Introduction to Personal Finance: Chapter 8 Investments

Introduction to Personal Finance

• Focus on investments in personal finance.

Investment Overview

• Stock Overview:
  • When purchasing stock, you buy ownership in a company.
  • Stocks (or shares/equity) represent ownership.
  • Publicly traded stocks are accessible on the stock market; privately held stocks are limited to select individuals.

Example Business Scenario - Bill's Cupcakes

1. Business Idea: Bill develops an idea for a cupcake shop.
2. Business Planning: He plans for expansion, costs projected at $10 million.
3. Fundraising: Utilizes an investment banker for further funding.
4. Incorporation: Establishes as a corporation, issues 1,000,000 shares.
5. IPO: Institutes an initial public offering (IPO), raising $10 million, with the investment bank receiving $2 million.

Why Buy Stock

• After being sold in the IPO market, stock is resold in the secondary market:
  • Bid Price: Highest a buyer will pay for shares.
  • Ask Price: Lowest a seller will receive for shares.

Rights of Shareholders

• Investors conduct transactions via stock exchanges and are entitled to profits.
• Investors appoint company managers through elections.

Earning from Shares

• Stocks can generate income:
  • Example: If Bill's Cupcakes sells a cupcake for 2 (with 1.70 in expenses), the profit would be:
    ext{Net Profit} = ext{Gross Sales} - ext{Expenses} = 2 - 1.70 = 0.30.
    For 10,000,000 cupcakes: ext{Total Profit} = 10,000,000 imes 0.30 = 3,000,000.

Calculating Earnings Per Share (EPS)

• With a total profit 3,000,000 and 1,000,000 shares:
  ext{EPS} = rac{ ext{Total Profit}}{ ext{Total Shares}} = rac{3,000,000}{1,000,000} = 3.00.

Wealth Creation through Stocks

• Two Key Methods:
  1. Hold shares for capital appreciation.
  2. Receiving dividends.

Types of Stocks

• Growth Stocks: Focused on price appreciation.
• Income Stocks: Heavy dividend payers.
• Growth and Income Stocks: Combination of appreciation and dividends.

Stock Purchase Process

• Open a brokerage account:
  • Full-service brokers: Offer advice (e.g., Merrill Lynch).
  • Discount brokers: Self-service trades (e.g., TD Ameritrade).

Stock Market Dynamics

• Stock Exchanges: NYSE and NASDAQ as major platforms.
• Valuation Methods: Using discounted dividend valuation for regular dividend-paying companies.
• Price/Earnings Ratio: P/E ratio indicates how much one pays for a dollar in earnings; typically ranges from 10 to 30.

Market Capitalization

• Classified by market cap:
  • Large Cap: > 10 ext{ billion}.
  • Mid Cap: 2 - 10 ext{ billion}.
  • Small Cap: < 2 ext{ billion}.

Bond Market Fundamentals

• Bonds: Loans to corporations/governments; provide fixed income.
• Key Features of Bonds:
  • Face Value: Amount repaid at maturity.
  • Maturity Date: Length of loan.
  • Coupon Rate: Interest paid to bondholder.

Types of Bonds

• Corporate Bonds: Generally higher yields compared to government bonds.
• Government Bonds: Includes Treasury bills, bonds, and notes based on the duration.
• Municipal Bonds: Issued by local governments, tax-exempt interest.

Risks Related to Bonds

• Default Risk: Risk of issuer failing to meet obligations.
• Bond ratings (AAA to D) determine risk levels.

Interest Rates and Monetary Policy

• The Federal Reserve influences interest rates, targeting stable prices and employment through the federal funds rate.

Understanding Employment Types Related to Economic Policy

• Various unemployment types impact economic conditions, including seasonal, structural, cyclical, and frictional unemployment.

Mutual Funds Overview

• Pools of money from multiple investors for diversified portfolios.
• Passive vs Active Management:
  • Passive: Tracks market index.
  • Active: Seeks higher returns than market averages.

Considerations for Mutual Fund Investments

• Tips for minimizing fees:
  • Avoid sales-loaded funds and high expense ratios.

Exchange-Traded Funds (ETFs)

• Features of ETFs:
  • Traded throughout the day like stocks.
  • Generally lower fees compared to mutual funds.
  • Immediate diversification.

Foreign Investments

• Provide growth opportunities and risks.
• Currency exchange rates can impact investment values.

Risk Management and Your Portfolio

• Understanding correlations can help mitigate risk.
• Asset allocation and diversification are key to effective risk management.

Investor Protection and Financial Advisors

• Securities Investor Protection Corporation (SIPC) protects investors, but due diligence is necessary.
• Types of Advisors:
  • Commission-based vs fee-only; seek certified professionals for trustworthy advice.