Personal Finance

Personal Finance:

How people budget, save, and spend their wealth

Congratulations!You’ve just won $100,000!You have two options. You can….A)Take the money now, ORB)Get it 5 years from now

What do you choose???

Most People Would Choose Option A

But why?

1)You might be dead 5 years from now

2) You can earn interest on that money now!

The Time Value of MoneyDefinition – the core principle of finance which holds that a certain amount of money, as long as it can earn interest, is worth more the sooner it is received

Interest: money paid for the right to use someone else’s money right now – a.k.a. the price of borrowing money

If you choose Option A in the previous example, you can increase the future value of the money by investing it and earning interest over the next five years

If you choose Option B, the future value of the $100,000 five years from now is….just $100,000

If you choose Option A and invest the $100,000 at an annual interest rate of 5%, the future value of your investment at the end of the first year is $105,000

If you reinvest the money for another year, your investment will grow to $110,250 ($105,000 x 1.05)

Interest

If you reinvest the money for a third year, your investment will grow to $115,762.50 ($110,250 x 1.05)

After 5 years, the initial investment will have grown to $127,628.16

Future Value of MoneyFuture Value =

Present Value x (1 + annual interest rate) (number of years)

In our example, the future value of the initial investment after 5 years is:

$100,0000 x (1 + 0.05)5 =

$127,628.16!

Future Value of MoneyFuture Value =

Present Value x (1 + annual interest rate) (number of years)

In our example, the future value of the initial investment after 5 years is:

$100,0000 x (1 + 0.05)5 =

$127,628.16!

Present Value of Money

If you choose option A, the present value is… $100,000

Present Value: how much consumption your investment gives you if you spend it today

To find the present value of option B, we have to pretend that the $100,000 is the future value of an amount that you invested today

Present Value x (1 + interest rate) (# of years)

Future Value =

Present Value

=Future Value

(1 + interest rate)number of years

In our example

Present Value

=Future Value

(1 + interest rate)number of years

In our example

Present Value

=Future Value

(1 + .05)number of years

In our example

Present Value

=Future Value

(1 + .05)5

In our example

Present Value

=$100,000

(1 + .05)5

In our example

Present Value

=$100,000

1.276

Present Value =

In our example

$78,352.62

In other words….

Choosing Option B is like taking $78,352.62 now instead of $100,000 now

Bottom line:

Don’t be a dummy

Take the money now!!!!

Investing

Ways to invest

1)Stocks2)Bonds

What if you could own a business without ever having to show up at work? What if you could sit back, relax, and collect dividend checks as the money rolls in?

This can be a realityAll you have to do is own stock!

Stocks are one of the greatest tools ever invented for wealth creation

What is Stock?Stock is a share of ownership in a company

Stock represents a claim to a company’s assets and profits

Holding a company’s stock means you are one of the many owners (shareholders) of a company, and therefore, you have a claim to everything the company owns

This means you own a sliver of every piece of furniture it owns, every trademark it owns, and the rights it has under every contract it is a party to

Owning stock entitles you to some say in how the business is run

Each share you own entitles you to vote for the board of directors

Board of directors make key operational decisions (e.g. who to hire as the CEO)

Being a shareholder also entitles you to a portion of the company's profits and assets

Profits are sometimes paid out in the form of dividends, or a share of the company’s profits

If the company goes out of business, a shareholder also gets a portion of the company’s assets (machinery, building, tools, etc.)

Why would a company issue stock?

To raise money! Companies need $ to operate

Issuing stock is called equity financing. It’s advantageous for the company because it doesn’t require the company to pay back the money or make interest payments.

All that the shareholders get in return for their money is the hope that the shares will issue dividends, and/or someday be worth more than what they paid for them.

RiskStocks come with no guarantees you’ll get any $ back

1) Companies aren’t required to pay dividends

2) If company whose stock you own fails and its stock price falls to $0, you’ll lose your entire investment

Risk: The Bright Side

Historically, investing in stocks has had an average return of 10-12%.

Taking on more risk demands a higher return on your investment.

This is far better than most other types of investments

The Stock Market

The stock market can be split into two main sections: the primary market and the secondary market.

The primary market is where brand new stock is first sold through initial public offerings (IPOs).

All subsequent trading of the stock happens in the secondary market

The Stock Market

Most stocks are traded through exchanges.

The two biggest exchanges in the U.S. are the New York Stock Exchange (NYSE), founded in 1792, and the NASDAQ, founded in 1971.

Stock Exchanges

If you want to know how the stock market is performing overall, you can look at an index of stocks for the whole market or a segment of the market.

The most famous example is the Dow Jones Industrial Average (i.e. “The Dow”)

Stock Indexes

The news media tends to portray the Dow as a measure of the health economy as a whole

“The Dow is up, so the economy is doing well!

This is generally true, but the Dow moves more sharply

Bonds

•An I.O.U.!•When you buy a bond, you are basically lending money to the issuer•In return for the money, the issuer gives you a piece of paper (the bond)…•on which it promises to pay you a fixed interest rate (usually gradually, but sometimes in one lump sum)…•PLUS pay you back the money you lent (the face value, or principal)…•on a certain date (the maturity date)

What is a Bond?

•The bond market is massive.•There is currently $36 trillion in total U.S. outstanding bond debt.•Daily trading volume in the bond market: $900 billion (1/2 or $450 billion is U.S. Government securities).•Daily Trade Volume on the U.S. Stock Market: $100 billion.

The Bond Market vs. The Stock Market

•U.S. Treasury securities (i.e. “Treasuries”) – such as bills, notes and bonds – are I.O.U.s from the U.S. government•When you buy a Treasury, you are lending money to Uncle Sam (or reimbursing someone who did)•Because the government can always raise taxes and/or create new money to repay its debts, Treasuries are considered the safest of all investments.

Government Bonds

•If you own a bond and interest rates go up, the value of your bond (the price) on the open market will go down. Why?•When interest rates rise, new bonds come to market with higher yields (interest rates) than older ones, making the older bonds less attractive•Demand for these old bonds goes down, lowering their prices.•When interest rates fall, new bonds come to market with lower yields than older bonds, making those older, higher-yielding bonds worth more and their prices go up.

Bond Prices and Interest Rates

Example:• A bond is trading at $950 and has a face value of $1,000

(to be paid at maturity in one year)• This bond's rate of return is 5.26% ((1000-950) / 950 =

5.26%).• For someone to pay $950 for this bond, she has to be

happy with a 5.26% return. • But her happiness with this return depends on what

other options she has in the bond market. • If current interest rates were to rise, giving newly issued

bonds a yield of 10%, then the old bond yielding 5.26% would not only be less attractive, it wouldn't be in demand at all.

• To attract demand, the price of the bond would have to fall enough to match the same return yielded by the new bonds in the market.

• In this case, the bond's market price would drop from $950 to $909 (which gives a 10% yield). 

•When the Fed buys government bonds, it raises demand and price of bonds, which in turn lowers interest rate on bonds.  

•When the Fed sells, the bond supply increases and bond prices fall, which raises interest rate yield on bonds.

Government Bonds and the Fed