Investment Strategies and Risk Management in Personal Finance

Before beginning an investment program…

…our financial lives should be in order

Savings

The accumulation of excess funds by intentionally spending less than earned.

Investing

Taking some of the money saved and putting it to work so that it makes even more money.

Unearned or passive income

Money made in investing is sometimes called that because once we have sacrificed and saved, we don't have to do extra work to earn the investment returns.

Securities

Negotiable instruments of ownership or debt, including common stock, preferred stock, bonds and mutual funds, and by buying real estate.

Stocks

Shares of ownership in a corporation.

Bonds

Represent loans to companies and governments.

Portfolio

The collection of multiple investments in different assets chosen to meet our investment goals.

the longer we stay with an investment

the less likely we are to lose money and the more likely that we will earn returns close to those shown large

Financial risk

Tied to the possibility that the company will fail to pay any return to the investor.

Total return

The income an investment generates from a combination of current income and capital gains.

Current income

Money received while we own an investment, usually received on a regular basis as interest, rent, or dividends.

Rent

Payment received in return for allowing someone to use our real property, such as land, machinery, or a building.

Dividend

A portion of a company's earnings that the firm pays out to its shareholders.

Capital gain

occurs only when we actually sell an investment that has increased in value. It is calculated by subtracting the total amount paid for the investment (including purchase transaction costs) from the higher price at which it is sold (minus any sales transaction costs).

Rate of return

The total return on an investment expressed as a percentage of its price.

Speculative risk

Exists in situations that offer potential for gain as well as for loss.

Investment risk

the uncertainty that the yield on an investment will deviate from what is expected. For most investments, the greater the risk is, the higher the potential return.

Treasury bill (T-bill)

a government IOU of less than one year. Because T-bills are essentially risk-free investments, they pay low returns. Some invest in T-bills to safeguard their money until it can be invested at a later time. Others, perhaps already in retirement, are concerned only with preserving their savings.

Equity risk premium

demand this for our willingness to make investments for which there is no guarantee of future success. This risk premium constitutes the difference between a riskier investment’s expected return and the totally safe return on the T-bill.

Risk tolerance

Our willingness to weather changes in the values of our investments.

Investment philosophy

one’s general approach to tolerance for risk in investments, whether it is conservative, moderate, or aggressive, given the financial goal(s) to be achieved. The more risk we take, within reason, the more we can expect to earn and accumulate over the long term.

Conservative investment philosophy

we accept very little risk and are generally rewarded with relatively low rates of return for seeking the twin goals of a moderate amount of current income and preservation of capital.

Preservation of capital

We do not want to lose any of the money we have invested.

Risk averse

one who tends to dislike the ups and downs of the market and is unable to put money into investments that seem risky. About 25 percent of investors describe themselves as conservative investors,

Conservative investors include

Treasury bills, notes, and bonds, municipal bonds, high-quality (blue-chip) corporate bonds and stocks, balanced mutual funds (which own both stocks and bonds), certificates of deposit, and annuities.

Moderate investment philosophy

Held by those seeking capital gains through slow and steady growth in the value of their investments along with some current income.

Aggressive investment philosophy

Strive for a very high return by accepting a high level of risk.

Aggressive investors include

capital gains.

Active investor

carefully studies the economy, market trends, and investment alternatives; regularly monitors these factors; and makes decisions to buy and sell, perhaps three or four or more times a year, with or without the advice of a professional.

Calculating the Real Rate of Return (After Taxes and Inflation) on Investments

1. Identify the rate of return before income taxes.

2. Subtract the effects of income taxes to obtain the after-tax return.

3. Subtract the effects of inflation from the aftertax return to obtain the real rate of return on the investment after taxes and inflation.

Passive investor

Does not actively engage in trading of securities or spend large amounts of time monitoring their investments.

do-it-yourself (DIY) investors

do not generally require the advice or services of a wealth manager.

SMART goals

Specific, Measurable, Attainable, Realistic, and Time goals.

Lending investments

deposit money in banks, credit unions, and savings and loan association (via savings account and certificates of deposit) or by lending money to the government (via treasury notes and bonds as well as state and local bonds) businesses (corporate bonds), mortgage-backed bonds (such as Ginnie Macs), and life insurance companies (annuities)

debts

generally offer both a fixed maturity and a fixed income.

Fixed maturity

Borrower agrees to repay the principal to the investor on a specific date.

Fixed income

Borrower agrees to pay the investor a specific rate of return for use of the principal.

