Chapter 10

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Chapter 10

  1. 1. Personal Finance: An Integrated Planning Approach Winger & Frasca Chapter 10 Investment Basics
  2. 2. Major Topics <ul><li>Risk and Return </li></ul><ul><li>The Rewards of Diversification </li></ul><ul><li>Applying a Risk-Return Model </li></ul><ul><li>Building and Changing a Portfolio </li></ul>
  3. 3. Risk and Return <ul><li>What Is Risk? </li></ul><ul><li>Sources of Risk </li></ul><ul><li>How Much Return Do You Need for the Investment Risks You Take? </li></ul><ul><li>The Iron Law of Risk and Return </li></ul><ul><ul><li>To Earn Higher Returns, </li></ul></ul><ul><ul><li>You Must Take Greater Risks </li></ul></ul>
  4. 4. Return Variability A B C Investment A: no return variation, no risk Investment B: some return variation, some risk Investment C: wide return variation, much risk 5% 6% 8% 10% -8%
  5. 5. Nature of Risk <ul><li>The More Variable an Investment’s Return, the Greater Its Risk </li></ul><ul><li>A Highly Variable Return Could Lead to Investment Losses if the Investment Needs to be Sold </li></ul><ul><li>However, the Longer the Investment is Held, the Greater the Chances of Earning the Long-Run Rate of Return </li></ul>
  6. 6. Sources of Risk <ul><li>Changing Economic Conditions </li></ul><ul><li>Changing Conditions of the Security Issuer </li></ul>
  7. 7. Risk and Changing Economic Conditions <ul><li>Inflation Risk--Inflation Increases and the Return on Your Investment Does Not Keep Pace </li></ul><ul><li>Business Cycle Risk--Your Investment’s Return Fluctuates in Tandem with the Overall Business Cycle </li></ul><ul><li>Interest-Rate Risk--Newly-Issued Bonds Offer Higher Rates than Your Bonds </li></ul>
  8. 8. Risk and Changing Conditions of the Security Issuer <ul><li>Management Risk--The Company in Which You Invested Has Poor Managers </li></ul><ul><li>Business Risk--Risks Associated with a Company’s Product/Service Lines </li></ul><ul><li>Financial Risk--The Risk of Insolvency Because the Company Has Borrowed Too Much </li></ul>
  9. 9. Average Annual Returns on Financial Assets: 1970-2000 <ul><li>Common Stocks 12.92% </li></ul><ul><li>90-Day U.S. Treasury Bills 7.76% </li></ul><ul><ul><li>Source: Federal Reserve Bank of St. Louis </li></ul></ul>
  10. 10. Growth of $1,000 Invested in Financial Assets: 1970-2000 <ul><li>Common Stocks $43,180 </li></ul><ul><li>90 Day U.S. Treasury Bills $10,135 </li></ul>
  11. 11. Risks With Financial Assets: 1970-2000 <ul><li>Annual Returns </li></ul><ul><li>Highest Lowest Range </li></ul><ul><li>Stocks 37.4% -26.5% 63.9% </li></ul><ul><li>T-Bills 14.1 2.8 11.3 </li></ul>
  12. 12. Investment Risk Premium <ul><ul><li>Return on U.S. Treasury Bills (T-Bills) Is Free of Risk </li></ul></ul><ul><ul><li>Any Investment’s Return in Excess of the T-Bill Return is Called the Investment’s Risk Premium </li></ul></ul><ul><ul><li>An Important Concept is Market Risk Premium: </li></ul></ul><ul><ul><ul><li>Using 1970-2000 Historical Data, this Premium is 5.16 (12.92% - 7.76%) </li></ul></ul></ul><ul><ul><ul><li>Using long-term data, the premium is close to 8% </li></ul></ul></ul><ul><ul><ul><li>Controversy Exists over Value for the Premium </li></ul></ul></ul>
  13. 13. A Portfolio <ul><li>A Portfolio is Simply </li></ul><ul><li>a Group of Assets </li></ul><ul><li>Held at the Same </li></ul><ul><li>Time </li></ul>Stocks Bonds Bills
  14. 14. Diversification <ul><li>Diversification Lowers Investment Risk </li></ul><ul><li>It Accomplishes this Goal Because Asset Returns Are Poorly Correlated </li></ul><ul><li>Diversification is Not Effective if Asset Returns Are Strongly, Positively Correlated </li></ul><ul><li>The Return Correlations Among Stocks, Bonds, and Bills Are Low; Holding These Investments in a Portfolio is Effective </li></ul>
  15. 15. An Example of Negative Return Correlation <ul><li>As A’s Return </li></ul><ul><li>Changes </li></ul><ul><li>B’s Return Changes in the Opposite Direction </li></ul><ul><li>Holding Each Gives a 10% Constant Return </li></ul>B 10% A
  16. 16. Diversification Guidelines <ul><li>Diversify Among Intangibles and Tangibles </li></ul><ul><ul><li>Remember: A House Is a Major Tangible </li></ul></ul><ul><li>Diversify Globally </li></ul><ul><ul><li>Invest in Foreign Securities </li></ul></ul><ul><li>Diversify within Asset Groups </li></ul><ul><ul><li>Own a Variety of Common Stocks </li></ul></ul>
  17. 17. Portfolio Risk and the Number of Stocks Held Market Risk: Remains Unchanged Random Risk: Lowered by Increasing the Number of Stocks in the Portfolio Risk Number of Stocks in Portfolio 1 5 10 15
