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NACUBO Endowment Study


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NACUBO Endowment Study

  1. 1. Basics of Investing Louis R. Morrell Vice President for Investments/Treasurer August 2005 FOREWORD Although the economic environment is ever-changing, the basic principles of investing remain constant. One should avoid the tendency to deviate from those principles in response to passing fads, hot concepts, and volatile markets. The market (stocks and bonds) goes up 71% of the time. While rising markets benefit most investors, your success will depend upon what you do during the 29% of the time when the market moves sideways or declines. A mistake in these periods can be very costly. MARKET VOLATILITY One major distinction that an investor must be able to make is the difference between a market correction and a bear market. For the sake of simplicity, the national press generally describes a correction as a loss of 10% or more from a stock market high, and a bear market as any loss of 20% or more. Such a distinction is far too simplistic. In my opinion, corrections occur when stock prices get too high based on corporate earnings expectations. Stock prices then begin to fall (or adjust) until they reach a more reasonable level. In contrast, a bear market begins when basic economic fundamentals deteriorate which includes such factors as: the rate of inflation, level of interest rates, state of the economy, rate of unemployment, factory production, consumer confidence, size of federal deficit, consumer spending, etc. This is a critical distinction, as bear markets can be severe in terms of loss of market value and they can last for a long time. Below is a history of recent bear markets for both stocks and bonds: RECENT BEAR MARKETS - STOCKS RECENT BEAR MARKETS - BONDS Length Length Start of bear market Percent price decline Start of bear market Percent price decline (in months) (in months) August 1956 15 -21.6% March 1967 38 -23.0% December 1961 6 -28.0% March 1971 54 -18.2% February 1966 8 -22.2% December1976 39 -32.7% November 1968 18 -36.1% June 1980 15 -27.9% January 1973 21 -48.2% May 1983 13 -17.1% September 1976 17 -19.4% January 1987 9 -15.5% January 1981 19 -25.8% October1993 13 -17.9% August 1987 3 -33.5% December 1998 13 -14.6% July 1990 3 -19.9% March 2000 31 -47.4% Average 24 -20.9% Average 14 -30.2% Scource: Vanguard Fixed Income Group Scource: Standard & Poor's Corporation
  2. 2. As noted above, the average loss in value for stock bear markets amounted to 30.2% and it lasted an average of 14 months. While bonds are considered less risky than stocks, bear markets also apply to bonds. When a bear market comes, one must be very patient and resist the temptation to sell at or near the bottom in an attempt to avoid further losses. Knowing what bear markets are, that one must expect them, how long they might last, how severe they can be, and that recovery always follows, better prepares an investor for coping with them. Stock and Bond Market Valuation Factors It is important that an investor have a basic understanding of how stock prices and bond prices are set. Like any product or service, the price represents what a buyer is willing to pay and a seller is willing to accept at a given point in time. Stock prices are influenced primarily by a combination of the following factors: A. Level of Corporate Earnings – The higher the earnings, the more valuable the corporation and the higher its stock price. B. Earnings Growth Rate – The higher the earnings growth rate, the more valuable the corporation and the higher its stock price. C. Quality of Earnings – Quality means dependability of future earnings. A corporation that owns a brand name product, or one that makes a unique product or provides a unique service that is not generally available from competitors, has earnings considered to be of high quality. A strong competitive position is considered the single most important characteristic a company can have. D. Number of Shares Outstanding – The value of the earnings of a corporation and its assets is influenced by the number of shares outstanding. When a corporation issues new shares of stock, the price per share falls. When a corporation buys back some of its shares, the price per share rises. E. Inflation Outlook – Low or falling inflation increases the price of a share of stock or bond since its earnings or interest payments become more valuable to an investor. F. Dividend Rates – High or increasing dividends enhance the value of a share of stock as such dividends in effect reduce the cost of the stock to its purchaser. One common valuation measure of a stock and the market as a whole is what is known as the price:earnings ratio. The ratio expresses how much an investor is willing to pay for a dollar of earnings. For example, a corporation with earnings of $2 per share, whose stock sells for $50 per share has a price:earnings ratio of 25:1. Thus, in considering the shares of two different corporations with each other, an investor is able to compare their relative price:earnings ratios to determine how expensive they are. The same situation applies to the stock market as a whole. For example, an investor can look at the p:e ratio of all stocks in the 2
