1. Chapter 12: Introduction to Investment Planning Chapter 12 Introduction to Investment Planning

2.  2005 Kaplan Financial 2 Chapter 12: Introduction to Investment Planning Establishing Financial Goals Typical Financial Goals Common Investment Goals Capital accumulation Preservation of capital Maximizing returns Minimizing risk Budgeting Methods of Increasing Savings

3.  2005 Kaplan Financial 3 Chapter 12: Introduction to Investment Planning Investment Risks Systematic Risks Market risk Interest rate risk Purchasing power risk Foreign currency (exchange rate) risk Reinvestment risk Unsystematic Risks Business risk Financial risk Default risk Country (or regulation) risk

4.  2005 Kaplan Financial 4 Chapter 12: Introduction to Investment Planning Investment Risks (cont’d) Risk and Return There is a direct relationship between risk and return. As the level of risk increases, the expected return increases, and as the level of risk decreases, the expected return decreases. Liquidity vs. Marketability

5.  2005 Kaplan Financial 5 Chapter 12: Introduction to Investment Planning Investment Choices Lending investments Default risk Interest rate risk Ownership investments in business Ownership investments in real estate Cash flow Depreciation deduction Low correlation with other assets

6.  2005 Kaplan Financial 6 Chapter 12: Introduction to Investment Planning Investment Choice (cont.) Derivatives Options Puts Calls Futures Direct vs. Indirect Investing

7.  2005 Kaplan Financial 7 Chapter 12: Introduction to Investment Planning Measures of Risk Beta – a measure of systematic risk derived from regression analysis Standard Deviation – measures total volatility (systematic and unsystematic risk) Semivariance – measures downside volatility

8.  2005 Kaplan Financial 8 Chapter 12: Introduction to Investment Planning Measures of Return Holding period return Arithmetic mean Geometric mean Internal rate of return Real rate of return

9.  2005 Kaplan Financial 9 Chapter 12: Introduction to Investment Planning Holding Period Return HPR = EI – BI +/- Cashflows BI EI = Ending Value of Investment BI = Beginning Value of Investment

10.  2005 Kaplan Financial 10 Chapter 12: Introduction to Investment Planning Arithmetic Mean AM = HPR 1 + HPR 2 + HPR 3 + HPR t n HPR t = Return for period t n = Number of periods

11.  2005 Kaplan Financial 11 Chapter 12: Introduction to Investment Planning Geometric Mean GM is interest rate when solving: PV = -100 FV = 100 (1+R 1 ) (1+R 2 ) (1+R 3 ) (1+R n ) N = n R n = Return for period n n = Number of periods

12.  2005 Kaplan Financial 12 Chapter 12: Introduction to Investment Planning Internal Rate of Return PV CF 1 1 k + ( ) 1 CF 2 1 k + ( ) 2 ¼ + CF n 1 k+ ( + ) n + = PV = Present Value CF n = Cash flow for period n n = Number of cash flows k = IRR

13.  2005 Kaplan Financial 13 Chapter 12: Introduction to Investment Planning Real Rate of Return Real return 1 R n + ( ) 1 I + ( ) 1– = R n = Nominal rate of return I = Inflation rate

14.  2005 Kaplan Financial 14 Chapter 12: Introduction to Investment Planning Modern Portfolio Theory Modern portfolio theory is the concept that describes the diversification process among a portfolio’s asset classes

15.  2005 Kaplan Financial 15 Chapter 12: Introduction to Investment Planning The Efficient Frontier

16.  2005 Kaplan Financial 16 Chapter 12: Introduction to Investment Planning Markowitz’s Three Rules 1. Same return – choose lower risk. 2. Same risk – choose higher return. 3. Choose higher return with lower risk.

17.  2005 Kaplan Financial 17 Chapter 12: Introduction to Investment Planning Modern Portfolio Theory (cont’d) The following are the foundation for most of the asset allocation (mean- variance optimization) software packages used by financial planners: Standard Deviation of a Multi-Asset Portfolio Expected Return of the Portfolio

18.  2005 Kaplan Financial 18 Chapter 12: Introduction to Investment Planning Correlation Coefficient R = +1.0 perfect positive correlation R = -1.0 perfect negative correlation R = 0 no correlation R 2 = Coefficient of determination

19.  2005 Kaplan Financial 19 Chapter 12: Introduction to Investment Planning Investment Strategies and Theories Efficient Market Hypothesis Active vs. Passive Investing Indexing Timing the Market