pfl - secondary saveing and investing
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Saving & Investing
Dr. Katie Sauer
Metropolitan State College of Denver
(ksauer5@mscd.edu)
Presented at
Junior Achievements Elementary School Personal Financial Literacy Workshop
in collaboration with
the Colorado Council for Economic Education
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Session Overview
I. Basic TerminologyII. Saving
III. Turning Savings into Investment
IV. Time Value of Money
V. Managing Risk
VI. The Big Picture
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I. Basic Terminology
savings = income taxes spending on goods and services
investment = something acquired for future income or benefit
- investments can generate income(e.g. interest, dividends)
- investments can appreciate in value
(e.g. house, gold)
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By itself, savings is just what is left over from your income
after taxes and your spending.
When you take your savings and put it in an account that earns
interest or buy a stock or a house, you are investing.
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II. Saving
Why do people save?
According to the Federal Reserves triennial Survey of Consumer
Finances:
http://www.federalreserve.gov/pubs/bulletin/2009/pdf/scf09.pdf
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How much do people save?
Thesavings rate is the percent of after-tax income that is saved.
The Bureau of Economic Analysis (www.bea.gov) has been
tracking US household saving rates since 1959.
Year Average Savings Rate
1960s 8.21%
1970s 9.6%
1980s 8.61%
1990s 5.5%2000- Oct 2008 2.82%
Since Oct 2008 5.77%
http://research.stlouisfed.org/fred2/data/PSAVERT.txt
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The saving rate has been trending down since the early 1980s.
In recessions, people tend to save more.
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How much do people want to have saved
for emergencies and unexpected situations?
http://www.federalreserve.gov/pubs/bulletin/2009/pdf/scf09.pdf
As income rises, so does the amount that households want to
have saved.
As income rises, the percent of income that households need to
save to meet their goal tends to fall.
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A household with income of $15,000, wanting to save $2,000 will
have to save what percent of their income?
percent of income saved = $2,000 x 100
$15,000
percent of income saved = 13.3%
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A household with income of $250,000 wanting to save $20,000
will have to save what percent of their income?
percent of income saved = $20,000 x 100$250,000
percent of income saved = 8%
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Not all households have a saving account.
http://www.federalreserve.gov/pubs/bulletin/2009/pdf/scf09.pdf
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Common Types of Savings Accounts
Regular Savings account
Can be readily accessed
Easy to transfer funds
Money market accountOften a minimum balance
Some allow checking
Certificate of deposit (CD)
Specific term
- all earn interest
- all are FDIC insured to $250,000
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III. Turning Savings into Investment
The Financial System is the group of institutions in an economy
that help to match savers with borrowers
The US economy has two basic types of financial institutions:
- financial markets
- financial intermediaries
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A.Financial Intermediaries are institutions where funds are
transferred indirectly from savers to investors.
Examples:
1. Banks accept savings deposits and make loans.
- pay interest to depositors, charge interest to borrowers
2. Mutual Funds are institutions that sell shares to the public and
use the proceeds to buy a portfolio of stocks and bonds.
- allows individuals with a small amount of money to
diversify
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B.Financial Markets are institutions where funds are transferred
directly from savers to investors.
Examples:
1.Bond Market
A bond is a certificate ofindebtedness.
IOU
When a firm or government issues a bond, they are borrowing
money from anyone who buys the bond.
They are promising to pay you back a certain value in the future.
A bond has a date of maturity and a rate of interest associated
with it.
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Suppose you buy a $1,000 bond that matures in 5 years and pays
6% interest.
- Today, you give up $1,000 and receive the bond.
- You will receive periodic interest payments of 6% for
the next 5 years.
1,000 x 0.06 = $60
- At the end of the 5 years, you receive $1,000.
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Bonds can be sold at par value (face value) or at a discount or at a
premium.
Characteristics that determine a bonds value:
term: length of time until the bond matures- longer maturity time riskier
credit risk: the probability that the borrower will fail to pay the
interest or the principal
tax treatment: some bonds have interest that is tax free
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Issue price: $18.75
Maturity date: May 2008
Interest over 30 years: $87.92
Final value: $106.67 Treasurydirect.gov
US Government Bond:
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2. Stock Market
A stock is a claim of partial ownership of a firm.
- shareholder
If you buy a stock, you are not guaranteed to get your money back.
The price of a stock generally reflects the perception of a firms
future profitability.
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What determines the price of a stock?
a. Fundamental analysis is the study of a companys accounting
statements and future prospects.
It includes doing an economic analysis, industry analysis, and
company analysis.
- P/E ratio (stock price / net income per share)
- competitors
- the market for its product
- management- credit risk
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b. The Efficient Markets Hypothesis is the theory that asset prices
reflect all publicly available information about the value of theasset.
- each company listed on a stock exchange is followed
closely by many many people
- equilibrium of supply and demand sets the price
According to this theory, at the market price, the number of people
wanting to sell exactly equals the number wanting to buy.
Remember, any stock that you think is hot and about to increase
in value, someone else thought it was not hot and was willing to
sell it.
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c. Market Irrationality
Stock prices sometimes seem to be driven by psychological
reasons.
Herd Mentality is the tendency for individuals to copy the
actions of a larger group, even though without the group theperson may not choose to take the action on their own.
