Your Money
Spending it, Borrowing it, Saving
it, Protecting it
The stock market
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Stock: Equity or ownership in a corporation.
Why stock? Buy it because you expect it to increase
in value, or expect the corporation to pay part or all
of their profits (dividends)
Some stocks provide both: appreciation in value
(growth) and income
Corporation gets proceeds from initial sale (initial
public offering (IPO) only
Stocks…


All proceeds from subsequent sales go to the
owner of the stock (stockholder)
Price of the stock, as with other commodities,
depends on the supply of and the demand for
the stock
Market for shares
P
S
Q* = total # of outstanding shares
D
Q
*
Q
Common vs. preferred stock

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Common stocks: Most stocks; no guarantee of
making money (growth or income)
Value of common stocks may increase or decrease
May or may not receive dividends  risky endeavor,
compensated with potential return (growth or
income)
Preferred stock (less risky)  certain dividend
guaranteed; but only that  income but limited
growth (capital gain)
Chips and splits

Blue chips: typically used to denote stocks in
large companies that were most valuable

Generally largest, most consistently profitable
firms
 Not necessarily the case today

Stock splits: change in the number of total
outstanding shares
Stock split

When the price of stock gets fairly high, company
may decide to ‘split’ the share to reduce the price of
each share  result: more shares, lower price

E.g. share sells for $100. You own 10 shares. Total value
= $100 x 10 = $1000
 Company decides a ‘2 for 1’ split  those with 1 share
now have 2, total value same.
 New price = $1000/ (2x 10) = $50 each
Price changes

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Price of a stock can change at any time (market price
risk)
Can use a supply and demand diagram to understand
the change
Notice that many people on ‘Atkins’ diet. So you
want to invest in Atkins Nutritionals, Inc. Others
may think the same, demand for Atkins stock
increases. (D1)
If hear that Atkins is bad for you, then want to get rid
of stock. (D2)
Market for Atkins stock
P
S
Q* = # shares outstanding
P1
D1
P*
D
P2
Q*
Q
Value of stock

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Price of stock is one measure of value.
Return on investment: another measure of
value = the amount earned on the stock
(profit/ investment)
Cyclical stocks: company performance
depends heavily on that of the economy. If
economy is doing well, so will these e.g.
Airlines, Hotels
Value of stock
Factors that determine stock value:


•

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Earnings (growth rate)
Competition in industry
Availability of new markets
Management strengths and weaknesses
Overall environment of economy
 Bottoms-up analysis
Buying stocks

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About 43% of Americans own stock
Owned either directly or through mutual funds,
pensions or insurers
Types of investors:

Institutional: invests own assets or those of others it holds
in trust e.g. mutual funds, pension funds 

CalPERS (California Public Employees’ Retirement System) 
worth $207 B as of 1/06; 64% in stocks
Buying stocks

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Individual investors: account for 45% of all trades;
average $10 000
Investment styles:



Buy and hold: long-term view, buy stock and wait for it
to appreciate
Day trading: extremely short-term view, looking to make
quick profits (less than 17% of individuals made profit
this way)
Investment clubs: get together with some friends, pool
your money, make investments

Beardstown Ladies
Buying styles

Dollar- cost averaging:
regardless of the price
of the stock, you buy
the same amount each
month. At times you
pay more, at times less,
but works out on
average.
Reading stock tables

WSJ – business publication

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Most often used by professionals
Also can find many places online e.g. money website
52 wks Hi & Lo – for the past 52 weeks
Yld % - dividend as % of current price
PE – Price/ Earnings ratio – relationship between stock price
and earnings for the last 4 quarters  often used to compare
stocks (here past earnings not future)

Forward PE – uses expected earnings (forecast)
Reading stock tables

Volume - # of shares traded the previous day (x 100
to get actual shares)

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Large volume typically indicates some information
revealed
Hi, Lo, Close – stock price of previous day
Net change – compared to closing from previous day
Sym – stock symbol (unique to company)
Keeping up with the (Dow)
Joneses…
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Stock market activity is reported daily in averages
and indexes designed to assess the state of the
economy
Price changes of one stock matters more to
stockholder, but market as a whole is a measure of
economic activity
Market activity typically reported via indexes:
Indices…


DJIA (Dow Jones Industrial Average) – the
Dow – most widely reported; composed of
prices of 30 major industrial companies
S&P 500 (Standard & Poor’s 500) - a
representative sample of 500 leading
companies in leading industries of the U.S.
economy
More indices…

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NYSE composite index: all stocks traded on
the NYSE
Russell 2000: follows 2000 of the smallest
companies
Wilshire 5000: nearly all stocks traded in US
markets
What’s good for the index is good
for the…


