chapter 10

© Winger & Frasca, Personal Finance: An Integrated Planning Approach, 5th Ed., Prentice Hall Inc.

Personal Finance:An Integrated Planning Approach

Winger & Frasca

Chapter 10 Investment Basics


Major TopicsMajor Topics

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


Risk and ReturnRisk and Return

● What Is Risk?● Sources of Risk● How Much Return Do You Need for the

Investment Risks You Take?● The Iron Law of Risk and Return

– To Earn Higher Returns,– You Must Take Greater Risks


Return VariabilityReturn Variability

A B C

Investment A: noreturn variation,no risk

Investment B: some return variation, somerisk

Investment C:wide returnvariation, muchrisk

5%

6%8%

10%

-8%


Nature of RiskNature of Risk

● The More Variable an Investment’s Return, the Greater Its Risk

● A Highly Variable Return Could Lead to Investment Losses if the Investment Needs to be Sold

● However, the Longer the Investment is Held, the Greater the Chances of Earning the Long-Run Rate of Return


Sources of RiskSources of Risk

● Changing Economic Conditions● Changing Conditions of the Security Issuer


Risk and Changing Economic Risk and Changing Economic Conditions Conditions

● Inflation Risk--Inflation Increases and the Return on Your Investment Does Not Keep Pace

● Business Cycle Risk--Your Investment’s Return Fluctuates in Tandem with the Overall Business Cycle

● Interest-Rate Risk--Newly-Issued Bonds Offer Higher Rates than Your Bonds


Risk and Changing Conditions of Risk and Changing Conditions of the Security Issuerthe Security Issuer

● Management Risk--The Company in Which You Invested Has Poor Managers

● Business Risk--Risks Associated with a Company’s Product/Service Lines

● Financial Risk--The Risk of Insolvency Because the Company Has Borrowed Too Much


Average Annual Returns on Average Annual Returns on Financial Assets: 1970-2000Financial Assets: 1970-2000

● Common Stocks 12.92%● 90-Day U.S. Treasury Bills 7.76%

– Source: Federal Reserve Bank of St. Louis


Growth of $1,000 Invested in Growth of $1,000 Invested in Financial Assets: 1970-2000Financial Assets: 1970-2000

● Common Stocks $43,180● 90 Day U.S. Treasury Bills $10,135


Risks With Financial Assets: Risks With Financial Assets: 1970-20001970-2000

Annual Returns

Highest Lowest Range

Stocks 37.4% -26.5% 63.9%

T-Bills 14.1 2.8 11.3


Investment Risk PremiumInvestment Risk Premium

– Return on U.S. Treasury Bills (T-Bills) Is Free of Risk

– Any Investment’s Return in Excess of the T-Bill Return is Called the Investment’s Risk Premium

– An Important Concept is Market Risk Premium:• Using 1970-2000 Historical Data, this Premium is

5.16 (12.92% - 7.76%)• Using long-term data, the premium is close to 8%• Controversy Exists over Value for the Premium


A Portfolio A Portfolio

A Portfolio is Simply

a Group of Assets

Held at the Same

Time

Stocks

Bonds

Bills


DiversificationDiversification

● Diversification Lowers Investment Risk● It Accomplishes this Goal Because Asset

Returns Are Poorly Correlated● Diversification is Not Effective if Asset

Returns Are Strongly, Positively Correlated● The Return Correlations Among Stocks,

Bonds, and Bills Are Low; Holding These Investments in a Portfolio is Effective


An Example of Negative Return An Example of Negative Return CorrelationCorrelation

As A’s Return

Changes

B’s Return Changes in the Opposite Direction

Holding Each Gives a 10% Constant Return

B

10%

A


Diversification GuidelinesDiversification Guidelines

● Diversify Among Intangibles and Tangibles– Remember: A House Is a Major Tangible

● Diversify Globally– Invest in Foreign Securities

● Diversify within Asset Groups– Own a Variety of Common Stocks


Portfolio Risk and the Number of Portfolio Risk and the Number of Stocks HeldStocks Held

Market Risk: Remains Unchanged

Random Risk: Lowered by Increasingthe Number of Stocks in the Portfolio

Risk

Number of Stocks in Portfolio

1 5 10 15


Market and Random RisksMarket and Random Risks

● Random Risks Are Those Associated with Specific Companies– These Tend to “Balance Out” if A Sufficient

