Garman/Forgue

Personal FinanceNinth Edition

Chapter 13:

Investment

Fundamentals

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Learning Objectives

1. Explain how to get started as an investor.

2. Discover your own investment philosophy.

3. Identify the kinds of investments that match your interests.

4. Describe the major factors that affect the rate of return on investments.

5. Decide which of the five long-term investment strategies you will utilize.

6. Create your own investment plan.

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1. Starting Your Investment Program

• Saving vs. Investing…What’s the difference?

– Put Your Money to Work!

– Build “real” wealth

– Rate of return; Time

– Sacrifices are necessary:

• Start early, invest regularly

• Delay 5: Double Down

– We invest in securities [stocks, bonds, mutual funds]

– Our invested assets make up our portfolio

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Are you ready to invest? Balances on high interest credit cards?

Adequate insurance protection?

An emergency fund that is easily accessible?

A monthly budget?

Contributing to your employer’s retirement plan?

Decide why you want to invest Achieve financial goals [kids’ education, house down payment]

Supplement income

Reduce tax liability

Retire comfortably

For fun!

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It takes money to

make money!

Getting money to invest

Pay yourself first

Save-- don’t spend– extra funds

Make it automatic

Scrimp for a month

Break a habit, make use of the money

If you want to be able to invest $1,000 this year, ask yourself these questions… before you buy!

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Investors hope for a POSITIVE RETURN

• Current Income Versus Capital Gain

– Current Income is received on a regular basis while you own the investment

• dividends from stock; interest from bonds

• taxed at your marginal tax rate

– Capital gains occur only when you sell the investment

• results from you selling it for more than you bought it for

• taxed at special lower rates

• Capital losses are also possible!

• Rate of Return (yield) is an investment’s total yearly return in the form of a percentage

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What investment returns are possible?– Levels of RETURN ARE related to RISK

– Average returns from 1926 – 2006:

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2. Your Investment Philosophy

• How to handle investment risk– Pure risk vs. Speculative risk

– Investment risk: uncertainty about returns

– Tradeoff: Between risk and return

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Ultraconservative “Investors” Are Really Just “Savers”

• People that invest very conservatively

• They do not get ahead financially over the long term because taxes and inflation offset most of their interest earnings

• You can accept more risk when investing for long-term goals

• Remember “The Rule of 72”?

– 72/4% = 18 years

– 72/8% = 9 years

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What is Your Investment Philosophy?

• Your approach to risk tolerance in investments

• Risk tolerance: your ability to handle changes in your investments’ value

• Levels of Risk Tolerance:

• conservative; moderate; aggressive

•We must take risks that will enable us to reach our financial goals

• Greater risk = greater potential for returns RCRE Investment Risk Tolerance Quiz available online at:

www.rce.rutgers.edu/money/riskquiz/

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Investment Philosophy:• Conservative: Risk averse

– Goal = preserve capital

• Moderate: Risk indifferent– Goal = long-term profit

• Aggressive: Risk seeker– Goal = short-term, quick profit

Investment Approach:• Active Investor – studies the economy, market trends,

and investment alternatives – Usually buys individual stocks/seeks quick profits

• Passive Investor – does not spend much time monitoring investments.– Usually buys mutual funds/seeks long-term profits

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3. Identify the Types of Investments You Want to Make

• Your investments should match your interests

• You can invest in 2 ways: lending or owning

• Debts – “loanership” (lending) investments

– the borrower agrees to repay the principal to the investor on a specific date (maturity).

– the borrower agrees to pay the investor a specific rate of interest at regular intervals.

• Equities – “ownership” investments

– Potential for a higher return by sharing in profits

Pg. 363 Overview of Investment Alternatives

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4. How Risk and Other Factors Affect Return

• Random risk

– All of your eggs are in one basket

– What happens if that basket breaks?

• Diversification

– “Spread the wealth”!

– A way of reducing random risk

– Averages out the high & low returns, reducing overall risk

• Market risk (undiversifiable)

– Risk results from economic influences that affect entire market

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Effects of Diversification:Lower Total Return + Less Overall Risk

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The Tax Consequencesin Investment Fundamentals

Did you Know? PG 366

• After-Tax Return

• Tax-Deferred Investments

• Tax-Exempt Investments

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5. Establish Your Long-TermInvestment Strategy

• 4 Strategies

– Investing is not “rocket science”… “just do it”

– Start as early as possible

• Investments should provide a positive Real Rate of Return

• Understand the economy as a whole: how are Securities Markets performing?

– Bear Market

– Bull Market

Example: 10% return, 7.5% after taxes (25% tax bracket), 3% inflation, real rate of return of 4.5% after taxes and inflation

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A 10-Year Delay in Investing Can Cost you over $500,000 PG 367

Assumption: $2000 / yr in a tax-deferred account earning 10%

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Trying to Time the Market is Too Difficult to Accomplish

• Long-term investors must be able to withstand some market volatility

• What are Market Timers? Constant “shifters”– Hope to capture the upside of rising stock prices while

avoiding most of the downside

• Very difficult to catch market highs and lows…have to be right twice

• Miss the “best trading days” when prices rebound

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Strategy #1: Buy-and-Hold“The secret to investment success is benign neglect.”

• The Emphasis: Hold on to investments in good times and bad

• The Action: Buy a diversified mix of stocks or mutual funds, reinvest the dividends, and hold on almost indefinitely

• The Expectation: The value of assets will increase over the long run with the growth of the American and world economies

• The Challenge: Do not react emotionally to day-to-day changes that occur in the market

• The Advice: Buy more shares when prices are lower during normal market downturns

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Strategy #2: Dollar-Cost Averaging

• The Action: Invest equal sums of money at regular intervals regardless of the price of the investment

• The Emphasis: Invest regularly, automatically

• The Expectation: You will be buying more shares when stock price is down and less when the price is up => reducing average cost per share

• Buying shares regularly through a “DRIP”, pg 371

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Strategy #3: Portfolio Diversification“Diversification is the single most important rule in investing.”

• The Action: Create your portfolio by choosing different asset classes

• The Emphasis: Spread the wealth! Choose assets based on their dissimilar risk-return characteristics

• The Expectation: Different asset classes react differently to economic changes; when one performs poorly, the others will perform well.

• The Advice: Never keep more than 10% of your assets in one investment

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Diversification Averages Out an Investor’s Returns

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Diversified Investment Portfolios

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Strategy #4: Asset Allocation“More than 90% of an investor’s returns are a result of proper allocation.”

• The Action: Decide on the proportions of your investment portfolio that will be devoted to various asset categories

• The Emphasis: You are in the right place at the right time! your allocation proportions reflect your age, risk tolerance, goals, time horizon

• The Expectation: Your portfolio allocation will maximize returns and reduce risk

• The Advice: Maintain your desired allocation, rebalancing when necessary

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Model Portfoliosand Time Horizons

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RebalancingAssets

in Your Portfolio

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Creating YourOwn Investment Plan

• Investment plan: an explanation of your investment philosophy and your logic on investing to reach specific goals

• What are the time horizons for your investment goals?

– Building up an amount for a down payment on a home?

– Creating a college fund for a child?

– Putting away money for retirement?