Slides by Pamela L. Hall
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Transcript of Slides by Pamela L. Hall
1
Slides by Pamela L. Hall
Western Washington University
The Investment Decision
Chapter 12
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Why Invest?
Some people have specific reasons for investing Supplement current income Reduce current and future tax liability Send children to college Retire comfortably For fun
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Why Invest? We’re living longer—thus, we’ll have a longer period
of retirement Personal incomes are not rising rapidly
Experts expect personal incomes to keep pace with inflation To raise your standard of living, you’ll need to earn more than
inflation
The labor market is changing People are changing jobs many times during their life and
spend some time unemployed Saving/investing can help you weather the storm
Self-directed retirement plans are now the norm Individual is responsible for most, if not all, investment
decisions
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The Steps in the Investment Process
Know your goalsYour present situation will impact those
goals If one goal is a secure retirement and your
employer does not offer a retirement savings plan, you’ll have to do this on your own
If you already own your own home, saving for a down payment wouldn’t be a goal—maybe you’d be focused on paying down your mortgage
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Assessing Risk and ReturnHow long do you plan to invest (your expected
holding period)? Over longer time periods you can afford more risk
What level of expected return is required to meet your goals? Higher expected returns mean taking higher risks
How much risk are you comfortable with? If you panic at every daily fluctuation, you should
stick with lower risk investments Personal characteristics, such as age and income
influence risk tolerance
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Selecting the Right Investment
Examine your investment goals, time horizon, risk tolerance, desired return, etc. and choose your investments
Stocks—represent ownership in a company Share in the company’s profits
May receive cash dividends May receive capital appreciation (main reason people
invest in stocks) No maturity date
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Selecting the Right Investment
Bonds—represents a promissory note issued by a corporation/entity promising to pay interest and principal Bonds don’t have to pay interest, but if they
have a coupon rate they should Bonds usually have a maturity date (up to 30
years or so) Receive benefits through interest income
Main reason people invest in bonds May experience price appreciation
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Selecting the Right Investment Money market instrument—a lending investment that
matures within one year Examples include
Treasury bills Bank savings accounts
Typically pay low interest rates but are very low risk
Two aspects to investment selection, or asset allocation
Strategic Decisions concerning the general mix of investments (i.e., 50%
stocks, 30% bonds, 20% money market) Tactical
Selecting specific investments that are best for you (i.e., choosing an index mutual fund for the stock portion of your investments)
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Managing Your Investments
Buy-and-hold philosophy A passive approach wherein you
purchase a set of investments and do not manipulate the investments Make changes only if and when your goals or
personal situation changes
Active philosophy Actively watch the performance of your
investments, buying/selling as you see fit
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Understanding Risk and Return
By investing you EXPECT to earn some rate of return, but it always has some degree of risk because it is an EXPECTATION
Sources of Investment Returns Income
Dividends (stocks) Interest (bonds)
Capital appreciation (price of investment increases)
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Understanding Risk and Return
Compare the income vs price change portion of various investments over a recent 10-year period:
Investment
Average Annual Return
Income Portion
Price Change Portion
Stocks 12.5% Little Most
Bonds 7.8% Most Little
Money market
4.4% All None
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Measuring Investment Returns
Total Return represents the return you earned on the amount you invested over a certain time period (usually one year, but not necessarily) Includes both income and price changes
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Measuring Investment Returns
Example: You bought 1,000 shares of stock one year ago at a price of $50. You sold it for $55 because you felt the future uncertainly was too great. During that time you received dividends of $1 per share. Calculate your total return from your investment. Total Return = (Selling Price + Dividends –
Purchase Price) Purchase Price Total Return = ($55 + $1 - $50) $50 = 12%
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Calculating Average Returns
Examine the two investments:
Annual Return
EOY Value of $1,000
(cumulative)
Year A B A B
1 15% 45% $1,150 1,450
2 15% 0% 1,322.5 1,450
3 15% 0% 1,520.88 1,450
Average (Arithmetic)
15% 15% Clearly A is the better
investment.Average
(Compound)
15% 13.18%
Measures actual change in wealth.
Can overstate the actual return to investor.
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What is Investment Risk? Risk is the uncertainty that an investment’s actual
return will not be what you expected it to be There’s an upside and a downside Types of investment risk:
Default risk Credit risk Tax risk Purchasing power risk Interest rate risk Market risk Event risk
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Measuring Investment Risk Some types of risk are easy to measure
Market risk
-20.0%
-10.0%
0.0%
10.0%
20.0%
30.0%
40.0%
1975 1977 1979 1981 1983 1985 1987 1989 1991 1993 1995 1997 1999 2001
An
nu
al R
etu
rn
T-bills
Stocks
Figure 12.4Annual Returns on Stocks and Treasury Bills: 1985-2001
Stocks have more market risk
than T-bills.
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Are Risk and Holding Period Related?
The longer your holding period the more risk you should consider taking
Between 1926 and 2001 stocks had returns < 0% for 22 of the 76 years But when looking at a longer 10-year
holding period, there were only negative returns for 2 of the 66 rolling 10-year periods
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Figure 12.5: Stock, Bond, and Treasury Bill Average Returns
0.0%
2.0%
4.0%
6.0%
8.0%
10.0%
12.0%
14.0%
16.0%
76 years 25 years 10 years
Periods Ending 12/31/2001
Av
erag
e A
nn
ual
Ret
urn
Stocks Bonds
T-bills Inflation
T-bills have only slightly
outperformed inflation.
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Figure 12.6: Investment Growth over the 25-Years Ending 12/31/01
$24,101
$8,708
$5,106
$3,049
$0
$5,000
$10,000
$15,000
$20,000
$25,000
$30,000
Stocks Bonds T-bills Inflation
Gro
wth
of
$1,0
00 In
ves
tmen
t (1
976-
2001
)
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Comparing Stocks, Bonds and T-bills Stability of principal
Value of investment will never fall below what you originally invested
T-bills are the winner
Current income Historically bonds have paid more income than stocks or t-
bills
Stability of income Bonds are the winner—you know how much income you are
promised each year
Growth of income Stocks are the winner because dividends tend to grow over
time, while bond income remains fixed
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Some Lessons for New InvestorsTo earn high returns, you have to be willing to
take high risksDiversification is helpful
Can help reduce risk without decreasing return a great deal (due to co-movement)
Past performance is not a guarantee of future performance
Financial Markets are fairly efficient Fair, orderly and very competitive (lots of buyers
and sellers) No “easy money”
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Some Lessons for New Investors Avoiding common investment mistakes
Chasing returns Investing your money based on how well an investment
performed last period Fad Investing
Investing in something simply because others are doing so Buying right after a major price increase or selling right after
a major price decline Hanging onto a loser Investing with no plan Trusting the self-proclaimed gurus Fearing the wrong risks
Being unwilling to take risks—especially if you have a long-term investment horizon
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Sources of Investment Information Problem isn’t that there is too little information, but
too much Periodicals and newspapers
Newspapers, local & business-oriented Investor’s Business Daily The Wall Street Journal Barron’s
Periodicals Time U.S. News & World Report Business Week Forbes Kiplinger’s Personal Finance Money
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Sources of Investment Information
Investment advisory services Moody’s and Standard & Poor’s Value Line Morningstar Brokerage firms Investment newsletters
Computerized sources of investment information
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Web Links
Good source for basicshttp://www.investoreducation.org/index.cfm
http://moneycentral.msn.com/home.asphttp://www.quicken.com/investments/basics/
http://www.kiplinger.comhttp://www.morningstar.comhttp://www.vanguard.comhttp://www.nyse.comhttp://www.nasdaq-amex.com