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1.

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Research a mutual fund family such as Vanguard, American Funds, T. Rowe Price, and so forth.

Identify one mutual fund from that family for each of the following categories:

o Actively managed common stock fund.

o Fixed income fund.

o Balanced fund.

o International fund.

o Fund devoted to retirement investing.

Write a 90- to 175-word mutual fund evaluation for each category above in your evaluation:

o Analysis of the characteristics of each fund.

o Recommendation of the type of investor to which each fund is suited.

13 Investment Fundamentals

YOU MUST BE KIDDING, RIGHT?

Twins Tiffany and Taylor Jackson have worked for the same employer for many years. Tiffany started early to save and invest for retirement by putting $5000 away each year for 15 years starting at age 25 and never added any more money to the account. Taylor waited until age 40 to begin saving for retirement and he invested $5000 per year for 25 years until retirement at age 65. Assuming that they both earn a 6 percent annual return, how much more money will Tiffany have accumulated for retirement than Taylor by the time they reach age 65?

A. $ 98,919

B. $174,231

C. $274,323

D. $373,242

The answer is A, $98,919. Tiffany's account balance at age 65 is projected at $373,242 and Taylor's is $274,323. Even though Tiffany saved for only 15 years compared with Taylor's 25 years of saving, Tiffany's long-term investment approach had her starting to save early in her working career for retirement. Thus, she accumulated 36 percent more money than her brother ($373,242 – $274,323 = $98,919/$274,323). Starting early on long-term investment goals is a money-winning idea!

LEARNING OBJECTIVES

After reading this chapter, you should be able to:

Explain how to get started as an investor.

Identify your investment philosophy and invest accordingly.

Describe the major risk factors that affect the rate of return on investments.

Decide which of the four long-term investment strategies you will utilize.

Create your own investment plan.

Use Monte Carlo Advice when investing for retirement.

WHAT DO YOU RECOMMEND?

Shavenellyee and Sarena are sisters, both in their 20s. Shavenellyee drives a leased BMW convertible, and she makes about $42,000, including tips, as a part-time bartender at two different restaurants. Although she has no employee benefits, she enjoys having flexible work hours so that she can go to the beach and the local nightspots. Currently, Shavenellyee has $10,000 in credit card debt. She has $1500 in a bank savings account, and two years ago she opened an individual retirement account (IRA) with a $1000 investment in a mutual fund. Her sister Sarena drives a paid-for Honda CR-V, pays her credit card purchases in full each month, and sacrifices some of her salary by putting $100 per month into her employer's company stock through her 401(k) retirement account. Over the past seven years, the stock price, which was once about $40, has risen to almost $70, and Sarena's 401(k) plan is now worth about $16,000. Sarena also has invested about $14,000 in a Roth IRA mutual fund account that is currently invested in an aggressive growth mutual fund, and she plans to use that money for a down payment on a home purchase. She earns $58,000 as a manager of a restaurant, plus she receives an annual bonus ranging from $2000 to $4000 every January that she uses for a spring vacation in Mexico. Sarena's employer provides many employee benefits.

What do you recommend to Shavenellyee and Sarena on the subject of investment fundamentals regarding:

1. Portfolio diversification for Sarena?

2. Dollar-cost averaging for Shavenellyee ?

3. Investment alternatives for Sarena?

YOUR NEXT FIVE YEARS

In the next five years, you can start achieving financial success by doing the following related to investment fundamentals:

1. Start investing early in life by sacrificing some income and putting some cash into a diversified investment portfolio for the future.

2. Avoid thinking about short-term results and accept substantial risk when investing for the long term.

3. Invest regularly through your employer's retirement plan.

4. Invest no more than 5 or 10 percent of your portfolio in any single company stock, including that of your employer.

5. Rebalance your portfolio at least once a year based on your chosen asset allocation strategy.

At many points in this book, we have encouraged you to set aside funds for the future, especially by accumulating funds through regular savings. Financial writer Andrew Tobias argues that saving more is the smartest, safest investment move you will ever make. Save every nickel you can. Then you will have funds for investing.

Investments can be tricky, of course. When the stock market crashed in 2008, millions of American investors lost 40 to 50 percent of their investment assets and some lost even more. The biggest declines occurred in portfolios that were poorly diversified, as their money was not spread among various types of investments. Those who had a well-diversified portfolio lost only about 20 percent. People who remained invested (instead of selling while the market was declining week after week) were happy when the market started its rebound only 2 years later. Within another year the market doubled and those who remained in the market recovered all their losses. Since then they made even more gains, plus an additional 29 percent return last year. Patience is critically important when investing.

Despite the ups and downs of the world's stock markets, one of the best ways to make money over the long term—especially for retirement—is to invest in stocks, bonds, and mutual funds. This remains the best advice! The earning power of the U.S. and world economies, even with occasional serious fluctuations, endures. This chapter explains both why this is true and how to succeed during an economic recession; in an economy growing at a slow pace; or in the course of a rapidly growing economy.

13.1 STARTING YOUR INVESTMENT PROGRAM

To help secure a desirable future lifestyle, you cannot spend every dollar that you earn today. Instead, you must sacrifice by setting aside some of your current income and invest it. You postpone the pleasure of using money for here-and-now consumption so you can have more in the future. To be inancially successful, you are wise to start investing early in life, invest regularly, and stay invested. Why? Because, for every five years you delay investing, you will have to double your monthly investment amount to achieve the same goals. Remember: You—and no one else—are responsible for your own financial success.

13.1a Investing Is More than Saving

Savings is the accumulation of excess funds by intentionally spending less than you earn. Investing is more. Investing is taking some of the money you are saving and putting it to work so that it makes you even more money. Your goals and the time it will take to reach those goals dictate the investment strategies you follow and the investment alternatives you choose.

investing Putting saved money to work so that it makes you even more money.

The most common ways that people invest are by putting money into assets called securities , such as stocks, bonds, and mutual funds (often purchased through their employer-sponsored retirement accounts), and by buying real estate. Stocks are shares of ownership in a corporation, and bonds represent loans to companies and governments. Essentially, they are IOUs that are bought and sold among investors. All of your investment assets make up your portfolio , which is the collection of multiple investments in different assets chosen to meet your investment goals.

securities Assets suitable for investment, including stocks, bonds, and mutual funds.

stocks Shares of ownership in a corporation.

bond A debt instrument issued by an organization that promises repayment at a specific time and the right to receive regular interest payments during the life of the bond.

portfolio Collection of investments assembled to meet your investment goals.

13.1b What Investment Returns Are Possible?

Figure 13-1 shows the long-term rates of return on some popular investments. While stock market returns have averaged about 9.6 percent over the long term, the returns in the first decade of the millennium were extremely low and then much higher in more recent years.

LEARNING OBJECTIVE 1

Explain how to get started as an investor.

Figure 13-1 Long-Term Rates of Return on Investments (Annualized returns since 1926)

Since 1927, the worst 20-year performance for stocks was a gain of 3 percent annually. Over the past 80 years, the chance of making money during any one year in the stock market has been 66 percent. Over five years, the probability increases to 81 percent; over ten years, it increases to 89 percent.

DO IT IN CLASS

13.1c Gains (and Losses) Plus Dividends Equals One's Total Return

When people invest their money, they take a financial risk (also called business risk)— namely, the possibility that the investment will fail to pay any return to the investor. At the extremes, a company could have a very good year earning a considerable profit, or it could go bankrupt, causing investors to lose all of their money.

Investors hope that their investments will earn them a positive total return , which is the income an investment generates from a combination of current income and capital gains. Current income is money received while you own an investment. It is usually received on a regular basis as interest, rent, or dividends.

total return Income an investment generates from current income and capital gains.

current income Money received while you own an investment; usually received regularly as interest, rent, or dividends.

As we have noted elsewhere in the text, interest for an investor is the return earned for lending money. Rent is payment received in return for allowing someone to use your real estate property, such as land or a building. A dividend is a portion of a company's earnings that the firm pays out to its shareholders. For example, Eliza Rodriguez from Ypsilanti, Michigan, purchased 100 shares of H&M stock at $45 per share ($4500) last year. The company paid dividends of $3 per share during the year, so Eliza received $300 in cash dividends as current income.

interest Charge for borrowing money; investors in bonds earn interest.

DID YOU KNOW

Bias toward Minimizing Investment Losses

People engaged in the understanding investment fundamentals have a bias toward certain behaviors that can be harmful, such as a tendency toward forgetting about their investment losses. People usually forget about losses and instead remember more clearly their successes, convinced that they are above-average investors. What to do? When one has investment losses, stop and think, and learn from mistakes.

DID YOU KNOW

Money Websites for Investment Fundamentals

Informative websites for investment fundamentals, including tips for young adults are:

Bankrate.com' risk tolerance quiz (www.bankrate.com/finance/financial-literacy/quiz-what-is-your-risk-tolerance.aspx)

Fundamentals of Investing (www.financialwisdom.com)

Financial Soundings' limited management accounts (www.financialsoundings.com)

How To Be Set For Life (www.howtobesetforlife.com/articles/6-investment-fundamentals/)

Kiplinger.com's risk tolerance quiz (www.kiplinger.com/quiz/investing/T031-S001-the-investor-psychology-quiz/index.xhtml)

Motley Fool (www.fool.com/how-to-invest/thirteen-steps/index.aspx)

Wikipedia on asset allocation (en.wikipedia.org/wiki/Asset_allocation)

A capital gain occurs only when you 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). For example, if the price of H&M company stock rose to $52 during the year, Eliza could sell it for a capital gain. If Eliza paid a transaction cost of $1 per share at both purchase and time of sale, her capital gain would be $500 [($5200 − $100) – ($4500 + $100)].

capital gain Increase in the value of an initial investment (less costs) realized upon the sale of the investment.

