Investments: Analysis and Behavior

Chapter 1- Introduction

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Learning Objectives

Learn the power of building wealth through investing over time.

Understand the nature and performance of financial assets.

Identify common objectives of investors. Practice obtaining important financial information. Become acquainted with job opportunities in the financial

services sector.

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Buy High, Sell Low?! It is obvious that investors should buy low and

sell high in order to build wealth over time. So why do investors frequently buy high and sell

low? (like buying in 2007 and selling in early 2009)

The investment process involves analytical analysis of investment alternatives that are filtered through a decision process that is filled with psychological biases. To be a successful investor, you should be able to

use the analytical tools and control your emotions and psychological biases!

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Building Wealth Save a significant part of your income (10-20% or

more). Invest in a broadly diversified portfolio that

promises a significant positive rate of return. Give your investments lots of time to grow.

How important are time and return?

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Over a 24-year period, a 9% return leads to twice the wealth of 6% returns, and 12% returns almost quadruple the wealth generated by a 6% return.

Table 1.1 Compound Interest Leads to Amazing Growth

Look What $10,000 Turns into

Number With an Investment Return of:

of Years 6% 9% 12%

1 $10,600 $10,900 $11,200

2 11,236 11,881 12,544

3 11,910 12,950 14,049

4 12,625 14,116 15,735

6 14,185 16,771 19,738

8 15,938 19,926 24,760

12 20,122 28,127 38,960

16 25,404 39,703 61,304

20 32,071 56,044 96,463

24 40,489 79,111 151,786

28 51,117 111,671 238,839

32 64,534 157,633 375,817

36 81,473 222,512 591,356

40 102,857 314,094 930,510

(Note: Annual compounding is assumed.)

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Asset Classes

Cash Reserves – Offer modest income with stability of principalShort-term money market instruments (borrow and

lend for the short-term)U.S. Treasury bills, Savings deposits, CDsCommercial Paper

BondsDebt obligations over one yearTreasury Notes, Treasury Bonds, Municipal BondsCorporate Bonds

StocksCommon stock is ownership of a public corporation

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Historical Returns of Stocks and Bonds

Stocks have earned an average return of about 12% per year for the past 50 years. Returns vary slightly depending what index is

used.Long-term Treasury bonds have earned

around 6% per year. 50%/50% allocation to stocks/bonds would

average around 9% per year.Both stock and bond returns have been

volatile!

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Treasury InstrumentsTreasury Bill

Treasury obligation with maturities of one year or less

Treasury NoteTreasury obligation with maturities of more than 2

years but less than 10 years

Treasury BondTreasury obligation with maturities of 10 to 30 years

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Stocks Treasury Treasury

Year (S&P 500) Bonds Bills

1970 4.0% 12.11% 6.5%

1971 14.3% 13.23% 4.3%

1972 19.0% 5.69% 4.1%

1973 -14.7% -1.11% 7.0%

1974 -26.5% 4.35% 7.9%

1975 37.2% 9.20% 5.8%

1976 23.8% 16.75% 5.0%

1977 -7.2% -0.69% 5.3%

1978 6.6% -1.18% 7.2%

1979 18.4% -1.23% 10.0%

1980 32.4% -3.95% 11.5%

1981 -4.9% 1.86% 14.0%

1982 21.4% 40.36% 10.7%

1983 22.5% 0.65% 8.6%

1984 6.3% 15.48% 9.6%

1985 32.2% 30.97% 7.5%

1986 18.5% 24.53% 6.0%

1987 5.2% -2.71% 5.8%

1988 16.8% 9.67% 6.7%

1989 31.5% 18.11% 8.1%

1990 -3.2% 6.18% 7.5%

1991 30.6% 19.30% 5.4%

1992 7.7% 8.05% 3.5%

1993 10.0% 18.24% 3.0%

1994 1.3% -7.77% 4.3%

1995 37.4% 31.67% 5.5%

1996 23.1% -0.93% 5.0%

1997 33.4% 15.08% 5.1%

1998 28.6% 13.52% 4.8%

1999 21.0% -8.74% 4.7%

2000 -9.1% 20.11% 5.9%

2001 -11.9% 4.56% 3.5%

2002 -22.1% 17.17% 1.6%

2003 28.7% 2.06% 1.0%

2004 10.9% 7.70% 1.4%

2005 4.9% 3.05% 3.1%

2006 15.8% 1.85% 4.7%

2007 3.5% 9.8% 4.4%

Average 13.2% 6.4% 4.9%

Median 15.1% 3.6% 4.7%

Table 1.3 Returns on Common Stocks, Treasury Bonds, and Treasury Bills, 1950-2007

