Muddy Points from Thursday FICA v. FICO? Define. The best-known and most widely used credit score model in the United States, the FICO score is calculated.

Muddy Points from Thursday FICA v. FICO? Define. The best-known and most widely used credit score model in the United States, the FICO score is calculated statistically, with information from a consumer's credit files. The score is sold by FICO, the company. FICO was founded in 1956 as Fair, Isaac and Company by engineer Bill Fair and mathematician Earl Isaac. Traded on the NYSE.

Muddy Points FICA Federal Insurance Contributions Act: –US Federal payroll tax imposed on both employees and employers –to fund Social Security and Medicare

Muddy Points If my econ class is only a semester long, how much detail do I need to spend on Annuity and Compound Interest equations? Economics course: –Assume: High school Responsible for PFL as well as straight economics

Standard 3: Economics Grade Level Expectation: High School 5. Analyze strategic spending, saving, and investment options to achieve the objectives of diversification, liquidity, income and growth. –Selected Evidence Outcomes & 21 st Century Skills: Investments available for diversified portfolio How economic cycles affect financial decisions Investments to achieve liquidity, growth, income. How compound interest manifests in investment and debt situations. Invest

Muddy Points Please provide recommended reading list for PFL instructors, including: –Case studies of individuals who have found great earning success. I do not know of resource to suggest. –Background information on how to motivate students toward rational financial choices. If the students have opportunity to make money, they are likely motivated.

Muddy Points Why are index funds capable of such low fees? –Do not have to hire high cost portfolio managers and researchers who pick the stocks. Merely buy the stocks in the Index –e.g., the S&P 500

Muddy Points Can we go over Wednesday’s [tax calculation] homework? –No!

Hultstrom Household Wage and Salary Income: $20,000 Other Income: $0 Purchases of Goods and Services: $15,000 Value of Land and House: $0 (renters) Income Tax: $1000 + ($10,000 x.20)= $3000 Payroll Tax: $20,000 x.06= $1200 Sales Taxes: $15,000 x.05 = $750 Property Tax: $0 x.01 = $0 Total Taxes: $3000 + $1200 + $750 + $0 = $4950 Net Income (after tax): $20,000 - $4950 = $15,050 Saving: $15,050 - $15,000 = $50

Rodriguez Household Wage and Salary Income: $60,000 Other Income: $0 Purchases of Goods and Services: $36,000 Value of Land and House: $100,000 Income Tax: $7000 + ($20,000 x.25) = $12,000 Detail behind this tax calculation?

Rodriguez Household Wage and Salary Income: $60,000 Other Income: $0 Purchases of Goods and Services: $36,000 Value of Land and House: $100,000 Income Tax: $7000 + ($20,000 x.25) = $12,000 How calculate the $12,000 income tax? $1000 + $6000 + $5000 10% of 1 st $10,000 20% of next $30,000 25% of last $20,000 $7000 + 25% on income from $40K to $100K

Rodriguez Household Wage and Salary Income: $60,000 Other Income: $0 Purchases of Goods and Services: $36,000 Value of Land and House: $100,000 Income Tax: $7000 + ($20,000 x.25) = $12,000 Payroll Tax: $60,000 x.06 = $3600 Sales Taxes: $36,000 x.05 = $1800 Property Tax: $100,000 x.01 = $1000 Total Taxes: $12000 + $3600 + $1800 + $1000 = $18,400 Net Income (after tax): $60,000 - $18,400 = $41,600 Saving: $41,600 - $36,000 = $5,600

Jones Household Wage and Salary Income: $200,000 Other Income (interest & dividends): $50,000 Purchases of Goods and Services: $140,000 Value of Land and House: $1,000,000 Income Tax: $22,000 + ($150,000 x.30) = $67,000 Payroll Tax: $100,000 x.06 = $6,000 Sales Taxes: $140,000 x.05 = $7,000 Property Tax: $1,000,000 x.01 = $10,000 Total Taxes: $67000 + $6000 + $7000 + $10000 = $90,000 Net Income (after tax): $250,000 - $90,000 = $160,000 Saving: $160,000 - $140,000 = $20,000

Proportional, Progressive, or Regressive? Income Tax: all income Hultstrom HH%Rodriguez HHJones HH $3000$12000$67000 3000/20000 = 15% 12,000 /60,000 = 20% 67,000/250,000 = 26.8% Progressive

Proportional, Progressive, or Regressive? Payroll Tax: wage & salary income Payroll Tax: all income –Regressive if there is any other income Since no payroll tax paid on other income Hultstrom HHRodriguez HHJones HH $1200$3600$6000 1200/20000 = 6%3600/60000 = 6%6000/200000 = 3% Proportional, up to $100K Regressive over $100K

Proportional, Progressive, or Regressive? Sales Tax: on purchases of goods & services Sales Tax: on all income Hultstrom HHRodriguez HHJones HH $750$1800$7000 750/15000 = 5%1800/36000= 5%7000/140000 = 5% Proportional Hultstrom HHRodriguez HHJones HH $750$1800$7000 750/20000 = 3.75%1800/60000= 3%7000/250000 = 2.8% Regressive

