Finance: Personal Another Perspective
Investments 1:
Before you Invest
1
Objectives
A. Know what to do before you invest
B. Understand the ten principles of successful
investing
C. Understand the major asset classes
D. Review the risk and return history of the
major asset classes
2
Where We Are . . . .
We have completed thus far:
Putting Personal Financial Management into
perspective.
You are living on a budget and know where
your resources go
You are managing your short-term money
wisely
You have protected yourself through insurance
You are making wise big-ticket purchases
We now will begin the section on investing for the
long-term
3
Your Personal Financial Plan
Section XII: Investment Plan
Includes your detailed Investment Plan (you can
copy an outline from TT05A and that instructions
are TT5B)
I. What are your risk and return objectives?
II. What are your investment guidelines and
constraints?
III. What is your Investment Policy?
IV. When will you Evaluate, Modify, and
Communicate results?
Includes your current investments and allocations
4
Your Financial Plan (continued)
Action Plan:
What are you proposed investments and allocations?
Include copies from any financial source, i.e.,
Morningstar, Yahoofinance, etc., on a minimum
of 4 financial assets you will invest in:
Emergency Fund or Funds
Core Financial Asset or Assets
Diversification Asset or Assets
Opportunistic Asset or Assets (only if you
want)
Include TT27 Expected Return Simulation and
TT13 Investment Process spreadsheet
5
Investment Assignments for Today
Investments 1: Before you Invest
1. Copy Teaching Tool 5A: Investment Plan
Example
2. Add your information and complete the
introduction to each of the four sections
3. Take TT16: Risk Tolerance test. Determine the
type of investor you are: very conservative,
conservative, moderate, aggressive, very aggressive
4. Develop your preliminary asset allocation
targets, i.e., your weights of stocks, bonds, and cash
in your portfolio for before retirement and after
retirement from your risk tolerance test.
6
Investment Assignments for Today (continued)
Investments 4: Bond Basics
1. Bond Volatility. Open TT23: Return Simulation
for Asset Classes. Look at the amount of volatility
for bonds compared to other asset classes in the tab
labeled Charts when you push F9 (calculate)
2. Bond Returns. Open TT27: Expected Return
Simulation and Benchmarks. Go to the tab labeled
Returns and Risk. Review the 1, 5, 10, 25, etc.
year return for bonds compared to other asset
classes. Are they more or less volatile? Higher or
lower returns?
3. Think about what percentage of your portfolio
should be in bonds from your risk tolerance results.
7
Teaching Investments
Please note that I teach investment differently
from that taught in most textbooks
Most textbooks take a financial assets approach,
which will change over time.
New assets are always being developed and
sold
A principles-based approach is better
The principles should not change over time
8
Teaching Investments (continued)
Teaching Investments is really learning about
six key questions:
1. What are financial markets?
How do they operate?
2. What are asset classes?
Why are they important?
3. What are financial assets/instruments?
What are their advantages and disadvantages
(i.e., their return and risk)?
9
Teaching Investments (continued)
4. What is your asset allocation?
How will it change over time?
5. What is your Investment Plan (i.e., your
investment objectives, guidelines and
constraints)?
How will you invest?
6. How will you build your portfolio?
How will you monitor it as well?
10
A. Questions to Ask Before you Invest
What should you do before you start
investing?
Is there a priority to paying bills?
Who/which bills should we pay first?
Are there certain things you should never do
without?
What about health and life insurance?
Are their other bills more important than
investing?
What about high-interest items such as credit
cards and consumer loans?
Is there a purpose to investing?
11
Before You Invest: The Hourglass Top
1. Are your priorities in order and are you square with the Lord?
2. Do you have adequate health and life insurance?
3. Are you out of high-interest rate credit card and consumer debt?
4. Have you written down your personal goals, do you live on
a budget, and do you have a well-written investment plan?
If you can answer these affirmatively, you are ready to invest !12
Before you Invest (continued)
What does the top of the hourglass do?
It helps you keep your priorities in order
And what should those priorities be?
God
Family
Personal responsibility
Your personal goals, budget, and a well-written
Investment Plan
13
Questions
Do you know what questions you should ask
and what you should do before you invest?
