Personal Financial Literacy

Session 2: Saving and Investing

Teaching

In the Elementary Grades

Katie Sauer, Ph.D.University of Colorado

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Session Overview

I. Saving

II. Financial SystemA. StocksB. Bonds

III. Taxes on Investments

IV. Time Value of Money

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Saving

In the broadest sense of the definition, savings is what a person has left over after paying taxes and buying goods and services.

The act of saving generally implies that an individual is storing their funds for future use.

Every three years, the Federal Reserve conducts a large-scale survey of households’ finances.

Survey of Consumer Finances

One area of the survey deals with savings.

Why do people save?

People are asked about the “most important reason” they save.

~ education~ for the family~ buy a home~ purchases

~ retirement~ liquidity~ investment~ no particular reason

Investments1%

Purchases12%

No Reason1%

Education8%

Do Not Save4%

Retirement30%

Buy Home3%

Family6%

Liquidity35%

Top Reasons People Save

2010 Survey of Consumer Financeswww.federalreserve.gov

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Did you know, only 67% of surveyed households report having a savings account!?!?

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The median household in the survey reported wanting to have $5,000 of precautionary savings.

- about 11% of its annual income

Lower income households report wanting to have $2,000 in savings and high income households as much as $30,000.

The savings rate is the percent of after-tax income that is saved.

The Bureau of Economic Analysis has been tracking US household saving rates since 1959.

The St. Louis Federal Reserve releases easy-to-use data on this rate.

PSAVERT

Savings Rate

http://research.stlouisfed.org/fred2/series/PSAVERT

Years Average Savings Rate1960s 8.2%1970s 9.6%1980s 8.6%1990s 5.5%2000 - Oct 2008 2.8%Oct 2008 - Jun2011 5.1%Jul2011 - Dec2012 3.9%Jan2013 - Apr2013 2.4%

http://research.stlouisfed.org/fred2/series/PSAVERT

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There are a variety of types of banking institutions:

• Retail banks• Credit unions• Commercial banks• Savings banks • Investment banks• Central banks

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You probably do your own banking at either a retail bank or a credit union.  A retail bank’s customers are individuals or households, rather than corporations. Services offered typically include transactional accounts, savings accounts, mortgages, personal loans, debit cards, and credit cards.  A credit union offers the same types of services but is owned and controlled by its members. Because a credit union exists to serve its members (not shareholders), it typically funnels any “profits” back into providing lower interest rates on credit.

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As an individual, you may also do banking at a savings bank or a savings and loan association.  A savings bank’s primary purpose is accepting savings deposits but it can offer other banking services as well.  Savings and loan associations are also called “thrifts”.

• accept deposits for savings and transaction accounts and they make mortgages

• tend to be smaller than other banks• more focused on the local communities in which

they operate

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Large businesses or corporations do their banking at commercial banks.

These types of banks typically do not handle accounts for individuals.

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Investment banks are not banks in the typical sense of the word.

• they do not take deposits!• they assists individuals, corporations, and

governments in a variety of activities. • issue stock• mergers and acquisitions• trade foreign currency

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Central Banks oversee a nation’s banking system and sets the amount of money in the economy.

• US Federal Reserve • Bank of Canada• Central Bank of Brazil• Reserve Bank of Australia• Monetary Authority of Singapore

Central banks act like the “banking system’s bank”. • retail, commercial, and investment banks have

accounts at central banks• individuals and firms do not

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The Financial System

The financial system is the group of institutions in an economy that help to match people and firms that have excess financial capital with people and firms looking to borrow or raise financial capital.  There are two basic types of institutions in the financial system:

• financial intermediaries• financial markets

 

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Financial intermediaries are institutions where funds are transferred indirectly between parties.

Ex. a bank  • You deposit your funds at the bank.• Someone else approaches the bank for a loan. • The bank makes the loan using your funds. • The borrower pays back the loan. • You earn interest on your account. • You and the borrower never meet and don’t transact

directly. • The bank is the intermediary going between you

two.

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A mutual fund is another example.

This is an institution that buys an assortment of stocks and bonds (called a portfolio) and then sells shares of the portfolio to the public.

