study guide

explain the difference between asset allocation and diversification

• The greater the risk, the greater the expected return and vice versa.  The greater the time invested the greater the expected return and vice versa. 

• Long term goals are funded with risky assets.  Short term goals are funded with safe assets that are liquid such as cash or short-term bonds.

• Asset allocation involves distributing assets among various asset classes and is expressed as a percentage.  For example, one with $100,000 to invest may invest 10% in CDs or $10,000.  The investor may have another 60% in stocks or $60,000.   

  
  

• As one gets closer to retirement risk is reduced.  A retiree (or close to it) does not have much time to recover from market downturns.  

  
  

How much should a two-earner family have in reserves in case of job loss?  What about a single person?

• Younger people tend to take more risk because they have many years to recover from market downturns.  Greater risk usually leads to greater return over the long term.

• Asset allocation involves distributing assets among various asset classes and is expressed as a percentage.  For example, one with $100,000 to invest may invest 10% in CDs or $10,000.  The investor may have another 60% in stocks or $60,000.   

  Diversification involves buying a VARIETY of assets within each ASSET CLASS.  For example, the $60,000 in stocks may include 30 different stocks to be diversified. 

  
  

•  financial goals for retirees that their financial plans MUST accomplish.

• This family should have at least three months of living expenses in cash reserves.  A single person or one earner family should have at least six months of living expenses in cash reserves. 

  
  

Which types of goals (time horizon) are planned by with risky assets?  Which types of goals (time horizon) are planned using liquid and assets?

• Long term goals are funded with risky assets.  Short term goals are funded with safe assets that are liquid such as cash or short-term bonds. 

  
  

• The greater the risk, the greater the expected return and vice versa.  The greater the time invested the greater the expected return and vice versa.  

  Tradeoff:  If one wants less risk then they should expect lower return.  You are trading off potential return as you reduce risk. 

  
  

• As one gets closer to retirement risk is reduced.  A retiree (or close to it) does not have much time to recover from market downturns.

• Compounding interest adds interest to the principal to increase the principal.  By increasing the principle (adding the interest) even more interest is earned the next period.  Please see the video. 

  
  

Explain the relationship between risk and expected return and time and expected return. What is the tradeoff between risk and expected return?

• We rebalance to get to the original investment percentages that we wanted at the beginning of the period.  In other words, if you wanted 60% stocks in January and at the end of the year your stocks are 70% of the portfolio, then you would sell10% of the stocks to get to the original 60%.

• Asset allocation involves distributing assets among various asset classes and is expressed as a percentage.  For example, one with $100,000 to invest may invest 10% in CDs or $10,000.  The investor may have another 60% in stocks or $60,000.   

  Diversification involves buying a VARIETY of assets within each ASSET CLASS.  For example, the $60,000 in stocks may include 30 different stocks to be diversified.  

  
  

• financial goals for retirees that their financial plans MUST accomplish.

• The greater the risk, the greater the expected return and vice versa.  The greater the time invested the greater the expected return and vice versa.  

  Tradeoff:  If one wants less risk then they should expect lower return.  You are trading off potential return as you reduce risk.

  
  

Explain how one manages risk in younger years to plan for retirement.

• Long term goals are funded with risky assets.  Short term goals are funded with safe assets that are liquid such as cash or short-term bonds. 

  
  

• Younger people tend to take more risk because they have many years to recover from market downturns.  Greater risk usually leads to greater return over the long term. 

  
  

• The stated rate is the amount of interest that the bank will pay, but the yield reflects the actual earnings based on how often a CD is compounded.  The more it compounds the greater the yield.  If two CDs each have a stated rate of 3%, but one compounds semiannually and one compounds monthly, then the one that compounds monthly has the greatest yield. 

  
  

• We rebalance to get to the original investment percentages that we wanted at the beginning of the period.  In other words, if you wanted 60% stocks in January and at the end of the year your stocks are 70% of the portfolio, then you would sell10% of the stocks to get to the original 60%. 

Explain how one manages risk as he/she is close to retirement.