14
B. Understand the 10 Principles of
Successful Investing
Is there one right way to invest?
No. There are multiple ways and multiple
methods depending on your personal goals and
budget
The key is for you to know yourself and what
you are trying to accomplish
Is there one right way to teach investing?
No. But while there are many different ways, the
principles should be the same.
15
Principles for Successful Investing (continued)
How have most equity investors done?
Each year, DALBAR puts out an annual book on
Quantitative Analysis of Investor Behavior. It
discusses how average equity fund investors have
done versus the benchmark over the past 20 years.
Year
2006
2007
2008
2009
2010
2011
* Dalbar 2005- 2009
Period
1986-2005
1987-2006
1988-2007
1989-2008
1990-2009
1991-2010
Investor
Returns*
3.9%
4.3%
4.5%
1.9%
3.2%
3.8%
Index
Returns
11.9%
11.8%
11.8%
8.4%
8.2%
9.1%
Difference
-8.0%
-7.5%
-7.3%
-6.5%
-5.0%
-5.3%
16
Principles for Successful Investing (continued)
How have most bond investors done?
DALBAR points out that bond investors have done
equally poorly versus the bond benchmark over the
past 20 years.
Year
2006
2007
2008
2009
2010
2011
Period
1986-2005
1987-2006
1988-2007
1989-2008
1990-2009
1991-2010
Investor Index
Returns* Returns
1.8%
9.7%
1.7%
8.6%
1.6%
8.0%**
0.8%
7.4%
1.0%
7.0%
1.0%
6.9%
Difference
-8.1%
-6.9%
-6.4%
-6.6%
-6.0%
-5.9%
Dalbar QAIB 2007- 2011, www.dalbar.com, ** Estimate, not
given in report
17
Principles for Successful Investing (continued)
Elder Dallin H. Oaks commented:
We live in a complex society, where even the simplest
principle can be exquisitely difficult to apply. I admire
investors who are determined not to obtain income or
investment profits from transactions that add to the
sum total of sin and misery in the world. But they will
have difficulty finding investments that meet this high
standard. Such complexities make it difficult to
prescribe firm rules. We must rely on teaching correct
principles, which each member should personally
apply to govern his or her own circumstances (Dallin
H. Oaks, Brothers Keeper, Ensign, Nov. 1986, 20).
18
Principles for Successful Investing (continued)
1. Know yourself
Know your goals
Have well-written and thought-out goals
Know your budget
Live within your means, and save and invest
Know your ability to tolerate risk
Know what kind of investor you are
Invest accordingly
Develop a sleep-well portfolio based on
principles you can depend on for a lifetime so
that you can sleep well at night
19
Principles for Successful Investing (continued)
Watch overconfidence
Men trade 45% more than women
Their annualized returns were 2.7% less
Single men trade 67% more than single women
Their annualized returns were 1.4% less
Most investors have significantly (> 5% a year)
underperformed the market over the last 20 years
(DALBARs Annual Quantitative Analysis of Investor Behavior 2011)
Watch on-line trading
Before on-line, investors beat the market by 1.9%
Afterwards, they underperformed by 3.6%
Carla Fried, The Problem with your Investment Approach, Business 2.0,
November 2003, p. 146
20
Principles for Successful Investing (continued)
2. Understand Risk
Risk is inherent in all investing activities
There are lots of different types of risk
Inflation, business, interest rate, financial,
market, political and regulatory, exchange
rate, call, and liquidity risk
Invest at a risk level you are comfortable with
Find that risk level
Taking a risk tolerance test may help. Take
TT16 A Risk Tolerance Test to get a sense
on how much risk you can tolerate
21
Principles for Successful Investing (continued)
3. Stay diversified
Always invest in different asset classes and assets
Diversification is your key defense against risk
Make sure you understand the risks of each
and every asset class you invest in
Its a risky place out there. Be prepared!
Remember that the numbers you see for
specific asset class performance are from
diversified portfolios, not single assets!
