The Principles of Investing Lesson 16.2

Starter You buy a new car for $20,000 and finance 100% of it at 4.9% for 5 years. How much will your monthly payment be? (Use the TVM Solver on your TI) You buy a new house for $650,000. You pay 20% down and finance 80% over 30 years at 5%. How much are your payments? If the interest rate goes up to 6%, how much would your payments be?

Investment Principles Regular periodic investments –Dollar cost averaging –Make it AUTOMATIC!!! –Pay yourself first. Diversification –Asset allocation Rebalancing –Buy low, sell high!

Dollar Cost Averaging Assume you buy $100 worth of ABC fund on the first of each month. On Jan. 1, it cost $10 per share, so you bought 10 shares. On Feb. 1, it cost $15 so you bought 6.7 shares. On Mar. 1, it cost $20 so you bought 5 shares. Find the average price of shares over the three month period –( ) / 3 = $15 Find the average price per share you paid –$300 / 21.7 shares = $13.82 per share So your average cost was less than the average share price!

Make it Automatic Monthly contributions to your account should NOT depend on a conscious decision each month. Ways to automate: –Have your employer deduct from check –Have your investment company deduct from your checking account Results: –You get used to paycheck, don’t notice loss –Dollar Cost Averaging!

Diversification Spread your investments across several unrelated types of investments. Some important asset classes: –Large cap US stocks –Small cap US stocks –Foreign stocks –US Treasury bonds –Corporate bonds –Real estate –Gold or other commodities –Cash (like money market funds) Choose a mix of 3 to 5 asset classes appropriate to your risk/reward preferences

Rebalancing Consider a portfolio made up of 50% large US stocks, 25% US Treasury bonds, and 25% real estate. If we invest $10,000 our initial portfolio will have $5000 in stock, $2500 in bonds and $2500 in real estate. Now suppose that one year goes by and the returns in each class are: –Stocks +5% –Bonds +3% –Real estate -3% Calculate the value of each investment

Year-end values Stocks: $5000 x 1.05 = $5250 Bonds: $2500 x 1.03 = 2575 R.E.:$2500 x.97 = $2425 Portfolio value = $10,250 Calculate how much should be in each asset class to match the way we set up the portfolio

New Year-start values Stocks: $10,250 x 50% = $5125 Bonds: $10,250 x 25% = $2563 R.E.:$10,250 x 25% = $2563 Calculate how much money should be moved between asset classes to restore the original proportions.

Balancing Transfers Stocks and bonds have too much so need to lose dollars. Real estate has too little so needs to add dollars Stocks: $ $5125 = $125 decrease Bonds: $ $2563 = $12 decrease R.E.:$ $2425 = $138 add These transfers re-establish the original proportions. Result: We sold a portion of the assets that increased in value (sell high) and bought more of these that decreased in value (buy low)