Why indexes? They serve as important tools
for measuring the overall health of stock
market; also benchmarks for comparing your
own portfolios
This past year:

DJIA: last 52 wks ~8%
 S&P 500: 52 wks ~10%
Up and down and up and down
and…
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Stock market has cycles (ups and downs) – hard to predict
these, but can be explained
As people invest in the market – generally market goes up
As people pull out of the market – generally it goes down
Few other factors (political, social and economic also affect
peoples’ decision to invest)

Risks:
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Financial: probability that initial investment not recovered
Liquidity: ability to turn money into cash
Inflation: higher the inflation, lower the real rate of return
Fraud: schemes and scams
Market Price Risk
Factors
Positive Factors
Negative Factors
Ample money supply
Tight money supply
Tax cuts
Tax increases
Low interest rates
High interest rates
High employment rate
High unemployment rate
Political stability
conflicts; unstable govt
Bulls and bears and lions and…
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Bull market: rising market (values are increasing,
indexes are increasing)
 Typically a reflection of a booming economy as
well  people are spending money, low
unemployment
Bear market: falling market (approx 20% of value)
Usually bear markets last shorter than bull markets
Though drops is market occur quickly (1929
(12.8%), 1987(22.6%)), rises tend to take a while
Let the chips fall where they may…
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Blue chip stock performance during the two crashes:
1929 (market -12.8%):


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AT&T: - 12.7%
Kodak: -18.7%
Sears: -12.5%
1987 (market -22.6%):

AT&T: - 21.2%
 Kodak:
- 30.2%
 Sears:
- 25.3%
Reflecting the economy

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Stock market activity affected by economy,
since companies affected by economy
Business cycles in the economy (ups and
downs in GDP) related to cycles in stock
market
Scenario

Imagine a scenario:

Profits decrease in a company (people sell shares in the
firm, ‘wealth’ of stockholders decreases)
 Firm slows down, lays off employees
 Unemployment rises
 Wages fall  people less ‘wealthy’ (those laid off sell
their shares)
 Company makes money  higher profits (market value
increases (stock price) for those holding shares)
Scenario

More workers hired since company doing well
 Unemployment decreases
 Wages rise  people wealthy again (invest once
again in stock market, where prices have been
rising)
 Profits decrease  cycle starts all over
How to smooth cycles?

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Interest rates play a huge role in the economy
affects borrowing by corporations, individuals 
affects economy (lower spending, lower GDP)
Fed controls interest rates
How? Increases rates to cause economic slowdown,
lowers rates to encourage economic growth, through
money supply and rate it charges bankers
Fed and stocks

How does the Fed influence the stock market?

Raises interest rates to combat inflation
 Higher rates, negative impact on people wanting
to invest in stock market  stock prices fall
 Economy slows down (higher rates) prices and
wages fall  companies start coming back to
profitability
Can Anyone tell you how to spend
your money? (Ch 9)

Pecuniary emulation
up with the Joneses’  wondering how
they could afford it?
 ‘Keeping
People spend their money differently, but there
are average patterns. Table 5 (p 45)
 Majority of expenses: Shelter, Transportation

Spending patterns
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As income rises, most expenditures as a percent of
income decrease (total amount spent does not change
too much) except for insurance, pension & SS
(usually a certain % spent, regardless of income),
savings & taxes  more money, ability to save more
Also varies with age
As age increases, spend more (%) on food, utilities
and health care; less on taxes, SS
Back to money…
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Paper bills get worn out pretty quick.
Need to be replaced.
Average lifespan of $1: between 13 – 18
months.
How does new currency get into your hands?

The treasury ships new money to the Federal
Reserve banks.
New Money


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
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Federal Reserve banks return old money to the
treasury, who shred and burn it.
The Fed then distributes the money to individual
banks in its regions.
The banks send back old worn out bills back to the
Fed branch.
The banks distribute the new money to its customers
(in exchange for old ones, of course!)
They get used, world goes around ($$)…
Other forms of money

Currency is not the only type of money.
 Checks
 Debit
cards
 Not credit cards
1998: 70% of all households have at least 1
credit card
 Estimated that roughly 84% of those pay their
bill in full monthly.

