muddy points from thursday fica v. fico? define. the best-known and most widely used credit score...

Muddy Points from Thursday• FICA v. FICO? Define.

• The best-known and most widely used credit score model in the United States, the FICO score is calculated statistically, with information from a consumer's credit files.

• The score is sold by FICO, the company.

• FICO was founded in 1956 as Fair, Isaac and Company by engineer Bill Fair and mathematician Earl Isaac.

• Traded on the NYSE.

Muddy Points

• FICA

• Federal Insurance Contributions Act:– US Federal payroll tax imposed on both

employees and employers

– to fund Social Security and Medicare

Muddy Points

• If my econ class is only a semester long, how much detail do I need to spend on Annuity and Compound Interest equations?

• Economics course:– Assume:

• High school• Responsible for PFL as well as straight economics

Standard 3: EconomicsGrade Level Expectation: High School

5. Analyze strategic spending, saving, and investment options to achieve the objectives of diversification, liquidity, income and growth.

– Selected Evidence Outcomes & 21st Century Skills:

• Investments available for diversified portfolio• How economic cycles affect financial decisions• Investments to achieve liquidity, growth, income.• How compound interest manifests in investment and

debt situations.

Invest

Muddy Points

• Please provide recommended reading list for PFL instructors, including:– Case studies of individuals who have found

great earning success.• I do not know of resource to suggest.

– Background information on how to motivate students toward rational financial choices.• If the students have opportunity to make money, they

are likely motivated.

Muddy Points

• Why are index funds capable of such low fees?

– Do not have to hire high cost portfolio managers and researchers who pick the stocks.• Merely buy the stocks in the Index

– e.g., the S&P 500

Muddy Points

• Can we go over Wednesday’s [tax calculation] homework?

– No!

Hultstrom Household • Wage and Salary Income: $20,000 • Other Income: $0 • Purchases of Goods and Services: $15,000 • Value of Land and House: $0 (renters) • Income Tax: $1000 + ($10,000 x .20) =

$3000 • Payroll Tax: $20,000 x .06 =

$1200 • Sales Taxes: $15,000 x .05 = $750 • Property Tax: $0 x .01 = $0 • Total Taxes: $3000

+ $1200 + $750 + $0 = $4950 • Net Income (after tax): $20,000 - $4950 = $15,050 • Saving: $15,050 - $15,000 = $50

Rodriguez Household • Wage and Salary Income: $60,000 • Other Income: $0 • Purchases of Goods and Services: $36,000 • Value of Land and House: $100,000

• Income Tax: $7000 + ($20,000 x .25) = $12,000

• Detail behind this tax calculation?

Rodriguez Household • Wage and Salary Income: $60,000 • Other Income: $0 • Purchases of Goods and Services: $36,000 • Value of Land and House: $100,000• Income Tax: $7000 + ($20,000 x .25) = $12,000

How calculate the $12,000 income tax?

$1000 + $6000 + $5000

10% of 1st $10,000 20% of next $30,000 25% of last $20,000

$7000 + 25% on income

from $40K to $100K

Rodriguez Household

• Wage and Salary Income: $60,000 • Other Income: $0 • Purchases of Goods and Services: $36,000 • Value of Land and House: $100,000• Income Tax: $7000 + ($20,000 x .25) = $12,000 • Payroll Tax: $60,000 x .06 = $3600 • Sales Taxes: $36,000 x .05 = $1800 • Property Tax: $100,000 x .01 = $1000 • Total Taxes: $12000 + $3600 + $1800 + $1000 = $18,400 • Net Income (after tax): $60,000 - $18,400 = $41,600 • Saving: $41,600 - $36,000 = $5,600

Jones Household

• Wage and Salary Income: $200,000 • Other Income (interest & dividends): $50,000• Purchases of Goods and Services: $140,000 • Value of Land and House: $1,000,000 • Income Tax: $22,000 + ($150,000 x .30) =

$67,000 • Payroll Tax: $100,000 x .06 =

$6,000 • Sales Taxes: $140,000 x .05 =

$7,000 • Property Tax: $1,000,000 x .01 =

$10,000 • Total Taxes: $67000 + $6000 + $7000 + $10000 =

$90,000 • Net Income (after tax): $250,000 - $90,000 =

$160,000 • Saving: $160,000 - $140,000 =

$20,000

Proportional, Progressive, or Regressive?

• Income Tax: all income

Hultstrom HH% Rodriguez HH Jones HH

$3000 $12000 $67000

3000/20000 = 15%

12,000 /60,000 = 20%

67,000/250,000 = 26.8%

Progressive


• Payroll Tax: wage & salary income

• Payroll Tax: all income– Regressive if there is any other income

• Since no payroll tax paid on other income

Hultstrom HH Rodriguez HH Jones HH

$1200 $3600 $6000

1200/20000 = 6% 3600/60000 = 6% 6000/200000 = 3%

Proportional, up to $100K

Regressive over $100K


• Sales Tax: on purchases of goods & services

• Sales Tax: on all income


$750 $1800 $7000

750/15000 = 5% 1800/36000= 5% 7000/140000 = 5%

Proportional


$750 $1800 $7000

750/20000 = 3.75% 1800/60000= 3% 7000/250000 = 2.8%

Regressive

Muddy Points

• Do you have practice problems for the formulas?– YES … see the Handout that was on your table

this AM.