Muddy Points Do you have practice problems for the formulas? –YES … see the Handout that was on your table this AM. Good resource to read more about these? –Wikipedia “time value of money”

Practice with Time Value of Money (#1) Inherit $10,000. –Invest at 8% for 40 years. –Therefore: P n = P 0 (1+i) n = 10,000(1.08) 40 –Table A-3: n = 40, i = 8%  Factor: 21.725 P n = P(Factor) = $10,000 (21.725) = $217,250

Practice with Time Value of Money (#2) IRA has grown from $10,000 to $19,672 in 10 years. –Find the “total return” (or CAGR). –Therefore: P n = P 0 (1+i) n – 19,672 = 10,000(1 + i) 10 –Table A-3: n = 10, but we don’t know i. But we do know that: P n = P 0 (Factor) … therefore Factor = P n /P 0 = $19,672/$10,000 = 1.9672  Read across n = 10, looking for Factor = 1.9672 Result: i = 7%

Practice with Time Value of Money (#3) Find present value of $100,000 received 5 years from today. P 0 = Pn/(1+i) n = 100,000/(1.12) 5 Or, using Table A-1: –n = 5 and i = 12% –Factor: 0.5674 –Thus, P(Factor) = $100,000(0.5674) – = $56,740.

Five-Year Annuity 1234512345 P(1+i) 4 + P(1+i) 3 + P(1+i) 2 + P(1+i) 1 + P Factor in Table A-4 for n & i Year: P PPPP

Statement 9 At age 18, you decide not to purchase vending machine soft drinks &save $1.50 a day. You invest this $1.50 a day at 8% annual interest until you are 67. At age 67, your savings are almost $150,000. –Because of the power of compound interest, small savings can make a difference, about $300,000 in this case. False Save

50-Year Annuity 1920…….6768 P(1+i) 49 + P(1+i) 48 + … + P(1+i) 1 + P Factor in Table for n & i Age: P = $547.50 PP PPP

Use Annuity Table to Calculate Annuity: –n = 50 years – i = 8% –Factor: from the table: 573.77 –Annual annuity: 365 x $1.50 = $547.50 Value of Annuity = P (Factor) = $547.50 (573.77) = $314,139

Two Volunteers? Eat one at a time. After eating each one, note on piece of paper how good each successive one tastes – use of ranking of: 10 = absolutely delicious - the best 9 = really good, but not as good as a 10 8 = quite good, but not as high as a 9... and so on … 3 = only fair 2 = mediocre 1 = less than a 2 0 = my lowest taste ranking – no more satisfaction eating Like these?

Life is Full of Gambles: The Economics of Risk Go skiing –Risk breaking your leg Drive to work –Risk an auto accident Live in a house –Risk a fire Savings in stock market –Risk a fall in stock prices Savings in bonds –Risk a rise in interest rates Invest U.S. T-bills –Risk rapid inflation & loss of purchasing power

A Bet Anyone? A third party will flip a coin: –heads, I pay you $1,000 –tails, you pay me $1,000 Anyone want to play?

Risk Aversion Most people would reject this bet Why? Most people are risk averse –dislike bad things happening to them –But more specifically, –dislike bad things more than they like comparable good things –That is, the pain of losing $1,000 > pleasure from winning $1,000

Data from Our Volunteer “Law of Diminishing Marginal Utility” –or, diminishing marginal satisfaction

The cartoons even address marginal utility!

Definition Marginal benefit (utility, satisfaction): the added benefit gained from one more unit –let’s assume your ranking (1 to 10) is also your marginal utility or satisfaction received from each cup

Another Example from Previous Experiment For Reese’s Butter Cups How much you like (0 – 10) each added cup –Last class volunteer ate 5 cups … data next slide

Quantity Marginal Benefit Total Utility 110 2818 3624 4428 5129 60 Marginal and Total Utility

Utility 35 30 25 20 15 10 5 0 Quantity of Cups 0 1 2 3 4 5 6 QMBTU 110 2818 3624 4428 5129 60 Diminishing marginal utility … total utility rises, but at diminishing rate

Utility 35 30 25 20 15 10 5 0 Wealth 0 1 2 3 4 5 6 Total utility Suppose we measure wealth on the horizontal axis

Risk Aversion is Common Most people have diminishing marginal utility  basis for risk aversion in most people Logic: –Dollar gained when income is low adds more to utility than a dollar gained when income is high –Having an additional dollar matters more when facing hard times than when things are good –Insurance: transfers a dollar from high-income states (where it is valued less) to low-income states (where it is valued more)

Dealing with Risk Aversion 1. Buy Insurance: –Person facing risk pays a fee to insurance company Which agrees to accept all or part of financial risk –Types of insurance: Health, Automobile, Homeowner (Renter), Disability, Life Living too long (fee paid today, annuity until die)