Federal Reserve System
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Monetary Policy: the Fed injects and
withdraws money from the economy in order
to regulate it.
Money supply: the amount of money that
people have available to spend (cash,
checking accounts)
Federal Reserve system
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If money supply is increased, typically economy grows
quickly, companies hire more workers, people spend more
If money supply is decreased, economy slows down,
unemployment increases etc.
More money there is in the economy, the higher is the price
level, less purchasing power (inflation)
As fed changes money supply, the interest rate changes.
Increase Ms  interest rate falls, decrease Ms  interest rate
rises.
Do you need a budget? (Ch 10)
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If living within paycheck, paying all bills on time,
saving money and doing all without a budget, then
one is not needed.
But, even if one of the above not met, then need a
budget.
Four main elements to a budget: income, expense
categories, time period and implementation.
Budget woes…

Income to Use: wages and salaries, rental
income, regular investment income (bonds,
dividends etc), pension income, and any other
regular income received.
 If
want to account for taxes, use gross income, else
use net income (after taxes).
 Loans are not income  expense
Budget expenses
Most important category
 Categories need to be neither too broad nor too
specific.
 Break down of categories:


either as food, clothing, utilities etc
 Or as based on locations (furniture,gas etc)

Pg 50
Budget

Time Period: monthly, weekly, yearly
 Best
to do monthly, since major expenses occur
once a month: rent / mortgage, utilities, car
payments, credit cards.
 Some get paid once a month, others bi-weekly;
either way make sure your expenses and income
are of the same time period
Budget
Implementation: hardest part
 Save receipts, cancelled checks for all
payments made in a month
 Account for all income.

Cars: To lease or own?
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For same car, lease payments less than loan payments  since
not paying for whole car
Leasing: only paying for value of car during time you lease it
(paying for the depreciation)
‘Loaning’ : paying for whole value
Cars depreciate most in first two years  typically when
leased
When lease? If you want a new car every couple of years,
businesses
Best strategy: Buy (new car) and hold (it for a long time)
How much debt is too much?
(Ch 12)
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If own a house, probably the largest share of your
debt.
Other forms: student loans, credit cards, etc.
How much is too much? 20% rule
If credit payments (excluding mortgage) are more
than 20% of take- home pay trouble!
Comes from typical spending patterns  once all
essentials accounted for, typically have 20% left over
 average
Example

Achilles takes home $2000 every month. He pays
$300 for his 4-horsepower vehicle. He also owes
$200 a month to a creditor, Lenderus. Is Achilles
headed for trouble?
 Achilles



monthly credit payments:
$300+200 = 500
Take home: $2000
% = 500/ 2000 x 100 = 25%
 According
to the rule, he is headed for trouble.
Now you try it!

Patroclus takes home $1500 a month. He pays
$175 for his wagon, gives $550 to Lenderus as
mortgage payments, pays $50 towards his
student loan, taken to study under Achilles. Is
he, like his master Achilles, headed for
trouble?
How you can get out of debt
(Ch 13)

How do you get into trouble with debt?
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
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Take on too much
Maintain your debt, but suffer drastic drop in income
2nd alternative usually occurs during recessions, with layoffs.
How to get out of debt?



No more debt
Spending control  reduce ‘other spending’ and pay off debt
Regular payment schedule to pay off debt entirely
How you can get out of debt

Step 1: No more debt!
 Stay

away from the mall, don’t look at ads!
Step 2: Reduce ‘other’ expenses
dieting: just ‘eat’ less!  Hard to do
 Start thinking of cheaper alternatives (watch
Martha Stewart living)
 Like

Step 3: Rigid monthly plan
 See
table 9, pg 66
Example
Paul owes $8000 on his Visa. The annual
percentage is 18%. He can afford $200 per month.
How long before he pays it off completely?


Divide total debt by monthly payment.



8000/ 200 = 40
Locate the interest rate column on the table.
Look down column until number closest to step 1 result.
Example 2
Suppose Peter wants to pay off his loan in 3 years.
He owes $8000 as well and pays 18% interest to his
credit card. What would he have to pay monthly to
accomplish this task?


Find the interest rate column (18%).
Find the month row (36 months = 3 yrs).
Use the number (27.66) to calculate monthly payment:
Debt/ number = Monthly payment



8000/ 27.66 = $289.23
Now you try it!


I owe $14, 000 to my neighborhood ‘shark’
who is a nice guy and charges me 13% on my
‘loan’. How long before I can pay him off, if
I pay him $155 per month?
I owe $6, 000 to my bank. They charge me
6%. What monthly payments do I need to
make to pay off my loan in 5 years?
Debt Calculator
Are all interest rates the same? (Ch 14)
Now you decide you want a loan: debt
consolidation, house, car etc.
 How do you know which is the lowest possible
rate you can get?
 2 possible types:

 Tax
favored
 Fixed vs. adjustable rates
Tax-favored

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The interest that you pay on these loans is tax
deductible.
These deductions reduce your taxable income, which
reduces the actual tax you pay.
Most commonly loans for homes.
Choice difficult when facing 8% tax-favored loan or
6% loan?
How calculate? Using tax bracket
Which is the better rate?