Use TT23 Return Simulation Worksheet
to see the effects of diversification
22
Principles for Successful Investing (continued)
4. Invest low cost and tax-efficiently
Control what you can.
You cannot control returns, but you can control
your costs, fees, and taxes
A $1 saved is more than a $1 earned
because:
You pay taxes on every new dollar
earned, and a dollar saved can earn
income and income on income
(compound interest)
Realize that frequent trading incurs significant
costs, both in terms of transactions costs and
taxes
23
Source: Jason Karceski, Miles Livingston, Edward ONeal, Mutual Fund Brokerage
Commissions, January 2004, p. 12.
24
Source: Jason Karceski, Miles Livingston, Edward ONeal, Mutual Fund Brokerage Commissions, January 2004, p. 12.
Principles for Successful Investing (continued)
Defer or eliminate taxes as much as possible
Remember, mutual funds distribute 90% of all
capital gains and dividends each year that you must
pay taxes on
Invest tax-efficiently so you dont have to pay
more taxes each April
Its not what you make, but what you keep after
taxes and inflation that makes you wealthy
25
Principles for Successful Investing (continued)
5. Invest long-term
Avoid short-term and day trading
Its expensive and generates transactions costs
and taxes
Invest wisely
There are no get-rich-quick schemes that work.
Stay at least partly in the market
Taking money out of the market or not
continuing to save and invest stops your
progress
26
Trading Costs and Returns
27
Principles for Successful Investing (continued)
6. If you must invest in individual assets, know
what you invest in and who you invest with
When investing in individual assets, do your
homework
Know what you are investing in
Know who you are investing with
Be aware of the environment in which the
company operates
Be very careful and invest wisely
28
Principles for Successful Investing (continued)
7. Monitor portfolio performance
Measure performance. President Thomas S.
Monson stated:
When performance is measured, performance
improves. Where performance is measured and
reported, the rate of improvement accelerates
(General Conference reports, 1970).
How can you know how you are doing if
you dont check your performance against
some benchmark?
Interestingly, most investors have underperformed
the market benchmarks over the last 20 years
(DALBARs Annual Quantitative Analysis of Investor Behavior 2011)
29
Principles for Successful Investing (continued)
8. Dont waste too much time, money, and
energy trying to beat the market, unless you
have a lot of time, money, and energy
It is very difficult, expensive, and time consuming
to try and beat the market
If you want to trade, trade tax-efficiently and in
tax-deferred accounts
If your actively managed funds underperform, look to index funds as inexpensive,
tax efficient and very viable alternatives to
actively managed funds
30
Principles for Successful Investing (continued)
9. Invest only with high quality, licensed, and
reputable people and institutions
When help is needed, dont be afraid to get help.
But get good help from good people consistent
with the principles discussed
And compare the performance of that help to
your benchmarks after taxes (and to a passive
portfolio)
Use the best resources available
Know how those resources are compensated
Work only with licensed and registered advisors
Get references for any resources
31
Principles for Successful Investing (continued)
10. Develop a good investment plan consistent
with your goals, budget, and these principles,
and follow it closely
Think it through and write it wisely
Its your roadmap to success
If you write it wisely and invest accordingly, it will
save you much heartache in the future
And you will likely achieve your personal goals
32
Questions:
Do you understand the ten principles of
successful investing and why they are
important?
33
C. Understand Asset Classes
Investing is similar to going to an amusement
park.
People go (invest) on rides in areas they like:
Higher risk investments are like the roller
coaster--they require a stronger stomach, but the
thrill (and return) is generally much greater
Lower risk investments are like the merry-goround. While they are fun, they may be too
sedate for some investors
Other rides are in-between
The key is to find out what you like to ride on and
to ride on that ride!
34
Asset Classes (continued)
What are asset classes?
Asset classes are broad categories of investments
with specific (and similar) risk and return
characteristics
How are they distinguished?
Asset classes are distinguished by characteristics
specific to particular groups of securities, such as
type of financial instrument, market capitalization,
maturity, geographic location, etc.
What are the major asset classes?
Cash and cash equivalents, fixed income, and
equities
35
Cash and Cash Equivalents
Major Goal
Liquidity and to preserve capital
Cash includes CDs, money market funds, Tbills, and commercial paper, etc.
