Investment Fundamentals: Get Started, Identify Philosophy, and Create a Plan

1. Chapter 13 Investment Fundamentals

2. Learning Objectives • Explain how to get started as an investor. • Identify your investment philosophy and invest accordingly. • Describethe major factors that affect the rate of return on investments. • Decide which of the four long-term investment strategies you will utilize. • Create your own investment plan.

3. Starting Your Investment Program • Investing is more than saving. It may include: • Savings • Investing • Securities • Stocks • Portfolio • Are you ready to invest?

4. Starting Your Investment Program • Decide why you want to invest. • To achieve goals – Education, Car, Home, Vacation, etc. • To gain wealth and security • To increase current income • To meet retirement needs • To maximize enjoyment of life • Where can you get the money to invest? • Pay Yourself First • Save – don’t spend –extra funds • Participate in employer 401(k) Plan • Get a part-time job • Participate in Employers plan • Make savings automatic

5. Starting Your Investment Program • What investment returns are possible? • Financial (or Business) Risk – the possibility the investment will fail to pay a return to the investor. • Total Return – Income an investment generates from current income and capital gains • Current Income – Money received while you own an investment; usually received regularly as interest, rent or dividends • Interest – Charge for borrowing money; bond investors earn interest. • Rent – payment received in return for allowing someone to use your real estate property such as land or a building.

6. Starting Your Investment Program • What investment returns are possible? • Dividend – A portion of a company’s earnings that the firm pays out to its shareholders. • Capital Gain – An increase in the value of an initial investment realized upon the sale of the investment. • Capital Loss – A decrease in paper value of an initial investment; only realized if sold • Rate of Return (or Yield) – Total return on an investment expressed as a percentage of its price.

7. The Long-TermRates of Return on Investments Key Message: The higher the Risk; the higher the potential return.

8. Your Investment Philosophy • How to handle investment risk: • Pure risk – No gain possible; only loss. Avoid, Reduce, Transfer or Accept it • Speculative risk – Involves the potential for either a gain or loss; equity investments might do either. • Investment risk – The possibility that the yield on an investment will deviate from its expected return. • Operating Income is primary risk driver • Cash Flow is key to sustained growth

9. What is yourInvestment Philosophy? • Are you a conservative Investor? • Preservation of capital – A risk adverse investor is one who prefers to avoid any risk of loss from initial investment. • Ex: bondholders, CD’s, U.S. Treasury Bills • Are you a moderate investor? • Risk indifferent – An investor willing to accept some risk and seeks capital gains through slow and steady growth in investment value • Ex: Mutual Funds, large cap investor, insurance funds. • Are you an aggressive investor? • Risk seeker – An investor primarily seeks capital gains often with a short time horizon. • Ex: small cap stocks, IPO investors, Venture Capital Investors

10. Your Investment Philosophy • Should you take an active or passive investing approach? Which Type Are You? • An active investor who manages their own account, studies the economy, market trends and investment alternatives and regularly buys and sells three to four times per year with or without professional advice. • A passive investor is one who does not actively engage in trading securities or monitors their investments but seeks to match the market return via mutual funds or other managed investments in the longer term. • Market efficiency is the speed at which new information is reflected in investment prices suggesting that security prices are reflective of their true value at all times because publicly available information has driven market prices to the correct level.

11. Identify the kinds ofinvestments you want to make. • Do you want to lend or own? • Lend = Bonds • Debts • Fixed maturity • Fixed income • Equities, growth • Choose investments for their components of total return. Fixed income vs. capital growth!

12. Investments for Various Time Horizons

13. Random and Market Risk • Random (or unsystematic) risk – Risk of owning only one investment of a particular type that may do very poorly in the future due to uncontrollable or random factors that do not affect the rest of the market. Ex: Operating Income below Forecast • Diversification – The process of reducing risk by spreading investment money among several investment opportunities. Ex: Buy multiple securities across multiple industries such as healthcare, technology and financial services • Systematic (or market or undiversifiable) risk – Risk that the value of an investment may drop due to influences and events that affect all similar investments. Ex: Inflation, interest rates and economic growth

14. Other Types of Investment Risks • Business failure (or financial) risk – The possibility an investment will fail or a business will go bankrupt and result in loss of investment. • Inflation (or purchasing power) risk – The danger your money will not grow as fast as the cost of living and not be worth as much in the future. • Time risk – The longer the time period, the greater the risk of loss. • Business cycle risk – the change in periods from expansion to contraction results in market volatility for an investment

15. Other Types of Investment Risks • Market Volatility Risk – All investments are subject to occasional sharp changes in price as a result of events affecting a particular company or the overall market for similar investments. • Liquidity Risk – Liquidity is the speed and ease with which an asset can be converted to cash. • Reinvestment Risk – Risk that the return on a future investment will not be the same as the return earned by the original investment • Marketability Risk – When an investor has to sell an asset quickly it may not sell at or near the market price.

