Personal Finance Interactives - EconEd
http://www.econedlink.org/personalfinance/
Monday, June 30, 2008
Wednesday, June 25, 2008
Personal Investments - Questions for Further Study
1. Stocks and bonds. Explain the difference between stocks and bonds.
2. Stocks. Explain the difference between blue chip stocks and aggressive growth stocks.
3. Bonds. Explain the difference between government bonds, municipal bonds, corporate bonds, and junk bonds.
4. Risk and rate of return. For each of the following pairs of investments, which has more risk and thus a higher potential rate of return?
a. a U.S. government bond or a U.S. corporate bond.
b. a junk bond or a municipal bond.
c. a blue chip stock or an aggressive growth stock.
d. an aggressive growth stock or a municipal bond.
5. Social Security. The Social Security system was set up so current workers pay taxes that are used to pay benefits to current recipients.
a. Is it fair for you to be asked to pay for debts incurred by previous generations? If so, how much debt is fair and for whom would you be willing to pay?
b. Is it fair for future generations to be asked to pay for debts incurred by your generation?
c. What are the social benefits of the Social Security system? How would society be affected by the reduction or elimination of the Social Security system?
2. Stocks. Explain the difference between blue chip stocks and aggressive growth stocks.
3. Bonds. Explain the difference between government bonds, municipal bonds, corporate bonds, and junk bonds.
4. Risk and rate of return. For each of the following pairs of investments, which has more risk and thus a higher potential rate of return?
a. a U.S. government bond or a U.S. corporate bond.
b. a junk bond or a municipal bond.
c. a blue chip stock or an aggressive growth stock.
d. an aggressive growth stock or a municipal bond.
5. Social Security. The Social Security system was set up so current workers pay taxes that are used to pay benefits to current recipients.
a. Is it fair for you to be asked to pay for debts incurred by previous generations? If so, how much debt is fair and for whom would you be willing to pay?
b. Is it fair for future generations to be asked to pay for debts incurred by your generation?
c. What are the social benefits of the Social Security system? How would society be affected by the reduction or elimination of the Social Security system?
Saturday, June 14, 2008
The Uncertain Future of Entitlement Programs
The uncertain future of the Social Security system provides many young adults with an additional incentive to use personal investments to save for their retirement. Social Security is a government entitlement program that provides financial payments to elderly and disabled Americans. Entitlement programs provide benefits to recipients who by law are entitled to receive benefits if the meet the eligibility requirements. Prior to Social Security, many elderly and disabled Americans lacked enough income to buy the necessities of life. Since the establishment of the Social Security program, however, the poverty rate for elderly Americans has been lower than for the rest of the population.
Many people think Social Security is a federal savings plan that should provide them with a comfortable retirement. This was never its intention, however. Its purpose has always been to help ensure Americans have enough income to buy the necessities of life, even if they are no longer able to earn very much income from jobs. It was designed as a social safety net to keep people out of poverty.
The funds used to provide Social Security benefits are obtained from taxes on workers and employers. Current benefits are funded with taxes on current workers. This structure works well if the number of workers grows at the same rate or faster than the number of beneficiaries. The demographics of the baby boom generation create a problem for the Social Security system, however. The baby boom refers to the increase in the global population from 1946-1964. As baby-boomers retire, the number of beneficiaries increases significantly faster than the number of workers paying into the system.
Proposed reforms of the Social Security system are controversial. Many Americans expect to receive Social Security benefits that are at least as generous as the payments given to previous generations. Americans are reluctant to pay additional taxes, however. In order to maintain the Social Security program in its current structure, however, taxes must be increased or the government must borrow from future generations by increasing the public debt. Another option is to reduce Social Security benefits.
The uncertainty of the future of the Social Security system provides an additional incentive to start saving early for one’s retirement. Social Security benefits, even in today’s modest amounts, may not be available to all Americans in the future.
Many people think Social Security is a federal savings plan that should provide them with a comfortable retirement. This was never its intention, however. Its purpose has always been to help ensure Americans have enough income to buy the necessities of life, even if they are no longer able to earn very much income from jobs. It was designed as a social safety net to keep people out of poverty.