  3. 3. S&P 500 to determine whether stocks are expensive or cheap at any point in time. On a long-term basis, the price:earnings ratio of the stock market has averaged 16:1. Bond prices are influenced primarily by a combination of the following factors: A. Yield of Bond – Generally, the yield of a particular bond relative to the bond market as a whole influences its price. For example, a bond yielding 6% when the market is yielding 5% will be more valuable than a bond yielding 5%. B. Possibility of Default – Bonds of U.S. government agencies are not subject to default and, on the basis of credit ratings, are more valuable than bonds issued by corporations. The bond prices of corporations that have deteriorating financial conditions usually fall which raises their yield. C. Inflation Outlook – When inflation is low or falling, bond prices rise as the future interest payments become more valuable in terms of purchasing power. D. Supply and Demand – As the supply of bonds falls, prices rise as issuers of bonds are willing to pay lower interest rates. The movement of foreign investors into and out of the U.S. bond market influences supply and demand as does the level of issuance activity by the U.S. government and corporations. Two important factors that must be addressed when considering your future income requirements are inflation and life expectancy. Assuming a 4% rate of inflation, the purchasing power value of a dollar would fall, as follows: Period Purchasing Power Initial year in retirement $1.00 5 years later $0.82 10 years later $0.68 15 years later $0.56 20 years later $0.46 25 years later $0.38 The impact of inflation is be tied directly to life expectancy (how long the money must last) as follows: Current Expected Number of Years Age Men Women Couples 55 22.3 27.0 34.4 60 18.5 22.6 29.7 62 17.1 21.2 27.8 65 15.1 18.9 25.0 67 13.8 17.4 23.2 70 12.0 15.3 20.6 3
  4. 4. It is critical that, in financial planning, one focus on life expectancy and not on the number of years to the start of retirement. The need for income growth does not end upon entering into retirement; it continues over one’s lifetime. It should be noted that when two lives are involved, the life expectancy of one of the two persons surviving increases sharply. This magnifies inflation risk and the need to take steps to protect against it. Annuities pay lower annual amounts when two lives are involved as a result of the combined longer life expectancy. Inflation has an impact on the value of both one’s principal and the income stream. In a sense, inflation is the opposite of compound interest as the value of money received is discounted as time passes. For example, in a period of inflation, with a bond that pays a fixed rate of interest, the economic value of each coupon payment is worth less than the one that preceded it. The “rule of 72” is a reliable guide to measure the impact of inflation. It is based on dividing 72 by the annual inflation rate to determine the number of years it will take for prices to double. For example, when inflation is at 10%, prices will double in seven years (72 ÷ 10 = 7), and when it is 4% they will double in 18 years. This is a particularly worrisome matter for persons in retirement. Those hardest hit by inflation are living on fixed incomes. As you develop a strategy for retirement fund management, future income requirements must be the first consideration. It is generally assumed that in retirement one will be able to get by with between 70% to 90% of what was earned in the final year of employment. The percent of final salary needed in retirement to maintain your standard of living is called the “replacement ratio.” The ratio is a person’s gross income after retirement, divided by his or her gross income prior to retirement. For example, assume that a person who earns $70,000 per year retires and receives $50,000 which represents the combination of Social Security and other retirement income. The replacement ratio would be 72% ($50,000/ $70,000). Usually one is able to get by in retirement with less income due to the following factors: 1. Social Security taxes do not apply in retirement. 2. It is no longer necessary to set aside a portion of annual income to cover retirement costs in the future. 3. Work-related costs such as transportation, clothing and meals are reduced. 4. Income taxes are lower in retirement. 5. Social Security benefits are partially or completely tax free which reduces taxable income and thus income tax liability. The replacement ratio is intended to let an investor know how much income will be needed in retirement to maintain one’s standard of living. Although the answer to the above question is unique to each person, the following results are based on actual data collected from a very large data base. Thus, one is able to ascertain how his/her projected income compares to what others are actually receiving in retirement. The following chart shows projected replacement ratios by pre-retirement income level. 4
