Chapter 6 Principles of Investing

Investing in Financial Assets Investment Strategies Investing in Stocks Investing in Bond

(C) 2001 Contemporary Engineering Economics

Investment Basics
Liquidity How accessible is your money? Risk What is the safety involved? Return How much profit will you be able to expect from your investment?

(C) 2001 Contemporary Engineering Economics

How to Determine Your Expected Return

Real Return 2% 4% 0%

U.S. Treasury Bills

Inflation

Very safe Risk-free real return Risk premium

Risk premium

Total expected return 6%

Inflation

Real Return Inflation

2% 4% 20%

Very risky
Amazon.com

Risk premium

Total expected return 26%

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(C) 2001 Contemporary Engineering Economics

Figuring Average Versus Compound Return

Period Year 1 Year 2 Year 3 Return 5% 10% 12%

5%

10%

12%

Average rate of return

Compound Rate of Return

F (1 0.05)(1 0.10)(1 0.12) 1.2936 (1 i )3 1.2936 i 8.96%
4

5% 10% 12% i 3 9%

(C) 2001 Contemporary Engineering Economics

Annual Investment Yield (Base investment of $1,000)

Investment Year 1 Year 2 Year 3 Case 1 9% 9% 9% Case 2 Case 3 5% 10% 12% 0% 7% 20% Case 4 0% 0% 27% Case 5 -1% -1% 29% Case 6 -5% -8% 40%

Compound Versus Average Rate of Return

Investment Average return Balance at the end of year 3 Compound return Case 1 9.00% $1,295 9.00% Case 2 Case 3 9.00% 9.00% Case 4 9.00% $1,270 8.29% Case 5 9.00% $1,264 8.13% Case 6 9.00% $1,224 6.96%

$1,294 $1,284 8.96% 8.69%

(C) 2001 Contemporary Engineering Economics

How to Determine Expected Financial Risk

Risk: the chance that some unfavorable event will occur. Volatility measures the deviation from the expected value, or sudden swings in valuefrom high to low, or the reverse. Standard deviation measures the degree of volatility when you have the probabilistic information about the uncertain event. Beta measures how closely a funds performance correlates with broader stock market movement. Alpha shows whether a fund is producing better or worse returns than expected, given the risk it takes.
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Returns from Various Investment Classes

Average Annual Return 1970-1997
U.S. Stocks International Stocks Cash Equivalent Real Estate U.S. Bonds 13.0% 12.7% 6.8% 8.8% 9.3%

Best Year
37.6% (1995) 39.4% (1993) 14.1% (1981) 20.5% (1979) 33.5% (1982)

Worst year
-26.5% (1974) -26.2% (1974) 3.0% (1991) -5.6% (1991) -5.6% (1994)
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(C) 2001 Contemporary Engineering Economics

Investment Strategies
Trade-Off between Risk and Reward
Cash: the least risky with the lowest returns Debt: moderately risky with moderate returns Equities: the most risky but offering the greatest payoff

Dollar-cost averaging concept Broader diversification reduces risk Broader diversification increase expected return
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Dollar-Cost Averaging Concept

Timing
Month 1 Amount Invested $1,000 Fund Unit Price $5.00 No. of Units Ending Fund Purchased Balance 200 $1,000

Month 2
Month 3

$1,000
$1,000

$4.00
$2.50

250
400

$1,800
$2,125

Month 4
Month 5 Totals

$1,000
$1,000 $5,000

$3.75
$5.00

267
200 1,317

$4,189
$6,585

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Broader Diversification Increases Return

Amount $2,000 $2,000 $2,000 $2,000 $2,000 Investment Buying lottery tickets Under the mattress Term deposit (CD) Corporate bond Mutual fund (stocks)
(C) 2001 Contemporary Engineering Economics

Expected Return -100% (?) 0% 5% 10% 15%

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Option 1

Amount

Investment

Expected Return

Value in 25 years

$10,000 $2,000
$2,000

Bond Lottery tickets

Mattress Term deposit (CD) Corporate bond Mutual fund (stocks)

7% -100%
0% 5% 10% 15%

$54,274 $0
$2,000 $6,773 $21.669 $65,838 $96,280

$2,000 $2,000 $2,000

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Investing in Stocks
Stocks: Ownership shares in a corporation Ownership: If a company issues 1M shares, and you buy 10,000 shares, you own a 10% of the company. Valuation: (1) cash dividend and (2) share appreciation at the time of sale

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Conceptual Stock Valuation

IBM Computer: Given: Stock price as of July 20, 2001: $105.50/share Earnings growth for next 5 years: 13% Expected cash dividend in 2002: $2.00/share Expected stock price in 3 years: $230/share Required return on your investment: 10% Find: Current value of stock

$2 $2(1 013 . ) $2(1 013 . )2 $230 P 2 (1 010 . ) (1 010 . ) (1 010 . )3 $175.61 $105.50, underpriced
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What Are Your Odds?