Because you are not directly choosing the stocks and bonds and not directly buying them, a mutual fund is a financial intermediary – going between you and the stocks and bonds.

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Financial Markets

Financial markets are institutions where funds are transferred directly between parties.

Ex. stock market, bond market

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Stocks

A stock is a claim of partial ownership of a firm.- shareholder

If you buy a stock, you are not guaranteed to get your money back.

The price of a stock generally reflects the perception of a firm’s future profitability.

From: Google Finance 3/08/2013

Company name Name of stock exchange and stock symbol

Current price per share; the last price a share was traded at

Change: compared to most recent closing price

Percent change: Change x 100 Close price

Range: Today’s high and low price

52 Week: High and low price for the last 52 weeks

Vol/Avg: Volume = Number of shares traded todayAverage = Average number of shares traded daily

Shares: The number of shares outstanding

Inst. Own (Institutional Ownership): Percentage of the shares that the firm owns

Mkt cap (Market Capitalization): A measure of the total value of the company (Total Shares Outstanding x Current Price per Share)

P/E (Price-to-Earnings Ratio): Current price of a share divided by last year’s earnings per share.

EPS (Earnings Per Share): Amount of the company’s earnings divided by the number of outstanding shares.

Div/Yield: Dividend = The amount of money the firm will pay you (typically each quarter) for each share you own.

Yield = Dividend amount / current share price

Not all firms pay dividends.

Beta: A statistical estimate of how closely the stock’s performance matches the stock market in general.

The higher the beta, the closer the stock matches the general market.

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Stock Markets

Stocks are bought and sold in organized markets called exchanges.

The US has two major stock exchanges.• The New York Stock exchange, or NYSE, is

also called the Big Board.• NASDAQ stands for National Association of

Securities Dealers Automated Quotations• only virtual trading

The S&P 500

• Used as a measure of the general level of stock prices

• Includes the stock prices of 500 publicly traded companies

• Representative of U.S. industry

Retrieved 2/22/2013

S&P 500January 2004 – January 2013

Yahoo Finance

An S&P 500 value of 1500 is a good reference point.

- This is about where the index was before the financial crisis.- This is where the index was back to at the beginning of 2013.

The financial crisis took the value down to 700.

S&P 500 – Additional Information

• DJIA, “The Dow”

• 30, large, publicly traded firms

• Coca-Cola, IBM, Walt Disney,

Microsoft, ExxonMobile

• Representative of US industry

The Dow Jones Industrial Average

Retrieved 6/19/2013

Dow Jones Industrial AverageJanuary 2004 – January 2013

Yahoo Finance

A Dow value of 15,000 is a good reference point.

- The index was almost that high before the financial crisis.- About where the index was back to in 2013.

The financial crisis took the value down to below 7,000.

Dow Jones – Additional Information

NASDAQ Composite• National Association of Securities

Dealers Automated Quotations

• All 3,000 firms traded on the NASDAQ stock exchange

• Technology companies and growth companies

NASDAQ CompositeJanuary 2004 – January 2013

Yahoo Finance

A NASDAQ value of 3,000 is a good reference point.

- The index was up to 2,800 before the financial crisis.

- The index is around 3,000 in 2013.

The financial crisis took the value down to just below 1,300.

NASDAQ – Additional Information

Bear and Bull Markets

A Bull Market refers to an upward trend in the stock market, and optimism about continued gains.

A Bear Market refers to a downward trend in the stock market, and pessimism about the future.

Bonds

A bond is a certificate of indebtedness. “IOU”

When a firm or government issues a bond, they are borrowing money from anyone who buys the bond.

They are promising to pay you back a certain value in the future.

For a bond, the terms are fixed in advance. That is, the denomination of the bond, the date of maturity, and interest rate are all determined before the bond is issued.  The denomination or face value of the bond says how much money you’ll be getting on the date of maturity, which is when you get the money, typically 30 days to 30 years.  The interest rate or coupon rate tells you how much interest you’ll be earning each year.

When bonds are first issued, they can be sold at face value (par), a discount, or a premium.  Firms and governments issue new debt in the primary market. Bonds can be resold in the secondary market.

The Bond Market

Usually refers to the market for US government bonds.