- when the stock market is booming and everyone is
investing, a person might decide it is a great time to buy
some stocks, too
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Reading a stock page:
52W high / low: highest/lowest prices paid in past year
Stock: company name
Ticker (symb): stock symbolDiv: the dividend paid annually for each share owned
%: annual dividend divided by the current stock price
P/E: price of a share divided by last years earnings per share
Vol 00s: how many shares were traded yesterday add two zeros
High/Low: highest and lowest price paid yesterdayClose (last): last price paid yesterday at market close
Net chg (chg): difference between price of most recent trade and
close yesterday
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2 biggest stock exchanges in the world:
New York Stock ExchangeNASDAQ
Stock market indexes:
Dow Jones Industrial Average = price-weighted average of 30 large
companies
S&P 500 = index of 500 large-cap companies
cap stands for market capitalization which is the equityvalue of the company
- large-cap means $10billion = $100billion
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NASDAQ Composite = index of all stocks traded on theNASDAQ stock exchange
Russell 1000 = index of the highest 1,000 stocks in the Russell
3000 Index
Russell 2000 = small-cap index of the bottom 2,000 stocks in the
Russell 3000 Index
Russell 3000 = index of 3,000 publicly traded companies
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http://www.federalreserve.gov/pubs/bulletin/2009/pdf/scf09.pdf
C. The Value of Household Assets
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http://www.federalreserve.gov/pubs/bulletin/2009/pdf/scf09.pdf
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Where do people get their information on investing?
http://www.federalreserve.gov/pubs/bulletin/2009/pdf/scf09.pdf
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IV. The Time Value of Money
Intuitively we understand that an amount of money today is more
valuable than the same amount of money in the future.
- inflation
- earn interest
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Future Value is the amount of money that can result from an amount
of money we have today.
Future Value = Present Value x (1 + r )
Ex: $18,000 wedding, 4% interest, 40 years
Future Value = 18,000 x (1.04)
Future Value = $86,418
Ex: $18,000 wedding, 6% interest, 40 years
Future Value = 18,000 x (1.06)
Future Value = $185,142
n
40
40
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Suppose you spend $1000 to go to a relaxing all-inclusive resort
in Mexico for spring break.
If you had invested the $1,000 at 5% interest, how much money
would you have had in 10 years?
Future Value = 1000 x (1.05)
Future Value = $1628.89
If you invested it for 20 years, how much would you have?
Future Value = 1000 x (1.05)
Future Value = $2653.30
10
20
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The higher the interest rate, the higher the future value of your
money saved today.
The longer the time frame, the higher the future value of your
money saved today.
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Present Value is the amount of money one would need today to
produce a given amount of money in the future.
Present Value = Future Value / (1 + r )
Ex. you want to have $1,000,000 in 25 years and the interest rate is5%
Present Value = 1,000,000 / (1.05)
Present Value = $295,303
If you put $295,303 in an account earning 5% interest, youd have
$1million in 25 years.
n
25
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Suppose instead you want the $1,000,000 in 40 years.
Present Value = 1,000,000 / (1.05)
Present Value = $142,045.68
40
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Suppose when your child begins his/her college education, you
promise to give you son/daughter $1000 cash if they graduate in 4
years. If your savings account earns 8% interest, how muchmoney would you need to put in today to have $1000 in 4 years?
Present Value = 1000 / (1.08)
Present Value = $735.03
Suppose instead your account earns 2% interest.
Present Value = 1000 / (1.02)
Present Value = $923.85
4
4
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The higher the interest rate, the smaller the amount of money
needed in the present to obtain a particular future amount.
The longer the time frame, the smaller the amount of moneyneeded in the present to obtain a particular future amount.
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V. Managing Risk
Risk Aversion is a dislike of uncertainty.
Practical advice for risk-averse people:dont put all your eggs in one basket
Diversify!
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Firm-specific riskonly affects a single company.
ex: a software firm that goes bankrupt because they sold
a low quality product that no one bought
Market riskis the risk associated with the entire economy.ex: in a recession, even good firms face hard times and
may have financial troubles
You can avoid firm-specific risk by diversifying but you cantavoid market risk.
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To some degree, you can avoid some of the market risk associated
with a particular nations economy.
ex: buy assets in nations outside the US
However, as nations become more and more engaged in the global
economy, there is a global market risk that is unavoidable.
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Keep in mind, there is always a tradeoff between risk and reward.- savings account is safe, but pays lower interest
- stocks are riskier, but pay a higher return
- US bonds are safer, 4% interest
- in spring 2010 Greek bonds were much riskier, 11% interest
If you ever hear of an investment that pays a high rate of return, you
should assume that it is risky and not a sure thing.
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Risk tolerance changes with age.
When a person is early in their working years, investing in
relatively riskier assets is okay.
- can ride out the ups and downs of the stock market
can have big payoffs and can recover from any losses
When a person is getting closer to retirement, investing in safer
assets is wise.
- if the stock market has a downturn in the few years
before retirement little time to make up that loss
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savings
business investment
physical capital
capital per worker
productivity
standard of living
Besides being
beneficial for
households,
savings is alsoimportant for the
economy as a
whole:
VI. The Big Picture
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