Capital losses can occur as well. For most investments, a trade-off arises between capital gains and current income. Investments with potential for high capital gains often pay little current income, and investments that pay substantial current income generally have little or no potential for capital gains. Long-term investors are often willing to forgo current income in favor of possibly earning substantial future capital gains.

capital loss Decrease in paper value of an initial investment; only realized if sold.

The rate of return , or yield , is the total return on an investment expressed as a percentage of its price. It is usually stated on an annualized basis, and it includes dividends and capital gains. For example, if Eliza sells the H&M stock for $52 per share after one year, she will have a total return of $800 ($300 in dividends plus $500 in capital gains). Her yield would be 17.78 percent ($800 ÷ $4500).

rate of return/yield Total return on an investment expressed as a percentage of its price.

FINANCIAL POWER POINT

Out of the Market? You Missed a 45 Percent Gain

If you had been out of stocks during the market's ten best days in the past decade, according to Charles Schwab, you would have missed out on 45 percent of the gains.

13.1d Your Investing Future Looks Promising

Corporate profits—and investor's returns—are difficult to earn when the United States and the world's large economies are struggling. During such challenging economic times, one's average investment returns from stocks are likely to be about 6 percent. This is likely to come from a 2 percent dividend yield for stocks and an earnings growth rate of around 4 percent. These are still good returns when inflation is low.

CONCEPT CHECK 13.1

1. How does savings differ from investing?

2. Why were returns so poor for the first decade of the millennium?

3. What are the two parts of an investor's total return?

4. What stock market returns can be anticipated in the near- to mid-term, and why?

13.2 IDENTIFY YOUR INVESTMENT PHILOSOPHY AND INVEST ACCORDINGLY

Achieving financial success requires that you understand your investment philosophy and adhere to it when investing. Thus, you also need to know about investment risk and what to do about it. Keep in mind the advice offered by investment guru Warren Buffett, “The first rule of investing is don't lose money; the second rule is don't forget Rule No. 1.”

13.2a You Can Learn to Handle Investment Risk

Pure risk, which exists when there is no potential for gain, only the possibility of loss, was discussed in Chapter 10. Investments, in contrast, are subject to speculative risk , which exists in situations that offer potential for gain as well as for loss. Investment risk represents 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. This potential for gain is what motivates people to accept increasingly greater levels of risk, as illustrated in Figure 13-2. Nevertheless, many people remain seriously averse to risk.

speculative risk Involves the potential for either gain or loss; equity investments might do either.

investment risk The possibility that the yield on an investment will deviate from its expected return.

Figure 13-2 also provides insight about possible investment choices. Don't be overwhelmed because these investments are explained in the following chapters. You will learn how to make informed investment decisions for yourself.

13.2b Investors Demand a Risk Premium

One popular investment is the short-term Treasury bill, or T-bill, which is a government IOU of less than one year. Because T-bills are risk-free investments, they pay too low a return for most people, perhaps only 0.25 or 0.35 percent. Some people invest in T-bills to safeguard their money until it can be invested at a later time.

LEARNING OBJECTIVE 2

Identify your investment philosophy and invest accordingly.

DO IT IN CLASS

Figure 13-2 Risk Pyramid Reveals the Trade-Offs Between Risk and Return

Investors need the promise of a high return to warrant placing their money at risk in an investment. When making investments, people demand a risk premium (or equity risk premium) for their 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 premium (or equity risk premium) The difference between a riskier investment's expected return and the totally safe return on the T-bill.

If the expected return is 8 percent on stocks and 2 percent on ten-year Treasury securities, the risk premium is 6 percent. Industry experts figure that the amount of the risk premium for most investors is 3 to 6 percent, although the long-term average is 8 percent. Higher-risk investments carry higher-risk premiums.

13.2c What Is Your Investment Philosophy?

Investors have to take risks that are appropriate to reach their financial goals. The task is to find the right balance and make choices accordingly. You must weigh the risks of an investment with the likelihood of not reaching your goal.

Your risk tolerance is your willingness to weather changes in the values of your investments. This is not the same as your capacity to take risk. To be successful in investing, your risk tolerance must be factored into your investment philosophy. If you lose sleep over your investments, you know it is time to reduce your risk and adjust your investment philosophy.

risk tolerance An investor's willingness to weather changes in the value of your investments, that is, to weather investment risk.

An investment philosophy is one's general approach to tolerance for risk in investments, whether it is conservative, moderate, or aggressive, given the financial goals to be achieved. The more risk you take, within reason, the more you can expect to earn and accumulate over the long term. However, just because you are comfortable with a risky portfolio does not mean that you actually need one. By the same token, you still need to be aggressive enough to meet your financial goals. Wise investors follow their investment philosophy without wavering; they do not change course unless their basic objectives change.

investment philosophy Investor's general approach to tolerance for risk in investments, whether it is conservative, moderate, or aggressive, given the investor's financial goals.

Are You a Conservative Investor? If you have a conservative investment philosophy , you 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 means that you do not want to lose any of the money you have invested. In short, you could be characterized as an investor who is risk averse . This is one who tends to dislike risk and is unable to put money into investments that seem risky.

conservative investment philosophy (risk aversion) Investors with this philosophy 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.

risk averse In investments, one who tends to dislike risk and is unable to put money into investments that seem risky.

Conservative investors focus on protecting themselves. They do so by carefully avoiding losses and trying to stay with investments that demonstrate gains, often for long time periods (perhaps for five or ten years). Tactically, they rarely sell their investments. Investors who are approaching retirement or who are planning to withdraw money from their investments in the near future often adhere to a conservative investment philosophy.

Conservative investors typically consider investing in obligations issued by the government. Examples 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. A bond is essentially a loan that the investor makes to a government or a corporation. It is a debt of the issuer. Over the course of a year, a conservative investor with $1000 could possibly lose $20 and is likely to gain $20 to $30.

Are You a Moderate Investor? People with a moderate investment philosophy seek capital gains through slow and steady growth in the value of their investments along with some current income. They invite only a fair amount of risk of capital loss. Most have no immediate need for the funds but instead focus on laying the investment foundation for later years or building on such a base. Moderate investors are fairly comfortable during rising and falling market conditions. They remain secure in the knowledge that they are investing for the long term. Their tactics might include spreading investment funds among several choices and adjusting their portfolio by trading some assets perhaps once or twice a year.

moderate investment philosophy (risk indifference) Investors with this philosophy accept some risk as they seek capital gains through slow and steady growth in investment value along with current income.

People seeking moderate returns consider investing in dividend-paying common stocks, growth and income mutual funds, high-quality corporate bonds, government bonds, and real estate. Over the course of a year, a moderate investor with $1000 could possibly lose $150 and is likely to gain $40 to $60.

Are You an Aggressive Investor? If you choose to strive for a very high return by accepting a high level of risk, you have an aggressive investment philosophy . As such, you could be characterized as a risk seeker. Aggressive investors primarily seek capital gains. Many such investors take a short-term approach, remaining confident that they can profit substantially during major upswings in market prices.

aggressive investment philosophy (risk seeker) Investors with this philosophy primarily seek capital gains, often with a short time horizon.

People seeking exceptionally high returns consider investing in common stocks of new or fast-growing companies, high-yielding junk bonds, and aggressive-growth mutual funds. Such investors also may put their money into limited real estate partnerships, undeveloped land, precious metals, gems, commodity futures, stock-index futures, and collectibles. Devotees of this investment philosophy sometimes do not diversify by spreading their funds among many alternatives. Also, they may adopt short-term tactics to increase capital gains. For example, aggressive investors might place most of their investment funds in a single stock in the hope that it will rise 10 percent over 90 days, giving a yield of more than 30 percent annually. Those shares could then be sold and the money invested elsewhere. Investment tactics for aggressive investors are discussed in Chapter 16.

Aggressive investors must be emotionally and financially able to weather substantial short-term losses—such as a downward swing in a stock's price of 30 or 40 percent—even though they might expect that an upswing in price will occur in the future. Over the course of a year, an aggressive investor with $1000 could possibly lose $300 and could gain $100, $200, $300, or even more.

FINANCIAL POWER POINT

Take a Risk-Tolerance Quiz

Find out how much risk you can comfortably tolerate by taking a risk-tolerance quiz at one of the following websites:

• Bankrate.com: www.bankrate.com/finance/financial-literacy/use-investments-to-reach-your-goals-2.aspx.

• Kiplinger: www.kiplinger.com/quiz/investing/T031-S001-the-investor-psychology-quiz/.

13.2d Should You Take an Active or Passive Investing Approach?

Another aspect of your personal investment philosophy is your level of involvement in investing. That is, do you want to be an active or passive investor?

Active Investing An 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. In addition, active investors stay alert because the prices of many investments vary with certain news events, world happenings, and economic and political variables. Knowing what is going on in the larger world helps active investors understand when to buy or to sell investments quickly so as to reap profits and/or reduce losses.

Passive Investing Succeeds over the Long Term A passive investor does not actively engage in trading of securities or spend large amounts of time monitoring his or her investments. Such an individual may make regular investments in securities, such as mutual funds (described in Chapter 15), and his or her assets are rarely sold for short-term profits. Instead, passive investors simply aim to match the returns of the entire market. They ignore “hot” tips and the investment of the day touted in the financial press. They keep their emotions in check, and they earn higher returns than active investors over the long term. Most long-term investors utilize a passive approach.

