L5 Financial Plans

Personal Finance: Turning Money
into Wealth
Seventh Edition
Chapter 11
Investment Basics
Copyright © 2016, 2014, 2012 Pearson Education, Inc. All Rights Reserved.
Learning Objectives (1 of 2)
11.1 Set your goals and be ready to invest.
11.2 Manage risk in your investments.
11.3 Allocate your assets in the manner that is best for you.
11.4 Understand how difficult it is to beat the market.
Learning Objectives (2 of 2)
11.5 Identify and describe the primary and secondary
securities markets.
11.6 Trade securities using a broker.
11.7 Locate and use several different sources of investment
information to trade securities.
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.
Before You Invest
• Decide what your goals are.
• Know how much can you set aside to meet those goals.
• Know the difference between investing and speculating.
Investing Versus Speculating
• Investment—an asset that generates a return
• Income return—usually in the form of dividends or interest
payments
• Speculation—an asset whose value depends solely on
supply and demand
• Derivative securities—value derived from value of other
assets
• Option—right of owner to buy or sell an asset
Setting Investment Goals (1 of 2)
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.
Setting Investment Goals (2 of 2)
• Formalize goals:
– Short-term – within 1 year
– Intermediate-term – 1-10 years
– Long-term – over 10 years
• Goals should be realistic:
– Consequences, if not accomplished
– Willing to make financial sacrifices
– How much money is needed?
– When do I need the money?
Financial Reality Check
• Have a grip on your financial affairs
• Make sure you’re living within your means
• Have adequate insurance
• Keep emergency funds
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
Fitting Taxes Into Investing
• Compare investment returns on an after-tax 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
Investment Choices
• Lending Investments—savings accounts and bonds
which are debt instruments issued by corporations and
the government.
• Ownership Investments—preferred stocks and common
stocks which represent ownership in a corporation, along
with income-producing real estate.
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
Ownership Investments
• Real estate—your home, rental apartments and
investments in income-producing property
– Illiquid—hard to sell off
• Stock—fractional ownership in a corporation
• Owner or equity holder—owns stock
• Dividend—a payment by a corporation to its shareholders
The Returns from Investing
• Capital gain or loss—gain (or loss) on the sale of a capital
asset.
• Income return—any payments you receive directly from
the company or organization in which you’ve invested.
Calculating Returns
(ending value  beginning value)  income return

