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Introduction to Investments

Introduction to Investments. Spring 2012, BUS-123 Introduction to Investments Frank Paiano – “Paco” Professor, Business, Professional & Technical Studies. Welcome, Everyone!. First – A Perspective.

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Introduction to Investments

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  1. Introduction to Investments Spring 2012, BUS-123 Introduction to Investments Frank Paiano – “Paco” Professor, Business, Professional & Technical Studies Welcome, Everyone!

  2. First – A Perspective “It is a gloomy moment in history. Never has the future seemed so dark and incalculable. The United States is beset with racial, industrial and commercial chaos, drifting we know not where. Of our troubles, no one can see the end.” Harper’s Magazine, 1847

  3. CHAPTERS1, 3, Lecture Notes A Brief History of Risk and Return(Chapter 1) Security Types (Chapter 3) Time Horizon & Short-term Investments(Lecture) What I have tried to do here is create what I believe should be the contents of the first chapter of an Introduction to Investments & Securities textbook. “In investing money, the amount of interest you want should depend upon on whether you want to eat well or sleep well” -- J. Kenfield Morley

  4. What is an Investment? • An investment is any vehicle into which resources can be placed with the expectation that it will generate positive income, or that its value will be preserved or increased, or both • Investment returns (a.k.a. investment rewards) • Income – interest, dividends, rent • a.k.a. cash flows • Increased value / Decreased value • a.k.a. capital gains, capital appreciation (Yippee!) • a.k.a. capital losses (Boo! Hiss!) Investments come in all shapes, flavors and sizes

  5. Types of Investments • Securities • Investments that represent debt or ownership or the legal right to acquire or sell an ownership interest • (a.k.a. financial investments) • Property • Real property (land, buildings) and personal property (precious metals, autos, art, collectibles, etc.) • (a.k.a. real estate, hard assets, tangible assets, commodities) • Personal • Examples: Education and Training, Travel • College is often the best investment a person will ever make – Why? This class concentrates on securities

  6. Types of Investments (continued) • Primary Assets • Debt • Funds lent in exchange for interest income and the promised repayment of the loan at a given future date • Examples: Bonds, Short-term investments (savings accts, etc.) • Equity • Ownership in a business or a property • Examples: Stocks (corporations), Partnerships, Sole Proprietorships, Real Estate, Real Estate Investment Trusts • Derivative Assets • Securities that derive their value from an underlying security or asset – normally highly speculative • Examples: Options, Futures Some in the industry do not classify derivatives as investments

  7. Types of Investments (continued) • Direct Investments • Your name is on the investment and you control the investment – can buy or sell as you wish • Examples: Real Estate, Stocks, Bonds • Indirect Investments • Someone else is in control of the investment • You have limited control, or more likely, no control over the underlying investment • Examples: Mutual Funds, REIT, Limited Partnership* *You can buy or sell your shares in the mutual fund, REIT, or limited partnership, but you do not control the underlying investments

  8. Types of Investments (continued) • Domestic Investments • Based inside the United States • International Investments (a.k.a. Foreign) • Based outside the United States • Be careful of this subtle distinction • International (a.k.a. Foreign)≠ Global Global = Domestic and International “The world is a very small place these days economically.” Sixty-five percent (by value) of the parts in the Ford Mustang come from the U.S. and Canada. Ninety percent of the parts in the Toyota Sienna – which is built in Indiana – come from the U.S. and Canada. Which is the more American car? (Forbes)

  9. Domestic or Foreign? Types of Investments (continued) Fox Network Seagram’s Bayer Aspirin Vaseline Friskies Motel 6 Union Bank Volvo & Saab Foreign Foreign Budweiser Shell Oil Ben & Jerry’s Farmers Ins Arco Gerber Carnation Cup-a-Soup Foreign Foreign Foreign Foreign Foreign Foreign Foreign Foreign Foreign Foreign Foreign Foreign Domestic Foreign Foreign Domestic or Foreign?

  10. Global Investing Types of Investments (continued) Which country had the best average annual return over the past quarter century? Average annual return from 1973 to 2009 Top 18 countries according to per capita income (alphabetical order) The return of the stock markets in the developed world has been 9.2%.

  11. Types of Investments (continued) • Short-term Investments • Up to a 1 year • Intermediate-term Investments • 2 to 5 years • Long-term Investments • 5 or more years These are general guidelines used throughout the industry • I disagree with the general guidelines. Here are mine: • Short-term – 1 to 2 years • Intermediate – 3 to 5, maybe even 6 or even 7 years • Long-term – 7 years or longer (10 to 30 years) Before you make an investment, you must know your time horizon!