They are called Treasury Securities and there are three types:

• T-bills mature in less than a year• T-notes mature in 2 to 10 years• T-bonds mature in 20 to 30 years.

The yield is a measure of the return you get on a bond.

Yield = Coupon amount x 100% Bond price

yearly interest earned

current price

Yield

The price of a bond is $950.

Its coupon is $60.

Yield = Coupon / Price x 100%= $60 / $950 x 100%= 6.31%

Yield Example

When the bond is selling at par (face value), the yield is equal to the coupon rate.

When the bond sells at a discount, the yield is higher than the coupon rate.

When the bond sells at a premium,the yield is lower than the coupon rate.

Yield and Coupon Rate

Bond prices are always changing (secondary market) so if you have a bond, its yield is always changing, too.

Previous Example:

The price of a bond is $950.Its coupon is $60.

Yield = Coupon / Price x 100%= $60 / $950 x 100%= 6.31%

New Example:

The price of the bond falls to $800. (In secondary market)Its coupon is still $60. (Won’t change)

Yield = Coupon / Price x 100%= $60 / $800 x 100%= 7.5%

As the price of a bond goes down, the yield goes up.

If you hear in the news “bond yields are up” …

… you know that means bond prices are down.

- and you can buy a bond at a discount.

Taxes on Bond Interest

Suppose you own a bond that pays you a coupon of $60 in 2013.

You owe taxes on that $60 of interest that you earned.

Taxes on Stocks and Bonds

We previously learned that interest income is part of your gross income:

Taxes on Stock Dividends

Suppose you are single and your taxable income in 2013 is $40,000.

You own some stock that pays you a dividend of $500 that year.

You owe taxes on the $500, at a rate corresponding to the income tax bracket you are in.

Tax brackets for a single person for 2013

Tax Bracket Tax Rate over but not over 10% $0 $8,925 15% $8,925 $36,250 25% $36,250 $87,850 28% $87,850 $183,250 33% $183,250 $398,350 35% $398,350 $400,000 39.6% $400,000

On your dividend of $500, you owe:$500 x 0.25 = $125 in taxes

Suppose instead your taxable income is $450,000 and you received a dividend of $500.

Tax brackets for a single person for 2013

Tax Bracket Tax Rate over but not over 10% $0 $8,925 15% $8,925 $36,250 25% $36,250 $87,850 28% $87,850 $183,250 33% $183,250 $398,350 35% $398,350 $400,000 39.6% $400,000

On your dividend of $500, you owe:$500 x 0.396 = $198 in taxes

It’s important to keep these taxes in mind.

If you receive $500 in interest or as a dividend,

you don’t actually have an extra $500 to spend!

If you sell a stock or bond for more than you pay for it, you have made a capital gain.

Examples: Buy a bond for $1,000, sell it for $1,200 =

Capital gain of $200

Buy stock for $10, sell it for $50 = Capital gain of $40

If you owned the stock or bond for less than one year, you have made a short term capital gain.

These gains are taxed like dividends are, i.e.,according to your tax bracket

Suppose your short term capital gain is $1,000 and your taxable income is $100,000.

On your capital gain of $1,000, you owe:$1000 x 0.28 = $280 in taxes

Tax brackets for a single person for 2013

Tax Bracket Tax Rate over but not over 10% $0 $8,925 15% $8,925 $36,250 25% $36,250 $87,850 28% $87,850 $183,250 33% $183,250 $398,350 35% $398,350 $400,000 39.6% $400,000

If you owned the stock for more than one year before selling it, you’ve made a long term capital gain.

Long term gains are taxed at 0%, 15%, or 20%, depending on which tax bracket your regular taxable income is in.

Tax brackets for a single person for 2013

Tax Bracket Tax Rate over but not over 10% $0 $8,925 15% $8,925 $36,250 25% $36,250 $87,850 28% $87,850 $183,250 33% $183,250 $398,350 35% $398,350 $400,000 39.6% $400,000

On your long term capital gain of $1,000, you owe:

$1,000 x 0.15 = $150 in taxes

Long Term Capital Gains Tax Rate

0%0%

15%15%15%15%20%

You do not owe capital gains taxes until you sell your stock or bond.

If you sell a stock or bond for less than you pay for it, you do not owe

taxes on your loss amount.

