11A
Investing Basics and
Evaluating Bonds #1
What does this chart tell you about investing?
11-1
Why People Invest
• To achieve financial goals, such as the
purchase of a new car, a down payment
on a home, or paying for a child’s
education.
• To increase current income.
• To gain wealth and a feeling of financial
security.
• To have funds available during retirement
years.
Objective 1
Explain Why You Should Establish an
Investment Program
Establishing Investment Goals
• Financial goals should be:
– Specific
– Measurable
– Tailored to your financial needs
– Aimed at what you want to accomplish
• Financial goals should be the driving
force behind your investment plan
11-3
Establishing Investment Goals
1.
What will you use the money for?
2.
How much money do you need to satisfy your investment goals?
3.
How will you obtain the money?
4.
How long will it take you to obtain the money?
5.
How much risk are you willing to assume in an investment program?
6.
What possible economic or personal conditions could alter your
investment goals?
7.
Considering your economic circumstances, are your investment goals
reasonable?
8.
Are you willing to make the sacrifices necessary to ensure that you meet
your investment goals?
9.
What will the consequences be if you don’t reach your investment goals?
11-4
Performing a Financial Checkup
• Work to balance your budget
– Do you regularly spend more than you make?
– Pay off high interest credit card debt first
• Obtain adequate insurance protection
• Start an emergency fund you can access quickly
– Three months of living expenses
• Have access to other sources of cash for emergencies
– Pre-approved line of credit
– Cash advance on your credit card
11-5
Surviving a Financial Crisis
1. Establish a larger than usual emergency fund
2. Know what you owe
•
Identify debts that must be paid
3. Reduce spending
4. Pay off credit cards
5. Apply for a line of credit at your bank, credit
union, or financial institution
6. Notify credit card companies and lenders if
you are unable to make payments
7. Monitor the value of your investment and
retirement accounts
11-6
Getting the Money Needed to Start
an Investing Program
• Pay yourself first
• Take advantage of employer-
sponsored retirement programs
• Participate in elective savings programs
• Make a special savings effort one or two
months each year
• Take advantage of gifts, inheritances,
and windfalls
11-7
The Value of Long-Term
Investing Programs
• Even small amounts invested regularly
grow over a long period of time
• If you begin saving $2,000 each year.
depending on the rate of return, you could
have over $1 million by the time you are age
65 (See Exhibit 11-1 on page 356)
• The higher the rate of return, the greater the
investment risk
11-8
Objective 2
Describe How Safety, Risk, Income,
Growth, and Liquidity Affect Your
Investment Decisions
Factors Affecting the Choice of Investments
• Safety and risk
– Risk = uncertainty about the outcome
– Investment Safety = minimal risk of loss
– Risk-Return Trade-Off
• The potential return on any investment should
be directly related to the risk the investor
assumes
– Speculative investments are high risk, made by
those seeking a large profit in a short time
11-9
Components of the Risk Factor
• Inflation Risk  during periods of high inflation,
your investment return may not keep pace with
inflation; lose purchasing power
• Interest Rate Risk  the value of bonds or
preferred stock may increase or decrease with
changes in interest rates
• Business Failure Risk  affects stocks and
corporate bonds (when business is not profitable)
• Market Risk  the risk of being in the market
versus in a risk-free asset (stocks follow market cycle)
11-10
Investment Income, Growth
and Liquidity
•
Investment Income
– A predictable source of income (dividends
or interest)
– Most conservative = passbook savings,
CDs and government securities
– Other choices:
•
•
•
•
•
•
Municipal and corporate bonds
Preferred stock
Utility stocks
Selected common stocks
Selected Mutual funds
Rental real estate
11-11
Investment Income, Growth
and Liquidity
•
Investment Growth
–
–
–
•
Growth in value (price appreciation)
Common stock usually offers the greatest potential for
growth
Mutual funds and real estate offer growth potential
Investment Liquidity
–
2 Dimensions:
• Ability to buy or sell investment quickly
• Without substantially affecting the investment’s
value
• Bank accounts VERY liquid; CDs have penalties;
stocks and bonds could lose money upon sale
11-12
Traditional Investment Evaluation
Factors
11-13
Objective 3
Identify the Factors That Can Reduce
Investment Risk
Asset Allocation = The process of spreading your
assets among several different types of investments
(choose % weightings in each)
• The ratio of stocks, bonds, cash assets, other securities
in your portfolio (Conservative, Moderate, Aggressive portfolios
with different asset weights: conservative portfolio = less stock)
• Most important determinant of overall investment success
= Diversification (“eggs in different baskets”)
11-14
Portfolio Management & Asset
Allocation
Other Factors to Consider:
– Your Tolerance for Risk
• At what point can you no longer sleep easily?
