Personal Investments
GBUS 108
Creating Wealth for a Lifetime
Instructor’s Book
Disclaimer
This course is developed for educational purposes and non-commercial use. It should not be
construed as endorsement for any financial products or services. It in no way intends to convey
legal, real estate, employee benefits, tax, insurance, or financial planning advice. It is a simple
overview to educate those who are new to these subjects. Consultation with a professional is
recommended for individual advice. These topics are complicated, dynamic, and constantly
changing. Please check for current regulations, rules and laws.
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Table of Contents
ABOUT THIS COURSE FOR INSTRUCTORS .................................................... 5
ABOUT THIS COURSE FOR STUDENTS ........................................................... 8
UNIT 1: GETTING STARTED............................................................................. 10
Setting Financial Goals ............................................................................................................... 14
Education ................................................................................................................................... 15
First House ................................................................................................................................. 15
Retirement.................................................................................................................................. 16
Other goals................................................................................................................................. 18
Create a spending plan ............................................................................................................... 18
Protect Your Wealth .................................................................................................................... 22
Future Financial Behavior Evaluation ........................................................................................ 24
UNIT 2. TAX-ADVANTAGED SAVINGS ............................................................ 25
IRAs ............................................................................................................................................... 26
Traditional IRA ........................................................................................................................... 26
Roth IRA..................................................................................................................................... 27
Savings and Thrift Plan - 401K Plans ........................................................................................ 28
401K Asset Allocation ................................................................................................................ 30
Comparing 401Ks to Traditional and Roth IRAs ........................................................................ 33
Assignment – What you need for retirement .......................................................................... 34
UNIT 3: INVESTMENTS ..................................................................................... 35
Income Investments .................................................................................................................... 35
Certificates of Deposit ................................................................................................................ 36
Types of Certificates of Deposit (CDs) ...................................................................................... 37
Traditional CD ........................................................................................................................ 38
Bump-up CD ........................................................................................................................... 38
Liquid CD ................................................................................................................................ 38
Zero-coupon CD ..................................................................................................................... 38
Callable CDs........................................................................................................................... 38
Brokerage CD ......................................................................................................................... 39
Early Withdrawal Penalties ........................................................................................................ 39
Activity: Class contest for highest CD rate: ........................................................................... 40
Online Resources – CDs .......................................................... Error! Bookmark not defined.
Bonds ............................................................................................................................................ 41
How do you make money from bonds? ..................................................................................... 42
(1) Collect the Yield—Buy and Hold ....................................................................................... 42
(2) Gain (or Loss) on Selling or Buying .................................................................................. 43
Why buy bonds? ........................................................................................................................ 44
U.S. Treasury Issues ................................................................................................................. 44
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Treasury Bills ............................................................................................................................. 46
Treasury Notes .......................................................................................................................... 46
Treasury Bonds .......................................................................................................................... 46
Treasury Inflation Protected Securities or TIPS ......................................................................... 46
Savings Bonds ........................................................................................................................... 47
Series EE Bonds ........................................................................................................................ 47
I-Bonds ....................................................................................................................................... 47
Activity: Compare Current Treasury Issue Rates ................................................................... 48
Corporate Bonds ......................................................................................................................... 48
Municipal Bonds ......................................................................................................................... 51
Mortgage-backed bonds ............................................................................................................ 51
Zero coupon bonds .................................................................................................................... 51
Zero-coupon bonds .................................................................................................................... 52
Bond funds ................................................................................................................................. 52
Activity – Select a Bond.......................................................................................................... 52
Assignment – Check out interest rates .................................................................................. 53
Online Resources - Bonds ....................................................... Error! Bookmark not defined.
US Stocks ..................................................................................................................................... 53
Real Estate ................................................................................................................................... 54
International ................................................................................................................................. 55
Commodities ................................................................................................................................ 56
Options ......................................................................................................................................... 56
Activity – Compare international rates ................................................................................... 57
Monitor your investments ........................................................................................................... 57
Activity – Check a fund against its index ................................................................................ 59
Online Resources - Stocks ....................................................... Error! Bookmark not defined.
UNIT 4: SELECTING YOUR INVESTMENTS .................................................... 60
Risk and Return ........................................................................................................................... 60
Activity - Risk Return .............................................................................................................. 62
Asset Allocation........................................................................................................................... 63
The Best Return ........................................................................................................................... 64
The Least Risk ............................................................................................................................. 66
Reducing Risk .............................................................................................................................. 67
Activity – How the pros asset allocate .................................................................................... 68
Assignment – Asset Allocation ............................................................................................... 69
Online Resources – Asset Allocation ....................................... Error! Bookmark not defined.
UNIT 5: SELECTING FUNDS............................................................................. 70
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Mutual Funds ............................................................................................................................. 71
Closed-end Funds ...................................................................................................................... 71
Exchange Traded Funds (EFTs) and Unit Trusts ...................................................................... 71
Fees and expenses .................................................................................................................... 71
Activity – How the pros asset allocate ...................................... Error! Bookmark not defined.
Assignment – Asset Allocation ................................................. Error! Bookmark not defined.
Online resources for funds ....................................................... Error! Bookmark not defined.
UNIT 6: WHEN TO BUY AND SELL .................................................................. 74
Bond or CD Ladder ...................................................................................................................... 76
Assignment – Bond Laddering ............................................................................................... 79
Buy and hold stock index funds ................................................................................................ 80
Rebalancing Your Portfolio ........................................................................................................ 82
UNIT 7: PROTECTING YOUR WEALTH ........................................................... 84
Prospective Financial Planner Questionnaire ........................................................................ 88
Activity – Selecting a financial advisor ................................................................................... 92
Investment Fraud ......................................................................................................................... 92
Activity – How to resist a scam............................................................................................... 95
Activity – What would you discuss with your significant other about investing? .................... 95
Activity – What would you teach your children about investing? ........................................... 95
APPENDIX ......................................................................................................... 97
The Time Value of Money ........................................................................................................... 97
Future value – What my savings will be worth in the future. ..................................................... 98
Present Value – What I set aside today for a future goal. ....................................................... 101
Future value of an annuity – Value of saving every year ......................................................... 103
Future value of an annuity – savings needed for future goal. .................................................. 105
Planning For Uncertainty .......................................................................................................... 107
Inflation Uncertainty ................................................................................................................. 107
Return Uncertainty ................................................................................................................... 108
Create a saving plan .................................................................................................................. 109
GLOSSARY ...................................................................................................... 115
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About this course for instructors
Personal Investments is a one-credit college course that teaches the basics of investing. It is part
of a set of six courses that also cover money management, saving, credit, real estate and risk
management. Personal investments will focus on financial goals, tax-advantaged vehicles,
investments, historical risk and return, asset allocation, fund evaluation, and the protection of
wealth. The goal of the course is to teach learners to establish good savings and investing habits
which take full advantage of the time value of money. Behavioral finance research has shown
that, even though learners have the knowledge, they are genetically hard-wired to make the
wrong decisions when it comes to investing. The most effective strategy is to teach them a few
simple habits that will serve them throughout their financial life.
The approach to investing promulgated by this book is one that uses asset allocation, index
funds, laddering, and rebalancing to manage a portfolio. Research has shown that individual
investors should not stock pick and that index funds outperform actively-managed funds in the
long run mainly because of their low fees. Most individual investors spend relatively little time on
their portfolio; therefore asset allocation will serve them well. Laddering is used to manage
interest rate risk in fixed income investments. Rebalancing makes the buy and sell decision for
individual investors. The major types of investments will be covered so that the learner will know
what a diversified portfolio consists of. This book also teaches other investing concepts such as
risk and return so that learners will be able to understand the volatility of markets and why it is
important to stay the course.
There will be repetition of financial behavior lessons promoted in the other modules including
automatic saving of at least 10% of income and use of tax-advantaged savings vehicles.
The focus in this book is on activities and assignments that will get the learner to adopt behaviors
rather than acquire in-depth knowledge on investments. The learner should be able to
demonstrate mastery by selecting and managing a portfolio in a 401k or an IRA. There are four
key assignments that allow the learner to demonstrate their grasp of tax-advantaged saving,
laddering, asset allocation, and fund selection as well.
Episodes of the PBS program MoneyTrack (also funded by IPT) can be also used by instructors.
.
Personal Investments are very personal and it is dynamic. Encourage students to “Only share
what they are comfortable sharing with others.” A student always has the option to “pass” on
a question that they feel is too personal.
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Personal Investing Lesson Plan
TOPIC
ASSIGNMENTS
ACTIVITES AND DISCUSSION
MUST COVER
IF TIME PERMITS
Financial behavior inventory
Introduce yourself to the class.
Talk about your financial dreams and nightmares.
MoneyTrack Episode 111 The future
View the Mr. Earl video at
mms://real.wa.gov/dfi/earlseg.wmv
What did Mr. Earl do right? What is your action
plan?
Financial goals
Spending plan
Time value of money
calculations
401K
Roth IRA
IRA
Can you afford to
retire?
http://www.pbs.org/wgb
h/pages/frontline/retire
ment/
Other bonds
Real estate
International
Commodities
Unit 1
Introduction
Unit 2
Taxadvantaged
savings
What you need for
retirement p. 32
Unit 3
Investments
Check out interest
rates p. 51
Class contest for best CD rates.
MoneyTrack Episode 204 Retirement reality check
Can you afford to retire?
http://www.pbs.org/wgbh/pages/frontline/retirement
/
CDs
Treasury bonds
Stocks
Selecting your
investments
Asset allocation p.
68
Do risk return of different asset classes using
www.morningstar.com.
MoneyTrack Episode 201 Back to Basics
MoneyTrack Episode 206 The Guru Show
Risk and return
Asset allocation
Graphing and
interpreting risk return
Unit 5
Selecting
funds
Fund selection for
401k – p. 74
Choose a fund and share it with the class.
MoneyTrack Episode 108 Financial Makeover
Mutual funds
Fee expenses
Closed end funds
ETFs
Unit 6
When to buy
and sell
Bond laddering p.
78
Rebalancing p. 82
Bond laddering activity
MoneyTrack Episode 212 Changing lanes
Laddering
Rebalancing
Other strategies
Unit 7
Protect your
wealth
Questions to ask a
financial planner.
What will you teach your children about investing?
Video – Stolen Futures
MoneyTrack Episode 214, 215 Need to Know
Selecting advice.
Identity theft and
fraud.
Unit
4
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Personal Investing 90-minute Session
Topics
Investments
Selecting funds
Tax-advantaged investments
Activities
View the Mr. Earl video at
mms://real.wa.gov/dfi/earlseg.wmv
What did Mr. Earl do right? What
is your action plan?
Evaluating funds using
Morningstar.com
Select funds for a 401K
Must Cover
Stocks, CD, treasuries
Risk return
If Time Permits
Other bonds
International
Index funds
Fees
Rebalancing
Asset allocation
401K
Roth and traditional IRAs
Time value of money calculations
Effects of cashing out, taking
loans
Investment fraud
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About this course for students
It used to be that you could work 30 years with a company and then retire in comfort. If you were
loyal to your company, your company would take care of you with a nice pension and health
coverage. In the old days, paying for college wasn’t such a burden. No more. Folks stay on
average 5 years at a job before they move on. College educations can cost as much as a house
in some parts of the country. What’s more, this generation is facing social security shortfalls,
longer lives and higher medical expenses. You’re on your own and facing a financial future that
has become more uncertain. It’s up to you to save and invest for your financial security and to
achieve our financial goals.
Now over half of families own stocks either directly or indirectly in their retirement accounts, up
from one third in 1989. In our retirement accounts, we have all kinds of instruments to choose
from—bonds, international investments, real estate, and more. How does one decide?
You have to acquire the knowledge and skills to make these decisions. This includes knowing
what assets are and how they’ve behaved in the past, how to allocate your money into different
assets and how to move your money around. On the other hand, investing is not as complicated
as some might lead you to believe. We have the knowledge and experience now to point
individual investors in the right direction with a few simple steps. Knowledge is power in the
investment world. Planning is essential to success.
This course will teach you important concepts about investments including return, risk and
correlation. It will provide an introduction to the different types of investments. It will teach you to
evaluate different funds and investment advisors. It will give you some basic information on how
to protect yourself from fraud.
The book includes “In-Class” activities and questions, with answers supplied at the end of the
material. The workbook complements the learning objectives with Key Assignments, Discussion
Questions, and Activities are designed for the students to complete out of class. There are lots of
websites and calculators that are located in the workbook to assist you in decision making, for
now and in the future.
Personal Investments are very personal and it is dynamic. The situation changes constantly. You
will be asked to share your views and experiences. Only share what you are comfortable
sharing with others. A student always has the option to “pass” on a question that they feel is too
personal.
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Investing Strategies for a Lifetime
Starting Out
Protect
financial
dreams




Avoid
financial
nightmares



Set exciting goals
Make a spending
plan
Establish a
record-keeping
system
Establish good
credit habits and
history
Having excessive
credit card debt
Taking too much
in student loans
Victimized by
identity theft
Twenties









Create an
emergency fund
Learn about savings
instruments
Learn about bonds
Get adequate auto,
health, and rental
insurance
Form a financial
team with your
partner
Lacking financial
skills
Focusing on shortterm satisfaction
and not long-term
needs
Destroying
relationships over
financial problems
Financial ruin from
inadequate
insurance
Twenties - Thirties








Reach financial goal
of purchasing a
home
Establish a 401k
account
Start IRAs
Learn about major
asset classes and
their risk and return
Create a plan to
financially survive a
job change
situation.
Not taking
advantage of the
time value of money
by saving early
Unable to invest
because lacking
understanding of
investments and
their characteristics
Taking on too much
debt - Bankruptcy
Thirties



Establish taxadvantaged
education funds for
children
Create a will to
protect your assets
Expand investment
portfolio by asset
allocation
Forties - Fifties







Lack of
diversification in
investment portfolio
Taking on too much
debt - Bankruptcy
Untimely death with
no will






Upgrade and
maintain house
Reach financial goal
of adequate funds for
kids’ college
education
Asset allocation and
rebalanced
investment portfolios
to accommodate
retirement
Able to care for
parents if desired
Using home equity to
spend or pay off old
debts
Unable to pay for
major replacements
on house
Taking loans on
401Ks
Not enough money
for kids’ college
educations
Not able to care for
parents
Bankruptcy
Sixties - Plus










