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Roadmap for Investing Wisely for a Lifetime

Leslie LumBellevue Community College

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The Roadmap

• Save

• Focus on financial goals

• Understand returns

• Understand risk

• Asset allocation

• Monitor your investments

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Rule #1: You can make more money saving aggressively than you can investing aggressively

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How much does a typical family make?

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What happens to your income over your life?

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How are we doing at savings?

Savings rate as a percent of disposable income

-5

0

5

10

15

20

25

30

1929 1934 1939 1944 1949 1954 1959 1964 1969 1974 1979 1984 1989 1994 1999 2004

Source: http://www.bea.gov/bea/dn/nipaweb/TableView.asp#Mid

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Could we save more?

2004 Household Saving Rates (as a percent of disposable income)

-4.0 -2.0 0.0 2.0 4.0 6.0 8.0 10.0 12.0 14.0

Australia

Austria

Canada

Finland

France

Germany

Ireland

Italy

Japan

Korea

Netherlands

Norway

Sweden

Switzerland

United States

http://stats.oecd.org/WBOS/default.aspx?DatasetCode=REFSERIES

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Rule #2: If you don’t have goals, you won’t achieve them.

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Annual Budget vs Long-Term Financial Goals

• Trade off between spending money now and setting aside money for long-term goals

• How do you make your decision?

• What are the costs?

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Lay out your goals

• Down payment on house

• Wedding

• College tuition

• Starting your own business

• Retirement

• Estate (Inheritance or charity)

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Rule #3: Know how to measure returns.

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Returns

Always calculate returns on an annualized basis

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Calculate the annualized return

• You have an outstanding balance of $500 on your credit card. You are late in paying and were only able to pay the minimum $10. Your APR on the card is 22% above prime. The late payment charge is $35. Assume the prime rate is 7% now.

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Calculating returns – time value of money

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Calculating lost return

• You want to buy a HDTV set for $1500. What is this (future) costing you? (Use 20 years and 8% return. We use 8% because it’s historically the rate of return on investments over a long period of time.)– $1785– $3393– $4837– $6991

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You are a typical employee in your 20s who when you left your job in 2005 cashed out (66% do) your 401K account of less than $10,000. What is the cost of cashing out your account if your balance was $8000?

Calculating lost return

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Which is more?

• Saving $4000 a year from 25 to 45 years old and then no more savings but hold in account

• Saving $8000 (double) a year from 45 to 65 years old 0

100000200000300000400000500000600000700000800000900000

25 to 45years

45 to 65years

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It’s a moving target

• House in 10 years. Today’s price $200,000

• Kid’s college education in 18 years. Today’s price $50,000

• 2% inflation 3% inflation?

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That’s not the only uncertainty

$800,000 retirement goal in 30 years

At 8% returns?

At 10% returns?

Future Investment Returns Are Uncertain

6%

9%

5%6%

14%

8%

-2%

18%19%

-5%

0%

5%

10%

15%

20%

25%

1970's 1980's 1990's 2000's

Av

era

ge

Ye

arl

y R

etu

rn f

or

De

ca

de Cash

Bond

Stock

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The financial plan

Katie is 25 and trying to plan her financial future. Here are her financial goals in today’s dollars (black) and inflated to when they are due (red).

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Katie does her plan and knows that her heaviest savings will happen in her 30s and 40s.

She also does sensitivity analysis on various inflation and return rates.

She knows that she should save as much as she can when she is younger.

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Rule #4: Understand risk

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Investment Risks

• Market risk

• Business risk

• Interest rate

• Inflation risk

• Political risk

• Fraud risk

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Major asset classes

Annual Return on Cash (Treasury Bill Total Return 1971-2000)

0%

5%

10%

15%

20%

25%

30%

35%

40%

45%

50%

1971

1972

1973

1974

1975

1976

1977

1978

1979

1980

1981

1982

1983

1984

1985

1986

1987

1988

1989

1990

1991

1992

1993

1994

1995

1996

1997

1998

1999

2000

Source: Global Financial Data, www.globalfindata.com

Average 6.7%Standard Deviation 2.7%

About 70% of returns fall within one standard deviation of the average

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BondsAnnual Return on Bonds (Total Return Government Bonds 1971-2000)

