1. Llad Phillips1 Introduction to Economics Linking Personal Investment with the US Economy Macroeconomics

2. Llad Phillips2 Econ 109 Class Page Econ Home Page: http://www.econ.ucsb.edu Econ Home Page: http://www.econ.ucsb.edu http://www.econ.ucsb.edu

3. Llad Phillips3 Labs(sections) 12617 F 9:00-9:50 AMJalama Lab, Phelps 1517 MCL12625M 2:00-2:50 PMMiramar Lab, Phelps 1526 12633 M 7:00-7:50 PMMiramar Lab, Phelps 1526 12641W 8:00-8:50 AMMiramar Lab, Phelps 1526 12658T 6:30- 7:20 PMMiramar Lab, Phelps 1526 12666F 1:00-1:50 PMLedbetter Lab, Phelps 1530 http://www.ic.ucsb.edu/faculty/labs/ Checking Instructional Computing Lab Scedules

4. Llad Phillips4 Lecture Outline Guidelines for personal financial well-being Guidelines for personal financial well-being Bonds Bonds Stocks Stocks Choosing an efficient portfolio Choosing an efficient portfolio The best portfolio for you The best portfolio for you Making Your Wealth Grow Making Your Wealth Grow Where does the long run growth in stocks come from? Growth in corporate profits (net earnings), which in turn depends on the economy doing well Where does the long run growth in stocks come from? Growth in corporate profits (net earnings), which in turn depends on the economy doing well

5. Llad Phillips5 Part Two Macroeconomics and the US Economy 5. Thursday, Oct. 10, Lecture Five: "Capital Asset Pricing Model" Tracking asset markets and the US economy capital asset pricing model Growth rate of your personal wealth Value of a share of stock The impact of business cycles on corporate profits Reading Assignment: O’Sullivan and Sheffrin, Ch. 20, “Measuring a Nation’s Production and Income” emphasis: measuring the ouput of the economy, circular flow O’Sullivan and Sheffrin, Ch. 21, “Unemployment and Inflation” Problems O & S Text p. 434: 1, 5, 6, 7, 8, 9,10,11 p. 450: 1, 2, 3, 4, 5, 6, 7, 8 Tuesday, Oct. 22, 25 minute QUIZ, You will need scantron sheet and #2 pencil.

6. Llad Phillips6 Part I Guidelines for Personal Finance, Summary Guidelines for Personal Finance, Summary Life is Risky, How to Cope? Life is Risky, How to Cope?  Risk from the Economy, e.g. inflation  Market Risk, e.g. stocks, bonds, real estate

7. Llad Phillips7 Guidelines for Personal Finance Keep you expenditures within your means Keep you expenditures within your means  pay off your credit card debt Save 10% of your income Save 10% of your income  pay yourself first Diversify your investments Diversify your investments  cash, for emergencies  housing, to build wealth and provide shelter  treasury bonds, as a safe investment  stock index fund, for growing your wealth

8. Llad Phillips8 Life is Risky; How to Cope? Protect against inflation Protect against inflation  don’t put all your money in cash or checking hedge your bets, don’t bet on just one market but diversify among markets hedge your bets, don’t bet on just one market but diversify among markets  real estate  bonds  stocks hedge your bets, diversify within markets hedge your bets, diversify within markets  laddering bonds  stock index fund

9. Llad Phillips9 Inflation Http://stats.bls.gov/eag/eag.us.htm

10. Llad Phillips10 Erosion of Purchasing Power $7289

11. Llad Phillips11 $41,500 $182,335

12. Llad Phillips12 30-Year Mortgage Rate of Interest Http://research.stlouisfed.org/fred2/

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16. Llad Phillips16 Interest Rate Vs. Length (Maturity) of the Treasury Bond

17. Llad Phillips17 Http://www.publidebt.treas.gov/sec/sectrdir.htm

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20. Llad Phillips20 Dow Jones Industrials Index http://www.quicken.com

21. Growth Rate 13% per Year

22. Llad Phillips22 Part II Choosing among investment options, the efficient portfolio Choosing among investment options, the efficient portfolio  example: six UC investment funds  tradeoff: the higher the rate of return, the higher the risk  called Markowitz Portfolio Analysis Choosing the best portfolio for you Choosing the best portfolio for you

23. Llad Phillips23 Example: UC Funds Suppose you invest up to $10,000 per year in a tax sheltered 403(b) plan Suppose you invest up to $10,000 per year in a tax sheltered 403(b) plan  you have to save $10,000, but you would have to pay income taxes if you took it as income UC investment alternatives UC investment alternatives  guaranteed insurance contract(GIC)  savings fund  money market fund  bond fund  stock index fund  multi-asset fund

