Module 4 Notes - RCSC PDF

Preview

Summary

Lecture and coursework notes for the entirety of Module 4....

Description

Introduction to Investing: Preparing for the Unexpected Building wealth over a lifetime begins with a habit of saving Saving = the act of generating a financial surplus Savings = money put aside to achieve short-term goals Financial Emergencies = job loss, car repairs, medical/dental expenses, unexpected home repairs, emergency travel, unexpected budget gaps Preparing for the Unexpected - An emergency fund contains easily accessible money that is specifically set aside to cover unexpected financial needs Building an Emergency fund - #1 Start saving, #2 save $1,000, #3 save 3 months worth of expenses, #4 save up to 6 months of expenses (more if you have unstable work) - If you use your emergency fund, immediately start rebuilding it Determining the Amount of your Emergency Fund - Estimate your monthly living expenses - Minimum monthly dollar amount you need each month - All your essential expenses (minus taxes, savings, and discretionary spending) - Determine your monetary assets - Highly liquid assets such as cash, savings account balances and possibly checking account funds Emergency Fund Ratio = monetary assets/monthly living expenses - Example: if you pay $1,000 in rent, $200 for monthly utilities, $200 for student loan payment, $250 for car payment, $50 for car insurance, $150 for health insurance, $50 for a cell phone, and your bare minimum grocery budget is $250 = $2,150, assets =$4,500. 4500/2150 equals 2.1 months Where should you store your emergency fund? - In a savings account: - Easy access to funds (through in person withdrawals or transfers to checking account), but limited withdrawals are limited each month (6) - Hopefully interest-bearing to earn a small return on your deposit - Insured up to $250,000 for individuals - In a Certificate of Deposit (CD) - An interest-bearing account that earns a higher return on your deposit compared to a savings account (usually) - Generally purchased with a lump sum amount - Restricted access to funds with penalty for early withdrawal Key Take-Away: The first step in preparing to invest is to build an emergency fund

-

After reaching your emergency fund, pay off debt, invest, or both.

Part 2 - Saving vs. Investing Inflation - Defined as a sustained increase in the general level of prices for goods and services - Measured as an annual percentage increase - As inflation rises, every dollar you own buys a smaller percentage of a good or service Inflation Impacts Returns - Nominal return: actual percentage return

-

Real rate of return: inflation-adjusted return

Investing: - The act of allocating funds to an asset or committing capital to an endeavor, with the expectation of generating an income or profit. Investments: - Assets purchased to reach long-term financial goals Ideal Strategy: - Combine both options over your financial journey to accumulate wealth Key Take-Away: To overcome inflation, you must generate high returns from investments Part 3 - Risk and Return Savings

Investments

-The purpose of saving money is so that you have money if you need it in the short term -Savings are low risk funds that must be liquid when you need them -Yields low returns

- Investments are for wealth building -Invested funds should not be needed for many years -Involves greater risk -Yields much greater returns when left alone long enough to ride out turbulence in the market.

Risk = the degree of uncertainty and or potential financial loss inherent in an investment decision Return = the money you make on an investment The First Rule of Risk - Rule 1: Greater financial risks are associated with higher expected returns

-

Rule 2: Financial risk increases as asset liquidity risk increases Rule 3: Financial risk increases as marketability risk increases - Marketability risk = the ability to sell your asset relatively quickly and receive cash in a timely manner Bringing the Rules Together - For higher returns, you must be willing to: take greater financial risk, sacrifice some liquidity (take on liquidity risk), give up some marketability (increase marketability risk) Risk Tolerance - Your willingness to engage in risky behavior where outcomes are both unknown and potentially negative - Your risk tolerance encompasses a wide range of attitudes, including your willingness to invest in assets with (1) liquidity risk and (2) marketability risk Risk Tolerance Can Change - Build your financial knowledge, experience and confidence. Increasing your financial capacity. - Financial capacity is your ability to withstand a financial loss. With more assets and more security, comes an increased ability to take risks. Building a Portfolio - A portfolio is a grouping of investments, generally from a number of asset categories, into one place (retirement plan). - Asset categories: different types of investment assets such as stocks, bonds, and real estate. - Your portfolio should align with your risk tolerance. Diversification - The spreading of investments across different types of assets as a way to manage financial risk. Keeping a portfolio with a mix of asset classes is one way to achieve diversification. Diversification helps to reduce risk from volatility. - Volatility refers to how wildly returns fluctuate over time ______________________________________________________________________________ Stocks Lecture Part 1 Stock = a share in the ownership of a company, a claim on the company’s assets and earnings Why do companies issue stocks? - When a business wishes to raise capital, to fund growth or invest in the business, pay out a founding owner who wishes to succeed ownership Issuing Stock vs. Borrowing

