Fundamentals of Investing

presented by

Lynn Gillette
Fred Smith
and Don Stewart

The purpose of this paper, and the corresponding workshop series in March 2007, is to give investors the
knowledge and confidence to manage their investment assets, especially retirement portfolios such as IRAs
and 401(k) plans. It is suitable for beginning investors who want to learn the fundamental concepts before
developing an investing strategy. Experienced investors may also find this a useful refresher course. Much
of the material used in this paper is taken from the American Association of Individual Investors (AAII)
resources listed in the references on the last page.

Copyright 2007 Frederick J. Smith

3/30/07 FundInv.doc
 Contents
Page
Chapter 1: Introduction
Investment Goals, Principles of Investing 3
Your Personal Investment Profile 4
Chapter 2: Return
Total Return, Arithmetic and Geometric Means, Internal Rate of Return 5
Present Value and Future Value, Rule of 72 6
Chapter 3: Risk
Subjective Risk, Objective Measurements, Standard Deviation 7
RiskGrades, Beta
Chapter 4: Risk Control and Risk-Adjusted Returns
Time Diversification, Dollar Cost Averaging, Value Averaging 9
Portfolio Diversification 10
Risk/Return Measurement, Sharpe Ratio, Treynor Ratio 11
Chapter 5: Asset Allocation
Brinson Study 12
An Overview of Primary Asset Classes; Cash, Bonds, Stocks 13
Simple 2- and 3-Asset Model Portfolios 15
Chapter 6: Building a Portfolio
Characteristics and Performance of Asset Classes; Money Market Funds, Bonds 17
Stocks 21
International Investments 24
Real Estate Investments 25
Building a Multi-Asset Portfolio 27
Monitoring and Rebalancing 29
Chapter 7: Investment Vehicles
Mutual Funds 30
Closed-end Funds, ETFs, REITs 31
Individual Bonds and Stocks 32
Chapter 8: Stock Analysis … The Annual Report
Balance Sheet, Income Statement, Cash Flow Statement 33
Financial Ratios 37
The Dividend Discount Model (DDM), Constant Growth DDM 39
Chapter 9: Fundamentals of Stock Screening
Screening Programs and Techniques 40
Chapter 10: Modern Portfolio Theory
Basic Modern Portfolio Theory 41
Efficient Market Hypothesis 44
Chapter 11: Timing the Market; A Slippery Slope
Buy and Hold Investing, Market Cycles, Day Trading ! 46
References
Further Reading, Websites 47

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 Chapter 1: Introduction
What is an Investment ?
An investment is the current commitment of money or other resources in the expectation of reaping
future benefits.

Investment Goals
Typical reasons to invest include saving for a child’s education or perhaps to buy a house, or of
course for retirement. Most people cannot rely on a corporate pension plan and/or Social Security to fund
their retirement goals. Therefore they need to save now for their future needs.

Net Worth / Current Annual Spending

35
30
Net Worth Ratio

25
Age 60
20
Age 65
15
Age 72
10
5
0
25 30 35 40 45 50 55 60 65 70
Age

Figure 1.1 Ratio of Net Worth to Annual Spending required to retire at ages 60, 65 or 72.

Figure 1.1 shows the value of your retirement portfolio, as a multiple of your annual spending,
needed to retire at various ages. First calculate your current annual spending budget. Next subtract any
expected income, if any, from other sources such as pensions or Social Security. For example, suppose you
plan to retire at age 65 and that you need $60,000 per annum (pa). Following the dashed line on the graph
you can see that at age 55 you should currently have 15 times $60,000, i.e. $900,000 in your retirement
account. At age 65 you should have 25 times $60,000, i.e. $1.5M in your account. This will allow you to
withdraw 4% pa for your retirement income. If you retire later you can save more slowly, and withdraw
perhaps 5% pa. Of course if you want to retire earlier you need to save more aggressively, and can only
withdraw a smaller amount, say 3% pa, for a longer retirement period.

Basic Principles of Investing

There are two overriding principles of investing:
1. Understand how personal circumstances affect each individual’s investment decisions.
Notice that individual needs and circumstances may differ. What constitutes a good
investment decision for one person may be very wrong for another. That is why we focus
first on the Personal Investor Profile on the next page.
2. Understand the relationship between risk and return.
This may seem trivial but it is fundamental to making good investment decisions. We will
cover this topic in depth shortly.

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 Your Personal Investor Profile

The optimum investment portfolio for each individual depends on four personal parameters:

Time Horizon
This depends on how soon you need to take money out of your investment portfolio. It is easy to
determine if you are investing for a single-event goal like buying a house or funding a child’s education. A
retirement plan could have a blend of short, intermediate and long-term goals depending on your current
age and status. Typically a time horizon of less than 5 years is considered short-term, and over 5 – 10 years
is long-term.

Risk Tolerance
Your personal tolerance for risk is a somewhat subjective assessment, with no right or wrong
answers. It is often referred to as eat well or sleep well decision ! Taking on too much risk can lead to
panic selling at the first market downturn, thereby following a “buy high, sell low” strategy. It is important
to be honest with yourself in making this assessment. As a guideline, a typical response (albeit somewhat
arbitrary) to a one-year loss might be as follows:
Low risk tolerance Less than 5% loss in any year
Moderate risk tolerance 6% to 15% loss in a year
High risk tolerance Over 16% loss in a year.

Return Needs
Do you want to emphasize current income or future growth (or a little of each) ? Some investors,
e.g. retirees, may depend on their investment portfolio for annual income. Therefore they may want
investments which emphasize consistent periodic payments and protection of principal. On the other hand,
investors with a long time horizon generally seek growth opportunities and protection against inflation. As
with everything else in life, there are trade-offs; you can’t have everything.

Tax Exposure
Investors in higher income tax brackets need to be aware of the tax implications. Unfortunately the
tax laws are in a constant state of flux. Parameters to keep an eye on include tax treatment for interest and
dividend income, short-term and long-term capital gains, and of course the Alternative Minimum Tax
(AMT). Bottom line: its only what is left after inflation and taxes that counts !

Note that your Personal Investor Profile will change over time. As your career advances you
acquire more assets, and become more financially secure. Certainly as you approach and enter retirement
your needs change. The following chart may be a useful guide, but remember that your individual case
may be different.

Early Middle Late Early Late

Career Career Career Retirement Retirement
Time Horizon Long Long Long Long/Intermediate Inter/Short
Risk Tolerance High High Moderate Moderate Low
Return Needs Growth Growth Growth Growth/Income Income
Tax Exposure Low High High Moderate Low

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 Chapter 2: Return
Total Return
The total return is the sum of the interest or dividend return on the investment and the capital gain
(or loss) when the investment is sold.
i.e. Total Return = Interest or Dividend Income per annum + Capital Gain realized on sale.
For example, if you bought a stock for $100 at the beginning of this year, and receive $2 dividend at the
end of the year and then sell the stock for $107, your total return is given by
$2/$100 + $7/$100 = 2% dividend yield + 7% capital gain = 9% total return.

The term “real return” is used for returns which have been corrected for inflation.
i.e. Real Return = Nominal Return – Inflation
For example in the above case, if inflation was 3% for the year, the real return would be 9% -3% = 6%.

Arithmetic Mean
Suppose you had an investment with total returns of 9%, -5% and 14% for three consecutive years.
How well did you do over the three year period ?
If you use the arithmetic mean or average, you get (9% - 5% + 14%)/3 = 6.0% pa.
The general formula is
rAA = (r1 + r2 + ….. +rn) / n (Use AVERAGE function in Excel)
where r1, r2, rn are the individual rates of return and rAA is the arithmetic average rate.
Although this simple average may be useful in some situations it can be misleading in others.

Geometric Mean
A more accurate way to calculate your return is to use the geometric mean as follows:
Geometric Mean = {(1+9%) x (1-5%) x (1+ 14%) } ^ (1/3) -1
= {1.09 x .95 x 1.14} ^ .333 –1 = 1.18 ^ .333 -1
= 1.0569 –1 = 0.0568 = 5.68% pa.
i.e. 5.68% is the Compound Annual Growth Rate or CAGR.
It is also known as the Time-Weighted Return.
The general formula is
rGM = {(1 + r1)(1 + r2) ….. (1 + rn)}^(1/n) – 1 (Use GEOMEAN in Excel)
where r1, r2, rn are the individual rates of return and rGM is the geometric mean rate.

The difference between the arithmetic and geometric means can be quite large in some cases. For
Example, a newsletter might boast that they turned $10,000 into $25,000 in ten years and argue that their
average return was 150% / 10 years = 15% per annum.
In reality their annual return was {($25,000 / $10,000) ^ (1/10)} – 1 = 9.6% pa.
Note: If you gain 20% in one year, followed by a 20% loss the next year, your overall return is a 4% loss.
If you lose 50% in one year it takes almost two years of 50% gains to get back to your initial investment.

Internal Rate of Return

For the examples above we dealt with returns over uniform time periods. For uneven cash flows we
use the Internal Rate of Return, IRR, also known as the Dollar-Weighted Return (Use the IRR or XIRR
function in Excel). The IRR represents that interest rate which, if compounded over the holding period,
Page 5
gives the same total return as the uneven cash flows. There is no general formula for the IRR since it can
only be calculated using an iterative process.

Present Value (PV) and Future Value (FV)

The future value of an investment is calculated from the present value using the formula
Future Value = Present Value x (1 + r1)(1 + r2) ….. (1 + rn)
where r1, r2, rn are the individual rates of return.

In the previous example, if you invested $10,000 at the start of the first year, the value at the end of the
third year is given by
Future Value = $10,000 x (1+9%) x (1-5%) x (1+ 14%)
= $10,000 x 1.09 x .95 x 1.14 = $11,804.70
As before the CAGR is given by: {$11,804.70 / $10,000 }^ 0.333 – 1 = 0.0568 = 5.68%

Rule of 72
Tip: For an investment with an annual rate of return, r, the number of years, n, required to double
the investment is given approximately by: n = 72/r,
i.e. r x n = 72 approximately.

