NACUBO Endowment Study
Published on: Mar 3, 2016
Transcripts - NACUBO Endowment Study
Basics of Investing
Louis R. Morrell
Vice President for Investments/Treasurer
Although the economic environment is ever-changing, the basic principles of investing
remain constant. One should avoid the tendency to deviate from those principles in response
to passing fads, hot concepts, and volatile markets. The market (stocks and bonds) goes up
71% of the time. While rising markets benefit most investors, your success will depend upon
what you do during the 29% of the time when the market moves sideways or declines. A
mistake in these periods can be very costly.
One major distinction that an investor must be able to make is the difference between a
market correction and a bear market. For the sake of simplicity, the national press
generally describes a correction as a loss of 10% or more from a stock market high, and a
bear market as any loss of 20% or more. Such a distinction is far too simplistic. In my
opinion, corrections occur when stock prices get too high based on corporate earnings
expectations. Stock prices then begin to fall (or adjust) until they reach a more
reasonable level. In contrast, a bear market begins when basic economic fundamentals
deteriorate which includes such factors as: the rate of inflation, level of interest rates,
state of the economy, rate of unemployment, factory production, consumer confidence,
size of federal deficit, consumer spending, etc. This is a critical distinction, as bear
markets can be severe in terms of loss of market value and they can last for a long time.
Below is a history of recent bear markets for both stocks and bonds:
RECENT BEAR MARKETS - STOCKS RECENT BEAR MARKETS - BONDS
Start of bear market Percent price decline Start of bear market Percent price decline
(in months) (in months)
August 1956 15 -21.6% March 1967 38 -23.0%
December 1961 6 -28.0% March 1971 54 -18.2%
February 1966 8 -22.2% December1976 39 -32.7%
November 1968 18 -36.1% June 1980 15 -27.9%
January 1973 21 -48.2% May 1983 13 -17.1%
September 1976 17 -19.4% January 1987 9 -15.5%
January 1981 19 -25.8% October1993 13 -17.9%
August 1987 3 -33.5% December 1998 13 -14.6%
July 1990 3 -19.9%
March 2000 31 -47.4% Average 24 -20.9%
Average 14 -30.2% Scource: Vanguard Fixed Income Group
Scource: Standard & Poor's Corporation
As noted above, the average loss in value for stock bear markets amounted to 30.2% and it
lasted an average of 14 months. While bonds are considered less risky than stocks, bear
markets also apply to bonds.
When a bear market comes, one must be very patient and resist the temptation to sell at or
near the bottom in an attempt to avoid further losses. Knowing what bear markets are, that
one must expect them, how long they might last, how severe they can be, and that recovery
always follows, better prepares an investor for coping with them.
Stock and Bond Market Valuation Factors
It is important that an investor have a basic understanding of how stock prices and bond
prices are set. Like any product or service, the price represents what a buyer is willing to pay
and a seller is willing to accept at a given point in time.
Stock prices are influenced primarily by a combination of the following factors:
A. Level of Corporate Earnings – The higher the earnings, the more valuable the
corporation and the higher its stock price.
B. Earnings Growth Rate – The higher the earnings growth rate, the more
valuable the corporation and the higher its stock price.
C. Quality of Earnings – Quality means dependability of future earnings. A
corporation that owns a brand name product, or one that makes a unique product
or provides a unique service that is not generally available from competitors, has
earnings considered to be of high quality. A strong competitive position is
considered the single most important characteristic a company can have.
D. Number of Shares Outstanding – The value of the earnings of a corporation
and its assets is influenced by the number of shares outstanding. When a
corporation issues new shares of stock, the price per share falls. When a
corporation buys back some of its shares, the price per share rises.
E. Inflation Outlook – Low or falling inflation increases the price of a share of
stock or bond since its earnings or interest payments become more valuable to
F. Dividend Rates – High or increasing dividends enhance the value of a share of
stock as such dividends in effect reduce the cost of the stock to its purchaser.
One common valuation measure of a stock and the market as a whole is what is known as the
price:earnings ratio. The ratio expresses how much an investor is willing to pay for a dollar
of earnings. For example, a corporation with earnings of $2 per share, whose stock sells for
$50 per share has a price:earnings ratio of 25:1. Thus, in considering the shares of two
different corporations with each other, an investor is able to compare their relative
price:earnings ratios to determine how expensive they are. The same situation applies to the
stock market as a whole. For example, an investor can look at the p:e ratio of all stocks in the
S&P 500 to determine whether stocks are expensive or cheap at any point in time. On a
long-term basis, the price:earnings ratio of the stock market has averaged 16:1.