-10%

0%

10%

20%

30%

40%

50%

19

71

19

72

19

73

19

74

19

75

19

76

19

77

19

78

19

79

19

80

19

81

19

82

19

83

19

84

19

85

19

86

19

87

19

88

19

89

19

90

19

91

19

92

19

93

19

94

19

95

19

96

19

97

19

98

19

99

20

00

Source: Global Financial Data

Average 9.9%

Standard Deviation 9.3%

About 70% of returns fall within one standard deviation of the average

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Annual Return on Stocks(Total Return S&P 500 1971-2000)

-30%

-20%

-10%

0%

10%

20%

30%

40%

50%

1971

1972

1973

1974

1975

1976

1977

1978

1979

1980

1981

1982

1983

1984

1985

1986

1987

1988

1989

1990

1991

1992

1993

1994

1995

1996

1997

1998

1999

2000

Source: Global Financial Data

Average 14.5%

Standard Deviation

16.5%

About 70% of returns fall within one standard deviation of the average

Stocks

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The more return you need, the more risk you take.The more risk you take, the more return you need.

Major Asset Classes (1971-2000)

0%

2%

4%

6%

8%

10%

12%

14%

16%

18%

0% 2% 4% 6% 8% 10% 12% 14% 16%

Risk (Standard Deviation)

Return (Annual Return)

T-BillsAverage Return 6.7%

Standard Deviation 2.7%

BondsAverage Return 9.9%

Standard Deviation 9.3%

StocksAverage Annual Return 14.5%

Standard Deviation 16.5%

Lessons to learn:

If you want a higher return, you need to invest in riskier assets (stocks)

The more return, the more risk.

322% gain guaranteed?

Only if 322% loss guaranteed!

Return versus Risk

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Given the same return, the investment with less risk is better

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The Northwest is the best.

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Bonds – Risk Return

0%

1%

2%

3%

4%

5%

6%

7%

0% 1% 2% 3% 4% 5% 6% 7% 8% 9%

Risk (Standard Deviation)

Re

turn

(A

ve

rag

e A

nn

ua

l Re

turn

)

Short term T-Bills

Intermediate Corporate Bonds

Long Term Treasuries

Long Corporate

Source: Morningstar.com (3 years of data ending Nov 2006)

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Stock – Risk Return

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Sectors – Risk Return

0%

5%

10%

15%

20%

25%

30%

35%

0% 2% 4% 6% 8% 10% 12% 14% 16% 18% 20%

Risk (Standard Deviation)

Ret

urn

(Ave

rag

e A

nnu

al R

etur

n)

Source: Morningstar.com (3 years of data ending Nov 2006)

Telecom

Financial

ConsumerHealth

Materials

Real Estate

Energy

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International – Risk Return

0%

5%

10%

15%

20%

25%

30%

35%

40%

45%

50%

0% 5% 10% 15% 20% 25% 30% 35%

Risk (Standard Deviation)

Ret

urn

(Ave

rage

Ann

ual R

etur

n)

BrazilMexico

Emerging MarketsSpain

Australia

GermanyUK

Hong Kong Japan

Taiwan

Source: Morningstar.com (3 years of data ending Nov 2006)

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Combined – Risk Return

Rank the categories in order of return

Rank the asset classes in order of risk

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How do you get both a good return and low risk?

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Risk of loss in stocks is high year to year

Annual Stock Price Changes from 1900 to 2006(Percent change year to year in S&P 500)

-55%

-35%

-15%

5%

25%

45%

1900 1910 1920 1930 1940 1950 1960 1970 1980 1990 2000

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Over 5 years, risk of loss is lowerAverage Previous Five Years S&P 500 Gains

-15%

-10%

-5%

0%

5%

10%

15%

20%

25%

30%

1900 1910 1920 1930 1940 1950 1960 1970 1980 1990 2000

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Over 10 years, risk of loss is small

Average Previous Ten Years S&P 500 Gains

-4%

-2%

0%

2%

4%

6%

8%

10%

12%

14%

16%

18%

1900 1910 1920 1930 1940 1950 1960 1970 1980 1990 2000

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Lesson?

