Lesson 4
Unit objectives
Most people have to work for their money. And once they have earned it, they have an important choice to make:
Whether your income is small or large, setting aside some of it for investments requires self-discipline. You decide to postpone buying certain things you’d like to have now in order to enjoy the longer-term benefits of having your money work for you through savings and investments.
The current savings rate of households in Maine and the rest of the United States on average is less than 4 percent of income after taxes. Teenagers and adults who begin the savings habit early are more likely to have money available for things they want in the future.
Making your money work for you is what saving and investing is all about. You can measure your investment success by keeping track of how well you make your money work. Is you net worth increasing over time? Is inflation robbing you of the buying power of your saving dollars, or are your investment earnings staying ahead of the inflation rate?
Why People Save and Invest
There are many reasons why people save and invest. One reason is financial security. A fund for emergencies helps people cope with unexpected events such as illness, unemployment and accidents.
Saving and investing is also used to reach financial goals such as a new car, a college education, a trip or a down payment on a house. Of course, one of the most important reasons for people to save and invest is to provide the funds for a comfortable, financially secured retirement.
Another reason why people save and invest is to earn more money. A sum of money can be saved and invested in long-term securities that produce higher yields. For example, some mutual funds and government securities require a minimum investment of $1,000 or more.
Places to Accumulate Savings
The rates of return and risk for savings are usually lower than other forms of investment. Return is the income from savings or an investment. Risk is the uncertainty that you will receive an expected return. Savings are also usually more liquid. That is, you may quickly and easily convert your investment to cash.
Certificates of Deposit, often referred to as CDs, are purchased for specific amounts of money at a fixed rate of interest for a specified period of time. CDs may be purchased for as little as $500 but generally are priced at $1,000, $5,000, or $10,000.
You may buy a CD for as little time as seven days, or for as long as several years. The longer time usually carries a higher interest rate. If you cash in the CD before the maturity date, you will pay interest penalties. CDs are insured if the financial institution where you purchase the CD is a member of FDIC.
Higher-Risk Investments
Common types of higher-risk investments include some stocks and mutual funds, real estate, collectibles and futures contracts. The decision about which investment to choose is influenced by factors such as yield, risk, and liquidity.
Investments may produce income while you own the investment through the payments. When you sell an investment for more than its purchase price, the profit is known as a capitol gain, also called growth or capital appreciation.
Higher-risk investment choices for income include
Higher-risk investment choices for capital gains include
Stocks. When you own shares of stock, you become part-owner of a company. If the company does well, the value of your stock should go up over time. If the company does not do well, the value of your investment will decrease. Companies may distribute a portion of their profits to shareholders as dividends.
Companies issue two types of stock, common and preferred. Common stock is the basic form of ownership in a company. People who hold common stock have last claim on the assets of a firm after the Internal Revenue Service, creditors, bondholders, and preferred stockholders. Common stockholders have what is known as "residual rights" to corporate assets upon dissolution, often as a result of bankruptcy.
Preferred stock is ownership in a company that has a claim on the assets and earnings of a firm before those of common stockholders but after bondholders. The safety of the principal of preferred stock is greater than that of common stock.
Selecting individual stocks requires time, effort, and knowledge. The objective of buying stocks is to choose those that will increase in value over time. The friendly advice "buy low and sell high" is easier said than done. Selecting stocks is both an art and a science.
Bonds. When you own a bond you have loaned money to a company or a governmental unit. In return, the borrower promises to repay the amount borrowed plus interest. Corporate bonds are issued by publicly owned companies, while municipal bonds are issued by state or local governments.
The price of a bond will fluctuate as interest rates go up or down. When interest rates in the economy have gone up, prices of currently trading bonds tend to go down and vice versa. If you hold the bond to maturity, you will receive an amount stated on the bond known as the face value. For example, if you buy five corporate bonds at $1,000 each and the bonds mature in 20 years, even if the value of the bond changes over the period of time you hold in it, the bonds will be worth a total of $5,000 at the time of maturity. In addition, the borrower may promise to pay you an interest payment twice a year for 20 years. The declared interest of the bond is called the coupon rate.
Municipal bonds are interest-bearing, long-term bonds issued by the state and local governments. They are used to finance schools, roads, hospitals and libraries. Investors receive a lower rate of return in exchange for having the interest exempt from federal income tax. In addition to federal tax exemption, some states exempt income from municipal bonds from state income tax if you are a resident of the state issuing the bond.
"Junk bonds" is a slang term for speculative, high-risk, high-interest rate corporate or municipal bonds. The default rate is much higher on junk bonds than on higher-quality bonds. Junk bonds may be issued by companies of little financial strength and are rated as below investment grade.