Bond prices are influenced primarily by a combination of the following factors:
A. Yield of Bond – Generally, the yield of a particular bond relative to the bond
market as a whole influences its price. For example, a bond yielding 6% when
the market is yielding 5% will be more valuable than a bond yielding 5%.
B. Possibility of Default – Bonds of U.S. government agencies are not subject to
default and, on the basis of credit ratings, are more valuable than bonds issued
by corporations. The bond prices of corporations that have deteriorating
financial conditions usually fall which raises their yield.
C. Inflation Outlook – When inflation is low or falling, bond prices rise as the
future interest payments become more valuable in terms of purchasing power.
D. Supply and Demand – As the supply of bonds falls, prices rise as issuers of
bonds are willing to pay lower interest rates. The movement of foreign investors
into and out of the U.S. bond market influences supply and demand as does the
level of issuance activity by the U.S. government and corporations.
Two important factors that must be addressed when considering your future income
requirements are inflation and life expectancy.
Assuming a 4% rate of inflation, the purchasing power value of a dollar would fall, as
Period Purchasing Power
Initial year in retirement $1.00
5 years later $0.82
10 years later $0.68
15 years later $0.56
20 years later $0.46
25 years later $0.38
The impact of inflation is be tied directly to life expectancy (how long the money must last)
Current Expected Number of Years
Age Men Women Couples
55 22.3 27.0 34.4
60 18.5 22.6 29.7
62 17.1 21.2 27.8
65 15.1 18.9 25.0
67 13.8 17.4 23.2
70 12.0 15.3 20.6
It is critical that, in financial planning, one focus on life expectancy and not on the number of
years to the start of retirement. The need for income growth does not end upon entering into
retirement; it continues over one’s lifetime. It should be noted that when two lives are
involved, the life expectancy of one of the two persons surviving increases sharply. This
magnifies inflation risk and the need to take steps to protect against it. Annuities pay lower
annual amounts when two lives are involved as a result of the combined longer life
Inflation has an impact on the value of both one’s principal and the income stream. In a
sense, inflation is the opposite of compound interest as the value of money received is
discounted as time passes. For example, in a period of inflation, with a bond that pays a
fixed rate of interest, the economic value of each coupon payment is worth less than the one
that preceded it. The “rule of 72” is a reliable guide to measure the impact of inflation. It is
based on dividing 72 by the annual inflation rate to determine the number of years it will take
for prices to double. For example, when inflation is at 10%, prices will double in seven years
(72 ÷ 10 = 7), and when it is 4% they will double in 18 years. This is a particularly
worrisome matter for persons in retirement. Those hardest hit by inflation are living on fixed
As you develop a strategy for retirement fund management, future income requirements must
be the first consideration. It is generally assumed that in retirement one will be able to get by
with between 70% to 90% of what was earned in the final year of employment. The percent
of final salary needed in retirement to maintain your standard of living is called the
“replacement ratio.” The ratio is a person’s gross income after retirement, divided by his or
her gross income prior to retirement. For example, assume that a person who earns $70,000
per year retires and receives $50,000 which represents the combination of Social Security and
other retirement income. The replacement ratio would be 72% ($50,000/ $70,000). Usually
one is able to get by in retirement with less income due to the following factors:
1. Social Security taxes do not apply in retirement.
2. It is no longer necessary to set aside a portion of annual income to cover retirement
costs in the future.
3. Work-related costs such as transportation, clothing and meals are reduced.
4. Income taxes are lower in retirement.
5. Social Security benefits are partially or completely tax free which reduces taxable
income and thus income tax liability.
The replacement ratio is intended to let an investor know how much income will be needed in
retirement to maintain one’s standard of living. Although the answer to the above question is
unique to each person, the following results are based on actual data collected from a very
large data base. Thus, one is able to ascertain how his/her projected income compares to what
others are actually receiving in retirement. The following chart shows projected replacement
ratios by pre-retirement income level.
