Personal Finance and Investing

Exam 5

Monthly Consumer Credit Payments should be limited to what percentage of after-tax (take home) income?

20% of your net (after-tax) income.

Example:

Net monthly income = $2,500 —> $2,500 × 0.2 = $500 (max credit payment)

• Add up monthly/annual consumer credit payments and divide by your take-home pay

How large of an emergency fund should you have?

It should be an amount of money you can obtain quickly in case of immediate need.

• 3–6 months’ living expenses (minimum of monthly expenses x 3)

In 2018, how much debt did the average American have? (excluding mtg and student)

$38k on average

What do consumer credit payments include?

Credit cards, auto loans, and installment loans

What do consumer credit payment not include

Mortgages and student loans

What is the TMV? (Time Value of Money)

This is the concept that money available at present is worth more than the identical sum in the future due to its potential earning capacity. This core principle of finance holds that, provided money can earn interest, any amount of money is worth more the sooner it is received.

• This is the most important element for your financial success

What to Consider:

• Length of time you are investing

• Rate of return earned

• Compound interest is very powerful

How to calculate TMV

Using software and tables in the textbook!

PRACTICE

4 Risk Factors associated with almost every investment?

1. Inflation Risk: things cost more than they do today, which is especially bad for people on fixed income or older ppl

2. Interest Rate Risk: If you are locked into something earning 2% for 10 years and rates go up 5%, you are stuck earning the 2%

• Rates Go Up Bond Prices Go Down

• See ex

3. Business Failure Risk: You are in business OR you invest in a stock of APPLE, and they end up going out of business, you could lose everything!

4. Market Risk: The stock market goes up and down, you will be exposed to this risk, the quicker you become comfortable with this the more successful you will be with your long-term money

What does Liquidity Mean?

Ability to buy or sell quickly without substantially affecting the value

• A CD is a safe investment, but if you sell it early to get your money, you will pay some sort of penalty

• Savings and checking and very liquid

• Your house is an investment, but it is less liquid. You can’t just say, I need money and sell your house within a couple of minutes.

What is Asset Allocation

Spreading your money overall several different types of investments to lessen risk

• It’s also about having the right mix of risk and safety. Everybody is different given their goals, age, emotional strength, past experiences, etc.

• This term is said to account for 90% of your volatility (ups and downs) that you will experience. It’s not as important to focus on the ACTUAL players (individual stocks, mutual funds, etc.) but rather the exposure you have to the broader categories that will drive about 50% of your actual returns

What we can control - High impact and high control

• Portfolio construction, assets protected, asset allocation, income taxes, diversification (country, style, sector)

Low impact and low control

• Government policy, inflation, and interest rates

What percentage of the variance of portfolio returns is due to asset allocation?

Over 90% (market timing and picking the right stock are relatively unimportant)

According to some financial experts, how do you use your age to determine your asset allocation?

Younger investors can take more risk because they have more time

• Rule of thumb says to subtract your age from 100

• If you are 22 and putting money into a new 401k to invest for your retirement 40+ years from now, you should be invested 78% in stocks and 22% in bonds/cash

Who are the three main issuers of bonds?

U.S. government, state and local governments, and corporations

What are the three main reasons investors purchase bonds?

Interest income, stability, and repayment at maturity

• Bonds issued by states and municipals issue bonds to build roads, hospitals, bridges, education funds, etc. If you invest i one of these bonds, you will earn a Federally tax-free interest rate because you are supporting local governments grow, and spend money

• Lots of retirees use bonds to produce a dependable and lower volatility income stream to supplement their SSI and pension

How do you determine the current yield on a bond?

Annual interest amount / price of bond

• It is the ratio of the interest payment to the bond’s current market price.

• Current yield = annual interest payment / current market price of the bond

• Ex. The current yield of a $1,000 par value bond with 8% coupon rate and market price of $700 = $80 / $700 = 11.4%

What are bond ratings? Who are the 2 leading providers of bond ratings?

The ultimate risk when investing in bonds is the DEFAULT RISK. This is the risk that person, company or government that you buy the bond from goes under and can no longer make the interest rate payments to you and cannot give your money back because they don’t have any.

• The higher the risk, typically means the higher the rate you will get

1. Moody’s

2. S & P (Standard and Poors)

3. Fitch

• These are companies that go and look at the underlying strength of the company, government, or municipality that is issuing the bond. This is to help investors understand the risks associated with what they are going to buy.

Why do companies issue stock?

