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PDF Editor FAQ

Do you use a financial adviser and what do you invest your personal money into?

I don’t use any one particular financial advisor. I do rely upon advice, and ask questions of, my CPA and the CFPs who work at Northwestern Mutual Life and Vanguard. I like Janus Henderson, T. Rowe Price, and Franklin Templeton, too.I no longer trust Fidelity and am on the verge of filing a complaint with FINRA.Personal money is invested in a combination of large-cap and small/ medium-cap funds, international bond funds, municipal bonds, minor holdings of individual stocks, and cash savings in money markets and CDs.

What are the most basic financial concepts that everyone should learn? I’m 25 and a medical student. I want to know more about finance in a broad sense. What are some essential concepts I should know about? Any blog or website recommendations?

I am currently putting together a small primer for the same on the UoQ blog. 3 chapters have been complete; more in the coming days.Structure:Chapter 1: The "risk-return tradeoff", and the need for diversificationChapter 2: The time value of moneyChapter 3: Investment criteria (NPV, IRR, Payback), and Capital rationing1. Chapter 1: The "risk-return" tradeoffFour of the most common words/phrases in Finance are interlinked. You will find people from all walks of the Financial world - be it traders, brokers, investment analysts, wealth managers, insurance agents - talking about risk, return, risk-return tradefoff, and diversification.Basic definitionsRisk: Risk is negative. It is the potential loss that can occur when you undertake any initiative. It is the uncertainty in the expected outcome of your initiative.Risk is everywhere - you risk losing all your savings if the bank goes bankrupt, or if the price of your property suddenly plummets due to a bubble burst, or your startup fails costing you your entire capital and time invested till date.Usually, instruments backed by governments (bonds, T-bills) or by large corporations (like stocks, savings accounts) are low on risk.Risk is usually measure using Standard deviation of the portfolio return.Return: Return is positive. It is the reward you get for your efforts.It can be the interest you earn from your deposits in a savings account, the dividend from a stock, the capital gain from selling a property at a price higher than you purchased it for.Risk-return trade-off: The relationship between risk and return is a fairly simple direct relationship.The higher the return desired, the higher should be the risk appetite. If there was an option where the risk was low for a high-return investment opportunity, everyone would flock to it, thus driving up its demand and lowering the return.(For relationship between supply, demand, and price, see: Supply and Demand)Basically, "no pain, no gain".Diversification: Diversification is the finance way of saying "Do not put all your eggs in the same basket".If you invest in a single financial instrument (security, stock, bond, derivative), you risk losing all your investment. However, with judicious selection of different investment vehicles and allocating your funds in an optimal manner, you can maximize your returns without increasing your risk or exposure.Portfolio: A portfolio is nothing but a collection of your various investments.So if you have $100 and you put $40 in your savings account, buy $30 worth of a 10-year bond, and buy Google stocks worth the remaining $30, those 3 will comprise your portfolio.Measuring riskLet's play a game. You invest $100. You roll a dice; based on the outcome, you get/lose some money.Roll 1: Lose 10%Roll 2: Get 20%Roll 3: Lose 30%Roll 4: Get 40%Roll 5: Lose 50%Roll 6: Get 60%Since the chances of each are equal (=1/6), the expected return (or payoff) is just a probability-weighted average.