Chapter 11

Investments Basics

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Learning Objectives
1. Set your goals and be ready to invest.
2. Calculate interest rates and real rates of
return.
3. Manage risk in your investments.
4. Allocate your assets in the manner that is
best for you.
5. Understand how difficult it is to beat the
market.
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Introduction
Investing goals should be to protect and
make money.
Important to understand investing from a
common sense perspective.
A solid grounding in investing will help you
reach your financial goals and avoid pitfalls.

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Before You Invest

Decide what your goals are.
How much can you set aside to meet those
goals?
Know the difference between investing and
speculating.

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Investing Versus Speculating

Investmentan asset that generates a return
Income return
Speculationan asset whose value depends
solely on supply and demand
Derivative securitiesvalue derived from value
of other assets
Optionright of owner to buy or sell an asset

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Setting Investment Goals

1. Write down your goals and prioritize them.
2. Attach costs to them.
3. Figure out when the money for those goals
will be needed.
4. Periodically reevaluate your goals.

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Setting Investment Goals

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

Goals should be realistic:

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Consequences, if not accomplished

Willing to make financial sacrifices
How much money is needed?
When do I need the money?

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Financial Reality Check

Have a grip on your financial affairs
Make sure youre living within your means
Have adequate insurance
Keep emergency funds

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Starting Your Investment

Program
Pay yourself first
Make investing automatic
Take advantage of Uncle Sam and your
employer
Windfalls
Make 2 months a year investment months
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Fitting Taxes Into Investing

Compare investment returns on an aftertax basis
Marginal tax rate
Tax-free investment alternatives
Investments on a tax-deferred basis
With taxes, capital gains and dividend
income are better than ordinary income

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Investment Choices
Lending Investmentssavings accounts
and bonds which are debt instruments
issued by corporations and
the government.
Ownership Investmentspreferred stocks
and common stocks which represent
ownership in a corporation, along with
income-producing real estate.

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Lending Investments
Maturity date
Par Value or Principal
Coupon interest rate
Know ahead of time what return will be
If issuer goes bankrupt, bondholder can lose
entire investment

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Ownership Investments
Real estateyour home, rental apartments
and investments in income-producing property
Illiquid-hard to sell off

Stockfractional ownership in a corporation

Owner or equity holderowns stock
Dividenda payment by a corporation to its
shareholders

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The Returns from Investing

Capital gain or lossgain (or loss) on the
sale of a capital asset.
Income returnany payments you receive
directly from the company or organization in
which youve invested.

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Market Interest Rates

Need to understand interest rates.
Interest rates affect the value of stocks,
bonds, and real estate.
Interest rates also determine earnings on
savings and tied closely to inflation.

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Nominal and Real Rates of

Return
Nominal (or quoted) rate of returnthe rate
of return earned on an investment, without
any adjustment for inflation.
Real rate of returnthe current or nominal
rate of return minus the inflation rate.

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Historical Interest Rates

Nominal interest rates have dropped
somewhat over the past 20 years.
Real rate of return can be calculated by
subtracting the inflation rate from the
nominal interest rate.
Real rate of return can be negative.

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Figure 11.1 Interest and

Inflation Rates, 19882010

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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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A Look at Risk-Return Trade-Offs

Risk is related to potential return.
The more risk you assume, the greater the
potential rewardbut also the greater
possibility of losing your money.
You must eliminate risk without affecting
potential return.
Balance amount of risk with amount of return
needed.
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Historical Levels of Risk and

Return
Investments that produce higher returns
have higher levels of risk associated with
them.

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Figure 11.2 RiskReturn

Relationship

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Sources of Risk in the

Risk-Return Trade-Off
Interest rate risk
Inflation risk
Business risk
Financial risk

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Sources of Risk in the

Risk-Return Trade-Off
Liquidity risk
Market risk
Political and regulatory risk
Exchange rate risk
Call risk

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Diversification
The elimination of risk by investing in
different assets.
Allows extreme good and bad returns to
cancel each other out.
Reduced risk without affected expected
return.

