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Chapter 10

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  • 1. Personal Finance: An Integrated Planning Approach Winger & Frasca Chapter 10 Investment Basics
  • 2. Major Topics
    • Risk and Return
    • The Rewards of Diversification
    • Applying a Risk-Return Model
    • Building and Changing a Portfolio
  • 3. Risk and Return
    • What Is Risk?
    • Sources of Risk
    • How Much Return Do You Need for the Investment Risks You Take?
    • The Iron Law of Risk and Return
      • To Earn Higher Returns,
      • You Must Take Greater Risks
  • 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. Nature of Risk
    • The More Variable an Investment’s Return, the Greater Its Risk
    • A Highly Variable Return Could Lead to Investment Losses if the Investment Needs to be Sold
    • However, the Longer the Investment is Held, the Greater the Chances of Earning the Long-Run Rate of Return
  • 6. Sources of Risk
    • Changing Economic Conditions
    • Changing Conditions of the Security Issuer
  • 7. Risk and Changing Economic Conditions
    • Inflation Risk--Inflation Increases and the Return on Your Investment Does Not Keep Pace
    • Business Cycle Risk--Your Investment’s Return Fluctuates in Tandem with the Overall Business Cycle
    • Interest-Rate Risk--Newly-Issued Bonds Offer Higher Rates than Your Bonds
  • 8. Risk and Changing Conditions of the Security Issuer
    • Management Risk--The Company in Which You Invested Has Poor Managers
    • Business Risk--Risks Associated with a Company’s Product/Service Lines
    • Financial Risk--The Risk of Insolvency Because the Company Has Borrowed Too Much
  • 9. Average Annual Returns on Financial Assets: 1970-2000
    • Common Stocks 12.92%
    • 90-Day U.S. Treasury Bills 7.76%
      • Source: Federal Reserve Bank of St. Louis
  • 10. Growth of $1,000 Invested in Financial Assets: 1970-2000
    • Common Stocks $43,180
    • 90 Day U.S. Treasury Bills $10,135
  • 11. Risks With Financial Assets: 1970-2000
    • Annual Returns
    • Highest Lowest Range
    • Stocks 37.4% -26.5% 63.9%
    • T-Bills 14.1 2.8 11.3
  • 12. Investment Risk Premium
      • Return on U.S. Treasury Bills (T-Bills) Is Free of Risk
      • Any Investment’s Return in Excess of the T-Bill Return is Called the Investment’s Risk Premium
      • An Important Concept is Market Risk Premium:
        • Using 1970-2000 Historical Data, this Premium is 5.16 (12.92% - 7.76%)
        • Using long-term data, the premium is close to 8%
        • Controversy Exists over Value for the Premium
  • 13. A Portfolio
    • A Portfolio is Simply
    • a Group of Assets
    • Held at the Same
    • Time
    Stocks Bonds Bills
  • 14. Diversification
    • Diversification Lowers Investment Risk
    • It Accomplishes this Goal Because Asset Returns Are Poorly Correlated
    • Diversification is Not Effective if Asset Returns Are Strongly, Positively Correlated
    • The Return Correlations Among Stocks, Bonds, and Bills Are Low; Holding These Investments in a Portfolio is Effective
  • 15. An Example of Negative Return Correlation
    • As A’s Return
    • Changes
    • B’s Return Changes in the Opposite Direction
    • Holding Each Gives a 10% Constant Return
    B 10% A
  • 16. Diversification Guidelines
    • Diversify Among Intangibles and Tangibles
      • Remember: A House Is a Major Tangible
    • Diversify Globally
      • Invest in Foreign Securities
    • Diversify within Asset Groups
      • Own a Variety of Common Stocks
  • 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. Market and Random Risks
    • Random Risks Are Those Associated with Specific Companies
      • These Tend to “Balance Out” if A Sufficient Number of Stocks Are Held (About 20)
      • Holding Too Few Stocks is Foolish: You Take Risks That Can Be Eliminated
    • Market Risk is the Risk Associated with the Overall Market: It Cannot Be Reduced by Holding More Stocks
  • 19. Managing Market Risk
    • If Your Portfolio Is as Risky as the Overall Market, You Should Earn the Market Risk Premium (Say, 8%)
    • If Your Portfolio is Riskier, Then You Should Earn an Extra Premium (Something More than 8%)
    • A Precise Risk Measurement is Needed: A Stock’s Beta
  • 20. The Beta Risk Measurement
    • Beta Measures a Stock’s Risk in Relation to the Overall Market Risk
    • 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
    • While Betas Can Be Negative, Most Are Positive
  • 21. Sample Beta Values
    • America Online 2.6
    • AT&T 1.0
    • Barrick Gold 0.7
    • Gillette 0.8
    • Intel 1.5
    • Southwest Airlines 0.8
    • Texaco 0.3
  • 22. Estimating Required Return
    • First, Determine the Stock’s Risk Premium
      • Find its Beta (say 1.5)
      • Multiply by the Market Risk Premium (say, 8%)
      • So, 1.5 x 8% = 12%
    • Second, Add the Current Risk-Free Rate (say 5%)
      • Then, Required Return = 12% + 5% = 17%
  • 23. Making Stock Selections
    • Find a Stock’s Alpha Value:
      • Alpha = Expected Return - Required Return
    • Select Stocks with the Largest Alpha Values
    • Understand that Determining Required Return is Very Difficult
  • 24. Selecting Stocks: An Example
    • Stk Beta Req. Exp. Alpha Decision
    • Ret. Ret. Value
    • % % %
    • _________________________________
    • A 0.5 7.8 10.0 +2.2 Strong Buy
    • B 1.5 16.3 14.0 -2.3 Strong Sell
    • C 2.0 20.5 21.0 +0.5 Neutral
  • 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. Acquiring Securities
    • Dollar Cost Averaging
      • Make Equal $ Investments At Regular Time Intervals
      • Over Time, You Invest at an Average Cost
    • Routine Investment Plans
      • Dividend Reinvestment Plans (DRIPS)
      • Choosing to Reinvest Dividends with Your Mutual Fund
  • 27. DCA:$1,000 Invested Each Month Date Shares bought Price Total shares Total cost Avg cost Cuml. profit
  • 28. When To Sell Securities
    • If the Security Becomes Over-Valued
    • To Gain Certain Tax Advantages, Such as Capital Losses
    • Your Investment Objectives Change
      • You Need to Be More Conservative, or
      • You Need More Current Income
  • 29. Economic Changes and the Portfolio
    • As Economic Conditions Change, You Can:
      • Ignore Such Changes--This is a Buy-and-Hold Strategy
      • Try to Exploit Such Changes to Enhance Your Return--This is Called a Market Timing Approach
    • If Economic Conditions Don’t Change
      • Don’t Change Portfolio Allocations
  • 30. Some Issues on Market Timing
    • Timing is Very Difficult--There is Little Evidence Showing that Professionals Can Time the Market Well
    • Timing Can Add to Investment Risk in the Sense That It Increases Potential Gains and Losses
    • Bottom Line: Construct a Sound Portfolio and Stick With It!
  • 31. Hypothetical Returns and Market Timing Period Treasury bills Common stocks Correct guess Incorrect guess
  • 32. Next Chapter 11 Stocks and Bonds

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