econ
Investments - Investing in Your Future
Overview of Investments
Investment: An asset purchased with the hope that its value will grow (appreciate) over time.
Savings: Putting money in a safe place, with no risk of loss.
The difference between saving and investing includes the potential returns and risks involved.
Emergency Fund
Emergency Fund: An amount set aside in savings to cover unexpected expenses.
Most financial experts recommend maintaining an emergency cash reserve sufficient to cover three to six months' worth of household expenses.
Reasons for Investing
Increases Wealth:
Investments generally provide higher returns than savings, thus increasing assets and net worth.
Beat Inflation:
Inflation: A general increase in prices over time. Money in savings accounts may not keep pace with inflation, leading to a decrease in purchasing power.
Historical Context of Inflation and Savings Rates
Historical data showcasing rate of inflation vs. savings interest rates from 1965 to 2014, showing how savings interest rates have often been lower than inflation rates.
Types of Investments
Stock: A share of ownership in a corporation, entitling the owner to a claim on part of the company’s assets and earnings.
Bond: A loan made to a corporation or government; bondholders receive interest.
Investing vs. Gambling
Investing:
Purchase of an asset with the expectation that it will increase in value over time. Profits are made by selling the asset at a higher price than the purchase price.
Gambling:
Risks valued possession based on uncertain outcomes. No ownership of an asset takes place.
Both involve risk and choice; however, successful investing relies on informed decisions, while gambling often requires luck.
Time-frame distinction: Gambling is often time-bound, while investing may span long durations.
Investing Risks
Risk Definition: The chance that an investment's return will be lower than expected.
Return: Gain or loss of an investment over a specified period.
Example investments include companies like Blockbuster and Toys R Us, which have lost all value.
Various types of risks include:
Interest Rate Risk: E.g., a 2% APR on a CD versus a 3% increase in inflation.
Market Risk: E.g., a decline in Dow Jones from 28,000 to 20,000.
Company/Industry Risk: E.g., Chipotle's food quality issues.
Non-Market Risk: Factors such as terrorism, natural disasters, or political upheaval.
Risk and Return Comparison
Risk and return are directly related; investments vary in risk and potential return.
Categories based on risk include:
High-Risk, High-Return: Stocks, mutual funds, real estate.
Medium Risk: Corporate bonds, municipal bonds, and certain annuities.
Low Risk, Low Return: U.S. government savings bonds, savings accounts, CDs, money market accounts.
Collectibles as Investments
Collectibles: Unique items that are rare or highly valued (e.g., artwork, trading cards, antiques).
Risks:
Can experience drastic price drops if demand falls.
Difficult to sell and may require costly insurance.
Criteria for Choosing an Investment
Factors to Consider:
Degree of safety (risk of loss)
Expected growth rate exceeding inflation
Liquidity (ease of converting to cash)
Expected dividends or interest
Reasonable purchase price and fees
Tax benefits (tax savings or deferrals)
Understanding Liquidity
Liquidity Definition: The speed and ease with which an investment can be converted to cash.
Bank accounts: Highly liquid, except CDs.
Stocks and bonds: Somewhat liquid.
Real estate and collectibles are typically illiquid.
Market Diversification
Diversification: The strategy of investing in a variety of assets to reduce market risk.
Wise Investment Practices
Strategies for successful investing include:
Define financial goals.
Invest at a measured pace.
Follow through consistently.
Maintain accurate records.
Seek sound investment advice.
Stay informed about investment options.
Who Can Help You?
Financial Advisor:
An educated professional aiding individuals and businesses in setting and meeting long-term financial goals.
Provides advice on investments, insurance, mortgages, etc.
Payment structures vary (flat fee or commission-based).
Understanding Stocks
Stockholder: An individual who owns shares of stock.
Profits from Stocks:
Capital Gains: Profits from the sale of stocks, bonds, or real estate.
Dividends: Distributions of profits to stockholders.
Impact of Bankruptcy on Shareholders
Upon a company's bankruptcy, stock prices may drop significantly or become worthless.
Debt repayment hierarchy follows: government, bank loans, creditors, bondholders, shareholders.
Shareholders are not liable for company debts beyond their investment.
Differences Between Stockbrokers and Financial Advisors
Stockbroker:
Acts as an intermediary for buying/selling stocks; compensated through commissions.
Financial Advisor:
Provides comprehensive financial planning and advice; structured as flat fees or commissions based on services.