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Diversifying Risk Away

Portfolioa group of investments held by an
individual
Systematic or Market-Related or
Nondiversifiable Riskportion of a securitys
risk or variability that cannot be eliminated
through diversification.
Unsystematic or Firm-Specific or CompanyUnique Risk or Diversifiable Riskrisk or
variability that can be eliminated with
diversification.
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Figure 11.3 The Reduction of Risk as

the Number of Stocks in the Portfolio
Increases

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Understanding Your Tolerance

for Risk
Need to recognize your tolerance for risk
and invest accordingly.
Take one of many risk-tolerance tests.
Review your past actions.

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Figure 11.4
Risk Tolerance
Quiz

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The Time Dimension of Investing

and Asset Allocation
As the length of the investment horizon
increases, you can afford to invest in riskier
assets.
If investment horizon is longer, will probably
end up with a lot more if you invest in some
risky assets.

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Meeting Your Investment Goals and

the Time Dimension of Risk
With any long-term investment, there will be
bad years and good years.
With time, dispersion (variability) of returns in
these years converges toward the average.
What kinds of assets should you invest in?
Investment in bonds will give less uncertainty
over time but will give smaller ultimate value
than investing in riskier assets like stocks.

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Figure 11.5 Reduction of Risk

over Time, 19502010

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Asset Allocation
How your money should be divided among
stocks, bonds, and other investments.
Investments diversified in different classes of
investments.
Common stocks more appropriate for the
long-term horizon.
Asset allocation is the most important
investing task that is not a one-time decision.

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TABLE 11.1 Factors Impacting Your

Asset Allocation Decision

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Asset Allocation and the Early YearsA Time

of Wealth Accumulation (Through Age 54)

Investment horizon is quite long, investors

should place majority of savings into
common stocks.
80% common stocks and 20% in bonds
quite common.

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Figure 11.6 Risk and Return to Benchmark

Asset Allocation Breakdown During
the Early Years

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Asset Allocation and Approaching Retirement

The Golden Years (Ages 55 to 64)

Preserve level of wealth and allow it to

grow.
Start moving some of retirement portfolio
into bonds.
Maintain a diversified portfolio.
Own 60% stocks and 40% bonds.

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Figure 11.7 Risk and Return to Benchmark Asset

Allocation Breakdown Approaching RetirementThe
Golden Years

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Asset Allocation and the Retirement

Years (Over Age 65)
Spending more than saving.
Income primary, capital appreciation
secondary.
Safety through diversification and movement
away from common stocks.
Own 40% stocks, 40% bonds, 20% T-bills.
Later own 20% common, 60% bonds, and
20% T-bills.
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Figure 11.8 Risk and Return to Benchmark

Asset Allocation Breakdown During
Retirement Years

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Figure 11.9 Risk and Return to Benchmark

Asset Allocation Breakdown During
the Late Retirement Years

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What You Should Know About

Efficient Markets
Efficient marketa market in which
information about the stock is reflected in
the stock price.
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.

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Beating the Market

Half the time you should outperform the
market, and half the time you should
underperform.
Difficult for superstars of investing to pick
underpriced stocks and time the market.
Keep your plan and invest for the long term.
If you try to time the market, you just as
likely to miss an upswing as you are to avoid
an downswing.
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Checklist 11.1

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Thinking Back to Principle 9:

Mind Games and Your Money
Overconfidence
Disposition Effect
House Money Effect
Loss then Risk Aversion Effect
Herd Behavior

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Summary
Decide on goals and how much to set aside
then develop an investment plan.
Interest rates are important in determining
value of an investment and are tied to the
rate of inflation.
There are different sources of risk
associated with investments.

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Summary
As your investment time horizon lengthens,
invest in more riskier assets.
Asset allocation ensures diversification and
time dimension of investment in different
classes.
It is very difficult to beat the market and as
a result you should keep to your plan and
invest for the long term.

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