1 Chapter 11 – Investment Basics Investment is something that generates a return through dividends, interest and/or market appreciation –Speculation – a bet price will go up or down Financial Planning – everything begins with your goals –Checklist: set goals, focus on time frame, be realistic, risk appetite, taxes, reality of plan

2 Goal Setting Write them down and then ask –Consequence of failing? –Willing to make necessary sacrifices? –How much money needed? –When?

3 Starting the Program Longer you postpone, harder to reach goal –Time is your best ally Set aside savings first, can spend the rest Take advantage of Uncle Sam and employer –Tax–free or tax-deferred –Company match savings plans

4 Personal Profile Age and stage in career Need for liquidity and cash flow needs Size of portfolio Income tax bracket Required rate of return Your risk tolerance

5 What’s Important to You? Liquidity and safety Current versus future income Capital growth Diversification Marketability Ease of management

6 Types of Investments Lending investments – fixed returns known in advance; has maturity date Ownership investments – stocks and real estate (but illiquid) Stocks – ownership interest in a corporation –As profits and dividends increase, so should price; no upside limit

7 Bonds Pay interest periodically – Usually semiannually Often fixed for life of the bond At maturity repay principal Many, many kinds and features Subject to different types of risk As interest rates rise, bond prices fall

8 Interest Rates Nominal yield is the quoted rate, such as a bond yielding 10% Starts with risk-free rate – return with no risk such as short-term Treasury bills –To get to the nominal rate, add premiums for inflation, default, maturity and liquidity risks to risk-free rate Real rate – nominal rate less inflation

9 Common Stock Common stockholders own the company and elect directors Returns come from increase in market value and dividends Rate of return equals End value – Begin Value + Dividends Beginning Value

10 Annual Rates of Return 1926 to 2000 Avg Ann Stand Risk Security Returns Dev Prem Small Co Stocks 17.3% 33.4% 13.4% Common Stock L-T Corp Bonds L-T Govt Bonds Med-term Govt US T-Bills Inflation

11 Average Annual Returns

Dow – 30 Industrials+3.15% S&P S&P Small Cap Treasury Bondsflat Dollardown

My guess – stocks up modestly (5 to 10%); bonds down Wild cards –Inflation –Corporate earnings –Interest rates –Exchange rates

15 Diversification Purchase a variety of securities –Good and bad returns cancel each other –Reduces risk but not returns You cannot eliminate all risk –Stock prices tend to move together –If have 25 – 30 stocks, adding one more does not reduce risk by much.

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19 Investment Time Horizon Time horizon -very important –More volatility over one year than in 20 As time horizon increases, can take more risk –Time horizon has important role in determining how to invest savings Attitude towards risk varies by person

20 Time- phased Allocations Wealth acquisition period (up to 54): –Author recommends 80% in stocks Approaching retirement (55 – 64): –Preserve wealth – 60% stocks, 40% bonds Retirement (65 and over): –40% stock, 40% bonds, 20% short-term