• Good resource to read more about these?– Wikipedia “time value of money”

Practice with Time Value of Money(#1)

• Inherit $10,000. – Invest at 8% for 40 years.

– Therefore: Pn = P0(1+i)n = 10,000(1.08)40

– Table A-3: n = 40, i = 8%

Factor: 21.725

Pn = P(Factor) = $10,000 (21.725) = $217,250


• IRA has grown from $10,000 to $19,672 in 10 years. – Find the “total return” (or CAGR).

– Therefore: Pn = P0(1+i)n

– 19,672 = 10,000(1 + i)10

– Table A-3: n = 10, but we don’t know i.

But we do know that: Pn = P0(Factor) … therefore

Factor = Pn/P0 = $19,672/$10,000 = 1.9672

Read across n = 10, looking for Factor = 1.9672

Result: i = 7%


• Find present value of $100,000 received 5 years from today.

• P0 = Pn/(1+i)n = 100,000/(1.12)5

• Or, using Table A-1:

– n = 5 and i = 12%

– Factor: 0.5674– Thus, P(Factor) = $100,000(0.5674)– = $56,740.

Five-Year Annuity

1 2 3 4 5

P(1+i)4 + P(1+i)3 + P(1+i)2 + P(1+i)1 + P

i

1 i)(1P P Annuity of Value

n

n

Factor in Table A-4 for n & i

Year:

P P P P P

Statement 9• At age 18, you decide not to

purchase vending machine soft drinks &save $1.50 a day.

• You invest this $1.50 a day at 8% annual interest until you are 67.

• At age 67, your savings are almost $150,000.– Because of the power of compound

interest, small savings can make a difference, • about $300,000 in this case.

• False Save

50-Year Annuity

19 20 ……. 67 68

P(1+i)49 + P(1+i)48 + … + P(1+i)1 + P

0.08

1 0.08)(1P P Annuity of Value

50

50

Factor in Table for n & i

Age:

P = $547.50

P P P P P

Use Annuity Table to Calculate• Annuity:

– n = 50 years – i = 8%

– Factor: from the table:• 573.77

– Annual annuity:• 365 x $1.50 = $547.50

• Value of Annuity = P (Factor)

= $547.50 (573.77) = $314,139

Two Volunteers?Eat one at a time.

After eating each one, note on piece of paper how good each successive one tastes – use of ranking of:

10 = absolutely delicious - the best 9 = really good, but not as good as a 10 8 = quite good, but not as high as a 9 . . . and so on … 3 = only fair 2 = mediocre 1 = less than a 2 0 = my lowest taste ranking – no more satisfaction eating

Like these?

Life is Full of Gambles:The Economics of Risk

• Go skiing – Risk breaking your leg

• Drive to work– Risk an auto accident

• Live in a house– Risk a fire

• Savings in stock market– Risk a fall in stock prices

• Savings in bonds– Risk a rise in interest rates

• Invest U.S. T-bills– Risk rapid inflation & loss

of purchasing power

A Bet Anyone?

• A third party will flip a coin:– heads, I pay you $1,000– tails, you pay me $1,000

• Anyone want to play?

Risk Aversion• Most people would reject this bet

• Why?

• Most people are risk averse– dislike bad things happening to them

– But more specifically,

– dislike bad things more than they like comparable good things

– That is, • the pain of losing $1,000 > pleasure from winning $1,000

Data from Our Volunteer

• “Law of Diminishing Marginal Utility” – or, diminishing marginal satisfaction

The cartoons even address marginal utility!

Definition

• Marginal benefit (utility, satisfaction):

• the added benefit gained from one more unit– let’s assume your ranking (1 to 10) is also

your marginal utility or satisfaction received from each cup

Another Example from Previous Experiment

• For Reese’s Butter Cups• How much you like (0 – 10) each added cup

– Last class volunteer ate 5 cups … • data next slide

Quantity

Marginal Benefit

Total Utility

1 10 10

2 8 18

3 6 24

4 4 28

5 1 29

6 0 29

Marginal and Total Utility

Utility

35

30

25

20

15

10

5

0

Quantity of Cups

0 1 2 3 4 5 6

Q MB TU

1 10 10

2 8 18

3 6 24

4 4 28

5 1 29

6 0 29

Diminishing marginal utility … total utility rises, but at

diminishing rate

Utility

35

30

25

20

15

10

5

0

Wealth0 1 2 3 4 5 6

Total utility

Suppose we measure wealth on the horizontal axis

Risk Aversion is Common• Most people have diminishing marginal utility

basis for risk aversion in most people

• Logic:– Dollar gained when income is low adds more to utility than a

dollar gained when income is high

– Having an additional dollar matters more when facing hard times than when things are good

