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Copyright Leslie Lum
The Roadmap
• Focus on financial goals
• Understand returns
• Understand and learn to like risk
• Asset allocation NOT investment selection
• Improve after-tax returns
• Monitor your investments
Copyright Leslie Lum
How are we doing at savings?
Net Saving as a Percent of Gross National Income
0
2
4
6
8
10
12
14
16
18
1940 1946 1952 1958 1964 1970 1976 1982 1988 1994 2000
Copyright Leslie Lum
Could we save more?Domestic Savings
0%
5%
10%
15%
20%
25%
30%
35%
40%
45%
Belgiu
mBra
zil
Canad
a
China
Czech
Republic
Denmar
k
France
Germ
any
Irela
ndIta
ly
Japan
Netherla
nds
Singap
ore
Sweden
Switzerla
ndU.K
.U.S
.
% o
f 19
99 G
DP
Source: World Bank - Genuine Domestic Savings
Copyright Leslie Lum
One Two Three Four Five
Average annual expenditures 23,657 43,693 47,406 55,201 52,565
Food 2,831 5,432 6,173 7,472 8,178
Food at home 1,525 3,128 3,664 4,472 5,157
Food away from home 1,306 2,304 2,509 3,000 3,020
Alcoholic beverages 280 468 419 436 358
Housing 8,768 13,536 15,596 18,322 16,930
Apparel and services 837 1,547 1,916 2,503 2,698
Transportation 3,839 8,683 9,562 10,459 10,185
Health care 1,558 3,093 2,532 2,581 2,379
Entertainment \2 1,041 2,421 2,263 2,821 2,554
Personal care products and services 316 563 603 693 689
Reading 93 159 130 135 110
Education 498 597 938 1,426 1,119
Tobacco products and smoking supplies 193 310 351 329 364
Miscellaneous 423 650 658 801 661
Cash contributions 1,032 1,810 1,179 1,270 1,385
Personal insurance and pensions 1,948 4,424 5,087 5,952 4,956
Personal taxes \1 1,592 3,701 2,332 2,838 1,444
Copyright Leslie Lum
Annual Budget vs Long-Term Financial Goals
• Trade off between spending money now and setting aside money for long-term goals
• How do you make your decision?
• What are the costs?
Copyright Leslie Lum
Making your money work for you.What would you have if you did the
following with $100 in 1996?
• Bought a round of beer (or a good meal)
• Put it in the bank for 5% interest per year
• Bought a stock index fund
Copyright Leslie Lum
Let’s use compounding another way—to find the (future) cost of a purchase
decision• You want to buy a HDTV set for $1500. What
is this (future) costing you? (Use 20 years and 8% return. We use 8% because it’s historically the rate of return on investments over a long period of time.)– $1785– $3393– $4837– $6991
Copyright Leslie Lum
(Future) costing
You are a typical employee in your 20s who when you left your job in 2005 cashed out (66% do) your 401K account of less than $10,000. What is the cost of cashing out your account if your balance was $8000?
Copyright Leslie Lum
Lay out your goals
• Down payment on house (The more you put down the less risk to default and less monthly payments)
• Wedding (yours or your kids)• Car (Budget or goal?)• College tuition (you/your kids/your grandkids)(http://cgi.money.cnn.com/tools/collegecost/collegecost.html)
• Starting your own business• Retirement (Rule of thumb – annual income divided by
4%) (http://sites.stockpoint.com/aarp_rc/wm/Retirement/Retirement.asp?act=LOGIN)
• Estate (Inheritance or charity)
Copyright Leslie Lum
How do you save for big goals?
• $40,000 down payment on a house in 10 years
• $50,000 college tuition for your kid in 15 years
• $800,000 for retirement in 30 years • Just a minute---is it possible to save for big
goals?
Copyright Leslie Lum
For big goals save every year(8% return)
• $40,000 down payment on house in 10 years ($2761 every year)
• $50,000 college tuition in 15 years ($1841 every year)
• $800,000 retirement in 30 years ($7062 every year)
Copyright Leslie Lum
Which is more?
• Saving $4000 a year from 25 to 45 years old and then no more savings
• Saving $8000 (double) a year from 45 to 65 years old
0100000200000300000400000500000600000700000800000900000
25 to 45years
45 to 65years
Copyright Leslie Lum
You’re 25 and plan to retire in 40 years. How much do you save every
year to have a $1 M nest egg.
• If you start at age 45.
• If you start at age 35.
• If you start now.
Copyright Leslie Lum
It’s a moving target
• House in 10 years. Today’s price $200,000
• Kid’s college education in 18 years. Today’s price $50,000
• 2% inflation 3% inflation?
Copyright Leslie Lum
That’s not the only uncertainty
$800,000 retirement goal in 30 years
At 8% returns?
At 10% returns?
