VIEWS: 9 PAGES: 71 POSTED ON: 5/18/2012
Investment Strategies RICHARD E. MCDERMOTT Disclaimer The information presented is represents my own opinions. I am not an investment advisor and there are many out there who know more than I. This information is not investment advice. The opinions offered may or may not work in your particular situation. Never invest more money than you can afford to lose and seek competent advice before making decisions. Basic Principles Basic Principles No one, regardless of what they say, know the future. People use heuristic and statistical models to predict future economic events but these models assume. The future will be like the past. The model captures all significant variables. These assumptions are not always true. Basic Principles No one, regardless of what they say, know the future. I have seen investment news letter predict that the market is going up in a January edition, predict it is going down in a May edition, and when it goes up make the following statement: “As we predicted in January the market went up . . .” Basic Principles There are a lot of sharks out there. If your investment advisor is so good at predicting the future, why doesn’t he or she spend full time investing their own money and getting rich? Why delete one’s efforts publishing a newsletter? Guess who he wants for dinner? Basic Principles If an investment seems too good to be true it probably is. For a good education on investment fraud, watch CNBC’s “Greed: Scams, Schemes, and Broken Dreams.” One red flag is promises of consistent unusually high returns. Basic Principles Never invest in anything you don’t control This is a personal decision that might not be applicable to all people. Basic Principles Never invest unless you can accurately assess the risk Remember that to play the game of marbles you can’t lose all your marbles. You are better off making a reasonable return over a long time than “making it really big” a couple of times and then losing it all. Basic Principles Don’t trust anyone Do your homework Get the opinion of outside experts Be skeptical Verify what you have been told Establish controls to protect your money Basic Principles Diversify By investment type Stocks, bonds, real estate By degree of risk and expected return By industry Geographically And so on Basic Principles Start early While most of my students don’t have huge sums of money, they have time. We will discuss the impact of compounding of principle and interest in a moment. Get a plan and stick with it. Basic Principles Never invest in anything you don’t understand. Do you homework Ask questions If you don’t understand the answers ask again If you still don’t understand the answers, don’t invest. Basic Principles Have an exit strategy Private stock placement—when will the stock go public Publically traded stocks—when will I take profits, stop losses? Time Value of Money Time Value of Money One of the most effective tools a student (of any major) can learn. A Little Theory . . . Assume we invest a lump sum of $100 in time period Money zero. The interest rate is 10% per year. $300 $200 $100 Time 0 1 2 3 A Little Theory . . . Present value and We let it grow for three future value of a years. Money lump sum. In one year it is worth $100 x 1.10 = $110 In two years it is worth $110 x 1.1 = $121 $130 $133.10 In three years it is worth $120 $121 x 1.10 = $133.10 $100 Time 0 1 2 3 To Illustrate . . . Present value and The first year we make a payment future value of an of $100. That amount grows with Money annuity. interest until we make a second payment which in turn grows with New interest until we make a third Axis payment. $331 At the end of three years we have $331 from the annuity. $300 The future value of 3 payments of $200 $100 at 10% interest per period is $331. $100 Again, we could calculate this from annuity tables or using a financial calculator. Time 0 1 2 3 Let’s apply this to buying a home One of the largest investments people make is the purchase of a home. Financing a home the right way can save hundreds of thousands of dollars and provide funds for other investments as we will soon see. Mortgage A mortgage is a form of annuity Equal payments Equally spaced Payment periods can vary considerably—from ten to fifty years. The typical mortgage today is 30 years. One tip: as mortgage rates go up the payoff period should go down. I will explain why in a moment. Mortgage Payment A mortgage depends upon the following factors: The amount borrowed The time of the loan The interest rate Each of these can be calculated with a business calculator using the following buttons. N I/Yr PV Pmt FV Financial Calculator N I/Yr PV Pmt FV Number of Payments Interest per Year Present Value Payment Future Value The mastery of a financial calculator is an essential skill for any investor. Unfortunately, teaching that skill is beyond the scope of this presentation. Purchase a financial calculator and read the instruction manual