Since we are on the topic of investments for the week, this discussion forum is very straightforward: Assume you just inherited $100,000. How would you invest it? Keep in mind that there are many different types of investment vehicles and many different types of asset classes. Use the information you’ve learned from this week’s chapters to help make that decision. You may also reference future chapters if you would like to consider investments besides stocks.
CHAPTER CONTEXT: THE BIG PICTURE
This chapter, the first in “Part 4: Managing Your Investments,” explains the importance of setting investment goals, calculating the investment impact of taxes, and understanding risks, diversification, asset allocation, and market efficiency. Other chapters in this section will consider specific investment strategies and investment products, such as stocks, bonds, real estate, and mutual funds. This chapter establishes a foundation for the section by providing an argument for the need to plan carefully before making an investment decision. An important message to students is the need to differentiate between investing and speculating.
This chapter introduces the process of investing to accomplish goals in the financial plan. The importance of establishing investment goals is stressed, as well as strategies for creating an investment plan to reach those goals. The difference between investing and speculating is considered. Two basic investment categories are discussed: lending and ownership investments. The importance of understanding the roles of interest rates and risk is presented. Six concepts to keep in mind when creating and managing an investment plan are provided, followed by the definition of diversification and diversification strategies. Sections on risk tolerance and asset allocation are next. This chapter concludes with an introduction to securities markets. Emphasis is given to distinguishing between the primary securities market, where initial public offerings and seasoned new issues are traded, and the secondary market. A discussion concerning the definition and roles of organized and over-the-counter (OTC) exchanges is presented. The goals of the Securities and Exchange Commission (SEC) and self-regulatory organizations, as they relate to securities regulation, are discussed. The process and terms of trading actual securities such as stocks and bonds is also presented. The roles of full service, discount service, and deep discount service brokers are discussed in terms of costs, commissions, and service. A review of behavioral biases ends the chapter.
LEARNING OBJECTIVES AND KEY TERMS
After reading this chapter, students should be able to accomplish the following objectives and define the associated key terms:
- Set your goals and be ready to invest.
- Income return
- Derivative securities
- Maturity date
- Par value or principle
- Coupon interest rate
- Capital gain or loss
- Manage risk in your investments.
- Nominal (or quoted) rate of return
- Real rate of return
- Interest rate risk
- Inflation risk
- Business risk
- Financial risk
- Liquidity risk
- Market risk
- Political and regulatory risk
- Exchange rate risk
- Call risk
- Calling a bond
- Systematic or market-related or nondiversifiable risk
- Unsystematic or firm-specific or company-unique risk or diversifiable risk
- Allocate your assets in the manner that is best for you.
- Asset allocation
- Understand how difficult it is to beat the market.
- Efficient market
- Identify and describe the primary and secondary securities markets.
- Securities markets
- Primary market
- Initial public offering (IPO)
- Seasoned new issue
- Investment banker
- Secondary markets
- Organized exchange
- Over-the-counter market
- Bid price
- Ask or offer price
- American Depository Receipt (ADR)
- Trade securities using a broker.
- Round lot
- Odd lot
- Day order
- Open or good-till-canceled (GTC) orders
- Fill or kill order
- Discretionary account
- Market order
- Limit order
- Stop or stop-loss order
- Short selling
- Margin requirement
- Asset management account
- Cash accounts
- Margin accounts
- Margin or initial margin
- Maintenance margin
- Margin call
- Joint tenancy with the right of survivorship
- Tenancy-in-common account
- Discount or online broker
- Full-service broker or account executive
- Online trading
- Day traders
- Locate and use several different sources of investment information to trade securities.
