BFIN 210 Final

Investment Pyramid Level 1 (Financial Security)

This level represents the base of the pyramid and consists of low risk, low return investments.
For example: cash, savings accounts, CDs, and other low-risk liquid assets (assets that can easily be converted to cash)

Investment Pyramid Level 2 (Safety and Income)

This level focuses on investments that aim to provide safety and generate income.
Examples: Bonds and bond funds, which are considered safer than stocks and can provide regular interest payments.

Investment Pyramid Level 3 (Growth)

This level focuses on investments with higher potential returns but also higher risk than levels 1 and 2.
Examples: Stocks and stock mutual funds, which have the potential for capital appreciation.
Aims to grow the value of your portfolio over the long term, but with a higher level of volatility (how much the price of an investment goes up and down)

Investment Pyramid Level 4 (Speculation)

This involves high-risk, high-return investments.
Examples: speculative stocks, options, commodities, and similar high-risk investments
Prices can be very unpredictable, and there's a chance of losing a substantial amount of money

"Banks" Deposit Type Financial Institutions

Commercial banks, savings and loan associations, savings banks, credit unions.

Non-Deposit Type Financial Institutions

financial institutions such as mutual funds and stock brokerage firms, which don't provide checking and savings accounts

3 C's When Choosing Banks

Costs:
- rate of interest
- minimum balance requirements
- fees

Conveniences:
- location
- available atms
- direct deposit services etc.

Considerations:
- Personal attention
- financial advice/budgeting help
- safety

Rate of Return on Saving

Factors influencing rates of return include:
Risk - No or low risk = no or low return. (most important)
Convenience
Ease of Access
Time to Access
Minimum Balance Requirements

Cash Management Alternative - Checking Account

Advantages:
Extremely liquid, cash available whenever needed
Safe, most are federally insured
Low or no minimum balance
Convenient - check writing, ATM's, online transfers

Disadvantages:
Lowest rate of return
Watch out for usage fees
Opportunity cost of keeping too high a balance

Cash Management Alternative - High Yield Savings Account

Advantages:
Liquid
Safe; most are federally insured
Slightly higher interest rate than a Checking Account

Disadvantages:
Some minimum holding time
Some minimum balance
Low interest rate

Cash Management Alternative - Certificates of Deposit (CD's)

Characteristics:
Usually pay a fixed agreed upon rate of interest
Funds are on deposit for a "locked" period of time
Locked term could be from 30 days to several years.

Advantages:
Safe
Higher interest rate than traditional checking/savings accounts

Disadvantages:
Early withdrawal penalty or forego some or all interest
Fixed interest rate
Minimum deposit requirements

Cash Management Alternative - Money Market Mutual Funds (MMMFs)

Investors pool money and receive interest/returns on investments less an administrative fee (usually <1% of total investment)
Investments include high-quality securities, CD's, US Bonds, etc.

Advantages:
Higher interest rates paid
Check writing
Limited risk
Disadvantages:
Administrative fees
Minimum initial investment
Comes with some investment risk; Not insured
Most conservative mutual fund

Cash Management Activities - U.S Treasury Bills

Short-term debt issued by the federal government with maturities from 3-12 months.

Advantages:
Risk-free
May offer tax benefits

Disadvantages:
Low rate of return

Cash Management Activities - U.S. Savings Bonds

Series EE and I bonds are safe, low-risk savings products issued by the Treasury with low denominations for longer maturities

Advantages:
Safe
Affordable
May offer tax benefits
No commissions or fees

Disadvantages:
Low liquidity
Long maturity
Semi-annual compounding

I bonds

government backed bonds with rates tied to inflation
-these bonds are sold at face value
-they are tax free
-can earn interest, but interest rates change every 6 months

Moving Money Around

- cash
- personal checks (Money remains in your account until the check is cleared, may take a few days)
- Cashiers Check (Bank takes funds out of your account and places it into theirs)
- Certified Check (Bank 'certifies' that the check will clear when cashed
- Money Order (form of pre paid check)
- Electronic Funds Transfer (EFT)

Difference Between Investing and Speculating

Investment:
Definition: Buying things that make money.
Examples:Primary ResidenceRental PropertyStocks (Derivative securities)

Speculation:
Definition: Buying things that rely on supply and demand.
Examples:ArtGoldCollectibles

Key Difference:
Investing: Gets returns (money back).
Speculating: Depends on buying and selling trends.

