Ch 13: Assignment - Investment Fundamentals

Modern portfolio theory (MPT) Modern portfolio theory (MPT) is an investment strategy with the goal of identifying an investor's acceptable level of risk tolerance (usually based on a mathematical model taking into account several relevant factors) and then finding an optimal combination of diversified assets that have the highest expected returns for that level of risk. One popular form of MPT consists of performing a large number of trial runs with a particular portfolio mix of investments. Then the probability that a particular portfolio will reach an investor's goal is calculated. This version of the MPT is called ___ . The individual trial runs involved in this strategy are called ___.

Monte Carlo Analysis Simulations

Beginning to invest earlier in life can have a dramatic impact on your total investment returns in the long run. Consider the following example. As all values are denominated in U.S. dollars, you do not have to enter any dollar signs. The Wisdom of Investing Early Ash is an early investor. At age 30, she begins $3,000 per year in a tax-deferred account. The funds in her investment account compound at 9% annually. She continues investing until age 40, when she stops contributing to her investment account altogether. After 10 years of cumulative investing, Ash has invested a total of ___ in her investment account. From that point on, Ash's investments continue to compound until she reaches age 65. By contrast, Victor is a late start investor. Victor waits until age 40 to begin his long-term investment plan. Starting at age 40, Victor invests $3,000 per year into a similar tax-deferred account. The funds in his account compound at the same rate of 9% annually. Victor continues investing until he reaches age 65. After 25 years of cumulative investing, Victor has invested a total of___ in his investment account. Compare the amount of money that Ash has at age 65 with the amount of money that Victor has at age 65. Ash (Early Investor) Age Total Investment Account Value 30$3,000$3,2703515,00019,5704030,00049,68145-76,44050-117,61355-180,96260-278,43365-428,403 Victor (Late Start Investor) Age Total Investment Account Value 30--35--40$3,000$3,2704515,00019,5705030,00049,6815545,00096,0106060,000167,2946575,000276,972 At age 65, ___ has a higher account value than ___ . A total cumulative investment of $30,000 gets the early investor at age 65. But the late start investor, who invested much more money ($75,000), has only ____ at age 65. You can see from this example that investing early can have a significant impact on your long-term investment returns.

30,000 75,000 Ash Victor 428,403 276,972

Rate of return (yield) The rate of return, or yield, is the total return on an investment expressed as a percentage of its purchase price. The rate of return is usually stated on an annualized basis. For example, if you have an investment worth $1,000 that yields $120 of total return per year, then the investment would have a 12% annual rate of return (or yield). Consider the following example: Hanna has purchased 100 shares of A&S Communications stock at a purchase price of $35 per share. Over the next year, A&S Communications pays a total of $5 per share in dividends to its shareholders. At the end of the year, Hanna sells her A&S Communications stock for $39 per share. In addition, Hanna paid a transaction cost of $1 per share both at the time of purchase and at the time of sale. Part A—Current Income (Dividends): Over the year that Hanna owns her shares of A&S Communications stock, she receives a total of $ ___ in current income in the form of dividends. Part B—Capital Gains: The total amount that Hanna has paid for her A&S Communications stock is $ ___. The total amount of money that Hanna receives after selling her shares of A&S Communications stock is $ ___. Therefore, Hanna's investment achieves a capital gain of $ ___. Part C—Total Return: Over the year that she owns the A&S Communications stock, Hanna earns a total return of $ ___. Part D—Rate of Return (Yield): The rate of return on an investment is the total return on the investment expressed as a percentage of its price. Calculate the rate of return by dividing the total return by the total purchase price (not including transaction costs because these are already taken into account in the capital gains portion of the total return). Round your rate of return to two decimal places. In the example given, the total return is $ ___, and the total purchase price (excluding transaction costs) is $ ___. Therefore, the rate of return on Hanna's investment in A&S Communications stock is ___%.

