Asset Classes & Financial Markets

Lecture 11

This lecture is part of Chapter 5:Becoming a Millionaire

Today’s Lecture

Asset classes

Historical performance

Be critical of numbers,know what they mean.

Be aware! The data used in this lecture have not been verified nor are they complete.

They are used for illustrative purposes only!

Asset Classes

While we have already talked about these, it is important to realize the qualitative difference between them.

• Cash and Money Markets• Bonds• Real Estate• Stocks

The major asset classes are:

There are of course other asset classes … some better than others

• Cards (Pokemon, Baseball)• Collections (Coins, Stamps)• Art (Paintings, Sculptures)

Asset Classes

Asset classes like cards and collections may be excellent but we shall focus here on the ‘financial’ asset classes of stocks, bonds and money markets plus real estate.

The main reasons being that theses classes are by far the largest and most liquid and therefore suitable for all investors.

Whether or not an asset class is major, its performance will always be benchmarked. Perhaps the most important reference benchmark is inflation.

Asset Classes & Inflation

We already had a look at inflation in the lecture on the time value of money.

If we have a 1000 dollars today, we can ask two (equivalent) questions:

• How many dollars do we need in 25 years to buy the same goods that we can buy now for the 1000 dollars?• What are the 1000 dollars worth in 25 years if we keep them stored in our mattress?

Inflation revisited

A B C D E F G H I23 Inflation45 Present Value 1,000.006 Inflation 4.80% In this many years 25789 Dollars needed to buy the same: $3,228.731011 Worth in present dollars: $309.7212131415

=FV(D6,H6,0,-D5)

=PV(D6,H6,0,-D5)

That’s a big amount! In order to get a bit a better idea about the effect of inflation, it is useful to plot a graph.

Inflation revisitedA B C D E F G H I J K L

23 Inflation45 Present Value 1,000.006 Inflation 4.80%78 Numbers of Years 1 5 10 15 20 25 30 359 Worth in present dollars: $954.20 $791.03 $625.73 $494.97 $391.54 $309.72 $245.00 $193.8010 Dollars needed to buy the same: $1,048.00 $1,264.17 $1,598.13 $2,020.32 $2,554.03 $3,228.73 $4,081.68 $5,159.9411121314

The money grows on trees act

$0.00

$1,000.00

$2,000.00

$3,000.00

$4,000.00

$5,000.00

$6,000.00

0 10 20 30 40

The disappearing money act

$0.00

$200.00

$400.00

$600.00

$800.00

$1,000.00

$1,200.00

0 5 10 15 20 25 30 35 40

Asset Classes & Inflation

Let’s see what this would mean for a bit a higher rate.

Say 24%, the same rate most credit card companies charge you for overdue amounts.

Inflation revisited

A B C D E F G H I J K L23 Inflation45 Present Value 1,000.006 Inflation 24.00%78 Numbers of Years 1 5 10 15 20 25 30 359 Worth in present dollars: $806 $341.1 $116.35 $39.69 $13.54 $4.62 $1.58 $0.5410 Dollars needed to buy the same: $1,240 $2,932 $8,594 $25,196 $73,864 $216,542 $634,820 $1,861,05411121314

The I'm so good act

$0

$500,000

$1,000,000

$1,500,000

$2,000,000

0 10 20 30 40

The disappearing money act

$0

$100

$200

$300

$400

$500

$600

$700

$800

$900

0 10 20 30 40

Credit cards are a baaaaad idea (if you don’t pay at once)!!!!

$0.54$1,861,054

Yes!!! These are the correct numbers!Your $1000 will be worth 54 cents!