rate of return 
beginning value
(ending value  beginning value)  income return 1

average annual rate of return  
beginning value N
A 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.
• Balance amount of risk with amount of return needed.
Figure 11.1 Risk–Return
Relationship (1 of 2)
Nominal and Real Rates of Return
• Nominal (or quoted) rate of return—rate of return earned
on an investment without any adjustment for inflation
• Real rate of return—nominal rate of return after you’ve
taken out inflation
Historical Levels of Risk and Return
• Historical levels of return bear a strong resemblance
to the risk-return trade-off graph
• Investments with higher levels of risk produce higher
returns
Figure 11.1 Risk–Return
Relationship (2 of 2)
Sources of Risk in the Risk-Return
Trade-Off (1 of 2)
• Interest rate risk
• Inflation risk
• Business risk
• Financial risk
Sources of Risk in the Risk-Return
Trade-Off (2 of 2)
• Liquidity risk
• Market risk
• Political and regulatory risk
• Exchange rate risk
• Call risk
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.
Diversifying Away Risk
• Portfolio—a group of investments held by an individual
• Systematic or Market-Related or Nondiversifiable Risk—
portion of a security’s risk or variability that cannot be
eliminated through diversification.
• Unsystematic or Firm-Specific or Company-Unique Risk or
Diversifiable Risk—risk or variability that can be eliminated
with diversification.
Figure 11.2 The Reduction of Risk as the
Number of Stocks in the Portfolio Increases
Understanding Your Tolerance and
Capacity for Risk
• Need to recognize your tolerance for risk and invest
accordingly.
• Take one of many risk-tolerance tests.
– njaes.rutgers.edu
• Risk capacity refers to your ability to take risk.
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.
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.
Figure 11.3 Reduction of Risk over
Time, 1950–2013
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.
Table 11.1 Factors Impacting Your
Asset Allocation Decision
There isn’t a single asset allocation that works for everyone. However, regardless of what asset allocation you
use, you should be well diversified with both stocks and bonds. In addition, you should build up an emergency
fund before you begin investing for long-term goals. Three factors that you should consider in making your asset
allocation decision are:
• Time horizon. The more time until you need the money, the more risk you can afford to take. The longer
time horizon will give you more time to adjust your portfolio, consumption, and working habits if your
investments perform poorly during the early years. If your time horizon is more than 10 years, you should
emphasize more risky investments such as stocks that carry higher expected returns to achieve your long-
term financial goals.
• Capacity for risk and financial situation. How much risk can you afford to take? In answering this
question, consider these questions: Are you at the point where you feel comfortable that you have enough
saved to meet your goals? How secure is your job? Do you have a pension plan at work that will provide a
steady income at retirement? How much money do you owe or have you saved? Do you have a big enough
emergency fund to allow you to avoid tapping into your long-term investments at an inopportune time such
as in the midst of a market downturn? If you have a limited capacity for risk, you should make sure that you
have sufficient short-term bonds and cash investments in your portfolio to cover emergencies in case of the
unexpected.
• Risk tolerance. Different people have different tolerances for risk. Still, to achieve long-term goals, it is
probably necessary to take some risks and invest in common stock. If you have a low tolerance for risk, try
to learn more about investing—that may make you more comfortable taking the risks you need to take.
Nevertheless, you will want to balance your investments in such a way that you can still sleep at night even
during times of market volatility. You should also try to develop an investment plan that you are comfortable
with and that you can stick with through market ups and downs.
Figure 11.4 Different Asset Allocation
Portfolios with Average Returns, 1950–2013
What You Should Know About
Efficient Markets
• Efficient market—a 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.
Security Markets
• Securities—stocks and bonds—are issued by corporations
to raise money
• Securities markets—a place where you buy and sell
securities
– Primary and secondary markets
• After the initial issue (initial public offering—IPO), securities
are traded among investors
Primary Markets
• Market where newly issues securities are traded
– Initial public offering (IPO)
– Seasoned new issues
– Investment banker
– Underwriter
– Prospectus
Secondary Markets—Stocks
• Markets where previously issued securities are traded
• Organized exchange—a physical location where stocks
trade
– New York Stock Exchange (NYSE)
• Over-the-counter market—transactions conducted over
phone or computer
– Bid price—highest price someone is willing to pay for
a security
– Ask or offer price—lowest price someone is willing to
sell a security
International Markets
• Around for centuries
• Some foreign shares traded on exchanges in the U.S.
• American Depository Receipt (ADR)
– International stocks can be traded through ADRs
Regulation of the Securities Markets
• Aimed at protecting investors so that all have a fair chance
of making money.
• Securities and Exchange Commission (SEC)—federal
• Self-regulation—exchanges and FINRA
• Insider trading and market abuses
– Churning
Placing an Order
• Order Size
– Round lots
– Odd lots
• Time Period for Which the Order Will Remain Outstanding
– Day orders
– Open orders or Good-till-cancelled (GTC) orders
– Fill or kill orders
– Discretionary account
Types of Orders
• Market Orders—buy or sell immediately at the best price
available
• Limit Orders—trade is to be made only at a certain price
or better
• Stop or Stop-Loss Orders—order to sell if the price drops
below a specified level or to buy if the price climbs above
a specified level
Short Selling
• Short selling—the more the price drops, the more money
your make
• Borrow stock from the broker and then sell it
• Margin requirement—collateral
• Sell high and later buy low and return stock to broker
• If price increases, you buy back for more than the sold
price, and lose money
Figure 11.5 Profits from Purchasing
Versus Selling Short
Dealing with Brokers
• Most common way to purchase stock is through
stockbroker—licensed to buy or sell stocks for others
• Full-Service Brokers or Account Executive—paid
commissions based on sales volume
• Discount and Online Brokers—execute trades but do
not provide advice
Brokerage Accounts
• Asset management account—comprehensive financial
services package that can include a checking account; a
credit card; a money market mutual fund; loans; automatic
payment on any fixed debt (such as mortgages);
brokerage services (buying and selling stocks or bonds);
and a system for the direct payment of interest, dividends,
and proceeds from security sales into the money market
mutual fund
• Primary advantage is the automation asset management
accounts provide
Cash Versus Margin Accounts
• Cash Accounts
• Margin Accounts
• Margin or Initial Margin
• Maintenance margin
• Margin call
Joint Accounts
• Joint Tenancy Account with the Right of Survivorship—
when one owner dies, the other receives full ownership
of assets in the account.
• Tenancy-in-Common Account—the deceased’s portion
of the account goes to the heirs of the deceased, not the
surviving account holder.
Choosing a Broker
• Using a full-service broker—personal service and advice
but for higher price
• Using a discount broker—keep transaction costs down
with less personal service but some offer free research
reports
• Making the decision—become knowledgeable on your
choices
Online Trading
• Day traders—trade, generally on internet, with a very
short-term time horizon.
• Be prepared to suffer severe financial losses.
• Don’t confuse day trading with investing.
• Don’t believe claims of easy profits.
• Watch out for “hot tips” or “expert advice.”
Sources of Investment Information
• Corporate Sources
• Brokerage Firm Reports
• The Press
• Investment Advisory Services
• Internet Sources
Table 11.2 Great Sources of
Investment Information on the Web
Web site: Yahoo! Finance
Address: finance.yahoo.com
• This Web site provides news on investments and personal finance, market updates, and a wealth of information on
individual stocks, including quotes, historical prices, interactive charts, key statistics, analyst opinions, and financial
statements. Without question, it is one of the best Web sites out there, and it’s free! Go to it, enter a company’s
name in the “get quotes” box, and see what you get. Also, click on “Investing,” “News,” and “Personal Finance.”
Web site: CNNMoney.com
Address: money.cnn.com
• Included on this Web site is up-to-date information on the stock market, including articles and prices, along with
business and personal finance news.
Web site: Money 101—CNNMoney.com
Address: money.cnn.com
• This is a small section of the CNNMoney.com Web site, but it has a wealth of information on personal finance. It will
introduce you to the basics of investing, making a budget, asset allocation, and many other investment and
personal finance topics.
Web site: The Motley Fool
Address: fool.com
• The Motley Fool provides headline investment news and commentary, along with basic advice on investing and
retirement.
Web site: EDGAR
Address: sec.gov
• The Securities and Exchange Commission (the government group that oversees stock trading) provides free
electronic access to statements, periodic reports, and other forms that firms are required to file.
Summary (1 of 3)
• Determine your goals and start investing.
• Investing is not the same as speculation.
• Risks associated with investments include interest rate
risk, inflation risk, business risk, financial risk, liquidity risk,
market risk, political and regulatory risk, exchange rate
risk, and call risk.
• You can take more risk with a longer time horizon.
Summary (2 of 3)
• Risk can be reduced through asset allocation.
• Don’t try to time the market.
• Primary securities markets is where new securities are
sold.
• Previously issued securities are traded in the secondary
markets which can be organized exchanges.
Summary (3 of 3)
• Market orders, limit order, and stop-loss orders are
used to specify your buying and selling preferences.
• Do your research.
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