An active investor keeps a close watch on the economy and financial markets.

13.2e Identify the Kinds of Investments You Want to Make

The investments you choose should match your interests. Before investing, think about lending versus owning, short term versus long term, and how to select investments that are likely to provide your desired potential total return.

Do You Want Lending Investments or Ownership Investments? You can invest money in two ways, by lending or by owning. When you lend your money, you receive some form of IOU and the promise of repayment plus interest. The interest is a form of current income while you hold the investment.

You can lend by depositing money in banks, credit unions, and savings and loan associations (via savings accounts and certificates of deposit) or by lending money to governments (via Treasury notes and bonds as well as state and local bonds), businesses (corporate bonds), mortgage-backed bonds (such as Ginnie Maes), and life insurance companies (annuities).

These lending investments, or debts , generally offer both a fixed maturity and a fixed income. With a fixed maturity , the borrower agrees to repay the principal to the investor on a specific date. With a fixed income , the borrower agrees to pay the investor a specific rate of return for use of the principal. Such investments allow lenders to be fairly confident that they will receive a certain amount of interest income for a specified period of time and that the borrowed funds will eventually be returned. Thus, the return is somewhat assured.

debts Lending investments that typically offer both a fixed maturity and a fixed income.

fixed maturity Specific date on which a borrower agrees to repay the principal to the investor.

fixed income Specific rate of return that a borrower agrees to pay the investor for use of the principal (initial investment).

No matter how much profit the borrower makes with your funds, the investing lender at best receives only the fixed return promised at the time of the initial investment. Lending investments rarely result in capital gains.

Alternatively, you may invest money through ownership of an asset. Ownership investments are often called equities . You can 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 your funds in corporate stocks and bonds), put money into your own business, purchase real estate, buy commodity futures (pork bellies or oranges), or buy investment-quality collectibles (such as rare antiques or gold). Ownership investments have the potential for providing current income; however, the emphasis is usually upon achieving substantial capital gains.

equities Ownership equities such as common or preferred stocks, equity mutual funds, real estate, and so on that focus on capital gains more than on income.

Making Short-, Intermediate-, and Long-Term Investments When investing for a short-term goal, such as less than one year, you would want to be very conservative to ensure that a sudden drop in the market would not jeopardize your reaching the goal before the market has time to recover. You want to be confident that you preserve the value of what you have. After all, you don't want to lose money in an investment when you need to use that money for a near-term goal, such as college tuition, or be forced to sell an investment because you need cash in a hurry. People with a short or intermediate time horizon require investments that offer some predictability and stability. As a result, these investors are usually more interested in current income than capital gains.

By contrast, if you are investing to achieve long-term goals, you want your money to grow. Long-term investors usually invite more risk by seeking capital gains as well as current income.

When investing for long-term goals, you can afford to be more aggressive. That is one reason why the stock market is a good place to save for retirement. After you retire, you can leave a portion of your portfolio in stocks or stock mutual funds since you likely will still have 20 to 25 years before you need the last dollars in your nest egg.

Long-term investors seek growth in the value of their investments that exceeds the rate of inflation. In other words, they want their investments to provide a positive real rate of return . This is the return after subtracting the effects of both inflation and income taxes.

real rate of return Return on an investment after subtracting the effects of inflation and income taxes.

DID YOU KNOW

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

1. Identify the rate of return before income taxes . Perhaps you think that a stock will offer a return of 10 percent in one year, including current income and capital gains.

2. Subtract the effects of your marginal tax rate on the rate of return to obtain the after-tax return . If you are in the 25 percent federal income tax bracket, the calculation is (1 − 0.25) × 0.10 = 0.075 = 7.5 percent.

3. Subtract the effects of inflation from the after-tax return to obtain the real rate of return on the investment after taxes and inflation . If you estimate an annual inflation of 4 percent, the calculation gives 3.5 percent (7.5 percent – 4.0 percent). Thus, your before-tax rate of return of 10 percent provides a real rate of return of 3.5 percent after taxes and inflation.

13.2f Choose Investments for Their Components of Total Return

When investing, you want to build a portfolio of investments that will provide the necessary potential total return through current income and capital gains in the proportions that you desire. One stock might provide an anticipated cash dividend of 1.5 percent and an expected annual price appreciation of 6 percent, for a total anticipated return of 7.5 percent. Another choice offering the same projected total return might be a stock with expected annual cash dividends of 2.5 percent and capital gains of 5 percent.

13.2g What Should You Do Next?

Once you have clarified your investment philosophy, whether to lend or own, active or passive, understand the investment timeline of your financial goals, and accept the components of your anticipated total return, you will be able to make investing decisions with confidence and conviction. You will be able to show patience by following your long-term views rather than making emotional and wrong decisions—in other words, mistakes—about your money. The investments you choose and the returns earned will match your investment philosophy.

CONCEPT CHECK 13.2

1. Summarize your investment philosophy and general approach to tolerance for risk.

2. Indicate whether you view yourself as an active or passive investor, and explain why.

3. Summarize your personal views on lending or owning investments.

4. Which type of investment return—current income or capital gains— seems more attractive to you? Why?

13.3 RISKS AND OTHER FACTORS AFFECT THE INVESTOR's RETURN

To be a successful investor, you must understand the major factors that affect the rate of return on investments. Being informed, you can then take the appropriate risks when making investment decisions.

LEARNING OBJECTIVE 3

Describe the major factors that affect the rate of return on investments.

Random Risk Is Reduced by Diversification, Eventually Random risk (also called unsystematic risk ) is 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. If you invest in only one stock, its value might rise or fall. If you invest in two or three stocks, the odds are lessened that all of their prices will fall at the same time. Such 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.

random/unsystematic risk 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 due to uncontrollable or random factors that do not affect the rest of the market.

diversification Process of reducing risk by spreading investment money among several different investment opportunities.

The principle holds that when you own different types of investment assets in a portfolio, some assets should be rising when others are falling. It results in a potential rate of return on all of the investments that is lower than the potential return on a single alternative, but the return is more predictable and the risk of loss is lower. Diversification does not mean that you will not lose money. Diversification averages out the high and low returns. While investors might be disappointed with a lower return from a diversified portfolio, they would be even more disappointed by the return in a down market from one that is poorly diversified.

Research suggests that you can cut random risk in half by diversifying into as few as five stocks or bonds; you can eliminate random risk by holding 15 or more stocks or bonds. Rational investors diversify so as to reduce random risk, and over the long term—as little as a decade—it works. You also can diversify by investing in foreign stocks.

13.3a Market Risk and the Great Recession

Diversification among stocks or bonds cannot eliminate all risks. Some risk would exist even if you owned all of the stocks in a market because stock prices in general move up and down over time. Market risk (also known as systematic or nondiversifiable risk ) is the possibility for an investor to experience losses due to unknown factors that affect the overall performance of the financial markets.

market risk/systematic risk/undiversifiable risk The possibility for an investor to experience losses due to unknown factors that affect the overall performance of the financial markets.

In this case, the value of an investment may drop 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 terrorist attacks. Market risk cannot be eliminated but it can be reduced by dividing your portfolio among several different markets.

The Great Recession Not all markets normally will decline at the same time, but it can happen. The Great Recession of December 2007 through March of 2009 impacted the whole world and it demonstrates the possibility of a mistake in the logic of efficient markets as all types of investments (e.g., credit, investments, and real estate) fell in unison. The systemic collapse proves that once-in-a-lifetime financial disasters not only can occur, but do. The mission of the Financial Stability Oversight Council is to identify financial companies in need of government intervention before they collapse and negatively affect the American economy.

The Congressional Budget Office (CBO) predicts that the U.S. economy will continue to crawl along at a 2.4 percent rate of annual growth through 2022, rather than a more typical growth rate of 3.0 percent or higher.

U.S. and world markets are continuing to recover in today's challenging economic environment. Over the short term, diversification cannot protect your investments against market declines. Over the long term, and this suggests that if you remain invested in the market during your entire lifespan, you will likely experience a significant down market that will take back a sizable chunk of your wealth. But in time you will get it all back and then some.

Market Risk in an Investor's Portfolio Market risk remains after an investor's portfolio has been fully diversified within a particular market. Over the years, market risk for all investments has averaged about 8 percent. As a consequence of this risk, the return on any single securities investment (such as a stock), through no fault of its own, might vary up and down about 8 percent annually. The total risk in an investment consists of the sum of the random risk and the market risk.

13.3b Types of Investment Risks

A number of other investment risks affect investor returns:

DO IT IN CLASS

• Business failure risk. Business failure risk, also called financial risk , is the possibility that the investment will fail, perhaps go bankrupt, and result in a massive or total loss of one's invested funds.

financial risk Possibility that an investment will fail to pay a return to the investor.

• Inflation risk. Inflation risk may be the most important concern for the long-term investor. Inflation risk, also called purchasing power risk, is the danger that your money will not grow as fast as inflation and therefore not be worth as much in the future as it is today. Over the long term, inflation in the United States has averaged 3.1 percent annually. Historically, common stocks and real estate have reduced inflation risk, as their values tend to rise with inflation over many years. However, all ownership investments are also subject to deflation risk. This is the chance that the value of an investment will decline when overall prices decline. Housing prices declined 30 to 60 percent in many U.S. communities as a result of the Great Recession.

• Time horizon risk. The role of time affects all investments. The sooner your invested money is supposed to be returned to you—the time horizon of an investment—the less the likelihood that something could go wrong. The more time your money is invested, the more it is at risk. For taking longer-term risks, investors expect and normally receive higher returns.