  12. Types of Investments (continued) • Liquid Investments • Easily and quickly converted into cash • There is a ready market to purchase the investment and change of ownership happens quickly • Examples: Stocks, Bonds, Mutual Funds, REITs • Illiquid Investments • May be difficult to convert into cash • Market for investment is small or change of ownership happens slowly or both • Examples: Real Estate, Partnerships, Collectibles

  13. Risk & the Risk/Return Spectrum • Risk is the chance that actual investment returns will differ from the expected returns • What is the typical definition of risk? • “The possibility of suffering harm or loss; danger” • In general, the higher the expectation of investment returns, the higher the risk level • The Risk / Return Spectrum • Low-risk – 3% to 5% • Moderate-risk – 5% to 8% • High-risk – 8% to 12% • Speculative-risk – Greater than 12% • Speculation is often not considered investing • (I certainly do not consider it investing…) These are my guidelines

  14. Let’s Try Some Examples… • What type of investment is… • Bank of America passbook savings account • Nestle’s Foods, Inc. • Southwestern College Propositions AA & R Bonds • Duplex in Spring Valley (rent one, live in other) • Qualcomm Corporation • Loan to Uncle Harry Short, Inter, or Long Term? Low, Moderate, or High Risk? Security or Property? Domestic or Foreign? Debt or Equity? Liquid or Illiquid? Direct or Indirect?

  15. Measuring Investment Return • Return is straight-forward to measure • Total Dollar Return • The return on an investment measured in dollars that accounts for all cash flows and capital gains or losses • Total Percent Return • The return on an investment measured as a percentage that accounts for all cash flows and capital gains or losses Measures of return allow us to compare investment alternatives

  16. Measuring Investment Risk • Risk is difficult to measure • There are many ways, all of them are imperfect • One popular measure is standard deviation • Standard Deviation • Measures the volatility of an investment • In any given year, there is about a ⅔ chance that the return of an investment will be within one standard deviation of the historical average return (average return plus or minus one standard deviation) • The higher the standard deviation, the more volatile the investment • The greater the variance from the norm We will investigate standard deviation in detail later in this chapter

  17. Investments Overview • Equity Securities – a.k.a. Common Stocks • Fixed-Income Securities – a.k.a. Bonds • Short-term Investments – a.k.a. “Cash” • Mutual Funds – a.k.a. Investment Companies • Hybrid Securities – Preferred Stocks, Convertible Securities • Others – Real Estate, Physical Assets • Derivatives – Options, Futures Let us look at each in more detail

  18. Chapters 5 through 8, 17 Investments Overview (continued) • Equity Securities – a.k.a. Common Stocks • Represents ownership in a corporation • Investors receive… • Dividends – optional payments to shareholders • Capital Gains – shares increase in value • Limited Liability • Moderate-risk to high-risk to speculative-risk • “Volatility” – euphemism for “I lost a whole lotta’ money!” • Historically best returns over time • 8% to 12% (I normally tell people 8% to 10%) • Should be considered a long-term investment 2008 Definition: “Stocks are equity investment instruments designed to lose value.”

  19. Chapters 9 & 10, 18 through 20 Investments Overview (continued) • Fixed-Income Securities – a.k.a. Bonds • Long-term loans to • Corporations (Corporate bonds) • State and local governments (Municipal bonds) • Federal government (Treasury bonds) • Bond investors lend their money to the bond issuers (corporation, state or local municipality, Treasury) • The bond investors then receive interest and a promise that the loan will be repaid when due • Historically much less riskier than stocks but… • Also less reward – 4-6% (govt/mun) to 6-8% (corp) • Good intermediate-term / long-term investment 2008 Definition: “Bonds are fixed-rate investment instruments designed to lose value.”

  20. Lecture Notes, Chapters 3, 19 Investments Overview (continued) • Short-term Investments • a.k.a. “Cash” “Short-term vehicles” • Normally up to 1 year (1 to 3 years) • Usually guaranteed (or pretty darned close) • Liquid (many let you simply write a check!) • Very low risk of losing principal • Hence, very low reward • 2% to 5% over time (currently less than 1%) • “A place to park your money” • Also used for holding an “emergency fund” 2008 Definition: “Short-term investments are instruments designed to accept what remains of investors’ money after they have given up on stocks and bonds.”