  5. 5. REPLACEMENT RATIO Replacement Ratios Pre-Retirement Social Private and Income Security Employer Sources Total ($000) (%) (%) (%) $20 65 24 89 30 56 28 84 40 51 29 80 50 48 29 77 60 43 32 75 70 39 37 76 80 35 42 77 90 33 45 78 Source: Aon Consulting Let’s look at an example from the above table. For someone with pre-retirement income of $40,000, it is assumed that in retirement their replacement ratio would be 80%, or $32,000 per year ($40,000 x 80%). Of this amount, Social Security is expected to provide $20,400 ($40,000 x 51%). The remaining $11,600 ($40,000 x 29%) is expected to come from private and employer sources. Therefore, depending on how much your employer contributes, it is very likely that you will be responsible for a significant portion of your retirement income. CRITICAL CONCEPTS IN ASSET SELECTION AND MANAGEMENT Psychological Factors Psychology plays a major role in investing which can lead an investor to be his/her own worst enemy. One must be able to put events into a long-term perspective. This is of course difficult for those who demand short-term results. Studies have shown that most people draw limited pleasure when positive things happen to their assets; yet, when negative things happen they experience unlimited discouragement. This can result in illogical action to avoid negative situations along with a lack of discipline in carrying out one’s investment plan. One requirement for success is open-mindedness. Many people carry psychological bonds or commitment in a certain asset class (or classes). For example, one might be strongly attracted to real estate or to stocks of well-known companies. Such a bias, while at times helpful to the short-term, is counterproductive as it can lead to a loss of objectivity. To achieve success, all investment alternatives must compete with one another based on risk:return characteristics. As will be developed later in this document, a key element of a successful investment strategy is diversification of asset classes. For example, one should not take the common position that bonds are the only safe investment or that stocks are too risky. 5
  6. 6. Another undesirable personal tendency is to select only those investments that provide cash flow return through interest payments or dividends. People with such a tendency equate results only with in-hand, tangible cash returns. A final personality flaw involves what could be called a “trader’s mentality.” Such persons attempt to buy low and sell high over relatively short periods of time – perhaps as short as a single day or week. This can be very counterproductive. It is much more difficult to predict tomorrow’s price movement of an investment than it is next year’s. The shorter the period, the more difficult prediction becomes and the higher the probability of making a costly mistake. There are four common personality flaws that most people have: 1. Hope – encourages you to hold a stock that was a mistake to buy in the first place. 2. Boredom – encourages you to sell a good stock that is considered dull. 3. Greed – encourages you to ignore reality and make buying decisions based on good things that have happened in the past, even though conditions may have changed, with the expectation that the stock will be sold before its price collapses. 4. Fear – encourages you to sell at the first sign of possible trouble out of a concern that you will lose everything. Being conscious of common psychological tendencies can help one to protect himself against basic negative consequences. Saving vs. Investing When developing an investment strategy, it is important to recognize the distinction between saving and investing. Saving is a relatively short-term activity designed to provide a set dollar amount at some point in the future, usually for a specific purpose such as buying an automobile. The major goal in saving is to avoid the risk that the dollar amount objective will not be achieved. That is, a saver is usually willing to give up much of the opportunity for gain in value to ensure that the desired targeted goal is reached. Savings should be liquid – easily converted to cash – to be used for such things as emergencies, college tuition payments, down payment on a home, or a vacation. Savings are best segregated and not considered part of one’s assets held towards longer- term needs such as retirement. In contrast, investing is longer-term in nature with the individual willing to accept more short-term risk in the expectation of achieving a greater long-term gain. Investing involves a minor emphasis on protecting capital against temporary losses and a major emphasis on making it grow permanently. Investment strategy should be reflected in what is known as an investment plan which contains a combination of the following components/personal characteristics: 1. a permanent capital base – assets that can be assigned (invested) on a long-term basis; 2. an investor with a proper temperament to accept risk, be disciplined, and be patient; and 6
  7. 7. 3. one who has a basic knowledge and understanding of the investment process. This document is directed toward investing, not saving. Achieving a high investment return over a longer time period, with an acceptable and reasonable degree of volatility, is the nature of investing. That is, there will be periods when assets lose value. However, it is anticipated that short-term losses will be more than offset by longer-term gains. Such a time frame means that to be successful in accumulating retirement wealth, an investor must have patience. Active vs. Passive (Indexed) Investing One fundamental decision that you must make is whether to select “active” or “passive” management for your retirement fund assets. Passive investing is a strategy of building an investment portfolio designed to match the returns of a benchmark portfolio such as large U.S. corporations (represented by the S&P 500), small U.S. corporations (Russell 2000), or the overall stock market (Russell 3000 or Wilshire 5000). The S&P 500 is the most widely used index in fund investing. The manager takes no position in attempting to select individual stocks or bonds; instead, he/she buys them all – both the good and the bad within the index. Thus, one’s investment returns mirror the overall market. As the market goes