Transcript Diversification

., REVIEW BOOK: Personal Finance. Retrieved Oct 1, 2009 from http://www.flatworldknowledge.com/node/50890
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What are your financial goals?
 Financial Independence
 Just starting your own financial life apart from your
parent(s)/guardian(s)
 Financial Stability
 Managing all of your financial resources effectively, but
unprepared to meet financial emergencies
 Financial Security
 The ability to manage and absorb financial
emergencies
 IMO, one of the best and easiest ways to attain
Financial Security is to create passive income
through investments
Ways To Earn $1,000,000
 Invest $1 a day at 5% for 100 years
 Invest $1 a day at 10% for 56 years
 Invest $1 a day at 15% for 40 years
 Invest $1 a day at 20% for 32 years
 Invest $10 a day at 20% for 20 years
(approximately $300 a month)
 Invest $850 a month at 20% for 10 years
A Primer on Financial Investment Options
1. Federal Government Securities


Treasury Securities
U.S. Savings Bonds
 What are the costs/benefits of investing your money in
the federal government from a household’s cost-benefit
perspective?

Low risk




no default risk
Highly liquid
Earnings are exempt from state and local taxes
Relatively low rates of return

price of safety
2. Bonds (non-Federal govt) - issued by municipal governments and
corporations to raise money needed for a long period of time. Once
you purchase them, you earn a fixed, simple interest income for the
life of the bond or until you sell it.

Costs and benefits

default risk varies (2.25% junk bonds to 0.15% all bonds)

very liquid

inflation risk is high because bonds are purchased at a fixed
interest rate

Municipal bonds are federal tax-free
Effective Yield of a Tax-Free
Investment
 Not paying tax effectively increases your rate of
return
 you get to keep all of your profits, instead of only
a portion


r
 1  taxbracket 100


 Example: 28% tax bracket, 5% rate of return
 .05 
 1  .28 100


= 6.94%
Descriptive Terms for Bond Features
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Bond Ratings
A plus sign (“+”) following a rating indicates that it is likely to be upgraded, while a minus sign (“-“) following a rating indicates
that it is likely to be downgraded.
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Bond Prices, Bond Yields, and Interest
Rates
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Bond Characteristics and Risk
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3. Certificates of Deposit - long-term deposits with
institutions


purchased from banks, S&L’s, credit unions
purchased from a stock broker
 Costs and benefits



low default risk (marginally greater with stock
broker)
some liquidity risk (less with stock broker)
sometimes inflation risk (less w/ variable rates)
4. Precious Metals typically viewed as a major
alternative to holding currencies. Thus, in
inflationary times (when money is losing value)
the demand for precious metals rises, bidding up
their prices.



gold
silver
platinum
 Costs and Benefits


high market volatility risk
very low inflation risk
5. Stock Market investing
 2 types of people
 Investing in the stock market = gambling
 I know I should invest in the stock market, but I’m not sure
where to start
 The nature of business
 Businesses sell stock to raise capital
 Investing in the stock market is simply investing in
companies
5. Stock Market investing
 Stocks are a claim on the net earnings of a
company after the claims of creditors are satisfied.
Returns of investment in stocks can take the form
of:


interest income (dividends)
capital gains (appreciation or growth)
 Costs and benefits


higher default risk (can be reduced through
diversification)
somewhat illiquid (can always sell, but perhaps not
at the price you’d like)
Stocks - Costs and benefits continued:


little inflation risk
high time/money costs associated with managing
stock investments unless one diversifies.
Shanghai Stock Exchange (SSE)
Stock Comparisons
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Playing the Stock Market
February 2008/September 29, 2009
COMPANY / INDUSTRY
SHARE PRICE
COMPANY / INDUSTRY
SHARE PRICE
Exxon / Oil & Gas (XOM)
$81.44/$69.11
Hawaiian Airlines / Airline
(HA)
$4.82/$8.23
Chevron / Oil & Gas
(CVX)
$92.32/$71.15
Idenix Pharmaceuticals /
Health Care (IDIX)
$4.94/$3.10
Fairfax Financial Holding/
Property Insurance (FFH)
$308.15/$379.48
Maxwell Technologies /
Hybrid Vehicles (MXWL)
$7.78/$18.30
Landauer Inc. /
Healthcare (LDR)
$49.84/$54.64
Hasbro / Recreational
Products (HAS)
$24.75/$27.44
Colgate-Palmolive /
Consumer Goods (CL)
$74.46/$76.59
Disney / Entertainment
(DIS)
$31.50/$28.07
Rangold Resources/
Gold (GOLD)
$42.60/$68.35
Wal-Mart / Retail (WMT)
$48.83/$49.50
Amgen / Biotechnology
(AMGN)
$46.31/$60.86
Gilead Sciences Inc /
Biopharmaceuticals
(GILD)
$44.87/$46.18
Halliburton / Engineering
& Construction (HAL)
$34.09/$27.10
Fred’s / Retail (FRED)
$8.63/$12.68
Ross Stores / Retail
(ROST)
$27.09/$48.23
Wells Fargo / banking
(WFC)
$30.08/$28.60
Micron / Computer
Hardware (MU)
$7.84/$8.23
Harley Davidson (HOG)
$37.16/$23.04
What is the Yield or Rate of Return on a
Financial Investment?
Percentage Change:
 new  old  