Social Private and
Security Employer Sources Total
($000) (%) (%) (%)
$20 65 24 89
30 56 28 84
40 51 29 80
50 48 29 77
60 43 32 75
70 39 37 76
80 35 42 77
90 33 45 78
Source: Aon Consulting
Let’s look at an example from the above table. For someone with pre-retirement income of
$40,000, it is assumed that in retirement their replacement ratio would be 80%, or $32,000
per year ($40,000 x 80%). Of this amount, Social Security is expected to provide $20,400
($40,000 x 51%). The remaining $11,600 ($40,000 x 29%) is expected to come from private
and employer sources. Therefore, depending on how much your employer contributes, it is
very likely that you will be responsible for a significant portion of your retirement income.
CRITICAL CONCEPTS IN ASSET SELECTION AND MANAGEMENT
Psychology plays a major role in investing which can lead an investor to be his/her own
worst enemy. One must be able to put events into a long-term perspective. This is of
course difficult for those who demand short-term results. Studies have shown that most
people draw limited pleasure when positive things happen to their assets; yet, when
negative things happen they experience unlimited discouragement. This can result in
illogical action to avoid negative situations along with a lack of discipline in carrying out
one’s investment plan.
One requirement for success is open-mindedness. Many people carry psychological bonds or
commitment in a certain asset class (or classes). For example, one might be strongly
attracted to real estate or to stocks of well-known companies. Such a bias, while at times
helpful to the short-term, is counterproductive as it can lead to a loss of objectivity. To
achieve success, all investment alternatives must compete with one another based on
risk:return characteristics. As will be developed later in this document, a key element of a
successful investment strategy is diversification of asset classes. For example, one should
not take the common position that bonds are the only safe investment or that stocks are too
Another undesirable personal tendency is to select only those investments that provide cash
flow return through interest payments or dividends. People with such a tendency equate
results only with in-hand, tangible cash returns. A final personality flaw involves what could
be called a “trader’s mentality.” Such persons attempt to buy low and sell high over
relatively short periods of time – perhaps as short as a single day or week. This can be very
counterproductive. It is much more difficult to predict tomorrow’s price movement of an
investment than it is next year’s. The shorter the period, the more difficult prediction
becomes and the higher the probability of making a costly mistake.
There are four common personality flaws that most people have:
1. Hope – encourages you to hold a stock that was a mistake to buy in the first
2. Boredom – encourages you to sell a good stock that is considered dull.
3. Greed – encourages you to ignore reality and make buying decisions based on
good things that have happened in the past, even though conditions may have
changed, with the expectation that the stock will be sold before its price
4. Fear – encourages you to sell at the first sign of possible trouble out of a
concern that you will lose everything.
Being conscious of common psychological tendencies can help one to protect himself against
basic negative consequences.
Saving vs. Investing
When developing an investment strategy, it is important to recognize the distinction
between saving and investing. Saving is a relatively short-term activity designed to
provide a set dollar amount at some point in the future, usually for a specific purpose
such as buying an automobile. The major goal in saving is to avoid the risk that the
dollar amount objective will not be achieved. That is, a saver is usually willing to give
up much of the opportunity for gain in value to ensure that the desired targeted goal is
reached. Savings should be liquid – easily converted to cash – to be used for such things
as emergencies, college tuition payments, down payment on a home, or a vacation.
Savings are best segregated and not considered part of one’s assets held towards longer-
term needs such as retirement. In contrast, investing is longer-term in nature with the
individual willing to accept more short-term risk in the expectation of achieving a greater
long-term gain. Investing involves a minor emphasis on protecting capital against
temporary losses and a major emphasis on making it grow permanently.
Investment strategy should be reflected in what is known as an investment plan which
contains a combination of the following components/personal characteristics:
1. a permanent capital base – assets that can be assigned (invested) on a long-term basis;
2. an investor with a proper temperament to accept risk, be disciplined, and be patient; and
3. one who has a basic knowledge and understanding of the investment process.
This document is directed toward investing, not saving. Achieving a high investment return
over a longer time period, with an acceptable and reasonable degree of volatility, is the nature
of investing. That is, there will be periods when assets lose value. However, it is anticipated
that short-term losses will be more than offset by longer-term gains. Such a time frame
means that to be successful in accumulating retirement wealth, an investor must have
Active vs. Passive (Indexed) Investing
One fundamental decision that you must make is whether to select “active” or “passive”
management for your retirement fund assets. Passive investing is a strategy of building an
investment portfolio designed to match the returns of a benchmark portfolio such as large
U.S. corporations (represented by the S&P 500), small U.S. corporations (Russell 2000), or
the overall stock market (Russell 3000 or Wilshire 5000). The S&P 500 is the most widely
used index in fund investing. The manager takes no position in attempting to select
individual stocks or bonds; instead, he/she buys them all – both the good and the bad within
the index. Thus, one’s investment returns mirror the overall market. As the market goes up
or down, so too does the value of your investment.