I. Before You Invest
A. Investing Versus Speculating
B. Setting Investment Goals
C. Financial Reality Check
D. Starting Your Investment Program
1. Pay yourself first
2. Make investing automatic
3. Take advantage of Uncle Sam and your employer
5. Make 2 months each year investment months
E. Fitting Taxes into Investing
F. Investment choices
1. Lending investments
2. Ownership investments
G. The Returns from Investing
II. A Look at Risk–Return Trade-Offs
A. Nominal and Real Rates of Return
B. Historical Levels of Risk and Return
C. Sources of Risk in the Risk–Return Trade-Off
1. Interest rate risk
2. Inflation risk
3. Business risk
4. Financial risk
5. Liquidity risk
6. Market risk
7. Political and regulatory risk
8. Exchange rate risk
9. Call risk
1. Diversifying away risk
E. Understanding Your Tolerance and Capacity for Risk
III. The Time Dimension of Investing and Asset Allocation
A. Meeting Your Investment Goals and the Time Dimension of Risk
B. Asset Allocation
IV. What You Should Know About Efficient Markets
V. Security Markets
- The Primary Markets
- Secondary Markets—Stocks
- The New York Stock Exchange (NYSE)
- Over-the-counter (OTC) market
- The rise of electronic trading
- International Markets
- Regulation of the Securities Markets
- SEC regulation
- Insider trading and market abuses
- How Securities Are Traded
- Placing an Order
- Order size
- Time period for which the order will remain outstanding
- Types of Orders
- Market orders
- Limit orders
- Stop orders
- Short Selling
- Dealing with Brokers
- Brokerage Accounts
- Cash Versus Margin Accounts
- Joint Accounts
- Choosing a Broker
- Using a full-service broker
- Using a discount/online broker
- Making the decision
- Online Trading
- Sources of Investment Information
- Corporate Sources
- Brokerage Firm Reports
- The Press
- Investment Advisory Sources
- Internet Sources
VIII. Behavioral Insights
A. Principle 9: Mind games, your financial personality, and your money
C. Disposition effect
D. House money effect
E. Loss then risk aversion effect
F. Herd behavior
- Action Plan
- Principle 10: Just do it!
Principle 1: The Best Protection Is Knowledge
To be a successful investor, you must understand the basics and logic of investing.
Principle 2: Nothing Happens Without a Plan
In order to meet investment goals, you must have a plan. Sometimes the best investment plan is a simple plan that is easy to implement and manage.
Principle 3: The Time Value of Money
An investor’s best ally is time. The earlier an investment plan is developed and put into place, the easier it is to achieve goals and objectives.
Principle 4: Taxes Affect Personal Finance Decisions
The marginal tax rate—the tax rate paid on your next dollar of earnings—plays an important role when selecting investments. It is also important to evaluate investments on an after-tax basis or looking for ways to make investments grow on a tax-deferred basis, keeping in mind that capital gains are taxed at a lower rate than income returns. In the final evaluation, taxes make some investments better and some worse than they would otherwise be.
Principle 6: Waste Not, Want Not—Smart Spending Matters
Keeping costs to a minimum helps you take advantage of the time value of money to an even greater extent. Using a discount broker can help you achieve this goal.
Principle 8: The Risk–Return Trade-Off
Inflation is a form of risk for investors because it erodes the purchasing power of savings. In order to be compensated for inflation risk, you, as an investor, should demand a greater return from your investments. In addition, the more risk (inflation or otherwise) you are willing to assume, the greater the potential reward for that investment. Most investors understand diversification as not putting all their eggs in one basket. However, to mitigate some of the potential negative effects of taking on more risk, you should diversify. Diversification works by having positive returns of one investment offset negative returns of another investment.
Principle 9: Mind Games and Your Money
Investors can make bad decisions through common behavioral biases. The most common biases include overconfidence, disposition effect, house money effect, loss then risk aversion effect, and the herding behavior. Each of these biases can lead an investor to make irrational decisions such as treating “won” money differently than “made” money or doubling-down on a losing investment thereby cutting there perceived loss in half because they only have to make it “half-way back” to break even. This may just be throwing good money after bad.
Principle 10: Just Do It!
Regardless of how much money you make or how old you are, it is important to begin saving and investing as soon as possible. Each day reduces the compounding advantages of time.
REVIEW QUESTIONS AND ANSWERS
Review the following questions and answers to gauge how well you have understood the material presented in the chapter.
- 1. Explain the difference between investing and speculating. Give an example of each.
Investing and speculating are defined as follows:
- Investing entails putting your money in an asset that generates a return. Examples include real estate, stocks, and bonds.
- Speculating generates returns entirely from supply and demand. Examples include comic books, coins, art, futures, options, and gems.
- Why is it important to maintain an adequate emergency fund before creating and implementing an investment program?
As Principle 5 highlights, unexpected events that require immediate use of cash happen occasionally. By having an emergency fund separate from investment monies, you will have liquid funds to cover unexpected expenses without having to interfere with your investment goals. Financial planners typically recommend that 3 to 6 months’ expenses should be set aside into an emergency fund.
