Personal Finance
Investing Basics
Bill Klinger
Personal Finance
• Review
– Exam
Investing
• First things first
– Pay off debts before investing. Why?
– Example
• Securities
– Stocks, bonds, or money market instruments that represent an
obligation on the part of the issuer.
Securities
• Three major asset classes
– Cash
– Bonds (fixed income)
– Stocks (equities)
• There are others
– Real estate
– Commodities
– Collectables
• Asset allocation
– The percent of your assets in each category
– Very important concept in investing
Securities Markets
• Primary Market—market where new security issues
are first sold to investors; the issuer receives the
proceeds from the sale.
– Initial Public Offering (IPO)
• Secondary Market—financial markets where
previously issued securities are traded among
investors.
– Examples: NY Stock Exchange and the NASDAQ
– Firm makes no money on price changes
1-5
Returns and Rates
• Nominal
– Quoted rate or amount
– The printed value
• Real
– Subtracts inflation
Real rate = nominal rate – inflation rate
Cash
• Money Market Instruments—short-term debt
securities
– Mature within one year
– Examples:
•
•
•
•
U.S. Treasury Bills,
Commercial paper,
Repurchase agreements
Certificates of Deposit (CDs)
• Treasury Bills are special
– The “risk-free asset”
• Returns come from interest
Stocks
(Equities)
• Represent ownership in a firm
• Types
– Common
– Preferred
• Markets
– Primary
• IPO
– Secondary
• Investors
– Institutional
– Individual
• Market cap
– Value of company = (price of a share of stock) x (# of shares)
Equity Returns
• Dividends
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–
–
–
–
Profits returned to the owners
Optional for common stock
Required for preferred stock
Usually quarterly
Sometimes one-time event
• Change in price
– Based on investors’ view of a firm’s future
– Will cause a capital gain or loss
Bonds
(Fixed Income)
• Long-term debt
• Corporate
• Municipal
– State and local government
• Federal
– Treasure Bonds (>2 year maturity)
• Returns
– Interest
– Capital gain / loss if sold before maturity
Investment Return
• Holding period return (total return)
Stocks
return = (priceend – pricebeginning + dividend) / pricebeginning
Bonds
return = (priceend – pricebeginning + interest) / pricebeginning
Taxes on Returns
• Ordinary income tax
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–
–
–
Taxed at marginal rate
Interest
Dividends
Capital gains for securities held less than 1 year
• Capital gains tax
– Currently 15%
– On sale of securities held more than 1 year
• Do example exhibit 14.1
Investment Risks
• Systemic risks
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–
–
–
Risks that all investments share
Economy
Terrorism
Government laws and actions (e.g. the Fed)
• Idiosyncratic risk
– Risk unique to a firm
– E.g. Exploding smart phone, E.coli in food, sticking gas pedals
• Inflation
Measuring Risk
• Range of returns
• Standard deviation
• Subjective evaluation
Exercise
• Deal or No Deal
– You have a 50/50 chance of getting either $500,000 or $1. I offer
you either those odds or $200,000 guaranteed. What do you
take?
– You have a 50/50 chance of either losing $100 or losing $1. I
offer you either those odds or a guaranteed loss of $45. What
do you take?
• What affects your decision?
– Expected value
– Expected utility
1-15
Investment Risks
• Cash
• Stocks (equities)
• Bonds (fixed-income)
Risk – By Asset Class
Worst Annual Return
Since 1925
Average Annual Return
Since 1925
-43.4%
9.6%
Stocks
(-67.6% worst 12 mo.) (162.9% best 12 mo.)
Bonds
Cash
-7.8%
5.5%
.1%
3.7%
Sources: personal.fidelity.com, Morgan Stanley, www.efficientfrontier.com, Federal Reserve – St. Louis
In Class
• In groups of two
– Chapter 14 Financial Planning Problems