Paid all debts in full
Adequate health
and long term care
insurance coverage
Estate plan
Updated will
Ladder ed
investments or
annuities to cover
for retirement
income
Income to last
lifetime
Not able to care for
self
Inadequate health
coverage
Not enough income
for retirement
Victimized by fraud
because of lack of
education.
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Unit 1: Getting Started
Your Financial Life
Growing your career
and managing
life’s ups and downs
High
School and
College
Retirement
Income
$60,000
$40,000
$20,000
Childhood
You begin by
being a financial
drain to your
middle-class
parents costing
$10,000 a year
or $184,000
until you leave
the roost—and
that doesn’t
include college
tuition.
You’re starting to
earn money (not
much) and
getting the
education
($80,000 for a
public university)
to earn more.
This is when you
start with credit
cards (33% have
over $2000
outstanding
balance) and
student loans
($20,000 average
for a bachelors).
You start a 401K
or IRA to save for
retirement.
10
20
Starting a
family
Your earnings start
to take off and you
settle down to start
a family. With that
comes your first
house (down
payment of about
$30,000),
mortgage, and the
kids who now drain
you $10,000 a
year. You need an
emergency fund of
six months. You
protect your assets
with life, property,
liability, disability
and health
insurance. You
create a will.
30
You move towards
your peak earning
years and use this
time to grow your
wealth with proper
asset allocation and
rebalancing.
You upgrade your
house and save for
your kids’ college
education ($100,000
each) and your
retirement ($1 million).
You will change jobs
(every 2 to 4 years)
and may be
unemployed (by
choice or not) at
times. You may
divorce (77% fall in
wealth). You may
have to care for your
parents ($5500 per
year). All these could
set you back.
40
50
Your income could
fall well before you
reach retirement age.
You continue to
accumulate for
retirement and plan
how your nest egg will
last for the rest of your
life. You protect your
health and assets with
long term care
insurance. You may
work longer because
you need to or
because you want to.
60
If you’ve been good
about saving, you will
enter retirement debtfree and comfortable for
the rest of your life. If
you haven’t, the only
option is to continue
working if you can. You
asset allocate,
rebalance, and ladder
your investments to give
you a steady distribution
of income. Healthcare
becomes a big expense.
You protect yourself
from fraud. You update
your estate plan.
70
80
-$10,000
Age (years)
How does a typical person look---financially? Not as prosperous as most of us believe. The
typical family income in Washington State is $63,000 in 2006 dollars. Household income tends to
go down during recessions and recover afterwards. Although it’s increased throughout most of
the last century, it’s been flattening in recent years and still hasn’t recovered from the last
recession to its 2000 peak. This means that income might not grow as quickly in the future. Some
evidence suggests that people coming out in the workforce now may be the first generation to
make less than their parents, mainly because the US economy is not growing as quickly as it
used to. According to the Economic Mobility study, the economy grew 17% in the last generation
as compared to 52% in previous generations.
Washington
Total:
2-person families
3-person families
4-person families
5-person families
6-person families
7-or-more-person
families
2006
Median
Income
63,705
58,584
66,252
75,140
68,562
62,484
61,212
Source: US Census
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Updated 2009
Your income changes depending on the economy, tending to go up during good times and down
during bad. It also changes depending on where you are in your life. You start your life as a
financial drain on your parents, costing most middle-income families about $10,000 a year. Your
income rises as you get more established in life, peaks about the time you are 50 years old and
then declines as you move towards retirement and retire. But this chart doesn’t tell the whole
story.
What can you do to improve your financial status? Education has an impact. Here is a chart that
describes the impact of education on your salary. There is a big jump in earnings when you get
your college degree and even a bigger jump if you get a professional degree such as engineer,
accountant, lawyer or doctor. Keep in mind that even with the same education, women make 60%
to 70% of what men make. Some speculate that this is because women are still the main
caregivers for both parents and children and may take time off to give this care.
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Of course, your financial life doesn’t proceed as smoothly as even these charts show. Right now
the average time that someone stays in a job is about 5 years. So that there’s a pretty good
chance that you’ll be unemployed, underemployed, or self-employed for periods in your working
life. On average folks have 4.5 spells of unemployment during their working life and they last on
average about 3 months. This suggests that having an emergency fund or 3 to 6 months of
income to tide you over such periods is a very good idea.
Other life events such as marriage (70% of people get married) can have an effect on your
financial life. Marriage increases a person’s wealth by about 77% because two can live as
cheaply as one and half. Divorce (40% to 50% of first marriages end in divorce) can have a
significant impact on your financial life. Divorce can decrease your wealth by 77%. Marriage
becomes the most significant financial decision you will make in your lifetime.
You already know that children can have an impact as well. Just as you cost your parents so your
kids will cost you $10,000 a year for a total of $184,000. When they go to college, the average
cost of a college education at a Washington state public university is $20,000 per year or about
$80,000 for a bachelor’s degree. Other colleges can be priced at
http://apps.collegeboard.com/search/index.jsp. At the same time as you pay for your kid’s
education, you may have to bear some financial responsibility for your parents ($5500 per year).
It follows that net worth or the amount of wealth you have also increases as you age. Your net
worth---what you own (home, retirement accounts, investments, etc.) less what you owe
(mortgage, car loans, etc.)--grows over your lifetime and declines as you retire and no longer
earn money.
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Debt is a big part of your net worth formula. The goal is to keep your financing payments (credit
card payments, car loans, student loans and mortgage payments) well below 40% of your income
while you are working and to pay down all debt by the time you retire.
For most folks, as can be seen by the graph above, their home is the largest part of their net
worth. People tend to buy their first house when they are 32 (typically 1812 square feet for
$236,500 in Washington state) and upgrade when they are older ($300,000). That house can also
be a financial drain with replacing the roof, appliances, the furnace, or even a major renovation.
However, as a financial asset, don’t depend on your home. Most folks view their homes very
emotionally and will not sell it even when they retire. About 70% of people who retire don’t sell or
even take money out of their homes to fund their retirement.
Location
Kennewick-Richland-Pasco
Portland-Vancouver-Beaverton
Seattle-Tacoma-Bellevue
Spokane
Yakima
2006 Median Price
$156,100
280,800
361,200
184,100
136,500
Source: National Association of Realtors
As you head into retirement, you have to deal with making sure that your financial resources last
you for the rest of your life and that you have taken precautions to protect your assets. Senior
citizens are targets of all the scam artists because they have assets and they are trusting or often
lonely. As you navigate your way through your financial life, it’s important to learn crucial skills to
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Updated 2009
help you deal with all the twists and turns that can be thrown at you. It’s important that you get
smart about your money no matter where you are in this journey.
Now that you have a good idea of what your financial life looks like, you need to acquire the
investing skills and habits that will serve you through your life. In this first section, you will learn
about setting goals and creating a spending plan. These two items are of vital importance in
keeping your investing program on track.
Setting Financial Goals
The first important step in your strategy to a secure financial future is to have goals. When we
don’t have goals we drift and at the end of our work lives, we wonder why we didn’t do what we
wanted (whatever that was). When we have goals, we achieve them, especially if they are written
down.
Now you will have short-term and long term goals. The short-term ones can include a car or a
vacation. Long term goals are the house, your children’s education and your retirement. Lay out
your lifetime financial goals. That’s right—for your whole life. It is tough because we tend to have
short-term horizons. But, you need to think about all your goals now because some of them will
take a long time to achieve.
According to The Facts about Saving and Investing (1999) put out by the SEC, two out of three of
all US families fail to reach one major financial goal. Identify financial or saving goals that excite
you, such as saving to buy a car; staying home with the kids; leaving an awful job; paying off your
mortgage; starting your own business; traveling with your family or friends, helping others, and
more.
Set realistic goals using the SMART approach:
Specific. Smart goals are specific enough to suggest action.
“Save money for a used car.”
Measurable. Goals need to be measurable when you’ve reached your goal.
“This used car will cost $8000 so I need to save $1,000 for a down payment.
Attainable. Goals need to be reasonable.
“$8000 for a used car (versus $20,000 for a new car) is reasonable for my
circumstances.”
Realistic. The goals need to make sense.
“I make $30,000 a year so a used car so saving $84 a month for $1000 makes sense.”
Time-related. Set a definite target date.
“I can save $84 per month and reach $1000 within 12 months.”
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Education
Education seems to be a necessity in this new global age where higher skill sets are necessary.
But, education is also a big ticket item with students paying on average $10,000 a year in tuition
plus $10,000 in living expenses to go to Washington state’s public four-year universities. For four
years, this can add up to $80,000. If you go on to pursue a professional degree such as a law or
medical degree, the cost goes over $100,000. Even community college costs $4000 a year. With
this large cost, often grandparents must chip in along with parents to ensure that the kids in the
family have a chance to get the college education.
Activity
What is the difference in cost between a public and private university? Check out colleges in
Washington State such as Seattle University and Whitman and compare them to the University of
Washington and Washington State. http://cgi.money.cnn.com/tools/collegecost/collegecost.html
First House
The first major financial goal for most folks starting out is the house. If you’re living in a typical
Washington state city a house might cost you $200,000, or $40,000 down payment (keep in mind
that these prices vary greatly depending on where you live).
Activity
Although these sites are not totally accurate, check out www.zillow.com as to the price of a house
in a neighborhood that you want to live in. How much will you have to pay for the house?
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Retirement
Most of you are going to live longer than the current life expectancy (about 78 years) because of
developments that are prolonging life. This means that you will have to ensure that you have
enough money for a longer period of time. If you think Social Security will take care of your
lengthening requirements, you might want to reconsider. Social Security currently gives you a
minimum wage (the average payment as of 2006 is $955 a month and the maximum is $1500). It
covers about 42% of retired people’s needs if they made $15,000 before they retired. If they
made $60,000, Social Security covers 25% of their needs. Right now workers are putting more
into the social security than retirees are taking out. But that is expected to change in about 25
years. At that time, according to the Social Security Administration, people who retire will receive
only 75% of the current entitlement. Reviewing you Social Security report gives you an amount
that you can consider as a “floor” of your retirement income. If you don’t want to live at that
income level (about 25%) you will need to start saving. We will address Social Security again in
Unit 6.
Although folks think that they will reduce spending when they retire, most keep their level of
spending up. Many people keep their homes (and all the expenses that come with them) when
they retire. When you get older, some expenses get bigger. Your medical costs increase.
Medicare takes care of 54% of your needs, but you must pay extra for doctor’s visits. If you need
long-term care such as a nursing home, you have to pay the bill yourself.
Nowadays, most people are resigned to the fact that employers will no longer take care of you
when you retire. Most people don’t work long enough at any company to even qualify for the
traditional pension plans. It’s true that employers are slowly phasing out traditional pension plans
and phasing in retirement savings plans (401k) that require you to save and invest for yourself.
Employers believe that these types of plans match what workers do. Most workers don’t stay the
5 years necessary to get any benefits, let alone the 30 years it takes to get adequate benefits
from the traditional plans. With the 401k plans, when these workers leave they can take their
retirement accounts with them.
Although many people know that these retirement savings plans will be their main source of
retirement income, about 18% don’t contribute at all. When people leave their companies, many
cash out and spend their retirement money instead of “rolling it over” into other retirement plans.
This means at their next job, they start out with nothing in retirement. Younger folks tend to do
this most and they are the most hurt by cashing out. Even small amounts set aside early in your
working life can work hard for you over time. If you’re cashing out, most of the benefits of
compounding are lost.
The experts don’t always agree on the amount you need for retirement because there’s so much
uncertainty involved in the amount of social security and your longevity not to mention inflation
rates and rates of return. It’s estimated that baby boomers (who are starting to retire now) have
about one third of what they need to retire.
As a rule of thumb, you can estimate the amount of money that you expect to live on a year and
divide by 4% to come up with what you might need in your retirement fund if you have no other
sources of retirement income.
Question
When you retire, Medicare takes care of what portion of your medical expenses when you retire?
a) One quarter
Page 16
Updated 2009
b) One half
c) Three quarters
Answer
When you retire, Medicare takes care of what portion of your medical expenses when you retire?
a) One quarter
b) One half
c) Three quarters
Correct answer b. Medicare only covers hospital and prescription drugs. Doctor visits and longterm care is not covered.
Question
When you retire, Social Security benefits can cover what portion of your living expenses?
a) One quarter
b) One half
c) Three quarters
Answer
When you retire, Social Security benefits can cover what portion of your living expenses?
a) One quarter
b) One half
c) Three quarters
It depends on how much you made before. If you made $15,000, social security may cover three
quarters or more of your income. If you made more income, social security will cover less. In the
future, social security is expected to cover only 25% to 33% of your income.
Question
Your life expectancy when you reach age 65 is:
a) 13 years
b) 18 years
c) 23 years
Answer
Your life expectancy when you reach age 65 is:
a) 13 years
b) 18 years
c) 23 years
If you are 65 now, your life expectancy is 18 years. That is older than the average life expectancy
because if you reach 65, you increase the odds of living longer.
Page 17
Updated 2009
Other goals
Maybe you’ve got other goals, like starting your own business (Jeff Bezos used $60,000 of his
own money to start Amazon.com). Lay them all out and put a price on them. You won't get there
from here unless you do. According to the 2004 Consumer Finance Survey, here are the top
reasons people save:
Retirement
34.7%
Liquidity
Purchases
Buying own home
For the family
Investment
Education
30
7.7
5
4.7
1.5
11.60
Once you've got your list of goals, post them where you will see them every day, re-evaluate
every year. Your needs may change. Tax time is a good time since you’re looking at your
finances any way. Your tax return will tell you how much you earned and you should figure out
how much you spent. Did you save enough for the year? Check out your goals. Do you have
additional goals now? (A life event—marriage, having kids, etc. — tends to change your financial
goals.)
Activity
Estimate how much you will need when you retire. Use a simple rule of thumb. Most people will
take out 4% of their retirement fund for annual living expenses. Decide what level of lifestyle you
want when you retire (e.g. $40,000, $60,000, etc.) and divide by 4%.
Create a spending plan
A spending plan is a planning tool to help you manage your money. It is the core of your financial
strategy and if implemented and made a habit all your life, you will achieve financial security. A
spending plan helps you identify your personal financial goals, analyze what income you have
available, know what you are spending money on, and develop steps to achieve your personal
financial goals. A spending plan will help you:
 Achieve financial goals and dreams.
 Keep a positive attitude about personal finances.
 Save for those important things such as a new car, college education, wedding, new
house, comfortable retirement, or travel.
 Lower stress level and reduce conflicts in your family.
 Control spending so that you conserve your wealth.
 Eliminate unnecessary debt.
This is how Americans spend their money according to the Bureau of Labor Table of 2004
Expenses by Family Size.
Page 18
Updated 2009
Expenditures Total (In
dollars)
Food at home
Food away from home
Alcoholic beverages
Housing
Apparel
Transportation
Healthcare
Entertainment
Personal
Reading
Education
Tobacco
Miscellaneous
Cash contributions
Personal insurance and pensions
Personal Taxes
One person
Two person
$40,359
Three
person
$45,508
Four
person
$54,395
Five or
more
$53,805
$23,507
1,533
1,302
314
8,371
862
4,012
1,441
1,097
297
111
423
203
518
1,063
1,960
1,829
2,954
2,336
400
12,944
1,650
7,692
2,827
2,051
512
168
476
312
744
1,429
3,864
3,599
3,696
2,512
315
14,744
2,013
9,348
2,265
2,137
555
139
830
397
843
1,167
4,547
3,066
4,404
3,043
368
17,914
2,643
10,775
2,253
2,787
614
155
1,059
349
1,156
1,287
5,589
3,900
5,151
3,042
309
17,317
2,893
11,123
2,150
2,718
658
131
984
416
743
1,399
4,770
2,652
Source: 2004 Consumer Expenditure Survey, Bureau of Labor Statistics
Start by collecting your pay stubs, household and other bills, expense receipts, checkbook or
online checking data, checking and credit card statements. Sort the receipts by categories and
sections listed on the Spending Plan Worksheet (see appendix). The sections are: Income,
Fixed Expenses, Variable Expenses Discretionary Expenses and Adjustments to Spending Plan.
Total the dollar amounts in each of these categories for one month. Don't forget to record your
cash expenditures and online transactions. Look to see where your cash goes, especially if you
make frequent ATM withdrawals from your bank accounts.
To make it easier to create a spending plan that will work for you, a 4-step process will be used to
develop each section of the Spending Plan Worksheet.
1.
2.
3.
4.
Calculate your monthly income
Calculate fixed, variable and discretionary expenses
Calculate Net Income (Monthly Income minus Total Expenses)
Analyze expenses starting with your discretionary expenses and make spending plan
adjustments such that you can achieve your saving goals. If necessary, identify your debts to
pay down and create a debt reduction plan
For more details on how to create a spending plan, you can refer to the first module of this series
on Money Management. It is important that you have a spending plan each year and that you
track all expenses to your spending plan. This could include a good manual record-keeping
system. Here are some suggestions on the financial records you should keep.
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Updated 2009
What financial records to keep and for how long?
Type of record
Bills
Length of
Time
One-year to
permanently
Credit card receipts and
statements
45 days to
seven years
Bank records
One-year to
permanently
Paycheck stubs
One year
Taxes
Seven years
Tax returns (forms) filed with IRS
Receipts/canceled checks
(charitable contributions, mortgage
interest, alimony and retirement
plan contributions)
Records for tax deductions you
Reason to Keep
 Review your bill statements once a year.
 For most cases, when the canceled
check from a paid bill was shown on
your checking statement (or the
canceled check has been returned
with your statement), you can shred or
burn the bill.
 However, bills for large purchases, such
as appliances, furniture, cars, jewelry,
computers, rugs, collectibles, antiques,
etc., should be kept in an insurance file
for proof of their value in the event of
loss, damage, flood, or fire.
 Keep your original receipts until you get
your monthly statement.
 Shred or burn the receipts if the receipts
match the monthly statement
 If a large purchase listed above, keep the
receipt.
 Go through your checks each year and
keep those related to your taxes,
business expenses, mortgage
payments and home improvements.
 Shred or burn those that have no longterm importance.
 Keep all your paycheck stubs until you
receive your annual W-2 form from
your employer; make sure the
information matches the stubs and W2.
 If it does match, shred or burn the stubs.
 If it does not match, request a corrected
form, known as a W-2c.
The IRS has three years from your tax filing
date to audit your tax returns, if it finds
questionable good faith errors.
 The three-year deadline also applies if
you discover a mistake in your return
and decide to file an amended tax
return to claim a refund.
 The IRS has six years to challenge your
return if it thinks you under-reported
your gross income by 25% or more.
Page 20
Updated 2009
took on your tax forms
There is no time limit if you failed to file
your return or filed a fraudulent tax return.
IRA contributions
Permanently
If you made a non-deductible contribution
to your IRA, keep your records indefinitely
to prove that you paid tax on this money
when it comes time for you to withdraw
from your IRA account(s).
Retirement/Savings plan
statements
One year to
permanently
 Keep the quarterly statements from your
401(k) or other plans until you receive
the annual summary statement. If it
matches up, then shred or burn the
quarterly statements.
 Keep the annual summary statements
until you retire or close the account.
Brokerage statements
Until you
sell the
securities
Keep the purchase confirmations or sales
slips from your brokerage or mutual fund to
prove whether you have capital gains or
losses at tax time.
House/condominium records
Six years to
permanently
 Maintain deeds, mortgage documents,
title, cost of improvements, and closing
statements in a safe place
permanently.
 Keep tax, rental agreements, rental
receipts and repairs for 7 years.
 Keep records of the expenses incurred in
selling and buying the house/property,
such as legal fees and your real estate
agent’s commission, for six years after
you sell your house.
 Keeping these records is important
because any improvements you make
on your house, as well as expenses in
selling it, are added to the original
purchase price or cost basis. This
adds up to a greater profit (also called
capital gains) when you sell your
house. Therefore, you lower your
capital gains tax from the sale of your
house.
Loan agreements
When
outstanding
 Keep copies of all outstanding loan
agreements and most recent
statements indicating how much you
have repaid
Insurance policies
Long term
care and life
insurance –
permanently
 Keep your insurance cards in your cars
as required by law.
 Keep copies of your most recent
homeowners, auto, and umbrella
insurance policies so that claims can
be made easily and efficiently.
Others one
year after
Page 21
Updated 2009
Health care expenses
expiration
 Keep both long-term care and life
insurance in a safe place and let a
responsible person know how to find
them.
 Create and update an annual inventory
of all personal property. Include
appraisals or receipts. Keep a copy of
this in a safe place outside of your
home.
One year to
seven years
 Keep your original receipts to file health
insurance and flexible spending
account claims
 Keep medical receipts for deductions that
you claimed on your tax return
Protect Your Wealth
The Federal Trade Commission received over 674,354 Consumer Sentinel complaints in 2006,
64% represented fraud and 36% were identity theft complaints. Identity theft occurs when a thief
uses another person’s personal identification to open new credit card accounts, take over existing
accounts, and obtains loans in the victim’s name, of otherwise steal funds from the victim.
Victims go through a difficult and time-consuming ordeal to clear their names. They must first try
to convince the lenders and the credit-reporting agencies that they are victims of identity theft.
They also must deal with calls from collection agencies and endless paperwork in trying to
remove erroneous information and fraudulent accounts from a credit record.
Credit card fraud (28%) was the most common form of reported identity theft followed by phone
or utilities fraud (19%), bank fraud (18%), and employment fraud (13%). Other significant
categories of identity theft reported by victims were government documents/benefits fraud and
loan fraud. The percentage of complaints about “Electronic Fund Transfer” related identity theft
doubled between 2002 and 2004.
Thieves get information from
 Garbage – pre-approved credit cards, bank and credit card statements, and utility bills
 Mailboxes – both incoming and outgoing mail
 Loan applications – banks, car dealerships, mortgage companies
 Rental applications – cars or apartments
 Schools – classroom attendance sheets that list the student’s Social Security number
 Desk drawers in the workplace
 Certifications/licenses placed on walls (in the workplace)
 Job applications
 Health club applications
 Internet – information resulting from the sale of personal banking and investment details, chat
rooms, and false merchants
 Telephone companies
 Information freely given by the public – from warranty cards, for contests, to department
stores, and “Win a Free Membership…” forms
Advice to avoid identity theft
Page 22
Updated 2009











Don’t disclose any personal information that isn’t integral to a transaction.
Be careful of any personal information that you give on yourself in social networking sites and
safeguard financial information on your computer or other file storage centers.
Carry only one or two credit cards that you use regularly.
Keep your Social Security number as private as possible. If a salesperson requests it, don’t
give it. If your health plan prints it on your membership card, ask for one without it. Don’t write
it on your class attendance sheet (your school already has your number on official records).
Divulge this number only for legitimate purposes, such as paying taxes, requesting credit, or
obtaining a driver’s license. Check to see if your social security number is on the internet at
StolenIDSearch.com.
Shred or burn mail containing personal information – from account numbers to travel
itineraries.
Prevent mail theft. Have a locked mailbox. Don’t leave mail in your mailbox for the mail
carrier. Don’t have new checkbooks delivered to your home.
Lock up your personal papers and canceled checks in your home, in case of a break-in.
Be cautious on the telephone. Never give out your name, address, Social Security number, or
other personal information unless you initiate the call and you check to see that the number
of legitimate.
Secure all your financial files on your computer and don’t store your personal information on
the web storage files that can be hacked into. Don’t disclose personal information on social
networking sites.
Demand secure information handling. If you’re filling out a credit application at a department
store or auto dealership, find out what the establishment does with old applications. If it
doesn’t lock them in file cabinets or shred them, take your business elsewhere.
Pay attention to your bills. If you suddenly stop receiving your mail, particularly bills, that
could be a sign that someone has taken over your account.
Fraud examiners recommend that people review their credit reports once a year; all three
bureaus will need to be contacted.
 Equifax – To order a credit report: 800-685-1111. To report fraud: 800-525-6285
 Experian – To order a credit report and report fraud: 888-EXPERIAN (888-397-3742)
 Trans Union – To order a credit report: 800-888-4213. To report fraud: 800-680-7289
It’s also wise to opt out of pre-approved credit offers by calling 888-5-OPT-OUT (888-567-8688).
A scam artist can retrieve a discarded credit card offer and send it to the company, saying, “Yes,
I’m interested – and here’s my new mailing address!” Sign up on the National “Do Not Call”
Registry (www.donotcall.gov or 1-888-382-1222) to eliminate telephone calls.
Page 23
Updated 2009
Future Financial Behavior Evaluation
The goal of all financial education is to get you to adopt important
behaviors that will ensure your financial security. Check all the financial
behaviors that you engage in. Do this inventory every year.
Check if you
will adopt in
the next
year.
Pay all my bills and loan payments on time.
Have a recordkeeping system for my financial affairs.
Balance my checkbook and monitor all my financial transactions monthly.
Track all my expenses.
Use a spending plan or budget.
Have an emergency savings fund.
If yes, how many months of expenses:
1-3 months ____4-6 months ____
Save or invest money from every paycheck. If yes, percent paycheck saved
__%
Save for long-term goals.
If yes, which goals: (Check any that apply.)
Education____ Car ____ Home ____ Home upgrade ____ Vacation _____
Plan and set goals for financial future.
Have money in more than one type of investment. If yes, check any that
apply:
Individual stocks ____ Mutual Funds ____ Bonds ____ Real Estate ____
Treasury bills or CDs ____ International ____ Commodities ____
Calculated net worth in the past two years.
Participate in employer’s retirement plan. 401(k) ___ 403 (b) __ Other: ____
Have insurance to protect my loved ones.
If yes, check any that apply:
Health ___ Life___ Property___ Auto___ Disability ___ Umbrella _____
Put money into other retirement plan:
Roth IRA ___ Traditional IRA __ SEP or SIMPLE IRA __
Review my credit report annually.
Pay credit card balances in full each month.
Research and compare offers before applying for a credit card or loan.
Do my own taxes.
Read about personal money management to improve how I’m doing.
Page 24
Updated 2009
Unit 2. Tax-advantaged Savings
The traditional Individual Retirement Account (IRA) was set up by the US government in 1973 for
workers who did not have employment-based pensions and in 1981 the government extended it
to all workers to encourage saving for retirement. Since 1981, responsibility for retirement savings
has shifted from the employer to the employee. Most large employers have set up 401k accounts
where employees can contribute to their retirement accounts. Any smart investor will use these
tax-advantaged accounts in building his or her nest egg.
Whether you contribute to an IRA or a 401k, retirement savings accounts work the best when you
save over a long period of time. The following table and graph shows that if you save $4000 per
year, you can reach a goal of $1 million if you start early at age 25 and save for 40 years at a 7%
return. If you wait until you are 40 to start saving for your retirement, you can still save a
substantial amount. Another fact is that no matter when you start saving, it is your earnings and
not your contributions or what you put in the account that makes up the majority of your nest egg.
Therefore, it is important to make contributions so that you can to get the benefit of your money
working for you.
Number
of
years
Savings
per year
Total
contributions
(what you
put in)
Earnings
(what your
investments
earn)
Total
25-65 years
40
4000
$160,000
$798,540
$958,540
30-65 years
35
4000
$140,000
$552,947
$692,947
35-65 years
30
4000
$120.000
$377,843
$497,843
40-65 years
25
4000
$100,000
$252,996
$352,996.
Page 25
Updated 2009
IRAs
Who is eligible
What is the maximum you
can contribute
Roth IRA
Anyone who had income from
working and his or her
nonworking spouse.
There are income limits.
Check www.irs.gov Publication
590 for the latest limits.
You cannot contribution more
than you earn in
compensation. Up to $5000
(2008) $6000 for those 50 and
over.
Check www.irs.gov Publication
590 for the latest limits.
Tax status of contributions
Contributions must be aftertax.
Tax status of earnings
Earnings are tax free.
Withdrawals
Contributions may be
withdrawn without penalty.
Earnings can be withdrawn
without penalty for some
expenses. See www.irs.gov
Pulication 590 for the list.
Otherwise there is a 10%
penalty in addition to tax.
None
Mandatory age for
withdrawals
Traditional IRA
Anyone up with age 70 ½ with
income from working and his
or her nonworking spouse.
There are no income limits.
You cannot contribute more
than you earn in
compensation. Up to $10,000
per couple ($5000 each)
combined contribution or
$10,000 ($6000 each) for
those 50 and over.
Check www.irs.gov Publication
590 for the latest limits.
Contributions may be pretax
up to certain income limits.
Check www.irs.gov Publication
590 for the latest limits.
Earnings are tax deferred. You
pay ordinary income tax when
you take the money out
therefore missing out on lower
capital gains tax.
Withdrawals made before age
59 ½ will be subject to a
penalty of 10% in addition to
tax.
70 1/2
Traditional IRA
The traditional Individual Retirement Account (IRA) was set up by the US government in 1973 for
workers who did not have employment-based pensions and in 1981 extended it to all workers to
encourage saving for retirement. Since that time it has gone through many changes and the
current 2008 rules allow people to contribute up a maximum of $5000 ($6000 for those over 50
years old) with pretax dollars for those workers who make up to $50,000 for a single filer or Head
of Household and $75,000 for a married couple filing a joint return or qualifying widow(er). These
amounts change annually and they can be found in the IRS publication 590, Individual Retirement
Arrangements (IRAS). Http://www.irs.gov/publications/p590/ar01.html.
Anybody who earns compensation (wages, salaries, tips, professional fees, bonuses,
commissions, self-employed income, or even alimony), can make their own contributions to an
Page 26
Updated 2009
IRA. You have to set up your account with a trustee (most brokerage firms or banks are trustees),
can’t put in more than your compensation or $5000 per year, must make your contribution in cash
(except for rollovers), and must follow a few other stipulations. A non-working spouse in a
household can contribute as well.
You can transfer your IRA between trustees or financial companies. You can rollover other
retirement plan assets to an IRA. Most financial planners recommend that you set up a separate
“rollover IRA” for this so that if you want to roll the assets into your new company’s plan, you can
do this easily. When you rollover your retirement plan assets, it’s best to do a direct rollover from
one trustee to another even though you are allowed 60 days to complete the rollover. If you use
the 60 days, you will be subject to mandatory 20% withholding for federal income tax, which you
would have to replace if you want to roll over your entire distribution to your IRA. If you hold the
assets for more than 60 days, your distribution will be subject to current income taxes and a 10%
early withdrawal penalty if you are under age 59½. You can also convert to a traditional IRA to a
Roth IRA. (Read the IRS rules for this.)
If you withdraw from your IRA before age 59½, you pay a 10% penalty. This is in addition to the
ordinary income tax you would pay on the withdrawal. There are hardship withdrawals that are
exempt from the 10% penalty but you must pay ordinary income tax on them. As of 2008 these
were:







Un-reimbursed medical expenses that are more than 7.5 percent of your adjusted gross
income.
Medical insurance for yourself, your spouse and your dependents if you lose your job.
Distributions that you take because of you are disabled before age 59 1/2 are not subject
to the penalty tax.
You are the beneficiary of a deceased IRA owner.
You can receive distributions from an IRA that are part of a series of substantially equal
payments over your life.
Expenses for higher education during the year (check for details).
You will not be penalized on a distribution of up to $10,000 used to buy, build or rebuild a
first home.
Check the IRS for the latest exceptions. You could pay extra taxes if you don’t withdraw the
minimum required (according to life expectancy tables) starting age 70½. You can’t borrow from
your IRA and you can’t use it as security for a loan.
For these workers who put their money in pretax, a traditional IRA is very similar to the 401K
(described later) except that the contribution limit for the 401K is much higher and the company
may match the employee’s contributions. Traditional IRAs may also be partially or fully pretax up
to certain income limits. Check http://www.irs.gov/publications/p590/ch02.html#d0e8996 for the
latest guidelines.
Roth IRA
Different from a traditional IRA, contributions to Roth IRAs are made after tax. Why would anyone
want to contribute? Well, the distributions are tax-free. This benefits those who are young and will
accumulate large returns on their accounts. The contribution limits are the same as with the
traditional IRA. However, those eligible to contribute must be within the income limits (check
http://www.irs.gov/publications/p590/ch02.html#d0e8996 for the latest limits). Roth IRAs have
another advantage in that they are not subject to minimum distribution requirements.
Page 27
Updated 2009
Roth IRAs also allow withdrawals of contributions without penalty. Financial planners think that
these are winners for people with moderate incomes and low tax brackets. You may also convert
your traditional IRA to a Roth IRA if you are within certain income limits. However, you must pay
taxes on your account in order to do so.
Other types of IRAs are also available for employees of smaller firms. For more information about
IRAs, go to the IRS website http://www.irs.gov/taxtopics/tc451.html.
.
Savings and Thrift Plan - 401K Plans
Many folks save for retirement through company-sponsored plans. Most of these are structured
as 401K (named after the IRS code that established them in 1981) company plans where
employees can make pretax contributions to their own accounts. According to the Investment
Company Institute, in 2006 there were 43 million participants in 457,830 plans with $2.1 trillion in
assets. Depending on the plan, employees may also make after-tax contributions where tax on
the investment income is deferred until retirement. Here are some key actions to take on your
401K.









