Investment Basics

1. Chapter 11

PART 4:
MANAGING YOUR INVESTMENTS
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.
11-2

3. Investing Versus Speculating

When you buy an investment, you put money
in an asset that generates a return.
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Part of that is income:
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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.
11-3

4. Investing Versus Speculating

With speculation, assets don’t generate an income
return and their value depends entirely on supply
and demand.
Examples include:
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Gold coins
Baseball cards
Non-income producing real estate
Gems
Derivative securities
11-4

5. Investing Versus Speculating

Derivative securities derive their value from
the value of another asset.
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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
11-5

6. 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.
11-6

7. 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.
11-7

8. Setting Investment Goals

When you make a plan, you must:
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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.
11-8

9. Setting Investment Goals

Formalize goals into:
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Short-term – within 1 year
Intermediate-term – 1-10 years
Long-term – over 10 years
11-9

10. Setting Investment Goals

Focus on which goals are important by asking:
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If I don’t 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?
11-10

11. Fitting Taxes into Investing

Compare returns on an after-tax basis:
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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.
11-11

12. Starting Your Investment Program

Tips to Get Started
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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.
11-12

13. Investment Choices

Lending Investments
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Savings accounts
Ownership Investments
and bonds.
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Debt instruments
issued by
corporations and
the government.
Preferred stocks and
common stocks which
represent ownership in
a corporation.
Income-producing real
estate.
11-13

14. 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.
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Principal returned on maturity date.
Corporate bonds issued in $1000 units.
Pay semiannual interest.
Coupon rate is the annual interest rate.
11-14

15. Ownership Investments

Real estate investments in income-producing
properties are illiquid.
Stocks, or equities, are the most popular
ownership investment.
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Stocks may pay a quarterly dividend.
Preferred stock dividends are fixed.
Common stock has voting rights.
Bond interest is paid prior to stock dividends.
11-15

16. 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.
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Real rate = nominal rate - inflation rate
11-16

17. 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 riskfree. Their interest rate is considered to be
the risk-free rate.
11-17

18. 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.
11-18

19. 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.
11-19

20. 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.
11-20

21. 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.
11-21

22. Sources of Risk in the Risk-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.
11-22

23. Sources of Risk in the Risk-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.
11-23

24. Sources of Risk in the Risk-Return Trade-Off

Market Rate Risk – associated with overall
market movements.
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Bull markets – stocks appreciate in value
Bear markets – stocks decline in price
11-24

25. Diversification

“Don’t 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.
11-25

26. 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 isn’t
eliminated through diversification.
Risk unique to one stock can be countered and
cancelled out by the variability of another stock in the
portfolio.
11-26

27. Systematic and Unsystematic Risk

Systematic Risk
Market-related or nondiversifiable risk.
That portion of a
stock’s 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.
11-27

28. How to Measure the Ultimate Risk on Your Portfolio

For risk associated with investment returns,
look at:
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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.
11-28

29. 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.
11-29

30. 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.
11-30

31. 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.
11-31

32. 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.
11-32

33. What You Should Know About Efficient Markets

Deals with the speed at which new
information is reflected in prices.
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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.
11-33