up or down, so too does the value of your investment. In contrast, active investing is based on a strategy designed to outperform the broad stock and bond markets. It is assumed that the manager is able to select individual stocks or bonds with above-average returns – avoiding the poor performers, selecting the good ones, in order to beat the market. Compared to the index funds, as a group, active equity managers have had relatively poor performance. At first glance, it may seem odd that portfolios consisting of carefully researched and selected high-quality companies are not able to beat the stock market. On closer examination, one must bear in mind that the stock market return represents the collective results of the decisions of all investors. Thus, in the aggregate, individual managers cannot beat the market since they are the market. The S&P 500 was created in 1957 and consists of 500 stocks that include 400 industrial, 40 utility, 20 transportation, and 40 financial issues. The stocks are selected by a committee that uses size, liquidity, and industry representation as a criterion. It is market-cap weighted which means that size is a factor in determining how much influence the performance of a single company has on the index as a whole. The larger the company the greater the influence its performance has on the performance of the S&P 500. In terms of the total U.S. stock market, the S&P 500 represents approximately 75% of the value of the whole market. There are individual active managers who have outperformed an indexed approach on a fairly regular basis. Historically, however, only about one-tenth of actively managed funds have been able to do so on a consistent basis. Indexing works for the following reasons: 1. Stocks in the S&P 500 have had higher average returns than the market as a whole. 2. Index funds have lower costs (generally less than 20% of the cost of active management). 3. Index funds have lower turnover resulting in a savings in transactions expense. 4. The S&P 500 constantly changes to include more successful companies. 7
  8. 8. 5. Index funds are generally more diversified than active funds. There are market cycles in which many active managers are able to outperform indexes. When deciding whether to seek active management or to take an indexed approach, one should focus on the cycle of the market and the ability of a manager to outperform as indicated by past results. Is the current period one in which active management appears best and does the manager being considered have a proven record of success in outperforming the markets in periods like this? Tax Deferral One of the most attractive features of retirement plans is that the contributions made to them are tax deferred as are the investment gains prior to retirement. That is, federal and state income taxes are not assessed against the payments made to your retirement fund through contributions made by the institution on your behalf or by you on a voluntary basis. This deferral can be seen as a form of retirement-fund-contribution-matching by the government. In addition, earnings (investment returns) on the retirement fund balance are also deferred and taxes will not be due until the monies are withdrawn from the fund in the form of retirement benefits. It is important to realize that the contributions and gains are tax-deferred and not tax-exempt. Being tax-deferred, all of the money in your retirement account goes to work upon receipt and begins to earn investment returns. The greater the retirement fund balance, the greater the level of future benefits. Tax deferral combined with compound interest, as noted below, can have a major impact on the level of your retirement fund. Compound Interest Perhaps the most important and powerful concept in investing is compound interest which works like magic. It is what links capital growth to time. For example, let us assume that one were to invest $100 at a 5% earnings rate for a 10-year period. Below is the projected outcome: Year Principal Earnings Compounding Total 1 $ 100.00 $ 5.00 $ --- $ 105.00 2 105.00 5.00 .25 110.25 3 110.25 5.00 .51 115.76 4 115.76 5.00 .78 121.54 5 121.54 5.00 1.07 127.61 6 127.61 5.00 1.38 133.99 7 133.99 5.00 1.69 140.68 8 140.68 5.00 2.03 147.71 9 147.71 5.00 2.38 155.09 10 155.09 5.00 2.75 162.84 $50.00 $12.84 As noted above, the total income from the stated earnings rate of 5% amounts to $50.00 over the ten-year period. However, the annual compounding has provided an extra $12.84 in 8
  9. 9. return. While that might not seem very much, it does represent 12.84% of the original investment of $100. The compounding gets much more significant as the interest rate increases and the period of compounding is extended. For example, if one were to increase the above earnings rate to 15% and extend the period to 30 years, the original $100 would become $6,621.10 of which $450 would represent the total of the annual $15 earnings payments and the balance of $6,071.10 would come from compounding. Therefore, approximately 92% of the fund balance is the result of compounding. E ffe c ts o f C o m p o u n d in g a t 1 5 % $ 7 ,1 0 0 .0 0 $ 6 ,1 0 0 .0 0 Increase in Total $ 5 ,1 0 0 .0 0 $ 4 ,1 0 0 .0 0 $ 3 ,1 0 0 .0 0 $ 2 ,1 0 0 .0 0 $ 1 ,1 0 0 .0 0 $ 1 0 0 .0 0 0 5 10 15 20 25 30 Y e a rs The relationship between earnings rate and time required to double one’s investment is shown below: Earnings Period to Double Rate Investment 1% 72 years 3% 24 years 5% 14 years 7% 10 years 9% 8 years 11% 7 years 13% 6 years 15% 5 years The lessons from this exercise are: 1. Principal grows at a compound rate of earnings. 2. The higher the earnings rate, the higher the return. 3. The faster (more frequent) the compounding, the higher the return. 4. At some point in time, compounding becomes more financially significant than the 9