For example, an investment with a 6% pa return will double in 12 years.

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 Chapter 3: Risk
Causes of Risk
Risk is volatility or uncertainty in the outcome of an investment, and comes from many sources:
Market risk, Industry risk, Inflation risk, Interest rate risk, Default risk, Liquidity risk, etc.
Fine print: Past performance is no guarantee of future results !

Subjective risk
This is a personal decision with no right or wrong answer. How much can you afford to lose ?

Remember your Personal Investment Profile. A short-term time horizon limits your investment
options because you cannot diversify across market cycles. A longer time horizon allows you to take on
more risk with the potential for a greater return. Ultimately, this decision is driven by individual personal
characteristics.

Objective measurements
The objective risk measurements are statistical in nature, but we don’t need to get into any heavy-
duty math to use them. They depend on gauging the dependability of the returns.

Figure 3.1 Normal Distribution Curve (from Reference 5)

Standard deviation
The standard deviation, or sigma, measures the total volatility of a series of returns, regardless of
the cause. Technically it is calculated from the following formula
Sigma = square root of the mean value of the squared deviations from the mean
but it is easier to use the STDEV function in Excel.
If a series of returns has normal distribution (see Figure 3.1) with a mean value of 8% and a sigma
of 5%, then there is
a 68.26% probability that any year’s return will fall between +/- 1 sigma (3% to 13%)
or a 95.44% probability that it will fall between +/- 2 sigmas (–2% to +18%)
or a 99.74% probability that it will fall between +/- 3 sigmas ( –7% to + 23%)

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 For example, the table below shows how the geometric mean and standard deviation vary for three
different portfolios with the same arithmetic mean.

__Period Returns (%)__ Arithmetic Geometric Standard FV of

Portfolio 1 2 3 4 Average Mean Deviation $10,000
A 10.0 10.0 10.0 10.0 10.0 10.0 0.0 $14,641
B 25.0 -5.0 5.0 15.0 10.0 9.4 12.9 $14,339
C 20.0 0.0 -10.0 30.0 10.0 8.9 18.3 $14,040

RiskGrades
RiskGrades is a time weighted computation of standard deviation, normalized to the value of all the
world’s equities. The measure was developed by RiskMetrics Group, and can be a useful independent
assessment of the volatility of an investment asset or portfolio. A detailed description is available at the
RiskGrades website, www.riskgrades.com which is free to individual investors.

Beta
Beta is a measure of the volatility of an investment relative to a benchmark, e.g. S&P 500. Thus it
measures the sensitivity of the investment to movements of the market as a whole. Note that, since market
risk is only part of the total risk, beta is not a complete measure of the investment risk.

For example, if an investment has a Beta of 1.2 then it is 20% more volatile than the benchmark, i.e. if the
benchmark loses 10% on a given day the investment can be expected to lose 12%.

Note that leveraging an investment (borrowing some of the cost) increases the risk as well as the potential
return.

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 Chapter 4: Risk Control and Risk-Adjusted Returns
Techniques to minimize risk
There are two primary methods to control risk. The first relies on spreading the market entry and
exit times over multiple time periods instead of as a single transaction. The second technique involves
building a portfolio of diverse investments hoping that their volatilities will tend to cancel each other.

Time diversification.
In October 1987 the stock market lost over 20% for the one month. However, anyone who
remained invested in the broad market throughout 1987 had a positive 5.2% return for the year.
Moreover, an investor who stayed in the market for the 5-year period from 1987 thru 1991 earned a
15.4% compound annual growth rate.

Moral: Time in the market beats timing the market (usually !). For those who fear investing all
their money in the market at the worst time (i.e. at a market peak), either of the techniques below
makes the process easier.

Dollar Cost Averaging: Invest a fixed dollar amount at equal periods, say monthly.

Amount Share # Total Total

Month Added Price Shares Shares Value
1 $1000 $10 100 100 $1000
2 $1000 $9 111 211 $1899
3 $1000 $8 125 337 $2696
4 $1000 $10 100 437 $4370
5 $1000 $12 83 520 $6240
6 $1000 $11 91 611 $6721
Total $6000 $60 611
Average price of purchased shares = $60 / 6 = $10.00
Average cost of purchased shares = $6000 / 611 = $9.83

Value Averaging: Add (or subtract) an amount each month to increase (or decrease) the total value
of the investment at a predetermined rate.

Amount Share # Total Total

Month Added Price Shares Shares Value
1 $1000 $10 100 100 $1000
2 $1100 $9 122 222 $2000
3 $1224 $8 153 375 $3000
4 $250 $10 25 400 $4000
5 $200 $12 17 417 $5000
6 $1413 $11 128 545 $6000
Total $5187 $60 545

Average price of purchased shares = $60 / 6 = $10.00

Average cost of purchased shares = $5187 / 545 = $9.52

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 Portfolio diversification
Building a diversified portfolio is the classic method to reduce risk. Ideally the individual
investments should behave differently to each other, i.e. have low (or preferably negative) correlation
coefficients. In that way their short-term peaks and dips tend to cancel each other out and you are left with
the overall long-term trend of the market. Two assets with a correlation coefficient of 1.0 (the maximum
possible) will move in perfect lock-step with each other. If they have a negative correlation coefficient
they will tend to move in opposite directions. Coefficients close to zero indicate assets which tend to move
independently of each other.

The primary purpose in building a diversified portfolio is to control risk. If we have a portfolio with
two risky assets, as shown in Figure 4.1, the portfolio itself will be just as volatile as the individual
investments. This is because the two investments are perfectly correlated with each other, and cannot help
to smooth out the volatility of the portfolio.

Investment A Investment B Port folio

Figure 4.1 Portfolio with Two Positively Correlated Assets

However, if the two investments are negatively correlated as shown in Figure 4.2, then their
separate volatilities cancel each other, giving the portfolio a steady return. Unfortunately this is an
idealized case which cannot be realized fully in practice.

Investment A Investment B Portfolio

Figure 4.2 Portfolio with Two Negatively Correlated Assets

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 Nonetheless we can find practical investments which show partial negative correlation, as modeled
in Figure 4.3. In this case the portfolio still shows some volatility, but it has been reduced significantly.
Thus our goal in building a portfolio is to find investments which work together to give us a good return
with an acceptable level of risk.

Investment A Investment B Portfolio

Figure 4.3 Portfolio with Two Partially Correlated Assets

The table below gives an approximate guide to the long-term correlations between various asset
classes. These will be discussed in greater detail later.
Common Int’l Real
T-Bills Bonds Stock Stock Estate
T-Bills 1.00
Bonds 0.25 1.00
Common Stocks -0.10 0.20 1.00
International Stocks -0.15 -0.10 0.70 1.00
Real Estate 0.40 -0.10 0.05 0.15 1.00

If we are building a diverse portfolio of mutual funds a total of five to ten funds should be adequate
provided they are carefully chosen. On the other hand we probably need 15 to 25 carefully chosen
individual stocks to form a diversified portfolio. This issue will be addressed in greater detail later.

Risk/Return Measurement
There are numerous methods to measure the return of a portfolio per unit of risk. Two of the more
common metrics are shown below.
Sharpe Ratio = (Expected return – Risk-free return) / Standard Deviation
Treynor Ratio = (Expected return – Risk-free return) / Beta
Note that, since the standard deviation measures the total volatility from all sources, the Sharpe
Ratio is valid in all cases. On the other hand, the Treynor Ratio is only meaningful for a diversified
portfolio which tracks its benchmark well because beta only measures market risk (not total risk)

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 Chapter 5: Asset Allocation
Brinson Study
From 1986 thru 1991, Gary Brinson, Randolf Hood and Gilbert Beebower (Reference 12) showed
that asset allocation was the critical element defining the performance of an investment portfolio.
Over 91% of portfolio return can be attributed to the asset allocation of the major classes.
Less than 5% contributed by individual stock picking.
Less than 2% contributed by trying to time the market.
These results were challenged by William Janke in 1997 (Reference 13). However the debate over the past
ten years, and numerous follow-on studies, have largely supported Brinson’s original data. The bottom line
is that the primary asset allocation is by far the most important decision in managing a portfolio.

Figure 5.1 Performance of a Portfolio with a mix of Stocks and Bonds (from Reference 5)

Since the correlation between stocks and bonds traditionally is quite low, it can be useful to build a
portfolio using a mix of each. This way, when the stock market is down, perhaps the bonds can provide a
cushion, and vice versa. Figure 5.1 shows the performance of a two-asset portfolio, i.e. stocks and bonds.
The all-stock portfolio has a return of 17% with a standard deviation of 25%, while the all-bond portfolio
has a return of 19% and a standard deviation of 12%.

It is interesting to note that the risk for the bond portfolio can be reduced by adding a small
percentage of the riskier stock portfolio. This improves the return of the total portfolio to about 11.5%
while simultaneously reducing the standard deviation to 11%. This is because of the lack of correlation
between the stock and bond portfolios. What would the graph look like if the two portfolios were perfectly
correlated ? How about if the portfolios were perfectly negatively correlated ?

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 An Overview of Primary Asset Classes

First we look at the fundamental characteristics of three primary asset classes, i.e. cash or money
market funds, bonds and stocks. Later we will cover these in greater detail, along with other asset classes.

Cash and Cash Equivalents

This class includes savings accounts, T-Bills, money market funds and Certificates of Deposit
(CDs). These are the simplest forms of investment everyone is familiar with. You lend money, usually for
a short duration, to a bank or other institute which pays you interest for the use of your money. When you
cash out you get your full principal back, so the risk is low. Therefore the interest rate is usually low too.

