Basics of Investing IIIEconomics 98 / 198

Spring 2008Copyright 2007 Jason Lee

Schedule

• Announcements

• Quiz

• Current Events

• Today’s Lecture Content

• Next Week

Announcements

• Simulation Sign-Ups / Money (last chance)

• Rules of Investment Simulation

QUIZ

CURRENT EVENT / NEWS

Recessions & the Stock Market (S&P 500: 1951 – 1975)

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Source: Global Financial Data

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Recessions & the Stock Market (S&P 500: 1976 – 2007)

Source: Global Financial Data

LECTURE CONTENT

Today’s Lecture

• Basic investing concepts– Risk-Reward / Financial Goals / Understanding Yourself

• Portfolio Management– Diversification– Concentration

• Different investment securities– Bonds / CDs / Money Market– Mutual Funds / Exchanged-Traded Funds

• Market Psychology

More Market Basics

Market Hours

• Trading day begins 930AM EST and ends 4PM EST (630AM – 1PM)

• Orders outside of trading day will not go through

• Pre-market trading• After-hour trading

Basic Investing Concepts

Determining Your Financial Goals

• Investing is a long car trip. There needs to be a lot of planning that goes into it.– How much money do you want to make? By

when?– Will you need to live off your investments in

future years?– What will you be using your money for?

• Having a good understanding of yourself will allow you to align your risk tolerance with various strategies

Determining Your Investment Style

• What kind of person and investor do you want to be?– Shooting for singles and doubles, aiming for slow

and steady gains?– Sitting on the sidelines, relying on and cheering

someone else?– Willing to take risks, go for homers, and achieve

maximum gains?

• Think about your risk tolerance, time horizons for your investments, and your time commitment

The Risk / Return Tradeoff

• “principle that potential return rises with an increase in risk”– Lower risk with lower returns– Higher risk with high returns

• Important to know your personal risk tolerance when choosing investments– Balance between risk and reward

Source: Investopedia. “Determining Risk and The Risk Pyramid.” May 2 2003

What is Your Risk Tolerance?

Source: Investopedia. “Determining Risk and The Risk Pyramid.” May 2 2003

Portfolio Management

Portfolio

• “collection of assets—such as stock, bonds, and mutual funds—held by an investor”

• Portfolio Management– Deciding type of investment mix and

allocation for your portfolio– Risk versus performance

Active versus Passive Management

You choose?

versus

Someone else chooses for you?

Active versus Passive Management

• Examples (Active Management)– Buying / selling different stocks– Discuss with your broker which stocks to invest– Choosing between different mutual funds

• Example (Passive Management)– Choose one mutual fund and forgetting about it

for the next 10 years– Buying an index fund or having your portfolio

match the index fund at all times

How many stocks should I own?

Diversification

versus

Concentration

“Don’t put all your eggs in one basket”

Diversification

Diversification

• Mixing a wide selection of investments within a portfolio– By industry, sizes, geographic locations, or

other characteristics

• Positive performance of some investments may neutralize the negative performance of others

Diversification…What’s the Catch?

• Limits your upside potential– Hot stock makes up only 5% of your portfolio– 50% increase will have small effect

• Many investors tend to over-diversify– Harder to keep track, slower to react – Less you know about one area of positions– Over-diversification usually leads to matching

market performance (What’s the point then?)– Commissions becomes an issue with low capital

Concentration

“putting your eggs in a few baskets that you know well and watching them very carefully”

Concentration

• Goal: Keep losses small and ride profits for big gains– Effect: big gains have major effect on your

portfolio value

• Note: Avoid temptation of committing too much of portfolio into one position

–Why? Psychology

How Many to Concentrate on?

Account Size # of stocks

$3,000 2

$5,000 - $20,000 3

$20,000 - $100,000 4 or 5

$1,000 - $1,000,000 5 or 6

$1,000,000 - $5,000,000 6 or 8

Other Investment Securities

Mutual Funds & Exchange-Traded Funds

Various investment securities

• Money market funds– Type of risk-free debt investment that has slightly better

returns than savings– Typically mature in less than 1 year– Very liquid (ie. easy to buy/sell and convert to cash)– Usually traded through institutions in high volumes

• Certificate of deposits (CDs)– Certificate to the bearer to receive interest– Issued by commercial banks for 1 month to years– Short-term CD’s generally 5.29% percent or up– Bearer can’t withdraw money until term is up

