Chapter 12 (Personal Finance) Notes 2

E X E R C I S E S 1. Brainstorm with classmates expressions or homilies relating to investing, such as you gotta pay to play; you gotta play to win; no pain, no gain; it takes money to make money; and so on. What does each of these expressions really mean? How do they relate to the concepts of investment risk and return on investment?In what ways are risks and returns in a reciprocal relationship? 2. Draft an individual investment policy statement as a guide to your future investment planning. What will be the advantages of having an investment policy statement? In My Notes or your personal finance journal, record your general return objectives and specific goals at this time. What is a return objective? 3. What is your level of risk tolerance? How would you rate your risk tolerance on a five-point scale (with one indicating “most risk averse”)? In your personal finance journal, record how your asset base, time horizon, and liquidity needs define your ability to undertake investment risk. Then describe the personality characteristics, past experiences, and knowledge base that you feel help shape your degree of willingness to undertake risk. Now check your beliefs by taking the Risk Tolerance Quiz at http://www.isi-su.com/new/ risktol2.htm. How do the results compare with your estimate? Compare the results with the Risk Tolerance Questionnaire at Kiplinger’s (http://www.kiplinger.com/tools/riskfind.html) and other tests of risk tolerance offered on commercial Web sites. What conclusions do you draw from these tests? What percent of your investments do you now think you could put into stocks? What factor could you change that might enable you to tolerate more risk? 4. In My Notes or your personal finance journal, record the constraints you face against reaching your investment goals. With what types of constraints must you reconcile your investment planning? The more you need to use your money to live and the less time you have to achieve your goals, the greater the constraints in your investment planning. Revise your statement of goals and return objectives as needed to ensure it is realistic in light of your constraints. 3. MEASURING RETURN AND RISK L E A R N I N G 1. 2. 3. 4. 5. O B J E C T I V E S Characterize the relationship between risk and return. Describe the differences between actual and expected returns. Explain how actual and expected returns are calculated. Define investment risk and explain how it is measured. Define the different kinds of investment risk. You want to choose investments that will combine to achieve the return objectives and level of risk that’s right for you, but how do you know what the right combination will be? You can’t predict the future, but you can make an educated guess based on an investment’s past history. To do this, you need to know how to read or use the information available. Perhaps the most critical information to have about an investment is its potential return and susceptibility to types of risk. 3.1 Return Returns are always calculated as annual rates of return, or the percentage of return created for each unit (dollar) of original value. If an investment earns 5 percent, for example, that means that for every $100 invested, you would earn $5 per year (because $5 = 5% of $100). Returns are created in two ways: the investment creates income or the investment gains (or loses) value. To calculate the annual rate of return for an investment, you need to know the income created, the gain (loss) in value, and the original value at the beginning of the year. The percentage return can be calculated as in Figure 12.8. F I G U RE 12. 8 Calculating Percentage Return expected return The return expected for an investment based on its average historical performance. Statistically, it is the mean or average of the investment’s past performance. Note that if the ending value is greater than the original value, then Ending value − Original value > 0 (is greater than zero), and you have a gain that adds to your return. If the ending value is less, then Ending value − Original value < 0 (is less than zero), and you have a loss that detracts from your return. If there is no gain or loss, if Ending value − Original value = 0 (is the same), then your return is simply the income that the investment created. For example, if you buy a share of stock for $100, and it pays no dividend, and a year later the market price is $105, then your return = [0 + (105 − 100)] ÷ 100 = 5 ÷ 100 = 5%. If the same stock paid a dividend of $2, then your return = [2 + (105 − 100)] ÷ 100 = 7 ÷ 100 = 7%. If the information you have shows more than one year’s results, you can calculate the annual return using what you learned in Chapter 4 about the relationships of time and value. For example, if an investment was worth $10,000 five years ago and is worth $14,026 today, then $10,000 × (1+ r)5 = $14,026. Solving for r—the annual rate of return, assuming you have not taken the returns out in the meantime—and using a calculator, a computer application, or doing the math, you get 7 percent. So the $10,000 investment must have earned at a rate of 7 percent per year to be worth $14,026 five years later, other factors being equal. While information about current and past returns is useful, investment professionals are more concerned with the expected return for the investment, that is, how much it may be expected to earn in the future. Estimating the expected