Asset Classes & Financial Markets

1. Asset Classes & Financial Markets Lecture 11 This lecture is part of Chapter 5: Becoming a Millionaire

2. Today’s Lecture • Asset classes • Historical performance • Be critical of numbers,know what they mean. Be aware! The data used in this lecture have not been verified nor are they complete. They are used for illustrative purposes only!

3. Asset Classes While we have already talked about these, it is important to realize the qualitative difference between them. The major asset classes are: • Cash and Money Markets • Bonds • Real Estate • Stocks There are of course other asset classes … some better than others • Cards (Pokemon, Baseball) • Collections (Coins, Stamps) • Art (Paintings, Sculptures)

4. Asset Classes Asset classes like cards and collections may be excellent but we shall focus here on the ‘financial’ asset classes of stocks, bonds and money markets plus real estate. The main reasons being that theses classes are by far the largest and most liquid and therefore suitable for all investors. Whether or not an asset class is major, its performance will always be benchmarked. Perhaps the most important reference benchmark is inflation.

5. Asset Classes & Inflation • We already had a look at inflation in the lecture on the time value of money. • If we have a 1000 dollars today, we can ask two (equivalent) questions: • How many dollars do we need in 25 years to buy the same goods that we can buy now for the 1000 dollars? • What are the 1000 dollars worth in 25 years if we keep them stored in our mattress?

6. Inflation revisited =FV(D6,H6,0,-D5) =PV(D6,H6,0,-D5) That’s a big amount! In order to get a bit a better idea about the effect of inflation, it is useful to plot a graph.

7. Inflation revisited

8. Asset Classes & Inflation Let’s see what this would mean for a bit a higher rate. Say 24%, the same rate most credit card companies charge you for overdue amounts.

9. Credit cards are a baaaaad idea (if you don’t pay at once)!!!! Inflation revisited Credit Cards Yes!!! These are the correct numbers! Your $1000 will be worth 54 cents! $0.54 $1,861,054

10. Inflation revisited It is also illustrative to see what a change in interest rates means

11. Asset Classes & Inflation So whatever we do, we need to take inflation into account when comparing the performance of asset classes. Actually, there is no reason to be sad. As such, moderate inflation is not necessarily a bad thing as long as your income growth and/or return on investment can outpace it sufficiently.

12. Asset Classes & Risk As mentioned in the lecture on values, risk is an essential issue when evaluating the merits of an investment. Asset Class Risk Money Market Bonds Stocks Extremely low Very low Medium to High Hopefully, this will be reflected in the historical returns.

13. Historical Data Let us have a look at Siegel’s data again. Stocks Bonds Gold Dollar

14. Historical Data - CPI The consumer price index (CPI) is a good proxy for inflation and therefore a closely watched number. A lot of information (for the US) can be found at the website of the bureau of labour: http://stats.bls.gov/cpi/home.htm A good page for some useful statistics is: http://146.142.4.24/cgi-bin/surveymost?cu . Lets get the average data for most of the past century.

15. Historical Data - CPI • How does one get these data into Excel? • Fortunately, Excel can open html files. But everything ends up in one column.

16. Historical Data - CPI Use the ‘Text to Columns’ feature in the Data menu, throw out the monthly data and calculate the percentages. =(B3-B2)/B2 That’s better!

17. Historical Data - CPI Let us compare: Compounded with a simple average Compounded with the correct average inflation Rate Actual Data =AVERAGE(C3:C88) =POWER((B88/B2),1/(A88-A2))-1 =FV($G$4,A88-$A$2,0,-$B$2) A big difference! =FV($G$3,A88-$A$2,0,-$B$2)

18. Historical Data - CPI What is historical? Which period should one look at? CPI, when compounding with the correct average inflation rate Actual CPI Compounded Average Inflation? High Inflation? Low Inflation?

19. Historical Data – Dow Jones The Dow Jones is a good reference for the overall performance of the stock market. Dow Jones has a nice website with many data: http://averages.dowjones.com/home.html As does Standard and Poor’s: http://www.spglobal.com/index.html

20. Historical Data – Dow Jones The difference between the two periods is very big. Repeat: Do not blindly trust averages. These calculations do not take dividends into account.

21. Historical Data – Dow Jones Let us see what happens if we take dividend into account =D7*(1+C6+$G$16) Dividend has a significant impact. And of course we should not use the average but the yearly values for the dividend.

22. Historical Data - Bonds Quite a lot of information on bonds can be found at: http://www.federalreserve.gov/rnd.htm

23. Historical Data – Bonds Yield on the 10 year treasury note

24. Historical Data – Comparing It is illustrative to compare the relative changes:

25. Historical Data – Comparing .. And the what that means for 1000 dollars: Are stocks really better than bonds?

26. Comparison Once again, the conclusion one can draw from these data depends entirely on one’s perspective. The numbers alone mean little. The interpretation of the numbers must bejustified by sound arguments. Understanding is the ONLY way even if itmeans going through some math! Solelymemorizing convenient Excel functions ispointless!

27. Key Points of the Day • The comparison of data is essential in understanding business data. • Know what the numbers mean. The average, e.g., may not be what you think. • The three main asset classeshave rather different historicalperformances.