Mutual funds. A mutual fund invest the pooled money of its shareholders in various types of investments. The fund manager buys and sells securities for the fund’s shareholders. Mutual funds are not risk free. Their values rise and fall along with the securities in the fund.
Benefits of mutual funds for the beginning investor include
Each mutual fund has an objective that determines the types of securities it invests in. The fund objectives are stated clearly in the prospectus, which is the legal document describing the fund.
For example, the fund objective may be "growth and income." This growth and income fund might own common stock of emerging companies and common and preferred stocks and bonds of large, well-known "blue-chip" companies.
Fund Objective Likely Investment Holdings
More than 8,000 different mutual funds are available on the open market. The investor should learn the objective of the fund, what securities the fund owns, the level of risk, and its earnings record as compared with similar funds.
All mutual funds have annual management fees. Some funds have additional fees when shares are bought and sold.
A redemption fee may be charged when shares are sold. The fund prospectus must disclose all fees and costs related to the funds. The one, five and ten-year earnings record, after fees, must be revealed.
The shares in mutual fund are priced by dividing the current market value of investments owned by the mutual fund shares. As the value of the securities in the fund goes up or down, the value of the shares changes accordingly.
Many mutual funds are part of a family of funds. An investment company may offer a number of funds with different objectives, and the investor may switch from one fund to another within the same family at little or no expense. For example, if you own a bond fund and you believe stocks are going to do well, you could switch your investment dollars into the stock funds within the same family of funds.
Real Estate. Home ownership is an investment. Like other investments, homes can appreciate in value and serve as a hedge against inflation. Houses can also drop in value and fail to keep pace with inflation.
Direct ownership of rental units and commercial buildings takes considerable time, skill, knowledge and risk tolerance on the part of the individual owner. Purchasing a rental property, for example, without full knowledge and experience could cause losses far exceeding the original investment.
Collectibles. Antiques, stamps, precious metals or gems pay no interest or dividends and depend on an increase in value over time for a return on investment. The rewards as well as the losses of owning collectibles can be great. Financial advisers caution against collectibles because there is no regulated marketplace, liquidity can be a problem, information regarding pricing is almost nonexistent, and fraud is rampant in markets for coins, gems, synthetic gems and precious metals.
Futures Contracts. A futures contract is a commitment to buy or sell a specific amount of a commodity at a specific future date and price. Futures contract deal in products ranging from corn, soybeans, wheat and cattle to gold, crude oil, Japanese yen and U.S. Treasury bonds. This speculative investment is only for knowledgeable investors who are willing to take high risk. Futures should never be more than a small portion of a total investment portfolio.
SELECTING SAVINGS AND INVESTMENTS
Factors to consider when selecting savings and investments include liquidity, risk, return, inflation, diversification, taxes and stage in the life cycle.
Liquidity
How quickly will you need your money? Savings held in bank accounts and money market funds are appropriate for short-term needs of a year or less because they are liquid. Investments such as stocks and bonds are suitable for longer-term goals, as they are less liquid. Keep in mind the liquidity is the speed and ease with which an asset can be converted into cash.
Savings vehicles such as certificates of deposit cannot be converted into cash prior to the maturity date without penalty. While stocks and bonds can be sold at any time, if and investor is forced to sell when the market is down, there can be a loss of the original money invested.
Risk
As a general rule, the greater the promised return the greater the risk. Risk tolerance is a person’s ability to ride out the ups and downs of the market without panicking when the values of investments go down. Risk tolerances vary from person to person and at different stages in the life cycle. Young adults with growing income potential may take greater investment risks than people who are approaching retirement.
How much should a person expect to earn on an investment? Average investment return over time has been the inflation rate plus three percent. For example, if the current inflation rate is five percent, an investor might expect an average return on an investment of about eight percent. Some investments will yield less, others more. Some investments are up over 50% this year.
Next year also looks good for large capital stocks. Most mutual funds are fine but watch out of scam artist.
If you are promised a return on an investment that is greater than three percent over the inflation rate, be alert to high risk and possible fraud. The return may be too good to be true. A scam artist may promise an unrealistically high return just to get your money.
People who don’t sleep well at night when the principal value of their investment goes down should select savings and investment with less risk. On the other hand, investments that guarantee the safety of principal may not maintain purchasing power in times of high inflation.
Individuals who can ride out market ups and downs without panic can comfortably put their money in investment that pay above average returns.
Return
The basic idea of investing is to commit money today with the expectation of financial return in the future. The return can come from earnings, growth or tax advantages.
