Personal Finance: An Integrated Planning Approach

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Personal FinanceAn Integrated Planning Approach

• Winger and Frasca
• Chapter 10
• Investment Basics
• Understanding Risk and Return

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Introduction

• Risk is a fundamental component of investing.
• Risk must be understood and managed.
• Diversification is an important way to manage
  risk.
• Professional investors know that diversification
  involves diversification across asset classes as
  well as within asset groups.
• In selecting securities, it is important to
  understand and measure market risk.
• Then securities can be selected by choosing
  securities with expected returns that exceed
  required returns.

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Chapter Objectives

1. To grasp the nature of risk and its sources and
   to relate risk to investment return
2. To see the importance of diversification and to
   understand how it reduces investment risk
3. To understand how to accomplish adequate
   diversification, both among asset groups and
   within an asset group

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Chapter Objectives (Continued)

1. To grasp the concepts of required return and
   expected return and to see how they are used in
   security selection
2. To become familiar with important methods and
   issues involved in establishing a portfolio and
   making changes over time

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Topic Outline

• Risk and Return
• The Rewards of Diversification
• Applying a Risk-Return Model
• Building and Changing a Portfolio

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Risk and Return

• What is Risk?
• Sources of Risk
• How Much Return Do You Need?
• The Iron Law of Risk and Return
• To earn higher returns, you must take greater
  risks.
• There is a strong positive correlation between
  higher investment return and greater risk.

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Return Variability
10
8

5
6
A
B
C
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Investment A no return variation, no risk
Investment B some return variation, some risk
Investment C wide return variation, much risk
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What Is Risk?

• Investment risk is defined as The more variable
  an investments return, the greater its risk.
• The more uncertainty associated with the expected
  outcome, the greater the risk of the investment.
• A highly variable return could lead to investment
  losses if the investment must be sold.
• The longer the time period before an investment
  pays off, the greater the risk.
• Investors with long investment horizons can
  handle more risk.

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Sources of Risk

• There are two basic sources of risk
• Changing Economic Conditions
• Changing Conditions of the Issuer

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Changing Economic Conditions

• Inflation risk Will your investment returns keep
  pace with inflation? If not, your return may be
  insufficient.
• Business cycle risk Your investment return
  fluctuates in concert with the overall business
  cycle.
• Interest rate risk Bond prices fluctuate as
  interest rates in the economy change. In fact,
  bond prices move in the opposite direction of
  interest rates.

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Changing Conditions of the Issuer

• Management risk The company you invested in has
  poor managers. Some portfolio managers only
  invest in companies with good management.
• Business risk Risks associated with the
  companys products/service lines
• Financial risk The risk of bankruptcy because
  the company has borrowed too much money

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Average Annual Returns on Financial Assets
19702004

• Common Stocks 11.30
• 90-Day U.S. Treasury Bills 7.23
• Source Federal Reserve Bank of St. Louis

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Growth of 1,000 Invested in Financial Assets
19702004

• Common Stocks 38,078
• 90-Day U.S. Treasury Bills 10,739
  

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Risks with Financial Assets19702004
Annual Returns
Highest Lowest
Range Stocks 37.4 26.5
63.9 T-Bills 14.1 1.0
13.1
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Risk Premiums

• Return on U.S. Treasury Bills (T-Bills) is
  considered risk free because they have a short
  maturity and they are guaranteed by the U.S.
  Government.
• Any return in excess of the T-Bill return is
  called the investments risk premium.
• An important concept is the market risk premium.
• From 19702004, this premium was 4.07
  (11.37.23).
• Using longer term data, the premium is close to
  8.
• Controversy exists over the value for the premium.

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A Portfolio
A Portfolio is simply a group of assets held at
the same time
Stocks
Bills
Bonds
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Why Diversification Works

• Diversification means owning a variety of
  investments.
• The portfolio of investments can have less risk
  than the individual investments due to
  correlation.
• Diversification lowers investment risk because
• Asset returns are poorly correlated.
• The return correlations among stocks, bonds, and
  T-bills are low so holding these investments in a
  portfolio is an effective way to reduce risk.
• Diversification is not effective if asset returns
  are strongly positively correlated.

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An Example of Negative Return Correlation
As As Return Changes Bs Return Changes
in the Opposite Direction Holding each gives a
10 constant return
A
10
B
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Diversification Guidelines

• Diversify among intangibles and tangibles
• Remember A house is a major tangible asset.
• Diversify globally
• Invest in foreign securities
• Diversify within asset groups
• Own a variety of common stocks

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Portfolio Risk and the Number of Stocks Held

Risk
Random Risk Lowered by increasing the number of
stocks in the portfolio
Market Risk Remains Unchanged
1
5
15
10
Number of Stocks in Portfolio
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Market and Random Risks

• Random risks are those associated with specific
  companies. This risk can be eliminated by owning
  a sufficient number of stocks.
• These tend to balance out if a sufficient
  number of stocks are owned (about 20).
• Holding too few stocks is foolish because you are
  taking risks that can be eliminated.
• Market risk is the risk associated with the
  overall market.
• It cannot be reduced by owning more stocks.

