Personal Finance Investing Basics Bill Klinger

Personal Finance Review Exam

Investing First things first Securities Pay off debts before investing. Why? Example Securities Stocks, bonds, or money market instruments that represent an obligation on the part of the issuer.

Securities Three major asset classes There are others Asset allocation Cash Bonds (fixed income) Stocks (equities) There are others Real estate Commodities Collectables Asset allocation The percent of your assets in each category Very important concept in investing

Securities Markets Primary Market—market where new security issues are first sold to investors; the issuer receives the proceeds from the sale. Initial Public Offering (IPO) Secondary Market—financial markets where previously issued securities are traded among investors. Examples: NY Stock Exchange and the NASDAQ Firm makes no money on price changes

Returns and Rates Nominal Real Quoted rate or amount The printed value Subtracts inflation Real rate = nominal rate – inflation rate

Cash Money Market Instruments—short-term debt securities Mature within one year Examples: U.S. Treasury Bills, Commercial paper, Repurchase agreements Certificates of Deposit (CDs) Treasury Bills are special The “risk-free asset” Returns come from interest Generally low-risk securities that are purchased by investors when they have surplus cash.

Stocks (Equities) Represent ownership in a firm Types Markets Common Preferred Markets Primary IPO Secondary Investors Institutional Individual Market cap Value of company = (price of a share of stock) x (# of shares)

Equity Returns Dividends Change in price Profits returned to the owners Optional for common stock Required for preferred stock Usually quarterly Sometimes one-time event Change in price Based on investors’ view of a firm’s future Will cause a capital gain or loss

Bonds (Fixed Income) Long-term debt Corporate Municipal Federal State and local government Federal Treasure Bonds (>2 year maturity) Returns Interest Capital gain / loss if sold before maturity

Investment Return Holding period return (total return) Stocks return = (priceend – pricebeginning + dividend) / pricebeginning Bonds return = (priceend – pricebeginning + interest) / pricebeginning

Taxes on Returns Ordinary income tax Capital gains tax Taxed at marginal rate Interest Dividends Capital gains for securities held less than 1 year Capital gains tax Currently 15% On sale of securities held more than 1 year Do example exhibit 14.1

Investment Risks Systemic risks Idiosyncratic risk Inflation Risks that all investments share Economy Terrorism Government laws and actions (e.g. the Fed) Idiosyncratic risk Risk unique to a firm E.g. Exploding smart phone, E.coli in food, sticking gas pedals Inflation

Measuring Risk Range of returns Standard deviation Subjective evaluation

Exercise Deal or No Deal What affects your decision? You have a 50/50 chance of getting either $500,000 or $1. I offer you either those odds or $200,000 guaranteed. What do you take? You have a 50/50 chance of either losing $100 or losing $1. I offer you either those odds or a guaranteed loss of $45. What do you take? What affects your decision? Expected value Expected utility

Investment Risks Cash Stocks (equities) Bonds (fixed-income)

Average Annual Return Since 1925 Risk – By Asset Class Worst Annual Return Since 1925 Average Annual Return Since 1925 Stocks -43.4% (-67.6% worst 12 mo.) 9.6% (162.9% best 12 mo.) Bonds -7.8% 5.5% Cash .1% 3.7% Sources: personal.fidelity.com, Morgan Stanley, www.efficientfrontier.com, Federal Reserve – St. Louis

In Class In groups of two Chapter 14 Financial Planning Problems