• Business-cycle risk. As we discussed in Chapter 1, economic growth usually does not occur in a smooth and steady manner and this affects profits as well as investment returns. This is known as business-cycle risk . Instead, periods of expansion lasting three or four years are often followed by contractions in the economy, called recessions, that may last a year or longer. The profits of most industries follow the business cycle. Some businesses do not experience business-cycle risk because they continue to earn profits during economic downturns. Examples are gasoline retailers, supermarkets, and utility companies.

business-cycle risk The fact that economic growth usually does not occur in a smooth and steady manner, and this impacts profits as well as investment returns.

• Market-volatility risk. All investments are subject to occasional sharp changes in price as a result of events affecting a particular company or the overall market for similar investments, and this is market-volatility risk . For example, the value of a single stock, such as that of a technology company like Apple, might change 10 or even 20 percent in a single day. Also, all technology stocks could decline 2 or perhaps 5 percent if two or three competitors announce poor earnings. In recent years the number of days with a 4 percent swing in the overall stock market prices ranged from 2 to 11.

market-volatility risk The fact that all investments are subject to occasional sharp changes in price as a result of events affecting a particular company or the overall market for similar investments.

• Liquidity risk. Liquidity is the speed and ease with which an asset can be converted to cash. You can sell your stock investments in one day, but rules state that it may take up to four days to have the proceeds available in cash. You will never truly know the value of liquidity until you need it and you do not have it. Liquidity risk is 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). Real estate is illiquid because it may take weeks, months, or even years to sell.

liquidity The speed and ease with which an asset can be converted to cash.

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).

• Marketability risk. When you have to sell a certain asset quickly, it may not sell at or near the market price. This possibility is referred to as marketability risk. Selling real estate in a hurry, for example, may require the seller to substantially reduce the price in order to sell to a willing buyer.

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

13.3c Commission Costs Reduce Returns

Buying and selling investments may result in a number of transaction costs. Examples include “fix-up costs” when preparing a home for sale, appraisal fees for collectibles, and storage costs for precious metals. Commissions are usually the largest transaction cost in investments. 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. The commission charged to buy an investment (one commission) and then later sell it (a second commission) is partially based on the value of the transaction.

commissions Fees or percentages of the selling price paid to salespeople, agents, and companies for their services in buying or selling an investment.

Commission ranges are as follows: stocks, 1.5 to 2.5 percent (although trades can be made on the Internet for less than $10); bonds, 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; and collectibles, 15.0 to 30.0 percent.

DID YOU KNOW

“Improve Returns by Minimizing Expenses”

Vanguard's Total Stock Index mutual fund charges a mere 0.17% in management expenses while the typical actively managed mutual fund charges 1.4%. The results after 30 years of investing $4000 annually with both accounts earning 5 percent: Low management fee: $270,594 ; high management fee: $217,479. An extra $53,115 is a big difference!

13.3d Leverage May or May Not Increase Returns

Another factor that can affect return on investment is leverage . In the leveraging process, 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. You can become financially overextended by using leverage, a factor you should not ignore. For example, housing investors during the last decade were shocked when home values declined 5, 10, or even 15 percent in a year, thus forcing many real estate investors into bankruptcy. In many U.S. cities housing prices dropped 50 percent or more. Now prices are rising in most markets.

leverage Using borrowed funds to invest with the goal of earning a rate of return in excess of the after-tax costs of borrowing.

CONCEPT CHECK 13.3

1. Distinguish between random risk and market risk.

2. Summarize three other types of investment risks that may affect returns.

3. Explain how transactions costs and leverage may increase or decrease investment returns.

13.4 ESTABLISHING YOUR LONG-TERM INVESTMENT STRATEGY

Investing is not rocket science! Anyone reading this book and following its recommendations for making long-term investments can become a successful investor.

LEARNING OBJECTIVE 4

Decide which of the four long-term investment strategies you will utilize.

13.4a Long-Term Investors Understand Bull and Bear Markets and Corrections

Long-term investors understand how the securities markets (places where stocks and bonds are traded) are performing as a whole. That is, are the markets moving up, moving down, or remaining stagnant?

securities markets Places where stocks and bonds are traded (or in the case of electronic trading, the way in which securities are traded).

Bull Markets Are Profitable for Investors A bull market results when securities prices have risen 20 percent or more over time. Historically, the more than 20 bull markets averaging 55 months in length have seen an average gain of 159 percent.

bull market Market in which securities prices have risen 20 percent or more over time.

Bear Markets Turn into Bull Markets A securities market in which prices have declined in value by 20 percent or more from previous highs, often over the course of several weeks or months, is called a bear market . Four bear markets have occurred since 1980. Bear markets are what clear the decks for a longer-lasting recovery and drives valuations down to truly low levels from which bigger gains can spring.

bear market Market in which securities prices have declined in value by 20 percent or more from previous highs, often over the course of several weeks or months.

The bear market that started in October 2007 saw stock prices decline 55 percent by March 2009. Then the optimistic bull buyers took over thinking that surely the U.S. economy had already reached rock bottom and that stock prices were certain to rise as the economy recovered. Since March 9, 2009 when stock prices stopped falling the U.S. bull market saw a 100+ percent rally in just a few years, a gigantic move, and tech stocks rose an amazing 200+ percent in 5 years.

A bull in the market is a person who expects securities prices to go up; a bear expects the general market to decline. The origin of these terms is unknown, but some suggest that they refer to the ways that the animals attack: Bears thrust their claws downward, and bulls move their horns upward. Historically, bear markets last, on average, about 9 months; bull markets average 55 months in length.

Market Corrections Also Occur Another type of short-term market trend is called a market correction, which typically occur every 18 months. A market correction is a reverse movement of at least 10 percent in a stock, bond, commodity, or index to adjust for recent price rises. They interrupt an uptrend in the market or an asset.

market correction A short term price decline in the stock markets of at least 10 percent in a stock, bond, commodity or index to adjust for a recent price rises.

13.4b Long-Term Investors Accept Substantial Market Volatility

In an average year, the price of a typical stock fluctuates up and down by about 50 percent; thus, the price of a stock selling for $30 per share in January might range from $15 to $45 before the end of the following December. It is not unusual for overall stock market prices to fall (or rise) 3, 4, or 5 percent in a single day. In a recent year the stock market fluctuated 11 times by more than 4 percent in one day. That tells us that today's stock markets are riskier than yesterday's. Terrifying daily swings are likely to remain a constant during these turbulent economic times. Such swings are today's “new normal.”

Long-term investors who get scared during market downturns and withdraw most or all of their investing dollars miss out on the subsequent increase in prices during the next up market. Long-term investors must learn to accept market volatility by ignoring short-term market movements.

market volatility The likelihood of large price swings in securities due to a company's success (or lack of it) and various market conditions.

13.4c Long-Term Investors Do Not Practice Market Timing

Investors get into trouble when they start to think too much like traders. Market timers attempt to predict the short-term movements of various markets (or market segments) and, based on those predictions, move capital from one segment to another in order to capture market gains and avoid market losses. Essentially, market timers try to outguess the trend of stocks or other prices. For example, an investor worried about the future might sell his or her stock investments and move to cash. Another investor who anticipates increasing future stock prices might get 100 percent invested in stocks.

market timers Investors who attempt to predict the short-term movements of various markets (or market segments) and, based on those predictions, move capital from one segment to another in order to capture market gains and avoid market losses.

To succeed in timing the market, you need to know just the right time to buy and just the right time to sell, know what signals suggest you take action, and exhibit the discipline to do it. Market timers often sell at the first sign of trouble and then keep their money out of the market until better opportunities are apparent. If you try to time the market, you are just as likely to miss an upswing as you are to avoid a downswing. Note that market timers are competing against graduates from Chicago, Stanford, and Wharton who do the same job full time for big paychecks.

Market Timing Loses Money Market efficiency has to do with the speed at which new information is reflected in investment prices. The theory is 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 efficiency The speed at which new information is reflected in investment prices suggesting that security prices are reflective of their true value at all times because publicly available information has driven market prices to the correct level.

When information is reported in the financial press, it is already too late for the typical investor to act and make a profit. And individuals don't always even know which information is relevant. Therefore, individual investors cannot pursue an active investment strategy that beats the market because they are just as likely to invest in an overpriced security rather than one that is undervalued. Thus, these investors typically earn substantially less than average market returns every year.

Not surprisingly, stock analysts and investment managers believe they can make better choices than the average investor in part because they can act on information more quickly than other investors. The reality, however, is that 70 to 80 percent of investment managers, and oftentimes 90 percent in any given year fail to beat the average returns of the stock market.

DID YOU KNOW

Women Are Better Investors than Men

Research suggests that women are better investors than men. The big reason is that men are overconfident about their financial prowess and as a result they make more mistakes. A woman's investment portfolio exceeds a man's by about 1 percentage point every year. Investing $4000 annually for 30 years earning 6 percent shows that a woman's portfolio will amount to $316,000 and the man's earning 5 percent will be $266,000, a $50,000 difference, which adds up to 18.8 percent more.

13.4d Long-Term Investors Avoid Trading Mistakes

Long-term investors avoid trading mistakes by not trading too much, buying high and selling low, and by avoiding herd behavior.

Trading Too Much Loses Money One cause of lower returns is trading too much. The more you trade, the more likely you are to make a wealth-destroying mistake. Such investors also often sell winners too soon and keep losers too long. Don't make the mistake of trading when you should be investing.

Buying High and Selling Low Loses Money Emotion, not logic, often rules investing decisions. Investors often overreact when buying and selling as their thinking goes through alternating times of panic and euphoria. When plunging portfolio values become too much to accept, investors just want the pain to end so they sell, which presumably means big losses. This is “buying high and selling low,” which is the opposite of what investors should do.