• The greater the risk, the greater the expected return and vice versa.  The greater the time invested the greater the expected return and vice versa.  

  Tradeoff:  If one wants less risk then they should expect lower return.  You are trading off potential return as you reduce risk.  

  
  

• The stated rate is the amount of interest that the bank will pay, but the yield reflects the actual earnings based on how often a CD is compounded.  The more it compounds the greater the yield.  If two CDs each have a stated rate of 3%, but one compounds semiannually and one compounds monthly, then the one that compounds monthly has the greatest yield.

• As one gets closer to retirement risk is reduced.  A retiree (or close to it) does not have much time to recover from market downturns.  

  
  

• We rebalance to get to the original investment percentages that we wanted at the beginning of the period.  In other words, if you wanted 60% stocks in January and at the end of the year your stocks are 70% of the portfolio, then you would sell10% of the stocks to get to the original 60%.

Explain how one manages risk in retirement. What are the two major (financial) goals for retirees that their financial plans MUST accomplish.

• In retirement risk is greatly reduced, but an investor may still have some risk because growth is needed.   Some people live thirty or more years in retirement, so they need some risk to grow the money, but they generally reduce risky assets to about 10 – 15% of a portfolio, or even lower.

• We rebalance to get to the original investment percentages that we wanted at the beginning of the period.  In other words, if you wanted 60% stocks in January and at the end of the year your stocks are 70% of the portfolio, then you would sell10% of the stocks to get to the original 60%.

• The stated rate is the amount of interest that the bank will pay, but the yield reflects the actual earnings based on how often a CD is compounded.  The more it compounds the greater the yield.  If two CDs each have a stated rate of 3%, but one compounds semiannually and one compounds monthly, then the one that compounds monthly has the greatest yield

• Long term goals are funded with risky assets.  Short term goals are funded with safe assets that are liquid such as cash or short-term bonds

Explain the benefits of compound interest.

• Younger people tend to take more risk because they have many years to recover from market downturns.  Greater risk usually leads to greater return over the long term.

• As one gets closer to retirement risk is reduced.  A retiree (or close to it) does not have much time to recover from market downturns

• The stated rate is the amount of interest that the bank will pay, but the yield reflects the actual earnings based on how often a CD is compounded.  The more it compounds the greater the yield.  If two CDs each have a stated rate of 3%, but one compounds semiannually and one compounds monthly, then the one that compounds monthly has the greatest yield.

• Compounding interest adds interest to the principal to increase the principal.  By increasing the principle (adding the interest) even more interest is earned the next period.

Why do we periodically rebalance an investment portfolio?

• The stated rate is the amount of interest that the bank will pay, but the yield reflects the actual earnings based on how often a CD is compounded.  The more it compounds the greater the yield.  If two CDs each have a stated rate of 3%, but one compounds semiannually and one compounds monthly, then the one that compounds monthly has the greatest yield.

• We rebalance to get to the original investment percentages that we wanted at the beginning of the period.  In other words, if you wanted 60% stocks in January and at the end of the year your stocks are 70% of the portfolio, then you would sell10% of the stocks to get to the original 60%.

• Younger people tend to take more risk because they have many years to recover from market downturns.  Greater risk usually leads to greater return over the long term. 

  
  

• This family should have at least three months of living expenses in cash reserves.  A single person or one earner family should have at least six months of living expenses in cash reserves.

Regarding certificates of deposit, explain why the stated rate is different from the yield?

• Compounding interest adds interest to the principal to increase the principal.  By increasing the principle (adding the interest) even more interest is earned the next period.

• In retirement risk is greatly reduced, but an investor may still have some risk because growth is needed.   Some people live thirty or more years in retirement, so they need some risk to grow the money, but they generally reduce risky assets to about 10 – 15% of a portfolio, or even lower. 

• The stated rate is the amount of interest that the bank will pay, but the yield reflects the actual earnings based on how often a CD is compounded.  The more it compounds the greater the yield.  If two CDs each have a stated rate of 3%, but one compounds semiannually and one compounds monthly, then the one that compounds monthly has the greatest yield.