Vanguard Treasury Money Market Fund

Year Return $100.00
1997 5.12% $105.12
1998 5.00% $110.38
1999 4.55% $115.40
2000 5.80% $122.09
2001 3.99% $126.96
2002 1.51% $128.88
2003 0.82% $129.94
2004 1.00% $131.24
2005 2.77% $134.87
2006 4.55% $141.01
A/G Mean 3.51% 3.50%
Std.Dev. 1.84% -

Figure 5.2 Performance of Vanguard Treasury Money Market Fund 1997 – 2006.

As a proxy for this class we can look at the performance of the Vanguard Treasury Money Market
Fund over the past ten years. (See chart in Figure 5.2). This fund invests only in high quality short-term
(<90 days) securities (at least 80% are T-Bills) backed by the full faith and credit of the U.S. government.
As can be seen, over the past ten years, the average interest rate has been about 3.5% with a standard
deviation of just less than 2%.

Bonds
A bond is also a loan of money to an entity which uses it for its own purposes. Typically the entity
can be a corporation, or a municipal or federal government agency. The term of the bond can range all the
way from one year to over thirty years. After a bond issues its principal value varies inversely with current
interest rates. For example if you paid $1000 for a bond yielding 5% interest payments ($50) every year,
this bond would only be worth $833 if the interest rates later rose to 6%. This is because someone wishing
to buy a bond would expect to match the 6% yield he could get from a buying a new bond ($833 x 6% =
$50). If you need to cash out before the bond is due you may suffer a capital gain or loss. The total return
on long-term bonds can be quite volatile in an environment where interest rates are changing.

To get an idea of the overall performance of this asset class we can look at the Vanguard Total
Bond Market Index Fund charted in Figure 5.3. This fund tracks the performance of a broad range of
domestic bonds, with an average maturity of 5 years. The chart shows an average yield of about 6% over
the ten-year period, with a standard deviation of almost 4%. This is a higher return than the T-Bill fund,
but be aware that 1999 was a negative year.

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 Vanguard Total Bond Index Fund
Year Return $100.00
1997 9.44% $109.44
1998 8.58% $118.83
1999 -0.76% $117.93
2000 11.39% $131.36
2001 8.43% $142.43
2002 8.26% $154.20
2003 3.97% $160.32
2004 4.24% $167.12
2005 2.40% $171.13
2006 4.27% $178.43
A/G Mean 6.02% 5.96%
Std.Dev/SR 3.76% 0.655

Figure 5.3 Performance of Vanguard Total Bond Index Fund 1997 – 2006.

Stocks
Stock represents a fractional ownership position in a company. Thus if you 100 shares of IBM
stock, by definition you own a small fractional part of IBM, and are entitled to all the benefits (including
dividends) of that ownership. We will cover the characteristics of stocks in detail later, including
capitalization, style, domestic and foreign stocks, etc.

Vanguard Total Stock Market Index Fund

Year Return $100.00
1997 30.99% $130.99
1998 23.26% $161.46
1999 23.81% $199.90
2000 -10.57% $178.77
2001 -10.97% $159.16
2002 -20.96% $125.80
2003 31.35% $165.24
2004 12.52% $185.93
2005 5.98% $197.05
2006 15.51% $227.61
A/G Mean 10.09% 8.57%
Std.Dev/SR 18.67% 0.272

Figure 5.4 Performance of Vanguard Total Stock Market Index Fund 1997 – 2006.

The Vanguard Total Stock Market Index Fund is used here as a proxy for the U.S. stock market.
This fund attempts to replicate the return of the overall stock market. The chart is shown in Figure 5.4. As
can be seen, the total return over the past ten years is significantly higher than for the bond fund, but with a
much higher volatility. The standard deviation is 18.6%, dropping the Sharpe ratio to 0.272. Note that
1999 was a good year, but it was followed by three bad years when the market lost a total of about 40%.

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 Simple 2- and 3-Asset Model Portfolios

The 10-year charts below show the returns for three portfolios with different mixes of money
market, bonds and stocks. These portfolios can be considered aggressive, moderate and conservative,
perhaps suitable for investors aged 25, 45 and 65 respectively.

Simple 2-Asset Portfolio (10% Bonds + 90% Stocks)

Year Return $100.00
1997 28.84% $128.84
1998 21.79% $156.91
1999 21.35% $190.42
2000 -8.37% $174.47
2001 -9.03% $158.72
2002 -18.04% $130.09
2003 28.61% $167.31
2004 11.69% $186.87
2005 5.62% $197.37
2006 14.39% $225.77
A/G Mean 9.69% 8.48%
Std.Dev/SR 16.65% 0.300

Figure 5.5 Performance of Aggressive Portfolio with 10% Bonds and 90% Stocks.

Simple 2-Asset Portfolio (30% Bonds + 70% Stocks)

Year Return $100.00
1997 24.53% $124.53
1998 18.86% $148.01
1999 16.44% $172.34
2000 -3.98% $165.47
2001 -5.15% $156.95
2002 -12.19% $137.81
2003 23.14% $169.70
2004 10.04% $186.73
2005 4.91% $195.89
2006 12.14% $219.67
A/G Mean 8.87% 8.19%
Std.Dev/SR 12.64% 0.371

Figure 5.6 Performance of Moderate Portfolio with 30% Bonds and70% Stocks.

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 Simple 3-Asset Portfolio (10% MM + 40% Bonds + 50% Stocks)
Year Return $100.00
1997 19.78% $119.78
1998 15.56% $138.42
1999 12.06% $155.11
2000 -0.15% $154.88
2001 -1.71% $152.23
2002 -7.03% $141.53
2003 17.35% $166.08
2004 8.06% $179.46
2005 4.23% $187.05
2006 9.92% $205.60
A/G Mean 7.81% 7.47%
Std.Dev/SR 8.84% 0.450

Figure 5.7 Performance of Conservative Portfolio with 10% MM, 40% Bonds and 50% Stocks.

The results are summarized below. Although the performance for the moderate and conservative
portfolios was slightly below the aggressive portfolio the standard deviation was reduced significantly.
Also the performance for the worst year (2002) improved from –18% for the aggressive portfolio to –12%
and –7% respectively for the moderate and conservative portfolios.

Life Stage MMkt Bonds Stocks AvgRet Std.Dev Sharpe

Starting career 0% 10% 90% 9.7% 16.7% 0.300
Mid-career 0% 30% 70% 8.9% 12.6% 0.371
Retired 10% 40% 50% 7.8% 8.8% 0.450

Note that the purpose of building a diversified portfolio is primarily to control risk. A 25-year old
investor, with his whole career ahead of him, should be willing to take on more risk hoping for a potentially
higher return. Having a clearly defined Personal Investment Profile is critical to this decision.

The table below gives the approximate correlation coefficients for the three major asset classes, as
well as international stocks and real estate.

Domestic International
T-Bills Bonds Stock Stock Real Estate
T-Bills 1.00
Bonds 0.25 1.00
Domestic Stock -0.10 0.20 1.00
International Stock -0.15 -0.10 0.70 1.00
Real Estate 0.40 -0.10 0.05 0.15 1.00

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 Chapter 6: Building a Portfolio
A Detailed Look at Asset Class Characteristics

Money Market Performance

Vanguard Prime Money Market Fund

Year Return $100.00
1997 5.44% $105.44
1998 5.38% $111.11
1999 5.01% $116.68
2000 6.29% $124.02
2001 4.19% $129.21
2002 1.65% $131.35
2003 0.90% $132.53
2004 1.11% $134.00
2005 3.01% $138.03
2006 4.88% $144.77
A/G Mean 3.79% 3.77%
Std.Dev/SR 1.97% 0.138

Figure 6.1 Performance of Vanguard Prime Money Market Fund 1997 – 2006.

Note that the return from this money market fund is slightly higher than from the T-Bill fund
because the risk is higher, i.e. this fund is not backed by the full faith and credit of the US government.
However nobody has ever lost money yet in a money market account.

Bond Characteristics

Term
Bonds can be classified as short-term (say 1 – 5 years), intermediate-term (5 – 10 years) and
long-term (10 – 30 years). As we have seen earlier, the value of a bond fluctuates inversely with the
prevailing interest rate. This effect is particularly strong for longer term bonds. Thus an investor
who is committing his money to a volatile long-term bond will usually demand a higher return.

Vanguard Short-Term Bond Index Fund

Year Return $100.00
1997 7.04% $107.04
1998 7.63% $115.21
1999 2.08% $117.60
2000 8.84% $128.00
2001 8.88% $139.37
2002 6.10% $147.87
2003 3.37% $152.85
2004 1.70% $155.45
2005 1.31% $157.49
2006 4.09% $163.93
A/G Mean 5.10% 5.07%
Std.Dev/SR 2.95% 0.532

Figure 6.2 Performance of Vanguard Short-Term Bond Index Fund 1997-2006.

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 Vanguard Intermediate-Term Bond Index Fund
Year Return $100.00
1997 9.41% $109.41
1998 10.09% $120.45
1999 -3.00% $116.84
2000 12.78% $131.77
2001 9.28% $144.00
2002 10.85% $159.62
2003 5.65% $168.64
2004 5.22% $177.44
2005 1.75% $180.55
2006 3.91% $187.61
A/G Mean 6.59% 6.49%
Std.Dev/SR 4.82% 0.622

Figure 6.3 Performance of Vanguard Intermediate Term Bond Index Fund 1997 – 2006.

Vanguard Long-Term Bond Index Fund

Year Return $100.00
1997 14.30% $114.30
1998 11.98% $127.99
1999 -7.85% $117.95
2000 16.64% $137.57
2001 8.17% $148.81
2002 14.35% $170.17
2003 5.50% $179.53
2004 8.40% $194.61
2005 5.32% $204.96
2006 2.67% $210.43
A/G Mean 7.95% 7.72%
Std.Dev/SR 7.18% 0.589

Figure 6.4 Performance of Vanguard Long-Term Bond Index Fund 1997-2006.

