Lesson 04: Return and Risks

The Concept of Return

•         Return

–        The level of profit from an investment, or

–        The reward for investing

•         Components of Return

–        Current income: cash or near-cash that is received as a result of owning an investment

–        Capital gains (or losses): the difference between the proceeds from the sale of an investment and its original purchase price

•         Total Return: the sum of the current income and the capital gain (or loss) earned on an investment over a specified period of time

Why Return is Important

•         Allows comparison of actual or expected gains with the levels of gain needed

•         Allows us to “keep score” on how our investments are doing compared to our expectations

•         Historical Performance

–        Provides a basis for future expectations

–        Does not guarantee future performance

•         Expected Return

–        Return an investor thinks an investment will earn in the future

–        Determines what an investor is willing to pay for an investment or if they are willing to make an investment

The Time Value of Money and Returns

•         The sooner you receive a return on a given investment, the better

•         A dollar received today is worth more than a dollar received in the future

•         The sooner your money can begin earning interest, the faster it will grow

Determining a Satisfactory Investment

•         Satisfactory Investment: one for which the present value of benefits equals or exceeds the present value of its costs

Holding Period Return (HPR)

•         Holding Period: the period of time over which an investor wishes to measure the return on an investment vehicle

-The total return earned from holding an investment for a specified holding period (usually 1 year or less)

•         Realized Return: current return actually received by an investor during the given return period

•         Paper Return: return that has been achieved but not yet realized (no sale has taken place)

Sources of Risk

•         Risk-Return Tradeoff is the relationship between risk and return, in which investments with more risk should provide higher returns, and vice versa

•         Risk is the chance that the actual return from an investment may differ from what
is expected

•         Currency Exchange Risk is the risk caused by the varying exchange rates between the currencies of two countries. (Discussed in
Chapter 2)

      -Types of Investments Affected

•         International stocks or ADRs

•         International bonds

      -Examples of Currency Exchange Risk

•         U.S. dollar gets “stronger” against foreign currency, reducing value of foreign investment

•         Business Risk is the degree of uncertainty associated with an investment’s earnings and the investment’s ability to pay the returns owed to investors.

      -Types of Investments Affected

–        Common stocks

–        Preferred stocks

      -Examples of Business Risk

–        Decline in company profits or market share

–        Bad management decisions

–       

•         Financial Risk is the degree of uncertainty of payment resulting from a firm’s mix of debt and equity; the larger the proportion of debt financing, the greater this risk.

      -Types of Investments Affected

–        Common stocks

–        Corporate bonds

      -Examples of Financial Risk

–        Company can’t get additional loans for growth or to fund operations

–        Company defaults on bonds

•         Purchasing Power Risk is the chance that changing price levels (inflation or deflation) will adversely affect investment returns.

      -Types of Investments Affected

–        Bonds (fixed income)

–        Certificates of deposit

      -Examples of Purchasing Power Risk

–        Movie that was $8.00 last year is $9.00 this year

•         Interest Rate Risk is the chance that changes in interest rates will adversely affect a security’s value.

      -Types of Investments Affected

–        Bonds (fixed income)

–        Preferred stocks

      -Examples of Interest Rate Risk

–        Market values of existing bonds decrease as market interest rates increase

–        Income from an investment is reinvested at a lower interest rate than the original rate

–       

•         Liquidity Risk is the risk of not being able to liquidate an investment conveniently and at a reasonable price.

      -Types of Investments Affected

–        Some small company stocks

–        Real estate

      -Examples of Liquidity Risk

–        The price of a house has to be lowered for a quick sale

•         Tax Risk is the chance that Congress will make unfavorable changes in tax laws, driving down the after-tax returns and market values of certain investments.

      -Types of Investments Affected

–        Municipal bonds

–        Real estate

      -Examples of Tax Risk

–        Lower tax rates reduce the tax benefit of municipal bond interest

–        Limits on deductions from real estate losses

•         Market Risk is the risk of decline in investment returns because of market factors independent of the given investment.

      -Types of Investments Affected

–        All types of investments

      -Examples of Market Risk

–        Stock market decline on bad news

–        Political upheaval

–        Changes in economic conditions

•         Event Risk comes from an unexpected event that has a significant and unusually immediate effect on the underlying value of an investment.