Future Investment Returns Are Uncertain
6%
9%
5%6%
14%
8%
-2%
18%19%
-5%
0%
5%
10%
15%
20%
25%
1970's 1980's 1990's 2000's
Av
era
ge
Ye
arl
y R
etu
rn f
or
De
ca
de Cash
Bond
Stock
Copyright Leslie Lum
Katie is 25 and trying to plan her financial future. Here are her financial goals in today’s dollars (black) and inflated to when they are due (red).
Copyright Leslie Lum
Katie does her plan and knows that her heaviest savings will happen in her 30s and 40s.
She also does sensitivity analysis on various inflation and return rates.
She knows that she should save as much as she can when she is younger.
Copyright Leslie Lum
Calculate the return
• You will get your paycheck next week but you need $100 now. You arrange for a payday loan paying a fee of $15 for the use of $100. The payday loan company will collect the $100 electronically from your bank account when your pay check is deposited next week. What is the rate charged?
Copyright Leslie Lum
Historical returns of major asset classes
How Stocks Have PerformedAnnual Total Returns 1971-2000
-30%
-20%
-10%
0%
10%
20%
30%
40%
50%
1971
1972
1973
1974
1975
1976
1977
1978
1979
1980
1981
1982
1983
1984
1985
1986
1987
1988
1989
1990
1991
1992
1993
1994
1995
1996
1997
1998
1999
2000
T-Bill Total Return
Government Bonds Total Return
Stocks Total Return
Source: Global Financial Data www.globalfindata.com
Average annual returns over the past 30 years:
Cash 7%
Bonds 9%
Stocks 15%
Conclusion: If you need higher returns to reach financial goals, you have to invest in stocks.
Copyright Leslie Lum
Major asset classes: Risk & ReturnAnnual Return on Cash
(Treasury Bill Total Return 1971-2000)
0%
5%
10%
15%
20%
25%
30%
35%
40%
45%
50%
1971
1972
1973
1974
1975
1976
1977
1978
1979
1980
1981
1982
1983
1984
1985
1986
1987
1988
1989
1990
1991
1992
1993
1994
1995
1996
1997
1998
1999
2000
Source: Global Financial Data, www.globalfindata.com
Average 6.7%Standard Deviation 2.7%
About 70% of returns fall within one standard deviation of the average
Copyright Leslie Lum
Annual Return on Bonds (Total Return Government Bonds 1971-2000)
-10%
0%
10%
20%
30%
40%
50%
19
71
19
72
19
73
19
74
19
75
19
76
19
77
19
78
19
79
19
80
19
81
19
82
19
83
19
84
19
85
19
86
19
87
19
88
19
89
19
90
19
91
19
92
19
93
19
94
19
95
19
96
19
97
19
98
19
99
20
00
Source: Global Financial Data
Average 9.9%
Standard Deviation 9.3%
About 70% of returns fall within one standard deviation of the average
Copyright Leslie Lum
Annual Return on Stocks(Total Return S&P 500 1971-2000)
-30%
-20%
-10%
0%
10%
20%
30%
40%
50%
1971
1972
1973
1974
1975
1976
1977
1978
1979
1980
1981
1982
1983
1984
1985
1986
1987
1988
1989
1990
1991
1992
1993
1994
1995
1996
1997
1998
1999
2000
Source: Global Financial Data
Average 14.5%
Standard Deviation
16.5%
About 70% of returns fall within one standard deviation of the average
Copyright Leslie Lum
The more return you need, the more risk you take.The more risk you take, the more return you need.
Major Asset Classes (1971-2000)
0%
2%
4%
6%
8%
10%
12%
14%
16%
18%
0% 2% 4% 6% 8% 10% 12% 14% 16%
Risk (Standard Deviation)
Return (Annual Return)
T-BillsAverage Return 6.7%
Standard Deviation 2.7%
BondsAverage Return 9.9%
Standard Deviation 9.3%
StocksAverage Annual Return 14.5%
Standard Deviation 16.5%
If you receive an offer of a guaranteed high return, is that possible?
Only if they guarantee a high loss as well.
There are no guarantees in any investment. All investments go up and down. Higher return means higher risk.
Copyright Leslie Lum
After inflation, the 6% return is the best!!
Year Nominal Return Inflation Rate Real Return 1980 14% 12.5% 1.3% 1996 6% 3.3% 2.6% 1974 10% 12.3% -2%
Copyright Leslie Lum
Can you predict the best return?
0% 20% 40% 60% 80% 100% 120% 140% 160%
1980 Small Stocks
1981 Treasury Bills
1982 Government Bonds
1983 Small Stocks
1984 Corporate Bonds
1985 Europe
1986 EAFE
1987 Emerging Asia
1988 Emerging Asia
1989 Latin America
1990 Corporate Bonds
1991 Latin America
1992 Small Stocks
1993 Emerging Asia
1994 Latin America
1995 S&P 500
1996 S&P 500
1997 S&P 500
1998 S&P 500
1999 Latin America
2000 Mid Cap Stocks
Best-Performing Asset Class(1980-2000)
Based on Index
Copyright Leslie Lum
Does the risk double with two investments?
