University of Wisconsin - Madison Retirement Association Fundamental Concepts of Investing September 15, 2009 Jim Hamre Steve Hawk 1
Investment Environment Large Federal Budget Deficits Potential for Higher Inflation Higher Inflation Results in Higher Interest Rates 2
Real Interest + Inflation = Interest Rate Rate Rate Examples: 3% Real + 2% Inflation = 5% Interest Interest Rate Rate Rate 3% Real + 6% Inflation = 9% Interest Interest Rate Rate Rate Analysis: 9% Interest Rate 6% Inflation Rate = 3% Real Interest Rate 3
INDIVIDUAL INVESTMENTS 4
Savings Accounts & Money Market Accounts Withdraw funds anytime Interest rate can change anytime FDIC-insured up to $250,000 Non-insured may have higher rates and greater risk 5
Certificates of Deposit Fixed term (12 months, 18 months, 2 years, 3 years) Penalty for funds withdrawn prior to end of stated term Fixed interest rate (possible bump) FDIC-insured up to $250,000 Non-insured may have higher rates and greater risk 6
Common Stocks Represents ownership in a corporation Corporation can enter bankruptcy Common stock has no preference in liquidation governments, mortgages, liens, and preferred stock have preference to funds May be publicly-traded or privately-held No guarantee of future dividends Price-per-share can increase or decrease 7
Total Return on Common Stock: Change in Price + Dividend = Total Return Examples: 5% Price Increase + 2% Dividend = +7% Total Return 8% Price Decrease + 2% Dividend = -6% Total Return Buying Common Stock: Use Dollar-Cost Averaging NOT Market Timing 8
Date Price Close Investment # of Shares 14-Aug-2009 996.220 $10,000.00 10.04 31-Jul-2009 987.480 $10,000.00 10.13 30-Jun-2009 919.320 $10,000.00 10.88 29-May-2009 919.140 $10,000.00 10.88 30-Apr-2009 872.810 $10,000.00 11.46 31-Mar-2009 797.870 $10,000.00 12.53 27-Feb-2009 735.090 $10,000.00 13.60 30-Jan-2009 825.880 $10,000.00 12.11 31-Dec-2008 903.250 $10,000.00 11.07 28-Nov-2008 896.240 $10,000.00 11.16 31-Oct-2008 968.750 $10,000.00 10.32 30-Sep-2008 1166.360 $10,000.00 8.57 29-Aug-2008 1282.830 $10,000.00 7.80 31-Jul-2008 1267.380 $10,000.00 7.89 Totals $140,000.00 148.44 9
Preferred Stocks Possible Preferences: Preferred Dividends before Common Dividends. Preference over Common in Liquidation. Conversion to Common Stock or Bonds. Requires special knowledge to trade due to illiquid markets. 10
Corporate Bonds Debt of a corporation May be based only on general credit May be Convertible into Common Stock at owner s option May be Callable for predetermined cash amount at corporation s option Fixed Interest Payment Fixed Maturity Value 11
Bond Yield: As the market price of a bond increases, the Interest Payment stays the same and the Bond Yield decreases As the market price of a bond decreases, the Interest Payment stays the same and the Bond Yield increases In both cases, the Maturity Value of the bond stays the same. 12
Example: $10,000 Maturity Value bond pays $600 interest each year On July 1, 2005, the market interest rate is 6%; this bond will have a Market Price of $600 / 6% = $10,000 On July 1, 2006, if the market interest rate decreases to 5%, the Market Price of this bond will increase to $600 / 5% = $12,000 On July 1, 2007, if the market interest rate increases to 6.66%, the Market Price of this bond will decrease to $600 / 6.66% = $9,000 13
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In the previous chart, if the prevailing bond interest rate increases from 3.5% to 9.0%: A bond maturing in 10 years will experience a 35.77% drop in market value A bond maturing in 30 years will experience a 56.75 drop in market value 15