- What are five ways to find money to invest?
There are several ways almost anyone can find money from daily living expenses to start an investment program. Examples include paying yourself first, using automatic withholding for investments, taking advantage of matching contributions offered by employers or government tax-favored investments (e.g., IRAs and other retirement plans), investing any windfalls received, and picking two months per year to cut spending and increase investing.
- Why should you look for tax-favored investment strategies? How can these strategies help you attain your goals?
Tax-favored investments consist of two different types of investment vehicles—tax deferred and tax free. Tax-deferred investment accounts, which may also be tax deductible, allow income to be generated without creating a tax consequence until the investment is withdrawn. Tax-free investments, which are not typically tax deductible, grow without tax consequences (tax deferred) and can also be withdrawn tax free. Either of these types of investment accounts effectively increases the rate of return because the returns are not reduced by taxation.
- Name and briefly describe the two basic categories of investments. Provide two examples of each.
Lending investments: debt instruments indicate that you’ve loaned money to an individual or firm. Examples include savings accounts and U.S. Treasury bills.
Ownership investments: these investments represent ownership in an asset or enterprise. Examples include real estate and stocks.
- What are the three primary points of information needed to evaluate the potential total and annual return of a lending investment?
An investor should know the current “market” price, the par value, and the coupon rate. The current price tells the investor how much they will have to pay for the bond. The par value tells the investor how much they will receive if they hold the bond until maturity. Most bonds have a par value of $1,000. The coupon rate tells the investor how much income they will receive on a periodic basis between the time of purchase and the maturity date.
The difference between the purchase price and the par value is the potential capital gain (or loss) the investor could expect. This difference is then added to (or subtracted from) the current income stream to determine the total return. If the total return is divided by the investor’s initial investment, it is then stated as a percentage return. To calculate annualized return, the percentage return is then divided by the holding period, stated in a number of years and fractions thereof, in decimal form.
- Remembering the information from the tax chapter, when it comes to income taxes, why is capital gain income better than dividends or interest income?
Under current tax law, capital gains are better than income returns because taxes are only paid when the investment is sold and the profits are realized, and for those in the highest tax brackets (e.g., 35 percent) capital gains are taxed at a lower rate. This difference is enhanced whenever an investment is held longer than 12 months because long-term capital gains are taxed at either 15 percent or 5 percent, depending on one’s marginal tax bracket.
- What is the basic difference between the nominal rate of return and the real rate of return? Which of them might be a better measure of how well an investment has performed? Why?
The nominal rate of return, sometimes referred to as the quoted rate, is the return earned on an investment unadjusted for inflation. The real rate of return is the nominal rate minus the inflation rate. The real rate of return is a better measure of how well an investment has performed because it takes into account changes in purchasing power.
- Investors need to be aware of nine sources of risk when calculating the risk–return trade-off. List and briefly describe these nine sources of risk.
- Interest rate risk: Fluctuations in security prices due to changes in the market interest rate.
- Inflation risk: The likelihood that rising prices will deteriorate the purchasing power of an investor’s money, and that changes in the anticipated level of inflation will result in interest rate changes, which, in turn, will cause security price fluctuations.
- Business risk: The risk that fluctuations in investment value may be caused by good or bad management decisions, or how well or poorly a firm’s products or services are doing in the marketplace.
- Financial risk: Risk associated with the use of debt by a firm. The more debt a firm takes on, the more interest and principal a firm must pay. If a firm can’t make these payments, for whatever reason, bankruptcy will result.
- Liquidity risk: This risk deals with the inability of investors to sell a security quickly and at a fair market price.
- Market risk: The risk associated with overall market fluctuations.
- Political and regulatory risk: These risks result from unanticipated changes–in the tax code or legal environment–that have been imposed by the government.
- Exchange rate risk: If an investor owns non-U.S. securities, this risk refers to the variability in earnings that result from changing exchange rates. An increase in exchange rates (i.e., the U.S. dollar increases in value) decreases the total return of a foreign investment for U.S. investors.
- Call risk: The risk to bondholders than their bond may be redeemed prior to maturity.
- Differentiate between systematic and unsystematic risk. Which of these is more important to the average investor? Why?