Offers a fixed rate of return
Cash includes:
Money market funds which seek to preserve the
value of your investment and still offer
competitive returns
Short-term interest-bearing investments includes
Treasury bills and Savings Bonds, loans to the
U.S. Government, and commercial paper, loans
to corporations
36
Cash and Cash Equivalents (continued)
Advantages
Liquidity and stability of principal. You can turn
these into cash quickly and easily
Low risk. There is little risk of losing principal
since the borrowers have good credit and loans are
for short periods
Good investment for money you plan to use in less
than 3-5 years and dont want to take risks
Disadvantages
Less attractive as medium-to-long-term
investments (> 5 years) as returns on cash and cash
equivalents are unlikely to keep up with inflation
37
Cash and Cash Equivalents (continued)
Thoughts on Cash:
Cash is great for liquidityespecially for your
Emergency Fund
However, returns on cash are unlikely to keep
up with taxes and inflation
Use cash for liquidity and some
diversification, but realize that this asset
class will add little to performance
38
Fixed Income (or Bonds)
Major Goal
Provide income and to earn returns in excess of
inflation
There are two different types of fixed income
assets:
Taxable bonds include U.S. Treasuries,
corporate bonds and agency issues (bonds
issued by U.S. government agencies, like
Ginnie Mae).
Tax-free bonds include revenue or general
obligation bonds issued by local or state
governments and agencies. Such bonds are
generally free from federal and state taxes.
39
Fixed-income (continued)
Types of Fixed-Income Investment Vehicles:
Short-term bonds/bond funds
Bonds that mature in < 5 five years
Short-term bonds are less vulnerable to
interest rate risk than long-term bonds
Generally considered good investments for
anyone needing a dependable stream of
income (dividends)
Intermediate-term bonds/bond funds
Bonds with a maturity of 310 years
These are more susceptible to interest rate
risk
40
Fixed-income (continued)
Long-term bonds/junk bonds/bond funds
Bonds with a maturity of 10 or more years
These have the highest yields, but are the
most vulnerable to interest rate volatility
Inflation Protected securities
Securities whose yield is linked to the rate of
inflation as measured by a specific inflation
index
U.S. Government Savings bonds
I Bonds: Interest rate linked to inflation
EE Bonds: Fixed interest rate
41
Fixed-income (continued)
Bond mutual funds
Different from buying individual bonds. Mutual
funds buy and sell bonds before they mature
Investing in a fund means you are buying a share in
thousands of different bonds in a changing
portfolio.
Income from fixed-income fund fluctuates as
mutual funds buy and sell bonds.
The market value of your fund changes depending
on whether the fund is selling bonds at a loss or
gain.
The longer the maturity of the bonds (see the
average maturity) the more dramatically your
principal will gain or lose value as interest rates
42
Fixed-income (continued)
Advantages
Offers greater return than cash, but greater risk
Good diversification tool when holding a long-term
stock portfolio, as bonds move differently than
stocks
Disadvantages
Returns have been historically lower than stocks
Very susceptible to interest rate and other risks
Generally, fixed income assets alone are not good
long-term investments because they dont provide
enough growth to beat inflation over long periods
of time. Must be part of an overall portfolio
43
Fixed-income (continued)
Thoughts on fixed income
You get a fixed interest and the future principle
Investment income and capital gains may be
subject to federal, state, and local taxes.
The longer the bonds maturity, the higher the
yield. This "interest rate risk" is because your
principal is exposed for a longer period of time.
The lower the borrowers credit rating the higher
its risk, and the higher the interest you receive.
The value of your principal is not fixed because the
price of bonds fluctuates with changes in interest
rates. If interest rates rise, your bond becomes less
valuable, unless you hold till it maturity.
44
Equities (or Stocks)
Major Goal
Provide growth and earn returns in excess of
inflation. Over long periods of time, the stock
market historically has been the only major asset
class to consistently outpace inflation
A share is ownership in a businesses earnings
and assets
You get a proportionate share of the profits by
receiving dividends, and also benefit from
increases in the companys share price
Mature companies are a likelier source of
dividends (rapidly growing companies often
prefer to reinvest profits)
45
Equities
(continued)
Equity asset classes
Asset classes are delineated by market
capitalization (which is shares outstanding
multiplied by the stock's current market price),
type of company (growth versus value), and
geographic area.
