… A gambling attitude toward the markets… over- confidence A gambling attitude toward the markets… over- confidence Dreams that could be impossible to reach… Dreams that could be impossible to reach… Dreams that are very possible to reach… Dreams that are very possible to reach… An aversion toward risk… whatever that may be An aversion toward risk… whatever that may be Annoying you at times… Annoying you at times… And don’t forget that… Life Happens And don’t forget that… Life Happens

3. 3 Because Of This… Building portfolios is not only a science, but it is an art Building portfolios is not only a science, but it is an art Having a nice irrelevant conversation with the client is necessary to build a relationship, but also to discover new “needs” and “objectives” Having a nice irrelevant conversation with the client is necessary to build a relationship, but also to discover new “needs” and “objectives” Client needs & objectives change over time (years even days) Client needs & objectives change over time (years even days) Portfolios are managed with continuously changing objectives Portfolios are managed with continuously changing objectives

4. 4 Individual Investor Life Cycle Age Accumulation Long-term: Retirement, Children’s college Short-term: House, Car Consolidation Long-term: Retirement Short-term: Vacations, Children’s College Spending Phase Gifting Phase Long-term: Estate Planning Short-term: Lifestyle Needs, Gifts Phases are Shifting

5. 5 Portfolio Management Process State the Objective – Mission statement of the portfolio, who and what it serves and why: income, and/or capital appreciation. State the Objective – Mission statement of the portfolio, who and what it serves and why: income, and/or capital appreciation. Identify the Constraints – there are always going to be constraints: taxes, legal, emotions, etc. Identify the Constraints – there are always going to be constraints: taxes, legal, emotions, etc. Formulate the Investment Policy – develop the “business plan” of the portfolio listing out return, risk and all the other issues associated with the portfolio Formulate the Investment Policy – develop the “business plan” of the portfolio listing out return, risk and all the other issues associated with the portfolio Study Market and Economic Conditions to forecast future trends – This is everything that you learned in Economic, Industry, Financial Statements, etc. Study Market and Economic Conditions to forecast future trends – This is everything that you learned in Economic, Industry, Financial Statements, etc. Monitor Performance – keep in touch with what is going on in the portfolio, and… Monitor Performance – keep in touch with what is going on in the portfolio, and… Reevaluate & Modify the Portfolio – rebalance and/or reconfigure according to the policy and markets Reevaluate & Modify the Portfolio – rebalance and/or reconfigure according to the policy and markets

6. 6 Role of the Portfolio Manager Bottom Line? You need someone to manage the whole process of investing – Bottom Line? You need someone to manage the whole process of investing – Minimizing individual security risk (company, industry, or unsystematic risk) Minimizing individual security risk (company, industry, or unsystematic risk) Making sure that the portfolio is well-diversified among industry, country and company Making sure that the portfolio is well-diversified among industry, country and company Managing the tax consequences of the portfolio – esp. for expensive people Managing the tax consequences of the portfolio – esp. for expensive people Most importantly, making sure the portfolio caters to the client needs via an Investment Policy Statement – Most importantly, making sure the portfolio caters to the client needs via an Investment Policy Statement – Return – capital gain vs.income Return – capital gain vs.income Risk Tolerance – varies typically according to age Risk Tolerance – varies typically according to age Tax Issues – maximizing after-tax returns Tax Issues – maximizing after-tax returns Time – retirement, college payments Time – retirement, college payments Liquidity – usually driven by time needs Liquidity – usually driven by time needs Legal Issues – trust and pensions have special legal issues Legal Issues – trust and pensions have special legal issues Other Unique Needs of the client Other Unique Needs of the client

7. 7 Realistic Investor Goals Current income Current income generate spendable funds generate spendable funds Capital preservation Capital preservation minimize risk of real loss minimize risk of real loss strongly risk-averse or cash needs are soon strongly risk-averse or cash needs are soon Capital appreciation Capital appreciation capital gains for real growth for future needs capital gains for real growth for future needs growth strategy with accepted risk growth strategy with accepted risk Total Return Total Return Capital Gains & Income Capital Gains & Income Desire to have “medium” risk exposure Desire to have “medium” risk exposure

8. What Is Asset Allocation? Cash BondsStocks Asset allocation is the process of combining asset classes such as stocks, bonds, and cash in a portfolio in order to meet your goals.

9. 9 The Need For Asset Allocation An investment strategy is based on four decisions An investment strategy is based on four decisions What asset classes to consider for investment What asset classes to consider for investment What normal or policy weights to assign to each eligible class What normal or policy weights to assign to each eligible class The allowable allocation ranges based on policy weights The allowable allocation ranges based on policy weights What specific securities to purchase for the portfolio to satisfy the strategy What specific securities to purchase for the portfolio to satisfy the strategy 90+% of the overall investment return is due to the first two decisions, not the selection of individual investments (BHB 1991) 90+% of the overall investment return is due to the first two decisions, not the selection of individual investments (BHB 1991) 70% of the overall investment return is due to style (Sharpe 1992) 70% of the overall investment return is due to style (Sharpe 1992)

10. Asset Allocation Policy 100 Asset Allocation Policy + Market Timing Asset Allocation Policy + Market Timing + Security Selection Asset Allocation Policy + Market Timing + Security Selection + Other Is Asset Allocation Important? 91.5% 93.3% 97.9% 100% 80604020 0 Percent Contributing Factors of Portfolio Performance