Insurance Activity The Insurance Game: Is Insurance Worth Buying? Divide into 9 Groups of 4 each (one 3) Distribute: –One complete deck of cards to each Group

The Situation You are a young single person –earning an annual income of $24,000 –living in a rented apartment You will have to decide: –What types of insurance, if any, you want to buy and what level of coverage for each type

Risk: Possibility of Financial Loss Risks you face: displayed on Visual 10 – 1 –Visual shows what could happen to you

Activity Procedure Each person select insurance & level of coverage –Applies throughout the activity Each year: –A card is randomly drawn in each group  what happens that year to each person in group –e.g., “8” drawn  each person needed: »10 office visits ($200 x 10) + $6,000 hospital = $8,000, if no health insurance –Note: replace the card into deck for the next year’s draw

Activity Procedure (continued) “Double” card events (e.g, “K-K”): –only occur if that card is drawn in consecutive years possible in year 2 and beyond, for example: –Year 1: K drawn  major fire causes $4K damages –Year 2: K drawn  K - K has occurred  one-year major disability costing $24,000 in income

Activity 10 – 1: Insurance Different types (5) of insurance from which to choose : –Health –Automobile –Renter’s –Disability –Life Within each, several options for amounts of coverage –As coverage rises  premium rises due to higher insurance company payout –NOTE: premiums shown are annual, covering you one year

Types of Insurance & Terms Health –Co-pay: amount you pay for each office visit –Hospitalization: insurance company pays % shown Automobile –Deductible: amount you must pay due to accident Insurance company pays anything above deductible –combine comprehensive and collision for simplicity Liability: protects from damages you cause others up to amount shown –you are responsible for additional

Types of Insurance Renter’s Insurance –Deductible: amount you have to pay on loss Insurance company covers above deductible Covers: loss of personal property Disability Insurance –Each unit coverage pays $500 /mo for lost income Maximum of 4 units = $2,000/month  $24,000/year Life Insurance –Each unit pays beneficiaries $10,000

Weigh Benefit vs. Cost in Making Insurance Decision B(X)C(X) Reduce losses when “bad things” happen to you - see Activity 10 – 1 Insurance Premiums you pay - see Activity 10 – 1 Forgetting anything …??

Choice involves cost » choosing is refusing » choose to buy insurance » refuse to invest $ spent on premiums » suppose could earn 10% » $1,000 on premium  $100 return foregone Key Economic Concept Revisited

Weigh Benefit vs. Cost in Making Insurance Decision B(X)C(X) Lower losses when “bad things” happen - see Activity 10 – 1 Insurance Premiums paid + Lost Return on Premium In our example: $1,000(1 + 0.10) = $1,100

Now Ready to Complete Activity 10 – 1 Decide what types & levels of coverage you desire –RESTRICTION: ALL states require basic liability coverage with car insurance, so you must choose at least Option 3 Since no way of knowing what will happen to you, there is no exact right amount of insurance –Goal: buy enough coverage to protect yourself from losses, but not so much that you end up spending far more on insurance than it is worth. Compare B(X) v. C(X) & make choice with which you are comfortable

Activity 10 – 2 Enter the Total Annual Insurance Premiums (bottom of Activity 10 – 1) for every year in Column (1) of Activity 10 – 2. –i.e., premium is constant throughout Then, complete Column (2) for every year –opportunity cost constant throughout

Your Life is About to Begin Each year – shuffle the deck, then one person in each group draw one card at random –Each person in group experiences same event depicted in Visual 10 – 1. –Then: Fill in Column (3) –actual loss if you had no insurance Fill in Column (4) – actual loss if you had insurance –Same event for all in group, but since not same coverage, Column (4) may differ for each member –Each group is experiencing a different “life”

Conduct 8 Years Completing Columns (3) – (4) after each year’s draw After completing 8 years: –Sum the values in Column (4) –Fill in the blanks at the bottom of Activity 10 – 2 Questions? Begin...

Bar Chart Activity

Comparing Losses With & Without Insurance (four students – min insurance to max insurance) Based on a sample running of game

Activity Debrief Who is really happy that you bought the insurance you did? Who wishes you would have purchased a lot less insurance?

The Nature of Insurance If you experienced particularly costly events, likely happy if you bought a lot of insurance –Losses without insurance would have been much bigger If you experienced fairly inexpensive events, likely unhappy if you bought a lot of insurance –Losses without insurance would have been much less.

Premiums Based on Expected Payouts of Insurance Company (plus operating cost and profit) Thus, –There must be some people who pay more in premiums than they get back in claims and perhaps feeling they shouldn’t have purchased so much coverage –The insurance company uses this extra premium to pay the claims of those who pay less in premiums than claims.