500 3600 3800 200 700 700 3500 20.00

Various types of investments have different long-term rates of return. When you invest your money, you are taking a financial risk, which is the possibility that the investment will fail to produce the desired return (or, in the worst-case scenario, any return at all). For example, if you invest in a particular company's stock, the company could have a very good year and earn considerable profit. Or in an extreme case, the company could go bankrupt, causing investors to lose all of their invested money. Therefore, smart investing involves attempting to earn a positive total return, which is the income that an investment generates from a combination of current income and capital gains. ___ is the money received while you own an investment. By contrast, ___ is the increase in the value of an investment when you actually sell the investment. In general, there is a trade-off between capital gains and current income. Investments with high potential for capital gains often pay little current income, and investments that pay substantial current income generally have little to no potential for capital gains. Current Income There are many kinds of current income, including ___ (the charge for borrowing money paid to the lender of the money) and ___ (payment received for allowing someone else to use your real estate property). Another kind of current income is a dividend, which is a portion of a company's earnings that the firm pays out to its shareholders. For example, suppose that Layla purchases 100 shares of Purple Chicken Footwear Company stock at $35 per share, for an initial investment of $3,500. Over the next year, the company pays dividends totaling $5 per share. Compute the amount of cash dividends that Layla receives as current income during the year: Number of Shares: 100 shares Dividend Value per Share: x $5 Current Income from Dividends: =$___

Current Income a capital gain interest rent 500

Total return - Capital gains Various types of investments have different long-term rates of return. When you invest your money, you are taking a financial risk, which is the possibility that the investment will fail to produce the desired return (or, in the worst-case scenario, any return at all). For example, if you invest in a particular company's stock, the company could have a very good year and earn considerable profit. Or in an extreme case, the company could go bankrupt, causing investors to lose all of their invested money. Therefore, smart investing involves attempting to earn a positive total return, which is the income that an investment generates from a combination of current income and capital gains. ___ is the money received while you own an investment. By contrast, ___ is the increase in the value of an investment when you actually sell the investment. In general, there is a trade-off between capital gains and current income. Investments with high potential for capital gains often pay little current income, and investments that pay substantial current income generally have little to no potential for capital gains. Capital Gains A capital gain occurs only when you ___ the investment. It is the result of ___ in the value of the initial investment. A capital gain is calculated by subtracting the total amount paid for the investment (including purchase transaction costs) from the higher sale price (minus any sales transaction costs). Assume Leila purchased 100 shares of B&E Software stock at an initial price of $40 per share. In addition, she paid $1 per share in transaction costs. Later, Leila sold the investment for $53 per share. Once again transaction costs were $1 per share. Because Leila sold her investment at a price that is ___ than the initial purchase price, Leila has a capital gain after selling the investment. To calculate the amount of Leila's capital gain, subtract the total amount paid for the investment (including transaction costs) from the higher sale price (minus transaction costs). Complete this calculation as follows: Total received from selling the investment - Total paid off the investment = Capital Gain ($ ___ - $ ___) - ($ ___ + $___) = $ ____

Current Income a capital gain sell an increase higher ($ 5300 - $ 100) - ($ 4000 + $100) = $ 1100

Strategy 1 - Buy and hold One popular long-term investment strategy is buy and hold (also called buy to hold). Buy-and-hold investors usually buy a widely diversified set of stocks or mutual funds that they plan to hold on to for a long period of time, often 20 years or longer. Buy and hold investors often reinvest the dividends from their investments, which means that they purchase additional shares of their investments with the dividend payments. You can usually set up your investment account to automatically reinvest your dividend payments for you. Buy-and-hold investors expect that the value of their investments will ____ along with the growth of the economy. Buy-and-hold investors ____ react emotionally to the short-term fluctuations in the market. Selling high-quality investments in a market downturn (called a bear market) usually ___ a good strategy. Although it may seem counterintuitive, a buy-and-hold investor should consider buying ___ shares of an investment when the market is down. This is because he or she will be able to buy a greater number of shares for the same amount of money while the market is down and investment prices are lower. Consider the following example of buy-and-hold investing: Kriten inherits $45,000 from a distant relative. She decides to invest her inheritance in a diversified, dividend-paying mutual fund. At the time of her initial investment, she purchases 1,500 shares at a price of $30 per share. Over the next 30 years, the mutual fund increases in value at an average rate of 9% per year. In addition, the fund pays an annual cash dividend of 3% per year. Because Kriten understands that reinvesting her dividends can make a big difference to her total long-term returns, she reinvests her dividends every year in order to purchase additional shares of the fund. The following graph depicts the growth of Kriten's investment as a result of her long-term buy-and-hold strategy: Kriten is using a buy-and-hold strategy for several reasons. First, she is investing for the ___ term. Second, she ____ react emotionally to the day-to-day fluctuations in the market. In addition, she reinvests the cash dividends from her investments by purchasing additional shares. You can see from this example that buy-and-hold investing can be a powerful long-term investment strategy, as long as you choose strong investments that are likely to increase in value over time. Although Kriten's initial investment is only $45,000, after 30 years she has ___ in her account.

