Download Chapter 13 - Carlin Business

Garman/Forgue
Personal Finance
Ninth Edition
Chapter 13:
Investment
Fundamentals
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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
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
It takes
money to
make
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 Consequences
in Investment Fundamentals
Did you Know? PG 366
• After-Tax Return
• Tax-Deferred Investments
• Tax-Exempt Investments
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5. Establish Your Long-Term
Investment Strategy
• 4 Strategies
Example: 10% return, 7.5% after taxes
(25% tax bracket), 3% inflation, real rate of
return of 4.5% after taxes and inflation
– 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
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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 Portfolios
and Time Horizons
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Rebalancing
Assets
in Your
Portfolio
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Creating Your
Own 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?
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