Earnings on your investment can be in the form of interest, dividends or rent payments. You will recall that interest is the payment received in exchange for the loan of money. A dividend is payment to stockholders from the earnings of a corporation. Rent is a payment received in return for the use of property.
Growth comes from price appreciation on the investment that is sold for more than you paid for it. Appreciation, or capital gain, is income realized when you sell property or securities for more than you the purchase price. Of course you may have to sell for less than you paid, and have a capital loss.
For example, say you buy 100 shares of no-load stock mutual fund at $20 a share for a total of $2,000. If during the year the fund pays dividends totaling 1 dollar a share, your income from the investment would be $100. If you sold the shares at the end of the year for $22 a share, you would have a profit of $2 a share or $200. Your return of earnings plus appreciation would be $300. You had a very good year. This example ignored commissions and fees however, and your ran the risk of having so sell your shares for less than the $20 you paid.
Inflation
Inflation is an important factor for investors to consider because it reduces the purchasing power of money. The value of money is measured in the amount of goods and services it will purchase, and inflation is a general rise in the price of goods and services.
Historically, corporate stocks and real estate have been good investment in inflationary times, while bonds and other fixed return investments have lagged behind. People on fixed incomes such as retirees are hurt most by inflation. Social Security requirement payments are indexed to inflation to help these people cope with the rising cost of goods and services.
Diversification
The process of reducing risk by spreading the money among various types of investments is diversification. Because certain investments perform better than others in certain economic conditions, an investor can spread the risk by following the advice, "Don’t put all your eggs in one basket." An investor’s "basket" of securities and investments, known as a portfolio, can consist of investment options with varied risk-return characteristics. When interest rates are high, for example, stock prices tend to go down and bond prices go up. When interest rates are low, stock prices tend to rise and bond prices go down. One industry can be down while other industries are doing well. The auto business can be down, for example, while the housing industry prospers.
Taxes
Tax-deferred investments are those that have earnings that will not be taxed until the money is taken out of the investment. Examples of tax-deferred investments are U.S. Series EE Savings Bonds, and retirement plans such as traditional Individual Retirement Accounts (IRAs) and employer savings plans known as 401-K plans. Other alternatives include Self-Employed Plans (SEP), SEP-IRAs, Keoughs and teachers’ pension plans.
For example, if you accumulate $15,000 in a tax-deferred savings plan at work and leave it there for 20 years earning ten percent interest, the $15,000 will be worth $100,912. If you place the money in a taxable savings plan, the same $15,000 would be worth only $60,254. The difference is over $40,000.
In a taxable savings account, you would have paid taxes on the earnings each year thus reducing the amount of money available to earn additional interest. Earnings from the tax-deferred savings plan will be taxed when the money is withdrawn from the account, but in meantime it grows in a much more rapid rate.
Beginning in tax year 1998, Roth IRAs came into being. The Roth IRA, named after U.S. Senator William Roth from Delaware who created the legislation for this new IRA, provides no tax deduction for contributions you make, but instead provides a benefit that isn’t available for other savings vehicles: if you meet certain requirements, the earnings are tax free when you withdraw them. In other words, you trade of tax deductibility on the front end to escape paying taxes on your investment earnings. Young people, who are in lower tax brackets can use the Roth IRA to get an early start on retirement savings.
It is important to participate in employee savings and investment plans sponsored by your employer. In some cases employers will match the amount of money put in by the employee. If employees do not contribute, their employers may not as well, which is like throwing away money.
Workers who are not covered by an employer-sponsored retirement plan, or whose income is below certain limits may invest up to $2,000 each year in a tax deferred IRA and deduct the $2,000 from current taxable income.
HOW LONG WILL IT TAKE TO DOUBLE YOUR MONEY?
The old saying that "time is money" certainly applies to everyday decisions people make about whether to spend or save money and how much to save to meet specific goals. Factors that affect the future value of money include:
To explore the impact of time on the future value of an investment, consider two investors who are both age 25. Investor A regularly invests $2,000 a year for ten years. Interest on the account is allowed to remain in the account so that interest is earned on interest. Investor B waits ten years, until age 35, before starting an annual savings program of $2,000 per year. Despite the fact that Investor B saves for thirty-one years, Investor A has a much larger amount at retirement—nearly $200,000 more.
WEB SITES
Alliance for Investor Education
Financial Literacy 2001
National Association of Securities Dealers, Inc.
National Futures Association
National Institute for Consumer Education
http://www.emich.edu/public/coe/nice
Investor Protection Trust
http://www.investorprotection.org
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