Equities or Ownership Equities

(ownership investments); buy common or preferred corporate stock (to obtain part ownership in a corporation) in publicly owned companies, purchase shares in a mutual fund company (which invests our funds in corporate stocks and bonds), put money into our own business, purchase real estate, buy commodity futures (pork bellies or oranges), or buy investment-quality collectibles (such as rare antiques or coins).

Real Rate of Return

Return after accounting for the effects of both inflation and income taxes.

Brokers

Adhere to suitability standard.

Suitability Standard

Brokers are free to sell investments generating the heftiest profits and commissions, as long as they are judged 'suitable' for a client based on factors like investment goals, age or risk tolerance.

Fiduciary Standard

Financial advisors are legally obligated to always act in the best interest of the client at all times, even at the cost of their own firm.

Certified Financial Professional™ (CFP®)

All financial advisors working as a Certified Financial Professional™ (CFP®) are held to a strict standard of fiduciary duty.

Random Risk

the risk associated with owning only one investment of a particular type (such as stock in one company) that, by chance, may do very poorly in the future because of uncontrollable or random factors, such as labor unrest, lawsuits, and product recalls.

Diversification

the process of reducing risk by spreading investment money among several different investment opportunities—provides one effective method of managing random risk as it reduces the ups and downs of a portfolio.

Market Risk

the possibility for an investor to experience losses due to unknown factors that affect the overall performance of the financial markets.

Market risk occurs

when the value of an investment drops due to influences and events that affect all similar investments. Examples include a change in economic, social, political, or general market conditions; fluctuations in investor preferences; or other broad market-moving factors, such as a recession, political turmoil, changes in interest rates, and natural disasters.

Total Risk

In an investment consists of the sum of the random risk and the market risk.

Business Failure Risk

The possibility that the investment will fail, perhaps go bankrupt, and result in a massive or total loss of one's invested funds.

Inflation Risk

the danger that our money will not grow as fast as inflation and, therefore, not be worth as much in the future as it is today.

Deflation Risk

the chance that the value of an investment will decline when overall prices decline.

Time Horizon Risk

the sooner our invested money is supposed to be returned to us—the time horizon of an investment—the less the likelihood that something could go wrong. The more time our money is invested, the more it is at risk.

Regulatory Risk

Results from changes in the income tax or legal environments set by a government.

Business-Cycle Risk

the fact that economic growth usually does not occur in a smooth and steady manner and this affects profits as well as investment returns.

recessions

contractions in the economy, last one or more year

Market-Volatility Risk

All investments are subject to occasional sharp changes in price as a result of events affecting a particular market for similar investments

Global Investment Risk

The more globally diversified our portfolios, the smoother our total investment returns should be over time. However, international investing exposes us to additional unknowns.

Liquidity Risk

the risk that a given security or asset cannot be traded quickly enough in the market to prevent a loss (or make the required profit).

Liquidity

the speed and ease with high an asset can be converted to cash

Illiquid

take weeks, months, or even years to sell, all while market values continue to change.

Marketability Risk

When we have to sell a certain asset quickly, it may not sell at or near the market price.

Reinvestment Risk

The risk that the return on a future investment will not be the same as the return earned by the original investment.

Commissions

usually the largest transaction cost in investments. Much like the fees paid to real estate professionals, these are fees or percentages of the units or selling price paid to salespeople, agents, and companies for their services—that is, to buy or sell an investment.

Commission range widely based on the investment product and the level of service offered in the transaction.

-stock transactions may require a 1.5 to 2.5 percent commission to a full-service broker

-trades can be made on the Internet for less than $10;

-bonds typically trade with commissions between 0 to 2.0 percent;

-mutual funds, 0 to 8.5 percent;

-real estate, 4.5 to 7.5 percent;

-options and futures contracts, 4.0 to 6.0 percent;

-limited partnerships, 10.0 to 15.0 percent;

-collectibles perhaps as high as 15.0 to 30.0 percent depending on the type of item.

Leverage

Borrowed funds are used to make an investment with the goal of earning a rate of return in excess of the after-tax costs of borrowing.

Securities Markets

Places where stocks and bonds are traded.

Bull Market

results when securities prices have risen 20 percent or more following two 20 percent declines in the market. last an average of about four years and have seen an average gain of 112 percent.

Bear Market

securities market in which prices have declined in value by 20% or more from previous highs, often over the course of several weeks or months. Average length around 16 months, average decline is 36%

Bull (in the market)

is a person who optimistically expects securities prices to go up, regardless of where we may be at any given time in the market

Bear

A person who pessimistically expects the general market to decline.