= [math] 1/6*(-10+20-30+40-50+60) [/math]= 5%However, the risk is the standard deviation,= [math] \sigma = \sqrt{\frac{1}{6} {\sum(r(e)-r(i))^2}} [/math]= [math] 38.62% [/math]The same method can be used for calculating the return and risk of any asset.Consider you invested 100 rupees in a stock on Jan 1, 2010. The value of the stock now (as of Jan 1, 2015; 5 year period) is 150. Moreover, the below is the returns on the 1st of January each year starting 2010.Jan 1, 2010: 100Jan 1, 2011: 110Jan 1, 2012: 115Jan 1, 2013: 130Jan 1, 2014: 145Jan 1, 2015: 150Since returns are compounded, you can use the formula to calculate the rate of return:[math] a*(1+r)^n = A [/math]where,a = initial investment = 100r = rate of returnn = number of years (or time periods)A = final value = 150[math] 100*(1+r)^5 = 150 [/math][math] (1+r) = \frac{150}{100}^\frac{1}{5} [/math][math] (1+r) = 1.0844 [/math][math] r = 0.0844 = 8.44% [/math]This is the average rate of return. However, the individual rates are not the same.2011: 110/100 = 10%2012: 115/110 = 4.55%2013: 130/115 = 13.04%2014: 145/130 = 11.54%2015: 150/145 = 3.45%The risk (variance) is:= [math] \sigma = \sqrt{\frac{1}{5} {\sum(8.44-r(i))^2}} [/math]= [math] 3.83% [/math]Note: Until you invest in an asset that guarantees a fixed return (fixed deposit etc), the return is never guaranteed. Most of the times, it is derived by extrapolating the historical data, and correcting it with intelligent assumptions regarding the future trajectory.Calculating the return risk of a portfolioIn the earlier section, we learnt how to calculate the risk of a single financial asset. Calculation of the risk of a portfolio containing multiple assets is slightly more complicated.Consider the following portfolio:Total = $100$30 - Facebook stocks - (expected return, risk) = (15%, 25%)$70 - Google stocks - (expected return, risk) = (12%, 20%)The expected return of the portfolio is simply a weighted average of the expected returns of the two investments.= [math] 0.3*15% + 0.7*12% [/math]= [math] 12.9% [/math]The risk however, is again slightly more complicated and is given by the formula:[math] \sqrt{(x^2*A^2) + (y^2*B^2) + 2*(x*A*y*B*{\rho})} [/math]where,x and y are the percentage share of the two stocks in the portfolioA and B are their respective risksand [math]\rho[/math] is a variable called covariance coefficient.Covariance coefficient is nothing but the degree of interdependence between the two assets. For example, if you buy stocks in 2 oil companies, there will be a high degree of covariance as they are both in the same industry and their prices might move in tandem (to the degree to which the prices are influenced by external factors, which will remain more or less same for both the companies).Covariance coefficient lies between -1 and 1. -1 for assets whose prices move completely in opposite directions (increase in 10% in one leads to decrease in 10% for another), 0 for assets whose prices are independent, and 1 for assets whose prices move in tandem in the same direction.Since Facebook and Google are both in the technology space, there covariance coefficient will be between 0 and 1 (let us say 0.4).Risk of portfolio:= [math] \sqrt{(0.3^2*25^2) + (0.7^2*20^2) + 2*(0.3*25*0.7*20*0.4)} [/math]= [math] \sqrt {336.25} [/math]= [math] 18.33% [/math]Modern portfolio theoryJust because you are willing to take more risk, does not mean that you will get higher returns. You can make a really stupid choice and invest in send money to The Nigerian Prince in hopes of receiving a multi-million dollar inheritance or promise of royalty, but that would not be a sound business decision.Modern Portfolio Theory attempts to maximize your returns for a certain level of risk you are willing to undertake.Consider the following portfolios (each dot represents one portfolio, and can be identified using just 2 parameters (expected return (y-axis), and risk (x-axis)).As you can see, the ones in the red represent sort of a boundary, or a limit. All the portfolios in red are Pareto-optimal portfolios. That means, for that amount of risk, they give you the best return.