1 roadmap for investing wisely for a lifetime leslie lum bellevue community college
TRANSCRIPT
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Roadmap for Investing Wisely for a Lifetime
Leslie LumBellevue Community College
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The Roadmap
• Save
• Focus on financial goals
• Understand returns
• Understand risk
• Asset allocation
• Monitor your investments
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Rule #1: You can make more money saving aggressively than you can investing aggressively
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How much does a typical family make?
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What happens to your income over your life?
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How are we doing at savings?
Savings rate as a percent of disposable income
-5
0
5
10
15
20
25
30
1929 1934 1939 1944 1949 1954 1959 1964 1969 1974 1979 1984 1989 1994 1999 2004
Source: http://www.bea.gov/bea/dn/nipaweb/TableView.asp#Mid
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Could we save more?
2004 Household Saving Rates (as a percent of disposable income)
-4.0 -2.0 0.0 2.0 4.0 6.0 8.0 10.0 12.0 14.0
Australia
Austria
Canada
Finland
France
Germany
Ireland
Italy
Japan
Korea
Netherlands
Norway
Sweden
Switzerland
United States
http://stats.oecd.org/WBOS/default.aspx?DatasetCode=REFSERIES
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Rule #2: If you don’t have goals, you won’t achieve them.
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Annual Budget vs Long-Term Financial Goals
• Trade off between spending money now and setting aside money for long-term goals
• How do you make your decision?
• What are the costs?
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Lay out your goals
• Down payment on house
• Wedding
• College tuition
• Starting your own business
• Retirement
• Estate (Inheritance or charity)
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Rule #3: Know how to measure returns.
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Returns
Always calculate returns on an annualized basis
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Calculate the annualized return
• You have an outstanding balance of $500 on your credit card. You are late in paying and were only able to pay the minimum $10. Your APR on the card is 22% above prime. The late payment charge is $35. Assume the prime rate is 7% now.
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Calculating returns – time value of money
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Calculating lost return
• You want to buy a HDTV set for $1500. What is this (future) costing you? (Use 20 years and 8% return. We use 8% because it’s historically the rate of return on investments over a long period of time.)– $1785– $3393– $4837– $6991
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You are a typical employee in your 20s who when you left your job in 2005 cashed out (66% do) your 401K account of less than $10,000. What is the cost of cashing out your account if your balance was $8000?
Calculating lost return
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Which is more?
• Saving $4000 a year from 25 to 45 years old and then no more savings but hold in account
• Saving $8000 (double) a year from 45 to 65 years old 0
100000200000300000400000500000600000700000800000900000
25 to 45years
45 to 65years
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It’s a moving target
• House in 10 years. Today’s price $200,000
• Kid’s college education in 18 years. Today’s price $50,000
• 2% inflation 3% inflation?
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That’s not the only uncertainty
$800,000 retirement goal in 30 years
At 8% returns?
At 10% returns?
Future Investment Returns Are Uncertain
6%
9%
5%6%
14%
8%
-2%
18%19%
-5%
0%
5%
10%
15%
20%
25%
1970's 1980's 1990's 2000's
Av
era
ge
Ye
arl
y R
etu
rn f
or
De
ca
de Cash
Bond
Stock
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The financial plan
Katie is 25 and trying to plan her financial future. Here are her financial goals in today’s dollars (black) and inflated to when they are due (red).
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Katie does her plan and knows that her heaviest savings will happen in her 30s and 40s.
She also does sensitivity analysis on various inflation and return rates.
She knows that she should save as much as she can when she is younger.