or ask for a separate PowerPoint presentation I have prepared. A mortgage payment has two parts Interest which is paid first Principle which is paid second Remember a mortgage has a fixed number of payments of equal fixed amounts paid at equal intervals. Let’s illustrate this . . . Mark Adams wants to finance a $100,000 mortgage with monthly payments for 30 years at 12%* a year (1% a month) Using a financial calculator (or Excel) we determine that the mortgage payment will be $1,028.61. In my life I have seen home mortgage rates as high as 18%. Application of the payment Mark Adams makes his first payment of $1,028.61 on January 1, 2012. Interest is paid first so let’s calculate that. 12%/12 = 1% a month x $100,000 = $1,000. This is what the allocation looks like. Monthly Payment $1,028.61 Less interest to the bank -$1,000,00 Amount applied to the loan $28.61 What! I pay the bank $1,028.61 and only reduce my loan by $28.61! Let’s look at the amortization schedule for the first year Beginning Principal Ending Payment Time Balance Interest Due Principal Due Property Tax Paid Balance Made 1 $100,000.00 $1,000.00 $28.61 0 $0.00 $28.61 $99,971.39 $1,028.61 2 $99,971.39 $999.71 $28.90 0 $0.00 $28.90 $99,942.49 $1,028.61 3 $99,942.49 $999.42 $29.19 0 $0.00 $29.19 $99,913.30 $1,028.61 4 $99,913.30 $999.13 $29.48 0 $0.00 $29.48 $99,883.82 $1,028.61 5 $99,883.82 $998.84 $29.77 0 $0.00 $29.77 $99,854.05 $1,028.61 6 $99,854.05 $998.54 $30.07 0 $0.00 $30.07 $99,823.97 $1,028.61 7 $99,823.97 $998.24 $30.37 0 $0.00 $30.37 $99,793.60 $1,028.61 8 $99,793.60 $997.94 $30.68 0 $0.00 $30.68 $99,762.93 $1,028.61 9 $99,762.93 $997.63 $30.98 0 $0.00 $30.98 $99,731.94 $1,028.61 10 $99,731.94 $997.32 $31.29 0 $0.00 $31.29 $99,700.65 $1,028.61 11 $99,700.65 $997.01 $31.61 0 $0.00 $31.61 $99,669.04 $1,028.61 12 $99,669.04 $996.69 $31.92 0 $0.00 $31.92 $99,637.12 $1,028.61 $362.88 $12,343.35 Note at the end of the year he has paid $12,343.35 in payments but only reduced his loan by $362.88! What if . . . What if the first month, he pays not only his regular payment of $1,028.66 but includes the principle payment of $28.90 for the second month? In that even he will skip from his first payment to his third. He will never pay that second payment of $1,028.61. Not a bad investment—invest $28.90 to save $1,028.68! Beginning Principal Ending Payment Time Balance Interest Due Principal Due Property Tax Paid Balance Made 1 $100,000.00 $1,000.00 $28.61 0 $0.00 $28.61 $99,971.39 $1,028.61 2 $99,971.39 $999.71 $28.90 0 $0.00 $28.90 $99,942.49 $1,028.61 3 $99,942.49 $999.42 $29.19 0 $0.00 $29.19 $99,913.30 $1,028.61 4 $99,913.30 $999.13 $29.48 0 $0.00 $29.48 $99,883.82 $1,028.61 5 $99,883.82 $998.84 $29.77 0 $0.00 $29.77 $99,854.05 $1,028.61 6 $99,854.05 $998.54 $30.07 0 $0.00 $30.07 $99,823.97 $1,028.61 7 $99,823.97 $998.24 $30.37 0 $0.00 $30.37 $99,793.60 $1,028.61 8 $99,793.60 $997.94 $30.68 0 $0.00 $30.68 $99,762.93 $1,028.61 9 $99,762.93 $997.63 $30.98 0 $0.00 $30.98 $99,731.94 $1,028.61 10 $99,731.94 $997.32 $31.29 0 $0.00 $31.29 $99,700.65 $1,028.61 11 $99,700.65 $997.01 $31.61 0 $0.00 $31.61 $99,669.04 $1,028.61 12 $99,669.04 $996.69 $31.92 0 $0.00 $31.92 $99,637.12 $1,028.61 $362.88 $12,343.35 What if . . ? What if, instead of buying that new SUV, he encloses (in addition to his monthly check of $1,028.61) and additional $334.27. He will then skip from his 1st payment to his 13th payment and will never make those 11 payments of $1,026.61 (a total savings of $12,343.32). He will still need to make a payment next month, but it will be the 13th payment. Beginning Principal Ending Payment Time Balance Interest Due Principal Due Property Tax Paid Balance Made 1 $100,000.00 $1,000.00 $28.61 0 $0.00 $28.61 $99,971.39 $1,028.61 2 $99,971.39 $999.71 $28.90 0 $0.00 $28.90 $99,942.49 $1,028.61 3 $99,942.49 $999.42 $29.19 0 $0.00 $29.19 $99,913.30 $1,028.61 4 $99,913.30 $999.13 $29.48 0 $0.00 $29.48 $99,883.82 $1,028.61 5 $99,883.82 $998.84 $29.77 0 $0.00 $29.77 $99,854.05 $1,028.61 6 $99,854.05 $998.54 $30.07 0 $0.00 $30.07 $99,823.97 $1,028.61 7 $99,823.97 $998.24 $30.37 0 $0.00 $30.37 $99,793.60 $1,028.61 8 $99,793.60 $997.94 $30.68 0 $0.00 $30.68 $99,762.93 $1,028.61 9 $99,762.93 $997.63 $30.98 0 $0.00 $30.98 $99,731.94 $1,028.61 10 $99,731.94 $997.32 $31.29 0 $0.00 $31.29 $99,700.65 $1,028.61 11 $99,700.65 $997.01 $31.61 0 $0.00 $31.61 $99,669.04 $1,028.61 12 $99,669.04 $996.69 $31.92 0 $0.00 $31.92 $99,637.12 $1,028.61 $362.88 $12,343.35 Look how little difference in monthly payments a change length of mortgage makes Number of Years Monthly Payment Total Paid 15 $1200.17 $219,090.60 20 1101.09 264,261.60 30 1028.61 370,299.60 40 1008.50 484,08000 50 1002.56 601,536.00 100 1001.01 1,200,012.00 The purpose of this exercise is not to tell you what to do, but to show you how you can determine the impact of different decision options. Let’s Have Some fun Assume there are twin brothers, Fred and Frank They have the same income and the same