  21. Lecture Notes, Chapters 3, 19 Investments Overview (continued) • Short-term Investments – Examples • Deposit accounts at financial institutions • Passbook savings accounts at banks, share accounts at credit unions • Series EE or I savings bonds • U.S. Treasury bills (T-bills) • Certificates of Deposit (CDs) • Money market accounts • Money market mutual funds • Commercial paper (Corporate IOUs) • Banker’s acceptance notes (Bank IOUs) More about short-term investments later in this presentation…

  22. Investments Overview Chapter 4 (continued) • Mutual Funds • a.k.a. Investment companies • A company that pools investors’ money and invests in a diversified portfolio of securities • Investors get… • Diversification • Mutual fund can purchase hundreds of securities • Professional money management • Very popular form of investment • Range from low-risk to speculative-risk 2008 Definition: “Yeah, them too.”

  23. Investments Overview (continued) STOCKS BONDS “CASH” Balanced mutual funds Stock mutual funds Bond mutual funds Money market mutual funds a “mutual” fund a.k.a. investment company Professional Money Management Diversification Approximately 50% of American households own mutual funds. Or used to …

  24. Chapters 3 and 18 Investments Overview (continued) • Hybrid Investments • Preferred Stock • Represents ownership in corporation, but… • Dividends are not considered optional • Convertible Securities • A bond or preferred stock that can be converted into common stock • Hybrid investments are designed to offer the stability of fixed-income investments (bonds) with the opportunity for capital growth of equity investments (stocks) Some in the industry categorize these with stocks, some categorize them with bonds

  25. Investments Overview Lecture Notes (continued) • Other Popular Investment Vehicles • Real estate • Examples: residential, commercial, raw land, Real Estate Investment Trusts (REITs) • Tangible assets • Examples: precious metals, jewels, art, collectibles • Tax-advantaged investments • Examples: oil and gas limited partnerships, low-income housing projects If there is sufficient time and interest, we will look at some or all of these, especially real estate and tangible assets. By the way, none of these were spared in 2008, either.

  26. Investments (???) Overview Chapters 14 and 15 (continued) • Derivative Assets • Speculative securities that derive their value from an underlying security or asset • Options – a.k.a. Options Contracts • Calls and puts • Futures – a.k.a. Futures Contracts • Commodities • Stock indexes • Many in the financial world (myself included) do not categorize these as investments The derivative speculators did not feel so all alone in 2008. Usually, they are the only ones who are proud to have only lost 30%.

  27. Our Emphases in this Course • Equities – a.k.a. Stocks • You are an owner • Fixed-Income Securities – a.k.a. Bonds • You are a loaner • Short-term Securities – a.k.a. “Cash” • Your principal is safe (often guaranteed) • Mutual Funds – a.k.a. Investment Companies • Your investments are managed on your behalf For the vast majority of investors, these are the most popular and most important financial investment options

  28. Investments: What are ___? Investment companies that pool investors' money and invest in a diversified portfolio of securities. Investors get diversification and professional money management. • short-term securities • common stocks • bonds • mutual funds The correct answer is (D). Investment company is the legal term; mutual fund is the popular term.

  29. Investments: What are ___? Represent ownership in a corporation. Investors receive dividends and capital gains (or capital losses). • hybrid securities • common stocks • bonds • short-term securities The correct answer is (B). When people use the term “stocks,” they are talking about common stocks.

  30. Investments: What are ___? Investments with very little risk, and correspondingly, very little return. Often used as a place to "park your money" or for an emergency fund of 3 to 6 months income. • hybrid securities • common stocks • bonds • short-term securities The correct answer is (D). Low risk, low return.

  31. Investments: What are ___? Fixed-income securities that represent loans to corporations, municipalities (state & local governments & agencies), and the Federal government. Investors receive interest and a promise to repay the loan. • hybrid securities • common stocks • bonds • short-term securities The correct answer is (C). Bonds are “fixed-income” investments.

  32. Investments: What are ___? Securities designed to offer the stability of fixed-income investments with the opportunity for capital growth of equity investments. Examples include preferred stock and convertible bonds. • derivatives • common stocks • bonds • hybrid securities The correct answer is (D). The best (?) of both worlds.

  33. Investments: What are ___? Speculative securities that derive their value from an underlying security or asset. Examples include options contracts and futures contracts. • derivatives • hybrid securities • bonds • short-term securities The correct answer is (A). You can make a lot of money; you can lose a lot of money.