The key is having two
investments which aren’t correlated.
Copyright Leslie Lum
Adding a riskier investment to your portfolio decreases overall risk.
Adding 10% stock to a T-bill portfolio
6.0%
6.5%
7.0%
7.5%
8.0%
8.5%
2.0% 2.2% 2.4% 2.6% 2.8% 3.0% 3.2% 3.4% 3.6% 3.8% 4.0%
Risk (Standard Deviation)
Ret
urn
(A
vera
ge
An
nu
al %
)
90% T-Bill, 10% Stock
100% T-Bill
Increases return.
Reducesrisk!
Data based on 20 years of returns.
Copyright Leslie Lum
If you allocate the right amount you reduce risk and increase return!
Adding stock to a T-bill portfolio
5.0%
7.0%
9.0%
11.0%
13.0%
15.0%
17.0%
19.0%
21.0%
1.5% 3.5% 5.5% 7.5% 9.5% 11.5% 13.5% 15.5%
10% Stock
0% Stock
20% Stock
30% 40%
50%
60%
70%
80%
90%
100% Stock
Data based on 20 years of returns.
20% stock gives more return with about the same amount of risk
as 0% stock.
Copyright Leslie Lum
Some investors think of risk as the maximum loss they are willing to take. What does asset
allocation do for that?Year-End Close Price Annual Gain
Ford J&J Ford J&J
1990 7.44 15.081991 7.86 24.49 6% 62%1992 11.98 21.99 52% -10%1993 18.03 20.02 51% -9%1994 15.58 25.03 -14% 25%1995 16.14 39.83 4% 59%1996 18.03 47.05 12% 18%1997 27.15 63.18 51% 34%1998 32.82 81.49 21% 29%1999 29.82 91.65 -9% 12%2000 23.19 104.71 -22% 14%
Average annual return 15% 24%Standard deviation 26% 23%
Copyright Leslie Lum
You can reduce your maximum loss by diversifying.
Year-End Close Price Annual Gain Asset Allocation20% Ford , 80% J&J
Ford Year J&J Year Ford J&J
1990 7.44 15.081991 7.86 24.49 6% 62% (20% x 6%) + (80% x 62%) = 51%1992 11.98 21.99 52% -10% (20% x 52%) + (80% x –10%) = 2%1993 18.03 20.02 51% -9% (20% x 51%) + (80% x –9%) = 3%1994 15.58 25.03 -14% 25% (20% x -14%) + (80% x 25%) = 17%1995 16.14 39.83 4% 59% (20% x 4%) + (80% x 59%) = 48%1996 18.03 47.05 12% 18% (20% x 12%) + (80% x 18%) = 17%1997 27.15 63.18 51% 34% (20% x 51%) + (80% x 34%) = 37%1998 32.82 81.49 21% 29% (20% x 21%) + (80% x 29%) = 27%1999 29.82 91.65 -9% 12% (20% x -9%) + (80% x 12%) =8%2000 23.19 104.71 -22% 14% (20% x -22%) + (80% x 14%) = 7%
Average annual return 15% 24% 22%Standard deviation 26% 23% 17%
Copyright Leslie Lum
How “smart money” asset allocates• Calpers is the California pension system
which manages $216 B. Check out their current and target asset allocation (available on their Web site www.calpers.ca.gov under Quick Facts). What differences do you see? What does their target allocation suggest?
Copyright Leslie Lum
Retirement
Traditional IRAs - $4000 per year (Catch-up for those over 50 years)
Tax deferred. Depending on income, may be able to contribute pre-tax
Taxes are paid at ordinary income rate when money is withdrawn.
Roth IRA - $4000 per year (Catch-up for those over 50 years)
No taxes when withdrawn. Contributions are after-tax.
Limited to those under AGI of $90,000 (single) and $150,000 (couple)
401K Employer may match at typically 50 cents for every dollar. Tax deferred. Contribute with pretax dollars. Tax credits for low-income ($25,000 single, $50,000 couple).
Taxed at ordinary income when money is withdrawn.
Copyright Leslie Lum
Education
529 Up to total of about $300,000 for some plans.
Must be used for tuition, fees, room, board, and graduate school.
Coverdell Contribute up to $2,000 a year.
Post-secondary costs; K-12 costs, some computers. Income limits.
Savings Bonds Interest earned is tax-free if used for qualified higher-education purposes.
Tuition and mandatory fees. Income limits.
Copyright Leslie Lum
Monitor Your Investments
• Rebalance periodically – but if you buy and sell a lot you will lose money
• Change allocation if you have different cash flow requirements
• Risk and return - Prune the low return/high risk investments
• Compare your performance to the indexes.• Don’t make whipsaw changes to your asset
allocation