CH 12: Introduction to Investment Concepts Introduction to Investing Investing is based on the concept that forgoing immediate consumption results in greater future consumption (through compound interest and appreciation). Therefore, the FIRST step to investing is to SAVE rather then CONSUME. Establishing SMART Financial Goals The second step is proper goal setting Goals establish the financial target Strategies create the means to reach the target Specific Measurable Attainable Realistic Timely NOT a vague idea that someday I d like to be rich Time Horizon of Goals Effects Investment Choices Short term (<2 years) Saving for down payment on automobile Creating an emergency fund Conservative investments Intermediate (2 10 years) Funding child s college education Saving for down payment on home Moderate risk investments Long term (>10 years) Saving for retirement More aggressive investments FNCE5610 Lecture 5 Page 1 of 15
Impediments to Achieving Goals Taxes Inflation, why postpone consumption if purchasing power will be less? Poor: planning, goal setting, discipline (spending more then earned) Investment risks Fundamental Investment Goals Capital accumulation No need for capital = no need to invest Preservation of capital Inflation protection for accumulated wealth at minimal risk Maximizing returns Greater returns generally require greater risk Minimizing risk EVERONE wants HIGH returns and LOW risk, but this is unrealistic and must be balanced to best achieve financial goals Budgeting Saving money from current budget to achieve financial goals is the first step This can be accomplished by: Limiting short-term credit to amounts easily paid off each month NOTE: pay off high interest debt FIRST. Paying off 18% debt is like getting a GUARANTEED 18% after tax return! Managing income and expenses monthly Increase savings by reducing discretionary expenditures (there is often little short term control of income) Methods of Increasing Savings PAY YOURSELF FIRST BY: Payroll deduction into savings/investments FNCE5610 Lecture 5 Page 2 of 15
Systematic transfers of dollars from checking account automatically every month into an investment (all mutual funds allow this) Allocating a portion of future raises or any lump sums (tax refund) to savings Elective savings programs (401(k)) Begin saving early Time/Savings Example Investment Risk Uncertainty of future outcomes= risk, this means different things to different investors BUT All investors expect higher returns for higher levels of risk AND All investors must accept SOME degree of risk TWO Risk Types 1) Systematic Risks Risks affected by broad macroeconomic factors FNCE5610 Lecture 5 Page 3 of 15
Cannot be eliminated (non-diversifiable risk) because at least one risk factor effects each security. Also known as Beta risk Market risk-securities tend to move with the market up or down, depending on changes in the economic environment Purchasing power risk Risk that inflation will erode real value of investor s assets Bonds maturity value is fixed their purchasing power is not Interest rate risk Risk that interest rates will affect the current value of securities Interest rates are inversely related to value of bonds and stocks Reinvestment risk Risk that future earnings distributed cannot be reinvested at a rate of return equal to the expected yield of current investments Zero-coupon bonds free of such risk: nothing paid until maturity so nothing to reinvest Foreign Currency Risk Risk that a change in relationship between value of dollar and value of foreign currency will occur Example John invests $1 million in Loco Caliente, which is based in Mexico; conversion rate is 10 pesos to $1; John has invested 10 million pesos in Locao Caliente John sells his interest for 15 million pesos; conversion rate is now 12 pesos to $1 (The $ went UP in value relative to Pesos) John receives $1.25 million Gain on investment: 50% (5 million pesos 10 million pesos) Loss on conversion: 16.67% (10 pesos 12 pesos) Overall gain: 25% ($250,000 $1 million) 2) Unsystematic Risks Risks unique to single security, company, industry, or country (Measured by Alpha ) CAN be eliminated through diversification (owning 25-30+ diversified stocks) FNCE5610 Lecture 5 Page 4 of 15
Types of Unsystematic Risk Business risk Speculative nature of business, management, and philosophy Uncertainty of operating income Utilities are less risky than cyclical companies Financial risk Risk created by leverage of firm Use of debt magnifies return on equity (ROE) Default risk Associated with the inability of a business to pay its debt US government securities are default-risk free Tracked by rating agencies (Moody s) Country (regulation) risk Associated with the potentially adverse effect of changes in a country s laws or political situation FNCE5610 Lecture 5 Page 5 of 15