  10. 10. base earnings rate in influencing the size of the asset accumulation. 5. The sooner one invests (saves) the greater the financial impact of compounding. Total Return Concept In the prior section, reference was made to an interest bearing investment such as a savings account. That is, in each period, interest is earned and credited – either added to principal or spent. Any change in the market value of the principal of the fund must come from the addition of interest income payments or new additions. In contrast, changes in the value of the principal of a stock fund are the result of what active investors believe the price of a stock should be, which is reflected in the price of a stock on the stock exchange. There are thousands of investors (individual and institutional) seeking to gain from price increases in stocks. They study financial reports, talk to each other, visit companies, etc. They also consider “investor psychology” which influences share prices in the short-run. As noted earlier, investing involves a major emphasis on making one’s principal grow. One critical aspect of investing is an approach known as the “total return concept.” Total return represents the change in market value of an investment as a result of a combination of interest, dividends, and price appreciation/depreciation. The total return may be realized (when the assets gaining or losing value are sold) or unrealized (when the assets gaining or losing value are held). Because dividends and interest payments are more predictable than changes in share prices, many investors forego the opportunity for financial gain from appreciation by placing too much emphasis on yield. Some investors buy high- yielding items which can be very risky but offer little opportunity for growth of principal value. In selecting investments, it is best to think of “total return” – what you believe to be the best investment in terms of an opportunity for gain from a combination of price appreciation and yield. Owner Or Lender There are two basic things that one can do with investment assets: lend them to someone or buy something with them. These alternatives result in two different relationships between the party issuing a security and the party acquiring it. The person providing the money is either an investor or a lender. (There is one type of instrument called a convertible bond which has characteristics of both investing and lending.) A bond holder is a lender who has a contractual relationship to the issuer of a security. In return for the use of capital, the issuer agrees to return the borrowed funds at some future date in addition to providing periodic payments (interest) for the use of the funds (capital). The best thing that can happen to a lender is that he will ultimately receive all of the interest payments due plus his original loan amount, as promised. The worst thing that can happen is default as the lender will not receive his original loan amount and perhaps nor all of the interest payments that are due to him. Historically, bonds have not performed all that well over extended periods. Each year they tend to return about three percent more than the annual rate of inflation. In periods of rising inflation, bond investors have often lost value. The price of a bond moves in the opposite direction of interest rates, rising when rates fall and falling when rates rise. An owner is free to sell a bond at any time – at a gain or at a loss. 10
  11. 11. In contrast, an investor who acquires shares of stock becomes an owner of the company issuing the stock. As an owner, you are able to share in the success of a company. If its sales and profits rise, chances are that the share price will go up as well. In addition, you benefit from the amount of dividends paid to you as a shareholder. Successful companies generally raise the amount of their dividends over time. While it is true that, for a bond holder, success, in terms of rising profits, would increase the probability that a lender would receive his principal back, along with all interest payments due, neither the amount of the principal nor the level of interest payments would increase as a result of the company’s good fortune. Thus, while owning a stock is more risky than buying a bond, in the sense that there is less assurance that one would get his money back, stocks offer a much greater opportunity for financial gain when a company is successful. Dollar Cost Averaging This concept involves investing fixed amounts on a regular basis irrespective of how the market is doing. Such an approach means that an investor buys more shares when prices are low and fewer shares when prices are high. It allows one to avoid the risk of investing a large sum of money at the market top and prevents one from investing a large amount when share prices are at the bottom. Studies have shown that lump-sum investing actually leads to higher returns than dollar cost averaging. This results from the upward bias of stock prices which rise 71% of the time. In retirement plans, most people use a dollar cost averaging approach since the investment money comes from one’s salary. Also, such a practice reduces one’s natural fear of buying a large number of shares just before