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1. The Investment Decision Chapter 12 2. Why Invest? <ul><li>Some people have specific reasons for investing…
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  • 1. The Investment Decision Chapter 12
  • 2. Why Invest? <ul><li>Some people have specific reasons for investing </li></ul><ul><ul><li>Supplement current income </li></ul></ul><ul><ul><li>Reduce current and future tax liability </li></ul></ul><ul><ul><li>Send children to college </li></ul></ul><ul><ul><li>Retire comfortably </li></ul></ul><ul><ul><li>For fun </li></ul></ul>
  • 3. Why Invest? <ul><li>We’re living longer—thus, we’ll have a longer period of retirement </li></ul><ul><li>Personal incomes are not rising rapidly </li></ul><ul><ul><li>Experts expect personal incomes to keep pace with inflation </li></ul></ul><ul><ul><ul><li>To raise your standard of living, you’ll need to earn more than inflation </li></ul></ul></ul><ul><li>The labor market is changing </li></ul><ul><ul><li>People are changing jobs many times during their life and spend some time unemployed </li></ul></ul><ul><ul><li>Saving/investing can help you weather the storm </li></ul></ul><ul><li>Self-directed retirement plans are now the norm </li></ul><ul><ul><li>Individual is responsible for most, if not all, investment decisions </li></ul></ul>
  • 4. The Steps in the Investment Process <ul><li>Know your goals </li></ul><ul><li>Your present situation will impact those goals </li></ul><ul><ul><li>If one goal is a secure retirement and your employer does not offer a retirement savings plan, you’ll have to do this on your own </li></ul></ul><ul><ul><li>If you already own your own home, saving for a down payment wouldn’t be a goal—maybe you’d be focused on paying down your mortgage </li></ul></ul>
  • 5. Assessing Risk and Return <ul><li>How long do you plan to invest (your expected holding period)? </li></ul><ul><ul><li>Over longer time periods you can afford more risk </li></ul></ul><ul><li>What level of expected return is required to meet your goals? </li></ul><ul><ul><li>Higher expected returns mean taking higher risks </li></ul></ul><ul><li>How much risk are you comfortable with? </li></ul><ul><ul><li>If you panic at every daily fluctuation, you should stick with lower risk investments </li></ul></ul><ul><ul><li>Personal characteristics, such as age and income influence risk tolerance </li></ul></ul>
  • 6. Selecting the Right Investment <ul><li>Examine your investment goals, time horizon, risk tolerance, desired return, etc . and choose your investments </li></ul><ul><li>Stocks—represent ownership in a company </li></ul><ul><ul><li>Share in the company’s profits </li></ul></ul><ul><ul><ul><li>May receive cash dividends </li></ul></ul></ul><ul><ul><ul><li>May receive capital appreciation (main reason people invest in stocks) </li></ul></ul></ul><ul><ul><li>No maturity date </li></ul></ul>
  • 7. Selecting the Right Investment <ul><li>Bonds—represents a promissory note issued by a corporation/entity promising to pay interest and principal </li></ul><ul><ul><li>Bonds don’t have to pay interest, but if they have a coupon rate they should </li></ul></ul><ul><ul><li>Bonds usually have a maturity date (up to 30 years or so) </li></ul></ul><ul><ul><ul><li>Receive benefits through interest income </li></ul></ul></ul><ul><ul><ul><ul><li>Main reason people invest in bonds </li></ul></ul></ul></ul><ul><ul><ul><li>May experience price appreciation </li></ul></ul></ul>
  • 8. Selecting the Right Investment <ul><li>Money market instrument—a lending investment that matures within one year </li></ul><ul><ul><li>Examples include </li></ul></ul><ul><ul><ul><li>Treasury bills </li></ul></ul></ul><ul><ul><ul><li>Bank savings accounts </li></ul></ul></ul><ul><ul><li>Typically pay low interest rates but are very low risk </li></ul></ul><ul><li>Two aspects to investment selection, or asset allocation </li></ul><ul><ul><li>Strategic </li></ul></ul><ul><ul><ul><li>Decisions concerning the general mix of investments ( i.e ., 50% stocks, 30% bonds, 20% money market) </li></ul></ul></ul><ul><ul><li>Tactical </li></ul></ul><ul><ul><ul><li>Selecting specific investments that are best for you ( i.e ., choosing an index mutual fund for the stock portion of your investments) </li></ul></ul></ul>