The benchmarks for each asset class tend to
change over time, but equity asset classes can
be generally defined as follows:
Capitalization: Large, mid, and small
Type: Growth, blend, and value
Geographic area: US, international, global
and emerging markets
46
Equities
(continued)
What is market capitalization?
It is one measure of the size of a company.
How is it calculated?
It is calculated by multiplying the market price of
the stock by the number of shares (i.e. ownership
pieces) outstanding. The greater the capitalization,
the larger the company
How is it used?
It is used to weight companies in various
benchmarks
It is used to determine certain classes of companies,
i.e. large-cap, mid-cap, small-cap, etc.
47
Equities
(continued)
Large-cap (capitalization) stocks
Large caps are stocks with a market capitalization
greater than $10 billion in the US, and smaller
capitalizations for international companies
These are the generally the largest, most well
established companies in the US, with a history of
sales and earnings as well as notable market share
Traditionally, large cap was synonymous with
"dividend-paying company," but this is no longer a
standard for classification.
These are generally mature corporations with a long
track record of steady growth and dividends
48
Equities
(continued)
Mid-cap or mid-capitalization stocks
These are stocks with capitalization between
roughly $2 billion and $10 billion
These stocks tend to grow faster than big cap
companies, and are generally less volatile than
small cap companies
Mid-caps generally perform similar to the smallcap asset class. For asset-allocation purposes, midcaps are generally not considered a major asset
class.
49
Equities
(continued)
Small-cap or small capitalization stocks
Small-cap stocks are companies with a market
capitalization less than $2 billion
These are smaller, sometimes newer, US and
global companies that are still developing and may
have a smaller market share than their large-cap
counterparts.
Small-cap stocks are subject to greater volatility
and may fail more frequently than companies in
other asset categories, but are generally expected to
grow faster than bigger companies
50
Equities
(continued)
Within the equity stock categories are two
separate types of stocks: growth and value
Growth stocks
These are fast-track companies whose earnings
are expected to grow very rapidly. Frequently
these are companies developing new
technologies or new ways of doing things
Value stocks
These are inexpensive (in terms of low PE and
low P/BV ratios), companies that have potential
for good long-term return through both
appreciation and dividends
Blend stocks part of both value and growth
51
Equities
(continued)
International/Global/Emerging Market stocks
These are stocks of companies based entirely
outside the U.S. or throughout the world
These can be of any size (small-cap, large-cap),
any type (value, growth) and from any part of the
world. Funds that contain a mixture of U.S. and
foreign holdings are called global funds.
International investments involve additional risks,
which include differences in financial accounting
standards, currency fluctuations, political
instability, foreign taxes and regulations, and the
potential for illiquid markets.
52
Equities
(continued)
Stock Mutual Funds
These are funds that own stock in specific groups
or types of companies
You are buying a share in multiple companies
which change over time depending on the fund
manager
You are responsible for paying taxes on all
distributions by the mutual fund, which are taxed at
your levelnot the fund level
Mutual funds are delineated by investment
objective, which can be any of the equity asset
classes discussed
53
Equities
(continued)
Advantages
Offer highest return of the major asset classes
Growth and value stocks tend to perform in
alternating cyclesit makes sense to own both
Good investment for long-term investingthey
have consistently beat inflation over the long-term
Disadvantages
Offer less stability of principal than other asset
classes, and subject to short-term price fluctuations
(so very risky for short-term investments)
If youre investing for less than 3-5 years, only a
small portion (if any) of your investments should
54
Equities
(continued)
Thoughts on Stocks
Stocks have given the highest consistent returns of
any asset class, although with the highest risk
While volatile in the short-term, over time they
have continued to deliver returns far in excess of
taxes and inflation
To grow your portfolio in excess of taxes and
inflation, generally you will need to include some
equities in your portfolio
Through broad diversification, you can reduce
some of the risk of this asset class
55
Questions
Any questions on asset classes?
