Personal finance 6th madura chapter 14 investing funadmentals

Personal Finance SIXTH EDITION Chapter 14 Investing Fundamentals Copyright © 2017, 2014, 2011 Pearson Education, Inc All Rights Reserved Chapter Objectives (1 of 2) 14.1 Describe the common types of investments available to investors 14.2 Explain how to measure the return on investments 14.3 Identify the risks of investments 14.4 Explain the trade-off between the return and risk of investments Copyright © 2017, 2014, 2011 Pearson Education, Inc All Rights Reserved Chapter Objectives (2 of 2) 14.5 Describe common investment mistakes that should be avoided 14.6 Explain how personal investing fits within your financial plan Copyright © 2017, 2014, 2011 Pearson Education, Inc All Rights Reserved Types of Investments (1 of 6) • First, review personal balance sheet • Consider paying off loans before investing • Even though investing may be more attractive, paying liabilities first usually makes more sense • Ensure adequate liquidity Copyright © 2017, 2014, 2011 Pearson Education, Inc All Rights Reserved Types of Investments (2 of 6) • Money market securities • Stocks – Common versus preferred stock  Common stock: a certificate issued by a firm to raise funds that represents partial ownership in the firm  Preferred stock: a certificate issued by a firm to raise funds that entitles shareholders to first priority to receive dividends Copyright © 2017, 2014, 2011 Pearson Education, Inc All Rights Reserved Types of Investments (3 of 6) – Primary and secondary stock markets – Primary market: a market where newly issued securities are traded  Initial public offering (IPO): the first offering of a firm’s stock to the public – Secondary market: a market where existing stocks are traded Copyright © 2017, 2014, 2011 Pearson Education, Inc All Rights Reserved Types of Investments (4 of 6) • Types of investors – Institutional investors: professionals responsible for managing money on behalf of the clients they serve – Portfolio managers: employees of financial institutions who make investment decisions – Individual investors: individuals who invest funds in securities – Day traders: investors who buy stocks and then sell them on the same day Copyright © 2017, 2014, 2011 Pearson Education, Inc All Rights Reserved Financial Planning Online (1 of 2) • Go to http://www.renaissancecapital.com • This Web site provides information about firms that are about to engage in an IPO and also summarizes the performance of recent IPOs Copyright © 2017, 2014, 2011 Pearson Education, Inc All Rights Reserved Financial Planning Online (2 of 2) • Go to the finance section of Yahoo.com • This Web site provides historical price movements for a stock that you specify Type in the symbol for your stock then click on “Charts.” You can easily monitor the price of a stock you already own or may purchase in the future Copyright © 2017, 2014, 2011 Pearson Education, Inc All Rights Reserved Types of Investments (5 of 6) • Bonds – Long-term debt securities issued by government agencies or corporations • Mutual Funds – Sell shares to individuals and invest the proceeds in a portfolio of investments Copyright © 2017, 2014, 2011 Pearson Education, Inc All Rights Reserved Investment Return (6 of 7) EXHIBIT 14.1 Comparing the Tax Effects on Short- and Long-Term Capital Gains If Stock Is Held for One Year If Stock Is Held for More Than One Year $100 $100 Short-term capital gain 800 Long-term capital gain 800 $900 $900 Tax on dividends (15%) $15 $15 Short-term capital gains tax (35%) 280 Long-term capital gains tax (15%) 120 Total taxes $295 $135 After-tax income $605 $765 Dividends Total income Copyright © 2017, 2014, 2011 Pearson Education, Inc All Rights Reserved Investment Return (7 of 7) • How your wealth is influenced by your return – Any return saved increases the value of assets and therefore increases wealth – Future value calculations can help estimate these increases Copyright © 2017, 2014, 2011 Pearson Education, Inc All Rights Reserved Risk from Investing (1 of 3) • Returns are uncertain • Illustration of risk – Some types of investments are similar to gambling and appeal to investors because of the potential of a large gain – Many investors in denial about the risk involved Copyright © 2017, 2014, 2011 Pearson Education, Inc All Rights Reserved Risk from Investing (2 of 3) • Risk due to uncertainty surrounding economic conditions – Future values of investments are dependent on the demand by investors – 2005-2007 the economy was very strong – 2008-2009 the economy was very weak Copyright © 2017, 2014, 2011 Pearson Education, Inc All Rights Reserved Risk from Investing (3 of 3) • Measuring an investment’s risk – Range of returns: returns of a specific investment over a given period – Standard deviation: the degree of volatility in the stock’s return over time – Subjective measures of risk  Bond rating agencies are one example where investors can assess risk based on the firm’s bond rating Copyright © 2017, 2014, 2011 Pearson Education, Inc All Rights Reserved Trade-off Between Return and Risk (1 of 3) • Return-risk trade-off among stocks – Small firms tend to have more growth potential, but higher risk – IPOs may offer high returns, but also have high risk, especially for individual investors • Return-risk trade-off among bonds – Large, well-known firms have low return, low risk – High-risk bonds offer higher payments Copyright © 2017, 2014, 2011 Pearson Education, Inc All Rights Reserved Trade-off Between Return and Risk (2 of 3) • Risk-return trade-off among mutual funds – Mutual funds containing small stocks are more risky than those containing large stocks – Mutual funds containing bonds of weak corporations are more risky than those with bonds of creditworthy corporations Copyright © 2017, 2014, 2011 Pearson Education, Inc All Rights Reserved Trade-off Between Return