– Insurance: transfers a dollar from • high-income states (where it is valued less) to • low-income states (where it is valued more)

Dealing with Risk Aversion

• 1. Buy Insurance:

– Person facing risk pays a fee to insurance company• Which agrees to accept all or part of financial risk

– Types of insurance:• Health, Automobile, Homeowner (Renter), Disability, Life• Living too long (fee paid today, annuity until die)

Insurance ActivityThe Insurance Game:

Is Insurance Worth Buying?

• Divide into 9 Groups of 4 each (one 3)

• Distribute:– One complete deck of cards to each Group

The Situation

• You are a young single person – earning an annual income of $24,000– living in a rented apartment

• You will have to decide:– What types of insurance, if any, you want to buy

• and what level of coverage for each type

Risk: Possibility of Financial Loss

• Risks you face: displayed on Visual 10 – 1 – Visual shows what could happen to you

Activity Procedure

• Each person select insurance & level of coverage– Applies throughout the activity

• Each year:– A card is randomly drawn in each group

what happens that year to each person in group– e.g., “8” drawn each person needed:

» 10 office visits ($200 x 10) + $6,000 hospital

= $8,000, if no health insurance

– Note: replace the card into deck for the next year’s draw

Activity Procedure(continued)

• “Double” card events (e.g, “K-K”): – only occur if that card is drawn in consecutive years

• possible in year 2 and beyond, for example:

– Year 1: K drawn major fire causes $4K damages

– Year 2: K drawn K - K has occurred

one-year major disability costing $24,000 in income

Activity 10 – 1: Insurance • Different types (5) of insurance from which to choose:

– Health– Automobile – Renter’s – Disability– Life

• Within each, several options for amounts of coverage– As coverage rises premium rises due to higher insurance

company payout– NOTE: premiums shown are annual, covering you one year

Types of Insurance & Terms• Health

– Co-pay: amount you pay for each office visit– Hospitalization: insurance company pays % shown

• Automobile– Deductible: amount you must pay due to accident

• Insurance company pays anything above deductible– combine comprehensive and collision for simplicity

• Liability: protects from damages you cause others up to amount shown

– you are responsible for additional

Types of Insurance• Renter’s Insurance

– Deductible: amount you have to pay on loss• Insurance company covers above deductible• Covers: loss of personal property

• Disability Insurance– Each unit coverage pays $500 /mo for lost income

• Maximum of 4 units = $2,000/month $24,000/year

• Life Insurance– Each unit pays beneficiaries $10,000

Weigh Benefit vs. Cost in Making Insurance Decision

B(X) C(X)

Reduce losses when “bad things” happen to you

- see Activity 10 – 1

Insurance Premiums you pay


Forgetting anything …??

• Choice involves cost» choosing is refusing

» choose to buy insurance» refuse to invest $ spent on premiums

» suppose could earn 10%» $1,000 on premium® $100 return foregone

Key Economic Concept Revisited

Weigh Benefit vs. Cost in Making Insurance Decision

B(X) C(X)

Lower losses when “bad things” happen


Insurance Premiums paid

+Lost Return on Premium

In our example: $1,000(1 + 0.10) = $1,100

Now Ready to Complete Activity 10 – 1

• Decide what types & levels of coverage you desire– RESTRICTION: ALL states require basic liability

coverage with car insurance, so you must choose at least Option 3

• Since no way of knowing what will happen to you, there is no exact right amount of insurance

– Goal: buy enough coverage to protect yourself from losses, but not so much that you end up spending far more on insurance than it is worth.

• Compare B(X) v. C(X) & make choice with which you are comfortable

Activity 10 – 2

• Enter the Total Annual Insurance Premiums (bottom of Activity 10 – 1) for every year in Column (1) of Activity 10 – 2. – i.e., premium is constant throughout

• Then, complete Column (2) for every year– opportunity cost constant throughout

Your Life is About to Begin• Each year – shuffle the deck, then one person in

each group draw one card at random– Each person in group experiences same event

depicted in Visual 10 – 1. – Then:

• Fill in Column (3) –actual loss if you had no insurance• Fill in Column (4) – actual loss if you had insurance

– Same event for all in group, but since not same coverage, Column (4) may differ for each member

– Each group is experiencing a different “life”

Conduct 8 Years

• Completing Columns (3) – (4) after each year’s draw

• After completing 8 years:– Sum the values in Column (4)– Fill in the blanks at the bottom of Activity 10 – 2

• Questions?• Begin . . .

Activity Debrief

• Who is really happy that you bought the insurance you did?

• Who wishes you would have purchased a lot less insurance?

