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  • Experiencing

    Financial Literacy

    An Illustrated Introduction to Personal Finance

    Margaret Williams Mathew Georghiou

  • 2 GoVenture Experiencing Financial Literacy

    GoVenture Experiencing Financial Literacy

    This resource is designed to be a stand-alone learning tool, as well as a supplement for use with GoVenture software simulations.

    Authors: Margaret Williams, Mathew Georghiou. Cover Design: Wendy McElmon

    ISBN 1-894353-13-7

    Copyright ©2005, First Edition by MediaSpark Information Technology Solutions Incorporated (MediaSpark)

    All rights reserved. No part of this publication may be reproduced or transmitted in English or in other languages in any form or by any means, electronic or mechanical, including photocopy, recording, or any information storage and retrieval system, without permission in writing from the publisher.

    GoVenture and MediaSpark are registered trademarks or trademarks of MediaSpark in Canada, the United States, and other countries.

    MediaSpark Incorporated, Publisher PO Box 975 Sydney, Nova Scotia Canada B1P 6J4 www.mediaspark.com www.goventure.net

    USA and Canada Version – First Printing, 2005

    Disclaimer

    GoVenture is a learning simulation. As such, it should not be used to make real-life investment decisions. Similarly, all GoVenture information resources have been designed for learning purposes only and should not be used to make business, legal, financial, or other decisions. Consult appropriate professional advisors prior to undertaking any venture.

    MediaSpark will not be liable, in any event, for any damages whatsoever (including, without limitation, damages for loss of business profits, loss of business information, interruption, or other pecuniary loss) arising out of use or inability to use the materials, even if MediaSpark has been specifically advised of the possibility of such damages. In no event will MediaSpark’s liability for any damages ever exceed the cost of the license fees (as outlined by MediaSpark) paid by you for your right to use this material. MediaSpark makes no representation that this material is free of defects.

  • Table of Contents 3

    Contents

    1. Welcome ................................................................................................... 5

    2. GoVenture Financial Literacy..................................................................... 7

    What is the GoVenture Financial Literacy Simulation ..............................................................7

    What Makes GoVenture Financial Literacy Unique ..................................................................7

    GoVenture for You .............................................................................................................8

    What You Need to Play GoVenture Financial Literacy ..............................................................9

    More Information.............................................................................................................10

    Section I: Introduction to Personal Finance ................................................... 11

    3. Your Personal Finances ........................................................................... 13

    Cash Flow.......................................................................................................................13

    Assets, Liabilities, and Net Worth (Equity) ..........................................................................14

    4. Your Assets ............................................................................................. 17

    Cash ..............................................................................................................................17

    Investment Securities ......................................................................................................17

    Capital Assets .................................................................................................................17

    Investment Property or Personal Use Property ....................................................................18

    5. Your Liabilities ........................................................................................ 21

    Borrowing, Debt, Loans, and Credit — What Are They?.........................................................21

    Why Do People Borrow? ...................................................................................................22

    Interest Payments ...........................................................................................................23

    Credit Ratings .................................................................................................................24

    Revolving Credit and Loans...............................................................................................24

    Rents and Leases ............................................................................................................26

    Family Loans and Loan Guarantees....................................................................................26

    Consumption, Income, and Wealth Taxes ...........................................................................27

    6. Managing Your Assets and Liabilities ...................................................... 29

    Setting Goals and Planning ...............................................................................................29

    Monitoring Your Financial Health........................................................................................31

    Insuring Your Life and Assets ............................................................................................35

    Living and Retiring Comfortably.........................................................................................38

    7. Key Investment Concepts ....................................................................... 39

    Time Value of Money........................................................................................................39

    Return on Investment (ROI) .............................................................................................40

    Rate of Return.................................................................................................................42

    Risk and Return...............................................................................................................43

  • 4 GoVenture Experiencing Financial Literacy

    Economic Influences ........................................................................................................46 Economic Indicators .........................................................................................................52

    8. Making Your Money Grow........................................................................ 55

    Savings and Debt Investments ..........................................................................................57 Equity Investments ..........................................................................................................60 Gambling........................................................................................................................62 Qualified Retirement Plans ................................................................................................63 Summary........................................................................................................................63

    9. Next Steps............................................................................................... 65

    Section II: Additional Reference Material ....................................................... 67

    10. The Investment Timetable ...................................................................... 69

    11. Calculating the Return on Investment..................................................... 71

    Comparing Investments and Rates of Return.......................................................................71 Simple Rates of Return.....................................................................................................72 Compound Rates of Return ...............................................................................................74

    12. Bank Accounts ........................................................................................ 77

    Checking Accounts ...........................................................................................................77 Savings Accounts.............................................................................................................78 Term Deposits .................................................................................................................79 Electronic Banking Services...............................................................................................79 Risks and Benefits — Bank Accounts ..................................................................................80

    13. Credit and Loans ..................................................................................... 81

    Credit Cards — Financial Institution Credit Cards .................................................................81 Credit Cards — Retail Charge Cards ...................................................................................83 Personal Line of Credit......................................................................................................84 Overdraft Protection.........................................................................................................84 Personal/Consumer Loans.................................................................................................85

    14. Taxes ...................................................................................................... 87

    Direct and Indirect Taxes..................................................................................................87 Sales Tax........................................................................................................................87 Income Tax.....................................................................................................................87 Real Estate Tax (Property Tax) ..........................................................................................90 Estate Tax ......................................................................................................................90 Tax Shelters....................................................................................................................91

  • Chapter 1 Welcome 5

    Experiencing Financial Literacy

    An Illustrated Introduction to Personal Finance

    1. Welcome This document is an illustrated introduction to the basics of personal finance. It is a companion piece to MediaSpark’s GoVenture Financial Literacy simulation. The purpose of this document is to provide a complete overview of the key elements of personal finance, as well as to explain the basic options and decisions that can be made — all in a condensed, easy-to-read format.

    The GoVenture Advisor

    The GoVenture Advisor — the animated “GO” character — will alert you to features in the GoVenture software simulation, examples of concepts, and where you will find more information on a topic in the second section of this book.

    GO to the GoVenture Financial Literacy simulation software to apply these techniques.

    GO here to see an example of a concept discussed in the text. For more information on this topic, GO to the indicated area(s) in Section II: Additional Reference Materials.

  • 6 GoVenture Experiencing Financial Literacy

  • Chapter 2 GoVenture Financial Literacy 7

    2. GoVenture Financial Literacy

    What is the GoVenture Financial Literacy Simulation The fastest and most effective way to learn the basics of money management! GoVenture Financial Literacy is a realistic software simulation designed to help youth and adults learn about personal money management decisions in a fun and educational manner. Like a flight simulator for finance and life, GoVenture Financial Literacy enables you to learn-by-doing. It’s easy to use, visual, interactive, and exciting! Establish your life plan, enter your financial information — job, budget, home, transportation, and living expenses — and then live your financial future for up to 10 years. Watch your savings grow and shrink based upon the economy, your investment decisions, and your personal spending habits. What kind of lifestyle will you be able to afford? Try GoVenture Financial Literacy and find out! Practice your money management skills on your own, or against your friends and classmates. Gain practical experience so you have the knowledge and ability to plan your own financial future. Unlike any book, course, or seminar, GoVenture Financial Literacy enables you to gain years of finance and life experience in minutes! Play again and again — every new simulation you run is different!

    What Makes GoVenture Financial Literacy Unique GoVenture simulations enable learning-by-doing, an approach that cognitive scientists have identified as the fastest and most effective way for human beings to learn. GoVenture simulations immerse the learner in a highly visual and interactive environment in such rewarding ways that the learner feels both intellectually and emotionally engaged in the experience - as if he or she were personally living it. GoVenture Financial Literacy is designed to meet three key objectives, which differentiate it from other personal finance products:

    1. GoVenture helps you identify personal life goals and set your goals in a visual environment.

    It is difficult to identify and set financial goals, and these goals are not intuitive when expressed as purely mathematical concepts. GoVenture uses a visual interface to help identify goals and make it easier to relate to the financial concepts.