56
D. Review the Risk and Return History
of the Major Asset Classes
What is risk?
Is it the risk of losing all your money?
Is it the risk of losing principle?
It is the risk of not achieving a specific holding
period return?
How is it measured?
Historically, government securities were considered
risk-free
Later, analysts started using variance (or standard
deviation squared) as a better measure of risk.
Currently, investors also use Beta, which is a
measure of how the stock moves with the market
57
Risk (continued)
Key Risk Concepts:
Risk
Investment risk. The probability of not
achieving some specific return objective
Risk-free rate
The rate of return that can be obtained with
certainty
Risk premium
The difference between the expected return and
the risk-free rate
Risk aversion
The reluctance to accept risk
58
Investing versus Gambling
Investing
The odds are in your favor
There is a favorable risk-return tradeoff
It is part of a long-term plan
You have done your homework
It involves the creation of wealth
Gambling
The odds are in anothers favor
There is no favorable risk-return tradeoff
There is no long-term plan
There is no homework, only chance
It is a zero-sum gameno wealth is created
59
Return
What is return?
Return is the change in the value of a financial asset
or portfolio over a specific period, which includes
any dividends, distributions, or interest received
from the asset or portfolio during that period. It is
also called a holding period return
Why is it important?
It is a measure of how much your asset or portfolio
has grown over a specific holding period
Once you have calculated your return, you can
compare your return to benchmarks to see how
you have done
60
Return (continued)
How is it calculated?
Your holding period return is:
(ending price beginning price + div./distributions)
beginning price
The dividends and distributions includes all
dividends and distributions received, including
dividends/distributions that were received but
reinvested in the portfolio
To calculate after-tax returns, you would deduct
the taxes to be paid from your dividend and
distribution amounts
The holding period return can be annualized,
depending on the holding period of the asset
61
Returns (continued)
Why study the history of asset class
performance, when we know the future will not
be like the past?
President Gordon B. Hinckley stated:
All of us need to be reminded of the past. It is
from history that we gain knowledge which can
save us from repeating mistakes and on which
we can build for the future (Reach with a
Rescuing Hand, New Era, July 1997, 4).
62
Returns: Asset Class Returns
63
Returns: Historical Risk and Return
64
Returns: S&P 500 One-year
Since 1926
65
Returns: S&P500 5 Year
Since 1930
66
Returns: S&P 500 10 Year Returns
67
67
Equity Asset Class Returns and Risk
(through 2010)
1
Year
5
Years
10
Years
25
Years
50
Years
75
Years
85
Years
S&P500
Compound Return
Standard Deviation
15.1%
18.4%
2.3%
17.7%
1.4%
16.3%
9.9%
15.8%
9.7%
15.1%
10.4%
15.9%
9.9%
19.2%
SmallCap
Compound Return
Standard Deviation
31.3%
24.1%
3.2%
23.7%
9.6%
22.0%
10.8%
20.7%
13.5%
21.4%
13.7%
24.5%
12.1%
29.1%
T-bond
Compound Return
Standard Deviation
10.2%
13.0%
5.6%
13.1%
6.6%
11.8%
8.9%
10.3%
7.1%
10.1%
5.5%
8.6%
5.5%
8.3%
T-bill
Compound Return
Standard Deviation
0.1%
0.0%
2.2%
0.6%
2.2%
0.5%
4.1%
0.6%
5.3%
0.8%
3.8%
0.9%
3.6%
0.9%
EAFE (International)
Compound Return
Standard Deviation
8.2%
22.0%
2.9%
21.5%
3.9%
18.6%
8.5%
18.2%
Emerging Markets
Compound Return
Standard Deviation
19.2%
20.3%
13.1%
28.0%
16.2%
24.7%
REITs
Compound Return
Standard Deviation
28.5%
19.8%
3.0%
33.0%
10.6%
25.5%
CPI
Compound Return
Standard Deviation
1.5%
0.5%
4.1%
1.2%
3.8%
1.6%
3.0%
1.9%
2.2%
68
1.7%
2.3%
1.5%
2.8%
1.1%
68
Things Learned
There is a positive relationship between risk and
return
While equities are volatile on a monthly basis, over
longer periods of time the bad periods are offset by
good periods
The longer the time period, the more likely you will
have positive returns
69
Questions
Any questions on asset class risk and return
history?