(to see this, just draw any line perpendicular to the x-axis, and see that the highest point it touches along the y-axis is the pareto optimal portfolio (highest return).A broader discussion is out of the scope of the current exercise.Diversification - what it means, and why is it needed.Diversification is nothing but spreading your investments across asset classes, industries and geographies, to disperse your risk.If you invest in a Saudi oil company, a US tech company, and a Japanese bank, you have shielded your investments both in terms of industry and geography. Political turbulence in Saudi won't affect the other two stocks; similarly a tech bubble burst will have little effect on the other two.To diversify, you will need to create a portfolio of stocks with 0 or negative covariance coefficient. Also, using the Modern Portfolio Theory, you can optimize your portfolio to get the best return.Example (from: Investing 101: How Diversification Reduces Risk)Let’s look at the returns of three mutual funds from 30 June 1989 to 30 June 2009: The Fidelity Intermediate Bond Fund (FTHRX), which holds bonds that mature in five or so years; the Vanguard 500 (VFINX), which very closely mimics the performance of the Standard & Poor’s 500 index of large U.S. stocks; and the T. Rowe Price International Discovery Fund (PRIDX), which invests in small companies from all over the world.We can make a few observations about these returns:Compounding is cool. Even by just earning approximately 6% a year, the initial investment more than tripled over two decades. Earn a bit over 9%, and you could almost sextuple your investment (and have fun saying “sextuple” to your friends).Higher return comes with higher risk. Yes, the T. Rowe Price fund posted the best long-term performance, but its worst years were really worse.You don’t always get that higher return. While the Vanguard 500 beat the Fidelity bond fund, that was due to the extraordinary returns of stocks in the 1990s. Over the past decade, U.S. large-company stocks actually have lost to bonds. (In fact, as I wrote over at The Motley Fool, the return on such stocks from 1999-2008 was even worse than the 10-year returns during the Depression.)Earning a little bit more can lead to big bucks. The annualized return of the Vanguard 500 was just 1.52% more than the annualized return on the Fidelity bond fund. Yet the difference in the amount $100,000 grew to after 20 years was huge; the Vanguard 500 earned an extra $108,568, 33% more than what an investor earned in the bond fund. I’ve said it before, and I’ll say it again: That’s the power of earning a little bit more — or paying a little bit less — over the long term. (It is pure coincidence that the difference between the returns of the two funds, or 1.52%, is very close to the average expense ratio charged by actively managed mutual funds. But it’s a telling illustration: If you’re paying that much annually to invest in a mutual fund, but not getting superior results in return, you could be giving up tens of thousands of dollars.)Investing one-third of the portfolio into each of those funds and rebalancing annually. What do you think the annual return would be?You might pick a number that is the average of the annualized returns on those funds, which would be 7.67%. But here are the actual numbers:Well, looky there. You got a return that beat the arithmetic average of the three returns. It significantly outperformed the S&P 500, and it did so with a lot less volatility (as indicated by its worst years not being as bad). By owning assets that move in different directions at different degrees and at different times, along with some regular rebalancing, you get a return that beats the average returns of the investments in the portfolio. The whole is greater than the sum of its parts.2. Chapter 2: The time value of money"A dollar today is worth more than a dollar tomorrow"The above statement portrays one of the basic sentiments of Finance, also called the "Time value of money".It basically has to do with the Opportunity cost of investment. If given the choice to take $100 now vs $100 a year later, you should always go for the 1st option. Because then you can invest the $100 for a year in your bank account which pays 5% interest per year, and the end of 1st year, you will have $105.Basically, even if offered a choice between $100 now vs $104.99 a year later, go for the 1st option (given that the Risk-free interest rate is at least 5%).A. Future value (FV)Suppose you have [math] $X [/math] right now. What will be the value of your investment [math] n [/math] years later?Assume that the risk-free interest rate is [math] r% [/math] (and is constant). The FV of your investment after [math] n [/math] years is [math] $Y [/math].Taking the compound interest formula,[math] Y = X(1+r)^n [/math]A general formula will be:[math] Y = X(1+r_1)(1+r_2)(1+r_3)..