    2. GoVenture is not a tool to document your financial life; it is a teaching tool which helps you learn about personal finance.

  • 8 GoVenture Experiencing Financial Literacy

    Many products on the market help document your personal finances, but they are designed to record data, or perhaps to calculate mathematical projections — not to teach. GoVenture is designed as a teaching tool.

    3. GoVenture lets you “live” your possible financial future for 10 years.

    As a simulation, GoVenture allows you to “live” your life in a virtual environment for up to 10 years. You can replay the simulation unlimited times to try different strategies or different personal goals.

    GoVenture Financial Literacy is designed to be used as a learning program on its own, or to complement other learning materials, courses, programs, and curricula. It can provide a valuable learning opportunity for an individual or an entire class, within a single hour of use or over an extended period of time. The educational foundation and ease of integration in the classroom and curriculum make GoVenture Financial Literacy the first choice among learners who are in the early stages of learning about personal finance, as well as educators and trainers who are providing basic finance and life skills training.

    GoVenture for You

    Personal Planning

    Planning your future is perhaps the most important strategy you must develop and monitor. GoVenture allows you to experience up to 10 years of virtual results in a few hours – and more importantly, learn from this experience. You can see what happens in different economic environments, and with different investment portfolios. You can even learn how to adjust for unexpected events. GoVenture can make you better prepared to address your actual personal financial future.

    Education

    GoVenture has been designed to be suitable for a variety of instructional approaches and levels. Whether the need is to create a completely new curriculum or to enhance an existing one, GoVenture offers a successful and valuable experience for instructors and learners, from middle school to adult education.

    Investment

    GoVenture includes basic investment options that introduce strategies to balance risk, income generation and growth. You are placed in changing economic conditions which will further challenge your investment skills. The ability to play over and over again at no real financial risk helps develop a more intuitive understanding of investing.

  • Chapter 2 GoVenture Financial Literacy 9

    Career and Family

    GoVenture provides you with the ability to plan major career and family objectives, and then simulates how they might affect your personal finances and future goals. It helps you develop a greater understanding of the financial and time commitments needed to meet these objectives.

    Economics

    GoVenture brings the study of economics to life in a controlled environment. Key economic factors are simulated, without the complexity of true worldwide economies. Using the GoVenture experience, you can learn how economic changes influence markets and affect you on a personal level.

    Mathematics

    GoVenture can be used to enhance mathematical skills. While prices and current totals are calculated by the simulation, you must project your cash requirements, investment returns, and future expenses so that you can manage your cash flow and increase your net worth.

    Life Skills Training

    GoVenture helps develop a number of necessary skills for success in the fast-paced Knowledge Economy, including: planning, just-in-time learning, problem solving, organization, critical thinking, and risk management. GoVenture addresses life skills training directly by immersing you in a simulated world of experience that transcends the limitations of traditional teaching and learning approaches.

    Unlike conventional educational materials, games and Internet portals, GoVenture offers a comprehensive learning experience. Simulations are combined with a wide range of learning resources for quick and easy integration into self-directed or facilitated learning environments.

    What You Need to Play GoVenture Financial Literacy GoVenture Financial Literacy is designed using proven technologies that will operate on personal computers, either stand-alone or over the Internet. For specific system requirements, please refer to the software documentation.

  • 10 GoVenture Experiencing Financial Literacy

    More Information For more information on GoVenture Financial Literacy and other simulations, visit the GoVenture.NETwork Internet portal or contact MediaSpark at:

    Sales: 1-800-331-2282 USA/Canada Telephone: 902-562-0042 Fax: 902-562-1252 Internet: www.goventure.net

  • 11

    Section I: Introduction to Personal Finance

  • 12 GoVenture Experiencing Financial Literacy

  • Chapter 3 Your Personal Finances 13

    3. Your Personal Finances Whenever you own things of value (called “assets”) and have access to money (also an asset), you are looking after your finances, in one way or another. Personal finance is the term used to describe this management of your assets. The two key elements of personal finance are how you make your money and how you spend your money — your cash flow. How you plan and manage your money is the focus used in this document.

    Cash Flow Making money represents all the ways you receive cash. You might make money by working at a job, by buying and selling stocks, or even winning the lottery. These are your sources of incoming cash. Spending money is something that most people find easy to do. Spending represents the uses of your cash. Together, making money and spending it represent the basic concept of cash flow — how money flows in and out of your accounts: Cash in, minus Cash out.

    Making Money (Cash In)

    There are two primary types of money you can make: earned income and unearned income. These are general categories, but they are good terms to show the basic difference between money you work for and other money you receive.

    Earned Income

    Most people think of making money by finding a job and getting a salary or an hourly wage. This usually means working for a business, organization, or the government. Or, you might become an author and earn royalties from your books. You could also be self-employed and earn a salary from your business. Earned income is money you get from your employment, that is, what you earn for yourself in your profession, career, or job. But there are other ways to make money.

    Unearned Income

    If you start a business, your company might generate profits for you. You might receive inheritance money or trust fund income from your relatives. You might receive gifts; or you might get lucky and win money from bingo, or betting, or the lottery.

  • 14 GoVenture Experiencing Financial Literacy

    The most common way to produce more income than you yourself can earn is to put your money to work for you and to let it earn more money for you. This type of income generally comes from interest on savings or from gains on selling things you own. While the tax law calls this “unearned income,” it doesn’t happen by itself. You have to work at managing your money carefully in order to make it grow.

    Spending Money (Cash Out)

    Spending money is easy! Making sure you spend within your means is not. When deciding how to spend your money, you must plan both for your current expenses and for your future financial goals. Your current expenses cover the essential cost of living — expenses such as housing, transportation, food and clothing. Additional discretionary expenses will be budgeted to cover optional expenses like entertainment, extra clothes, hobbies, education, and charitable donations. Discretionary expenses are those expenses over which you have more control, and which are not mandatory for you to live and earn your wages. But you should also consider the future, and your family’s future. You may have children to put through university. You may need a bigger house for your family. And, you need to plan for your retirement, when you stop earning wages and live off your savings and other benefits eligible to you. Regardless of what your specific goals are, part of how you “spend” your cash is likely to include putting some money aside to meet your future financial requirements. (For more detailed information on Cash Flow, see Chapter 6: Managing Your Assets and Liabilities: Monitoring Your Financial Health.)

    Assets, Liabilities, and Net Worth (Equity) When you apply for a loan, the bank will want to know your net worth. Net worth is an indicator of your personal wealth. If you are looking to your future, you can watch the change in your net worth as a mark of progress towards your future goals. But, what is net worth? To answer that question, you have to understand assets and liabilities.

    Assets

    An asset is an item of economic value, which you own, and which is cash or could be sold for cash. It is important to distinguish between an item of economic value and an item that may only have sentimental value. While something may be emotionally important to you, if no one will buy it, then it is said to have no cash value and is not considered an asset.

    In GoVenture Financial Literacy, you set up your income and expenses by choosing a job and lifestyle. You can buy and sell assets, change your expenses, make investments, and more.

  • Chapter 3 Your Personal Finances 15

    Liabilities

    A liability is a debt — money or equivalent monetary value of things that you owe someone else. You have liabilities to your telephone company for using their service. You may have credit card bills, a mortgage, a car loan, or other types of borrowings or payments due.

    Net Worth (Equity)

    Net worth, also called equity, is the total worth of the things you own (your assets) minus all your debts (your liabilities). Or, you can think of it as the amount you would have left over if you sold all your assets and paid off every single one of your debts today. If the number is positive and growing, that is good. If your net worth is negative and shrinking, you may be in financial trouble.

