Investing 101

By: Bruce McNutt

Part 1 : Creating a Diversified Portfolio

Part 2 : Investing in the Stock Market, Indexing vs Active Management

The Goal of the Personal Investor

Your goal is to manage a well diversified portfolio through dollar cost averaging that meets your risk assessment needs through proper asset allocation in each of the asset classes.

Your goal is to manage a well diversified portfolio through dollar cost averaging that meets your risk assessment needs through proper asset allocation in each of the asset classes.

Investing vs. Saving

Saving:

Holding onto the money you already have

Investing

Using your money to make more money

Investing

Successful Investing requires time and a well thought out plan.

Successful investing requires a good understanding of the financial markets and investing strategy, unless you want to pay someone else to do it for you.

How Investments Grow

Investments grow for two reasons, through a process called compounding, and because you add money to them.

“The most powerful force in the Universe is Compounded Interest” Albert Einstein

Compounding means that not only does your original investment grow, but the interest you earn grows as well

This calculator is at www.moneychimp.com

A Word About Dollar Cost Averaging

When an investor puts a little bit in his investment on a regular basis (i.e. every paycheck) he is said to be Dollar Cost Averaging.

The idea is to but more shares when the market is down and fewer shares when the market is up

https://flagship.vanguard.com/VGApp/hnw/planningeducation/retirement/PEdRetInvHowMuchToSaveContent.jsp

Why it’s so important to start early

The 3 Most Common Investments

CashStocks Bonds

Other Common Investments

Real EstatePrecious Metals

Cash

Cash refers to money you have in a bank account, money market, or C.D. type of investment.

These accounts are virtually guaranteed to pay you the interest they promise.

They are considered very low risk, and usually low reward

Bonds

When you purchase a bond, you are really loaning money to either a government or company and they are promising to pay you back with interest

There are MANY types of bonds.

The Stock Market

When you buy a stock, you are buying a piece of a company (a share) that someone else is selling

OR

During an IPO (Initial Public Offering) you are still buying shares, but now you are giving money to the actual company.

Risk vs. Reward

Risk : Anything that can cause your investment to go down in value

Reward : Your investment goes up in value

Risk vs. Reward

There is no such thing as reward without risk in investing.

As a general rule, the higher the potential reward, the greater the risk

Loan $20,000 to a friend to go drill for oil Put $20,000 in a C.D.

Relative Risk

Lowest Mid Highest

Cash X

Bonds X

Stocks X

Risk

Investment

Type

Relative Potential Reward

Potential Reward

Potential Reward when Investing in Cash

You will earn the percent the investment guarantees.

These percentages usually run in the 1%-5% Range

Types of Risks when Investing in Cash

Inflation Risk : The rate of inflation may outpace your rate of return

The Risk of the Unexpected:

Potential Reward when Investing in Bonds

The long term rate of return on Bonds is in the 6-7% range.

Types of Risks when Investing in Bonds

Call Risk : The issuer of the bond decides to pay off in full their obligation on their bonds

Credit Risk : The issuer of the bond fails to pay their interest or principal (default)(The federal government has never defaulted on a bond obligation)

Interest Rate Risk : changing interest rates cause bond prices to change

Potential Reward when Investing in Stocks

The historical long term rate of return on Stocks is around 10%

Types of Risks when Investing in Stocks Market Risk : The Stock Market can (and will) go down

over certain time intervals

Investment Style Risk : The specific types of stocks you invest in can (and will) go down

Manager Risk : the person you have picking your stocks picks bad ones

Expense Risk : The fees you pay cut into your gains

The Million Dollar Question

How do you know how much of my money to put in each type of investment?

Asset Allocation

Your ASSET ALLOCATION is the answer to your million dollar question.

Asset Allocation means what percent of your money is invested in each type of investment.

Ultra Conservative : 100% Cash

0% Bonds

0% Stocks

Ultra Aggressive : 0% Cash

0% Bonds

100% Stocks

What is your personal Asset Allocation

Your asset allocation is based on your risk tolerance, and there is no one size fits all formula

Your risk tolerance is a function of… Your age Your personal risk tolerance Your financial position

Marge:

24 years old. No family yet Has $100 per month to invest

Bill

45 years old Has 14 years until retirement Has $100 per month to invest and already

has $70,000 in his 403(b)(7)

Jane

62 years old Retiring next year Already has $200,000 in her 403(b)(7) Will rely on this money for retirement

income

The General Rule

You should have a number of months worth of emergency money in cash.