taste in houses. Dream Home They have purchased the Dream House plans for the same home, a large brick colonial costing $250,000. To simplify calculations assume no down payment, interest rate 8%, and no inflation. Fred’s Decision Fred has to have things NOW!!! He borrows the money and incurs an $1,831.34 monthly payment for thirty years. Frank’s Decision Frank is a little more patient. He has the same money to make a house payment withy. He takes the financial calculator and determines how much house he can buy with the 10 year mortgage for $1,834.41 per month. He buys a modest home for $151,195 Jump Ahead Ten Years Frank Fred Frank’s home is paid Fred has made the for. same payments. He has $151,195 equity He still owes $219,312. in his home, He has $30,688 equity in his home. What Does Frank Do? Frank takes his $1515,195 equity and makes a down payment on the $250,000 home. The remaining mortgage after the down payment is $98,805. He continues making the $1,834.41 mortgage payment each year. We are now 187 months out Frank Fred It takes 67 months (5 Fred still owes $187,966. He has 173 payments still years 7 months) for to make. Frank to retire this new Since Frank no longer mortgage. has a mortgage, payment, he invests the He now owns the big amount he would have home outright. paid each month in the stock market. The historical return on the stock market has been 10% a year. Thirty Years After Initial Purchase Fred Frank Fred finally finishes Frank has the same paying off the 30 year home but in addition mortgage. he has $710,850 in He has the $250,000 savings. home. His total net worth is $980,851. Both have made the same payments. Another Illustration on the Time Value of Money Young couples often believe they don’t have a lot of money to invest for retirement. What they do have, however, is time. The earlier they start, the better. Rob and Rich Fred and Frank have two cousins that resemble them—Rob and Rich. Both are concerned about retirement. Rob and Rich At age 25, Rob makes 5 yearly deposits of $2,000 in a mutual fund earning 12% (remember the current rates are at a historical low). He never makes another deposit. Rich during these years saves nothing. He spends his money on wine, women and song . . . and the rest of it he plain wastes. At the end of the 5th year Rich wakes up, He starts depositing $2,000 a year. Rob and Rich It takes Rich almost 25 years to catch up with his brother. When they both retire at age 65, Rob who has made 6 deposits of $2,000 has $856,957.79 in his savings account. Rob who has made 34 deposits of $2,000 each has $861, 329.69 in his account. How important is time when you are compounding interest? Investing in Real Estate Flipping Houses Money can be made but you must be careful. The popular series “Flip this House” lost more money for people than it made them. To make money you must. Buy at the right price (distressed). Buy at the right location. Only do those things that add significantly to the value of the home. Keep your costs low (doing you own work helps). Rentals Strategy of accumulating rentals works best if you are going to live in one place. They provide a continuous flow of income that can pay off the mortgage. Depending upon the tax code, there may be certain tax advantages. They often appreciate in value over the years. They involve the hassle of being a land lord. If the stock market crashes, you still have your property. Land Some believe that strategic investments in raw land provide higher long-run returns. Identify where the city will grow and buy outside the perimeter. Study future plans for transportation arteries into the city. Land provides no interim cash flow to pay down the mortgage. There are no landlord hassles. Stocks Historically they have outperformed bonds by 3% Since 1930 the average return on stocks has been 19% Our nation has never faced a similar situation as far as national debt is concerned. Forecasting the future using the past may be risky. Most analysts believe that the market is too optimistic, it is not reacting to bad news like the Japan earthquakes and the Libian War. Why? One reason may be that interest rates are so low, that investment houses are being pushed in the market to try and find some kind of return. No country that has printed money to buy down national debt has avoided excessive inflation. Many feel that when the current recession ends, that we may be hit by historically high hyper-inflation. The question is, how will this affect the stock market? Two Investment Models Fundamental Analysis Technical Analysis Depends on the Highly statistically fundamentals of the driven. company. Uses price patterns, Uses earnings and flags, trend lines, ratios like debt/equity ratios. moving averages, and momentum theory. Warren Buffet is a fundamental analysis man. Fundamental Analysis Typically taught in finance courses and in some chapters in accounting textbooks. Looks at the pricing of capital assets, future