1. Chapter 11
Investment Basics

2. Investing Versus Speculating
When you buy an investment, you put money in an asset that generates a return.
Part of that is income:
Rent on real estate
Dividends on stock
Interest on bonds
Even if the stock or bond does not pay income now, in the future it may.

3. Investing Versus Speculating
With speculation, assets don’t generate an income return and their value depends entirely on supply and demand.
Examples include:
Gold coins
Baseball cards
Gems
Derivative securities

4. Investing Versus Speculating
Derivative securities derive their value from the value of another asset.
Futures - a written contract to buy or sell a commodity in the future.
Options - the right to buy or sell an asset at a set price on or before maturity date.
Call option – right to buy
Put option – right to sell

5. Investing Versus Speculating
Futures contracts deal with commodities such as oil, soybeans, or corn.
It requires the holder to buy or sell the asset, regardless of what happens to its value in the interim.
Contract sets a price and a future time at which you will buy or sell the asset.
With futures, it is possible to lose more than you invested.

6. Investing Versus Speculating
Options markets and futures markets are a “zero sum game.”
If someone makes money, then someone must lose money.
If profits and losses are added up, the total would be zero.
Can lose more than invested.

7. Setting Investment Goals
When you make a plan, you must:
Write down your goals and prioritize them.
Attach costs to them.
Determine when the money for those goals will be needed.
Periodically reevaluate your goals.

8. Setting Investment Goals
Formalize goals into:
Short-term – within 1 year
Intermediate-term – 1-10 years
Long-term – over 10 years

9. Setting Investment Goals
Focus on which goals are important by asking:
If I don’t accomplish this goal, what are the consequences?
Am I willing to make the financial sacrifices necessary to meet this goal?
How much money do I need to accomplish this goal?
When do I need this money?

10. Fitting Taxes into Investing
Compare returns on an after-tax basis:
Marginal tax is the rate you pay on the next dollar of earnings.
Make investments on a tax-deferred basis so no taxes are paid until liquidation.
Capital gains and dividend income are better than ordinary income.

11. Financial Reality Check
Before you put your investment program into place:
Make sure you are living within your means
Make sure you have adequate insurance
Keep emergency funds
Put your financial house in order before you consider investing.

12. Starting Your Investment Program
Tips to Get Started
Pay yourself first – set aside savings, so spending remains.
Make investing automatic – use automatic withholding.
Take advantage of Uncle Sam and your employer – try matching investments.
Windfalls – invest some or all.
Make 2 months a year your investment months if you are having trouble starting your investment program – reduce spending in these 2 months.

13. Ownership Investments
Investment Choices
Lending Investments
Savings accounts and bonds.
Debt instruments issued by corporations and the government.
Ownership Investments
Preferred stocks and common stocks which represent ownership in a corporation.
Income-producing real estate.

14. Lending Investments
A savings account pays interest on the balance held in the account.
With a bond, the return is usually fixed and known ahead of time.
Principal returned on maturity date.
Par value or principal is the face value of the bond (the amount you receive when the bond matures).
Corporate bonds issued in $1000 units.
Pay semiannual interest.
Coupon rate is the annual interest rate.

15. Ownership Investments
Real estate investments in income-producing properties are illiquid.
Stocks, or equities, are the most popular ownership investment.
Stocks may pay a quarterly dividend.
Preferred stock dividends are fixed.
Common stock has voting rights.
Bond interest is paid prior to stock dividends.

16. The Returns from Investing
Two ways to receive your return:
An investment can go up or down in value
Capital gain or loss
An investment will generate an income return
Interest and dividends

17. Market Interest Rates
Interest rates affect the value of stocks, bonds, and real estate.
Nominal rate of return is not adjusted for inflation.
Real rate of return adjusts for inflation.
Real rate = nominal rate - inflation rate

18. What Makes Up Interest Rate Risk?
Real risk-free rate of return is what investors receive for delaying consumption.
Short-term Treasury bills are virtually risk-free. Their interest rate is considered to be the risk-free rate.

19. What Makes Up Interest Rate Risk?
Inflation Risk Premium
Return above the real rate of return to compensate for anticipated inflation.
Default Risk Premium
Compensates investors for taking on the risk of default.