Try to put away 10% to 15% of your income for retirement.
Max out on the employer contribution. This is money that you shouldn’t leave behind.
Invest in index funds and save on fees.
Avoid taking out a loan on your 401K.
Determine an asset allocation that makes sense for your time horizon (your age will
impact how long you have to invest and that will influence your asset selection.)
Set aside your money every paycheck and automatically use dollar cost averaging to buy
your funds.
Rebalance your portfolio to keep your designated asset allocation.
Ask about fees. You can lobby for a lower cost provider if you think that fees are too high.
Don’t cash out your 401K when you leave a company. It can hurt you in the future.
If you contribute to a 401K, your money is put before taxes--that means your salary is reduced for
tax purposes. To encourage saving, some plans will automatically make you a participant,
contributing 3% of your salary unless you opt out. The maximum contribution is $15,500 in 2008
($16,500 in 2009) with an additional catch-up of $5000 ($5,500 in 2009) for those over 50 years
old. About 82% of employees contribute and on average participants put in 6.8% of salary.
Employers may match all or part of this contribution. This means that they will put in some money
for each dollar that you put in. About 91% of employers match up to on average 3.3% of your
salary in 2006. This means that for every dollar you put in, on average most employers will put in
50 cents. If your employer matches your contribution, the 401K is the best way to save for your
retirement.
Many employers require that an employee work for a certain period of time to earn the right to
keep the employer match. This is called a “vesting” schedule. Let’s say you make $50,000 a year
and contribute 3% or $1500 to your 401K every year. Your employer contributes $0.50 for every
$1 you put in, contributing $750 a year. There is a five year vesting schedule, at 20% a year.
Page 28
Updated 2009
Year
1
2
3
4
5
Cumulative
contribution at
$1500 a year
1500
3000
4500
6000
7500
Cumulative
Employer Match
at $750 a year
750
1500
2250
3000
3750
Vested
Employer match that you can
take with you if you leave
20%
40%
60%
80%
100%
150
600
1350
2400
3750
If you leave after two years, you would only be 40% vested meaning you could only take 40% of
the total company match of $1500. You could, of course, take your contribution of $3000 for a
total of $3600 [($1500*40%)+3000]. If you leave after 4 years, you could take 80% of the total
employer match of $3000. This with your contribution of $6000 would total to $8400. Sometimes
the “vesting schedule” is based on the number of hours worked, or a calendar date, or an
anniversary of hire date. An employee should be knowledgeable about her plans vesting
schedule. Each plan can be different.
Most 401Ks allow employees to make their own decisions among investment selections.
Companies offer 10 or more selections. Most allow changes at any time and the rest allow at
least 4 changes a year. It is very important that you review your choices for your investments. No
one cares about your money as much as your do.
About 82% of plans allow loans to the employee. Depending on the company plan, employees
may borrow up to a maximum of 50% of the account balance or $50,000. Where permitted, about
25% of participants have loans for an average balance of about $6000. The loan must be repaid
with after-tax payroll deductions. Most plans have restrictions on what the money can used for if
you borrow it. The top items on the list are: Home purchase, education, and medical expenses.
Loans are not a good idea as you have less money working for your retirement. Remember if
you borrow from your 401k, the loan can become immediately due if you are terminated or
quit.
You can start withdrawing money when you hit age 59½ and no later than age 70½. You can
withdraw before age 59½, but only for “hardship” reasons defined by the government, and you
may still have to pay 10% penalty tax on these withdrawals. If you quit your job and your account
is more than $5000, you can leave your money with the company plan. You also have the option
of moving your money to your new company’s plan or moving your money into a “Rollover IRA.”
Even though you have 60 days to decide, it’s best to make these arrangements ahead of time. If
the check is made out to you for a later decision, 20% will be withheld for taxes (which you don’t
get back until you file your return). There is a 10% penalty for withdrawing before age 59 ½ and
you have to pay taxes on your withdrawal on top of that.
Here is an example of how a 401K works. Jill is single and makes $30,000 a year gross salary.
She usually pays about 15% tax on her salary. Her employer will match her 401K contributions by
50 cents for every dollar that she puts in up to a maximum of 6%. Jill puts in $1800 or 6% of her
salary. Her employer matches 50 cents on her dollar so it puts in $900. Her salary for tax
purposes has been reduced to $28,200 so if she stays at the same tax rate, she would save an
additional $270 in taxes (15% of $1800). (Her taxes are deferred until she draws the income from
the IRA.) If her employers continue to contribute in the same way and she receives an 8% return,
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she would have over $100,000 that she would not have otherwise. In actual case, Jill’s salary will
increase and so will her employer’s contributions so the amount could be substantially more.
One key point to make about 401Ks: The taxes do not disappear. They are deferred, meaning
when you take the money out at retirement, you will have to pay taxes on the distributions. Also,
another disadvantage is that you will pay taxes at ordinary income tax rates which would be
higher than the capital gains tax rate that may be applicable to some of your investments. This
reason may make a Roth IRA attractive since the contributions to Roth IRAs are made after tax,
the distributions are tax-free.
401K Asset Allocation
Once you are eligible for a 401K and have decided to contribute, you will be asked to decide how
you want to allocate your contributions. About 52% of 401K plans offer 10 or more selections of
investments. You will learn more about these investments later on in this book. Here are the most
commonly offered:
Money market funds. These funds generally return at the short-term interest rates. Money
market funds are low return and relatively low risk. Some employees increase their
allocation in money market funds when they are preparing to take cash out.
Equity funds. Funds that invest in stocks. About 8000 different American companies are listed
on the three major US stock exchanges. If you were to buy every single share of stock
out there (pay the market value), you would spend about $12 trillion. Worldwide there are
54 stock exchanges and the total value of companies was $32 trillion as of the end of
December 2008. When you own a stock, you own a piece of the company. In addition to
being categorized as domestic and international, stocks can be categorized as large,
medium or small. Larger plans may have selections in indexed funds, growth funds, and
international funds. As compared to bonds, stocks have higher return and higher risk.
Bond funds. These funds invest in bonds. The safest bonds are US Treasury bonds. Other
bonds include corporate bonds or bonds issued by foreign countries. Bond funds do not
behave like bonds that you buy and hold to maturity. There may be capital gains or
losses if interest rates move. Bonds tend to be lower risk and lower return than stocks.
Target allocation funds. These allocate assets based on the age or risk tolerance of the
investor. They may allocate more to stocks if the employee is young and more to bonds
when the employee is older. For employees who don’t know how to allocate, these funds
are an easy alternative however you should still study them to see if they meet your
requirements.
Guaranteed Investment Contracts (GICs). GICs are fixed-rate investments insurance
companies sell to retirement plans. A GIC behaves almost as if you had invested your
money in a bond which you are holding until maturity. These tend to be low risk if you
hold them until their due date.
Company stock. Some companies make their contributions (the employer match) in company
stock. They also allow employees to choose company stock as an investment option. The
danger with having too much of your account in one stock is that you could take a large
drop in your portfolio is this stock does poorly.
As can be seen by the chart below, employees tend to allocate assets based on the market
performance. During the recession of 2002, the allocation into equity funds fell by over 10%. This
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is an indication that employees are reacting to the market. Allocation into company stock has
fallen from almost 20% in 1996 to about 15% in 2004. This is a good sign as too much of your
account in one stock is a dangerous thing.
Experts recommend that;
1. Pay yourself first by putting regular contributions into your accounts.
2. Don’t put too much of your assets in any one category (30% to 40% maximum) and not
more than 4% in one stock including your employer’s stock. (What does your “pie chart”
look like?)
3. Invest in index funds for lower fees.
4. Change your asset allocation goals as you near retirement to make sure that you will
have the income you need.
You also don’t have to determine which fund has the best manager. By paying yourself first 10%15% out of every paycheck, you will use dollar cost averaging to buy into your 401K which is
better than trying to outsmart the market. Since it’s been shown that we can’t outsmart the
market, putting in regular amounts is the best tactic to take. (The vast majority of people buy high
and sell low as will be shown later.)
Rebalance or buy and sell investments in asset classes to match your asset allocation goals. So,
if stocks do really well and your stock allocation grows to 50%, you will sell stocks and buy
another asset that has dropped to less than your allocation. Studies show that this is an effective
way to maximize your return and take the edge off down markets.
Asset allocation also changes with age. Younger participants put more of their assets in equity or
stock funds. Older participants move more assets to fixed income so that there will be less risk as
they near retirement and require the funds. Because assets get larger as the worker gets older,
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Updated 2009
he or she relies more on investment returns to increase the value of the account. Younger
workers increase the value of their accounts with contributions .
If you have a 401K with a company match available and don’t participate, you are losing out.
About 18% to 25% of employees don’t participate or contribute to them. This is especially
prevalent in younger folks, as about half of those under 25 don’t contribute. If you don’t diversify
your investments, you can lose out as well. A heavy allocation to company stock has hurt workers
at Enron, Qwest, MCI Worldcom and other companies where the stock took a drubbing (dramatic
loss in value).
When people leave a company, 60% of younger folks will cash out their 401Ks instead of moving
them over into a rollover IRA. This costs you a lot. Let’s say you have $6000 when you cash out.
You will pay a 10% penalty of $600 plus taxes on the $6000 (at 15%) or $900. So $1500 is out
the door leaving you with $4500 to spend. That’s not the entire cost. In 40 years that $6000 at 8%
return would have grown to $130,000. With your job change, and cash out, you end up starting
back at square zero.
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Comparing 401Ks to Traditional and Roth IRAs
401K
Roth IRA
Traditional IRA
Who is eligible Determined by employer.
Anyone up with age 70 ½
with income from working
and his or her nonworking
spouse. There are no
income limits.
Maximum you
can contribute
Anyone who had
income from working
and his or her
nonworking spouse.
There are income
limits.
$15,500 (2008 with cost of $5000 (2008 with cost
living after that) or
of living after than)
maximum set by employer. each with $1000
$5000 catch-up
catch-up contributions
contribution for those 50
for those over 50.
and over.
Your employer may
contribute a match
which makes this
attractive.
Contributions are pretax.
Contributions must be
after-tax.
$5000 (2008 with cost of
living after that) each with
$1000 catch-up
contributions for those
over 50.
Withdrawals made before
age 59 ½ will be subject to
a penalty of 10% in
addition to tax.
Contributions may be
withdrawn without
penalty.
Earnings can be
withdrawn without
penalty for some
expenses.
Withdrawals made before
age 59 ½ will be subject to
a penalty of 10% in
addition to tax.
None
70 1/2
Tax status of
contributions
Tax status of
earnings
Withdrawals
Contributions may be
pretax up to certain
income limits.
Earnings are tax deferred. Earnings are tax free. Earnings are tax deferred.
You pay ordinary income
You pay ordinary income
tax when you take the
tax when you take the
money out therefore
money out therefore
missing out on lower
missing out on lower
capital gains tax.
capital gains tax.
Mandatory age 70 1/2
for withdrawals
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Assignment – What you need for retirement
What age do you want to retire?
What lifestyle do you want at retirement? What will this lifestyle cost?
What will your health care costs be when you retire?
Total the two
What will you need in your retirement account?
(Divide the number above by 4%)
Determine how much you will have to save each year to reach your retirement goal
using the calculator:
http://www.bankrate.com/brm/calculators/retirement/401k_retirement_calculator.asp
Copy the results into your paper. (Click on report)
Reflect on what you have to do to achieve your retirement goal. Will you have to reduce your
expectations of the lifestyle? Will you have to increase your contributions to retirement?
What action will you take to make it happen?
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Unit 3: Investments
You have your financial goals for your life and your spending plan plus a good record-keeping
system designed. Now you can start accumulating an emergency fund and investing. Remember,
time is your ally when you save early because of compounding. Time is your enemy if you have
debt because of compounding. So make sure that your credit card debt and installment debt are
under control before you embark on a saving and investing plan.
Income Investments
When folks are starting their investing, it’s important to invest in what they understand. Most folks
start with bank products such as certificates of deposit. These are part of a category of
investment or asset class called income investments. Many of them, such as bank CDs and
treasury bonds, are among the safest investments and the easiest to understand. However, other
income investments can be pretty risky. Here is a table that summarizes some of the more
common income investments.
Income Investments
Vehicle
Advantages (+)
Disadvantages (–)
Savings Accounts:
usually no minimum amount
usually very liquid – unlimited
withdrawals
very safe - FDIC insured
lower interest rate
Money Market Accounts:
higher rate than savings account
very safe - FDIC insured
somewhat liquid – can make
withdrawals
minimum deposit required,
often $1,000 to $2,500
6 withdrawals per month
Certificates of Deposit (CDs)
higher rate than savings account
very safe - FDIC insured
Term-time period: 3 months to 5 years
minimum deposit required,
often $500 to $2,500
illiquid - penalty for early
withdrawal
safe- guaranteed by US government
small minimum purchase of $25;
higher rate than savings account
can purchase directly from Treasury
interest may be tax-exempt if used for
education
Lower interest rates than
Treasuries
Illiquid – cannot cash out in
first year
Penalty for withdrawal
within five years
Savings Bonds (bonds issued by the
U.S. government to help pay its
expenses)
Term time period: 20 – 30 years
Treasuries
Safe – guaranteed by US government
Higher interest than savings account
and saving bonds
Noncallable
Liquid – can be sold on secondary
High minimums of $1000
May result in capital loss if
interest rates rise
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market
Capital gain possible if interest rates
fall
Choices of many maturities up to 30
years
Not taxed at state or local level
Term time period: 90 days to 30 years
Money Market Mutual Funds
Higher interest than savings account
Tax exempt interest available
Not FDIC insured
Corporate Bonds
Higher interest than treasury bonds.
Riskier than treasuries as
they depend on the
fortunes of one company.
Companies can fail.
Municipal Bonds
Interest may be tax-exempt. Some of
these bonds may be insured to reduce
risk.
Mortgage-backed Bonds
Interest is payable monthly and is
usually higher than treasury bonds.
Riskier than treasuries as
they depend on the
economic health of one
region. Local economies
can become depressed.
Has a high call risk as
homeowners prepay
mortgages. Previously
thought to be safe as
homeowners tend not to
default on loans. However,
in 2008-10, these can be
risky because of higher
default rates.
Certificates of Deposit
When your liquid savings account (s) has grown to build up an emergency fund of three to six
months of living expenses, you should consider a longer-term investment with a higher yield. A
common fixed income investment is a certificate of deposit or a CD, which earns higher interest
rate than most money market investments. A CD is a short to medium-term, FDIC insured
investment. CDs pay higher yields than most liquid savings accounts, money market accounts
and money market mutual funds. But, to earn the higher yield you must give up access to your
money for a specified period of time called a term.
Common features about CDs are:
 CDs are not liquid, since your money is committed for a period of time, and will incur penalty
fees for withdrawing your money early before the term expires (before it reaches maturity).

You invest a fixed amount of money for a period of time called term and the ending date
called maturity date.
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
You’re guaranteed your principal (deposit amount) plus a fixed amount of interest, which you
can receive periodically throughout the term and you have the option to withdraw the interest
payments as they are paid by the bank or credit union.

When the term expires you can cash out the principal and interest, or roll over (start the term
again) the CD for another term with a new interest rate.

CDs can be purchased for almost any time duration with the most popular CDs between
three months and five years. Usually, the longer you allow the bank or credit union to use
your money, the higher your interest rate, however longer terms can be subject to more
interest rate fluctuations.

CDs are issued by banks and credit unions but can be purchased through banks, credit
unions or brokerages in their offices or online over the internet. CD considerations are:
o
o
o
o
o
o
Interest rate
Interest yield includes the effect of compounding interest rate and is higher than the
interest rate (APR)
Time-based fixed income with a set maturity date.
Penalties fees for cashing out the CD before the maturity date
Interest payments may be withdrawn as they are paid by the bank.
CDs are insured by the FDIC up to $100,000 ($250,000 on retirement accounts)
Types of Certificates of Deposit (CDs)
The terms of a CD can range from one month to five years or more. How do you decide whether
to buy a short-term or long-term CD? Consider the interest rate environment. Are rates extremely
low? If so, go for the shorter term so your money is not tied up if rates rise in the near term. It’s
very frustrating collecting 2% interest on a long-term CD when market rates increase and current
CDs are paying 6%.
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Are rates high or expected to drop? Go for the longer term to lock-in the high rate for as long as
possible. Your goal is to try to balance risk (the chance that your money will be tied up at a lower
interest rate than what's available elsewhere) and return (the longer the term, the higher the
interest rate). The traditional CD is the most popular type of CD, but financial institutions are
offering a variety other CDs with some flexibility. The more popular types are:
Traditional CD
A Traditional CD is a deposit of a fixed amount of money for a specific term and earns a set
interest rate. At the end of the term you can cash out the CD or “roll over” the CD for another term
(earns a new rate of interest). There are stiff penalties for early withdrawal of you money, which
will cause you to lose interest and possibly principal. Each financial institution determines the
penalties and they must tell you (disclose) when the CD account is opened.
Bump-up CD
This CD allows you to take advantage of rising interest rates. For example, if you bought a threeyear term CD at a set interest rate and six months into the term the financial institution now offers
an additional quarter point (1/4% ) interest increase on new CDs. With a bump-up CD you have
the option to tell the bank you want to earn the higher interest rate for the rest of the term of your
CD. Financial institutions that offer this option generally allow one bump-up per term. A
disadvantage is that you may earn a lower initial interest rate than on a traditional three-year CD.
Be realistic about the interest rate situation and expectations before you buy a bump-up CD.
Liquid CD
You can withdraw money from a Liquid CD without incurring a penalty, but you may have to
maintain a minimum balance in the CD account to earn that opportunity. The liquid CD interest
rate should be higher than the financial institution’s money market account interest rate, but is
usually lower than a traditional CD of the same term and minimum. How soon after opening the
liquid CD account will you need to make a withdrawal? Money must stay in the liquid CD account
for seven days before it can be withdrawn without penalty according to Federal law. Financial
institutions can establish the penalty-fee withdrawal for any period beyond the seven day period.
Zero-coupon CD
You buy a zero-coupon CD at a deep discount to the par value (the amount you’ll get when the
CD matures). For example, you may buy a $10,000 (par value) CD for $5,000 with a 10 year
term, with a 7% interest rate, which you will receive $10,000 when the term is up in 10 years. You
do not receive “interest” until the term is up. You are earning “phantom interest income” which
you do not receive until the term is up. However you have to report and pay federal income taxes
(if applicable) on the increased value (interest) of the CD each year. In this example, you‘d owe
tax on the first $350 you haven’t actually received. Therefore, be sure you have the money to
cover the taxes you may owe.
Callable CDs
Callable CDs can be “called” away from you (basically the bank gives your money back and you
gain no more interest) after the call-protection period ends, but before the CD term ends
(maturity). For example, if you bought a three-year CD with a six-month call protection period, the
CD would be callable after the first six months. Why would they “call” a CD? If interest rates go
down after your CD was issued, the financial institution can call or payoff the interest earned to
date and end the term of the callable CD. The callable CD usually earns a higher interest rate
than a traditional CD. But the disadvantage is that you may have to reinvest at a lower rate if they
are called."
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Brokerage CD
Brokerage CDs are sold through a brokerage (stock brokerage firm) usually issued from a bank.
Banks may use brokers as sales representatives to locate investors willing to purchase CDs from
their banks. CDs from brokerages pay higher rates than CDs from your local bank or credit union
since banks use brokered CDs to compete in the national markets. The brokerage CDs are more
liquid than bank CDs since they can be traded like bonds on the national secondary market, but
there is no guarantee that you won’t take a loss if you sell them before maturity in the national
secondary market. Brokerage CDs may be also be callable CDs and they are backed by the
FDIC.
Early Withdrawal Penalties
Early withdrawal penalties can be costly. Federal law requires that all CDs that are cashed out
early are subject to a minimum penalty of at least seven days interest on money withdrawn within
the first six days after deposit. Beyond that time period banks are free to determine their own
penalties. Examples of penalties for early withdrawal are:
CD term period
30 days
Two to 12 months
13 to 36 months
Interest penalty
All interest
Three months
Six months
The penalties are more costly the earlier you withdraw (or cash out) your money. For example, if
you bought a 12-month CD and needed to cash out after four months, you would have to pay six
months’ of interest when you had only earned four months of interest. Which means you would
need to pay the withdrawal penalty from principal. It is best to buy a CD when you have a
sufficient emergency fund in a savings account, so you won’t need to cash out your CD.
Question
Why invest in CDs?
Answer
A certificate of deposit, or a CD, which earns higher interest rate than most money market
investments and it is a FDIC insured investment. CDs pay higher yields than most liquid savings
accounts, money market accounts and money market mutual funds. To earn the higher yield you
must give up access to your money for a specified period of time.
Question
Which CD allows you to increase the interest rate during the term of the CD?
A. Traditional CD
B. Bump-up CD
C. Liquid CD
D. Zero-coupon CD
Answer
B. Bump-up CD
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Question
Is you have to cash in your CD before the specified period of time, can you lose part of your
principal?
Answer
Is you have to cash in your CD before the specified period of time, can you lose part of your
principal?
Yes
Assignment: Class contest for highest CD rate.
Competitive, higher rate CD interest rates are offered by many financial institutions to attract
money to their institution. Check out your local banks, brokerage firms, the online banks or
Bankrate.com’s survey for the list of the highest CD rates offered by financial institutions,
www.bankrate.com.
Go online into any banks or credit unions, websites, or www.bankrate.com to find what CD types,
minimums and rates they offer. Print out information about the CDs information for two
financial institutions, and highlight the type of information listed below to compare CDs at
different financial institutions.
Bank/Credit
Union
CD
Type
Minimum
Deposit
CD
Rate
Term
Compounding
Method
Annual
Percentage
Yield
Comments/
Description
Present your findings to the class and judge who found the highest rate.
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Bonds
Bonds are interest-bearing certificates or IOUs issued by a government, government agency, or
business (called the issuer) promising to pay you, the bond holder, a specified amount of money
(based on a coupon rate) within a specified period of time (term or maturity) on a specified date
(called a maturity date). Bonds are issued by public and private entities for a variety of reasons. In
return for your money, the issuer pays you interest much like a bank would on your deposit.
Some bonds pay you interest monthly, some every three months or quarterly, some pay twice a
year, some pay all the interest at the end of the term (zero coupon). Issuers may reserve the right
to redeem the bond before the maturity date (call) and this tends to happen when interest rates
fall. As a bondholder, you are a creditor. For investors, bonds provide a buffer of stability against
the volatility of stocks.
Governments (federal, state, local, and foreign) issue bonds because they need money to pay for
projects like roads, hospitals, or schools. If the federal government spends more than it gets in
taxes (as it did for a number of years until 1998), it borrows to cover this shortfall. Companies
issue bonds for the same reason that you borrow money. Companies also need money to replace
aging equipment, renovate their buildings, or pay for major marketing programs.
Used with permission of Leslie Lum
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Updated 2009
Bonds play a vital role in our economy. They allow companies to grow and governments to
provide services and infrastructure. Although seemingly less exciting than stocks, bonds play an
important role in a well-balanced portfolio as well. Returns from bonds are generally lower than
stocks; however, they are less risky. Bond risk and return can act as a counter to the higher risk
and return of stocks.
High-quality bonds are great in that they can give you a fixed stream of income—unlike stocks,
which don't always pay dividends and can be pretty finicky about giving you a return at all. If you
invest in a 10-year $1,000 Treasury bond issued by the US Treasury with a 6% coupon, you
know you will get $60 in interest every year for 10 years and at the end of the 10 years, you will
get your $1000 or face value (also known as par value) back.
Bond income allows you to schedule when funds will become available to you. For anyone who's
retired, bond income is handy to have. Say you have a $500,000 nest egg, and you want to travel
the world for a few years. If you put your money in the stock market, there's no guarantee what
you'll get on a year-to-year basis. But put it in high-quality bonds with an 8% coupon, and you
know that you'll get $40,000 per year no matter what. Yes, you'll miss out on the 25% that you
might get in the stock market some years but you'll also miss out on years when the market
returns nothing at all or years like 2000 when the market fell 13%. It can also be used to plan for
other term goals such as education and home purchases.
How do you make money from bonds?
Most people assume that there is only one way to make money on bonds: You collect interest
and that's that. Well, they're wrong. There are two ways you can make money on bonds. The first
is to collect the yield (interest). The second is to realize a gain (or loss) when interest rates fall (or
rise).
(1) Collect the Yield—Buy and Hold
You buy a government bond for $1000 with a 6% coupon and a 10-year maturity. You then get
$60 every year for 10 years and your $1000 back at the end. This is the "what you see is what
you get" strategy (see the graphic below). You buy the bond when it's issued and hold it until
maturity, you get interest or yield on your bond, and that's the extent of your return.
Many investors buy bonds exclusively for their yield. For high-quality bonds or Treasuries where
there is little chance of the issuer going under, you can depend on the interest coming in as
agreed.
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Used with permission of Leslie Lum
(2) Gain (or Loss) on Selling or Buying
If you buy, or sell, the bond on the secondary market, things get a lot more complicated.
Remember, interest rates go up and down. A bond is priced on the going market interest rate
(which changes often). Interest rates may have been 6% last year, when interest rates go down,
investors can only get 5% now. There's no reason why you should give more interest than the
market. So if you sell a $1000 par value bond with a 6% coupon in a 5% market, you want to sell
it so that it yields 5% instead of 6%. Now the annual interest paid by the issuer is still going to be
6% of par, or $60. The issuer has to pay this according to the bond agreement. In order to give
only a 5% yield, you get to sell the bond for more than you paid—that is, at a premium. You
make a capital gain on it. This is true for any bond you sell after interest rates fall. It is
counterintuitive so it bears repeating: If interest rates go down, the price of your bond goes
up.
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Used with permission of Leslie Lum
But the opposite can also happen—when interest rates can rise what happens to bonds?
What if interest rates go up to 7% and you had the same $1000 par value bond with a 6%
coupon? Well, the investor who buys it will want 7%; otherwise, they will pass on your bond and
go elsewhere. To give the buyer 7%, you have to sell the bond at a discount, or for less than
what you paid. Now you have a capital loss. Here's the matching bookend to the previous
example: If interest rates go up, the price of your bond goes down.
Why buy bonds?
There are risks with bonds that may cause people to avoid them. If you purchase a bond with a
low interest rate and long maturity, you could lose out when interest rates rise. One of the worse
cases is if inflation rises higher than the interest rate you are getting. Then you will lose
purchasing power as well. A bond with a call feature can hurt you when interest rates go down.
You will lose your higher return if the issuer redeems the bond. Bonds issued by corporations can
also go down in value if the company hits hard times. But, for most individual investors who buy
high-quality bonds and hold them to maturity, bonds can be an effective part of their portfolios.
Bond interest can provide a steady stream of income for those who are relying on their
investments to live. They tend to provide higher interest rates than saving accounts. They can
offset the downturns in stock investments. They can provide capital gains if interest rates go
down.
U.S. Treasury Issues
In order to finance the U.S. federal deficit, our government borrows money from investors. As of
the beginning of 2007, the government had $5 trillion in outstanding debt. Of this, $200 billion was
in savings bonds and the rest ($4.8 trillion) was in Treasuries. Government bonds are the easiest
to buy or sell and the safest ones as well because they are backed by the full taxing authority of
the US government. Since the federal government can raise taxes to pay interest and pay back
principal on bonds, there is not much chance of default on the bond. Because of this, U.S.
Treasuries pay lower interest rates compared to other kinds of bonds. U.S. Treasury bills, notes,
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and bonds, in addition to the U.S. savings bonds are less risky than other types of bonds but they
are still subject to inflation and interest rate risk.




