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
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•
•
•
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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?
What are your financial goals?
• Financial Independence
• Just starting your own financial life apart from your
parent(s)/guardian(s)
• Financial Stability
• Managing all of your financial resources effectively,
but unprepared to meet financial emergencies
• Financial Security
• The ability to manage and absorb financial
emergencies
• IMO, one of the best and easiest ways to attain
Financial Security is to create passive income
through investments
Steps to Create a Personal Investing Plan
Step 1
My investment goals are:
____________________
____________________
Step 2
By ___________, I will
have obtained $_______.
Step 3
I have $__________
available to invest.
Date _____________
Step 9
Continue evaluating choices.
Step 4
Possible investment alternatives:
1._________________
2._________________
3._________________
4._________________
Step 8
Final decision
1._______________
2._______________
Step 7
Investment decision
1._______________
2._______________
3._______________
Step 6
Projected return on each alternative
1.__________
2.__________
3.__________
4.__________
Step 5
Risk factors for each alternative
1.____________________
2.____________________
3.____________________
4.____________________
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
ATTENTION!
•Difference in return is a major
distinction between savings and
investing.
•Successful investors begin to live off
earnings, without spending wealth itself.
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
WHY PEOPLE INVEST:
• Achieve financial goals
• Increase current income
• Gain wealth and financial security
• Have funds available for retirement
Preparations for Investing
PREREQUISITES TO INVESTING:
• Live within means
• Continue savings program
• Establish lines of credit
• Carry adequate insurance
• Establish investment goals
Preparations for Investing
INVESTMENT RETURNS:
• Interest
• Dividends
• Rent
• Capital gain/loss
• Rate of return or yield
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
Personal Investment Philosophy
• Handling risk
• Ultraconservative strategies
• Conservative
• Moderate
• Aggressive
Personal Investment Philosophy
• Handling risk
• Ultraconservative strategies
• Conservative
• Moderate
• Aggressive
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
• Buy
• Buy
• Buy
stock
mutual funds
real estate
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
• The
• The
• The
decision to invest
type of investment
investment strategy
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://njaes.rutgers.edu/money/riskquiz/
Income From Investments
• Safest
• CDs
• savings bonds
• T-bills
• Higher potential income
• municipal bonds
• corporate bonds
• preferred stocks
• mutual funds
• real estate
Investment Pyramid
High risk
Commodities
Junk bonds
Options
High Quality
Stocks
Mutual funds
Utility
stocks
CDs
Rental
property
Government
Securities
Money
Market
Corporate
bonds
Savings
Accounts
Cash
Low
risk
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
Major Factors That Affect Rate of Return
• INVESTMENT RISK:
• Pure
• Speculative
• Risk pyramid
Major Factors That Affect Rate of Return
• INVESTMENT RISK TYPES:
• Inflation
• Deflation
• Interest rate
• Financial
• Market volatility
• Political
Major Factors That Affect Rate of Return
• INVESTMENT RISK:
• Random or unsystematic
• Diversification
• Market or systematic
Major Factors That Affect Rate of Return
• Leverage
• Taxes
• Marginal tax rate
• Taxable vs. tax-free income
• Buying and selling costs/commissions
• Inflation
Risk Tolerance
., REVIEW BOOK: Personal Finance. Retrieved Oct 1, 2009 from http://www.flatworldknowledge.com/node/50890
.
Calculating Percentage Rate of Return
Major Factors that Affect Rate of Return
• CALCULATE REAL 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
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
Management Strategies — Long-Term
Investors
• Business-cycle timing
• Dollar-cost averaging
• Portfolio diversification
• Asset allocation
Investment Alternatives
• What is stock?
• part ownership in a
company
• the money you pay
for shares of stock
provides equity
capital for the
business
An Example of Asset Allocation
., REVIEW BOOK: Personal Finance. Retrieved Oct 1, 2009 from http://www.flatworldknowledge.com/node/50890
.
Levels of Diversification
., REVIEW BOOK: Personal Finance. Retrieved Oct 1, 2009 from http://www.flatworldknowledge.com/node/50890
.
Investment Alternatives
(continued)
• 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 is
repaid at maturity (1-30 years)
• You can keep the bond until
maturity or sell it to another
investor
Investment Alternatives
(continued)
• 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
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
$110,000 in 2012)
• Defined Benefit Private Pension Plans
Discretionary Financial Investment for
Retirement
• Defined Contribution Pension Plans
• 401(k), 403(b), IRA
• Roth IRA
• Roth 401(k)
Income and Consumption Over the Life
Cycle
$
70,000
60,000
50,000
40,000
30,000
20,000
10,000
0
Income
Consumption
25
35
45
55 65
Age
75
85
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
Annual returns for stocks, T Bonds, T
Bills from 1981 - 2011
•
http://huntingtonfunds.com/ftp/brochures/Real_Return_CDs.pdf
Average
$100 invested in
1981 was
worth___ in
2011:
Common
Stocks-S&P 500
Small Company
Stocks
Treasury Bills
10.42%
$2,160.13
9.55%
$1,690.38
5.20%
$481.38
Treasury Bonds
10.69%
2,330.02