Investment Basics. Copyright © 2010 Pearson Education, Inc. Publishing as Prentice Hall 5-2 All rights reserved. No part of this publication may be reproduced,

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.


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.


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.


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


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.


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?


Financial Reality Check

Have a grip on your financial affairs

Make sure you’re living within your means

Have adequate insurance

Keep emergency funds


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


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


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.


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


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


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.


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.


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.


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.



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.


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


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.



Sources of Risk in theRisk-Return Trade-Off

Interest rate risk

Inflation risk

Business risk

Financial risk


Sources of Risk in theRisk-Return Trade-Off

Liquidity risk

Market risk

Political and regulatory risk

Exchange rate risk

Call risk


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.


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.



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



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.


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.



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.



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.



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.



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.




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.


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.



Thinking Back to Principle 9: Mind Games and Your Money

Overconfidence

Disposition Effect

House Money Effect

Loss then Risk Aversion Effect

Herd Behavior


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.


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.

Documents

Investment Basics. Copyright © 2010 Pearson Education, Inc. Publishing as Prentice Hall 5-2 All rights reserved. No part of this publication may be reproduced,