Basics of Investing III: Economics 98 / 198 Spring 2008

Basics of Investing III
Economics 98 / 198
Spring 2008
Copyright 2008 Lawrence Wu
Schedule
Quiz
Current Events
Todays Lecture Content
Next Week
QUIZ
CURRENT EVENT / NEWS
Crude Oil tops $100/barrel again

After the February 7th low of $88.11, it began
steadily rising again.
After the Presidents Day weekend, the New
York Mercantile Exchange rose prices by
$4.51, 4.7%, to $100.01 for the March
delivery.
Due in part to OPECs seasonal production
cuts.
Also, the Big Spring refinery in Dallas, with
a 70,000 barrel a day capacity was shut down
due to blast.
Effects
Analysts are unsure whether the market
demand, due to the slowing economy, will
legitimize the rise in price.
Inflation could rise due to supply jitters.
Drivers could see a an increased price at the
pump due to the approaching spring driving
season.
* Information from Article titled Supply worries spur crude back above $100 a barrel from MarketWatch by
DowJones; http://www.marketwatch.com/news/story/crude-makes-swift-climb-
back/story.aspx?guid=%7B463E952B-0B60-48BA-901C-0874DDC7CE70%7D
February 19
- crude oil closes above $100 a barrel -
Dow Jones, S&P, and NASDAQ plummet as crude prices rise

above $100 a barrel for the first time
Why???
1. Alon USA in Texas shuts down
because of an explosion and a
fire
2. Speculation that OPEC will lower
production
3. March crude oil contract expires
February 20 crude prices rise
due to short-covering in advance
of the expiration
LECTURE CONTENT
Todays Lecture
Basic investing concepts
Risk-Reward / Financial Goals / Understanding Your
Appetite for Risk
Portfolio Management
Diversification
Concentration
Different investment securities
Bonds / CDs / Money Market
Mutual Funds / Exchanged-Traded Funds
Market Psychology
Basic Investing Concepts
Determining Your Financial Goals

Investing is a long car trip. There needs to
be a lot of planning that goes into it.
How much money do you want to make? By
when?
Will you need to live off your investments in
future years?
What will you be using your money for?
Having a good understanding of yourself will allow
you to align your risk tolerance with various
strategies
Determining Your Investment Style

What kind of person and investor do
you want to be?
Shooting for singles and doubles, aiming for slow
and steady gains?
Sitting on the sidelines, relying on and cheering
someone else?
Willing to take risks, go for homers, and achieve
maximum gains?
Think about your risk tolerance, time horizons for
your investments, and your time commitment
The Risk / Return Tradeoff

principle that expected return rises
with an increase in risk
Lower risk with lower returns
Higher risk with high returns
Important to know your personal risk

tolerance when choosing investments
Balance between risk and reward
Risk Tolerance
Young people should
be in stocks
Time is our best
friend
BUT, need to be able

to handle the
markets volatility
If not then get out!
What is Your Risk Tolerance?
Source: Investopedia. Determining Risk and The Risk Pyramid. May 2 2003
Source: Investopedia. Determining Risk and The Risk Pyramid. May 2 2003
(Expected) Return vs. Risk
Portfolio
Definition: collection of assetssuch
as stock, bonds, and mutual funds
held by an investor
Deciding type of investment mix and
allocation for your portfolio
Risk versus performance
Asset Allocation
Income
Balanced
Growth
Active versus Passive Management
Buy, sell, buy, sell

versus
Buy and sit?
Active versus Passive Management

Examples (Active Management)
Buying / selling individual stocks
Discuss with your broker which stocks to buy
Choosing between different mutual funds
Example (Passive Management)

Buying an index fund that mirrors the S&P 500
Having your portfolio match the index fund at all
times (relatively hard and expensive)
Typically has lower fees
Distribution of Returns of Actively Managed Funds
How many stocks should I own?
Diversification
versus
Concentration
Diversification
Dont put all your eggs in one basket
Diversification
Mixing a wide selection of investments
within a portfolio
By industry, sizes, geographic locations, or
other characteristics
Positive performance of some

investments may neutralize the
negative performance of others
DiversificationWhats the Catch?