Corporations issue common stock to finance their business startup costs and help pay for expansion and their ongoing business activities. Corporate managers prefer selling common stock as a method of financing for several reasons (equity, dividends not mandatory, voting rights and control of the company)

What are the two ways to make money buying common stock?

Common stock: the most basic form of ownership for a corporation

1. Income from dividends (distribution of money, stock, or other property that a corporation pays to stockholders)

2. Dollar appreciation of stock value (if the stock price increases, you must decide to sell it at the higher price or hold it. If you sell it, the dollar amount of difference between the purchase price and the selling price represents your profit)

Blue Chip

A stock that is issued by large, stable corporations that often have a history of paying dividends and that generally attracts conservative investors

Cyclical Stock

A stock that follows the business cycle of advances and declines in the economy

Growth Stock

A stock issued by a corporation that has the potential of increasing sales revenues and earning profits above the average of all firms in the market

How do you compute earnings per share?

These are a corporation’s earnings divided by the number of outstanding shares of a firm’s common stock.

• This calculation is used to evaluate the financial health of a corporation

• EPS = Earnings / # of shares outstanding

How do you compute the price-to-earnings ratio?

This is used to evaluate a potential stock investment. It is the price of a share of stock divided by the corporation’s earnings per share of stock.

• The higher the PE ratio, the more investors are paying for earnings.

• Avg. PE ratio for the stock market is 15-25 for any specific year.

How do you compute the dividend yield of a stock?

This is the annual-divided amount divided by the stock’s current price per share.

• This is used to monitor the value of investments.

• An increase in this is a healthy sign for any stock investment.

An Investment Bank

A financial firm that assists corporations in raising funds, usually by helping to sell new security issues.

An Initial Public Offering (IPO)

Occurs when a corporation sells stock to the general public for the first time.

• The money from this can be used to repay debt, to increase working capital, etc.

The Secondary Market

Once sold in the primary market, stocks can be sold in this market. It is a market for existing financial securities that are currently traded among investors.

• When you purchase stock in this market, the transaction is completed on a securities exchange or through the over-the-counter market

What is the NY Stock Exchange

The NYSE is the largest securities exchange in the world. Most of the members represent brokerage firms that often charge commissions on security trades made by their representatives for their customers.

• The Designated Market Maker is the cornerstone. (AKA specialists), are obligated to maintain a fair and orderly market by establishing prices for specific stocks so that buy and sell transactions can be completed on a securities exchange.

What is the over-the-counter/NASDAQ market?

The OTC is a network of dealers who buy and sell the stocks of corporations that are not listed on a securities exchange.

• Most OTC securities are traded through Nasdaq, which is an electronic marketplace for stocks

When you place a stock market order, how many days do you have to pay for it?

This is just a request to buy or sell a stock at the best available price. Payment for a stock market order is generally required within two business days after the transaction.

What is the range of commission costs to buy a stock at a discount brokerage firm?

Full-service brokers charge about 1% of the transaction amount.

• additional commission charges may be based on the number of shares and the value of stock bought and sold.

Discount brokerage firms say that you are responsible for making investment decisions, they don’t charge as high of a commission as full-service firms.

What does buying on margin mean?

You borrow part of the money needed to buy a particular stock. It is set by the Federal Reserve Board.

• It is currently 50%, so you can borrow up to half of the total stock purchase price.

• People buy this because they can increase the return on an investment

What does the term selling short mean?

If you think a stock’s price is going to decrease, you can make money by selling short. This is selling stock that has been borrowed from a brokerage firm and must be replaced at a later date.

Mutual Fund

·      Pools of money from many different investments

·      There are many different types of mutual funds… in the US, there are about 9,500 different mutual funds, but only about 3,500 publicly traded companies!

·      Benefits: Professional management and diversification (it’s also convenient and highly liquid)

What are the two major reasons why investors buy mutual funds?

1. Professional management

2. Diversification —> (it’s also convenient and highly liquid)

Open-ended mutual fund?

Open-ended funds mean shares are issued and redeemed by the investment company that runs the actual mutual fund.

• MF’s are bought and sold once per day after the market closes, actively managed, and prices are set once per day after the market closes (mutually part of an entire investment fund)

Exchange Traded Fund

• ETF’s typically will invest in a given sector (MJ), index (SPY), or style (VTV). They are held to mandate and don’t deviate from this, so they are not making “active” bets on what will happen; they just stay invested per their mandate

• ETF’s will trade like a stock, where you can sell them whenever the markets are open

• Actively bought and sold throughout the day, passively managed, prices go up and down throughout the day.

What do MF’s and ETF’s have in common?