In contrast, active investing is based on a strategy designed to outperform the broad stock and
bond markets. It is assumed that the manager is able to select individual stocks or bonds with
above-average returns – avoiding the poor performers, selecting the good ones, in order to
beat the market. Compared to the index funds, as a group, active equity managers have had
relatively poor performance. At first glance, it may seem odd that portfolios consisting of
carefully researched and selected high-quality companies are not able to beat the stock
market. On closer examination, one must bear in mind that the stock market return
represents the collective results of the decisions of all investors. Thus, in the aggregate,
individual managers cannot beat the market since they are the market.
The S&P 500 was created in 1957 and consists of 500 stocks that include 400 industrial, 40
utility, 20 transportation, and 40 financial issues. The stocks are selected by a committee that
uses size, liquidity, and industry representation as a criterion. It is market-cap weighted
which means that size is a factor in determining how much influence the performance of a
single company has on the index as a whole. The larger the company the greater the
influence its performance has on the performance of the S&P 500. In terms of the total U.S.
stock market, the S&P 500 represents approximately 75% of the value of the whole market.
There are individual active managers who have outperformed an indexed approach on a fairly
regular basis. Historically, however, only about one-tenth of actively managed funds have
been able to do so on a consistent basis.
Indexing works for the following reasons:
1. Stocks in the S&P 500 have had higher average returns than the market as a whole.
2. Index funds have lower costs (generally less than 20% of the cost of active management).
3. Index funds have lower turnover resulting in a savings in transactions expense.
4. The S&P 500 constantly changes to include more successful companies.
5. Index funds are generally more diversified than active funds.
There are market cycles in which many active managers are able to outperform indexes.
When deciding whether to seek active management or to take an indexed approach, one
should focus on the cycle of the market and the ability of a manager to outperform as
indicated by past results. Is the current period one in which active management appears best
and does the manager being considered have a proven record of success in outperforming the
markets in periods like this?
One of the most attractive features of retirement plans is that the contributions made to
them are tax deferred as are the investment gains prior to retirement. That is, federal and
state income taxes are not assessed against the payments made to your retirement fund
through contributions made by the institution on your behalf or by you on a voluntary
basis. This deferral can be seen as a form of retirement-fund-contribution-matching by
the government. In addition, earnings (investment returns) on the retirement fund
balance are also deferred and taxes will not be due until the monies are withdrawn from
the fund in the form of retirement benefits. It is important to realize that the contributions
and gains are tax-deferred and not tax-exempt. Being tax-deferred, all of the money in
your retirement account goes to work upon receipt and begins to earn investment returns.
The greater the retirement fund balance, the greater the level of future benefits. Tax
deferral combined with compound interest, as noted below, can have a major impact on
the level of your retirement fund.
Perhaps the most important and powerful concept in investing is compound interest which
works like magic. It is what links capital growth to time. For example, let us assume that
one were to invest $100 at a 5% earnings rate for a 10-year period. Below is the projected
Year Principal Earnings Compounding Total
1 $ 100.00 $ 5.00 $ --- $ 105.00
2 105.00 5.00 .25 110.25
3 110.25 5.00 .51 115.76
4 115.76 5.00 .78 121.54
5 121.54 5.00 1.07 127.61
6 127.61 5.00 1.38 133.99
7 133.99 5.00 1.69 140.68
8 140.68 5.00 2.03 147.71
9 147.71 5.00 2.38 155.09
10 155.09 5.00 2.75 162.84
As noted above, the total income from the stated earnings rate of 5% amounts to $50.00 over
the ten-year period. However, the annual compounding has provided an extra $12.84 in
return. While that might not seem very much, it does represent 12.84% of the original
investment of $100.
The compounding gets much more significant as the interest rate increases and the period of
compounding is extended. For example, if one were to increase the above earnings rate to
15% and extend the period to 30 years, the original $100 would become $6,621.10 of which
$450 would represent the total of the annual $15 earnings payments and the balance of
$6,071.10 would come from compounding. Therefore, approximately 92% of the fund
balance is the result of compounding.