Increase should not is not more long does not between $800,000 and $899,99

Portfolio rebalancing Portfolio rebalancing is the process of bringing the different asset classes (stocks, bonds, and cash) back into proper relationship following a significant change in the value of one or more of them. You should normally rebalance your portfolio ___ to return your investments to the proper balance when they no longer conform to your investment plan. Suppose that you begin an investment program with a portfolio that has an asset allocation of 30% bonds, 60% equities, and 10% cash investments: Original Asset Allocation Equities: 60% Cash: 10% Bonds: 30% One year later, some investments have performed better than others. After a year the portfolio now consists of 40% bonds, 40% equities, and 20% cash investments: One Year Later Equities: 40% Cash: 20% Bonds: 40% (Portfolio needs rebalancing) To rebalance this portfolio back to its original asset allocation, you should sell some of your ____ and use the proceeds to purchase additional shares of ____.

Once a year bonds and cash investments equities

Strategy 3 - Dollar-cost averaging Dollar-cost averaging is a systematic program of investing equal sums of money at regular intervals, regardless of the price of the investment. Investing by dollar-cost averaging means that you purchase ___ number of shares when the share price is down. And you purchase ___ number of shares when the price is up. Therefore, dollar-cost averaging allows you to purchase most of your investment shares at ____ costs. Suppose that Felix is an investor using a dollar-cost averaging investment strategy. Each month Felix invests $400, regardless of the price of the investment at that particular time. The following table shows how a dollar-cost averaging strategy would affect Felix's investment in a fluctuating market, a declining market, and a rising market. For each market type, calculate the average share price and the average share cost based on the information given in the table. Note: Round your answers to the nearest penny. Fluctuating Market Regular Investment: Share Price:Shares Acquired: Period 1:$400:$25: 16 Period 2: 400: 20: 20 Period 3:400:25:16 Period 4:400:20:20 Period 5:400:25:16 Totals:$2,000$11588 Average share price: ___ Average share cost: ___ Declining Market: Regular Investment:Share PriceShares Acquired Period 1:$400:$25:16 Period 2:400:20:20 Period 3:400:20:20 Period 4:400:10:40 Period 5:400850Totals:$2,000$83146 Average share price: ___ Average share cost: ___ Rising Market: Regular InvestmentShare Price: Shares Acquired Period 1:$400: $5: 80 Period 2:400: 8: 50 Period 3:400: 10: 40 Period 4:400: 20: 20 Period 5:400: 25: 16 Totals:$2,000$68206 Average share price: ___ Average share cost: ___ Hints: • To calculate the average share price, simply divide the share price total by the number of investment periods (5). • To calculate the average share cost, simply divide the total amount invested by the total number of shares purchased. Round your answers to nearest dollar. Enter all values as positive • In the fluctuating market, Felix purchased a total of ___shares. At the end of the last investment period, his investment is worth ___ per share, which means that Felix's final account balance would be ___. However, Felix has invested a total of $2,000, which means that he has received a ___ of ___ . Round your answers to nearest dollar. Enter all values as positive. • In the declining market, Felix purchased a total of ___ shares. At the end of the last investment period, his investment is worth ___per share, which means that Felix's final account balance would be ___ . However, Felix has invested a total of $2,000, which means that he has received a ___of ___ . If you are using a dollar-cost averaging strategy, and if you sell your investment shares when the market is significantly down, you will not profit. This means that you should keep investing as long as the longer-term prospect suggests an eventual increase in price. Round your answers to nearest dollar. Enter all values as positive. • In the rising market, Felix purchased a total of ___shares. At the end of the last investment period, his investment is worth ___per share, which means that Felix's final account balance would be ___. However, Felix has invested a total of $2,000, which means that he has received a ___ of ___ . You will generally profit from dollar-cost averaging in a rising market because you will buy fewer and fewer shares as the price continues to rise.