16. The Risk Pyramid Futures contracts have the highest risk; potential return Savings bonds, CD’s and US Treasuries are lowest risk

17. The Wisdom of Starting to Invest Early in Life • Early Investor accumulates $285K after saving for 10 years • Late Investor accumulates $185K after saving for 25 years • Both investors earned 9% and invested $2K/Year

18. Establish Your Long-TermInvestment Strategy • Strategy 1: Buy and hold anticipates long-term economic growth. • Buy-and-Hold (or Buy to Hold) • Buy a diversified mix of stock or mutual funds • Reinvest the dividends and buy more stocks • Hold onto investments indefinite time period • Long term = 5+ Years

19. Establish Your Long-TermInvestment Strategy • Strategy 2: Dollar-cost averaging buys at “below average” costs. • Dollar-Cost Averaging (or Cost Averaging) – Invest equal sum at regular intervals. Ex: Invest $100 in stock every 2 weeks indefinitely • Below-Average Costs – Buy more shares when price is down and fewer shares when price is high. Results in purchase at below average cost. • Dollar-cost averaging in a fluctuating market: • Average Share Price – Share Price divided by number of investment periods. Ex: ($20+$25+$10+$20)/4 = $18.75 Per Share Avg. Price • Average Share Cost – Total investment divided by number of shared held. Ex: $500 for 50 shares + $250 for 25 shares + $1,000 for 25 Shares = $1,750/100 shares = $17.50 Avg. cost/share. It represents cost basis for income tax purposes.

20. Dollar-Cost Averaging for a Stock or Mutual Fund Investment Note the same $1,500 investment between 3 economic scenarios of rising & declining market yields big difference in share quantity purchased and average share cost.

21. Establish Your Long-TermInvestment Strategy • Strategy 3: Portfolio diversification reduces portfolio volatility. • Selecting different asset classes of investments such as stocks, bonds, mutual funds, real estate, etc. rather than only 1 class. • Selection based on return potential and also for dissimilar risk/return characteristics. • Strategy 4: Asset allocation keeps you in the right investment categories at the right time. • Investor allocates a specific proportion of investment portfolio among various asset categories • A form of diversification that helps preserve capital by allocating among mix of stocks (70%), bonds (20%) and treasury (10%).

22. Diversification Averages Out an Investor’s Returns Mix of investments with positive & negative returns but overall have 7.1% avg. return The benefit of diversification is balance and stabilization of total realized return

23. RebalancingAssets in Your Portfolio Investor risk tolerance must be considered when rebalancing portfolio

24. Model Portfoliosand Time Horizons Key Message: “Invest Early – Invest often” Long term investment period (11+ years) suggest equity holdings

25. Establish Your Long-TermInvestment Strategy • Modern portfolio theory evolves from asset allocation • Modern Portfolio Theory (or MPT) – Identify investor risk tolerance and then find optimal portfolio that results in highest expected returns. • Monte Carlo Analysis – a computerizes simulation which calculates hundred of possible investment outcomes to determine the probability of achieving a particular goal. Uses historical data for simulation of probable outcome • Your investment plan reflects your investment philosophy and your logic for investing to reach specific goals.

26. TheTop 3 FinancialMissteps In Investing People experience challenges when they: • Invest only money that is left over at the end of the month. • Follow a conservative investment philosophy for long-term goals. • Fail to regularly rebalance the assets in their portfolio.

27. Good Money Habits inInvesting Fundamentals • Sacrifice some of your income by investing now for your future needs and lifestyle. • Start early in life to invest in a diversified portfolio of assets consistent with your investment philosophy. • When investing for the long term, willingly accept more risk. • Visit http://www.finance.yahoo.comevery weekday for one month to become familiar with how and why the stock market moves from day to day.

28. Good Money Habits inInvesting Fundamentals • Invest regularly through your employer’s retirement plan using an asset allocation strategy. • Invest no more than 10 percent of your portfolio in your company stock, or any single company stock, for that matter. • Follow the buy-and-hold long-term approach to investing. • Invest in stocks, mutual funds, bonds, and real estate, not life insurance or annuities.