100


old

Find the percentage change of each of your 3
stocks, and then find your average rate of return
(assuming 1 share of each stock)
Compound Annual Growth Rate
(Annualized Return)
 A problem with talking about average investment
returns is that there is real ambiguity about what
people mean by "average". For example, if you had
an investment that went up 100% one year and then
came down 50% the next, you certainly wouldn't say
that you had an average return of 25% = (100% 50%)/2, because your principal is back where it
started: your real annualized gain is zero.
 In this example, the 25% is the simple average, or
"arithmetic mean". The zero percent that you really
got is the "geometric mean", also called the
"annualized return", or the "CAGR" for Compound
Annual Growth Rate.
What is the Yield or Rate of Return on a
Financial Investment?
 Annualized Percentage Change:


  new  old 

  1  100
1  
old





1
n
Example: original price=$20/share, current
price=$100/share, stock held for 9 years
What is the Yield or Rate of Return on a
Financial Investment?
1


9


 100  20 
  1  100
1  
20






=19.58%
Examples of Security Indexes
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Annualized Return of the S&P 500(adjusted for inflation)
http://www.moneychimp.com/features/market_cagr.htm
2008
-37.22%
2007
5.46%
2006
15.74%
2005
4.79%
2004
10.82%
2003
28.72%
2002
-22.27%
2001
-11.98%
2000
-9.11%
1999
21.11%
1998
28.73%
1997
33.67%
1996
23.06%
NASDAQ Composite Index, 1991-2002
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Stock Market Average Returns
by decade (not adjusted for inflation)
1900s
1910s
1920s
1930s
1940s
1950s
1960s
1970s
1980s
1990s
9.88%
4.67%
15.47%
-0.12%
9.06%
19.61%
7.78%
5.80%
17.68%
18.30%
Some Numbers…
 How would $1 invested in 1872 grow, with the interest and






dividends reinvested, if held until 2000?
A $1 investment in a portfolio comprised entirely of stocks
would grow to $6,410.
Invested in a portfolio comprised of 75 percent stocks and
25 percent bonds, the $1 would grow to $2,706.
A 60 percent stock and 40 percent bond portfolio would
grow to $1,484.
A portfolio weighted with 75 percent bonds would grow to
$289.
For the period 1871 to 1996, stocks outperformed bonds
59.5% of the time over a one-year holding period, but
when the holding period was 10 years, stocks
outperformed bonds 82.1% of the time
When the holding period was 30 years, stocks always
outperformed bonds.
Some Numbers…
http://radio.weblogs.com/0103811/2003/05/06.html
 From 1926-2003




Nominal return of the entire stock market =
12.56%
Compounded nominal annual rate of return =
10.7%
Compounded real annual rate of return = 7%
Of course, this is no guarantee of future
performance, but it gives us some room for
estimation
How to research an investment
 Talk to your broker


Traditional brokerage house
Discount brokerage house
 Research online


Most brokerage firms have research pages you can
search
Can use the finance sections of yahoo.com,
moneycentral.msn.com, and etc.
Ratios and Their Uses
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Stock Market investing
 Some terms:
 Bear market = general time of falling prices
 Bull market = general time of rising prices
 Margin = borrowing money from your broker to purchase
securities
 Dollar Cost Averaging (DCA)
 Committing a set amount of money per month, and always
purchasing securities with that money
 ‘Averaging’ means that you purchase more shares when the
price is down and fewer shares when the price is high.
 Caution: DCA may not be all it is purported to be
 http://moneycentral.msn.com/content/P104966.asp
Definition
Role
Growth Stock
Underestimated potential
for growth
Expect a higher rate of
return and no dividends.
Value Stock
Undervalued by the
market; under-priced
Expect a higher than
average return.
Defensive Stock
Less volatility than the
overall market and less
sensitive to market
changes.
Expect the value to fall
less than the market’s
during a market decline
Stock Market investing, cont.
 Really good information available at
http://beginnersinvest.about.com/ especially under
the “Investing 101” and “Investing Lessons” links
 Bottom line  commit to do it, and then just do
it!
Lessons from
Warren Buffet
We care because he is one of
the wealthiest Americans
Why listen to him?
 He is the single most successful stock market
investor in history.
 If you had put $10,000 in his investment
company Berkshire Hathaway (BRK.A) when
it was created in 1965 ($19/share), you would
have about $53,163,160 today $101,010
Sept. 29, 2009). The S&P stock index for the
same amount and length of time you would
only have $500,000.
Starting young
 He bought his first share of stock at age 11
and he now regrets that he
started too late!
 He bought a small farm at age 14 with
savings from delivering
newspapers.
His advice to young people:
 Stay away from credit cards and invest in yourself
 Money doesn't create man, but it is the man who





