Llad Phillips1 Introduction to Economics Elements of Personal Finance

Llad Phillips2 4. Thursday, Oct 8, Lecture Four: "Markowitz Efficiency Portfolio Analysis" Wall Street Journal Video, Guide to Money and Markets ( on reserve in Kerr Hall) Markowitz Efficient Portfolio Analysis Reading Assignment: Guide to Understanding Personal Finance, Ch. 5, "Investing" O’Sullivan and Sheffrin: Ch. 4, “Supply, Demand and Market Equilibrium” emphasis: the law of demand and market supply Problems O & S Text p. 78: 1, 2, 3, 4, 5, 6, 7

Llad Phillips3 Outline: Lecture Four Video Guide to Money and Markets Video Guide to Money and Markets Interest rate, % per year, APR Interest rate, % per year, APR Determinants of Personal Income (cont.) Determinants of Personal Income (cont.) Markowitz Efficient Portfolio Analysis Markowitz Efficient Portfolio Analysis

Llad Phillips4 Interest Rate Per Year On A Loan Example: One Payment loan amount: $1000 loan amount: $1000 annual interest rate: 10% annual interest rate: 10% one payment at the end of the year one payment at the end of the year  pay back principal: $1,000  pay the interest on $1000 for a year: $100  principal*interest rate = interest  $1000*0.1 = $100  total payment due: $1100

Llad Phillips5 Interest Rate Per Year On A Loan Example: Twelve Monthly Payments loan amount: $1000 loan amount: $1000 annual interest rate: 10% annual interest rate: 10% Twelve Monthly Payments Twelve Monthly Payments  pay back principal of $1000  pay interest on the amount owed  declining amount owed since you pay back some principal each month, until balance of principal owed is zero after twelve payments  use Excel’s PMT function to calculate

Llad Phillips6 $1000 Principal Time one year Declining Balance, 12 monthly payments one payment of principal plus interest at the end of the year

Llad Phillips7 Twelve Monthly Payments

Llad Phillips8 Determinants of Personal Income Life Cycle Model Life Cycle Model Learning and Earning Learning and Earning Your Market Wage Depends on Your Market Wage Depends on  your human capital Allocating your time between Learning and Earning Allocating your time between Learning and Earning  24 hour endowment  your tastes for learning versus earning

Llad Phillips9 24 hours0 hours Leisure (learning) Earnings $480 Opportunities for trading leisure for earnings (income) at a rate, $20 per hour, the market wage, determined by your stock of human capital(step one of the paradigm: describing the alternatives for choice) $ 0

Llad Phillips10 Choosing Between Learning and Earning How much time for learning? How much time for learning? How much time for earning? How much time for earning? This choice, like all choices depends on your tastes This choice, like all choices depends on your tastes  Do you want to earn and consume now?  Do you want to learn, earn more in the future, and consume more in the future?

Llad Phillips11 Economists Assume You Can make Comparisons example: more leisure and less income versus less leisure and more income example: more leisure and less income versus less leisure and more income  recall Lecture One: an Altima Vs. a Taurus

Llad Phillips12 Economists Assume You Can Make Tradeoffs How much income will you demand to give up your leisure? How much income will you demand to give up your leisure?

24 hours 0 hours Leisure (learning) Earnings $480 $ 0 Iso-Preference Curves: You value all points on a curve equally(step two of the paradigm: valuing the alternatives for choice) Depicting your tastes graphically: iso-preference or indifference curves

24 hours0 hours Leisure (learning) Earnings $480 $ 0 Iso-Preference Curves: You value all points on a curve equally high low value high value Depicting your tastes graphically

24 hours0 hours Leisure (learning) Earnings $480 $ 0 Iso-Preference Curves: You value all points on a curve equally high low value high value The choice between leisure and earning now:picking the best alternative alternatives

24 hours0 hours Leisure (learning) Earnings $480 $ 0 high low value high value Optimum 15 hours of leisure $180 for 9 hrs of work Individual’s Supply of Labor

Llad Phillips17 Personal Investing How do you choose between stocks or bonds as a personal investment? How do you choose between stocks or bonds as a personal investment? How do you choose between mutual funds? How do you choose between mutual funds? Are stocks and bonds too risky? Should you keep your money in cash or gold? Are stocks and bonds too risky? Should you keep your money in cash or gold?