      -Types of Investments Affected

–        All types of investments

      -Examples of Event Risk

–        Decrease in value of insurance company stock after
a major hurricane

–        Decrease in value of real estate after a major earthquake

Figure 4.2  Risk-Return Tradeoffs for Various Investment Vehicles

Steps in the Decision Process:
Combining Return and Risk

•         Estimate the expected return using present value methods and historical/projected return rates

•         Assess the risk of the investment by looking at historical/projected returns using standard deviation or coefficient of variation of returns

•         Evaluate the risk-return of each investment alternative to make sure the return is reasonable given the level of risk

•         Select the investment vehicles that offer the highest expected returns associated with the level of risk you are willing to accept

Referance:

1) Gitman, Joehnk; Fundamentals Investing 10th Edition; 2008

Lesson 03: Types of markets in stocks

•         Broker Markets: consists of national and regional securities exchanges

–        60% of the total dollar volume of all shares in U.S. stock market trade here

–        New York Stock Exchange (NYSE) is largest and most well-known

–        Trades are executed when a buyer and a seller are brought together by a broker and the trade takes place directly between the buyer and seller

•         Dealer Markets: consists of both the Nasdaq market and the OTC market

–        Trades are executed with a dealer (market maker) in the middle.  Sellers sell to a market maker at a stated price.  The market maker then offers the securities to a buyer.

Figure 2.3 Broker and Dealer Markets

 

Copyright © 2008 Pearson Addison-Wesley. All rights reserved.

Over-the-counter (OTC) Market: involves trading in smaller, unlisted securities

Brokers Market

•         The New York Stock Exchange (NYSE)

–        Largest stock exchange—over 2,700 companies

–        Over 350 billion shares of stock traded in 2005

–        Accounts for 90% of stocks traded on exchanges

–        Specialists make transactions in key stocks

–        Strictest listing policies

•         The American Exchange (AMEX)

–        About 700 companies and 4% of stocks traded

–        Major market for Exchange Traded Funds

–        Typically smaller and younger companies who cannot meet stricter listing requirements for NYSE

•         Regional Stock Exchanges

–        Typically lists between 100–500 companies, usually with local and regional appeal

–        Listing requirements are more lenient than NYSE

–        Often include stocks that are also listed on NYSE or AMEX

–        Best-known: Midwest, Pacific, Philadelphia, Boston, and Cincinnati

•         Options Exchanges

–        Allows trading of options

–        Best-known: Chicago Board Options Exchange (CBOE)

•         Futures Exchanges

–        Allows trading of financial futures

–        Best-known: Chicago Board of Trade (CBT)

Dealer Market

•         No centralized trading floor; comprised of market makers linked by telecommunications network Both IPOs and secondary distributions are sold on OTC

–        40% of the total dollar volume of all shares in U.S. stock market trade here

–        Both IPOs and secondary distributions are sold on OTC

•         Bid Price: the highest price offered by market maker to purchase a given security

•         Ask Price: the lowest price at which a market maker is willing to sell a given security

•         Nasdaq

–        Largest dealer market

–        Lists large companies (Microsoft, Intel, Dell, eBay) and smaller companies

•         Over-the-counter (OTC) Bulletin Board

–        Lists smaller companies that cannot or don’t wish to be listed on Nasdaq

–        Companies are regulated by SEC

•         Over-the-counter (OTC) Pink Sheets

–        Lists smaller companies that are not regulated by SEC

–        Liquidity is minimal or almost non-existent

–        Very risky; many nearly worthless stocks

General Market Conditions

Bull Market

            1) Favorable markets

            2) Rising prices

            3) Investor/consumer optimism

            4) Economic growth and recovery

            5) Government stimulus

Bear Market

            1) Unfavorable markets

            2) Falling prices

            3) Investor/consumer pessimism

            4) Economic slowdown

            5) Government restraint

Globalization of Securities Markets

Diversification: the inclusion of a number of different investment vehicles in a portfolio to increase returns or reduce risks

Use of International Securities Improves Diversification

–        More industries and securities available

–        Securities denominated in different currencies

–        Opportunities in rapidly expanding economies  

International Investment Performance

–        Opportunities for high returns

–        Foreign securities markets do not necessarily move with the U.S. securities market

