1. Intro to Financial Management
Personal Finances

2. 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

3. 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

4. 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!

5. 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?

6. Risk and Diversification
With large portfolio, 30 – 200 stocks, idiosyncratic moves cancel out!

7. The Efficient Frontier

8. 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?

9. Diversification with Stocks and Bonds
Note: adding some stock to a 100% Treasury portfolio increases the return and decreases the risk!

10. 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

11. 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

12. 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?

13. 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

14. 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

15. 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

16. 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

17. Retirement Planning
Why should you care now?

18. 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

19. 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

20. 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%

21. 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

22. Retirement Vehicles
401(k)’s
IRA
Roth IRA