Intro to Financial Management

1. Intro to Financial Management Personal Finances

2. Review • Homework • Dividend payment theories • Residual dividend theory • Clientele theory • Information effect • Agency costs • Expectations theory • Earnings predictability concerns • Policies • Constant dividend payout • Stable dollar • Small regular plus end-of-year • One-time • Stock splits and dividends

3. Modern Portfolio Theory • Diversification can • Reduce risk • Increase returns • Objective is to • Maximize return for a given level of risk or • Minimize risk for a given level of return

4. Not All Risk is the Same Firm Risk = Systemic risk + Idiosyncratic Risk BusinessCycles Financial Markets Global Conditions Risk Unique to the Firm Source of Correlation Idiosyncratic risk can be diversified away!

5. Diversification – Simple Example IBM and AT&T When IBM went down, AT&T went up. When AT&T went down, IBM went up. If stocks are perfectly positively correlated, diversification has no effect on risk If stocks are perfectly negatively correlated, portfolio is perfectly diversified. What do you want as an investor?

6. Risk and Diversification With large portfolio, 30 – 200 stocks, idiosyncratic moves cancel out!

7. The Efficient Frontier

8. Modern Portfolio Theory • Optimal portfolio is a combination of the “market portfolio” and the risk-free asset • So… what is the market portfolio? • S&P 500? • Wilshire 5000? • Total world index? • What about bonds?

9. Diversification with Stocks and Bonds Note: adding some stock to a 100% Treasury portfolio increases the return and decreases the risk!

10. Market Portfolio • What about other asset classes? • REITS • TIPS • Commodities • How is one to decide on a market portfolio? • Simple approach 60/40 stocks/bond • Include other asset classes • Six Ways from Sunday portfolio http://www.dallasnews.com/business/columnists/scott-burns/20100904-The-joy-of-portfolio-cooking-2502.ece • All-Weather Portfolio • Asset allocation is your most significant investment decision

11. What to Invest In? • Index funds • Track an index • Low cost • Types • Total market • S&P 500 • Total bond • REITs • TIPS • Precious metals • International • Managed funds • Fund has a stated objective • Fund manager invests to maximize returns subject to objective

12. Can You Beat the Market? • Efficient market hypothesis • Investment exercise • Thought experiment • What if advisors are actually bad and only get it right 40% of the time? • You can’t consistently beat the market • But many will try • Are you tempted by Apple, Facebook, gold?

13. Market Analysis • Technical analysis • Looks at historical returns • Looks for patterns • Patterns suggest investment direction • Fundamental analysis • Tries to understand the why’s • Looks for underlying causes • Inflation • GDP growth • Relationships (e.g. oil to plastics and farm products) • Exchange rates

14. Post Modern Portfolio Theory Two Ways to Make Money • Beta • Your market portfolio • Has systemic risk from asset class • Easy, inexpensive to create • Alpha • Your bet against the market, you know better than everyone else • Zero-sum game • There are winners and losers • Has idiosyncratic risk, comes from skill of investment advisor • Hard, expensive to create

15. Post Modern Portfolio TheoryPractical Application • First, set aside emergency money • Determine how many months of income 3 – 6 • Leave in a money market fund • Pick how much you want to bet – your alpha • Specify as a percent • Place your bet • Be prepared to lose it • Invest the remaining percent in your market portfolio – beta

16. Market Timing • Can you time the market? • Who do you listen to? • Do you know better than the pros? • Do the pros know? • Two schools of thought • Dollar cost averaging • Go to your strategy

17. Retirement Planning Why should you care now?

18. You Can Never Catch Up Person A: Saves $2000 per year from age 22 to age 35 and then stops Person B: Starts saving $2000 per year beginning at age 35 and never stops Both earn 8% on their investments. At age 75: Person A has $1M in savings Person B has $561K in savings

19. How Much Do You Need? • Calculate your income requirement • Use today’s dollars (remember time value of money) Current income - Pension - Social Security (maybe) = Income need • Rough estimate of the portfolio you must have= income need x 25 • Conversely, can live off of 4% of your portfolio • E.g. If have $1M, then can live off $40k per year

20. How Much Do You Need? • Previous calculation was in today’s dollars • You may need 4 times that amount in the future • Inflation has averaged 4% since 1929 • At that rate, prices will go up 4x in 36 years • Start saving now • Minimally 10% • Shoot for > 20%

21. Are You On Track? • Under Accumulator of Wealth (UAW) net worth < age * (.10 * pretax income) • Average Accumulator of Wealth (AAW) net worth = age * (.10 * pretax income) • Prodigious Accumulator of Wealth (PAW) net worth > age * (.10 * pretax income) If age 30 with pretax income of $60,000, then you need net worth = 30 * (.10 * 60000) = $180,000 If age 40 with pretax income of $100,000, then you need net worth = 40 * (.10 * 100000) = $400,000 • A guideline, not a law of physics • Not good for young ages

22. Retirement Vehicles 401(k)’s IRA Roth IRA