prices fall. In effect, dollar cost averaging matches the temperament of most investors. When an individual has a large sum of money to invest, a hybrid approach to dollar cost averaging might be considered. It involves investing a large part (say 50%) of the money immediately followed by a gradual investment of the balance. In conclusion, if you are seeking the highest return without consideration of risk, use a lump- sum approach. If you are more concerned about risk and willing to accept a lower return, use dollar cost averaging. ASSET CLASS DESCRIPTIONS Below is a brief description of the most common investment choices. Money Market Funds, Treasury Bills, and Certificates of Deposit These instruments provide a very safe investment with always a positive rate of return. The investment return is directly tied to interest rates. With a money market fund, if rates rise, income goes up; if rates fall, income declines. Thus, this asset offers some protection against inflation which moves in the same direction as interest rates. The primary disadvantage is that the expected return will almost always be lower than stocks or bonds. Treasury bills and certificates of deposit are very safe in terms of return of principal when held to maturity. 11
  12. 12. Their relatively short maturities provide protection against rises in interest rates and their net proceeds can be reinvested at higher interest rates in the near future when they mature. Bond (Fixed Income) Investments As noted earlier, a bond is called a fixed income security because it pays a specified dollar amount of interest on a scheduled basis. For most retirement fund investors, three types of bonds are considered: corporate, U.S. Treasury, and international. They have differing maturities: short-term, intermediate, and long-term. Intermediate bonds usually have maturities between two and ten years. Long-term bonds have maturities between seven and thirty years. There are also short-term bond funds whose maturities are usually under three years. They are not recommended for retirement funds because they do not vary significantly from money market funds in terms of interest payments while offering less protection than money market funds in the event of rising inflation and interest rates. As a general rule, interest rates paid vary according to the maturity of a bond with the longer the term, the higher the rate. However, if interest rates rise, the value of the principal of a long-term bond fund will fall to a greater extent than an intermediate bond fund. Thus, one must decide where to place emphasis – on long-term bonds for higher return or intermediate bonds for protection of principal. Corporate bonds are issued by companies and backed by the financial capacity of the issuer. Corporate bonds are assigned ratings that are intended to measure the corporation’s ability to meet its obligations of the bond. The highest quality corporate bonds are called “investment grade.” They are relatively free of risk but not as safe as U.S. Treasury bonds. To compensate for the slightly higher risk, they pay higher rates of interest than U.S. Treasury bonds. Some corporate bonds are backed by specific assets of the issuer which reduces risk as contrasted to other bonds that are backed by the corporation’s general credit. Corporate bonds that are below investment grade, and thus subject to a higher probability of default of interest payments and return of principal, are called high-yield or “junk” bonds. Such bonds are usually issued by companies with high levels of debt or poor track records of financial performance (revenue and profits). As such, they are generally not recommended for retirement funds unless one would want to substitute them for equities. U.S. Treasury bonds are direct obligations of the United States government and are considered the safest of bonds. Their safety results in the payment of relatively low interest rates. International bonds are issued by foreign companies or foreign governments. The risk of such bonds is greater than U.S. issues as follows: 12
  13. 13. • The credit ratings of U.S. government issues are generally higher than those issued by most foreign countries. The possibility of default on U.S. government obligations is nil. • Foreign governments’ securities regulations for companies issuing bonds often are not a strict as those in the U.S. • Financial and other information related to foreign issuers of debt often is less comprehensive than that of U.S. companies. • There is a currency risk in that even if the issuer pays interest and principal in a timely fashion, payments made in, yen or euros, etc., could decline in value relative to the U.S. dollar. To offset the above risks, international bonds generally provide investors with the possibility of greater returns than U.S. issues. Currency value fluctuations can work in favor of as well as against international bond investors. Limited information available to investors allows knowledgeable analysts to capitalize on inefficient bond markets. In addition, interest rates (over the longer term) in different markets tend not to move in the same direction so that a decline in the value of a bond in an international market (because of a rise in interest rates there) might be offset by a rise in value of a U.S. bond (where interest rates are falling). The opposite is, of course, true. Thus, geographic diversification can reduce risk and enhance return. Stock Funds Unlike bonds, stocks offer no guaranteed return although some do pay