FIN 200: Personal Finance

1. FIN 200: Personal Finance Topic 15-Investment Fundamentals Lawrence Schrenk, Instructor

2. Learning Objectives • Explain the two basic assumption about investors. ▪ • Calculate both dollar and percentage returns. • Explain investment risk and how it is measured • Discuss the risk-return trade-off and its implications for investing. ▪

3. Inflation Review • Identify the following as either real or nominal values. • In 2020, a compact car is expected to cost $150,000. • When I retire, I hope to have saved enough to have an income of $60,000. • The contract says we need to pay $1,000 in ten years.

4. Inflation Review • If annual inflation is 3% what will a $0.90 candy bar cost in 4 years? • Input 4, Press N (This is annual so N = 4) • Input 3, Press I/Y • Input .9, press +/-, press PV • Press CPT, FV to get $1.01

5. Inflation Review • How much do you need to save weekly at 4.5% to have $17,000 (in today’s dollars) in 10 years, if inflation is 2%? • Use the real rate for your calculation Real Rate of Interest = 4.5% - 2% = 2.5%. • Change P/Y to 52 • Input 520, Press N (10 x 52 = 520 monthly payments) • Input 2.5, Press I/Y (use the real interest rate) • Input 17,000, press +/-, press FV • Press CPT, PMT to get $28.78

6. Inflation Review

7. Investment Basics

8. Types of Investments • CD’s • Stocks • Bonds • Mutual Funds • Derivative Securities • Currency Trading • International Investments • Real Estate, etc.

9. Two Assumptions • Assumption One: You Like Money • You always want more money • But you always want the next dollar less than the previous one. • Assumption Two: You Do Not Like Risk • Risk Aversion (versus Risk Neutral, Risk Loving) • Risk Loving in Small Things • Example: The Fair Gamble • Different Degrees of Risk Aversion

10. Investment Returns

11. Measuring Returns • You bought one share of IBM for $100, and sold it a year later for $110. • Dollar Return • Percentage Return

12. What are Pt and Pt-1? • The price you paid, Pt • This is what you invested • Including commissions, extra fees, etc. • The price you sell it for, Pt-1 • This is the price you get. • It may have different components • Stock: Capital Gains and Dividend • Deduct any costs of selling • Remember the tax consequences

13. Comparing Returns • For comparison, returns must be: • Percentage • Is $100.00 a good return? • On an investment of $1,000, $10,000, $100,000… • Annual • Is 10% a good return? • On an investment of 1, 5, 10 years… ▪ • Question: Is it hard to make a profit? ▪

14. Investment Risk

15. Risk: The Other Half • Is an annual return of 15% a good return? • This depends on the risk involved • Savings account? • Government bond? • Stock? ▪ • Key Concept: Knowing the return is never enough! ▪

16. Risk and Uncertainty • In every facet of our lives we face something unknown. • When this lack of knowledge is complete, it is often called ‘uncertainty’. • In many cases, however, we may not know what is going to happen, but we have some idea of its probability, and this we call ‘risk’.

17. What is Risk • Risk is the possibility that the realized value will differ from the expected value. • If an asset is risk free than I know that the realized value will be the expected value. • Greater risk is associated with greater likelihood that the realized value will differ from the expected value.

18. Downside versus Upside Risk • The realized value may either be higher or lower than the expected value. • If higher is better, e.g., a stock return, then we call this possibility ‘upside’ risk, and call the opposite ‘downside’ risk. • Some people think of risk as only downside risk, but we shall use the term for either type of risk, i.e., any deviation from what is expected.

19. Which is Riskier?

20. Which is Riskier? (cont’d) • Expected Return • Investment A = 10% • Investment B = 10% • Which is riskier? • For which is the possibility that the realized value will differ from the expected value greater? • Which is more likely to actually have a return of 10%?

21. Measuring Risk • Risk as volatility. • Volatility can be measured by the statistical calculation called ‘standard deviation’. • Standard Deviation (s) • Investment A = 10% • Investment B = 30% • The only thing you need to know about standard deviation: The larger the number the greater the risk.

22. Risk-Return Trade-Off • Recall the opening assumptions • We like return • We don’t like risk. • Basic Investment Goal • Get the greatest return for the least risk!

23. Selecting Stocks • Which stock would you choose from each pair? ?

24. Project Note

25. Ethical Dilemma Carlo and Rita have accumulated only half the money they will need for their daughter's college education. With college just two years away, they are concerned about how they will save the remaining amount in such a short time. While discussing his dilemma of financing his daughter's education, Sam tells Carlo about an investment that he made based on a tip from his cousin, Leo, that doubled his money in just over one year. Sam tells Carlo that Leo assured him that there was very little risk involved. Carlo asks Sam if he will contact Leo to see if he has any additional hot tips that could double his daughter's college savings in two years with virtually no risk. The next day at lunch Sam gives Carlo the name of a stock that Leo recommended. It is a small startup company that Leo believes will double within the next 24 months with virtually no risk. Carlo immediately invests his daughter's college fund into the stock of the company. Six months later, Carlo receives a letter from the company announcing they are out of business and closing their doors. Upon calling his broker, Carlo finds the stock is now worthless. a. Comment on Leo's ethics of assuring his friends and relatives that the investments he recommends can produce major rewards with virtually no risk. b. What basic investing principle did Carlo forget in his desire to fund his daughter's college education?