The funds used to provide Social Security benefits are obtained from taxes on workers and employers. Current benefits are funded with taxes on current workers. This structure works well if the number of workers grows at the same rate or faster than the number of beneficiaries. The demographics of the baby boom generation create a problem for the Social Security system, however. The baby boom refers to the increase in the global population from 1946-1964. As baby-boomers retire, the number of beneficiaries increases significantly faster than the number of workers paying into the system.
Proposed reforms of the Social Security system are controversial. Many Americans expect to receive Social Security benefits that are at least as generous as the payments given to previous generations. Americans are reluctant to pay additional taxes, however. In order to maintain the Social Security program in its current structure, however, taxes must be increased or the government must borrow from future generations by increasing the public debt. Another option is to reduce Social Security benefits.
The uncertainty of the future of the Social Security system provides an additional incentive to start saving early for one’s retirement. Social Security benefits, even in today’s modest amounts, may not be available to all Americans in the future.
Friday, June 13, 2008
Stock Market Indices
There are several indices that are used to measure the performance of stocks as financial assets. National news programs report the levels of the Dow Jones Industrial Average and the NASDAQ Composite Index every business day. Sources of financial news also regularly report the S & P 500 or the Fortune 500 indexes.
The Dow Jones Industrial Average is an index of 30 blue-chip stocks that are representative of all large well-established American corporations. It is commonly reported in the news as an indicator of the overall direction of the stock market. The 30 stocks chosen for inclusion in the Dow Jones Industrial Average are periodically altered to reflect changes in the composition of the broader stock market. The 30 corporations included in the Dow 30 index in 2004 are listed in the table below.
Dow 30 Corporations
3M Corporation Intel Corpration
Alcoa Inc. J.P. Morgan & Co., Inc.
Altria Group Inc. Johnson & Johnson
American Express Company McDonald’s Corporation
American International Group Inc. Merck & Co., Inc.
Boeing Co. Microsoft Corporation
Caterpillar Inc. Pfizer, Inc.
Citigroup, Inc. SBC Communications, Inc.
E.I. du Pont de Nemours and Company The Coca-Cola Company
Exxon Mobile Corp. The Home Depot, Inc.
General Electric Company The Proctor & Gamble Company
General Motors Corporation United Technologies Corporation
Hewlett Packard Co. Verizon Communications
Honeywell International, Inc. Wal-Mart Stores, Inc.
IBM The Walt Disney Company
Table 4. The 30 corporations included in the Dow Jones Industrial Average, the most commonly reported index of the U.S. stock market.
The NASDAQ Composite Index represents the stocks of smaller or less-known companies.
The Fortune 500 and the S&P 500 are indices of 500 stocks that are broad measures of the overall stock market.
The Dow Jones Industrial Average is an index of 30 blue-chip stocks that are representative of all large well-established American corporations. It is commonly reported in the news as an indicator of the overall direction of the stock market. The 30 stocks chosen for inclusion in the Dow Jones Industrial Average are periodically altered to reflect changes in the composition of the broader stock market. The 30 corporations included in the Dow 30 index in 2004 are listed in the table below.
Dow 30 Corporations
3M Corporation Intel Corpration
Alcoa Inc. J.P. Morgan & Co., Inc.
Altria Group Inc. Johnson & Johnson
American Express Company McDonald’s Corporation
American International Group Inc. Merck & Co., Inc.
Boeing Co. Microsoft Corporation
Caterpillar Inc. Pfizer, Inc.
Citigroup, Inc. SBC Communications, Inc.
E.I. du Pont de Nemours and Company The Coca-Cola Company
Exxon Mobile Corp. The Home Depot, Inc.
General Electric Company The Proctor & Gamble Company
General Motors Corporation United Technologies Corporation
Hewlett Packard Co. Verizon Communications
Honeywell International, Inc. Wal-Mart Stores, Inc.
IBM The Walt Disney Company
Table 4. The 30 corporations included in the Dow Jones Industrial Average, the most commonly reported index of the U.S. stock market.
The NASDAQ Composite Index represents the stocks of smaller or less-known companies.
The Fortune 500 and the S&P 500 are indices of 500 stocks that are broad measures of the overall stock market.
Thursday, June 12, 2008
Summary Table of Personal Investments
The four characteristics of investments are listed for these types of investments in Table 3.