Herd Behavior Loses Money At the other extreme, when the market prices are rapidly rising, people are fooled into thinking that it is safe to invest more (“I've got to put more money in there”) and lose their sense of caution because it must be safe if everyone else is buying. People follow the crowd and tend to push stock prices too far up or down. They look at behavior and assume it is based on knowledge, but often it's not. This is an illustration of 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 information.

herd behavior When emotion, not logic, rules investing decisions and investors decide to copy the observed decisions of other investors or movements in the markets rather than follow their own beliefs and information.

Herd behavior happens in part because people feel compelled to look at prices in the newspaper every day or watch the 24-hour financial news chatter, such as CNBC and CNN, whose TV talking heads spew financial factoids with minute-by-minute updates and sensationalize every blip in the stock markets. Such arcane and sometimes meaningless information creates anxiety or mania that can lead to bad decision making. Acquiring more “facts” is not the same as gaining knowledge or expertise.

The kinds of news and information on cable news and the blogosphere is not designed to appeal to our long-term, rational thought processes. It excites our emotions and fears, and sometimes stokes our prejudices and cynicism. It compels action, not patience. Therefore, ignore that kind of news and information. Stay focused on your long-term investing strategy and make decisions accordingly; otherwise, your returns will be less than the averages, like those of most American investors.

Long-Term Investors Avoid Too Many “Facts.”

13.4e There Are Only Four Strategies for Long-Term Investors

To succeed financially, you must establish your own long-term investment strategies. And follow them! Don't sabotage your plan by doing stupid thing like those described above. There are only four long-term investment strategies to follow, and they all hang together.

Strategy 1: Buy-and-Hold Anticipates Long-Term Economic Growth The secret to long-term investing success is benign neglect. Long-term investors need to relax with the confidence and knowledge that investing regularly and not trading frequently will create a substantial portfolio over time. Long-term investors do not follow or react emotionally to the day-to-day changes that occur in the market. Ignoring them is the best advice. Because most people are overly sensitive to short-term losses, daily monitoring could motivate one to make shortsighted buying and selling decisions.

Selling high-quality assets in a bear market is a poor strategy because sellers lock in their losses, plus they fail to realize that bear markets are typically short in duration (about 9 months). It is smart to buy more shares when prices are lower during market downturns because rising prices in a bull market always follow a bear market.

Most long-term investors use the investment strategy buy and hold (also called buy to hold ). That is, they buy a widely diversified mix of stocks and/ or mutual funds, reinvest the dividends by buying more stocks and mutual funds, and hold on to those investments almost indefinitely. With this approach, the investor expects that the values of the assets will increase over the long run in tandem with the growth of the U.S. and world economies. The investments may pay some current income as well. The investor's emphasis is on holding the assets through both good and bad economic times with the confidence that their values will go up over the long term. This is a wise strategy.

buy and hold/buy to hold Investment strategy in which investors buy a widely diversified mix of stocks and/or mutual funds, reinvest the dividends by buying more stocks and mutual funds, and hold onto those investments almost indefinitely.

Some critics argue that “buy and hold” is a discredited concept. But they are wrong because this remains the best approach for investing over 20 years or longer. Long-term investors must have the patience and fortitude necessary to tolerate bear markets, no matter how severe.

Buy and hold does not mean buy and ignore. Review your whole portfolio once a year to make sure that each remains a good investment. Questions to ask include: “Is the valuation too high?”; “Has the fundamental outlook of the company changed?”; “Does this asset still fit my investment plan?”; “Would I buy it today?” If necessary, sell the asset and keep the remainder of your portfolio.

FINANCIAL POWER POINT

The Stock Market Is for Long-Term Investors

While average return of the stock market has been 9.6 percent annually for almost 100 years, it still does okay even in terrible economic times. If you had invested at the peak of the market's March 2000 high and then survived the following two horrible bear markets, you still would have earned 3.5 percent annually.

Strategy 2: Dollar-Cost Averaging Buys at “Below-Average” Costs Dollar-cost averaging (or cost averaging ) is a 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. Since investments generally rise more than they fall, the “averaging” means that you purchase more shares when the price is down and fewer shares when the price is high. Most of the shares are, therefore, purchased at below-average costs .

dollar-cost averaging/cost averaging Systematic program of investing equal sums of money at regular intervals, regardless of the price of the investment.

below-average costs Average costs of an investment if more shares are purchased when the price is down and fewer shares are purchased when the price is high.

This strategy avoids the risks and responsibilities of investment timing because the stock purchases are made regularly (usually every month) regardless of the price. It also ignores all outside events and short-term gyrations of the market, providing the investor with a disciplined buying strategy.

Table 13-1 shows the results of dollar-cost averaging for a stock under varying market conditions (commissions are excluded). As an example, assume that you invest $300 into a stock every three months. Notice that dollar-cost averaging is successful in all three scenarios illustrated.

Dollar-Cost Averaging in a Fluctuating Market To illustrate the effects of dollar-cost averaging, assume that you first invested funds during the “fluctuating market” shown in Table 13-1. Because the initial price is $15 per share, you receive 20 shares for your investment of $300. Then the market drops—an extreme but easy-to-follow example—and the price falls to $10 per share. When you buy $300 worth of the stock now, you receive 30 shares. Three months later, the market price rebounds to $15 and you invest another $300, receiving 20 shares. The price then drops and rises again.

DID YOU KNOW

Sean's Success Story

Sean's financial life continues successfully. Only six years past college graduation, he has a retirement plan at work now worth over $90,000. He continues to have an aggressive investment philosophy and is invested in six mutual funds through his job. After paying off his car three years ago, Sean continued to make payments to himself, thus building up his savings account as well, which now is over $20,000. He is worried about the economy even though it has been rising recently, so he is keeping those dollars out of the stock market for the time being. Sean's employer recently announced that employees may now contribute up to 8 percent of their salaries to their retirement plan with a full match, so he is going online this weekend to bump up his contribution from 6 to 8 percent.

Table 13-1 Dollar-Cost Averaging for a Stock or Mutual Fund Investment

You now own 120 shares, thanks to your total investment of $1500. The average share price is calculated by averaging the amounts paid for the investment: Simply divide the share price total by the number of investment periods. In this example, the average share price is $13 ($65 ÷ 5). The average share cost , a more meaningful amount, is the actual cost basis of the investment used for income tax purposes. It is calculated by dividing the total amount invested by the total shares purchased. In this example, it is $12.50 ($1500 4 120). Based on the recent price of $15 per share, each of your 120 shares is worth on average $2.50 ($15 – $12.50) more than you paid for it. Thus, your gain is $300 (120 × $2.50; or $15 × 120 = $1800, $1800 − $1500 = $300).

average share price Calculated by dividing the share price total by the number of investment periods.

average share cost Actual cost basis of the investment used for income tax purposes, calculated by dividing the total amount invested by the total shares purchased.

Dollar-Cost Averaging in a Declining Market Markets may also decline over a time period. The “declining market” columns in Table 13-1 (representing a prolonged bear market of 15 months) show purchases of 190 shares for increasingly lower prices that eventually reach $5 per share at the bottom of the business cycle. In a declining market, if you keep investing using dollar-cost averaging, you will purchase a large volume of shares. If you sell when the market is down substantially, you will not profit. In this example, you have purchased 190 shares at an average cost of $7.89, and they now have a depressed price of $5. Selling at this point would result in a substantial loss of $550 [$1500 ‒ (190 × $5)]. Investing during a lousy market can be a benefit because shares are accumulated at low prices.

Dollar-Cost Averaging in a Rising Market During the “rising market” in Table 13-1, you continue to invest but buy fewer shares. The $1500 investment during the bull market bought only 140 shares for an average cost of $10.71. In this rising market, you profit because your 140 shares have a recent market price of $20 per share, for a total value of $2800 (140 × $20).

Almost anyone can profit in a rising market. If you use dollar-cost averaging over the long term, you will continue to buy in rising, falling, and fluctuating markets. The overall result will be that you buy more shares when the cost is down, thereby lowering the average share cost to below-average prices. The totals in Table 13-1, for example, reveal an overall investment of $4500 ($1500 + $1500 + $1500) used to purchase 450 shares (120 + 190 + 140) for an average cost of $10 per share ($4500 × 450). With the recent market price at $20, you will realize a long-term gain of $4500 ($20 current market price × 450 shares = $9000; $9000 − $4500 invested = $4500 gain). Note that the dollar-cost averaging method would remain valid if the time interval for investing were monthly, quarterly, or even semiannually. The benefits of dollar-cost averaging are derived, in part, from the regularity of investing.

ADVICE FROM A PROFESSIONAL

Use a Dividend-Reinvestment Plan to Dollar-Cost Average

Many well-known companies 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. Such a program is known as a dividend-reinvestment plan (DRIP). You simply sign up with the company, agreeing to buy a certain number of shares and to reinvest cash dividends into more shares of stock for little or no transaction fees. Investors' accounts are credited with fractional shares, too.

The Direct Stock Purchase Plan Clearinghouse at www.dripinvestor.com/clearinghouse/home.asp manages the DRIP for many companies. Coca Cola (stock symbol KO) is illustrative. It requires a minimum investment of $500 or minimum monthly investments of $50 each for at least 10 months. The enrollment fee is $10. Coca Cola will buy back shares for a transaction fee of only $15. Other companies offering DRIPs include AT&T, ExxonMobil, Home Depot, McDonald's, Johnson & Johnson, Verizon, and Chevron.

