Understanding Personal Finances and Investments Chapter Twenty Understanding Personal Finances and Investments Copyright © Cengage Learning. All rights reserved

Preparing for an Investment Program Managing Your Personal Finances The use of your personal funds to earn a financial return Personal budget is a specific plan for spending income Investment goals Personal investment goals must be Specific and measurable Tailored to individual needs Focused on the future Realistic in terms of economic conditions and opportunities Copyright © Cengage Learning. All rights reserved

Copyright © Cengage Learning. All rights reserved ? What financial goals do you want to achieve? How much money will you need, and when? What will you use the money for? Is it reasonable to assume that you can obtain the amount of money you will need to meet your investment goals? Do you expect your personal situation to change in a way that will affect your investment goals? What economic conditions could alter your investment goals? Are you willing to make the necessary sacrifices to ensure that your investment goals are met? What are the consequences of not obtaining your investment goals? Copyright © Cengage Learning. All rights reserved

Personal Investment Program Financial planner An individual who has had at least two years of training in investments, insurance, taxation, retirement planning, and estate planning and has passed a rigorous examination Begin by accumulating an emergency fund Invest funds according to your plan Monitor the plan Copyright © Cengage Learning. All rights reserved

Copyright © Cengage Learning. All rights reserved ? Learn to balance your budget Make savings a higher priority Take advantage of employer-sponsored retirement programs Participate in an elective savings program Make a special savings effort one or two months each year Take advantage of gifts, inheritances, and windfalls Source: Jack R. Kapoor, Les R. Dlabay, and Robert J. Hughes, Personal Finance, 9th ed. Copyright © 2009 by The McGraw Hill Companies, Inc. . Copyright © Cengage Learning. All rights reserved

Personal Investment Elements You must give up one to have the other two Risk Minimizing the risk of loss (e.g., investing in blue-chip stocks) Maximizing potential returns by assuming some risk Investment growth An increase in the value of that investment, such as mutual funds and real estate that appreciate in value Investment liquidity How easily an investment can be converted into cash Copyright © Cengage Learning. All rights reserved

Copyright © Cengage Learning. All rights reserved Types of Investors Everyone has a different level of tolerance toward risk and reward. Low Risk – Low Reward (I can’t loose more than $100) High Risk – High Reward (I can still sleep when I loose $5000). Copyright © Cengage Learning. All rights reserved

Surviving a Financial Crisis Seven steps you can take Establish a larger than usual emergency fund Know what you owe Reduce spending Pay off credit cards Apply for a line of credit at your bank, credit union, or financial institution Notify credit card companies and lenders if you are unable to make payments Monitor the value of your investment accounts Copyright © Cengage Learning. All rights reserved

Copyright © Cengage Learning. All rights reserved The primary market A market in which an investor purchases financial securities (via an investment bank) directly from the issuer of those securities Investment banking firm—an organization that assists corporations in raising funds, usually by helping sell new issues of stocks, bonds, or other financial securities High-risk investment—an investment (e.g., an IPO) made in the uncertain hope of earning a relatively large profit in a short time Copyright © Cengage Learning. All rights reserved

Copyright © Cengage Learning. All rights reserved The secondary market A market for existing financial securities that are traded between investors Securities exchange—a marketplace where member brokers meet to buy and sell securities New York Stock Exchange (NYSE), American Stock Exchange, regional exchanges, foreign exchanges Over-the-counter (OTC) market—a network of dealers who buy and sell the stocks of corporations that are not listed on a securities exchange Nasdaq—computerized electronic exchange system through which most over-the-counter stocks are traded Copyright © Cengage Learning. All rights reserved

Copyright © Cengage Learning. All rights reserved Account Executives An individual, sometimes called a stockbroker or registered representative, buys and sells securities for clients Full-service broker—provides personal investment advice and other market and investing information Discount broker—simply executes buy and sell orders for lower commissions than a full-service broker; does not offer advice Copyright © Cengage Learning. All rights reserved