The primary advantage of Treasury securities is safety. They have the strongest
guarantee of payment of interest and return of principal. As such many folks use these to
start their investments portfolios or fund financial goals such as education.
Because there are so many Treasuries issued, you can buy them for any maturity. They
are extremely liquid (traded in large volumes every day) so you can sell them at any time
for a fair market price.
Treasuries are not callable so investors are certain that they will have the income for the
life of the bond. They don’t have to worry that they will lose their income stream when
interest rates fall as may happen in mortgage-backed securities or with corporate bonds.
Treasury interest is exempt from state and local income taxes (but not federal taxes) and
may be a benefit to those in high-tax states (but Washington State does not have income
tax.)
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The main difference between treasuries is the maturity. The longer the maturity, the more risk. If a
friend borrows money from you and says that he will return it in a week is a lot less risky than
returning the money in ten years. Many things can happen in ten years that jeopardize you
getting your money back. Maturity with a bond works in the same way. There may be short
periods in time when this relationship doesn’t hold, but the longer the maturity the riskier the bond
so the more return is needed. This is demonstrated in the chart above where 5-year treasuries
give more interest than 90-day treasury bills because of their longer maturity.
Here are the different types of U.S Treasury issues which are classified by maturity.
Treasury Bills
Treasury bills are debt issued for terms of less than one year. The 90-day or 3-month interest rate
is an important financial benchmark. Treasury bills (T-bill) are sold at a discount to face value or
par. Let's say 9-month interest rates are 7%. You buy a T-bill that has a face value of $1000 for
$946.72. You hold it for nine months after which time the Treasury pays you $1000 at maturity.
This $1000 payment includes the amount you originally lent plus the interest at 7%.
Treasury Notes
Treasury Notes offer terms to maturity from 2, 3, 5, or 10 years, in denominations of $1,000. The
interest rate for Treasury Notes is set at an auction and T-Notes are sold periodically at auction.
Treasury Bonds
Treasury Bonds have terms to maturity between 10-30 years, in denominations of $1,000.
Treasury Inflation Protected Securities or TIPS
TIPS are bonds with maturities of 5, 10 and 20 years in denominations of $1,000 and are sold at
auction like Treasury Notes. TIPS are inflation-indexed. Every six months the Treasury adjusts
the principal by the Consumer Price Index (CPI) for inflation. Interest is then paid on the adjusted
principal. When the bond is redeemed, it is redeemed at the adjusted principal or the original
price whichever is higher. For more information on TIPs, go to
http://www.treasurydirect.gov/instit/statreg/auctreg/auctreg_gsrlist.htm.
Type
Maturity
Features
T-Bills
3, 6, or 12 months
Sold at a discount to face value. The interest paid at maturity is the difference
between what you paid and the face value (what you get at maturity).
T-Notes
2, 3, 5, or 10 years
Pays interest semiannually.
T-Bonds
11-30 years
Pays interest semiannually.
TIPS
5, 10, 20 years
Inflation protection-the principal is adjusted every six months by the CPI times the
fixed interest rate.
Treasury instruments can be purchased directly at Treasury auctions (see
www.savingsbonds.gov). Treasuries can also be purchased on the secondary market through a
broker or dealer.
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Savings Bonds
Savings bonds are issued by the U.S. government. The types are: EE Bonds and Series IBonds. These bonds typically have lower interest rates than comparable treasury bonds;
however, the minimum purchase is much lower. They may be purchased through financial
institutions or payroll savings or online at TreasuryDirect.
http://www.savingsbonds.gov/indiv/products/products.htm
Series EE Bonds
Series EE Bonds are safe, low-risk savings bonds issued by the US government. The advantage
is that you can purchase these for as little as $25 while the minimum for treasuries is $1000. EE
bonds can only be sold to the person to whom they are registered, so you cannot resell them, but
you can cash them in.
 The interest rates for future issues are set each May 1 and November 1 for new bonds.
With a fixed rate of interest EE-Bonds do not have inflation protection. Interest accrues
monthly and compounds semiannually. The US government guarantees the bond will
double in 20 years.
 Savings bonds are not as liquid as treasuries. Bonds held less than five years are subject
to a three-month interest penalty. EE bonds have an original maturity of 20 years, and
pay interest for 30 years. They must be held a minimum of one year.
 Paper bonds are sold at half the face value, i.e., you pay $25 for a $50 bond. Electronic
bonds, purchased via TreasuryDirect (http://www.savingsbonds.gov/), are sold at face
value.
 The interest on these bonds is not taxable at the state and local level. At the federal level,
you can choose to pay your tax when it is redeemed. The interest may be tax exempt
when you use the proceeds for higher education at a qualified institution.
I-Bonds
I-Bonds are inflation-indexed savings bonds with a fixed rate of interest plus an inflation premium.
I-Bonds are purchased at face value. You pay $50 for a $50 bond.