Llad Phillips18 Example: UC Funds Suppose you invest up to $9,500 per year in a tax sheltered 403(b) plan Suppose you invest up to $9,500 per year in a tax sheltered 403(b) plan  you have to save $9,500, but you would have to pay income taxes if you took it as income UC investment alternatives UC investment alternatives  guaranteed insurance contract(GIC)  savings fund  money market fund  bond fund  stock index fund  multi-asset fund

Llad Phillips19 Investment Concepts monthly return for June 1998 on an asset monthly return for June 1998 on an asset  price(June) - price(May) + dividends  price(June) - price(May): capital gain(loss)  dividends(interest): income from stocks(bonds) monthly rate of return for June 1998 monthly rate of return for June 1998  [price(June) - price(May) + dividends]/price(May)  in %, multiply by 100 annual rate: multiply by 12annual rate: multiply by 12

Llad Phillips20 Example: UC Funds/Mutual Funds Sources of information on UC funds Sources of information on UC funds  monthly, quarterly, annual, etc. rates of return  internet:  Notice, a publication of the UC Academic Senate Source of Information on Mutual Funds Source of Information on Mutual Funds  quarterly  The Wall Street Journal, Mutual Funds Quarterly Review, e.g. extra section in July 3, 1997 Journal

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Llad Phillips24 UC Funds: Equity Vs. Insurance Insurance Insurance  steady at a rate of return of about 0.6 per month or 7.2% per year  does not vary much  never negative Equity Equity  rate of return varies a lot from month to month  range of rates of return from about plus 8% in Nov. ‘96 to minus 5% in July ‘96  can turn negative: 7 months out of 22

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Llad Phillips27 Two Kinds of Assets low rate of return- low variability low rate of return- low variability want high rate of return return on average want high rate of return return on average want low variability want low variability  predictable average return high return-high variability high return-high variability want high rate of return on average want high rate of return on average want low variability want low variability Dilemma: which kind of asset to hold?

Llad Phillips28 Investment Principles or Maxims Don’t put all of your eggs in one basket Don’t put all of your eggs in one basket  hold a diversified portfolio  cash  bonds  stocks  real estate  advantage of a mutual fund  instead of holding one stock, e.g. Coca-Cola, you hold a bundle of stocks Choose the asset with the highest reward for a given level of risk Choose the asset with the highest reward for a given level of risk

Measures of Average Rate of Return and Variability: Mean & Std. Dev.

Llad Phillips32 Mean Returns & Standard Deviations

Llad Phillips33 Efficient Investment Portfolio

Llad Phillips34 Your portfolio should be on the efficient frontier But where on the frontier? But where on the frontier?  depends on your taste for reward and risk  reward, i.e. the mean rate of return is a good  risk is a bad

Llad Phillips35 Economic Paradigm: Valuation of Mean Return and Risk Assumption: Mean Return is Good, Risk is Bad: U =U(M,R) Mean Return, M Risk, R better worse Iso - Preference Curves A B C Prefer B to A; Prefer B to C

Llad Phillips36 Efficient Investment Portfolio Investor A: very risk averse

Llad Phillips37 Efficient Investment Portfolio Investor B: not very risk averse

Llad Phillips38 Efficient UC Investment Portfolio f*insurance contract + (1-f)*equity fund f*insurance contract + (1-f)*equity fund  where f can range from zero to one  example: 50:50, i.e one half of your nest egg is invested in the Insurance Contract and the other half is invested in the Equity Fund. mean return: 1/2 * /2*1.92 = 1.27 % per monthmean return: 1/2 * /2*1.92 = 1.27 % per month expected risk(standard deviation: 1/2* /2*3.02 =1.52expected risk(standard deviation: 1/2* /2*3.02 =1.52

Llad Phillips39 –exercise: show that this mean portfolio return –and expected risk lie on the efficient frontier – connecting the insurance contract and the –equity fund

Llad Phillips40 Summary-Vocabulary-Concepts Markowitz Portfolio Analysis Markowitz Portfolio Analysis stock index fund stock index fund bond fund bond fund money market fund money market fund guaranteed insurance contract guaranteed insurance contract monthly rate of return monthly rate of return capital gains capital gains dividends dividends mean rate of return on an asset mean rate of return on an asset risk of holding an asset risk of holding an asset a risk averse person a risk averse person investment portfolio investment portfolio

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