The Nature of Insurance

• If you experienced particularly costly events, likely happy if you bought a lot of insurance– Losses without insurance would have been much bigger

• If you experienced fairly inexpensive events, likely unhappy if you bought a lot of insurance– Losses without insurance would have been much less.

Premiums Based on Expected Payouts of Insurance Company

(plus operating cost and profit)

• Thus,– There must be some people who pay more in

premiums than they get back in claims• and perhaps feeling they shouldn’t have purchased so

much coverage

– The insurance company uses this extra premium to pay the claims of those who pay less in premiums than claims.

Insurance

• Every insurance contract is a gamble:

– Possible that you will not have accident

– Most years you pay premium• get nothing in return, except peace of mind

– Insurance company counting on fact that most people will not make claims• or they couldn’t survive

Insurance & the Economy

• Insurance:– Does not eliminate risk

• but spreads it around

– For example:• Owning fire insurance does not reduce the risk of losing

your home in fire– You could suffer “moral hazard” – take less care due to insurance

• But if the unlucky event occurs, – the insurance compensates you

• Risk shared among thousands of insured people

Simple Insurance Example• Assume:

– 100 young people all face the same risk of loss• statistically, only 1 accident occurs per year• if an accident occurs, the injured party has an accident loss

of $2,000– such a loss is catastrophic for one person to bear

• Idea: let’s spread the risk (insurance)– Since one accident occurs per year

• Our “society” incurs a loss of $2,000 per year• So,

– each of the 100 people pay an “insurance premium” of:» $20 per year

A Little More Reality

• The “society” decides that the burden of administering their internal insurance plan is too great – getting collections of premiums, etc.

• So, one person (an entrepreneur) says, •

“I’ll handle all the details if you pay me $500 per year.”

• Now, what happens to the premiums?– $2,500/100 = $25

– Greater than the expected loss of each person:• (Prob of accident) x ($ loss if accident) = 0.01($2,000) = $20

What Should We Insure?

• Since cost of insurance > expected loss• NOT a fair game!• Insurance is NOT a fair bet!

– So, most economists recommend insurance for:• large potential losses where you will be severely impacted

if accident occurs – catastrophic loss– e.g., Cancer or Liability

• But don’t necessarily insure small risk events– that you could self-insure

Over-insure?

• 34.4% of new-car buyers bought extended-warranty– up from 23.5% in 1999

• With the average car dealer now losing money (or making little) on each car sale, selling extended warranties is an important source of dealer profits– 65% of respondents said they spent significantly more for the

new-car warranty than they got back in repair savings

Early Retirement• Less time to build nest egg• More time to live off nest egg

– (But, studies find people who retire earlier live shorter lives)

→ early retirement is a risky choice

later retirement is less risky choice

• Retirement Data from the Department of Labor Statistics

• This trend is likely to continue going forward.

Age Range Labor Force Participation Rate (%)

1988 2012

55 – 64 54.6 64.5

65 – 74 16.0 26.8

Over 75 4.3 7.6

Problem:

Criteria

Risk Return Liquidity Income

Bonds

Stock

Savings Acct

How to Invest My Savings

Alternatives

Risk• . . . comes in many forms

– Liquidity risk, default risk, purchasing power risk

• . . . In this session we’ll only address a couple more types

Purchasing Power Risk

• Inflation risk

– T-bills (zero-coupon) have very little volatility risk

Recent 10-Year Period2002–2011

0.50

$3

2002 2004 2006 2008 2010

$1.20

1

• Treasury bills 1.8

Past performance is no guarantee of future results. Hypothetical value of $1 invested at the beginning of 2002. Assumes reinvestment of income and no transaction costs or taxes. This is for illustrative purposes only and not indicative of any investment. An investment cannot be made directly in an index. © 2012 Morningstar. All Rights Reserved. 3/1/2012


• Inflation risk

– T-bills (zero-coupon) have very little volatility risk, but • May not keep up with inflation

Lose purchasing power.

Recent 10-Year Period2002–2011

0.50

$3

2002 2004 2006 2008 2010

$1.20

1

• Treasury bills

$1.28

• Inflation 2.5

1.8



• Inflation risk

– T-bills (zero-coupon) have very little volatility risk, but • May not keep up with inflation

Lose purchasing power.

– Coupon bonds also face inflation

interest rate risk

0.10

1

10

100

1,000

1926 1936 1946 1956 1966 1976 1986 1996 2006

Stocks, Bonds, Bills, & Inflation: 1926–2012

• Govt bonds 5.7• Treasury bills 3.56

$21


Ibbotson® SBBI®

CAGR (%)

$10,000

$123

Why Do So Many Fear the Stock Market?

• It’s a dangerous, volatile place – … thousands of sophisticated

traders and brokers lurk to steal your hard-earned money!

• Many call it “gambling!”• But maybe the real source of

fear is . . .

