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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

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Goal Setting

• Write them down and then ask

– Consequence of failing?– Willing to make necessary sacrifices?– How much money needed?– When?

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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

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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

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What’s Important to You?

• Liquidity and safety

• Current versus future income

• Capital growth

• Diversification

• Marketability

• Ease of management

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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

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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

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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

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Common Stock

• Common stockholders own the company and elect directors

• Returns come from increase in market value and dividends

• Rate of return equalsEnd value – Begin Value + Dividends

Beginning Value

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Annual Rates of Return1926 to 2000

Avg Ann Stand RiskSecurity Returns Dev PremSmall Co Stocks 17.3% 33.4% 13.4%Common Stock 13.0 20.2 9.1L-T Corp Bonds 6.0 8.7 2.1L-T Govt Bonds 5.7 9.4 1.8Med-term Govt 5.5 5.8 1.6US T-Bills 3.9 3.2 0Inflation 3.2 4.4

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Average Annual Returns1926 - 2000

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2004

• Dow – 30 Industrials +3.15%

• S&P 500 +8.99

• S&P Small Cap +21.59

• Treasury Bonds flat

• Dollar down

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2005

• My guess – stocks up modestly (5 to 10%); bonds down

• Wild cards– Inflation– Corporate earnings– Interest rates– Exchange rates

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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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Total Risk in Stock_______________

Systematic Risk

Or Market Risk

Cannot be eliminated by buying different

stocks

Unsystematic Risk or

Company Unique Risk

Eliminated by buying different stocks

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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

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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