Liquidity and Marketability Liquidity Ability to sell an investment quickly Competitive price No loss of principal Little price concession Marketability Availability of a ready market Example: real estate is marketable but not considered liquid because it often takes a long time to find a buyer Investment Choices, THREE Types 1) Lending investments (bonds) Default risk (none with US government issues) Interest rate risk (inverse relationship) bond holders paid before stockholders 2) Ownership investments in business Stock Appreciation and dividends Greater risk then bonds 3) Ownership investments in real estate Rental Income Depreciation deduction Value changes have a low correlation with other assets Investment Choices (cont.) Derivatives: securities based on the value of another security Options contracts Put option The right to sell ( put to the buyer) the underlying security at a specific price within a specified time frame Call option: the right to buy the underlying security at a specific price within a stated time frame Futures contract: a contract to purchase (or sell) a specific commodity at a specific time for a certain price FNCE5610 Lecture 5 Page 6 of 15
Direct vs. Indirect Investing Direct Investing Purchase of the actual security (such as a stock through a brokerage account) Indirect Investing (Mutual Funds) Purchase of shares of a company that invests directly Professional management, diversification, investor services (systematic deposit++) Measures of Risk Investment risk is generally measured in terms of volatility Beta a measure of systematic risk - measures volatility of a portfolio of investments compared to the market as a whole (the market has a Beta of 1.0) A portfolio with a Beta of 1.2 would be 20% more volatile then the market..8= 20% less volatile. Best used with well diversified portfolios (little unsystematic risk so almost all Beta risk) and mutual funds that correlate well with the market Measures of Risk (cont.) Alpha measures the unsystematic risk unique to the security. Alpha of 1.09 means security is expected to increase 9% in a flat market. Standard deviation measures total volatility (systematic and unsystematic risk) by statistically determining how far the actual returns deviate from the average return. A portfolio with an expected return of 12% and a standard deviation of 10% would be expected to range between 2% and 22% 68% (1SD) of the time. Semivariance measures downside volatility (below the average returns) corrects for the possibility that a portfolio with high standard deviation is high mostly because of high POSITIVE returns Measures of Return Holding period return Arithmetic mean Geometric mean FNCE5610 Lecture 5 Page 7 of 15
Internal rate of return Real rate of return Holding Period Return EVI = Ending value of investment BVI = Beginning value of investment $100/$50 =100% return Does NOT account for LENGTH of hold FNCE5610 Lecture 5 Page 8 of 15
Arithmetic Mean Geometric Mean Geometric mean is internal rate of return when solving: PV = 100 FV = 100 (1 + R1)(1 + R2)(1 + R3)(1 + Rn) N = n Rn = return for period n n = number of periods Comparison Year 1 BOY=$100, EOY=$200. ROR=100% Year 2 BOY=$200, EOY= $100, ROR=(50%) Arithmetic Mean= (100+(50))/2= 25% Geometric mean= PV=-100, FV=100 n=2, I=0% The arithmetic mean is not as practical for evaluating investment returns as the geometric mean but is sometimes used nevertheless. FNCE5610 Lecture 5 Page 9 of 15
Internal Rate of Return FNCE5610 Lecture 5 Page 10 of 15
Real Rate of Return Rn = Nominal (stated) rate of return I = Inflation rate Real Return is Nominal return adjusted for inflation (same as used in education funding examples) Modern Portfolio Theory Modern portfolio theory is based on the diversification process. It determines an efficient frontier consisting of investment portfolios (through the process of asset allocation) with the highest expected return for a given level of risk The Efficient Frontier FNCE5610 Lecture 5 Page 11 of 15
Markowitz s Three Rules Same expected return choose lower risk Same risk choose higher expected return Choose a portfolio with a higher expected return and lower risk Modern Portfolio Theory (cont.) Most asset allocation software packages help build efficient portfolios using: Standard deviation of each asset class (historical or estimate) Expected return of each asset class (historical or estimate) correlation coefficients of each asset class Asset classes: Large-cap value, LC core, LC growth Small/Mid-cap value, SMC Core, SMC growth International Equity, Int. fixed, emerging market equity, US Treasury fixed, US Corp fixed, US Muni fixed Once the portfolio is created, return projections can be made to determine if it is tracking to meet objectives FNCE5610 Lecture 5 Page 12 of 15
