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Slides by Pamela L. Hall

Western Washington University

The Investment Decision

Chapter 12

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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

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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

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The Steps in the Investment Process

Know your goalsYour 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

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Assessing Risk and ReturnHow 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

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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

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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

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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)

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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

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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)

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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

Stocks 12.5% Little Most

Bonds 7.8% Most Little

Money market

4.4% All None

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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

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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%

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Calculating Average Returns

Examine the two investments:

Annual Return

EOY Value of $1,000

(cumulative)

Year A B A B

1 15% 45% $1,150 1,450

2 15% 0% 1,322.5 1,450

3 15% 0% 1,520.88 1,450

Average (Arithmetic)

15% 15% Clearly A is the better

investment.Average

(Compound)

15% 13.18%

Measures actual change in wealth.

Can overstate the actual return to investor.

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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

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Measuring Investment Risk Some types of risk are easy to measure

Market risk

-20.0%

-10.0%

0.0%

10.0%

20.0%

30.0%

40.0%

1975 1977 1979 1981 1983 1985 1987 1989 1991 1993 1995 1997 1999 2001

An

nu

al R

etu

rn

T-bills

Stocks

Figure 12.4Annual Returns on Stocks and Treasury Bills: 1985-2001

Stocks have more market risk

than T-bills.

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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

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Figure 12.5: Stock, Bond, and Treasury Bill Average Returns

0.0%

2.0%

4.0%

6.0%

8.0%

10.0%

12.0%

14.0%

16.0%

76 years 25 years 10 years

Periods Ending 12/31/2001

Av

erag

e A

nn

ual

Ret

urn

Stocks Bonds

T-bills Inflation

T-bills have only slightly

outperformed inflation.

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Figure 12.6: Investment Growth over the 25-Years Ending 12/31/01

$24,101

$8,708

$5,106

$3,049

$0

$5,000

$10,000

$15,000

$20,000

$25,000

$30,000

Stocks Bonds T-bills Inflation

Gro

wth

of

$1,0

00 In

ves

tmen

t (1

976-

2001

)

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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

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Some Lessons for New InvestorsTo earn high returns, you have to be willing to

take high risksDiversification 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”

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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

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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

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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

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Web Links

Good source for basicshttp://www.investoreducation.org/index.cfm

http://moneycentral.msn.com/home.asphttp://www.quicken.com/investments/basics/

http://www.kiplinger.comhttp://www.morningstar.comhttp://www.vanguard.comhttp://www.nyse.comhttp://www.nasdaq-amex.com