Source: Newsweek, November 10, 1997

Your chance of making return on your investment per year If you hold stocks for 1 year 3 years 5 years 10 years 20 years Your chance of losing money 26% 14% 10% 4% 0 0-10% 18% 28% 31% 42% 37%
(C) 2001 Contemporary Engineering Economics

10-20% 20% 39% 49% 53% 63%

20+ % 37% 19% 10% 1% 0

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What is Financial Option?

Call Option
The right To buy

Put Option
The right To sell

AOL July Call (2001)

100 shares of stock

Underlying asset

AOL stock

At a predetermined price

Strike (Exercise) price

$50

On or before a predetermined date

Expiration date

July 20, 2001

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Call Option
AOL Call Option July 2001
Stock Price July 20, 2001

Profit: $8.55 Current Price (04/09/01) Strike Price

Breakeven Price

Take partial loss

Option Premium

$39.47

$1.45

$50

$51.45

$60

(C) 2001 Contemporary Engineering Economics

Do Not Exercise: Loss limited to $1.45

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If stock price rises to $100

Hold to maturity and trade at the strike price

($100-$75)* 1000= $25,000 from trade -$ 5,900 premium $19,000 profit $5,000 from trade -$5,900 premium $ 900 loss

AOL Date: Feb 13, 2001 Price: $48.09 Strike price: $75 Premium: $5,900 for 1000 shares Expiration: Jan 2003

If stock price rises to $80

If stock price rises to $90 Trade for profit before option expires If stock price rises to $78

$15,000 from trade -$ 5,900 premium $ 9,100 profit

$3,000 from trade -$5,900 premium $2,900 loss Lose your premium only $5,900 loss
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Let the option expire

If stock price drops to $70

(C) 2001 Contemporary Engineering Economics

Investing in Bond
Bonds: Loans that investors make to corporations and governments. Face (par) value: Principal amount Coupon rate: yearly interest payment Maturity: the length of the loan
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Bond Price Notation Used in Financial Markets

Corporate Bonds
1/8=$1.25 5/8=$6.25

Treasury Bonds
1/32=$0.3125 2/32=$0.6250 3/32=$0.9375 4/32=$1.25 6/32=$1.5625 7/32=$1.8750 7/32=$2.1875 8/32=$2.50 9/32=$2.8125 10/32=$3.1250 11/32=$3.4375 12/32=$3.75 17/32=$5.3125 18/32=$5.6250 19/32=$5.9375 20/32=$6.25 21/32=$6.5625 22/32=$6.8750 23/32=$7.1875 24/32=$7.50 25/32=$7.8125 26/32=$8.1250 27/32=$8.4375 28/32=$8.75 29/32=$9.0625 30/32=$9.3750 31/32=$9.6875 32/32=$10 19

1/4=$2.50

3/4=$7.50

3/8=$3.75

1/8=$5.00

1=$10

13/32=$4.0625 14/32=$4.375 15/32=$4.6875 16/32=$5.00

(C) 2001 Contemporary Engineering Economics

No meaning, Spacing
Coupon rate Maturity date 2005

AT& T 7s05 $1,082.50

(C) 2001 Contemporary Engineering Economics

Closing price: 108 1 / 4

20

Types of Bonds and How They Are Issued in the Financial Market

(C) 2001 Contemporary Engineering Economics

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How Do Prices and Yields Work?

Yield to Maturity: The actual interest earned from a bond over the holding period Current Yield: The annual interest earned as a percentage of the current market price

(C) 2001 Contemporary Engineering Economics

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Bond Quotes
Maturity (2005) Trading volume

AT&T 7s05
Coupon rate of 7%

6.5% 5 million 108 1/4

Closing Market price $1,082.50
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Current yield
$70/108.25 = 6.47%
(C) 2001 Contemporary Engineering Economics

Yield to Maturity

(a) Yield to maturity: $996.25 $48.13( P / A, i,20) $1,000( P / F, i,20) i 4.84% per semiannual period ia (1 0.0484)2 1 9.91% (b) Current yield: $48.13 4.83% per semiannual period $996.25
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Summary
The three basic investment objects are: growth, income, and liquidity. The two greatest risks investors face are inflation and market volatility. Portfolios with long-term horizons need equities to offset inflation while short time frames requires debt and/or cash investments to reduce volatility
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 Dollar-cost averaging is a planned transfer, over a period, of equal amounts from one assets to another. Diversification by combining assets with different patterns of return, it is possible to achieve a higher rate of return without increasing significant risk. Investing in stocks and bonds is one of the most common investment activities among the American investors.
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