Income versus capital gain

Current investment income, such as interest, is taxed at one's marginal tax bracket, however, capital gains and qualified dividends are typically taxed at special lower rates.

Tax-deferred investments

The income and capital gains from investments within employer-sponsored retirement accounts are not subject to income taxes until the funds are withdrawn. Thus, such investments rise in value much more quickly than those that are taxed.

Tax-exempt income

Income earned from municipal bonds is exempt from federal income taxes. The higher the tax bracket for the investor, the more that can be saved in taxes, raising the after-tax return of the investment.

Tax-exempt investment account

The income and capital gains from investments within Roth IRA accounts are not subject to income taxes, unless the funds are removed from the account within five years of opening it.

Market correction

A reverse movement of at least 10 percent (but less than 20 percent) in a stock, bond, commodity, or index to adjust for recent, too rapid, price rises.

Market volatility

Tthe price dispersion of an investment based on historical prices over a specified period. If the prices of a security fluctuate rapidly in a short-time span, it is termed to have high volatility. If the prices of a security fluctuate slowly in a longer-time span, it is termed to have low volatility.

Common Trading Mistakes

-Being Overconfident

-Setting Unrealistic Goals

-Trading Too Much

-Buying High and Selling Low

-Borrowing to Invest to Recover Losses

-Taking on Too Much Risk

Hold and hope strategy

requires waiting for the stock to return to the purchase price, which may take

Averaging down

requires that we throw good money after bad in hopes that the stock will perform well, particularly if we are desperate to get even on an investment.

Loss aversion

We are more sensitive to declines in our investments than we are to investment gains.

Market efficiency

The speed at which new information is reflected in investment prices.

Efficient market hypothesis

That security prices are reflective of their true value at all times because publicly available information has driven market prices to the correct level.

Market timers

attempt to predict the short-term movements of various markets (or market segments) and, based on those predictions, move assets from one segment to another in order to capture market gains and avoid market losses. Essentially, market timers try to outguess the trend of stock prices.

Herd behavior

which arises when investors decide to copy the observed decisions of other investors or movements in the markets rather than follow their own beliefs and goals

Stock market bubble

a surge in equity prices, often more than warranted by the fundamentals and usually in a particular sector, followed by a drastic drop in prices as a massive selloff occurs.

Behavioral finance theory

attributes stock market bubbles to cognitive biases that lead to groupthink and herd behavior.

ex. dot-com bubble in the late 1990s where there was no attention given to the real underlying value and profit potential of many new technology companies. The dot-com bubble burst in 2000 leading to a significant bear market.

Buy and hold

Investors buy a widely diversified mix of stocks and/or mutual funds, reinvest the dividends, and hold on to those investments almost indefinitely.

Portfolio diversification

The practice of selecting a collection of different asset classes of investments chosen for their potential returns and dissimilar risk-return characteristics.

Dollar-cost averaging

systematic program of investing equal sums of money at regular intervals regardless of the price of the investment. In this approach, the same fixed dollar amount is invested in the same stock or mutual fund at regular intervals over a long time.

below-average costs

average costs of an investment if more shares are purchased when the price is high

average share price

calculated by averaging the amounts paid for the investment. Divide the share price total by the number of investment periods.

average share cost

more meaningful amount in terms of our portfolio, is the actual cost basis of the shares we acquired

Dividend-reinvestment plan (DRIP)

companies that allow investors to purchase shares of stock on a dollar-cost basis directly from them without the assistance of a stockbroker and then to continue to invest on a regular basis with low or no brokerage commissions

Asset allocation

a form of diversification, is deciding on the proportions of our investment portfolio that will be devoted to various categories of assets. Asset allocation helps preserve capital by selecting assets so as to protect the entire portfolio from negative events while remaining in a position to gain from positive events.

Asset Allocation Requires Only Three Basic Types of Investments

(1) stocks and/or stock mutual funds (equities),

(2) bonds (debt)

(3) cash (or cash equivalents like Treasury securities).

110 Rule

The percent to invest in equities is 110 minus our age.

120 Rule

The percent to invest in equities is found by subtracting age from 120, yielding a somewhat more aggressive portfolio and perhaps a better rule for someone with a higher risk tolerance.

New Portfolio Thinking Rules

Suggests proportions by age for investing in stocks and stock mutual funds with the remainder going to bonds and cash.

Rebalancing

an account management feature that automatically keeps the asset allocation in line with investment intentions. It allows individuals to keep their risk level in check and minimize risk. Rebalancing brings the different asset classes back into proper relationship following a significant change in one or more of the investment types.