Setting Investment Goals

SMART Goals: Specific, Measurable, Achievable, Relevant, Time-bound.
Prioritize: Arrange goals by importance.
Time Matters: Short, Intermediate, Long-term.
Reevaluate: Periodically check and adjust.
Realism Check: Consequences and sacrifices?

How Time Value of Money (TVM) Works

Discounting:
- Moving a cash flow backward in time.
- Calculates the Present Value, representing the value in today's dollars of a future sum of money.

Compounding:
- Moving a cash flow forward in time.
- Calculates the Future Value, indicating the value of an investment at some point in the future.

Variables In TVM Problems

- N: number of compounding periods
- i: interest rate
- PV: present value
- FV: future value
- PMT: periodic payment amount

Ways to Calculate TVM & Excel

Mathematically
Financial calculator (e.g. TI-BA35, HP-10BII)
Interest factor tables
Computer spreadsheets with formulas- (e.g., Microsoft Excel)
- Excel has built in functions (PV(), =FV(), =RATE(), =NPER(), =PMT())

The Rule of 72

Future Value is double for any combination of n and equal 72.
(FV = PV x 2)
E.g If an investment grows at an annual rate of 9% per year, how long will it take to double? = 72 / 9 = 8 years

Calculating Future Value

FV = PV x (FV Interest Factor)
FV Interest Factor = the amount your investment will increase over time
or FV = PV (1+t)^n

Calculating Present Value

PV = FV x (PV Interest Factor)
PV Interest Factor - how much less your future cash flow is worth today
or PV = FV(1/(1+t)^n))

Future Value of Annuities

An annuity is a series of equal dollar investments made on a regular basis.

FV = PMT x (FV Interest Factor of an Annuity)

Present Value of an Annuity/Amortized Loan

PV = PMT x (PV Interest Factor of an Annuity)

amortized loans are loans paid off in equal installments
Calculating Payoff amount of a loan:
PVA (Payoff Amount) = PMT x Interest Factor

Investment Choices

lending investments
- Financing personal / small business loans
- Financing government or corporation spending
ownership investments
- Stocks, which represent ownership in a corporation
- Real estate

Returns From Investing

Capital gain (or loss)
- Selling an asset for more (or less) than you bought it for.

Income
- Payments received directly from the company (or organization in which you've invested).

Risk premium

- The more risk you assume, the greater the potential reward, but also the greater the possibility of not having your money when you need it.

- Balancing risk involves considering:
- Level of return needed to reach your goals
- Amount of time you have to "weather the storms"
- Your personal risk tolerance

Diversification

Spreading out investments to reduce risk

Diversifiable vs. Non-diversifiable Risk

Systematic or Market-Related or Non-diversifiable Risk
• Portion of the total risk or variability that cannot be eliminated through diversification
• General risk associated with a particular type of asset

Unsystematic or Firm-Specific or Diversifiable Risk
• Risk or variability that CAN be eliminated with diversification.
• Stock specific variations due to company specific risks
• Extreme good and bad returns cancel each other out

Securities Markets

- Securities, including stocks and bonds, are issued by corporations to raise money.
- They are bought and sold in primary markets (new stock offerings) where funds go to the corporation.
- After the initial issue, securities are traded between investors in secondary markets, where the company does not receive any money.

Types of Orders

• Long Sales- You own the shares- You make money when buy low, sell high
• Market Orders- Buy or sell immediately at the best price available.
• Limit Orders- Trade is to be made only at a certain price or better.
• Short selling- Sell high and later buy low and return stock to broker.- The more the price drops, the more money your make.- Borrow stock from the broker and then sell it.- If price increases, you buy back for more than the sold price,and lose money.