Various Investment Securities

• Bonds– An IOU issued by a borrower to a lender– Loaning money for pre-determined time– Borrower pays a coupon payment during time-span as well

as lent amount– Borrowers range from banks, government, to corporations

• Advanced / Alternative Investments – Options– Hedge Funds– Private Equity– Futures / Derivatives

Mutual Fund Basics

• Nothing more than a collection of stocks and/or bonds

• You contribute your money to a company that manages a large fund (made up of other people’s money) and invests in a portfolio

• Often, these mutual funds can be hundreds of millions and billions of dollars

Mutual Fund Basics

• Various types of mutual funds– Equities, fixed-income, money market– Mutual funds usually variation of these assets

classes

• Also, other special types: global, international, specialty, index funds

• Costs:– Yearly fees to keep you invested in fund– Transaction fees paid when buy / sell shares– Also other various costs: administrative,

managing fees, etc.

Buying and Selling Funds

• Can buy mutual funds by contacting fund companies directly (ie. go to the company’s website)

• Can withdraw your money from fund at the end of market days usually

• If purchase mutual funds through third-parties (brokers, banks, planners), usually faced with extra sales charge (these are called loads)

Advantages Disadvantages

• Professional

Management

• Diversification

• Economies of Scale

• Liquidity

• Simplicity

• Professional

Management

(huh?!)

• Costs

• Dilution

• Taxes

• Reaction Time

Choosing Mutual Funds

• Always compare fund performance to stock market averages (S&P500, NASDAQ)– Pay attention to the years in which market

averages were down (anyone can make money in the bull market)

– Look for solid track records

• Make sure objectives of mutual fund are in line with your goals and risk / rewards desires– Aggressive growth? Slow, steady returns?

Exchange-Traded Funds

• Like mutual fund, but trades like stock– Represents a basket of stocks that reflect

an index / industry such as the S&P500 or alternative energy

– Diversification like an index fund, but the flexibility of a stock

• Value of ETF updated daily as supply and demand fluctuates

Exchange-Traded Funds

• Number of ETF for various industries and markets – International, oil, retail, emerging markets, etc.

• Buying and selling ETF as simple as buying / selling a stock– Symbols assigned to each ETF (QQQQ for Nasdaq

100 average) – Go to broker & enter buy order for QQQQ

• Can buy / sell at any point of the day

Advantages over Mutual Funds

• Lower costs• Greater tax efficiency • Easier asset allocation• No fraud (ETF’s are transparent)• Flexibility• Shorting opportunity

Sample ETF Symbols

ETF Ticker Fund Name Fund Description

IVV iShares S&P 500 Index Fund Large cap US stocks

IJH iShares S&P Mid Cap 400 Index Fund Mid cap US stocks

IWM iShares Russell 2000 Index Fund Small cap US stocks

EFA iShares MSCI EAFE Index Fund Large cap foreign developed market stocks

EEMiShares MSCI Emerging Markets Index

FundLarge cap emerging market stocks

RWRstreetTRACKS Wilshire REIT Index

FundReal estate investment trust index fund

LQDiShares GS $ Investop Corporate Bond

FundUS corporate bonds

SHYiShares Lehman 1 to 3 Year Treasury

Bond Fund US short-term Governement bonds

IEFiShares Lehman 7 to 10 Year Treasury

Bond Fund US long-term Governement bonds

TIP iShares Lehman TIPs Bond Fund US Governement inflation-protected bonds

Additional Resources for ETF’s

Radical Guide to ETF Investinghttp://www.radicalguides.com/2005/06/the_radical_gui.html

ETF Central (Charts)http://www.etf-fund-investing/technical_analysis_charts/

ETF Investorhttp://www.etfinvestor.com/

ETF Trendshttp://www.etftrends.com/

TRADING PSYCHOLOGY

Trading Psychology

Emotions severely impair your judgment in deciding whether to buy or sells tocks

HOPEFEARGREEDPRIDE

Psychology & The Stock Market

•Emotions can wreak havoc on your results and decisions

•Need to take emotion out of investing

•Do this by developing a system with rules to follow with discipline

Trading Psychology

“Your biggest enemy, when trading, is within yourself. Success will only come when you learn to control your emotions”

- Edwin Lefevre

Next Week

• Financial Statements Primer– Income Sheet– Balance Sheet– Cash Flow Statement

• Financial Ratios– P/E, ROE, Margins, etc.

• Earning Reports, Analyst Estimates

Reading

Assigned Reading:– SEC. Beginner’s Guide to Financial Statements– Look at Google’s financial statements (income

statement, balance sheet, cash flow statement)

Extra Reading: – Ratio Analysis (Investopedia)

http://www.investopedia.com/university/ratios/