Investments: Analysis and Behavior

1. Investments: Analysis and Behavior Chapter 1- Introduction

2. Learning Objectives • Learn the power of building wealth through investing over time. • Understand the nature and performance of financial assets. • Identify common objectives of investors. • Practice obtaining important financial information. • Become acquainted with job opportunities in the financial services sector.

3. Buy High, Sell Low?! • It is obvious that investors should buy low and sell high in order to build wealth over time. • So why do investors frequently buy high and sell low? (like buying in 2007 and selling in early 2009) • The investment process involves analytical analysis of investment alternatives that are filtered through a decision process that is filled with psychological biases. • To be a successful investor, you should be able to use the analytical tools and control your emotions and psychological biases!

4. Building Wealth • Save a significant part of your income (10-20% or more). • Invest in a broadly diversified portfolio that promises a significant positive rate of return. • Give your investments lots of time to grow. How important are time and return?

5. Over a 24-year period, a 9% return leads to twice the wealth of 6% returns, and 12% returns almost quadruple the wealth generated by a 6% return.

6. Asset Classes • Cash Reserves – Offer modest income with stability of principal • Short-term money market instruments (borrow and lend for the short-term) • U.S. Treasury bills, Savings deposits, CDs • Commercial Paper • Bonds • Debt obligations over one year • Treasury Notes, Treasury Bonds, Municipal Bonds • Corporate Bonds • Stocks • Common stock is ownership of a public corporation

7. Historical Returns of Stocks and Bonds • Stocks have earned an average return of about 12% per year for the past 50 years. • Returns vary slightly depending what index is used. • Long-term Treasury bonds have earned around 6% per year. • 50%/50% allocation to stocks/bonds would average around 9% per year. • Both stock and bond returns have been volatile!

8. Treasury Instruments • Treasury Bill • Treasury obligation with maturities of one year or less • Treasury Note • Treasury obligation with maturities of more than 2 years but less than 10 years • Treasury Bond • Treasury obligation with maturities of 10 to 30 years

9. Table 1.3 Returns on Common Stocks, Treasury Bonds, and Treasury Bills, 1950-2007

10. Start with $10,000 in each asset.

11. Investment Objectives • Why are you investing? • Retirement, down payment, vacation, … • Investment objectives are important. • Matching goal characteristics with investment characteristics. • Risk, return, time

12. Long-term Investing • Retirement plans from employers • Defined Benefit plans • Employer promise to pay a fixed retirement income. • Formula driven. • Employer does all the work and makes decisions • Defined Contribution plans • You save (tax deferred) from paycheck. • Employers may contribute too. • You make all the decisions • Benefit depends on contributions and investment return.

13. Young investors can accumulate significant wealth through regular investing of modest amounts. The longer you wait to start investing, however, the greater the cost to building significant wealth.

14. Key Investment Concepts • A portfolio • Diversified (hopefully!) collection of stocks, bonds and other assets. • Individual investments are often evaluated on how they change the characteristics of the portfolio. • Risk • Chance of economic loss. • Sometimes measured as a variation in return. • Expected Return • Anticipated gain of a specific period of time. • Often evaluated as compensation for taking certain types of risks.

15. Efficient Market Hypothesis • Idea that every security at every point in time is fairly priced. • Implication is that prices are unpredictable • Controversial • Market bubbles • Most professional investors don’t beat the market • Investment superstars • Hard to predict the direction of stock prices

16. Investment management performance • At any point in time, some investment managers are beating the market for the month, quarter or year. • A couple of years later, most of these managers are no longer performing so well. • Regression to the mean • Superstar exceptions • Warren Buffett, Chairman & CEO of Berkshire Hathaway • Net Worth: $47 Billion • Peter Lynch, Wall Street Investor and Research Consultant (Fidelity) • Net Worth: $325 Million • Sir John Templeton • Pioneered the use of globally diversified mutual funds and was considered to be one of the greatest global stock oickers

17. Valuing Assets – future value • Future Value Future value = Present sum × (1 + Interest rate)t The future value of a $5,000 investment earning 8% interest over a period of 15 years is future value = $5,000 × (1 + 0.08)15 = $15,861

18. Valuing Assets – present value • Present Value Present value = The present value of a $15,860 to be received in 15 years with an 8% rate of return is present value = = $5,000

19. Valuing Assets – payments Future value = Present value = Over the next 30 years, an employee contributes $3,000 per year to an investment expected to earn 9% per year. After 30 years, the employee will have: future value = = $408,923

20. Compound Frequency • Mortgages and auto loans use monthly payments and compounding • Dividends paid quarterly • Bonds pay semi-annually • Adjust the number of periods and rate What is the future value of a $1,000 investment 3 years from now if it receives a 9% annual return compounded (A) annually, (B) quarterly, and (C) continuously? Solution: (A) Future value = $1,000 X (1 + 0.09)3 = $1,295 (B) Future value = $1,000 X (1 + 0.0225)12 = $1,306 (C) Future value = $1,000 X e0.09x3 = $1,310 Approximately, e = 2.718

21. Behavior is important too • Incentives • Stockbroker and commissions • Mutual fund incentives • Psychology • The higher the degree of uncertainty in a decision, the more emotions and psychological biases are used to help make the decision. • People tend to think of investments as better or worse. Better means low risk and high return (which conflicts with financial theory!).

22. Getting information - Newspapers

23. Getting information - Magazines

24. Getting information - Online

25. Investment Industry Jobs • Working at • Commercial banks • Savings and credit unions • Securities firms • Investment banks • Companies • Credit rating agencies • Mutual funds • Life insurance companies • Securities exchanges • Jobs • Brokers • Traders • Portfolio managers • Financial planners • Investment bankers • Security analysts

26. Objectives of the course and text • Develop a clear understanding of the many useful and practical implications of financial theory. • Understand how the incentives of various market participants influence investor decisions and also highlight the impact of a person’s own psychology. • Acquire a framework for understanding the returns on all financial assets, including stocks, bonds and financial derivatives. • Gain familiarity with the institutions and language of Wall Street so as to facilitate the development of an effective personal investment strategy.