• See http://njaes.rutgers.edu/money/riskquiz/
– Your Investment Time Horizon
• When will you need the money?
• How long can your money continue to grow?
– Your Age
• Growth vs. income (older people more conservative)
• Recovery time if investments nosedive
• One guideline: 110 – age = % of portfolio in stock
11-15
Your Role in the Investment
Process
1. Evaluate potential Investments
2. Monitor the value of your investments
3. Keep accurate records
4. Other factors
 Seek help from personal financial
planner
 Consider the tax consequences of
selling investments
11-16
Objective 4
Understand Why Investors Purchase
Government Bonds
• Government bonds = written pledge to:
– Repay a specified sum of money (face value)
– At maturity
– Along with periodic interest (coupon payments)
• Sold to fund the national debt and the ongoing
costs of government
• Three levels of government issues:
– Federal
– State
– Local municipalities
11-17
U.S. Treasury Bills, Notes and Bonds
Treasury Bills (T-Bills)
•
•
•
•
•
$100 minimum
4, 13, 26 and 52 weeks to maturity
Sold at a discount
Federal, but no state, tax on interest earned
“Reciprocal immunity” doctrine
Treasury Notes
•
•
•
•
•
$100 units
Typical maturities = 2, 3, 5, 7, and 10 years
Interest paid every six months
Higher rate than T-bills (Why?)
Federal, but no state, tax on interest earned
11-18
U.S. Treasury Bills, Notes and Bonds
Treasury Bonds
•
•
•
•
Issued in minimum units of $100
30 year maturity dates
Interest rates higher than Treasury notes & bills
Interest paid every six months
Treasury Inflation-Protected Securities
(TIPS)
•
•
•
•
Sold in minimum units of $100
Sold with 5, 10 or 20 year maturities
Principal changes with inflation (measured by CPI)
Pays interest twice a year at a fixed rate
11-19
Federal Agency Debt Issues
• Essentially risk free
• Slightly higher interest rates than Treasury
securities (Why?)
• Minimum investment may be as high as $10,000
to $25,000
• Maturities range from 1 – 30 years
• Average maturity = 12 years
• Issuing agencies sample:
–
–
–
–
Fannie Mae
Freddie Mac
GNMA
TVA
11-20
State and Local Government
Securities
Municipal Bonds (“Munis”)
• Issued by a state or local government
–
–
–
–
Cities
Counties
School districts
Special taxing districts
• Funds used for ongoing costs and to build major
projects such as schools, airports, and bridges
• General Obligation Bonds
– Backed by the full faith, credit and taxing authority of the
issuing state or local government
• Revenue Bonds
– Repaid from money generated by the project the funds finance,
such as a toll bridge
11-21
State and Local Government
Securities
Municipal Bonds (“Munis”)
• Key characteristics:
– Interest exempt from federal taxes
– Capital gains may NOT be tax exempt
– Usually exempt from state and local taxes in
state where issued
– Exempt status determined by use of funds
– Lower rate of return than on taxable bonds
• Insured municipal bonds
– Private insurance to reduce risk
11-22
Taxable Equivalent Yield Formula
Used to compare tax-exempt and taxable
bonds
Tax - e xe m pt yield
Taxable Equivale nt Yie ld 
1 - Your tax rate
Exam ple :
.05
Taxable Equivale nt Yie ld 
 .0694  6.94%
1 - .28
11-23
Wrap Up
• Concept Check 11-1- Why Develop Specific
Investment Goals? Why Participate in
Employer Retirement Savings Plan? How
the TVoM Affects Investing.
• Exhibit 11-2- A Quick Test to Measure
Investment Risk
• Concept Check 11-2- Four Components of
Risk
• Concept Check 11-4- Taxable Equivalent
Yields