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Personal Investing 101

By Curtis Gary Dean FCAS, CFA, ChFC Distinguished Professor of Actuarial Science, Ball State University. Personal Investing 101. You’ve Heard It Before. Information is not new. Repeated again and again. Even so, most of you have no strategy or an inferior strategy.

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Personal Investing 101

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  1. By Curtis Gary Dean FCAS, CFA, ChFC Distinguished Professor of Actuarial Science, Ball State University Personal Investing 101

  2. You’ve Heard It Before • Information is not new. Repeated again and again. • Even so, most of you have no strategy or an inferior strategy. • You can beat most investors by wide margin by following a very simple plan.

  3. Average Annual Returns: 1926-2002

  4. Compound Growth • Stocks: $10,000 x (1.1019)30 = $183,766 • Bonds: $10,000 x (1.0588)30 = $55,516 • T-bills: $10,000 x (1.0379)30 = $30,526 • Stocks may not be quite as dominant in future, but still best bet for long-term growth.

  5. Fundamental Principles • Identify goals and select appropriate investments. • Diversify. • Defer taxes. Keep turnover low. • Keep investing expenses low. Make yourself rich, not the brokers. • Make a plan and stick to it. Do not chase yesterday’s winners.

  6. Identify goals and select appropriate investments • Short-term goals: money market, certificates of deposit, short-term bonds • Long-term goals: inflation-protected bonds, intermediate-term bonds, real estate, stocks

  7. Diversify • Across asset classes: money market, bonds, real estate, stocks • Within asset classes • Bonds: municipal, U.S. govt, corporate, mortgage-backed, inflation-protected • Stocks: industry, company size, value and growth, domestic and international

  8. Defer taxes • Selling securities creates taxable events • Use 401(k) and Roth IRA (if available) • Complications • 15% tax rate on long-term capital gains and dividends • 401(k) and regular IRA distributions taxed at ordinary income tax rates • Use $3,000 capital loss to offset ordinary income

  9. Investment expenses • Mutual fund operating expenses and management fees • Loads • Commissions * • Bid-ask spread * • Market impact * *Harder to identify

  10. Effect of expenses on returns • Average 7% market return for 30 years • If .15% eaten annually by expenses • $10,000 x (1.0685)30 = $72,985 • If 2.00% annual expenses • $10,000 x (1.050)30 = $43,219 • If 3.00% annual expenses • $10,000 x (1.040)30 = $32,434

  11. Selling Magazines • Money, Kiplinger’s Personal Finance, Smart Money, Forbes, Fortune, Business Week, etc. • Range of methodologies • Identifying yesterday’s winners • Buy me • “The 10 Best Funds” • “Annual Mutual Fund Edition” • “Best Funds for Today’s Market” • List of “best” regularly changes: taxes if you switch!

  12. Pretty Efficient Markets • Weak correlation between past and future performance • But, lousy funds tend to remain bad • Trying to beat market -> probably do worse than market because of expenses and chasing trends

  13. Fundamental Principles • Identify goals and select appropriate investments. • Diversify. • Defer taxes. Keep turnover low. • Keep investing expenses low. Make yourself rich, not the brokers. • Make a plan and stick to it. Do not chase yesterday’s winners.

  14. The Magic Bullets: Indexing • Invest in broad indices • MSCI® US Broad Market Index or Wilshire 5000 • Lehman Brothers Aggregate Bond Index • Morgan Stanley REIT Index • Diversified, tax efficient (stocks), and low expenses • Consistently beat most actively managed funds and investors • Use open-end mutual funds or ETFs

  15. Open-end mutual fund vs. ETF • ETF = Exchange Traded Fund • Traded on stock exchanges • Arbitrage opportunities keep prices in line with indices • Usually lower expense, but must pay commission • Open-end mutual fund • Your deposits used to purchase more stock for fund

  16. Examples: Annual Expense Ratios ETFs • Vanguard Total Stock Mkt VIPERS: 0.07%* • Vanguard REIT VIPERS: 0.12% • iShares MSCI EAFE Index: 0.35% Open-end Mutual Funds • Vanguard Total Stock Mkt Adm: 0.10% (0.19%) • Vanguard REIT Index Adm: 0.16% (0.21%) • Vanguard Total Int’l Stock Index: 0.31% *Average stock fund has expenses more than 25 times greater!!

  17. Total Stock Market Index

  18. Sample Portfolio for 40 year old • 47.5% - Vanguard Total Stock Mkt Index • 17.5% - Vanguard Total Int’l Stock Index • 5.0% - Vanguard REIT Index • 15.0% - Vanguard Total Bond Mkt Index • 15.0% - Inflation-protected bonds

  19. One Stop Shopping

  20. Personal Investing 102 • “Value stocks” produce higher returns over time • Low: Price/Book Value • Low: Price/Earnings • Reasonable dividends • “Value and Growth Investing: Review and Update,” by Louis K.C. Chan and Josef Lakonishok, Financial Analysts Journal, Vol. 60, No. 1

  21. Add Low Cost Value Funds to Mix • 30.0% - Vanguard Total Stock Mkt Index • 12.5% - Vanguard Value Index • 5.0% - Vanguard Small Cap Value Index • 10.0% - Vanguard Total Int’l Stock Index • 7.5% - Dodge & Cox Int’l Stock (.77%) • 5.0% - Vanguard REIT Index • 15.0% - Vanguard Total Bond Mkt Index • 15.0% - Inflation-protected bonds

  22. Tax Efficiency • Put REITS and bonds in tax-deferred accounts • Consider municipal bonds (funds) outside of tax-deferred accounts

  23. Recommended Reading • A Random Walk Down Wall Street by Burton Malkiel • The Four Pillars of Investing by William J. Bernstein • Common Sense on Mutual Funds by John C. Bogle • Winning the Loser’s Game by Charles D. Ellis • The Future for Investors by Jeremy J. Siegel • The Intelligent Asset Allocator by William J. Bernstein • Master and use what’s in these books and you will beat most professional money managers

  24. Resources • Online mutual fund research (free) • www.moneycentral.msn.com • Library • Stocks: Value Line Investment Survey ($598) • Funds: Morningstar Mutual Funds ($549)

  25. One Last Time: Fundamental Principles • Identify goals and select appropriate investments. • Diversify. • Defer taxes. Keep turnover low. • Keep investing expenses low. Make yourself rich, not the brokers. • Make a plan and stick to it. Do not chase yesterday’s winners.

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