Final Exam Notes - Textbook and Lecture PDF

Portfolio diversification is a better and safer way to invest rather than investing in individual stocks. Diversification reduces the risks of an investment dragging down the portfolio The investments that do not perform well are cancelled out by the ones that do perform well Consider paying...

Portfolio diversification is a better and safer way to invest rather than investing in individual stocks. Diversification reduces the risks of an investment dragging down the portfolio The investments that do not perform well are cancelled out by the ones that do perform well Consider paying off any loans or other outstanding liabilities before investing Your first priority should be to ensure adequate liquidity ◦ Can satisfy liquidity needs by depositing in a financial institution or in a low risk investment such as money market securities or guaranteed investment certificates (GICs) ◦ These types of investments have lower returns because they are focused on providing liquidity ◦ Consider a wide variety of investments if you have additional funds outside of your liquidity needs Types of Investments (asset classes) Money Market Securities Savings alternative Most money market funds provide interest income Low risk Stocks Partial ownership of a company Can be traded in a primary or a secondary market ◦ Primary Market: a market in which newly issued securities are traded ◦ Secondary Market: facilitates the trading of existing securities, allowing investors to sell their securities to other investors. 1 000 000+ shares of any large firm are traded in the secondary market every day on average The first offering of a firm’s shares to the public is known as an Initial Public Offering (IPO). Stock investors can be classified as institutional investors or individual investors. ◦ Institutional Investors: professionals employed by a financial institution who are responsible for managing large pools of money on behalf of their clients (ex. Pension fund) ◦ Individual Investors: individuals that commonly invest a portion of their income in stocks to earn a potentially higher return on their investment so that the money can grow by the time they want to use it. ◦ Portfolio Managers: the employees of financial institutions who make investment decisions, they manage a portfolio of securities including stocks. ◦ Day Traders: individual investors that buy stocks and then sell them on the same day, hoping to capitalize on very short-term movements in security prices. High risk Shareholders can earn returns in addition to dividends if the price of the stock increases by the time they sell it. The market value of a firm is based on the number of outstanding shares of stock multiplied by the price of the stock. The price of the stock is determined by dividing the market value of the firm by the number of outstanding shares of stock. The market price of a stock depends on the number of investors willing to supply the stock and the number of investors wanting to sell their stock. There is no limit to how high a stock’s price can rise If a firm performs well, the stock becomes more desirable to investors The increase in demand and the reduction of the number of shares for sale results in a higher price of stock ◦ The opposite is also true. Investors benefit when they invest in a well-managed firm because the firm’s earnings will usually increase, and so will its stock price. Capital gains = the difference between the selling price of an investor’s stock and its purchase price Common vs. Preferred Stocks Common Stock: a certificate issued by a firm to raise funds that represent partial ownership in a firm ◦ Investors that own common stock typically have the right to vote on key issues, such as the sale of the company and elect board of directors which is responsible for overseeing firm managers Investors who purchase common stock are seeking a return on their investment from stock price appreciation rather than dividend income Preferred Stock: a certificate issued by a firm to raise funds that entitles shareholders to first priority ahead of common stockholders to receive dividend income ◦ The price of preferred stock is not as volatile as common stock and does not have as much potential to increase substantially Investors who purchase preferred stock are seeking a return on their investment from dividend income rather than stock price appreciation Bonds Long-term debt securities issues by government agencies or corporations Government bonds are issued by the Bank of Canada on behalf of the federal government Corporate bonds are issued by corporations Mutual Funds Sells units to individuals and invests the proceeds in a portfolio of investments that may include money market securities, stocks, bonds, or other types of investments A type of pooled investment fund Managed by experienced portfolio managers Attractive to investors who have limited funds and want to invest in a diversified portfolio Publicly Traded Indexes Securities that move in tandem with a particular stock index representing a set of stocks Also known as Exchange Traded Funds (ETFs) because they trade on the stock exchanges like individual stocks Another type of pooled investment Sophisticated investors are unable to outperform various stock indexes on average ◦ Investors can ensure that their performance will be close to matching that index Investors can also invest in specific sector indexes (internet, energy, tech, finance, etc.) as well as market indexes Can achieve a degree of diversification by investing in indexes because indexes represent several stocks Real Estate Includes buying a home Home value increases if demand increases Return on a home is difficult to measure because it takes into account the financing costs, swellings costs, and carrying costs