Investment in Financial Capital
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Investment in Financial Capital
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Objectives
• Summarize reasons why people invest, what is required before beginning, how returns are earned, and some ways to obtain funds to invest.
• Determine your own investment philosophy.• Recognize the variety of investments available. • Identify the major factors that affect the return on
investment.• Specify some strategies of portfolio management
for long-term investors.• List three guidelines to use when deciding the
best time to sell investments.
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Establishing Investment Goals
• Financial goals should be specific and measurable.
• Why are you accumulating these funds?• How much do you need?• How will you get it?• How long will it take you to reach your goal? • How much risk are you willing to assume?• Are you willing to sacrifice current consumption to
invest for the future?• Is it realistic to try and save this amount?
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What are your financial goals?
• Financial Independence• Just starting your own financial life apart from your
parent(s)/guardian(s)• Financial Stability
• Managing all of your financial resources effectively, but unprepared to meet financial emergencies
• Financial Security• The ability to manage and absorb financial
emergencies• IMO, one of the best and easiest ways to attain
Financial Security is to create passive income through investments
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Steps to Create a Personal Investing Plan
Step 1My investment goals are:________________________________________
Step 2By ___________, I will
have obtained $_______.
Step 3I have $__________available to invest.
Date _____________
Step 4Possible investment alternatives:
1._________________2._________________3._________________4._________________
Step 5Risk factors for each alternative
1.____________________2.____________________3.____________________4.____________________
Step 6Projected return on each alternative
1.__________2.__________3.__________4.__________
Step 7Investment decision1._______________2._______________3._______________
Step 8Final decision
1._______________2._______________
Step 9Continue evaluating choices.
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Definitions:
• Saving: setting money aside for future use
• Investing: Putting the money to work for you or using your money to make more money
• Borrowing: Using next year’s income this year.
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Investment Fundamentals
•Difference in return is a major distinction between savings and investing.
•Successful investors begin to live off earnings, without spending wealth itself.
ATTENTION!
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Investment in Financial Capital
•Investment - use of economic resources to make a profit.
•Financial Capital - liquid resources of a government, business, or individual
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Preparations for Investing
• Achieve financial goals
• Increase current income
• Gain wealth and financial security
• Have funds available for retirement
WHY PEOPLE INVEST:
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Preparations for Investing
• Live within means
• Continue savings program
• Establish lines of credit
• Carry adequate insurance
• Establish investment goals
PREREQUISITES TO INVESTING:
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• Interest
• Dividends
• Rent
• Capital gain/loss
• Rate of return or yield
Preparations for Investing
INVESTMENT RETURNS:
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Performing a Financial Checkup
• Learn to live within your means• pay off high interest credit card debt
• Provide adequate insurance protection• Start an emergency fund
• three to nine months of living expenses• Have other sources of cash for emergencies
• line of credit• cash advance
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Getting Money to Start an Investing Program
• Pay yourself first• Participate in elective savings programs
• Payroll deduction• electronic transfer
• Make a special effort to save one or two months a year
• Take advantage of windfalls• Invest half of
your tax refund
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Value of Having a Long-Term Investing Program
• Many people don’t start investing because they only have a small amount to invest
but....
• Small amounts invested regularly become large amounts over time
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• Handling risk
• Ultraconservative strategies
• Conservative
• Moderate
• Aggressive
Personal Investment Philosophy
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• Handling risk
• Ultraconservative strategies
• Conservative
• Moderate
• Aggressive
Personal Investment Philosophy
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Investment Selection
• Lend or own
• Short-term or long-term
• Choose a vehicle
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Two ways to invest
• Lend: Promise of repayment of loan (principal) and interest• Deposit money in bank• Lending money to the government• Lending money to a business
• Own: Purchase an asset or equity• Buy stock• Buy mutual funds• Buy real estate• Buy collectibles
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Factors That Affect Investment Decisions
• Safety - minimal risk of loss• Risk - uncertainty about the
outcome• inflation risk• interest rate risk•business failure risk•market risk
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Factors that influence the investment decision: Risk Tolerance
• Risk represents the uncertainty that the yield on an investment will deviate from what is expected.
• The amount of risk a household can tolerate will determine:• The decision to invest• The type of investment• The investment strategy• The amount of investment
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Types of Investment Risk
• Inflation risk: investment returns will not keep up with inflation.
• Default risk: the risk of losing a major portion of or all of your investment
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Types of Investment Risk
• Interest rate risk: market interest rates rise devaluing fixed rate investments
• Marketability risk: having to sell a certain asset quickly; not being able to get the price you want. Also called liquidity risk.
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Risk Tolerance Quiz
• Take the quiz listed in notes….
http://njaes.rutgers.edu/money/riskquiz/
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Income From Investments
• Safest• CDs• savings bonds• T-bills
• Higher potential income• municipal bonds• corporate bonds• preferred stocks• mutual funds• real estate
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Investment Pyramid
CommoditiesJunk bonds
Options
Rentalproperty
Utility stocks
GovernmentSecurities
Corporatebonds
CDsMoneyMarket
Savings Accounts Cash
High QualityStocks
Mutual funds
High risk
Lowrisk
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Investment Growth and Liquidity
• Growth• increase in value•common stock•growth stocks retain earnings•bonds, mutual funds and real estate
• Liquidity•ease and speed to convert an asset to
cash
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• Pure
• Speculative
• Risk pyramid
• INVESTMENT RISK:
Major Factors That Affect Rate of Return
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• Inflation
• Deflation
• Interest rate
• Financial
• Market volatility
• Political
• INVESTMENT RISK TYPES:
Major Factors That Affect Rate of Return
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• Random or unsystematic
• Diversification
• Market or systematic
• INVESTMENT RISK:
Major Factors That Affect Rate of Return
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• Leverage
• Taxes• Marginal tax rate• Taxable vs. tax-free income
• Buying and selling costs/commissions
• Inflation
Major Factors That Affect Rate of Return
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Risk Tolerance
., REVIEW BOOK: Personal Finance. Retrieved Oct 1, 2009 from http://www.flatworldknowledge.com/node/50890 .
