Saving and Investing Basics

Objectives

• To identify reasons for saving and investing.

• To evaluate the costs and benefits of various savings options.

• To evaluate risk and return of various investment options.

• To design a plan for saving and investing.

• To analyze the relationship between risk and return.

• To interpret the role of goal setting in saving and investment.

Saving & Investment Basics

• Saving and investment are fundamental financial activities.

Saving

• Involves restricting expenses and keeping unspent money to accumulate it.

• Helps fulfill short- to intermediate-term goals.

• Main objective: maintain liquidity and meet future expenses without hassle.

  • High liquidity helps in tough situations like job loss.

  • Liquidity: the degree to which an asset can be quickly bought without affecting its price.

Investing

• Buying an asset to generate returns over time while managing risk and volatility.

  • Example: buying gold and holding it for its value to increase.

• Prime focus: beating the inflation rate with the widest possible margin.

  • Inflation: the rate at which the general level of prices for goods and services rises, decreasing purchasing power.

• Helps fulfill intermediate- and long-term goals.

Relationship Between Saving & Investing

• Closely related; investment follows saving.

• Saving is essential for accumulating capital, which is then invested.

• Inflation erodes the value of capital, necessitating investment in high-return assets.

• Without savings, investment is impossible, and without investment, savings lose value.

Benefits of Saving & Investing

• Diminish financial worries and bring peace of mind.

• Reduce stress related to:

  • Next month’s rent.

  • Emergency funds for unexpected events.

  • Savings for children’s education.

  • Funding retirement accounts.

• Makes money work; regular saving and investing can lead to living off investment income.

  • Examples: Roth IRA, bonds, and investment properties.

• The earlier an individual starts, the more time money has to grow through interest, compounding, or increased investment value.

Interest

• A reward for lending money.

• Collected on certain bank accounts because the money is available for banks to use.

• Two primary types:

  • Simple interest.

  • Compound interest.

Simple Interest

• Computed on the principal, excluding previously earned interest.

• Formula: Principle (P) \times Rate of interest (i) \times Amount of time (T) = Simple Interest

  • Example: 10,000 at 5% annual interest for three years earns 1,500 (10,000 \times 0.05 \times 3).

Compound Interest

• Calculated on the initial principal and the accumulated interest of previous periods.

• Formula: [P(1+ i)^n – 1] = Compound Interest

  • P = Principle, i = rate of interest, n = number of compounding periods.

  • Example: 10,000 at 5% annual interest for three years earns 10,000 [(1 + 0.05)^3 – 1] = 10,000 [1.157625 – 1] = 1,576.25.

Compounding

• Occurs when investments generate earnings, and those earnings generate further earnings.

• A powerful way to invest, best started early.

  • Example: A 25-year-old needs to invest 880.21 monthly to accumulate 1 million by age 60 (assuming a 5% return), while a 45-year-old needs to invest 3,741.27 monthly.

Financial Institutions

• Companies dealing with monetary transactions like deposits, loans, investments, and currency exchange.

• Encompass various operations, including banks, trust companies, insurance companies, brokerage firms, and investment dealers.

• Distribute financial resources in a planned way for potential users.

Categories of Financial Institutions

• Commercial Banks:

  • Provide security and convenience to customers.

  • Accept deposits, provide loans, and serve as payment agents.

• Investment Banks:

  • Perform services for businesses and governments.

  • Underwrite debt and equity offerings, act as intermediaries, and provide financial advisory services.

• Insurance Companies:

  • Pool risk by collecting premiums, helping manage risk and preserve wealth.

• Brokerages:

  • Intermediaries between buyers and sellers, compensated via commission.

Regulatory Agencies

• Government agencies overseeing the financial market in the United States.

Key Agencies

• Federal Reserve:

  • The central bank of the United States, providing a safe, flexible, and stable monetary financial system.

• Securities and Exchange Commission (SEC):

  • Created in 1934 to protect investors and maintain order in the securities market.

  • Oversees organizations like:

  • Financial Industry Regulatory Authority (FINRA).

  • Security Investor Protection Corp (SIPC).

Saving Options

Saving Defined

• Income not consumed, also referred to as deferred consumption.