1-10Start with $10,000 in each asset.

Figure 1.3 Building Wealth by Investing in Stocks, Bonds and Treasury Bills (1950-2007)

$0

$1,000,000

$2,000,000

$3,000,000

$4,000,000

$5,000,000

$6,000,000

$7,000,000

1950 1955 1960 1965 1970 1975 1980 1985 1990 1995 2000 2005

Years

Dol

lars

Bonds: $278,507

T-bills: $160,430

Stocks: $6,609,788

Data source: Council of Economic Advisors, Economic Report of the President, February 2008, and Lehman Brothers.

$10,000 invested in 1950

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Investment Objectives

Why are you investing?Retirement, down payment, vacation, …

Investment objectives are important.Matching goal characteristics with investment

characteristics.Risk, return, time

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Long-term Investing Retirement plans from employers

Defined Benefit plans Employer promise to pay a fixed retirement income. Formula driven. Employer does all the work and makes decisions

Defined Contribution plans You save (tax deferred) from paycheck. Employers may contribute too. You make all the decisions Benefit depends on contributions and investment return.

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Young investors can accumulate significant wealth through regular investing of modest amounts. The longer you wait to start investing, however, the greater the cost to building significant wealth.

The Long-term Payoff to Regular Investing Can Be Huge

Wealth Created With an

Amount Invested Number Investment Return of:

per Year of Years 6% 9% 12%

Young Investor

$300 40 $46,429 $101,365 $230,127

$1,200 40 185,714 405,459 920,510

$2,000 40 309,524 675,765 1,534,183

$6,000 40 928,572 2,027,295 4,602,549

$12,000 40 1,857,144 4,054,589 9,205,097

Middle-age Investor

$300 20 11,036 15,348 21,616

$1,200 20 44,143 61,392 86,463

$2,000 20 73,571 102,320 144,105

$6,000 20 220,714 306,961 432,315

$12,000 20 441,427 613,921 864,629

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Key Investment Concepts A portfolio

Diversified (hopefully!) collection of stocks, bonds and other assets.

Individual investments are often evaluated on how they change the characteristics of the portfolio.

Risk Chance of economic loss. Sometimes measured as a variation in return.

Expected Return Anticipated gain of a specific period of time. Often evaluated as compensation for taking certain types

of risks.

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Efficient Market Hypothesis

Idea that every security at every point in time is fairly priced. Implication is that prices are unpredictable

ControversialMarket bubblesMost professional investors don’t beat the marketInvestment superstarsHard to predict the direction of stock prices

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Investment management performance At any point in time, some investment managers are

beating the market for the month, quarter or year. A couple of years later, most of these managers are no

longer performing so well. Regression to the mean

Superstar exceptions Warren Buffett, Chairman & CEO of Berkshire Hathaway

Net Worth: $47 Billion

Peter Lynch, Wall Street Investor and Research Consultant (Fidelity)

Net Worth: $325 Million

Sir John Templeton Pioneered the use of globally diversified mutual funds and was considered to

be one of the greatest global stock oickers

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Valuing Assets – future value

Future ValueFuture value = Present sum × (1 + Interest rate)t

The future value of a $5,000 investment earning 8% interest over a period of 15 years is

future value = $5,000 × (1 + 0.08)15 = $15,861

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Valuing Assets – present value