Type of Investment Rate of Return Risk Liquidity Tax Breaks
Bank Accounts Very, very low or none Very, very low Extremely Liquid None
Money Market Funds Very Low Very Low Very Liquid None usually
(Exception: some tax-free municipal bond funds)
Certificates of Deposit (CDs) Low Very Low Not Liquid, unless you pay a substantial penalty None
Bond Mutual Funds
Low to Moderate Moderate
(Interest Rate Risk) Moderate None usually
(Exception: some tax-free municipal bond funds)
Stock Mutual Funds
(Blue Chip Stocks) Low to High High Moderate You only pay taxes on capital gains when you sell stocks.
Stock Mutual Funds
(Aggressive Growth Stocks) Low to Very High Very High Moderate You only pay taxes on capital gains when you sell stocks.
Real Estate
(e.g., buying a house) Varies with location Varies with location Not liquid.
(It usually takes several months to sell a house.) Mortgage interest payments may be tax-deductible
Table 3. The characteristics of various types of personal investments.
Most financial advisors point out that over the long term, stocks historically have provided a higher rate of return than most other types of financial investments. Past performance, however, is no guarantee of future results. Nothing in this book should be construed as a recommendation to buy or sell any financial assets or investments or to deal with any particular brokerage firm or other investment company.
Type of Investment Rate of Return Risk Liquidity Tax Breaks
Bank Accounts Very, very low or none Very, very low Extremely Liquid None
Money Market Funds Very Low Very Low Very Liquid None usually
(Exception: some tax-free municipal bond funds)
Certificates of Deposit (CDs) Low Very Low Not Liquid, unless you pay a substantial penalty None
Bond Mutual Funds
Low to Moderate Moderate
(Interest Rate Risk) Moderate None usually
(Exception: some tax-free municipal bond funds)
Stock Mutual Funds
(Blue Chip Stocks) Low to High High Moderate You only pay taxes on capital gains when you sell stocks.
Stock Mutual Funds
(Aggressive Growth Stocks) Low to Very High Very High Moderate You only pay taxes on capital gains when you sell stocks.
Real Estate
(e.g., buying a house) Varies with location Varies with location Not liquid.
(It usually takes several months to sell a house.) Mortgage interest payments may be tax-deductible
Table 3. The characteristics of various types of personal investments.
Most financial advisors point out that over the long term, stocks historically have provided a higher rate of return than most other types of financial investments. Past performance, however, is no guarantee of future results. Nothing in this book should be construed as a recommendation to buy or sell any financial assets or investments or to deal with any particular brokerage firm or other investment company.
Wednesday, June 11, 2008
Tuesday, June 10, 2008
Types of Investments
There are several different types of investments to consider when planning personal investments. The most appropriate investment depends on the investor’s objective.
Money that is needed to make purchases or pay bills in the near future, called transactions money, needs to be kept in a safe place with virtually no risk. The most common place to invest transactions money is in bank accounts.
Bank accounts are deposits in commercial banks or similar institutions, such as credit unions. A commercial bank is a financial institution that attempts to make a profit by paying depositors little or no interest and lending a portion of the deposits to borrowers at moderate to high rates of interest. A credit union is an institution that provides financial services similar to those offered by commercial banks, such as accepting deposits and making loans, but does not attempt to earn a profit. Credit unions were created to provide inexpensive financial services to their members. Thus credit unions may offer higher rates of return to depositors, lower interest rates to borrowers, and lower fees than commercial banks. Depositors use bank accounts to facilitate transactions. Money used to pay the rent or buy groceries and other living expenses can be held safely in checking or savings accounts at banks or credit unions.
Money that is being saved for a purchase in the next few years can potentially earn a higher rate of return than bank account deposits. When people save money for a down payment on a house or a car, for example, many financial advisors suggest investment in certificates of deposit or money market mutual funds.
Certificates of deposit (CDs) are financial instruments that promise to pay the purchaser a specified fixed rate of interest over a designated period of time if the purchaser promises not to withdraw the funds. CDs typically offer a higher rate of return than regular savings accounts because the purchaser is sacrificing liquidity. Any investment with a fixed rate of return, such as a CD or a bond, is subject to interest rate risk, however. Interest rate risk is the loss of a higher potential rate of return or the loss of the value of the financial asset if interest rates increase in the future.
When investors save money for the distant future, such as for retirement, they can consider a wider range of investments, such as bonds, stocks, mutual funds, and real estate.
