Download - Chapter 6 Principles of Investing
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(C) 2001 Contemporary Engineering Economics
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Chapter 6Principles of Investing
• Investing in Financial Assets
• Investment Strategies
• Investing in Stocks
• Investing in Bond
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Investment Basics
• Liquidity – How accessible is your money?
• Risk – What is the safety involved?
• Return – How much profit will you be able to expect from your investment?
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Real Return 2%
Inflation 4%
Risk premium 0%
Total expected return 6%
Real Return 2%
Inflation 4%
Risk premium 20%
Total expected return 26%
How to Determine Your Expected Return
Risk-free real return
InflationRisk
premium
U.S. Treasury Bills
Amazon.com
Very safe
Very risky
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Figuring Average Versus Compound Return
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1 0 05 1 0 10 1 0 12
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8 96%
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5% 10% 12%
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Period ReturnYear 1 5%Year 2 10%Year 3 12% 0 1 2 3
5% 10% 12%
Average rate of return Compound Rate of Return
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Compound Versus Average Rate of Return
Investment Case 1 Case 2 Case 3 Case 4 Case 5 Case 6
Average return 9.00% 9.00% 9.00% 9.00% 9.00% 9.00%
Balance at the end of year 3
$1,295 $1,294 $1,284 $1,270 $1,264 $1,224
Compound return 9.00% 8.96% 8.69% 8.29% 8.13% 6.96%
Annual Investment Yield (Base investment of $1,000)
Investment Case 1 Case 2 Case 3 Case 4 Case 5 Case 6
Year 1 9% 5% 0% 0% -1% -5%
Year 2 9% 10% 7% 0% -1% -8%
Year 3 9% 12% 20% 27% 29% 40%
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How to Determine Expected Financial Risk
• Risk: the chance that some unfavorable event will occur.
• Volatility measures the deviation from the expected value, or sudden swings in value—from high to low, or the reverse.
• Standard deviation measures the degree of volatility when you have the probabilistic information about the uncertain event.
• Beta measures how closely a fund’s performance correlates with broader stock market movement.
• Alpha shows whether a fund is producing better or worse returns than expected, given the risk it takes.
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Returns from Various Investment Classes
Average Annual Return 1970-1997
Best Year Worst year
U.S. Stocks 13.0% 37.6% (1995) -26.5% (1974)
International Stocks
12.7% 39.4% (1993) -26.2% (1974)
Cash Equivalent 6.8% 14.1% (1981) 3.0% (1991)
Real Estate 8.8% 20.5% (1979) -5.6% (1991)
U.S. Bonds 9.3% 33.5% (1982) -5.6% (1994)
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Investment Strategies
• Trade-Off between Risk and Reward– Cash: the least risky with the lowest returns– Debt: moderately risky with moderate returns– Equities: the most risky but offering the
greatest payoff
• Dollar-cost averaging concept• Broader diversification reduces risk• Broader diversification increase expected
return
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Dollar-Cost Averaging Concept
Timing
Amount Invested
Fund
Unit Price
No. of Units Purchased
Ending Fund Balance
Month 1 $1,000 $5.00 200 $1,000
Month 2 $1,000 $4.00 250 $1,800
Month 3 $1,000 $2.50 400 $2,125
Month 4 $1,000 $3.75 267 $4,189
Month 5 $1,000 $5.00 200 $6,585
Totals $5,000 1,317
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Broader Diversification Increases Return
Amount Investment Expected Return
$2,000 Buying lottery tickets
-100% (?)
$2,000 Under the mattress 0%
$2,000 Term deposit (CD) 5%
$2,000 Corporate bond 10%
$2,000 Mutual fund (stocks)
15%
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Option Amount Investment Expected Return
Value in 25 years
1 $10,000 Bond 7% $54,274
$2,000 Lottery tickets -100% $0
$2,000 Mattress 0% $2,000
2 $2,000 Term deposit (CD)
5% $6,773
$2,000 Corporate bond 10% $21.669
$2,000 Mutual fund (stocks)
15% $65,838
$96,280
1
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Investing in Stocks
• Stocks: Ownership shares in a corporation
• Ownership: If a company issues 1M shares, and you buy 10,000 shares, you own a 10% of the company.
• Valuation: (1) cash dividend and (2) share appreciation at the time of sale
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Conceptual Stock Valuation
IBM Computer:Given:Stock price as of July 20, 2001: $105.50/shareEarnings growth for next 5 years: 13%Expected cash dividend in 2002: $2.00/shareExpected stock price in 3 years: $230/shareRequired return on your investment: 10%Find: Current value of stock
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$175. $105. ,
1 010
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2
2
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underpriced
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What Are Your Odds?
