Download Lecture5 - UCSB Economics

Introduction to Economics
Linking Personal Investment with the
US Economy
Macroeconomics
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Econ 109 Class Page

Econ Home Page:
http://www.econ.ucsb.edu
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Labs(sections)
12617 F 9:00-9:50 AM
MCL 12625 M 2:00-2:50 PM
12633 M 7:00-7:50 PM
12641 W 8:00-8:50 AM
12658 T 6:30- 7:20 PM
12666 F 1:00-1:50 PM
Jalama Lab, Phelps 1517
Miramar Lab, Phelps 1526
Miramar Lab, Phelps 1526
Miramar Lab, Phelps 1526
Miramar Lab, Phelps 1526
Ledbetter Lab, Phelps 1530
Checking Instructional Computing Lab Scedules
http://www.ic.ucsb.edu/faculty/labs/
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Lecture Outline
Guidelines for personal financial well-being
 Bonds
 Stocks
 Choosing an efficient portfolio
 The best portfolio for you
 Making Your Wealth Grow
 Where does the long run growth in stocks
come from? Growth in corporate profits (net
earnings), which in turn depends on the
economy doing well
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
Part Two
Macroeconomics and the US Economy
5. Thursday, Oct. 10, Lecture Five: "Capital Asset Pricing Model"
Tracking asset markets and the US economy
capital asset pricing model
Growth rate of your personal wealth
Value of a share of stock
The impact of business cycles on corporate profits
Reading Assignment:
O’Sullivan and Sheffrin, Ch. 20, “Measuring a Nation’s Production and
Income” emphasis: measuring the ouput of the economy, circular flow
O’Sullivan and Sheffrin, Ch. 21, “Unemployment and Inflation”
Problems O & S Text
p. 434: 1, 5, 6, 7, 8, 9,10,11
p. 450: 1, 2, 3, 4, 5, 6, 7, 8
Tuesday, Oct. 22 , 25 minute QUIZ, You will need scantron sheet
and #2 pencil.
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Part I
Guidelines for Personal Finance, Summary
 Life is Risky, How to Cope?

 Risk
from the Economy, e.g. inflation
 Market Risk, e.g. stocks, bonds, real estate
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Guidelines for Personal Finance

Keep you expenditures within your means
 pay

Save 10% of your income
 pay

off your credit card debt
yourself first
Diversify your investments
 cash,
for emergencies
 housing, to build wealth and provide shelter
 treasury bonds, as a safe investment
 stock index fund, for growing your wealth
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Life is Risky; How to Cope?

Protect against inflation
 don’t

put all your money in cash or checking
hedge your bets, don’t bet on just one market
but diversify among markets
 real
estate
 bonds
 stocks

hedge your bets, diversify within markets
 laddering
bonds
 stock index fund
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Inflation
Http://stats.bls.gov/eag/eag.us.htm
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Erosion of Purchasing Power
The Purchasing Power of $10,000 Cash in 1990 As Time Passes
$12,000.00
$10,000.00
Value
$8,000.00
$7289
$6,000.00
$4,000.00
$2,000.00
$1988
1990
1992
1994
1996
1998
2000
2002
2004
Year
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Santa Barbara South Coast Median House Price in 1974 $
200000
$182,335
180000
160000
140000
1974 $
120000
100000
80000
60000
40000
20000
$41,500
0
1970
1975
1980
1985
1990
1995
2000
2005
Year
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30-Year Mortgage Rate of Interest
Http://research.stlouisfed.org/fred2/
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19
98
19
9
19 8
98
19 . 1
98
.1
19
99
19
9
19 9
99
19 . 1
99
.1
20
00
20
0
20 0
00
20 . 1
00
.1
20
01
20
0
20 1
01
20 . 1
01
.1
20
02
20
0
20 2
02
.1
Rate
Interest Rate, 2-Year Treasury and Inflation Rate
12
10
2-Year Treasury
Inflation
8
6
4
2
0
-2
-4
-6
Date
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Interest Rate Vs. Length (Maturity) of the Treasury Bond
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Http://www.publidebt.treas.gov/sec/sectrdir.htm
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19
98
.
19 01
98
.
19 04
98
.0
19 7
98
19 .1
99
.
19 01
99
.
19 04
99
.0
19 7
99
20 .1
00
.
20 01
00
.
20 04
00
.0
20 7
00
20 .1
01
.
20 01
01
.
20 04
01
.0
20 7
01
20 .1
02
.
20 01
02
.
20 04
02
.0
7
Rate
Total Return on S&P500 and Inflation Rate
15.00
10.00
5.00
0.00
-5.00
-10.00
-15.00
-20.00
S&P500
Inflation
Date
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Dow Jones Industrials Index
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http://www.quicken.com
20
Weekly Closings of the Dow Jones Indistrials
14000
12000
0.0025x
y = 1540.8e
2
R = 0.9552
Index
10000
8000
September 28 2001
6000
4000
Growth Rate 13%
per Year
2000
3-Jan-86
0
0
100
200
300
400
500
Week
600
700
800
900
Part II