like a mortgage interest and property taxes Return depends on the original down payment on the home, lower with smaller downpayment Value of a home can also decline over time, there is a risk of loss on your investment Can also invest in real estate by purchasing a rental property or land Rental property may include the purchase of additional homes, apartments, office buildings, or other commercial property which can be leased out to generate rental income The sale of these properties may also lead to capital gain or loss based on the supply and demand of similar properties in the area The price of the land is also based on supply and demand, little open land and dense population means higher prices Real Estate Investment Trusts (REITs) An income trust that owns, operates, or finances real estate that produces income A pooled investment fund Some are listed on the stock exchange and their shares can be purchased through a broker in the same way as stocks of corporations Can be purchased with small amounts of money, popular among individual investors Investment Return Individuals typically asses the performance of their investment based on its return. Return From Investing in Stocks Offers ROI through dividend income and stock price appreciation Dividends are usually between 1% and 3% of the stock’s price Firms that pay a high dividend tend to be older, and firms that pay low dividends tend to be younger ◦ This is due to growth potential The stocks of firms with substantial growth potential are referred to as growth stocks ◦ An investment in these younger firms have potential for very large returns because they have not reached their full potential ◦ This can be risky as they are also more likely to fail or experience weaker performance than older firms Value Stocks are another type of investment that offers substantial return ◦ They represent the stocks of firms that are currently undervalued by the market for reasons other than the performance of the businesses themselves ◦ Usually not newsworthy because they are often not associated with up-and-coming younger firms ◦ A knowledgeable investor would recognize this and purchase these shares with the hope that the shares will eventually be recognized by other investors The higher dividend paid by the firm, the lower its potential stock price appreciation ◦ Distributing dividends to shareholders limits the potential growth of the business and its value Income Stocks: stocks that provide investors with periodic income in the form of large dividends Returns From Investing in Bonds Offers return in the form of coupon payments and bond price appreciation Desirable for investors who want their investments to generate a fixed amount of income per year A bond’s price can increase over time and therefore may give investors a capital gain, the difference between the price sold and the price it was purchased for A bond’s price may also decline and lead to a capital loss ◦ Even the prices of treasury bonds decline in some periods Returns From Investing in Mutual Funds Returns occur from dividend and coupon payments May also result in a capital gain or loss Prices of shares may vary over time in response to changes in the values of the securities Returns From Investing in Real Estate Real estate that can be rented generates income in the form of rent payments Capital gains and losses can occur from the sale of a property The price of land changes over time in response to real estate development Individuals may purchase land as an investment, hoping it will appreciate in the future Investments that do not revise any periodic income have returns called the Holding Period Return (HPR) HPR can be even higher if an investor also earned additional periodic income over this time period An investor who receives $1000 in capital gains or dividends will pay less tax than an investor who receives $1000 in interest income. Any of the income from an investment that you save will increase the value of your assets. If the value of your investments increases and your liabilities do not increase, your wealth increases. Risk of Investing The risk of an investment comes from the uncertainty surrounding its return ◦ Future coupon and dividend payments are not guaranteed and its future price is uncertain, rental income might not be paid, etc. Unsystematic and Systematic Risk Unsystematic risk: a risk that is specific to a company, industry, or country ◦ Can be eliminated/reduced through diversification Systematic risk: a risk that affects all companies, industries, and countries ◦ Cannot be avoided Measuring an Investment’s Risk 3 common measures of returns ◦ Range of Returns ◦ Standard Deviation ◦ Beta Range of Returns reviewing the monthly returns of a specific investment over a given period ◦ Smallest to largest return ◦ Smaller range of return means less risk, wide range of return means more risk Standard Deviation of Returns measures the degree of volatility in the investment’s returns over time ◦ larger standard deviation means returns deviate further from the mean over time ◦ An investment with a high standard deviation is more likely to experience a large gain or loss in a given riskier Beta measures systematic risk of an investment relative to the overall stock market ◦ beta of 1 means volatility of investment and its performance will be similar to that of the stock market, beta less than 1 means less than stock market, beta more than 1 means more than stock market Subjective Measures of Risk the 3 measures of risk are not always accurate in predicting future changes in an investment’s price Investors may rely on experts to offer their risk assessments There is a trade-off between risk and return. The rate of return that fully compensates for an investment’s risk is called the Required Return. Real Rate of Return: measures the increase of purchasing power that an investment provides. Expected Inflation Premium: rate of inflation expected over an investments’s life The real rate if return and the expected inflation premium combine to determine the Risk-Free Rate. Any investment that is not risk-free contains a Risk Premium. the higher the risk, the higher the risk premium Smaller firms have more potential for faster growth, and their stocks have the potential to increase in value to a greater degree, though their stocks are risky. More mature firms have less potential for future growth, though their stocks are safer. IPOs are a risky investment and individual inversions often cannot purchase these stocks at their original price as institutional investors usually get to them first. Term deposits allow for fixed returns over a short-term with little risk. Disadvantage of relatively low returns Stable return over a long-term period, invest in a GIC or mutual funds that contain GICs. High returns, invest in land or in high-growth stocks. Asset Allocation: the process of allocating money across financial assets with the objective of achieving a desired return while maintaining risk at a tolerable level 90%+ of a portfolio’s return is due to asset allocation, not the actual selection of investments Building a Portfolio a set of multiple investments in different assets (stocks, bonds, real estate, etc.) ◦ diversification, reduces risk and exposure ◦ even if one investment performs poorly, the others can do well and cancel it out Insider Trading seeking out information that is not publicly available when deciding what to invest in Determining Portfolio Benefits comparing the return on the individual investments to the return of the overall portfolio The volatility of a portfolio is dependant on the volatility of each individual investment’s return, and by the correlation of the returns of each investment The more similar the returns of individual investments in a portfolio, the more volatile the portfolio’s returns are over time. Positive correlation = investment returns move in same direction (+/-) Negative correlation = investment returns move in opposite directions (+/-) negative correlation offers substantial diversification benefits Diversification is especially valuable in poor conditions. Strategies for Diversifying investing in different industries reduces exposure to one specific industry, reduces exposure to unsystematic risk ◦ less risky than investing in different companies in the same industry ◦ Limitations include conditions that affect an entire industry investing in different securities in various countries ◦ makes you less vulnerable to economic conditions in any single country ◦ International mutual funds or ETFs can diversify across different countries and add foreign stocks to your portfolio Asset Allocation Strategies Greater diversification benefits can be achieved by including other financial assets than stocks in your portfolio ◦ returns from stocks and returns from bonds are not highly correlated ◦ Bonds have less risk than stocks, and therefore have lower returns than stocks ◦ More bonds in your portfolio means less stock market risk but more interest-rate risk ◦ Bonds with shorter maturities have less risk to interest rates ◦ More allocation to bonds, less overall risk of a portfolio Asset allocation comes with costs like transaction fees. This can be reduced by investing in pooled investment funds. Constant Weighting Asset Allocation Portfolio is returned to its original asset allocation by selling investments that have increased in value and buying assets that have decreased in value May be adjusted annually or after a major market fluctuation Strategic Asset Allocation Portfolio allocation is adjusted based on shifts in market conditions or expectations Usually made with a long-term perspective Tactical Asset Allocation portfolio asset allocation is adjusted based on short-term expectations A form of market timing that uses sophisticated financial instruments to temporarily adjust your asset allocation to take advantage of short-term forecasts Your ideal asset allocation may not be appropriate for someone else because of your personal characteristics and investment goals (stage in live, risk tolerance, etc.) Investors early in life should invest in safe and liquid securities so they have easy access to funds if needed, or if they do not expect to need the funds they should consider investing in a diversified portfolio If close to retirement, investing in income-producing investments is common. No single asset allocation formula is suitable for everyone. Rule of thumb stocks: 100 - age = % or portfolio should be stock Income Trust Investments a flow-through investment vehicle that generates income and capital gains for investors Similar to mutual funds, investors purchase units of the trust ◦ funds from units used to invest in income-producing assets similar to a stock investment, prices of units will decrease if assets in the trust cannot generate adequate income 4 main categories ◦ Royalty income trusts ◦ Business investment trusts ◦ Utility trusts ◦ Real estate investment trusts Risk Tolerance Low risk tolerance, government bonds with short maturities Moderate risk tolerance, stock mutual funds representing S&P/TSX composite index High risk tolerance, individual stocks Expectations of Market Conditions Expect strong market conditions, may shift proportions to stock mutual funds Expect weak market conditions, may shift proportions to bond mutual funds Expect interest rates to decrease, may shift proportions to bonds with short maturities Expect favourable real estate conditions, may allocate to REITs As time passes, expectations can change. You should change the composition of your portfolio in response to changes in your