• Buy and hold market index funds (doesn’t work for individual stocks)

• Have an emergency fund (3 to 6 months) to tide you over

• Have other sources of income so you don’t have to cash out during down markets

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Rule #5: Asset allocate

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All eggs in one basket?

• 34.6 percent of families had stock in only one company

• 59.5 percent had stock in three or fewer companies

• 9.5 percent had stock in fifteen or more companies

Source: 2004 Consumer Finance Survey

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Can you predict the best return?

0% 20% 40% 60% 80% 100% 120% 140% 160%

1980 Small Stocks

1981 Treasury Bills

1982 Government Bonds

1983 Small Stocks

1984 Corporate Bonds

1985 Europe

1986 EAFE

1987 Emerging Asia

1988 Emerging Asia

1989 Latin America

1990 Corporate Bonds

1991 Latin America

1992 Small Stocks

1993 Emerging Asia

1994 Latin America

1995 S&P 500

1996 S&P 500

1997 S&P 500

1998 S&P 500

1999 Latin America

2000 Mid Cap Stocks

Best-Performing Asset Class(1980-2000)

Based on Index

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Does the risk double with two investments?

The key is having two

investments which aren’t correlated.

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Adding a riskier investment to your portfolio decreases overall risk.

Adding 10% stock to a T-bill portfolio

6.0%

6.5%

7.0%

7.5%

8.0%

8.5%

2.0% 2.2% 2.4% 2.6% 2.8% 3.0% 3.2% 3.4% 3.6% 3.8% 4.0%

Risk (Standard Deviation)

Ret

urn

(A

vera

ge

An

nu

al %

)

90% T-Bill, 10% Stock

100% T-Bill

Increases return.

Reducesrisk!

Data based on 20 years of returns.

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If you allocate the right amount you reduce risk and increase return!

Adding stock to a T-bill portfolio

5.0%

7.0%

9.0%

11.0%

13.0%

15.0%

17.0%

19.0%

21.0%

1.5% 3.5% 5.5% 7.5% 9.5% 11.5% 13.5% 15.5%

10% Stock

0% Stock

20% Stock

30% 40%

50%

60%

70%

80%

90%

100% Stock

Data based on 20 years of returns.

20% stock gives more return with about the same amount of risk

as 0% stock.

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Pension Fund Portfolio

Cash, 1%International Equities, 23%

Domestic Equities, 40%

Global Fixed Income, 23%

Real Estate, 8%Direct

Partnership, 6%

California Pension System $230.3 Billion

Source: www.calpers.ca.gov Investment Portfolio Market Value as of Dec. 31, 2006

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“Millionaires” Portfolio

15%

45%

Private Equity, 5%

International equities, 11%

Cash, 13%

Investment real estate, 7%

Other, 2%

Hedge Funds, 1%

Commodities, 1%

Households with investable assets

of $1 million to $10

million

Source: Fortune, 3/5/2007

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401K Allocations by Age

20%

13%

13%

52%

Fixed Income

Company stock

Balanced funds

Equity funds

Asset allocation for participants in their 20s

Fixed Income, 38%

Company stock, 13%Balanced funds, 10%

Equity funds, 37%

Asset allocation for participants in their 60s

Source: Investment Company Institute

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Rule # 6: Always watch your money.

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Investment Advice

• Take care in choosing your advisor– Experienced– Relevant education– Certified by professional body– Check for disciplinary actions (www.dfi.wa.gov)

• Don’t invest in anything you don’t understand• Watch what your advisor does

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Use indices to monitor your portfolio

Annual Returns of Selected Asset Classes

-30%

-20%

-10%

0%

10%

20%

30%

40%

50%

2002 2003 2004 2005 2006

PhiladelphiaGoldSilver

S&P Midcap

Russell 2000 SmallCap

S&P 500

EAFE InternationalDeveloped

NAREIT RealEstate

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Monitor Your Investments

• Rebalance periodically – but if you buy and sell a lot you will lose money

• Change allocation if you have different cash flow requirements

• Risk and return - Prune the low return/high risk investments

• Don’t make whipsaw changes to your asset allocation

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The Roadmap

• Save

• Focus on financial goals

• Understand returns

• Understand risk

• Asset allocation

• Monitor your investments