BUSF 51 – RETIREMENT PLANNING AND INVESTING
LECTURE #4 - INVESTING FOR RETIREMENT
ASSET ALLOCATION
There are 4 “asset classes” or investment choices:
· Cash and cash equivalents
· Fixed income securities (bonds)
· Stocks (equities)
· “Hard” assets, such as gold, artwork; not addressed in this class.
The risks of each financial investment are discussed below.
Cash and cash equivalents
These consist of bank savings and certificate of deposit (“CD”) accounts, and money market accounts. The risk to your principal is very low. The return on these investments is also very low. Currently, the return on one-year CD accounts will not even keep pace with inflation. So, cash and cash equivalents carry inflation risk—the possibility that you will not earn enough money to offset increases in cost of living.
Fixed income (bonds)
By purchasing bonds you are loaning money to either a governmental or corporate entity. You will usually earn a higher interest rate than offered by cash-type investments. Traditionally, bonds issued by the U.S. government have yielded 2 to 3% above the inflation rate.
Investments in bonds carry two types of risks:
· Credit risk: the risk that the borrower will not be able to repay the interest or principal back to the investor (bondholder). This risk is usually not associated with bonds issued by the U.S. federal government. It is a risk associated with local governments (think Orange County, early 1990s) and corporations (think WorldCom, 2002).
o FAQ: How can we mitigate (reduce) credit risk? There are two bond-rating services, Moody’s and Standard and Poor’s (“S&P), which “grade” a borrower’s ability to repay debt. For example: an S&P rating of AAA, AA, A, or BBB, would be considered “investment grade.” Anything below BBB would be considered high-risk. Look at the bond issuer’s rating before buying the bond.
· Interest rate risk: as interest rates rise, the value of existing bonds falls. Conversely, as interest rates fall, the value of existing bonds increases. Bonds with longer maturities (the amount of time left until the bond is repaid) have higher degrees of interest rate risk than bonds with shorter maturities.
Stocks (equities)
By investing in stocks you are a part owner of a company. The average rate of return on investments in stocks has been 6% above inflation since 1946. Investments in stocks carry both business risk and market risk.
o Business risk: the risk that the corporation you own stock in will suffer a decrease in business, lose money, and that the value of the stock you own will decline.
o Market risk: the risk that the stock market in general will decline and that most stocks will suffer losses.
Investments in stocks offer the greatest possibility of high returns and the greatest possibility of losses—especially in the “short term.”
o FAQ: Is there any way to diversify my investments in stocks if I don’t have a lot of money to invest? Yes. You can buy shares in a mutual fund. A mutual fund is a corporation, run by an investment adviser. The investment adviser selects the stocks to buy or sell. By owning shares in a mutual fund, you have indirect ownership of the stocks owned by that mutual fund.
Asset Allocation
So, how much of your “portfolio” (investments) should be put into stocks, bonds and cash? This depends on two key factors:
o Time horizon—when do you need the money?
o Risk tolerance—can you tolerate short-term losses in equities?
o For example, let’s say you’re investing to save a down payment for a house. You want to buy a house in three years. Would it be wise to invest that money in stocks? Most investment advisers say NO—the stock market can suffer huge losses in a short amount of time.
o What if you are saving for a 3-year old’s college fund? Most investment advisers would advise investing most of the money in stocks for the possibility of higher returns over time.