11. 11 Returns & Risk Of Different Asset Classes Higher returns should compensate for risk Higher returns should compensate for risk Policy statements must provide risk guidelines Policy statements must provide risk guidelines Measuring risk by standard deviation of returns over time indicates stocks are more risky than T-bills Measuring risk by standard deviation of returns over time indicates stocks are more risky than T-bills Measuring risk by probability of not meeting your investment return objective indicates risk of equities is small and risk of T-bills is large because of different expected returns Measuring risk by probability of not meeting your investment return objective indicates risk of equities is small and risk of T-bills is large because of different expected returns Focusing only on return variability ignores reinvestment risk and many other types of risk Focusing only on return variability ignores reinvestment risk and many other types of risk

12. 12 Historical Asset Performances: A Guide

13. Asset Class Returns Highs and Lows: 1926 - 1999 Small Company Stocks Large Company Stocks Long-Term Government Bonds Int.-Term Government Bonds Treasury Bills Each bar shows the range of annual total returns for each asset class over the period 1926-1999. 142.9% 54.0% 40.4% 14.7% 29.1% 0.0% -5.1% -9.2% -43.3% -58.0% -100% -50% 0% 50% 100% 150% Highest Annual Return Lowest Annual Return 3.8%5.2% 5.1% 11.3% 12.6% Average Return

14. Diversify To Reduce Risk Or Increase Return Risk is measured by standard deviation. Risk and return are based on annual data over the period 1970-1999. Portfolios presented are based on Modern Portfolio Theory. 1970 - 1999 Fixed Income Portfolio Return Risk 9.0% 8.5% Bonds 90% Cash 10% Higher Return Portfolio Return Risk 10.9% 8.5% Bonds 41% Cash 20% Stocks 39% Lower Risk Portfolio Return Risk 9.0% 6.1% Bonds 53% Cash 35% Stocks 12%

15. Assumes reinvestment of income and no transaction costs or taxes. 1926 - 1999 Return Before & After Inflation Compound Annual Return 11.3% 5.1% 3.8% 0% 5% 10% 15% StocksBondsCash 8.0% 2.0% 0.7% Stocks after Inflation Bonds after Inflation Cash after Inflation

16. 16 Monitor Performance Revise IPS as needed Revise IPS as needed Modify investment strategy accordingly Modify investment strategy accordingly Evaluate portfolio performance not only with market return or benchmark portfolio Evaluate portfolio performance not only with market return or benchmark portfolio Consider that relative performance will mean little when relative progress is on track Consider that relative performance will mean little when relative progress is on track

17. 17 Reevaluate & Modify Portfolio Asset Allocation – has fixed income/equity balance changed from the design Asset Allocation – has fixed income/equity balance changed from the design Style Under/Over-weights – is the portfolio tilted in style? Style Under/Over-weights – is the portfolio tilted in style? Industry Selection – based on the economic environment what might the best sectors be, or is the portfolio weighted too much in any 1 sector (i.e. 25%)? Industry Selection – based on the economic environment what might the best sectors be, or is the portfolio weighted too much in any 1 sector (i.e. 25%)? Security Concentrations – usually anything greater than 10% of the portfolio must be reduced in size Security Concentrations – usually anything greater than 10% of the portfolio must be reduced in size Security Selection – sell stocks that have poor fundamental issues in the future – and buy those that have positive changes ahead. Security Selection – sell stocks that have poor fundamental issues in the future – and buy those that have positive changes ahead. Key point – LT focus – not ST turnarounds. Why? Tax constraints. Key point – LT focus – not ST turnarounds. Why? Tax constraints.

18. 18 Understanding How Stocks Work

19. 19 What is a Stock? Legal ownership in a company through “shares” – purchase of stock implies you own a “slice” or “share ” of the company Legal ownership in a company through “shares” – purchase of stock implies you own a “slice” or “share ” of the company Stockholders have 1 st right to purchase new shares issued by the company – gives them right to maintain % share of ownership Stockholders have 1 st right to purchase new shares issued by the company – gives them right to maintain % share of ownership

20. 20 4 Characteristics of Stocks Voting Power - Ownership implies “control” having the right to appoint Board of Directors, who in turn, elect management Voting Power - Ownership implies “control” having the right to appoint Board of Directors, who in turn, elect management Residual Claim – you are last on the food chain to collect your investment if the company goes bankrupt Residual Claim – you are last on the food chain to collect your investment if the company goes bankrupt Limited Liability – can only lose the investment you make into the company – not more than that Limited Liability – can only lose the investment you make into the company – not more than that Stock Market Listing – stocks are traded between buyers and sellers in stock exchange Stock Market Listing – stocks are traded between buyers and sellers in stock exchange

21. 21 Return & Risk of Stocks Two Ways to Earn a Return on a Stock Two Ways to Earn a Return on a Stock Appreciation in Stock Price – if the investors perceive strong growth in the company’s sales & earnings, then investors will demand to buy more of the stock. As demand increases, the price of the stock increases. Appreciation in Stock Price – if the investors perceive strong growth in the company’s sales & earnings, then investors will demand to buy more of the stock. As demand increases, the price of the stock increases. Dividend Payment – if the company pays dividends Dividend Payment – if the company pays dividends