Insurance Every insurance contract is a gamble: –Possible that you will not have accident –Most years you pay premium get nothing in return, except peace of mind –Insurance company counting on fact that most people will not make claims or they couldn’t survive

Insurance & the Economy Insurance: –Does not eliminate risk but spreads it around –For example: Owning fire insurance does not reduce the risk of losing your home in fire –You could suffer “moral hazard” – take less care due to insurance But if the unlucky event occurs, –the insurance compensates you Risk shared among thousands of insured people

Simple Insurance Example Assume: –100 young people all face the same risk of loss statistically, only 1 accident occurs per year if an accident occurs, the injured party has an accident loss of $2,000 –such a loss is catastrophic for one person to bear Idea: let’s spread the risk (insurance) –Since one accident occurs per year Our “society” incurs a loss of $2,000 per year So, –each of the 100 people pay an “insurance premium” of: »$20 per year

A Little More Reality The “society” decides that the burden of administering their internal insurance plan is too great –getting collections of premiums, etc. So, one person (an entrepreneur) says, “I’ll handle all the details if you pay me $500 per year.” Now, what happens to the premiums? –$2,500/100 = $25 –Greater than the expected loss of each person: (Prob of accident) x ($ loss if accident) = 0.01($2,000) = $20

What Should We Insure? Since cost of insurance > expected loss NOT a fair game! Insurance is NOT a fair bet! –So, most economists recommend insurance for: large potential losses where you will be severely impacted if accident occurs – catastrophic loss –e.g., Cancer or Liability But don’t necessarily insure small risk events –that you could self-insure

Over- insure? 34.4% of new-car buyers bought extended-warranty –up from 23.5% in 1999 With the average car dealer now losing money (or making little) on each car sale, selling extended warranties is an important source of dealer profits –65% of respondents said they spent significantly more for the new-car warranty than they got back in repair savings

Early Retirement Less time to build nest egg More time to live off nest egg –(But, studies find people who retire earlier live shorter lives) → early retirement is a risky choice later retirement is less risky choice Retirement Data from the Department of Labor Statistics This trend is likely to continue going forward. Age RangeLabor Force Participation Rate (%) 19882012 55 – 6454.664.5 65 – 7416.026.8 Over 754.37.6

Problem: Criteria RiskReturnLiquidityIncome Bonds Stock Savings Acct How to Invest My Savings Alternatives

Risk... comes in many forms –Liquidity risk, default risk, purchasing power risk... In this session we’ll only address a couple more types

Purchasing Power Risk Inflation risk –T-bills (zero-coupon) have very little volatility risk

Recent 10-Year Period 2002–2011 0.50 $3 20022004200620082010 $1.20 1 Treasury bills 1.8 Past performance is no guarantee of future results. Hypothetical value of $1 invested at the beginning of 2002. Assumes reinvestment of income and no transaction costs or taxes. This is for illustrative purposes only and not indicative of any investment. An investment cannot be made directly in an index. © 2012 Morningstar. All Rights Reserved. 3/1/2012

Purchasing Power Risk Inflation risk –T-bills (zero-coupon) have very little volatility risk, but May not keep up with inflation  Lose purchasing power.

Recent 10-Year Period 2002–2011 0.50 $3 20022004200620082010 $1.20 1 Treasury bills $1.28 Inflation 2.5 1.8 Past performance is no guarantee of future results. Hypothetical value of $1 invested at the beginning of 2002. Assumes reinvestment of income and no transaction costs or taxes. This is for illustrative purposes only and not indicative of any investment. An investment cannot be made directly in an index. © 2012 Morningstar. All Rights Reserved. 3/1/2012

Purchasing Power Risk Inflation risk –T-bills (zero-coupon) have very little volatility risk, but May not keep up with inflation  Lose purchasing power. –Coupon bonds also face inflation  interest rate risk

0.10 1 10 100 1,000 192619361946195619661976198619962006 Stocks, Bonds, Bills, & Inflation: 1926–2012 Govt bonds 5.7 Treasury bills 3.56 $21 Past performance is no guarantee of future results. Hypothetical value of $1 invested at the beginning of 1926. Assumes reinvestment of income and no transaction costs or taxes. This is for illustrative purposes only and not indicative of any investment. An investment cannot be made directly in an index. © 2012 Morningstar. All Rights Reserved. 3/1/2012 Ibbotson ® SBBI ® CAGR (%) $10,000 $123

Why Do So Many Fear the Stock Market? It’s a dangerous, volatile place –… thousands of sophisticated traders and brokers lurk to steal your hard-earned money! Many call it “gambling!” But maybe the real source of fear is...

Adults Invested in the Stock Market

Market Volatility Risk

1 192619361946195619661976198619962006 Smooth and Steady: 1926–2012

1 192619361946195619661976198619962006 A Bumpy Ride: 1926–2012

Why Would Anyone Take This Risk? In High School saving for college In college and now need the money

Another spot to conduct this activity Raise the benefit –Now, B(X) > C(X), Choose the bar with the reward! –where B(X) = benefit of action X

Key Economic Concept s People respond to incentives

Would You Ride a Bull? –F or $5? –for $50? –for $500? –for $5,000? –for $50,000? Likely to get more risk takers as the reward rises!