Adults Invested in the Stock Market

Market Volatility Risk

1

1926 1936 1946 1956 1966 1976 1986 1996 2006

Smooth and Steady: 1926–2012

1

1926 1936 1946 1956 1966 1976 1986 1996 2006

A Bumpy Ride: 1926–2012

Why Would Anyone Take This Risk?

In High School saving for college

In college and now need the money

Another spot to conduct this

activity

• Raise the benefit

– Now, B(X) > C(X),

• Choose the bar with the reward!

–where B(X) = benefit of action X

Key Economic Concept

People respond to incentives

Would You Ride a Bull?

– For $5?– for $50?– for $500?– for $5,000?– for $50,000?

• Likely to get more risk takers as the reward rises!

Since Choice has a Cost

• Why choose it?

• People choose X if:

•B(X) > C(X)

B(X) C(X)

Greater Return . . . ® accept the risk of:

– Riding the Bull

– Riding the

Roller Coaster

… or

0.101926 1936 1946 1956 1966 1976 1986 1996 2006

Stocks and Bills: 1926–2012

$21

• Large stocks 9.8

• Treasury bills 3.56

CAGR (%)

$3,533

Strategies for Dealing with Risk

Strategies for Dealing with Risk

Time

$

1. Market Timing: Buy low, sell high!

Try to take advantage of volatility by “timing”

How Do Investors Fare?(Study by Dalbar, Inc.)

• 1984 – 2000:– S&P 500 (geometric mean ≡ total return) + 16.3%– Avg stock mutual fund investor (IRR): +

5.3%

• What’s happening?

Mutual Fund Merry-Go-Round• Possible explanation:

– Investors lack discipline to “buy and hold”• Chase the HOT fund, but

–This year’s star is next year’s dog

Hot-Hand Fallacy: Chasing Fund Performance

© 2011 Morningstar. All Rights Reserved. 3/1/2011

$10,000 in Mutual Fund

Cash flows

10-year mutual fund total return = 6.94%

–3

0

1

2

3

4

5

$6 billion

–1

20082001 2002 2003 2004 2005 2006 2007 20090

10

20

25

40

$45k

35

30

15

5

2010

–2

10-year average investor return = – 20.24%

Dangers of Market Timing1926–2009

$2,573

0

500

1,000

1,500

2,000

2,500

$3,000

S&P 500

$19.66

S&P minus best

37/1,008 months

$20.53

Treasury bills

$1.00 invested in 1926 in S&P 500

© 2010 Morningstar. All Rights Reserved. 3/1/2010 Ibbotson® SBBI®

$1(1.098)84

Advice Worth Heeding!

• “I’ve seen people get famous for being right once in a row.”

• “Smart investing doesn’t consist of buying good things, but rather of buying things well. Price is what matters most for investment success.”

• Howard Marks

Can you predict this?!

Market Timing?

Geometric Mean – Common Use• Mutual funds & financial analysts refer to as:

– “total return”– “compound annual growth rate” (CAGR)

• a time-weighted rate of return

• nothing added or withdrawn during the period

• e.g., started with $1.00 . . . – did not deposit or withdraw

– did not withdraw any interest or dividends

Reasonable measure of mutual fund management because it ignores variables that are outside the manager’s control

Is Geometric Return Good for Evaluating Individual Investor Performance?

• Total return: – computed by assuming that investors deposit

money at the beginning of the period – and pursue a buy-&-hold strategy

• Many investors deposit & withdraw funds– i.e., many investors do NOT buy & hold– need a “dollar-weighted” rate of return

• that takes into account the flow of funds in & out

Example: Investor Facts• Purchased 100 shares of mutual fund @ $20• During 1st year, fund’s P rises by 30%, to $26• Begin of 2nd year, purchase 200 shares @ $26• During 2nd year, P fell by 4% to end @ $24.96• End year 2: investor sells all shares @ $24.96

Summary

Begin Year 1 Begin Year 2 End Year 2Deposit: $2,000 Deposit: $5,200 Withdraw: $7,488

Evaluating the Fund Manager

• Use geometric return≡ Total Return

≡ time-weighted return

• Year 1: +30%

• Year 2: - 4%

• Thus, $1(1+.3)(1-.04) = $1.248

• To solve for total return:

• $1(1+ig)2 = 1.248

• 1 + ig = 1.248(0.5) = 1.117

• Thus, ig = 0.117, or 11.7%Reasonable measure of mutual fund management because it ignores variables outside the manager’s control

$1(1+i1)(1+i2)

Is Total Return a Good Measure of Our Investor’s Performance?

• When there are cash flows into & out of an account, – we must use “internal rate of return” (IRR) calculation.

• Definition of IRR: – The rate of interest that satisfies the condition that

the sum of the present value of the outflows

is equal to the sum of the present value of the inflows.– Math Behind the Market, p. 60

– or – the interest rate that makes the net present value of an

investment equal zero.