dividends. As noted earlier, stock represents ownership in a corporation. As such it has no absolute value and its price is dependent upon whether shareholders want to keep it and what other investors are willing to pay for it. If the company does well or becomes popular, its share price will rise. Stocks come in a number of varieties (styles), as follows: Income stocks have a history of paying consistent dividends that generally represent a percentage higher than the overall market. Such shares appeal to investors who wish to own stocks and desire income. Value stocks sell for prices that are lower than the market in relation to their earnings. Their prices also are lower than the market in comparison to the book value of the company’s assets. They appeal to investors who want price stability with the opportunity for an increase in value. Growth stocks have above-average growth rates in terms of sales and profits. Generally, their earnings are reinvested in the corporation to allow for expansion, with no or a low level of dividend payments to shareholders. Investors are willing to pay higher prices and receive little in the way of dividends in the expectation that share prices will rise, giving them the opportunity to sell them for return in the form of appreciation. 13
  14. 14. Small Company (Cap) stocks – each company has a market capitalization which is determined by multiplying the number of shares of stock outstanding by the current price of a share. Those corporations with capitalizations of $1 billion or under are considered small cap (company). Most small company stocks fall into the growth stock class and pay few, if any, dividends. Their rates of growth are generally higher than large company (cap) stocks since they operate from a smaller asset base. However, they can be risky in bad economic periods, having fewer resources to fall back on. Large Company (Cap) stocks have market capitalizations in excess of $5 billion with a much higher average. They generally have slower growth rates than small company stocks and often pay dividends to their shareholders. Because of their size, they are more resistant in difficult economic times than small company stocks. For this, an investor usually must pay a higher price in terms of cost per unit of earnings or per unit of assets. International stocks invest in overseas markets. Such items can provide attractive returns, as follows: • the stock rises in price providing a capital gain; • the company issues a dividend; • the currency of the country rises in relation to the U.S. dollar so that when foreign shares (or dividend payments received in foreign currency) are sold and converted to dollars, there is an additional financial gain. The opposite is true in that, like U.S. stocks, the price can fall or the dividend can be reduced or eliminated, and the foreign currency can fall in relation to the U.S. dollar resulting in a net loss. International stocks include both developed countries (Europe, Canada, Japan) and emerging markets (Latin America, Eastern Europe, and Southeast Asia). RISK MANAGEMENT AND ASSET RETURNS Risk Management Understanding investment return is a relatively easy matter. Understanding return as it relates to risk is much more complicated. By reviewing historical return data one is able to gain a perspective on the subject. Simply stated, risk measures both the volatility of how much the value (price) of an investment can change in the short-term and the predictability of the overall results in terms of the total return. Since risk and return are correlated to each other, unless one is willing to accept more risk he will probably not be able to achieve a higher return. Finding a balance between the two is a major challenge for investors; neither risk nor return should be considered in isolation. 14
  15. 15. When thinking about risk, most investors attempt to answer two questions: “What can go wrong?” and “What are the chances of it happening?” Risk comes in a number of forms, as follows: Market Risk: the danger that the stock market will fall either through a correction, which is usually a temporary adjustment of share values, or a bear market in which prices fall more steeply than a correction and last a long time before recovery begins. Inflation Risk: the danger that the value of your retirement fund and the income that it produces will not keep up with inflation, resulting in a deterioration of your financial position. Company Risk: the danger that something bad will happen to a particular company that represents a major part of your investment portfolio – perhaps a new competitor comes along, or a law suit is introduced, or reported earnings fall far below expectations. Credit Risk: the danger that the corporation whose bonds are in your investment portfolio runs into financial trouble and is unable to make interest payments or repay the principal of the bonds, or both. Interest Rate Risk: the danger that the general level of interest rates will rise making your fixed income investments worth less. The key to risk management is diversification. Simply stated, it is a process that leads to your portfolio being able to benefit from different investment environments. It is true that with diversification an investor will always have a return that is lower than had all of the assets been in those instruments with the highest return, but higher than the result of having all of your investments in instruments with the lowest returns. Diversification works because not all investments do well at the same time, nor are they apt to all do poorly at the same time. Diversification reduces risk but it cannot eliminate it completely. It is possible for two different types of assets to move temporarily in the same direction. For example, rising inflation, which leads to higher interest rates, depresses both stock prices and bond prices. Another example is when U.S. stocks are experiencing slow growth (or declining in value) foreign stocks might be going in the same direction. Reducing losses in down periods results in higher balances being available to benefit from up periods. Financial assets (stocks and bonds) have three types of risk: Inflation (purchasing power) Risk Principal (loss of) Risk Income (reduction) Risk 15