a greater a smaller below average 23.00 22.73 16.60 13.70 13.60 9.71 8825 2,200 gain 200 146 8 1,168 loss 832 206 25 5,150 gain 3,150

Strategy 4 - Asset allocation Asset allocation is the proportion of your overall investment portfolio that you have invested in various categories of assets. Typical asset categories include, for example, equities (stocks or stock mutual funds), bonds (or bond funds), and cash (or cash equivalents such as Treasury bills). The following table illustrates several model portfolios that you can use as a basis for your own investment plan, depending on various factors, such as your time horizon, your risk tolerance, and your investment philosophy: Risk Tolerance/Investment Philosophy Asset Allocation and Time Horizons 0-5 Years 6-10 Years 11+ Years 10% Cash20% Bonds100% EquitiesHigh Risk/Aggressive30% Bonds80% Equities60% Equities 20% Cash10% Cash20% BondsModerate Risk/Moderate40% Bonds30% Bonds80% Equities40% Equities60% Equities 35% Cash20% Cash10% CashLow Risk/Conservative40% Bonds40% Bonds30% Bonds25% Equities40% Equities60% Equities Suppose that Hannah is a single parent who would like to save some money for her daughter's college education. Her daughter is currently 10 years old and will begin college in approximately 8 years. Although Hannah would like her daughter's college savings to grow, she is also concerned about investing an entire portfolio into the stock market. However, she is comfortable with a medium level of risk for the sake of achieving some level of growth. Hannah is investor with a time horizon of . Using the asset allocation provided, what is the ideal asset allocation for Hannah's portfolio, based on her time horizon and investment philosophy? If your answer is zero enter "0". Recommended asset allocation for Hannah's portfolio: Cash: ___% Bonds: ___% Equities: ___% In general, if you have a longer time horizon and a higher risk tolerance, then a higher percentage of your portfolio should be in ___ . But if you are investing for a shorter time horizon, or if you have a more conservative investment philosophy, then you should invest a greater percentage of your portfolio in ____ .

a moderate 6 to 10 years 10 30 60 equities bonds

Active and passive investing An important aspect of your personal investment philosophy is your level of involvement in investing. That is, do you want to be an active investor or a passive investor? • If you carefully study the economy, market trends, and investment alternatives, and if you regularly buy and sell several times a year based on these factors, then you are ___ investor. • If you do not actively engage in trading securities or spend large amounts of time monitoring your investments, and if you make regular investments according to your overall investment philosophy, then you are ___ investor. Aleshanee and Jenny are both investors, but they have very different approaches to their investing strategies: Aleshanee Aleshanee regularly consults with her investment manager, who provides tips and insights into the latest market trends. Hoping to achieve a high rate of return by using this market information, Aleshanee has instructed her investment manager to find the best time to buy and sell her various investments. Aleshanee is ___ investor. Jenny Jenny is an employee at a major software company. Her company offers a 401(k) retirement plan. Jenny invests 15% of her income into a balanced mutual fund according to her long-term investment strategy. Although Jenny rebalances her investments every year, she generally ignores current market conditions and is not concerned with the day-to-day fluctuations in the stock market. Jenny is ___investor. Active investing depends on having enough information to make good investment decisions. The speed at which new information is reflected in investment prices is called ___ . Because it is difficult for many investors to gain access to enough information to make good decisions about individual investments, in most cases it is better for many investors to use a longer-term ___ investment strategy.