Choosing among investment options, the
efficient portfolio
 example:
six UC investment funds
 tradeoff: the higher the rate of return, the higher
the risk
 called Markowitz Portfolio Analysis

Choosing the best portfolio for you
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Example: UC Funds

Suppose you invest up to $10,000 per year
in a tax sheltered 403(b) plan
 you
have to save $10,000, but you would have
to pay income taxes if you took it as income

UC investment alternatives
 guaranteed
insurance contract(GIC)
 savings fund
 money market fund
 bond fund
 stock index fund
 multi-asset fund
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Investment Concepts
 monthly
return for June 2001 on an asset
price(June)
- price(May) + dividends
 price(June)
- price(May): capital gain(loss)
 dividends(interest): income from stocks(bonds)
 monthly
rate of return for June 2001
[price(June)
- price(May) +
dividends]/price(May)
 in
%, multiply by 100
• annual rate: multiply by 12
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Example: UC Funds/Mutual Funds
 Sources
of information on UC funds
monthly,
quarterly, annual, etc. rates of return
 internet:
http://atyourservice.ucop.edu
 Notice, a publication of the UC Academic Senate
 Source
of Information on Mutual Funds
quarterly
 The
Wall Street Journal, Mutual Funds Quarterly
Review, e.g. extra section in July 3, 1997 Journal
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-15
Year:Month
-5
-10
Equity Fund
Insurance Contract
Jun-01
Mar-01
Dec-00
Sep-00
Jun-00
Mar-00
Dec-99
Sep-99
Jun-99
Mar-99
Dec-98
Sep-98
Jun-98
Mar-98
Dec-97
Sep-97
Jun-97
Mar-97
Dec-96
Sep-96
Jun-96
Mar-96
Dec-95
Sep-95
Rate
Two UC Funds: Monthly Rate of Return, Sept 95 - Aug 01
10
5
0
9
7
5
3
1
-1
-3
-5
-7
-9
-1
1
12
Average = 1% per month
10
8
6
4
2
0
-1
3
Frequency
Distribution of Monthly Rates of Return
UC Stock Index Fund, Sept '95- Aug '01
Reward: Monthly Rate of Return
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UC Funds: Equity Vs. Insurance