    Net Worth = Assets — Liabilities To determine your net worth, make a list of all your assets and liabilities. Then subtract the liabilities from your assets. Keep in mind that the cash value of your assets is what they are worth if you sold them today, and not what you may have paid for them. Your liabilities are what you owe as of today, not the original amount, or last month’s bills. Here is an example of a net worth calculation:

    Net Worth Calculation, as of June 30, 2005

    Original Cost Current Value Assets Cash on Hand $ 150 $ 150 Cash in Checking Account 1,100 1,100 Cash in Savings Account 2,650 2,650 Personal Use Assets: - Automobile 25,000 13,000

    - House 150,000 175,000 Investment Assets:

    - Stocks, Bonds, Mutual Funds 50,000 70,000 - Other - Stamp Collection 500 1,500 $229,400 $263,400 Original Amount Liabilities Bills, Unpaid $ 750 $ 750 Credit Cards, Unpaid Balance 2,300 2,350 Automobile Loan 20,000 10,000 Mortgage (loan) for the House 120,000 110,000 Personal Line of Credit Loan 5,000 2,000 Other Loans & Obligations: - Family Loan 10,000 10,000 - Income & Property Taxes Due 0 0 - Personal Guaranty of Son’s Car Loan 15,000 13,000 $173,050 $138,100 Net Worth = Current Value of Assets — Liabilities $125,300

    Example

  • 16 GoVenture Experiencing Financial Literacy

    Note that your net worth is just a snapshot of today’s values. It does not include money you might make in the future, such as salary from your job, or an inheritance, or increases in the value of your assets. Nor does it include future loans and expenses due. All these future events are uncertain or unknown today.

    In GoVenture Financial Literacy, your net worth is constantly calculated and updated for the current market value of your assets, as well as for the up-to-date balance of your liabilities.

  • Chapter 4 Your Assets 17

    Bank Accounts

    4. Your Assets Your assets represent everything you own which has an economic value. Assets can be either cash or something which could be sold for cash. Almost everything you own and use for your own personal purposes now, or which you are saving for the future, is an asset, because most possessions have some economic value. Assets may also be categorized or described as:

    • Cash • Investment Securities • Capital (non-cash) Assets • Investment Property or Personal Use Property

    Cash Your cash assets include money which you have on hand in your wallet or elsewhere in your possession, money you have deposited in bank accounts, plus any checks or money orders which you have received but not yet cashed.

    Investment Securities Investments are assets which you have obtained in order to provide future increases in value. The increases may come from periodic payments you receive of interest income or dividends, or from appreciation. Appreciation means increases in the value of an item, so you can sell it at some future date for more money than it cost you to buy it. Be careful when using the term “investments,” because it can refer to several different things. Some people use the word “investments” to mean things like stocks, bonds, mutual funds, and certificates of deposit. However, it is more correct to call these items investment securities. With an investment security, you are given a piece of paper – a contract – which secures your ownership share of a certain asset. If you look back at the definition of investments in the first paragraph above, you will realize that investments mean much more than investment securities. Investments can also be actual, physical property you own: these are capital assets.

    Capital Assets Assets other than cash are often called capital assets (also called capital property and sometimes fixed assets). A capital asset is a physical item you own which usually cannot instantly be converted into cash, and which is usually held for a long period of time. Capital assets can include:

  • 18 GoVenture Experiencing Financial Literacy

    • Real estate • Automobiles • Art and antiques • Jewelry and gems • Gold, silver, and precious metals • Collectibles (stamp collections, coin collections, etc.) • Even animals can be capital property, for instance a racehorse, as long

    as there is a resale value.

    Note: For tax purposes, capital assets include your stocks, bonds, and mutual funds. What is common among all capital assets is that liquidating your property (converting it into cash) may take time. This is because there you cannot instantly sell a capital asset. For this reason, capital assets are usually considered long term investments.

    Investment Property or Personal Use Property Capital assets that are used for investment property are generally those which you do not use on a day-to-day basis. Investment properties are those assets you buy with the hope of selling at a gain. If you buy something for your own use or if you will never sell it, then it is not investment property. Capital assets are classified as either investment property or personal use property (non-investment property) for two reasons:

    1. Personal Financial Planning — You do not usually purchase something for your personal use in hopes of reselling it for a gain, an increase in monetary value. Its value to you is in having and using it. On the other hand, investment property is purchased for a future potential gain, and not for personal use.

    2. Income Taxes — When you sell any capital assets, capital gain income tax rules apply. If you decide to sell personal use property, there may be special capital gain exemptions for these transactions.

    Your car depreciates (loses value) the more you drive it. So, this would not be considered an investment. If, however, you owned an antique classic car which you only drove on special occasions and kept in good running order, this could be considered an investment property. Similarly, a baseball card collection or coin collection that you keep in mint condition would be an investment, as long as you might sell it some day. If you will never sell it, then it is not investment property.

    Example

  • Chapter 4 Your Assets 19

    The most common types of capital assets used for investment property are:

    • Real estate • Precious metals • Gems

    In all these cases, there are normally markets for buying and selling. Many other assets can be investment property, but often things like art and collectibles are kept for personal enjoyment and not for resale.

    In GoVenture Financial Literacy, you can buy and sell a wide range of assets for your personal use. You can invest in low, medium, and high risk investments.

  • 20 GoVenture Experiencing Financial Literacy

  • Chapter 5 Your Liabilities 21

    Credit and Loans

    5. Your Liabilities A liability is a debt — money or equivalent monetary value of things that you owe someone else. In your personal finances, your liabilities represent the money you owe on the goods and services which you purchased but have not completely paid for yet. This includes repaying any money borrowed to buy these things. Your liabilities also include any guaranties you may have made for other people’s loans. A loan guaranty makes you responsible for payment of the debt if the other people who borrowed the money do not make their own payments. Your liabilities can be classified in the following categories:

    • Unpaid bills • Unpaid credit card balances • Bank loans • Rents and leases • Family loans and loan guarantees • Unpaid taxes

    Your bills and taxes are normally paid off in a short period of time. Credit card balances and loans are paid off over a number of installments. Guaranties may never be paid by you, but since you are ultimately responsible for payment, any amounts you guaranty are a liability and reduce your net worth. All of these liabilities represent types of borrowing, debt or credit, because in all cases you (or someone you have guaranteed) have received something of value before it has been paid for fully.

    Borrowing, Debt, Loans, and Credit — What Are They? Borrowing, debt, and credit can be three terms for the same thing.

    Borrowing is to receive something of value, with a promise of giving something of equal or greater value back at some point in the future. You can borrow your neighbor’s lawn mower, or borrow $100 from your parents, or borrow money from a bank to buy a car. Debt or Loans, in financial terms, normally refer to a formal type of borrowing. It is an obligation (usually money) documented in a contract or legal agreement. You owe someone else and must make payment by a specified date. Borrowing money from a bank to buy a car would be a debt documented in a loan agreement.

    Credit has three different common definitions:

    1. Sometimes it is used to mean the same thing as debt. For example, at a store’s checkout counter the attendant might ask you, “Are you paying by cash or credit?” Here, credit means you will not pay for the merchandise today, but

  • 22 GoVenture Experiencing Financial Literacy

    Credit Cards, Line of Credit, Overdraft Protection, Personal Loans, Mortgages

    agree to pay either your credit card company, or your account at that store when you get their bill.

    2. It can also refer to your capacity to borrow, or the maximum amount of financial borrowing you can do. For example, if you are approved for a $20,000 loan to buy a car, then that is the maximum you can borrow from the bank to buy a car. If your credit card company provides you with a credit limit of $5,000, you cannot charge amounts over a total balance of $5,000 at any given time.

    3. The third definition of credit is a refund or reduction. This comes from accounting terms (debits and credits). If you return a purchase to a store, you may have heard someone say, “We’ll credit your account for this amount.”

    There are many different types of borrowing options. Some are specialized for the type of purchase, for example mortgages are for buying real estate. Others can be general loans for purchasing a variety of goods and services, for example credit cards. When deciding which type of credit to use, understand the advantages and drawbacks of each, so that you select the best option for your situation. For large borrowings, you should get professional financial advice to help you make your selection.

