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Investing Money What does it mean to invest money? Investing means putting your money where it can make more money by earning higher rates of return. Money should be invested to help you achieve your intermediate and long-term financial goals. Investing is riskier than savings, however, the longer the time period that you have before you need the money, the more risk you can assume. Investments will potentially earn a significantly higher return than traditional methods of savings and help your money outpace the rate of inflation. Important Investing Principles We are going to examine six important investing principles before we learn about different types of investments. These principles are: Pay Yourself First Risk versus Return The Time Value of Money (earned interest and compound interest) Diversification Dollar Cost Averaging The Rule of 72 The Pay Yourself First Rule (Investing) Whenever you receive money you should immediately invest a certain amount to meet intermediate financial goals (2-5 years) and long-term financial goals (over 5 years). As with the pay yourself first rule for savings, this is arguably the single most important factor in helping you achieve your financial goals. Risk versus Return (Investing) An important thing to understand when discussing investing is risk versus return. The lower the risk that an individual assumes the less the potential return. The higher the risk that an individual assumes the higher the potential return. The shorter the time period until the investment money is needed the more conservative the investment should be. The longer the time period until the investment money is needed the more aggressive or risky the investment can be. Understanding this rule will be helpful when deciding what the most appropriate type of investment is to help you reach your long-term financial goals. Time Value of Money Time value of money refers to the relationship between time, money, and the rate of interest. On the next few slides we are going to discuss the difference between earned interest and compound interest and how they relate to the time value of money. Earned Interest Earned interest is the payment you receive for allowing a financial institution or corporation to use your money. The bank compensates you for the use of your money by paying you interest. Interest = Principal x interest rate x time This is the interest for calculating earned interest (sometimes called simple interest). Earned Interest Example Principal= $1,000 Interest rate= 10% Time= 1 year $1,000 x .10 x 1 year = $100.00 Total amount= $1,100 Compound Interest “Compound interest is the most powerful force in the universe.” Albert Einstein Compound interest is the interest that is earned on interest. The formula for calculating compound interest is A = P (1 + i) ⁿ We will calculate an example on the next slide. Compound Interest A= the amount in the account P= the principal (the original amount of the investment) i= the interest rate n= the number of years compounded $1,000 (1+ .10)5 A= $1,610.51 Compound Interest Problems Use your calculator and the formula from the previous slides to calculate the value of the following investment scenarios. We are going to calculate compound interest on an annual basis. Problem 1 Diana invests $500 today in an account earning 7%. How much will it be worth in: 5 years? 10 years? 20 years? Problem 1 Answers $500(1+.07)5 $500 x 1.403= $701.28 $500(1+.07)10 $500 x 1.967= $983.50 $500(1 + .07)20 $500 x 3.870= $1935.00 Problem 2 Diana finds an account that earns 10%. How much will her $500.00 be worth at the new rate in 5 years? 10 years? 20 years? Problem 2 Answers $500 (1+.10)5 $500 x 1.610= $ 805 $500 (1+.10)10 $500 x 2.594= $ 1297 $500 (1+.10)20 $500 x 6.727= $ 3363.50 Diversification of Your Investments Diversification is reducing investment risk by putting money in several different types of investments. By spreading your money around, you’re reducing the impact that a drop in any one investment’s value can have on your overall investment portfolio. This follows the old saying about “not putting all of your eggs in one basket.” Dollar Cost Averaging This is the practice of investing a fixed amount in the same investment at regular intervals, regardless of what the market is doing. This is another key investment principle to know because it eliminates having to worry about investing at the “right” or “wrong” time. Dollar cost averaging evens out the ups and downs of the market. As the price of the investment rises, you simply end up purchasing fewer shares and when the price falls, you end up purchasing more. The Rule of 72 Mathematicians say that you can see how long it will take you to double your money simply by dividing 72 by the interest rate. An example of this would be if you were earning 6% interest on your investments. 72÷6= 12 This means that you would double your money in 12 years if the interest rate that you are earning is 6%. Types of Investments We are going to talk about some of the most common methods of investing. These include: Stocks Bonds Mutual funds Real estate Collectibles Continued We will spend time discussing each of these methods of investing. The first of these that we will discuss is investing in stocks.