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Copyright © Cengage Learning. All rights reserved Types of Orders Market order A request that a security be purchased or sold at the current market price Limit order A request that a security be bought or sold at a price that is equal to or better than some specified price Discretionary order An order to buy or sell a security that lets the broker decide when to execute the transaction and at what price Copyright © Cengage Learning. All rights reserved

Online security transactions Software can help investors evaluate potential investments, manage investments, monitor value, and place buy and sell orders online Investors must still analyze the information and make decisions Online trading generally has lower costs Program trading—a computer-driven program that monitors the market value of particular stocks and enters buy or sell orders when those stocks reach specified prices Copyright © Cengage Learning. All rights reserved

Copyright © Cengage Learning. All rights reserved Commissions Generally, online transactions are less expensive when compared to trading through a full-service brokerage firm Full-service brokerages charge a percentage of the transaction amount (as much as 1.5 to 2.0%) Copyright © Cengage Learning. All rights reserved

Copyright © Cengage Learning. All rights reserved ? Source: TD Ameritrade website, www.tdameritrade.com, accessed October 23, 2008. Copyright © Cengage Learning. All rights reserved

Laws making sure investors are protected 1st level: Federal regulation by the U.S. Congress Securities Act of 1933 (Truth in Securities Act) Provides for full disclosure Requires registration statement about the corporation and a prospectus describing the new security Legislation to curb insider trading Sarbanes-Oxley Act 2nd level: Securities and Exchange Commission (SEC) The agency that enforces federal securities regulations 3rd level: State regulation States require registration of stock issues and licensing of brokers and securities dealers Copyright © Cengage Learning. All rights reserved

Copyright © Cengage Learning. All rights reserved More security 4th level: Self-regulation by securities exchanges and brokerage firms NYSE has published rules, policies, and standards of conduct Standards apply to every member Each member firm the NYSE conducts business with is examined yearly Individual brokerage firms are responsible to ensure their employees are highly trained and meet rigorous ethical standards Copyright © Cengage Learning. All rights reserved

Copyright © Cengage Learning. All rights reserved Portfolio management The process of spreading your money among several different types of investments to lessen risk Asset allocation and your age The younger you are, the more growth-oriented investments can be Copyright © Cengage Learning. All rights reserved

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Copyright © Cengage Learning. All rights reserved Safe, but little growth Bank accounts Advantages—bank accounts are safe (low risk) and have definite rates of return Disadvantage—low risk means low investment returns Corporate bonds Primarily a long-term, income-producing investment with a value that fluctuates with market interest rates and the financial condition of the issuer Convertible bonds Interest-bearing corporate bonds that can also be exchanged for a specific number of shares of common stock Bond market value is equal to the underlying value of the stock Copyright © Cengage Learning. All rights reserved

Copyright © Cengage Learning. All rights reserved Bond Ratings Source: Moody’s Investors Service, www.moodyseurope.com, October 27, 2008; Standard & Poor’s Corporation, Standard & Poor’s Bond Guide, September 2008. Copyright © Cengage Learning. All rights reserved

Copyright © Cengage Learning. All rights reserved Government bonds Considered risk free; pay low interest Treasury bills—sold in minimum units of $1,000; short maturities Treasury notes—issued in $1,000 units with maturity of 1 to 10 years Treasury bonds—issued in minimum units of $1,000 with maturities from 10 to 30 years Savings bonds—(EE bonds) purchased for ½ their maturity value Municipal bonds—issued by a state or local government; may be exempt from federal taxes Copyright © Cengage Learning. All rights reserved

Copyright © Cengage Learning. All rights reserved Common Stock Dividends Dividend payments—cash payments as the result of a distribution of the company’s profits Capital Gain When you buy for a low price and sell for a higher price Market value—the price of one share of a stock at a particular time Stock splits The stock becomes so valuable that the company decides to “split” the number of shares Copyright © Cengage Learning. All rights reserved