Bonds re-priced semi-annually (May and November) by the Treasury Department. The
rate is determined as a composite of the fixed rate and the semi-annual inflation rate.
Bonds increase in value monthly, and the interest is compounded semiannually. The
interest accrues (builds up the value of the bond) and is paid at the maturity date.
Savings bonds earn interest for up to 30 years, but they can be cashed in after one year
with a penalty.
For federal tax purposes you may choose to report interest each year as it builds up or
you may defer federal tax payment on the interest until the I-Bond is cashed.
If an I-Bond is redeemed before five years, there is a three-month interest penalty.
If I-Bonds are used to pay for college tuition and fees in the same year as it is redeemed,
up to 100 percent of the interest may be exempt from federal taxes.
True or False
Question
If you buy a 12-month Treasury bill (T-bill), will you be paid interest twice a year?
Answer
False, T-bill interest in only paid annually.
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Question
Is it true that, T-bills, notes or bonds are not as safe as other types of bonds because you never
know when the government will start overspending again and the government will stop paying the
interest on the bonds?
Answer
False. Government bonds are guaranteed by the U.S. Government. They are the most secure of
investments.
Assignment: Compare Current Treasury Issue Rates
Compare the rates, terms and minimum purchase of T-Bills, or TIPS, T-Notes—print out and
highlight the information to compare the 3-month T-bill with the 3-year Treasury Note or TIPS:
Go to TreasuryDirect to check out the latest Treasury rates, terms and price per $100 of
purchase. http://www.savingsbonds.gov/RI/OFBills
Treasury Security Watch at Bankrate.com
http://www.bankrate.com/gookeyword/ratewatch/treasury.asp or any other website
where you can find this information.
Explain the difference in interest rates using your knowledge about bonds.
Corporate Bonds
Corporations raise money by selling corporate bonds. Corporate bonds are issued by large
corporations to finance their business operations. Smaller corporations don't have access to the
bond markets. When you buy a corporate bond you are loaning money to a corporation.
Corporate bonds can vary in quality and interest rates. Generally issuers such as the federal
government are safer than corporations so there is less return with a government bond as can be
seen in the figure below. Generally corporate bonds pay higher interest rates than Treasuries
because more risk is involved. A company is more likely to default—not pay back some or even
all the money it's borrowed.
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Corporate bonds are concentrated in four industry groups.
Types of Bonds
Industrial
Financial Services
Public Utilities
Transportation
Companies
Manufacturers, retailers, mining, energy, service
Banks, brokerage, insurance
Telephone, electric, gas, water
Airlines, railroads, trucking
Influencing Factors
Business cycle
Interest rates
Regulations, legislation
Oil prices
With regards to credit ratings, the key distinction is between investment-grade and junk bonds
(also known as high-yield bonds). Investment-grade bonds are more credit worthy and less risky.
They have lower returns. Junk bonds may have very high interest rates but they are extremely
risky. They may default which means that they will not pay interest nor return the principal.
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Bond Ratings
Moody's
Investment Grade
Best quality. Interest payments are protected
Aaa
by earnings and principal is secure.
Protection on interest is not as high as Aaa but
Aa
still high quality.
Over the long term, some risk to investment.
A
Adequate for now but may be unreliable over
Baa
time.
Non Investment Grade
Future is not certain. Moderate protection of
Ba
interest and principal. Some speculation.
Small protection of interest and principal.
B
Poor standing. May be in default.
Caa
Often in default. Highly speculative.
Ca
Extremely poor prospects. In default.
C
Standard and
Poor's
Quality
AAA
High grade
AA
High grade
A
BBB
Medium
Medium
BB
Speculative
B
CCC
CC
Speculative
Default
Default
Poor
Investment
No interest
In default
C
D
Corporate bonds are usually issued by corporations and sold by their investment bankers to
institutional investors. This is known as the primary market for bonds. Afterwards, the bonds can
be sold on the secondary market, either through the New York Stock Exchange where they are
listed in $1000 denominations or more likely on the over the counter market between
brokers/dealers.
Corporations typically issue a term bond with the company paying interest twice a year and repay
the principal at an agreed date in the future. Just as in Treasuries, the interest rate is called the
coupon rate and the length of the time the loan is outstanding is the term. The term is also
referred to as the maturity of the loan. For corporations, the term period can range from a few
years to 100 years. Corporate bonds can have call dates that are earlier than the maturity date
when the company has the option to pay back the loan in its entirety. Corporations use the call
date as an out when interest rates fall.
Corporations are dependent on the earnings to pay back the money they borrow. A financially
healthy company with good earnings is what you want. Most new investors would do better
sticking with higher quality bonds.
 Check out the company's credit rating. The higher the credit rating, the less risk of default.
Higher credit ratings also mean lower yields.
 Know what the company is borrowing money for. Sometimes, companies borrow money to
acquire or merge with another company. They may issue lower quality or junk bonds to
accomplish this. To compensate the investor for taking on this risk, junk bond interest rates
are always higher. Despite their high yields, junk bonds are not as easily traded as highquality bonds.
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As an investor, you need to evaluate the issuer, credit rating, yield relative to historical interest
rates, yield relative to similar bonds and treasuries, plus maturity (including call date). These all
help you select the right bond.
Municipal Bonds
Other kinds of bonds include municipal bonds which are issued by local governments. For
example, a city may issue a bond to build new schools. The interest on these bonds may be
exempt from federal and local income taxes and therefore offer lower rates than Treasuries.
According to the Federal Reserve’s Flow of Funds Report, in 2007 there is about $2.5 trillion in
this debt. About a third of it is held by individuals because of their tax exempt status. Municipal
bonds are often sold in $5000 denominations. Be aware that different municipalities can have
different credit ratings. Unlike the federal government which can tax the whole nation, local
governments are dependent on local taxes. Some municipal bonds are dependent on the
revenues generated from the project financed. If the local economy is not healthy, there may not
be a strong base to tax. Municipal bonds can be insured to make them safer.
Mortgage-backed bonds
Mortgage-backed bonds are formed by pooling mortgages together and selling them to investors.
As of 2008, there is $12 trillion of this debt. They provide the benefit of monthly payments. These
bonds have call risk because people can prepay their mortgages or redeem them before maturity
especially in times of declining interest rates. In the past, investors have looked on mortgagebacked bonds as relatively safe investments, especially when they were backed by Ginnie Mae,
the government agency. However, there are also varying levels of credit risk in mortgage-backed
bonds. Recently, sub-prime mortgages, which are comparable to junk bonds, have come to light
as very risky investments. With sub-primes, many homeowners were unable to support interest
rate increases have gone into foreclosure.
Zero coupon bonds
Used with permission of Leslie Lum
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Zero-coupon bonds
Zero-coupon bonds are a special kind of bond where the interest is paid at redemption. For
example, if you bought a 10-year zero-coupon $1000 par value at 6%, you would pay $553.68. At
the end of 10 years, you would receive $1000 back which would cover both the principal and
interest.
Zero-coupon bonds are helpful if you don’t have much cash but want to purchase a bond for a
financial goal at a set time. Because so much time passes before you are paid, you want to buy
only very safe zero-coupon bonds. Some investors buy zero-coupon Treasuries. Also, another
disadvantage is that you have to pay taxes on the interest every year even though you don’t
receive it until the end of 10 years. Investors get around this by putting their zero-coupon bonds in
tax-advantaged savings plans such as IRAs or they may purchase zero-coupon municipal bonds
with tax-exempt interest.
Bond funds
Bond funds may be managed by professional managers or they may follow a bond index. Funds
allow you to invest in a variety of bonds which will help with diversification. With bond funds, you
can invest in various maturities, Treasuries, foreign bonds, corporate bonds of various credit
ratings, and mortgage-backed bonds. Before you invest in a bond fund, make sure that you
understand the objective of the fund and the type of selections it makes. Some bond funds
invest in derivatives which can be very risky. You can check out the portfolio of a bond fund with a
fund rating company such as Morningstar www.morningstar.com.
Activity – Select a Bond
Go to www.fidelity.com. Look for fixed income products and Individual bonds. Select bonds from
the Secondary Market. If for example, you want a corporate bond, you can click on that. This will
bring up a query functionality. Just click Search and a chart will come up with all the corporate
bond offerings. If you mouse over any one of the points, you will see the bond issuer. Then you
can click on the point and all the details will come up for the bond. Be aware that there is an
analytic tab that you can click on to get more information. Check out corporate, mortgage, and
zero coupon bonds to see how they work.
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Assignment – Check out interest rates
Go to the www.bloomberg.com, finance.yahoo.com, www.bankrate.com and
www.savingsbonds.gov. Research the rates for the following income investments:
Vehicle
Range of rates
Explain why the rate is
higher or lower than a bank
savings account.
Savings Accounts:
Money Market Accounts:
Certificates of Deposit (CDs) Specify term.
Savings Bonds (bonds issued by the U.S.
government to help pay its expenses)
Treasuries (Specify term)
Inflation protected Treasuries (Specify term)
Money Market Mutual Funds
Corporate Bonds (Specify credit rating)
Municipal Bonds
Mortgage-backed Bonds
US Stocks
When you own a share of common stock, you own a share of the company. Owning stock is also
referred to as owning equity or having a shareholder stake since you are a shareholder in the
company. Stocks are historically much more volatile than bonds in that their prices can go up
and down much more.
US stocks are typically categorized by size or market capitalization. Market capitalization is
basically the price you have to pay to buy the company outright. To figure market capitalization
(also called market cap or market value), take the price of the stock and multiply it by every single
share in investors’ hands. Luckily most financial websites compute this for you (as it changes
every minute the market is open).
It is relevant because large companies perform differently from medium and small companies. As
a guideline, large companies have a market cap of over $10 B and medium-size companies have
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a market cap of between $1 B and $10 B. Small companies have a market cap of between $300
M and $1 B. Micro caps are under $300 million in value. Looking over a long period of time, small
cap stocks have had higher returns than large cap stocks. It follows that they are the higher risk
of the two.
Stocks are also categorized by industry because companies in an industry tend to perform in a
similar manner. The government uses the North American Industry Classification System
(NAICS) which has 1170 industries. Most financial services use a significantly smaller number for
investment analysis. Industries include retail, food processing, banks, computer hardware and
more. To simplify, industries can be grouped to form sectors. For example, oil refineries and
energy exploration companies are grouped together in the energy sector. Standard and Poors,
the rating service that compiles the S&P 500 index among others, has defined their sectors as
noted in the table below:
SP500 as of December 2008
Industry
Energy
Materials
Industrials
Consumer Discretionary
Consumer Staples
Health Care
Financials
Information Technology
Telecommunications Services
Utilities
Number
39
29
58
80
41
54
81
75
9
34
500
Market Cap
($ millions)
1,047,160
234,853
869,885
659,182
1,010,995
1,161,430
1,045,420
1,203,432
301,046
333,141
7,866,544
Percent
13%
3%
11%
8%
13%
15%
13%
15%
4%
4%
100%
Sectors and industries can be more risky than the overall stock market. Their risk return
characteristics can also change over a short period of time.
Real Estate
Real estate is the physical stuff—land and buildings. It is also known as property. As an
investment it can be broken down into residential (places where people live) and commercial
(office buildings, shopping centers, hotels, warehouses, manufacturing facilities, and such).
Estimates of worldwide value of commercial real estate are $14 trillion with the US having about
$4.7 trillion.
Investors can buy into real estate by buying the property itself, buying into companies that are
based on real estate, or buying into trusts that buy and manage these properties (These are
called RIET’s, Real Estate Investment Trusts). A big part of real estate is the mortgage or the
money you borrow from the bank to pay for it. Some count mortgage securities as part of this
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category. They will also include investing in mortgages and mortgage bankers as an investment
in real estate.
According to the 1995 Property Owners and Managers Survey conducted by the Department of
Commerce, property owners invest mainly for income. How does that work? Most investors buy
property for the rent it generates. Usually property investors can’t afford to pay cash up front for
the house so they’ll get a mortgage or borrow money from a bank. A mortgage involves monthly
payments that pay interest and principal. Then there are property taxes and maintenance
expenses. Now for good properties the rent will cover these expenses and still give some cash to
the owner after that. If the investor was astute in selecting the property, the income could give a
nice return on investment.
Income is not the only reason that investors like real estate. Properties held over a period of time
can appreciate or grow in value. Inflation has a part in the price increase as does supply factors
such as the number of properties being built and demand factors such as growth of prime housebuying age population (people in the their mid 30s). Economic good or bad times can also affect
real estate buying. If the economy is humming, businesses are more likely to need space and
people are more likely to buy homes.
Real estate, as with any other investment, the return fluctuates from year to year following a cycle
influenced by the nation’s economy and inflation rate. Real estate is generally looked as a hedge
against inflation. In the mid 2000s, a huge run-up in real estate prices caused a bubble that
resulted in huge drops in certain regions of the country.
International
The 51 stock exchanges in the World Federation of Exchanges accounted for companies with
$32 trillion in market value at the end of 2008. Of these, companies worth $12 trillion were in the
US. The following table lists all the exchanges. Over the past ten years, US exchanges and those
of developed countries in Europe and the rest of the world accounted for less growth than
markets in emerging economies such as China, India, and Latin America. As a result, many
investors are increasing the international component of their investments.
Common sense says that you can classify international markets by country. That is, research the
various countries and then decide whether to invest. This works for countries with large financial
markets but not as well for smaller ones since their financial markets might not be large enough
to invest in.
You can also classify international investments by region. For example, Europe is one region, as
are the Americas and Asia. This works well because countries in the same region do affect each
other more than distant countries. The trouble is that levels of sophistication may vary between
financial markets within a region.
The main distinction investors make is between developed and emerging markets. Developed
markets are countries which industrialized early. They have the most mature and often the largest
economies. As such, they have the lowest return and risk. The list of developed countries
includes Australia, Austria, Belgium, Canada, Denmark, Finland, France, Germany, Greece,
Hong Kong, Iceland, Ireland, Israel, Italy, Japan, South Korea, Luxembourg, Netherlands, NZ,
Norway, Portugal, Singapore, Spain, Sweden, Switzerland, Taiwan, UK, and the US. Emerging
markets covers just about every other country. They include Latin America, China, India, and
more. Emerging markets are roller coaster rides. They can be extremely high return and with that
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very high risk. As emerging markets grow more sophisticated, they move on to become
developed markets.
International investments include both stocks and bonds. Countries are given credit ratings which
determine what interest rate they will pay. These countries would issue what would be equivalent
to the US Treasury instruments. Often other countries which are very stable economically can
give higher interest rates. Also, as currencies fluctuate against the US dollar, there can be gains
and losses made.
Commodities
Commodities are raw materials such as oil, agricultural products such as wheat, cocoa or pork
bellies, metals such as silver, gold, or copper. Commodities also include currencies, Treasury
securities, and stock indexes. Speculators typically buy and sell commodities with options and
futures contracts on an exchange.
Commodities’ trading is one of the riskiest investment activities. Commodities are notoriously
volatile. It is best to commit only a small portion of your portfolio to commodities so that you will
not be hurt by large losses. With futures contracts, you can lose your entire investment and more.
It is possible to invest in commodities through mutual funds and exchange traded funds. In this
case, your loss would be limited to your investment.
Options
Options are more complicated than stocks and bonds and can be just as volatile as commodities.
They should not be a big part of your portfolio. A stock option is a contract that gives you the right
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(but not obligation) to buy or sell shares of a stock at a stated price (strike price) on or before a
given date (expiration date) in the next 3-36 months. If you pass the date and don't exercise the
option (actually buy or sell the stock), the option no longer exists. Whoever sells you the option is
obligated to sell (or buy) the shares from you at the stated price. Options can be on stocks
(individual investors most frequently buy these), bonds, currencies, commodities, or indexes.
They are not the security itself but a derivative of it.
Say you have an option to buy (a call option) a stock at $25. This option expires in 6 months and
to purchase this call, you pay a premium of $3. You don't hold the stock, so you don't have any
shareholder rights and your right to buy the stock goes away in 6 months. During these 6 months,
you can exercise your option and buy the stock. If you do, you have to shell out $25 a share. You
could also choose not to exercise your option. In that case, the option would expire and you'd be
out the $3 a share premium you paid. Options to sell (a put option) work in a similar way except
that you are betting that the stock will fall.
The advantage of an option is that you paid $3 to potentially get in on gain of a $25 stock. Of
course, this is great if the stock moves up, but if it moves down or only up a little, you lose your $3
per share. That's what makes options so risky. You're betting on the direction that the stock will
move (up versus down), the dollar value of the move (has to be more than the strike price plus
premium), and the time (within 6 months). This makes these investments risky and better to
avoid, unless you are a very sophisticated and experienced trader.
Activity – Compare international rates
Go to www.bloomberg.com. This site gives you interest rates. Click on Market Data and Bonds
and Rates.
Assess how interest rates have moved over the past year. This gives you a good idea of how
interest rates do change.
Explain what each of the following are and create a bar chart with interest rates from the following
for a 5-year and 10-year maturity:
Treasury
Municipal
Inflation-indexed
Corporate AAA
Japan
Germany
UK
Brazil
Australia
Monitor your investments
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To evaluate how your investments are doing, compare them to a relevant measuring stick. The
correct (and best) way to do this is to compare your stocks to an investment index that is
appropriate for its asset class.
Dow Jones Industrial Average: A collection of 30 stocks that represent the biggest and most
prestigious (also referred to as blue chip) companies in American industry. The DJIA is weighted
by price; therefore, the highest priced stock (currently IBM) will have the most influence on the
DJIA. Although you might think that the Dow Jones is a good indicator of the overall market. It
represents some of the largest companies, but it doesn’t take small companies into account at all.
For more information on the Dow Jones, check out http://averages.dowjones.com.
Standard and Poor’s 500 (S&P 500): A collection that represents the 500 largest stocks
(technically not the 500 largest since industry is also a factor) on the U.S. stock exchanges.
Although this index by no means represents all stocks (since there are 7000 U.S. stocks), it used
by as a benchmark for the market. The S&P 500 is weighted by market value; therefore, the
largest companies will have the most influence on the index.
Selection is based on trading volume, ownership (float criteria), fundamental analysis (the
company has to have earnings), market capitalization, and sector representation (leading
companies in sectors must be included). More information on this index can be gotten from
http://www.spglobal.com.
Russell 2000: Take the 3000 largest stocks and line them up in order. Get rid of the biggest 1000
and you're left with the next 2000. The Russell 2000 is used as a benchmark for smaller
companies, and companies in the index are weighted by market value. The Russell 2000 covers
less than 10% of the entire market cap out there. Frank Russell and Company, an investment
company, maintains the Russell 2000. The Frank Russell Company is in Tacoma, Washington.
More information can be found at www.russell.com.
Standard and Poor’s 400: This index is not as well known as its older brother, the Standard and
Poor’s 500, the Standard and Poor’s Midcap measures mid-cap stocks. Medium capitalization
stocks can behave very differently from their large cap brethren and it’s important to have a
benchmark for this type of stock. The Standard and Poor’s 400 consists of 400 stocks selected
for market size and sector representation. Trading volume and ownership are considerations as
well. If you prefer Standard and Poor’s for small cap as well, you can choose the Standard and
Poor’s 600 as your index. Some experts prefer this index because it does not turnover as often as
the Russell 2000.
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The most widely cited bond index is the Lehman Brothers Aggregate Bond Index. This
consists of some 5500 bonds of maturities greater than 1 year and of investment-grade quality
only. About 40% are government bonds, 20% are corporate bonds, 35% are mortgage-backed
bonds, and 5% are international bonds that are denominated in U.S. dollars. Most fund rating
services use this index to measure the performance of bond funds. Some funds invest based on
this index.
The set of indexes maintained by Morgan Stanley Capital Indexes www.msci.com are the ones
most commonly used as benchmarks for international investments. The MSCI World Index is an
index that includes all the developed markets in the world including the U.S. Since the U.S. is a
large chunk of this index, it tends to move the World Index quite a bit. If your goal is to measure
investments outside the U.S., this is not the measure to use.
That MSCI Europe Australasia Far East (EAFE) Index includes all developed markets outside
the U.S. It's the benchmark to use if you're measuring a developed-market portfolio that doesn't
include the U.S. The benchmark for European developed markets is the MSCI Europe Index. For
emerging markets, use the MSCI Emerging Market Index. These indexes are available through
finance Web sites such as finance.yahoo.com or through mutual fund rating services such as
www.morningstar.com.
Question
Why are stock indexes important?
Answer
Why are stock indexes important?
They allow you to compare your investments to a benchmark. Just measuring your investments
by whether they go up or down isn’t enough. You need to know how they’re doing against similar
investments.
Question
What the Dow Jones Industrial Average is a benchmark for?
Answer
What the Dow Jones Industrial Average is a benchmark for?
It’s a benchmark for the giant caps or the very largest companies.
Question
What is the S&P 500 a benchmark for?
Answer
What is the S&P 500 a benchmark for?
The way it’s used, you would think it’s a measure for all stocks. It isn’t. The companies in the S&P
500 are large, blue chip companies. Although it covers most of the market cap, it’s not close to
covering all U.S. companies (500 versus 7000).
Activity – Check a fund against its index
Find an international fund on www.morningstar.com. Go to funds, fund categories and then
choose an international fund. For the best comparison, choose fund that has been in existence
for 10 years.
Look at the graph and table which compares its performance against its index. How did it do?
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Unit 4: Selecting Your Investments
Risk and Return
Risk and return are the two key characteristics we look at when selecting investments. Return is
the easier of the two to understand. It is what your investment earns every year. The higher the
return, the better.
When we think of risk, we think of risky behavior such as bungee jumping or driving too fast. It’s
best to get rid of these ideas when thinking about risk in investments. Investment risk measures
how volatile the investment is. That is, how high does it go up and how low does it go down.
Investments that tend to be more volatile are considered riskier investments. Riskier investments
are not necessarily bad as although they tend to go down more, they also tend to go up more.
Investment pros use standard deviation to measure risk. The higher the number, the higher the
risk.
Average
Return %
42
Risk %
European large stocks
25
10
International stocks of developed countries
23
9
Real estate
22
17
Small cap stock - Small US companies $300 M to $2 B
15
12
Mid cap stock - Medium-sized US companies $1.5B to $5 B
16
10
S&P 500 - Largest US stocks
13
8
4
3
Index Funds (2007)
Emerging markets are international stocks of developing countries
Bonds
18
One important concept to master in investments is that risk and return go together. This
can be shown in the graph below where we plot return against risk. Studies find that the more
return you want, the more risk you have to take. If we look at the major asset classes over the
long term (stocks, bonds and cash), this holds true. As an investor you need to be willing to take
more risk to get higher returns. Conversely, you need to be willing to accept lower returns for less
risk.
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Now a word of caution. The relationship between risk and return holds for broad-based
investments such as large cap, medium cap and small cap stocks indices. The risk return
characteristics of investments can change if shorter time periods are used or if you look at more
narrow categories such as industries or specific countries. The risk return relationship does not
hold for individual stocks which can give you no return and much risk as shown by stocks such as
Wamu and Enron, both of whom dwindled away to nothing.
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Activity - Risk Return
Go to www.morningstar.com. Click on the funds tab, and then click on category returns.
Select one fund from each of the following categories:
Real Estate
Financial
Energy
International
Bond
Large cap
Small cap
Under the Risk Measures (left navigation), find the Mean (return) and Standard Deviation (risk)
Type of fund
Ticker symbol or
name
Return (Mean)
Risk (Standard
deviation)
Optional: Plot a risk return graph for your funds. Risk or standard deviation will be on the
horizontal axis and return or mean will be on the vertical axis. How did the risk return compare to
the table shown above.
Be prepared to present your work in class.
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Asset Allocation
According to the 2004 Survey of Consumer Finances, individual investors on average hold three
stocks. About one-third of investors hold only one stock (most likely the stock of the company
they work for). You could make an argument for this. There are so many investments out there.
Why not pick a few winners and leave it at that? Investors who’ve tried this (whether it’s with tech
stocks or their own company’s stock) have often found themselves in trouble. First, it’s tough to
pick winners. Even if you get lucky and find a winner, winners can become losers for (short and,
sometimes, very long) periods of time.
Enter asset allocation. Asset allocation purists believe in two basic tenets. The first is humans
were not meant to stock pick. Many studies show that even high-priced professional money
managers don’t beat the indexes. Other studies show that by selecting asset categories, you do
just as well when you select individual investments. Here is a pie chart representing the California
State Employees Pension Portfolio for 2006. Each “slice” represents the amount of money put in
the asset.
California Pension
System $230.3 Billion
Real Estate, 8%
Direct
Partnership, 6%
Cash, 1%
International
Equities, 23%
Global Fixed
Income, 23%
Domestic
Equities, 40%
Source: www.calpers.ca.gov Investment Portfolio Market Value as of Dec. 31, 2006
The second tenet is that by diversifying through asset allocation, you can hedge against a huge
fall. This makes intuitive sense. If you put all your money in technology stocks and technology
stocks do poorly, you will have a loss if you need to cash out for any reason. Understand that the
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investment game is—and always will be—partly a guessing game. To invest, you have to project
what will happen in the future. If you allocate your assets across a number of categories, you
reduce the risk and maximum loss on your portfolio.
Whether or not you subscribe to these two tenets, asset allocation should be the first thing you do
when you invest. Asset allocation is not putting all your eggs in one basket. Diversification or
investing in a number of asset classes is important because it is a way to get the most return
and—incredible but true—take the least risk.
Question
Explain whether it is easy to pick the next winning category in investments.
Answer
It’s difficult to predict which stock or even asset class will do the best in the future.
The Best Return
Hindsight—figuring out what investment did great in the past—is easy. But it’s tough to know
what will give great returns next year. For the 5 years previous to 2000, the S&P 500 did great.
Many investors put money in S&P index funds and thought they were genius investors because
they were raking it in. Well, that didn’t prove true for the next three years when the S&P returned 9% in 2000, fell further to -12% the next year and then even more at -22% in 2002. Then,
investors thought the end was never going to be in sight.
The fact of the matter is, over the long term, the S&P 500 returns more in the order of 11%. The
past few years have been extremely abnormal. In fact if you look at the years prior to 1995 in the
chart above, the S&P 500 did not dominate at all. Some years it was small cap stocks (1980,
1983, and 1992), others, it was bonds (1982, 1984, and 1990), Europe (1985), Asian emerging
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markets (1987, 1988, and 1993), emerging markets in Latin America (1989, 1991, 1994, 1999)—
even T-bills (1981).
Asian emerging markets yielded the best returns in the late 1980s. But, by the 1990s Asian
emerging markets stayed in negative territory for most of the decade as the Asian financial “flu”
hit the entire region. From 1998 to 2000 it was tech stocks and investors were proclaiming a new
era in which the market would never fall too far. Unfortunately tech stocks were not immune,
either, and lost over 60% of their value between March 2000 and March 2001.
The lesson of history is that the best you can do is allocate in different assets so that hopefully
one of the asset classes you choose will get you the great return you're looking for. Even if it’s not
100% of your portfolio, a great return on a portion of your portfolio can go a long
way.
50%
Return (Average Annual Return)
45%
40%
35%
30%
Bonds
25%
US Stocks
20%
Sectors
15%
International
10%
5%
0%
0%
5%
10%
15%
20%
25%
30%
35%
Risk (Standard Deviation)
Source: Morningstar.com (3 years of data ending Nov 2006)
Question
Rank the chart above in order of return:
Bond
US Stock
Sectors
International
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Answer
Rank in order of return:
Bond
US Stock
Sectors
International
1.
2.
3.
4.
Bond
US Stock
Sectors
International
Question
Rank in order of risk:
Bond
US Stock
Sectors
International
Answer
Rank in order of risk:
Bond
US Stock
Sectors
International
Same order: remember for the major asset classes, the more return, the more risk.
1. Bond
2. US Stock
3. Sectors
4. International
The Least Risk
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If you take one risky investment and put it together with another risky investment, you've doubled
your risk, right? That would be true if the two investments moved in tandem (went up or down
together), but if the investments always moved in exactly opposite directions, you basically could
cancel out any risk by putting the two investments together as shown in the figure above.
The trick is to make sure that the investments are not correlated. Correlation measures how
closely two investments move together in the same time period. Two investments that move
exactly alike have a correlation of +1. When they move exactly opposite, they have a correlation
of -1. Two investments can have a correlation anywhere between -1 and +1.
Although it is rare to find two investments that move in exactly opposite directions, we don't need
perfect negative correlation to reduce risk. Any time two investments don’t move exactly alike, it
works…the lower the correlation, the better.
Reducing Risk
Let's look at a simple example. You’ve kept your money in the bank for the past 20 years at 90day treasury bill rates because you don't want to lose money. Your average annual return has
been 7%, which isn't great but you've only had to deal with a risk of 3%. Now someone tells you
that stocks have returned 19% in the past 10 years. But the standard deviation or risk is 13%.
These stock returns are attractive, but you don't want to increase your risk. You can actually get a
better return with less risk by including some stocks in your portfolio. Look what happens above
when you put 10% of your portfolio into stocks. Your return goes up to 8%, but the standard
deviation actually goes down to less than 3%.
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If you boost your investment in stocks to 20%, your return goes up to 9% but your risk still stays
around 3%. After that risk starts to go up just as returns go up.
This demonstrates that investing in riskier assets with higher returns doesn't necessarily mean
that your total portfolio risk will go up. You can actually up your return and reduce risk if you
invest in the right combinations.
Asset allocation doesn't stop with the major asset classes. Within bonds, you can allocate among
various maturities (due dates of the bond) to bring down the risk of interest rate fluctuations.
Within stocks, you can allocate among small, medium, or large cap stocks. You can include
international investments. You can include real estate. Start with a low-risk portfolio and add
higher-risk-higher-return asset classes to increase your return, but always be on the lookout for
what happens to your risk. It is good to note that asset allocation is based on historical data, and
we know that past performance is not always an indication of future performance.
Activity – How the pros asset allocate
Go to the California pension website and look at what this $250 billion pension manager allocates
its portfolio for the employees of the state of California in the latest year
http://www.calpers.ca.gov/index.jsp?bc=/investments/assets/assetallocation.xml
Summarize their strategy.
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Assignment – Asset Allocation
Check all asset classes and subclasses you will invest in and determine what percent of your
portfolio you will place in each.
Percent
Asset
Risk (High, Medium, Low)
Cash
Large Cap
US
Small Cap
Stock
Sectors
International
Developed
Emerging
Corporate
Treasury
Treasury Inflation-Protected
US
Bond
Municipal
Mortgage
Short, medium, or long
Junk
Global
Developed
Emerging
Real Estate
Commodities
Other (specify)
1. Go through each category that you selected and explain what you think are the risk and
return characteristics of each.
2. Explain why you chose to allocate the percent you did.
3. What benefit do you think that each category you selected will bring to your portfolio.
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Unit 5: Selecting Funds
If you follow a strategy of asset allocation, you will most likely invest in funds that invest in a
broad cross section of assets. It is therefore important that you understand what funds are all
about.
According to the Investment Company Institute, the umbrella organization of the fund industry, 51
million or about 44% of all U.S. households (up from 6% in 1980) invested in mutual funds in
2007. That tallies up to 89.6 million individuals with a typical balance of $48,000 in a median of 4
mutual funds. To satisfy this demand, about 10,000 funds (a greater number than stocks listed)
are marketed to investors.
Funds are portfolios of assets managed by an investment manager or a team of managers or a
computer program for the individual investor. These portfolios can include stocks, bonds, real
estate, or combinations of these. All funds have an objective, which is what type of assets it
invests in. Some funds are actively managed—meaning the investment manager researches and
selects investments for the portfolio. Investments in an actively managed fund will change based
on the investment manager’s analysis. Others are index funds where stocks, bonds, or other
investments are selected based on a stock or bond index. A computer program that matches the
investments to the index maintains index funds.
Once the investments are selected, they are accumulated in a portfolio. For stocks, the value of
this portfolio is measured by taking the number of shares of each stock and multiplying by the
current price of the stock. For most funds, the value of the total portfolio or net asset value is
calculated daily. The fund is divided into units or shares and sold to investors. Units or shares are
quoted as net asset value per share. In the strange and wonderful world of funds, funds can sell
or have a market value that is more or less than their net asset value.
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Mutual Funds
As of the beginning of 2006, there were about 9000 mutual funds with a net asset value of $9
trillion. Mutual funds are also known as open-end funds. That’s because the number of mutual
fund shares is not fixed but can vary because investors move in or out of them. If an investor
wants to buy shares in a mutual fund, the fund manager simply buys more investments with the
cash coming in. If an investor wants to sell or redeem shares in a mutual fund, the fund manager
pays out the cash and sells investments to cover. The number of shares of a mutual fund thus
grows or contracts. This is different from a closed-end fund where the number of shares is fixed
when the fund is first offered.
Closed-end Funds
Closed-end funds are similar to mutual funds in many ways. A closed-end fund may also be
managed by an investment manager or team. What is the major difference? Closed-end fund
shares can’t be redeemed from the fund. The number of shares is set at the initial fund offering,
and the fund will not redeem any shares. Buying a closed-end fund doesn't mean that you'll never
be able to sell. You simply sell your shares through a stock exchange or over the counter.
So what’s the scoop here? Closed-end fund managers don’t have to deal with buying or selling
investments at the wrong time. Because shares can’t be redeemed from the fund, they don’t have
to worry about buying new investments when there are none to be had nor selling investments at
the wrong time. This is particularly important for more non-liquid investments such as bonds or
emerging-market stocks.
Exchange Traded Funds (EFTs) and Unit Trusts
Unit trusts are also used for stock investments. Just about every major brokerage firm has its own
set of unit trusts. Usually they are created on an investing theme. Sector unit trusts are a hot item.
Another theme is stocks with projected high performance. For stock unit trusts, the brokerage firm
may have a set date when the trust is liquidated. Some unit trusts allow the investor to redeem
shares in stock that can be held or sold on the exchanges.
The NYSE Alternext US has several exchange-traded funds (ETFs) or unit trusts that reflect
broad-based indexes like the Dow Jones (DIAMONDs), the Standard and Poor’s 500 (SPDRs),
sectors (available as both SPDR’s and iShares), and countries. Dividends are distributed to the
investor as they are received. These ETFs are priced lower per share than typical unit trusts in
brokerage firms which sell for about $1000 a unit. Like closed-end funds listed on the exchanges,
ETFs can be traded any time during the day; mutual funds, on the other hand, can only be bought
and sold at the end of the day.
Fees and expenses
Fund fees come in two types that are of interest to you as an investor. The first type is included in
the performance numbers published by fund rating services. These are typically added to the
fund’s expense ratio and subtracted from the return of a fund. The second type is not included in
the fund’s expense ratio and needs to be accounted for when evaluating a fund.
Here are some of the fees included in expense ratios:
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Investment Advisory or Management Fees. This is the money the fund manager receives for
managing the fund. It might include a fee to the fund company itself based on the size of the
fund's asset, and it might also include a performance fee that pays the manager more if the fund
outperforms the relevant index. These fees are taken out of the fund’s assets. Their cost ranges
from 0.5% to 1% of a fund's assets.
Administrative Fee. This is paid to run the fund's day-to-day operations. It includes recordkeeping and all transaction costs. This cost ranges from 0.2% to 0.4% of the fund's assets.
12b-1 Fee. According to the FINRA, funds are allowed to charge up to 1% for advertising,
marketing (0.25%) and distribution services (0.75%). The theory is if you market and increase
fund assets, you can hire better managers and have a better fund for all the shareholders.
Here are fees and charges that aren’t included in the fund’s expense ratio as calculated by most
fund rating services:
Sales Loads. FINRA regulations allow mutual funds to charge up to 8.5% or more in sales
charges (sales charges are really commissions) but most funds don’t charge more than 6%. Hefty
front-end sales charges mean that less of your money is going into investing. Most fund rating
services do not include sales load in the calculation of performance.
Transaction or Redemption Fees. These are charged when investors cash out. They
discourage fund holders from trying to time the market and moving in and out and in the
meantime hurting the fund holders who stay put. Instead of going to the fund company, these go
directly into the fund. The Securities and Exchange Commission limits these to 2%. This is not
included in the calculation of performance.
Maintenance Fee: Some fund companies charge a fee ($10-30) for smaller accounts. If you have
less than some limit (say $10,000), the fund company may charge you an account maintenance
fee to stay in the fund.
Fees and fund expenses are important topics when you buy funds. Think about it this way. Stocks
have returned “11%” over the long term. Take about 3% off for inflation, another 3% in taxes and
your return drops to 5%. With the cost of running funds averaging 1.5%, fund expense ratios can
really impact your return. In addition, you might have to pay a sales charge of 4% or 5%--another
huge impact on your return, especially if you’re a typical fund investor who holds for only two
years. You might argue that more fees mean more return. In a study done by John Bogle
(founder of Vanguard Funds), he showed that the lowest-cost 25 percent of funds (including all
expenses) perform much better than the highest-cost 25 percent of funds.
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Source: Statement of John C. Bogle to the United States Senate Governmental Affairs
Subcommittee, November 3, 2003
Additional studies have shown that, most years, actively-managed funds have a hard time
beating their index counterparts. These researchers conclude that even when active managers
do beat the indexes, any advantages are eaten up with fee costs.
The general conclusion is that the best strategy for the individual investor to take is to buy index
funds in the asset classes that you want in your portfolio.
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Index Fund
All Funds
Expense
Expense Ratio
Ratio %
%
Mutual Fund Category (2007)
Emerging markets are international stocks of developing
countries
European large stocks
International stocks of developed countries
Real estate
0.77
0.6
0.35
0.35
1.77
1.64
1.65
1.46
Small cap stock - Small US companies $300 M to $2 B
0.2
1.41
Mid cap stock - Medium-sized US companies $1.5B to
$5 B
0.2
1.39
S&P 500 - Largest US stocks
0.09
1.25
Bonds
0.2
1.05
Activity – Check fund fees
A class investigation of fund fees. Students will be assigned to find one fund in each of the
following categories and look for the funds expense ratio and any other fees. It will then be
compared to the index expense ratio. What did you find?
Mutual Fund Category
Emerging markets are international
stocks of developing countries
European large stocks
International stocks of developed
countries
Real estate
Small cap stock - Small US companies
$300 M to $2 B
Mid cap stock - Medium-sized US
companies $1.5B to $5 B
S&P 500 - Largest US stocks
Bonds
Index
Fund
Expense
Ratio %
Fund
name
Fund
Expense
Ratio %
Other fees
0.77
0.6
0.35
0.35
0.2
0.2
0.09
0.2
Assignment – Evaluate 529 plan
T Rowe Price a mutual fund company offers a 529 plan to save to college. Its portfolio for a
student who will attend college in 2018 consists of the following funds.
Equity Index 500 28%
Spectrum Income 26.25%
Blue Chip Growth 8.75%
Value 8.75%
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Small-Cap Stock 6.50%
International Growth & Income 4.25%
International Stock 4.25%
Overseas Stock 4.25%
Mid-Cap Growth 3.50%
Mid-Cap Value 3.50%
Emerging Markets Stock 2%
Check out these funds at T Rowe Price’s fund page in www.morningstar.com. You can click on
the fund name at:
http://quicktake.morningstar.com/FundFamily/FundList.asp?Country=USA&Symbol=75013
Find each fund’s performance as compared to the index and its fees. What is your conclusion
about the allocation and choice of funds?
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Unit 6: When to Buy and Sell
Deciding when to buy is easy. We determine our asset allocation and pay ourselves first by
deducting from each paycheck. It’s impossible to determine what the market will do from day to
day so investing on any given day doesn’t give you any advantages or disadvantages. Knowing
when to sell is another matter. In this section we discuss selling both bonds and other
investments.
Bond or CD Ladder
Bonds present stock investors a degree of stability to your investment portfolio; however rising
and falling interest rates can disrupt your investment strategy. Normally the longer the maturity
time period, the higher the bond’s yield since longer maturities give the bond to greater risk of
interest rate ups and downs over a longer period of time.
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Bond laddering is a better way to protect you from the risks of interest rate ups and downs and
at the same time manage the cash flow (yield or interest payments) from your bond investments.
A ladder can be used for CDs as well as bonds. A bond ladder involves buying several bonds
with varying maturities over a 5 to 10 year period.
For example, instead of buying $100,000 in bonds with a five year maturity you would buy
$10,000 bonds each year for five years. With the lump sum investment, you have all your bonds
maturing at the same time. With laddered bond investing, you would have a bond maturing every
year for five years. Looking at early 1980, this is what would have happened. With the lump sum
investment, you would have $153,700 after five years. Although interest rates were high in 1980,
you missed the even higher interest rates in 1981 and 1982. With bond laddering, you would
have $190,490. (As a caveat, this analysis doesn’t take into consideration the time value of
money.)
1980
1981
1982
1983
1984
1985
10.7%
12.8%
14.7%
10.0%
11.4%
10.9%
At maturity
Lump sum
100000
153700
Ladder
20000
20000
20000
20000
20000
20000
190490
The advantages of a bond ladder (or CD ladder) are:
 You will have a mixed yield portfolio of bonds coming due in the short and long term,
which will give you an appealing current bond yield.
 If interest rates go up, you will have a bond maturing shortly that you can reinvest at a
higher interest rate for another five year term.
 If interest rates drop, only a small portion of your portfolio (the one-year bond maturing)
would be reinvested at the lower rate.
 You can match your cash needs with how long you make the bond ladder by deciding the
type of bond for the ladder.
Be careful how you build your bond ladder. Here are some suggestions to keep in mind:
 Your bond ladder can have a different time frame than the five year example above.
However, the longer the maturity, the higher your yield but the risk will be greater.
 For your bond ladder, the more rungs on your ladder, the more diversified your
investment portfolio will be.
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Question
What is difference in the interest if you had invested $100,000 lump sum versus laddering
$20,000 in 5-year Treasuries for each year for the beginning of the 1970s? Try starting your
ladder on different years. Your interest is the rate times your investment times 5 years.
Year
1970
1971
1972
1973
1974
1975
1976
1977
1978
1979
1980
Rate
8.2%
5.9%
5.6%
6.3%
7.0%
7.4%
7.5%
6.6%
7.8%
9.2%
10.7%
Answer
Laddering doesn’t always turn out the best result but it seems to work well most of the time.
Year
Rate
Lump
1970
71
1972
1973
1974
1975
1976
1977
1978
1979
1980
8.2%
5.9%
5.6%
6.3%
7.0%
7.4%
7.5%
6.6%
7.8%
9.2%
10.7%
Interest
100000
20000
20000
20000
20000
20000
20000
40850
40350
Year
1970
1971
1972
1973
1974
1975
1976
1977
Rate
8.2%
5.9%
5.6%
6.3%
7.0%
7.4%
7.5%
6.6%
Ladder
Lump
100000
Ladder
20000
20000
20000
20000
20000
20000
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Updated 2009
1978
1979
1980
7.8%
9.2%
10.7%
Interest
29450
39640
Assignment – Bond Laddering
You have $50,000 to put into bonds. Choose one of the maturities (one, two, five or ten) below.
1. Do not ladder your money. Put all your money in one year and then check off every year
it matures until you have gone through 20 years.
2. Ladder your money. Average out the interest rates.
Compare the results. Did laddering reduce your interest rate risk?
Oneyear
rate
Twoyear
rate
Fiveyear
rate
Tenyear
rate
1980
12.06
11.50
10.74
10.80
1981
14.08
13.26
12.77
12.57
1982
14.32
14.57
14.65
14.59
1983
8.62
9.33
10.03
10.46
1984
9.90
10.64
11.37
11.67
1985
9.02
9.93
10.93
11.38
1986
7.73
8.14
8.68
9.19
1987
5.78
6.23
6.64
7.08
1988
6.99
7.63
8.18
8.67
1989
9.05
9.18
9.15
9.09
1990
7.92
8.09
8.12
8.21
1991
6.64
7.13
7.70
8.09
1992
4.15
4.96
6.24
7.03
1993
3.50
4.39
5.83
6.60
1994
3.54
4.14
5.09
5.75
1995
7.05
7.51
7.76
7.78
1996
5.09
5.11
5.36
5.65
1997
5.61
6.01
6.33
6.58
1998
5.24
5.36
5.42
5.54
1999
4.51
4.62
4.60
4.72
2000
6.12
6.44
6.58
6.66
2001
4.81
4.76
4.86
5.16
2002
2.16
3.03
4.34
5.04
2003
1.36
1.74
3.05
4.05
2004
1.24
1.76
3.12
4.15
2005
2.86
3.22
3.71
4.22
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Updated 2009
2006
4.45
4.40
4.35
4.42
2007
5.06
4.88
4.75
4.76
2008
2.71
2.48
2.98
3.74
Buy and hold stock index funds
Risk as measured by standard deviation gives you an idea of the odds of getting a return with a
given range in a given period of time. But the math is not the only issue. Investments are a
combination of the market and you. Your psychological profile will play a big part in what you will
invest in. If you can’t stomach seeing your investments fall in value, you should choose less risky
investments. Of course, that means that you won’t get the highest returns and you’ll have to
adjust either or both savings and goals to adapt. However, you’ll be able to sleep easily. You
need to assess your own risk tolerance. Some investment services will calculate the maximum
loss on a portfolio so that you can evaluate whether or not it’s something you can tolerate.
In the addition, the more you know about investing, the more you will learn to tolerate risk. Here’s
one easy lesson. Look at the chart below which shows year-by-year stock returns for the past 100
years. Some folks may look at the stock chart and decide that they will never invest in stocks
because some years stocks can fall over 30%. That means if you have a retirement account with
$100,000 in the stock market, you could lose $30,000 in one year.
Annual Stock Price Changes from 1900 to 2006
(Percent change year to year in S&P 500)
45%
25%
5%
1900
1910
1920
1930
1940
1950
1960
1970
1980
1990
2000
-15%
-35%
-55%
However, the following two graphs show that if you hold onto your stocks long enough, you can
mitigate the effects of a down year. The first graph below shows what happens if you average all
five-year periods. This basically means you hold onto your stocks for five years before selling.
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The number of negative returns is diminished. The second graph below shows what happens
when you average any ten-year periods. This would mean that you hold for 10 years before
selling. The negative impact is reduced even further. It’s important for high risk high return
investments to have the time to recover from downturns.
Average Previous Five Years S&P 500 Gains
30%
25%
20%
15%
10%
5%
0%
1900
1910
1920
1930
1940
1950
1960
1970
1980
1990
2000
-5%
-10%
-15%
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Average Previous Ten Years S&P 500 Gains
18%
16%
14%
12%
10%
8%
6%
4%
2%
0%
1900
-2%
1910
1920
1930
1940
1950
1960
1970
1980
1990
2000
-4%
For the most part, risk return tells us that we have to accept risk in order to get higher returns. We
have to deal with this on both a practical and psychological basis. Having an emergency fund for
three to six months of living is a good way to handle risk on a practical basis. If, for example, you
lose your job during a market down time, you won’t have to sell investments during a low point
but can instead tap into your emergency fund. As you become a more sophisticated investor, you
will come to become more relaxed when the market does its inevitable drops.
Rebalancing Your Portfolio
Academic types have long known that investors do worse than the average return on a fund and
the market index. One study, the Quantitative Analysis of Investor Behavior (QAIB) study done by
Dalbar, estimates that from 1984 to 2002 when the market returned 12.2% a year, investors got a
dismal 2.6%. On average fees can reduce the annual return by 3%. What accounted for the other
6%? Academicians agree that because individual investor’s attempts to time the market (buy low
sell high) made them buy and sell at the wrong time.
Dalbar contends the instead of buying low and selling high, investors were chasing returns by
pouring money into equity funds on market upswings and selling them on downturns or buying
high selling low. The average equity investor earned 2.57% annually even lower than the inflation
rate of 3.14% for the same time period. The average fixed income investor earned 4.24%
annually; compared to the long-term government bond index of 11.70%. On average, investors
hold funds for about 3 years.
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Looking at the chart below, you can see that based on information from the Investment Company
Institute, funds inflows (bars above 0) are highest when the market (line is highest) and fund
outflows (bars below 0) happen when the market is at its lowest.
Source: Statement of John C. Bogle to the United States Senate Governmental Affairs
Subcommittee, November 3, 2003
With stocks you will employ a different strategy. Given that it’s not possible for you to determine
when to jump in the market, just use your habit of paying yourself first as the best way to start
investing. Have your savings automatically deducted from your pay check. Put it into an index
fund based on how much you want to allocate in each asset class. As each asset class goes
through its cycle, it will grow and ebb.
To stop yourself from falling victim to the tendency of individual investors to sell at the wrong time,
use rebalancing. Rebalancing means if you’ve allocated 60% of your savings to stocks and
stocks have done very well in the past year and now your allocation has grown to 70%, you will
sell the 10% in excess of your planned allocation and put it in another asset class that has fallen.
For example, if you started with 60% stock and 40% bond in 1992 and you took no action on your
portfolio, this is how it would look year by year:
Year
1992
1993
1994
1995
1996
1997
1998
Bond
40%
40%
39%
35%
32%
27%
24%
Stock
60%
60%
61%
65%
68%
73%
76%
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1999
2000
2001
2002
2003
2004
2005
2006
21%
24%
28%
36%
31%
30%
29%
27%
79%
76%
72%
64%
69%
70%
71%
73%
Just taking a simple allocation between stocks and bonds over 15 years, you can see from the
chart below that rebalancing helps you reduce losses leaving you with a final value that is larger
than if you did not rebalance.
Final Value - No Action Portfolio $376,353
Final Value Rebalance Portfolio - $381,608
35%
30%
25%
No action
Rebalanced
20%
15%
10%
5%
0%
1992 1993 1994 1995 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005 2006
-5%
-10%
-15%
-20%
Unit 7: Protecting your wealth
An investment advisor is someone who can assist you with your financial planning and
investment needs. They are known as investment consultants, investment advisors, financial
planners, financial advisors, financial consultants, and so on. Most are certified or registered in
some form or fashion, and the Securities and Exchange Commission has regulations as to who
must be registered.
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There is no one regulatory body that oversees investment advice, and there are no set
requirements for being an investment consultant. Some advisors don’t have college degrees;
some have limited experience in the field; some are not certified at all. Of the ones who are
certified, the two biggest certifications are the Certified Financial Planner (CFP) and the
Chartered Financial Consultant (ChFC). Each of these certifications has about 35,000
professionals.
The industry attracts its share of con artists, and stories about scams appear regularly in the
media. You can also go to the Securities Exchange Commission Web site (www.sec.gov check
under “Litigation”) to read up on industry shenanigans. The sad fact is the first thing you need to
do when you check out financial advisors is see if they have any black marks on their record. The
best way to do this is to check with your state securities agency. Each state has an agency that
monitors banking, finance, and securities. The North American Securities Administrators
Association (www.nasaa.org) has links to all its member state securities agencies.
In Washington state, it is the Department of Financial Institutions (www.dfi.wa.gov) In addition,
you need to check with the advisor’s professional association. Most associations keep a list of
complaints. It is also suggested that you “Google” the advisor’s name. If complaints are registered
in other states, they will often show up in a “Google” search.
Each type of financial advisor has pros and cons. There are:



