Chapter 13 Investing Fundamentals

1. Chapter 13 Investing Fundamentals

2. Chapter 13Learning Objectives • Describe why you should establish an investment program • Assess how safety, risk, income, growth and liquidity affect your investment decisions • Explain how asset allocation and different investments alternatives affect your investment plan • Recognize the importance of your role in a personal investment program • Use various sources of financial information that can reduce risks and increase investment returns

3. Preparing for an Investment Program Objective 1: Describe why you should establish an investment program • ESTABLISHING INVESTMENT GOALS -- accumulating retirement funds -- enhancing current income -- saving for major expenditures -- sheltering income from taxes

4. Preparing for an Investment Program Objective 1: Describe why you should establish an investment program ESTABLISHING INVESTMENT GOALS • Financial goals should be specific and measurable. To develop your goals ask yourself. . . • What will you use the money for? • How much will you need for your goals? • How will you obtain the money? • How long will it take you to obtain the money? • How much risk are you willing to assume in an investment program?

5. Preparing for an Investment Program(continued) • What possible economic or personal conditions could alter your investment goals? • Given your economic circumstances, are your investment goals reasonable? • Are you willing to make the sacrifices necessary to meet your investment goals? • What will the consequences be if you don’t reach your investment goals?

6. Preparing for an Investment Program(continued) PERFORMING A FINANCIAL CHECKUP • Work to balance your budget • Do your regularly spend more than you make • Pay off high interest credit card debt first • Start an emergency fund you can access quickly • Three to nine months of living expenses • Have access to other sources of cash for emergencies • Line of credit is a short-term loan approved before the money is needed • Cash advance on your credit card

7. Preparing for an Investment Program(continued) GETTING THE MONEY NEEDED TO START AN INVESTMENT PROGRAM • How badly do you want to achieve your investment goals • Are you willing to sacrifice some purchases to provide financing for your investments • What do you value • Participate in elective savings programs • Payroll deduction or electronic transfer • Make extra effort to save one or two months each year • Take advantage of gifts, inheritances, and windfalls

8. Preparing for an Investment Program(continued) The value of long term investment program • After graduation, you plan to invest $200 per month in the stock market. If you earn 6% per year on your stocks, how much will you have accumulated after 10 years? • Use time value of money calculation: pmt = 200, I = 6/12 = 0.5, n = 10*12 = 120 FV = ? FV = $32,775

9. Preparing for an Investment Program(continued) The value of long term investment program • After graduation, you plan to invest $400 per month in the stock market. If you earn 6% per year on your stocks, how much will you have accumulated after 15 years? • Use time value of money calculation: pmt = 400, I = 6/12 = 0.5, n = 15*12 = 180 FV = ? FV = $116,327

10. Preparing for an Investment Program(continued) The value of long term investment program • After graduation, you plan to invest $400 per month in the stock market. If you earn 12% per year on your stocks, how much will you have accumulated after 15 years? • Use time value of money calculation: pmt = 400, I = 12/12 = 1, n = 15*12 = 180 FV = ? FV = $199,832

11. Preparing for an Investment Program(continued) The value of long term investment program • After graduation, you plan to invest $400 per month in the stock market. If you earn 12% per year on your stocks, how much will you have accumulated when you retire in 30 years? • Use time value of money calculation: pmt = 400, I = 12/12 = 1, n = 30*12 = 360 FV = ? FV = $?

12. Preparing for an Investment Program(continued) Comparison: $200, 6%, 10 years  32,775 $400, 6%, 15 years  116,327 $400, 12%, 15 years  199,832 $400, 12%, 30 years  1,397,985

13. Factors Affecting the Choice of Investments Objective 2: Assess how safety, risk, income, growth, and liquidity affect your investment decisions • Safety and risk • Safety in any investment means minimal risk of loss • Risk means a measure of uncertainty about the outcome

14. Factors Affecting the Choice of Investments Company A Company B

15. Factors Affecting the Choice of Investments • To get a general idea of a stock’s price variability, we could look at the stock’s price range over the past year. 52 weeks Yld Vol Net Hi Lo Sym Div % PE 100s Hi Lo Close Chg 134 80 IBM .52 .5 21 143402 98 95 9549 -3 115 40 MSFT … 29 558918 55 52 5194 -475

16. Factors Affecting the Choice of Investments • Investments range from very safe to very risky Annual Rates of Return 1926-2002 Standard Deviation Real Average Return Small- 33.2% 13.8% Stock Large- 20.5 9.1 Stock Long-term 8.7 3.1 Corp-bond Long-term 9.4 2.7 Gov-bond U.S. Tre-bill 3.2 0.7

17. Factors Affecting the Choice of Investments • The potential return on any investment should be directly related to the risk the investor assumes • Speculative investments are high risk • The Risk-Return Trade-Off