Credit Cards

Inflation revisited

A B C D E F G H I J K L23 Inflation45 Present Value 1,000.006 Number of years 2578 Inflation 1.00% 2.00% 3.00% 4.00% 5.00% 6.00% 8.00% 10.00%9 Worth in present dollars: $779.77 $609.53 $477.61 $375.12 $295.30 $233.00 $146.02 $92.3010 Dollars needed to buy the same: $1,282.43 $1,640.61 $2,093.78 $2,665.84 $3,386.35 $4,291.87 $6,848.48 $10,834.7111121314

The I'm so good actAmount needed for same goods vs

Inflation

$0.00$2,000.00$4,000.00$6,000.00$8,000.00

$10,000.00$12,000.00

0.00% 2.00% 4.00% 6.00% 8.00% 10.00% 12.00%

The disappearing money actValue in 25 years vs Inflation

$0.00

$200.00

$400.00

$600.00

$800.00

$1,000.00

0.00% 2.00% 4.00% 6.00% 8.00% 10.00% 12.00%

It is also illustrative to see what a change in interest rates means

Asset Classes & Inflation

So whatever we do, we need to take inflation into account when comparing the performance of asset classes.

Actually, there is no reason to be sad. As such, moderate inflation is not necessarily a bad thing as long as your income growth and/or return on investment can outpace it sufficiently.

Asset Classes & Risk

As mentioned in the lecture on values, risk is an essential issue when evaluating the merits of an investment.

Money MarketBondsStocks

Extremely lowVery low

Medium to High

Asset Class Risk

Hopefully, this will be reflected in the historical returns.

Historical Data

Let us have a look at Siegel’s data again.

Stocks

Bonds

Gold

Dollar

Historical Data - CPI

The consumer price index (CPI) is a good proxy for inflation and therefore a closely watched number. A lot of information (for the US) can be found at the website of the bureau of labour: http://stats.bls.gov/cpi/home.htm

A good page for some useful statistics is:

http://146.142.4.24/cgi-bin/surveymost?cu .

Lets get the average data for most of the past century.

Historical Data - CPI

How does one get these data into Excel? Fortunately, Excel can open html files. But everything ends up in one column.

Data extracted on: December 11, 2000 (10:34 PM)

Consumer Price Index-All Urban Consumers

Series ID : CUUR0000SA0

Data:

Year Jan Feb Mar Apr May Jun Jul Aug Sep Oct Nov Dec Ann1913 9.8 9.8 9.8 9.8 9.7 9.8 9.9 9.9 10.0 10.0 10.1 10.0 9.91914 10.0 9.9 9.9 9.8 9.9 9.9 10.0 10.2 10.2 10.1 10.2 10.1 10.01915 10.1 10.0 9.9 10.0 10.1 10.1 10.1 10.1 10.1 10.2 10.3 10.3 10.11916 10.4 10.4 10.5 10.6 10.7 10.8 10.8 10.9 11.1 11.3 11.5 11.6 10.9

Historical Data - CPI

Use the ‘Text to Columns’ feature in the Data menu, throw out the monthly data and calculate the percentages.

1954 26.9 0.75%1955 26.8 -0.37%1956 27.2 1.49%1957 28.1 3.31%1958 28.9 2.85%1959 29.1 0.69%1960 29.6 1.72%1961 29.9 1.01%1962 30.2 1.00%1963 30.6 1.32%1964 31 1.31%1965 31.5 1.61%1966 32.4 2.86%1967 33.4 3.09%1968 34.8 4.19%1969 36.7 5.46%1970 38.8 5.72%1971 40.5 4.38%1972 41.8 3.21%1973 44.4 6.22%1974 49.3 11.04%

=(B3-B2)/B2

That’s better!

Historical Data - CPILet us compare:

Year Ann Change Average Rate1913 9.901914 10.00 1.01% 10.24 10.23 Average: 3.47%1915 10.10 1.00% 10.60 10.57 Rate: 3.34%1916 10.90 7.92% 10.97 10.921917 12.80 17.43% 11.35 11.291918 15.10 17.97% 11.74 11.671996 156.90 2.95% 167.50 150.981997 160.50 2.29% 173.30 156.011998 163.00 1.56% 179.31 161.221999 166.60 2.21% 185.53 166.60

=AVERAGE(C3:C88)

A big difference!

=POWER((B88/B2),1/(A88-A2))-1

=FV($G$4,A88-$A$2,0,-$B$2)

=FV($G$3,A88-$A$2,0,-$B$2)

Actual DataCompounded with the correct average inflation Rate

Compounded with a simple average

Historical Data - CPIWhat is historical? Which period should one look at?