-

Issuing: does not require debt that will need to be repaid, must give up some control as ownership is distributed among shareholders - Borrowing: no need to give up business ownership, debt must be repaid or settled, even if business venture fails Stock: Private vs Public - Privately held stocks are available to a relatively small number of people or family members who own all the available shares. Publicly traded stocks can be bought in the stock market. Advantages of Being Privately Held - Do not need to provide profit and loss statements, cash flow statements, or balance sheets to the general public. Are only required to submit documentation to the tax authorities. Have greater autonomy in operations and a reduced cost of compliance with company law when compared to publicly-held companies. Advantages of Being Publicly Held - Can raise large amounts of capital in a short period of time which can allow for growth or buyout of founders or venture capitalists. Have shares that are more liquid (easy to sell) compared to private companies. The Creation of Stock 1. Idea for a new product or service (cupcake store) 2. Business expansion funded by loans and private investment (first store is opened using loans/savings) 3. Continued growth and fundraising with an underwriter (needs $10 million) 4. Incorporation (now a corporation with 1,000,000 shares for sale) 5. Selling shares in an initial public offering (IPO) Stock Exchanges Stock Investors: - Investors buy shares of stock in companies. Since investors own the company, they are legally entitled to share in the profits of the firm. The firm’s investors also appoint, through elections, the managers of the company. Stock Exchanges: - A stock exchange is an organized market where buyers and sellers conduct stock transactions (buy and sell shares of stock and other financial instruments). Exchanges facilitate efficient transactions in the market, providing liquidity. They ensure trading occurs in an orderly and fair manner. US Stock Exchanges: NYSE, NASDAQ, AMEX Foreign: Shanghai, Hong Kong, Japan - Most trades are executed electronically. Share prices fluctuate based on supply of and demand for available shares. Brokerage firms act as intermediaries between investors and

exchanges. How Do People Make Money with Stocks? Using Stocks to Create Wealth - There are two ways to make money owning stock: - Buying shares of stock in a profitable firm, holding the stock for a period of months or years, and then reselling the shares at a higher price (share price appreciation) - Capital Gain/Loss: the difference between the sale and purchase price of a stock - Receiving earnings in the form of dividends (profit distribution) Stock Prices and Dividends - Stock prices (share prices): the fair market value of a company’s shares. - What you would need to pay to buy a share of this company. - Stock prices are constantly changing. - Dividend: An investor’s share of a company's profits that get distributed to shareholders. - Not all profits get distributed as dividends. Dividend Yield, Earnings Per Share P/E Ratio - Dividend yield = a dividend expressed as a percentage of a company’s current share price. - Earnings per share (EPS) = a measure of the amount of a firm’s profit for each outstanding share of common stock. - Profit to Earnings Ratio: a stock valuation tool that is calculated by dividing a stock’s price per share by earnings per share. Income Generation -

Stocks are assets that have the potential to produce income. 1. One cupcake sells for $2 - gross sale. 2. Expenses such as ingredients, labor, rent, and taxes reduce the gross sales value ($1.90) 3. One cupcake may product a net profit of 10 cents (Gross sales - expenses - net profit) 4. With 10,000,000 cupcakes at $0.10 each, the firm generates $1,000,000 in profit. Ways to Classify Stocks - Domestic and International: where is the company headquartered? - Market Capitalization: is the price of a stock multiplied by the total number of shares in the marketplace. - Market Sector: communications, energy, financial, healthcare, industrial, materials, real estate, technology, utilities, consumer staples Growth Vs Income