(1+r_n)[/math]where [math](1+r_i)[/math] is the risk free interest rate in the [math]i^{th} [/math] year.All of the above is obviously assuming annual compounding.If interest is compounded continuously, the formula becomes,[math] Y = Xe^{(nt)} [/math]B. Present value (PV)The same formula can be tweaked to get the PV of any future cash flows from investments.B.1. Single cash flow in future:Taking the same example as above, suppose you get [math] $Y [/math], [math] n [/math] years from now, and [math] r [/math] is the risk-free interest rate, the PV of the cash flow is:[math] X = \frac{Y}{(1+r)^n} [/math]B.2. Series of equal cash flows:Suppose you have leased your house for [math] n [/math] years and you will be getting [math] $Y [/math] per year. The PV of the total [math] n [/math] cash flows will be:[math] X = \frac{Y}{(1+r)} + \frac{Y}{(1+r)^2} + \frac{Y}{(1+r)^3} + ... + \frac{Y}{(1+r)^n} [/math]Which is nothing but an geometric progression with multiplier = [math] \frac{1}{1+r} [/math][math] X = \frac{Y}{(1+r)} \frac{(1-\frac{1}{(1+r)^n})}{1-\frac{1}{(1+r)}} [/math][math] X = Y(\frac{1}{r} - \frac{1}{r(1+r)^n}) [/math]B.3. Series of cashflows (not equal):A more general formula that considers different cashflows, [math]C_1[/math], [math]C_2[/math], ... , [math]C_n[/math] and different rates of return [math]r_1[/math], [math]r_2[/math], ... , [math]r_n[/math] for the n periods is:[math] X = \frac{Y_1}{(1+r_1)} + \frac{Y_2}{(1+r_2)^2} + \frac{Y_3}{(1+r_3)^3} + ... + \frac{Y_n}{(1+r_n)^n} [/math]C. Perpetuities and annuitiesThe example in B.2. is what is called an annuity.A perpetuity is a special case of an annuity that pays a fixed sum every year for eternity.which is nothing but,[math] X = Y(\frac{1}{r} - \frac{1}{r(1+r)^n}) [/math][math] X = \frac{Y}{r}(1 - \frac{1}{(1+r)^n}) [/math]with n [math] \rightarrow \infty [/math]Now as n [math] \rightarrow \infty [/math] , [math]\frac{1}{(1+r)^n}[/math] [math] \rightarrow [/math] [math] 0 [/math]So, we get[math] X = \frac{Y}{r} [/math]Interesting observation: An n-year annuity is nothing but the difference between two perpetuities, one starting right away, and one starting from [math](n+1)^{th}[/math] year.Proof: A perpetuity starting from year 1 is given by:[math] X = \frac{Y}{r} [/math]So a perpetuity starting from year (n+1) is given by.[math] X = \frac{Y}{r(1+r)^n} [/math]Diff of the two is:[math] X = \frac{Y}{r} - \frac{Y}{r(1+r)^n} [/math]which is nothing but the annuity formula from B.2.For more details, check out: Present value, Future value, Principle of value additivity, Net present value, Perpetuities and annuitiesD. Growing PerpetuitiesTakingthe same example as in B.2, with one exception:The payout increases at the rate [math] g [/math], where [math] g. The formula for this perpetuity is: [math] X = Y\frac{(1+g)}{(1+r)} + Y\frac{(1+g)^2}{(1+r)^2} + Y\frac{(1+g)^3}{(1+r)^3} + ... [/math]or, [math] X = \frac{Y}{(r-g)} [/math]Of course, if [math]g=r[/math], or [math]g>r[/math], the series is an infinite, non-converging series, that does not have a sum.E. Problems and other resourcesPage on westga.eduPage on econ.yorku.caPage on jmu.eduPage on uncw.eduPage on csun.edu3. Chapter 3: Investment Criteria and Capital RationingThis chapter will deal with investment decisions, i.e., how and when to say YES or NO to a proposal. There are many ways to evaluate the same.A. NPV (Net Present Value)In the previous chapter, we saw that the PV of a series of cashflows is given by:[math] X = \frac{Y_1}{(1+r_1)} + \frac{Y_2}{(1+r_2)^2} + \frac{Y_3}{(1+r_3)^3} + ... + \frac{Y_n}{(1+r_n)^n} [/math]While investing, you will have to put in money at the beginning of the venture. This is a 'negative' cash flow for you.So,[math] NPV = Y_0 + \frac{Y_1}{(1+r_1)} + \frac{Y_2}{(1+r_2)^2} + \frac{Y_3}{(1+r_3)^3} + ... + \frac{Y_n}{(1+r_n)^n} [/math]Where [math]Y_0[/math] is the initial investment that you need to make, and will be negative.Investment criteria:[math] NPV > 0 [/math]Example: (from: Net present value (NPV) method)The management of Fine Electronics Company is considering to purchase an equipment to be attached with the main manufacturing machine. The equipment will cost $6,000 and will increase annual cash inflow by $2,200. The useful life of the equipment is 6 years. After 6 years it will have no salvage value. The management wants a 20% return on all investments.We have:[math] Y_0 = -$6000 [/math][math] Y_i = $2200 [/math][math] n = 6 [/math][math] r = 20% [/math][math] \therefore NPV = -6000 + \frac{2200}{1+0.20} + \frac{2200}{(1+0.20)^2} + ... + \frac{2200}{(1+0.20)^6} [/math]= [math] 1,317 [/math]which is [math] >0 [/math]Hence, the investment is a sound decision.Notice the term, salvage value. In this case it was 0; however, in most normal day cases, you can salvage some amount by selling the equipment at the end of its lifecycle.In this case, the NPV will increase by an amount,[math] \frac{Y_s}{(1+r)^n} [/math]where, [math] Y_s[/math] is the salvage value.B. IRR (Internal rate of return)Definition: IRR or The DCF (Discounted Cash Flow) rate of return is the rate at which the NPV of the project becomes zero, i.e.[math] NPV = Y_0 + \frac{Y_1}{(1+r_1)} + \frac{Y_2}{(1+r_2)^2} + \frac{Y_3}{(1+r_3)^3} + ... + \frac{Y_n}{(1+r_n)^n} =0 [/math]Calculation of NPV is a slightly tricky method. It is usually done by trial and error. You have the cashflows, you take a good guess for the IRR and calculate the NPV. If the NPV > 0, the actual IRR should be greater than your guess (and vice-versa). Repeating this process will narrow down the range of your IRR.Investment criteria:[math] IRR > (Opportunity cost of capital) [/math]However, IRR, as a method also has some drawbacks:#1. It can give results that directly conflict with the NPV method.From: Advantages and Disadvantages of the NPV and IRR MethodsAssume once again that Newco needs to purchase a new machine for its manufacturing plant. Newco has narrowed it down to two machines that meet its criteria (Machine A and Machine B), and now it has to choose one of the machines to purchase. Further, Newco has assumed the following analysis on which to base its decision:Figure 11.6: Potential Machines for NewcoAnswer:We first determine the NPV for each machine as follows:NPVA = ($5,000) + $2,768 + $2.553 = $321NPVB = ($10,000) + $5,350 + $5,106 = $456According to the NPV analysis alone, Machine B is the most appropriate choice for Newco to purchase.The next step is to determine the IRR for each machine using our financial calculator. The IRR for Machine A is equal to 13%, whereas the IRR for Machine B is equal to 11%.According to the IRR analysis alone, Machine A is the most appropriate choice for Newco to purchase.The NPV and IRR analysis for these two projects give us conflicting results. This is most likely due to the timing of the cash flows for each project as well as the size differential between the two projects.#2: There can be multiple rates of return for a single project.This happens when there is a combination of outflows and inflows during the lifetime of the project (a common scenario).From: Internal Rate Of Return Unconventional cash flows are common in capital budgeting since many projects require future capital outlays for maintenance and repairs. In such a scenario, an IRR might not exist, or there might be multiple internal rates of return. In the example below two IRRs exist - 12.7% and 787.3%.This is due to the fact that there are more than 1 sign change (once from -ve to +ve (Year 0 - Year 1) and then from +ve to -ve (Year 1 - Year 2).As a rule of thumb,total number of sign changes = number of rates of returnFurther reading: Internal rate of return: A cautionary taleC. Payback PeriodPayback period is the number of years in which the initial investment is recovered via the cash flows from the project.It is fairly simple to calculate.Consider