an active a passive an active a passive Marketing Efficiency passive

Lending (debts) versus owning (equities) You can invest money in two ways, by lending or by owning: • Lending investments are called ___ . When you lend your money, you receive some form of IOU and the promise of repayment plus interest. This interest is a form of ___ while you hold the investment. • Owning investments are called ___. Investing in an ownership investment means that you become a part owner of ___ . Indicate whether each of the following investments is a lending investment or an ownership investment: 1. Treasury note 2 Government bond 3. Corporate bond 4. Life insurance annuity 5. Common stock 6. Preferred corporate stock 7. Mutual fund 8. Real estate 9. Commodity future

debts current income equities an asset 1. Lending Investment 2. Lending Investment 3. Lending Investment 4. Lending Investment 5. Ownership Investment 6. Ownership Investment 7. Ownership Investment 8. Ownership Investment 9. Ownership Investment

How to handle investment risk - The risk pyramid and your investmentphilosophy For most types of investments, a greater degree of risk corresponds to a potential for greater returns. This potential for greater returns is what motivates investors to accept greater levels of risk. The following figure, called the risk pyramid, illustrates the relative levels of risk and potential for returns for several common types of investments. The Risk Pyramid The investments listed at the top of the risk pyramid have the ___ potential for higher returns, but they also have the ___ risk to the investor's capital. The investments listed at the bottom of the risk pyramid have the ___ safety of principal, but they also have the ___ risk of loss of purchasing power. For your money to grow, you must accept some degree of financial risk. Your risk tolerance is your ability to weather changes in the value of your investments. To be a successful investor, you must incorporate your degree of risk tolerance into your investment philosophy. An investment philosophy is your general approach to tolerance for risk in your investments, depending on the financial goals that you want to achieve. There are three general types of investment philosophies: conservative, moderate, and aggressive. • If you are primarily concerned with risk aversion and with the preservation of your capital, then you have ___ investment philosophy. You are more likely to invest your money in investments near the ___ of the risk pyramid, such as savings bonds, money market accounts, Treasury securities, and so on. • If you strive for a very high return by accepting a high level of risk, then you have ___ investments near the ___ of the risk pyramid, such as junk bonds, speculative stocks, call options, and so on. • If you seek capital gains through slow and steady growth in the value of your investments, then you have ___ investment philosophy. You are more likely to invest your money in investments near the ___ of the risk pyramid, such as blue-chip stocks, balanced mutual funds, growth stocks, and so on.

greatest greatest greatest greatest a conservative bottom an aggressive investment top a moderate middle

Strategy 2 - Portfolio diversification Owning too much of any single investment creates too great of a financial risk for the average investor. You should never keep more than 5% to 10% of your assets in one investment. To reduce the risk of owning only a single investment, you should use the strategy of portfolio diversification. Portfolio diversification is the practice of selecting a collection of different asset classes of investments (for example, stocks, bonds, mutual funds, real estate, and so on), which are chosen for their dissimilarity of risk-return characteristics. Different types of assets will react differently to economic and market conditions. By purchasing a variety of assets in different categories, an investor aims to achieve a ___ average return while ___ the portfolio's level of volatility and risk. Consider the following hypothetical portfolio consisting of nine individual investments, each of which has a different level of return: Portfolio Investment ID: Return (percentage) 1 -11% 2 -6% 3 +11% 4 +14% 5 +7% 6 -4% 7 -7% 8 +12% 9 +9% In this portfolio, the best-performing individual investment has a return of ____. And the worst-performing individual investment has a return of ___. But the overall portfolio has an average return of ____, which means that the portfolio as a whole ____ achieving a positive return. Because portfolio diversification averages out your total rate of return, diversification ___ the odds that you will lose money investing and ___ the odds that you will make money. Diversification is the single most important rule of investing.