  • 9. Managing Your Investments <ul><li>Buy-and-hold philosophy </li></ul><ul><ul><li>A passive approach wherein you purchase a set of investments and do not manipulate the investments </li></ul></ul><ul><ul><ul><li>Make changes only if and when your goals or personal situation changes </li></ul></ul></ul><ul><li>Active philosophy </li></ul><ul><ul><li>Actively watch the performance of your investments, buying/selling as you see fit </li></ul></ul>
  • 10. Understanding Risk and Return <ul><li>By investing you EXPECT to earn some rate of return, but it always has some degree of risk because it is an EXPECTATION </li></ul><ul><li>Sources of Investment Returns </li></ul><ul><ul><li>Income </li></ul></ul><ul><ul><ul><li>Dividends (stocks) </li></ul></ul></ul><ul><ul><ul><li>Interest (bonds) </li></ul></ul></ul><ul><ul><li>Capital appreciation (price of investment increases) </li></ul></ul>
  • 11. Understanding Risk and Return <ul><li>Compare the income vs price change portion of various investments over a recent 10-year period: </li></ul>None All 4.4% Money market Little Most 7.8% Bonds Most Little 12.5% Stocks Price Change Portion Income Portion Average Annual Return Investment
  • 12. Measuring Investment Returns <ul><li>Total Return represents the return you earned on the amount you invested over a certain time period (usually one year, but not necessarily) </li></ul><ul><ul><li>Includes both income and price changes </li></ul></ul>
  • 13. Measuring Investment Returns <ul><li>Example: You bought 1,000 shares of stock one year ago at a price of $50. You sold it for $55 because you felt the future uncertainly was too great. During that time you received dividends of $1 per share. Calculate your total return from your investment. </li></ul><ul><ul><li>Total Return = (Selling Price + Dividends – Purchase Price)  Purchase Price </li></ul></ul><ul><ul><li>Total Return = ($55 + $1 - $50)  $50 = 12% </li></ul></ul>
  • 14. Calculating Average Returns <ul><li>Examine the two investments: </li></ul>Measures actual change in wealth. Can overstate the actual return to investor. 13.18% 15% Average (Compound) Clearly A is the better investment. 15% 15% Average (Arithmetic) 1,450 1,520.88 0% 15% 3 1,450 1,322.5 0% 15% 2 1,450 $1,150 45% 15% 1 B A B A Year EOY Value of $1,000 (cumulative) Annual Return
  • 15. What is Investment Risk? <ul><li>Risk is the uncertainty that an investment’s actual return will not be what you expected it to be </li></ul><ul><li>There’s an upside and a downside </li></ul><ul><li>Types of investment risk: </li></ul><ul><ul><li>Default risk </li></ul></ul><ul><ul><li>Credit risk </li></ul></ul><ul><ul><li>Tax risk </li></ul></ul><ul><ul><li>Purchasing power risk </li></ul></ul><ul><ul><li>Interest rate risk </li></ul></ul><ul><ul><li>Market risk </li></ul></ul><ul><ul><li>Event risk </li></ul></ul>
  • 16. Measuring Investment Risk <ul><li>Some types of risk are easy to measure </li></ul><ul><ul><li>Market risk </li></ul></ul>Stocks have more market risk than T-bills. Figure 12.4 Annual Returns on Stocks and Treasury Bills: 1985-2001
  • 17. Are Risk and Holding Period Related? <ul><li>The longer your holding period the more risk you should consider taking </li></ul><ul><li>Between 1926 and 2001 stocks had returns < 0% for 22 of the 76 years </li></ul><ul><ul><li>But when looking at a longer 10-year holding period, there were only negative returns for 2 of the 66 rolling 10-year periods </li></ul></ul>
  • 18. Figure 12.5 : Stock, Bond, and Treasury Bill Average Returns T-bills have only slightly outperformed inflation.
