Risky Business Securities and Investments

Important Risk Questions? What is Risk? How is it measured? How do I avoid it? The possibility of the loss of an investment Dollars or percentage No guarantees, but diversification can reduce it Understanding risk can be key to whether you invest your money profitably and knowledgably or not. Risk is the possibility of losing all or part of your investment. It can be measured in terms of dollars or percentages. Diversifying, or spreading out your investments so they are different types, can help reduce the risk.

Calculating Investment Return Example: Investing $100 in a savings account earning 2% annual interest $100 x .02= $2 so now you have $102 Investing $100 in a stock and the value increases your money to $120 $120 - $100 = $20 Your return is $20 or $20/$100 = a 20% return You can calculate your return on your investment in a couple of ways. If you know the interest rate, you can multiply that by your investment, if it is simple interest. Compound interest is covered in another lesson. Or, in the case of stocks, you can subtract your initial investment from your final investment. Take that difference and divide it by your initial investment and that will give you your return on your investment.

Risk/Return Relationship Direct relationship As risk increases, return increases The lower the risk, the lower the return Risk There is a direct relationship between risk and return. This means that as the risk increases, the return increases. This also means that investments that have little risk, like certain bank accounts, also will have little reward, or lower interest rates. Return

Risk Tolerance – Part 1 Risk Averse-avoid risk if possible Neutral-just want a high return without considering risk Risk Seeking-look for risky investments Investors have different tolerances for risk. Some will seek out risk, sometimes without thinking about the potential reward. Some investors prefer the ‘slow and steady wins the race’ approach, meaning that even if they receive low interest rates, at least their initial investment will be there later. Some investors do not have a preference for risk. Have students go online and research different banks. Many of the students will choose banks that they have seen in their neighborhood. Have them comment on the different accounts and how much interest they can earn. Risk tolerance greatly depends on the stage of life investors are in.

Risk Tolerance – Part 2 Stage 5: less income, retirement, much more risk averse, 60s+ Stage 4: children grown, approaching retirement, more risk averse, 50s Stage 3: married with children, college to save for, not as risky, 40s Stage 2: possibly married, higher wage potential, somewhat risk-seeking, 30s Stage 1: single, early wage earner, more risk seeking, 20s Many investors’ objectives have to do with how far they are from retirement, whether or not they have children, a house, and other liabilities which can affect their ability to invest. Typically, the longer time until retirement, the more risk an investor can tolerate, while the closer the time until retirement, the less risk can be tolerated.

Types of Risk Risk Significance Liquidity Risk that the investment may not be able to be converted to cash when needed Market Risk that affects the market as a whole; affects mutual funds more than individual stocks Business Risk of a company going out of business; affects stocks and corporate bonds Inflation Risk that the inflation rate will be higher than your rate of return Interest Rate Risk that the interest rate will increase and your fixed-interest investments will be worth less Exchange Rate Risk that currency values can decrease causing foreign investments to be worth less Political Risk that government events or actions can affect the value of your investments Just as different investors have a different preference for risk, there are many types of risk that can affect the stability of investments. Some risk can be avoided, but some risk is out of the investor’s control.

Diversification Investing in several types of securities as opposed to only a single investment Also called asset allocation Theory that a pooling of assets can be safer than only one asset An example - investing in a mutual fund as opposed to a single company’s stock One way that statistically has been proven to reduce risk is to not ‘put all your eggs in one basket’. This means that you should select investments with varying degrees of risk so you can balance out your gains and losses. What can happen if you put all of your money into one company’s stock and that company goes bankrupt?

Asset Allocation Equities Stocks Mutual funds Fixed Income Securities Government bonds Corporate bonds Cash Equivalents Bank accounts Money market accounts Certificates of Deposit Real Estate When an investor’s portfolio is diversified, it should contain investments of different types of assets. The common types of assets are equities such as stocks and mutual funds, fixed-income securities such as bonds, cash equivalents such as bank accounts, and real estate. These have different levels of risk associated with each group of assets.

Corporate Bonds, Large Cap Stocks Risk Pyramid Futures, Penny Stocks Government Bonds Corporate Bonds, Large Cap Stocks Checking and Savings Accounts Many different types of investments can be displayed on a risk pyramid which shows diversification, or asset allocation, which means that certain assets fit at the bottom of the pyramid with less risk, some in the middle with a medium amount of risk, and some at the top with much greater risk. Of course, the higher they are on the pyramid, the higher their potential returns.

Lower-Risk Investments U.S. Savings Bonds Checking/Savings Accounts Certificates of Deposit Money Market Accounts Mutual Funds High credit-rating corporate bonds The lower the risk, the lower the returns. Examples of these are U.S. Savings Bonds, checking, savings, and money market accounts, as well as Certificates of Deposit (CDs), and some corporate bonds if the company issuing the bonds has a high credit-rating.

Medium-Risk Investments Preferred Stock High Quality Stocks Large-cap Stocks Growth Stocks Medium-risk securities include preferred stock, some higher-quality, more stable, large-cap stocks, as well as growth stocks. While stocks can be risky, larger companies are generally more stable. In addition, growth stocks are usually companies that are growing rapidly and may not be in a decline stage any time soon, so their stock may increase for a while. Ask students research some of these types of companies online and look at their stock charts to see if they have been increasing.

Higher-Risk Investments Small- and Mid-cap Stocks Mutual Funds in same industry Futures, commodities, collectibles Penny Stocks The higher-risk investments usually earn the highest returns because of their level of risk. Smaller company’s stock and penny stocks (stocks under $5) are higher risk. Generally mutual funds fit in the mid-risk category but if the funds are made up of stocks in the same industry and the industry has a downturn, there can be risk for these funds. Commodities and collectibles are items that can be traded, but they are risky because there has to be a need or a market for these types of products. They usually require a very specialized buyer; therefore, there is higher risk.

Formal Assessments Risk/Return Line Graph Assignment #1 – Following the example of the risk pyramid you learned about in this lesson, create a line graph showing the direct risk/return relationship between at least five different investments. Axes should be labeled.

Formal Assessments Your Own Portfolio Assignment #2 – Students will put together their own portfolio using the different types of investments discussed in this lesson. Virtually invest $5,000 for a six-month period and include at least three different investments according to their own level of risk tolerance. For example, if you want safe investments, you can calculate the return using savings account rates, certificate of deposit rates, and money market accounts. Specify how much of the $5,000 will go into which investments and determine how much money you will have at the end of six months. You may display your results in any manner you choose, but it should look professional.

Formal Assessments Financial Trivia Risk Tolerance Assignment #3 – Review the attached handout for the Financial Trivia. According to the directions, write in pen, not pencil, and answer trivia questions. As each question is asked, indicate whether or not you will go ‘double or nothing’(if you are very sure of the answer) on your answer, meaning you can get zero, five, or ten points for each question. Each question is worth five points. If the answer is incorrect, it is zero points. If you went ‘double or nothing’ and you are right, it is ten points. If it was incorrect, you get zero points. After the ten questions are completed, tally your scores and write a conclusion regarding your risk tolerance level and if it paid off or not.