Slides by Pamela L. Hall Western Washington University 1 The Investment Decision Chapter 12

2 Why Invest?  Some people have specific reasons for investing Supplement current income Reduce current and future tax liability Send children to college Retire comfortably For fun

3 Why Invest?  We’re living longer—thus, we’ll have a longer period of retirement  Personal incomes are not rising rapidly Experts expect personal incomes to keep pace with inflation  To raise your standard of living, you’ll need to earn more than inflation  The labor market is changing People are changing jobs many times during their life and spend some time unemployed Saving/investing can help you weather the storm  Self-directed retirement plans are now the norm Individual is responsible for most, if not all, investment decisions

4 The Steps in the Investment Process  Know your goals  Your present situation will impact those goals If one goal is a secure retirement and your employer does not offer a retirement savings plan, you’ll have to do this on your own If you already own your own home, saving for a down payment wouldn’t be a goal—maybe you’d be focused on paying down your mortgage

5 Assessing Risk and Return  How long do you plan to invest (your expected holding period)? Over longer time periods you can afford more risk  What level of expected return is required to meet your goals? Higher expected returns mean taking higher risks  How much risk are you comfortable with? If you panic at every daily fluctuation, you should stick with lower risk investments Personal characteristics, such as age and income influence risk tolerance

6 Selecting the Right Investment  Examine your investment goals, time horizon, risk tolerance, desired return, etc. and choose your investments  Stocks—represent ownership in a company Share in the company’s profits  May receive cash dividends  May receive capital appreciation (main reason people invest in stocks) No maturity date

7 Selecting the Right Investment  Bonds—represents a promissory note issued by a corporation/entity promising to pay interest and principal Bonds don’t have to pay interest, but if they have a coupon rate they should Bonds usually have a maturity date (up to 30 years or so)  Receive benefits through interest income Main reason people invest in bonds  May experience price appreciation

8 Selecting the Right Investment  Money market instrument—a lending investment that matures within one year Examples include  Treasury bills  Bank savings accounts Typically pay low interest rates but are very low risk  Two aspects to investment selection, or asset allocation Strategic  Decisions concerning the general mix of investments (i.e., 50% stocks, 30% bonds, 20% money market) Tactical  Selecting specific investments that are best for you (i.e., choosing an index mutual fund for the stock portion of your investments)

9 Managing Your Investments  Buy-and-hold philosophy A passive approach wherein you purchase a set of investments and do not manipulate the investments  Make changes only if and when your goals or personal situation changes  Active philosophy Actively watch the performance of your investments, buying/selling as you see fit

10 Understanding Risk and Return  By investing you EXPECT to earn some rate of return, but it always has some degree of risk because it is an EXPECTATION  Sources of Investment Returns Income  Dividends (stocks)  Interest (bonds) Capital appreciation (price of investment increases)

11 Understanding Risk and Return  Compare the income vs price change portion of various investments over a recent 10-year period: Investment Average Annual Return Income Portion Price Change Portion Stocks12.5%LittleMost Bonds7.8%MostLittle Money market4.4%AllNone

12 Measuring Investment Returns  Total Return represents the return you earned on the amount you invested over a certain time period (usually one year, but not necessarily) Includes both income and price changes

13 Measuring Investment Returns  Example: You bought 1,000 shares of stock one year ago at a price of $50. You sold it for $55 because you felt the future uncertainly was too great. During that time you received dividends of $1 per share. Calculate your total return from your investment. Total Return = (Selling Price + Dividends – Purchase Price)  Purchase Price Total Return = ($55 + $1 - $50)  $50 = 12%

14 Calculating Average Returns  Examine the two investments: Annual Return EOY Value of $1,000 (cumulative) YearABAB 115%45%$1,1501, %0%1,322.51, %0%1, ,450 Average (Arithmetic) 15% Clearly A is the better investment. Average (Compound) 15%13.18% Measures actual change in wealth. Can overstate the actual return to investor.

15 What is Investment Risk?  Risk is the uncertainty that an investment’s actual return will not be what you expected it to be  There’s an upside and a downside  Types of investment risk: Default risk Credit risk Tax risk Purchasing power risk Interest rate risk Market risk Event risk

16 Measuring Investment Risk  Some types of risk are easy to measure Market risk Figure 12.4 Annual Returns on Stocks and Treasury Bills: Stocks have more market risk than T-bills.

17 Are Risk and Holding Period Related?  The longer your holding period the more risk you should consider taking  Between 1926 and 2001 stocks had returns < 0% for 22 of the 76 years But when looking at a longer 10-year holding period, there were only negative returns for 2 of the 66 rolling 10-year periods

18 Figure 12.5 : Stock, Bond, and Treasury Bill Average Returns T-bills have only slightly outperformed inflation.

19 Figure 12.6 : I nvestment Growth over the 25-Years Ending 12/31/01

20 Comparing Stocks, Bonds and T-bills  Stability of principal Value of investment will never fall below what you originally invested  T-bills are the winner  Current income Historically bonds have paid more income than stocks or t-bills  Stability of income Bonds are the winner—you know how much income you are promised each year  Growth of income Stocks are the winner because dividends tend to grow over time, while bond income remains fixed

21 Some Lessons for New Investors  To earn high returns, you have to be willing to take high risks  Diversification is helpful Can help reduce risk without decreasing return a great deal (due to co-movement)  Past performance is not a guarantee of future performance  Financial Markets are fairly efficient Fair, orderly and very competitive (lots of buyers and sellers) No “easy money”

22 Some Lessons for New Investors  Avoiding common investment mistakes Chasing returns  Investing your money based on how well an investment performed last period Fad Investing  Investing in something simply because others are doing so Buying right after a major price increase or selling right after a major price decline Hanging onto a loser Investing with no plan Trusting the self-proclaimed gurus Fearing the wrong risks  Being unwilling to take risks—especially if you have a long-term investment horizon

23 Sources of Investment Information  Problem isn’t that there is too little information, but too much  Periodicals and newspapers Newspapers, local & business-oriented  Investor’s Business Daily  The Wall Street Journal  Barron’s Periodicals  Time  U.S. News & World Report  Business Week  Forbes  Kiplinger’s Personal Finance  Money

24 Sources of Investment Information  Investment advisory services Moody’s and Standard & Poor’s Value Line Morningstar Brokerage firms Investment newsletters  Computerized sources of investment information

25 Web Links  Good source for basics