return is complicated because many factors (i.e., current economic conditions, industry conditions, and market conditions) may affect that estimate. For investments with a long history, a strong indicator of future performance may be past performance. Economic cycles fluctuate, and industry and firm conditions vary, but over the long run, an investment that has survived has weathered all those storms. So you could look at the average of the returns for each year. There are several ways to do the math, but if you look at the average return for different investments of the same asset class or type (e.g., stocks of large companies) you could compare what they have returned, on average, over time. Figure 12.9 shows average returns on investments in the S&P 500, an index of large U.S. companies since 1990. F I G U RE 12. 9 S&P 500 Average Annual Return[4] If the time period you are looking at is long enough, you can reasonably assume that an investment’s average return over time is the return you can expect in the next year. For example, if a company’s stock has returned, on average, 9 percent per year over the last twenty years, then if next year is an average year, that investment should return 9 percent again. Over the eighteen-year span from 1990 to 2008, for example, the average return for the S&P 500 was 9.16 percent. Unless you have some reason to believe that next year will not be an average year, the average return can be your expected return. The longer the time period you consider, the less volatility there will be in the returns, and the more accurate your prediction of expected returns will be. Returns are the value created by an investment, through either income or gains. Returns are also your compensation for investing, for taking on some or all of the risk of the investment, whether it is a corporation, government, parcel of real estate, or work of art. Even if there is no risk, you must be paid for the use of liquidity that you give up to the investment (by investing). Returns are the benefits from investing, but they must be larger than its costs. There are at least two costs to investing: the opportunity cost of giving up cash and giving up all your other uses of that cash until you get it back in the future and the cost of the risk you take—the risk that you won’t get it all back. 3.2 Risk Investment risk is the idea that an investment will not perform as expected, that its actual return will deviate from the expected return. Risk is measured by the amount of volatility, that is, the difference between actual returns and average (expected) returns. This difference is referred to as the standard deviation. Returns with a large standard deviation (showing the greatest variance from the average) have higher volatility and are the riskier investments. As Figure 12.9 shows, an investment may do better or worse than its average. Thus, standard deviation can be used to define the expected range of investment returns. For the S&P 500, for example, the standard deviation from 1990 to 2008 was 19.54 percent. So, in any given year, the S&P 500 is expected to return 9.16 percent but its return could be as high as 67.78 percent or as low as −49.46 percent, based on its performance during that specific period. What risks are there? What would cause an investment to unexpectedly over- or underperform? Starting from the top (the big picture) and working down, there are economic risks, industry risks, < company risks, < asset class risks, < market risks. < < Economic risks are risks that something will upset the economy as a whole. The economic cycle may swing from expansion to recession, for example; inflation or deflation may increase, unemployment may increase, or interest rates may fluctuate. These macroeconomic factors affect everyone doing business in the economy. Most businesses are cyclical, growing when the economy grows and contracting when the economy contracts. Consumers tend to spend more disposable income when they are more confident about economic growth and the stability of their jobs and incomes. They tend to be more willing and able to finance purchases with debt or with credit, expanding their ability to purchase durable goods. So, demand for most goods and services increases as an economy expands, and businesses expand too. An exception is businesses that are countercyclical. Their growth accelerates when the economy is in a downturn and slows when the economy expands. For example, low-priced fast food chains typically have increased sales in an economic downturn because people substitute fast food for more expensive restaurant meals as they worry more about losing their jobs and incomes. standard deviation In finance, the statistical measure that calculates the frequency and amount by which actual returns differ from the average or expected returns. Industry risks usually involve economic factors that affect an entire industry or developments in technology that affect an industry’s markets. An example is the effect of a sudden increase in the price of oil (a macroeconomic event) on the airline industry. Every airline is affected by such an event, as an increase in the price of airplane fuel increases airline costs and reduces profits. An industry such as real estate is vulnerable to changes in interest rates. A rise in interest rates, for example, makes it harder for people to borrow money to finance purchases, which depresses the value of real estate. Company risk refers to the characteristics of specific businesses or firms that affect their performance, making them more or less vulnerable to economic and industry risks. These characteristics include how much debt financing the company uses, how well it creates economies of scale, how efficient its inventory management is, how flexible its labor relationships are, and so on. The asset class that an investment belongs to can also bear on its performance and risk. Investments (assets) are categorized in terms of the markets they trade in. Broadly defined, asset classes include F I G U RE 12 . 