Saving & Investing

Dr. Katie Sauer

Metropolitan State University of Denver (ksauer5@msudenver.edu)

Presented at Junior Achievement’s Elementary School Personal Financial Literacy Workshop

in collaboration with the Colorado Council for Economic Education

Session Overview

I. Basic TerminologyII. SavingIII. Turning Savings into InvestmentIV. Time Value of MoneyV. Managing RiskVI. The Big Picture

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)

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.

II. SavingWhy do people save?

According to the Federal Reserve’s triennial Survey of Consumer Finances:

http://www.federalreserve.gov/pubs/bulletin/2009/pdf/scf09.pdf

How much do people save?

The savings 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 Rate1960s 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

The saving rate has been trending down since the early 1980s.In recessions, people tend to save more.

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.

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%

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%

Not all households have a saving account.

http://www.federalreserve.gov/pubs/bulletin/2009/pdf/scf09.pdf

Common Types of Savings Accounts

Regular Savings accountCan be readily accessedEasy to transfer funds

Money market accountOften a minimum balanceSome allow checking

Certificate of deposit (CD)Specific term

- all earn interest- all are FDIC insured to $250,000

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

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

B. Financial Markets are institutions where funds are transferred directly from savers to investors.

Examples:1. Bond Market

A bond is a certificate of indebtedness. “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.

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.

Bonds can be sold at par value (face value) or at a discount or at a premium.

Characteristics that determine a bond’s 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

Issue price: $18.75Maturity date: May 2008Interest over 30 years: $87.92Final value: $106.67 Treasurydirect.gov

US Government Bond:

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 firm’s future profitability.

What determines the price of a stock?

a. Fundamental analysis is the study of a company’s 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

b. The Efficient Markets Hypothesis is the theory that asset prices reflect all publicly available information about the value of the asset.

- 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.

c. Market IrrationalityStock 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 the person 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

Following a StockGoogle Finance 2/21/12

current price per share, the last price a share was traded at

company namename of stock exchange and stock symbol

change: compared to most recent closing price

percent change: change x 100 close price

Range: daily high and low price

52 Week: high and low price for the last 52 weeks

Open: the price at the beginning of trading today

Vol/Avg: Volume = number of shares traded today Average = average number of shares traded daily

Mkt cap: Market Capitalization is a measure of the total value of the company

Mkt Cap= Total Shares Outstanding x Current Price

P/E: Price-to-Earnings Ratio is the price of a share divided by last year’s earnings per share

Div/Yield: a Dividend is the amount of money the firm will pay you (typ. each quarter) for each share you own. The Yield = dividend / price

- not all firms pay dividends

EPS: Earnings Per Share is the amount of earnings per each outstanding share

Shares: the number of shares outstanding

Beta: A statistical estimate of how closely the stock’s performance matches the stock market in general. The higher the beta, the closer the stock matches the general market.

Inst. Own: Institutional Ownership is percent of the shares that the firm owns

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

NASDAQ Composite = index of all stocks traded on the NASDAQ 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

http://www.federalreserve.gov/pubs/bulletin/2009/pdf/scf09.pdf

C. The Value of Household Assets

http://www.federalreserve.gov/pubs/bulletin/2009/pdf/scf09.pdf

Where do people get their information on investing?

http://www.federalreserve.gov/pubs/bulletin/2009/pdf/scf09.pdf

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

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

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

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.

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 is 5%

Present Value = 1,000,000 / (1.05)

Present Value = $295,303

If you put $295,303 in an account earning 5% interest, you’d have $1million in 25 years.

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25

Suppose instead you want the $1,000,000 in 40 years.

Present Value = 1,000,000 / (1.05)

Present Value = $142,045.68

40

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 much money 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

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4

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 money needed in the present to obtain a particular future amount.

V. Managing Risk

Risk Aversion is a dislike of uncertainty.

Practical advice for risk-averse people:don’t put all your eggs in one basket

Diversify!

Firm-specific risk only affects a single company.ex: a software firm that goes bankrupt because they solda low quality product that no one bought

Market risk is the risk associated with the entire economy. ex: in a recession, even good firms face hard times andmay have financial troubles

You can avoid firm-specific risk by diversifying but you can’t avoid market risk.

To some degree, you can avoid some of the market risk associated with a particular nation’s 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.

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.

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

savings

business investment

physical capital

capital per worker

productivity

standard of living

Besides being beneficial for households,savings is also important for the economy as a whole:

VI. The Big Picture