• Typically for smaller, short-term goals.

• Usually involves little risk of losing money.

• Generally earns a lower return compared to investments.

Saving Options

• Savings Accounts

• High-Yield Bank Accounts

• Certificates of Deposit (CD)

• Money Market Funds

• Annuities

• Qualified Tuition Plan

• 401K Plan

Savings Account

• Interest-bearing deposit account at a bank or credit union.

• Usually provides a modest interest rate.

• Differs from a checking account by not allowing checks or electronic debits.

• Generally for money not intended for daily expenses.

• Offers Federal Deposit Insurance Corporation (FDIC) coverage.

High-Yield Bank Account

• A type of savings account earning a higher interest rate than standard savings accounts.

  • Higher earnings due to larger initial deposit and limited access.

• Provides FDIC protection.

• Often offered to customers with other accounts at the bank.

Certificate of Deposit (CD)

• Saving certificate with a fixed maturity date and specified fixed interest rate.

• Generally offers a higher interest rate, especially with larger or longer deposits.

• Requires customers to keep money in the account for a specified time; otherwise, a penalty is assessed.

• Maturity periods include six-month, one-year, and five-year.

• FDIC insured.

Money Market Fund

• A type of mutual fund investing in low-risk securities.

• Considered one of the lowest-risk types.

• Typically provides a return similar to short-term interest rates.

• Not FDIC insured.

• Regulated by the Securities and Exchange Commission’s (SEC) Investment Company Act of 1940.

Annuity

• A contract between an investor and an insurance company where the company promises periodic payments to the investor.

  • The investor buys an annuity with a single payment or a series of payments (premiums).

• Often considered for retirement planning.

  • Some contracts save for retirement; others turn savings into retirement income.

Qualified Tuition Plan

• A tax-advantaged savings plan designed to encourage saving for future college costs.

• Authorized by section 529 of the Internal Revenue Code (529 plan).

• Covers educational expenses (tuition, fees, books, supplies, equipment, computers, software).

Types of Qualified Tuition Plans

• Prepaid Tuition Plans:

  • Allow prepaying tuition at today’s rates at eligible institutions.

  • Most do not cover room and board.

• College Savings Plans:

  • Investment account to save for future higher education expenses.

  • Offers a range of investment portfolio options (mutual funds and ETFs).

401K Plan

• An employer-sponsored retirement savings plan.

• Allows employees to save and invest pre-tax income.

  • Employers may also contribute (matching).

• Self-directed:

  • Employees decide how to invest the money.

Setting Savings Goals

• Motivates action, focuses on priorities, and avoids overspending.

• Helps people be better organized financially.

• Involves setting short-, intermediate-, and long-term goals.

Short-Term Goals

• Achieved in less than a year.

• Focus on improving the present financial situation.

• Examples:

  • Purchasing household furniture.

  • Saving for a family vacation.

  • Establishing an emergency fund.

Strategies for Short-Term Savings

• Determine the amount needed and divide by the time until needed.

  • Example: Saving \$5,000 in one year requires saving \$417 per month.

• Figure out how to fund this short-term savings bucket.

  • Savings accounts and money market funds are good choices.

Medium-Term Goals

• Achieved in about five years.

• Requires careful planning.

• May need to be broken down into smaller, short-term goals.

• Examples:

  • Saving for a down payment on a house.

  • Buying a new car.

  • Paying off student loans.

Strategies for Intermediate-Term Savings

• Similar to short-term goals but require more discipline.

  • Money market funds and CDs are safe choices.

  • If using CDs, time the maturity date close to when the money is needed to avoid penalties.

Long-Term Goals

• Achieved in about ten or more years.

• Requires thorough and specific planning.

• Examples:

  • Saving for a college education.

  • Saving for retirement.

Strategies for Long-Term Savings

• Saving for retirement:

  • Participate in an employer’s retirement plan (401K).

• Saving for children’s education:

  • 529 plans offer tax benefits while minimizing the impact on financial aid.

Saving Tips

• Recording expenses:

  • Keep track to identify spending patterns for improvement.

• Making a budget:

  • Outline how expenses measure up to income to create a spending plan and limit overspending.

• Planning on saving money:

  • Set aside 10 to 15 percent of income as savings.