20. What Makes Up Interest Rate Risk?
Maturity Risk Premium
Additional return demanded by investors on longer-term bonds.
Liquidity Risk Premium
For bonds that cannot be converted into cash quickly at a fair market price.

21. How Interest Rates Affect Returns on Other Investments
Expected returns on all investments are related.
What you can earn on one investment determines what you can earn on another.
Interest rates act as a “base” return. When interest rates go up, investors demand a higher return on other investments.

22. Look at Risk-Return Trade-Offs
Risk is related to potential return.
The more risk you assume, the greater the potential reward – but also the greater possibility of losing your money.
You must eliminate risk without affecting potential return.

23. Sources of Risk in the Risk-Return Trade-Off
Interest Rate Risk – the higher the interest rate, the less a bond is worth.
Inflation Risk – rising prices will erode purchasing power.
Business Risk – effects of good and bad management decisions.

24. Sources of Risk in the Risk-Return Trade-Off
Financial Risk – associated with the use of debt by the firm.
Liquidity Risk – inability to liquidate a security quickly and at a fair market price.

25. Sources of Risk in the Risk-Return Trade-Off
Market Rate Risk – associated with overall market movements.
Bull markets – stocks appreciate in value
Bear markets – stocks decline in price

26. Diversification “Don’t put all your eggs in one basket.”
Extreme good and bad returns cancel out, resulting in a reduction of the total variability or risk without affecting expected return.
Not only eliminates risk but also helps us understand what risk is relevant to investors.

27. Systematic and Unsystematic Risk
As you diversify, the variability or risk of the portfolio should decline.
Not all risk can be eliminated by diversification.
The risk in returns common to all stocks isn’t eliminated through diversification.
Risk unique to one stock can be countered and cancelled out by the variability of another stock in the portfolio.

28. Systematic and Unsystematic Risk
Market-related or non-diversifiable risk.
That portion of a stock’s risk not eliminated through diversification.
It affects all stocks.
Compensated for taking on this risk.
Unsystematic Risk
Firm-specific, company-unique, or diversifiable risk.
Risk that can be eliminated through diversification.
Factors unique to a specific stock.

29. Principle 11: The Time Dimension of Investing
As the length of the investment horizon increases, you can afford to invest in riskier assets.

30. How to Measure the Ultimate Risk on Your Portfolio
For risk associated with investment returns, look at:
Variability of the average annual return on your investment.
Uncertainty associated with the ultimate dollar value of the investment.
How much your investment will be worth at the end of your investment time horizon
How the ultimate dollar return on the investment compares to that of another investment.

31. How to Measure the Ultimate Risk on Your Portfolio
If investment time horizon is long and you invest in stocks, there is uncertainty about the ultimate value of investment, so take on additional risk.
Take on more risk as time horizon lengthens.
No place to hide in a crash, both stocks and bonds are affected.

32. Asset Allocation
How your money should be divided among stocks, bonds and other investments.
Investors should be diversified, holding different classes of investments.
Common stocks more appropriate for the long-term horizon.
Asset allocation is the most important investing task.

33. Asset Allocation and the Early Years
A Time of Wealth Accumulation
(Through Age 54)
Investment horizon is long.
Place the majority of savings into common stocks.
Own 80% stocks and 20% bonds.

34. Asset Allocation and Approaching Retirement
The Golden Years (Age 55-64)
Preserve level of wealth and allow it to grow.
Start moving into bonds.
Maintain a diversified portfolio.
Own 60% stocks and 40% bonds.

35. Asset Allocation and Approaching Retirement
The Retirement Years (Over Age 65)
Spending more than saving.
Income is primary, capital appreciation secondary.
Safety through diversification and movement away from common stocks.
Early on, own 40% stocks, 40% bonds, 20% T-bills. Later own 20% common, 60% bonds, and 20% T-bills.

36. What You Should Know About Efficient Markets
Deals with the speed at which new information is reflected in prices.
The more efficient the market, the faster prices react to new information.
If the stock market were truly efficient, then there would be no benefit from stock analysts.