–        Foreign securities markets tend to be more risky than U.S. markets

Indirect Ways to Invest in Foreign Securities

–        Purchase shares of U.S.-based multinational with substantial foreign operations

Direct Ways to Invest in Foreign Securities

–        Purchase securities on foreign stock exchanges

–        Buy securities of foreign companies that trade on U.S. stock exchanges

–        Buy American Depositary Receipts (ADRs): dollar denominated receipts for stocks of foreign companies held in vaults of banks

Risks of International Investing

Usual Investment Risks Still Apply

Government Policies Risks

–        Unstable foreign governments

–        Different laws in trade, labor or taxation

–        Different economic and political conditions

–        Less stringent regulation of foreign securities markets

Currency Exchange Rate Risks

–        Value of foreign currency fluctuates compared to
U.S. dollar

–        Value of foreign investments can go up and down with exchange rate fluctuations

Trading Hours of Securities Markets

1) Regular Trading Session for U.S. Exchanges  and Nasdaq

–        9:30 A.M. to 4:00 P.M. Eastern time

2) Extended-Hours Electronic-Trading Sessions

–        NYSE: 4:15 to 5:00 P.M. Eastern time

–        Nasdaq: 4:00 P.M. to 6:30 P.M. Eastern time

–        Orders only filled if matched with identical
opposing orders 

Next -> Lesson 4

Referance:
1) Gitman, Joehnk; Fundamentals Investing 10th Edition; 2008

Lesson 02: Investment Decision: Taxes, Market timing, and Short-Term Vehicles

“It’s not what you make, it’s what you keep that is important.”

Tax planning involves:

1) The desired profit/return after taxes.

2) Type of income received from investments

3) Timing of profit-taking and loss recognition

Short term investment also has the basics taxing like wages you earn
1) Federal: tax rates from 10% to 35%
2) State taxes

Types of Income for Individuals
1) Active Income: income from working (wages, salaries, pensions)

2)Portfolio Income: income from investments (interest, dividends, capital gains)

3) Passive Income: income from special investments (rents from real estate, royalties, limited partnerships)

Ordinary Income includes Active, portfolio and passive income. Taxed at progressive tax rates (rates go up as income goes up)

Tax bracket 2011

Marginal Tax Rate	Single	Jointly
10%	$0 – $8,350	$0 – $16,700
15%	$8,351– $33,950	$16,701 – $67,900
25%	$33,951 – $82,250	$67,901 – $137,050
28%	$82,251 – $171,550	$137,051 – $208,850
33%	$171,551 – $372,950	$208,851 – $372,950
35%	$372,951+	$372,951+

Capital Gain: amount by which the proceeds from the sale of a capital asset are more than its original purchase price

Capital Loss: amount by which the proceeds from the sale of a capital asset are less than its original purchase price

Taxation of Capital Gains

–        Capital assets held less than one year: ordinary income tax rates

–        Capital assets held more than one year: 15%
(or 5 %)

Taxation of Capital Losses

–        Capital losses can be used to offset capital gains

–        Up to $3,000 per year of capital losses can be used to offset ordinary income (such as wages)

Market Timing: process of identifying the current state of the economy/market and assessing the likelihood of its continuing on its present course

•         Three Conditions of the U.S. Economy

–        Recovery or expansion

•         Corporate profits are up, which helps stock prices

•         Growth-oriented and speculative stocks do well

–        Decline or recession

•         Values and returns on common stocks tend to fall

–        Change in the general direction of the economy’s movement

Figure 1.2  Different Stages of an Economic/Market Cycle

Copyright © 2008 Pearson Addison-Wesley. All rights reserved.

1) Interest rates are the single most important variable in determining returns to investors for bonds and fixed-income securities.

2) Interest rates and bond prices move in opposite directions:

–        When interest rates go up, bond prices go down

–        When interest rates go down, bond prices go up

The Role of Short-Term Investment

•     Liquidity: the ability of an investment to be converted into cash quickly and with little or no lossin value

•    Primary use is for emergency cash reserve or to save for a specific short-term financial goal

Short-Term Vehicles

• Advantages: High liquidity and Low risks of default

• Disadvantages: Low levels of return and Loss of potential purchasing power from inflation

Next -> Lesson 3

Referance:

1) Gitman, Joehnk; Fundamentals Investing 10th Edition; 2008