positive reducing +14% -11% +2.8% is decreases increases

To make sure that you can have the lifestyle you want in the future, you cannot spend every dollar that you earn today. It is important to sacrifice spending some of your money on immediate, short-term pleasures for the sake of having more in the future. You can help ensure your future financial success and stability by investing early in life, investing regularly, and staying invested for the long term. Investing is More than Saving To understand the reasons to start investing, you must understand that investing is more than saving: • ___ is the accumulation of excess funds by intentionally spending ___ than you earn. • ___ is taking some of the money that you ___ and putting it to work so that it makes you even money. Suppose that two people, Akshay and Amira, each earn $2,000 per month and spend $1,700 per month on expenses such as rent, food, gas, and entertainment. This leaves ___ each for Akshay and Amira to either save or invest every month. Now suppose that Akshay is a saver and Amira is an investor. Akshay puts his extra income each month into an ordinary savings account earning 1% interest (APY, or annual percentage yield). After 30 years, Akshay has $125,993.37 in his savings account because of compound interest and regular savings. But Amira invests her extra monthly income in the stock market. Although the stock market has fluctuated up and down over 30 years, Amira invests wisely and manages to receive an average rate of return of 8% per year on her investments. After 30 years, Amira has $448,220.98 in her investment account. From this example, you can see that Amira (the investor) has significantly ___ money than Akshay (the saver) after 30 years. This is because ___ has potential for greater rates of return than ___ , although investing also has greater risk.

saving less investing save $300 more investing saving

Types of investment risks How to Handle Investment Risk The total risk of an investment is the sum of the random risk and the market risk. You can alleviate the random risk of a single investment by investing in more than one investment at the same time, which is called diversification. Diversification often lowers the overall potential return on an investment, but it can help balance out the high and low returns on the various investments taken individually. Market risk can be partially alleviated by investing in more than one market at once, although market risk usually averages about 8%, which means that the value of an investment might normally fluctuate up or down about 8% during a single year. However, these short-term fluctuations are often irrelevant to an investment's long-term rate of return. Therefore, diversification and investing for the long-term are two of the best ways to reduce your level of total investment risk. Several types of investment risks can affect the rate of return on your investments: • In general, the longer that your money is invested, the longer it is subject to risk. This is known as ___ risk. For this reason, investors expect and normally receive higher returns on longer-term investments. • Economic growth usually does not occur in a smooth and steady manner. Periods of economic expansion are often followed by periods of contraction, known as recessions. The profits of most industries follow this cycle, resulting in ___ risk. • The risk that you may not be able to sell your investments (and receive the proceeds quickly) is called ___ risk. You can sell stocks and bonds relatively quickly and receive the money in a few days. However, real estate usually has ___ liquidity because it can take weeks, months, or years to sell. • 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. This results in risk known as ___ risk. These short-term fluctuations can seem terrifying for short-term investors, but long-term investors usually do not need to be concerned with these short-term price fluctuations. • The possibility that an investment will fail, perhaps by going bankrupt, resulting in a massive or total loss of your investment funds, is called ___ risk. This type of risk is also called ___ risk .• If you own only one investment of a particular type, then you may be subject to risk, which is the risk that the investment will perform poorly in the future because of random or uncontrollable factors (such as labor issues, lawsuits, and so on). This type of risk is also known as risk. You can reduce this type of risk by spreading your investment money among several different types of investments, which is ___ called . • The danger that your money will not grow as fast as inflation is called inflation risk, or ___ risk. Some types of investments, such as houses and real estate, are subject to ___ risk, which is the chance that the value of an investment will decline when overall prices decline. • The movement of stock and bond prices up and down over time results in ___ risk, which would still be present even if you have a diversified portfolio of multiple investments. This type of risk is also known as ___ risk. • The risk that the return on a future investment will not be the same as the return earned by the original investment is called ___ risk. • When you have to sell a certain asset quickly, it may not sell at (or near) the market price. This is known as ___ risk.

time horizon business-cycle liquidity lower market-violatility business failure finanical random unsystematic diversification purchasing power deflation market systematic reinvestment marketability