  • 19. Figure 12.6 : I nvestment Growth over the 25-Years Ending 12/31/01
  • 20. Comparing Stocks, Bonds and T-bills <ul><li>Stability of principal </li></ul><ul><ul><li>Value of investment will never fall below what you originally invested </li></ul></ul><ul><ul><ul><li>T-bills are the winner </li></ul></ul></ul><ul><li>Current income </li></ul><ul><ul><li>Historically bonds have paid more income than stocks or t-bills </li></ul></ul><ul><li>Stability of income </li></ul><ul><ul><li>Bonds are the winner—you know how much income you are promised each year </li></ul></ul><ul><li>Growth of income </li></ul><ul><ul><li>Stocks are the winner because dividends tend to grow over time, while bond income remains fixed </li></ul></ul>
  • 21. Some Lessons for New Investors <ul><li>To earn high returns, you have to be willing to take high risks </li></ul><ul><li>Diversification is helpful </li></ul><ul><ul><li>Can help reduce risk without decreasing return a great deal (due to co-movement) </li></ul></ul><ul><li>Past performance is not a guarantee of future performance </li></ul><ul><li>Financial Markets are fairly efficient </li></ul><ul><ul><li>Fair, orderly and very competitive (lots of buyers and sellers) </li></ul></ul><ul><ul><li>No “easy money” </li></ul></ul>
  • 22. Some Lessons for New Investors <ul><li>Avoiding common investment mistakes </li></ul><ul><ul><li>Chasing returns </li></ul></ul><ul><ul><ul><li>Investing your money based on how well an investment performed last period </li></ul></ul></ul><ul><ul><li>Fad Investing </li></ul></ul><ul><ul><ul><li>Investing in something simply because others are doing so </li></ul></ul></ul><ul><ul><li>Buying right after a major price increase or selling right after a major price decline </li></ul></ul><ul><ul><li>Hanging onto a loser </li></ul></ul><ul><ul><li>Investing with no plan </li></ul></ul><ul><ul><li>Trusting the self-proclaimed gurus </li></ul></ul><ul><ul><li>Fearing the wrong risks </li></ul></ul><ul><ul><ul><li>Being unwilling to take risks—especially if you have a long-term investment horizon </li></ul></ul></ul>
  • 23. Sources of Investment Information <ul><li>Problem isn’t that there is too little information, but too much </li></ul><ul><li>Periodicals and newspapers </li></ul><ul><ul><li>Newspapers, local & business-oriented </li></ul></ul><ul><ul><ul><li>Investor’s Business Daily </li></ul></ul></ul><ul><ul><ul><li>The Wall Street Journal </li></ul></ul></ul><ul><ul><ul><li>Barron’s </li></ul></ul></ul><ul><ul><li>Periodicals </li></ul></ul><ul><ul><ul><li>Time </li></ul></ul></ul><ul><ul><ul><li>U.S. News & World Report </li></ul></ul></ul><ul><ul><ul><li>Business Week </li></ul></ul></ul><ul><ul><ul><li>Forbes </li></ul></ul></ul><ul><ul><ul><li>Kiplinger’s Personal Finance </li></ul></ul></ul><ul><ul><ul><li>Money </li></ul></ul></ul>
  • 24. Sources of Investment Information <ul><li>Investment advisory services </li></ul><ul><ul><li>Moody’s and Standard & Poor’s </li></ul></ul><ul><ul><li>Value Line </li></ul></ul><ul><ul><li>Morningstar </li></ul></ul><ul><ul><li>Brokerage firms </li></ul></ul><ul><ul><li>Investment newsletters </li></ul></ul><ul><li>Computerized sources of investment information </li></ul>
  • 25. Web Links <ul><li>Good source for basics </li></ul><ul><ul><li>http://www.investoreducation.org/index.cfm </li></ul></ul><ul><ul><li>http://moneycentral.msn.com/home.asp </li></ul></ul><ul><ul><li>http://www.quicken.com/investments/basics/ </li></ul></ul><ul><ul><li>http://www.kiplinger.com </li></ul></ul><ul><ul><li>http://www.morningstar.com </li></ul></ul><ul><ul><li>http://www.vanguard.com </li></ul></ul><ul><ul><li>http://www.nyse.com </li></ul></ul><ul><ul><li>http://www.nasdaq-amex.com </li></ul></ul>
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