  16. 16. The risk:return characteristics of three basic investment alternatives are as follows: Short-Term Long-Term Common Characteristic Investment Bonds Stocks Long-Term Return Probability Low Moderate High Inflation Risk High Moderate Low Principal Risk Low Moderate High Income Change Risk High Low Low Asset Returns In terms of return by major asset class: Short-term assets provide long-term returns in line with the rate of inflation. For the past ten years (ended December 31, 2004) short-term assets have had an annual return of 4.1%. From 1945 - 2004, the average annual rate of return has been 4.5%. During the same period, the average annual inflation rate has been 4.0%. Thus inflation has been consuming approximately 89% of the return. Bonds provide for returns greater than short-term assets. For the past ten years (ended December 31, 2004) bonds have had an average annual return of 7.8%. From 1945 - 2004, the average annual rate of return on bonds has been 6.5%. Again, one must subtract the 4.0% average annual inflation rate to determine growth of purchasing power. There have been wide swings in terms of bond returns. For example, in the 1960s and early 1970s, inflation rose sharply causing a fall in bond values. More recently, with lower inflation rates, bonds have provided much higher returns. As a general rule, in forecasting bond performance for periods between 8 - 15 years, the best indicator is the yield at the time the forecast is made. For example, if long-term U.S. government bonds have been yielding between 5% - 6%. Thus, one could reasonably look to an average annual return of 5.5% for long-term bonds which is well above their historic rate of return and suggests that bonds may be relatively attractive as investments in the years ahead. While most investors concentrate on the yield of a bond, one must also consider changes in price which fluctuate as interest rates change. This is because bonds carry a fixed, stated rate of interest and the only way that the market can adjust for the changes in interest rates is by changing the price (value) of a bond. As interest rates fall, newly issued bonds are less attractive than older bonds that were previously issued at higher interest rates. So the older bonds become more desirable and their prices rise. They therefore sell at what is known as a premium. For example, assume you own a 30-year bond that yields 8%: If the Yield on The Price of the the New Bond: Old Bond will: rises to 9% fall 10% rises to 10% fall 19% falls to 7% rise 12% falls to 6% rise 28% 16
  17. 17. As noted in the asset description section of this guide, foreign bonds and high yield bonds offer higher yields than U.S. government bonds. However, they do so along with higher risk. Common stocks have historically provided higher returns than short-term instruments or bonds. For the past ten years (ended December 31, 2004) stocks have had an average annual return of 12.1%. From 1945 - 2004, the average annual rate of return (S&P 500) has been 11.9%. Approximately one-half of the return has come from dividends and the remainder from price appreciation. After adjustment for inflation, stocks have returned approximately 8% per year. However, they have done so at more risk (volatility in annual returns) as evidenced by a high annual return of 54% in 1933 and a low, negative return of 43% in 1931. The volatility of returns for stocks decreases rapidly as the holding period is extended. When considering ten- year periods (there were 82 of them between 1926 and 2004) there was only one (1929 - 1938) when stocks did not post a positive return. To illustrate the volatility of stock prices, the following table shows the best, worst, and average annual total returns for the U.S. stock market over various periods as measured by the Standard and Poor’s 500 Index, a widely used barometer of market activity. (Total returns consist of dividend income plus change in market price.) Although this example is based on the U.S. stock market, international stock prices and total returns fluctuate significantly, too. Note that the returns shown in the table do not include the costs of buying and selling stocks or other expenses that a real- world investment portfolio would incur. U.S. Stock Market Returns (1926-2004) 1 Year 5 Years 10 Years 20 Years Best 54.2 % 28.6 % 19.9 % 17.8 % Worst -43.1 -12.4 -0.8 3.1 Average 12.4 10.6 11.2 11.4 The table covers all of the 1-,5-,10-, and 20-year periods from 1926 through 2004 CLOSING By now, you should have an understanding of the basics of investing. To attain success in investing requires a combination of three elements: a basic understanding of investing fundamentals, a constant awareness of need for vigilance, and disciplined self-control. Thus, for the most part, success in your hands. 17