Your chance of making return on your investment per year
If you hold stocks for
Your chance of losing money
0-10% 10-20% 20+ %
1 year 26% 18% 20% 37%
3 years 14% 28% 39% 19%
5 years 10% 31% 49% 10%
10 years 4% 42% 53% 1%
20 years 0 37% 63% 0
Source: Newsweek, November 10, 1997
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What is Financial Option?
Call Option Put Option
100 shares of stock
At a predetermined
price
On or beforea predetermined
date
Strike (Exercise) price
Expiration date
AOL July Call (2001)
AOL stock
$50
July 20, 2001
The right To buy
The rightTo sell
Underlying asset
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Call Option
$1.45 $60$39.47
Current Price(04/09/01)
Option Premium
Stock PriceJuly 20, 2001
StrikePrice
$50
AOL Call Option July 2001
Profit: $8.55BreakevenPrice
$51.45 Do NotExercise:Loss limited to $1.45
Take partial loss
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Hold to maturityand trade at thestrike price
AOLDate:Feb 13, 2001Price:$48.09Strike price:$75Premium:$5,900 for 1000 shares
Expiration:Jan 2003
Trade for profit before optionexpires
Let the option expire If stock price drops to $70
If stock price rises to $100
If stock price rises to $78
If stock price rises to $90
If stock price rises to $80
($100-$75)* 1000=$25,000 from trade-$ 5,900 premium$19,000 profit
$5,000 from trade-$5,900 premium$ 900 loss
$15,000 from trade-$ 5,900 premium$ 9,100 profit
$3,000 from trade-$5,900 premium$2,900 loss
Lose yourpremium only$5,900 loss
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Investing in Bond
• Bonds: Loans that investors make to corporations and governments.
• Face (par) value: Principal amount
• Coupon rate: yearly interest payment
• Maturity: the length of the loan
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Bond Price Notation Used in Financial Markets
Corporate Bonds Treasury Bonds1/8=$1.25 5/8=$6.25 1/32=$0.3125
2/32=$0.6250
3/32=$0.9375
4/32=$1.25
17/32=$5.3125
18/32=$5.6250
19/32=$5.9375
20/32=$6.25
1/4=$2.50 3/4=$7.50 6/32=$1.5625
7/32=$1.8750
7/32=$2.1875
8/32=$2.50
21/32=$6.5625
22/32=$6.8750
23/32=$7.1875
24/32=$7.50
3/8=$3.75 9/32=$2.8125
10/32=$3.1250
11/32=$3.4375
12/32=$3.75
25/32=$7.8125
26/32=$8.1250
27/32=$8.4375
28/32=$8.75
1/8=$5.00 1=$10 13/32=$4.0625
14/32=$4.375
15/32=$4.6875
16/32=$5.00
29/32=$9.0625
30/32=$9.3750
31/32=$9.6875
32/32=$10
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AT& T 7s05
Closing price: 108 1 / 4
$1,082.50
Coupon rate
Maturity date2005
No meaning,Spacing
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Types of Bonds and How They Are Issued in the Financial Market
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How Do Prices and Yields Work?
• Yield to Maturity: The actual interest earned from a bond over the holding period
• Current Yield: The annual interest earned as a percentage of the current market price
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Bond Quotes
AT&T 7s05 6.5% 5 million 108 1/4
Coupon rate of 7%
Maturity (2005)
Current yield
Trading volume
ClosingMarket price
$1,082.50$70/108.25= 6.47%
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Yield to Maturity
(a) Yield to maturity:
per semiannual period
(b) Current yield:
per semiannual period
$996. $48. ( / , ,20) $1, ( / , ,20)
.
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$48.
$996..
25 13 000
4 84%
1 0 0484 1 9 91%
13
254 83%
2
P A i P F i
i
ia
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Summary
• The three basic investment objects are: growth, income, and liquidity.
• The two greatest risks investors face are inflation and market volatility.
• Portfolios with long-term horizons need equities to offset inflation while short time frames requires debt and/or cash investments to reduce volatility
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• Dollar-cost averaging is a planned transfer, over a period, of equal amounts from one assets to another.
• Diversification by combining assets with different patterns of return, it is possible to achieve a higher rate of return without increasing significant risk.
• Investing in stocks and bonds is one of the most common investment activities among the American investors.