22. 22 Caveats of Stock Ownership No Guarantee of Return – you can lose your investment No Guarantee of Return – you can lose your investment % Ownership Can Be Small – you are just 1 of many owners – you have some, but not a whole lot of influence % Ownership Can Be Small – you are just 1 of many owners – you have some, but not a whole lot of influence Mergers & Acquisitions – other companies can offer to “buy your share out” and replace your shares with theirs Mergers & Acquisitions – other companies can offer to “buy your share out” and replace your shares with theirs Voting Proxy Statements - investors should take an active role in voting for directors and management – they are “owners” Voting Proxy Statements - investors should take an active role in voting for directors and management – they are “owners”

23. 23 Conceptualizing Financial Statements Financial statements are guided by a set of accounting rules, called GAAP (Generally Accepted Accounting Principles). Financial statements are guided by a set of accounting rules, called GAAP (Generally Accepted Accounting Principles). Because of flexibility, financial statements can be manipulated to give a “better-than-expected” view of earnings. Because of flexibility, financial statements can be manipulated to give a “better-than-expected” view of earnings. Ratio Analysis & Footnotes is one of the key tools to understanding a company. Ratio Analysis & Footnotes is one of the key tools to understanding a company.

24. 24 Conceptualizing Companies Companies are dynamic, financial statements are static Companies are dynamic, financial statements are static One date of release : summary of 3, 6, 9 or 12-month activity One date of release : summary of 3, 6, 9 or 12-month activity Lagged : released approximately one month after quarter- or year-end Lagged : released approximately one month after quarter- or year-end Past-tense : information possibly already incorporated into the stock price (barring any major surprises) Past-tense : information possibly already incorporated into the stock price (barring any major surprises) Dynamic forces on companies are qualitative Dynamic forces on companies are qualitative The economic cycle The economic cycle Industry analysis Industry analysis Management strategy Management strategy

25. 25 Conceptualizing the 3 Financial Statements Think of analyzing your own finances… Think of analyzing your own finances… Financial analysis of companies is similar to personal financial planning Financial analysis of companies is similar to personal financial planning Your balance sheet = a loan application Your balance sheet = a loan application Income statement = your tax return Income statement = your tax return Cash & cash flow statement = Your checking account and salary Cash & cash flow statement = Your checking account and salary Footnotes to financial statements =how you would explain what the numbers really mean to an IRS auditor or loan agent Footnotes to financial statements =how you would explain what the numbers really mean to an IRS auditor or loan agent

26. 26 Net income (Profits) Depreciation Deferred income taxes Accounts receivable Inventory Accounts Payable Income from operations Cash provided by (used for) working capital Cash flows from operations Net cash provided by operating activities (Cash Flows From Operations)(CFFO or CFO) + = Net Operating Income= Other revenues - - - + Statement of Cash Flows (or... what REALLY happened this year) Issue of debt Retirement of debt Sale of common stock Dividends paid Net cash provided by financing - + - + = Cash from financing activities activities or + - Sale of assets Purchase of assets Cash from investing activities Net cash provided by investing activities + - = Income Statement (or... what do you tell the Government you made?) Sales Cost of sales (including depreciation expense) Selling and administrative expenses Restructuring expense Earnings before tax Income tax expense Other expenses - = - The sum of the last line in each box above = the change in cash balances Dividends on common stock Net income transferred to surplus or retained earnings Dividends on preferred stock - = - = Net income (Profits) = Net income available to common stock or + - + - + - = Gross profit on sales +/- Gains or losses or- + Restructuring charge not spent + Cash and temporary investments Accounts receivable Inventory Prepaid expenses Total current assets Property, plant and equipment Less: Depreciation Net property, plant, and equipment Intangible assets and goodwill Total long-term assets Accounts payable Taxes Payable Short-term notes payable Current portion of long term debt Total current liabilities Long-term debt less current portion Deferred tax liability Total long-term liabilities Common stock par Capital surplus Less treasury stock at cost Total owners' equity Liabilities + Owners' Equity Retained earnings Current liabilities Long-term liabilities Owners' equity Total liabilities + Owners' equity Current assets Long-term assets Total assets Assets Balance Sheet (or... what have you got?) Deferred tax assets

27. 27 Public Filings You Need to Know Form 10-K (due 90 days after fiscal year close) Form 10-K (due 90 days after fiscal year close) Income statement (aka Statement of Operations) Income statement (aka Statement of Operations) Balance Sheet Balance Sheet Cash Flow Statement Cash Flow Statement Footnotes to the Financial Statements Footnotes to the Financial Statements Management Discussion and Analysis Management Discussion and Analysis Auditor’s Report Auditor’s Report Liquidity Position and Capital Expenditures Liquidity Position and Capital Expenditures