  34. What are Reasonable Expectations? What are reasonable long-term expectations of returns from the following investments? • stocks • bonds • short-term securities • mutual funds • hybrid securities • derivatives 8% - 12% 4% - 8% 2% - 5% ? ? ? Now, let us look at investment returns and risks in detail…

  35. Investment Return– Revisited • Over the long term, equities (stocks) have produced the best returns • Equities – Stocks • 8% to 12% (I usually tell people 8% to 10%) • Fixed-income Securities – Bonds • Treasury & Municipal Bonds – 4% to 6% • Corporate Bonds – 6% to 8% • Short-term Investments – “Cash” • 2% to 5% • Mutual funds will more or less (often less) reflect the underlying assets that they invest in

  36. Growth of $1 Investment 1925 – 2009

  37. Growth of $1 Investment 1801 – 2009

  38. Investment Risk– Revisited • It is no accident that stocks and bonds have produced better returns than short-term investments (a.k.a. “cash”) • Otherwise, why would investors assume the higher risks of stocks and bonds? Why wouldn’t they just assume the… • Risk-free Rate of Return • The return on guaranteed short-term investments • Specifically, the return on U. S. Treasury Bills • Risk Premium • The reward for bearing risk; the extra return on a risky asset over the risk-free rate of return

  39. Investment Risk Premiums

  40. Investment Risk– Revisited (continued) • RiskversusReward; RiskversusReturn • Investment return is very straight-forward • How much did you start with and how much did you end with? That is your return! • But measuring how much risk you took to receive that return is much more difficult • Each year, the investment community measures the average annual return and the amount of variance from the average return • Using statistics, the resulting measures of risk are called variance and standard deviation

  41. Investment Risk– Revisited (continued) • Variance and Standard Deviation • We will leave the calculations for your statistics class • Suffice to say the higher the variance and standard deviation, the riskier the investment • i.e. The higher the variance and standard deviation, the more the investment return will deviate from the average annual return ? ? ? ? ? ? ? ? ? ? ? ? These are just fancy, schmancy terms for, “You Can Lose Yer Money!”

  42. Distribution of Annual Returns on Common Stocks: 1926 to 2011 Does this distribution resemble anything you are familiar with?

  43. The Normal Distribution – The “Bell curve” Investment returns over time tend to mirror a normal distribution

  44. Historical Returns, Standard Deviations, and Frequency Distributions: 1926-2009 The greater the standard deviation, the wider the distribution of returns and the riskier the investment

  45. Another View of RiskversusReturn Average Annual Return versus Annual Return Standard Deviation

  46. A Global View of RiskversusReturn Now we can complete the global picture regarding risk versus return. Who had the best risk-adjusted return? Sweden may have had the best average annual return, but you had to accept almost 60% more risk to get that return. The standard deviation of the developing world was 15.2% with a 9.2% average annual return.

  47. So, Does You’se Got’s It Yet? You’se Wants High Returns? You’se Gonna’ Gets High Risk! You’se Gonna’ Lose Some Money, Maybe All’s Yer Money! If’n Anybodies Tells You’se Different, De’re Lying! So when (not if) you see an advertisement for a “12% Safe Rate of Return,” you will know that the chances of losing your money are pretty high. When you see claims such as 300% or even 3000% (and you will if you are involved in investing for any length of time), sit on your hands and grab your wallet! P.S. By the way, they are also breaking the law. Examples: Wade Cook, WizeTrade, Day Trading Coach, Optionetics, etc.

  48. But Isn’t Somebody Doing It? • Yes, it is true • Some people make tremendous rates of return • But those people are not Investors • They are Traders(a.k.a. Speculators) • Being a Trader can be very profitable • But it is also very stressful and very perilous • And you are up against the best in the world Story: John Gutfreund versus John Meriweather John Bogle: http://www.forbes.com/2009/01/09/intelligentinvestingbogle.html

  49. So What is a Realistic Rate of Return For Me? • After you have taken this course, you will have a strong knowledge of the most popular types of investments • Stocks, Bonds, “Cash,” Mutual Funds, etc. • You will also know what levels of returns and what levels of risks you should reasonably expect to receive • And if you are a patient, long-term investor, I believe it is realistic to expect 8% to 10% • I am certainly working on it myself! Of course, as we will reiterate time and time again, there are no guarantees!

  50. But Is 9% or 10% Good Enough? • It turns out the answer to this question is,“YES!” • If you start early … • If you are patient and consistent … • If you do not get cocky or greedy … • If you do not chase after every “Next Big Thing” that comes along … • And most importantly,you don’t PANICwhen the market swoons! • As it inevitably will do from time to time • The trick is to take advantage of the Time Value of Money • a.k.a. Compound Annual Return

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