As can be seen in Figures 6.2 thru 6.4, the long-term bonds have a higher yield than the short-term
bonds, but the volatility is also higher. This is summarized in the following table.

Average Yield Standard Deviation Sharpe Ratio

Short-Term Bond 5.10% 2.95% 0.532
Intermediate Term Bond 6.59% 4.82% 0.622
Long-Term Bond 7.95% 7.18% 0.589

It is interesting to note that for this period the intermediate bond shows the optimum risk/return tradeoff as
measured by the Sharpe Ratio.

Page 18
 Most of the time, issuers of longer bonds are forced to offer higher returns to entice investors.
However occasionally (usually in times of uncertainty) the yield curve is “inverted”, i.e. the longer bonds
yield less than shorter bonds. This is the case in the current environment, as seen on the yield curve in
Figure 6.5

Figure 6.5 Yield Curves for June 30, 2003 and October 31, 2006 (A. G. Edwards)

The yield curve above for 6/30/03 shows the normal shape with the 30-year bonds yielding about 3
percentage points more than the 3-month T-Bills. The recent curve from October 2006 is “inverted”, i.e.
the 30-year yields are lower than the short-term yields. This has only occurred eight times in the past few
decades. It indicates an uncertainty about the market conditions; some might argue that it forecasts a
coming recession. In this case the inversion is so slight that few economists are worried about it.

Bond Quality
Various agencies issue bonds. The safest are those whose interest and principal are backed by
the full faith and credit of the U.S. government.

Treasuries: T-Bills Term less than 1 year

T-Notes Term between 1 year and five years
T-Bonds Term greater than 5 years
Treasuries are fully taxable at the FIT level, but are tax-free at the SIT level.

Page 19
 Munis: These are bonds issued by various municipalities to fund projects such as building schools,
jails, water treatment plants, etc. General Obligation (GO) bonds are backed by the full
taxing power of the municipality. Revenue bonds are backed by the specific project for
which they were issued and are therefore a little more risky than GO bonds.

The income from munis is usually tax free within their own state and also free of tax at the
federal level (but watch out for the AMT !).

Corporate Bonds are issued by individual companies, and backed by the creditworthiness of that
company. Various agencies such as Moodys and Standard & Poors rate the ability of
companies to repay the loan when it comes due. As expected, companies with lower ratings
must offer a higher return to attract investors.

High Yield Bonds: Bonds issue by companies with ratings below “investment grade” must carry a
higher interest rate to compensate for the additional risk. These are also know as “junk
bonds”. An example is shown in Figure 6.6 below.

Bond quality is rated by Moody’s and also by Standard and Poors. The table below, from Charles
Schwab data, summarizes these ratings.

Moody S&P Comments

Aaa AAA Guilt edged
Aa AA Very high quality
A A Investment-grade
Baa BBB Lowest investment-grade rating
Ba BB Somewhat speculative, low grade
B B Very speculative
Caa CCC Substantial risk
etc. etc. High yield bonds, Junk bonds

Vanguard High-Yield Corporate Bond Fund

Year Return $100.00
1997 11.91% $111.91
1998 5.62% $118.20
1999 2.55% $121.21
2000 -0.88% $120.15
2001 2.91% $123.64
2002 1.73% $125.78
2003 17.20% $147.42
2004 8.52% $159.98
2005 2.77% $164.41
2006 8.24% $177.95
A/G Mean 6.06% 5.93%
Std.Dev/SR 5.47% 0.445

Figure 6.6 Performance of Vanguard High-Yield Corporate Bond Fund.

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Stock Characteristics

Capitalization
The size of a company, as measured by its share price times the total number of shares,
is known as the capitalization. This can be broken down into three somewhat arbitrary divisions.
Large cap stocks Companies greater than $10B capitalization
Mid-cap stocks Companies between $2B and $10B capitalization
Small cap stocks Companies less than $2B capitalization.
For very small companies with a total capitalization less than $250M, the term Micro-cap, or Mini-
cap, is sometimes used.

The S&P 500 Index consists of 500 large cap stocks. The performance is shown in Figure 6.7. The
rest of the US stock market, excluding the S&P 500, is included in the Vanguard Extended Market
Index Fund, i.e. this fund consists of mid-cap and small-cap stocks. Its performance is shown in
Figure 6.8. As expected, the extended market is more volatile and rewards investors with a higher
long-term return.

Vanguard 500 Index Fund

Year Return $100.00
1997 33.19% $133.19
1998 28.62% $171.31
1999 21.07% $207.40
2000 -9.06% $188.61
2001 -12.02% $165.94
2002 -22.15% $129.19
2003 28.50% $166.00
2004 10.74% $183.83
2005 4.77% $192.60
2006 15.64% $222.72
A/G Mean 9.93% 8.34%
Std.Dev/SR 19.12% 0.253

Figure 6.7 Performance for Vanguard 500 Index Fund 1997-2006.

Vanguard Extended Market Index Fund

Year Return $100.00
1997 26.73% $126.73
1998 8.32% $137.27
1999 36.22% $186.99
2000 -15.55% $157.92
2001 -9.13% $143.50
2002 -18.06% $117.58
2003 43.43% $168.65
2004 18.71% $200.20
2005 10.29% $220.80
2006 14.27% $252.31
A/G Mean 11.52% 9.70%
Std.Dev/SR 20.99% 0.295

Figure 6.8 Performance of Vanguard Extended Market Index 1997 – 2006.

Page 21
 .
Style
Although somewhat artificial, companies can be classified into one of two styles.
Growth: These are companies which plough back most of their earnings (and/or borrow) to
fund additional growth.

Value: These companies tend to pay dividends because they cannot find a higher use for
their earnings. Very often the share price has been beaten down by bad press to the
point where the stock may represent a bargain if the company can recover.

The performance of Vanguard Small-Cap Growth and Small-Cap Value Index Funds is shown
respectively in Figures 6.9 and 6.10. As can be seen, the growth fund is the more volatile. For the
past few years value investments have tended to outperform growth, but many economists believe
that that is now changing.

Vanguard Small-Cap Value Index Fund

Year Return $100.00
1997 - - 40%
1998 - -
30%
1999 3.35% $103.35
2000 21.88% $125.96 20%
2001 13.70% $143.22
2002 -14.20% $122.88 10% Series1
2003 37.19% $168.58
0%
2004 23.55% $208.28
1997 1998 1999 2000 2001 2002 2003 2004 2005 2006
2005 6.07% $220.93 -10%
2006 19.24% $263.43
A/G Mean 13.85% 12.87% -20%
Std.Dev/SR 15.54% 0.603

Figure 6.9 Performance of Vanguard Small-Cap Growth Index Fund 1997 – 2006.

Vanguard Small-Cap Growth Index Fund

Year Return $100.00
1997 - - 50%
1998 - -
40%
1999 19.80% $119.80
2000 1.59% $121.70 30%
2001 -0.78% $120.76 20%
2002 -15.41% $102.15 Series1
10%
2003 42.88% $145.95
2004 16.05% $169.37 0%
2005 8.64% $184.01 1997 1998 1999 2000 2001 2002 2003 2004 2005 2006
-10%
2006 11.49% $205.15
A/G Mean 10.53% 9.40% -20%
Std.Dev/SR 17.11% 0.345

Figure 6.10 Performance of Vanguard Small-Cap Value Index Fund 1997 – 2006.

Page 22
Sectors
There are a few attempts to group stocks into ten or twelve different sectors. The following
classification is the most popular.

Sector Market Weight

Consumer Discretionary 11%
Consumer Staples 9%
Energy 9%
Financials 22%
Health Care 12%
Industrial 11%
Information Technology 16%
Materials 3%
Telecom Services 4%
Utilities 3%
100%

Most fund families provide sector funds and/or Exchange Traded Funds (ETFs) which limit their
holdings to specific sectors. However these tend to be rather volatile, and are beyond the scope of
this tutorial.

Page 23
International Investments
Since foreign markets sometimes behave differently to the US market, there is a benefit to
diversifying part of a portfolio into investments overseas. The following terms are in common usage.

Domestic United States only

International Outside the United States
Global Worldwide, including the United States
Developed Markets Countries with mature economies such as UK, France, Japan, etc.
Emerging Markets Countries whose economies are still in development ,
such as Brazil, Russia, India and China (the BRIC countries), Taiwan, etc

The performances for the Vanguard Total International Stock Index and the Emerging Markets
Stock Index are shown in Figures 6.11 and 6.12. As can be seen the Emerging Market Index is an
aggressive investment with a higher return over the past ten years, but with a very high standard deviation.

Vanguard Total International Stock Index Fund

Year Return $100.00
1997 -0.77% $99.23
1998 15.60% $114.71
1999 29.92% $149.03
2000 -15.61% $125.77
2001 -20.15% $100.43
2002 -15.08% $85.28
2003 40.34% $119.68
2004 20.84% $144.63
2005 15.57% $167.14
2006 26.64% $211.67
A/G Mean 9.73% 7.79%
Std.Dev/SR 21.30% 0.201

Figure 6.11 Performance of Vanguard Total International Stock Index Fund 1997 – 2006.

Vanguard Emerging Markets Stock Index Fund

Year Return $100.00
1997 -16.82% $83.18
1998 -18.12% $68.11
1999 61.57% $110.04
2000 -27.56% $79.71
2001 -2.88% $77.42
2002 -7.43% $71.67
2003 57.65% $112.98
2004 26.12% $142.49
2005 32.05% $188.16
2006 29.39% $243.46
A/G Mean 13.40% 9.31%
Std.Dev/SR 32.19% 0.180

Figure 6.12 Performance of Vanguard Emerging Markets Stock Index Fund 1997 – 2006

Page 24
Real Estate Characteristics
Real estate is usually treated as a separate asset class. Investment real estate can be classified into
three main types:
Residential: Single family homes, Apartments, Condos, etc
Commercial: Office space, Strip Malls, etc.
Industrial: Manufacturing plants, etc.

