Personal Finance

Chapter 13
Canaday
ESTABLISHING INVESTMENT GOALS

• Can be stated in terms of money or specific goals such as being able

to buy a house in 5 years.
 ESTABLISHING INVESTMENT GOALS
• The following questions will help you establish valid investment goals:
• 1. How much money do you need to satisfy your investment goals?
• 2. How will you obtain the money?
• 3. How long will it take you to obtain the money?
• 4. How much risk are you willing to assume in an investment program?
• 5. What possible economic or personal conditions could alter your investment goals?
• 6. Are you willing to make the sacrifices necessary to ensure that you meet your
• investment goals?
• 7. What will the consequences be if you don’t reach your investment goals?
• 8. Considering your economic circumstances, are your investment goals reasonable?
ESTABLISHING INVESTMENT GOALS

• Your investment goals are always oriented toward the future. Earlier, we classified
• goals as short term (within the next year), intermediate (one to five years), or long
• term (more than five years). These same classifications are also useful in planning
your investment planning.
PERFORMING A FINANCIAL CHECKUP

• We examine several factors you should consider before making your first
investment.
PERFORMING A FINANCIAL CHECKUP
• WORK TO BALANCE YOUR BUDGET.
• MANAGE YOUR CREDIT CARD DEBT
• Many individuals regularly spend more than they make. If you are paying high
interest rates on credit card balances or short/intermediate loans, it makes sense to
get your budget in order and pay these off before adding more to investments.
Why? The interest rate you will be paying on these debts will be greater than the
expected returns from the investments.
PERFORMING A FINANCIAL CHECKUP
• START AN EMERGENCY FUND
• An emergency fund is an amount of money you can obtain quickly in case of
immediate need.
• Have some liquid funds that can be easily accessed in case you run into a severe
negative financial shock such as job loss, someone in your family getting sick that
costs where it costs lots of money and/or lost wages, etc.
• HAVE ACCESS TO OTHER SOURCES OF CASH FOR EMERGENCY
NEEDS
• If you don’t think your emergency funds are sufficiently large, you may also want
to establish a line of credit with a financial institution. The cash advance provision
offered by major credit card companies can also be used in an emergency but has
discussed earlier can be costly.
MANAGING A FINANCIAL CRISIS
• Sometimes macroeconomies go through periods of crisis. To manage a financial
crisis, many experts recommend that you take action to make sure your financial
affairs are in order.
• Here are eight steps you can take:
• 1. Establish a larger than usual emergency fund. Under normal circumstances, an
emergency fund of three months’ living expenses is considered adequate, but you
may want to increase your fund in anticipation of a crisis.
• 2. Know what you owe. Make a list of all your debts and the amount of the
required monthly payments, and then identify the debts that must be paid.
• 3. Reduce spending. If you spending more than you make or aren’t saving enough
to manage a future crisis then cut back to the basics and reduce the amount of
money spent on entertainment, dining at restaurants, and vacations.
MANAGING A FINANCIAL CRISIS
• Eight steps continued:
• 4. Pay off credit cards. Get in the habit of paying your credit card bill in full each
month. People may be tempted to buy things they can’t really afford with credit
cards but the interest rates aren’t low.
• 5. Apply for a line of credit.
• 6. Notify credit card companies and lenders if you are unable to make payments.
Actually even if you are able to pay but are revolving debt you can ask the
financial institution to see if you can get a lower rate. If not you can try to move
the debt somewhere else with balance transfers or to a personal loan.
MANAGING A FINANCIAL CRISIS
• Eight steps continued:
• 7. Monitor the value of your investment and retirement accounts. Tracking the
value of your stock, mutual fund, and retirement accounts, for example, will help
you decide which investments to sell if you need cash for emergencies.
• 8. Consider converting investments to cash to preserve value. I suggest this only
as last resort.
GETTING THE MONEY NEEDED TO STARTAN INVESTMENT
PROGRAM
• PRIORITY OF INVESTMENT GOALS How badly do you want to achieve
your investment goals? Are you willing to sacrifice some purchases to provide
financing for your investments? The answers to both questions are extremely
important.
• What is important to you? What do you value? Each of these questions affects
your investment goals. At one extreme are people who save or invest as much of
each paycheck as they can. At the other extreme are people who spend everything
they make and run out of money before their next paycheck. Most people find
either extreme unacceptable and take a more middle-of-the-road approach.
GETTING THE MONEY NEEDED TO STARTAN INVESTMENT
PROGRAM
• An easy way to begin an investment program is to participate in an employer-
sponsored retirement account—often referred to as a 401(k) or a 403(b) account.
Many employers will match part or all of your contributions to a retirement
account.
• If you ever work somewhere with a employer contribution matching plan, I
suggest contribute enough so the employer contributions are maximized. It’s
equivalent to getting a pay raise.
• At one university I worked at when I contributed 6% of my gross salary the
university matched 8.5% of my gross salary. Any employee not contributing
gives up 8.5%, although you can’t access employer contributions until retirement
age.
• But not all employers in the United States have 401K plans or have plans with
high matching rates, but as we discussed earlier even contributions to IRAs are tax
deferred.
THE VALUE OF LONG-TERM INVESTMENT PROGRAMS
• There is no better time to begin an investment program than when you are young.
You should be familiar with the time value of money and the impact compounding
has over time.
THE VALUE OF LONG-TERM INVESTMENT PROGRAMS
THE VALUE OF LONG-TERM INVESTMENT PROGRAMS
 Factors Affecting the Choice of Investments
• Assess how safety, risk, income, growth, and liquidity affect your investment decisions.
• SAFETY AND RISK
• There is a tradeoff between safety and risk. Safety in an investment means minimal risk of
loss. On the other hand, risk in an investment means a measure of uncertainty about the
outcome.
• Investments range from very safe to very risky. Investments in certificates of deposit,
savings accounts, and short-term government bonds are extremely safe. On the other
hand, a speculative investment is a high-risk investment made in the hope of earning a
relatively large profit in a short time. Such investments offer the possibility of larger
dollar returns, but if they are unsuccessful, you may lose most or all of your initial
investment.
 Factors Affecting the Choice of Investments
• Assess how safety, risk, income, growth, and liquidity affect your investment decisions.
• SAFETY AND RISK
• There is a tradeoff between safety and risk. Safety in an investment means minimal risk of
loss. On the other hand, risk in an investment means a measure of uncertainty about the
outcome.
• Investments range from very safe to very risky. Investments in certificates of deposit,
savings accounts, and short-term government bonds are extremely safe. On the other
hand, a speculative investment is a high-risk investment made in the hope of earning a
relatively large profit in a short time. Such investments offer the possibility of larger
dollar returns, but if they are unsuccessful, you may lose most or all of your initial
investment.
 Factors Affecting the Choice of Investments
• EVALUATING YOUR TOLERANCE FOR RISK When investing, not everyone has the
same tolerance for risk.
• Some common factors influencing risk tolerance are:

