Investments 101 Return Requirements Liquidity

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Kathryn Richards
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1 Objectives and Constraints Objectives Constraints Investments 101 Return Requirements Liquidity Risk Tolerance Horizon Regulations Taxes Unique Needs Example: young business graduates Low net financial assets Long horizon of future earning potential (human capital) Future expenditure plans (pay off outstanding loans, buy real estate, establish career and family) Issues for young business graduates Begin accumulating financial assets to pay for long term financial goals Because human capital is (relatively) low risk, can probably afford to bear greater risk in financial investments May want to assure that human capital is low risk by buying term life insurance and disability insurance, especially if you have dependents Example: more seasoned/experienced parents of business graduates Higher net financial assets Shorter horizon of future earning potential Future expenditure plans Retirement Health questions Help children become established Questions for seasoned/experienced parents of business graduates Inventory sources of income after retirement After income from human capital stops Estimate future spending plans This results in a plan for savings/investment to meet spending plans 1

graduates Begin accumulating financial assets to pay for long term financial goals Because human capital is (relatively) low risk, can probably afford to bear greater risk in financial investments

2 Diversification Don t Put All Your Eggs in One Basket Most people prefer a smoother (more predictable) path of income & consumption. This is what we mean by risk aversion Concentrating investments increase risk without increasing reward (expected returns) Diversification: General Rules Portfolio of stocks that are chosen randomly and weighted equally become well diversified when you have about stocks. But, this is a dart-board stock selection Most people tend to buy stocks that they know something about because of the industry where they work, the place where they live, the friends they have, their hobbies, etc. Diversification: General Rules If you are not going to use the dart-board method: Buy stocks that are not related to your job Unless there is a big subsidy offered by your employer, avoid buying stock in the company where you work. You are stuck with your human capital (you can t sell it), so don t buy stocks that go up and down with your pay check. Diversification: General Rules Alternatively, you could buy mutual funds No-load funds with low expense ratios Index funds These investment vehicles provide low cost methods of getting diversification and low transactions costs Asset Allocation: How Much Risk Can You Stand? Once you have decided to hold a diversified portfolio (instead of trying to pick winners), you need to decide what mix of: Stocks, bonds, real estate, human capital, etc. This depends on your horizon and how comfortable you are with risk Asset Allocation: How Much Risk Can You Stand? For example, stocks have generally returned more than Treasury Bills over long time horizons. Note that for one year horizons stocks underperform Treasury Bills about one third of the time Relevant if you have big expenditure to pay in the near term. 2

and weighted equally become well diversified when you have about 40-60 stocks.

3 Stock Selection: Who Can Pick Winners Not me; Not mutual fund managers as a group On average Mutual funds underperform the market No evidence that future performance is related to past performance Stock Selection: Who Can Pick Winners Insiders They buy before prices rise and sell before they fall. But it is surprising how small the returns are. Could be due to U.S. laws against trading on material non-public information Could also be due to uncertainty about the quality of insiders information Historical Perspective Price Earnings Ratio Average annual real return is above 8% for stocks from Return is almost always positive if you hold for more than 10 years. In the short term, you can lose substantial amount of money in the stock market. How do you know if the market is too high or too low? Price Earnings Ratio Year P/E and Future Returns Annualized 10 year Return Stock-picking skill You can retire comfortably without ever learning how to pick a stock Price Earnings Ratio 3

material non-public information Could also be due to uncertainty about the quality of insiders information Historical Perspective Price Earnings Ratio Average annual real return is above 8% for

4 Market Timing Don t pull money in and out of the market trying to catch highs or lows Dollar-cost average Rebalance Return/risk tradeoff Earning a high return requires taking more risk, but taking more risk does not necessarily lead to a higher return How risk averse are you? You can t know how much risk you can tolerate until you ve tasted real losses Time value of money Power of compounding Start early Save more Nothing tops the 401(k) When you buy a stock, you think it ll be a winner. But you are buying it from someone who s happy to let it go Triple threat Defer tax on the contribution Matched contribution from employer Tax-deferred growth of your money 4

You can t know how much risk you can tolerate until you ve tasted real losses Time value of money Power of compounding Start early Save more Nothing tops the 401(k)

5 Investing and Speculating There is a difference between investing and speculating Great companies don t necessarily make great stocks A $2 stock can be expensive. A $100 stock can be cheap. Diversification Again Don t put more than 10% of your money in your company s stock Don t put more than 10% of your stock money into one company Trading The more you trade, the lower your returns are likely to be Fundamental law of bond investing Bond prices fall when interest rates rise, and vice versa. So you can lose money on bonds If you hold individual bonds to maturity, you almost never lose your money 5

Diversification Again Don t put more than 10% of your money in your company s stock Don t put more than 10% of your stock money into one company

6 Tax-free Investments Interest on municipal bonds is generally free from federal, state, and local taxes. Treasury bond interest is not subject to state and local taxes, but it is subject to federal taxes. Don t put tax-free bonds into a retirement account. You turn a tax-free investment into a taxable one because you are taxed when you withdraw money from tax-deferred account Mutual Funds Why mutual funds are great? Diversification Transactions costs Book-keeping Convenience Professional management Fund Performance Hot funds will go cold, but costs are forever Index funds beat most other funds over time Behavioral Finance Investors worst enemies are themselves. Be aware of the behavioral biases. Entertainment Value If you really love the entertainment value of trading, put aside 10% of your money (or however much you can afford to lose) for this purpose. You can get 90% of the thrill with 10% of your money. Is there an entertainment value when you are losing? Futures and Options Don t trade futures and options. Highly leveraged. Zero-sum game. Not for long term investment. Not for average investors. 6

You turn a tax-free investment into a taxable one because you are taxed when you withdraw money from tax-deferred account Mutual Funds Why mutual funds are great?

7 Conclusions Planning Diversification Asset Allocation Taxes Behavioral biases 7

Personal Investment Strategies. Personal Investment Strategies

Personal Investment Strategies Bill Schwert June 12, 1999 http://schwert.ssb.rochester.edu Why Do You Save (Invest)? Answers depend on: age dependents income assets liabilities Why Do You Save (Invest)?