E ffe c ts o f C o m p o u n d in g a t 1 5 %
$ 7 ,1 0 0 .0 0
$ 6 ,1 0 0 .0 0
Increase in Total
$ 5 ,1 0 0 .0 0
$ 4 ,1 0 0 .0 0
$ 3 ,1 0 0 .0 0
$ 2 ,1 0 0 .0 0
$ 1 ,1 0 0 .0 0
$ 1 0 0 .0 0
0 5 10 15 20 25 30
Y e a rs
The relationship between earnings rate and time required to double one’s investment is
Earnings Period to Double
1% 72 years
3% 24 years
5% 14 years
7% 10 years
9% 8 years
11% 7 years
13% 6 years
15% 5 years
The lessons from this exercise are:
1. Principal grows at a compound rate of earnings.
2. The higher the earnings rate, the higher the return.
3. The faster (more frequent) the compounding, the higher the return.
4. At some point in time, compounding becomes more financially significant than the
base earnings rate in influencing the size of the asset accumulation.
5. The sooner one invests (saves) the greater the financial impact of compounding.
Total Return Concept
In the prior section, reference was made to an interest bearing investment such as a
savings account. That is, in each period, interest is earned and credited – either added to
principal or spent. Any change in the market value of the principal of the fund must
come from the addition of interest income payments or new additions. In contrast,
changes in the value of the principal of a stock fund are the result of what active investors
believe the price of a stock should be, which is reflected in the price of a stock on the
stock exchange. There are thousands of investors (individual and institutional) seeking to
gain from price increases in stocks. They study financial reports, talk to each other, visit
companies, etc. They also consider “investor psychology” which influences share prices
in the short-run. As noted earlier, investing involves a major emphasis on making one’s
principal grow. One critical aspect of investing is an approach known as the “total return
Total return represents the change in market value of an investment as a result of a
combination of interest, dividends, and price appreciation/depreciation. The total return may
be realized (when the assets gaining or losing value are sold) or unrealized (when the assets
gaining or losing value are held). Because dividends and interest payments are more
predictable than changes in share prices, many investors forego the opportunity for financial
gain from appreciation by placing too much emphasis on yield. Some investors buy high-
yielding items which can be very risky but offer little opportunity for growth of principal
value. In selecting investments, it is best to think of “total return” – what you believe to be
the best investment in terms of an opportunity for gain from a combination of price
appreciation and yield.
Owner Or Lender
There are two basic things that one can do with investment assets: lend them to someone
or buy something with them. These alternatives result in two different relationships
between the party issuing a security and the party acquiring it. The person providing the
money is either an investor or a lender. (There is one type of instrument called a
convertible bond which has characteristics of both investing and lending.)
A bond holder is a lender who has a contractual relationship to the issuer of a security. In
return for the use of capital, the issuer agrees to return the borrowed funds at some future date
in addition to providing periodic payments (interest) for the use of the funds (capital). The
best thing that can happen to a lender is that he will ultimately receive all of the interest
payments due plus his original loan amount, as promised. The worst thing that can happen is
default as the lender will not receive his original loan amount and perhaps nor all of the
interest payments that are due to him. Historically, bonds have not performed all that well
over extended periods. Each year they tend to return about three percent more than the
annual rate of inflation. In periods of rising inflation, bond investors have often lost value.
The price of a bond moves in the opposite direction of interest rates, rising when rates fall
and falling when rates rise. An owner is free to sell a bond at any time – at a gain or at a loss.
In contrast, an investor who acquires shares of stock becomes an owner of the company
issuing the stock. As an owner, you are able to share in the success of a company. If its sales
and profits rise, chances are that the share price will go up as well. In addition, you benefit
from the amount of dividends paid to you as a shareholder. Successful companies generally
raise the amount of their dividends over time. While it is true that, for a bond holder,
success, in terms of rising profits, would increase the probability that a lender would receive
his principal back, along with all interest payments due, neither the amount of the principal
nor the level of interest payments would increase as a result of the company’s good fortune.
Thus, while owning a stock is more risky than buying a bond, in the sense that there is less
assurance that one would get his money back, stocks offer a much greater opportunity for
financial gain when a company is successful.
Dollar Cost Averaging
This concept involves investing fixed amounts on a regular basis irrespective of how the
market is doing. Such an approach means that an investor buys more shares when prices
are low and fewer shares when prices are high. It allows one to avoid the risk of
investing a large sum of money at the market top and prevents one from investing a large
amount when share prices are at the bottom. Studies have shown that lump-sum
investing actually leads to higher returns than dollar cost averaging. This results from the
upward bias of stock prices which rise 71% of the time.