  • Cut unnecessary spending.

• Setting goals:

  • Think of what to save for (short-, medium-, or long-term goals).

• Deciding on priorities:

  • Prioritize the most important goals and sacrifice shorter-term needs.

• Picking the right tools:

  • Choose the appropriate saving vehicles for each goal.

• Making savings automatic:

  • Use automated transfers between accounts.

• Watching savings grow:

  • Check progress regularly to stay inspired and fix problems quickly.

Investing

Investing Defined

• Allocation of money or resources with the expectation of future benefit.

• Can help reach bigger, long-term goals.

• May result in losing some or all the money invested.

• Has the potential for higher returns than saving options.

Investment Options

• Bonds

• Stocks

• Mutual Funds

• Index Funds

• Exchange-Traded Funds

• Real Estate

• Precious Metals

• Collectibles

Bond

• A loan an investor makes to an organization in exchange for interest payments and repayment of principal at maturity.

• Issued by governments, cities, and corporations.

• Returns are inversely related to interest rates.

  • When interest rates rise, bond prices generally fall, and vice versa.

• Risks vary depending on the types of bonds owned.

Stock

• A portion of ownership in a corporation.

• Represents a claim on the company’s assets and earnings.

  • Holders are entitled to earnings and responsible for risks.

• Can make money in two ways:

  • Capital Gains: Selling shares at a profit.

  • Dividends: Companies distributing profits to shareholders.

Mutual Fund

• A pool of funds collected from many investors to invest in securities (stocks, bonds, etc.).

• Diversifies assets into different securities.

• Managed by professional fund managers.

• Investments can be less risky than individual stocks and bonds.

Exchange-Traded Funds

• A bundle of securities matching a specific index.

• Allow investors to have a diversified portfolio.

• Includes:

  • International

  • Sector

  • Dividend

  • Market-cap index

Index Funds

• A type of mutual or exchange-traded fund to match the performance of a financial market index.

• Use a passive investment strategy.

• May:

  • Perform better than actively managed funds.

  • Have a lower cost ratio.

  • Decline in value when the market is down.

Real Estate

• Land and any physical property affixed to the land.

• Generally a great investment option.

  • Provides housing and can rise in value over time.

• Can also be rental property.

Precious Metals

• Rare metals with high economic value (gold, platinum, silver).

• Sought after to diversify portfolios as a hedge against inflation and financial uncertainty.

  • Non-correlated asset to most other assets.

Collectible

• An item valued and sought by collectors (antiques, arts, coins, comic books, stamps).

• Often worth far more than its original purchase price.

• Can be tricky as an investment.

  • Requires knowledge about the collectible and its market value.

  • Counterfeits are common.

Risk and Return

• Risk is the potential of losing something of value.

  • Results in uncertain, unpredictable, and uncontrollable outcomes.

• Return is the profit on an investment.

  • Comprises any change in value, interest, dividends, or other cash flow received.

Risk-Return Tradeoff

• When potential return rises, an increase in risk occurs.

  • Low risk is associated with low potential returns; high risk with high potential returns.

  • Example: Stocks have a potentially higher return than bonds but also more risks.

• Diversification reduces risk without sacrificing potential returns.

Diversification

• A risk management technique spreading assets into a portfolio with a wide variety of investments.

  • Example: Allocating assets into stocks, bonds, real estate, gold, or other commodities.

• Aims to maximize return and minimize risk by investing in different areas.

  • When stock prices fall, bond prices often rise, balancing the loss from the stocks.

Investment Tips

• Diversifying the portfolio:

  • Reduces risk and steadily builds wealth over time.

• Being a successful investor:

  • Conduct thorough research, accumulate knowledge, and make informed decisions.

• Only making investments which are understood:

  • Never invest in businesses not fully understood.

• Potentially using investment apps which allow investors to invest small amounts:

  • Be aware of fees and limits on diversification.

  • Consider long-term goals.

• Not overreacting:

  • Avoid quickly selling stocks based on bad news.

• Learning from mistakes and moving on:

  • Keep a record of mistakes to avoid them in the future.

• Getting help from professionals:

  • Consult a personal financial advisor for guidance.