Investment Basics

Copyright © 2010 Pearson Education, Inc. Publishing as Prentice Hall 5-2 All rights reserved. No part of this publication may be reproduced, stored in a retrieval system, or transmitted, in any form or by any means, electronic, mechanical, photocopying, recording, or otherwise, without the prior written permission of the publisher. Printed in the United States of America.

11-3 Copyright © 2010 Pearson Education, Inc. Publishing as Prentice Hall Learning Objectives 1. Set your goals and be ready to invest. 2. Calculate interest rates and real rates of return. 3. Manage risk in your investments. 4. Allocate your assets in the manner that is best for you. 5. Understand how difficult it is to beat the market.

11-4 Copyright © 2010 Pearson Education, Inc. Publishing as Prentice Hall Introduction Investing goals should be to protect and make money. Important to understand investing from a common sense perspective. A solid grounding in investing will help you reach your financial goals and avoid pitfalls.

11-5 Copyright © 2010 Pearson Education, Inc. Publishing as Prentice Hall Before You Invest Decide what your goals are. How much can you set aside to meet those goals? Know the difference between investing and speculating.

11-6 Copyright © 2010 Pearson Education, Inc. Publishing as Prentice Hall Investing Versus Speculating Investment—an asset that generates a return. Income return Speculation—an asset whose value depends solely on supply and demand. Derivative securities—value derived from value of other assets Option—right of owner to buy or sell an asset

11-7 Copyright © 2010 Pearson Education, Inc. Publishing as Prentice Hall Setting Investment Goals 1. Write down your goals and prioritize them. 2. Attach costs to them. 3. Figure out when the money for those goals will be needed. 4. Periodically reevaluate your goals.

11-8 Copyright © 2010 Pearson Education, Inc. Publishing as Prentice Hall 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 Willing to make financial sacrifices How much money is needed? When do I need the money?

11-9 Copyright © 2010 Pearson Education, Inc. Publishing as Prentice Hall Financial Reality Check Have a grip on your financial affairs Make sure you’re living within your means Have adequate insurance Keep emergency funds

11-10 Copyright © 2010 Pearson Education, Inc. Publishing as Prentice Hall 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

11-11 Copyright © 2010 Pearson Education, Inc. Publishing as Prentice Hall Fitting Taxes Into Investing Compare investment returns on an after- tax basis. Marginal tax rate Tax-free investment alternatives Investments on a tax-deferred basis With taxes, capital gains and dividend income are better than ordinary income

11-12 Copyright © 2010 Pearson Education, Inc. Publishing as Prentice Hall Investment Choices Lending Investments—savings accounts and bonds which are debt instruments issued by corporations and the government. Ownership Investments—preferred stocks and common stocks which represent ownership in a corporation, along with income-producing real estate.

11-13 Copyright © 2010 Pearson Education, Inc. Publishing as Prentice Hall 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

11-14 Copyright © 2010 Pearson Education, Inc. Publishing as Prentice Hall 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

11-15 Copyright © 2010 Pearson Education, Inc. Publishing as Prentice Hall The Returns from Investing Capital gain or loss—gain (or loss) on the sale of a capital asset. Income return—any payments you receive directly from the company or organization in which you’ve invested.

11-16 Copyright © 2010 Pearson Education, Inc. Publishing as Prentice Hall Market Interest Rates Need to understand interest rates Interest rates affect the value of stocks, bonds, and real estate. Interest rates also determine earnings on savings and tied closely to inflation.

11-17 Copyright © 2010 Pearson Education, Inc. Publishing as Prentice Hall 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.

11-18 Copyright © 2010 Pearson Education, Inc. Publishing as Prentice Hall Historical Interest Rates Nominal interest rates have dropped somewhat over the past 20 years. Real rate of return can be calculated by subtracting the inflation rate from the nominal interest rate. Real rate of return can be negative.

11-19 Copyright © 2010 Pearson Education, Inc. Publishing as Prentice Hall Figure 11.1

11-20 Copyright © 2010 Pearson Education, Inc. Publishing as Prentice Hall How Interest Rates Affect Returns on Other Investments Expected returns on all investments are related. What you can earn on one investment determines what you can earn on another. Interest rates act as a “base” return. When interest rates go up, investors demand a higher return on other investments.