Financial advisors in private practice, or firms who operate on a fee-only basis.
Brokers in large firms have access to research.
Tax accountants have a good handle on the complicated tax laws and how they affect
your return on investments.
Here’s a list of the kinds of investment advisors and what they do.
Type of Advisor
Check for Disciplinary Actions
Accountant. Certified public accountants (CPA) have
an accounting degree, worked under the supervision
of a CPA, and must pass a national exam. There are
about 400,000 CPAs out there. About 3000
accountants are Personal Financial Specialists, a
designation offered by the American Institute of
Certified Public Accountants for financial planning.
Certified. Registered with www.aicpa.org.
Attorney. Some lawyers provide financial planning
services, usually in estate planning (wills) or tax
planning.
For a listing of State Bar Associations, check
Professional Resources in
http://www.martindale.com/.
Broker/Dealer. A broker/dealer usually works for a firm
that is licensed to sell investments. Dealers (mostly
large companies) sell securities that they own. Brokers
buy and sell on behalf of investors.
Investors can request a public disclosure report on
brokers. Check with www.dfi.wa.gov for
Washington state.
State Board of Accountancy, www.nasba.org for
listing. For Washington state, it’s the
www.wscpa.org.
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Certified Financial Planners (CFP). CFPs have 3
years (with bachelor’s degree) of financial planning
experience, and must pass a 2-day exam covering
100 topics. They need 30 hours of continuing
education every 2 years. There are about 54,000
CFPs.
Certified. Registered with Certified Financial
Planner Board of Standards www.CFP-Board.org.
Check with www.dfi.wa.gov for Washington state.
Fee-only financial planners can be researched on
www.napfa.org. Issues around financial planners
are at www.fpanet.org
Chartered Financial Analysts (CFA). CFAs are mainly
employed as securities analysts. They must complete
the Association of Investment Management and
Research's experience, education, and exam
requirements. There are about 78,000 CFAs and,
worldwide, about 100,000 CFA hopefuls sit for the
exams every year.
.
Chartered Financial Consultant (ChFC). These are
certified by The American College, which is the
insurance industry’s educational arm. They need 3
years of business experience (a Bachelors degree
may qualify as 1 year) and they need to pass a 10course financial planning curriculum. About 33,000
professionals have this certification.
Certified. Check with your state insurance
regulator. (For listing, see www.naic.org) and state
securities agency (listing available through
www.nasaa.org). For Washington state, check with
(www.dfi.wa.gov)
Estate planners. These can be lawyers, accountants,
financial planners—they can be in the insurance
industry or work for a bank. They help you put
together a plan that gets most of your estate to your
heirs rather than to Uncle Sam.
For a listing of State Bar Associations, check
Professional Resources in
http://www.martindale.com.
Investment Advisor. Anyone who takes money for
financial advice on assets of $25 million or more must
register with the Securities and Exchange Commission
(advisors under $25 million with clients in 30 states
must also register). Everyone else has to register with
the state securities agencies (unless state law says
different). Stockbrokers are exempt because they are
sales agents who are watched by the National
Association of Securities Dealers.
Securities and Exchange Commission for
regulations, see www.sec.gov. State securities
agency, listing available through www.nasaa.org.
For Washington state, check with
(www.dfi.wa.gov)
Investment Advisor Representative. Someone who
works for an investment advisory firm and who
provides advice to clients. They must pass the Series
65 exam (for investor advisors) and an exam
developed by the North American Securities
Administrators Association.
Series 65 exam. Check the state securities agency
listing available through www.nasaa.org/. For
Washington state, check with (www.dfi.wa.gov)
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Registered Representative. A stockbroker usually
affiliated with a brokerage/dealer firm who
recommends securities to clients. A registered
representative has to pass the National
Association of Securities Dealers exam (usually
the Series 6 and 7) and also pass a state exam.
They must be registered with the NASD and
licensed with the local state securities agency.
Registered with state securities agencies
(listing available through www.nasaa.org). For
Washington state, check with (www.dfi.wa.gov)
Before you select an investment advisor, prepare a list of your financial goals and have a good
idea what your risk profile is. Taking a basic primer course on investing is also helpful. Don’t rush
to select an advisor. It can be a very costly mistake.
Understand that you can have any level of financial advice you choose. You can have the
financial advisor make all the decisions on your investment plan. You can use the advisor for
advice. You can devise your own plan and execute it yourself. There are no set rules for how
financial advisors are used, just as there are no set rules on how they are paid.
They can be paid on a commission basis, getting a fee or percent on the products they sell. For
example, if they sell a mutual fund to you, they might get a 2% commission on what you buy.
They can be paid on a fee-only basis where the only source of compensation is a fee from you.
This may be an hourly rate or a fixed annual fee. For example, you might negotiate a $2000 fee
to be paid every year. Many brokerage firms have been moving over to fee-only structure of 1%
to 3% of assets, touting that this provides more objective advice. However, a fee-only structure
may not be the best for you if you invest mainly in indices and don’t trade often. It’s also important
to clarify what you will get for your fee.
Advisors can be paid both commission and fees. They can be paid based on the assets they
manage for you. For example, they might charge you 0.5% to 5% of the assets they manage.
(Usually the more money you have, the less the percent.) This type of arrangement may not be
the best for individuals who invest mainly in index funds and buy and hold. As in all cases, fees
are all negotiable.
The important thing is that you understand exactly how they are paid. Much of the abuse that
happens in the financial services industry occurs because some advisors manage their own
compensation much better than they manage their clients’ assets. Ask for a copy of the firm’s
commission schedule. More commissions may be paid on the firm’s own products even though
they may not perform as well as other products.
Put in writing that you want full disclosure of compensation on any products that are
recommended and make sure you get it for every investment. Ask about any fees required for
opening, maintaining, or closing an account. On the other hand, make sure you understand what
you are getting for your money. If you’re not paying for advice, you won’t get advice.
Even though there are many choices of financial advisors out there, most people don’t take the
time to comparison shop. Before you select an advisor, talk to people at several firms. Meet with
them face to face at their offices. Make a list of questions to ask. You want an individual with a
fair (5–10 years) amount of experience (the burnout rate in this profession is high, especially
when they have quotas to meet). Get a copy of their Form ADV. This is the advisor’s registration
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form with the SEC. Part 1 covers the advisor’s education, business, and any problems with
regulators. Part 2 outlines services, fees, and strategies.
What is the advisor’s education? Does it relate to financial knowledge? Some insurance agents
who are new to managing investment may start to sell you funds available through their
companies. Although they may be excellent insurance agents, they may not be experienced
enough to handle your money. Ask about their clients. How many clients do they have? How long
do clients stay with them? What are the total assets they are advising on? What is the average
portfolio of their clients? Make sure you fit the profile. If your portfolio is too small, the advisor
might not pay enough attention to you. Ask if the advisor or an assistant will handle your portfolio.
Ask for at least three references. Most importantly, do you feel comfortable with the advisor?
Investing is a very personal activity. Does the advisor’s investing style match yours? You need to
feel that the advisor is working in your best interest.
Make sure that you have complete disclosure of any fees and the commission schedule. Ask
questions about conflict of interest. (This advisor might also be advising your business
competitor.) The advisor may get referral fees for recommending you to other financial,
accounting, or legal firms. Check with the state securities agency or the professional association
for any disciplinary actions. Ask if the brokerage firm is a member of the Securities Investor
Protection Corporation (SIPC). This organization provides limited protection if the firm goes
under. Ask if the firm has other insurance. Get it all in writing. The Certified Financial Planner
Board (www.cfp-board.org) has an extensive questionnaire that can be filled out by any advisor
you are considering.
Institutional investors most often have more than one investment advisor and it’s a good idea for
you to have more than one as well. You can ask for a second opinion on any investment advice
you are given. Also know that a major marketing tactic is to have an individual move all their
financial requirements by one firm because it encourages retention with the firm. Often even if the
individual is dissatisfied with service, it is a major hassle to move his or her assets to another firm
and he or she may not do so.
Here is the questionnaire that the Certified Financial Planner Board of Standards
(http://www.cfp.net/learn/knowledgebase.asp?id=8) recommends that you use in your
interview. It is best to have the financial planner complete it in writing and sign it for return to you.
Take notice as to how long and what care the planner takes to complete this form. This may be
an indication of how much care and attention that will be given to you.
Prospective Financial Planner Questionnaire
Planner's Name:
Company:
Address:
Phone:
Date:
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1. Do you have experience in providing advice on the topics below? If yes, indicate the number of
years.
o
o
o
o
o
o
o
Retirement planning
Investment planning
Tax planning
Estate planning
Insurance planning
Integrated planning
Other
2. What are your areas of specialization?
What qualifies you in this field?
3. a. How long have you been offering financial planning advice to clients?
o
o
o
o
Less than one year
One to four years
Five to 10 years
More than 10 years
b. How many clients do you currently have?
o
o
o
o
Less than 10 clients
10 to 39
40 to 79
80 +
4. Briefly describe your work history.
5. What are your educational qualifications?
Give area of study.
o
o
o
o
Certificate
Undergraduate degree
Advanced degree
Other
6. What financial planning designation(s) or certification(s) do you hold?
o
o
o
o
CERTIFIED FINANCIAL PLANNER™ or CFP®
Certified Public Accountant-Personal Financial Specialist (CPA-PFS)
Chartered Financial Consultant (ChFC)
Other
7. What financial planning continuing education requirements do you fulfill?
8. What licenses do you hold?
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o
o
o
o
o
Insurance
Securities
CPA
J.D.
Other
9. a. Are you personally licensed or registered as an investment adviser representative with a
state(s)?:
o
o
Yes
No
If no, why not?
b. Are you or your firm licensed or registered as an investment adviser with the:
o
o
State(s)?
Federal Government?
If no, why not?
c. Will you provide me with your disclosure document Form ADV Part II or its state equivalent?
o
o
Yes
No
If no, why not?
10. What services do you offer?
11. Describe your approach to financial planning.
12. a. Who will work with me?
o
o
Planner
Associate(s)
b. Will the same individual(s) review my financial situation?
o
o
Yes
No
If no, who will?
13. How are you paid for your services?
o
o
o
Fee
Commission
Fee and commission
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o
o
Salary
Other
14. What do you typically charge?
a. Fee:
Hourly rate $ _________
Flat fee (range) $ _________ to $ _________
Percentage of assets under management _________ percent
b. Commission:
What is the approximate percentage of the investment or premium you receive on?
stocks and bonds _________
mutual funds _________
annuities _________
insurance products _________
other _________
15. a. Do you have a business affiliation with any company whose products or services you are
recommending?
o
o
Yes
No
Explain:
b. Is any of your compensation based on selling products?
o
o
Yes
No
Explain:
c. Do professionals and sales agents to whom you may refer me send business, fees or any other
benefits to you?
o
o
Yes
No
Explain:
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d. Do you have an affiliation with a broker/dealer?
o
o
Yes
No
e. Are you an owner of, or connected with, any other company whose services or products I will
use?
o
o
Yes
No
Explain:
16. Do you provide a written client engagement agreement?
o
o
Yes
No
If no, why not?
Assignment – Selecting a financial advisor
Map out a plan for how you will find a financial advisor. Where will you find potential advisors?
How many will you research?
Taking the questionnaire above and the SEC has a list of questions available at
www.sec.gov/consumer/askqinv.htm. Come up with a list of questions to ask.

Are you registered with the state securities agency and have you ever been disciplined?

What training and experience do you have? How long have you been in the business?

What is your investment philosophy?

Describe your typical client.

Will you disclose to me how you get paid in every investment you recommend? Will you
disclose to me whenever you are participating in a sales contest?

What choices do I have in how I pay you?

Could anyone besides me benefit from your recommendations?
Investment Fraud
Never buy anything you don’t understand. Investment instruments come in all sizes and flavors.
Make sure the investment is registered. They can involve substantial risk. Get a second opinion if
you aren’t absolutely clear on what a particular investment is.
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Check to see that both the advisor and the product are registered with the Department of
Financial Institutions. Google the advisor and company to see if either appears in any complaint
lists.
Salespeople are trained to use a variety of tactics to “close the deal.” These tactics are also used
by scam artists to get at your money. It’s important you learn to resist these influence tactics so
you can evaluate the purchase objectively. Identify the pattern and know that you are a target.
Here are some of the tactics:
• Phantom Fixation – The objective is to put something that is completely unavailable
before you that appeals to health issues, wealth, popularity or avoiding death. Basically
this tactic preys on your insecurities and promises to fulfill your wildest dreams. It falls
into the category of too-good-to-be-true and most often is.
• Commitment – The salesperson tries to get you to commit but saying that your earnest
money or deposit will be lost. Often there are laws that say you have 3 days to reconsider
and get your funds back in full. Know your rights before you go in to buy.
• Authority – The salesperson will say that they’ve been in the business for years and know
that this is the best deal that they’ve seen. They might cite specific features. If you don’t
know the product well, you might believe the pitch.
• Social Proof – This tactic tries to get you to believe that everyone is getting one so you
should, too.
• Scarcity – This includes product scarcity (only three left), time scarcity (offer good only
today), and threats to take the offer away which often makes the consumer feel pressure
to buy now.
• Comparison – It is very common for sales pitches to show inflated regular prices to a
hugely discounted “sales price.” You need to comparison shop to see what kind of deal it
really is.
• Profiling – In cases where the salesperson wants to make a large sale, they will probe for
personal information and then customizes pitch.
• Friendship – The salesperson changes the relationship from con to victim into a
friendship transaction.
• Reciprocity – The sales pitch gives you a free gift or lunch. With this your response rate
doubles.
• Landscaping – The salesperson changes social interaction so it leads to where he or she
wants to go by setting the agenda, limiting choices or controlling information.
People are more prone to be susceptible to influence tactics when they’ve had some negative
event in their lives. These can be as major as losing a job, divorce or a death in the family. It can
be because you’ve been chewed out by your boss. Try to be aware of your mental state and don’t
engage in any major buying. Watch those around you to alert them.
Be careful of the following:
 Investments that promise high return. It’s too good to be true because usually it isn’t true.
Remember, high return usually means high risk.
 Investments that cannot be easily converted to cash. Check to see if there is a penalty if
you need to cash out early.
 Significant changes in investments. Any pending mergers can significantly change your
investment. Read any notices you get and keep up with the news on your investments.
 Past success is no guarantee of future performance. If advisors guarantee a return, you
probably want to lose them quick.
 High-pressure sales pitches can mean trouble. Be very skeptical of anyone who tells you
that you must invest quickly or you will lose the opportunity.
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