  18. 18. Market and Random Risks <ul><li>Random Risks Are Those Associated with Specific Companies </li></ul><ul><ul><li>These Tend to “Balance Out” if A Sufficient Number of Stocks Are Held (About 20) </li></ul></ul><ul><ul><li>Holding Too Few Stocks is Foolish: You Take Risks That Can Be Eliminated </li></ul></ul><ul><li>Market Risk is the Risk Associated with the Overall Market: It Cannot Be Reduced by Holding More Stocks </li></ul>
  19. 19. Managing Market Risk <ul><li>If Your Portfolio Is as Risky as the Overall Market, You Should Earn the Market Risk Premium (Say, 8%) </li></ul><ul><li>If Your Portfolio is Riskier, Then You Should Earn an Extra Premium (Something More than 8%) </li></ul><ul><li>A Precise Risk Measurement is Needed: A Stock’s Beta </li></ul>
  20. 20. The Beta Risk Measurement <ul><li>Beta Measures a Stock’s Risk in Relation to the Overall Market Risk </li></ul><ul><li>If the Market Goes Up and a Stock’s Price Goes Up by a Greater % Amount, It Has a Beta Greater than 1.0; if it Goes Up by a Smaller % Amount, it Has a Beta Less Than 1.0 </li></ul><ul><li>While Betas Can Be Negative, Most Are Positive </li></ul>
  21. 21. Sample Beta Values <ul><li>America Online 2.6 </li></ul><ul><li>AT&T 1.0 </li></ul><ul><li>Barrick Gold 0.7 </li></ul><ul><li>Gillette 0.8 </li></ul><ul><li>Intel 1.5 </li></ul><ul><li>Southwest Airlines 0.8 </li></ul><ul><li>Texaco 0.3 </li></ul>
  22. 22. Estimating Required Return <ul><li>First, Determine the Stock’s Risk Premium </li></ul><ul><ul><li>Find its Beta (say 1.5) </li></ul></ul><ul><ul><li>Multiply by the Market Risk Premium (say, 8%) </li></ul></ul><ul><ul><li>So, 1.5 x 8% = 12% </li></ul></ul><ul><li>Second, Add the Current Risk-Free Rate (say 5%) </li></ul><ul><ul><li>Then, Required Return = 12% + 5% = 17% </li></ul></ul>
  23. 23. Making Stock Selections <ul><li>Find a Stock’s Alpha Value: </li></ul><ul><ul><li>Alpha = Expected Return - Required Return </li></ul></ul><ul><li>Select Stocks with the Largest Alpha Values </li></ul><ul><li>Understand that Determining Required Return is Very Difficult </li></ul>
  24. 24. Selecting Stocks: An Example <ul><li>Stk Beta Req. Exp. Alpha Decision </li></ul><ul><li>Ret. Ret. Value </li></ul><ul><li>% % % </li></ul><ul><li>_________________________________ </li></ul><ul><li>A 0.5 7.8 10.0 +2.2 Strong Buy </li></ul><ul><li>B 1.5 16.3 14.0 -2.3 Strong Sell </li></ul><ul><li>C 2.0 20.5 21.0 +0.5 Neutral </li></ul>
  25. 25. Required Rates of Return in Relation to Beta Values Beta value 17 13 1.0 1.5 Rate of return in market Market risk premium = 8% 5 Required rates of return % Risk premium of 1.5 beta stock = 12% 0
  26. 26. Acquiring Securities <ul><li>Dollar Cost Averaging </li></ul><ul><ul><li>Make Equal $ Investments At Regular Time Intervals </li></ul></ul><ul><ul><li>Over Time, You Invest at an Average Cost </li></ul></ul><ul><li>Routine Investment Plans </li></ul><ul><ul><li>Dividend Reinvestment Plans (DRIPS) </li></ul></ul><ul><ul><li>Choosing to Reinvest Dividends with Your Mutual Fund </li></ul></ul>
  27. 27. DCA:$1,000 Invested Each Month Date Shares bought Price Total shares Total cost Avg cost Cuml. profit
  28. 28. When To Sell Securities <ul><li>If the Security Becomes Over-Valued </li></ul><ul><li>To Gain Certain Tax Advantages, Such as Capital Losses </li></ul><ul><li>Your Investment Objectives Change </li></ul><ul><ul><li>You Need to Be More Conservative, or </li></ul></ul><ul><ul><li>You Need More Current Income </li></ul></ul>
  29. 29. Economic Changes and the Portfolio <ul><li>As Economic Conditions Change, You Can: </li></ul><ul><ul><li>Ignore Such Changes--This is a Buy-and-Hold Strategy </li></ul></ul><ul><ul><li>Try to Exploit Such Changes to Enhance Your Return--This is Called a Market Timing Approach </li></ul></ul><ul><li>If Economic Conditions Don’t Change </li></ul><ul><ul><li>Don’t Change Portfolio Allocations </li></ul></ul>
  30. 30. Some Issues on Market Timing <ul><li>Timing is Very Difficult--There is Little Evidence Showing that Professionals Can Time the Market Well </li></ul><ul><li>Timing Can Add to Investment Risk in the Sense That It Increases Potential Gains and Losses </li></ul><ul><li>Bottom Line: Construct a Sound Portfolio and Stick With It! </li></ul>
  31. 31. Hypothetical Returns and Market Timing Period Treasury bills Common stocks Correct guess Incorrect guess
  32. 32. Next Chapter 11 Stocks and Bonds

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