• When people choose investments that have a higher degree of risk, they expect larger returns.
Simply put, one basic rule sums up the relationship between the factors of safety and risk: The
potential return on any investment should be directly related to the risk the investor assumes.
 Factors Affecting the Choice of Investments
• CALCULATING RETURN ON AN INVESTMENT When you invest, you expect a
return on your investment. To calculate rate of return, the total income you receive on
an investment over a specific period of time is divided by the original amount invested.
 COMPONENTS OF THE RISK FACTOR
• There are many types of risk with investments. Note that each type of investment does
not necessarily have each type of risk.
• INFLATION RISK
• If your investment specifies fixed payments and inflation rises above what was excepted
the real rate of return on the investment will fall.
• For example you invest $10,000 in a one year investment specifying a 10% rate of return
and you expect a 2% inflation rate. Therefore you expect roughly a 8% real rate of return.
But if inflation over the year turns out to be 30% your real rate of return would be
negative.
• Recall that 1 + i = (1+r)(1+inf) or i = r + inf + r*inf where i is the nominal rate, r the real
rate, inf the inflation rate.
• Solve for r, r = i-inf/1+inf = (0.1 – 0.3)/(1+0.3) = -15.4%
 COMPONENTS OF THE RISK FACTOR
• INFLATION RISK
• Investments indexed to price indexes eliminate inflation risk but also all else constant
offer lower returns (because the borrower is taking on the inflation risk).
• There is much less inflation risk with equities such as buying stocks. Why? Well, if there
is inflation companies will be able to increase the prices of the products they sell. Both
costs and revenues for companies rise with inflation.
 COMPONENTS OF THE RISK FACTOR
• INTEREST RATE RISK This risk may be related to inflation risk as interest rates can rise
due to rises expected inflation or rises in real interest rates. The interest rate risk
associated with government or corporate bonds or preferred stock is the result of changes
in the interest rates in the economy.
 I don’t like this approximate market value
COMPONENTS OF THE RISK FACTOR
calculation on page 434. IT can be way off!
• INTEREST RATE RISK
See below.