The younger you are, the greater percentage of your money that should be in stocks.

The closer you get to needing your money for daily living, the more that should be in bonds and cash

A Balanced Portfolio

A balanced portfolio is one that is adequately spread out within asset classes according to your asset allocation plan.

Asset Allocation Over Time

Most advisors recommend that as you age, you want to adjust you asset allocation to have less in stocks and more in bonds over time.

That way, as you get closer to needing the money, bad years in the market won’t substantially deplete your nest egg

What you want in your Asset Allocation

You want Diversification

Diversification : your assets are spread out within your asset allocation plan

Bad Plan on a 100,000 Portfolio

Stocks 40% Bonds 40% Cash 20%

Stocks: Microsoft $25,000 Wal-Mart $15,000

Bonds: Ford Motor Company Corporate Bonds $40,000

Cash: A 6 month C.D. $20,000

A Better Plan for a $100,000 Portfolio

Stocks 40% Bonds 40% Cash 20%

Stocks: Large Companies $25,000

Medium Companies $10,000

Small Companies $5,000

Bonds: Government Bonds $15,000

Corporate Bonds $5,000

Cash: A 6 month C.D. $5,000 A 9 month C.D. $5,000

A 12 month C.D. $5,000 A 15 month C.D. $5,000

What to Avoid

You want to avoid having too high a percentage of your money in any one place at any one time.

Enron

What a Professional Financial Advisor Does

1. Assess your risk tolerance

2. Set up a diversified portfolio

3. Manage your portfolio over time

Finding your own Asset Allocation

Go to almost any financial companies website and search asset allocation.

Try Vanguard, Fidelity, T.Rowe Price and then compare what each company says.

Google asset allocation, don’t do the ones you have to pay for.

Summary of Part 1

Part 2:Investing in the Stock Market

A Short Course in the History of the Stock Market

Mutual Funds

Purchasing shares of a mutual fund means you are buying shares of many companies at one time

Example of a Vanguard Fund

Why buy Mutual Funds as opposed to buying individual stocks?

Diversify, Diversify, Diversify

The point of buying many companies is to reduce risk, which of course reduces potential gain, but it keeps risk at a manageable level

The two main types of mutual funds

Index : An index is used to decide what stocks to hold in your fund : S&P 500, Wilshire 5000, Russell 2000, Dow Jones

Active : A fund manager, or a team of managers, decides what stocks to hold in your fund

American Fund Managers

Fees and Expenses

Expense Ratio All Mutual Funds charge an expense ratio Some mutual funds charge 12b-1

(advertising) fees Some funds are load funds that have a

sales charge when you either buy or sell fund shares

Lets Compare Two Funds

The Vanguard Small Cap Index Fund

The Trend-Star Small Cap Fund

The Prospectus

Fund Strategies

The strategy of an index fund is to mimic a particular index.

Vanguard 500 Fund

Index FundActive Fund

Who Manages the Fund

Nobody

Index FundActive Fund

Judging Performance

Costs and Fees Index FundActive Fund

Do Expenses Really Matter?

Assume you are going to invest $25,000 in both the Vanguard Small Cap Index Fund and the TrendStar Small Cap Fund for the next 25 years and the average rate of return will be 8%.

David Serchuk and James M. Clash June 5th, 2006 Forbes Magazine

There's a bracing logic to letting your money ride on an S&P 500 index fund. The most celebrated of them, the Vanguard 500 Index, has beaten 60% of all actively managed domestic stock funds over the past ten years. Buying an index fund means giving up on picking a smart money manager. But this saves you money management fees and also spares you the worry that your manager will do much worse than the averages.

My Recommendations for Learning About Investing Subscribe to Money Magazine (and read it).

Read Teach and Retire Rich by Dan Otter available at the www.403bwise.com website

Read the business section every day, especially the personal finance section

Find a friend to take the journey with you