Copyright ©2004 Pearson Education, Inc. All rights reserved. Chapter 13 Investing Fundamentals

Copyright ©2004 Pearson Education, Inc. All rights reserved.13-2 Chapter Objectives Describe the common types of investments Explain how to measure the return on investments Identify the risks of investments Explain the tradeoff between the return and risk of investments

Copyright ©2004 Pearson Education, Inc. All rights reserved.13-3 Chapter Objectives Describe common investment mistakes that should be avoided

Copyright ©2004 Pearson Education, Inc. All rights reserved.13-4 Types of Investments Money market securities Stocks –Primary and secondary stock markets –Primary market: a market where newly issued securities are traded Initial public offering (IPO): the first offering of a firm’s stock to the public –Secondary market: a market where existing stocks are traded

Copyright ©2004 Pearson Education, Inc. All rights reserved.13-5 Financial Planning Online: IPOs Go to: This Web site provides information about firms that are about to engage in an IPO and also summarizes the performance of recent IPOs

Copyright ©2004 Pearson Education, Inc. All rights reserved.13-6 Types of Investments Types of stock investors –Institutional investors: professionals who are responsible for investing the money of a financial institution on behalf of their clients –Portfolio managers: employees of financial institutions who make investment decisions –Individual investors: individuals who invest a portion of their own money

Copyright ©2004 Pearson Education, Inc. All rights reserved.13-7 Types of Investments Return from investing in stock –Returns come through dividends and price appreciation –Growth stocks: stocks of firms with substantial growth opportunities –Income stocks: stocks that provide investors with periodic income in the form of large dividends

Copyright ©2004 Pearson Education, Inc. All rights reserved.13-8 Financial Planning Online: Price Trends of Your Stocks Go to: This Web site provides historical price movements for a stock that you specify. Type in the symbol for your stock then click on “Charts.” You can easily monitor the price of a stock you already own or may purchase in the future.

Copyright ©2004 Pearson Education, Inc. All rights reserved.13-9 Types of Investments Common versus preferred stock –Common stock: a certificate issued by a firm to raise funds that represents partial ownership in the firm –Preferred stock: a certificate issued by a firm to raise funds that entitles shareholders to first priority to receive dividends Less risky than common stock

Copyright ©2004 Pearson Education, Inc. All rights reserved Types of Investments Bonds –Return from investing in bonds is in the form of coupon payments and price appreciation Mutual Funds –Return from investing in mutual funds comes from coupon or dividend payments generated by the portfolio of the fund

Copyright ©2004 Pearson Education, Inc. All rights reserved Types of Investments Publicly traded indexes: securities whose values move in tandem with a particular stock index representing a set of stocks –One of the most popular is the Standard & Poor’s Depository Receipt (S.P.D.R, also called Spider)

Copyright ©2004 Pearson Education, Inc. All rights reserved Types of Investments Real estate –Buying a home or purchasing rental property or land –Return from investing in real estate comes in the form of rent payments and selling the property for a higher price than paid for it

Copyright ©2004 Pearson Education, Inc. All rights reserved Investment Return and Risk Measuring the return on your investment R = Pt – Pt-1 Pt-1 R = return Pt = price when sold Pt-1 = price when purchased

Copyright ©2004 Pearson Education, Inc. All rights reserved Investment Return and Risk Example: If you pay $1,000 to make an investment and receive $1,100 when you sell the investment in one year, you earn a return of: R = $1,100 - $1,000 =.10 or 10% $1,000

Copyright ©2004 Pearson Education, Inc. All rights reserved Investment Return and Risk –Incorporating dividend or coupon payments Your return would be even higher if you also earned dividend or coupon payments R = Pt – Pt-1 + D Pt-1 D = dividends earned while you owned the investment

Copyright ©2004 Pearson Education, Inc. All rights reserved Investment Return and Risk –Differing tax rates on returns Interest payments, coupon payments and dividend payments taxed as ordinary income Capital gains from investments held one year or less are taxed as ordinary income Capital gains from investments held more than one year are subject to a long-term capital gains tax

Copyright ©2004 Pearson Education, Inc. All rights reserved Investment Return and Risk

Copyright ©2004 Pearson Education, Inc. All rights reserved Investment Return and Risk How wealth is influenced by your return on investment –Any return saved increases the value of assets and therefore increases wealth –Future value calculations can help estimate these increases

Copyright ©2004 Pearson Education, Inc. All rights reserved Investment Return and Risk Risk from investing –Returns are uncertain –Future values of investments are dependent on demand by investors –Before you select an investment, you should assess the risk

Copyright ©2004 Pearson Education, Inc. All rights reserved Investment Return and Risk –Measuring an investment’s risk Range of returns: returns of a specific investment over a given period Standard deviation of returns: the degree of volatility in the stock’s return over time A risky stock will normally have a relatively wide range of returns and a high standard deviation of returns There are other subjective measures of risk

Copyright ©2004 Pearson Education, Inc. All rights reserved Tradeoff Between Return and Risk Return-risk tradeoff among stocks –Small firms tend to have more growth potential, but higher risk –IPOs may offer high returns, but also have high risk, especially for individual investors Return-risk tradeoff among bonds –Large, well-known firms have low return, low risk –High risk bonds offer higher payments

Copyright ©2004 Pearson Education, Inc. All rights reserved Tradeoff Between Return and Risk Risk-return tradeoff among mutual funds –Mutual funds containing small stocks are more risky than those containing large stocks –Mutual funds containing bonds of weak corporations are more risky than those with bonds of creditworthy corporations

Copyright ©2004 Pearson Education, Inc. All rights reserved Tradeoff Between Return and Risk Return-risk tradeoff among real estate investments –Renters could default –Property value could decline Comparing different types of investments –Select investments that suit your personal objectives

Copyright ©2004 Pearson Education, Inc. All rights reserved Tradeoff Between Return and Risk

Copyright ©2004 Pearson Education, Inc. All rights reserved Learning From the Investment Mistakes of Others Making decisions based on unrealistic goals Borrowing to invest Taking risks to recover losses from previous investments Focus on Ethics: Falling prey to online investment fraud –Avoid making decisions without facts

Copyright ©2004 Pearson Education, Inc. All rights reserved How Investments Fit within Your Financial Plan Key decisions about investments that should be included in your financial plan are: –What are your investment goals? –Given your existing budget, should you make investments? –Based on your risk tolerance, how should you invest funds?

Copyright ©2004 Pearson Education, Inc. All rights reserved Integrating Key Concepts

Part 1: Financial Planning Tools Part 2: Liquidity Management Part 3: Financing Part 4: Protecting Your Assets and Income Part 5: Investing –In Chapter 13 we learned about investment fundamentals –In Chapter 14 we will learn about stock analysis and valuation –In Chapter 15 we will cover investing in stocks –In Chapter 16 we will learn about investing in bonds –In Chapter 17 we will learn about investing in mutual funds –In Chapter 18 we will cover asset allocation Part 6: Retirement and Estate Planning