Costs of Trading

- Sales commission to buy stock
- Commission to sell stock
- Transaction fee
- Annual fee for inactive accounts
- Use discount broker for large purchases
- Tax implications
- Marginal tax rate for short term
- Lower rate for longer term

Online Trading

Convenient for average investors to build a portfolio

Beware of day trading!
- Extremely risky
- Investing with a very short-term time horizon, usually intra-day.
- Be prepared to suffer severe financial losses.
- Significant transaction fees and no tax benefit!!!
- Don't confuse day trading with investing.
- Don't believe claims of easy profits.
- Watch out for "hot tips" or "expert advice."

Efficient Markets

A market in which information about the stock is reflected in the stock price.
The more efficient the market, the faster prices react to new information.
If the stock market were truly efficient, then there wouldbe no benefit from stock analysts.

Personal Risk Tolerance

Know your comfort level with risk.
Follow general advice on how to distribute your investments.
Consider the time you have for investing.
Longer investment horizon allows for riskier assets.
Adjust allocations based on personal preferences.
Stick to your investment strategy.

Time Dimension of Risk

Long-term investments have ups and downs.
Over time, returns tend to average out.
Choose assets based on your goal's time horizon.
Stocks involve more uncertainty each year but offer higher long-term returns.
Bonds provide less yearly uncertainty with smaller long-term returns.
Consider the time needed for a positive return when selecting assets.

beating the market

Expect to outperform and underperform the market half the time.
Picking underpriced stocks and timing the market is challenging.
Stick to your long-term investment plan.
Timing the market may lead to missing upswings and avoiding downswings.
Be cautious of the psychological aspects of investing.
People often share their successful picks, creating a biased view of investing.

Measuring market movements

Stock Market Index: Measures performance of a group of stocks representing the market or a sector (e.g., DJIA, S&P 500).

Bear Market: Marked by falling prices.

Bull Market: Marked by rising prices.

Common Stock Classification

Blue-Chip Stocks: Established, stable companies with a history of reliable performance.

Growth Stocks: Companies with high growth potential, often reinvesting earnings for expansion.

Income Stocks: Emphasize consistent dividends, appealing to income-focused investors.

Speculative Stocks: High risk, high reward, typically from emerging companies or industries.

Valuation of Common Stock

Technical Analysis Approach: Analyzing historical price trends and trading volumes to predict future stock movements.

Price/Earnings Ratio Approach: Evaluating a stock's current price relative to its earnings per share, indicating its valuation in relation to its profitability.

Discounted Dividends Valuation Model: Assessing a stock's value by discounting its future expected dividends to their present value, providing an estimate based on expected cash flows.

Technical Analysis Approach:

Emphasizes demand and supply:
- Greed pushes money into a rising market.
- Fear pulls money out of a declining market.

Utilizes charts and computer programs to identify price trends.

Involves interpreting charts, graphs, and mathematical calculations to spot trends.

Generally of limited value:
- Cannot predict trends before they occur.
- Encourages frequent market moves rather than long-term holding.

Valuation Models

- Fundamental Analysis
- Discounted Cashflow method
Determine the value of a stock by forecasting all future cash flows.
Value of a stock = Present value of all potential future cash flows.
- Dividend Discount Model
Evaluate stock value based on future dividends.
Value of a stock = Present value of all future dividends
Formula when no dividends: Dividends next year / (Required rate of return - Growth rate).

Dollar Cost Averaging

Purchasing a fixed dollar amount of stock at specified intervals
Same dollar amount each period will average out thefluctuations.
Sound investment strategy
Encourages good behavior...keeps you from trying to time the market
Transaction fees can be large

Buy and Hold Strategy

A passive investment strategy in which an investor buys stocks and holds them for a long period of time, regardless of fluctuations in the market.
Long-term investment approach.
Minimizes costs associated with frequent trading.
Tax advantages through deferred capital gains and lower tax rates.

