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