The Investment Decision
Chapter 12
Planning Your Financial Future, 4e
by: Boone, Kurtz & Hearth
Why Invest?
 Some people have specific reasons for
investing





Supplement current income
Reduce current and future tax liability
Send children to college
Retire comfortably
For fun
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Why Invest?
 We’re living longer—thus, we’ll have a longer period of

retirement
Personal incomes are not rising rapidly

Experts expect personal incomes to keep pace with inflation
 To raise your standard of living, you’ll need to earn more than
inflation
 The labor market is changing


People are changing jobs many times during their life and spend
some time unemployed
Saving/investing can help you weather the storm
 Self-directed retirement plans are now the norm

Individual is responsible for most, if not all, investment decisions
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The Steps in the Investment
Process
 Know your goals
 Your present situation will impact those goals


If one goal is a secure retirement and your employer
does not offer a retirement savings plan, you’ll have to
do this on your own
If you already own your own home, saving for a down
payment wouldn’t be a goal—maybe you’d be focused on
paying down your mortgage
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Assessing Risk and Return
 How long do you plan to invest (your expected
holding period)?

Over longer time periods you can afford more risk
 What level of
your goals?

expected return is required to meet
Higher expected returns mean taking higher risks
 How much risk are you comfortable with?


If you panic at every daily fluctuation, you should stick
with lower risk investments
Personal characteristics, such as age and income,
influence risk tolerance
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Selecting the Right Investment
 Examine your investment goals, time horizon, risk
tolerance, desired return, etc., and choose your
investments
 Stocks – represent ownership in a company

Share in the company’s profits
 May receive cash dividends
 May receive capital appreciation (main reason people invest in
stocks)

No maturity date
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Selecting the Right Investment
 Bonds – represents a promissory note issued by a
corporation/entity promising to pay interest and
principal


Bonds don’t have to pay interest, but if they have a
coupon rate they should
Bonds usually have a maturity date (up to 30 years or so)
 Receive benefits through interest income

Main reason people invest in bonds
 May experience price appreciation
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Selecting the Right Investment
 Money market instrument – a lending investment that
matures within one year

Examples include
 Treasury bills
 Bank savings accounts

Typically pay low interest rates but are very low risk
 Two aspects to investment selection, or asset allocation

Strategic
 Decisions concerning the general mix of investments (i.e., 50% stocks,
30% bonds, 20% money market)

Tactical
 Selecting specific investments that are best for you (i.e., choosing an
index mutual fund for the stock portion of your investments)
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Managing Your Investments
 Buy and hold philosophy

A passive approach wherein you purchase a set
of investments and do not manipulate the
investments
 Make changes only if and when your goals or
personal situation changes
 Active philosophy

Actively watch the performance of your
investments, buying/selling as you see fit
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Understanding Risk and Return
 By investing, you EXPECT to earn some rate of
return, but it always has some degree of risk
because it is an EXPECTATION
 Sources of Investment Returns

Income
 Dividends (stocks)
 Interest (bonds)

Capital appreciation (price of investment increases)
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Understanding Risk and Return
 Compare the income vs. price change portion
of various investments over a recent 10-year
period
Average
Annual
Return
Income
Portion
Price
Change
Portion
Stocks
10.6%
Little
Most
Bonds
6.6%
Most
Little
4%
All
None
Investment
Money market
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Measuring Investment Returns
 Total Return


Return you earned on the amount you invested
over a certain time period (usually one year, but
not necessarily)
Includes both income and price changes
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Measuring Investment Returns
 Example: You bought 1,000 shares of
stock
one year ago at a price of $50. You sold it for
$55 because you felt the future uncertainly
was too great. During that time you received
dividends of $1 per share. Calculate your
total return from your investment.


Total Return = (Selling Price + Dividends –
Purchase Price)  Purchase Price
Total Return = ($55 + $1 – $50)  $50 = 12%
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Calculating Average Returns
Annual Return
EOY Value of $1,000
(cumulative)
Year
A
B
A
B
1
15%
45%
$1,150
1,450
2
15%
0%
1,322.50
1,450
3
15%
0%
1,520.88
1,450
Average
(Arithmetic)
15%
15%
Average
(Compound)
15%
13.18%
Can overstate the
actual return to
investor.
Clearly A is the
better
investment.
Measures actual
change in wealth.
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What is Investment Risk?
 Risk is the uncertainty that an investment’s actual return


will not be what you expected it to be
There’s an upside and a downside
Types of investment risk

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Default risk
Credit risk
Tax risk
Purchasing power risk
Interest rate risk
Market risk
Event risk
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Figure 12.4: Annual Returns on Stocks
and Treasury Bills: 1979–2003
Stocks
have more
market risk
than T-bills.
Source: Based on data from Morningstar, Inc., and the Federal Reserve Board.
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Are Risk and Holding Period
Related?
 The longer your holding period, the more
risk you should consider taking
 Between 1926 and 2003, stocks had returns
< 0% for 22 of the 78 years

But when looking at a longer 10-year holding
period, there were only negative returns for 4 of
the 68 rolling 10-year periods
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Figure 12.5: Stock, Bond, and
Treasury Bill Average Returns
T-bills have
only slightly
outperformed
inflation.
Source: Based on data from Morningstar, Inc., and the Federal Reserve Board.
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Figure 12.6: Investment Growth
over a 25-Year Period: 1979–2003
Source: Based on data from Morningstar, Inc., and the Federal Reserve Board.
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Comparing Stocks, Bonds and
T-Bills
 Stability of

principal
Value of investment will never fall below what you originally
invested
 T-bills are the winner
 Current income

Historically bonds have paid more income than stocks or t-bills
 Stability of

Bonds are the winner—you know how much income you are
promised each year
 Growth of

income
income
Stocks are the winner because dividends tend to grow over time,
while bond income remains fixed
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Some Lessons for New Investors
 To earn high returns, you have to be willing to take
high risks
 Diversification is helpful

Can help reduce risk without decreasing return a great
deal (due to comovement)
 Past performance is not a guarantee of
performance
 Financial markets are fairly efficient


future
Fair, orderly, and very competitive (lots of buyers and
sellers)
No “easy money”
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Some Lessons for New Investors
 Avoiding common investment mistakes

Chasing returns
 Investing your money based on how well an investment performed last
period

Fad investing
 Investing in something simply because others are doing so




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Buying right after a major price increase or selling right after a
major price decline
Hanging onto a loser
Investing with no plan
Trusting the self-proclaimed gurus
Fearing the wrong risks
 Being unwilling to take risks—especially if you have a long-term
investment horizon
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Sources of Investment
Information
 Problem isn’t that there is too little information, but too

much
Periodicals and newspapers

Newspapers, local & business-oriented
 Investor’s Business Daily
 The Wall Street Journal
 Barron’s
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Periodicals
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Time
U.S. News & World Report
Business Week
Forbes
Kiplinger’s Personal Finance
Money
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Sources of Investment
Information
 Investment advisory services
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Moody’s and Standard & Poor’s
Value Line
Morningstar
Brokerage firms
Investment newsletters
 Computerized sources of
information
investment
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Web Links
Good source for basics
http://moneycentral.msn.com/investor/home.asp
http://www.quicken.com/
http://www.kiplinger.com/
http://www.morningstar.com/
http://www.vanguard.com/
http://www.nyse.com/
http://www.nasdaq.com/
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