Saving and Investing

What does it mean to save money? Saving means putting some of your money away for emergencies and/or short-term (less than one year) financial goals. Money that is saved for an emergency and/or short-term goals should be placed where there is very little risk of your money losing its value (the trade-off is that you will receive a minimal rate of return). Money that is saved for an emergency and/or a short-term financial purpose should be easily and readily accessible.

Savings Instruments We will discuss basic savings instruments such as savings accounts, money market accounts, and certificates of deposit when we discuss banking in a future unit.

What does it mean to invest money? Investing means putting your money where it can make more money by earning higher rates of return. Money should be invested to help you achieve your intermediate and long-term financial goals. Investing is riskier than savings, however, the longer the time period that you have before you need the money, the more risk you can assume. Investments will potentially earn a significantly higher return than traditional methods of savings and help your money outpace the rate of inflation.

Important Financial Principles These principles are: Pay Yourself First Risk versus Return The Time Value of Money (earned interest and compound interest) Diversification Dollar Cost Averaging The Rule of 72

Pay Yourself First This is arguably the most important financial rule that we will talk about in personal finance. Whenever you receive money you should immediately put a certain amount into an account that you will set aside to use later to meet your short-term financial goals (savings) and your intermediate and long-term financial goals (investing).

Risk versus Return An important thing to understand when discussing savings and investing is risk versus return. The lower the risk that an individual assumes the less the potential return (savings). The higher the risk that an individual assumes the higher the potential return (investing). The shorter the time period until the investment money is needed the more conservative the investment should be (savings). The longer the time period until the investment money is needed the more aggressive or risky the investment can be (investing).

Time Value of Money Time value of money refers to the relationship between time, money, and the rate of interest. On the next few slides we are going to discuss the difference between earned interest and compound interest and how they relate to the time value of money.

Earned Interest Earned interest is the payment you receive for allowing a financial institution or corporation to use your money. The bank compensates you for the use of your money by paying you interest. Interest = Principal x interest rate x time This is the interest for calculating earned interest (sometimes called simple interest).

Compound Interest “Compound interest is the most powerful force in the universe.” Albert Einstein Compound interest is the interest that is earned on interest. The formula for calculating compound interest is A = P (1 + i) ⁿ This formula assumes that the compounding will occur once annually. We will calculate an example on the next slide.

A= the amount in the account P= the principal (the original amount of the investment) i= the interest rate n= the number of years compounded $1,000 (1+ .10)5 A= $1,610.51

Problem 1 Diana invests $500 today in an account earning 7%. How much will it be worth in: 5 years? 10 years? 20 years?

Problem 1 Answers $500(1+.07)5 $500 x 1.403= $701.28 $500(1+.07)10 $500(1 + .07)20 $500 x 3.870= $1935.00

Problem 2 Diana finds an account that earns 10%. How much will her $500.00 be worth at the new rate in 5 years? 10 years? 20 years?

Problem 2 Answers $500 (1+.10)5 $500 x 1.610= $ 805 $500 (1+.10)10 $500 (1+.10)20 $500 x 6.727= $ 3363.50

Diversification of Your Investments Diversification is reducing investment risk by putting money in several different types of investments. By spreading your money around, you’re reducing the impact that a drop in any one investment’s value can have on your overall investment portfolio. This follows the old saying about “not putting all of your eggs in one basket.”

Dollar Cost Averaging This is the practice of investing a fixed amount in the same investment at regular intervals, regardless of what the market is doing. This is another key investment principle to know because it eliminates having to worry about investing at the “right” or “wrong” time. Dollar cost averaging evens out the ups and downs of the market. As the price of the investment rises, you simply end up purchasing fewer shares and when the price falls, you end up purchasing more.

The Rule of 72 Mathematicians say that you can see how long it will take you to double your money simply by dividing 72 by the interest rate. An example of this would be if you were earning 6% interest on your investments. 72÷6= 12 This means that you would double your money in 12 years if the interest rate that you are earning is 6%. Thank you Luca Pacioli for your Summa Mathematica!

Types of Investments We are going to talk about some of the most common methods of investing. These include: Stocks Mutual funds Bonds We will spend time discussing each of these methods of investing. We are going to begin by looking at stocks and one of the primary indicators of the stock market. This is the Dow Jones Industrial Average.