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FIN 200: Personal Finance

Topic 15-Investment FundamentalsLawrence Schrenk, Instructor

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Learning Objectives

1. Explain the two basic assumption about investors. ▪

2. Calculate both dollar and percentage returns.

3. Explain investment risk and how it is measured

4. Discuss the risk-return trade-off and its implications for investing. ▪

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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.

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Inflation Review

If annual inflation is 3% what will a $0.90 candy bar cost in 4 years?

1. Input 4, Press N (This is annual so N = 4)

2. Input 3, Press I/Y

3. Input .9, press +/-, press PV

4. Press CPT, FV to get $1.01

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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%.

1. Change P/Y to 52

2. Input 520, Press N (10 x 52 = 520 monthly payments)

3. Input 2.5, Press I/Y (use the real interest rate)

4. Input 17,000, press +/-, press FV

5. Press CPT, PMT to get $28.78

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Inflation Review

Cost of a $1 Can of Soda

$0.00

$0.50

$1.00

$1.50

$2.00

$2.50

1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16 17 18 19 20 21

Yea

rs

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Investment Basics

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Types of Investments

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

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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

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Investment Returns

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Measuring Returns

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

Percentage Return

1 110 100 $10Dollar t tR P P

1

1

110 10010%

100t t

Percentaget

P PR

P

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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

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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? ▪

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Investment Risk

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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! ▪

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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’.

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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.

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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.

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Which is Riskier?

-60%

-40%

-20%

0%

20%

40%

60%

80%

1 3 5 7 9 11 13 15 17 19 21 23 25 27 29

Investment A

Investment B

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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%?

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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.

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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!

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Selecting Stocks

Which stock would you choose from each pair?

R s

A 10% 20%

B 12% 15%

R s

C 11% 12%

D 10% 15%

R s

E 10% 15%

F 12% 15%

R s

G 10% 12%

H 12% 15%?

Project Note

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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?