and Risk (3 of 3) • Return-risk trade-off among real estate investments – Renters could default – Property value could decline • Comparing different types of investments – Select investments that suit your personal objectives Copyright © 2017, 2014, 2011 Pearson Education, Inc All Rights Reserved Exhibit 14.2 How Investment Decisions Vary with Your Situation EXHIBIT 14.2 How Investment Decisions Vary with Your Situation Situation Decision You have $1,000 to invest but will need the funds in one month to pay bills You need liquidity You should only consider money market securities You have $3,000 to invest but will need the funds in a year to make a tuition payment You should consider safe money market securities such as a one-year insured CD You have $5,000 to invest and will likely use the funds in about three years when you buy a home Consider a three-year insured CD or stocks of relatively stable firms that have relatively low risk You have $10,000 to invest and have no funds set aside for retirement in 20 years Consider investing in a diversified stock mutual fund You have $5,000 to invest You expect that you will be laid off from your job within the next year You should probably invest the funds in money market securities so that you will have easy access to the funds if you lose your job Copyright © 2017, 2014, 2011 Pearson Education, Inc All Rights Reserved Learning from Investment Mistakes • Making decisions based on unrealistic goals • Borrowing to invest – Investing with money that could have been used to pay off an existing loan • Taking risks to recover losses Copyright © 2017, 2014, 2011 Pearson Education, Inc All Rights Reserved How Investments Fit Within Your Financial Plan (1 of 5) • Key decisions about investments that should be included in your financial plan are: – What are your investment goals? – Given your existing budget, should you make investments? – Based on your risk tolerance, how should you invest funds? Copyright © 2017, 2014, 2011 Pearson Education, Inc All Rights Reserved How Investments Fit Within Your Financial Plan (2 of 5) EXHIBIT 14.3 How Investments Fit Within Stephanie Spratt’s Financial Plan GOALS FOR INVESTING Determine my investment goals Determine whether to make investments Determine the types of investments that would achieve my investment goals ANALYSIS OF FUNDING Monthly Cash Inflows – Typical Monthly Expenses $2,500 1,488 – Monthly Car Loan Payment 412 = Amount of Funds Available $600 Copyright © 2017, 2014, 2011 Pearson Education, Inc All Rights Reserved How Investments Fit Within Your Financial Plan (3 of 5) EXHIBIT 14.3 How Investments Fit Within Stephanie Spratt’s Financial Plan ANALYSIS OF POSSIBLE INVESTMENTS Type of Investment Assessment CDs and Other Money Market Securities Many money market securities provide good liquidity and are safe, but they typically offer low returns Stocks Can provide high returns, but are risky given the limited amount of funds I anticipate I will have for investing Bonds Some bonds have low risk, but they offer lower potential returns than stocks Real Estate The value of my home may increase over time Additional real estate investments can generate high returns but are usually risky Stock Mutual Funds Can provide high returns, and offer more diversification than investing in individual stocks, but can generate losses if stock market conditions are weak Bond Mutual Funds Offer more diversification than investing in individual bonds, but can generate losses if bond market conditions are weak Copyright © 2017, 2014, 2011 Pearson Education, Inc All Rights Reserved How Investments Fit Within Your Financial Plan (4 of 5) EXHIBIT 14.3 How Investments Fit Within Stephanie Spratt’s Financial Plan DECISIONS My primary investment goal is to maintain sufficient liquidity in any funds that I invest to cover any unanticipated expenses However, I would like to earn a return on any funds that I have until they are needed to cover expenses Copyright © 2017, 2014, 2011 Pearson Education, Inc All Rights Reserved How Investments Fit Within Your Financial Plan (5 of 5) EXHIBIT 14.3 How Investments Fit Within Stephanie Spratt’s Financial Plan After paying for my typical monthly expenses (not including recreation), I have $600 left each month I am not in a financial position to make long-term investments at this time because I will use some of these funds each month for recreation and will deposit the remaining funds in liquid accounts such as a money market fund I need to increase my liquidity since I might incur unexpected home repair expenses periodically Beyond maintaining liquidity, I hope to save enough money to pay o my car loan early Once I pay o that loan, I will reconsider whether to invest in riskier investments that have the potential to offer a higher return My salary should also increase over time, which will make investments more affordable When I start long-term investing, I will consider stock mutual funds and bond mutual funds rather than individual stocks or bonds I can periodically invest in mutual funds with small amounts of money and achieve diversification benefits Since I already own a home, I not want to invest in additional real estate Copyright © 2017, 2014, 2011 Pearson Education, Inc All Rights Reserved ... © 2017, 2 014, 2011 Pearson Education, Inc All Rights Reserved Chapter Objectives (2 of 2) 14. 5 Describe common investment mistakes that should be avoided 14. 6 Explain how personal investing fits.. .Chapter Objectives (1 of 2) 14. 1 Describe the common types of investments available to investors 14. 2 Explain how to measure the return on investments 14. 3 Identify the risks of investments 14. 4... 2017, 2 014, 2011 Pearson Education, Inc All Rights Reserved Types of Investments (1 of 6) • First, review personal balance sheet • Consider paying off loans before investing • Even though investing