A bond is a financial instrument that represents a loan from the purchaser of the bond to the issuer of the bond. For example, government bonds are a way for the government to borrow money. Municipal bonds are issued by state and local governments and frequently provide investors with tax breaks. Purchasers of municipal bonds are usually not required to pay taxes on the interest income earned from the bonds. Corporate bonds are issued by corporations that desire to borrow money directly from investors rather than through commercial banks. Junk bonds are corporate bonds issued by companies with high bankruptcy risk.
Stocks are shares of ownership in a corporation. By owning stock, the shareholder owns part of the corporation. Corporations typically pay quarterly dividends, which are the portion of profits paid to stockholders. The primary reason investors purchase stocks, however, is for capital gains. Capital gains are the increase in the value of the stock over time. Capital gains occur when the price of a stock rises as potential investors seek to buy ownership in the company.
Blue chip stocks are shares of ownership in large well-established corporations. Blue chip stocks are considered by most financial advisors to be less risky than shares of stock issued by relatively small, less-established corporations.
Aggressive growth stocks are shares of ownership in relatively small, less-established corporations. Because of their higher risk, they are considered by most financial advisors to have a higher potential return than blue-chip stocks.
Mutual funds are financial assets in which investors pool their investment funds and have them invested under the direction of a manager or management team. The primary benefit of mutual funds is diversification. Diversification means investors own small pieces of many different financial instruments rather than have all of their investment in one or a few such instruments. Diversification reduces bankruptcy risk. The investment options considered by the managers of a mutual fund are specified in a prospectus. A prospectus is a legal document that provides information to potential investors as required by law. Mutual funds may invest in stocks, bonds, real estate or other assets.
Money market funds are mutual funds that invest in short-term loans or other financial instruments that are similar to certificates of deposit.
Real estate refers to land, houses, and other buildings. An old adage suggests that the three most important attributes of real estate are location, location and location. The rates of return on real estate can be wildly unpredictable, ranging from extremely high gains to significant losses.
Money that is needed to make purchases or pay bills in the near future, called transactions money, needs to be kept in a safe place with virtually no risk. The most common place to invest transactions money is in bank accounts.
Bank accounts are deposits in commercial banks or similar institutions, such as credit unions. A commercial bank is a financial institution that attempts to make a profit by paying depositors little or no interest and lending a portion of the deposits to borrowers at moderate to high rates of interest. A credit union is an institution that provides financial services similar to those offered by commercial banks, such as accepting deposits and making loans, but does not attempt to earn a profit. Credit unions were created to provide inexpensive financial services to their members. Thus credit unions may offer higher rates of return to depositors, lower interest rates to borrowers, and lower fees than commercial banks. Depositors use bank accounts to facilitate transactions. Money used to pay the rent or buy groceries and other living expenses can be held safely in checking or savings accounts at banks or credit unions.
Money that is being saved for a purchase in the next few years can potentially earn a higher rate of return than bank account deposits. When people save money for a down payment on a house or a car, for example, many financial advisors suggest investment in certificates of deposit or money market mutual funds.
Certificates of deposit (CDs) are financial instruments that promise to pay the purchaser a specified fixed rate of interest over a designated period of time if the purchaser promises not to withdraw the funds. CDs typically offer a higher rate of return than regular savings accounts because the purchaser is sacrificing liquidity. Any investment with a fixed rate of return, such as a CD or a bond, is subject to interest rate risk, however. Interest rate risk is the loss of a higher potential rate of return or the loss of the value of the financial asset if interest rates increase in the future.
When investors save money for the distant future, such as for retirement, they can consider a wider range of investments, such as bonds, stocks, mutual funds, and real estate.
A bond is a financial instrument that represents a loan from the purchaser of the bond to the issuer of the bond. For example, government bonds are a way for the government to borrow money. Municipal bonds are issued by state and local governments and frequently provide investors with tax breaks. Purchasers of municipal bonds are usually not required to pay taxes on the interest income earned from the bonds. Corporate bonds are issued by corporations that desire to borrow money directly from investors rather than through commercial banks. Junk bonds are corporate bonds issued by companies with high bankruptcy risk.
Stocks are shares of ownership in a corporation. By owning stock, the shareholder owns part of the corporation. Corporations typically pay quarterly dividends, which are the portion of profits paid to stockholders. The primary reason investors purchase stocks, however, is for capital gains. Capital gains are the increase in the value of the stock over time. Capital gains occur when the price of a stock rises as potential investors seek to buy ownership in the company.