28. 28 Stock Market Indices (i.e., Indexes) Price-Weighted Index - each company represented by 1 share in index. Gives higher-priced shares more weight in determining performance of the index (e.g., Dow Jones Industrial Average) Price-Weighted Index - each company represented by 1 share in index. Gives higher-priced shares more weight in determining performance of the index (e.g., Dow Jones Industrial Average) Market Value-Weighted Index - weight of companies in index based on its market capitalization (stock price x # shares outstanding) – the higher the market value, the higher the weight in the index (e.g., S&P 500, NASDAQ) Market Value-Weighted Index - weight of companies in index based on its market capitalization (stock price x # shares outstanding) – the higher the market value, the higher the weight in the index (e.g., S&P 500, NASDAQ) Comparing your portfolio’s performance to the “market” depends on which index you are using and whether you are really comparing “apples to apples” or “ apples to oranges” Comparing your portfolio’s performance to the “market” depends on which index you are using and whether you are really comparing “apples to apples” or “ apples to oranges”

29. 29 Costs of Investing Commissions – Costs from the broker to implement trades one-way – must remember that you incur the cost when selling also Commissions – Costs from the broker to implement trades one-way – must remember that you incur the cost when selling also Bid-Ask Spread – brokers who “make a market” in the stock make the spread as their profit (or your cost) Bid-Ask Spread – brokers who “make a market” in the stock make the spread as their profit (or your cost) Market Impact Costs - if you are institutional (mutual or pension fund), your purchases/sales are large enough to move the stock price against you while buying or selling Market Impact Costs - if you are institutional (mutual or pension fund), your purchases/sales are large enough to move the stock price against you while buying or selling

30. 30 Buying Stock on Margin Definition - Borrowing Funds to Buy Stock - initially up to 50% of the equity purchase – called the Initial Margin Requirement Definition - Borrowing Funds to Buy Stock - initially up to 50% of the equity purchase – called the Initial Margin Requirement After the Purchase - must maintain at least 30% equity of the total account value – called the Maintenance Margin Requirement – to guard against default After the Purchase - must maintain at least 30% equity of the total account value – called the Maintenance Margin Requirement – to guard against default Primary Objective - Usually done to make higher returns on your equity via “using someone else’s funds” – but can also lose more than if you did not borrow the funds Primary Objective - Usually done to make higher returns on your equity via “using someone else’s funds” – but can also lose more than if you did not borrow the funds High Risk Strategy – only meant in cases where client has high amounts of liquidity (cash reserves) or has the risk tolerance (i.e., loves risk and has nerves of steel) High Risk Strategy – only meant in cases where client has high amounts of liquidity (cash reserves) or has the risk tolerance (i.e., loves risk and has nerves of steel)

31. 31 Buying Stock on Margin Example of Margin Trading Example of Margin Trading $10,000 of GE desired to be purchased with $5,000 personal funds and a $5,000 Margin Loan from broker $10,000 of GE desired to be purchased with $5,000 personal funds and a $5,000 Margin Loan from broker GE’s stock price is $50 per share = # of shares = 200 GE’s stock price is $50 per share = # of shares = 200 Interest Rate on Loan is 10% Interest Rate on Loan is 10% Ending Price Ending Value Loan Value Net Equity Maint. Margin Rate of Return % Chg Price $8016,0005,00011,00068.75%110%60% $5010,0005,000 50.00%-10%0% $306,0005,0001,00016.67%-90%-40% Bottom Line? Margin increases gain and loss returns substantially!

32. 32 Short Selling Definition – Instead of “Buying Low 1 st, And Selling High 2 nd,” you are doing this in reverse (Selling High, Buying Low) - You do this, when you think the stock price is overvalued and you decided to “short” or sell first, in expectation that the stock is going to fall Definition – Instead of “Buying Low 1 st, And Selling High 2 nd,” you are doing this in reverse (Selling High, Buying Low) - You do this, when you think the stock price is overvalued and you decided to “short” or sell first, in expectation that the stock is going to fall High Risk Strategy – only meant in cases where client has high amounts of liquidity (cash reserves) or has the risk tolerance (i.e., loves risk and has nerves of steel) High Risk Strategy – only meant in cases where client has high amounts of liquidity (cash reserves) or has the risk tolerance (i.e., loves risk and has nerves of steel)

33. 33 Procedure to Short Selling Borrow the Stock from Broker – as if you were taking a loan Borrow the Stock from Broker – as if you were taking a loan Sell the Stock in the Market – collecting the proceeds Sell the Stock in the Market – collecting the proceeds When Stock Price Declines – buy the stock back at lower price When Stock Price Declines – buy the stock back at lower price Return the Stock to the Broker – keep leftover funds as profit Return the Stock to the Broker – keep leftover funds as profit Similar Margin Requirements – as in Margin Trading Similar Margin Requirements – as in Margin Trading

34. 34 Basics on Portfolio Management Always make sure that your portfolio is diversified – not just 8-10 securities, but 20-30 minimum – across industries and countries Always make sure that your portfolio is diversified – not just 8-10 securities, but 20-30 minimum – across industries and countries Caveat emptor – there are 7,000 stocks and 10,000 mutual funds at a minimum to choose from in the USA – should you be picky about what you buy? YES!! Caveat emptor – there are 7,000 stocks and 10,000 mutual funds at a minimum to choose from in the USA – should you be picky about what you buy? YES!! Be “street smart” – make sure that what you are buying makes sense and you know the reasons why you are buying it – not just a “hot stock tip” – in other words, squeeze the tomatoes Be “street smart” – make sure that what you are buying makes sense and you know the reasons why you are buying it – not just a “hot stock tip” – in other words, squeeze the tomatoes

