Investment Basics

Investment Planning

  1. Determine your investment goals

  2. Obtain the money needed to invest

  3. Determine your risk tolerance

  4. Evaluate and choose investments consistent with your investment goals, risk tolerance and investment horizon

    • Start investing early

    • Look for investments that postpone taxes, such IRA or 401(k) retirement accounts

  5. Monitor the value of your investments

What are Investment Returns and Risk?

  • Investment returns

    • Measure the financial results of an investment

    • Can be expressed in dollar terms or percentage terms

  • Investment risk

    • Pertains to probability of earning a return less than expected

Risk-Return Tradeoff

  • Two key lessons from financial market history

    • There is a reward for bearing risk

    • The greater the risk, the greater the potential reward

  • Risk premium: reward for bearing risk

  • Your potential return on any investment should be directly related to the risk you assume

Types of Investment Risk

  • Inflation risk

    • Risk that the financial return on an investment may not keep pace with inflation

  • Interest rate risk

    • Change in price due to changes in interest rates

    • The value of a fixed income investment (gov’t or corporate bonds) decreases (increases) when overall interest rates in the economy increase (decrease)

Types of Investment Risk

  • Business failure (default) risk

    • Bad management, unsuccessful products, competition, and the economy may cause the business to be less profitable or fail

  • Market risk

    • Prices fluctuate because of general market movements and economic conditions

  • Liquidity risk

    • Risk of not being able to buy or sell an investment quickly without substantially affecting the investment’s value

Diversification

  • Diversification - holding many assets which have returns that do not move in the same direction and to the same degree, reduces the risk of the investment portfolio

  • Diversification is not just holding a lot of assets

    • If you own 50 internet stocks, then you are not diversified

    • However, if you own 50 stocks that span 20 different industries, then you are diversified

Asset Allocation

  • Asset allocation: the process of spreading your assets among several different types of investments such as stocks, bonds, and cash

  • Asset allocation if often expressed in percentages

    • What percentage of my assets do I want to put in stocks and mutual funds? What percentage do I want to put in bonds or CDs?

    • Rule of 110: subtract your age from 110 to determine what percentage of your portfolio should be allocated to stocks

Investment Pyramid

  • Level 1: Financial Security - cash, CDs, money-market mutual funds, and U.S. government bonds

  • Level 2: Safety and income - U.S. securities, selected corporate and municipal bonds, income stocks, and conservative mutual funds

  • Level 3: Growth - Growth stocks, growth-oriented mutual funds, and rental property

  • Level 4: Speculation - Speculative stocks, options, commodities, and other high-risk investments