The easiest way to invest in real estate, apart from your home, is thru a Real Estate Investment Trust
or REIT.

Vanguard REIT Index Fund

FiscalYear Return $100.00
1997 18.77% $118.77
1998 -16.32% $99.39
1999 -4.04% $95.37
2000 26.35% $120.50
2001 12.35% $135.38
2002 3.75% $140.46
2003 35.65% $190.54
2004 30.76% $249.14
2005 11.89% $278.77
2006 35.07% $376.53
A/G Mean 15.42% 14.18%
Std.Dev/SR 17.34% 0.616

Figure 6.13 Performance of Vanguard REIT Index Fund 1997 – 2006.

As can be seen in Figure 6.13, REITs have performed very well for the past few years, although
some people believe that run may now be over. Note that REITs behaved poorly in 1998-99, when stocks
were strong, but performed well in 2000 – 2002 when the stock market lost about 40%.

Asset Allocation Chart

A summary asset allocation chart for the Vanguard index funds is shown in Figure 6.14. This
includes the style (growth/value) and capitalization for the various funds. Also the ten-year performance,
standard deviation and Sharpe Ratios have been calculated.

Page 25
Figure 6.14 Asset Allocation Chart for Vanguard Index Funds.
Page 26
 Building A Multi-Asset Portfolio

Basic Strategy:
Build a diversified core portfolio using index funds or ETFs with an asset allocation which matches
your personal risk tolerance and performance needs.

Top-Down Step-by-Step Instructions

Step 1
Determine your Personal Investor Profile, i.e. where you personally fit on the risk/reward curve.
Remember this is somewhat subjective and there is no single “right answer”
Step 2
Determine the major asset allocation appropriate for you based on your risk tolerance.
What percentage is appropriate for you in cash equivalents (money markets) ?
What percentage in bonds ?
What percentage in stocks ?
Do you need some percentage in tangible assets to counteract inflation ?
Step 3
For each of the major asset classes in Step 2, divide your allocation amongst the various sub-groups
e.g. If you picked 30% in bonds, how much do you want in Treasuries ? Munis ? etc.
For your stock allocation, how much growth ? large cap ? domestic ? foreign ? etc.
Step 4
Now select the specific stocks, mutual funds, etc to implement your personal asset allocation.
Step 5
Monitor your portfolio and rebalance as needed. There are numerous ways to do this, but the details
are not as important as having a simple plan and sticking to it.
e.g. Rebalance at fixed time intervals, say every six months or every January
or Rebalance when your original allocations get off by more than a predetermined amount, say
10%.
Vanguard STAR Fund, VGSTX
FiscalYear Return $100.00
1997 21.15% $121.15 25%
1998 12.38% $136.15 20%
1999 7.13% $145.86 15%
2000 10.96% $161.84 10%
2001 0.50% $162.65 5% Series1
2002 -9.87% $146.60
0%
2003 22.70% $179.87 1997 1998 1999 2000 2001 2002 2003 2004 2005 2006
-5%
2004 11.60% $200.74
-10%
2005 7.44% $215.68
2006 11.64% $240.78 -15%
A/G Mean 9.56% 9.18%
Std.Dev/SR 9.40% 0.605
Figure 6.15 Performance of Vanguard STAR Fund 1997 - 2006

The Vanguard STAR fund is a “fund of funds” with assets diversified across Vanguard’s short-term
and intermediate term bond funds, as well as managed funds such as Windsor II, and also International
Growth and Value Funds. This represents the performance of a well-diversified portfolio over the past ten
years.

Page 27
 Vanguard's "Lazy Portfolios" as of 12/31/06

Symbol Fund 1-yr 3-yr 5-yr 10-yr A B C D E

VFISX Short-Term Treasury 4% 2% 3% 5% 15%

VFSTX Short-Term Inv Grade Index 5% 3% 4% 5% 40%
VIPSX Inflation-Protected Securities 0% 4% 7% 33% 15% 10%
VBMFX Total Bond Market Index 2% 4% 5% 6% 40%
VWEHX High-Yield Corporate 8% 6% 8% 6% 5%
VUSTX Long-Term Treasury 2% 5% 7% 7% 5%
VFINX 500 Index 16% 10% 6% 8% 10% 15%
VTSMX Total Stock Market Index 16% 11% 7% 9% 33% 30% 15% 5%
VIVAX Value Index 22% 15% 10% 9% 10% 10%
VEXMX Extended Market Index 14% 14% 12% 10% 10%
NAESX Small-Cap Index 16% 14% 12% 10% 10% 5%
VISVX Small-Cap Value Index 19% 16% 13% 10% 10% 5%
VISGX Small-Cap Growth Index 12% 12% 11% 5%
VGSIX REIT Index 35% 25% 23% 14% 20% 10% 5%
VGTSX Total International Stock Index 27% 21% 16% 8% 33% 20% 10%
VEURX European Stock Index 33% 21% 15% 11% 5% 5%
VPACX Pacific Stock Index 12% 18% 15% 3% 5% 15%
VEIEX Emerging Markets Stock Index 28% 29% 26% 9% 5% 20%
Total: 100% 100% 100% 100% 100%
Legend
A Scott Burns' Margaritaville Portfolio CAGR
B David Swensen's Yale University Portfolio 1-yr 14.2% 17.6% 14.4% 14.7% 15.7%
C Bill Schultheis' Coffeehouse Portfolio 3-yr 12.0% 13.5% 11.6% 11.3% 15.4%
D Bill Bernstein's No-Brainer Portfolio 5-yr 10.2% 11.5% 9.7% 9.4% 13.3%
E Ted Aronson's Modified Lazy Man's Portfolio

Derived from Lazy Portfolios Win Again , Paul Farrell, MarketWatch.com, 1/17/07. VgLzPrt.xls

Figure 6.16 Performance Details for Vanguard’s “Lazy Portfolios”

The data shown in Figure 6.16 above summarize the performance of five sample Vanguard “Lazy
Portfolios”. The are diversified portfolios assembled by various well respected money managers, and
reviewed regularly by Paul Farrell of MarketWatch.com. As can be seen, the portfolios contain from 3 to
11 of Vanguard’s funds. All data are for 5-year period ended 12/31/2006. The CAGR for this period
ranges from 9.4% pa to 13.3% pa, versus a return of 6.2% pa for the S&P 500 benchmark. These funds,
like the STAR fund, give a good measure of the performance to be expected from professionally managed
diversified portfolios over this ten-year period.

These are simple “set and forget” portfolios except for occasional rebalancing. It is possible to
build similar portfolios using mutual funds or ETFs from other fund families. Choose a family you feel
comfortable with.

Tip
Think BIG (Boring Is Good !). This is a low maintenance method to lock in the market’s long-term
return with minimal effort or risk. Remember that most professional active managers fail to accomplish

Page 28
this. If, after you have successfully achieved this level, you wish to shoot for the higher risk/reward end of
the curve, do so initially with perhaps 10 – 20% of you portfolio value.

Portfolio Monitoring and Maintenance

Once you have built a portfolio appropriate to your personal investment profile you should monitor
it at least annually and rebalance as necessary to the original asset allocation percentages. This can feel
counter-intuitive since it means selling off some of your winners and investing more in the funds which
have not performed well recently. However it is more appropriate to think of rebalancing as implementing
a buy low / sell high strategy. There are numerous techniques to implement rebalancing in practice, but the
two below are the most common.

1. Rebalance at regular time intervals, say in the first week of January every year. For most
portfolios annual rebalancing is adequate. However some people rebalance as often as quarterly.

2. Rebalance only when the performance of the various funds has changed your original allocation
by more than a predetermined amount. For example if your original allocation for a fund was 25%,
you might choose to only rebalance if that allocation dropped below 20% or rose above 30%.

The Callan Periodic Table of Investment Returns

Callan Associates publishes an interesting chart every year (see website on last page). The chart
shows the annual return for each of eight major indices as follows:
S&P 500 Large Cap Index
S&P 500 Large Cap Growth Index
S&P 500 Large Cap Value Index
Russell 2000 Small Cap Index.
Russell 2000 Small Cap Growth Index
Russell 2000 Small Cap Value Index
Morgan Stanley Capital International Europe Australasia and Far East (MSCI EAFE) Index
Lehman Brothers Aggregate Bond Index

The chart shows the ranking of the indices for each of the past 20 years. This is best viewed in color on the
Callan website. Then it is easier to appreciate the difficulty of attempting to predict the future. We can
only prepare for it by building a properly diversified portfolio.

Page 29
 Chapter 7: Investment Vehicles
Mutual Funds
An open-end mutual fund, usually called simply a mutual fund, is the most popular form of pooled
investment. The contributions of thousands of individual investors are pooled and managed by a
professional fund manager according to the stated objectives of the fund. Shares are purchased directly
from the fund at the Fair Market Value (FMV) at the close of trade for that day. Also the fund stands ready
to buy back its shares at any time.

Mutual funds provide numerous advantages to the investors.

1. Low entry level
2. Instant diversification
3. Professional management
4. Lower transaction costs due to economy of scale
5. Easy record-keeping for tax purposes, etc.

The primary disadvantage of mutual funds is their cost. All funds charge a management fee which
can range from a small fraction of a percent for some index funds to as much as 2% for specialized actively
managed funds.

In addition some fund families charge a load which can take many forms.
Front-end load: This is a sales charge at the time the fund is bought. It can be as high as
5.7%.
Back-end load: Instead of a front-end load some funds charge a fee which is due when the
fund is sold. Very often this load is reduced for each year you own the fund.
e.g. First year 5%
Second year 4%
Third year 3%
Fourth year 2%
Fifth year 1%
Subsequent years No back-end fee
12b-1 fee: This is an annual fee charged by some funds to cover their marketing and sales
costs.