Bond Ladder: Buy multiple bonds of varying remaining terms to be held to maturity. The yield of each bond is locked-in a the time of the purchase because the bond is being held to maturity. As the shortest term bond reaches maturity, invest the proceeds in another bond that will be added to the long end of the ladder. 16
3-Year Bond Ladder example: $10,000 ABC bond 2.0% yield due 12-31-09 $10,000 JKL bond 2.2% yield due 6-30-10 $10,000 XYZ bond 2.4% yield due 12-31-10 $10,000 RST bond 2.7% yield due 6-30-11 $10,000 EFG bond 3.1% yield due 12-31-11 $10,000 LMP bond 4.0% yield due 6-30-12 At 12-31-09, the ABC bond matures. the proceeds are reinvested in GHJ bond yielding 4.3% due 12-31-12. Can use Certificates of Deposit in the ladder rather than Bonds. 17
Federal Government Bonds Debt of the United States of America Viewed as very safe around the world Many different varieties Same relationship between price and yield as Corporate Bonds: As yield decreases, price increases. As yield increases, price decreases. Can use Federal Government Bonds in a ladder 18
Municipal Bonds Debt of a municipality Municipality can enter bankruptcy Income tax advantages to investors Current market is very illiquid usually have to hold to maturity Same relationship between price and yield as Corporate Bonds High transaction costs 19
Stocks vs. Bonds - The Debate of the Ages: For many years now we have had discussions about what is best, stocks or bonds? The answer seems clear because stocks have returned more than bonds historically. However the real question should be, What is best for you? 20
A Different View of The Historical Record: The table below presents the historical record of stocks vs. bonds organized by decade. When viewed in this fashion the volatility of the markets becomes evident. ASSET ALLOCATION and HISTORICAL RETURNS BY PORTFOLIO TYPE 100% Stocks 100% Bonds 75% Stocks / 25% Bonds 50% Stocks / 50% Bonds 25% Stocks / 75% Bonds 1926-2009 9.6% 5.3% 8.9% 8.0% 6.8% Returns by Decade 1926-1929 19.2% 4.2% 15.4% 11.7% 7.9% 1930's -0.1% 4.6% 2.1% 3.6% 4.4% 1940's 9.2% 1.8% 7.5% 5.8% 3.9% 1950's 19.4% 1.3% 15.2% 10.8% 6.2% 1960's 7.8% 3.5% 6.9% 5.9% 4.8% 1970's 5.9% 7.0% 6.4% 6.8% 7.0% 1980's 17.5% 11.9% 16.3% 14.9% 13.5% 1990's 18.2% 7.4% 15.6% 13.0% 10.2% 2000-7/31/09-2.6% 6.0% 0.1% 2.3% 4.3% 21
Only the decade of the 1940 s produced returns approximating the long term widely quoted average return. 22
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Decade of the 2000 s: The decade of the 2000 s is a perfect illustration of the fact that markets do not always work out according to their long term averages. 100% stock investment 24
Risk Reduction With Balanced Portfolios: 40% Bonds, 60% Stocks 25
Portfolio Withdrawals: Withdrawals substantially change the volatility of portfolios and require strategic policy adjustments. 26
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Balancing Assume 50% Common Stock and 50% Certificates of Deposit in a portfolio: $10,000 Common Stock (50%) $10,000 CDs (50%) 29
Rebalancing 1 year later: $6,000 Common Stock (38%) $10,000 CDs (62%) Convert $2,000 of CDs into Common Stock: $8,000 Common Stock (50%) $8,000 CDs (50%) 30
2 years later: $14,000 Common Stock (64%) $8,000 CDs (36%) Sell $3,000 Common Stock and acquire CDs: $11,000 Common Stock (50%) $11,000 CDs (50%) 31
Mutual Funds Can invest directly with the company managing the fund or buy into the fund through a broker Common Stock Funds: Large Cap (buys stock of large corps) Mid Cap (buys stock of mid-size corps) Small Cap (buys stock of small corps) Index Fund (buys representative group of stocks that mimic increases and decreases of a particular stock index, such as DJIA, S&P 500, or NASDAQ) low management fees 32
Bond Funds: Corporate Bond Funds Federal Government Bond Funds Municipal Bond Funds Other: Exchange Traded Funds Hedge Funds 33