11-21 Copyright © 2010 Pearson Education, Inc. Publishing as Prentice Hall A Look at Risk-Return Trade-Offs 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

11-22 Copyright © 2010 Pearson Education, Inc. Publishing as Prentice Hall Historical Levels of Risk and Return Average annual return against risk or variability of returns Investments that produce higher returns have higher levels of risk associated with them.

11-23 Copyright © 2010 Pearson Education, Inc. Publishing as Prentice Hall Figure 11.2

11-24 Copyright © 2010 Pearson Education, Inc. Publishing as Prentice Hall Sources of Risk in the Risk-Return Trade-Off Interest rate risk Inflation risk Business risk Financial risk

11-25 Copyright © 2010 Pearson Education, Inc. Publishing as Prentice Hall Sources of Risk in the Risk-Return Trade-Off Liquidity risk Market risk Political and regulatory risk Exchange rate risk Call risk

11-26 Copyright © 2010 Pearson Education, Inc. Publishing as Prentice Hall Diversification The elimination of risk by investing in different assets. Allows extreme good and bad returns to cancel each other out. Reduced risk without affected expected return.

11-27 Copyright © 2010 Pearson Education, Inc. Publishing as Prentice Hall 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.

11-28 Copyright © 2010 Pearson Education, Inc. Publishing as Prentice Hall Figure 11.3

11-29 Copyright © 2010 Pearson Education, Inc. Publishing as Prentice Hall Understanding Your Tolerance for Risk Need to recognize your tolerance for risk and invest accordingly. Take one of many risk-tolerance tests Review your past actions

11-30 Copyright © 2010 Pearson Education, Inc. Publishing as Prentice Hall Figure 11.4

11-31 Copyright © 2010 Pearson Education, Inc. Publishing as Prentice Hall The Time Dimension of Investing and Asset Allocation As the length of the investment horizon increases, 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.

11-32 Copyright © 2010 Pearson Education, Inc. Publishing as Prentice Hall 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.

11-33 Copyright © 2010 Pearson Education, Inc. Publishing as Prentice Hall Figure 11.5

11-34 Copyright © 2010 Pearson Education, Inc. Publishing as Prentice Hall Asset Allocation How your money should be divided among stocks, bonds, and other investments. Investments diversified in different classes of investments. Common stocks more appropriate for the long-term horizon. Asset allocation is the most important investing task that is not a one-time decision.

11-35 Copyright © 2010 Pearson Education, Inc. Publishing as Prentice Hall

11-36 Copyright © 2010 Pearson Education, Inc. Publishing as Prentice Hall 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.

11-37 Copyright © 2010 Pearson Education, Inc. Publishing as Prentice Hall Figure 11.6

11-38 Copyright © 2010 Pearson Education, Inc. Publishing as Prentice Hall 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.

11-39 Copyright © 2010 Pearson Education, Inc. Publishing as Prentice Hall Figure 11.7

11-40 Copyright © 2010 Pearson Education, Inc. Publishing as Prentice Hall Asset Allocation and the Retirement Years (Over Age 65) Spending more than saving. Income primary, capital appreciation secondary. Safety through diversification and movement away from common stocks. Own 40% stocks, 40% bonds, 20% T-bills. Later own 20% common, 60% bonds, and 20% T-bills.

11-41 Copyright © 2010 Pearson Education, Inc. Publishing as Prentice Hall Figure 11.8

11-42 Copyright © 2010 Pearson Education, Inc. Publishing as Prentice Hall Figure 11.9

11-43 Copyright © 2010 Pearson Education, Inc. Publishing as Prentice Hall 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.

11-44 Copyright © 2010 Pearson Education, Inc. Publishing as Prentice Hall 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.

11-45 Copyright © 2010 Pearson Education, Inc. Publishing as Prentice Hall Checklist 11.1

11-46 Copyright © 2010 Pearson Education, Inc. Publishing as Prentice Hall Thinking Back to Principle 9: Mind Games and Your Money Overconfidence Disposition Effect House Money Effect Loss then Risk Aversion Effect Herd Behavior

11-47 Copyright © 2010 Pearson Education, Inc. Publishing as Prentice Hall 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.

11-48 Copyright © 2010 Pearson Education, Inc. Publishing as Prentice Hall Summary As your investment time horizon lengthens, invest in more riskier assets. Asset allocation ensures diversification and time dimension of investment in different classes. It is very difficult to beat the market and as a result you should keep to your plan and invest for the long term.