Investment in Financial Capital
Objectives
• Summarize reasons why people invest, what is required before beginning, how returns are earned, and some ways to obtain funds to invest.
• Determine your own investment philosophy.• Recognize the variety of investments available. • Identify the major factors that affect the return on
investment.• Specify some strategies of portfolio management
for long-term investors.• List three guidelines to use when deciding the
best time to sell investments.
Establishing Investment Goals
• Financial goals should be specific and measurable.
• Why are you accumulating these funds?• How much do you need?• How will you get it?• How long will it take you to reach your goal? • How much risk are you willing to assume?• Are you willing to sacrifice current
consumption to invest for the future?• Is it realistic to try and save this amount?
Steps to Create a Personal Investing Plan
Step 1My investment goals are:________________________________________
Step 2By ___________, I will
have obtained $_______.
Step 3I have $__________available to invest.
Date _____________
Step 4Possible investment alternatives:
1._________________2._________________3._________________4._________________
Step 5Risk factors for each alternative
1.____________________2.____________________3.____________________4.____________________
Step 6Projected return on each alternative
1.__________2.__________3.__________4.__________
Step 7Investment decision1._______________2._______________3._______________
Step 8Final decision
1._______________2._______________
Step 9Continue evaluating choices.
Definitions:
• Saving: setting money aside for future use
• Investing: Putting the money to work for you or using your money to make more money
• Borrowing: Using next year’s income this year.
Investment Fundamentals
•Difference in return is a major distinction between savings and investing.
•Successful investors begin to live off earnings, without spending wealth itself.
ATTENTION!
Investment in Financial Capital
•Investment - use of economic resources to make a profit.
•Financial Capital - liquid resources of a government, business, or individual
Preparations for Investing
• Achieve financial goals
• Increase current income
• Gain wealth and financial security
• Have funds available for retirement
WHY PEOPLE INVEST:
Preparations for Investing
• Live within means
• Continue savings program
• Establish lines of credit
• Carry adequate insurance
• Establish investment goals
PREREQUISITES TO INVESTING:
• Interest
• Dividends
• Rent
• Capital gain/loss
• Rate of return or yield
Preparations for Investing
INVESTMENT RETURNS:
Performing a Financial Checkup
• Learn to live within your means• pay off high interest credit card debt
• Provide adequate insurance protection• Start an emergency fund
• three to nine months of living expenses• Have other sources of cash for emergencies
• line of credit• cash advance
Getting Money to Start an Investing Program
• Pay yourself first• Participate in elective savings programs
• Payroll deduction• electronic transfer
• Make a special effort to save one or two months a year
• Take advantage of windfalls• Invest half of
your tax refund
Value of Having a Long-Term Investing Program
• Many people don’t start investing because they only have a small amount to invest
but....
• Small amounts invested regularly become large amounts over time
• Handling risk
• Ultraconservative strategies
• Conservative
• Moderate
• Aggressive
Personal Investment Philosophy
• Handling risk
• Ultraconservative strategies
• Conservative
• Moderate
• Aggressive
Personal Investment Philosophy
Investment Selection
• Lend or own
• Short-term or long-term
• Choose a vehicle
Two ways to invest
• Lend: Promise of repayment of loan (principal) and interest• Deposit money in bank• Lending money to the government• Lending money to a business
• Own: Purchase an asset or equity• Buy stock• Buy mutual funds• Buy real estate• Buy collectibles
Factors That Affect Investment Decisions
• Safety - minimal risk of loss• Risk - uncertainty about the
outcome• inflation risk• interest rate risk•business failure risk•market risk
Factors that influence the investment decision: Risk Tolerance
• Risk represents the uncertainty that the yield on an investment will deviate from what is expected.
• The amount of risk a household can tolerate will determine:• The decision to invest• The type of investment• The investment strategy• The amount of investment
Types of Investment Risk
• Inflation risk: investment returns will not keep up with inflation.
• Default risk: the risk of losing a major portion of or all of your investment
Types of Investment Risk
• Interest rate risk: market interest rates rise devaluing fixed rate investments
• Marketability risk: having to sell a certain asset quickly; not being able to get the price you want. Also called liquidity risk.
Risk Tolerance Quiz
• Take the quiz listed in notes….• http://www.ag.ndsu.edu/money/05%20Risk%20Tolerance%20Quiz.pdf
Income From Investments
• Safest• CDs• savings bonds• T-bills
• Higher potential income• municipal bonds• corporate bonds• preferred stocks• mutual funds• real estate
Investment Pyramid
CommoditiesJunk bonds
Options
Rentalproperty
Utility stocks
GovernmentSecurities
Corporatebonds
CDsMoneyMarket
Savings Accounts Cash
High QualityStocks
Mutual funds
High risk
Lowrisk
Investment Growth and Liquidity
• Growth• increase in value•common stock•growth stocks retain earnings•bonds, mutual funds and real estate
• Liquidity•ease and speed to convert an asset to
cash
• Pure
• Speculative
• Risk pyramid
• INVESTMENT RISK:
Major Factors That Affect Rate of Return
• Inflation
• Deflation
• Interest rate
• Financial
• Market volatility
• Political
• INVESTMENT RISK TYPES:
Major Factors That Affect Rate of Return
• Random or unsystematic
• Diversification
• Market or systematic
• INVESTMENT RISK:
Major Factors That Affect Rate of Return
• Leverage
• Taxes• Marginal tax rate• Taxable vs. tax-free income
• Buying and selling costs/commissions
• Inflation
Major Factors That Affect Rate of Return
1. Identify before-tax return
2. Subtract marginal tax rate
3. Obtain net return after taxes
4. Subtract estimate of inflation
5. Obtain real rate
Major Factors that Affect Rate of Return
• CALCULATE REAL RATE OF RETURN:
Real Rate of Return Example
1. You are in the 28 percent tax bracket.
2. 1.0 - .28 = .72
3. If the yield on your investment is 6.25% then: .0625 x .72 = .045
4. Your after tax return is 4.5%
5. If inflation is 5%, your real rate of return after inflation is 4.75% (.05 x (1-.05) = .0475
• Business-cycle timing
• Dollar-cost averaging
• Portfolio diversification
• Asset allocation
Management Strategies — Long-Term Investors
Investment Alternatives
• What is stock? •part ownership in a
company• the money you pay for
shares of stock provides equity capital for the business
Investment Alternatives
• What is a bond? • a loan to a corporation, the
federal government, or a municipality
• The interest is paid twice a year, and the principal isrepaid at maturity (1-30 years)
• You can keep the bond until maturity or sell it to another investor
(continued)
Investment Alternatives
• What is a mutual fund? • investors’ money is pooled and invested
by a professional fund manager• you buy shares in the fund• provides diversification to reduce risk • funds range from conservative
to extremely speculative• match your needs with
a fund’s objective
(continued)
Monitor Your Investments
• Read your account statements• Chart the value of your investments• Maintain accurate and current
records• Calculate the current yield %
annual income from investment
market value of the investment
Sources of Investment Information
• Newspapers• Business Periodicals• Government Publications• Corporate Reports• Statistical Averages• Investor Services and newsletters
• Standard and Poor’s stock reports• Value Line• Moody’s investment service
Investment Philosophies
Best Time to Sell
• Take profits
• Cut losses
• “If wouldn’t buy it now, sell it”
Mandatory Financial Investment for Retirement• Employer / Employee Social Security
Contributions (15.3% of earnings up to a maximum taxable amount of $106,800 in 2009)
• Defined Benefit Private Pension Plans
• Defined Contribution Pension Plans• 401(k), 403(b), IRA• Roth IRA• Roth 401(k)
Discretionary Financial Investment for Retirement
Income and Consumption Over the Life Cycle
0
10,000
20,000
30,000
40,000
50,000
60,000
70,000
25 35 45 55 65 75 85
Age
$
Income
Consumption
Measures of Risk
• Beta - measures the variability in the rate of return of a particular stock relative to the larger stock market. • Beta stock A = 3.0 means the variability in
the rate of return of stock A is three times the market average
• Bond ratings - Standard and Poor’s and Moody’s ratings of bonds for default risk only.
The Relationship Between Rate of Return and Risk
• Risk and average rate of return are positively correlated.
• Risk and variance of rate of return are positively correlated.
Measuring the Rate of Return
• Typically think of rate of return in terms of interest paid per $1.00 invested. But, the timing of when you get this return varies depending on…
• income return - situation where the principal that is invested remains the same but the investor periodically receives income based on this investment.• Certificates of deposit• money market funds• bond interest• stock dividends
Calculating the Return on an Investment
Rate of Return is the total income you receive on an investment over a specific period of time divided by the original amount invested.
For example:
Assume you invest $3,000 in a mutual fund. Also assume the mutual fund pays you $50 dividends this year and that the mutual fund is worth $3,275 at the end of the year.
Step 1: Subtract the investment’s initial value from the investment’s value at the end of the year: $3,275 - $3,000 = $275
Step 2: Add the annual income to the amount calculated in Step 1.
$50 + $275 = $325
Step 3: Divide the total dollar amount of return calculated in Step 2 by the original investment.
$325/$3,000 = 0.108 = 10.8%
Measuring the Rate of Return
• Capital gain - situation where you get your return only when you sell the investment. •stocks•Real Estate•collectibles
• Sometimes, you get a combination of income and capital gains… makes it even more difficult to calculate the rate of return.
Measuring the Rate of Return
• The risk-return trade-off can also be managed by having a variety of investments in your portfolio
• BE DIVERSIFIED!
• Statistically, you need between 6-15 stocks in different in different industries to be fully diversified in the market
http://cpsinsurance.com/annuity/client_handouts/Real%20Rate%20of%20Return%20BW.pdf
Annual returns for stocks, T Bonds, T Bills from 1928 - 2008
• http://pages.stern.nyu.edu/~adamodar/New_Home_Page/datafile/histretSP.html
Average $100 invested in 1928 was worth___ in 2008:
Stocks 11.69% $128,968.10
Treasury Bills 3.91% $1,964.64
Treasury Bonds
5.26% $6,013.10
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