Limits your upside potential
Hot stock makes up only 5% of your portfolio
50% increase will have small effect
Many investors tend to over-diversify

Harder to keep track, slower to react
Know a little bit about every industries
Over-diversification usually leads to
underperforming the market (Whats the point
then?)
Concentration
putting your eggs in a few baskets that you know

well and watching them very carefully
Concentration
Goal: Keep losses small and ride profits
for big gains
Effect: big gains have major effect on your
portfolio value
Increases risk
Potential for big profits/losses is magnified
Fund managers cant do this
Other Investment Securities

Mutual Funds &
Exchange-Traded Funds
Various investment securities

Money market funds (~3-4%)
Type of risk-free debt investment that has slightly better
returns than savings
Typically mature in less than 1 year
Very liquid (i.e. easy to buy/sell and convert to cash)
Usually automatically get this in a brokerage account
Certificate of deposits (CDs) (3-6%)

Certificate to the bearer to receive interest
Issued by commercial banks from 1 month to years
Interest varies with length of maturity
Various Investment Securities

Bonds
An IOU issued by a borrower to a lender
Loaning money for pre-determined time
Borrower pays a coupon payment during time-span as well
as lent amount
Borrowers range from banks, government, to corporations
Advanced / Alternative Investments
Options
Hedge Funds
Private Equity
Futures / Derivatives
Mutual Fund Basics

Nothing more than a collection of stocks
and/or bonds
You contribute your money to a company
that manages a large fund (made up of other
peoples money) and invests in a portfolio
Often, these mutual funds can manage
hundreds of millions and billions of dollars
Mutual Fund Basics

Various types of mutual funds
Equities, fixed-income, money market

Mutual funds usually variation of these assets
classes
Also, other special types: global,

international, specialty, index funds
Costs:
Yearly fees (0.15%-2%)

Transaction fees paid when buy / sell shares
This is called the load look for No Load funds
Buying and Selling Funds

Can buy mutual funds by contacting fund
companies directly or through brokerages
Can withdraw your money from fund at the
end of market days usually
If purchase mutual funds through thirdparties (brokers, banks, planners), usually
faced with extra sales charge (these are
called loads)
Advantages
Disadvantages
Professional
Professional
Management
(huh?!)
Management
Periodic
Reinvestment (Dollar
Costs
Cost Averaging)
Dilution
Diversification
Taxes
Liquidity
Reaction Time
Simplicity
Choosing Mutual Funds

Always compare fund performance to stock
market averages (S&P500, NASDAQ)
Pay attention to the years in which market
averages were down (anyone can make money in
the bull market)
Look for solid track records
Make sure objectives of mutual fund are in

line with your goals and risk / rewards
desires
Aggressive growth? Slow, steady returns?
Like mutual fund, but trades like stock
Represents a basket of stocks that reflect
an index / industry such as the S&P500 or
alternative energy
Diversification like an index fund, but the
flexibility of a stock
Value of ETF updated daily as supply

and demand fluctuates
Number of ETF for various industries and
markets
International, oil, retail, emerging markets, etc.
Buying and selling ETF as simple as buying /

selling a stock
Symbols assigned to each ETF (QQQQ for Nasdaq

100 average)
Go to broker & enter buy order for QQQQ
Can buy / sell at any point of the day
Advantages over Mutual Funds

Lower costs
Greater tax efficiency
Easier asset allocation
No fraud (ETFs are transparent)
Flexibility
Shorting opportunity
Sample ETF Symbols

