Mankiw, Cha. 14 - The Basic Tools of Finance

finance

the field that studies how people make decisions regarding the allocation of resources over time and the handling of risk.

Money TODAY is more valuable than the same amount of money in the FUTURE due to the fact that savings can earn interest.

Money _(when?)_ is more valuable than the same amount of money _(when?)__

present value

the amount of money today needed to produce a future amount of money, given prevailing interest rates.

future value

the amount of money in the future that an amount of money today will yield, given prevailing interest rates.

compounding

the accumulation of a sum of money in, say, a bank account, where the interest earned remains in the account to earn additional interest in the future.

If r is the interest rate, than an amount X to be received in N years has a present value of {X divided by [(1 + r) to the Nth power] }.

OR… present value = future value / (1 + r).

present value formula -

If n represents the number of years and r is the interest rate…

future value = present value x [(1 + r) to the power of n].

future value formula -

discounting

It is called “discounting” because… remember: Money TODAY is more valuable than the same amount of money in the FUTURE.

the process of finding the present value of a future sum of money.

The rule of 70 clarifies the effects of compounding.

According to the rule of 70, if some amount grows at a rate of x percent per year, then that amount doubles in approximately 70/x years.

So… the higher the interest rate, the faster the amount will double.

What is the rule of 70?

risk averse

a dislike of uncertainty.

utility

a person’s subjective measure of well-being or satisfaction.

adverse selection

High-risk people benefit more from insurance protection and, therefore, are more likely to buy insurance than low-risk people.

moral hazard

After people buy insurance, they have less incentive to be careful about risky behavior because the insurance company will cover much of their losses.

diversification

the reduction of risk achieved by replacing a single risk with a large number of smaller, imperfectly correlated risks.

standard deviation

a statistic which measures the volatility of a variable - that is, how much a variable can be expected to fluctuate.

larger risk and potentially larger reward.

Larger standard deviation equals larger _?_ and potentially larger _?_.

firm-specific risk

risk that affects only a single company.

market risk

risk that affects all companies in the stock market.

firm-specific risk

Which kind of risk can be eliminated by increasing the number of stocks in a portfolio?

NO!

Can market risk ever be eliminated?

1). overvalued - the price is more than the value,

2). fairly valued - the price and value are equal,

3). undervalued - the price is less than the value.

the three different ways a stock can be valued:

You should search for undervalued stocks, because you will pay less than the business is worth.

When shopping for stocks, you should search for stocks that are valued in what way?

fundamental analysis

the study of a company’s accounting statements and future prospects to determine its value.

1). Do the research yourself by reading the companies’ annual reports,

2). rely on the advice of Wall Street analysts,

3). buy shares in a mutual fund, which has a manager who makes decisions for you.

three ways to rely on fundamental analysis when choosing a stock portfolio:

1). price,

2). dividend,

3). price-earnings ratio.

three key numbers to consider when following the stock of a company:

retained earnings

a company’s profits which are not paid out, and can be used to finance capital investments, increase cash reserves, or buy back their own shares.

dividend yield

the dividend expressed as a percentage of the stock’s price.

earnings per share

a company’s total earnings divided by the number of shares of stock outstanding.

price-earnings ratio (aka, the P/E)

the price of one share of a corporation’s stock divided by the corporation’s earnings per share over the past year.

*TIP: a higher P/E indicates that a corporation’s stock is expensive relative to its recent earnings. This means either, 1). people expect its earnings to rise in the future or that 2). the stock is overvalued.

efficient markets hypothesis

the theory that asset prices reflect all publicly available information about the value of an asset.

informational efficiency

the description of asset prices that rationally reflect all available information.

random walk

the path of a variable whose changes are impossible to predict

*(In other words, unless someone has inside information, changes in stock prices should be impossible to predict.)

Tip on diversified investing -

According to the IGM Economic Experts Panel in January 2019, “In general, absent any inside information, an equity investor can expect to do better by holding a well-diversified, low-fee, passive index fund than by holding a few stocks.”

speculative bubble

occurs when the price of an asset rises far above what appears to be its fundamental value.