Copyright © Cengage Learning. All rights reserved ? Source: Price data and dividend amounts were taken from the Yahoo Finance website, http://finance.yahoo.com, accessed October 26, 2008. Copyright © Cengage Learning. All rights reserved

Copyright © Cengage Learning. All rights reserved Preferred stock Stock in a corporation that has a claim on the dividends that supersedes common stock Cumulative preferred stock You get paid your dividends next year if the company doesn’t have the money to pay you this year Convertible preferred stock Stock that pays dividends and can also be exchanged for a fixed number of shares of common stock Copyright © Cengage Learning. All rights reserved

Copyright © Cengage Learning. All rights reserved Mutual Fund A professionally managed investment pool that combines and invests the funds of many individual investors Closed-end funds - a fixed number of shares Open-end funds - an unlimited number of shares Copyright © Cengage Learning. All rights reserved

Traditional Investment Alternatives (cont’d) Mutual funds (cont’d) Load funds Investors pay sales and purchase fees every time they purchase shares No-load funds No sales or purchase fees are charged Yearly management fee Managed funds Professional fund manager chooses securities in the fund Index funds Managers buy stocks or bonds contained in an index (such as Standard & Poor’s 500) Family of funds A group of mutual funds managed by one investment company Copyright © Cengage Learning. All rights reserved

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Traditional Investment Alternatives (cont’d) Types of mutual fund investments Aggressive growth stock funds Global stock funds Growth stock funds High-yield (junk) bond funds Income stock funds Index funds Long-term U.S. bond funds Sector stock funds Small-cap stock funds Copyright © Cengage Learning. All rights reserved

Copyright © Cengage Learning. All rights reserved Real Estate Advantage One of the best hedges against inflation Disadvantages Risk of the property losing of value due to poor location Buyers may be difficult to locate Real estate market may be in decline at time of sale Taxes, mortgage interest, and Installment payments can be a heavy burden Copyright © Cengage Learning. All rights reserved

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High-Risk Investment Techniques Selling short A brokerage firm offers to “lend” you stock the right now is selling at $12 a share for $8 a share and you accept it. If the price of the stock goes up to $15, you simply replace each share without any cost to you. If the price of the stock goes down to $10, you sell the shares that you browed for $8 and split the $2 profit with the brokerage firm If the brokerage firm would have held on to the stock, they would have lost $4 By lending the stocks to you, they made $1 of stocks that they weren’t using In addition, you make a $1 profit off stock that you just borrowed. Buying stock on margin Buying stock by borrowing part of the purchase price, usually from a stock brokerage firm Margin requirement—the portion of the price of a stock that cannot be borrowed; set by the Federal Reserve Board Making money by using other people’s money or stocks (Not Recommended for Novice Investors) Copyright © Cengage Learning. All rights reserved

Other high-risk investments Stock options Commodities Precious metals Gemstones Coins Antiques and collectibles Copyright © Cengage Learning. All rights reserved

Sources of Financial Information The Internet www.bloomberg.com http://money.cnn.com www.fool.com www.quicken.com www.sec.gov http://finance.yahoo.com Newspaper coverage of securities transactions Common and preferred stocks Bonds Mutual funds Copyright © Cengage Learning. All rights reserved

? Copyright © Cengage Learning. All rights reserved Source: Wall Street Journal, October 28, 2008, p. C9. Copyright © Cengage Learning. All rights reserved

Reading Bond Quotations Source: The Yahoo! Finance bond website at http://bonds.yahoo.com, accessed October 28, 2008. Copyright © Cengage Learning. All rights reserved

Reading Mutual Fund Quotations Source: Wall Street Journal, October 28, 2008, p. C11. Copyright © Cengage Learning. All rights reserved

Sources of Financial Information Security averages An average of the current market prices of selected securities Dow Jones Industrial Average 30 leading industrial corporations Standard & Poor’s 500 Stock Index New York Stock Exchange Composite Index American Stock Exchange Index Nasdaq Composite Index Copyright © Cengage Learning. All rights reserved