Date post: | 01-Apr-2015 |
Category: |
Documents |
Upload: | jaron-goodnough |
View: | 215 times |
Download: | 1 times |
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.
11-3Copyright © 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.
11-4Copyright © 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.
11-5Copyright © 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.
11-6Copyright © 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
11-7Copyright © 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.
11-8Copyright © 2010 Pearson Education, Inc. Publishing as Prentice Hall
Setting Investment GoalsFormalize goals:
Short-term – within 1 yearIntermediate-term – 1-10 yearsLong-term – over 10 years
Goals should be realistic:Consequences, if not accomplishedWilling to make financial sacrificesHow much money is needed?When do I need the money?
11-9Copyright © 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
11-10Copyright © 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
11-11Copyright © 2010 Pearson Education, Inc. Publishing as Prentice Hall
Fitting Taxes Into InvestingCompare 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
11-12Copyright © 2010 Pearson Education, Inc. Publishing as Prentice Hall
Investment Choices
Lending Investments—savings accounts and bonds which are debt instruments issued by corporations andthe government.
Ownership Investments—preferred stocks and common stocks which represent ownership in a corporation, along with income-producing real estate.
11-13Copyright © 2010 Pearson Education, Inc. Publishing as Prentice Hall
Lending InvestmentsMaturity 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
11-14Copyright © 2010 Pearson Education, Inc. Publishing as Prentice Hall
Ownership Investments
Real estate—your home, rental apartments and investments in income-producing propertyIlliquid-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
11-15Copyright © 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.
11-16Copyright © 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.
11-17Copyright © 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.
11-18Copyright © 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.
11-19Copyright © 2010 Pearson Education, Inc. Publishing as Prentice Hall
11-20Copyright © 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.
11-21Copyright © 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
11-22Copyright © 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.
11-23Copyright © 2010 Pearson Education, Inc. Publishing as Prentice Hall
11-24Copyright © 2010 Pearson Education, Inc. Publishing as Prentice Hall
Sources of Risk in theRisk-Return Trade-Off
Interest rate risk
Inflation risk
Business risk
Financial risk
11-25Copyright © 2010 Pearson Education, Inc. Publishing as Prentice Hall
Sources of Risk in theRisk-Return Trade-Off
Liquidity risk
Market risk
Political and regulatory risk
Exchange rate risk
Call risk
11-26Copyright © 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.
11-27Copyright © 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.
11-28Copyright © 2010 Pearson Education, Inc. Publishing as Prentice Hall
11-29Copyright © 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
11-30Copyright © 2010 Pearson Education, Inc. Publishing as Prentice Hall
11-31Copyright © 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.
11-32Copyright © 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.
11-33Copyright © 2010 Pearson Education, Inc. Publishing as Prentice Hall
11-34Copyright © 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.
11-35Copyright © 2010 Pearson Education, Inc. Publishing as Prentice Hall
11-36Copyright © 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.
11-37Copyright © 2010 Pearson Education, Inc. Publishing as Prentice Hall
11-38Copyright © 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.
11-39Copyright © 2010 Pearson Education, Inc. Publishing as Prentice Hall
11-40Copyright © 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.
11-41Copyright © 2010 Pearson Education, Inc. Publishing as Prentice Hall
11-42Copyright © 2010 Pearson Education, Inc. Publishing as Prentice Hall
11-43Copyright © 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.
11-44Copyright © 2010 Pearson Education, Inc. Publishing as Prentice Hall
Beating the MarketHalf 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.
11-45Copyright © 2010 Pearson Education, Inc. Publishing as Prentice Hall
11-46Copyright © 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
11-47Copyright © 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.
11-48Copyright © 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.