35. 35 Basics on Portfolio Management Make sure your portfolio does not become too concentrated in 1 name or 1 sector. Be receptive to sell if any 1 stock becomes greater than 10% of the portfolio – it may drive future performance, including downward Make sure your portfolio does not become too concentrated in 1 name or 1 sector. Be receptive to sell if any 1 stock becomes greater than 10% of the portfolio – it may drive future performance, including downward Just because you made good money on 1 stock or sector, please be aware that you might get “emotionally attached” to it – but keep in mind, stocks and money never were born with a “heart” Just because you made good money on 1 stock or sector, please be aware that you might get “emotionally attached” to it – but keep in mind, stocks and money never were born with a “heart”

36. 36 Understanding How Bonds Work

37. 37 Definition of a Bond Contractual loan that pays interest over a fixed term Contractual loan that pays interest over a fixed term Upon its maturity, the principal or the investment amount is returned to the lender of the bond Upon its maturity, the principal or the investment amount is returned to the lender of the bond Interest rate (called Coupon Rate) is typically fixed – hence, the alternative name for bonds as “fixed income” securities Interest rate (called Coupon Rate) is typically fixed – hence, the alternative name for bonds as “fixed income” securities An Income-Based Investment – focus on generating income and less so on capital appreciation <> stocks An Income-Based Investment – focus on generating income and less so on capital appreciation <> stocks Bond Contract is called an Indenture Agreement – which has all of the structure details about the bond and disclosures about the company issuing the bonds Bond Contract is called an Indenture Agreement – which has all of the structure details about the bond and disclosures about the company issuing the bonds Usually denominated in $1,000 units – $50,000 in Bonds = 50 Bonds Usually denominated in $1,000 units – $50,000 in Bonds = 50 Bonds

38. 38 Bond Classifications Registered vs. Bearer Forms Registered vs. Bearer Forms Security Security Collateral – secured by financial securities Collateral – secured by financial securities Mortgage – secured by real property, normally land or buildings Mortgage – secured by real property, normally land or buildings Debentures – unsecured Debentures – unsecured Notes – unsecured debt with original maturity less than 10 years Notes – unsecured debt with original maturity less than 10 years Seniority Seniority

39. 39 Major Classes of Bonds U.S. Treasury Bonds – issued by the U.S. Government and considered the safest type of bond U.S. Treasury Bonds – issued by the U.S. Government and considered the safest type of bond Corporate Bonds – issued by corporations to fund their projects and assets – carry higher risk than the U.S. Treasury bonds due to high risk of default (or non-payment of interest and/or principal) Corporate Bonds – issued by corporations to fund their projects and assets – carry higher risk than the U.S. Treasury bonds due to high risk of default (or non-payment of interest and/or principal) Municipal Bonds – issued by cities, counties, quasi- government agencies (like the Illinois State Tollway) and states to fund projects and general municipal funding. Municipal Bonds – issued by cities, counties, quasi- government agencies (like the Illinois State Tollway) and states to fund projects and general municipal funding.

40. 40 Major Classes of Bonds Foreign Bonds – issued by foreign governments as well as foreign corporations – can be denominated either in US Dollars or in foreign currency – considered to have multiple layers of risk, both in terms of the foreign entities willingness to pay as well as in currency risk terms Foreign Bonds – issued by foreign governments as well as foreign corporations – can be denominated either in US Dollars or in foreign currency – considered to have multiple layers of risk, both in terms of the foreign entities willingness to pay as well as in currency risk terms Securitized Certificates – issued by taking a group of assets such as mortgages, auto loans or credit cards and packaging them for issuance as a security. Considered to have higher quality than a single asset due to diversification. Cash flow is usually less predictable and dependent on changing levels of interest rates Securitized Certificates – issued by taking a group of assets such as mortgages, auto loans or credit cards and packaging them for issuance as a security. Considered to have higher quality than a single asset due to diversification. Cash flow is usually less predictable and dependent on changing levels of interest rates

41. 41 Key Characteristics of Bonds Par Value – stated value of a bond – usually $1000 par value per bond. $50,000 par is = to 50 bonds to buy. Par Value – stated value of a bond – usually $1000 par value per bond. $50,000 par is = to 50 bonds to buy. Coupon Interest Rate – the amount that is paid each period to a bondholder by the issuer. Rate is usually quoted as an annual rate, but payments are made usually semi-annually. Coupon Interest Rate – the amount that is paid each period to a bondholder by the issuer. Rate is usually quoted as an annual rate, but payments are made usually semi-annually. Coupon Payment = Coupon Interest Rate x Par Value Coupon Payment = Coupon Interest Rate x Par Value Maturity Date – when the bond matures – principal and last coupon payment paid on this day. Maturity Date – when the bond matures – principal and last coupon payment paid on this day. Price (Market Value) – what the value of the bond is worth. Better yet, what the market is valuing this Annuity Stream. Price (Market Value) – what the value of the bond is worth. Better yet, what the market is valuing this Annuity Stream.

42. M Bond Value ($) Years remaining to Maturity 1,372 1,211 1,000 837 775 3025 20 15 10 5 0 k d = 7%. k d = 13%. k d = 10%.