Since Choice has a Cost Why choose it? People choose X if: B(X) > C(X) B(X)C(X)

Greater Return...  accept the risk of: –Riding the Bull –Riding the Roller Coaster … or

0.10 192619361946195619661976198619962006 Stocks and Bills: 1926–2012 $21 Large stocks 9.8 Treasury bills 3.56 CAGR (%) $3,533

0.10 1 10 100 1,000 192619361946195619661976198619962006 Stocks, Bonds, Bills, & Inflation: 1926–2012 $13 Small stocks 11.9 Large stocks 9.8 Govt bonds 5.7 Treasury bills 3.5 6 Inflation 3.0 $21 Past performance is no guarantee of future results. Hypothetical value of $1 invested at the beginning of 1926. Assumes reinvestment of income and no transaction costs or taxes. This is for illustrative purposes only and not indicative of any investment. An investment cannot be made directly in an index. © 2012 Morningstar. All Rights Reserved. 3/1/2012 Ibbotson ® SBBI ® CAGR (%) $10,000 $18,365 $3,533 $123

Strategies for Dealing with Risk

Time $ 1. Market Timing: Buy low, sell high! Try to take advantage of volatility by “timing”

How Do Investors Fare? (Study by Dalbar, Inc.) 1984 – 2000: –S&P 500 (geometric mean ≡ total return) + 16.3% –Avg stock mutual fund investor (IRR): + 5.3% What’s happening?

Mutual Fund Merry-Go-Round Possible explanation: –Investors lack discipline to “buy and hold” Chase the HOT fund, but –This year’s star is next year’s dog

Hot-Hand Fallacy: Chasing Fund Performance © 2011 Morningstar. All Rights Reserved. 3/1/2011 $10,000 in Mutual Fund Cash flows 10-year mutual fund total return = 6.94% –3 0 1 2 3 4 5 $6 billion –1 200820012002200320042005200620072009 0 10 20 25 40 $45k 35 30 15 5 2010 –2 10-year average investor return = – 20.24%

Dangers of Market Timing 1926–2009 $2,573 0 500 1,000 1,500 2,000 2,500 $3,000 S&P 500 $19.66 S&P minus best 37/1,008 months $20.53 Treasury bills $1.00 invested in 1926 in S&P 500 © 2010 Morningstar. All Rights Reserved. 3/1/2010 Ibbotson ® SBBI ® $1(1.098) 84

Advice Worth Heeding! “I’ve seen people get famous for being right once in a row.” “Smart investing doesn’t consist of buying good things, but rather of buying things well. Price is what matters most for investment success.” Howard Marks

Can you predict this?! Market Timing?

Geometric Mean – Common Use Mutual funds & financial analysts refer to as: –“total return” –“compound annual growth rate” (CAGR) a time-weighted rate of return nothing added or withdrawn during the period e.g., started with $1.00... –did not deposit or withdraw –did not withdraw any interest or dividends Reasonable measure of mutual fund management because it ignores variables that are outside the manager’s control

Is Geometric Return Good for Evaluating Individual Investor Performance? Total return: –computed by assuming that investors deposit money at the beginning of the period –and pursue a buy-&-hold strategy Many investors deposit & withdraw funds –i.e., many investors do NOT buy & hold –need a “dollar-weighted” rate of return that takes into account the flow of funds in & out

Example: Investor Facts Purchased 100 shares of mutual fund @ $20 During 1 st year, fund’s P rises by 30%, to $26 Begin of 2 nd year, purchase 200 shares @ $26 During 2 nd year, P fell by 4% to end @ $24.96 End year 2: investor sells all shares @ $24.96 Summary Begin Year 1Begin Year 2End Year 2 Deposit: $2,000Deposit: $5,200Withdraw: $7,488

Evaluating the Fund Manager Use geometric return ≡ Total Return ≡ time-weighted return Year 1: +30% Year 2: - 4% Thus, $1(1+.3)(1-.04) = $1.248 To solve for total return: $1(1+i g ) 2 = 1.248 1 + i g = 1.248 (0.5) = 1.117 Thus, i g = 0.117, or 11.7% Reasonable measure of mutual fund management because it ignores variables outside the manager’s control $1(1+i 1 )(1+i 2 )

Is Total Return a Good Measure of Our Investor’s Performance? When there are cash flows into & out of an account, –we must use “internal rate of return” (IRR) calculation. Definition of IRR: –The rate of interest that satisfies the condition that the sum of the present value of the outflows is equal to the sum of the present value of the inflows. –Math Behind the Market, p. 60 –or –the interest rate that makes the net present value of an investment equal zero.