    Why Do People Borrow? Being able to borrow money allows you to have things before you can afford to pay for them. You may take a mortgage out on your home. Then you live there while you pay off the debt. You might take a loan out to buy a car, and pay the loan off while you are driving the car. Having the ability to borrow can improve your lifestyle and provide greater comfort than you might be able to otherwise afford. Without the ability to borrow, you would only be able to buy things by paying the full purchase price up front with cash.

    Example You want to buy a $15,000 car. But, you only have $5,000 saved today. Would you save up for the car or borrow to have it now? Review your options.

    A. Save $200 a month, for 5 years, then buy the car with cash: (The price of cars will go up over 5 years, too.)

    5 Years

    B. Borrow $10,000 to buy the car, repaying $225 a month, for 5 years:

    5 Years

  • Chapter 5 Your Liabilities 23

    Debt must be managed, to avoid borrowing too much so that the repayment requirements limit your cash available for basic necessities like food and shelter. Some governments which have overspent in the past are now paying millions of dollars a month in interest on the debt from this overspending. Personal debt is a lot less than this, but it can still cause hardship in repaying if you build up too much debt. Only you can decide the importance of your purchases and loans. But debt is not free, so you must manage your debt and current purchases against your ability to repay the debt.

    Interest Payments When you borrow money, you usually have to pay back more than the amount you borrow. This additional payment is called interest. Interest is the fee charged by the lender for the use of the borrowed money. The interest due is usually stated as an annual percentage (the interest rate) of the principal (the amount borrowed). Every payment you make on a loan goes first to pay for the current amount of interest due, and the remainder is used to reduce the amount of unpaid principal.

    Example Avoid Borrowing Too Much Money!

    Make sure you have enough money to live and pay your debts.

    What can you afford to borrow money for and buy?

    Your Monthly Income $500 Minus Your Monthly Living Expenses —$200 to $250 Left Over to Save or Pay Debt $250 to $300

    Sports Car Payment = $500 a month

    New Economy Car Payment = $200 a month

    Used Car Payment = $100 a month

    Widescreen Digital TV Payment = $85 a month

    Stereo System Payment = $50 a month

    MP3 Player Payment = $15 a month

    New Snowboarding Gear Payment = $100 a month

    Snowboarding Lessons Payment = $80 a month

    Ski Lift Season Pass Payment = $25 a month

    Example

    Lender Loans $1,000 Interest 5% a year (1,000 x 5%) Loan to be repaid after 5 Years

    Borrower Repays Year 1 - $50 Interest Year 2 - $50 Interest Year 3 - $50 Interest Year 4 - $50 Interest Year 5 - $1,000 Loan + $50 Interest Total Interest Paid = $250

  • 24 GoVenture Experiencing Financial Literacy

    Credit and Loans

    Credit Ratings If someone asks you if you have good credit, they are using credit to refer to your ability to take on more debt, and if you have a history of paying your debts on time. This is also called a credit rating. A credit rating is based on your history of borrowing and repayments. If you have never borrowed before, then you may find you have “no credit rating.”

    It is always good to have a “good credit rating.” This means that you pay your debts and meet your financial obligations on time, and that you may have the ability to borrow more and repay it if needed.

    People with bad credit have a history of not repaying their debts on time. If you have a bad credit rating, it will be difficult to borrow money in the future. People with no credit rating have no history of borrowing documented. It may also be difficult to borrow money if you have no credit rating. Credit bureaus are governed by state/provincial laws. They track information on personal uses of credit — how much you borrow, when you pay it off, and how prompt you are in paying your loans and other obligations like phone and electrical bills. Most of this information is kept on file for up to seven years.

    Banks, credit card companies, and other lenders will check your credit rating as part of their process in deciding to lend you money or not. You can get a copy of your own credit report by contacting your local credit bureau (check the telephone book’s yellow pages). There may be a small fee for the service, and it may take two or three weeks to obtain a written report. If you are unsure of how to obtain a copy of this report, contact your banker or financial advisor.

    Revolving Credit and Loans

    Revolving Credit

    Some debt arrangements allow you to borrow and repay and then borrow again. These are types of revolving credit, because you can go round and round – borrowing, paying back, and borrowing again – as long as you meet monthly minimum payments and do not exceed the total credit limit assigned to you.

    In GoVenture Financial Literacy, your credit rating is tracked, and can impact your ability to take out new loans.

  • Chapter 5 Your Liabilities 25

    Credit and Loans – Personal Loans

    A maximum credit limit is established and there are terms for minimum monthly payments. Then you decide how much you are going to borrow and how much above the minimum you will pay each month. Credit cards, personal lines of credit from your bank, and overdraft protection on checking accounts all operate in this manner.

    Loans

    Contrary to revolving credit, most loans are one-time borrowings, where all the money is provided when you sign the loan in one lump sum, and a fixed repayment schedule is set up. If you want to borrow more money later, you have to take out a new loan. Car loans, mortgages (loans to buy real estate), home improvement loans, and other personal loans are all set up in this fashion.

    Loans can be obtained from banks, credit unions, trust companies, and other financial institutions – including your life insurance company. What is common to them all is that there is a contractual agreement to repay the money loaned, plus a given interest fee over a specified number of payments.

    The repayment term, payment amounts and interest rates vary by type of loan, the type of lending institution, the riskiness of the loan for the lender, and the credit worthiness of the borrower.

    People who borrow money are called debtors: they owe a debt to repay the lender a certain amount of money. The lender is also sometimes called the creditor: this is the person or organization which has provided credit and loaned the money.

    You only paid $50 on last month’s balance. This month you can pay any amount between $25 and $382.48, the current balance. Until you make a payment, you only have $617.52 credit left for new charges. Can you follow the calculations on the monthly statement?

    Example Your Credit Card Monthly Statement

    GoVenture Bank Credit Card

    Statement Date November 30, 2003

    Credit Limit $1,000.00

    Available Credit $ 617.52 This month’s activity:

    Nov 2 GoVenture Hardware $ 35.53 Nov 6 The Ski Place $144.15 Nov 15 GoVenture Pizza $ 12.45 Nov 18 Payment - Thank You —$ 50.00 Nov 23 Cinemaplex 25 $ 25.00 Prior Balance $215.35 Payments Received $ 50.00 New Purchases $217.13 New Balance $382.48 Minimum Payment Due $ 25.00

    Payment Due Date – December 30

  • 26 GoVenture Experiencing Financial Literacy

    Secured and Unsecured Loans

    All loans are either secured or unsecured. A secured loan means you have pledged another asset against this debt. If you default on the loan, you lose the pledged asset. This is standard for car loans and real estate mortgages. Here the pledged asset is what you are buying. For example, if you don’t make your car loan payments, your car can be repossessed. If you don’t make your mortgage payments, you could lose your house. If this is done, the creditor sells the repossessed asset to pay off the balance of the loan.

    Unsecured loans have no pledged assets backing them up. You will have a lower borrowing limit if the loan is unsecured, because the financial institution’s risk of loss is higher if you don’t repay the loan.

    Rents and Leases Rents are agreements to pay for the use of an asset, usually to occupy certain space or to use certain goods. You might rent a car by the day. You can rent parking spaces and apartments by the month. You rent videos and DVD movies by the night. These are all types of rentals. You never own the asset; you only pay to use it for a while. A lease is a contractual agreement which allows you to have use of an asset over a long time (an apartment, a car, etc.) while making regular payments over a set time frame.

    Some leases, like an apartment lease, are just a long term rent. That is, you have no rights to purchase or own the asset at the end of the lease. So these assets are not part of your net worth. Other leases provide you the option to purchase the asset at the end of the lease. Depending on the lease, this purchase price might be the market value of the asset at that time, or a nominal charge like $1. These are called financing leases, and they are actually types of loans. You have a fixed repayment period, regular payments, and interest (usually a fixed rate). If you have an option to purchase or lease an asset, you should compare the costs, tax impacts, and benefits between taking out a personal loan to purchase and leasing. If you have ownership rights in the asset, then you should list the asset and the liability as part of your net worth calculation.

