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Intro to Financial Management
Personal Finances
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Review Homework Dividend payment theories
Residual dividend theory Clientele theory Information effect Agency costs Expectations theory Earnings predictability concerns Policies Constant dividend payout Stable dollar Small regular plus end-of-year One-time Stock splits and dividends
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Modern Portfolio Theory
Diversification can Reduce risk Increase returns Objective is to Maximize return for a given level of risk or Minimize risk for a given level of return
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Not All Risk is the Same Firm Risk = Systemic risk Idiosyncratic Risk Business Cycles Financial Markets Global Conditions Risk Unique to the Firm Source of Correlation Idiosyncratic risk can be diversified away!
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Diversification – Simple Example
IBM and AT&T When IBM went down, AT&T went up. When AT&T went down, IBM went up. If stocks are perfectly positively correlated, diversification has no effect on risk If stocks are perfectly negatively correlated, portfolio is perfectly diversified. What do you want as an investor?
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Risk and Diversification
With large portfolio, 30 – 200 stocks, idiosyncratic moves cancel out!
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The Efficient Frontier
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Modern Portfolio Theory
Optimal portfolio is a combination of the “market portfolio” and the risk-free asset So… what is the market portfolio? S&P 500? Wilshire 5000? Total world index? What about bonds?
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Diversification with Stocks and Bonds
Note: adding some stock to a 100% Treasury portfolio increases the return and decreases the risk!
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Market Portfolio What about other asset classes?
REITS TIPS Commodities How is one to decide on a market portfolio? Simple approach 60/40 stocks/bond Include other asset classes Six Ways from Sunday portfolio All-Weather Portfolio Asset allocation is your most significant investment decision
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What to Invest In? Index funds Managed funds Track an index Low cost
Types Total market S&P 500 Total bond REITs TIPS Precious metals International Managed funds Fund has a stated objective Fund manager invests to maximize returns subject to objective
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Can You Beat the Market? Efficient market hypothesis
Investment exercise Thought experiment What if advisors are actually bad and only get it right 40% of the time? You can’t consistently beat the market But many will try Are you tempted by Apple, Facebook, gold?
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Market Analysis Technical analysis Fundamental analysis
Looks at historical returns Looks for patterns Patterns suggest investment direction Fundamental analysis Tries to understand the why’s Looks for underlying causes Inflation GDP growth Relationships (e.g. oil to plastics and farm products) Exchange rates
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Post Modern Portfolio Theory
Two Ways to Make Money Beta Your market portfolio Has systemic risk from asset class Easy, inexpensive to create Alpha Your bet against the market, you know better than everyone else Zero-sum game There are winners and losers Has idiosyncratic risk, comes from skill of investment advisor Hard, expensive to create
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Post Modern Portfolio Theory Practical Application
First, set aside emergency money Determine how many months of income 3 – 6 Leave in a money market fund Pick how much you want to bet – your alpha Specify as a percent Place your bet Be prepared to lose it Invest the remaining percent in your market portfolio – beta
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Market Timing Can you time the market? Two schools of thought
Who do you listen to? Do you know better than the pros? Do the pros know? Two schools of thought Dollar cost averaging Go to your strategy
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Retirement Planning Why should you care now?
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You Can Never Catch Up Person A: Saves $2000 per year from age 22 to age 35 and then stops Person B: Starts saving $2000 per year beginning at age 35 and never stops Both earn 8% on their investments. At age 75: Person A has $1M in savings Person B has $561K in savings
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How Much Do You Need? Calculate your income requirement
Use today’s dollars (remember time value of money) Current income - Pension - Social Security (maybe) = Income need Rough estimate of the portfolio you must have = income need x 25 Conversely, can live off of 4% of your portfolio E.g. If have $1M, then can live off $40k per year
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How Much Do You Need? Previous calculation was in today’s dollars
You may need 4 times that amount in the future Inflation has averaged 4% since 1929 At that rate, prices will go up 4x in 36 years Start saving now Minimally 10% Shoot for > 20%
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Are You On Track? Under Accumulator of Wealth (UAW)
net worth < age * (.10 * pretax income) Average Accumulator of Wealth (AAW) net worth = age * (.10 * pretax income) Prodigious Accumulator of Wealth (PAW) net worth > age * (.10 * pretax income) If age 30 with pretax income of $60,000, then you need net worth = 30 * (.10 * 60000) = $180,000 If age 40 with pretax income of $100,000, then you need net worth = 40 * (.10 * ) = $400,000 A guideline, not a law of physics Not good for young ages
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Retirement Vehicles 401(k)’s IRA Roth IRA
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