market expectations, investment goals, and life circumstances. Learning From Investment Mistakes Making unrealistic goals, can lead to major losses Borrowing to invest rather than paying off an existing loan/debt Taking risks to recover losses from previous investments, can lead to even more losses and even bankruptcy If you cannot afford the possible loss, you should not make that investment. Do not adhere to unreliable online investment advice (fraud). Recognize the risk of investing when the market is inflated because of a speculative bubble. Lecture Material Not Included Investing Fundamentals 1. DRIP Dividend Reinvestment Plan, when you automatically reinvest dividends back into the same company you are in the same overall position in the day you buy more shares ◦ remember this when someone tells you that dividend investing is “best” Bonds Bondholders (owners of bonds) do not partake in the profits of the company, they do not make additional money from the company’s good performance ◦ all they get is the interest payments Interest rates go up, bonds go down Interest rates go down, bonds go up Cash is technically an asset class, though cash is often held as a cash equivalent (GICs, Term Deposits, Savings). Buying the dips the most difficult thing to do is knowing when to buy as the market is falling Keep buying Commodities agricultural and resource products (oil, natural gas, wheat, orange juice, etc.) Does not have very good long term track record of earning returns Classifications of Stocks geography: North America, international, emerging markets Size: micro cap (MFs 6. Dollar Cost Average all the time 7. Don’t get off the roller coaster Hedge Funds pooled investment Active returns Goal of generating high returns Limited partnership Accredited investors and require a large initial minimum investment Low liquidity ◦ lock up period: time investors cannot get their money back, 1 year ◦ Withdrawals can also happen only during designated time intervals non-accredited investors can only invest by investing at least 150,000 Accredited investors 25,000 or less Often fail Average fund exists for 5 years Qualifying metrics for Accredited investors net assets 5 million + Income of 200,000+ or 300,000 joint salary Financial assets 1,000,000 alone or joint Brokerage Accounts - How To Actually Invest step 1 is to open a self-directed brokerage account ◦ allows you to buy ETFs and mutual funds ◦ Account can either be a RRSP, TFSA, or a taxable account ◦ Can be associated with your bank, transfers usually instantaneous ◦ Or use another brokerage like Questrade, Wealthsimple, National Bank like brokerage account to bank account Transfer money Buy the investments you want Target Date Funds (TDF) A collective investment scheme designed to provide a simple investment solution through a portfolio who’s asset allocation mix becomes more conservative as the target date approaches ◦ usually retirement Advantages diversification Low minimum investment Automatic rebalancing Simplicity Low maintenance cost Expertise? Disadvantages Bonds Equity exposure, don’t get to choose equity classes High fees Every individual’s goals are different, might not make sense for you Robo Advisors Low cost Low account minimums Attract younger investors Distribution channel, no physical human asks you a series of questions Invest based on your profile Rebalance to stay with your profile Disadvantages bonds before you want them Equity exposure, can’t choose equity classes Computer doesn’t necessarily meant better TFSA vs. RRSP RRSP tax savings saves you more money on withdrawal if your income is larger than your retirement income RRSP tax savings spends you more money if your income is smaller than your retirement income REINVEST YOUR TAX REFUND FROM YOUR RRSP Lowest tax bracket, use TFSA first Second tax bracket, choice is yours Third tax bracket, RRSP first With RRSP Match 1. RSSP 2. FHSA 3. RFSA 4. RRSP Without RRSP Match 1. FHSA 2. TFSA 3. RRSP Buy ETFs in the USA in USD? Advantages greater variety of ETFs in USA Cheaper fees in USA Potentially avoid 15% withholding tax on US dividends Disadvantages subject to fee for converting between currencies (assuming you don’t use Norbert’s Gambit) Don’t worry about exchange rate fluctuations Must understand the difference in reported returns in comparable US and Canadian ETFs Withholding Taxes US investments that pay dividends can avoid income tax on dividends paid to investments held in an RRSP if the ETFs sell on US stock exchanges (except for TFSA accounts) ◦ cannot avoid tax on dividends if you buy ETFs on Canadian exchanges that invest in the US It can be tricky to evaluate returns of comparable ETFs because of different currencies. effectively the same once converted back to CAD Investment Fundamentals 1. To be in the top 1% of income earners globally, you need to earn an annual after tax income of only $60,000 USD. Use our good fortune. 1. Invest wisely 2. Obtain wealth 3. Help others S&P 500 has over 25 million employees that work every day. Why not have them work for you? Why Invest? 1. Make working optional 2. Travel 3. Donate money 4. Buy house 5. Financial freedom  Own all of the boats. Don’t get off the rollercoaster S&P 500 has an annualized average return of about 10%. Buy during dips in the market. Women are statistically better investors because they practice more patience and hold their investments, do not sell as often as men. The best investors are the ones who are dead because they never get off the roller coaster. The second best were the ones that forgot they had investment accounts. Short term rule of thumb keep any money you need to spend in the next 5 years in a high interest savings account. Long term rule of thumb invest all of the rest in the stock market on a consistent basis, no matter if it is up or down