    Family Loans and Loan Guarantees You may also receive loans from friends and family from time to time. Family loans are usually informal lending arrangements. These loans often have no written agreement, and may not require interest payments or set repayment terms. You might also be asked to loan a family member money at some point in time. Or you might be asked to guaranty the loan someone is taking out. A loan guaranty is also

    In GoVenture Financial Literacy, you have a credit card account. You can take out a mortgage or get a loan. You may have to pledge an asset in order to qualify for the loan.

  • Chapter 5 Your Liabilities 27

    Taxes

    called co-signing a loan. If you guaranty a loan, it means that if the borrower neglects to make the loan payments, you are then legally required to make the payments. You hopefully will never pay anything on these guarantees, but because you might have to do so, these guarantees are considered liabilities and reduce your net worth.

    Consumption, Income, and Wealth Taxes Taxes are funds that must be paid to the government in order to enable the government to pay for its operations; such as public schools, road maintenance, garbage collection, etc. Federal, state/provincial, and county/municipal levels of government each have rights to charge certain types of taxes. One way to look at taxes is to determine if they are charges on your:

    • Consumption of goods,

    • Income from wages and investments, or

    • Wealth from owning investments and capital assets. Consumption tax is levied on goods and services you purchase. Income tax is assessed on your earnings — whether from wages, interest income, dividend income, capital gains income, gambling income, or other types of cash and value you receive. Your wealth is your net worth. So wealth tax is a charge made based upon your net worth. The US and Canada do not have a wealth tax, but many other countries do. For instance you might have to pay a higher income tax rate if your net worth were over a certain amount in countries with a wealth tax. And while the US and Canada do not have a wealth tax, there are taxes on parts of your wealth. What comes closest to a wealth tax is real estate (property) tax. This tax is based on the value of your real estate. You pay it for as long as you own the property. Here are some common types of taxes, and how they would be categorized:

    TAX TAX ON

    Sales Tax Tobacco, Liquor, Gasoline Taxes

    Consumption

    Income Tax • Wages • Pension Income • Gambling Income • Interest Income • Dividends • Capital Gains

    Income Note that when you receive value from your wealth (interest, dividends, capital gains), it is taxed. But the total value of this investment wealth is not taxed.

    Real Estate (Property) Tax Estate Tax

    Wealth

  • 28 GoVenture Experiencing Financial Literacy

    Depending on the type of tax, you may pay the tax as part of your purchase (sales tax), receive a periodic bill for your taxes (real estate tax), or be required by law to make withholdings from your wages and fill out forms each year (income tax). Taxes are similar to other liabilities — if you do not pay them on time, you will be charged interest and penalty charges.

    In GoVenture Financial Literacy, you pay sales tax on your purchases. Income taxes are due each year in April. You will be prompted to file your income tax return.

  • Chapter 6 Managing Your Assets and Liabilities 29

    6. Managing Your Assets and Liabilities Whenever you choose to spend money, save it, give it away, or invest it, you are making a personal finance decision that will affect you in some way or another – either today or in the future.

    Making good personal finance decisions starts with understanding your own personal financial requirements and goals, and then understanding the options that are available to you for reaching your goals. The better you understand your goals and options, the better you will position yourself for the financial future you desire. Money management is a major cause of stress for people all over the world. By planning your financial future early in life and assessing your needs regularly, you can minimize your stress while maximizing your personal wealth.

    Setting Goals and Planning Most people have goals and dreams for the future. Realizing them often depends on your financial resources, which means the better you manage your money today and in the future, the greater the chance you will be successful. By setting goals, planning, and investing your money wisely, you are taking the first and most important steps to realizing your goals and dreams.

    Setting Goals

    To set your personal goals, think about what you want in the future, for yourself and your family. Do you want a large home? a vacation cottage in the country? a sports car? a comfortable retirement income? to have two children and send them both to university? Make a list of your goals. Set reasonable goals, or at least be willing to revise your goals to match the realities that you will face in the future.

    In GoVenture Financial Literacy, you set up your life goals, and then manage your finances to try your best to meet these goals.

  • 30 GoVenture Experiencing Financial Literacy

    Some of the most common goals which impact your personal finances are:

    • Education and training programs • Career • Marriage and family • Homes • Cars • Vacations • Money • Retirement income

    You may have other goals, like learning to play a musical instrument, owning certain assets, and more.

    Planning for Your Future

    Now that you have goals you wish to reach, you have to plan how you might achieve them. Think of this as a road map. You are at the beginning of a journey, and your goals are the destination. In between these points there are various routes. Several may lead to your goals. Others will take you away from them. The first step is to estimate how much money you think each of your goals will require. Then determine how many years you have until you need this money. You may find that your goals are not all at the end of your journey, but that several are along the way in a time line.

    This process may seem a daunting task to start with. But the important thing is to have a plan and to start acting on it.

    For instance, you may want to own a country home in five years. If your children are three and five years old now, then you will need their university tuition money in 13 to 15 years. However, your retirement may be 30 years away. How much more money do you need to make? Compare the estimated cost of your goals with what you have today (after you pay your liabilities). The difference is what you still need. Plus you need to have enough money to live as you work towards your goals. Now you have to look at your income and what you spend today, and at the ways you might obtain this additional wealth. Can you earn enough from your employment alone? Probably not. So what might you do?

    Example

  • Chapter 6 Managing Your Assets and Liabilities 31

    Investing

    Investments are assets which you have obtained in the hope that these assets will increase your wealth. Investing is the process of buying and selling assets to increase your wealth. The gains might come from interest or income generated by the investment. It might come from the increased value from the time of purchase to the time you sell. Or, it might come from a combination of both income and increased value. This is a very broad definition. It covers many types of investments, from savings accounts, to investment securities and capital assets. Like forks in the road, each investment option has different characteristics and risk. These will be discussed in more detail in subsequent chapters.

    Start Today!

    One of the most important rules of personal finance is to start on a plan today. If your plan shows you can only invest $5 or $50 a month, that is a start toward reaching your goals.

    Monitoring Your Financial Health The three most important tools in monitoring progress towards your financial goals are:

    • Cash Flow • Budget • Portfolio Management

    Cash Flow

    Your cash flow consists of money coming in and going out. What comes in are the sources of your cash, or income, and what goes out are called the uses of your cash, or expense.

    Income

    Income can be categorized as earned or unearned. As discussed in Chapter 3, this is either money from your employment or money from other sources. Income can also be categorized as regular (or recurring) or one-time. Examples of these different types of income are given on the next page.

  • 32 GoVenture Experiencing Financial Literacy

    Type of Income

    Income Item Regular One-Time

    Salary √ Earned Income Hourly Wages √ Contract Fee √ Bonus √

    Trust Income √ Unearned Income Annuity √ Inheritance or Gift √ Lottery Ticket Winnings √

    Expense

    Expenses are your bills and purchases. Some expenses are required in order for you to live and earn your wages, for instance food and clothing. However, even with these mandatory living expenses you often have choices of how much to spend. For example – should you rent or buy a house? Other expenses are more optional, or discretionary, such as how much to spend on entertainment.

    It is also important to differentiate between fixed and variable expenses. Fixed expenses are bills which tend to be the same each month or year, such as rent. Variable expenses are those which change often. Usually you have some control over your variable expenses. Here are some examples:

    Type of Expense

    Expense Item Fixed Variable

    Rent √ Mandatory Expenses Insurance √ Real Estate Tax √ Gas for Car/Transportation √ Food √ Medical Expenses √

    Gym Membership Fee √ Discretionary Expenses Education – Tuition Fee √ Vacation Cost √ Hair Cuts/Beauty Treatments √

    If you have more income than expense, you are said to have a positive cash flow (“in the black”). If your expense is higher than your income you have a negative cash flow (“in the red”).