24. Llad Phillips24 Investment Concepts monthly return for June 2001 on an asset monthly return for June 2001 on an asset  price(June) - price(May) + dividends  price(June) - price(May): capital gain(loss)  dividends(interest): income from stocks(bonds) monthly rate of return for June 2001 monthly rate of return for June 2001  [price(June) - price(May) + dividends]/price(May)  in %, multiply by 100 annual rate: multiply by 12annual rate: multiply by 12

25. Llad Phillips25 Example: UC Funds/Mutual Funds Sources of information on UC funds Sources of information on UC funds  monthly, quarterly, annual, etc. rates of return  internet: http://atyourservice.ucop.edu http://atyourservice.ucop.edu  Notice, a publication of the UC Academic Senate Source of Information on Mutual Funds Source of Information on Mutual Funds  quarterly  The Wall Street Journal, Mutual Funds Quarterly Review, e.g. extra section in July 3, 1997 Journal

29. Llad Phillips29 Average = 1% per month

30. Llad Phillips30 UC Funds: Equity Vs. Insurance Insurance Insurance  steady at a rate of return of about 0.6 per month or 7.2% per year  does not vary much  never negative Equity Equity  rate of return varies a lot from month to month  range of rates of return from about plus 9% in Mar. ‘00 to minus 13% in Aug ‘98  can turn negative: 29 months out of 72

33. Measures of Average Rate of Return and Variability: Mean & Std. Dev.

34. Mean Returns & Standard Deviations

35. Efficient Portfolio: Most Return for Given Risk

36. This frontier shows the efficient (best) options for investing, the first step of the economic paradigm

37. Efficient Portfolio: Most Return for Given Risk Slope is the second step of the paradigm, determining values: Market Price of Risk: 0.1% return per month for every 1% of variability per month

38. Llad Phillips38 Your portfolio should be on the efficient frontier But where on the frontier? But where on the frontier?  depends on your taste for reward and risk  reward, i.e. the mean rate of return is a good  risk is a bad

39. Llad Phillips39 Economic Paradigm: Valuation of Mean Return and Risk Assumption: Mean Return is Good, Risk is Bad: U =U(M,R) Mean Return, M Risk, R better worse Iso - Preference Curves A B C Prefer B to A; Prefer B to C

40. Efficient Portfolio: Most Return for Given Risk Investor A: very risk averse

41. Llad Phillips41 Efficient Investment Portfolio Investor B: not very risk averse

42. Llad Phillips42 Part III How do you make your nest egg grow? Do you need to take risks and get a super high rate of return? Do you need to take risks and get a super high rate of return?  not if your ratio of savings to wealth is high Strategy for the Long Run: Buy and Hold a Stock Index Fund Strategy for the Long Run: Buy and Hold a Stock Index Fund

43. Growth Rate 13% per Year

44. Llad Phillips44 Invest in A Stock Index Fund Exponential Growth Exponential Growth Historically: 20th Century, 11% per year Historically: 20th Century, 11% per year Since 1986: 13% per year Since 1986: 13% per year Betting that history will repeat itself Betting that history will repeat itself

45. Llad Phillips45 Two Ways to Grow Your Wealth Savings: increases your wealth Savings: increases your wealth rate of return: adds to your wealth rate of return: adds to your wealth Combine these two for rapid growth Combine these two for rapid growth

46. Llad Phillips46 Rate of Growth of Personal Wealth savings, s + increase in wealth,  w Stock of wealth, w rate of return, r + yield, r*w rate of growth of wealth,  w/w  rate of return, r + savings/wealth  w/w  r + s/w

47. Llad Phillips47 Relative Importance of Savings Younger Years Younger Years  income & savings are lower  wealth is smaller  ratio of savings to wealth may be high  savings is most important, rate of return less so  example  income of $60,000  savings of $6,000  wealth of $50,000  ratio of savings to wealth of 0.12 Older Years Older Years  wealth accumulates  ratio of savings to wealth falls  rate of return on wealth becomes more important  example  income of $100,000  savings of $20,000  wealth of $500,000  ratio of savings to wealth of 0.04

48. Llad Phillips48 Years to Double Wealth

49. Llad Phillips49 rate of return on wealth, r 4% 8% 12% 4%8%12% ratio of savings to wealth, s/w rate of growth of wealth,  w/w  w/w  r + s/w 0

50. Llad Phillips50 Rate of Growth of Personal Wealth If the rate of return, r, on wealth is zero If the rate of return, r, on wealth is zero  then the only source of growth in wealth is savings:  w/w = s/w  i.e. the only change in wealth,  w, is savings:  w = s If savings is zero If savings is zero  then the only source of growth in wealth is rate of return, r, and wealth will grow exponentially at the rate r:  w/w = r

51. Llad Phillips51 Summary How to Cope: Simplify Investment Strategy: Buy and Hold Step 1: Save Step 2: Diversify, i.e keep a cash reserve, buy a house, hold some treasury bonds,invest in stock index fund with IRA or 401 k. Using the Economic Paradigm to maximize return for a given risk level