Never give out information such as social security number, account numbers or
passwords or send money based on a telephone or email pitch.
Never make a check out personally to the advisor.
Never allow your statements to be delivered to your advisor instead of you.
Never invest based on inside or confidential information.
Watch out for excessive activity on your account.
Watch out for switching to investments of equal quality without good reason.
Always ask for immediate correction of any errors that you find on your statements.
Organize your financial records and keep all statements that you receive. For tax purposes, you
need to keep these for several years.
The following ranking of NASAA’s Top 10 threats to investors for 2005 is based on the order of
prevalence and seriousness as identified by an annual survey of state securities regulators. The
“unlucky thirteen” for 2006 are found at:
http://www.nasaa.org/nasaa_newsroom/current_nasaa_headlines/4240.cfm
1. Ponzi Schemes are investment scams where the con artists use money they get from new
investors to pay previous investors so it looks like investments have good returns when in fact
they do not.
2. Unlicensed individuals selling securities. It is important to check the credentials of anyone who
sells you financial products. Check with dfi.wa.gov to see if the individual is registered to sell
securities and if there has been any complaints filed against the individual. Try a Google search
as well to see if any issues have arisen in any other states.
3. Unregistered investment products. (viatical settlements, pay telephone and ATM leasing
contracts). Viatical settlements are investments where the con artists sells the life insurance
policy of a person who is dying so that you can claim the benefits. Other scams include leasing
contract for pay telephones of ATM where they say you will get the income. These are not
registered investment products. In addition to checking out the salesperson, you need to check
out the product.
4. Worthless promissory notes. Remember high return means high risk. These promissory notes
come with various pitches including agreements with foreign banks where interest rates are high.
5. Senior investment fraud. Seniors are often targeted for fraud by con artists who get their
names from mailing lists or other sources. They are called and screened to find out if they have
assets. Often the con artists will say that they are officials. They may obtain confidential
information that will allow them to access financial accounts.
6. High-yield investments. There is no such thing as a guaranteed high return. Be skeptical of
anyone who says he or she can provide this.
7. Internet fraud. Recent studies have shown that investors do respond to investor fraud that is
perpetuated through the internet including highly speculative stock recommendations.
8. Affinity fraud. Although most people would trust individuals they met through closely-knit
religious, political, or ethnic groups, often affinity fraud is perpetuated through these groups. The
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victim is befriended and encouraged to enter into a trusted relationship. When an investment is
presented these settings, you should be extremely wary.
9. Variable annuity practices. Although variable annuities are legitimate financial products (they
place mutual funds inside of an insurance wrapper for tax deferred potential investment growth),
commissions to those who sell variable annuities are very high, providing incentive for sellers to
suggest these for individuals such as seniors or short-term investors for whom these are not
suitable. Variable annuities are only appropriate for a very small portion of investors. There steep
penalties for early withdrawals. Be especially wary of any broker who wants to sell a variable
annuity to hold inside a 401(k) or IRA. There is no additional tax benefit to this arrangement.
10. Oil and gas scams. Oil and gas deals are being promoted via the Internet with claims of high
returns and attractive tax advantages. Promotional materials can be very attractive and officiallooking. High oil and gas prices help hype these types of scams which ask for a large investment
with significant minimums.
If you fall victim to a scam or con artist, it is important that you report this to the authorities as
soon as possible. This can be done through the Washington State Department of Financial
Institutions www.dfi.wa.gov or calling the hotline at 1-877-RING-DFI.
Activity – How to resist a scam
Role play scam artist and target. Find a partner and each person will be assigned the role of
either scam artist or target. The scam artist is to think up an investment and incorporate as many
of the persuasion tactics as possible. The target is to develop scripts to say no. This role play will
be performed in front of the class and the class must analyze which persuasion tactics were used
and how effective the response tactics were.
Activity – What would you discuss with your significant other about
investing?
In addition to being one of the signposts of your emotional life, marriage is also one of the most
significant events in your financial life. What will you discuss with your significant other when you
are entering into marriage? What is it important to have agreement on? What can you disagree or
be separate on?
Activity – What would you teach your children about investing?
Similar to a will that outlines your wishes for your children, what are the most important financial
lessons you want to pass onto your children? When would you start teaching them these
concepts?
Sources
Bankrate.com for general investing information and calculators.
Federal Reserve Bank of Dallas, www.dallasfed.org/ca/wealth/pdfs/wealth.pdf
Finance.yahoo.com for general investing information.
Financial Links on the web. www.bygpub.com/finance/FinanceLinks.htm
Investopedia.com for general investing information.
Page 95
Updated 2009
Marketwatch.com for general investing information and Lipper Mutual Fund rating.
moneycentral.msn.com for general financial education on all topics.
money.cnn.com/pf/ for general financial education on all topics.
morningstar.com for general investing education and mutual fund ratings.
Mscibarra.com for international indices.
Reuters.com for investing information.
Securities and Exchange Commission to check out investment advisors or file a complaint
www.sec.gov/investor.shtml
Securities Industry and Financial Market Association for information on bonds.
www.investinginbonds.com
Smartmoney.com for general investing information.
Spglobal.com for stock and other indices.
Treasury Direct to check out treasury rates and purchase bonds
www.savingsbonds.gov/indiv/products/products.htm
Washington Department of Financial Institutions for general information, to check out advisors or
file a complaint www.dfi.wa.gov/
Page 96
Updated 2009
Appendix
The Time Value of Money
The time value of money or compounding is a powerful tool. When you understand how it works,
it will change your financial life. You will understand why it’s important to build your financial
security now versus waiting until later. You will be able to evaluate financial options just as the
professionals do. Also, studies have shown that folks who understand the time value of money
are less susceptible to fraud. It is the basis for pricing just about every financial product there is
out there.
For example, if you save $25 a week for the next 40 years, how much money would you have?
Here’s the power of compounding: $150,000 to $350,000. The answer seems incredible but it’s
quite true.
Let’s try another example. What will give you more for retirement: saving $2000 from ages 25 to
45 and then keeping it in your account but putting no more savings in or saving twice as much
($4000) from 45 to 65?
We are going to cover four versions of the time value of money:
1. Future value of a sum of money now: This allows you to determine how much you will
have in the future if you put aside some money now.
2. Present value of a sum of money in the future: If you have a financial goal in the future,
say a down payment for a house in 10 years, this will tell you how much you have to set
aside today.
3. Future value of annual savings: This will let you calculate how much money you will have
in the future if you set aside a certain amount of money every year.
4. Annual savings needed for a sum of money in the future: This will tell you how much you
need to save every year for a goal like buying your first house or retirement.
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Future value – What my savings will be worth in the future.
If you put $100 in the bank for 2 years and get 5% per year, you would have $5 in interest the first
year and $5 in interest the second year, right? Not exactly. In the first year you would get $5 in
interest. However, in the second year you would actually get 5% times $105, or $5.25 in interest.
Why the fuss about a quarter? Because over a long period of time, it becomes a big deal.
Let's say you have $1000 in the bank over 10 years and you spend whatever interest you earn
each year, which would only be $50 a year times 10 years, or $500. But, if you leave the interest
in the bank, you earn $628.90 in interest, or $128.90 more. That's the beauty of compounding.
$1000  (1  0.05)10  $1628.90
Everyone knows that the better rate you invest at, the more money you will make. Investing at
10% is always going to be better than investing at 8%. The trouble is most investors can’t predict
with any certainty what their future returns will be. Everyone knows the longer you keep your
money invested, the more you will have. Keeping money invested for 10 years is always better
than 5 years. It’s just more time for the compounding to take effect. Is this something you can
control? Absolutely!
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Updated 2009
So, the important point is to start saving now. Saving now gives compounding more time to work
for you. Say you put $10,000 away for 5 years at 10%. At the end of 5 years, you’ll have about
$16,110. If you put $5,000 (half the amount) away for 40 years at 5% (half the return), you’ll end
up with over $35,000. Saving over a long period of time can overcome a low return.
Here is a table which shows what will happen to $1000 at various levels of return and various
years. To find the value of $1000 at 10% for 5 years, look down the first column until you get to
10% and across until you get to 5 years (the first column). You can see that the value is $1611 for
$1000.
For any other sum, take the sum divide by $1000 and multiply by the value you find in the table
for the appropriate return and number of years. For example, if you want to find the future value
of $5000 in 30 years at a 6% return. First look up the value at 6% and 30 years on the table. This
value if $5743 and then do the following:
$5000
 $5743  $28,715
$1000
Future Sum 
Value Now
 (Look up Table at __% and __ years)
$1,000
Table 1
Future Value per $1000 Investment Now
Return
2%
3%
4%
5%
6%
7%
8%
9%
10%
11%
12%
13%
14%
15%
5
$1,104
$1,159
$1,217
$1,276
$1,338
$1,403
$1,469
$1,539
$1,611
$1,685
$1,762
$1,842
$1,925
$2,011
10
$1,219
$1,344
$1,480
$1,629
$1,791
$1,967
$2,159
$2,367
$2,594
$2,839
$3,106
$3,395
$3,707
$4,046
15
$1,346
$1,558
$1,801
$2,079
$2,397
$2,759
$3,172
$3,642
$4,177
$4,785
$5,474
$6,254
$7,138
$8,137
20
$1,486
$1,806
$2,191
$2,653
$3,207
$3,870
$4,661
$5,604
$6,727
$8,062
$9,646
$11,523
$13,743
$16,367
Number of Years
25
30
$1,641
$1,811
$2,094
$2,427
$2,666
$3,243
$3,386
$4,322
$4,292
$5,743
$5,427
$7,612
$6,848
$10,063
$8,623
$13,268
$10,835
$17,449
$13,585
$22,892
$17,000
$29,960
$21,231
$39,116
$26,462
$50,950
$32,919
$66,212
35
$2,000
$2,814
$3,946
$5,516
$7,686
$10,677
$14,785
$20,414
$28,102
$38,575
$52,800
$72,069
$98,100
$133,176
40
$2,208
$3,262
$4,801
$7,040
$10,286
$14,974
$21,725
$31,409
$45,259
$65,001
$93,051
$132,782
$188,884
$267,864
45
$2,438
$3,782
$5,841
$8,985
$13,765
$21,002
$31,920
$48,327
$72,890
$109,530
$163,988
$244,641
$363,679
$538,769
Question
Think of that $1000 you spent on soda and candy in 1996. If you put your money in the bank for
5% interest per year, calculate what you have after 10 years in 2006. If you purchased $1000 in a
stock index fund, what would you have?
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Updated 2009
What if you did the following in 1996?
Bought $1000 of soda and candy (that’s about $20
a week)
Put $1000 in the bank at 5%
Today’s value
Bought $1000 of a stock index. ($1 in a stock index
fund in 1996 would be worth $1.91 in 2006.
Answer
Think of that $1000 you spent on soda and candy in 1996. If you put your money in the bank for
5% interest per year, calculate what you have after 10 years in 2006. If you purchased $1000 in a
stock index fund, what would you have?
What if you did the following in 1996?
Bought $1000 of soda and candy (that’s about $20
a week)
Today’s value
$0. The only thing you added was inches to your
waistline.
Put $1000 in the bank at 5%
$1629. Look up the table for 10 years and 5%.
Bought $1000 of stock index fund
$1 in a stock index fund would be worth $1.91
today. Your $100 in stock would be worth $1910.
Question
You have $2000 into a 529 plan to save for your kid’s college and got 8% return, what would you
in 20 years?
Answer
You have $2000 into a 529 plan to save for your kid’s college and got 8% return, what would you
have in 20 years?
Looking at the table, you get $4,661 for every $1000 invested at 8% for 20 years. You double that
to get $9322 for every $2000 invested.
Question
You put $4000 into an IRA to save for your retirement and got 9% return, what would you have
for your retirement in 30 years?
Answer
You put $4000 into an IRA to save for your retirement and got 9% return, what would you have
for your retirement in 30 years?
Looking at the table for 9% return and 30 years, you get $13,268 for every $1000 invested.
Multiply that by 4 and get $53,071.
Question
About 57% of people (especially the younger ones) who leave companies cash out their
retirement benefits of $8445. If you left this money in a retirement plan for 40 years at a return of
8%, calculate what it contributes to your retirement.
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Updated 2009
Answer
About 57% of people who leave companies cash out their retirement benefits of $8445. If you left
this money in a retirement plan for 40 years at a return of 8%, calculate what it contributes to your
retirement.
Looking at Table 1, you get $21,725 if you invest $1000 at 8% for 40 years. Multiply that by 8.445
and you get about $183,500 for your retirement fund. If you cash out, you pay taxes on your
withdrawal plus a 10% penalty on top of that. That would leave you with $6000 now versus
$183,500 when you retire.
Present Value – What I set aside today for a future goal.
Now let’s do a little math to figure out how much you need to set aside now to achieve your
financial goals in the future. To do this, we take the same equation we used in compounding and
algebraically solve for what we need to set aside today. Let’s say you want to pay cash for a car
in five years. This used car is going to cost you $8000. How much would you have to set aside
today at 8% return a year?
To handle what we need to set aside today for a future sum, we have created a table that allows
you to look up what you need to set aside today for $10,000 in the future. To find out for any other
sum, take the sum and divide by $10,000 and then multiply by the value you find in the table for
the return and number of years:
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Sum Needed Today 
Value in Future
 (Look up Table at __% and __ years)
$10,000
Table 2
Value to set aside for $10,000 in the future
Return
3%
4%
5%
6%
7%
8%
9%
10%
11%
12%
13%
14%
15%
5
$8,626
$8,219
$7,835
$7,473
$7,130
$6,806
$6,499
$6,209
$5,935
$5,674
$5,428
$5,194
$4,972
10
$7,441
$6,756
$6,139
$5,584
$5,083
$4,632
$4,224
$3,855
$3,522
$3,220
$2,946
$2,697
$2,472
15
$6,419
$5,553
$4,810
$4,173
$3,624
$3,152
$2,745
$2,394
$2,090
$1,827
$1,599
$1,401
$1,229
Number of Years
20
25
30
$5,537 $4,776 $4,120
$4,564 $3,751 $3,083
$3,769 $2,953 $2,314
$3,118 $2,330 $1,741
$2,584 $1,842 $1,314
$2,145 $1,460
$994
$1,784 $1,160
$754
$1,486
$923
$573
$1,240
$736
$437
$1,037
$588
$334
$868
$471
$256
$728
$378
$196
$611
$304
$151
35
$3,554
$2,534
$1,813
$1,301
$937
$676
$490
$356
$259
$189
$139
$102
$75
40
$3,066
$2,083
$1,420
$972
$668
$460
$318
$221
$154
$107
$75
$53
$37
45
$2,644
$1,712
$1,113
$727
$476
$313
$207
$137
$91
$61
$41
$27
$19
Question
Here are some typical goals. Estimate how much each costs:
Down payment on house
Wedding
Children’s college tuition
Starting your own business
Retirement
Answer
Here are some typical goals. See if you can estimate how much each costs.
Down payment on house (Assume 20% of the value of $200,000 house or condo–typically
$40,000)
Wedding ($10,000–20,000)
Children's college tuition ($25,000–$100,000 each child)
Starting your own business ($50,000 seems to be the common starting point)
Retirement (This is tough one to estimate as it depends on social security and your company
retirement plans. Use the simple rule of thumb to determine what income level will support your
lifestyle. For example, if you want a $50,000 lifestyle. Then divide that by 4%. This would give you
a $1.25 million retirement fund.)
Question
Let’s say you want to put $40,000 down on your first house 10 years from now. You expect
an investment rate of 7%. Calculate what you would have to set aside today.
Answer
Let’s say you want to put $40,000 down on your first house 7 years from now. You expect an
investment rate of 7%. Calculate what you would have to set aside today.
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You would have to set aside $5083 at 7% per year for 10 years to have $10,000. If you multiply
that by 4 to get $20,334 to or the amount you have to set aside for $40,000.
Question
Let’s say you want to start a business with $50,000 in 15 years. You expect a return rate of 8%.
What you would have to set aside today?
Answer
Let’s say you want to start a business with $50,000 in 15 years. You expect a return rate of 8%.
What you would have to set aside today?
You would have to set aside $3,152 for every $10,000. Multiplying by 5 for $50,000 you would
have to set aside $15,762 at 8% per year for 15 years.
Future value of an annuity – Value of saving every year
Setting goals is the fun part of the financial plan. It’s nice to think about the nice house you’re
going to buy or the retirement you will enjoy. But, there may be a big difference between what you
have today ($1000) and your financial goal for the future ($1 M for retirement). How do you get
from here to there?
It becomes apparent pretty quickly that for some goals, it’s impossible to set aside enough money
and achieve the goal. Most of us don’t have $10,000 that we can just tuck away for a future
financial goal. What it takes is a steady plan of saving every week to get there. This means
applying the future value of money formula to a stream of savings over many years.
The following table was compiled as a quick way of doing this calculation. Say you put away
$1000 a year for 15 years and you get 5% on your money. At the end of the 15 years, you will
have $21,579. That is a lot more that just putting away $1000 once for 15 years at 5% (see Table
1) which would give you $2079. For any other annual savings, use the following method of finding
what you will have in the future.
Future Sum 
Annual Savings
 (Look up Table at __% and __ years)
$1,000
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Table 3
Future Value of Saving $1000 Every Year
Return
3%
4%
5%
6%
7%
8%
9%
10%
11%
12%
13%
14%
15%
5
$5,309
$5,416
$5,526
$5,637
$5,751
$5,867
$5,985
$6,105
$6,228
$6,353
$6,480
$6,610
$6,742
10
$11,464
$12,006
$12,578
$13,181
$13,816
$14,487
$15,193
$15,937
$16,722
$17,549
$18,420
$19,337
$20,304
15
$18,599
$20,024
$21,579
$23,276
$25,129
$27,152
$29,361
$31,772
$34,405
$37,280
$40,417
$43,842
$47,580
20
$26,870
$29,778
$33,066
$36,786
$40,995
$45,762
$51,160
$57,275
$64,203
$72,052
$80,947
$91,025
$102,444
Number of Years
25
30
$36,459
$47,575
$41,646
$56,085
$47,727
$66,439
$54,865
$79,058
$63,249
$94,461
$73,106 $113,283
$84,701 $136,308
$98,347 $164,494
$114,413 $199,021
$133,334 $241,333
$155,620 $293,199
$181,871 $356,787
$212,793 $434,745
35
$60,462
$73,652
$90,320
$111,435
$138,237
$172,317
$215,711
$271,024
$341,590
$431,663
$546,681
$693,573
$881,170
40
$75,401
$95,026
$120,800
$154,762
$199,635
$259,057
$337,882
$442,593
$581,826
$767,091
$1,013,704
$1,342,025
$1,779,090
45
$92,720
$121,029
$159,700
$212,744
$285,749
$386,506
$525,859
$718,905
$986,639
$1,358,230
$1,874,165
$2,590,565
$3,585,128
Going back to the example presented at the beginning of this section: What if you save $25
(about the cost of coffee every day) a week? What would that be worth in 40 years? Well,
according to our calculations, $25 a week can come to $152,602.02 in 40 years. If you scrimp
and save a bit more and raise your savings to $50 a week, the amount in 40 years doubles to
over $300,000. Really saving very hard and raising it to $75 a week makes it very close to half a
million dollars in 40 years.
Interest rate
5%
5%
5%
Savings per week
$25
$50
$75
Number of Years
40
40
40
Future Value
$152,602.02
$305,204.03
$457,806.05
(Assumes daily compounding of interest.)
So, the amount of savings is one factor that can increase what you will have in 40 years. How
about finding better ways to invest your money. If you can find an 8% return (which would be a
combination of stocks and bonds over a long period) and you save at $75 a week, you would
increase your account to over $1 million over 40 years.
Interest rate
8%
8%
8%
Savings per week
$25
$50
$75
Number of Years
40
40
40
Future Value
$349,100.78
$698,201.57
$1,047,302.35
(Assumes daily compounding of interest.)
Question
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Updated 2009
You save $1000 every year at a 10% return. Look at the table and find the amount you will have
in 5 years.
Answer
You save $1000 every year at a 10% return. Calculate the amount you will have in 5 years.
This is a straight look-up on the table. Find the cross section of 10% and 5 years. You will have
$6105.
Question
You save $300 every year at a 5% return. Calculate the amount you will have in 45 years.
Answer
You save $300 every year at a 5% return. Calculate the amount you will have in 45 years.
Look at the table and find 5% and 45 years. The value is $159,700. Because you are saving $300
versus $1000, you have to multiply by 3/10 to get $47,910. It’s really amazing how putting away a
little every year can add up.
Future value of an annuity – savings needed for future goal.
Now let’s combine everything to determine what you need to set aside every year to reach a
financial goal in the future. Let’s say you need $50,000 to send your kid or grandkid to college in
15 years. You expect an 8% return. You can put $32,000 away right now but most of us don’t
have $32,000 waiting to be invested, so does that mean the kid has no chance of going to
college? You can put away $3700 every year for the next 15 years and get to $100,000 just as
well. $3700 a year sounds feasible for two people saving. Actually, saving every year works like a
charm. Even the most insurmountable goals (like $1 M for retirement) are pretty manageable if
you save on an annual basis ($2600—for 45 years at 8%).
For those of you who are mathematically inclined, here is the formula for figuring out how much
you need to save every year. Just remember, you don’t have to know the formula to calculate
what you need to save every year. There are plenty of calculators to do this for you.
You can also use the table below to approximate what you need to save on an annual basis to
reach a financial goal in the future.
Annual Savings Needed 
Value in Future
 (Look up Table at __% and __ years)
$100,000
Table 4
Savings per year to get $100,000 in the future
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Updated 2009
Return
3%
4%
5%
6%
7%
8%
9%
10%
11%
12%
13%
14%
15%
5
$18,835
$18,463
$18,097
$17,740
$17,389
$17,046
$16,709
$16,380
$16,057
$15,741
$15,431
$15,128
$14,832
10
$8,723
$8,329
$7,950
$7,587
$7,238
$6,903
$6,582
$6,275
$5,980
$5,698
$5,429
$5,171
$4,925
15
$5,377
$4,994
$4,634
$4,296
$3,979
$3,683
$3,406
$3,147
$2,907
$2,682
$2,474
$2,281
$2,102
Number of Years
20
25
30
$3,722 $2,743 $2,102
$3,358 $2,401 $1,783
$3,024 $2,095 $1,505
$2,718 $1,823 $1,265
$2,439 $1,581 $1,059
$2,185 $1,368
$883
$1,955 $1,181
$734
$1,746 $1,017
$608
$1,558
$874
$502
$1,388
$750
$414
$1,235
$643
$341
$1,099
$550
$280
$976
$470
$230
35
$1,654
$1,358
$1,107
$897
$723
$580
$464
$369
$293
$232
$183
$144
$113
40
$1,326
$1,052
$828
$646
$501
$386
$296
$226
$172
$130
$99
$75
$56
45
$1,079
$826
$626
$470
$350
$259
$190
$139
$101
$74
$53
$39
$28
Question
You are 25 years old and plan to retire at age 65 with $1 M. Calculate what you have to
save every year at 8% return if you start at age 45.
Answer
You are 25 years old and plan to retire at age 65 with $1 M. Calculate what you have to save
every year at a 10% return if you start at age 45.
If you start at age 45, you have 20 years to save. Looking at the table, that would be $1955 for
$100,000. Multiply this by 10 and you would have to save $19,550 a year, making it almost
impossible to reach the goal
Question
Calculate what you have to save every year at 8% return if you start at age 35.
Answer
Calculate what you have to save every year at 8% return if you start at age 35.
If you start at age 35, you have 30 years to save. You would have to set aside $883 a year for
$100,000 or $8830 for $1 million, a lot more manageable, but still a large sum to set aside every
year.
Question
Calculate what you have to save every year at 8% return if you start at age 25.
Answer
Calculate what you have to save every year at 8% return if you start at age 25.
Page 106
Updated 2009
You’ll have 40 years to save and that means you save $2300 a year, a far cry from the $386 per
year for $100,000 or $3860. This is totally manageable. The moral of the exercise: start saving
now.
Question
Which is more?
At age 25, you save $4000 a year for 20 years. Then let the money sit for the next 20 years until
age 65.
Staring at age 45, you save $8000 a year for 20 years until age 65.
Answer
You need to use both Table 1 and Table 3 to calculate this but saving between 25 and 45 yields
you twice the amount (over $800,000) of saving between 45 and 65.
Planning For Uncertainty
Inflation Uncertainty
Planning for the future is tough to do. It’s like try to hit a moving target. Think of sending your kids
to college in 15 years. A college education costs about $50,000 now. What will it cost in 15
years? Inflation is a factor in all financial plans.
For your kid’s college education, if educational inflation (which is currently higher than general
inflation at 7% a year) is a low 5% a year for the next 15 years, that same college education could
end up costing $104,000. If you planned to have $50,000, you’ll be short by $54,000 when the
bills start rolling in. What can you do to avoid this? Apply an inflation rate to your financial goals.
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Return Uncertainty
The other big uncertainty is how much return you’ll get on your investments. If you use a return
that’s higher than what you actually get, you’ll end up short. That is, for that same college
education, if you save based on a 10% return but get 8% instead, you’ll be $10,000 short of your
goal.
Most financial planners use history as a guide when it comes to trying to figure out what returns
will be in the future. Based on history, your return will vary depending on what asset class you
invest in. Of course, as the figure above shows, even for each of these categories you can get a
different return depending on which decade you look at.
Large stocks (S&P 500)
Bonds
Savings interest (T-bill)
Past 40 Years
13%
8%
6%
Just remember, the lower the return you use (the more conservative you are), the more you will
have to save. But, the more likely you’ll achieve your goal. If you want to make sure that you
achieve your goals, use a 6% return for your plan. The good news is, if you do get a better return,
you’ll exceed your goal and have money left over for other things.
Professional financial planners often do a sensitivity analysis on their projections using various
levels of inflation and returns. This way they can determine the probability that you will reach your
financial goals with various levels of savings. The moral of story is still rather simple. Aim for 10%
for retirement and 10% for other needs. If you can’t achieve these goals, then save as much as
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you can. If you don’t, you’ll have to downsize your goals to meet whatever savings you have. That
could mean giving up a house, education for a child, or a comfortable retirement.
Question
You want to buy a house in 10 years that costs $200,000 today. You think inflation will be
3% over the next 10 years. How much will the house cost?
Answer
You want to buy a house in 10 years that costs $200,000 today. You think inflation will be
3% over the next 10 years. How much will the house cost?
The house will cost about $270,000.
Question
You want to have a wedding that will cost $10,000 in 5 years. You think that you’ll invest in
bonds at 8%. Calculate the annual savings needed.
Answer
You want to have a wedding that will cost $10,000 in 5 years. You think that you’ll invest in bonds
at 8%. Calculate the annual savings needed.
You’ll have to save $1705 per year. Trouble is you might have trouble finding short-term bonds
that will give you 8%. Remember these returns are guidelines for the long term. To be safe, use
6% and put away $1780 a year.
Question
You want to save $75,000 for your kid’s college education in 20 years. You think that you’ll invest
in stocks at 8%. Calculate the annual savings needed.
Answer
You want to save $75,000 for your kid’s college education in 20 years. You think that you’ll
invest in stocks at 13%. Calculate the annual savings needed.
You’ll have to save $927 per year. Although 20 years is long enough for investing in the stock
market, who knows what the returns will be. Just to be safe, use 8% and put away an extra $720
per year for a total of $1640.
Create a saving plan
You can get pretty complicated with a saving plan, but the main lesson to be learned is that you
should save as much as you can. The saving plan is really a trade-off between immediate
(though not always lasting) gratification and long-term goals. It’s about how much you’re willing to
give up to be financially secure in an increasingly uncertain future.
A plan is just a guideline which you can use to start saving. It’ll give you an overview of your
savings needs over your lifetime. As you acquire more wealth, you will want to do more detailed
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planning. Knowing what you need to save early in life gives you a head start because you can
really let compounding work for you.
When you create your plan, know that there is uncertainty in both how inflation will go and what
returns you will get from your investments. There are no sure things. Most financial planners will
do a sensitivity analysis using various inflation rates and investment returns to see how it affects
the plan. This is a very good exercise to do. To be safe, choose a higher inflation rate and lower
return, this will result in a higher annual savings and more immediate sacrifice but you will be
more financially secure.
Your life is going to be full of twists and turns that you can’t predict. Once you develop your plan,
check it every year. Ask yourself these questions:





