Chapter 13 The Investment Decision Why Invest? –Supplement current income –To reduce current,...

Chapter 13 The Investment Decision

• Why Invest?– Supplement current income– To reduce current, future tax liability– To send children to college– To have a comfortable retirement– To make a down payment on a house


• The Importance of Investment DecisionsWe’re living longer

Personal income is showing flat growth

The labor market is changing (unemployed)

There is a trend toward self-directed retirement plans (away from Soc. Sec.)


• Step 1: Setting GoalsDetermine goals by asking yourself:

• Why are you investing?

• What do you want your investments to accomplish?

• What kind of time frame do you have?


• Step 2: Assessing Risk and ReturnHow long are you planning to invest?What is the return necessary to achieve your

goals?What is your tolerance for risk?


• How Long Do You Plan to Invest? General rule of thumb -- The longer the

holding period, the more aggressive you can afford to be (if all other things are equal)

– Influenced by age of investor• Someone under 40 will probably hold more

investments in stocks than someone who is 60 or older


• What Expected Return is Necessary?Future returns referred to as “expected

returns”Few guarantees when investingIf return generated DOES NOT match your

needs, you must eitherIncrease your contributionsInvest in instruments with higher returns/risk


• How Much Risk is Acceptable?Personal characteristics (income, age) play

role in risk tolerance

Those with low risk tolerance should limit choices to fairly safe investments

The longer the holding period, the more risk you should consider taking


• Step 3: Selecting the Right InvestmentStocks -- represent ownership in a corporation

– As stockholder, you share in profits through:• Dividends

• Increases in stock prices

– Primary motivation in buying stocks is price appreciation


• Step 3: Selecting the Right InvestmentBonds -- lending money to some organizationIssued by governments and corporationsEarn a pre-determined amount of interest

although price changes with interest ratesReceive “face value” (loan principal) when

bond maturesIncome (& Taxes Savings) primary reason to

buy bonds


• Step 3: Selecting the Right InvestmentMoney market instruments -- Also lending money

to an organization

Similar to bonds in that you receive pre-determined interest payments and “face value” upon maturity

Unlike bonds in that they mature within a year

• Examples: Treasury bills and bank savings accounts (CD’s)


• Step 4: Managing Your Investment

Two approaches exist:1. Passive -- Buy and hold philosophy. Retain

same investments for a long period of time

2. Active -- Regularly evaluate investment performance and make periodic changes.


• Sources of Investment ReturnsIncome -- Treasury bills and money market

instruments provide returns this way

Price Appreciation -- Common stocks

Both price appreciation and income -- Common stocks (through dividends and stock appreciation) and bonds (interest and price change in market value)


• Measuring Investment ReturnsOnly measurable returns are “historical”

ones (Ex Poste – the past)

Measure of “total return” incorporates both price changes and income

Usually total return is computed over a year


• Average ReturnGives an indication of how an investment has

performed over a period of timeAverage compound rate earned from the

beginning to the end of the three, five, or ten-year period

Similar to the compound rate of interest on a savings account


• What is Investment Risk?– The uncertainty that exists over what an

investor’s actual return will be over some period in the future

– Investment risk is the OPPOSITE side of investment return


• What is Investment Risk?– Investing in CD’s brings no uncertainty over

risk; but the return is lower

– Investing in stocks brings a wider range of risk; but often returns are higher

– This is the Risk/Return tradeoff


• Measuring Investment Risk– Simple measure of risk is the variability or

range of returns over a period of time

– The greater the variability of an investment, the more risk

– This is calculated simply as the Variance of an investment


• Relationship Between Risk and Holding Period The longer the holding period, the more risk you

should consider taking early in the investment

Some of the risk associated with investment tends to disappear as the length of the holding period increases, variability (variance) tends to decrees as the sample size (# of annual returns) grows.

Volatility of stocks has been much lower over five, ten, and twenty year period as compared to just a one-year period (Central Limit Theorem)


• Comparing Stocks, Bonds, and T-Bills– Most investors own a mixture of stocks,

bonds, and money market instruments– One way to evaluate these three options is to

compare them on the basis of their risks and returns


• Total Return ComparisonStocks far ahead of bonds and T-bills in total

return

Over past 73 years, T-bills’ returns have barely exceeded the rate of inflation


• Stability of Principal Comparison T-bills and money market instruments are

clear winners

• When a T-bill is purchased, owner can be almost certain to get back at least initial investment

• When stock is purchased, there is no such guarantee


• Current Income Comparison Bonds are winner in this category

– Over last 70 years• Bonds have paid about 5% a year in income

• Stocks about 4% a year in income

• T-bills about 3.5% a year in income


• Stability of Income ComparisonBonds are winner in this category

• With a bond you know exactly how much income you will receive

• Interest rates on T-bills, however, fluctuate from year to year

• Common stock dividends also vary from year to year


• Growth of Income ComparisonStocks are winner in this category

• Historically dividends have grown over time

• Bonds have fixed amount of interest over entire life

• T-bills rates vary from year to year, falling as well as rising


• Diversification is Beneficial– Diversification is spreading funds among

many different investments

– Investment equivalent of “NOT PUTTING ALL YOUR EGGS INTO ONE BASKET”

– Not diversifying is a common mistake among investors


• Diversification is Beneficial– Can reduce the risk of your investment,

without substantially lowering return– Can increase your return without

substantially increasing the risk– Can help you beat the risk/return tradeoff to

a certain degree


• Why does diversification work?– Because returns on different investments do

not perfectly match each other over time– Some perform well one year, while others

perform well in another year– This is known as correlation (positive,

negative, & zero) we hope for increases– “A Rising Tide Floats All Ships”


• The Past Does Not Guarantee the FutureInvestment decisions are often based on

historical information

A past good performance, however, is no guarantee of a future good performance

Even if the past repeats itself, variation is common


• Common Investment Mistakes1. Chasing returns2. Fad investing3. Buying and selling at the wrong times4. Hanging on to a loser5. Investing with no plan6. Trusting the self-proclaimed gurus7. Fearing the wrong risks


• Sources of Investment Information– Problem is sifting through massive amount

of information available

– Objective source -- presents historical and current data, with no opinion attached

– Subjective source -- presents historical and current data and makes recommendations


• Sources of Investment Information Newspapers

• Wall Street Journal• Barron’s

Periodicals• Business Week• Forbes • Fortune • Money


• Sources of Investment Information Investment Advisory Services

• Moody’s

• Standard and Poor’s

• Value Line

• Morningstar

• Brokerage Firms

• Investment newsletters


• Sources of Investment Information Computerized Sources– Web sites like Yahoo and CNNfn offer:

• Current stock, bond, and mutual fund prices• Current financial and economic news

– Provide ability to trade securities through on-line brokerage services (Ameritrade)

Chapter 13 The Investment Decision Why Invest? –Supplement current income –To reduce current,...

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