See TT23 Return and Risk Simulation
70
Review of Objectives
A. Do you know what to do before you
invest?
B. Do you understand the ten principles of
successful investing?
C. Do you understand the various asset
classes?
D. Have you reviewed the asset class risk
and return history?
71
Case Study #1
Data
Bill wants to know how much he will need to
save at the end of each year to have $1
million in savings when he retires in 30
years.
Calculations
Assuming Bill can earn an 8.5% return on his
investment, how much must he save each
year
Application
What assets would you recommend Bill use
to save?
72
Calculate how much Bill will need to save at the end of each year
assuming he has 30 years until retirement, will need $1 million in savings,
and can earn an 8.5% return. What assets should he use?
73
Case Study #1 Answer
Calculations
Set your calculator to 1 payment per year (annual)
N = 30, I = 8.5%, PV = 0, FV = $1,000,000
Solve for Bills annual payment?
Bill would need to save $8,050.58 annually
to reach his goal.
Recommendations
Bill could use any number of investment assets,
including stocks, bonds, cash, mutual funds, etc.
Because he is just starting out, I would encourage
him to consider the use of inexpensive, no-load
mutual funds as investment vehicles.
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Case Study #2
Data
Last year you purchased 100 shares of MSAM
Corporation for $40 per share. Over the past 12
months MSAMs price has gone up to $45 per share,
and you received a dividend of $1 per share.
Calculations
What was your total rate of return on your investment
in the MSAM stock?
75
Last year you purchased 100 shares of MSAM Corporation for $40 per share. Over the past
12 months MSAMs price has gone up to $45 per share, and you received a dividend of $1
per share. What was your total rate of return on your investment in the MSAM stock?
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Case Study #2 Answer
Calculations
This can be solved either on a total portfolio basis or
on a per share basis.
Total Portfolio
(($45*100 - $40 *100) + 1*100) / $40*100 = ?
Your return is 15.0%
Per Share basis
(($45 - $40) + 1) / $40 = ?
Your return is 15.0%
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Case Study #3
Data
Your investment in MSAM stock was so successful
that you decided to hold it for 5 more years.
Remember, you purchased 100 shares for $40 per
share. Unfortunately, the price of MSAM stock has not
risen; it is back to where you purchased it. The good
news is that you earned $1 per share for five years.
Calculations
What was your annualized total rate of return?
Application
Compared to a bank account earning 2.25% over
this same period, how did your stock do?
78
You purchased 100 shares of MSAM for $40 per share. Unfortunately, the price of MSAM
stock has not risen; but you did earn $1 per share for each of the five years. What was your
annualized total rate of return? Compared to a bank account earning 2.25% over this same
period, how did your stock do?
79
Case Study #3 Answer
Calculations
Your annualized rate of return is your return for the
total period, annualized, i.e., taking the geometric
return.
Your total return for the 5 year period is:
(($40*100 - $40*100) + 5*100) / ($40*100) = ?
12.5%
Taking that return and annualizing for 5 years
gives the following annual returns:
Geometric return = (1 + .125)^(1/5) = 2.38%
Average return = 12.5% / 5 = 2.5%
Using either method, it performed better than the
bank account
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Case Study #4
Data
Sam recently purchased a bond with a 10 year maturity
for $1,000 which pays annual interest of $100.
Calculations
What interest rate is Sam receiving?
If interest rates for ten year bonds today are 5%:
How much can Sam sell his bond for today?
How much could he sell the bond for tomorrow
if interest rates move up to 12%?
Applications
Based on your calculations, what is the relationship
between interest rates and the value between
81
Hassan recently purchased a bond with a 10 year maturity for $1000 which pays annual
interest of $100. What interest rate is Hassan receiving? If interest rates for ten year bonds
today are 5%: How much can Hassan sell his bond for today? How much could he sell the
bond for tomorrow if interest rates move up to 12%? Based on your calculations, what is the
relationship between interest rates and the value between bonds?