ETF Ticker
Fund Name
Fund Description
IVV
iShares S&P 500 Index Fund
Large cap US stocks
IJH
iShares S&P Mid Cap 400 Index Fund
Mid cap US stocks
IWM
iShares Russell 2000 Index Fund
Small cap US stocks
EFA
iShares MSCI EAFE Index Fund
Large cap foreign developed market stocks
EEM
iShares MSCI Emerging Markets Index

Large cap emerging market stocks
Fund
RWR
streetTRACKS Wilshire REIT Index

Fund
Real estate investment trust index fund
LQD
iShares GS $ Investop Corporate Bond

Fund
US corporate bonds
SHY
iShares Lehman 1 to 3 Year Treasury

Bond Fund
US short-term Governement bonds
IEF
iShares Lehman 7 to 10 Year Treasury

Bond Fund
US long-term Governement bonds
TIP
iShares Lehman TIPs Bond Fund
US Governement inflation-protected bonds
Additional Resources for ETFs

Index Funds & ETFs a Tiny Useful List
http://moneychimp.com/articles/index_funds/fund_list.htm
Radical Guide to ETF Investing

http://seekingalpha.com/article/15134-the-seeking-alpha-etf-inv
esting-guide
TRADING PSYCHOLOGY
Trading Psychology
Emotions severely impair your judgment
in deciding whether to buy or sell stocks
HOPE
FEAR
GREED
PRIDE
Psychology & The Stock Market

Emotions can wreak havoc on your
results and decisions
Need to take emotion out of investing
Do this by developing a system with
rules to follow with discipline
Next Week
Financial Statements Primer
Income Sheet
Balance Sheet
Cash Flow Statement
Financial Ratios
P/E, ROE, Margins, etc.
Earning Reports, Analyst Estimates
Reading
Assigned Reading:
SEC. Beginners Guide to Financial Statements
Look at Googles financial statements (income
statement, balance sheet, cash flow statement)
Extra Reading:
Ratio Analysis
http://www.investopedia.com/university/ratios/
Financial Concepts
http://www.investopedia.com/university/concepts/

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Basics of Investing III

CURRENT EVENT / NEWS

Crude Oil tops $100/barrel again

Dow Jones, S&P, and NASDAQ plummet as crude prices rise

Basic Investing Concepts

Determining Your Financial Goals

Determining Your Investment Style

The Risk / Return Tradeoff

Important to know your personal risk

BUT, need to be able

What is Your Risk Tolerance?

(Expected) Return vs. Risk

Active versus Passive Management

Buy, sell, buy, sell

Active versus Passive Management

Example (Passive Management)

Distribution of Returns of Actively Managed Funds

How many stocks should I own?

Dont put all your eggs in one basket

Positive performance of some

DiversificationWhats the Catch?

Many investors tend to over-diversify

putting your eggs in a few baskets that you know

Fund managers cant do this

Other Investment Securities

Various investment securities

Certificate of deposits (CDs) (3-6%)

Various Investment Securities

Advanced / Alternative Investments

Mutual Fund Basics

Mutual Fund Basics

Equities, fixed-income, money market

Also, other special types: global,

Yearly fees (0.15%-2%)

This is called the load look for No Load funds

Buying and Selling Funds

Choosing Mutual Funds

Make sure objectives of mutual fund are in

Value of ETF updated daily as supply

International, oil, retail, emerging markets, etc.

Buying and selling ETF as simple as buying /

Symbols assigned to each ETF (QQQQ for Nasdaq

Can buy / sell at any point of the day

Advantages over Mutual Funds

Sample ETF Symbols

iShares S&P 500 Index Fund

Large cap US stocks

iShares S&P Mid Cap 400 Index Fund

Mid cap US stocks

iShares Russell 2000 Index Fund

Small cap US stocks

iShares MSCI EAFE Index Fund

Large cap foreign developed market stocks

iShares MSCI Emerging Markets Index

streetTRACKS Wilshire REIT Index

Real estate investment trust index fund

iShares GS $ Investop Corporate Bond

iShares Lehman 1 to 3 Year Treasury