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Chapter 10
 

Chapter 10

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    Chapter 10 Chapter 10 Presentation Transcript

    • Personal Finance: An Integrated Planning Approach Winger & Frasca Chapter 10 Investment Basics
    • Major Topics
      • Risk and Return
      • The Rewards of Diversification
      • Applying a Risk-Return Model
      • Building and Changing a Portfolio
    • 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
    • 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%
    • 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
    • Sources of Risk
      • Changing Economic Conditions
      • Changing Conditions of the Security Issuer
    • 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
    • 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
    • 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
    • Growth of $1,000 Invested in Financial Assets: 1970-2000
      • Common Stocks $43,180
      • 90 Day U.S. Treasury Bills $10,135
    • 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
    • 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
    • A Portfolio
      • A Portfolio is Simply
      • a Group of Assets
      • Held at the Same
      • Time
      Stocks Bonds Bills
    • 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
    • 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
    • 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
    • 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
    • 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
    • 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
    • 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
    • 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
    • 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%
    • 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
    • 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
    • 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
    • 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
    • DCA:$1,000 Invested Each Month Date Shares bought Price Total shares Total cost Avg cost Cuml. profit
    • 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
    • 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
    • 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!
    • Hypothetical Returns and Market Timing Period Treasury bills Common stocks Correct guess Incorrect guess
    • Next Chapter 11 Stocks and Bonds