Jon Wentworth

Southern Adventist University, Collegedale, Tennessee

Dollar-Cost Averaging Offers Two Advantages The first advantage is that it reduces the average cost of shares of stock purchased over a relatively long period. Profits occur when prices for an investment fluctuate and eventually go up. Although this approach does not eliminate the possibility of loss, it does limit losses during times of declining prices. And profits accelerate during rising prices.

The second advantage is that dollar-cost averaging dictates investor discipline. This strategy of investing is not particularly glamorous, but it is the only approach that is almost guaranteed to make a profit for the investor. It takes neither brilliance nor luck, just discipline. People who invest regularly through individual retirement accounts (IRAs), employee stock ownership programs, and 401(k) retirement plans (all discussed in Chapter 17) enjoy the benefits of dollar-cost averaging. Dollar-cost averaging is a systematic strategy that will eventually get your portfolio where you want it to be.

Strategy 3: Portfolio Diversification Reduces Portfolio Volatility Owning too much of any one investment creates too great a financial risk. Experts advise that you never keep more than 5 or 10 percent of your assets in one investment, including your employer's stock. Many workers who invested too much in their employer's stock have seen their retirement funds disappear or be drastically reduced in value when their employers' stocks plunged in price.

DID YOU KNOW

The Tax Consequences in Investment Fundamentals

There are some favorable aspects to income taxes to think about when making investments.

1. Income versus capital gain . Current investment income, such as dividends and interest, is taxed at one's marginal tax bracket, likely 25 percent. Capital gains are taxed at special lower rates, likely at 10 or 15 percent.

2. 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.

3. After-tax return . When comparing similar investments, your objective is to earn the best after-tax return. This return is the net amount earned on an investment after payment of income taxes. (See Equation 4.1 on page 129.)

4. Tax-exempt income . Income earned from municipal bonds is exempt from federal income taxes.

5. Tax-exempt investments . 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.

Figure 13-3 Diversification via Asset Allocation Averages Out An Investor's return This chart represents a hypothetical mix of winning and losing various investments after one year. One investment, for instance, increased in value 13 percent; another declined 6 percent. While some investments lost value, over the year those losses were offset with the gains of others, and the overall portfolio earned a 7.1 percent average return.

Diversification is the single most important rule in investing. Portfolio diversification is the practice of selecting a collection of different asset classes of investments (such as stocks, bonds, mutual funds, real estate, and cash) that are chosen not only for their potential returns but also for their dissimilar risk-return characteristics.

portfolio diversification Practice of selecting a collection of different asset classes of investments (such as stocks, bonds, mutual funds, real estate, and cash) that are chosen not only for their potential returns but also for their dissimilar risk-return characteristics.

The goal of portfolio diversification is to create a collection of investments that will provide an acceptable level of return and an acceptable exposure to risk. This outcome can be achieved because asset classes typically react differently to economic and marketplace changes. The major benefit of having a diversified portfolio is that when one asset class performs poorly, there is a good chance that another will perform well, and vice versa, thus this strategy helps control your exposure to risk.

As shown in Figure 13-3 diversification reduces portfolio volatility while averaging out an investor's return. If you were totally invested in the investment that rose 13 percent, you would be happy; if you were totally invested in the investment that declined 10 percent, you would be sad. Instead your diversified portfolio over 9 investments averaged 7.1 percent, which is a respectable return. Diversification lowers the odds that you will lose money investing and increases the odds that you will make money.

The lack of diversification can quickly destroy one's investment portfolio. All stock prices dropped dramatically (actually 55%) during the Great Recession. Table 13-2 illustrates the point demonstrating that when stocks crash 50 percent, a $200,000 portfolio that is poorly diversified (too heavy on equities in this case) is devastated, in this case down $85,000.

Strategy 4: Asset Allocation Keeps You in the Right Investment Categories for Your Time Horizon Asset allocation , a form of diversification, is deciding on the proportions of your 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. This strategy helps control your exposure to risk.

asset allocation Form of diversification in which the investor decides on the proportions of an investment portfolio that will be devoted to various categories of assets.

Asset allocation rather than your choice of specific securities is the most important determinant of financial success. Research shows that more than 90 percent of returns earned by long-term investors result from having one's assets allocated in a diversified portfolio. Thus you must strive to own the right asset categories at the right time.

Your allocation proportions and investment choices need to reflect your age, income, family responsibilities, financial resources, risk tolerance, goals, retirement plans, and investment time horizon. You need not change the proportions of your asset allocation until your broad investment goals change—possibly not for another five or ten years. When your investment objectives change, perhaps because of marriage, birth of a child, child graduating from college, loss of employment, divorce, or death of a spouse, you may need to change your asset allocation as well. Otherwise, stay the course.

Table 13-2 The Great Recession Devastated Portfolios That Were Not Well Diversified

Asset Allocation Requires Only Three Types of Investments To achieve an appropriate mix of growth, income, and stability in your portfolio, you need a combination of three investments: (1) stocks and/or stock mutual funds (equities), (2) bonds (debt), and (3) cash (or cash equivalents like Treasury securities). You need a little cash or cash equivalents in your portfolio because this allows you to move more money into stocks when appropriate. Asset allocation requires that you keep your equities, debt, and cash at a fixed ratio for long time periods, occasionally rebalancing the allocations, perhaps quarterly or annually, so as to continue to meet your investment objectives.

Asset Allocation Rules of Thumb Consider these two rules of thumb to guide the stock and bond allocation of your portfolio:

1. The percent to invest in equities is 110 minus your age, multiplied by 1.25. For example, if you are 40 years old, calculate as follows: 110 − 40 = 70; 70 × 1.25 = 87.5. Therefore, a 40-year-old investor is advised to maintain a portfolio where 87.5 percent of the assets are in equities and 12.5 percent are in bonds and cash equivalents.

2. The percent to invest in equities is found by subtracting your age from 120. Put the resulting number in the form of the percentage of your portfolio to invest in stocks. Put the remainder in bonds. So if you are age 30, put 90 percent (120 — 30) in stocks and 10 percent in bonds and cash. Every year, subtract your age from 120 again and rebalance your portfolio as needed.

Know Your Risk Tolerance and How Much Time You Have to Invest Figure 13-4 illustrates model portfolios that reflect varying degrees of risk tolerance and time horizons. A young, risk-tolerant, long-term investor with an aggressive investment philosophy might have a portfolio that is 100 percent in equities because equities offer the highest return over the long term. Younger investors also have ample time to ride out market fluctuations and make up any major losses. A moderate approach with a time horizon of six to ten years might have an equities-bond-cash portfolio of 60/30/10 percent.

Rebalance Your Investments at Least Once a Year Portfolio rebalancing is the process of bringing the different asset classes back into proper relationship following a significant change in one or more of them. You must reset your asset allocation to return your portfolio to the proper mix of stocks, bonds, and cash when they no longer conform to your plan. Here is why.

Figure 13-4 Asset Allocation and Time Horizons

Assume you have a moderate investment philosophy and started out with a 50/40/10 bond-equities-cash portfolio, as shown in Figure 13-5, and a year later, stock values increased to 49 percent of your portfolio's value while bonds dropped to 42 percent. The result: Your portfolio is now too heavy in stocks and too light in bonds. It is too risky. As shown in Figure 13-5, this suggests that you sell some of your equities and use the proceeds to buy more bonds, thus rebalancing your portfolio according to your previously determined asset allocations.

When rebalancing, you will be selling high and buying low—the goal of all investors. It is temperamentally difficult for investors to rebalance. They don't like to sell assets that have increased in value because they hope those values will continue to increase. Rebalancing is an appropriate form of market timing as it provides some of the benefits of market timing without the risk.

Figure 13-5 Rebalance Assets in Your Investment Portfolio Even Though Values Increased

DO IT IN CLASS

ADVICE FROM A PROFESSIONAL

When to Sell an Investment

It is time to consider selling an investment when one of the following conditions has been met:

• Something significant about the company's business or its earnings has changed dramatically for the worse since you bought the company's stock.

• The stock is doing so well that it is overvalued, and the share price is much higher than what you believe the company is worth.

• The investment is performing poorly and causing you undue anxiety. The great financier Bernard Baruch advised, “Sell down to the level where you are sleeping well.”

• You need cash for a worthwhile purpose, and this investment appears the most fully priced.

• The investment no longer fits your situation or goals, and you have a more promising place to invest your money.

Diann Moorman

University of Georgia

About half of employees who participate in their employer-sponsored retirement plan have access to paid services that automatically rebalance employees' retirement assets. A worker can sign up for the services of a limited managed account . Once you have signed a contract with a vendor approved by your employer, you decide on your preferred asset allocation. Then under supervision by the limited managed account contract the company sells and buys your mutual fund assets, usually quarterly, on your behalf each time adjusting your portfolio back to your specified asset allocation percentages.

limited managed account An account at an investment firm whereby, for a fee, they sell and buy your mutual fund assets, usually quarterly, on your behalf to automatically rebalance your portfolio back to your specific standards.

The service may be paid for entirely or just subsidized by the employer. A study by Financial Engines and Aon Hewitt of 425,000 savers over 5 years found that the median annual returns of those workers who got these services was almost 3 percentage points higher than those who invested on their own. Financial Soundings charges $20 annually, and both Betterment and SigFig Wealthfront charge 0.25 percent annually. Similar programs are offered by Morningstar and Financial Engines.

