Investment Basics

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Learning Objectives
1. Set your goals and be ready to invest. 2. Calculate interest rates and real rates of return.

3. Manage risk in your investments.

4. Allocate your assets in the manner that is best for you. 5. Understand how difficult it is to beat the market.
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Introduction
Investing goals should be to protect and make money.
Important to understand investing from a common sense perspective. A solid grounding in investing will help you reach your financial goals and avoid pitfalls.
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Before You Invest

Decide what your goals are.
How much can you set aside to meet those

goals?

Know the difference between investing and

speculating.

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Investing Versus Speculating

Investmentan asset that generates a return.

Income return
Speculationan asset whose value depends

solely on supply and demand.

Derivative securitiesvalue derived from

value of other assets

Optionright of owner to buy or sell an asset

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Setting Investment Goals

1. Write down your goals and prioritize them. 2. Attach costs to them.

3. Figure out when the money for those goals will be needed. 4. Periodically reevaluate your goals.

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Setting Investment Goals

Formalize goals:
Short-term within 1 year Intermediate-term 1-10 years Long-term over 10 years

Goals should be realistic:

Consequences, if not accomplished Willing to make financial sacrifices

How much money is needed?

When do I need the money?

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Financial Reality Check

Have a grip on your financial affairs
Make sure youre living within your means Have adequate insurance

Keep emergency funds

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Starting Your Investment Program

Pay yourself first Make investing automatic Take advantage of Uncle Sam and your employer Windfalls Make 2 months a year investment months

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Fitting Taxes Into Investing

Compare investment returns on an after-

tax basis.

Marginal tax rate Tax-free investment alternatives Investments on a tax-deferred basis With taxes, capital gains and dividend income are better than ordinary income
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Investment Choices
Lending Investmentssavings accounts and bonds which are debt instruments issued by corporations and the government.

Ownership Investmentspreferred stocks and common stocks which represent ownership in a corporation, along with income-producing real estate.
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Lending Investments
Maturity date Par Value or Principal

Coupon interest rate

Know ahead of time what return will be If issuer goes bankrupt, bondholder can lose entire investment
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Ownership Investments
Real estateyour home, rental apartments

and investments in income-producing property Illiquid-hard to sell off

Stockfractional ownership in a corporation

Owner or equity holderowns stock Dividenda payment by a corporation to its shareholders
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The Returns from Investing

Capital gain or lossgain (or loss) on the sale of a capital asset.
Income returnany payments you receive directly from the company or organization in which youve invested.

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Market Interest Rates

Need to understand interest rates Interest rates affect the value of stocks, bonds, and real estate. Interest rates also determine earnings on savings and tied closely to inflation.

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Nominal and Real Rates of Return

Nominal (or quoted) rate of returnthe rate of return earned on an investment, without any adjustment for inflation.
Real rate of returnthe current or nominal rate of return minus the inflation rate.

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Historical Interest Rates

Nominal interest rates have dropped somewhat over the past 20 years.
Real rate of return can be calculated by subtracting the inflation rate from the nominal interest rate. Real rate of return can be negative.

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Figure 11.1

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How Interest Rates Affect Returns on Other Investments

Expected returns on all investments are related. What you can earn on one investment

determines what you can earn on another.

Interest rates act as a base return. When interest rates go up, investors demand a higher return on other investments.
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A Look at Risk-Return Trade-Offs

Risk is related to potential return. The more risk you assume, the greater the potential reward but also the greater possibility of losing your money. You must eliminate risk without affecting potential return. Balance amount of risk with amount of return needed
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Historical Levels of Risk and Return

Average annual return against risk or variability of returns
Investments that produce higher returns have higher levels of risk associated with them.

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Figure 11.2

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Sources of Risk in the Risk-Return Trade-Off

Interest rate risk
Inflation risk Business risk

Financial risk

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Sources of Risk in the Risk-Return Trade-Off

Liquidity risk
Market risk Political and regulatory risk Exchange rate risk Call risk
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Diversification
The elimination of risk by investing in

different assets.

Allows extreme good and bad returns to

cancel each other out.

Reduced risk without affected expected

return.

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Diversifying Risk Away

Portfolioa group of investments held by an

individual

Systematic or Market-Related or

Nondiversifiable Riskportion of a securitys risk or variability that cannot be eliminated through diversification.

Unsystematic or Firm-Specific or Company-

Unique Risk or Diversifiable Riskrisk or variability that can be eliminated with diversification.

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Figure 11.3

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Understanding Your Tolerance for Risk

Need to recognize your tolerance for risk and invest accordingly. Take one of many risk-tolerance tests
Review your past actions

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Figure 11.4

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The Time Dimension of Investing and Asset Allocation

As the length of the investment horizon increases, you can afford to invest in riskier assets.
If investment horizon is longer, will probably end up with a lot more if you invest in some risky assets.

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Meeting Your Investment Goals and the Time Dimension of Risk

With any long-term investment, there will be

bad years and good years.

With time, dispersion (variability) of returns in these years converges toward the average. What kinds of assets should you invest in?

Investment in bonds will give less uncertainty over time but will give smaller ultimate value than investing in riskier assets like stocks.
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Figure 11.5

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Asset Allocation
How your money should be divided among stocks, bonds, and other investments. Investments diversified in different classes of investments. Common stocks more appropriate for the long-term horizon. Asset allocation is the most important investing task that is not a one-time decision.
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Asset Allocation and the Early YearsA Time of Wealth Accumulation (Through Age 54)
Investment horizon is quite long, investors should place majority of savings into common stocks. 80% common stocks and 20% in bonds quite common.

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Figure 11.6

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Asset Allocation and Approaching RetirementThe Golden Years (Ages 55 to 64)

Preserve level of wealth and allow it to grow. Start moving some of retirement portfolio into bonds. Maintain a diversified portfolio.
Own 60% stocks and 40% bonds.
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Figure 11.7

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Asset Allocation and the Retirement Years (Over Age 65)

Spending more than saving. Income primary, capital appreciation secondary.

Safety through diversification and movement away from common stocks.

Own 40% stocks, 40% bonds, 20% T-bills. Later own 20% common, 60% bonds, and 20% T-bills.
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Figure 11.8

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Figure 11.9

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What You Should Know About Efficient Markets

Efficient marketa market in which information about the stock is reflected in the stock price
The more efficient the market, the faster prices react to new information.

If the stock market were truly efficient, then there would be no benefit from stock analysts.
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Beating the Market

Half the time you should outperform the market, and half the time you should underperform. Difficult for superstars of investing to pick

underpriced stocks and time the market.

Keep your plan and invest for the long

term. If you try to time the market, you just as likely to miss an upswing as you are to avoid an downswing.
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Checklist 11.1

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Thinking Back to Principle 9: Mind Games and Your Money

Overconfidence
Disposition Effect House Money Effect Loss then Risk Aversion Effect Herd Behavior
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Summary
Decide on goals and how much to set

aside then develop an investment plan.

Interest rates are important in determining

value of an investment and are tied to the rate of inflation.

There are different sources of risk associated with investments.

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Summary
As your investment time horizon lengthens, invest in more riskier assets. Asset allocation ensures diversification and time dimension of investment in different classes.

It is very difficult to beat the market and as a result you should keep to your plan and invest for the long term.
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