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Rule #4: Understand risk
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Investment Risks
• Market risk
• Business risk
• Interest rate
• Inflation risk
• Political risk
• Fraud risk
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Major asset classes
Annual Return on Cash (Treasury Bill Total Return 1971-2000)
0%
5%
10%
15%
20%
25%
30%
35%
40%
45%
50%
1971
1972
1973
1974
1975
1976
1977
1978
1979
1980
1981
1982
1983
1984
1985
1986
1987
1988
1989
1990
1991
1992
1993
1994
1995
1996
1997
1998
1999
2000
Source: Global Financial Data, www.globalfindata.com
Average 6.7%Standard Deviation 2.7%
About 70% of returns fall within one standard deviation of the average
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BondsAnnual Return on Bonds (Total Return Government Bonds 1971-2000)
-10%
0%
10%
20%
30%
40%
50%
19
71
19
72
19
73
19
74
19
75
19
76
19
77
19
78
19
79
19
80
19
81
19
82
19
83
19
84
19
85
19
86
19
87
19
88
19
89
19
90
19
91
19
92
19
93
19
94
19
95
19
96
19
97
19
98
19
99
20
00
Source: Global Financial Data
Average 9.9%
Standard Deviation 9.3%
About 70% of returns fall within one standard deviation of the average
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Annual Return on Stocks(Total Return S&P 500 1971-2000)
-30%
-20%
-10%
0%
10%
20%
30%
40%
50%
1971
1972
1973
1974
1975
1976
1977
1978
1979
1980
1981
1982
1983
1984
1985
1986
1987
1988
1989
1990
1991
1992
1993
1994
1995
1996
1997
1998
1999
2000
Source: Global Financial Data
Average 14.5%
Standard Deviation
16.5%
About 70% of returns fall within one standard deviation of the average
Stocks
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The more return you need, the more risk you take.The more risk you take, the more return you need.
Major Asset Classes (1971-2000)
0%
2%
4%
6%
8%
10%
12%
14%
16%
18%
0% 2% 4% 6% 8% 10% 12% 14% 16%
Risk (Standard Deviation)
Return (Annual Return)
T-BillsAverage Return 6.7%
Standard Deviation 2.7%
BondsAverage Return 9.9%
Standard Deviation 9.3%
StocksAverage Annual Return 14.5%
Standard Deviation 16.5%
Lessons to learn:
If you want a higher return, you need to invest in riskier assets (stocks)
The more return, the more risk.
322% gain guaranteed?
Only if 322% loss guaranteed!
Return versus Risk
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Given the same return, the investment with less risk is better
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The Northwest is the best.
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Bonds – Risk Return
0%
1%
2%
3%
4%
5%
6%
7%
0% 1% 2% 3% 4% 5% 6% 7% 8% 9%
Risk (Standard Deviation)
Re
turn
(A
ve
rag
e A
nn
ua
l Re
turn
)
Short term T-Bills
Intermediate Corporate Bonds
Long Term Treasuries
Long Corporate
Source: Morningstar.com (3 years of data ending Nov 2006)
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Stock – Risk Return
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Sectors – Risk Return
0%
5%
10%
15%
20%
25%
30%
35%
0% 2% 4% 6% 8% 10% 12% 14% 16% 18% 20%
Risk (Standard Deviation)
Ret
urn
(Ave
rag
e A
nnu
al R
etur
n)
Source: Morningstar.com (3 years of data ending Nov 2006)
Telecom
Financial
ConsumerHealth
Materials
Real Estate
Energy
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International – Risk Return
0%
5%
10%
15%
20%
25%
30%
35%
40%
45%
50%
0% 5% 10% 15% 20% 25% 30% 35%
Risk (Standard Deviation)
Ret
urn
(Ave
rage
Ann
ual R
etur
n)
BrazilMexico
Emerging MarketsSpain
Australia
GermanyUK
Hong Kong Japan
Taiwan
Source: Morningstar.com (3 years of data ending Nov 2006)
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Combined – Risk Return
Rank the categories in order of return
Rank the asset classes in order of risk
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How do you get both a good return and low risk?
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Risk of loss in stocks is high year to year
Annual Stock Price Changes from 1900 to 2006(Percent change year to year in S&P 500)
-55%
-35%
-15%
5%
25%
45%
1900 1910 1920 1930 1940 1950 1960 1970 1980 1990 2000
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Over 5 years, risk of loss is lowerAverage Previous Five Years S&P 500 Gains
-15%
-10%
-5%
0%
5%
10%
15%
20%
25%
30%
1900 1910 1920 1930 1940 1950 1960 1970 1980 1990 2000
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Over 10 years, risk of loss is small
Average Previous Ten Years S&P 500 Gains
-4%
-2%
0%
2%
4%
6%
8%
10%
12%
14%
16%
18%
1900 1910 1920 1930 1940 1950 1960 1970 1980 1990 2000
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Lesson?