43. 43 Bond Risks Default Risk – Risk that you are not going to get your original principal back due to the company going bankrupt. Default Risk – Risk that you are not going to get your original principal back due to the company going bankrupt. Interest Rate Risk – as interest rates rise, the price (and value) of the bond falls. Capital Loss!! Interest Rate Risk – as interest rates rise, the price (and value) of the bond falls. Capital Loss!! Reinvestment Rate Risk – has to do with the reinvestment of interest and principal payments. Reinvestment Rate Risk – has to do with the reinvestment of interest and principal payments. Interest Payments – what do you do with the interest payments (beside spend it) – if rates decline, your return is lower as you reinvest these at a lower rate. Interest Payments – what do you do with the interest payments (beside spend it) – if rates decline, your return is lower as you reinvest these at a lower rate. Principal Payments – what do you do when you get your money (principal) back – if rates decline, your principal gets reinvested at a lower rate. Principal Payments – what do you do when you get your money (principal) back – if rates decline, your principal gets reinvested at a lower rate. Keep in mind that Callable Bonds also have reinvestment rate risk. The company will only call the bonds when rates decline. You have both interest and principal payment reinvestment rate risk. Keep in mind that Callable Bonds also have reinvestment rate risk. The company will only call the bonds when rates decline. You have both interest and principal payment reinvestment rate risk.

44. What is Interest Rate Risk? Also, called Price Risk… kdkd 1-year Change 10-year Change 5% $1,048$1,386 10% 1,000 +4.8% -4.4% 1,000 +38.6% -25.1% 15% 956749 Interest rate risk: Rising k d causes bond’s price to fall. Which bond has more risk? 1-year or 10- year?

45. 45 Price Yield Prices and Yield / Interest Rates

46. 46 Default Risk Premium (Credit Risk) Investment GradeJunk Bonds Moody’sAaaAaABaaBaBCaaC S&PAAAAAABBBBBBCCCD

47. 47 Corporate Bond Spreads – AA & BB

48. 48 Benefits of Bonds in Portfolios Historically Lower Risk Historically Lower Risk Diversification Benefits Diversification Benefits Income Generation Income Generation Expand Efficient Opportunities Expand Efficient Opportunities Potential Growth Potential Growth

49. 49 Fixed Income Maturity (Interest Rate) Risk 1.5% -1.3% 5.9% -4.5% 9.8% -8.7% -10% -5% 0% 5% 10% 15% 1970 - 1999 Short-Term Gov’t Bond Intermediate-Term Gov’t Bond Average Rise in Price during Declining Interest Rate Periods Average Decline in Price during Rising Interest Rate Periods Long-Term Gov’t Bond

50. Using Bonds to Diversify Risk is measured by standard deviation. Risk and return are based on annual data over the period 1970-1999. Portfolios presented are based on Modern Portfolio Theory. Original Portfolio Return Risk 10.8% 8.0% 1970 - 1999 Stocks 50% Cash 50% Lower Risk Portfolio Return Risk 10.8% 7.6% Stocks 38% Bonds 43% Cash 19%

51. Based on annual data over the period 1970-1999. Bonds 85% 6% 9% Stocks Bonds Produce Greater Income 1970 - 1999 2% 73% 25% Capital Appreciation Income Reinvestment of Income

52. 52 Bond Prices & Yields Over Time $0 $.20 $.40 $.60 $.80 $1.00 $1.20 $1.40 $1.60 1925193519451955196519751985 1999 0% 2% 4% 6% 8% 10% 12% 14% 16% Bond Yields (%) Bond Prices ($) When Yields Increase, Bond Prices Decrease

53. 53 Understanding How Mutual Funds Work

54. 54 Definition of an Investment Company Financial intermediaries (i.e., middlemen) that collect funds from individual investors and invest those funds in a diversified pool of stocks, bonds, or other assets based on the company’s focus or specialty. (i.e., a bond fund, an international fund) Financial intermediaries (i.e., middlemen) that collect funds from individual investors and invest those funds in a diversified pool of stocks, bonds, or other assets based on the company’s focus or specialty. (i.e., a bond fund, an international fund) Benefits to the Individual Investor – Benefits to the Individual Investor – Recordkeeping & Administration – for all holdings in the fund Recordkeeping & Administration – for all holdings in the fund Diversification & Divisibility – if the investor has a small amount of money they can have instant ownership of many stocks, not just one. They can also easily buy more (in increments of $, not 100 share blocks) Diversification & Divisibility – if the investor has a small amount of money they can have instant ownership of many stocks, not just one. They can also easily buy more (in increments of $, not 100 share blocks) Professional Management – this is of course relative – you must do you homework on management – but it does beat doing the research yourself Professional Management – this is of course relative – you must do you homework on management – but it does beat doing the research yourself Lower Transaction Costs – due to pooling of funds, commissions, fees, and market impact costs are lower Lower Transaction Costs – due to pooling of funds, commissions, fees, and market impact costs are lower