82
Case Study #4 Answer
Calculations
The bonds current yield is $100/$1000 = 10%
At 5% Sam can sell his bond for:
N=10, I=5%, PMT=100, FV=1,000, solve PV?
$1,386.07
At 12% Sam can sell his bond for:
N=10, I=12%, PMT=100, FV=1,000, solve PV?
$887.00
This implies a negative relationship between bond
prices and interest rates. In other words, as interest
rates increase bond prices fall, and when interest rates
decrease bond prices rise.
83
Case Study #5
Data
Ryan is 35 years old, and took the Risk Tolerance test from
the teaching tools (Teaching Tool 16). He determined that
he was moderate in terms of risk.
Application
Based on the rule of thumb of his age in bonds and the
results from the Risk Tolerance test, which of the following
most likely represents Ryans preferred asset allocation
(assume his emergency fund is included in cash and bonds):
A. 35% cash, 40% large cap, 25% bonds
B. 25% cash, 35% large cap, 25% small cap, 15%
international
C. 10% cash, 25% bonds, 50% large cap, 15% small
cap
D. 15% bonds, 30% large cap, 30% small cap, 25%
84
You are 35 years old and moderate in terms of risk. Which of the following most likely
represents your asset allocation (assume your emergency fund is included in cash and
bonds): A. 35% cash, 40% large cap, 25% bonds; B. 25% cash, 35% large cap, 25% small
cap, 15% international; C. 10% cash, 25% bonds, 50% large cap, 15% small cap; and
D. 15% bonds, 30% large cap, 30% small cap, 25% international.
85
Case Study #5 Answer
Ryans preferred allocation would likely be C for
the following reasons:
Portfolio A has too much exposure to cash and
bonds.
Portfolio B has too large an allocation to
international and small cap (40%), both much
more risky.
Portfolio C is more consistent with your risk
exposure, i.e., 35% in bonds and cash, and has
some (limited) exposure to small caps
Portfolio D has too little exposure to bonds and
cash, and too much small cap and international.
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Case Study #6
Data
Assume the same information from Problem 5, but now
Ryans result from his Risk Tolerance test (Learning Tool
16) was aggressive in terms of risk.
Application
(a) Based on the same rule of thumb, which of the
following most likely represents Ryans asset allocation:
A. 35% cash, 40% large cap, 25% bonds
B. 25% cash, 35% large cap, 25% small cap, 15%
international
C. 10% cash, 25% bonds, 50% large cap, 15% small cap
D. 15% bonds, 30% large cap, 30% small cap, 25%
international
(b) What would his allocation be if his results were very
87
You are 35 years old and aggressive. Which of the following most likely represents your
asset allocation: A. 35% cash, 40% large cap, 25% bonds; B. 25% cash, 35% large cap,
25% small cap, 15% international; C. 10% cash, 25% bonds, 50% large cap, 15% small
cap; and D. 15% bonds, 30% large cap, 30% small cap, 25% international. (b) What would
your allocation be if your results were very aggressive?
88
Case Study #6 Answer
(a) The preferred allocation for aggressive would
be B.
Portfolio A has too much exposure to cash for
his risk level
Portfolio B is recommended. It has a larger
allocation to international and small cap (40%),
a lesser allocation to bonds and cash, and is
more consistent with his risk results
Portfolio C has too much (35%) in bonds and
cash, and likely not enough to the riskier assets
Portfolio D has too little exposure to bonds and
cash, and likely too much small cap and
international.
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Case Study #6 Answer
(b) The preferred allocation for very aggressive
would be D.
Portfolio A has too much exposure to cash for
his risk level, but a good allocation to small cap
(more risky)
Portfolio B has a large allocation to international
and small cap (40%), consistent with his risk
results, but too much cash
Portfolio C has too much (35%) in bonds and
cash, and likely not enough to riskier assets
Portfolio D has less exposure to bonds and cash,
and much more small cap and international
(55%), consistent with very aggressive risk
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