52. Llad Phillips52 Investment Principles or Maxims Don’t put all of your eggs in one basket Don’t put all of your eggs in one basket  hold a diversified portfolio  cash  bonds  stocks  real estate  advantage of a mutual fund or stock index fund  instead of holding one stock, e.g. Coca-Cola, you hold a bundle of stocks Choose the asset with the highest reward for a given level of risk Choose the asset with the highest reward for a given level of risk

53. Llad Phillips53 Part IV Value of a share of stock Value of a share of stock  depends on the stream of expected future net earnings per share The Impact of the Business Cycle on Corporate Profits The Impact of the Business Cycle on Corporate Profits

54. Llad Phillips54 Your Stocks Market Indices The Economy corporate earnings(profits)

55. Llad Phillips55 Tracking Assets and Markets What is the relationship between the monthly rate of return on the UC Index Fund and an index of the stock market, such as the Standard and Poor’s Index of 500 Stocks (S&P 500) ? What is the relationship between the monthly rate of return on the UC Index Fund and an index of the stock market, such as the Standard and Poor’s Index of 500 Stocks (S&P 500) ?

56. Llad Phillips56 Example: The UC Index Fund and the Standard & Poor’s 500 mean rate of return on the UC Index Fund varies with the mean rate of return on Standard & Poor’s Index of 500 Stocks mean rate of return on the UC Index Fund varies with the mean rate of return on Standard & Poor’s Index of 500 Stocks  capital asset pricing model

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59. Llad Phillips59 Sources of Information: stock prices Daily Quotes Daily Quotes  Business Section of Los Angeles Times  Wall Street Journal Internet graphics Internet graphics  http://bigcharts.marketwatch.com/  http://www.quicken.com/investments

60. Llad Phillips60 Percentage Changes in IBM Versus the Dow

61. Llad Phillips61 Where does the growth in financial wealth come from? What is the relationship between financial markets and the economy? What is the relationship between financial markets and the economy?

62. Llad Phillips62 http://www.globalexposure.com/ Last Ten Years 1948-

63. Llad Phillips63 Corporate profits after taxes doubled from $160 billion in early 1987 to $320 billion in early 1994 doubled from $160 billion in early 1987 to $320 billion in early 1994 doubling in about seven years implies an average rate of growth of about 10% per year doubling in about seven years implies an average rate of growth of about 10% per year this rate of growth is comparable to the 11% rate of growth in the Dow since 1986 this rate of growth is comparable to the 11% rate of growth in the Dow since 1986

64. Llad Phillips64 Economic Concept present value of a stream of expected future net earnings, or profits, per share present value of a stream of expected future net earnings, or profits, per share  PV(t) = ENE(t) + ENE(t+1)/(1+i)  may know this year’s net earnings, NE(t)  your expectations of the future affect your best guess for next year, ENE(t+1)  at an interest rate of 7%, $1.07 next year is equivalent to a $1 this year to compare dollar values for different years, they have to be discounted to a common yearto compare dollar values for different years, they have to be discounted to a common year  PV(t) = ENE(t) + ENE(t+1)/(1+i) + ENE(t+2)/(1+i) 2 +...

65. Llad Phillips65 Income-Expense Statement for an Individual IncomeExpenditure Savings Income-Expense Statement for a Business Firm Gross RevenueCost Profit(net revenue, net earnings)

66. Llad Phillips66 Your Stocks Market Indices The Economy corporate earnings(profits) Index of Leading Economic Indicators Gross Domestic Product Unemployment Rate

67. Llad Phillips67 1948- Index of Leading Indicators

68. Llad Phillips68 Labs : Resources for Economists on the Internet http://rfe.wustl.edu/

69. Llad Phillips69 The US Business Cycle expansions, or recoveries, the period from trough to peak, tend to last a lot longer than recessions, the period from peak to trough expansions, or recoveries, the period from trough to peak, tend to last a lot longer than recessions, the period from peak to trough

70. Llad Phillips70 US Postwar Expansions

71. Llad Phillips71 US Business Cycle Note the long expansions in the eighties and the nineties Note the long expansions in the eighties and the nineties  is there a new economic regime or order?  are business cycles a relic of the past? Note the long expansion in the sixties Note the long expansion in the sixties  economists then talked about “fine tuning” the economy  then came along the problems of the seventies  a couple of recessions  inflation

72. Llad Phillips72 Summary-Vocabulary-Concepts capital asset pricing model capital asset pricing model market risk market risk asset specific risk asset specific risk stock’s beta,  stock’s beta,  moving average moving average exponential growth exponential growth Dow Jones Industrials Dow Jones Industrials present value present value net earnings per share net earnings per share expectations expectations discount factor discount factor corporate profits after taxes corporate profits after taxes business cycle business cycle peak peak trough trough index of leading indicators index of leading indicators