created money.
Live your life as simple as you are.
Don't do what others say. Just listen to them, but do
what makes you feel good.
Don't go on brand names. Wear those things in
which you feel comfortable.
Don't waste your money on unnecessary
things. Spend on those who really are in need.
After all, it's your life. Why give others the chance to
rule your life?
6. Mutual Funds - pool of resources created by
investing organization. Resources are invested in
a wide array of financial instruments including:





precious metals
stocks
bonds
real estate
government securities
 Mutual funds are distinguished by what they
invest in.
 Costs and Benefits




Broad diversification
Less time spent in financial management (benefit
from professional manager)
Tax implications (capital gains)
Fees
A basic mutual fund that has no or low
fees is a ….
 No-Load Index Fund

Dow Jones Industrial Average



Comprised of 30 stocks
More expensive stocks influence the avg
S&P 500



Index, so the value itself is meaningless; must
compare to other years
Base = 1941-1943 = 10
If the index = 1000, the average stock price has
increased 100 times
What are some of Heather’s objections
to mutual funds?
 80% of mutual funds underperform the stock
market in general because of FEES
 Too many stocks dilute returns

Warren Buffett says not to have more than 12
 The average actively managed fund returns
2% less per year than the market in general
 Over 50 years, $10,000 grows to


$1,173,908 at 10%
$469,016 at 8%
Mutual funds are structured in three
ways:
 Closed-end funds
 Open-end funds (most funds)
 Exchange-traded funds (ETF)
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Value of Mutual Funds
 Net Asset Value (NAV)


NAV = (Market value of fund securities – fund
liabilities ÷ number of shares outstanding.
NAV is usually calculated once per day at the
close of trading except for EFTs.
A Mutual Fund Example
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So, what drives households’
investment choices?
 Very little active investment on the part of
households -- why?




High time costs
Risk averse nature
Time horizons
View financial investment as “residual” category of
household expenditures
Do people really own FC investments?
 52% of Americans own stocks or stock-based
mutual funds
 Financial assets represent 42% of people’s assets

Stocks/stock funds = 34% of assets
Retirement accounts = another 28% of assets

2001 SCF – cited in Azicorbe & Kennickell (2003)

Major Asset Bubbles Since 1636
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Key Takeaways
Commodities are
•natural or cultivated resources.
•traded to hedge revenue or production needs or to speculate on resources’ prices.
•traded on commodities exchanges through brokers.
Derivatives are instruments based on the future, and therefore uncertain, price of another security,
such as a share of stock, a government bond, a currency, or a commodity.
Mutual funds are portfolios of investments designed to achieve maximum diversification with
minimal cost through economies of scale.
An index fund is a mutual fund designed to replicate the performance of an asset class or selection
of investments listed on an index.
An exchange-traded fund is a mutual fund whose shares are traded on an exchange.
Institutional and individual investors differ in the use of different investment instruments and in
using them to create appropriate portfolios
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Key Takeaways
Bonds are
• a way to raise capital through borrowing,
used by corporations and governments.
• an investment for the bondholder that
creates return through regular fixed or
floating interest payments on the debt
and the repayment of principal at
maturity.
• Traded on bond exchanges through
brokers.
Key Takeaways
Stocks are
• a way to raise capital through selling
ownership or equity.
• an investment for shareholders that creates
return through the distribution of corporate
profits as dividends or through gains (losses)
in corporate value.
• traded on stock exchanges through member
brokers.
Key Takeaways
 Commodities are



Natural or cultivated resources.
Traded to hedge revenue or production
needs or to speculate on resources’ prices.
Traded on commodities exchanges
through brokers.
Key Takeaways
 Derivatives are

Instruments based on the future, and
therefore uncertain, price of another
security, such as a share of stock, a
government bond, a currrency, or a
commodity.
Key Takeaways
 Mutual funds are

Portfolios of investments designed to
achieve maximum diversification with
minimal cost through economies of scale.


An index fund is a mutual fund designed to
replicate the performance of an asset class or
selection of investments listed on an index.
An exchange-traded fund is a mutual fund
whose shares are traded on an exchange.