applying the planning process Chapter 11 Fundamental Concepts in Investing Where Does This Fit in Your Comprehensive Financial Plan Protection Plan for death and incapacity Chapters 16 17 Build wealth Save and invest to meet short term and long term goals Chapters 11 15 Secure basic needs Liquidity consumer purchases and Investing and Your Financial Plan Should first take care of the foundation and security elements of your plan Set goals and a budget Establish an emergency fund Reduce high interest credit Buy adequate insurance Buy a home credit decisions insurance employee benefits Chapters 5 10 Establish a firm foundation Evaluate your finances acquire tools and skills set goals develop a budget Chapters 1 4 Investing to Achieve a Goal Useful Time Value Calculations What is the purpose of the investment plan How much do you need in the future to meet your financial goal How much can you currently allocate to your investment plan How much time until you need the money How much risk and what types of risk can you afford to take If you know your target accumulation FV Calculate the required saving PMT given your time horizon n and expected after tax return on investment i If you know how much you can save PMT Calculate the amount it will grow to in the future FV given your time horizon n and expected after tax return on investment i 1 Major Asset Classes Investing By Lending and Owning Investing by lending A debt investor lends money to another person business or government entity Return on investment is from interest on the loan amount and sometimes a capital gain Investing by owning An equity investor is a part owner in a business Return on investment can be from dividends and capital gains Riskier than debt since cash flows are uncertain Risk and Return Two sources of return Current cash flow Increase in value of investment over time Two sources of risk Risk you won t get promised cash flows Risk your asset will decline in value over time Assessing Risk Aversion Which of the following statements comes closest to the amount of financial risk that you are willing to take when you save or make investments a Take substantial financial risk expecting to earn substantial returns b Take above average financial risk expecting to earn above average returns c Take average financial risk expecting to earn average returns d Not willing to take any financial risks Common stock Chapter 12 Preferred stock Chapter 13 Bonds Chapter 13 Fixed income investments Mutual funds Chapter 14 Real estate Chapter 14 Speculative investments The Risk Return Tradeoff All else equal people prefer less risk Risk aversion Prefer an amount of money for certain to a risky gamble that has the same expected value Example Choose from 1 Heads You win 50 10 2 20 for certain Tails You lose Measuring Return Riskier investment greater return because you get a risk premium for bearing risk Inflation risk Interest rate risk Reinvestment risk Default risk Liquidity risk Market risk 2 Inflation Risk A dollar today is worth more than a dollar tomorrow Inflation erodes the value of your investment principal to be received in the future Interest Rate Risk Maturity Risk Value of an investment is the present value of future cash flows If interest rates go up the present value goes down The longer the time until you will receive the cash flow the bigger this effect Often called maturity risk for this reason Most important for to debt investments Reinvestment Risk If you hold short term debt securities you must reinvest your principal when it matures If rates are falling you will have to reinvest at lower rates Reinvestment rate risk greater for shortterm debt investments Interest rate risk greater for long term debt Debt Security Risk Premiums Default and Liquidity Risk Default risk Risk that you will not receive promised or expected cash flows Example You buy stocks or bonds and the company goes bankrupt Liquidity risk Risk that you will not be able to convert your investment to cash without loss of value Depends on how active a market there is for this type of asset Market Risk The risk associated with general market movements and economic conditions Bull market Prices rising Bear market Prices falling Returns on similar investments tend to be correlated Can be specific effects by asset class industry sector geographic region or country 3 Diversification Risk Reduction from Diversification Don t put all your eggs in one basket Some price changes are company specific If you hold the stocks or bonds of several different companies the negative events should not be perfectly correlated some stocks will do well when others do poorly Objective of diversification Hold enough different securities to eliminate the effects of company specific risks Asset Allocation The process of deciding on the proportional allocation of your money To each asset class To different securities within asset classes Asset allocation is how you achieve diversification Passive Investment Strategies Buy and hold Dollar cost averaging Buying in equal dollar amounts at regular intervals rather than making one large purchase Direct investment plans Direct purchase of stock from company Dividend reinvestment plans Dividends automatically converted to additional shares of company stock Investment Strategies Active versus passive investing An active investor attempts to identify investments and asset classes that are undervalued in the short run and to make returns by buying those that are under priced and selling those that are overpriced A passive investor selects investments that will over the long term provide desired outcomes Tax Planning and Investments Favorable tax treatment of capital gains Tax rates on ordinary income 10 to 35 Tax rates on long term capital gains 5 to 15 Long term gain Assets must be held for one year or longer Same rates also apply to certain dividend income 4 Tax Planning and Investments Tax deferred You pay tax on the income at some point in the future e g Traditional deductible IRA retirement plans Section 529 education saving accounts Some Simple Rules Start early Keep good records Do your homework Stick to the plan Tax exempt You never pay tax on the income Example Treasury bills state exempt municipal bonds federal exempt 5