    Example

    Example

    The terms “in the black” and “in the red” come from the color of the ink that bookkeepers historically used to record positive and negative values in manual ledgers.

  • Chapter 6 Managing Your Assets and Liabilities 33

    Determining your cash flow helps you to project if you will have a cash shortfall or surplus. If you have a shortfall, you will either have to cut back your spending, earn more money, or borrow money. If you have a surplus, you can decide if you are going to spend it or invest it. To determine cash flow, pick a period of time (such as a month) and record all money coming in and going out, as well as how much money you currently have. Note that not all liabilities are paid in the same periods. For example, real estate taxes are generally paid every six months, and insurance is usually an annual charge. You may find it easier to show a reserve (money you set aside each month) for the monthly portion of these less frequent charges in your cash flow.

    Budgets

    A budget is an itemized list of estimated expenditures and the expected ways to pay for them, for a given time period. By budgeting you can manage your finances better, and watch to make sure you don’t spend more money than you budgeted.

    In addition to income and expense items, budgets often include planned amounts for savings or investment. For instance, you might have money taken out of your paycheck for a retirement plan. Or, you might make monthly payments to a savings

    Amount Sources of Cash Regular Income

    • Salary, net take-home pay $ 3,000 • Interest on Savings Account 20

    One-Time Income • Birthday Money, Gift 100 • Sale of Stock (for car down payment) 5,300

    Loans and Debt Funds Received • Car Loan 15,000

    Total Cash IN $ 23,420 Uses of Cash Special Purchase

    • New Car $ 20,000

    Living Expenses • Rent 1,200 • Utilities 200 • Car Loan Payment 200 • Gas/Transportation 100 • Food 250 • Health Care 100 • Insurance Reserve 100 • Real Estate Tax Reserve 150

    Discretionary Expenses • Clothing 100 • Entertainment & Recreation 100 • Donations & Charities 100 • Miscellaneous 100

    Total Cash OUT $ 22,700 Surplus Cash for Spending or Investment $ 720

    Example

  • 34 GoVenture Experiencing Financial Literacy

    account. These are uses of your cash that may remove it from easy access, but the money is still yours. Think of it as paying yourself.

    The main difference between a budget and a cash flow is that budget use estimates and cash flows use actual amounts. A budget is an estimate, done before the money is earned and spent. A cash flow shows actual results of earnings and expenses. It is also useful to compare your budget with what actually happened. This helps you to make your future budgets more accurate.

    Portfolio Management

    A collection of investments is known as a portfolio. Portfolio management means watching all your investments, and balancing your various investment needs. The most common portfolio management issues are:

    • Liquidity • Investment Income • Growth/Capital Gain • Risk • Tax Planning

    Liquidity

    Liquidity means how easily your investment could be cashed and used. If you are saving for your retirement, you won’t need the cash for many, many years. However, if you’re saving for this year’s vacation, you have to be sure you will have the cash available in time for your trip.

    Investment Income

    Some types of investments make periodic payments of interest or dividends: this is called investment income. If you need investments to generate regular income without selling assets or reducing the principal amount, then you must choose investment options which will do this.

    Growth/Capital Gain

    The value to some investments is not periodic income, but the increase in the overall value of the asset. When you sell the asset, you receive more money that you paid for it. This is called growth or capital gain. In many cases this growth can exceed the sum of all the interest you might have received from another investment. Unlike interest income and dividends, you must sell this asset to get cash back and any capital gain.

    Risk

    Risk is uncertainty. Whenever there is an unknown future, there is risk. Many investment decisions you make will carry a risk that the investment will not provide the future value you expect. You might lose some of your money or even all of it. Or, you might gain a little or a lot. Each investment carries a certain risk that it will not perform as anticipated. It is likely that your portfolio will have a blend of different risk levels.

    In GoVenture Financial Literacy, you choose your investments and manage your portfolio.

  • Chapter 6 Managing Your Assets and Liabilities 35

    Tax Planning

    Another part of your portfolio management is tax planning. You must plan the most advantageous manner for investing with your income taxes in mind. Certain investments provide ways to reduce or defer tax payments. For example, there are many retirement plans which defer all taxes until the time you use the money after you retire. Government bonds are usually tax exempt. If you want to avoid current income tax on your investments, your portfolio may include some tax exempt or tax deferred investments.

    Insuring Your Life and Assets There are no guarantees in life, but you can pay a reasonable cost to insure against the unexpected loss of certain assets, and even your life. There are three major categories of insurance products:

    • Those used as investments.

    • Those used to pay for the costs of loss or damage.

    • Medical and health insurance.

    Annuities and certain types of life insurance are used as investment instruments. Other insurance guards against your financial loss to property (house, car, possessions, travel, lawsuit claims, slander), or your health and ability to earn a living (medical, loss of use, or disability coverage). Insurance is a contract, called a policy. You, the insured, pay a specific sum or series of payments (called premiums) to the insurer or underwriter. In return for your money, the insurer agrees to guaranty against the loss of certain specified risks, up to specified limits. You can insure many things, but some insurance may be so expensive that you decide to do without it. The most common types of insurance purchased are:

    • Life Insurance • Health Insurance • Automobile Insurance • Property Insurance

    Life Insurance

    Like the name implies, life insurance insures your life. That is, it pays an individual whom you name, your beneficiary, a certain amount of money when you die. There are exclusions: for instance, death by suicide is not covered. Why do you need life insurance? Obviously the benefit does not go to you. But the life insurance payment to your beneficiary can be used to:

    • Cover the costs of your funeral and settling your estate, and • Provide your family members with financial security.

  • 36 GoVenture Experiencing Financial Literacy

    Buying life insurance is important, and it can be confusing. There are a number of policies to choose from, and it is often difficult to compare one to the other when you are shopping for the right policy. Some insurance companies offer policies which include a savings component. In these cases there is monetary value to you in your lifetime, in addition to the death benefit, the amount paid to your beneficiary upon your death. The basic types of life insurance policies can be broken down into two major categories: term life and whole life. Annuities are a third category. Annuities are primarily a savings vehicle, but they pay a death benefit and are considered an insurance product.

    Do You Need Life Insurance?

    The best way to decide this is to ask yourself, “Would my death create a financial hardship for anyone?” If the answer is “yes,” you need life insurance.

    Some people recommend buying life insurance when you’re young so that the premiums will be low. If your death would not create a financial hardship on anyone, then you may wish to invest the money instead of spending the money on insurance premiums. High wealth individuals should also consider the tax impact on your estate. When properly structured the life insurance death benefit may be completely exempt from estate taxation. So your beneficiaries could use it to pay the taxes on your estate.

    How Much Do You Need?

    This is more difficult to determine. Some people just pick a number out of the air. Some people use a number equal to four or five times their annual income. Others take a more analytical approach:

    What would immediately need to be paid?

    • Funeral expenses • Estate taxes and probate costs • Mortgage • Debt • Children’s college funds

    What would your family need to maintain their standard of living?

    What other income would your family have after you are gone?

    • Social Security (US) or Social Insurance (Canada) benefits • Retirement benefits • Savings and investments • Their own wages and earnings

    What economic factors do you have to consider?

    • Inflation • Interest rates

  • Chapter 6 Managing Your Assets and Liabilities 37

    It is complex, especially when you try to estimate how much inflation will erode the future insurance benefit. Insurance agents can help you with these estimates. Ultimately, it will probably come to a compromise between the future benefit you would like to have and what you can afford today.

    Health Insurance

    Health insurance is recommended in the US and usually is available through your employer’s group plans. In Canada basic health coverage is provided to all residents, but supplemental plans may be desired to cover prescriptions, dental care, and when traveling out of your home province. Other insurance options include coverage for the possible loss of your ability to earn a living: disability coverage, or for specialized professions, loss of use (e.g. a surgeon would insure his hands).