1 0 © 2010 Jupiterimages Corporation asset class A kind of investment distinguished by its uses and market (e.g., stock, bonds, fine art, real estate, currency). corporate stock or equities (shares in public corporations, domestic, or foreign); bonds or the public debts of corporation or governments; < commodities or resources (e.g., oil, coffee, or gold); < derivatives or contracts based on the performance of other underlying assets; < real estate (both residential and commercial); < < < fine art and collectibles (e.g., stamps, coins, baseball cards, or vintage cars). Within those broad categories, there are finer distinctions. For example, corporate stock is classified as large cap, mid cap, or small cap, depending on the size of the corporation as measured by its market capitalization (the aggregate value of its stock). Bonds are distinguished as corporate or government and as short-term, intermediate-term, or long-term, depending on the maturity date. Risks can affect entire asset classes. Changes in the inflation rate can make corporate bonds more or less valuable, for example, or more or less able to create valuable returns. In addition, changes in a market can affect an investment’s value. When the stock market fell unexpectedly and significantly, as it did in October of 1929, 1987, and 2008, all stocks were affected, regardless of relative exposure to other kinds of risk. After such an event, the market is usually less efficient or less liquid; that is, there is less trading and less efficient pricing of assets (stocks) because there is less information flowing between buyers and sellers. The loss in market efficiency further affects the value of assets traded. As you can see, the link between risk and return is reciprocal. The question for investors and their advisors is: How can you get higher returns with less risk? K E Y < < < < < < < T A K E A WA Y S There is a direct relationship between risk and return because investors will demand more compensation for sharing more investment risk. Actual return includes any gain or loss of asset value plus any income produced by the asset during a period. Actual return can be calculated using the beginning and ending asset values for the period and any investment income earned during the period. Expected return is the average return the asset has generated based on historical data of actual returns. Investment risk is the possibility that an investment’s actual return will not be its expected return. The standard deviation is a statistical measure used to calculate how often and how far the average actual return differs from the expected return. Investment risk is exposure to < < < < < economic risk, industry risk, company- or firm-specific risk, asset class risk, or market risk. E X E R C I S E S 1. Selecting a security to invest in, such as a stock or fund, requires analyzing its returns. You can view the annual returns as well as average returns over a five-, ten-, fifteen-, or twenty-year period. Charts of returns can show the amount of volatility in the short term and over the longer term. What do you need to know to calculate the annual rate of return for an investment? Consider that at the beginning of 2010 Ali invests $5,000 in a mutual fund. The fund has a gain in value of $200, but generates no income. What is the annual percentage rate of return? What do you need to know to estimate the expected return of an investment in the future? If the fund Ali invests in has an average fifteen-year annual return of 7 percent, what percentage rate of return should he expect for 2011? Find the estimated annualized rate of return for a hypothetical portfolio by using the calculator at http://www.mymoneyblog.com/archives/2007/01/ estimate-your-portfolios-rate-of-return-calculator.html. 2. Try the AARP’s investment return calculator at http://www.aarp.org/money/toolkit/articles/ investment_return_calculator.html, experimenting with different figures to solve for a range of situations. Use the information on that page to answer the following questions. Can the future rate of return on an investment be estimated with any certainty? Do investments that pay higher rates of return carry higher volatility? Do investments that pay higher rates of return carry higher risk? What accounts for differences between the actual return and the expected return on an investment? 3. The standard deviation on the rate of return on an investment is a measure of its volatility, or risk. What would a standard deviation of zero mean? What would a standard deviation of 10 percent mean? 4. What kinds of risk are included in investment risk? Go online to survey current or recent financial news. Find and present a specific example of the impact of each type of investment risk. In each case, how did the type of risk affect investment performance? 