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Investment in Financial Capital

Investment in Financial Capital. 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.

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Investment in Financial Capital

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  1. Investment in Financial Capital

  2. 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. Objectives

  3. 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?

  4. Steps to Create a Personal Investing Plan Step 1 My investment goals are: ____________________ ____________________ Step 2 By ___________, I will have obtained $_______. Step 3 I have $__________ available to invest. Date _____________ Step 9 Continue evaluating choices. Step 4 Possible investment alternatives: 1._________________ 2._________________ 3._________________ 4._________________ Step 8 Final decision 1._______________ 2._______________ Step 6 Projected return on each alternative 1.__________ 2.__________ 3.__________ 4.__________ Step 5 Risk factors for each alternative 1.____________________ 2.____________________ 3.____________________ 4.____________________ Step 7 Investment decision 1._______________ 2._______________ 3._______________

  5. 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.

  6. Difference in return is a major distinction between savings and investing. Successful investors begin to live off earnings, without spending wealth itself. Investment Fundamentals ATTENTION!

  7. Investment in Financial Capital • Investment - use of economic resources to make a profit. • Financial Capital - liquid resources of a government, business, or individual

  8. Achieve financial goals Increase current income Gain wealth and financial security Have funds available for retirement Preparations for Investing WHY PEOPLE INVEST:

  9. Live within means Continue savings program Establish lines of credit Carry adequate insurance Establish investment goals Preparations for Investing PREREQUISITES TO INVESTING:

  10. Interest Dividends Rent Capital gain/loss Rate of return or yield Preparations for Investing INVESTMENT RETURNS:

  11. 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

  12. 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

  13. Value of Having a Long-Term Investing Program • Many people don’t start investing because they only have a small amount to investbut.... • Small amounts invested regularly become large amounts over time

  14. Personal Investment Philosophy • Handling risk • Ultraconservative strategies • Conservative • Moderate • Aggressive

  15. Personal Investment Philosophy • Handling risk • Ultraconservative strategies • Conservative • Moderate • Aggressive

  16. Investment Selection • Lend or own • Short-term or long-term • Choose a vehicle

  17. 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

  18. 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

  19. 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

  20. 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

  21. 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.

  22. Risk Tolerance Quiz • Take the quiz listed in notes…. • http://www.ag.ndsu.edu/money/05%20Risk%20Tolerance%20Quiz.pdf

  23. Income From Investments • Safest • CDs • savings bonds • T-bills • Higher potential income • municipal bonds • corporate bonds • preferred stocks • mutual funds • real estate

  24. CommoditiesJunk bondsOptions High Quality Rentalproperty Stocks Mutual funds Government Corporatebonds Utility stocks Securities MoneyMarket Savings Accounts CDs Cash Investment Pyramid High risk Lowrisk

  25. 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

  26. Major Factors That Affect Rate of Return • INVESTMENT RISK: • Pure • Speculative • Risk pyramid

  27. Major Factors That Affect Rate of Return • INVESTMENT RISK TYPES: • Financial • Market volatility • Political • Inflation • Deflation • Interest rate

  28. Major Factors That Affect Rate of Return • INVESTMENT RISK: • Random or unsystematic • Diversification • Market or systematic

  29. Major Factors That Affect Rate of Return • Leverage • Taxes • Marginal tax rate • Taxable vs. tax-free income • Buying and selling costs/commissions • Inflation

  30. Major Factors that Affect Rate of Return • CALCULATE REAL RATE OF RETURN: • Identify before-tax return • Subtract marginal tax rate • Obtain net return after taxes • Subtract estimate of inflation • Obtain real rate

  31. Real Rate of Return Example • 1. You are in the 28 percent tax bracket. • 1.0 - .28 = .72 • If the yield on your investment is 6.25% then: .0625 x .72 = .045 • Your after tax return is 4.5% • If inflation is 5%, your real rate of return after inflation is 4.75% (.05 x (1-.05) = .0475

  32. Management Strategies — Long-Term Investors • Business-cycle timing • Dollar-cost averaging • Portfolio diversification • Asset allocation

  33. Investment Alternatives • What is stock? • part ownership in a company • the money you pay for shares of stock provides equity capital for the business

  34. Investment Alternatives (continued) • What is a bond? • a loan to a corporation, the federal government, or a municipality • The interest is paid twice a year, and the principal isrepaid at maturity (1-30 years) • You can keep the bond until maturity or sell it to another investor

  35. Investment Alternatives (continued) • What is a mutual fund? • investors’ money is pooled and invested by a professional fund manager • you buy shares in the fund • provides diversification to reduce risk • funds range from conservative to extremely speculative • match your needs with a fund’s objective

  36. annual income from investment market value of the investment Monitor Your Investments • Read your account statements • Chart the value of your investments • Maintain accurate and current records • Calculate the current yield %

  37. 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

  38. Investment Philosophies

  39. Best Time to Sell • Take profits • Cut losses • “If wouldn’t buy it now, sell it”

  40. Mandatory Financial Investment for Retirement • Employer / Employee Social Security Contributions (15.3% of earnings up to a maximum taxable amount of $106,800 in 2009) • Defined Benefit Private Pension Plans

  41. Discretionary Financial Investment for Retirement • Defined Contribution Pension Plans • 401(k), 403(b), IRA • Roth IRA • Roth 401(k)

  42. Income and Consumption Over the Life Cycle

  43. 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.

  44. 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.

  45. 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

  46. 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%

  47. 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.

  48. 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

  49. http://cpsinsurance.com/annuity/client_handouts/Real%20Rate%20of%20Return%20BW.pdfhttp://cpsinsurance.com/annuity/client_handouts/Real%20Rate%20of%20Return%20BW.pdf

  50. Annual returns for stocks, T Bonds, T Bills from 1928 - 2008 • http://pages.stern.nyu.edu/~adamodar/New_Home_Page/datafile/histretSP.html

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