In retirement plans, most people use a dollar cost averaging approach since the investment
money comes from one’s salary. Also, such a practice reduces one’s natural fear of buying a
large number of shares just before prices fall. In effect, dollar cost averaging matches the
temperament of most investors.
When an individual has a large sum of money to invest, a hybrid approach to dollar cost
averaging might be considered. It involves investing a large part (say 50%) of the money
immediately followed by a gradual investment of the balance.
In conclusion, if you are seeking the highest return without consideration of risk, use a lump-
sum approach. If you are more concerned about risk and willing to accept a lower return, use
dollar cost averaging.
ASSET CLASS DESCRIPTIONS
Below is a brief description of the most common investment choices.
Money Market Funds, Treasury Bills, and Certificates of Deposit
These instruments provide a very safe investment with always a positive rate of return. The
investment return is directly tied to interest rates. With a money market fund, if rates rise,
income goes up; if rates fall, income declines. Thus, this asset offers some protection against
inflation which moves in the same direction as interest rates. The primary disadvantage is
that the expected return will almost always be lower than stocks or bonds. Treasury bills and
certificates of deposit are very safe in terms of return of principal when held to maturity.
Their relatively short maturities provide protection against rises in interest rates and their net
proceeds can be reinvested at higher interest rates in the near future when they mature.
Bond (Fixed Income) Investments
As noted earlier, a bond is called a fixed income security because it pays a specified
dollar amount of interest on a scheduled basis. For most retirement fund investors, three
types of bonds are considered: corporate, U.S. Treasury, and international. They have
differing maturities: short-term, intermediate, and long-term.
Intermediate bonds usually have maturities between two and ten years. Long-term bonds
have maturities between seven and thirty years. There are also short-term bond funds whose
maturities are usually under three years. They are not recommended for retirement funds
because they do not vary significantly from money market funds in terms of interest
payments while offering less protection than money market funds in the event of rising
inflation and interest rates.
As a general rule, interest rates paid vary according to the maturity of a bond with the longer
the term, the higher the rate. However, if interest rates rise, the value of the principal of a
long-term bond fund will fall to a greater extent than an intermediate bond fund. Thus, one
must decide where to place emphasis – on long-term bonds for higher return or intermediate
bonds for protection of principal.
Corporate bonds are issued by companies and backed by the financial capacity of
the issuer. Corporate bonds are assigned ratings that are intended to measure the
corporation’s ability to meet its obligations of the bond. The highest quality
corporate bonds are called “investment grade.” They are relatively free of risk but
not as safe as U.S. Treasury bonds. To compensate for the slightly higher risk, they
pay higher rates of interest than U.S. Treasury bonds. Some corporate bonds are
backed by specific assets of the issuer which reduces risk as contrasted to other bonds
that are backed by the corporation’s general credit. Corporate bonds that are below
investment grade, and thus subject to a higher probability of default of interest
payments and return of principal, are called high-yield or “junk” bonds. Such bonds
are usually issued by companies with high levels of debt or poor track records of
financial performance (revenue and profits). As such, they are generally not
recommended for retirement funds unless one would want to substitute them for
U.S. Treasury bonds are direct obligations of the United States government and are
considered the safest of bonds. Their safety results in the payment of relatively low
International bonds are issued by foreign companies or foreign governments. The
risk of such bonds is greater than U.S. issues as follows:
• The credit ratings of U.S. government issues are generally higher than those
issued by most foreign countries. The possibility of default on U.S. government
obligations is nil.
• Foreign governments’ securities regulations for companies issuing bonds often
are not a strict as those in the U.S.
• Financial and other information related to foreign issuers of debt often is less
comprehensive than that of U.S. companies.
• There is a currency risk in that even if the issuer pays interest and principal in a
timely fashion, payments made in, yen or euros, etc., could decline in value
relative to the U.S. dollar.
To offset the above risks, international bonds generally provide investors with the
possibility of greater returns than U.S. issues. Currency value fluctuations can work
in favor of as well as against international bond investors. Limited information
available to investors allows knowledgeable analysts to capitalize on inefficient bond
markets. In addition, interest rates (over the longer term) in different markets tend
not to move in the same direction so that a decline in the value of a bond in an
international market (because of a rise in interest rates there) might be offset by a rise
in value of a U.S. bond (where interest rates are falling). The opposite is, of course,
true. Thus, geographic diversification can reduce risk and enhance return.