DID YOU KNOW

Bias toward Not Selling

People engaged in the understanding investment fundamentals have a bias toward certain behaviors that can be harmful, such as a tendency toward refusing to sell poorly performing investments that have lost value, clinging to the hope that the assets will eventually regain their old values. What to do? Regularly monitor your portfolio and sell investments that are no longer providing the desired return and then reinvest the money elsewhere.

CONCEPT CHECK 13.4

1. Summarize what the buy-and-hold strategy is all about.

2. Explain the concept of dollar-cost averaging including why one invests at below-average costs.

3. What is the goal of portfolio diversification, and how is this accomplished?

4. What is asset allocation, and why does it work?

5. What happens to a worker's 401(k) retirement account if he or she signs up for a limited management account service?

13.5 USE MONTE CARLO ADVICE TO HELP YOU INVEST FOR RETIREMENT

Employer-based financial advice must follow the requirements of the Pension Protection Act. The advice must be based on computer simulations of projected investment performance using Monte Carlo analysis , an evolution of the long-term strategy of asset allocation. Here, the goal is to identify the investor's acceptable level of risk tolerance and then find an optimal portfolio of assets that may reduce overall portfolio volatility while providing the highest expected returns for that level of risk. This technique performs a large number of trial runs of a particular portfolio mix of investments, called simulations.

Monte Carlo analysis Technique that performs a large number of trial runs of a particular portfolio mix of investments, called simulations, to find an optimal allocation for a particular investor's goals and risk tolerance.

LEARNING OBJECTIVE 5

Use Monte Carlo Advice when investing for retirement.

13.5a Monte Carlo Simulations

Monte Carlo simulations, named for the famous casino site, can be used to model the performance of hundreds or even thousands of individual mutual funds and stocks through thousands of fluctuating securities markets. The simulations allow you to estimate the probability of reaching your financial goals, such as a specific retirement income at a certain point in the future.

The mathematical simulations are based on long-term historical risk and return characteristics for various mixes of stock, bond, and short-term investment asset classes. Each simulation estimates how much you need to save—the accumulation phase—of your investments performed better or worse than expected, and it gives the odds that your assets will last throughout the retirement time period—the distribution phase—after you choose a given set of investments and establish a withdrawal amount. These calculations are probabilities, not certainties.

By using Monte Carlo simulations, investors can get a fairly realistic view of how much their current investments may yield in retirement. Investors often learn that they are playing it too safe by investing too conservatively, and this may prevent them from reaching their goals. By evaluating the trade-offs among various combinations of retirement plan contribution levels, diverse investment mixes, overall portfolio risk, projected retirement age, and retirement income goals, Monte Carlo simulations let you understand how certain changes in these factors will affect the chance that you will have enough money in retirement. Some investors may have to learn to be comfortable with increased risk, while others may have to save more or work longer. See Figure 13-6 for illustrative Monte Carlo calculations.

13.5b Monte Carlo Software Programs Available

Software programs can be used to assist investors in creating an efficient portfolio using Monte Carlo simulations. Products are available from Financial Engines, Financial Soundings, Morningstar, and Vanguard. Many employers offer employees free or low-cost access to Monte Carlo analysis as an employee benefit for retirement planning, often through an outside firm that offers limited management accounts.

DID YOU KNOW

Your Worst Financial Blunders in Investment Fundamentals

Based on others' financial woes, you will make mistakes in personal finance when you:

1. Buy and sell more than you should.

2. Diversify less than you should.

3. Hold on to a bad investment long after evidence shows it was a bad decision.

Figure 13-6 Monte Carlo Simulation from Financial Engines

CONCEPT CHECK 13.5

1. Review Figure 13-6, Monte Carlo Simulation from Financial Engines, and give your impressions of the “New Strategy” recommendations.

2. What do you think about paying $20 a year for Monte Carlo simulations through your employer from a limited management company?

LEARNING OBJECTIVE 6

Create your own investment plan.

13.6 CREATING YOUR OWN INVESTMENT PLAN

To create an investment plan , which is a reflection of your investment philosophy and your logic on investing to reach specific goals, see the illustrated plan for Christina Garcia in Figure 13-7. Christina's plan includes saving for retirement as well as to buy a vehicle. You can begin creating your own investment plan by identifying your financial goals and explaining your investment philosophy as called for in Steps 1 and 2 in Figure 13-7.

investment plan An explanation of your investment philosophy and your logic on investing to reach specific goals.

To help in your thinking for Step 3 in Figure 13-7, consider the time horizons of various investments. (Terms new to you are explained in the chapters that follow.) What are the time horizons for your investment goals? Are you building up an amount for a down payment on a home, creating a college fund for a child, or putting away money for retirement? Or are all three time horizons relevant? Keep in mind why you are investing and proceed accordingly. Now calculate the numbers. How much money do you need to achieve each goal, and by when? What is the total of your current investment assets? Do the math.

Step 4 in Figure 13-7 asks about investment alternatives. Review Figure 13-1 on the long-term rates of return on various investments. Then examine Figure 13-2 because it shows the trade-offs between risk and return on investment alternatives. Next take a pencil or pen and delete some investment choices that do not appeal to you or match your investment philosophy. You will be left with alternatives that better fit your investment goals and philosophy.

FINANCIAL POWER POINT

Create Your Financial Plan on the Web

To obtain an overall assessment of your financial progress and advice on how to achieve your goals, you may want to consult an online financial advisor to construct a financial plan. Prices vary from $250 to $500 or more. Check out Fidelity .com, Schwab.com, TRowePrice.com, and Vanguard.com.

DID YOU KNOW

Turn Bad Habits into Good Ones

Do You Do This?

Make small contribution to employer's retirement plan

Invest conservatively for retirement

Try to time investments to market ups and downs

Ignore transaction costs on investments

Invest mostly in employer's stock

Do This Instead!

Contribute the maximum

Invest aggressively for long-term goals

Stay invested for the long term

Hold down transaction costs

Reduce holding to 5 or 10 percent

Figure 13-7 Christina Garcia's Investment Plan After some thinking and reading, Christina, age 24, jotted down some investment plan notes.

DO IT NOW!

You know more about investment fundamentals after reading this chapter, so get started right now by:

1. Writing down your investment philosophy.

2. Recording the percentages you would allocate to stocks, bonds, and cash equivalents using an asset allocation strategy to save for retirement.

3. Starting to save even a small amount perhaps by signing up to automatically transfer some money every payday to a savings or investment account.

Now you have started to create an investment plan, so record your responses to Steps 5, 6, and 7. Then create an investment portfolio appropriate for your life now using Figure 13-4 as a model. All that remains is to put your plan into action. That means filling out forms to open an investment account, selecting your investments, writing checks for your first investing dollars, and monitoring your investments. These topics are examined in the chapters that follow.

When you take the appropriate retirement planning action steps, including a moderate amount of risk when investing, you will be able to relax with the confidence that you are making wise decisions about your investment assets and the knowledge that your money will grow and will be there to fund your lifestyle during the last quarter of your life.

CONCEPT CHECK 13.6

1. Review Figures 13-1 and 13-2, and record in writing an investment plan to fund your retirement, presumably one of your own long-term goals.

WHAT DO YOU RECOMMEND NOW?

Now that you have read the chapter on investment fundamentals, what do you recommend to Shavenellyee and Sarena on the subject regarding:

1. Portfolio diversification for Shavenellyee?

2. Dollar-cost averaging for Shavenellyee?

3. Investment alternatives for Shavenellyee?

BIG PICTURE SUMMARY OF LEARNING OBJECTIVES

LO1 Explain how to get started as an investor.

Before investing, think about how investing is more than savings, the investment returns which are possible, and the long-term rates of return on investment choices. Investors hope that their investments will earn them a positive total return, which is the income an investment generates from current income and capital gains.

LO2 Identify your investment philosophy and invest accordingly.

Achieving financial success requires that you understand your investment philosophy and adhere to it when investing. An investment philosophy is one's general approach to tolerance for risk in investments, whether it is conservative, moderate, or aggressive, given the financial goals to be achieved. You also need to know about investment risk and what to do about it. Before investing your money, you need to think about lending versus owning, short term versus long term, and how to select investments that are likely to provide your desired potential total return.

LO3 Describe the major risk factors that affect the rate of return on investments.

Because of the uncertainty that surrounds investments, people often follow a conservative course in an effort to keep their risk low. Being too conservative when investing means that they risk not reaching their financial goals. To be a successful investor, you must understand the major risk factors that affect the rate of return on investments so you can then take the appropriate risks when making investment decisions. Key concepts include random and market risk.

LO4 Decide which of the four long-term investment strategies you will utilize.

To succeed as an investor, you must establish your own long-term investment strategy. Most investors accept the fact that they cannot time the market with any consistency. Most long-term investors are passive investors. They wisely ignore the ups and downs of the stock market and the business cycle and simply use the four investment strategies of buy and hold, dollar-cost averaging, diversification, and asset allocation. Rebalancing your portfolio at least once a year is critical to success.

LO5 Use Monte Carlo Advice when investing for retirement.

By using Monte Carlo simulations, investors can get a more realistic view of how much their current investments may yield later on during retirement. Investors may learn that they are playing it too safe by investing too conservatively today, and this may prevent them from reaching their long-term goals. Some investors may have to learn to be comfortable with increased risk, while others may have to save more or work longer.

LO6 Create your own investment plan.

An investment plan is an explanation of your investment philosophy and your logic on investing to reach specific goals. Steps include identifying your goals, contemplating which types of investments might best fit your investment goals, clarifying your investment philosophy, learning about investment alternatives, and narrowing down your choices.

LET's TALK ABOUT IT

1. Why Invest. Why should people invest? Give three reasons each for college students, young college graduates in their 20s, couples with young children, and people in their 50s.