18. Factors Affecting the Choice of Investments (continued)

19. Factors Affecting the Choice of Investments (continued) Calculate return on an investment • Rate of return: income you receive on an investment over a specific period of time divided by the original amount invested • Buy 1000 shares of Microsoft at $25, sell it at $30 a year later, and you receive $1 dividend per share. What is the rate of return for this investment? • Capital gain: 1000 * (30-25) = $5,000 • Dividend: $1*1000 = $5,000 • Total income: 5000 + 5000 = $10,000 • Rate of return : 10,000 / (25* 1000) = 40%

20. Factors Affecting the Choice of Investments (continued) COMPONENTS OF THE RISK FACTOR • Inflation risk - during periods of high inflation your investment return may not keep pace with the inflation rate • Interest rate risk - you may invest in a bond at a 6%, rates later go up to 8%; your bond price falls • Business failure risk - bad management or products affect stocks and corporate bonds and mutual funds that invest in stock • Market risk - prices fluctuate because of behaviors of investors • Global investment risk - changes in currency affect the return on your investment

21. Factors Affecting the Choice of Investments (continued) INVESTMENT INCOME • Safest investments – predictable income • Savings accounts and certificates of deposit • U.S. savings bonds • United States treasury bills • Higher potential income investments include… • Municipal bonds • Corporate bonds • Preferred stocks and income common stocks • Income mutual funds • Real estate rental property

22. Factors Affecting the Choice of Investments (continued) INVESTMENT GROWTH • Growth means investment will increase in value • Common stock • Growth companies pay little or no dividends, but reinvest in the company • Mutual funds, government and corporate bonds, and real estate offer growth potential • Gemstones and collectibles - more speculative • INVESTMENT LIQUIDITY • Ability to buy or sell an investment quickly without substantially affecting the investment’s value; e.g. Real estate is not a very liquid investment

23. Asset Allocation and Investment Alternatives • Asset Allocation • The process of placing your assets among several types of investments which lessens your investment risk • Types of assets -- stocks of large corporations -- stocks of medium-sized corporations -- stocks of small companies -- foreign stocks -- bonds -- cash

24. Asset Allocation and Investment Alternatives(contined)

25. Asset Allocation and Investment Alternatives(contined)

26. Asset Allocation and Investment Alternatives(contined) • Time Factor • The longer that you are invested the better your returns • Your Age • The type and style of your investments should change with your age

28. Asset Allocation and Investment Alternatives Investment alternatives Stock or equity financing • Equity capital is provided by stockholders who buy shares of a company’s stock. • Stockholders are owners and share in the success of the company. • A corporation is not required to repay the money obtained from the sale of stock. • The corporation is under no legal obligation to pay dividends to stockholders: they may instead retain all or part of earnings.

29. Asset Allocation and Investment Alternatives(continued) CORPORATE AND GOVERNMENT BONDS • A bond is a loan to a corporation, the federal government, or a municipality • Bondholders receive periodic interest payments, and the principal is repaid at maturity (1-30 years) • Bondholders can keep the bond until maturity or sell it to another investor before maturity

30. Asset Allocation and Investment Alternatives(continued) • Mutual funds • Investors’ money is pooled and invested by a professional fund manager • You buy shares in the fund • Provides diversification to reduce risk • Funds range from conservative to extremely speculative • Match your needs with a fund’s objective

31. Asset Allocation and Investment Alternatives(continued) REAL ESTATE • The goal of a real estate investment is to buy a property and sell it at a profit. Nationally, 3% appreciation in price a year is average. • Location, location, location is important. • Before you buy real estate... • Is the property priced competitively? • What type, if any, of financing is available? • How much are the taxes? • What is the condition of the buildings and houses in the immediate area? • Why are the present owners selling? • Could the property decrease in value?

32. Asset Allocation and Investment Alternatives(continued) OTHER SPECULATIVE INVESTMENTS • Speculative investments • A speculative investment is a high-risk investment made in the hope of earning a relatively large profit in a short time Typical speculative investments include: • Antiques and collectibles • Call and put options • Derivatives • Commodities • Coins and stamps • Precious metals and gemstones

33. A Personal Plan for Investing • Establish realistic goals • Determine the amount of money needed to meet your goals • Specify the amount of money available to fund your investments • List different investments you want to evaluate • Evaluate risk and potential return for each • Reduce possible investments to a reasonable number • Choose at least two different investments • Continue to evaluate your investment program

34. Factors that Reduce Investment Risk Objective 4: Recognize the importance of your role in a personal investment program YOUR ROLE IN THE INVESTMENT PROCESS • Evaluate potential investments • Seek the assistance of a financial planner (see Appendix at the back of the text) • Monitor the value of your investments • Keep accurate and current records • Consider the tax consequences of selling your investments

35. Sources of Investment Information Objective 5: Use the various sources of financial information that can reduce risks and increase the investment returns • The Internet • A wealth of investment information is available • View sites such as www.fool.com and www.money.cnn.com • Newspapers and news programs • Business periodicals such as Smart Money and government publications • Corporate Reports • Investor services and newsletters, such as ValueLine or Morningstar and financial calculators