4. DIVERSIFICATION: RETURN WITH LESS RISK L E A R N I N G O B J E C T I V E S 1. Explain the use of diversification in portfolio strategy. 2. List the steps in creating a portfolio strategy, explaining the importance of each step. 3. Compare and contrast active and passive portfolio strategies. Every investor wants to maximize return, the earnings or gains from giving up surplus cash. And every investor wants to minimize risk, because it is costly. To invest is to assume risk, and you assume risk expecting to be compensated through return. The more risk assumed, the more the promised return. So, to increase return you must increase risk. To lessen risk, you must expect less return, but another way to lessen risk is to diversify—to spread out your investments among a number of different asset classes. Investing in different asset classes reduces your exposure to economic, asset class, and market risks. Concentrating investment concentrates risk. Diversifying investments spreads risk by having more than one kind of investment and thus more than one kind of risk. To truly diversify, you need to invest in assets that are not vulnerable to one or more kinds of risk. For example, you may want to diversify between cyclical and countercyclical investments, reducing economic risk; among different sectors of the economy, reducing industry risks; < among different kinds of investments, reducing asset class risk; < among different kinds of firms, reducing company risks. < < To diversify well, you have to look at your collection of investments as a whole—as a portfolio—rather than as a gathering of separate investments. If you choose the investments well, if they are truly different from each other, the whole can actually be more valuable than the sum of its parts. 4.1 Steps to Diversification In traditional portfolio theory, there are three levels or steps to diversifying: capital allocation, asset allocation, and security selection. capital allocation A strategy of diversifying a portfolio between risky and riskless assets. asset allocation The strategy of achieving portfolio diversification by investing in different asset classes. Capital allocation is diversifying your capital between risky and riskless investments. A “riskless” asset is the short-term (less than ninety-day) U.S. Treasury bill. Because it has such a short time to maturity, it won’t be much affected by interest rate changes, and it is probably impossible for the U.S. government to become insolvent—go bankrupt—and have to default on its debt within such a short time. The capital allocation decision is the first diversification decision. It determines the portfolio’s overall exposure to risk, or the proportion of the portfolio that is invested in risky assets. That, in turn, will determine the portfolio’s level of return. The second diversification decision is asset allocation, deciding which asset classes, and therefore which risks and which markets, to invest in. Asset allocations are specified in terms of the percentage of the portfolio’s total value that will be invested in each asset class. To maintain the desired allocation, the percentages are adjusted periodically as asset values change. Figure 12.11 shows an asset allocation for an investor’s portfolio. F I G U RE 12. 11 Proposed Asset Allocation life cycle investing An investment strategy in which asset allocation is based on the investor’s age or stage of life. security selection The process of choosing individual securities to be included in the portfolio. Asset allocation is based on the expected returns and relative risk of each asset class and how it will contribute to the return and risk of the portfolio as a whole. If the asset classes you choose are truly diverse, then the portfolio’s risk can be lower than the sum of the assets’ risks. One example of an asset allocation strategy is life cycle investing—changing your asset allocation as you age. When you retire, for example, and forgo income from working, you become dependent on income from your investments. As you approach retirement age, therefore, you typically shift your asset allocation to less risky asset classes to protect the value of your investments. Security selection is the third step in diversification, choosing individual investments within each asset class. Here is the chance to achieve industry or sector and company diversification. For example, if you decided to include corporate stock in your portfolio (asset allocation), you decide which corporation’s stock to invest in. Choosing corporations in different industries, or companies of different sizes or ages, will diversify your stock holdings. You will have less risk than if you invested in just one corporation’s stock. Diversification is not defined by the number of investments but by their different characteristics and performance. 4.2 Investment Strategies Capital allocation decides the amount of overall risk in the portfolio; asset allocation tries to maximize the return you can get for that amount of risk. Security selection further diversifies within each asset class. Figure 12.12 demonstrates the three levels of diversification. F I G U RE 1 2 . 