    Automobile Insurance

    Certain amounts of automobile insurance are mandatory by law. Most drivers carry more than legal requirements to pay for damages and cover lawsuits from others. Insurance coverage usually includes payment for damage to the vehicle, and medical costs from personal injury if you cause an accident.

    Property Insurance

    Your mortgage lender will require that you purchase certain amounts of insurance against damage to the house you are buying. Homeowner policies usually cover both the structure and a specified amount of personal goods within it. If you do not own your home, you can also purchase insurance for just your personal belongings, and not the building itself. Special high-value items should be identified separately to your insurer, for example — computers, jewelry, boats, antiques, coin or stamp collections, etc.

    Other Insurance

    Other types of liability insurance and short term coverage for travel and goods are also available. Specialty coverage can range from personal liability insurance to pet insurance. To decide if you should have the coverage, consider the risk that such a loss might occur, and then the cost of the loss versus the cost of insurance.

  • 38 GoVenture Experiencing Financial Literacy

    The Investment Timetable

    Living and Retiring Comfortably

    By calculating your net worth and keeping an eye on your cash flow, you can begin to determine what your future financial health might look like. If you expect to retire at a young age, then you will need to build up enough net worth to be able to do so, including factors such as inflation. Or you can simply plan to balance your

    current life style with enough investment to assure a comfortable retirement at a later time in your life. There are trends for investment portfolios in “an average person’s” lifetime. Many people find they are not “an average person,” and their financial requirements are different, or they don’t have the expected investment portfolio for their age level. So an investment timetable should be used only as a general guideline. It is never too late to start saving and investing. But your age, family responsibilities, and financial commitments may require you to adapt the investment strategy to your specific situation. In your younger years, you will want to look to long-range growth investments. You may be able to afford to take some higher risks, as you will have time to adjust for losses. As you grow older, you will continue to diversify your portfolio of investments. Then, as you approach your retirement, consolidate your holdings and reduce the amount of high risk investments. During retirement years, you will likely wish to have more income generating investments and low risk to give you security.

    In GoVenture Financial Literacy, you make all your investment decisions — year-to-year, and week-to-week.

    Early Years To Mid 30s Get started! Growth-oriented.

    Middle Years Mid 30s – Late 40s Build value and invest! Diversify. Growth-oriented.

    Retirement Years 60 and over Security! Income-oriented. More conservative.

    Pre-Retirement Years Late 40s – Retirement Consolidate! Diversify but reduce amount of high risk.

  • Chapter 7 Key Investment Concepts 39

    7. Key Investment Concepts

    Before you can start to evaluate the benefits of different investment options, you must understand some key investment concepts:

    • Time Value of Money • Return on Investment • Risk and Return • Economic Influences

    The value of your investment is measured by the amount of value returned to you and the holding period of your investment. Returns vary greatly, as does the potential risk in each investment. So time, risk, the rate of return, and the possible economic influences must be considered when making your investment decisions.

    Time Value of Money Lenders and investors want to have the dollars they loan, or invest, today to be worth more when those dollars are returned in the future. There are two components in the future value they are looking to cover:

    1. Inflation 2. Opportunity Cost

    Inflation

    The time value of money means, in part, that the worth of money changes over time. As time passes, each dollar will usually buy less and less value. This is called inflation. As the prices of goods rise over time, a dollar in the future will not buy as many goods as it does today.

    In terms of investing money, if you invested a dollar today and only got one dollar back 50 years from now, you are likely to lose value in terms of your buying power. Fifty years from now you might need $5 or $10 to keep the same buying

    Have you ever heard one of your older relatives say, “A dollar today just isn’t worth what it used to be! In my day, well, you could buy …”

    So if a 25-cent candy bar in the 1950’s now costs $1.00, then the value of today’s dollar is much less, because it takes four times as much money to buy the same item (i.e. in 1950 you could buy four candy bars for $1.00, but now you only get one).

    Example

  • 40 GoVenture Experiencing Financial Literacy

    power. This is one reason that banks charge interest when they loan money — to try to make sure the value of the money being repaid in the future is at least the same as the value of the money they are loaning or investing today.

    Opportunity Cost

    The opportunity cost is an estimate of the value you did not get from other possible uses of your money. If you could invest your money for five years and be guaranteed to get back exactly the amount of original investment plus inflation, would you do it? Probably not. That is because you

    would be no better off than you are today with the money. Your buying power would not have grown at all. During those five years, if you had kept the money you might be able to use it to do a lot of other things — build a bigger house, buy a better car, or make another investment — because you have other opportunities for the money. Ideally, you would like to get your money back, with inflation and some additional amount to compensate for the other opportunities you did not take. Perhaps it is easiest to think of this opportunity cost as the charge for using your money over a period of time. It could even be considered as a type of “profit,” so that you wish to get your principal, plus inflation, plus some profit back from your investment.

    Return on Investment (ROI) The extra value that you want back from your investment is the called the return on investment (ROI). This is the benefit (the “return”) you expect to receive in the future. There are three ways to receive a return on your investment:

    1. Interest Income 2. Dividends 3. Capital Gains

    The type of investment determines whether your return is interest, dividend, or capital gain. Here are some common investments:

    Possible Types of Return Type of Investment Interest Dividend Capital Gain Savings Account √ Treasury Bill √ Bond √ √ Stock √ √ Diamonds √ Real Estate √

    Example

  • Chapter 7 Key Investment Concepts 41

    Interest Income

    Interest is the fee charged by a lender (investor) when providing money to a borrower. When you borrow money, you repay the amount you borrowed plus interest. When you loan money, you receive the interest income plus repayment of the original amount you loaned. For example

    Dividends

    A dividend is a distribution of part of a company’s profits, which is paid by the company to its shareholders (another name for investors, because they hold shares of stock in the company). Dividends are authorized by the Board of Directors, and are generally paid quarterly, semi-annually, or annually. Most often, dividends are paid yearly. Not all companies pay dividends – in fact, most companies do not. Generally companies reinvest profits back into the company in order to grow the company, instead of paying dividends.

    Capital Gains

    With capital gains, an investor expects to make money through an increase in the overall value of an asset (such as property, art, shares in a company, etc.). This increase is called capital gain because investors make a gain on their capital assets: that is, they receive more value than what it cost to purchase the asset. Capital gains offer the potential for very high rates of return on investments – much more than dividends and interest normally provide. Capital gains are what have made some people overnight millionaires. There is always the possibility that you might end up selling an asset for less than you paid for it. This is called a capital loss.

    Company-A Issues dividends of $0.50 per Share.

    You own 100 Shares. You will receive $50 (100 Shares x $0.50 per Share) in dividends as your share of the profits

    Example

    Example

    Lender/Investor Loans $1,000 Interest 5% a year (1,000 x 5%) Loan to be repaid after 5 Years Return on Investment = $250 (5 years x $1,000 x 5%)

    Borrower Repays Year 1 - $50 Interest Year 2 - $50 Interest Year 3 - $50 Interest Year 4 - $50 Interest Year 5 - $1,000 Loan + $50 Interest Total Interest Paid = $250

  • 42 GoVenture Experiencing Financial Literacy

    Rate of Return Investments not only have different types of return, or gain, but also have levels of return and different time periods for the return. When the return on investment is expressed as a percentage of the original investment, it is called the rate of return on investment, usually shortened to just the rate of return. By calculating a rate of return, you can more easily compare the value of different investments. The higher the rate of return, the bigger your monetary gain will be. The total dollars you gain from an investment will vary depending on the amount invested, the length of time you hold the investment, and the rate of return. The rate of return is usually calculated on an annual basis to help you compare investments of different durations. There are several different ways to calculate the rate of return. Simple rates of return are easiest to compute, but the most commonly used rates of return are compound rates. Simple rates of return compute the gain as a percentage of the original amount for the entire period. To get an annual rate, you divide by the number of years. Compound rates are more complicated calculations because they adjust for the time value of money, as if you had re-invested your periodic gain at the same rate — like getting interest on your interest. Compound rates of return are lower than simple rates for the same return on an investment. Therefore, when comparing rates of return, make sure you are comparing the same types of rates.