Have my goals changed?
Has inflation been different than what I expected?
How have my investments done? Can I keep using the same rate of return?
Do I have to save more?
Will my investments cover my new goals? Do I have to change my strategy and selection?
Question
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You are working 20 hours a week at $10 an hour and have been taking 15 credits. You decide to
increase to 40 hours a week so you don’t have to skimp on living expenses as much but now you
are taking 10 credits. Are you making a good financial decision?
Answer
You are working 20 hours a week at $10 an hour and have been taking 15 credits. You decide to
increase to 40 hours a week so you don’t have to skimp on living expenses as much but now you
are taking 10 credits. Are you making a good financial decision?
It seems like you’re ahead $200 a week or $2200 for the quarter, BUT you’ve just delayed
receiving your degree by a quarter. If this continues for a long period of time you could delay for
years. When you earn your bachelor’s degree, your income per year can go up $10,000 to
$20,000 so you’re putting off that extra $10,000 to $20,000 per year that you delay. Here’s the
additional bad news, the less credits you take the less likely you are to stay in school. So if you
drop out and don’t finish, that decision can cost you $500,000 to $1 million over your lifetime plus
better health, increased life span and other great benefits that a college degree brings to its
recipients.
Question
Which is more? Assume that you earn 8%.
a) Saving $4000 a year from 25 to 45 years old and then not adding any more savings but
allowing the account to grow.
b) Saving $8000 (double) a year from 45 to 65 years old.
Answer
a) Using Table 2, saving $1000 a year for 20 years (from 25 to 45 years) at 8% will give you
get $45,762. For $4000 annual savings, multiply by 4 for $183,048. Now that stays in the
account at 8% a year for another 20 years (from 45 to 65 years). Use Table 1 for $4661
per $1000 put away. So multiply $183,048 by 4.661 and get $853,187.
b) Using Table 2, saving $1000 a year at 8% for 20 years (from 45 to 65 years) will give you
$45,762. This time, you multiply by 8 for $8000 a year and get $366,096, less than half
the amount.
Question
How much is the soda and candy you buy everyday worth in long-term savings? Assume you
spend $25 a week on soda and candy. For simplicity sake, multiply this by 50 for a full year. If you
cut your candy and soda for 20 years and invest at 7%, what will you have?
Answer
$25 per week times 50 weeks is $1250 per year. Look up 7% by 20 years on Table 2 and you get
$40,995. Multiply that by 1.25 and you get $51,244. That’s expensive candy and soda!
Question 1
How much is that new HDTV worth in long-term savings? Prices have gone down on HDTVs and
you want to buy one for $1500. It seems a bargain because only a year ago it was $3000. How
much is this HDTV costing you in long-term savings? Use 5 years and 8%.
Answer
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Using Table 1, $1000 for 5 years at 8% is $1469. Multiply by 1.5 to get $2204. Now that doesn’t
seem to be a big difference but, if prices continue to fall (and they will), you could get three of the
same HDTVs for that price.
Question
For each of the following financial goals, calculate the effect of inflation on the goal and then
calculate the annual savings required on the inflated goal.
To calculate the inflated financial goal, use Table 1.
To calculate the annual savings required, use Table 2 and multiply by inflation goal divided by
$1000.
Goal
House
Amount
$
75,000.00
$
50,000.00
$
40,000.00
Years to Goal
15
10
5
Inflation Rate
2%
3%
3%
Return
7%
9%
8%
Education
$
$
$
50,000.00
40,000.00
20,000.00
20
15
10
4%
3%
3%
8%
7%
6%
Retirement
$ 800,000.00
$ 800,000.00
$ 800,000.00
$ 1,500,000.00
$ 1,500,000.00
$ 1,500,000.00
40
30
25
30
30
30
2%
2%
2%
3%
2%
2%
8%
8%
8%
7%
8%
6%
Answer
Years to
Goal
15
10
5
Inflation
Rate
2%
3%
3%
Return
7%
9%
8%
Inflated
Financial Goal
$100,940.13
$67,195.82
$46,370.96
Annual Savings
Required
$4,016.87
$4,422.83
$7,904.23
50,000.00
40,000.00
20,000.00
20
15
10
4%
3%
3%
8%
7%
6%
$109,556.16
$62,318.70
$26,878.33
$2,394.04
$2,479.95
$2,039.20
$ 800,000.00
$ 800,000.00
$ 800,000.00
$ 1,500,000.00
$ 1,500,000.00
$ 1,500,000.00
40
30
25
30
30
30
2%
2%
2%
3%
2%
2%
8%
8%
8%
7%
8%
6%
$1,766,431.73
$1,449,089.27
$1,312,484.80
$3,640,893.71
$2,717,042.38
$2,717,042.38
$6,818.71
$12,791.74
$17,953.19
$38,543.97
$23,984.51
$34,367.63
Goal
House
Amount
$
75,000.00
$
50,000.00
$
40,000.00
Education
$
$
$
Retirement
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Activity
Creating a simple saving plan.
List all your financial goals.
Cost out each.
Determine how many years to each goal. Bring it to the nearest 5 years so we can use the tables.
Select an inflation rate. Historically inflation has averaged 2% to 4%.
Select a return. Historically investments have returned 4% to 11%.
After you complete this, list at what age you have to save the most money.
Reflect on what you have to do to meet your financial goals.
Goal
Amount
Years to
Goal
Inflation
Rate
Return
Inflated
Financial
Goal
Annual
Savings
Required
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Do a sensitivity analysis using a higher inflation rate and lower return.
Goal
Amount
Years
to
Goal
Inflation
Rate
Return
Inflated
Financial
Goal
Annual Savings
Required
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Glossary
Term
Definition
12b-1 fees
A fee charged by funds to cover marketing and distribution costs. Current
maximum is 1%.
account
agreement
An agreement that you would sign with your brokerage firm regarding your
investment account.
accountant
A financial professional who advises on or prepares tax returns or financial
statements for individuals or companies and is certified by the State Board of
Accountancy.
accounts
payable
Liability on the balance sheet. Amount owed to company's supplier when product
is delivered but not paid for.
accounts
receivable
Asset on the balance sheet. Amount owed to company when product is
delivered by not paid for by the customer.
actively
managed
For funds, actively managed funds have a manager or team of managers who
select the investments.
administrative
fee
Fee paid to run a fund's day-to-day operations.
American
Stock
Exchange
The second largest physical-floor exchange in the U.S. where stocks, options,
and other instruments can be bought or sold.
analyst
An analyst is usually employed by a large financial services firm to analyze a
company's market, competitors and financials to determine if it is a good
investment prospect.
annual interest
The interest (in dollars) that you receive from a bond every year.
annualized
return
Calculated by taking the total return on an investment and dividing by the
number of years invested.
annuity
Regular payments made based on an up-front investment.
appreciate
To grow in value.
asset
What the company owns. An individual's investments may also be called assets.
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asset
allocation
Selecting investments to get the most return for the least risk.
asset classes
Different categories of investments.
asset-backed
bonds
Bonds that are backed by automobile loans, credit card balances, or home
equity loans.
auction
Where buyers bid for items sold.
auditor
Auditors review the financial statements of a company and give an opinion as to
whether or not they fairly represent what actually happened.
average
annual return
Calculated by taking the year-to-year return on an investment and dividing by the
number of years.
balance sheet
Part of the company's financial statements, the balance sheet gives a snapshot
of financial health.
balanced fund
A fund which invests in both bonds and stocks.
barbell
A strategy for investing in bonds concentrated at very low and very high
maturities.
Barclays
Global Fund
Advisors
Financial firm that advises on international investments.
basis point
For interest rates, 100 basis points equal 1%.
benchmark
For investments, usually an index (basket of investments) used to compare the
performance of other portfolios.
beta
Measures the volatility of an investment. The higher the beta, the higher the
volatility.
bid
What the buyer wants to pay.
binding
arbitration
For brokerage accounts, binding arbitration means any dispute with the
brokerage firm will be settled by an arbitrator.
blue chip
High quality stocks.
bond
An IOU that a government, corporation, federal agency, or foreign government
gives you in return for money you lend them.
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Bond Buyer
Municipal
Bond Index
A benchmark for municipal bonds.
bondholder
An investor who owns a bond.
bond index
A measuring stick for how bonds are doing.
broker
Brokers buy and sell investments on behalf of investors.
bull market
A market where stocks are going up.
capital
appreciation
Profit made when an investment grows in value.
capital gain
The profit that occurs when you sell an investment for more than you paid for it.
capital loss
The loss that occurs when you have to sell an investment that has fallen.
Chartered
Financial
Analyst
A financial professional who does financial analysis of companies and is certified
by the Association of Investment Management and Research.
Chartered
Financial
Consultant
A financial professional who provides financial advice and is certified by the
insurance industry.
Chicago Board
of Options
Exchange
The largest options exchange in the world with 50% of options traded. Uses a
combination of brokers and market makers.
Chicago
Mercantile
Exchange
An exchange in Chicago where future contracts and options on commodities are
bought and sold.
closed-end
fund
A fund in which shares cannot be redeemed from the fund but are traded on an
exchange or over the counter.
commission
Fee paid to broker to execute a trade.
commodity
Products such as wheat, coffee, gold, livestock or oil sold in bulk.
commodity
futures
A contract to buy or sell commodities for delivery sometime in the future.
common
shareholder
An investor who has common shares in a company is an owner of the company.
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common
shares
Shares of ownership in a company with voting rights.
compounded
Allowing your interest to earn interest.
confirmation
A form which confirms your trade was made by your broker.
Consumer
Price Index
A measure of prices for a set basket of goods.
convertible
bond
Bonds which can be converted into a set shares of the company's (issuer's)
stocks.
corporate
bonds
An IOU that a corporation gives you which includes interest to be paid in return
for money that you lend them.
corporation
A legal form of a business which allows the company to issue stock.
correlation
How closely two investments move together.
country risk
When investing internationally, country risk is the risk of the particular country.
coupon
The annual interest on a bond, calculated on a term bond by taking the coupon
rate and multiplying by the par value.
coupon rate
The interest rate on a bond when it is first issued.
credit rating
Grade given to bond issuers that indicates their ability to fulfill their obligation to
pay interest and principal to the bondholder.
credit risk
The risk that the issuer of a bond will be downgraded of go into default.
currency
In a word---money.
currency
futures
A contract to buy or sell currency of a country for delivery sometime in the future.
currency risk
When the rate of exchange of a foreign company fluctuates with U.S. currency.
current yield
Annual interest divided by the buy price of the bond.
CUSIP
Unique number assigned to securities by the Committee on Uniform Securities
Identification Procedures.
debt
Anything the company owes.
decile rank
Rank as given in 10% chunks. A decile rank of 1 would mean the top 10%
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default
For bonds, the issuer defaults when it cannot pay some or all of the interest or
principal to the bondholder.
default risk
For bonds, the risk that the issuer cannot pay interest or principal to the bond
holder.
deficit
For many years, the federal government spent more than it took in taxes. The
result of this is the federal deficit.
defined benefit
plan
A pension plan based on the number of years you worked with the company.
defined
contribution
plan
A retirement plan where your income of retirement is based on what you put in.
deflation
Decline in prices and opposed to inflation (the rise in prices).
derivatives
Contracts to buy or sell a stock or commodity.
devalue
Lowering the value of a country's currency relative to other currencies.
developed
market
For international investments, developed markets are countries furthest along in
industrialization.
DIAMONDS
Unit trusts which hold a portfolio of the Dow Jones 30 stocks and are traded on
the American Stock Exchange.
discount
For bonds, selling at less than par value.
discount
brokers
A brokerage firm that provides less service for investors who want to make their
own decisions on investments. Commissions for trades at discount brokers are
lower than those of full-service brokers.
discount rate
Rate that the Federal Reserve charges to its member banks to borrow short term
money.
discretionary
authority
For brokerage accounts, when you give discretionary authority to your broker,
he/she can make trades without your approval.
dividend
Payments to shareholders in cash or stock.
dividend
reinvestment
plan
Plans where current shareholders can reinvest any dividends they get back into
company stock.
dividend yield
Calculated by taking dividends given per year divided by the current price of the
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stock.
diversification
Not putting all your investment eggs in one basket.
Dow Jones
Industrial
Average
An index of 30 blue chip stocks that is used as a benchmark for how large cap
stocks are doing.
EAFE
International index that includes the developed markets of Europe, Australasia
and the Far East.
economic
Indicators
Measurements that give a heads-up to what the economy will do.
economy
Economic output of a country or all the goods and services produced in that
country.
efficient
markets
The theory that the markets accurately reflect all the information and expectation
about investments.
emerging
For international investments, emerging markets are less sophisticated financial
markets.
emerging
market
For international investments, emerging markets are less sophisticated financial
markets.
employee
stock options
Options to purchase company stock that is given by the company to employees.
entrepreneur
An individual who has started up a new business.
estate
planning
Planning for the event of your death.
euro
Currency of the European Union.
exchange
A marketplace in which the buyer and sellers meet to trade financial instruments.
exchange
member
Firms that are members of the stock exchange and allowed to trade.
exchange rate
Used to convert your U.S. dollars to a foreign currency.
exchangetraded fund
Funds traded on a stock exchange sold at market value.
exempt from
Earnings from some investments may be exempt or not taxed by the federal or
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taxes
state and local governments.
expense ratio
Expenses of a mutual fund divided by the assets.
face value
The amount the bond issuer will pay back when the bond is due.
federal funds
rate
Rate that banks can borrow from each other.
Federal
Reserve
The central bank of the U.S.
fixed
For bonds, bonds that pay a fixed amount of interest yearly.
For mortgages, where you pay the same interest rate throughout the life of the
mortgage.
fixed income
Usually refers to bonds that pay a fixed amount of interest yearly.
fixed interest
Bonds that pay a fixed amount of interest yearly.
fund family
Financial service firms which manage a number of mutual and other funds.
fund manager
Someone who manages a fund.
fund
Funds are portfolios of assets managed by an investment manager or a
computer program for the individual investor.
future value
The value of an investment after a number of years based on a rate of return.
growth
For stocks, growth stocks are a category that is priced higher.
growth rates
Increase in value usually given as a percent.
high yield
A speculative-grade bond that yields more but is riskier.
high yield
bond
A speculative-grade bond that yields more but is riskier.
hybrid
A fund which invests in both bonds and stocks.
illiquid
An illiquid investment is one that you cannot sell easily at a good price.
income
For financial statements, income refers to the profit of a company. For the
investor, it refers to yearly payments gotten from an investment.
index
A benchmark for comparing investments of a category.
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index fund
A fund in which investments are selected based on an index.
Individual
Retirement
Account
A retirement account that may have tax benefits.
industry
A way of classifying companies into groupings that have common
characteristics.
inflation
Increase in price without any increase in value. For ordinary people, inflation is
measured by the Consumer Price Index.
inflationindexed
Treasuries
Bonds issued by the U.S. Treasury which are indexed to inflation. They are
meant to give the investor a real yield.
insurance
Paying a premium to cover in the event of a loss.
interest
When you borrow money from someone, you have to pay interest.
investment
advisor
Anyone who is taking money for financial advice. There are rules for registration
with the SEC.
investment
advisor
representative
A financial professional who works for an investment advisory firm and passed
the Series 65 exam.
investment
advisory fees
For funds, this is the fee the fund manager receives for selecting investments.
investment
banker
Wholesalers of stocks or bonds. They price the issue, package it, and sell it to
investors. They also provide advice on mergers and acquisitions.
Investment
Company
Institute
The umbrella organization of the funds industry.
investment
grade
For bonds, higher quality bonds given at least a Baa or BBB rating.
investment
manager
Anyone who is taking money for financial advice. There are rules for registration
with the SEC.
IRA
Individual Retirement Account which allows you to save on a tax-advantaged
basis.
iShares
Index shares listed on the American Stock Exchange are exchange traded unit
trusts.
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junk bond
A speculative-grade bond that yields more but is riskier.
ladder
A bond investing strategy which spreads purchases over various maturities.
large cap
Company with a market capitalization of over $5 billion.
Lehman
Brothers
Aggregate
Bond Index
Benchmark for bond performance.
leverage
Borrowing money to cover the cost of an investment.
liquid
When an investment can be converted to cash quickly and without a big hit in
price.
liquidation
Selling your investment.
liquidity
How easily the investment is converted to cash without a big hit in price.
listed
companies
Companies listed on a stock exchange.
load fund
For mutual funds, a load fund has sales charges.
long term
bond
Bonds with maturity greater than 12 years.
maintenance
fee
For funds, an account maintenance fee is usually charged for smaller accounts.
management
fee
For funds, this is money the fund manager receives for managing the fund.
margin
Borrowing money to buy stock.
margin
account
For brokerage accounts, this allows the investor to buy securities with money
borrowed from the broker.
margin
requirement
If the price of a stock purchase on margin or a naked option falls you may be
required to provide additional money.
market
capitalization
The value of a company or a stock market.
market
interest rate
The current interest rate.
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market timing
Trying to predict whether the market is going up or down.
market value
What it would cost to buy the company. The number of shares multiplied by the
price per share.
maturity
The date a bond comes due or is paid back.
maturity date
For bonds, the time period when the bond will be paid back.
MSCI EAFE
International index that includes the developed markets of Europe, Australasia
and the Far East.
medium cap
Company with market capitalization between $1 billion and $5 billion.
medium term
bond
Bonds with maturity of between 5 and 12 years.
micro cap
Company with market capitalization of under $300 million.
money
manager
Someone who manages or invests money for a living.
money market
These are bond markets where money is borrowed or on loan for less than three
years.
Morgan
Stanley
Capital Index
A set of international indexes that are used widely to measure performance of
global investments.
mortgage
A loan used to buy real estate.
mortgage
securities
A bundle of mortgages, divided the bundle into units, and sold to investors.
MSCI
Emerging
Market Index
International stock index that includes all emerging markets.
MSCI Europe
Index
International index that includes developed markets in Europe.
MSCI World
Index
International index that includes all developed markets including the U.S.
municipal
bond
Bonds issued by state or local governments.
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mutual fund
Pools of money unmanaged or managed by an investment manager and sold in
shares to individual investors.
mutual fund
rating service
Services that rate mutual funds so that investors can compare.
NASDAQ
National Association of Securities Dealers Quotation System is a network of 500
dealers who will respond to any offer to buy or sell stock listed on this exchange.
net worth
What a company or individual owns free and clear of debt.
New York
Stock
Exchange
The largest (in market value) and most established U.S. stock exchange.
no-load
mutual fund
Mutual funds which do not charge sales fees but may charge other fees.
nominal rate
Also known as the coupon rate on a bond, this is the annual interest rate paid on
the par value of the bond.
nominal return
Also known as the coupon rate on a bond, this is the annual interest rate paid on
the par value of the bond.
par value
What the issuer of a bond will pay back to the bondholder at maturity.
passive
strategy
An investment strategy that involves use of indexes versus active selection of
investments.
PE
Current price of the stock divided by earnings per share.
PE/Growth
Used for valuation, Price Earnings ratio divided by Growth rate. This gives an
indication of how much the investor is paying for each percent of growth.
Personal
Financial
Specialist
A financial professional who provides financial advice and is certified both as an
accountant and has passed the personal financial planning education program.
portfolio
For you, the combination of all your investments in stocks, bonds, cash, and
other financial instruments. For funds, the portfolio is listing of all the investments
selected by the fund's management.
premium
Paying a price over par or face value of a bond.
prepayment
When the individual homeowner pays principal back before it is due.
principal
For mortgages, the amount borrowed is the principal. Principal is repaid when
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repayment
the borrower pays back any or all of the amount borrowed.
private
investor
Investors who were solicited privately to invest in a company and may not be
subject to SEC regulations.
R-square
A measure of how closely an investment moves with an index.
real estate
An asset class that invests in property such as apartments, shopping malls,
office buildings or other real property.
redeem
For bonds, when the issuer pays back the entire amount borrowed. For funds,
when shareholders want to cash out their shares.
redemption
For bonds, when the issuer pays back the entire amount borrowed.
redemption
fee
A charge when you sell or redeem your shares in a fund.
Registered
representative
Typically a stock broker who has passed the Series 7 exam.
risk
The chance that you will lose a portion of all the money you invested.
Russell 2000
An index for small capitalization stocks.
S&P 500
A collection that represents the 500 largest stocks (technically not the 500
largest since industry is also a factor) on the U.S. stock exchanges.
sales charge
A fee when you buy a fund.
sales load
A fee when you buy a fund.
SEC
The government agency charged with protecting the investor.
secondary
market
The primary market is the first time a security is offered. The secondary market
is any "resales" of securities after that.
sector
A grouping of industries used by investors to classify investments.
secured
For bonds, this means the bond is backed by assets of the company.
Securities and
Exchange
Commission
The government agency charged with protecting the investor.
security
A general term for stocks, bonds, options, rights or warrants.
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shares
Equity of a company.
Sharpe ratio
A measure of risk and return calculated by taking the annual return of an
investment subtracting the risk-free return and dividing by the standard
deviation.
short term
bond
Bonds of less than 2 years maturity.
small cap
Company with market capitalization of between $300 M and $1 B.
SPDR
Exchange traded fund that wants to mimic the performance of the Standard and
Poor's 500.
Standard and
Poor's
Financial service company that is best known for its Standard and Poor's 500
index, but also does securities analysis and credit rating.
Standard and
Poor's 400
An index for medium capitalization stocks.
Standard and
Poor's 500
A collection that represents the 500 largest stocks (technically not the 500
largest since industry is also a factor) on the U.S. stock exchanges.
Standard
Deviation
A measure of variability calculated by taking each measure subtracting the
average, squaring the result, adding, dividing by the number and taking the
square root.
stock
Ownership shares in a company.
stock
exchange
A place (physical or electronic) where brokers and dealers meet to buy and sell
stocks.
stock index
A basket of stocks used as a benchmark for stock performance.
term
The period until the bond comes due.
term bond
A term bond runs a specified period of time and must be paid up at maturity.
total holding
return
The total profit over whatever period you held the investment.
transaction
fees
Fees that go directly to the fund instead of the fund company that are used to
discourage fund holders from cashing out.
Treasuries
Treasuries are the debt that the federal government issues to finance the
government deficit.
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Treasury bills
Debt issued by the federal government for terms of one year or less.
Treasury
bonds
Debt issued by the federal government for a term of 30 years.
Treasury
notes
Debt issued by the federal government for terms of 2, 5, or 10 years.
treasury
shares
Shares of stock that has been repurchased by the company.
U.S. Treasury
The government's banker.
unit trusts
Unmanaged portfolio of investments in which the selected investments doesn't
change.
variable
interest
Interest rate that is allowed to fluctuate based on a predetermined benchmark
interest rate.
variable
mortgage
Interest on a variable mortgage changes at specified periods based on a
predetermined benchmark interest rate.
volatility
For investments, the extent to which returns go up and down.
Wilshire 5000
An overall market index that includes about 8,000 stocks.
yield
For stocks, annual dividend divided by the current stock price. For bonds, there
is nominal yield, current yield, yield to maturity, and yield to call.
yield curve
A graph at a given point in time which shows the interest rate on the vertical axis
and maturity on the horizontal axis.
yield spread
strategy
Exploiting short-term glitches in the normal relationship between interest rates.
yield to call
The return on a bond if you hold it until the first date the company is allowed to
call or redeem the bond.
yield to
maturity
The return on a bond if you hold it for the full life of the bond.
zero coupon
A bond that pays all interest and principal at maturity.
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