Many funds are traded without any load, i.e. they are no-load funds. Numerous studies have shown
that no-load funds on average outperform load funds by the amount of the load. In other words the only
thing a load buys you is a salesman’s time.

There are numerous index funds available which seek to track the performance of all the major
indices, e.g. S&P 500. Most of these index funds have very low management fees (often less than 0.25%)
since they are not actively managed.

Documentation
Prospectus: Each fund must by law provide you with a prospectus before you invest. This
will contain the following data as a minimum.
Fund Objective: formally defines the fund’s investment goals
Risks of investing in the fund
Annual returns for the past ten years
How to buy, exchange or sell shares of the fund.
Page 30
 Annual Report: This gives the recent performance and current holdings for the fund. Very
often quarterly or semi-annual reports are also issued.

Statements are issued monthly, quarterly, semi-annually or annually. Retain a copy of the
annual statements for your records as long as you own the fund. The other
statements can be discarded as soon as they are reconciled with your annual
statement.

1099-Div: Mutual funds issue these as a record of the tax information they have filed with
the government. Your pro-rata share of the funds transactions is on the 1099-Div and
must be transferred to your personal income tax returns.

Closed-end Funds
Closed end funds behave very similarly to regular mutual funds in all regards except the manner in
which they are traded. Only a finite number of shares is issued initially by the fund; thereafter all trades are
done with your stock broker at the current market price. Since the current market price may be higher or
lower than the FMV of the separate components of the fund, it can trade at a premium or discount to the
FMV. A popular strategy is to try to buy funds at a deep discount and hold them until the discount narrows
or turns to a premium.

Exchange Traded Funds (ETFs)

ETFs are pooled investments very similar to index mutual funds. They may have lower
management fees, but must be traded by your stock broker for a small commission. If you want to make a
large one-time purchase an ETF may suit you better than the equivalent mutual fund. However if you plan
to dollar-cost-average into a fund with purchases on a regular basis, the index fund would probably be
cheaper.

Since ETFs are traded with your stock broker like common stock, you have a few options not
available with a mutual fund.
1. When trading an ETF you get the current price at the time of the transaction, as opposed
to the FMV of a mutual fund computed at the close of the business day.
2. ETFs can be sold short just like a stock.

Real Estate Investment Trusts (REITs)

A REIT is a pooled investment of real estate assets. Like a mutual fund it gives you instant
diversification for a low initial investment. Also, unlike direct ownership, it can be traded
immediately, avoiding the traditional real estate liquidity problem.

REITs come in two major flavors:

1. Mortgage REITs invest in real estate backed mortgages, and provide you with interest
income. Mortgage REITS comprise only about 7% of the total REIT industry.
2. Equity REITs are fractional interests in real estate ownership and operational income.
Historically they pay good dividends, but the dividends are not qualified for tax purposes,
i.e. they are taxed as ordinary income. Hence it is best to hold these investments in a tax
deferred account.

Page 31
Alternative Investments
There are numerous other types of investment which require a special care and knowledge beyond
the scope of this brief tutorial.
Collectibles: fine art, coins, stamps
Commodities and Commodity Futures: oil, gas, precious metals, grains, pork bellies, etc.
Options and Derivatives
Hedge Funds
Many of these suffer from one or more of the following characteristics: (i) high volatility, (ii) liquidity
problems, (iii) high entry level, (iv) high fees.

Tip: Never invest in anything that you don’t fully understand.

Individual bonds
Treasuries can be bought through your stock broker (for a small commission), or from Treasury
Direct without a commission. It is easy to open an account at their website www.treasurydirect.gov.

Although it is possible to purchase individual bonds, it is usually more practical to use bond mutual
funds to provide the fixed income portion of your portfolio. However an individual bond has one
beneficial characteristic not offered by a fund; it matures on a date certain. Thus your risk of a
capital loss disappears if you are willing to hold the bond to maturity. Furthermore this allows you
to build a bond (or T-Bill) ladder with maturities ranging from a few months to several years. As
each bond matures it can be replaced with another, choosing a maturity to extend the ladder another
step.

The major risks of investing in bonds are (a) interest rate risk, and (b) default risk.

Individual stocks
Usually it is more practical to own stocks as part of a pooled investment vehicle such as a mutual
fund or ETF because of the instant diversification inherent with the fund. However there are a few
reasons why an experienced investor might want to invest part of his portfolio in individual stocks.
1. Avoid the fund management fees
2. Owning individual stocks gives the investor full control over the timing of his trades so that
he can optimize his taxable capital gains and losses at the end of each year.
3. Most mutual funds are too large to invest in very small-cap stocks. Thus an investor can
potentially exploit the inefficiencies of a market from which the large institutions are
excluded. However this can be a volatile market, and not for the faint of heart.

Documentation
The Annual Report is management’s report card to the owners, i.e. the investors. Read the
Chairman’s report to get an overview of the company’s activities for the past year. Next are the
financial statements, which are described in detail on the following pages.
Balance Sheet
Income Statement
Statement of Cash Flows
Then check out the CPA’s letter authenticating the accounting practices. Finally, read the footnotes
to the financial statements. Remember that the large print giveth and the small print taketh away !

Page 32
 Chapter 8: Stock Analysis … The Annual Report
The financial statements for Home Depot are shown in Figures 8.1 thru 8.3. Simplified versions are
used below to highlight the major components of each statement.

The Balance Sheet as of 1/29/06 (amounts in millions except per share data)
Assets: Current assets (with a life less than one year)
Cash and cash equivalents $ 793
Receivables 2,396
Inventories 11,401
Other assets 756
Total current assets 15,346
Property, plant and equipment (PPE) 31,530
Less depreciation 6,629
Net PPE 24,901
Other Assets 4,235
Total assets 44,482
Liabilities: Current liabilities (with a life less than one year)
Loans payable 900
Accounts payable 6,032
Income taxes due 388
Other liabilities 5,581
Total current liabilities 12,901
Long-term debt 2,672
Deferred income taxes 1,023
Other long-term liabilities 977
Total liabilities 17,573
Stockholders’ Equity: (equals Assets – Liabilities)
Common stock 120
Retained earnings 28,943
Other (2,154)
Total stockholders equity 26,909
Total liabilities plus stockholders’ equity 44,482

The Income Statement for Fiscal Year ended 1/29/06 (amounts in millions except per share data)
Operating revenues
Sales revenues na
less returns and allowances na
equals Net Sales $ 81,511
less Cost of Sales 54,191
equals Gross Profit 27,320
less Operating expenses
General and administrative expenses 16,485
Depreciation and amortization 1,472
equals Operating Income 9,363 continued on Page 35
Page 33
Figure 8.1 Balance Sheet for Home Depot, 1/29/06
Page 34
Figure 8.2 Income Statement for Home Depot for Fiscal Year ended 1/29/06

The Income Statement continued from Page 33

Operating income $ 9,363
Non-operating income -
Earnings before Interest and Taxes (EBIT) 9,363
less net interest expense ($81)
Earnings before income taxes 9,282
less income taxes 3,444
equals Net Earnings 5,838

Average common shares 2,138

Earnings per share (EPS) $2.73

Page 35
Figure 8.3 Cash Flow Statement for Home Depot for Fiscal Year ended 1/29/06

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Statement of Cash Flows for Fiscal Year ended 1/29/06 (amounts in millions)
Cash Flows from Operating Activities
Net earnings $ 5,838
Depreciation and amortization 1,579
Other (933)
Net Cash Flow from Operations 6,484

Cash Flows from Investing Activities

Additions to (disposal of) PPE (3,881)
Purchase of Investments (18,230)
Other 17,525
Net Cash Flow from Investments (4,586)

Cash Flows from Financing Activities

Repurchase of Common Stock (3,040)
Dividends paid to stockholders (857)
Other 2,285
Net Cash Flow from Financing (1,612)

Net increase (decrease) in cash/equivalents 286

Financial Ratios
Return ratios: measure the company’s annual return.
Return on Equity, ROE = Net profits / Common equity
This is one of the fundamental measures of a company’s business. However care
must be taken in its use since the value can be affected by the firm’s financial
leverage.
For Home Depot, the ROE = $5,838M / $26,909M = 22%
Return on Assets, ROA = Earnings before Interest and Taxes (EBIT) / Total assets.
Measures the efficiency of the firm’s use of its assets.
For Home Depot, the ROA = $9,363M / $44,482M = 21%

Liquidity and Coverage ratios: used to evaluate the riskiness of a firm’s securities.
Current Ratio = Current assets / Current liabilities
Represents the ability of the firm to pay off its current liabilities (< 1 year) by
liquidating current assets.
For Home Depot, the Current Ratio = $15,346M / $12,901M = 1.19
Quick Ratio = (Cash + Receivables) / Current Liabilities
Also known as the Acid Test Ratio
Similar to the current ratio except that it excludes inventories from current assets.
For Home Depot, the Quick Ratio = $3,189M / $12,901M = 0.25

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 Interest Coverage Ratio = Earnings before Interest and Taxes (i.e. EBIT) / Interest expense
Also known as the Times Interest Ratio
Measures the financial leverage of the company.
For Home Depot, the Interest Coverage Ratio = $9,363M / 81M = 116

Market Price ratios: measure the current value of the company.