the example above:[math] Y_0 = -$6000 [/math][math] Y_i = $2200 [/math]The cash flow after year 3 will be [math] 2200*3 = 6,600 [/math], which is greater than the initial investment of [math] 6000 [/math].Hence [/math] Payback_period = 3 [/math]which is [math] <4 [/math], and hence the investment is a sound one.Investment criteria:[math] Payback\:Period < N [/math]where [math] N [/math] is the cutoff decided by the firm or the individual. For example, if a company wants all of its investments to breakeven before 4 years,[math] N = 4 [/math]Discounted payback:In calculating payback period, we only considered the cash flows; however, we must discount them at the appropriate rate of return. Since the company decided on 20%, we will use that:The discounted cashflows are:[math] Y_i = \frac{2200}{(1+0.20)^i} [/math]or [math] 1833.33, 1527.78, 1273.15, 1060.96, 884.13, 736.77 [/math]Now after year 3, total discounted cash flow is [math] 4634.26 [/math] which is [math] < 6000 [/math]After year 4, it is [math] 5695.22 [/math], still less than the initial investment. Only after year 5, does it exceed [math] 6000 [/math] ( [math] 6579.35 [/math]).So, [math] Discounted\:Payback\:Period = 5 [/math], which is [math] >4 [math].Hence, the investment should not go forward.D. Capital rationingYou always do not have enough money to invest everywhere. The same is the case with companies.Definition: Capital rationing is the process of allocating your limited resources in a way to maximize the return (optimal allocation problem).From: Capital Rationing ExampleAn Example: (Firm’s Cost of Capital = 12%)Independent projects ranked according to their IRRs:Project Project Size→ IRRE $20,000→ 21.0%B 25,000 →19.0G 25,000→ 18.0H 10,000→ 17.5D 25,000 →16.5A 15,000→ 14.0F 15,000 →11.0C 30,000 →10.0No Capital Rationing - Only projects F and C would be rejected. The firm’s capital budget would be $120,000.Existence of Capital Rationing - Suppose the capital budget is constrained to be $80,000. Using the IRR criterion, only projects E, B, G, and H, would be accepted, even though projects D and A's IRR is higher than our cost of capital but we can not include because of our capital budget is limited upto $ 80000.However, this is not the best method. Ordering the options in decreasing order of return might not always give the optimal allocation. For that, you will need to construct all possible combinations of investments (investment portfolios) and check their total return.Let's say you have 7 optionsOption 1: Investment $5, NPV $10Option 2: Investment $5, NPV $9Option 3: Investment $1, NPV $6Option 4: Investment $1, NPV $5Option 5: Investment $1, NPV $4Option 6: Investment $1, NPV $3Option 7: Investment $1, NPV $2Now if your total budget is $10, and you see the ranked list of investment options, you will select {Option 1 + Option 2}, for a total NPV of $19.However, you could have done better by selecting {Option 1 + Option 3 + Option 4 + Option 5 + Option 6 + Option 7}. In this case your total NPV is $30.Further reading:Page on university.akelius.dePage on kfupm.edu.saPage on www.economics-sociology.euhttp://wps.aw.com/wps/media/objects/222/227412/ebook/ch09/chapter09.pdfExtra. Reading materialFinancial Markets (2011) with Robert Shiller (23 part lecture series from Nobel-prize winning economist)Financial Theory with John GeanakoplosTutorials | InvestopediaFinancial Concepts: Introduction | Investopedia

I am a twenty-year-old student with $1,200 to invest. What should I do with it?

It really depends on your investment horizon. How soon do you need the money?If this is for your retirement, I recommend a diverse portfolio of index mutual funds or exchange-traded funds, covering the U.S. and foreign stock markets and real estate such as the SPDR S&P 500 ETF (SPY), Vanguard Total International Stock Index Fund (VGTSX) and Vanguard REIT Index ETF (VNQ).If you need the money in less than five years, I recommend in index bond fund such as Vanguard Bond Index ETF (BND).Most major mutual fund providers such as Schwab, Fidelity and T. Rowe Price offer similar index funds.

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