-

Stocks focused on stock price appreciation are called growth stocks Stocks that pay out a large portion of earnings in dividends are called income stocks Stocks that provide shareholders a combination of stock price appreciation and dividends are called growth and income stocks ______________________________________________________________________________ Bonds Part 1 - Bonds represent contractual loans to corporations and governments - They are a debt investment in which an investor loans money to an entity (typically corporate or governmental) which borrows the funds for a defined period of time at a variable or fixed interest rate. Types of Bonds - State and local government bonds, US treasury bonds, mortgage-related bonds, corporate bonds, other bonds. How Bonds Work - When a company or government needs to raise money to finance new projects, maintain ongoing operations, or refinance existing debts, they may issue bonds directly to investors instead of obtaining loans from a bank. Advantages: - Provide low-risk fixed income in the form of interest payments. Help investors diversify a portfolio. Bond Features - The face value (or par value) of the bond: the amount of money that the bond issuer will pay to the bondholder on the maturity date. - The maturity date of the bond: the length of the loan contract (a few months, years, or decades in the future) - The coupon rate of the bond: the interest rate that the bond issuer has agreed to pay the bondholder. - The coupon payment for the bond: the dollar amount of interest that the bond issuer will pay the bondholder. Example: - Imagine a bond with a face value of $25,000, 3.5% interest (coupon rate) and a maturity date of 5 years. How much does this bond pay each year? Pays $875 per year, quarterly $218.75. Bondholders will receive $4.375 in interest for the life of this loan, and receive their initial $25,000 (face value) upon maturity of the bond. Interest vs. Dividends - Corporation Distribution of Interest and Dividends to Investors Bonds 201 - Bonds vs. Banks: why would a company choose to issue a bond rather than taking out a

loan from the bank? 1. Lower interest rates 2. Fewer restrictions Advantage of issuing stocks = no loan to repay Advantage of issuing bonds = share price and dividends not diluted Buying and Selling Bonds - Bonds can be bought and sold on secondary markets. Depending on current interest rates, bonds can be sold at a premium, or at a discount. Bond Values - Current interest rate equal to the coupon rate - Current interest rate less than the coupon rate - Current interest rate greater than the coupon rate How Bonds Work - A premium bond is a bond trading above its par value: a bond trades at a premium when it offers a coupon rate higher than prevailing interest rates. This is because investors want a higher yield and will pay more for it. - A discount bond that is issued for less than its par (or face) value. A bond is considered a discount bond when it has a lower interest rate than the current market rate, and consequently is sold at a lower price. Default Risk - Order of repayment if entity defaults: IRS, banks, senior bondholders, subordinate bondholders, stockholders (preferred, then common) Accounting for Taxes - Municipal bonds are exempt from federal income tax. US treasuries and some municipal bonds are exempt from state income tax. Corporate bonds are not exempt from either federal or state income tax. Risks of Bonds - There is no guarantee that the issuer won’t default on its debt. Interest-rate, liquidity, inflation, and call risks apply to bonds. - Short-term bonds are typically less risky. Long-term bonds generally have a higher interest rate but are considered riskier because their prices can be fairly volatile over a 10+ year period. ______________________________________________________________________________ Week 12 - Due 11/12/21: Mutual Funds and ETFs Reading 8.4, 8.5, 8.6 Mutual Funds and ETFs Parts 1-3

As a general rule, the higher the risk of an investment, the higher the potential return. The Risk and Return Tradeoff: Throughout your life, you must balance two opposing goals: 1) Generate high returns on your investments 2) Limit your exposure to financial loss The Problem with Investing In Stock: If you invest in one company, you have the potential to generate large returns, but also the potential to lose everything. The value of your investment is tied to your company’s value -- and can go up or down. The Problem with Investing in Bonds: If you have a high-quality bond, you have a lower probability of losing your money, but your returns will also be small. Low risk yields low returns on your investment. Diversification: Spreading your investments across different types of assets as a way to manage financial risk. - How can I achieve diversification? - Spread your money around. Buy stock in multiple companies across multiple industries in more than one asset class (market cap). Buy stocks from US and foreign companies. Invest in real estate. - Challenges to Diversifying a Portfolio with Individual Stocks and Bonds - Time and expertise needed to research many companies across many industries and countries. Many stocks are cost prohibitive or small investors. Mutual Funds and ETFs - Ofer the potential for high returns - Reduce risk by limiting exposure to any one company’s risk of loss or default Mutual Funds = are investments that pool individual investors’ money. By pooling funds, investors can spread their money around across a wide assortment of securities and reduce unsystematic risk. (allow diversity with minimal funds) Part 2 - Mutual Funds and ETFs Market Indices = a market index is an unmanaged grouping of stock (or bonds) that has been identified as representative of some aspect of the economy or stock or bond market. - Common Indices: S&P 500, Russell 2000 Index, DJIA… Mutual Fund Management: - Passively managed mutual funds (index funds) are set to mirror returns in the market, rather than beat them