1 2 Levels of Diversification Just as life cycle investing is a strategy for asset allocation, investing in index funds is a strategy for security selection. Indexes are a way of measuring the performance of an entire asset class by measuring returns for a portfolio containing all the investments in that asset class. Essentially, the index becomes a benchmark for the asset class, a standard against which any specific investment in that asset class can be measured. An index fund is an investment that holds the same securities as the index, so it provides a way for you to invest in an entire asset class without having to select particular securities. For example, if you invest in the S&P 500 Index fund, you are investing in the five hundred largest corporations in the United States—the asset class of large corporations. There are indexes and index funds for most asset classes. By investing in an index, you are achieving the most diversification possible for that asset class without having to make individual investments, that is, without having to make any security selection decisions. This strategy of bypassing the security selection decision is called passive management. It also has the advantage of saving transaction costs (broker’s fees) because you can invest in the entire index through only one transaction rather than the many transactions that picking investments would require. In contrast, making security selection decisions to maximize returns and minimize risks is called active management. Investors who favor active management feel that the advantages of picking specific investments, after careful research and analysis, are worth the added transaction costs. Actively managed portfolios may achieve diversification based on the quality, rather than the quantity, of securities selected. Also, asset allocation can be actively managed through the strategy of market timing—shifting the asset allocation in anticipation of economic shifts or market volatility. For example, if you forecast a period of higher inflation, you would reduce allocation in fixed-rate bonds or debt instruments, because inflation erodes the value of the fixed repayments. Until the inflation passes, you would shift your allocation so that more of your portfolio is in stocks, say, and less in bonds. It is rare, however, for active investors or investment managers to achieve superior results over time. More commonly, an investment manager is unable to achieve consistently better returns within an asset class than the returns of the passively managed index.[5] benchmark A standard, often an index of securities, representing an industry or asset class and used as an indicator of growth potential or as a basis of comparison for similar of disparate industries or assets. passive management An investment strategy that does not include security selection within an asset class; the investment is expected to perform as well as the benchmark index. active management An investment strategy that includes security selection within an asset class in order to outperform the asset class benchmark. market timing The practice of basing investment strategy on predictions of future market changes or on asset return forecasts. K E Y < < < < < < < T A K E A WA Y S Diversification can decrease portfolio risk through choosing investments with different risk characteristics and exposures. A portfolio strategy involves capital allocation decisions, asset allocation decisions, security selection decisions. Active management is a portfolio strategy including security selection decisions and market timing. Passive management is a portfolio strategy omitting security selection decisions and relying on index funds to represent asset classes, while maintaining a long-term asset allocation. E X E R C I S E S 1. What is the meaning of the expressions “don’t count your chickens before they hatch” and “don’t put all your eggs in one basket”? How do these expressions relate to the challenge of reducing exposure to investment risks and building a high-performance investment portfolio? View ING’s presentation and graph on diversification and listen to the audio at http://www.ingdelivers.com/pointers/diversification. In the example, how does diversification lower risk? Which business sectors would you choose to invest in for a diversified portfolio? 2. Draft a provisional portfolio strategy. In My Notes or your personal finance journal, describe your capital allocation decisions. Then identify the asset classes you are thinking of investing in. Describe how you might allocate assets to diversify your portfolio. Draw a pie chart showing your asset allocation. Draw another pie chart to show how life cycle investing might affect your asset allocation decisions in the future. How might you use the strategy of market timing in changing your asset allocation decisions? Next, outline the steps you would take to select specific securities. How would you know which stocks, bonds, or funds to invest in? How are index funds useful as an alternative to security selection? What are the advantages and disadvantages of investing in an index fund such as the Dow Jones Industrial Average? (Go to http://money.cnn.com/data/markets/dow/ to find out.) 3. Do you favor an active or a passive investment management strategy? Why? Identify all the pros and cons of these investment strategies and debate them with classmates. What factors favor an active approach? What factors favor a passive approach? Which strategy might prove more beneficial for first-time investors? 4. View the online video blog “3 Keys to Investing” at http://www.allbusiness.com/personal-finance/ 4968227-1.html. What advice does the speaker, Miranda Marquit (October 26, 2007), have for novice investors? According to this source, what are the three keys to successful investing?