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Managing Market Risk

• Market risk cannot be eliminated it must be
  managed.
• You manage risk by earning a return that
  compensates you for the risk that you are
  assuming.
• Market risk is measured by a statistical measure
  known as beta.
• If your portfolio is as risky as the overall
  stock market, you should earn the market risk
  premium.
• If your portfolio is more risky than the overall
  stock market, you should earn more than the
  market risk premium.

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The Beta Risk Measurement

• Beta is a statistical measure that compares the
  risk of an individual stock to the risk of the
  entire market.
• If a stock has a beta greater than 1, it is
  considered more risky than the overall stock
  market.
• Therefore, the return for this stock should be
  greater than the return of the overall stock
  market.
• If a stock has a beta less than 1, it is less
  risky than the overall stock market.
• The return for this stock should be less than the
  return for the overall stock market.

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Sample Beta Values

• Sirius 3.9
• Micron Technology 2.4
• eBay 1.7
• Citigroup 1.4
• Southwest Airlines 0.9
• Barrick Gold 0.4
• Exxon-Mobil 0.4
• Kellogg 0.1

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Estimating a Stocks Required Return

• First, determine the stocks risk premium
• Find its beta (example 1.5)
• Multiply the beta by the market risk premium
  (say, 8)
• Market risk premium 1.5 8 12
• Second, add the current risk-free rate (say 5)
• Required return 12 5 17

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Making Stock Selections

• Find the stocks excess return (also called
  alpha).
• Alpha expected return required return
• Select stocks with positive alpha values.
• Choose the stocks with the largest alpha values.
• Understand that determining expected and required
  returns is very difficult.
• Finding the required return is especially
  problematic.
• Beta may not always be a good measure of risk.
• Beta is calculated from historical data.

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Selecting Stocks An Example
Stock Beta Req. Exp. Alpha Decision
Ret. Ret. Value
_________________________
________ A 0.5 7.8 10.0 2.2
Strong Buy B 1.5 16.3 14.0 2.3
Strong Sell C 2.0 20.5 21.0 0.5
Neutral
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Required Rates of Return in Relation to Beta
Values
Required rates of return
17
Rate of return in market
Risk premium of 1.5 beta stock 12
13
Market risk premium 8
5
0
1.0
1.5
Beta value
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Acquiring Securities

• Dollar Cost Averaging (DCA)
• You make equal investments at regular time
  intervals.
• Over time, you invest at an average cost.
• It also has the advantage of establishing a
  periodic investment habit.
• Routine Investment Plans
• Dividend reinvestment plans (DRIPs)
• Choose to reinvest dividends rather than
  receiving cash.
• Also, many mutual funds allow you to set up
  automatic transfers from your checking account to
  a mutual fund.

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DCA 1,000 Invested Each Month
Shares purchased
Total shares
Total cost
Avg cost
Cuml. profit
Date
Price
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Selling Securities

• The decision to sell securities is at least as
  difficult as the decision to purchase. Some
  investors believe it is the hardest decision.
• When should an investor sell?
• If the security becomes overvalued
• Tax reasons such as offsetting capital gains and
  losses
• Your investment objectives change such as the
  need for current income as compared to price
  appreciation.

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Economic Changes and the Portfolio

• Buy and hold strategy Ignore economic changes
  and stick with your security selection
• Economic cycles are difficult to forecast so
  trying to anticipate changing conditions and
  adjusting your portfolio is almost impossible.
• Market-timing strategy Try to enhance your
  return by anticipating economic cycles. Investors
  with this strategy must believe it possible to
  forecast changing economic cycles.
• If economic conditions dont change, stick with
  your portfolio allocations.

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Some Issues on Market Timing

• Timing is very difficult. There is little
  evidence supporting the idea that professional
  investment managers can time the market well.
• Timing can add to investment risk in the sense
  that it increases potential gains and losses.
• Bottom line Construct a sound portfolio and
  stick with it!

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Discussion Questions

• Explain the iron law of risk and return.
• Define risk.
• Identify the risks associated with the changing
  conditions of the security issuer.
• Explain the concept of the investment risk
  premium.
• Explain why diversification can lower investment
  risk.
• Identify the guidelines of diversification.
• Compare random and market risk.

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NEXTChapter 11Stocks and Bonds