55. 55 Types of Investment Companies Managed Investment Companies (mutual funds) Managed Investment Companies (mutual funds) Open-End – issues shares every time a buyer adds money to the mutual fund – investor buys shares at NAV. Open-End – issues shares every time a buyer adds money to the mutual fund – investor buys shares at NAV. Closed-End – trade like stocks on the exchange. Investor buys at the current stock prices (which could be higher or lower than the NAV). Closed-End – trade like stocks on the exchange. Investor buys at the current stock prices (which could be higher or lower than the NAV). Unit Investment Trust – pool of money invested in a portfolio whose investments are fixed for the life of the fund. Usually Bonds given that they have a maturity, but also seen used with stocks for a 1 year term. Unit Investment Trust – pool of money invested in a portfolio whose investments are fixed for the life of the fund. Usually Bonds given that they have a maturity, but also seen used with stocks for a 1 year term. Commingled Funds (i.e., limited partnerships) – similar to Open- Ended Funds, but instead of buying shares, you are buying units at NAV. Usually offered by banks & insurance companies. Commingled Funds (i.e., limited partnerships) – similar to Open- Ended Funds, but instead of buying shares, you are buying units at NAV. Usually offered by banks & insurance companies. Real Estate Investment Trusts (REITs) – a closed-ended fund that invests in real estate Real Estate Investment Trusts (REITs) – a closed-ended fund that invests in real estate

56. 56 Used as a basis for valuation of investment company shares. Used as a basis for valuation of investment company shares. Selling new shares Selling new shares Redeeming existing shares Redeeming existing shares Market Value of Assets - Liabilities Shares Outstanding Shares Outstanding Open Ended Funds – NAV is Price Open Ended Funds – NAV is Price Closed Ended Funds - NAV is compared to Stock Price of Fund Closed Ended Funds - NAV is compared to Stock Price of Fund Net Asset Value and Price

57. 57 Shares Outstanding Closed-end: no change unless new stock is offered. Closed-end: no change unless new stock is offered. Open-end: changes when new shares are sold or old shares are redeemed. Open-end: changes when new shares are sold or old shares are redeemed.Pricing Open-end: Net Asset Value (NAV) Open-end: Net Asset Value (NAV) Closed-end: Premium or discount to NAV Closed-end: Premium or discount to NAV Open-End and Closed- End Funds: Key Differences

58. 58 Money Market Money Market Fixed Income Fixed Income Equity Equity Balance & Income Balance & Income Asset Allocation Asset Allocation Indexed Indexed Specialized Sector Specialized Sector Investment Policies

59. 59 Fee Structure Fee Structure Front-end load Front-end load Back-end load Back-end load Operating expenses Operating expenses 12 b-1 charges 12 b-1 charges distribution costs paid by the fund distribution costs paid by the fund Alternative to a load Alternative to a load Fees and performance Fees and performance Costs of Investing in Mutual Funds

60. 60 Exchange Traded Funds Allow investors to trade funds based on indexes like stock. Allow investors to trade funds based on indexes like stock. Examples Examples SPDRS SPDRS WEBS WEBS HOLDERS HOLDERS Allow sector specialization Allow sector specialization

61. 61 A First Look at Fund Performance Benchmark: Wilshire 5000 Benchmark: Wilshire 5000 Results Results Most funds underperform Most funds underperform Not fair comparison because of costs Not fair comparison because of costs Adjusted Benchmark: Wilshire 5000 with passive management costs considered. Adjusted Benchmark: Wilshire 5000 with passive management costs considered. The majority of funds still under-perform. The majority of funds still under-perform.

62. 62 Consistency of Fund Performance Do some mutual funds consistently outperform? Do some mutual funds consistently outperform? Evidence suggests that some funds show consistent stronger performance. Evidence suggests that some funds show consistent stronger performance. Depends on measurement interval Depends on measurement interval Depends on time period Depends on time period Evidence shows consistent poor performance. Evidence shows consistent poor performance.

63. 63 Rate of Return Calculations for Funds Performance – History has shown that 80% of mutual fund managers do not beat the “market” – so why bother? Main difference is that they are comparing apples and oranges. Performance – History has shown that 80% of mutual fund managers do not beat the “market” – so why bother? Main difference is that they are comparing apples and oranges. Mutual fund managers charge fees and hence their performance will be lower. In other words, you cannot get around the fees period – even if you bought the index yourself – you would still have commission charges. Mutual fund managers charge fees and hence their performance will be lower. In other words, you cannot get around the fees period – even if you bought the index yourself – you would still have commission charges. Past Performance does not completely indicate future performance, but do remember you are investing in the mutual fund manager. If his/her performance is poor, then it is likely that it might remain poor (if he is not fired, that is) – Money Magazine flaws as an example of this. Past Performance does not completely indicate future performance, but do remember you are investing in the mutual fund manager. If his/her performance is poor, then it is likely that it might remain poor (if he is not fired, that is) – Money Magazine flaws as an example of this.

64. 64 Wiesenberger’s Investment Companies Wiesenberger’s Investment Companies Morningstar Morningstar Investment Company Institute Investment Company Institute Popular press Popular press Investment services Investment services Information Sources on Mutual Funds

65. 65 Measuring Fund Performance – Category Ranks and Ratings You can view all mutual funds as 1 peer group – but everyone is investing with a different “style” You can view all mutual funds as 1 peer group – but everyone is investing with a different “style” Category ratings are used to see who did better within a “category” of style. Category ratings are used to see who did better within a “category” of style. Certain investment styles perform better than others at any point in time – if that is the case, then managers must be compared to their peers… Certain investment styles perform better than others at any point in time – if that is the case, then managers must be compared to their peers… Category Style = Investment Objective of the Fund Category Style = Investment Objective of the Fund Helps to determine what funds do well even when style is out of favor Helps to determine what funds do well even when style is out of favor Points out funds that are just riding on the coat tails of their group Points out funds that are just riding on the coat tails of their group