Insurance
 steady
at a rate of
return of about 0.6
per month or 7.2%
per year
 does not vary much
 never negative
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
Equity
 rate
of return varies
a lot from month to
month
 range of rates of
return from about
plus 9% in Mar. ‘00
to minus 13% in
Aug ‘98
 can turn negative:
29 months out of 72
30
Year:Month
Jun-01
Mar-01
Dec-00
Sep-00
Jun-00
Mar-00
Dec-99
Sep-99
Jun-99
Mar-99
Dec-98
Sep-98
Jun-98
0.20
Mar-98
0.30
Dec-97
Sep-97
Jun-97
Mar-97
Dec-96
Sep-96
Jun-96
Mar-96
Dec-95
Sep-95
Rate
Three "Safe" UC Funds :M onthly Rates of Return
0.70
0.60
0.50
0.40
Insurance Contract
Money Market Fund
Savings Fund
0.10
0.00
-15
Year:Month
-5
-10
Bond Fund
Equity Fund
Multi Asset (Mix) Fund
Jun-01
Mar-01
Dec-00
Sep-00
Jun-00
Mar-00
Dec-99
Sep-99
Jun-99
Mar-99
Dec-98
Sep-98
Jun-98
Mar-98
Dec-97
Sep-97
Jun-97
Mar-97
Dec-96
Sep-96
Jun-96
Mar-96
Dec-95
Sep-95
Rate
Three "Volatile" UC Funds, Monthly Rates of Return
10
5
0
Measures of Average Rate of Return and Variability: Mean & Std. Dev.
Date
Bond
95.09
95.1
95.11
95.12
96.01
96.02
96.03
96.04
96.05
96.06
96.07
96.08
96.09
96.1
96.11
96.12
97.01
97.02
97.03
97.04
97.05
97.06
mean
standard deviation
Equity
2.66
2.4
3.9
2.83
-0.51
-5.42
-0.63
-0.75
0.78
1.68
0.34
0.35
4.21
7
5.56
-4.16
0.04
1.35
-3.59
2.23
2.59
2.75
1.16
3.00
Insurance
4
-0.26
4.07
-0.13
3.32
2.35
-0.24
1.6
2.56
-0.12
-5.01
2.33
4.59
0.39
7.69
-1.25
4.59
0.42
-2.33
4.09
6.16
3.5
0.64
0.66
0.64
0.66
0.64
0.6
0.64
0.61
0.63
0.61
0.63
0.63
0.61
0.63
0.61
0.62
0.62
0.56
0.64
0.6
0.62
0.6
1.92
2.95
0.62
0.02
Money Market Multi-Asset
Savings
0.49
2.09
0.49
0.64
0.47
2.39
0.48
0.78
0.47
1.23
0.43
-0.12
0.45
0.02
0.43
0.62
0.44
1.27
0.44
0.5
0.46
-1.43
0.46
1.08
0.45
2.6
0.46
1.77
0.45
3.97
0.47
-1.1
0.46
1.82
0.41
0.62
0.45
-1.31
0.45
2.08
0.47
2.91
0.46
2.02
0.46
0.02
1.11
1.38
0.52
0.53
0.51
0.52
0.52
0.49
0.52
0.5
0.51
0.5
0.51
0.51
0.49
0.52
0.49
0.51
0.52
0.46
0.54
0.5
0.51
0.5
0.51
0.02
Mean Returns & Standard Deviations
Return Versus Risk for Six UC Funds Sept 95-Aug 01
1.20
Equity
1.00
Average Return
Bond
0.80
0.60
Multi-Asset
Insurance
Savings
0.40
Money Market
0.20
0.00
0.00
0.50
1.00
1.50
2.00
2.50
3.00
Risk: Volatility
3.50
4.00
4.50
5.00
Efficient Portfolio: Most Return for Given Risk
Return Versus Risk for Six UC Funds Sept 95-Aug 01
1.20
Equity
1.00
Average Return
Bond
0.80
0.60
Multi-Asset
Insurance
Savings
0.40
Money Market
0.20
0.00
0.00
0.50
1.00
1.50
2.00
2.50
3.00
Risk: Volatility
3.50
4.00
4.50
5.00
Efficient Portfolio: Most Return for Given Risk
Return Versus Risk for Six UC Funds Sept 95-Aug 01
1.20
Equity
1.00
Average Return
Bond
0.80
0.60
Multi-Asset
Insurance
This frontier shows the efficient (best)
options for investing, the first step
of the economic paradigm
Savings
0.40
Money Market
0.20
0.00
0.00
0.50
1.00
1.50
2.00
2.50
3.00
Risk: Volatility
3.50
4.00
4.50
5.00
Efficient Portfolio: Most Return for Given Risk
Return Versus Risk for Six UC Funds Sept 95-Aug 01
1.20
Equity
1.00
Average Return
Bond
0.80
0.60
Multi-Asset
Insurance
Slope is the second step of the
paradigm, determining values:
Market Price of Risk: 0.1%
return per month for every 1%
of variability per month
Savings
0.40
Money Market
0.20
0.00
0.00
0.50
1.00
1.50
2.00
2.50
3.00
Risk: Volatility
3.50
4.00
4.50
5.00
Your portfolio should be on the
efficient frontier
 But
where on the frontier?
depends
on your taste for reward and risk
 reward,
i.e. the mean rate of return is a good
 risk is a bad
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Economic Paradigm: Valuation of Mean Return and Risk
Assumption: Mean Return is Good, Risk is Bad: U =U(M,R)
better
Mean
Return,
M
worse
B
C
A
Iso - Preference Curves
Prefer B to A; Prefer B to C
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Risk, R
39
Efficient Portfolio: Most Return for Given Risk
Return Versus Risk for Six UC Funds Sept 95-Aug 01
1.20
Investor A: very risk averse
Equity
1.00
Average Return
Bond
0.80
0.60
Multi-Asset
Insurance
Savings
0.40
Money Market
0.20
0.00
0.00
0.50
1.00
1.50
2.00
2.50
3.00
Risk: Volatility
3.50
4.00
4.50
5.00
Efficient Investment Portfolio
UC Funds: Mean Return Vs. Risk (Standard Deviation)
2.00
Investor B: not very risk averse
Equity
1.80
1.60
Mean Return
1.40
1.20
Multi-Asset
Bond
1.00
0.80
0.60
Insurance
Savings
0.40
Money Market
0.20
0.00
0.00
0.50
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1.00
1.50
2.00
Standard Deviation
2.50
3.00
3.50
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Part III
How do you make your nest egg grow?