Setting Up IRR Begin Year 1Begin Year 2End Year 2 Deposit: $2,000Deposit: $5,200Withdraw: $7,488 The interest rate that makes the net present value = 0

Solution This particular problem could be solved by using quadratic formula, however –Many more complicated problems must be solved through computer iteration Using Microsoft Excel: IRR = IRR(-2,000, -5,200, 7,488) = 0.031 –i.e, the investor earned 3.1% per year IRR

Total Return v. Investor Return In this example, –the geometric return (total return) is: 11.7% –time-weighted, assumes buy-and-hold by investor –the IRR (Investor Return on Morningstar) is: 3.1% –a dollar-weighted return Why such a significant difference? –Many investors chase hot funds...

Recall: Investor Facts Purchased 100 shares of mutual fund @ $20 During 1 st year, fund’s P rises by 30%, to $26 Begin of 2 nd year, purchase 200 shares @ $26 During 2 nd year, P fell by 4% to end @ $24.96 End year 2: investor sells all shares @ $24.96 Chase what’s hot … –first year:30% return: buy, buy, buy –second year:- 4% return –end 2 nd year:it’s down:sell, sell, sell

Study by Dalbar, Inc. Geometric mean return: S&P 500 recent 20 year period (1988 – 2008) –≈ 12% i.e., if buy and hold, earn 12% annual rate of return Average investor return (IRR) –takes into account inflow & outflow i.e., chasing hot funds! –≈ 4%

Prudent Strategies to Deal with Risk 2. Invest for the Long Term... if you think long-term, the ups exceed the downs. or, spread risk over more years!

 Focus on short-term instead of long-term risk Result: Time-inconsistent behavior  Interest in long term but act short term  Overly sensitive to recent volatility  Act as though time horizon far shorter than it is Short-Term Focus

When shown a distribution of 1-year returns When shown a distribution of 30-year returns Stocks Short-Term Focus Source: Shlomo Benartzi and Richard H. Thaler, “Risk Aversion or Myopia? Choices in Repeated Gambles and Retirement Investments,” March 1999. 40% 60% 10% 90% Bonds

Reduction of Risk Over Time 1926–2006 Small stocksLarge stocksGovernment bondsTreasury bills -60 -30 0 30 60 90 120 150% 1-year Holding period 5-year20-year1-year5-year20-year1-year5-year20-year1-year5-year20-year 12.7% 10.4% 5.4% 3.7%

1926–2009 Geometric Return Arithmetic annual return Standard Deviation 12.3% 17.4% 5.8% 3.8% 3.1% Treasury bills 3.7% 3.1% Large stocks Government bonds Inflation 9.8% 5.4% 3.0% 20.5% 9.6% 4.2% –90% 0 90% Small stocks* 11.9%32.8% *Small company stock total return (1933) = 142.9%. Histograms Largest Standard Deviation? Smallest Standard Deviation?

Nominal GDP & the S&P 500

Prudent Strategies to Deal with Risk All money in one stock? –Could spill all the eggs Don’t Put All Your Eggs in One Basket

It Can Be Tempting! All Your Eggs in One Basket? –Great if you “hit it big” Wal-Mart –If you had purchased $1,000 of Wal-Mart stock in 1970 at its IPO –held it through 1999, would have grown to: » over $6,000,000! Not so great if things go south –Enron

Prudent Strategies to Deal with Risk Diversify across asset class –Stocks and bonds Diversify within asset class –Stock from different industries Don’t Put All Your Eggs in One Basket 3. Diversify

Benefit of Diversification Time $

Cost of Diversification Time $

$9.31 $6.25 $3.72 $20 10 1 1987 199 219972002 Diversified Portfolios 1987–2006 11.8% 9.6% 6.8% Portfolio 1 (100% Stocks) Portfolio 2 (50% Stocks, 50% Bonds) Portfolio 3 (100% Bonds – 5 yr.)

A Bull Market “Characterized by optimism, investor confidence and expectations that strong results will continue. The use of “Bull” to describe markets comes from the way bulls attack their opponents. A bull thrusts its horns up into the air. These actions are metaphors for the movement of a market. If the trend is up, it’s a “bull market.”

A Bear Market Downward trend in the market that investors believe will continue in the long run, which, in turn, perpetuates the spiral. Downturn of 20% or more in multiple broad market indexes, such as the DJIA or S&P 500, over at least a two- month period –not to be confused with a correction a short-term trend with duration < two months A bear will swipe its paws downward upon its unfortunate prey

Diversification – Cost & Benefit $3,000 Bull market 2,500 2,000 1,500 1,000 500 1996 1997 19981999200020012002 250 500 750 1,000 1,250 $1,500 $1,181 $2,555 $624 $1,484 $1,763 $985 Stocks 50/50 portfolio Bonds Bear market

Risk & Return Diagram 12 10 8 6 4 57911131517 Return (%) Risk (% standard deviation) 100% Bonds 100% Stocks 8.4 60% Stocks 40% Bonds ?