Setting Up IRR

Begin Year 1 Begin Year 2 End Year 2

Deposit: $2,000 Deposit: $5,200 Withdraw: $7,488

0)1(

488,7$

)1(

200,5$

)1(

000,2$210

iii

NPV

• The interest rate that makes the net present value = 0

Solution

• This particular problem could be solved by using quadratic formula, however– Many more complicated problems must be

solved through computer iteration

• Using Microsoft Excel:• IRR = IRR(-2,000, -5,200, 7,488) = 0.031

– i.e, the investor earned 3.1% per year IRR

Total Return v. Investor Return

• In this example,– the geometric return (total return) is:

• 11.7%– time-weighted, assumes buy-and-hold by investor

– the IRR (Investor Return on Morningstar) is:• 3.1%

– a dollar-weighted return

• Why such a significant difference?– Many investors chase hot funds ...

Recall: Investor Facts• Purchased 100 shares of mutual fund @ $20• During 1st year, fund’s P rises by 30%, to $26• Begin of 2nd year, purchase 200 shares @ $26• During 2nd year, P fell by 4% to end @ $24.96• End year 2: investor sells all shares @ $24.96

• Chase what’s hot … – first year: 30% return: buy, buy, buy– second year: - 4% return– end 2nd year: it’s down: sell, sell, sell

Study by Dalbar, Inc.

• Geometric mean return: S&P 500 recent 20 year period (1988 – 2008) – ≈ 12%

• i.e., if buy and hold, earn 12% annual rate of return

• Average investor return (IRR) – takes into account inflow & outflow

• i.e., chasing hot funds!

– ≈ 4%

Prudent Strategies to Deal with Risk

2. Invest for the Long Term

. . . if you think long-term, the ups exceed the downs.

or, spread risk over more years!

0.10

1

10

100

1,000

$10,000

1926 1936 1946 1956 1966 1976 1986 1996 2006

12.1% • Small stocks

Ibbotson® SBBI®

Small Stocks 1926–2010


Which gray circle is bigger?

Which gray bar is longer?

Are the gray horizontal lines

parallel?

What Do You See?© 2011 Morningstar. All Rights Reserved. 3/1/2011

They are the same size

They are the same size

The horizontal lines are parallel

Key Insight from Behavioral Economics:

Humans Don’t Always View Things Rationally© 2011 Morningstar. All Rights Reserved. 3/1/2011

Focus on short-term instead of long-term risk

Result: Time-inconsistent behavior Interest in long term but act short term

Overly sensitive to recent volatility

Act as though time horizon far shorter than it is

Short-Term Focus

When shown a distribution of 1-year returns

When shown a distribution of 30-year returns

Stocks

Short-Term Focus

Source:

Shlomo Benartzi and Richard H. Thaler, “Risk Aversion or Myopia? Choices in Repeated Gambles and Retirement Investments,” March 1999.

40%

60%

10%

90%

Bonds

Reduction of Risk Over Time1926–2006

Small stocks Large stocks Government bonds Treasury bills

-60

-30

0

30

60

90

120

150%

1-year

Holding period

5-year 20-year 1-year 5-year 20-year 1-year 5-year 20-year 1-year 5-year 20-year

12.7%10.4% 5.4%

3.7%

1926–2009

GeometricReturn

Arithmeticannualreturn

StandardDeviation

12.3%

17.4%

5.8%

3.8%

3.1%

Treasurybills

3.7% 3.1%

Large stocks

Governmentbonds

Inflation

9.8%

5.4%

3.0%

20.5%

9.6%

4.2%

–90%0

90%

Small stocks*

11.9% 32.8%

*Small company stock total return (1933) = 142.9%.

Histograms

Largest Standard Deviation?Smallest Standard Deviation?

Nominal GDP & the S&P 500


• All money in one stock?– Could spill all the eggs

Don’t Put All Your Eggs in One Basket

It Can Be Tempting!

• All Your Eggs in One Basket? – Great if you “hit it big”

• Wal-Mart–If you had purchased $1,000 of Wal-Mart

stock in 1970 at its IPO –held it through 1999, would have grown to:

» over $6,000,000!

• Not so great if things go south– Enron


• Diversify across asset class– Stocks and bonds

• Diversify within asset class– Stock from different

industries

Don’t Put All Your Eggs in One Basket

3. Diversify

Benefit of Diversification

Time

$

Cost of Diversification

Time

$

$9.31

$6.25

$3.72

$20

10

11987 1992 1997 2002

Diversified Portfolios 1987–2006

11.8%

9.6%

6.8%

• Portfolio 1 (100% Stocks)

• Portfolio 2 (50% Stocks, 50% Bonds)

• Portfolio 3 (100% Bonds – 5 yr.)

A Bull Market

• “Characterized by optimism, investor confidence and expectations that strong results will continue.