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Calculating Percentage Rate of Return
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1. Identify before-tax return
2. Subtract marginal tax rate
3. Obtain net return after taxes
4. Subtract estimate of inflation
5. Obtain real rate
Major Factors that Affect Rate of Return
• CALCULATE REAL RATE OF RETURN:
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Real Rate of Return Example
1. You are in the 28 percent tax bracket.
2. 1.0 - .28 = .72
3. If the yield on your investment is 6.25% then: .0625 x .72 = .045
4. Your after tax return is 4.5%
5. If inflation is 5%, your real rate of return after inflation is 4.75% (.05 x (1-.05) = .0475
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• Business-cycle timing
• Dollar-cost averaging
• Portfolio diversification
• Asset allocation
Management Strategies — Long-Term Investors
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Investment Alternatives
• What is stock? •part ownership in a
company• the money you pay for
shares of stock provides equity capital for the business
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An Example of Asset Allocation
., REVIEW BOOK: Personal Finance. Retrieved Oct 1, 2009 from http://www.flatworldknowledge.com/node/50890 .
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Levels of Diversification
., REVIEW BOOK: Personal Finance. Retrieved Oct 1, 2009 from http://www.flatworldknowledge.com/node/50890 .
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Investment Alternatives
• What is a bond? • a loan to a corporation, the
federal government, or a municipality
• The interest is paid twice a year, and the principal isrepaid at maturity (1-30 years)
• You can keep the bond until maturity or sell it to another investor
(continued)
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Investment Alternatives
• What is a mutual fund? • investors’ money is pooled and invested
by a professional fund manager• you buy shares in the fund• provides diversification to reduce risk • funds range from conservative
to extremely speculative• match your needs with
a fund’s objective
(continued)
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Monitor Your Investments
• Read your account statements• Chart the value of your investments• Maintain accurate and current
records• Calculate the current yield %
annual income from investment
market value of the investment
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Sources of Investment Information
• Newspapers• Business Periodicals• Government Publications• Corporate Reports• Statistical Averages• Investor Services and newsletters
• Standard and Poor’s stock reports• Value Line• Moody’s investment service
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Investment Philosophies
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Best Time to Sell
• Take profits
• Cut losses
• “If wouldn’t buy it now, sell it”
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Mandatory Financial Investment for Retirement• Employer / Employee Social Security
Contributions (15.3% of earnings up to a maximum taxable amount of $110,000 in 2012)
• Defined Benefit Private Pension Plans
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• Defined Contribution Pension Plans• 401(k), 403(b), IRA• Roth IRA• Roth 401(k)
Discretionary Financial Investment for Retirement
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Income and Consumption Over the Life Cycle
0
10,000
20,000
30,000
40,000
50,000
60,000
70,000
25 35 45 55 65 75 85
Age
$
Income
Consumption
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Measures of Risk
• Beta - measures the variability in the rate of return of a particular stock relative to the larger stock market. • Beta stock A = 3.0 means the variability in
the rate of return of stock A is three times the market average
• Bond ratings - Standard and Poor’s and Moody’s ratings of bonds for default risk only.
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The Relationship Between Rate of Return and Risk
• Risk and average rate of return are positively correlated.
• Risk and variance of rate of return are positively correlated.
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Measuring the Rate of Return
• Typically think of rate of return in terms of interest paid per $1.00 invested. But, the timing of when you get this return varies depending on…
• income return - situation where the principal that is invested remains the same but the investor periodically receives income based on this investment.• Certificates of deposit• money market funds• bond interest• stock dividends
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Calculating the Return on an Investment
Rate of Return is the total income you receive on an investment over a specific period of time divided by the original amount invested.
For example:
Assume you invest $3,000 in a mutual fund. Also assume the mutual fund pays you $50 dividends this year and that the mutual fund is worth $3,275 at the end of the year.
Step 1: Subtract the investment’s initial value from the investment’s value at the end of the year: $3,275 - $3,000 = $275
Step 2: Add the annual income to the amount calculated in Step 1.
$50 + $275 = $325
Step 3: Divide the total dollar amount of return calculated in Step 2 by the original investment.
$325/$3,000 = 0.108 = 10.8%
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Measuring the Rate of Return
• Capital gain - situation where you get your return only when you sell the investment. •stocks•Real Estate•collectibles
• Sometimes, you get a combination of income and capital gains… makes it even more difficult to calculate the rate of return.
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Measuring the Rate of Return
• The risk-return trade-off can also be managed by having a variety of investments in your portfolio
• BE DIVERSIFIED!
• Statistically, you need between 6-15 stocks in different in different industries to be fully diversified in the market
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Annual returns for stocks, T Bonds, T Bills from 1981 - 2011
Average $100 invested in 1981 was worth___ in 2011:
Common Stocks-S&P 500
10.42% $2,160.13
Small Company Stocks
9.55% $1,690.38
Treasury Bills 5.20% $481.38
Treasury Bonds 10.69% 2,330.02
• http://huntingtonfunds.com/ftp/brochures/Real_Return_CDs.pdf