Correlation Coefficient (R) Key to the asset allocation concept How the change in one assets return relates to another assets return: R = +1.0; perfect positive correlation R = 1.0; perfect negative correlation R = 0; no correlation you want assets in your portfolio that DON T all have high correlation with each other, so that they won t all move in the same direction in reaction to an event Risk Tolerance Each investor has a different level of portfolio risk that is appropriate for their: Investment time frame Income and assets Income Vs. appreciation goals Capital preservation goals Comfort level with volatility The end result: efficient portfolio allocations based on goals and risk tolerance Investment Strategies and Theories Efficient market hypothesis (EMH) The theory that the market constantly prices securities fairly and efficiently and investors cannot outperform the market on a risk adjusted basis. All information is already built into the price and only NEW information will effect the price therefore technical (searching for recurring stock patterns) or fundamental (value based on earnings, sales, industry analysis+) analysis is futile. Many studies have shown that it is difficult for professional managers to outperform the market. FNCE5610 Lecture 5 Page 13 of 15
Active Versus Passive Investing Active management strategies use research to attempt to find undervalued securities and earn higher returns then passive management approaches Passive management holds a well diversified portfolio based on asset allocation and rebalances over time Other Strategies Indexing: a passive approach using a portfolio of the same securities, in the same proportion, as an index (S&P 500) simple, low cost, can be diversified Timing the market Using a variety of indicators and models timers attempt to be fully invested in up markets and in cash in down markets. Knowing when to get in and out is very difficult and studies show over 90% of timing systems fail, (and 10% are going to fail soon???) Summary Asset Allocation: 1. Determine goals and objectives considering such factors age, time horizon, family situation, risk tolerance,income level, liquidity needs, and taxes 2. Select asset classes consistent with objectives (choose NON-correlated classes and diversify WITHIN the classes) 3. Determine weighting for each class selected for the portfolio 4. Rebalance as need to maintain weightings 5. Typical allocation: 65% stocks, 25% bonds 10% cash FNCE5610 Lecture 5 Page 14 of 15
Beta A measure of a portfolio's sensitivity to market movements (as represented by a benchmark index). The benchmark index, such as the S&P 500 or EAFE index, has a beta of 1.0. A beta of more (less) than 1.0 indicates that a fund's historical returns have fluctuated more (less) than the benchmark index. Beta is a more reliable measure of volatility when used in combination with a high R² which indicates a high correlation between the movements in a fund's returns and movements in a benchmark index. R 2 A measurement of how closely the portfolio's performance correlates with the performance of a benchmark index, such as the S&P 500. R² is a proportion which ranges between 0.00 and 1.00. An R² of 1.00 indicates perfect correlation to the benchmark index, that is, all of the portfolio's fluctuations are explained by performance fluctuations of the index, while an R² of 0.00 indicates no correlation. Therefore, the lower the R², the more the fund's performance is affected by factors other than the market as measured by that benchmark index. Alpha A risk-adjusted performance measure. A positive (negative) alpha indicates stronger (poorer) fund performance than predicted by the fund's level of risk (measured by beta). Alpha and beta are more reliable measures when used in combination with a high R2 which indicates a high correlation between the movements in a fund's returns and movements in a benchmark index. Alpha is annualized. Standard Deviation Statistical measure of how much a return varies over an extended period of time. The more variable the returns, the larger the standard deviation. Investors may examine historical standard deviation in conjunction with historical returns to decide whether an investment's volatility would have been acceptable given the returns it would have produced. A higher standard deviation indicates a wider dispersion of past returns and thus greater historical volatility. Standard deviation does not indicate how an investment actually performed, but it does indicate the volatility of its returns over time. Standard deviation is annualized. The returns used for this calculation are not load-adjusted. FNCE5610 Lecture 5 Page 15 of 15