FFM Final: Chapter 13 (Investment Fundamentals)

Long-Term Investors Accept Substantial Market Volatility

-Market Volatility: the likelihood of large price swings in securities (the places where stocks and bonds are traded) due to a company's success (or lack of it) and various market conditions

Market-Volatility Risk

-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 invesment

Strategy 2: Dollar-Cost Averaging Buys at "Below-Average" Costs

*Dollar-Cost Averaging (or cost averaging): 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 -This strategy avoids the risks and responsibilities of investment timing because the stock purchases are made regularly regardless of the price -It also avoids all outside events and short-term gyrations of the market, providing the investor with a disciplined buying strategy *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 -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 *Dollar-Cost Averaging in a Declining Market -Markets may decline over a time period -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 -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, you continue to invest but buy fewer shares *Dollar-Cost Averaging Offers Two Advantages 1) 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 2) Dollar-cost averaging dictates investor discipline -This approach might not be glamorous, but it is the only approach that is almost guaranteed to make a profit for the investor

Interest (rent and dividends)

*Interest: for an investor the interest is the return earned for lending money -Rent: payment received in return for allowing someone to use your real estate property -Dividend: a portion of a company's earnings that the firm pays out to it's shareholders Ex) Eliza purchased 100 shares of H&M stock at $45 for share last year. The company paid dividends of $3 per share during the year, so Eliza received $300 in cash dividends as current income

Investment Risk (pure risk, speculative risk, investment risk)

*Pure Risk: exists when there is no potential for gain, only the possibility of loss *Speculative Risk: exists in situations that offer potential for gain as well as for loss -When you invest in stock markets this is the risk you take; there is a strong possibility of gain and there is a strong possibility for loss *Investment Risk: represents the uncertainty that the yield of an investment will deviate from what is expected -For most investments, the greater the risk is, the higher the potential return -The potential for gain is what motivates people to accept increasingly greater levels of risk

Investing (savings, investment, securities, stocks, bonds, portfolio)

*Savings: the accumulation of excess funds by intentionally spending less than you earn -Investing is more *Investing: taking some of the money you are saving and putting it to work so that it makes you even more money -When you invest you earn money on your money -Your goals and the time it will take to reach those goals dictate the investment strategies you follow and the invest alternatives you choose *Securities: the most common ways that people invest are by putting money into assets called securities -These are 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 *Bonds- represent loans to companies and governments -They are IOU's that are bought and sold among investors *Portfolio: the collection of multiple investments in different assets chosen to meet your investment goals -All of your investment assets make up your portfolio -Visualize a pie; a portion is invested in stocks, a portion is invested in bonds, a portion is invested in a savings account, a portion is in real estate, a portion is in cash (checkings, money market account, liquid cash)

Four Strategies for Long-Term Investors: Strategy 1- Buy-and-Hold Anticipates Long-Term Economic Growth

*The secret to long-term investing success if 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 -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: 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 -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 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 (WISE strategy) -Buy and hold does NOT mean buy and ignore; it is important to review your portfolio once a year to make sure that each remains a good investment

Long-Term Investors Do not Practice Market Timing

-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

Financial Risk

-Also called Business Risk *Financial Risk: the possibility that the investment will fail to pay any return to the investor. When people invest their money they take a financial risk -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

Strategy 4: Asset Allocation Keeps You in the Right Investment Categories for Your Time Horizon

-Asset Allocation: a form of diversification in which the investor decides on the proportions of an investment portfolio that will be devoted to various categories of assets Ex) 60% in stocks, 30% in bonds -Where you are going to allocate your money and the percentages you want in those particular investments -Also referred to as, "balancing your portfolio" -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 -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 to change the proportions of your asset allocation over time)

Types of Investment Risks: Business Failure Risk

-Business Failure Risks, 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

Business-Cycle Risk

-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 -Expansion, peak, contraction, and trough -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 -Companies go through highs and lows in business (Ex- Netflix, didn't start out doing so well and then got really popular) -Some businesses do not experience business-cycle risk because they continue to earn profits during economic downturns Ex) Gasoline retailers, supermarkets, and utility companies

Types of Investment Risk: 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 -Common stocks and real estate have reduced inflation risk, as their values tend to rise with inflation over many years Ex) How much money you might think you will need in retirement years is subject to inflation, so you have to keep in mind rising prices (a million dollars today is not going to be the same as it is years from now) *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 Ex) Housing prices

Liquidity Risk

-Liquidity: the speed an easy with which an asset can be converted to cash -You can sell your stock investments in one day, but rules state that is 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: 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) Ex) Real estate is illiquid because it may take weeks, months, or even years to sell

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 -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

Market (Systematic) Risk

-Market Risk: The possibility for an investor to experiences losses due to unknown factors that affect the overall performance of the financial markets -Diversification among stocks or bonds cannot eliminate all risks; some risk would exist even if you owned all of the stocks in a market -In this case, the value of an investment may drop due to influences and events that affect all similar investments Ex) a change in economic, social, political, or general market conditions (The Great Recession when all markets declined at the same time) -Market Risk cannot be eliminated but it can be reduced by dividing your portfolio among several different markets

Strategy 3: Portfolio Diversification Reduces Portfolio Volatility

-Owning too much of any one investment creates too great a financial risk -Diversification is the single most important rule in investing -Portfolio Diversification: 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 -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 -Asset classes typically react differently to economic and market-place changes so if something goes wrong in one market, you won't lose all your investments because they are all in different markets -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 Ex) You don't want to invest in only one stock. If that stock goes up, it's great. But if it goes down, that's not great. If you have five or six companies you are investing in, you have a better chance of balancing out your gains and losses opposed to just having on stock and investing in one company

The Risk-Return Trade Off: A Fundamental Investing Concept

-The higher the return, the higher the risk -If you want higher return, you will most likely have to accept more risk

Investment Risk: Random (Unsystematic) Risk

-The risk associated with owning only one investment of a particular type (such as a stock in one company) that, by chance, may do very poorly in the future because of uncontrollable or random factors -Arises out of the possibility that any one investment may go up or down -Diversification: the process of reducing risk by spreading investment money among several different investment opportunities -Provides one effective method of managing random risk -The KEY to REDUCING random risk Ex) If you invest in two or three stocks, the odds are lessened that all of their prices will fall at the same time -The principle holds that when you own different types of investment assets in a portfolio, some assets should be rising when others are falling -Averages out the high and low returns; does not mean you won't lose money -Research shows that you can cut random risk in half by diversifying into as few as five stocks or bonds

Reinvestment Risk

-The risk that the return on a future investment will not be the same as the return earned by the original investment

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 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

Marketability Risk

-When you have to sell a certain asset quickly, it may not sell at or near the market price Ex) Selling real estate in a hurry may require the seller to substantially reduce the price in order to sell to a willing buyer

Investment Fundamentals

-You cannot spend every dollar that you earn today -It is important to start investing early in life, invest regularly, and stay invested -Start investing early in life by sacrificing some of your current income and putting some cash into a diversified investment portfolio for the future -Avoid thinking about short-term results and accept substantial risk when investing for the long-term -Invest regularly through your employer's retirement plan -YOU- and no one else- are responsible for your own financial successes -For every 5 years you delay investing, you will have to double your monthly investment amount to achieve the same goals

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 -The goal of all investors is to sell high and buy low