2. Long-Term Rates of Return. Review Figure 13-1, “Long-Term Rates of Return on Investments” on page 383. and offer your views on which two investment types would be most suitable for yourself.

3. Market Risk. What do you think is the likelihood of years of poor stock market returns.

4. What Is Your Tolerance for Risk in Investing? Is it the same as for other members of your class? Why or why not?

5. Risk and Return Trade-Offs. Review Figure 13-2, “The Risk Pyramid Reveals the Trade-Offs Between Risk and Return” on page 385 and give your views on which three investments would be most suitable for you.

6. Your Investment Philosophy. Is your investment philosophy conservative, moderate, or aggressive? Give two reasons to support the adoption of your philosophy. How does your view compare with the philosophies of other members of your class?

7. Review the section on “Types of Investment Risks” on page 391, and note two that might worry you the most in the world of investing.

DO IT IN CLASS PAGE 391

8. Invest How Much? Assume you have graduated from college and have a good-paying job. If you had to commit to investing regularly right now, how much money would you put away every month? Explain why. How does your view compare with the views of other members of your class?

DO THE MATH

1. Annual Investments. Sheldon Cooper and Amy Farrah live in Pasadena, California, have as a new investment goal to create a college fund for their newborn daughter. They estimate that they will need $200,000 in 18 years. Assuming that the Cooper-Fowler family could obtain a return of 5 percent, how much would they need to invest annually to reach their goal? Use Appendix A-3 or the Garman/Forgue companion website.

2. Number of Years. Mary Cooper, Sheldon's mother, who lives in Texas, wants to help pay for her grandchild's education. How long will it take Mary to reach her goal of $200,000 if she invests $10,000 per year, earning 6 percent? Use Appendix A-3 or the Garman/Forgue companion website.

3. Future Cost. If one year of college currently costs $15,000, how much will one year cost Michelle Spindle's newborn daughter, Melissa, in 18 years, assuming a 5 percent annual rate of inflation? Use Appendix A-1 or the Garman/Forgue companion website.

4. Returns and Actions. Kunal Nayyar from California, had $50,000 in investments at the beginning of the year that consisted of a diversified portfolio of stocks (40 percent), bonds (40 percent), and cash equivalents (20 percent). His returns over the past 12 months were 13 percent on stocks, 6 percent on bonds, and 1 percent on cash equivalents.

DO IT IN CLASS PAGE 400

(a) What is Kunal's average return for the year?

(b) If Kunal wanted to rebalance his portfolio to its original position, what specific actions should he take?

5. Early Investor Wins. Jordan and Jeremy, who are twins living in Rexburg, Idaho, took different approaches to investing. Jordan saved $2000 per year for ten years starting at age 23 and never added any more money to the account. Jeremy saved $2000 per year for 20 years starting at age 35. Assuming that the brothers earned a 6 percent return, who had accumulated the most by the time they reached age 63? Use Appendix A-1 and Appendix A-3 or the Garman/Forgue companion website.

FINANCIAL PLANNING CASES

CASE 1

The Johnsons Embark on a Solid Investment Program

After nearly eight years of marriage, Harry and Belinda's finances have improved, even though they have incurred debts for an automobile loan and a condominium. Because they did not contribute very much to their retirement plans every year, Harry's account is currently worth only $28,000 and Brenda's is $31,000, but they do have $12,000 in investments outside their employers' retirement plans.

DO IT IN CLASS PAGES 383 AND 385

Therefore, the Johnsons have decided to seriously forgo some current spending for the next three years to concentrate on getting a solid investment program under way while they still have two incomes available and before they start a family. They are willing to accept a moderate amount of risk and expect to invest between $600 and $800 per month over the next three years. Respond to the following questions:

(a) In what types of investments (choose only two) might the Johnsons place the first $2000? (Review Figures 13-1 and 13-2 for ideas and available options, and consider the types of investment risks inherent in each choice.) Give reasons for your selections.

(b) In what types of investments might they place the next $4000? Why?

(c) What types of investments should they choose for the next $10,000? Why?

CASE 2

Victor and Maria Hernandez Try to Catch Up on Their Investments

The expenses associated with sending two children through college prevented Victor and Maria Hernandez from adding substantially to their investment program. Now that their younger son, Joseph, has completed school and is working full time, they would like to build up their investments quickly. Victor is 47 years old and wants to retire early, perhaps by age 60. In addition to the retirement program at his place of employment, Victor believes that their investment portfolio, currently valued at $70,000, will need to triple to $210,000 by retirement time. He and Maria realize that they will have to sacrifice a lot of current spending to save and invest for retirement.

(a) What rate of return is needed on the $70,000 portfolio to reach their goal of $210,000 (assuming no additional contributions)? Use Appendix A-3 or visit the Garman/Forgue companion website.

(b) Victor and Maria think they will need a total of $400,000 for a retirement financial nest egg. Therefore, they will need to create an additional sum of $190,000 through new investments. Assuming an annual return of 8 percent, how much do the Hernandezes need to invest each year to reach their goal of $190,000? Use Appendix A-3 or visit the Garman/Forgue companion website.

(c) If they assume a 6 percent annual return, how much do the Hernandezes need to invest each year to reach their goal of $190,000? Use Appendix A-3 or visit the Garman/Forgue companion website.

CASE 3

Julia Price's Goal Is to Buy a Luxury Condominium

It has been about 20 years since Julia graduated with a major in aeronautical engineering, and she has been quite successful in her career and her personal finances. Accordingly she wants to sell her home and buy a luxury condominium. She has $40,000 in savings, and she figures that she can continue her savings and investment program for three more years before making a 20 percent down payment on a luxury condominium. The home that she wants to purchase is currently priced at $450,000. Julia thinks she should invest her $40,000 and additional savings during the next three years by using lending investments like certificates of deposit and bonds rather than owning stocks or stock mutual funds. Offer your opinions about her thinking.

CASE 4

A First-Time Investor Gets a Head start

Lucia Gomez, a flight attendant from Indiana, Pennsylvania, is thinking about jump-starting a retirement savings plan by investing the $50,000 gift that her elderly uncle gave her. She also wants to invest $1000 a month for the next 25 years for retirement. Lucia knows little about investments and does not seem to have a big desire to learn.

(a) What can you suggest to Lucia about figuring out her investment philosophy? (Hint: Mention the information in Figure 13-2 in your response.)

(b) Would you recommend active or passive investing for her, and why?

(c) Should Lucia be a lender or owner?

(d) Identify three risks to her retirement investments that Lucia should try to avoid, and explain how she can avoid them.

(e) Select two of the four recommended investment strategies to recommend to Lucia, and explain why she should follow them.

(f) If Lucia's $50,000 is invested in a standard investment account and her $1000 monthly is invested in a tax-sheltered account, with each account growing at 5 percent annually for 25 percent in 25 years, how much money will she have accumulated in each account? (Hint: Adjust the lump-sum investment for 25 percent taxes.)

BE YOUR OWN PERSONAL FINANCIAL MANAGER

1. Your Personal Risk Pyramid. Review Figure 13-2, “The Risk Pyramid Reveals the Trade-Offs Between Risk and Return,” and record your opinions on which types of risk you are probably willing to take over the next ten years in the world of investing by listing the names of the investments with which you would be comfortable.

2. What Is Your Investment Philosophy? Review the section titled “Identify Your Investment Philosophy and Invest Accordingly” and then complete Worksheet 50: My Investment Philosophy from “My Personal Financial Planner” to record various aspects of your approach to investing.

3. Your Long-Term Investment Strategies. Complete Worksheet 51: My Preferred Long-Term Investment Strategies from “My Personal Financial Planner” by check marking the strategies you like and that you might follow during your investing life.

4. Real Return on Investments. Review the box “Did You Know? Calculate the Real Rate of Return (After Taxes and Inflation) on Investments” and complete Worksheet 53: The Real Return on My Investments from “My Personal Financial Planner” by inserting some realistic numbers next to the examples.

ON THE NET

Go to the Web pages indicated to complete these exercises.

1. Why Invest? Visit the John Hancock website www.jhinvestments.com/Article.aspx?ArticleID={79432E5F-30DF-4624-94F8-FC319EA99D71} and read the article titled “Why Invest?” Compare what you read there with what is in this chapter.

2. Investing for Beginners Visit the Investing for Beginners website invest-for-beginners.blogspot.com/ and read the series of short articles on that page. Compare what you read there with what is in this chapter.

3. Herd Behavior Visit the Investopedia website www.investopedia.com/university/behavioral_finance/behavioral8.asp#axzz1yB21OU00 and read the article on herd behavior on that page. Compare with what you read in this chapter.

4. Asset Allocation Visit the Wikipedia website en.wikipedia .org/wiki/Asset_allocation and read it's contents. Compare with what you have read in this chapter.

5. Monte Carlo Simulation Visit the Financial Engines website corp.financialengines.com/. Click on “How We Help You” and read the links that are there. Compare with what you have read in this chapter.

ACTION INVOLVEMENT PROJECTS

1. Your Investment Strategy. The text discusses four strategies for long-term investors on pages 394-401. Which one appeals to you most and why?

2. Risk-Tolerance Quiz. Go to two of the risk-tolerance quiz websites listed in “Financial Power Point: Take a Risk-Tolerance Quiz” on page 387 and offer some comments on how they differ.

3. Current Investment Magazine Article. Obtain a current issue of Money or Kiplinger's Personal Finance and summarize an article that offers suggestions on investing.

Visit the Garman/Forgue companion website at www.cengagebrain.com .