Major U.S. Stock Exchanges
New York Stock Exchange (NYSE): Largest worldwide marketplace for stocks.
NASDAQ: Competitor of NYSE, primarily manages tech company trades through computers.
Stocks can only be traded on one exchange at a time.
Ticker Symbol
Ticker Symbol: An abbreviation of letters/numbers used to uniquely identify publicly traded stocks.
Understanding Stock Varieties and Terms
Common Stock: Ownership unit entitling dividends and voting rights.
Preferred Stock: Entitles owners to dividends before common stockholders; no voting rights.
Market Conditions
Bull Market: When investors are optimistic, leading to stock buying.
Bear Market: When investors are pessimistic, leading to stock selling.
Stock Price Movements
Prices fluctuate based on supply and demand:
Excess sellers with few buyers lead to price drops.
High buyer interest with few sellers leads to rising prices.
Bid: Highest price a buyer will pay for a stock.
Ask: Lowest price a seller will accept for a stock.
Market Price: Last trade price of the stock.
Markets Explained
Primary Market: Where new stocks are issued to investors (e.g., IPOs).
Secondary Market: Where existing stocks are traded between investors (e.g., NYSE, NASDAQ).
Mutual Funds
A professionally managed pool of money with a specific investment objective.
Investors contribute to the fund, and managers handle trades and research.
Fees in Mutual Funds
All mutual funds charge fees as follows:
Expense Ratio: Annual management fee (typically <1%).
Front-end Load: Fee when shares are purchased.
Back-end Load: Fee when shares are sold.
It's wise to seek funds with low fees to maximize returns.
Bond Investments
Bonds are loans to companies or governments, generally seen as safer than stocks.
Types of Bonds:
Corporate Bonds: Issued by private companies.
Municipal Bonds: Issued by state/local governments.
Treasury Bonds: Issued by the U.S. government.
How Bonds Work
Bonds can be purchased on the stock exchange.
Every bond has key features:
Maturity Date: When the principal is due.
Face Value: Amount paid back at maturity (typically $1,000).
Interest Rate: Coupon rate, typically paid twice a year.
Earnings from Bonds
Ways to earn on bonds:
Holding to maturity to collect interest and redeem for face value.
Trading bonds on exchanges where prices fluctuate based on interest rates and credit risk.
Interest Definitions
Simple Interest: Earn interest only on the initial investment.
Compound Interest: Earn interest on both the initial investment and the interest earned.
More frequent compounding yields higher returns.
Illustration of Interest Over Time
Example provided showing growth of $100 over time at a 10% annual interest rate for both simple and compound interest over different periods (1-50 years).
The Magic Penny Thought Experiment
Comparing $1,000,000 today to a penny that doubles in value daily for 30 days, illustrating the power of compounding in a dramatic fashion.
Rule of 72
A formula to estimate the time it takes for an investment to double: (Years = \frac{72}{Interest Rate})
Example: 3% interest takes approximately 24 years to double investments.
Retirement Savings Importance
Experts estimate that approximately 70% of pre-retirement income will be necessary for retirement living.
Data reveals that many Americans do not save adequately, despite the increasing costs associated with retirement.
Retirement Accounts
Separate investment accounts designated for retirement purposes.
401(k): Common employer-sponsored plan with potential employer matching contributions.
Contributions and growth are typically tax-deferred until withdrawal.
Understanding Tax-Deferral and Retirement Plans
Tax-Deferred: No taxation on contributions or earnings until withdrawal, potentially optimal if lower tax brackets are achieved in retirement.
Types of Retirement Plans
403(b) Plan: For employees of government/nonprofit organizations.
Defined-Contribution Plans: Retirement benefits based on contributions and investment performance; such contributions are tax-deferred.
Withdrawal penalties apply for early distributions (before age 59 ½).
Individual Retirement Account (IRA)
Traditional IRA: Contributions made pre-tax, accruing tax-deferred growth.
Roth IRA: Contributions are taxed, but earnings remain untaxed upon qualified withdrawal.
Defined Benefit Plans (Pension Plans)
Retirement plans calculating benefits based on factors like tenure and salary. Examples illustrate payment structures based on years served.
Social Security as a Safety Net
Primarily designed to provide financial support to retirees who no longer work.
Amounts vary based on contributions and claiming age; typical monthly benefits offered at retirement age are discussed.