PART 4:

MANAGING YOUR INVESTMENTS

Chapter 11

Investment Basics
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.

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Investing Versus Speculating
 When 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.

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Investing Versus Speculating
 With speculation, assets don’t generate an income
return and their value depends entirely on supply
and demand.

 Examples include:
– Gold coins
– Baseball cards
– Non-income producing real estate
– Gems
– Derivative securities

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Investing Versus Speculating
 Derivative 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

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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.

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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.

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Setting Investment Goals

 When 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
needed.
– Periodically reevaluate your goals.

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Setting Investment Goals

 Formalize goals into:

– Short-term – within 1 year
– Intermediate-term – 1-10 years
– Long-term – over 10 years

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Setting Investment Goals
 Focus on which goals are important by asking:
– 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?

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Fitting Taxes into Investing
 Compare returns on an after-tax basis:
– 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.

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Starting Your Investment Program

Tips to Get Started

– 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.

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Investment Choices

Lending Investments Ownership Investments

– Savings accounts  Preferred stocks and

and bonds. common stocks which
represent ownership in
– Debt instruments a corporation.
issued by
corporations and
 Income-producing real
the government. estate.

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

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Ownership Investments

 Real estate investments in income-producing

properties are illiquid.
 Stocks, or equities, are the most popular
ownership investment.
– Stocks may pay a quarterly dividend.
– Preferred stock dividends are fixed.
– Common stock has voting rights.
– Bond interest is paid prior to stock dividends.

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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.
– Real rate = nominal rate - inflation rate

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

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What Makes Up Interest Rate Risk?

Inflation Risk Premium Default Risk Premium

 Return above the real  Compensates investors
rate of return to for taking on the risk of
compensate for default.
anticipated inflation.

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What Makes Up Interest Rate Risk?

Maturity Risk Premium Liquidity Risk Premium

 Additional return  For bonds that cannot
demanded by investors be converted into cash
on longer-term bonds. quickly at a fair market
price.

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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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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.

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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.

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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.

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Sources of Risk in the
Risk-Return Trade-Off

 Market Rate Risk – associated with overall

market movements.
– Bull markets – stocks appreciate in value
– Bear markets – stocks decline in price

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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.

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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.

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Systematic and Unsystematic Risk

Systematic Risk Unsystematic Risk

 Market-related or non-  Firm-specific,
diversifiable risk. company-unique, or
 That portion of a diversifiable risk.
stock’s risk not
eliminated through
 Risk that can be
diversification. eliminated through
 It affects all stocks. diversification.
 Compensated for  Factors unique to a
taking on this risk. specific stock.

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How to Measure the Ultimate Risk
on Your Portfolio

 For risk associated with investment returns,

look at:
– 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.

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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.

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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.

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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.

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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.

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What You Should Know About
Efficient Markets

 Deals 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
analysts.

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