• The use of “Bull” to describe markets comes from the way bulls attack their opponents. A bull thrusts its horns up into the air. These actions are metaphors for the movement of a market. If the trend is up, it’s a “bull market.”

A Bear Market

• Downward trend in the market that investors believe will continue in the long run, which, in turn, perpetuates the spiral.

• Downturn of 20% or more in multiple broad market indexes, such as the DJIA or S&P 500, over at least a two-month period– not to be confused with a correction

• a short-term trend with duration < two months

A bear will swipe its paws downward upon its unfortunate

prey

Diversification – Cost & Benefit$3,000 Bull market

2,500

2,000

1,500

1,000

5001996 1997 1998 1999 2000 2001 2002

250

500

750

1,000

1,250

$1,500

$1,181

$2,555

$624

$1,484

$1,763

$985

• Stocks

• 50/50 portfolio

• Bonds

Bear market

Risk & Return Diagram12

10

8

6

45 7 9 11 13 15 17

Return (%)

Risk (% standard deviation)

100% Bonds

100% Stocks

8.4

60% Stocks 40% Bonds

?

12

10

8

6

45 7 9 11 13 15 17

Return (%)


100% Bonds

100% Stocks

8.460% Stocks 40% Bonds

5.92

• The Efficient Frontier

If there were no benefit from diversification, then we would lie upon this linear combination of

bonds and stocks

Actual Stock Market: 1970–200613

12

11

10

910 11 12 13 14 15 16 17

100% Stocks

80% Stocks, 20% Bonds

100% Bonds




Return (%)


Efficient frontier

What Makes This Work?

• How can we combine stocks and bonds

– and get a portfolio mean return that is the weighted average of the stocks and bonds

– but the standard deviation (volatility) is lower than either stocks or bonds?

Correlation is High in Crisis

Diversified Portfolios in Various Market ConditionsPerformance during and after select bear markets

• Past performance is no guarantee of future results. Diversified portfolio: 35% stocks, 40% bonds, 25% Treasury bills. Hypothetical value of $1,000 invested at the beginning of January 1973 and Nov 2007, respectively. This is for illustrative purposes only and not indicative of any investment. An investment cannot be made directly in an index. © 2011 Morningstar. All Rights Reserved. 3/1/2011

Mid-1970s recession (1973–76) 2007 bear market & aftermath (Nov 2007–Dec 2010)

$1,150

$1,014

$1,072

$872

$1,250

1,000

750

250 Jan1973

Jan1974

Jan1975

Jan1976

Nov 2007

Nov 2008

Nov2009

Nov 2010

• Stocks

• Diversified portfolio

500 35% stocks, 40% bonds, and 25% Treasury bills

Risk & Stock Diversification

1 2 4 6 8 16 30 50 100 1000

Number of stocks in portfolio

Market Risk

Diversifiable Risk

Too Much of a Good Thing?

• Diversification has benefits, but …

Over-Diversification?

• Peter Lynch refers to “di-worse-ification”

– mutual funds might purchase so many separate companies

• Selecting companies lower on value list–dilutes return

How Achieve Diversification?

• Passive management approach– “index funds”

• Achieve “market” rate of return– Slightly below, due to cost

• Active management approach– Assumes can “beat the market”

– Tough to do.

– Higher costs due to portfolio selection

“Beauty Contest”

• Rules of the Game:– Each player will select a number from 0 to 100– Winner is the player whose number is closest to

the number that is 70% of the average of all player chosen numbers.

Active Management

• A. Do it yourself:– Adequate diversification requires > $50,000

– NASD survey• People overestimate their abilities/understanding

– Expensive hobby – why do it yourself?• Maybe you can beat the market!?• You want to learn for later career• You simply have fun with it

Active Management

• B. Professional management

– Investment adviser• Typical fee: 1% of asset value

–Mutual fund

Diversify with Mutual Funds

• Mutual fund pools investors’ money

• Puts it into the markets on your behalf– you own small amounts of many different assets

• Good way to avoid the risk that comes from owning any one asset

Picking Mutual Funds?

• Check on web sites for fund– e.g., Fidelity.com, Vanguard.com, Roycefunds.com

• Factors to consider:– Longevity/stability of fund managers– Management investment philosophy

• Long-term focus; not over diversified– Management track record– Expense ratios: preferably less than average of 1.5%– Portfolio turnover: preferably below 20%– Preference for “no load” funds

Small Sample of Funds

• Locate names of funds through– Recommendations

• From other friends• From Wall Street Journal, or other articles

– Search recommendations by:• Morningstar.com• Other firm

– Then, review web page of fund for information . . . • Not necessarily recommended,

– although appeared satisfactory at one time

Equity Income Fund

• Objective:– provide substantial dividend income as well as

long-term capital appreciation through investments in common stocks of established companies.• Turnover rate: 12% of fund

– % of fund bought and sold during year

https://individual.troweprice.com/public/Retail

Fund Performance(through March 2013)

• T. Rowe Price:– 5-year total return:

5.5%– 10-year total return:

9.0%– Since 1985:

11.0%

• Benchmark: S&P 500– 5-year total return: 6.0%– 10-year total return:

8.0%– Since 1985:

10.5%Minimum amount required to open an account: $2,500

IRA minimum: $1,000


Investment Philosophy• This fund offers a relatively conservative, value-oriented way to

pursue substantial dividend income and long-term capital growth potential.