1.
2.
3.
4.
Two loans: 8% tax- favored vs. 6%
Find your tax bracket (from chap 21).
Tax-favored rate x tax bracket
Tax-favored rate – result from 2. = after tax, taxfavored rate
Compare result from 3. to 6% (rate which is not tax
– favored): if tax- favored rate lower, then better
choice, or else the other rate is better.
Example One

Harry needs a new car when returning to Hogwarts
this fall. He is offered a loan of 6% by Mr. Jigger, the
local car salesman. When his uncle’s family passed
away due to some unfortunate spell, he became the
sole owner of their house. Thus he can also get a taxfavored 8% loan from the Bank of the Kappas. What
should Harry do? (Assume his tax bracket is 28%)
Example One
1.
2.
3.
4.
Tax bracket: 28%
.28 x 8% = 2.24%
8% - 2.24% = 5.76%
5.76% < 6%, so Harry better off going to the
Kappas.
Now you try it

Harry’s best friend, Ron Weasley, also wants
to buy a new car. He owns a house left to him
by Agrippa, a wizard. He has the same options
as Harry for financing his new ride (8% from
the Kappas, or 6% from Mr. Jigger).
However, being slightly less wealthy, Ron’s
tax bracket is 15%. What do you suggest he
do?
Fixed vs. Adjustable Rates

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Fixed rate: never changes for the duration of the
loan, regardless of what interest rates do.
Adjustable rate: rises and falls with interest rates.
Typically fixed rates > adjustable rates
When fixed? If interest rates low and expected to rise
in the future
When adjustable? If rates high and expected to fall.
Rule of thumb
If own house for shorter time period, better off
with adjustable rate (may not go up much in
the short time you own the house)
 Rule of thumb: Own house less than 5 yrs, go
with adjustable rate mortgage (ARM), if more
than 5 years, go with fixed.
 How else can you lower the rates on a
mortgage? Points…

What’s the point?

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Point: paying the lender to lower the rate on your mortgage
One point = one % of mortgage loan
If loan is for $100,000, then need to pay $1,000 to have lower
mortgage rate.
How much lower? Depends on the deal.
Typically, longer stay in a house, the better it is to pay the
points
Why not increase down payment with available cash?
Typically better to pay points than reduce loan amount.
How can you save money? (Ch 15)
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Life-cycle of saving: saving depends largely on stage
in life: young, middle-age, retirement.
Young households: typically spend more than they
earn and hence borrow money
Middle-age households: typically spend less than they
earn and hence save.
Retired : again spend more than they earn
Savings  investment economic growth
How much should you save? (Ch 16)



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Say saving for college, retirement  uncertainty
since do not need the money for 18 – 20 years (need
to account for purchasing power)
Easier to save later in life than earlier
Nominal rate = real rate + inflation
Real rate of interest: more predictable and rarely
fluctuates much (0 – 3 % typically, lower risk
investments closer to 0)
Keeping it real

If inflation > nominal rate, then real rate is negative.
E.g. Japan in the early ’90s.
 If
you are paid 4% return on your investment, and inflation
is 5% per year, then your ‘real’ rate is -1%.



Use Table 10 to figure out what you need to save.
More conservative, the lower the real interest rate
(closer to 0)
E.g. if invest primarily in bonds, use 0%; if mix of
stocks and bonds, use 3%; if primarily stocks and
other risky ventures, use 7%.
Keeping it real
1.
2.
3.
4.
5.
Select the real interest rate, say 3%
Pick the number of years the money will be needed
for. E.g. college = 4 yrs; retirement = 30 yrs.
LHS column, # of yrs of saving (say can save for
the next 30 yrs, for retirement)
Find the intersection of 1, 2 and 3.
Multiply the amount by x/1000, where x is the
amount/ yr you will need.
example

1.
2.
3.
4.
5.
6.
I want to retire in 30 years. I will be around for 30 years
after I retire. I think conservatively (real return is 3%). I
will need $30,000 in today’s dollars to have a good life.
How much do I need to save per month in the first year?
Real rate = 3%
# of yrs $ needed = 30
# of yrs of saving = 30
Future purchase (today’s $) = 30,000/1000 = 3
From table: $34 x 3 = $102/ month
Increase with inflation.
Example 2

John and George want to get into business
together. They calculate that they need $8000
for a down payment on their business loan, if
they bought the business today. They plan to
save up for the next 5 years to have the down
payment. If they can expect a real rate of
interest of 7%, how much should they save per
month in the first year?