Personal Finance: An Integrated Planning Approach

1. Personal Finance:An Integrated Planning Approach Winger and Frasca Chapter 10 Investment Basics: Understanding Risk and Return

2. Introduction • Risk is a fundamental component of investing. • Risk must be understood and managed. • Diversification is an important way to manage risk. • Professional investors know that diversification involves diversification across asset classes as well as within asset groups. • In selecting securities, it is important to understand and measure market risk. • Then securities can be selected by choosing securities with expected returns that exceed required returns.

3. Chapter Objectives • To grasp the nature of risk and its sources and to relate risk to investment return • To see the importance of diversification and to understand how it reduces investment risk • To understand how to accomplish adequate diversification, both among asset groups and within an asset group

4. Chapter Objectives (Continued) • To grasp the concepts of required return and expected return and to see how they are used in security selection • To become familiar with important methods and issues involved in establishing a portfolio and making changes over time

5. Topic Outline • Risk and Return • The Rewards of Diversification • Applying a Risk-Return Model • Building and Changing a Portfolio

6. Risk and Return • What is Risk? • Sources of Risk • How Much Return Do You Need? • The Iron Law of Risk and Return • To earn higher returns, you must take greater risks. • There is a strong positive correlation between higher investment return and greater risk.

7. Return Variability 10% 8% 5% 6% A B C –8% Investment A: no return variation, no risk Investment B: some return variation, some risk Investment C: wide return variation, much risk

8. What Is Risk? • Investment risk is defined as: The more variable an investment’s return, the greater its risk. • The more uncertainty associated with the expected outcome, the greater the risk of the investment. • A highly variable return could lead to investment losses if the investment must be sold. • The longer the time period before an investment pays off, the greater the risk. • Investors with long investment horizons can handle more risk.

9. Sources of Risk There are two basic sources of risk: • Changing Economic Conditions • Changing Conditions of the Issuer

10. Changing Economic Conditions • Inflation risk: Will your investment returns keep pace with inflation? If not, your return may be insufficient. • Business cycle risk: Your investment return fluctuates in concert with the overall business cycle. • Interest rate risk: Bond prices fluctuate as interest rates in the economy change. In fact, bond prices move in the opposite direction of interest rates.

11. Changing Conditions of the Issuer • Management risk: The company you invested in has poor managers. Some portfolio managers only invest in companies with good management. • Business risk: Risks associated with the company’s products/service lines • Financial risk: The risk of bankruptcy because the company has borrowed too much money

12. Average Annual Returns on Financial Assets: 1970–2004 • Common Stocks 11.30% • 90-Day U.S. Treasury Bills 7.23% • Source: Federal Reserve Bank of St. Louis

13. Growth of $1,000 Invested in Financial Assets: 1970–2004 • Common Stocks $38,078 • 90-Day U.S. Treasury Bills $10,739

14. Risks with Financial Assets:1970–2004 Annual Returns Highest Lowest Range Stocks 37.4% –26.5% 63.9% T-Bills 14.1 1.0 13.1

15. Risk Premiums • Return on U.S. Treasury Bills (T-Bills) is considered risk free because they have a short maturity and they are guaranteed by the U.S. Government. • Any return in excess of the T-Bill return is called the investment’s risk premium. • An important concept is the market risk premium. • From 1970–2004, this premium was 4.07% (11.3%–7.23%). • Using longer term data, the premium is close to 8%. • Controversy exists over the value for the premium.

16. A Portfolio A Portfolio is simply a group of assets held at the same time Stocks Bills Bonds

17. Why Diversification Works • Diversification means owning a variety of investments. • The portfolio of investments can have less risk than the individual investments due to correlation. • Diversification lowers investment risk because: • Asset returns are poorly correlated. • The return correlations among stocks, bonds, and T-bills are low so holding these investments in a portfolio is an effective way to reduce risk. • Diversification is not effective if asset returns are strongly positively correlated.

