1. Chapter 11PART 4:
MANAGING YOUR INVESTMENTS
2. Learning ObjectivesSet your goals and be ready to invest.
Understand how taxes affect your
Calculate interest rates and real rates of
Manage risk in your investments.
Allocate your assets in the manner that is
best for you.
3. Investing Versus SpeculatingWhen 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.
4. Investing Versus SpeculatingWith speculation, assets don’t generate an income
return and their value depends entirely on supply
Non-income producing real estate
5. Investing Versus SpeculatingDerivative 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
6. Investing Versus SpeculatingFutures 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
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
7. Investing Versus SpeculatingOptions 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 GoalsWhen 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
Periodically reevaluate your goals.
9. Setting Investment GoalsFormalize goals into:
Short-term – within 1 year
Intermediate-term – 1-10 years
Long-term – over 10 years
10. Setting Investment GoalsFocus on which goals are important by asking:
If I don’t accomplish this goal, what are the
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 InvestingCompare returns on an after-tax basis:
Marginal tax is the rate you pay on the next dollar
Make investments on a tax-deferred basis so no
taxes are paid until liquidation.
Capital gains and dividend income are better than
12. Starting Your Investment ProgramTips to Get Started
Pay yourself first – set aside savings, so spending
Make investing automatic – use automatic withholding.
Take advantage of Uncle Sam and your employer – try
Windfalls – invest some or all.
Make 2 months a year investment months – reduce
13. Investment ChoicesLending Investments
Preferred stocks and
common stocks which
represent ownership in
14. Lending InvestmentsA 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.
15. Ownership InvestmentsReal estate investments in income-producing
properties are illiquid.
Stocks, or equities, are the most popular
Stocks may pay a quarterly dividend.
Preferred stock dividends are fixed.
Common stock has voting rights.
Bond interest is paid prior to stock dividends.
16. Market Interest RatesInterest rates affect the value of stocks,
bonds, and real estate.
Nominal rate of return is not adjusted for
Real rate of return adjusts for inflation.
Real rate = nominal rate - inflation rate
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.
18. What Makes Up Interest Rate Risk?Inflation Risk Premium
Return above the real
rate of return to
Default Risk Premium
for taking on the risk of
19. What Makes Up Interest Rate Risk?Maturity Risk Premium
demanded by investors
on longer-term bonds.
Liquidity Risk Premium
For bonds that cannot
be converted into cash
quickly at a fair market
20. How Interest Rates Affect Returns on Other InvestmentsExpected 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.
21. Look at Risk-Return Trade-OffsRisk 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
22. Sources of Risk in the Risk-Return Trade-OffInterest Rate Risk – the higher the interest
rate, the less a bond is worth.
Inflation Risk – rising prices will erode
Business Risk – effects of good and bad
23. Sources of Risk in the Risk-Return Trade-OffFinancial Risk – associated with the use of
debt by the firm.
Liquidity Risk – inability to liquidate a security
quickly and at a fair market price.
24. Sources of Risk in the Risk-Return Trade-OffMarket Rate Risk – associated with overall
Bull markets – stocks appreciate in value
Bear markets – stocks decline in price
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.
26. Systematic and Unsystematic RiskAs you diversify, the variability or risk of the portfolio
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
27. Systematic and Unsystematic RiskSystematic Risk
Market-related or nondiversifiable risk.
That portion of a
stock’s risk not
It affects all stocks.
taking on this risk.
Risk that can be
Factors unique to a
28. How to Measure the Ultimate Risk on Your PortfolioFor risk associated with investment returns,
Variability of the average annual return on your
Uncertainty associated with the ultimate dollar
value of the investment.
How the ultimate dollar return on the investment
compares to that of another investment.
29. How to Measure the Ultimate Risk on Your PortfolioIf 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.
30. Asset AllocationHow 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
Asset allocation is the most important
31. Asset Allocation and Approaching RetirementThe 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.
32. Asset Allocation and Approaching RetirementThe Retirement Years (Over Age 65)
Spending more than saving.
Income is primary, capital appreciation secondary.
Safety through diversification and movement away from
Early on, own 40% stocks, 40% bonds, 20% T-bills. Later
own 20% common, 60% bonds, and 20% T-bills.
33. What You Should Know About Efficient MarketsDeals 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