• Buy and hold market index funds (doesn’t work for individual stocks)
• Have an emergency fund (3 to 6 months) to tide you over
• Have other sources of income so you don’t have to cash out during down markets
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Rule #5: Asset allocate
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All eggs in one basket?
• 34.6 percent of families had stock in only one company
• 59.5 percent had stock in three or fewer companies
• 9.5 percent had stock in fifteen or more companies
Source: 2004 Consumer Finance Survey
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Can you predict the best return?
0% 20% 40% 60% 80% 100% 120% 140% 160%
1980 Small Stocks
1981 Treasury Bills
1982 Government Bonds
1983 Small Stocks
1984 Corporate Bonds
1985 Europe
1986 EAFE
1987 Emerging Asia
1988 Emerging Asia
1989 Latin America
1990 Corporate Bonds
1991 Latin America
1992 Small Stocks
1993 Emerging Asia
1994 Latin America
1995 S&P 500
1996 S&P 500
1997 S&P 500
1998 S&P 500
1999 Latin America
2000 Mid Cap Stocks
Best-Performing Asset Class(1980-2000)
Based on Index
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Does the risk double with two investments?
The key is having two
investments which aren’t correlated.
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Adding a riskier investment to your portfolio decreases overall risk.
Adding 10% stock to a T-bill portfolio
6.0%
6.5%
7.0%
7.5%
8.0%
8.5%
2.0% 2.2% 2.4% 2.6% 2.8% 3.0% 3.2% 3.4% 3.6% 3.8% 4.0%
Risk (Standard Deviation)
Ret
urn
(A
vera
ge
An
nu
al %
)
90% T-Bill, 10% Stock
100% T-Bill
Increases return.
Reducesrisk!
Data based on 20 years of returns.
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If you allocate the right amount you reduce risk and increase return!
Adding stock to a T-bill portfolio
5.0%
7.0%
9.0%
11.0%
13.0%
15.0%
17.0%
19.0%
21.0%
1.5% 3.5% 5.5% 7.5% 9.5% 11.5% 13.5% 15.5%
10% Stock
0% Stock
20% Stock
30% 40%
50%
60%
70%
80%
90%
100% Stock
Data based on 20 years of returns.
20% stock gives more return with about the same amount of risk
as 0% stock.
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Pension Fund Portfolio
Cash, 1%International Equities, 23%
Domestic Equities, 40%
Global Fixed Income, 23%
Real Estate, 8%Direct
Partnership, 6%
California Pension System $230.3 Billion
Source: www.calpers.ca.gov Investment Portfolio Market Value as of Dec. 31, 2006
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“Millionaires” Portfolio
15%
45%
Private Equity, 5%
International equities, 11%
Cash, 13%
Investment real estate, 7%
Other, 2%
Hedge Funds, 1%
Commodities, 1%
Households with investable assets
of $1 million to $10
million
Source: Fortune, 3/5/2007
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401K Allocations by Age
20%
13%
13%
52%
Fixed Income
Company stock
Balanced funds
Equity funds
Asset allocation for participants in their 20s
Fixed Income, 38%
Company stock, 13%Balanced funds, 10%
Equity funds, 37%
Asset allocation for participants in their 60s
Source: Investment Company Institute
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Rule # 6: Always watch your money.
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Investment Advice
• Take care in choosing your advisor– Experienced– Relevant education– Certified by professional body– Check for disciplinary actions (www.dfi.wa.gov)
• Don’t invest in anything you don’t understand• Watch what your advisor does
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Use indices to monitor your portfolio
Annual Returns of Selected Asset Classes
-30%
-20%
-10%
0%
10%
20%
30%
40%
50%
2002 2003 2004 2005 2006
PhiladelphiaGoldSilver
S&P Midcap
Russell 2000 SmallCap
S&P 500
EAFE InternationalDeveloped
NAREIT RealEstate
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Monitor Your Investments
• Rebalance periodically – but if you buy and sell a lot you will lose money
• Change allocation if you have different cash flow requirements
• Risk and return - Prune the low return/high risk investments
• Don’t make whipsaw changes to your asset allocation
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The Roadmap
• Save
• Focus on financial goals
• Understand returns
• Understand risk
• Asset allocation
• Monitor your investments