Intro to Financial Management

Personal Finances

Review

• Homework• Dividend payment theories

– Residual dividend theory

– Clientele theory

– Information effect

– Agency costs

– Expectations theory

• Earnings predictability concerns• Policies

– Constant dividend payout

– Stable dollar

– Small regular plus end-of-year

– One-time

• Stock splits and dividends

Modern Portfolio Theory

• Diversification can– Reduce risk– Increase returns

• Objective is to– Maximize return for a given level of risk

or– Minimize risk for a given level of return

Not All Risk is the Same

Firm Risk = Systemic risk + Idiosyncratic Risk

BusinessCycles

FinancialMarkets

GlobalConditions

Risk Unique to theFirm

Source of Correlation

Idiosyncratic risk can be diversified away!

Diversification – Simple Example

IBM and AT&T

When IBM went down, AT&T went up.When AT&T went down, IBM went up.

If stocks are perfectly positively correlated, diversification has no effect on risk

If stocks are perfectly negatively correlated, portfolio is perfectly diversified.

What do you want as an investor?

Risk and Diversification

With large portfolio, 30 – 200 stocks, idiosyncratic moves cancel out!

The Efficient Frontier

Modern Portfolio Theory

• Optimal portfolio is a combination of the “market portfolio” and the risk-free asset

• So… what is the market portfolio?– S&P 500?– Wilshire 5000? – Total world index?

• What about bonds?

Diversification with Stocks and Bonds

Note: adding some stock to a 100% Treasury portfolio increases the return and decreases the risk!

Market Portfolio

• What about other asset classes?– REITS– TIPS– Commodities

• How is one to decide on a market portfolio?– Simple approach 60/40 stocks/bond– Include other asset classes

• Six Ways from Sunday portfolio http://www.dallasnews.com/business/columnists/scott-burns/20100904-The-joy-of-portfolio-cooking-2502.ece

– All-Weather Portfolio

• Asset allocation is your most significant investment decision

What to Invest In?

• Index funds– Track an index– Low cost– Types

• Total market

• S&P 500

• Total bond

• REITs

• TIPS

• Precious metals

• International

• Managed funds– Fund has a stated objective– Fund manager invests to maximize returns subject to objective

Can You Beat the Market?

• Efficient market hypothesis• Investment exercise• Thought experiment

– What if advisors are actually bad and only get it right 40% of the time?

• You can’t consistently beat the market– But many will try– Are you tempted by Apple, Facebook, gold?

Market Analysis

• Technical analysis– Looks at historical returns– Looks for patterns– Patterns suggest investment direction

• Fundamental analysis– Tries to understand the why’s– Looks for underlying causes

• Inflation

• GDP growth

• Relationships (e.g. oil to plastics and farm products)

• Exchange rates

Post Modern Portfolio Theory

Two Ways to Make Money•Beta

– Your market portfolio– Has systemic risk from asset class– Easy, inexpensive to create

•Alpha– Your bet against the market, you know better than everyone else– Zero-sum game

• There are winners and losers

– Has idiosyncratic risk, comes from skill of investment advisor– Hard, expensive to create

Post Modern Portfolio TheoryPractical Application

• First, set aside emergency money– Determine how many months of income 3 – 6– Leave in a money market fund

• Pick how much you want to bet – your alpha– Specify as a percent– Place your bet– Be prepared to lose it

• Invest the remaining percent in your market portfolio – beta

Market Timing

• Can you time the market?– Who do you listen to?– Do you know better than the pros?– Do the pros know?

• Two schools of thought– Dollar cost averaging– Go to your strategy

Retirement Planning

• Why should you care now?

1-18

You Can Never Catch Up

Person A: Saves $2000 per year from age 22 to age 35 and then stopsPerson B: Starts saving $2000 per year beginning at age 35 and never stops Both earn 8% on their investments.At age 75: Person A has $1M in savings Person B has $561K in savings

Savings Comparison

-100,000200,000300,000400,000500,000600,000700,000800,000900,000

1,000,000

22 26 30 34 38 42 46 50 54 58 62 66 70 74

Age

Sav

ing

s

Savings A

Savings B

How Much Do You Need?

• Calculate your income requirement– Use today’s dollars (remember time value of money)

Current income

- Pension

- Social Security (maybe)

= Income need

• Rough estimate of the portfolio you must have= income need x 25

• Conversely, can live off of 4% of your portfolio– E.g. If have $1M, then can live off $40k per year

How Much Do You Need?

• Previous calculation was in today’s dollars• You may need 4 times that amount in the future

– Inflation has averaged 4% since 1929– At that rate, prices will go up 4x in 36 years

• Start saving now– Minimally 10%– Shoot for > 20%

Are You On Track?

• Under Accumulator of Wealth (UAW)net worth < age * (.10 * pretax income)

• Average Accumulator of Wealth (AAW)net worth = age * (.10 * pretax income)

• Prodigious Accumulator of Wealth (PAW)net worth > age * (.10 * pretax income)

If age 30 with pretax income of $60,000, then you need net worth = 30 * (.10 * 60000) = $180,000

If age 40 with pretax income of $100,000, then you need net worth = 40 * (.10 * 100000) = $400,000

• A guideline, not a law of physics–Not good for young ages

Retirement Vehicles

• 401(k)’s• IRA• Roth IRA