• It invests in common stocks of established firms that are expected to pay above-average dividends.

• By investing in stocks that appear to be out of favor or undervalued, the fund should be less volatile than one investing in growth stocks.

• If, as the manager expects, the underpriced holdings regain favor in the marketplace, their stock prices may rise—providing capital appreciation opportunities.

• The value approach carries the risk that the market will not recognize a security’s true worth for a long time, or that a stock judged to be undervalued may actually be appropriately priced.

Price/earnings or P/E ratio: 13.8


Top 10 Holdings• AT&T • Apache • Chevron • Exxon Mobil • General Electric • International Paper • JPMorgan Chase • Royal Dutch Shell • US Bancorp • Wells Fargo


• Financials 20.3% • Industrials & Busn Services 14.0%• Energy 13.8% • Consumer Discretionary 10.4% • Information Technology 8.0% • Health Care 6.9% • Utilities 5.9% • Consumer Staples 5.6% • Materials 4.6% • Telecommunication Services 3.8%

Sector Diversification


Portfolio Manager

• Brian C. Rogers • B.A., Harvard College • M.B.A., Harvard Business School

– Managed Fund Since: 10/31/1985

To Summarize

• How much one saves out of income

Three Key Variables Pn = (1 + i)n P0

Three Key Variables

PN = (1 + i)n P0

• Interest rate, i–Compound interest is

powerful

–e.g., consider 2 cases: one-time investment of $10,000 for 40 years

– A invested at 8%

– B invested at 5%

Power of Compounding: Importance of i2010 - 2050

Years invested:Amount Contributed:Rate of return:

$0

$50,000

$100,000

$150,000

$200,000

$250,000

$300,000

$10,000

$217,245

Investment B 40

$10,0008%

$10,000

$70,400

Investment A40

$10,0005%

PN = P0(1+i)n

= $10,000(1.05)40

PN = $10,000(1.08)40

0.10

1

10

100

1,000

$10,000

1926 1936 1946 1956 1966 1976 1986 1996 2006

$2,982

$21

9.9%• Large stocks

• T-bills 3.6%

Ibbotson® SBBI®

142 times greater!

U.S. T-Bills & S&P 500, 1926–2010

2.7 times greater


0.10

1

10

100

1,000

$10,000

1926 1936 1946 1956 1966 1976 1986 1996 2006

Ibbotson® SBBI®

Have Been Focused on Market Volatility Risk

Can avoid volatility risk with T-Bills


0.10

1

10

100

1,000

$10,000

1926 1936 1946 1956 1966 1976 1986 1996 2006

$21

• T-bills 3.6

Compound Annual Return (%)

$12

• Inflation 3.0

Ibbotson® SBBI®

• Inflation risk

– maintain purchasing power

However, “Every Choice Has a Cost!”


• Real return 0.6

0.10

1

10

100

1,000

$10,000

1926 1936 1946 1956 1966 1976 1986 1996 2006

Dealing with Inflation Risk?Mind the Gap in Rates of Return

$2,982

$21

$12

12.1% 9.95.5

$93

• Small stocks

• Gov’t bonds

• Inflation

• Large stocks

• T-bills 3.6

$16,055

3.0

Ibbotson® SBBI® © 2011 Morningstar. All Rights Reserved. 3/1/2011

Two Key Variables PN = (1 + i)n P0

• Interest rate, i • Length of investment, n– Start early to benefit from

compounding

– Consider investors A & B– Both invest in S&P 500:

• A invests $2,000 per year from 1990 - 1999, then watches grow.

• B invests $4,000 per year from 2000 - 2009.

– Note: these are “annuities”

Power of Compounding: Importance of n

Years contributing: 10

Annual contribution: $2,000

Years contributing: 10

Annual amount contributed: $4,000

Investor BInvestor A

$40,000

$42,118$20,000

$60,759

0

20

40

60

80

100

120

$140k

1990 – 2009 2000 – 2009

Investor A Investor B

Invested in S&P 500

Invested in S&P 500

Two Key Messages from Compound Interest Story

• Save and Invest . . .

– Early• Consider . . .

– Stocks

Conclusion

• Take a long-term perspective• Reinvest interest, dividends• Do not remove principal• Don’t chase the hot fund!

• Recognize the importance of:• Starting early, and• Minding the gap – pay attention to rates of return

– some stocks (via mutual/index funds) in portfolio

• Diversify– Through mutual funds

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