    Company-A Share Price is $1

    You buy 100 Shares for $100 (100 x $1)

    Example Today Sometime in the Future

    Company-A Share Price is $3

    You sell 100 Shares for $300 (100 x $3) Your Capital Gain = $200 ($300 - $100)

    Calculating the Return on Investment

    You invest $10,000, and 3 years later you get $13,000 back.

    Simple Rate of Return $13,000 — $10,000 = $3,000 Gain (Return on Investment) $3,000 ÷ $10,000 = 30% Rate of Return over the 3 years.

    Simple Annual Rate of Return $3,000 ÷ $10,000 ÷ 3 Years = 10% a Year

    Compound Annual Rate of Return = 9.1% a Year, compounded annually (see Calculating Rates of Return)

    Example

  • Chapter 7 Key Investment Concepts 43

    This may seem easy, but often your investment decisions have many different options. When in doubt, seek professional investment advice.

    Risk and Return Risk is uncertainty. With investments, this means the uncertainty of how much of your investment you could lose or gain. There are many types of investments, each of which has varying levels of risk and possible returns. The better you can balance the risks and potential returns of your investments, the better you should be able to meet your investment goals.

    Risk versus Return

    There are no investments that can be made with 100% guarantees of the future outcome. Even if you decide to stuff money in your mattress, your house might catch fire or mice could chew up your money.

    Calculating the Return on Investment

    For instance, how would you compare the following investments?

    • Mutual Funds, $25,000, expected to grow by $15,300 in 5 years. • Real Estate purchase of $50,000, expected to be worth $150,000 in 6

    years. • Stock purchase of $75,000 in a growth company, expected to triple in

    value in 4 years. Knowing the rate of return for each investment option makes it much easier to compare them:

    Mutual Fund Real Estate Stock Investment $25,000 $50,000 $75,000 Expected Growth

    Grow by $15,300 in 5 yrs

    triple in 6 years triple in 4 years

    Future Value $40,300 $150,000 $225,000 Return (Gain) $15,300 $100,000 $150,000 Compound Annual Rate of Return

    10%

    20%

    32%

    You can now see that the stock investment is expected to have the highest rate of return. It is still not an easy decision, but knowing the rate of return makes them easier to compare. You must next balance the amount of money you have to invest, the length of time you can invest it before you need the cash back, and the risk that the expected return might not happen.

    Example

  • 44 GoVenture Experiencing Financial Literacy

    The risk of each investment will vary. The risk can range from almost none to extremely high. At the same time, the potential return will run parallel to the perceived risk. That means that the lower the risk, the lower the expected return is. And the higher the risk, the higher the potential return is. Low risk investments are those where it is unlikely you will lose any part of your investment. Low risk investments only return a small amount of income. Examples of low risk options would include:

    • Passbook savings account

    • Bank term deposits

    • Federal government savings bonds

    • Guaranteed rate annuities

    High risk investments are those where it might be possible to lose your entire investment. These investments often have the potential to give you extremely high returns, in repayment for risking your money. Examples of high risk options would include:

    • Stock in high risk companies, e.g. drilling for oil

    • Investing in what the future price of certain commodities will be (Futures)

    Risk and reward potentials vary from investment to investment. This makes reviewing the risk-reward profile a key feature of each investment decision.

    Your Risk Profile

    When determining where to invest your money, you must understand the risk involved: Could you lose the potential benefit? Could you lose part of your original investment? Could you lose all of your original investment? How likely is this to happen? Is the risk lower if you hold the investment over a long period of time?

    And most importantly, you must understand your own willingness to take this risk. For instance, which of the following statements would you select as best describing your investment risk preferences:

    � I like to gamble; I want to try for big gains; and I don’t care if I lose the

    whole amount.

    � I’m willing to risk a lot, but I don’t want to lose all of my principal.

    � I’m willing to invest some in riskier options, but I don’t want to lose more than ______% of the original principal amount.

    � I am fairly conservative. I’d like to keep as much of the principal as possible, even if it means lower returns.

    � I don’t want to lose any of the original principal amount, even if it means low returns.

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    In developing your risk profile consider the following issues:

    • How much money do you want to make?

    • When do you need the money?

    • How much loss can you tolerate?

    • What is the minimum amount you need?

    • What is your knowledge level as an investor?

    How much money do you want to make?

    The greater the amount of gain needed to meet your financial goals, the more you may need to invest in higher yield opportunities (those with a higher return) — and thus take on moderate to high risk.

    When do you need the money?

    How soon you need to access the money will also depend on how much risk you might need to accept to reach your financial goals. The less time you have to build your net worth to your target level, then the higher the rate of return you will need to achieve this. And that will mean taking on more risk. If certain levels of risk are unacceptable to you, then you may need to adjust your goals.

    How much loss can you tolerate?

    Remember there are no guarantees in investing. Therefore, you must identify how much you would be willing to lose, or how much you could lose and still meet your base level goals. If you have already lost near your maximum amount from earlier risky investments, then you will have to revise your risk profile for future investments.

    What is the minimum amount you need?

    Determine the minimum level of net worth for your financial security. You can use this as a base level, or minimum for your goals. When assessing the rate of return, investment risk, and loss potential compare the possible outcomes to this minimum level. This may help you decide if you are willing to accept certain new risks.

    What is your knowledge level as an investor?

    Know what you don’t know, and what you do when it comes to investing. The less you know about an investment, the riskier it becomes. For example, if you happen to know a particular company or industry, you are better able to project a company’s chances of success. Your investment then becomes less of a bet the company will make good, and more of an informed estimate that the company will do well. You can increase your own understanding, or hire the services of qualified investment advisors to reduce some risk in your investment choices.

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    Economic Influences The economy is all around us. If affects everyone in the world in some way or another. Having a basic understanding of the economy is invaluable in making personal investment decisions. There are several national and global factors that affect the economy, which in turn affect your ability to make and spend money. For example, when the economy is weak, companies may lay off employees, stock markets may crash, and interest rates may drop. When the economy is strong, companies may hire more employees, salaries may increase, interest rates rise, and the stock market may boom. Changes in economic conditions affect people in some way or another — sometimes in very complex relationships. By understanding some of the basics about the ups and downs of the economy, you can make better financial decisions. The following are key factors that affect the economy. Each is described in sections that follow.

    • Interest Rates • Inflation • Foreign Exchange Rates • Financial Markets • Government Spending and Policy • Global Events

    Interest Rate

    What is it?

    Interest is the cost of a loan. When someone gives you a loan, they expect you to pay back the principal (amount of money you receive) plus interest (their profit). The higher the interest rate, the more the loan costs you. Or, if you loan money to the government or a company by purchasing a bond, you, too, expect to get interest plus your original investment back. Common terms used to describe interest are prime rate for a bank loan, and coupon rate for a bond. Prime rate is the interest rate set by major banks for loans to their best corporate customers. Individuals are usually charged interest rates higher than the prime rate for their loans. The coupon rate is the interest rate paid on a bond to the purchaser of the bond.

    In GoVenture Financial Literacy, you can track the economic trends, and use this information to help you with your investment and other decisions.

  • Chapter 7 Key Investment Concepts 47

    Example

    Cause/Effect

    In most loans the interest rate is set by the lender (the person or company providing the loan). In the case of bonds, the interest rate is set by the borrower (the company or organization offering the bond), based on current market conditions. Interest rates vary by type of loan and the credit rating of the borrower. Generally, the higher the risk of default is, the higher the interest rate is. Default means the failure to make the payments or to meet other requirements of a loan or legal agreement. Interest rates also fluctuate with changes in inflation, so that the interest rate covers the rate of inflation (see below) plus a reasonable return on top of inflation.

    Inflation

    CAUTION: $1 today is not the same $1 in the future — because of inflation.

    What i