Assume that the market price of Home Depot is $41 per share when calculating the ratios below.
Price/Dividend Ratio, P/D = Market price / Annual dividends per share
Many investors regard the P/D ratio as more reliable than the P/E ratio below since
the latter can be “manipulated” more easily by management in the financial
statements.
The Dividend Yield, D/P is the reciprocal of the P/D Ratio.
For Home Depot, the P/D Ratio = $41/$0.40 = 102
and the Dividend Yield = $0.40/$41 = 1.0%

Price/Earnings Ratio, P/E = Market price / Earnings per share

This ratio is also referred to as the P/E multiple.
The Forward P/E Ratio uses the estimated earnings for the next 12 months instead
of the past year.
The Earnings Yield (=E/P) is the reciprocal of the P/E ratio.
For Home Depot, the P/E Ratio = $41/$2.73 = 15
and the Earnings Yield = $2.73/$41 = 6.7%

Price/Book, P/B = Market price / Book value (i.e. shareholders’ equity) per share
Investors sometimes see the book value of a company as a “floor’ supporting the price.
For Home Depot, the P/B Ratio = $41/$12.59 = 3.3

Price/Sales, P/S = Market price / Annual sales per share.

This ratio is most often used for new companies which do not have any net earnings
yet.
For Home Depot, the P/S Ratio = $41/$38.12 = 1.1

The values for the above ratios vary considerably from one market sector to another, and also
between value and growth styles. To assess a particular stock it is best to compare it to others in the same
industry, or to the industry average.

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The Dividend Discount Model (DDM)
The Intrinsic Value of a stock, V0, is equal to the Present Value of the firm’s expected future net cash
flows, discounted by the required rate of return.

i.e. V0 = D1/(1+r) + D2/(1+r)^2 + ….. + Dn/(1+r)^n + ….. Equation (1)

where Dn is the expected dividend at the end of the nth year, and r is the required rate of return.

The Constant Growth DDM

If we assume that the annual dividends are growing at a constant rate, g, then
D1 = D0(1+g)
D2 = D0(1+g)^2
………………. etc.
Therefore, substituting for D1, D2, etc. in Equation (1) gives
V0 = D0(1+g)/(1+r) + D0(1+g)^2/(1+r)^2 + ….. Equation (2)
Using the techniques of mathematical induction, we multiply both sides by (1+r)/(1+g)
V0(1+r)/(1+g) = D0 + D0(1+g)/(1+r) + D0(1+g)^2/(1+r)^2 + ….. Equation (3)
Subtracting Equation (2) from Equation (3) gives
V0{(1+r)/(1+g) – 1} = D0
Therefore V0 = D0(1+g)/(r-g)
i.e. V0 = D1/(r-g)

For example, if a stock is expected to pay a $4 dividend next year, with an expected growth rate of
5% per annum, and your required rate of return is 12%, then the intrinsic value of the stock is given by
V0 = $4.00/(0.12 – 0.05) = $57.14
If the stock is currently trading for less than $57.14 you may want to consider buying it. If it is currently
trading above this price it may be overvalued. However there are a few important points to keep in mind.
1. All of the numbers used in the calculation are only estimates of expected future values, and can
change quickly.
2. All the large professional investors have access to the same (or better) information you used in the
calculation and may have driven the current stock price close to its intrinsic value.
3. Since different investors may require different discount rates, the intrinsic value of a stock will not
be the same or all investors.

The intrinsic value of a stock should only be used as a guide to its price. Obviously it is important to
look at other fundamental parameters before buying the stock.

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 Chapter 9: Fundamentals of Stock Screening
It is not practical to build an optimized stock portfolio by making selections from the 8000
candidates available without using a computer. The goal of most computerized screening programs is to
eliminate the bulk of the stocks which are not appropriate for our needs and give us a short list of perhaps
20 or 30 stocks for further analysis.

Screening programs either contain their own database of stocks, or we must access the data
elsewhere. Either way, the database usually has 100 or more parameters relating to as many as 8000
stocks. Typically a database includes data on the stock’s price, earnings and dividends, returns for various
time periods, revenues, etc, etc. It is up to us to determine which of these parameters is important in our
screen, and what an appropriate value or range should be for each parameter. In other words, we need to
identify the types of stocks which might be suitable for our individual portfolio as determined by our
Investment Profile. This way we can program the screen to search the full database and give us a short list
of stocks which are potential matches.

Before starting to screen your own stocks it is useful to review the screens available in AAII’s Stock
Investor Pro screening tool. These include over 50 pre-programmed screens emulating the techniques of
well-known investors such as Warren Bufffett, William O’Neil and Marty Zweig, as outlined in their
books. One value screen following Buffett’s value approach includes the following elements:
Market cap >/= $1B
Gross Operating Income > 0 for each of the past seven years
Return on Equity > 15 for each of the past three years
LT Debt/Equity < Industry LT Debt/Equity
etc., etc.

When run on the 2/28/07 Stock Investor Pro database, this screen output 49 stocks which are potential
candidates for further analysis at this time. Note that many of these screens call for a portfolio with an
extremely high turnover rate, ranging from a few percent to as high as 30% or 40% per month. Therefore
most investors use the screens to identify stocks to buy, but then hold the stocks long-term.

It is important to note that the short list from the screening program is personalized, i.e. it is
designed to match our Investment Profile. Furthermore, this list is just a start. We must still look at these
stocks in more detail to see if they truly fit our needs. For example, if stocks with a high P/E ratio are
generally considered overpriced, why not screen for under-priced stocks with a low P/E ratio ? If our
screen gives us a list of candidates with P/E ratios of 4 or 5, should we consider these to be bargains ? First
we should ask why they are so under-priced. In all probability we may find that these companies are in
serious trouble, e.g. in bankruptcy. They may still be worth considering, but we need to do our due
diligence to determine the probability of them successfully emerging from bankruptcy. Always be
skeptical of the results until you have satisfied yourself that they make sense.

A final word of warning: Computers are great tools, but before we ever sit in front of a computer
we must be crystal clear on our needs and what we are trying to accomplish. Also keep the following
truisms in mind.
The GIGO principle: Garbage In, Garbage Out !
To err is human, but to really screw up you need a computer !

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 Chapter 10: Modern Portfolio Theory
Modern Portfolio Theory, MPT, was developed by Harry Markowitz and William Sharpe in the
early 1950s, and earned them each a Nobel Prize in economics. It addresses the efficiency of a diversified
portfolio, i.e. how to achieve the best tradeoff between portfolio risk and return.

Figure 10.1 Capital Allocation Line for a Risk-Free Asset and a Risky Asset.
(from Reference 5)
First let’s look at a portfolio combining a risk-free asset (e.g. T-Bills) with a risky asset such as a
stock portfolio. In figure 10.1 these are indicated by F and P respectively. The straight line connecting the
two assets is called the Capital Allocation Line, CAL. The slope of the line is given by the risk premium
(i.e. the difference between the returns of the risky and risk-free assets) divided by the standard deviation.
We should now recognize this as the Sharpe ratio. An investor can adjust the overall risk of his portfolio
by selecting the relative mix of the two assets. Also he can increase his potential return (and risk) by
buying the stocks on margin. This moves the overall portfolio point out beyond P on the extended CAL.

Figure 10.2 Curve showing Portfolio of Two Risky Assets. (from Reference 5)
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 Next, let’s look at the case where we have two risky assets, such as portfolios of stocks and bonds.
This is represented by the curve shown in Figure 10.2, which we discussed in an earlier chapter. The shape
of the curve is determined by the correlation between the two portfolios. For stocks and bonds the
correlation coefficient has historically been about 0.2. If they were perfectly correlated the curve would
degenerate into a straight line connecting the two portfolios. In that case there would be no diversification
advantage to be gained by mixing the two assets.

As can be seen, the minimum risk portfolio occurs for a small fraction of the stock fund blended
into a mostly bond portfolio. A rational investor would not own a lower percentage of stocks because this
would move him down the curve to a lower return while simultaneously increasing his risk. On the other
hand, it is perfectly logical to target a higher return (and risk) by moving up the curve from the minimum
risk point, i.e. towards a higher percentage of stocks.

Figure 10.3 Portfolio of Risk-Free Asset and Two Risky Assets.

(from Reference 5)

Finally, we examine the case where we have a risk-free asset combined with a portfolio of two risky
assets. What is the optimum mix for the stock and bond funds ? Our first thought might be to draw the
CAL from the risk-free asset to the minimum risk point, A, for the risky portfolio as shown by CALA in
Figure 10.3. As we have already seen, the slope of this line is the Sharpe ratio, i.e. the risk premium per
unit risk. But we can increase the slope of the CAL by moving up to point B on the curve, as shown by
CALB. In fact the optimum point, with the highest Sharpe ratio, occurs when the CAL is tangential to the
risky curve.

It is interesting to note that the optimum risky portfolio is theoretically the same for all investors
since it is determined only by the risks and returns for the assets, along with their correlation coefficients.
In fact we can view the market index as a good approximation for an optimum risky portfolio. However,
the individual investor can still determine his risk/reward trade-off (to match his Personal Investor Profile)
by moving back and forth along the optimum CAL between the risk-free asset and the optimized risky
portfolio.
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The Efficient Frontier

Figure 10.4 The Efficient Frontier of Risky Assets. (from Reference 5)

If we plot the returns of various risky assets against their standard deviations we get a scatter plot
similar to the one shown in Figure 10.4. If the correlation coefficients for the asset pairs are also know, we
can use a computer to calculate the optimum combinations of assets for a portfolio. This will form a curve,
known as the Efficient Frontier, which represents the set of portfolios with the maximum return for each
level of portfolio risk. The portfolios on the Efficient Frontier are efficiently diversified; we have used
their correlation, or more accurately lack of correlation, to maximum effect. By definition, all of the
individual assets will lie below the Efficient Frontier because they are not efficiently diversified.

Figure 10.5 on the next page shows an actual efficient frontier plot for Vanguard Total Stock
Market and Total Bond Index Funds, with the familiar shape. This graph was generated using a Portfolio
Optimizer program developed by Bob Smithson, and available free on AAII’s Silicon Valley chapter
website. Monthly data for the index funds for the three years from 2004 through 2006 was used as input,
along with the risk-free return for the period which was 2.75% per annum. Since monthly data was used,
the axes of the graph are graduated in monthly return and standard deviation values. For this time period
the program calculated the optimum portfolio mix of 64% Total Stock Market Index and 36% Total Bond
Index, shown by the red diamond on the curve. The monthly return for this optimum return is 0.68%, with
a monthly standard deviation of 1.53%, and a Sharpe ratio of 0.30.