Systematic risk is that portion of a stock’s risk or variability that cannot be eliminated through diversification. Unsystematic risk is an investment’s risk or variability that can be eliminated through diversification. Unsystematic risk is important for investors because this risk can be reduced through diversification.
- Why might investors not be willing to take risks with their investment portfolios even though they take risks elsewhere? What investment concepts might help them be more willing to take an appropriate amount of risk?
Typically, people are more conservative with their investments because of a lack of knowledge about their risk tolerance or investment products. Principle 8: Risk and Return Go Hand in Hand addresses several concepts that can increase investors’ comfort level.
- The risk–return trade-off tells investors that as their level of acceptable risk increases, their level of expected return should also increases.
- The time dimension of investing dictates that higher levels of risk should only be assumed as the time horizon lengthens.
- Diversification reduces the effects of unsystematic risk on the value of a portfolio
- What is the long-term relationship between risk and time? Why is this relationship such an important concept to remember when developing and implementing an investment program?
Principle 8 indicates that some of the risk of any investment seems to disappear as the length of the investment horizon increases. In other words, the longer an investment is held, the less risky it becomes. Although the actual risk of the investment doesn’t actually “disappear,” longer time horizons allow investors to adjust expenditures and increase income over time, which tends to reduce the risk of holding certain investments by smoothing the effects of the potential ups and downs of the market.
- What is meant by the term “asset allocation”? What makes asset allocation such a simple and powerful concept?
Asset allocation is a method for dividing investment money among asset classes, such as stocks, bonds, cash, and real estate. An asset allocation strategy will be influenced by an investor’s time horizon and financial stability (e.g., emergency savings fund). This simple concept is a powerful one because it is an effective method for reducing unsystematic risk through diversification of asset holdings.
- What is the purpose for adjusting your asset allocation as you age? Why wouldn’t “the best” or highest returning portfolio always be prudent?
As you age, your asset allocation should change to accommodate your shorter time horizon. Remaining overly exposed to risky or volatile investments could have a detrimental effect on your portfolio value. By reducing the volatility in your portfolio, you limit your chance of suffering an unrecoverable loss.
- What is the relationship between market efficiency and the success of market timing? Does market timing work consistently? What six efficient market concepts should be considered when investing?
A perfectly efficient market is one where security prices always equal their true value at all times. In effect, efficient market theory states that individuals cannot systematically “beat the market” and that investors should try to stick with their investment plans. Timing the market involves buying stocks before the market rises and selling stocks before the market falls. Systems to “beat the market” do not work consistently and, in fact, seem to provide little help in picking winning investments. Rather than trying to employ some system to beat the market, to maximize returns investors should (1) beware of “hot tips,” (2) keep to their plan and invest for the long term, (3) focus on the asset allocation process, (4) keep commissions down, (5) diversify their portfolio, and (6) seek professional advice if needed.
- Discussion Board Assignment
Class participation is an important expectation of this course. Students are expected to offer feedback (and replies when inclined) to the discussion questions that have been posed for each forum. Students are expected to actively participate in EACH discussion forum throughout the semester. The faculty role is as an observer and facilitator. I will be reading all messages and I may interject in the discussion if needed. Students posting on past week’s boards will not allow for stimulating discussions with classmates; as such, late discussion contributions will not receive any credit.
Discussion Board Evaluation of Assignment:
Postings will be evaluated on the quality of the postings and at times, to the degree that the postings promote discussion with classmates. Participation on all 5 discussion boards throughout the semester is required, and 2 postings will be randomly chosen to be evaluated on the scale below.
It is also understood that students will receive 0 points for late discussion posts.
|0-15 points||16-20 points||21-25 points|
|Minimal Response to the discussion board question||Posting responds to the question but does not demonstrate a thorough understanding of the subject matter.||Posting fully addresses the discussion board question(s), demonstrates a thorough understanding of the subject matter, and shows a good amount of effort.|
Some key suggestions:
- Answer the specific central question that was asked
- Incorporate pertinent and detailed information from assigned readings (whenever applicable) and supplemental material.
- Maintain focus/avoid being sidetracked by tangents
- Present all information clearly and concisely and in an organized manner
- Do much more than merely restate the question and offer a brief response
- Avoid distracting grammar/spelling/etc. problems (please proofread prior to posting)
- Originality of thought is important (do not just copy and paste from PowerPoints or directly from the textbook).