18. An Example of Negative Return Correlation AsA’s Return Changes B’s Return Changes in the Opposite Direction Holding each gives a 10% constant return A 10% B

19. Diversification Guidelines • Diversify among intangibles and tangibles • Remember: A house is a major tangible asset. • Diversify globally • Invest in foreign securities • Diversify within asset groups • Own a variety of common stocks

20. Portfolio Risk and the Number of Stocks Held Risk Random Risk: Lowered by increasing the number of stocks in the portfolio Market Risk: Remains Unchanged 1 5 15 10 Number of Stocks in Portfolio

21. Market and Random Risks • Random risks are those associated with specific companies. This risk can be eliminated by owning a sufficient number of stocks. • These tend to “balance out” if a sufficient number of stocks are owned (about 20). • Holding too few stocks is foolish because you are taking risks that can be eliminated. • Market risk is the risk associated with the overall market. • It cannot be reduced by owning more stocks.

22. Managing Market Risk • Market risk cannot be eliminated; it must be managed. • You manage risk by earning a return that compensates you for the risk that you are assuming. • Market risk is measured by a statistical measure known as beta. • If your portfolio is as risky as the overall stock market, you should earn the market risk premium. • If your portfolio is more risky than the overall stock market, you should earn more than the market risk premium.

23. The Beta Risk Measurement • Beta is a statistical measure that compares the risk of an individual stock to the risk of the entire market. • If a stock has a beta greater than 1, it is considered more risky than the overall stock market. • Therefore, the return for this stock should be greater than the return of the overall stock market. • If a stock has a beta less than 1, it is less risky than the overall stock market. • The return for this stock should be less than the return for the overall stock market.

24. Sample Beta Values • Sirius 3.9 • Micron Technology 2.4 • eBay 1.7 • Citigroup 1.4 • Southwest Airlines 0.9 • Barrick Gold 0.4 • Exxon-Mobil 0.4 • Kellogg –0.1

25. Estimating a Stock’s Required Return • First, determine the stock’s risk premium • Find its beta (example: 1.5) • Multiply the beta by the market risk premium (say, 8%) • Market risk premium = 1.5 × 8% = 12% • Second, add the current risk-free rate (say 5%) • Required return = 12% + 5% = 17%

26. Making Stock Selections • Find the stock’s excess return (also called alpha). • Alpha = expected return – required return • Select stocks with positive alpha values. • Choose the stocks with the largest alpha values. • Understand that determining expected and required returns is very difficult. • Finding the required return is especially problematic. • Beta may not always be a good measure of risk. • Beta is calculated from historical data.

27. Selecting Stocks: An Example Stock 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

28. Required Rates of Return in Relation to Beta Values Required rates of return % 17 Rate of return in market Risk premium of 1.5 beta stock = 12% 13 Market risk premium = 8% 5 0 1.0 1.5 Beta value

29. Acquiring Securities • Dollar Cost Averaging (DCA) • You make equal $ investments at regular time intervals. • Over time, you invest at an average cost. • It also has the advantage of establishing a periodic investment habit. • Routine Investment Plans • Dividend reinvestment plans (DRIPs) • Choose to reinvest dividends rather than receiving cash. • Also, many mutual funds allow you to set up automatic transfers from your checking account to a mutual fund.

30. DCA: $1,000 Invested Each Month Shares purchased Total shares Total cost Avg cost Cuml. profit Date Price

31. Selling Securities • The decision to sell securities is at least as difficult as the decision to purchase. Some investors believe it is the hardest decision. • When should an investor sell? • If the security becomes overvalued • Tax reasons such as offsetting capital gains and losses • Your investment objectives change such as the need for current income as compared to price appreciation.

32. Economic Changes and the Portfolio • Buy and hold strategy: Ignore economic changes and stick with your security selection • Economic cycles are difficult to forecast so trying to anticipate changing conditions and adjusting your portfolio is almost impossible. • Market-timing strategy: Try to enhance your return by anticipating economic cycles. Investors with this strategy must believe it possible to forecast changing economic cycles. • If economic conditions don’t change, stick with your portfolio allocations.

33. Some Issues on Market Timing • Timing is very difficult. There is little evidence supporting the idea that professional investment managers 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!

34. Discussion Questions • Explain the iron law of risk and return. • Define risk. • Identify the risks associated with the changing conditions of the security issuer. • Explain the concept of the investment risk premium. • Explain why diversification can lower investment risk. • Identify the guidelines of diversification. • Compare random and market risk.

35. NEXT:Chapter 11Stocks and Bonds