Do you need to take risks and get a super
high rate of return?
 not

if your ratio of savings to wealth is high
Strategy for the Long Run: Buy and Hold a
Stock Index Fund
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Weekly Closings of the Dow Jones Indistrials
14000
12000
0.0025x
y = 1540.8e
2
R = 0.9552
Index
10000
8000
September 28 2001
6000
4000
Growth Rate 13%
per Year
2000
3-Jan-86
0
0
100
200
300
400
500
Week
600
700
800
900
Invest in A Stock Index Fund
Exponential Growth
 Historically: 20th Century, 11% per year
 Since 1986: 13% per year
 Betting that history will repeat itself

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Two Ways to Grow Your Wealth
Savings: increases your wealth
 rate of return: adds to your wealth
 Combine these two for rapid growth

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Rate of Growth of Personal Wealth
savings, s
+
+
increase
in wealth, w
Stock of
wealth, w
yield, r*w
rate of
return, r
rate of growth of wealth, w/w  rate of return, r + savings/wealth
w/w  r + s/w
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Relative
Importance
of
Savings
 Younger Years
 income
& savings are
lower
 wealth is smaller
 ratio of savings to wealth
may be high
 savings is most important,
rate of return less so
 example
income of $60,000
 savings of $6,000
 wealth of $50,000
 ratio of savings to wealth of 0.12

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
Older Years
 wealth
accumulates
 ratio of savings to
wealth falls
 rate of return on
wealth becomes
more important
 example
income of $100,000
 savings of $20,000
 wealth of $500,000
 ratio of savings to
wealth of 0.04

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Years to Double Wealth
Rate of Growth of
Wealth, 100*w/w
4%
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Years to Double
17.3
8%
8.7
10%
6.9
16%
4.3
48
rate of return
on wealth, r
rate of growth of wealth, w/w
w/w r + s/w
12%
8%
4%
0
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4%
8%
12%
ratio of
savings to
wealth, s/w
49
Rate of Growth of Personal Wealth

If the rate of return, r, on wealth is zero
 then
the only source of growth in wealth is
savings: w/w = s/w
 i.e. the only change in wealth, w, is savings:
w = s

If savings is zero
 then
the only source of growth in wealth is rate
of return, r, and wealth will grow exponentially
at the rate r: w/w = r
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Summary
How to Cope: Simplify
Investment Strategy:
Buy and Hold
Step 1: Save
Step 2: Diversify, i.e keep a cash
reserve, buy a house, hold some
treasury bonds,invest in
stock index fund with IRA or
401 k.
Using the Economic Paradigm
to maximize return for a given
risk level
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Investment Principles or Maxims
 Don’t
hold
put all of your eggs in one basket
a diversified portfolio
 cash
 bonds
 stocks
 real
estate
advantage
of a mutual fund or stock index fund
 instead
of holding one stock, e.g. Coca-Cola, you
hold a bundle of stocks
 Choose
the asset with the highest reward for
a given level of risk
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Part IV