12 10 8 6 4 57911131517 Return (%) Risk (% standard deviation) 100% Bonds 100% Stocks 8.4 60% Stocks 40% Bonds 5.92 The Efficient Frontier If there were no benefit from diversification, then we would lie upon this linear combination of bonds and stocks

Actual Stock Market: 1970–2006 13 12 11 10 9 11121314151617 100% Stocks 80% Stocks, 20% Bonds 100% Bonds 60% Stocks, 40% Bonds 50% Stocks, 50% Bonds 25% Stocks, 75% Bonds Return (%) Risk (% standard deviation) Efficient frontier

What Makes This Work? How can we combine stocks and bonds –and get a portfolio mean return that is the weighted average of the stocks and bonds –but the standard deviation (volatility) is lower than either stocks or bonds?

Correlation is High in Crisis

Diversified Portfolios in Various Market Conditions Performance during and after select bear markets Past performance is no guarantee of future results. Diversified portfolio: 35% stocks, 40% bonds, 25% Treasury bills. Hypothetical value of $1,000 invested at the beginning of January 1973 and Nov 2007, respectively. This is for illustrative purposes only and not indicative of any investment. An investment cannot be made directly in an index. © 2011 Morningstar. All Rights Reserved. 3/1/2011 Mid-1970s recession (1973–76) 2007 bear market & aftermath (Nov 2007–Dec 2010) $ 1,150 $1,014 $1,072 $872 $1,250 1,000 750 250 Jan 1973 Jan 1974 Jan 1975 Jan 1976 Nov 2007 Nov 2008 Nov 2009 Nov 2010 Stocks Diversified portfolio 500 35% stocks, 40% bonds, and 25% Treasury bills

Risk & Stock Diversification 1 2 4 6 81630501001000 Number of stocks in portfolio Market Risk Diversifiable Risk

Too Much of a Good Thing? Diversification has benefits, but …

Over-Diversification? Peter Lynch refers to “di-worse-ification” – mutual funds might purchase so many separate companies Selecting companies lower on value list –dilutes return

How Achieve Diversification? Passive management approach –“index funds” Achieve “market” rate of return –Slightly below, due to cost Active management approach –Assumes can “beat the market” –Tough to do. –Higher costs due to portfolio selection

“Beauty Contest” Rules of the Game: –Each player will select a number from 0 to 100 –Winner is the player whose number is closest to the number that is 70% of the average of all player chosen numbers.

Active Management A. Do it yourself: –Adequate diversification requires > $50,000 –NASD survey People overestimate their abilities/understanding –Expensive hobby – why do it yourself? Maybe you can beat the market!? You want to learn for later career You simply have fun with it

Active Management B. Professional management –Investment adviser Typical fee: 1% of asset value –Mutual fund

Diversify with Mutual Funds Mutual fund pools investors’ money Puts it into the markets on your behalf –you own small amounts of many different assets Good way to avoid the risk that comes from owning any one asset

Picking Mutual Funds? Check on web sites for fund –e.g., Fidelity.com, Vanguard.com, Roycefunds.com Factors to consider: –Longevity/stability of fund managers –Management investment philosophy Long-term focus; not over diversified –Management track record –Expense ratios: preferably less than average of 1.5% –Portfolio turnover: preferably below 20% –Preference for “no load” funds

Small Sample of Funds Locate names of funds through –Recommendations From other friends From Wall Street Journal, or other articles –Search recommendations by: Morningstar.com Other firm –Then, review web page of fund for information... Not necessarily recommended, –although appeared satisfactory at one time

Equity Income Fund Objective: –provide substantial dividend income as well as long-term capital appreciation through investments in common stocks of established companies. Turnover rate: 12% of fund –% of fund bought and sold during year

Fund Performance (through March 2013) T. Rowe Price: – 5-year total return: 5.5% –10-year total return: 9.0% –Since 1985: 11.0% Benchmark: S&P 500 –5-year total return:6.0% –10-year total return : 8.0% –Since 1985: 10.5% Minimum amount required to open an account: $2,500 IRA minimum: $1,000

Investment Philosophy This fund offers a relatively conservative, value-oriented way to pursue substantial dividend income and long-term capital growth potential. It invests in common stocks of established firms that are expected to pay above-average dividends. By investing in stocks that appear to be out of favor or undervalued, the fund should be less volatile than one investing in growth stocks. If, as the manager expects, the underpriced holdings regain favor in the marketplace, their stock prices may rise—providing capital appreciation opportunities. The value approach carries the risk that the market will not recognize a security’s true worth for a long time, or that a stock judged to be undervalued may actually be appropriately priced. Price/earnings or P/E ratio: 13.8

Top 10 Holdings AT&T Apache Chevron Exxon Mobil General Electric International Paper JPMorgan Chase Royal Dutch Shell US Bancorp Wells Fargo

Financials 20.3% Industrials & Busn Services 14.0% Energy 13.8% Consumer Discretionary 10.4% Information Technology 8.0% Health Care 6.9% Utilities 5.9% Consumer Staples 5.6% Materials 4.6% Telecommunication Services 3.8% Sector Diversification