earnings flows, return on equity, and so on. Different analysts use different tools. Some feel low price earnings ratios are a possible signal to buy. Others feel they are a strong signal to sell. Read “24 Essential Lessons for Investment Success” by William J. O’Neil. Publisher of Investors Business Daily—an excellent newspaper. Prof. McDermott has adopted much of his philosophy. Technical Analysis What does market momentum tell us? If you were standing at a railroad crossing and a train rolled by you at 70 miles per hour, what is the probability you could guess accurately if the train were going to stop in the next 100 yards or so? If you threw a ball into the air, and knew its weight, and present momentum, and a little physics, how accurately could you predict when it would change directions (from up to down)? Technical Analysis Some analysts place significant weight on sentiment indicators. These are gauges of market psychology. Often they will tell you to do just opposite of what you should be doing. Some investors tout contrarianism. “Be fearful when others are greedy and greedy only when others are fearful.” Warren Buffet Some Important Sentiment Indicators Investors Intelligence Advisory Sentiment Index Index of Investor Optimism (can be used as contrarian signal) American Association of Individual Investors Survey Chicago Board of Options Exchange Options Volatility Index And so on. Very Brief Exposure to Technical Analysis Tools Stochastics Popular with futures traders Standard formula uses short time spans The theory is that prices tend to close near the upper end of a trading range during an uptrend. As the trend matures, the tendency for prices to clo9se away from the higher end of the trading range becomes pronounced. In a downward moving market the opposite hold true. Stochastic Indicator The stochastic indicator attempts, therefore, to measure points in a rising trend at which the closing prices tend to cluster around the lows for the period in question and vice versa. Fundamental Analysis Ratios Technical Analysis RYAIX 3/12/2011 %k = (current close-lowest low)/(highest high – lowest low)*100 %D = 3-day SMA of K Moving Average Convergency-Divergence (MACD) Simple but effective momentum indicator. MACD turns two trend-following indicators , moving averages, into a momentum oscillator by subtracting the longer moving average from the shorter moving average. MACD fluctuates above and below the zero line as moving averages converge, cross and diverge. Traders look for signal line crossovers, centerline crossovers, and divergences to generate signals. MACD indicates undersold or oversold Candlestick Charts Intended to show which way stock is going to move. There are dozens of configurations that can be used to predict future market movement. Candlestick Signals Other Sources http://stockcharts.com Technical Analysis Explained by Martin J. Pring Hundreds of other resources on the web Options An option is a contract to buy or sell a specific financial product officially known as the option's underlying instrument or underlying interest. For equity options, the underlying instrument is a stock, exchange-traded fund (ETF), or similar product. Quoted fromo OIC—The Options Industry Council. www.optionseducation.org Options The contract itself is very precise. It establishes a specific price, called the strike price, at which the contract may be exercised, or acted on. And it has an expiration date. When an option expires, it no longer has value and no longer exists. Quoted fromo OIC—The Options Industry Council. www.optionseducation.org Options Options come in two varieties, calls and puts, and you can buy or sell either type. You make those choices - whether to buy or sell and whether to choose a call or a put - based on what you want to achieve as an options investor. Options A call allows you to buy a stock at a future date at a specific price. A put allows you to put a stock to another person at a future date at a specific price. Covered Call Options Strategies: Covered Call The covered call is a strategy in which an investor writes a call option contract while at the same time owning an equivalent number of shares of the underlying stock. Market Opinion? Neutral to Bullish on the Underlying Stock When to Use? Though the covered call can be utilized in any market condition, it is most often employed when the investor, while bullish on the underlying stock, feels that its market value will experience little range over the lifetime of the call contract. The investor desires to either generate additional income (over dividends) from shares of the underlying stock, and/or provide a limited amount of protection against a decline in underlying stock value. Covered Calls $82.00/$5067 = .02 for 38 days or 19% a year return Tyco International The End This is where we will end today, if we continue tomorrow we can discuss other options strategies.
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