They both pool money from many investors to buy investments, provide diversification, and can hold a wide variety of different investments (stocks, bonds, commodities, etc.)

• BUT index funds are much cheaper than MF’s, but there are exceptions to this. Vanguard has both MFs and ETFs at extremely competitive fees

• Keep expense ratios below 0.25%!!! Average MF fee is 1.20%

What is the difference between a load fund and a no-load fund?

• The “load” refers to the commission you will pay to a person who is acting as your broker or advisor.

  ·      No-load funds are those that don’t have an upfront commission

  ·      These can be really high fees…some of them reaching as high as 5.5%. So If you wanted to buy $100k worth of a loaded mutual fund, you pay $5,500 right away towards a fee, and now your account is instantly worth $94,500! Meaning you need the investment to make $5,500 or almost 6% to get back to your original investment.

  ·      Don’t buy a loaded Mutual fund! Vanguard will never have a load. You should be keeping money for yourself

What do the ABCs of Mutual Funds mean?

If someone recommends buying an MF and the name of the fund ends in one of these letters: A, B, or C… run away, these are loaded funds

What is generally the range of annual fees for managers of mutual funds?

• Loads = 3-5%

• Ongoing expenses of MFs = 1-2%

What is an index fund?

·      Invest in the same as included in the index … it’s the form of a mutual fund where they sell once per day, but have the structure of an ETF where they just follow an index at a very low fee, just like an ETF

·      Can get funds that trade the entire US stock market for about 0.03% or $3 for every $1,000 that you invest… with very low fees, if not no fees to buy and sell

·      Three Total US stock Market index funds (notice they don’t have ABC after them and are below 0.25%): VTSAX (Vanguard) 0.04%, FSKAX (Fidelity) 0.015%, and SWTSX (Charles Schwab) 0.03%

-       Buy index funds offered…

Low-Cost Index Strategy

-       65% of account: Schwab US broad market ETF (fee = 0.03%)

-       25% of account: Vanguard developed markets ETF (fee = 0.05%)

-       10% of account: Vanguard emerging markets ETF (fee = 0.08%)

What is an aggressive growth fund

An aggressive growth fund has companies that have high expectations that they will grow really quickly, but this can open you up to some pretty scary short-term losses. But if you can stomach this and invest for the Long Term (10+ years), then you will have a better chance of making more money at the end of the day

What is a balanced fund?

• The balance fund will have a strategy of “balancing” risk by having one fund that invests in both stocks AND bonds. Less risk and over a longer period of time, less return (most likely)

What is a socially responsible fund?

·      SRI or ESG (environment, social, governance)  will avoid certain industries like oil, guns, gambling, etc. (Note that Amazon, tesla, etc. are considered ethical in this case, so it’s tricky)

·      These have always been more expensive than other mutual funds, but due to technology, these fees have come way down, making them more popular with people who want to invest with their conscience

·      We have clients that need this, and it’s a great thing…two sides…nonprofits can go either way

·      DOING better lately due to no exposure to oil/fossil fuels

·      ESG Investment strategy: 65% of account = Vanguard ESG US stock ETF (ESGV), 35% of account = Vanguard ESG international stocks ETF, 0.10% combined fee!

What is a life cycle or target-date fund?

·      Initially, the fund is riskier (more stocks) when you buy it, and as you get older, it becomes less risky (more bonds) automatically

·      So, you select the date you want to retire, say 2050… since we are far away from then, the fund will have mostly stocks. But as the years go by and you get closer to the “target date” of 1050, then things become safer by selling stocks and buying more bonds

·      These are the most popular 401(k) investment options because they’re a nice set it and forget it option, by only buying one investment

·      Choose based on your retirement date

What are some of the reasons managed mutual funds fail to outperform Index funds? (Kiplinger article).

·      Fees!

·      Too much risk or too much tinkering…if you aren’t the average, then you will by definition either outperform the avg. or you will underperform the average. It is very difficult to outperform on a regular basis.

·      There has only been one mutual fund that beat the S&P 500 10 years in a row. Legg Mason value

What is a mutual fund reinvestment plan?

·      Income dividends, capital gains distributions are automatically distributed into additional shares of the fund

·      Keep buying more shares…gathering nuts like a squirrel

·      Reinvest those dividends = compound interest

·      When the market is down  look to buy stocks at good prices, because you don’t need the money for many years

What are the two main reasons GDP increases over time?

1. Population growth

2. Increase in Productivity

How much should a 40 year old have in stock investments based on the formula of subtracting your age from a certain number is:

100 - 40 = 60%