Blue chip stocks are shares of ownership in large well-established corporations. Blue chip stocks are considered by most financial advisors to be less risky than shares of stock issued by relatively small, less-established corporations.
Aggressive growth stocks are shares of ownership in relatively small, less-established corporations. Because of their higher risk, they are considered by most financial advisors to have a higher potential return than blue-chip stocks.
Mutual funds are financial assets in which investors pool their investment funds and have them invested under the direction of a manager or management team. The primary benefit of mutual funds is diversification. Diversification means investors own small pieces of many different financial instruments rather than have all of their investment in one or a few such instruments. Diversification reduces bankruptcy risk. The investment options considered by the managers of a mutual fund are specified in a prospectus. A prospectus is a legal document that provides information to potential investors as required by law. Mutual funds may invest in stocks, bonds, real estate or other assets.
Money market funds are mutual funds that invest in short-term loans or other financial instruments that are similar to certificates of deposit.
Real estate refers to land, houses, and other buildings. An old adage suggests that the three most important attributes of real estate are location, location and location. The rates of return on real estate can be wildly unpredictable, ranging from extremely high gains to significant losses.
Monday, June 9, 2008
Characteristics of Investments
When making decisions about personal investments, one should consider four characteristics:
1. Rate of Return
2. Risk
3. Liquidity
4. Tax Breaks
The rate of return is the payment an investor earns from engaging in an investment activity. It is sometimes referred to as the interest rate. For example, if an investor earns interest on deposits in a savings account at a bank, the interest earned is the rate of return. The nominal rate of return is the stated rate of return of an investment. Investors should care more about the real rate of return, however. The real rate of return is the nominal rate of return adjusted for inflation.
Real Rate of Return = Nominal Rate of Return - Inflation Rate
Nominal Rate of Return = Real Rate of Return + Inflation Rate
Inflation Rate = Nominal Rate of Return - Real Rate of Return
Suppose a savings account pays the depositor 8 percent interest per year, but the inflation rate is 3 percent per year. The nominal rate of return is 8 percent per year, but the real rate of return is only 5 percent per year.
Risk refers to the relative likelihood that an investment will lose value. Investments with greater risk generally offer the potential for a greater rate of return. There are two types of risk one should consider when choosing personal investments. Bankruptcy risk is the relative likelihood that the firm or institution in which you invest goes bankrupt and does not pay you the return they promised you. Market risk is the relative likelihood that your investment will lose value because of fluctuations in the economy.
Shares of stock of large, well-established corporations, such as General Motors or Sears, have much less bankruptcy risk than new or relatively unknown companies. All stocks are subject to market risk, however. The value of a stock tends to rise when potential investors are optimistic about the company’s earnings in the future. Similarly, a stock price tends to fall when investors are pessimistic about the company’s upcoming profits. Uncertainty about the economy, such as the effects of a war, can cause stock prices to remain steady or fall. When the uncertainty is removed, stock prices are more likely to rise.
When the economy performs well, as indicated by positive economic growth, low inflation, and low unemployment, then the stocks of most corporations tend to rise. When the economy grows slowly or shrinks and suffers from high inflation or high unemployment, however, then most stock prices fall.
Liquidity refers to how quickly an investment can be converted into money. Investments with less liquidity generally offer a higher rate of return than investments that can be easily converted into cash. For example, if you purchase a 12-month certificate of deposit (CD) from a bank, you will usually receive a higher rate of return than the interest rate offered on regular savings accounts. By purchasing a 12-month bank CD, you are promising the bank you will not withdraw your money for the next year. Since the bank knows you will not be withdrawing your money, they can loan the entire amount to other customers. To compensate you for sacrificing liquidity, banks usually pay a higher interest rate on certificates of deposit than on savings accounts.
Tax breaks are the benefits some investments provide in the form of reduced tax liability. For example, when state and local governments borrow money by selling municipal bonds, the interest on those investments is frequently exempt from state income taxes.
1. Rate of Return
2. Risk
3. Liquidity
4. Tax Breaks
The rate of return is the payment an investor earns from engaging in an investment activity. It is sometimes referred to as the interest rate. For example, if an investor earns interest on deposits in a savings account at a bank, the interest earned is the rate of return. The nominal rate of return is the stated rate of return of an investment. Investors should care more about the real rate of return, however. The real rate of return is the nominal rate of return adjusted for inflation.
