Chapter 13 The Investment Decision Why Invest? –Supplement current income –To reduce current, future tax liability –To send children to college –To have a comfortable retirement –To make a down payment on a house

Chapter 13 The Investment Decision The Importance of Investment Decisions We’re living longer Personal income is showing flat growth The labor market is changing (unemployed) There is a trend toward self-directed retirement plans (away from Soc. Sec.)

Chapter 13 The Investment Decision Step 1: Setting Goals Determine goals by asking yourself: Why are you investing? What do you want your investments to accomplish? What kind of time frame do you have?

Chapter 13 The Investment Decision Step 2: Assessing Risk and Return How long are you planning to invest? What is the return necessary to achieve your goals? What is your tolerance for risk?

Chapter 13 The Investment Decision How Long Do You Plan to Invest? General rule of thumb -- The longer the holding period, the more aggressive you can afford to be (if all other things are equal) –Influenced by age of investor Someone under 40 will probably hold more investments in stocks than someone who is 60 or older

Chapter 13 The Investment Decision What Expected Return is Necessary?  Future returns referred to as “expected returns”  Few guarantees when investing  If return generated DOES NOT match your needs, you must either  Increase your contributions  Invest in instruments with higher returns/risk

Chapter 13 The Investment Decision How Much Risk is Acceptable? Personal characteristics (income, age) play role in risk tolerance Those with low risk tolerance should limit choices to fairly safe investments The longer the holding period, the more risk you should consider taking

Chapter 13 The Investment Decision Step 3: Selecting the Right Investment Stocks -- represent ownership in a corporation –As stockholder, you share in profits through: Dividends Increases in stock prices –Primary motivation in buying stocks is price appreciation

Chapter 13 The Investment Decision Step 3: Selecting the Right Investment Bonds -- lending money to some organization Issued by governments and corporations Earn a pre-determined amount of interest although price changes with interest rates Receive “face value” (loan principal) when bond matures Income (& Taxes Savings) primary reason to buy bonds

Chapter 13 The Investment Decision Step 3: Selecting the Right Investment Money market instruments -- Also lending money to an organization  Similar to bonds in that you receive pre- determined interest payments and “face value” upon maturity  Unlike bonds in that they mature within a year Examples: Treasury bills and bank savings accounts (CD’s)

Chapter 13 The Investment Decision Step 4: Managing Your Investment Two approaches exist: 1. Passive -- Buy and hold philosophy. Retain same investments for a long period of time 2. Active -- Regularly evaluate investment performance and make periodic changes.

Chapter 13 The Investment Decision Sources of Investment Returns Income -- Treasury bills and money market instruments provide returns this way Price Appreciation -- Common stocks Both price appreciation and income -- Common stocks (through dividends and stock appreciation) and bonds (interest and price change in market value)

Chapter 13 The Investment Decision Measuring Investment Returns Only measurable returns are “historical” ones (Ex Poste – the past) Measure of “total return” incorporates both price changes and income Usually total return is computed over a year

Chapter 13 The Investment Decision Average Return Gives an indication of how an investment has performed over a period of time Average compound rate earned from the beginning to the end of the three, five, or ten-year period Similar to the compound rate of interest on a savings account

Chapter 13 The Investment Decision What is Investment Risk? –The uncertainty that exists over what an investor’s actual return will be over some period in the future –Investment risk is the OPPOSITE side of investment return

Chapter 13 The Investment Decision What is Investment Risk? –Investing in CD’s brings no uncertainty over risk; but the return is lower –Investing in stocks brings a wider range of risk; but often returns are higher –This is the Risk/Return tradeoff

Chapter 13 The Investment Decision Measuring Investment Risk –Simple measure of risk is the variability or range of returns over a period of time –The greater the variability of an investment, the more risk –This is calculated simply as the Variance of an investment

Chapter 13 The Investment Decision Relationship Between Risk and Holding Period 4The longer the holding period, the more risk you should consider taking early in the investment 4Some of the risk associated with investment tends to disappear as the length of the holding period increases, variability (variance) tends to decrees as the sample size (# of annual returns) grows. 4Volatility of stocks has been much lower over five, ten, and twenty year period as compared to just a one-year period (Central Limit Theorem)

Chapter 13 The Investment Decision Comparing Stocks, Bonds, and T-Bills –Most investors own a mixture of stocks, bonds, and money market instruments –One way to evaluate these three options is to compare them on the basis of their risks and returns

Chapter 13 The Investment Decision Total Return Comparison Stocks far ahead of bonds and T-bills in total return Over past 73 years, T-bills’ returns have barely exceeded the rate of inflation

Chapter 13 The Investment Decision Stability of Principal Comparison T-bills and money market instruments are clear winners When a T-bill is purchased, owner can be almost certain to get back at least initial investment When stock is purchased, there is no such guarantee

Chapter 13 The Investment Decision Current Income Comparison Bonds are winner in this category –Over last 70 years Bonds have paid about 5% a year in income Stocks about 4% a year in income T-bills about 3.5% a year in income

Chapter 13 The Investment Decision Stability of Income Comparison Bonds are winner in this category With a bond you know exactly how much income you will receive Interest rates on T-bills, however, fluctuate from year to year Common stock dividends also vary from year to year

Chapter 13 The Investment Decision Growth of Income Comparison Stocks are winner in this category Historically dividends have grown over time Bonds have fixed amount of interest over entire life T-bills rates vary from year to year, falling as well as rising

Chapter 13 The Investment Decision Diversification is Beneficial –Diversification is spreading funds among many different investments –Investment equivalent of “NOT PUTTING ALL YOUR EGGS INTO ONE BASKET” –Not diversifying is a common mistake among investors

Chapter 13 The Investment Decision Diversification is Beneficial –Can reduce the risk of your investment, without substantially lowering return –Can increase your return without substantially increasing the risk –Can help you beat the risk/return tradeoff to a certain degree

Chapter 13 The Investment Decision Why does diversification work? –Because returns on different investments do not perfectly match each other over time –Some perform well one year, while others perform well in another year –This is known as correlation (positive, negative, & zero) we hope for increases –“A Rising Tide Floats All Ships”

Chapter 13 The Investment Decision The Past Does Not Guarantee the Future Investment decisions are often based on historical information A past good performance, however, is no guarantee of a future good performance Even if the past repeats itself, variation is common

Chapter 13 The Investment Decision Common Investment Mistakes 1. Chasing returns 2. Fad investing 3. Buying and selling at the wrong times 4. Hanging on to a loser 5. Investing with no plan 6. Trusting the self-proclaimed gurus 7. Fearing the wrong risks

Chapter 13 The Investment Decision Sources of Investment Information –Problem is sifting through massive amount of information available –Objective source -- presents historical and current data, with no opinion attached –Subjective source -- presents historical and current data and makes recommendations

Chapter 13 The Investment Decision Sources of Investment Information  Newspapers Wall Street Journal Barron’s  Periodicals Business Week Forbes Fortune Money

Chapter 13 The Investment Decision Sources of Investment Information  Investment Advisory Services Moody’s Standard and Poor’s Value Line Morningstar Brokerage Firms Investment newsletters

Chapter 13 The Investment Decision Sources of Investment Information  Computerized Sources –Web sites like Yahoo and CNNfn offer: Current stock, bond, and mutual fund prices Current financial and economic news –Provide ability to trade securities through on-line brokerage services (Ameritrade)