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Investments – An Overview (chapter 13)

 

I. First step:  Emergency Fund – 3 months of living expenses.  Put in interest bearing savings account.  You must have a separate emergency fund BEFORE you take up investment strategies for the long term.

 

II. The goals of investment management:

 

Maximize Return

Minimize Risk

 

Each of these goals is almost always in conflict with the other.

The investment advisor (and you) must determine the “risk level” that is appropriate for each investor (you).  (The amount of “risk tolerance” will depend on personal choice, “stage of life”, other factors such as married/single, children, job security, goals, etc.)

 

Stage of Life examples:

 

Young Adult, Middle-aged Adult, Retirement.  Each stage of life has different return/risk tradeoffs.

 

III. Calculating Returns

 

There are two returns on an investment: 1. any periodic payment (such as a dividend or interest payment, and 2. the capital gain or loss (when the asset, such as a stock or bond, goes up or down in value).

 

A. Return for a single period:

 

Return on Investment = ((P1 – P0) + D1) / P0

 

Example:  Joe buys Sears stock for $85 per share..  He receives a dividend of $8, then sells the stock for $91.  What was Joe’s return on investment in Sears?

 

Return on Investment = (91-85) + 8 / 85 = 14/85 = .165 or 16.5%

 

B. Calculating Annualized Returns

 

So that we can compare returns for different time periods, we often “annualize” returns – i.e. find out how much we made “per year” on a stock or other investment.

 

There are two different ways to calculate annualized returns, one (arithmetic) is easy, the other (geometric) is a bit harder.

 

 

 

 

 

 

1. Arithmetic returns are simply the “arithmetic average” (which is what most people think of as simply the average).

 

Example: Assume Anna held Dell stock for 4 years.  In those 4 years, she earned 9%, 22%, 11% and -6% (in the 4th year, she lost money).

 

Her arithmetic average return would be (9+22+11-6)/4 = 9%

 

 

2. Geometric returns are the average compound returns.

 

The formula for the geometric return is in two steps:

 

Step 1. (1 + percent return) * (1 + percent return) * (1 + percent return) = total return

 

Step 2. Geometric average return = ((total return) ^ (1/number of years)) - 1

 

Example:  Assume Anna held Dell stock for 4 years.  In those 4 years, she earned 9%, 22%, 11% and -6% (in the 4th year, she lost money).

 

Here’s how to calculate the geometric return:

 

Geometric Ave. Return = (1.09 * 1.22 * 1.11 * .94) ^(1/4) - 1 = 1.085 – 1 = .085 or 8.5%

 

3. Important Differences between Arithmetic and Geometric Returns:

 

a. The arithmetic return is always greater than or equal to the geometric return (the two are equal when the returns are constant).

 

b. The arithmetic return can be deceiving.

 

Example:  Suppose you made 50% the first year, then lost 50% the second year.

 

The arithmetic return will be zero.  (which implies you have not gained or lost money).

 

But, you have lost money.  Let’s say you started with $100.

 

Year 1:  $100 * .50 = profit of $50.  You now have $150

 

Year 2:  $150 * -.50 = loss of $75.  You now have $75.

 

Overall, you lost $25 (from $100 down to $75), but the arithmetic average return of zero implies you broke even.

 

 

IV. Measuring Risk

 

A. In finance, “risk” is defined as the “variability of returns”. 

 

For instance, a certificate of deposit (held until maturity) will return 5% every year (not 3% one year and, then, 7% the next year).  But, 5%, every year.  There is no variance in that return.  This would be considered a low risk investment.

 

Now, consider a tech stock such as Intel.  This stock may have returns such as this:  10%, -4%, 43%, -11%.  Your return is higher.  But, so is the variance of returns (i.e. so is the risk).

Each investor must balance his or her desire for return with his or her “risk tolerance”.

 

For a single asset portfolio (if you’re holding only one stock), risk is measured as the “standard deviation” of the stock’s historical returns.

 

You will not have to calculate standard deviation for this class.  It will always be given.  (You have taken a statistics class to teach you standard deviation).

 

B. Historical Performance of Different Types of Assets

 

Roger Ibbotson publishes an annual book called “Stocks, Bonds, Bills and Inflation”, or “SBBI”.  In this book, he tracks (and updates annually) the return and risk of each type of investment, and, compares the investments to inflation.

 

Here are the averages from 1926-2004:

 

                                                                           Average Return        Standard Deviation

 

Small Cap Stocks                                                         17.5%                          33.1%

Large Cap Stocks                                                        12.4%                          20.3%

Long Term Corporate Bonds                                          6.2%                            8.6%             

Long Term Government Bonds                           5.8%                            9.3%

Short Term Government T-Bills                                      3.8%                            3.1%

Inflation                                                                           3.1%                            4.3%

 

 

 

 

 

 

 

 

 

 

1. Lessons from this historical data:

 

  1. There is, indeed, a tradeoff between return and risk.  Historical numbers show the tradeoff.  The tradeoff is not simply a theoretical construct.
  2. Small cap stocks (and stocks in general) provide for a higher return than bonds.  Investors with high “risk tolerance” should invest a suitable portion of their savings in stocks.  (Notice:  “suitable portion”, not “all”)
  3. Historical inflation averages 3.1% per year.  Assets that do not beat the inflation rate are actually losing money in “real terms”.

 

2. More on the startling effects of Time Value of Money

 

If you invested $1 in 1925 in each of the following asset classes, on average, your investment would be worth (in 2004):

Small Cap Stocks                                           $12,968                                                

Large Cap Stocks                                               2,533                                                           

Long Term Government Bonds                     66                          

Short Term Government T-Bills                             18

Inflation                                                                     11          

                          

3. The Efficient Market Hypothesis

 

In simple terms, “there are no bargains in the stock market”.  In finance jargon, “the market has already discounted all available information.  This information is already fully reflected in the stock’s price”. 

 

The EMH has many implications:  You can’t beat the market.  You should diversify, and, not try to time the market.