Portfolio Manager Brian C. Rogers B.A., Harvard College M.B.A., Harvard Business School –Managed Fund Since: 10/31/1985

Longleaf Partners Value investors. –long-term performance time horizon when purchasing a company is five years –well-managed companies –market prices < 60% of intrinsic value mid to large cap companies significantly undervalued. sell stocks when approach our appraisal. –generally own 25 or fewer stocks concentrated portfolios for two main reasons –limit the portfolios to our very best ideas, –know the companies we own extremely well. Investment Philosophy

Fund Performance Longleaf Partners: – 10-year avg:15.1% Benchmark: S&P 500 –10-year avg : 12.1% Minimum amount required to open an account: -- closed to new investors Longleaf Partners

Asset Allocation Common stocks73% Short-term securities/cash27% Longleaf Partners

Top Ten Stock Holdings CompanyIndustryHoldings Vivendi Telecomm & Entertainment 6.6%Vivendi Philips Electronics Electronics Manufacturer 6.2%Philips Electronics FedEx Corporation Time Sensitive Package Delivery 5.8%FedEx Corporation Walt Disney Entertainment and Broadcasting 5.7%Walt Disney Comcast Corporation Broadband Cable Operator 5.2%Comcast Corporation Yum! Brands Franchisor/Owner Taco Bell, KFC, PH 5.2%Yum! Brands NipponKoa Insurance Co. Japanese Non-Life Insurance 4.8%NipponKoa Insurance Co. DIRECTV Satellite Broadcaster 4.5%DIRECTV General Motors Finance, Truck, & Auto Businesses 3.9%General Motors Aon Insurance Brokerage and Consulting 3.9%Aon Total: 51.8% Longleaf Partners

To Summarize

How much one saves out of income Three Key Variables P n = (1 + i) n P 0

Three Key Variables P N = (1 + i ) n P 0 Interest rate, i –Compound interest is powerful –e.g., consider 2 cases: one-time investment of $10,000 for 40 years –A invested at 8% –B invested at 5%

Power of Compounding: Importance of i 2010 - 2050 Years invested: Amount Contributed: Rate of return: $0 $50,000 $100,000 $150,000 $200,000 $250,000 $300,000 $10,000 $217,245 Investment B 40 $10,000 8% $10,000 $70,400 Investment A 40 $10,000 5% P N = P 0 (1+i) n = $10,000(1.05) 40 P N = $10,000(1.08) 40

0.10 1 10 100 1,000 $10,000 192619361946195619661976198619962006 $2,982 $21 9.9% Large stocks T-bills 3.6% Ibbotson ® SBBI ® 142 times greater! U.S. T-Bills & S&P 500, 1926–2010 2.7 times greater © 2011 Morningstar. All Rights Reserved. 3/1/2011

0.10 1 10 100 1,000 $10,000 192619361946195619661976198619962006 Ibbotson ® SBBI ® Have Been Focused on Market Volatility Risk Can avoid volatility risk with T-Bills © 2011 Morningstar. All Rights Reserved. 3/1/2011

0.10 1 10 100 1,000 $10,000 192619361946195619661976198619962006 $21 T-bills 3.6 Compound Annual Return (%) $12 Inflation 3.0 Ibbotson ® SBBI ® Inflation risk –maintain purchasing power However, “Every Choice Has a Cost!” © 2011 Morningstar. All Rights Reserved. 3/1/2011 Real return 0.6

0.10 1 10 100 1,000 $10,000 192619361946195619661976198619962006 Dealing with Inflation Risk? Mind the Gap in Rates of Return $2,982 $21 $12 12.1% 9.9 5.5 $93 Small stocks Gov’t bonds Inflation Large stocks T-bills 3.6 $16,055 3.0 Ibbotson ® SBBI ® © 2011 Morningstar. All Rights Reserved. 3/1/2011

Two Key Variables P N = (1 + i) n P 0 Interest rate, i Length of investment, n –Start early to benefit from compounding –Consider investors A & B –Both invest in S&P 500: A invests $2,000 per year from 1990 - 1999, then watches grow. B invests $4,000 per year from 2000 - 2009. –Note: these are “annuities”

Power of Compounding: Importance of n Years contributing:10 Annual contribution:$2,000 Years contributing:10 Annual amount contributed: $4,000 Investor BInvestor A $40,000 $42,118 $20,000 $60,759 0 20 40 60 80 100 120 $140k 1990 – 20092000 – 2009 Investor AInvestor B Invested in S&P 500

Two Key Messages from Compound Interest Story Save and Invest... – Early Consider... – Stocks

Conclusion Take a long-term perspective Reinvest interest, dividends Do not remove principal Don’t chase the hot fund! Recognize the importance of: Starting early, and Minding the gap – pay attention to rates of return –some stocks (via mutual/index funds) in portfolio Diversify –Through mutual funds

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Muddy Points from Thursday FICA v. FICO? Define. The best-known and most widely used credit score model in the United States, the FICO score is calculated.

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