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 Figure 10.5 Efficient Frontier Plot for Vanguard Total Stock Market and Bond Index Funds.

This graph is an example of using real-world data. It also indicates why we need to exercise
judgment in interpreting the computer results. I have drawn in the CAL line from the risk-free return
(0.23% per month) though the optimum portfolio, and tangential to the curve. The slope of this line
graphically shows the maximum Sharpe ratio. It is apparent that the mix of the two funds can change
significantly from the optimum values calculated by the computer with a minimal effect on the Sharpe
ratio. In fact it looks like the portfolio could swing from about 30% stocks all the way to 100% stocks with
very little degradation of the optimum Sharpe ratio. Also note that if the risk-free rate had been
considerably lower for the period the allocation between the two funds would have been more critical.
Finally, if we re-run this software using a different time period, say one year or 5 years, we could get very
different results. It is imperative to understand these sensitivities when using any software, and to be
careful in interpreting the results.

Efficient Market Hypothesis

The Efficient Market Hypothesis, EMH, states that the prices of securities usually reflect all the
available information about the securities at that time. The hypothesis comes in three forms:
Weak form: Stock prices already reflect all information contained in the history of past trading.
Semi-strong form: Stock prices already reflect all publicly available information.
Strong form: Stock prices reflect all relevant information, including insider information.

If the EMH is valid, all securities will be fairly valued; competitive bidding will eliminate under-
priced or over-priced stocks. Changes in security prices will only be triggered by new information, and
will be reflected immediately. This leads to the random price movements, evidenced by the “random-
walk” patterns seen in practice.

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 The implications of the EMH are that technical analysis and stock charting can’t work.
Fundamental analysis doesn’t fare much better. Only analysts with a unique insight will be rewarded for
their research. The goal is not to buy great firms, but to buy firms which are better than everyone’s
expectations. Active management is largely a waste of time. A passive low cost strategy is better, using
index funds or ETFs.

But …..
….. what about Warren Buffet ? Bill Miller ? Peter Lynch ? Don’t these great investors prove the
EMH wrong ? For example, Peter Lynch managed Fidelity’s Magellan Fund for 13 years and he
outperformed the S&P 500 for 11 of those years. Was that just luck ? Maybe !

Consider a ten-year experiment with 1000 active fund managers. Their average performance should
track the market average. At the end of the first year half of them will have performed above the market
average, and half below. Throw out the 500 under-performers, who obviously are poor managers, and
continue the experiment. At the end of the second year we are down to 250 good managers. At the end of
the tenth year we are left with one manager who has beaten the market for ten straight years. Is he a
genius, or just lucky ? Would it be wise to bet your retirement portfolio on this great track record for the
eleventh year ?

What about October 19, 1987, when the S&P 500 lost 20% in one day ? How does the EMH
explain that ? It can’t. Research has shown that there were no new information releases then to justify a
20% re-evaluation. There are certainly times when crowd psychology overrides the EMH, but the instances
are few.

The skepticism about the EMH is exemplified by the following joke. Two economist walking along
see a $20 bill on the sidewalk. As one reaches for it, the other says “Don’t bother; if it was real someone
would have picked it up already !”

In spite of the anomalies, many investors still believe that the market is mostly efficient. There may
be small segments which are less efficient because they are not readily accessible to the large institutional
investors. For example, the individual investor has a decided advantage with small-cap stocks. Also,
closed-end funds are not heavily traded, and appear to offer an opportunity to acquire stocks at a significant
discount to their fair market value.

Active versus Passive Portfolio Management

As we have seen, the EMT strategy is to build a diversified portfolio which suits your Investment
Profile using index mutual funds and/or exchange traded funds. The goal is to get the diversification you
need as cheaply as possible, and rebalance perhaps annually.

Those investors who are convinced they can beat this passive strategy may want to consider using a
Core + Satellite strategy. Retain the passive strategy for a 70% - 80% core of your portfolio and use the
remaining assets to seek a higher return. Before you embark on an active management strategy remember
that over 70% of active fund managers fail to beat their respective indices for the long term.

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 Chapter 11: Timing the Market; A Slippery Slope

Buy and Hold

The EMH indicates that our optimum strategy is to buy a diversified portfolio of index funds and
hold it forever. Does this make sense ? Is it rational to hold our carefully diversified portfolio through the
major economic cycles which form the background to our investing environment ?

Long Market Cycles (> 5 years)

Historically, inflation and interest rates swing through long-term cycles. For example, during the
Jimmy Carter years both these rates were in the high teens. They have been dropping since, with some
bumps along the way. Certainly it can make sense to adjust your stock/bond allocation to this long-term
cycle. Some investors suggest lightening up on stocks when the earnings yield falls below the T-Bill rate,
as happened in the late 1990s. Also, the returns from large-cap and small-cap stocks seem to follow cycles
of several years, as do the returns from growth and value investments. Surely even a die-hard buy and hold
investor would be tempted to track the changing market conditions and to adjust his portfolio accordingly ?
Two possible approaches suggest themselves.
1. Weak Timing Adjustment. If we feel we can identify the major market cycles we might consider
tweaking our standard asset allocation by a small amount (perhaps +/- 5%) to track the forecast
environment. For example, at this time there are arguments that value stocks are giving way to
growth again. Do we want to overweight our growth allocation by a few percent, and underweight
our value allocation ? The hope is to do better than the average market return, but there is a risk
that we could possibly do worse. Note that MPT still applies and we still need a balanced portfolio
optimized for risk/return. An annual rebalancing of the portfolio should be adequate.

2. Strong Timing Adjustment. If we are confident we can identify the major cycles, then why not exit
the unfavorable securities completely, i.e. switch totally from value to growth stocks ? Again our
hope to do significantly better than market returns, but the risk is high if we are wrong. MPT has
little meaning here. There is no need to build a low correlation portfolio if the unattractive
securities will be sold in the down cycles. Because of the increased risk of mistiming the market we
probably should monitor our portfolio monthly in this case.

Short Market Cycles (< 5 years)

This is a similar situation to the Strong Timing case above, but we need to monitor our portfolio on
a daily or weekly basis instead of monthly. The risk increases as the cycle become shorted and less
predictable. Note that there is a tendency for significant portions of stock market moves to occur at the
very beginning of the cycle. There is a good chance that we would miss out on these. In other words, the
historical deck is stacked against us being able to capitalize consistently on short market cycles.

Ultra-Short Cycles
A day trader must monitor his investments, or rather speculations, continuously. Most serious
investors believe it is not possible to make money trying to find useable patterns in the random fluctuations
of daily trading.

Conclusion
Unless you are a very experienced investor, your first choice for the bulk of your retirement
portfolio should probably be in a diversified portfolio of index funds or ETFs. If you really want to try
“beating the market”, either by timing or stock picking, it would be prudent to venture only a small portion
of your portfolio initially, and leave the rest in your diversified portfolio.
Page 46
 References
1. Investing Basics … and Beyond by Maria Crawford Scott, AAII, 2005.
2. Stock Investing Strategies by Maria Crawford Scott and John Bajkowski, AAII, 2004
3. Maximum Return Minimum Risk by James B. Cloonan, AAII, 2005
4. The Top Mutual Funds, AAII annual guide, 2007
References 1 through 3 are tutorials by AAII (including the book accompanying this workshop),
and cover the fundamental concepts of investing. Much of this information is available at the AAII
website listed below. Reference 4 is AAII’s annual guide to no-load and low-load mutual funds.
5. Essentials of Investments by Zvi Bodie et al, Third edition 1998
This is an excellent textbook, and many of the diagrams in this workshop are drawn from it. It
could be useful as a reference, but is not likely to be read from cover to cover.
6. A Random Walk Down Wall Street by Burton Malkiel
7. Common Sense on Mutual Funds by John Bogle
8. Winning the Loser’s Game by Charles D. Ellis 2002
These three books are easy to read, and give a good overview of the investing world without any
gimmicks. This is especially true of Burton Malkiel’s classic Random Walk book.
9. Stocks for the Long Run by Jeremy Siegel
10. Fire Your Stock Analyst ! by Harry Domash 2003
These two books cover the fundamentals of stock analysis
11. Asset Allocation by Roger Gibson 1990
This is the classic book on asset allocation, but can be a little heavy on math at times.
12. Determinants of Portfolio Performance by Brinson et al, Financial Analyst Journal, July/Aug 1986
13. The Asset Allocation Hoax by William Janke, Journal of Financial Planning, February 1997
14. Asset Allocation Revisited by William O’Rielly et al, FPA Journal, January 2000
Reference 12 is the original Brinson study. Reference 14 is a good summary of the debate over
Brinson’s work, and has a useful bibliography for those who want to dig deeper.

Websites
www.aaii.com AAII’s national website
www.siliconvalleyaaii.org Local Silicon Valley chapter website
www.vanguard.com Vanguard Group mutual fund family
www.trprice.com T. Rowe Price mutual fund family
www.franklin.com Franklin Templeton mutual fund family
www.finance.yahoo.com Yahoo financial website
www.smartmoney.com Smart Money magazine
www.moneycentral.msn.com MSN financial website
www.morningstar.com Morningstar website
www.riskgrades.com RiskGrades website
www.callan.com/resource/period_table/pertbl.pdf Callan Chart available here
www.treasurydirect.gov US Treasury Dept, for direct purchase of T-Bills etc.
www.investinbonds.com Useful info in Bonds
www.investinreits.com Useful info on REITS
www.nareit.com Official NAREIT website.

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