Principles of Finance

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Principles of Finance

• Personal Finances

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Review

• Homework
• Dividend payment theories
• Residual dividend theory
• Clientele theory
• Information effect
• Agency costs
• Expectations theory
• Earnings predictability concerns
• Policies
• Constant dividend payout
• Stable dollar
• Small regular plus end-of-year
• One-time
• Stock splits and dividends

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Modern Portfolio Theory

• Diversification can
• Reduce risk
• Increase returns
• Objective is to
• Maximize return for a given level of risk
• or
• Minimize risk for a given level of return

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Not All Risk is the Same

• Firm Risk Systematic risk
  Idiosyncratic Risk

BusinessCycles
Financial Markets
Global Conditions
Risk Unique to the Firm
Source of Correlation
Idiosyncratic risk can be diversified away!
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Diversification Simple Example
IBM and ATT
When IBM went down, ATT went up. When ATT went
down, IBM went up.
If stocks are perfectly positively correlated,
diversification has no effect on risk If stocks
are perfectly negatively correlated, portfolio is
perfectly diversified. What do you want as an
investor?
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Risk and Diversification
With large portfolio, 30 200 stocks,
idiosyncratic moves cancel out!
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The Efficient Frontier
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Modern Portfolio Theory

• Optimal portfolio is a combination of the market
  portfolio and the risk-free asset
• So what is the market portfolio?
• SP 500?
• Wilshire 5000?
• Total world index?
• What about bonds?

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Diversification with Stocks and Bonds
Note adding some stock to a 100 Treasury
portfolio increases the return and decreases the
risk!
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Market Portfolio

• What about other asset classes?
• REITS
• TIPS
• Commodities
• How is one to decide on a market portfolio?
• Simple approach 60/40 stocks/bond
• Include other asset classes
• Six Ways from Sunday portfolio http//www.dallasne
  ws.com/business/columnists/scott-burns/20100904-Th
  e-joy-of-portfolio-cooking-2502.ece
• All-Weather Portfolio
• Asset allocation is your most significant
  investment decision

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What to Invest In?

• Index funds
• Track an index
• Low cost
• Types
• Total market
• SP 500
• Total bond
• REITs
• TIPS
• Precious metals
• International
• Managed funds
• Fund has a stated objective
• Fund manager invests to maximize returns subject
  to objective

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Can You Beat the Market?

• Efficient market hypothesis
• Investment exercise
• Thought experiment
• What if advisors are actually bad and only get it
  right 40 of the time?
• You cant consistently beat the market
• But many will try
• Are you tempted by Apple, Facebook, gold?

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Market Analysis

• Technical analysis
• Looks at historical returns
• Looks for patterns
• Patterns suggest investment direction
• Fundamental analysis
• Tries to understand the whys
• Looks for underlying causes
• Inflation
• GDP growth
• Relationships (e.g. oil to plastics and farm
  products)
• Exchange rates

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Post Modern Portfolio Theory

• Two Ways to Make Money
• Beta
• Your market portfolio
• Has systemic risk from asset class
• Easy, inexpensive to create
• Alpha
• Your bet against the market, you know better than
  everyone else
• Zero-sum game
• There are winners and losers
• Has idiosyncratic risk, comes from skill of
  investment advisor
• Hard, expensive to create

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Post Modern Portfolio TheoryPractical Application

• First, set aside emergency money
• Determine how many months of income 3 6
• Leave in a money market fund
• Pick how much you want to bet your alpha
• Specify as a percent
• Place your bet
• Be prepared to lose it
• Invest the remaining percent in your market
  portfolio beta

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Market Timing

• Can you time the market?
• Who do you listen to?
• Do you know better than the pros?
• Do the pros know?
• Two schools of thought
• Dollar cost averaging
• Go to your strategy

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Retirement Planning

• Why should you care now?

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You Can Never Catch Up
Person A Saves 2000 per year from age 22 to age
35 and then stops Person B Starts saving 2000
per year beginning at age 35 and never stops
Both earn 8 on their
investments. At age 75 Person
A has 1M in savings Person B
has 561K in savings
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How Much Do You Need?

• Calculate your income requirement
• Use todays dollars (remember time value of
  money)
• Current income
• - Pension
• - Social Security (maybe)
• Income need
• Rough estimate of the portfolio you must have
  income need x 25
• Conversely, can live off of 4 of your portfolio
• E.g. If have 1M, then can live off 40k per year

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How Much Do You Need?

• Previous calculation was in todays dollars
• You may need 4 times that amount in the future
• Inflation has averaged 4 since 1929
• At that rate, prices will go up 4x in 36 years
• Start saving now
• Minimally 10
• Shoot for gt 20

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Are You On Track?

• Under Accumulator of Wealth (UAW)
• net worth lt age (.10 pretax income)
• Average Accumulator of Wealth (AAW)
• net worth age (.10 pretax income)
• Prodigious Accumulator of Wealth (PAW)
• net worth gt age (.10 pretax income)
• If age 30 with pretax income of 60,000, then you
  need net worth 30 (.10 60000) 180,000
• If age 40 with pretax income of 100,000, then
  you need net worth 40 (.10 100000)
  400,000
• A guideline, not a law of physics
• Not good for young ages

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Retirement Vehicles

• 401(k)s
• IRA
• Roth IRA