Unlike bonds, stocks offer no guaranteed return although some do pay dividends. As noted
earlier, stock represents ownership in a corporation. As such it has no absolute value and
its price is dependent upon whether shareholders want to keep it and what other investors
are willing to pay for it. If the company does well or becomes popular, its share price
Stocks come in a number of varieties (styles), as follows:
Income stocks have a history of paying consistent dividends that generally represent
a percentage higher than the overall market. Such shares appeal to investors who
wish to own stocks and desire income.
Value stocks sell for prices that are lower than the market in relation to their
earnings. Their prices also are lower than the market in comparison to the book value
of the company’s assets. They appeal to investors who want price stability with the
opportunity for an increase in value.
Growth stocks have above-average growth rates in terms of sales and profits.
Generally, their earnings are reinvested in the corporation to allow for expansion,
with no or a low level of dividend payments to shareholders. Investors are willing to
pay higher prices and receive little in the way of dividends in the expectation that
share prices will rise, giving them the opportunity to sell them for return in the form
Small Company (Cap) stocks – each company has a market capitalization which is
determined by multiplying the number of shares of stock outstanding by the current
price of a share. Those corporations with capitalizations of $1 billion or under are
considered small cap (company). Most small company stocks fall into the growth
stock class and pay few, if any, dividends. Their rates of growth are generally higher
than large company (cap) stocks since they operate from a smaller asset base.
However, they can be risky in bad economic periods, having fewer resources to fall
Large Company (Cap) stocks have market capitalizations in excess of $5 billion
with a much higher average. They generally have slower growth rates than small
company stocks and often pay dividends to their shareholders. Because of their size,
they are more resistant in difficult economic times than small company stocks. For
this, an investor usually must pay a higher price in terms of cost per unit of earnings
or per unit of assets.
International stocks invest in overseas markets. Such items can provide attractive
returns, as follows:
• the stock rises in price providing a capital gain;
• the company issues a dividend;
• the currency of the country rises in relation to the U.S. dollar so that when foreign
shares (or dividend payments received in foreign currency) are sold and
converted to dollars, there is an additional financial gain.
The opposite is true in that, like U.S. stocks, the price can fall or the dividend can be
reduced or eliminated, and the foreign currency can fall in relation to the U.S. dollar
resulting in a net loss.
International stocks include both developed countries (Europe, Canada, Japan) and
emerging markets (Latin America, Eastern Europe, and Southeast Asia).
RISK MANAGEMENT AND ASSET RETURNS
Understanding investment return is a relatively easy matter. Understanding return as it relates
to risk is much more complicated. By reviewing historical return data one is able to gain a
perspective on the subject.
Simply stated, risk measures both the volatility of how much the value (price) of an
investment can change in the short-term and the predictability of the overall results in terms
of the total return. Since risk and return are correlated to each other, unless one is willing to
accept more risk he will probably not be able to achieve a higher return. Finding a balance
between the two is a major challenge for investors; neither risk nor return should be
considered in isolation.
When thinking about risk, most investors attempt to answer two questions: “What can go
wrong?” and “What are the chances of it happening?” Risk comes in a number of forms, as
Market Risk: the danger that the stock market will fall either through a correction,
which is usually a temporary adjustment of share values, or a bear market in which
prices fall more steeply than a correction and last a long time before recovery begins.
Inflation Risk: the danger that the value of your retirement fund and the income that
it produces will not keep up with inflation, resulting in a deterioration of your
Company Risk: the danger that something bad will happen to a particular company
that represents a major part of your investment portfolio – perhaps a new competitor
comes along, or a law suit is introduced, or reported earnings fall far below
Credit Risk: the danger that the corporation whose bonds are in your investment
portfolio runs into financial trouble and is unable to make interest payments or repay
the principal of the bonds, or both.
Interest Rate Risk: the danger that the general level of interest rates will rise making
your fixed income investments worth less.
The key to risk management is diversification. Simply stated, it is a process that leads to
your portfolio being able to benefit from different investment environments. It is true
that with diversification an investor will always have a return that is lower than had all of
the assets been in those instruments with the highest return, but higher than the result of
having all of your investments in instruments with the lowest returns. Diversification
works because not all investments do well at the same time, nor are they apt to all do
poorly at the same time.
Diversification reduces risk but it cannot eliminate it completely. It is possible for two
different types of assets to move temporarily in the same direction. For example, rising
inflation, which leads to higher interest rates, depresses both stock prices and bond prices.
