Investment Basics - Set Goals, Manage Risk, and Allocate Assets

1. Chapter 11 Investment Basics Professor Payne, Finance 4100

2. Learning Objectives • Set your goals and be ready to invest. • Manage risk in your investments. • Allocate your assets in the manner that is best for you. • Understand how difficult it is to beat the market.

3. Learning Objectives • Identify and describe the primary and secondary securities markets. • Trade securities using a broker. • Locate and use several different sources of investment information to trade securities.

4. 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.

5. Before You Invest • Decide what your goals are. • Know how much can you set aside to meet those goals. • Know the difference between investing and speculating.

6. Investing Versus Speculating • Investment—an asset that generates a return • Income return—usually in the form of dividends or interest payments • Speculation—an asset whose value depends solely on supply and demand • Derivative securities—value derived from value of other assets • Option—right of owner to buy or sell an asset

7. Setting Investment Goals • Write down your goals and prioritize them. • Attach costs to them. • Figure out when the money for those goals will be needed. • Periodically reevaluate your goals.

8. 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?

9. Financial Reality Check • Have a grip on your financial affairs • Make sure you’re living within your means • Have adequate insurance • Keep emergency funds

10. Starting Your Investment Program • Pay yourself first • Make investing automatic • Take advantage of Uncle Sam and your employer • Windfalls

11. 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

12. Investment Choices • Lending Investments—savings accounts and bonds which are debt instruments issued by corporations and the government. • Ownership Investments—preferred stocks and common stocks which represent ownership in a corporation, along with income-producing real estate.

13. 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

14. Ownership Investments • Real estate—your home, rental apartments and investments in income-producing property • Illiquid—hard to sell off • Stock—fractional ownership in a corporation • Owner or equity holder—owns stock • Dividend—a payment by a corporation to its shareholders

15. The Returns from Investing • Capital gain or loss—gain (or loss) on the sale of a capital asset. • Income return—any payments you receive directly from the company or organization in which you’ve invested.

16. Calculating Returns

17. 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 attempt to reduce risk without affecting potential return. • Balance amount of risk with amount of return needed.

19. Nominal and Real Rates of Return • Nominal (or quoted) rate of return—rate of return earned on an investment without any adjustment for inflation • Real rate of return—nominal rate of return after you’ve taken out inflation

20. Historical Levels of Risk and Return • Historical levels of return bear a strong resemblance to the risk-return trade-off graph • Investments with higher levels of risk produce higher returns

22. Sources of Risk in theRisk-Return Trade-Off • Interest rate risk • Inflation risk • Business risk • Financial risk

23. Sources of Risk in theRisk-Return Trade-Off • Liquidity risk • Market risk • Political and regulatory risk • Exchange rate risk • Call risk

24. 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.

25. Diversifying Away Risk • Portfolio—a group of investments held by an individual • Systematic or Market-Related or Nondiversifiable Risk—portion of a security’s risk or variability that cannot be eliminated through diversification. • Unsystematic or Firm-Specific or Company-Unique Risk or Diversifiable Risk—risk or variability that can be eliminated with diversification.

27. Understanding Your Tolerance and Capacity for Risk • Need to recognize your tolerance for risk and invest accordingly. • Take one of many risk-tolerance tests. • http://njaes.rutgers.edu/money/riskquiz/ • Risk capacity refers to your ability to take risk.

28. 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.

29. 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.

31. 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.

34. What You Should Know About Efficient Markets • Efficient market—a 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 analysis.

35. Security Markets • Securities—stocks and bonds—are issued by corporations to raise money • Securities markets—a place where you buy and sell securities • Primary and secondary markets • After the initial issue (initial public offering—IPO), securities are traded among investors

36. Primary Markets • Market where newly issued securities are traded • Initial public offering (IPO) • Seasoned new issues • Investment banker • Underwriter • Prospectus

37. Secondary Markets—Stocks • Markets where previously issued securities are traded • Organized exchange—a physical location where stocks trade • New York Stock Exchange (NYSE) • Over-the-counter market—transactions conducted over phone or computer • Bid price—highest price someone is willing to pay for a security • Ask or offer price—lowest price someone is willing to sell a security

38. International Markets • Around for centuries • Some foreign shares traded on exchanges in the U.S. • American Depository Receipt (ADR) • International stocks can be traded through ADRs

39. Regulation of the Securities Markets • Aimed at protecting investors so that all have a fair chance of making money • Securities and Exchange Commission (SEC)—federal • Self-regulation—exchanges and FINRA • Insider trading and market abuses • Churning

40. Placing an Order • Order Size • Round lots • Odd lots • Time Period for Which the Order Will Remain Outstanding • Day orders • Open orders or good-till-cancelled orders • Fill or kill orders • Discretionary account

41. Types of Orders • Market Orders—buy or sell immediately at the best price available • Limit Orders—trade is to be made only at a certain price or better • Stop or Stop-Loss Orders—order to sell if the price drops below a specified level or to buy if the price climbs above a specified level

42. Short Selling • Short selling—the more the price drops, the more money your make • Borrow stock from the broker and then sell it • Margin requirement—collateral • Sell high and later buy low and return stock to broker • If price increases, you buy back for more than the sold price, and lose money

44. Dealing with Brokers • Most common way to purchase stock is through stockbroker—licensed to buy or sell stocks for others • Full-Service Brokers or Account Executive—paid commissions based on sales volume • Discount and Online Brokers—execute trades but do not provide advice

45. Brokerage Accounts • Asset management account—comprehensive financial services package that can include a checking account; a credit card; a money market mutual fund; loans; automatic payment on any fixed debt (such as mortgages); brokerage services (buying and selling stocks or bonds); and a system for the direct payment of interest, dividends, and proceeds from security sales into the money market mutual fund • Primary advantage is the automation asset management accounts provide

46. Cash Versus Margin Accounts • Cash Accounts • Margin Accounts • Margin or Initial Margin • Maintenance margin • Margin call

47. Joint Accounts • Joint Tenancy Account with the Right of Survivorship—when one owner dies, the other receives full ownership of assets in the account. • Tenancy-in-Common Account—the deceased’s portion of the account goes to the heirs of the deceased, not the surviving account holder.

48. Choosing a Broker • Using a full-service broker—personal service and advice but for higher price • Using a discount broker—keep transaction costs down with less personal service but some offer free research reports • Making the decision—become knowledgeable on your choices

49. Online Trading • Day traders—trade, generally on internet, with a very short-term time horizon. • Be prepared to suffer severe financial losses. • Don’t confuse day trading with investing. • Don’t believe claims of easy profits. • Watch out for “hot tips” or “expert advice.”

50. Sources of Investment Information • Corporate Sources • Brokerage Firm Reports • The Press • Investment Advisory Services • Internet Sources