-

Actively managed mutual funds are professionally selected portfolios that attempt to provide superior risk-adjusted returns. - Seek to bring a higher return than the stock market overall. Value-oriented investors look for underpriced stocks or bargains. Growth-oriented investors seek stock where the share price is quickly increasing. - Passively managed funds have typically higher returns that actively managed (7.68-6.74%)

When selecting a mutual fund, compare fees! - Avoid sales-loaded mutual funds. A sales load is a one-time commission paid to an investment salesperson either when the mutual fund is purchased or sold. Look for noload mutual funds. - Avoid paying 12b-1 fees, if possible. A 12b-1 fee is an annual fund marketing expense passed on to shareholders in the mutual fund. - Fees: Expense Ratio - Buy the mutual fund with the lowest expense ratio: a mutual fund’s expense ratio is a measure of the total management fees and expenses charged to the mutual fund annually. - It is the % of the mutual fund used to pay these annual fees. Expense ratios range from less than 0.1% to more than 2.5%. The lower the expenses, the higher your returns. Target Date Funds - a special type of asset allocation fund managed based on an individual’s expected year of retirement. Part 3 - ETFs Issues with Mutual Funds - Mutual fund investors can only sell or buy shares in a mutual fund at the end of the trading day. Mutual fund investors can only sell mutual fund shares back to the company that originally issued them ETFs - An exchange traded fund (ETF) is an investment that combines the features of a mutual fund, with the ease of buying and selling a stock: - Investors can buy and sell ETF shares throughout the trading day - Nearly all ETFs are index-based securities - ETFs fees tend to be lower than mutual fund fees ______________________________________________________________________________ Retirement Planning Notes - Part 1 and Part 2

Intro to Personal Finance - 10.1, 10.2, 8.8 Retirement Options - Many people in the past retired with a pension plan which provides a retiree with a guaranteed payment from his or her employer for the remainder of the retiree’s life - Today it is likely you will have a defined contribution plan. Sets how much you and your employer will deposit into a retirement account. Why the Change? - People are living longer and long retirements are expensive. Companies don’t want to be on the hook for expensive retirement payouts long into the future. Workers don’t like the risk of a company/government defaulting on pension benefits. Social Security - Implemented in 1937 to pay retirees a basic retirement income benefit. The Social Security program is a pay as you go system, meaning that current taxes fund the vast majority of the current retirement benefits of retirees. Benefits are based on a formula designed to replace a certain percentage of your lifetime income. Risks of Defined Contribution Plans - Workers must take action and plan for retirement, including setting aside today’s income to fund future needs - Many workers feel unprepared to take action and delay saving for retirement. - If workers don’t save adequately for retirement, they may have to depend on Social Security alone. The average SS benefit in 2019: $1,422 a month. - Define contribution plans transfer risk and rewards to workers and away from companies. Retirement Planning: A Step-by-Step Guide Debt vs. Retirement (Ordering Your Financial Goals) - Financial Goal #1: Pay the minimum due on all debts to stay current and protect your credit score. - Financial Goal #2: Save up a 3-6 month emergency fund. - Financial Goal #3: Pay off high-interest debts (credit cards) - Financial Goal #4: Take advantage of any company matched retirement plans, up to the company match (ex. 3%) - Financial Goal #5: Begin paying off low-interest debts - Financial Goal #6: Open a Roth IRA and begin saving for retirement (if possible, pursue goals 5 and 6 simultaneously) Step 1: How Much Will You Need? - Depends on average annual career income, wage replacement rate, income replaced by social security, percentage of income you need to replace, amount of income you need to replace, amount of money needed at retirement

Step 2: How Much Should You Be Saving? - Depends on age and amo...