Another example is when U.S. stocks are experiencing slow growth (or declining in value)
foreign stocks might be going in the same direction. Reducing losses in down periods results
in higher balances being available to benefit from up periods.
Financial assets (stocks and bonds) have three types of risk:
Inflation (purchasing power) Risk
Principal (loss of) Risk
Income (reduction) Risk
The risk:return characteristics of three basic investment alternatives are as follows:
Short-Term Long-Term Common
Characteristic Investment Bonds Stocks
Long-Term Return Probability Low Moderate High
Inflation Risk High Moderate Low
Principal Risk Low Moderate High
Income Change Risk High Low Low
In terms of return by major asset class:
Short-term assets provide long-term returns in line with the rate of inflation. For the
past ten years (ended December 31, 2004) short-term assets have had an annual return
of 4.1%. From 1945 - 2004, the average annual rate of return has been 4.5%. During
the same period, the average annual inflation rate has been 4.0%. Thus inflation has
been consuming approximately 89% of the return.
Bonds provide for returns greater than short-term assets. For the past ten years
(ended December 31, 2004) bonds have had an average annual return of 7.8%. From
1945 - 2004, the average annual rate of return on bonds has been 6.5%. Again, one
must subtract the 4.0% average annual inflation rate to determine growth of
purchasing power. There have been wide swings in terms of bond returns. For
example, in the 1960s and early 1970s, inflation rose sharply causing a fall in bond
values. More recently, with lower inflation rates, bonds have provided much higher
returns. As a general rule, in forecasting bond performance for periods between 8 -
15 years, the best indicator is the yield at the time the forecast is made. For example,
if long-term U.S. government bonds have been yielding between 5% - 6%. Thus, one
could reasonably look to an average annual return of 5.5% for long-term bonds which
is well above their historic rate of return and suggests that bonds may be relatively
attractive as investments in the years ahead. While most investors concentrate on the
yield of a bond, one must also consider changes in price which fluctuate as interest
rates change. This is because bonds carry a fixed, stated rate of interest and the only
way that the market can adjust for the changes in interest rates is by changing the
price (value) of a bond. As interest rates fall, newly issued bonds are less attractive
than older bonds that were previously issued at higher interest rates. So the older
bonds become more desirable and their prices rise. They therefore sell at what is
known as a premium. For example, assume you own a 30-year bond that yields 8%:
If the Yield on The Price of the
the New Bond: Old Bond will:
rises to 9% fall 10%
rises to 10% fall 19%
falls to 7% rise 12%
falls to 6% rise 28%
As noted in the asset description section of this guide, foreign bonds and high yield
bonds offer higher yields than U.S. government bonds. However, they do so along
with higher risk.
Common stocks have historically provided higher returns than short-term
instruments or bonds. For the past ten years (ended December 31, 2004) stocks have
had an average annual return of 12.1%. From 1945 - 2004, the average annual rate of
return (S&P 500) has been 11.9%. Approximately one-half of the return has come
from dividends and the remainder from price appreciation. After adjustment for
inflation, stocks have returned approximately 8% per year. However, they have done
so at more risk (volatility in annual returns) as evidenced by a high annual return of
54% in 1933 and a low, negative return of 43% in 1931. The volatility of returns for
stocks decreases rapidly as the holding period is extended. When considering ten-
year periods (there were 82 of them between 1926 and 2004) there was only one
(1929 - 1938) when stocks did not post a positive return.
To illustrate the volatility of stock prices, the following table shows the best, worst,
and average annual total returns for the U.S. stock market over various periods as
measured by the Standard and Poor’s 500 Index, a widely used barometer of market
activity. (Total returns consist of dividend income plus change in market price.)
Although this example is based on the U.S. stock market, international stock prices
and total returns fluctuate significantly, too. Note that the returns shown in the table
do not include the costs of buying and selling stocks or other expenses that a real-
world investment portfolio would incur.
U.S. Stock Market Returns (1926-2004)
1 Year 5 Years 10 Years 20 Years
Best 54.2 % 28.6 % 19.9 % 17.8 %
Worst -43.1 -12.4 -0.8 3.1
Average 12.4 10.6 11.2 11.4
The table covers all of the 1-,5-,10-, and 20-year periods from 1926 through 2004
By now, you should have an understanding of the basics of investing. To attain
success in investing requires a combination of three elements: a basic understanding
of investing fundamentals, a constant awareness of need for vigilance, and disciplined
self-control. Thus, for the most part, success in your hands.