Actual calculation if the bond matures in one year. Suppose the bond matures in one year.
At the end of one year it will pay out the face value of $!,000 and the coupon of $100 for a
total of $1,100. If interest rates rise to 11%. What is $1,100 in one year worth in present
value terms when the interest rate is 11%? $1,100/(1+.11) = $990.99. So the value of your
bond would fall from $1,000 to $990.99.
 COMPONENTS OF THE RISK FACTOR
• The actual drop in bond prices associated with the fall in interest rates depends on the
time to maturity. For a short term bond the price change is relatively small. In the one
year example the price fell from $1,000 to $990.99.
• The longer the time to maturity, the larger the impact a given interest rate change has on a
price of a bond.
• In other words. longer-term bonds have more inflation risk than short term bonds.
 COMPONENTS OF THE RISK FACTOR
• A coupon bond of face value of $1,000 and a coupon payment of 10% that lasts for two
years with coupon payments once a year would pay the investor the following cash flows:
$100 in one year and $1,100 in two years. In year one, it just pays the coupon of $100
(coupon rateXface value), but when the bond matures in two years it pays a coupon of
$100 and the face value amount of $1,000.
• What is the Present Value of these cash flows?
• PV = $100/(1+i) + $1,100/(1+i)^2 When i is 10%, PV = $100/1.1 + $1,100/(1.1)^2 =
$1,000.
• What happens if the interest rate goes up to 11%?
• PV = $100/1.11 + $1,100/(1.11)^2 = $982.87.
• Thus, the interest rate rise from 10% to 11% causes the price of the bond to fall more for
the two year bond ($1,000 to $982.87) than the one year bond ($1,000 to $990.99).
 COMPONENTS OF THE RISK FACTOR
• BUSINESS FAILURE RISK
• The risk of business failure is associated with investments in stock, municipal bonds,
corporate bonds, and mutual funds that invest in stocks or bonds. With each of these
investments, you face the possibility that bad management, unsuccessful products,
competition, or a host of other factors will cause the business to be less profitable than
originally anticipated.
• I think it is common practice and that it makes more sense to think of this type of risk as a
part of market risk which we will discuss shortly
 COMPONENTS OF THE RISK FACTOR
• GLOBAL INVESTMENT RISK Some markets in the world can go up while others go
down. I also think it makes sense to think about this in terms of market risk which we
will discuss next except for then exchange rate component.
• If you invest in other currencies your rate of return does not only depend on the rate of
return on the investment but on what happens to the exchange rate (assuming you want
the money brought back into your domestic currency).
• For example if you buy a stake in real estate in the United States and earn a 10% rate of
return, your net return can be greater or less than 10% depending on what happens to the
RMB-USD exchange rate over the course of the investment.
 COMPONENTS OF THE RISK FACTOR
• MARKET RISK Two different types of risk—systematic and unsystematic—can
• affect the market value of stocks, bonds, mutual funds, real estate, and other investments.
• Systematic risk occurs because of overall risks in the market and the economy.
• Factors such as an economic crisis, increasing interest rates, changes in consumer
purchasing power, and wars all represent sources of systematic risk. Because this type of
risk affects the entire market, it is not possible to eliminate the risk through
diversification.
• Unsystematic risk affects a specific company or a specific industry.
• Because this type of risk affects one company or one industry, unsystematic risk can be
reduced by diversifying an investment portfolio. For example, an investor who owns 30
different stocks in different industries can reduce unsystematic risk because she or he is
well diversified.
 COMPONENTS OF THE RISK FACTOR
• Investors holding onto unsystematic risk will NOT be compensated with higher expected
returns because this type of risk can easily be eliminated through diversification.
 Investment Income vs Growth
• INVESTMENT INCOME
• Investors sometimes purchase certain investments because they want a predictable source
of income. If investment income is a primary objective, you can also choose municipal
bonds, corporate bonds, preferred stocks, utility stocks, or selected common stock issues.
• When purchasing these investments, most investors are concerned about the
issuer’sability to continue making periodic interest or dividend payments.
• INVESTMENT GROWTH
• To investors, growth means their investments will increase in value. Often the greatest
opportunity for growth is an investment in common stock. Companies with better than
average earnings potential, sales revenues that are increasing, and managers who can
solve the problems associated with rapid expansion are often considered to be growth
companies. These same companies generally pay little or no dividends. Thus, investors
often sacrifice immediate cash dividends in return for greater dollar value in the future.
 Asset Allocation and Investment Alternatives
• Asset allocation is the process of spreading your assets among several different types
• of investments (sometimes referred to as asset classes) to lessen risk. While the term
• asset allocation is a fancy way of saying it, simply put, it really means that you need
• to diversify and avoid the pitfall of putting all your eggs in one basket—a common
• mistake made by investors.
 Asset Allocation and Investment Alternatives
• The diversification provided by investing in different asset classes provides a measure of
safety and reduces risk, because a loss in one investment is usually offset by gains from
other types of investments. Typical asset classes include
• • Stocks issued by large corporations (large cap).
• • Stocks issued by medium-size corporations (midcap).
• • Stocks issued by small, rapidly growing companies
• (small cap).
• • Foreign stocks.
• • Bonds.
• • Cash.
• Note: Mutual funds can also be included as an asset class, but the typical mutual fund will
invest in the above securities or a combination of the above securities.
 Asset Allocation and Investment Alternatives
• The percentage of your investments in each asset class should be heavily influenced by
your risk tolerance which depends on many factors such as age, investment objectives,
etc.
• To help you decide how much risk is appropriate for your investment program, many
financial planners suggest that you think of your investment program as a type of pyramid
with four levels.
Asset Allocation and Investment Alternatives
 Asset Allocation and Investment Alternatives
• The percentage of your investments in each asset class should be heavily influenced by
your risk tolerance which depends on many factors such as age, investment objectives,
etc.
• To help you decide how much risk is appropriate for your investment program, many
financial planners suggest that you think of your investment program as a type of pyramid
with four levels.