Investment Fundamentals Chapter 13: Investment Fundamentals

Learning Objectives Explain how to get started as an investor. Discover your own investment philosophy. Identify the kinds of investments that match your interests. Describe the major factors that affect the rate of return on investments. Decide which of the five long-term investment strategies you will utilize. Create your own investment plan.

1. Starting Your Investment Program Saving vs. Investing…What’s the difference? Put Your Money to Work! Build “real” wealth Rate of return; Time Sacrifices are necessary: Start early, invest regularly Delay 5: Double Down We invest in securities [stocks, bonds, mutual funds] Our invested assets make up our portfolio

Decide why you want to invest Are you ready to invest? Balances on high interest credit cards? Adequate insurance protection? An emergency fund that is easily accessible? A monthly budget? Contributing to your employer’s retirement plan? Decide why you want to invest Achieve financial goals [kids’ education, house down payment] Supplement income Reduce tax liability Retire comfortably For fun!

It takes money to make money! Getting money to invest Pay yourself first Save-- don’t spend– extra funds Make it automatic Scrimp for a month Break a habit, make use of the money It takes money to make money! If you want to be able to invest $1,000 this year, ask yourself these questions… before you buy!

Investors hope for a POSITIVE RETURN Current Income Versus Capital Gain Current Income is received on a regular basis while you own the investment dividends from stock; interest from bonds taxed at your marginal tax rate Capital gains occur only when you sell the investment results from you selling it for more than you bought it for taxed at special lower rates Capital losses are also possible! Rate of Return (yield) is an investment’s total yearly return in the form of a percentage

What investment returns are possible? Levels of RETURN ARE related to RISK Average returns from 1926 – 2006:

2. Your Investment Philosophy How to handle investment risk Pure risk vs. Speculative risk Investment risk: uncertainty about returns Tradeoff: Between risk and return

Ultraconservative “Investors” Are Really Just “Savers” People that invest very conservatively They do not get ahead financially over the long term because taxes and inflation offset most of their interest earnings You can accept more risk when investing for long-term goals Remember “The Rule of 72”? 72/4% = 18 years 72/8% = 9 years

What is Your Investment Philosophy? Your approach to risk tolerance in investments Risk tolerance: your ability to handle changes in your investments’ value Levels of Risk Tolerance: conservative; moderate; aggressive We must take risks that will enable us to reach our financial goals Greater risk = greater potential for returns RCRE Investment Risk Tolerance Quiz available online at: www.rce.rutgers.edu/money/riskquiz/

Investment Philosophy: Conservative: Risk averse Goal = preserve capital Moderate: Risk indifferent Goal = long-term profit Aggressive: Risk seeker Goal = short-term, quick profit Investment Approach: Active Investor – studies the economy, market trends, and investment alternatives Usually buys individual stocks/seeks quick profits Passive Investor – does not spend much time monitoring investments. Usually buys mutual funds/seeks long-term profits

3. Identify the Types of Investments You Want to Make Your investments should match your interests You can invest in 2 ways: lending or owning Debts – “loanership” (lending) investments the borrower agrees to repay the principal to the investor on a specific date (maturity). the borrower agrees to pay the investor a specific rate of interest at regular intervals. Equities – “ownership” investments Potential for a higher return by sharing in profits Pg. 363 Overview of Investment Alternatives

4. How Risk and Other Factors Affect Return Random risk All of your eggs are in one basket What happens if that basket breaks? Diversification “Spread the wealth”! A way of reducing random risk Averages out the high & low returns, reducing overall risk Market risk (undiversifiable) Risk results from economic influences that affect entire market

Effects of Diversification: Lower Total Return + Less Overall Risk

The Tax Consequences in Investment Fundamentals Did you Know? PG 366 After-Tax Return Tax-Deferred Investments Tax-Exempt Investments

5. Establish Your Long-Term Investment Strategy Example: 10% return, 7.5% after taxes (25% tax bracket), 3% inflation, real rate of return of 4.5% after taxes and inflation 4 Strategies Investing is not “rocket science”… “just do it” Start as early as possible Investments should provide a positive Real Rate of Return Understand the economy as a whole: how are Securities Markets performing? Bear Market Bull Market

A 10-Year Delay in Investing Can Cost you over $500,000 PG 367 Assumption: $2000 / yr in a tax-deferred account earning 10%

Trying to Time the Market is Too Difficult to Accomplish Long-term investors must be able to withstand some market volatility What are Market Timers? Constant “shifters” Hope to capture the upside of rising stock prices while avoiding most of the downside Very difficult to catch market highs and lows…have to be right twice Miss the “best trading days” when prices rebound

Strategy #1: Buy-and-Hold “The secret to investment success is benign neglect.” The Emphasis: Hold on to investments in good times and bad The Action: Buy a diversified mix of stocks or mutual funds, reinvest the dividends, and hold on almost indefinitely The Expectation: The value of assets will increase over the long run with the growth of the American and world economies The Challenge: Do not react emotionally to day-to-day changes that occur in the market The Advice: Buy more shares when prices are lower during normal market downturns

Strategy #2: Dollar-Cost Averaging The Action: Invest equal sums of money at regular intervals regardless of the price of the investment The Emphasis: Invest regularly, automatically The Expectation: You will be buying more shares when stock price is down and less when the price is up => reducing average cost per share Buying shares regularly through a “DRIP”, pg 371

Strategy #3: Portfolio Diversification “Diversification is the single most important rule in investing.” The Action: Create your portfolio by choosing different asset classes The Emphasis: Spread the wealth! Choose assets based on their dissimilar risk-return characteristics The Expectation: Different asset classes react differently to economic changes; when one performs poorly, the others will perform well. The Advice: Never keep more than 10% of your assets in one investment

Diversification Averages Out an Investor’s Returns

Diversified Investment Portfolios

Strategy #4: Asset Allocation “More than 90% of an investor’s returns are a result of proper allocation.” The Action: Decide on the proportions of your investment portfolio that will be devoted to various asset categories The Emphasis: You are in the right place at the right time! your allocation proportions reflect your age, risk tolerance, goals, time horizon The Expectation: Your portfolio allocation will maximize returns and reduce risk The Advice: Maintain your desired allocation, rebalancing when necessary

Model Portfolios and Time Horizons

Rebalancing Assets in Your Portfolio

Creating Your Own Investment Plan Investment plan: an explanation of your investment philosophy and your logic on investing to reach specific goals What are the time horizons for your investment goals? Building up an amount for a down payment on a home? Creating a college fund for a child? Putting away money for retirement?