YearActual CPI Change Rate1913 9.901914 10.00 1.01% 10.231915 10.10 1.00% 10.57 Rate: 3.34%1916 10.90 7.92% 10.921917 12.80 17.43% 11.291918 15.10 17.97% 11.671919 17.30 14.57% 12.061920 20.00 15.61% 12.461921 17.90 -10.50% 12.871922 16.80 -6.15% 13.301923 17.10 1.79% 13.751924 17.10 0.00% 14.211925 17.50 2.34% 14.681926 17.70 1.14% 15.171927 17.40 -1.69% 15.681928 17.10 -1.72% 16.201929 17.10 0.00% 16.741930 16.70 -2.34% 17.301931 15.20 -8.98% 17.881932 13.70 -9.87% 18.471933 13.00 -5.11% 19.091934 13.40 3.08% 19.721935 13.70 2.24% 20.38

0.0020.0040.0060.0080.00

100.00120.00140.00160.00180.00

1900 1920 1940 1960 1980 2000 2020

Average Inflation?

High Inflation?

Low Inflation?

Actual CPI

Compounded

CPI, when compounding with the correct average inflation rate

Historical Data – Dow Jones

The Dow Jones is a good reference for the overall performance of the stock market.

Dow Jones has a nice website with many data:

http://averages.dowjones.com/home.html

As does Standard and Poor’s:

http://www.spglobal.com/index.html

Historical Data – Dow Jones

The difference between the two periods is very big.

Pd. Ending Close %change31/12/1999 11,497 25.22% Simple Average 8.10%31/12/1998 9,181 16.10% Compounding Rate 5.76%31/12/1997 7,908 22.64%31/12/1996 6,448 26.01%31/12/1995 5,117 33.45% Simple Avergage 8.86%31/12/1994 3,834 2.14% Compounding Rate 10.86%31/12/1993 3,754 13.72%31/12/1992 3,301 4.17%31/12/1991 3,169 20.32%31/12/1990 2,634 -4.34%31/12/1989 2,753 26.96%31/12/1988 2,169 11.85%31/12/1987 1,939 2.26%31/12/1986 1,896 22.58%31/12/1985 1,547 27.66%31/12/1984 1,212 -3.74%31/12/1983 1,259 20.27%31/12/1982 1,047 19.60%31/12/1981 875 -9.23%31/12/1980 964 14.93%

Since 1913

Since 1965

These calculations do not take dividends into account.

Repeat: Do not blindly trust averages.

Historical Data – Dow Jones

Let us see what happens if we take dividend into accountPd. Ending Close %change w/Dividend

31/12/1999 11,497.12 25.22% 83,132.67 Simple Average 8.11%31/12/1998 9,181.43 16.10% 65,345.60 Compounding Rate 8.01%31/12/1997 7,908.25 22.64% 55,330.7431/12/1996 6,448.27 26.01% 44,392.4431/12/1995 5,117.12 33.45% 34,678.8831/12/1994 3,834.44 2.14% 25,602.7231/12/1993 3,754.09 13.72% 24,584.9031/12/1992 3,301.11 4.17% 21,245.1631/12/1991 3,168.83 20.32% 20,010.52 Simple Average 8.86%31/12/1990 2,633.66 -4.34% 16,359.15 Compounding Rate 13.78%31/12/1989 2,753.20 26.96% 16,751.1331/12/1988 2,168.57 11.85% 12,989.4031/12/1987 1,938.83 2.26% 11,409.2231/12/1986 1,895.95 22.58% 10,943.0531/12/1985 1,546.67 27.66% 8,783.95 Assumed Dividend 2.00%31/12/1984 1,211.57 -3.74% 6,774.6031/12/1983 1,258.64 20.27% 6,894.5731/12/1982 1,046.54 19.60% 5,638.8131/12/1981 875.00 -9.23% 4,637.1831/12/1980 963.99 14.93% 4,998.57

Since 1913

Since 1965

Dividend has a significant impact. And of course we should not use the average but the yearly values for the dividend.

