Investment Basics

1
Chapter 11

• Investment Basics

2
Learning Objectives

• Set your goals and be ready to invest.
• Understand how taxes affect your investments.
• Calculate interest rates and real rates of
  return.
• Manage risk in your investments.
• Allocate your assets in the manner that is best
  for you.

3
Investing Versus Speculating

• When you buy an investment, you put money in an
  asset that generates a return.
• Part of that is income
• Rent on real estate
• Dividends on stock
• Interest on bonds
• Even if the stock or bond does not pay income
  now, in the future it may.

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Investing Versus Speculating

• With speculation, assets dont generate an income
  return and their value depends entirely on supply
  and demand.
• Examples include
• Gold coins
• Baseball cards
• Non-income producing real estate
• Gems
• Derivative securities

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Investing Versus Speculating

• Derivative securities derive their value from the
  value of another asset.
• Futures - a written contract to buy or sell a
  commodity in the future.
• Options - the right to buy or sell an asset at a
  set price on or before maturity date.
• Call option right to buy
• Put option right to sell

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Investing Versus Speculating

• Futures contracts deal with commodities such as
  oil, soybeans, or corn.
• It requires the holder to buy or sell the asset,
  regardless of what happens to its value in the
  interim.
• Contract sets a price and a future time at which
  you will buy or sell the asset.
• With futures, it is possible to lose more than
  you invested.

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Investing Versus Speculating

• Options markets and futures markets are a zero
  sum game.
• If someone makes money, then someone must lose
  money.
• If profits and losses are added up, the total
  would be zero.
• Can lose more than invested.

8
Setting Investment Goals

• When you make a plan, you must
• Write down your goals and prioritize them.
• Attach costs to them.
• Determine when the money for those goals will be
  needed.
• Periodically reevaluate your goals.

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Setting Investment Goals

• Formalize goals into
• Short-term within 1 year
• Intermediate-term 1-10 years
• Long-term over 10 years

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Setting Investment Goals

• Focus on which goals are important by asking
• If I dont accomplish this goal, what are the
  consequences?
• Am I willing to make the financial sacrifices
  necessary to meet this goal?
• How much money do I need to accomplish this goal?
• When do I need this money?

11
Fitting Taxes into Investing

• Compare returns on an after-tax basis
• Marginal tax is the rate you pay on the next
  dollar of earnings.
• Make investments on a tax-deferred basis so no
  taxes are paid until liquidation.
• Capital gains and dividend income are better than
  ordinary income.

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Starting Your Investment Program

• Tips to Get Started
• Pay yourself first set aside savings, so
  spending remains.
• Make investing automatic use automatic
  withholding.
• Take advantage of Uncle Sam and your employer
  try matching investments.
• Windfalls invest some or all.
• Make 2 months a year investment months reduce
  spending.

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Investment Choices

• Lending Investments
• Savings accounts and bonds.
• Debt instruments issued by corporations andthe
  government.

• Ownership Investments
• Preferred stocks and common stocks which
  represent ownership in a corporation.
• Income-producing real estate.

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Lending Investments

• A savings account pays interest on the balance
  held in the account.
• With a bond, the return is usually fixed and
  known ahead of time.
• Principal returned on maturity date.
• Corporate bonds issued in 1000 units.
• Pay semiannual interest.
• Coupon rate is the annual interest rate.

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Ownership Investments

• Real estate investments in income-producing
  properties are illiquid.
• Stocks, or equities, are the most popular
  ownership investment.
• Stocks may pay a quarterly dividend.
• Preferred stock dividends are fixed.
• Common stock has voting rights.
• Bond interest is paid prior to stock dividends.

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Market Interest Rates

• Interest rates affect the value of stocks, bonds,
  and real estate.
• Nominal rate of return is not adjusted for
  inflation.
• Real rate of return adjusts for inflation.
• Real rate nominal rate - inflation rate

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What Makes Up Interest Rate Risk?

• Real risk-free rate of return is what investors
  receive for delaying consumption.
• Short-term Treasury bills are virtually
  risk-free. Their interest rate is considered to
  be the risk-free rate.

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What Makes Up Interest Rate Risk?

• Inflation Risk Premium
• Return above the real rate of return to
  compensate for anticipated inflation.

• Default Risk Premium
• Compensates investors for taking on the risk of
  default.

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What Makes Up Interest Rate Risk?

• Maturity Risk Premium
• Additional return demanded by investors on
  longer-term bonds.

• Liquidity Risk Premium
• For bonds that cannot be converted into cash
  quickly at a fair market price.

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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.

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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.

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Sources of Risk in theRisk-Return Trade-Off

• Interest Rate Risk the higher the interest
  rate, the less a bond is worth.
• Inflation Risk rising prices will erode
  purchasing power.
• Business Risk effects of good and bad
  management decisions.

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Sources of Risk in theRisk-Return Trade-Off

• Financial Risk associated with the use of debt
  by the firm.
• Liquidity Risk inability to liquidate a
  security quickly and at a fair market price.

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Sources of Risk in theRisk-Return Trade-Off

• Market Rate Risk associated with overall market
  movements.
• Bull markets stocks appreciate in value
• Bear markets stocks decline in price

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Diversification

• Dont put all your eggs in one basket.
• Extreme good and bad returns cancel out,
  resulting in a reduction of the total variability
  or risk without affecting expected return.
• Not only eliminates risk but also helps us
  understand what risk is relevant to investors.

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Systematic and Unsystematic Risk

• As you diversify, the variability or risk of the
  portfolio should decline.
• Not all risk can be eliminated by
  diversification.
• The risk in returns common to all stocks isnt
  eliminated through diversification.
• Risk unique to one stock can be countered and
  cancelled out by the variability of another stock
  in the portfolio.

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Systematic and Unsystematic Risk

• Systematic Risk
• Market-related or non-diversifiable risk.
• That portion of a stocks risk not eliminated
  through diversification.
• It affects all stocks.
• Compensated for taking on this risk.

• Unsystematic Risk
• Firm-specific, company-unique, or diversifiable
  risk.
• Risk that can be eliminated through
  diversification.
• Factors unique to a specific stock.

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How to Measure the Ultimate Risk on Your Portfolio

• For risk associated with investment returns, look
  at
• Variability of the average annual return on your
  investment.
• Uncertainty associated with the ultimate dollar
  value of the investment.
• How the ultimate dollar return on the investment
  compares to that of another investment.

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How to Measure the Ultimate Risk on Your Portfolio

• If investment time horizon is long and you invest
  in stocks, there is uncertainty about the
  ultimate value of investment, so take on
  additional risk.
• Take on more risk as time horizon lengthens.
• No place to hide in a crash, both stocks and
  bonds are affected.

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Asset Allocation

• How your money should be divided among stocks,
  bonds and other investments.
• Investors should be diversified, holding
  different classes of investments.
• Common stocks more appropriate for the long-term
  horizon.
• Asset allocation is the most important investing
  task.

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Asset Allocation and Approaching Retirement

• The Golden Years (Age 55-64)
• Preserve level of wealth and allow it to grow.
• Start moving into bonds.
• Maintain a diversified portfolio.
• Own 60 stocks and 40 bonds.

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Asset Allocation and Approaching Retirement

• The Retirement Years (Over Age 65)
• Spending more than saving.
• Income is primary, capital appreciation
  secondary.
• Safety through diversification and movement away
  from common stocks.
• Early on, own 40 stocks, 40 bonds, 20 T-bills.
  Later own 20 common, 60 bonds, and 20 T-bills.

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What You Should Know About Efficient Markets

• Deals with the speed at which new information is
  reflected in prices.
• 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.