66. 66 Categories Identify the Real Competition For example: International Equity For example: International Equity Foreign Foreign World World Diversified Emerging Markets Diversified Emerging Markets Regional Regional International Hybrid International Hybrid This reaffirms that returns do not tell the whole story – This reaffirms that returns do not tell the whole story – 10 YR Trailing Return (1/2001) 10 YR Trailing Return (1/2001) Janus Twenty21.63% Janus Twenty21.63% Weitz Partners Value21.57% Weitz Partners Value21.57%

67. 67 Value Blend Growth Large Medium Small Morningstar Equity Style Box Classifies a fund based on – Classifies a fund based on – Style —Value, Blend, Growth Style —Value, Blend, Growth Size — Small, Medium, Large Size — Small, Medium, Large

68. 68 Style Box Breakpoints Market Capitalization Market Capitalization Large – >= $10 billion Large – >= $10 billion Medium – = $1.6 billion Medium – = $1.6 billion Small – < $1.6 billion Small – < $1.6 billion Style Types – Relative Valuation Ratios vs. Market Style Types – Relative Valuation Ratios vs. Market Value –rel. P/E + rel. P/B <1.75 Value –rel. P/E + rel. P/B <1.75 Blend –rel. P/E + rel. P/B = 1.75-2.25 Blend –rel. P/E + rel. P/B = 1.75-2.25 Growth – rel. P/E + rel. P/B >2.25 Growth – rel. P/E + rel. P/B >2.25

69. 69 Styles <> Objectives FundObjectiveActual Style Oakmark SelectGrowthMid Value Pioneer Cap GrowthSmall Co.Mid Value Prudential Equity IncEquity Inc.Mid Value

70. 70 Styles <> Objectives FundObjectiveActual Style Large Growth Vanguard Growth IndexGrowth Large Growth SequoiaGrowthLarge Value DelafieldGrowthSmall Value

71. 71 Value Blend Growth Large Medium Small Value Blend Growth Twenty Weitz Current Equity Style Box Large Cap GrowthMid Cap Value

72. 72 Janus Twenty Top Holdings

73. 73 Weitz Top Holdings

74. 74 Janus Twenty Portfolio Breakdown

75. 75 Weitz Partners Value Portfolio Breakdown

76. 76 Janus Twenty Sector Exposure

77. 77 Weitz Partners Value Sector Exposure

78. 78 Risk Measures TwentyWeitz Morningstar Risk (10 YR)1.320.59 Standard Deviation24.7214.18 Morningstar Risk Ratio = Fund SD / Market SD Morningstar Risk Ratio = Fund SD / Market SD It is a Relative Measure of Risk It is a Relative Measure of Risk

79. 79 Five Key Points in Picking Funds How has the fund performed? How has the fund performed? Compare with appropriate index Compare with appropriate index Compare with peer group Compare with peer group Examine after-tax returns, if relevant Examine after-tax returns, if relevant How risky has the fund been? How risky has the fund been? Big returns spell risk Big returns spell risk Are you comfortable with the level of volatility? Are you comfortable with the level of volatility? Morningstar risk & standard deviation Morningstar risk & standard deviation What does the fund own? What does the fund own? Value vs. Growth Value vs. Growth Sectors Sectors U.S. and Foreign U.S. and Foreign Who runs the fund? Who runs the fund? Who earned the fund’s record? Who earned the fund’s record? Where does this manager come from? Where does this manager come from? What’s the fund family like? What’s the fund family like? What does the fund cost? What does the fund cost? Low expenses are best Low expenses are best Load funds aren’t bad if performance is justified, but rare Load funds aren’t bad if performance is justified, but rare

80. 80 Understanding Global Investing

81. Why Invest Globally? Investment Opportunities – roughly 50% of the global stock market currently Foreign Investment Opportunities – roughly 50% of the global stock market currently Foreign Market History Market History Growth Potential – faster growing economies Growth Potential – faster growing economies Diversification Benefits – Expand Efficient Range Diversification Benefits – Expand Efficient Range

82. Each bar shows the range of annual total returns for each region over the period 1970-1999. Global Stock Market Returns Highest and Lowest Historical Annual Returns for Each Region 1970 - 1999 United States International Europe 37.4% 69.9% 79.8% 107.5% -26.5% -23.2% -22.8% -34.3% Pacific 13.7% 13.2% 13.8% 13.4% Average Return - 40% - 20% 0% 20% 40% 60% 80% 100% 120%

83. 83 Domestic Versus Global U.S. BondsU.S. StocksInternational Stocks 1970 - 1999 Domestic Portfolio Global Portfolio Risk is measured by standard deviation. Risk and return are based on annual data over the period 1970-1999. Average Return Risk 10.8% 12.0% 40% 60% Average Return Risk 10.0% 12.0% 40% 18% 42%

84. 84 Risks Of Foreign Investing Currency Risk Currency Risk Economic/Political Risk Economic/Political Risk Market Liquidity Risk Market Liquidity Risk Differences in Accounting Standards Differences in Accounting Standards Costs of Investing Internationally Costs of Investing Internationally

85. 85 The End! Thank You!