=D7*(1+C6+$G$16)

Historical Data - Bonds

Quite a lot of information on bonds can be found at:

http://www.federalreserve.gov/rnd.htm

Historical Data – Bonds

Yield on the 10 year treasury note

Year Yield1962 3.95 1.04 1961 11963 4.00 1.081964 4.19 1.13 Simple Average 7.53%1965 4.28 1.17 Compounded Rate 7.51%1966 4.93 1.231967 5.07 1.291968 5.64 1.371969 6.67 1.461970 7.35 1.571971 6.16 1.661972 6.21 1.771973 6.85 1.891974 7.56 2.031975 7.99 2.191976 7.61 2.361977 7.42 2.531978 8.41 2.751979 9.43 3.011980 11.43 3.35

0.00

2.00

4.00

6.00

8.00

10.00

12.00

14.00

16.00

1960 1970 1980 1990 2000 2010

Historical Data – Comparing

It is illustrative to compare the relative changes:

Year Bond Yield CPI Change DJ Change1962 3.95% 1.00% -10.81%1963 4.00% 1.32% 17.00%1964 4.19% 1.31% 14.57%1965 4.28% 1.61% 10.88%1966 4.93% 2.86% -18.94%1967 5.07% 3.09% 15.20%1968 5.64% 4.19% 4.27%1969 6.67% 5.46% -15.19%1970 7.35% 5.72% 4.82%1971 6.16% 4.38% 6.11%1972 6.21% 3.21% 14.58%1973 6.85% 6.22% -16.58%1974 7.56% 11.04% -27.57%1975 7.99% 9.13% 38.32%1976 7.61% 5.76% 17.86%1977 7.42% 6.50% -17.27%1978 8.41% 7.59% -3.15%1979 9.43% 11.35% 4.19%1980 11.43% 13.50% 14.93%1981 13.92% 10.32% -9.23%

-40.00%

-30.00%

-20.00%

-10.00%

0.00%

10.00%

20.00%

30.00%

40.00%

50.00%

1960 1970 1980 1990 2000 2010

Bond Yield CPI Change DJ Change

Historical Data – Comparing.. And the what that means for 1000 dollars:

Year Bonds CPI Stocks no/D Stocks w/ D 1000 Starting sum1962 1039.50 1010.00 891.90 911.90 Divid Assumed average annual dividend on DJ stocks1963 1081.08 1023.33 1043.52 1085.16 2%1964 1126.38 1036.74 1195.56 1264.971965 1174.59 1053.43 1325.64 1427.901966 1232.49 1083.56 1074.57 1186.011967 1294.98 1117.04 1237.90 1390.011968 1368.02 1163.84 1290.76 1477.161969 1459.26 1227.39 1094.69 1282.321970 1566.52 1297.60 1147.46 1369.781971 1663.02 1354.43 1217.56 1480.871972 1766.29 1397.91 1395.09 1726.401973 1887.28 1484.86 1163.78 1474.691974 2029.96 1648.79 842.93 1097.611975 2192.15 1799.32 1165.94 1540.171976 2358.98 1902.96 1374.17 1846.041977 2534.01 2026.65 1136.85 1564.151978 2747.12 2180.48 1101.04 1546.161979 3006.18 2427.96 1147.18 1641.871980 3349.78 2755.73 1318.45 1919.841981 3816.07 3040.13 1196.76 1781.041982 4312.55 3227.40 1431.32 2165.741983 4791.24 3331.00 1721.45 2648.051984 5388.23 3474.90 1657.07 2601.98

0.00

5000.00

10000.00

15000.00

20000.00

25000.00

30000.00

35000.00

1960 1970 1980 1990 2000 2010

Bonds CPI Stocks no/D Stocks w / D

Are stocks really better than bonds?

Comparison

Once again, the conclusion one can draw from these data depends entirely on one’s perspective. The numbers alone mean little.

The interpretation of the numbers must bejustified by sound arguments.

Understanding is the ONLY way even if itmeans going through some math! Solelymemorizing convenient Excel functions ispointless!

Key Points of the Day

The comparison of data is essential in understanding business data.

Know what the numbers mean. The average, e.g., may not be what you think.

The three main asset classeshave rather different historicalperformances.