Present ValuePresent value =

The present value of a $15,860 to be received in 15 years with an 8% rate of return is present value = = $5,000

trateInterest 1

sum Future

1508.01

$15,860

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Valuing Assets – payments

Future value =

Present value =

Over the next 30 years, an employee contributes $3,000 per year to an investment expected to earn 9% per year. After 30 years, the employee will have:

future value = = $408,923

rateinterest

1-rateinterest 1Payment

t

trateinterest 1rateinterest

1-rateinterest 1Payment

t

0.09

1-09.013000$

30

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Compound Frequency Mortgages and auto loans use monthly

payments and compoundingDividends paid quarterlyBonds pay semi-annually

Adjust the number of periods and rate

What is the future value of a $1,000 investment 3 years from now if it receives a 9% annual return compounded (A) annually, (B) quarterly, and (C) continuously?

Solution: (A) Future value = $1,000 X (1 + 0.09)3 = $1,295

(B) Future value = $1,000 X (1 + 0.0225)12 = $1,306(C) Future value = $1,000 X e0.09x3 = $1,310

Approximately, e = 2.718

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Behavior is important too Incentives

Stockbroker and commissions

Mutual fund incentives

PsychologyThe higher the degree of uncertainty in a

decision, the more emotions and psychological biases are used to help make the decision.

People tend to think of investments as better or worse. Better means low risk and high return (which conflicts with financial theory!).

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Getting information - Newspapers

Barron’s www.barrons.com Biting market commentary once a week, portfolio analysis and databank.

Investor’s Business Daily www.investors.com Founder William O’Neal dispenses stock picking, charting, and momentum strategies. Big on investor education.

The Wall Street Journal http://online.wsj.com/home/us The daily paper when it comes to financial news and information. Print subscribers get interactive access at a bargain price.

USA Today www.usatoday.com/money Don’t underestimate “McPaper’s” Money Section when it comes to business, economic, and financial news. It’s terrific!

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Getting information - MagazinesBusiness Week http://businessweek.com/index.html Timely business news and analysis,

useful business school, career and small business information.

The Economist www.economist.com Offers analysis and opinion on the business and political events of the week.

Forbes http://forbes.com Terrific commentary on economics and financial markets from an all-star stable of regular columnists.

Fortune http://money.cnn.com/magazines/fortune Famous for Fortune 500 company list. Interesting advice on career development.

Kiplinger's Personal Finance www.kiplinger.com Provides practical guidance on saving, investing, planning for retirement, and major purchases.

Money http://money.cnn.com Interesting market commentary, company and mutual fund analysis aimed at novice investors.

Smart Money www.smartmoney.com Serves the need for personal finance information for affluent, sophisticated, professional, and managerial Americans.

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Getting information - OnlineCBS MarketWatch http://cbs.marketwatch.com Focused on financial news and

information. Individual investors can find news, commentary, advice, and stock price information.

The Motley Fool www.fool.com An online forum designed to "educate, amuse and enrich investors." A constant stream of witty investment advice on active message boards.

MSN Money http://moneycentral.msn.com Investing highlights for customized portfolios, market reports, mutual fund directory, retirement and personal finance.

TheStreet.com www.thestreet.com A full menu of stock analysis, market commentary, and biting satire.

U.S. Securities and Exchange Commission

www.sec.gov This is the place to find free access to official SEC filings by individual companies, obrain information about individual brokers, or file a complaint about shady business practices

Yahoo! Finance http://finance.yahoo.com A terrific web site with U.S. markets, world markets, quotes, financial news, and data.

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Investment Industry Jobs Jobs

Brokers Traders Portfolio managers Financial planners Investment bankers Security analysts

Working at Commercial banks Savings and credit unions Securities firms Investment banks Companies Credit rating agencies Mutual funds Life insurance companies Securities exchanges

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Objectives of the course and text

Develop a clear understanding of the many useful and practical implications of financial theory.

Understand how the incentives of various market participants influence investor decisions and also highlight the impact of a person’s own psychology.

Acquire a framework for understanding the returns on all financial assets, including stocks, bonds and financial derivatives.

Gain familiarity with the institutions and language of Wall Street so as to facilitate the development of an effective personal investment strategy.