Number of Stocks Are Held (About 20)– Holding Too Few Stocks is Foolish: You Take

Risks That Can Be Eliminated

● Market Risk is the Risk Associated with the Overall Market: It Cannot Be Reduced by Holding More Stocks


Managing Market RiskManaging Market Risk

● If Your Portfolio Is as Risky as the Overall Market, You Should Earn the Market Risk Premium (Say, 8%)

● If Your Portfolio is Riskier, Then You Should Earn an Extra Premium (Something More than 8%)

● A Precise Risk Measurement is Needed: A Stock’s Beta


The Beta Risk MeasurementThe Beta Risk Measurement

● Beta Measures a Stock’s Risk in Relation to the Overall Market Risk

● If the Market Goes Up and a Stock’s Price Goes Up by a Greater % Amount, It Has a Beta Greater than 1.0; if it Goes Up by a Smaller % Amount, it Has a Beta Less Than 1.0

● While Betas Can Be Negative, Most Are Positive


Sample Beta ValuesSample Beta Values

● America Online 2.6● AT&T 1.0● Barrick Gold 0.7● Gillette 0.8● Intel 1.5● Southwest Airlines 0.8● Texaco 0.3


Estimating Required ReturnEstimating Required Return

● First, Determine the Stock’s Risk Premium– Find its Beta (say 1.5)– Multiply by the Market Risk Premium (say, 8%)– So, 1.5 x 8% = 12%

● Second, Add the Current Risk-Free Rate (say 5%)Then, Required Return = 12% + 5% = 17%


Making Stock SelectionsMaking Stock Selections

● Find a Stock’s Alpha Value:Alpha = Expected Return - Required Return

● Select Stocks with the Largest Alpha Values

● Understand that Determining Required Return is Very Difficult


Selecting Stocks: An ExampleSelecting Stocks: An Example

Stk 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


Required Rates of Return in Required Rates of Return in Relation to Beta ValuesRelation to Beta Values

Beta value

17

13

1.0 1.5

Rate of return in market

Market risk premium = 8%

5

Required rates of return %

Risk premium of 1.5 beta stock = 12%

0


Acquiring SecuritiesAcquiring Securities

● Dollar Cost Averaging– Make Equal $ Investments At Regular Time

Intervals– Over Time, You Invest at an Average Cost

● Routine Investment Plans– Dividend Reinvestment Plans (DRIPS)– Choosing to Reinvest Dividends with Your

Mutual Fund


DCA:$1,000 Invested Each DCA:$1,000 Invested Each MonthMonth

1/1 100.00 $10 100.00 $1,000 $10.00 $ -0-

2/1 83.33 12 183.33 2,000 10.91 200

3/1 125.00 8 308.33 3,000 9.73 (533)

4/1 100.00 10 408.33 4,000 9.80 83

5/1 166.67 6 575.00 5,000 8.70 (1,550)

6/1 100.00 10 675.00 6,000 8.89 750

Date Shares bought Price Total

sharesTotal cost

Avg cost

Cuml. profit


When To Sell SecuritiesWhen To Sell Securities

● If the Security Becomes Over-Valued● To Gain Certain Tax Advantages, Such as

Capital Losses● Your Investment Objectives Change

– You Need to Be More Conservative, or– You Need More Current Income


Economic Changes and the Economic Changes and the PortfolioPortfolio

● As Economic Conditions Change, You Can:– Ignore Such Changes--This is a Buy-and-Hold

Strategy– Try to Exploit Such Changes to Enhance Your

Return--This is Called a Market Timing Approach

● If Economic Conditions Don’t Change– Don’t Change Portfolio Allocations


Some Issues on Market TimingSome Issues on Market Timing

● Timing is Very Difficult--There is Little Evidence Showing that Professionals 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!


Hypothetical Returns andHypothetical Returns and Market Timing Market Timing

1 +10% +40% +40% +10%2 +8% -20% +8% -20%3 +12% +50% +50% +12%4 +6 -10% +6% -10%

Total +36% +60% +104% -8%Ave.

Return+9% +15% +26% -2%

Period Treasury bills

Common stocks

Correct guess

Incorrect guess


NextNextChapter 11Chapter 11

Stocks and BondsStocks and Bonds

chapter 10

Documents

riskreturn modelbuilding

unchangedrandom risk

risk of insolvency

investments return

investment risk premiumreturn

variable return

market risk premium

security issuermanagement