Dividend Reinvestment Plan (DRIP)

an investment plan that allows the investor to automatically reinvest stock dividends in the same company's stock without paying any brokerage fees
DRIPs facilitate automatic reinvestment of dividends.
Cost-effective due to the absence of brokerage fees.
A strategic way to compound wealth over time.
Important to note tax implications despite reinvesting dividends.

Beta

measure of how responsive a stock or portfolio is to changes in the market portfolio.
- Beta benchmark for market = 1
- Beta > 1—stock moves up and down more than market
- Beta <1—stock moves up and down less than the market

Basic Bond Terminology and Features

• Par value
- Face value
- Paid at maturity
• Maturity
- End of the term of the bond
• Coupon Interest Rate
- Many bonds pay interest in form of coupons
- Expressed as an annual % of face value

Bond Yield

• Current Yield
- Ratio of annual interest payment to the bond's CURRENT market price
• Yield to maturity
- True yield or return that the bondholder receives if a bond is held to maturity
- A measure of expected return
- Not always the ACTUAL return

Mutual Funds

investments that reduce risk to shareholders by investing in many different stocks
Each investor holds a share in the fund corresponding to their investment
Provides an easy way to hold a variety of stocks and bonds, spreading risk across different investments.

Advantages of mutual funds:
- Professional management
- Minimal transaction costs
- Liquidity
- Flexibility
- Avoidance of bad brokers

Disadvantages of mutual funds:
- Can have lower-than-market performance
- Costs
- Common stock risks
- You can't diversity away a market crash

Common Sources of Retirement Income

• Social Security
• Defined Benefit Plans
• Defined Contribution Plans
• Individual Retirement Accounts

Social Security and Financing it

Primary source of retirement income for many senior citizens.
- Paid through FICA taxes.
- Today's taxes support benefits for current retirees.
- Your payments are not saved or invested for you.
- Future adjustments may include raising retirement age or limiting benefits for the wealthy.

Social Security Eligibility

• > 95% of Americans are covered.
• Pay into system to be eligible and receive credits.
•Earn credits based on earnings, up to a maximum of 4 credits per year.
•With 40 credits, eligible for retirement, disability, and survivor benefits.

Retirement Benefits

• Benefits formula—replace 42% of average earnings based on number of earnings years, average level of earnings, adjustments for inflation, income brackets.
• Full benefits at the "full" retirement age.
• Reduced benefits at 62
• Increased benefits if you delay retirement.

Cash Balanced Plan

- Workers receive a percentage of their pay yearly, along with a predetermined interest rate
- Employers contribute a percentage of your salary annually into an account, growing at the 30-year Treasury bond rate.
- Benefits are easier to track and are portable across different employment situations.

defined contribution plan

You and/or your employer contribute directly to a dedicated retirement account.
Functions as a personal savings account for retirement.
Includes options such as Profit-Sharing Plans and Employee Stock Ownership Plans (ESOP).
Examples like the 401(k) Plan fall under this category.

Retirement Plans for the Self-Employed andSmall Business Employees

Keogh Plan or Self-Employed Retirement Plan
Simplified Employee Pension Plan (SEP-IRA)
Savings Incentive Match Plan for Employees or SIMPLE plan

Individual Retirement Account (Traditional)

• Tax advantaged—contribution may or may not be tax-deductible depending on individual's level of income and whether he/she, or spouse, is covered by a company retirement plan.
• Restrictions on timing and amount of withdrawals but can rollover a distribution.
• Saver's tax credit

Individual Retirement Account (Roth)

• Contributions are not tax deductible but made out of after-tax income.
• Money grows tax free and withdrawals are tax free.
• No withdrawal restrictions or tax penalty like traditional IRA but can also rollover.

Choose the Roth IRA if you can pay your taxes ahead of time.