Value of a share of stock
 depends
on the stream of expected future net
earnings per share

The Impact of the Business Cycle on
Corporate Profits
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Your Stocks
Market
Indices
corporate earnings(profits)
The Economy
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Tracking Assets and Markets

What is the relationship between the
monthly rate of return on the UC Index
Fund and an index of the stock market, such
as the Standard and Poor’s Index of 500
Stocks (S&P 500) ?
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Example: The UC Index Fund
and the Standard & Poor’s 500

mean rate of return on the UC Index Fund
varies with the mean rate of return on
Standard & Poor’s Index of 500 Stocks
 capital
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asset pricing model
56
Monthly Rates of Return: UC Index Fund, S&P500
8
UC Equity
S&P 500
6
2
97.05
97.03
97.01
96.11
96.09
96.07
96.05
96.03
96.01
-2
95.11
0
95.09
Percent
4
-4
-6
Date
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Variation of Rewards: UC Index Fund Vs. S&P 500
8
96.11
6
UC Index
4
2
0
-6
-4
-2
0
2
4
6
8
-2
y = 0.8127x + 0.0474
2
R = 0.8727
-4
96.07
-6
S&P 500
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Sources of Information: stock prices

Daily Quotes
 Business
Section of Los Angeles Times
 Wall Street Journal

Internet graphics
 http://bigcharts.marketwatch.com/
 http://www.quicken.com/investments
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Percentage Changes in IBM Versus the Dow
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Where does the growth in
financial wealth come from?

What is the relationship between financial
markets and the economy?
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http://www.globalexposure.com/
Last Ten Years
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Corporate profits after taxes
doubled from $160 billion in early 1987 to
$320 billion in early 1994
 doubling in about seven years implies an
average rate of growth of about 10% per
year
 this rate of growth is comparable to the 11%
rate of growth in the Dow since 1986

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Economic Concept

present value of a stream of expected future
net earnings, or profits, per share
 PV(t)
= ENE(t) + ENE(t+1)/(1+i)
 may
know this year’s net earnings, NE(t)
 your expectations of the future affect your best guess
for next year, ENE(t+1)
 at an interest rate of 7%, $1.07 next year is
equivalent to a $1 this year
• to compare dollar values for different years, they have to
be discounted to a common year
 PV(t)
= ENE(t) + ENE(t+1)/(1+i) +
ENE(t+2)/(1+i)2 + ...
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Income-Expense Statement for an Individual
Income
Expenditure
Savings
Income-Expense Statement for a Business Firm
Gross Revenue
Cost
Profit (net revenue, net earnings)
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Your Stocks
Market
Indices
corporate earnings(profits)
The Economy
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Index of Leading Economic Indicators
Gross Domestic Product
Unemployment Rate
66
Index of Leading Indicators
1948-
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Labs : Resources for Economists on the Internet
http://rfe.wustl.edu/
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The US Business Cycle

expansions, or recoveries, the period from
trough to peak, tend to last a lot longer than
recessions, the period from peak to trough
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US Postwar Expansions
Trough - Peak
Duration, Months
Oct. ‘45 - Nov. ‘48
37
Oct. ‘49 - July ‘53
45
May ‘54 - Aug. ‘57
39
April ‘58 - April ‘60
24
Feb. ‘61 - Dec. ‘69
106
Nov. 70 - Nov. ‘73
36
March ‘75 - Jan. ‘80
58
July’80 - July ‘81
12
Nov. ‘82 - July ‘90
92
March ‘91 – April ‘01
121
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70
US Business Cycle

Note the long expansions in the eighties and
the nineties
 is
there a new economic regime or order?
 are business cycles a relic of the past?

Note the long expansion in the sixties
 economists
then talked about “fine tuning” the
economy
 then came along the problems of the seventies
a
couple of recessions
 inflation
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Summary-Vocabulary-Concepts





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capital asset pricing
model
market risk
asset specific risk
stock’s beta, 
moving average
exponential growth
Dow Jones Industrials
present value
Llad Phillips
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net earnings per share
expectations
discount factor
corporate profits after
taxes
business cycle
peak
trough
index of leading
indicators
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