 Explain the function of capital markets in a market economy  Identify how diversification can reduce risk in an investment portfolio

THE MARKET BASKET History of United States Postage Rates ( Rate for first-class postage for a one-ounce letter) Source: Date Rate Date Rate July 6, centsFebruary 3, cents August 1, centsJanuary 1, cents January 7, centsJanuary 10, cents January 7, centsJanuary 7, cents May 16, centsJune 30, cents March 2, centsJanuary 8, cents December 31, centsMay 14, cents May 29, centsMay 12, cents March 22, centsMay 11, cents November 1, centsJanuary 22, cents February 17, centsJanuary 27, cents April 3, cents

THE MARKET BASKET Inflation Inflation is a general, sustained upward movement of prices for goods and services in an economy. As a result of inflation, it takes more money to buy the same goods and services. Inflation means prices go up!

THE MARKET BASKET The Bureau of Labor Statistics (BLS) is a federal agency that collects and analyzes economic data. The BLS reports price changes using the consumer price index (CPI) a market basket of consumer goods and services Items are divided into more than 200 categories, arranged into eight major groups:

The Eight Major Groups of the CPI Food and beverages Housing Apparel Transportation Medical care Recreation Education and communication Other goods and services THE MARKET BASKET

The CPI inflation rate can be determined comparing the percentage increase in the price level of goods and services from one time period to another. Inflation rate Annual CPI Inflation Rate Formula: CPI later year ─ CPI earlier year CPI earlier year THE ARKET BASKET THE MARKET BASKET X 100

1. Raise Capital 2. Storing, Protecting, and Making Profitable Use of Excess Capital 3. Insuring Against Risk 4. Speculation

 What does it mean to “raise capital”? Why is this important within the economy? ( )

 Financial markets allow individuals, firms, and governments to do things today that they could not otherwise afford  Capital ◦ 1. Financial assets or the financial value of assets, such as cash. 2. The factories, machinery and equipment owned by a business and used in production.

 What is “excess capital”? What is the role of financial instruments in putting excess capital to use?  How does this work?

 Nominal return = how much money one earns in Interest Nominal return  Inflation calculated from the Consumer Price Index (CPI)Consumer Price Index (CPI) ◦ 1.6%  Real Return = Nominal return – Inflation  Investing allows “excess capital” to not lose real value

 What is risk? What role does insurance play in negotiating risk?

 Insurance  Futures Contract- an agreement to sell a product in the future for a currently determined price  Credit Default Swaps (CDO’s)  Diversify investments (more later)

 What does it mean to “speculate”? (157)

 The act of trading in an asset, or conducting a financial transaction, that has a significant risk of losing most or all of the initial outlay, in expectation of a substantial gain  Basically Gambling

 Stocks  Dividend  Bonds  Mutual Fund  Index Fund

 A type of security that signifies ownership in a corporation and represents a claim on part of the corporation's assets and earnings.  Return comes from two factors: ◦ Change in price of the share ◦ Dividends

 A distribution of a portion of a company's earnings, decided by the board of directors, to a class of its shareholders.

 A debt investment in which an investor loans money to an entity (corporate or governmental) that borrows the funds for a defined period of time at a fixed interest rate  Stocks Versus Bonds Stocks Versus Bonds

 an investment vehicle that is made up of a pool of funds collected from many investors for the purpose of investing in securities such as stocks or bonds

 An index fund (also index tracker) is a fund that aims to replicate the movements of an index regardless of market conditions.

 Standard and Poor’s 500  Made up of 500 Large Cap companies meant to mirror to US economy over all  Large Cap = market capitalization value of more than $10 billion ◦ Wal-Mart ◦ Microsoft ◦ General Electric  Market Capitalization= number of stock shares X stock price

 How does the “efficient markets theory” play a role in how the financial markets work?  How is investing (buying stocks, etc.) like a line at the grocery store?

 An investment theory that it is impossible to "beat the market" because stock market efficiency causes existing share prices to always incorporate and reflect all relevant information.  the only way an investor can possibly obtain higher returns is by purchasing riskier investments.

 What other factors in how people invest challenge the efficient markets theory?

 Save, Invest, Repeat  Take Risk, Earn  Diversify  Invest for the Long Term

 A good rule of thumb for young people is often: ◦ 50% of income used for needs ◦ 30% for lifestyle choices ◦ 20% saved

 More risk = higher return  More risk = higher probability of loss of principle

Diversification and Risk The Pyramid of Risks and Reward Highest Risk - Highest Potential Return or Loss 4. government bonds 3. certificates of deposit 5. corporate bonds 6. mutual funds 7. stocks 8. real estate 9. collectibles 1. cash and checking accounts 2. savings accounts 10. commodities Lowest Risk - Lowest Potential Return or Loss

Diversification and Risk Portfolio a collection of financial investments held by an individual or financial organization Diversification investing in various financial instruments in order to reduce risk

Diversification and Risk Would you bet $100 on a coin flip if the deal were that you keep your $100 and receive an additional $5.00 for heads, but lose $100 for tails? Would you bet $100 on a coin flip if the deal were that you keep your $100 and receive an additional $100 for heads, but lose $100 for tails? Would you bet $100 on a coin flip if the deal were that you keep your $100 and receive an additional $400 for heads, but lose $100 for tails?

Diversification and Risk Invest only what you can afford to lose. Invest at your comfort level. Invest according to your age.

 Diversify across different financial instruments ◦ Stocks ◦ Bonds ◦ Cash and CD’s ◦ Diversify across sectors and geographic locations  Electronically Traded Funds (ETF’s) and Mutual funds can provide easy diversification