SOLD !!

The Time Value of Money

Intuitively we understand that an amount of money today is more valuable than the same amount of money in the future.

- inflation- earn interest

Suppose you’d like to have $10,000 in 5 years.

If your account pays 8% interest annually, how much would you have to put in today to yield $10,000 in 5 years?

Future Value = $10,000

Present Value = ?

trFVPV

1

interest rate

number of years

trFVPV

1

FV = $10,000r = 8% = 0.08t = 5 508.01

000,10$

PV

4693.1000,10$

PV 96.805,6$

If you put $6,805.96 in an account earning 8% interest, in 5 years you would have $10,000.

The present value of $10,000 five years from now is $6,805.96 today (assuming 8% interest rate).

Suppose you don’t have that sum of money to start with and instead want to make annual contributions to your account.

1)1()(

trrFVPayment

FV = $10,000r = 0.08t = 5

4693.0800$

Payment 67.704,1$

If every year you put $1,704.67 in an account earning 8% interest, in 5 years you would have $10,000.

1)1()(

trrFVPayment

1)08.01()08.0(000,10$

5 Payment

If you wanted to make monthly contributions, you’d use the same formula, with a slight modification.

Annual contribution Monthly contribution

1)1()(

trrFVPayment

112

1

12)12)((

tr

rFVPayment

FV = 10,000r = 0.08/12 =0.0067t = (5)(12) = 60

493.067

Payment 90.135$

If every month you put $135.90 in an account earning 8% interest, in 5 years you would have $10,000.

1)1()(

trrFVPayment

1)0067.01()0067.0(000,10

60 Payment

According to a Wall Street Journal article, the average cost of a wedding is $18,000 and the average bride is 26 years old. “A Lavish Wedding Costs More Than You Think” 2.20.2010

Suppose a woman took that $18,000 and invested it, earning 4% interest. How much money would she have when she retired?

Assume 40 working years, retiring at 66 years of age.

Future Value = ?

Present Value = $18,000

trPVFV )1(

interest rate

number of years

PV = $18,000r = 4% = 0.04t = 40

40)04.01(000,18$ FV

37.418,86$FV

If she put $18,000 in an account earning 4% interest, in 40 years she would have $86,418.37.

trPVFV )1(

)801.4(000,18$FV

For every one dollar spent now, she foregoes $4.80 of future dollars.

PV = 1r = 4% = 0.04t = 40

40)04.01(1 FV

80.4$FV

trPVFV )1(

)801.4(1FV

For every one dollar spent today, this woman foregoes having more dollars in the future.

Factors that increase the future value of your money:

• Start with a larger amount now (PV)

• Earn a higher interest rate (r)

• Start investing sooner, so the number of years is larger (t)

trPVFV )1(

Suppose you deposit $1000 into an account that pays you 10% interest. One year later you have $1100.

If inflation that year is:

0% then your purchasing power has increased by 10%.2% then your purchasing power has increased by 8%.10% then your purchasing power has not changed.13% then your purchasing power has decreased by 3%.

The nominal interest rate is the interest rate as reported. It’s the rate you:• See on your credit card statement• Pay on your car loan• Earn on your savings account

The real interest rate is the rate earned after the effects of inflation are taken out.

Nominal versus Real Interest Rate

Relationship Between Real and Nominal Interest Rates

Real Inflation Nominal interest rate + rate = interest rate

Back to example: Nominal interest rate = 10%

If inflation is 0%:Real interest rate + 0% = 10%Real interest rate = 10%

If inflation is 7%:Real interest rate + 7% = 10%Real interest rate = 3%

When investing your money, you’d like the nominal interest rate to exceed the inflation rate.

• Then the real interest rate will be positive.

• Your purchasing power is growing.

At the very least, you’d like the nominal rate to be equal to the inflation rate.

• Then your real interest rate is zero.• Your purchasing power is constant

over time.

The Lender’s Point of View

When making a loan, the lender will quote you the nominal interest rate.

To determine the nominal interest rate to charge you:

Real rate of return + Risk premium + Expected inflation rate Nominal interest rate

3%+ 2%+ 4% 9%

© 2013 Colorado Council for Economic Education www.ccee.net