Real Rate of Return = Nominal Rate of Return - Inflation Rate
Nominal Rate of Return = Real Rate of Return + Inflation Rate
Inflation Rate = Nominal Rate of Return - Real Rate of Return
Suppose a savings account pays the depositor 8 percent interest per year, but the inflation rate is 3 percent per year. The nominal rate of return is 8 percent per year, but the real rate of return is only 5 percent per year.
Risk refers to the relative likelihood that an investment will lose value. Investments with greater risk generally offer the potential for a greater rate of return. There are two types of risk one should consider when choosing personal investments. Bankruptcy risk is the relative likelihood that the firm or institution in which you invest goes bankrupt and does not pay you the return they promised you. Market risk is the relative likelihood that your investment will lose value because of fluctuations in the economy.
Shares of stock of large, well-established corporations, such as General Motors or Sears, have much less bankruptcy risk than new or relatively unknown companies. All stocks are subject to market risk, however. The value of a stock tends to rise when potential investors are optimistic about the company’s earnings in the future. Similarly, a stock price tends to fall when investors are pessimistic about the company’s upcoming profits. Uncertainty about the economy, such as the effects of a war, can cause stock prices to remain steady or fall. When the uncertainty is removed, stock prices are more likely to rise.
When the economy performs well, as indicated by positive economic growth, low inflation, and low unemployment, then the stocks of most corporations tend to rise. When the economy grows slowly or shrinks and suffers from high inflation or high unemployment, however, then most stock prices fall.
Liquidity refers to how quickly an investment can be converted into money. Investments with less liquidity generally offer a higher rate of return than investments that can be easily converted into cash. For example, if you purchase a 12-month certificate of deposit (CD) from a bank, you will usually receive a higher rate of return than the interest rate offered on regular savings accounts. By purchasing a 12-month bank CD, you are promising the bank you will not withdraw your money for the next year. Since the bank knows you will not be withdrawing your money, they can loan the entire amount to other customers. To compensate you for sacrificing liquidity, banks usually pay a higher interest rate on certificates of deposit than on savings accounts.
Tax breaks are the benefits some investments provide in the form of reduced tax liability. For example, when state and local governments borrow money by selling municipal bonds, the interest on those investments is frequently exempt from state income taxes.
Sunday, June 8, 2008
Key Concepts of Investing
The key concepts of personal investments are:
(1) Start saving as soon as possible to receive the most benefit from compound interest. Compound interest is most powerful when there is a long time horizon. If you plan to retire at age 65, then if you begin saving for your retirement at age 25 you will have 40 years to benefit from compounding. If you wait until you are 40 years old to begin saving for your retirement, you will only have 25 years of compounding before retirement.
(2) Higher rates of return have a significant impact on the future value of investments. Small differences in rates of return can make a big difference when you are investing for a long period of time. If you are willing to accept higher risk or sacrifice liquidity, you might consider investments with a higher potential rate of return as compensation.
(1) Start saving as soon as possible to receive the most benefit from compound interest. Compound interest is most powerful when there is a long time horizon. If you plan to retire at age 65, then if you begin saving for your retirement at age 25 you will have 40 years to benefit from compounding. If you wait until you are 40 years old to begin saving for your retirement, you will only have 25 years of compounding before retirement.
(2) Higher rates of return have a significant impact on the future value of investments. Small differences in rates of return can make a big difference when you are investing for a long period of time. If you are willing to accept higher risk or sacrifice liquidity, you might consider investments with a higher potential rate of return as compensation.
Saturday, June 7, 2008
The Rule of 70
The rule of 70 is a way to approximate the relationship between present and future values. The rule of 70 states that if a variable grows at a rate of x percent per year, then that variable doubles in approximately 70/x years.
x 70/x Application of the rule of 70
to the rate of return on personal investments
1 70 If an investment earns a rate of return of 1% per year, then the value of the investment will double in approximately 70 years.
2 35 If an investment earns a rate of return of 2% per year, then the value of the investment will double in approximately 35 years.
3 23.33 If an investment earns a rate of return of 3% per year, then the value of the investment will double in approximately 23 years.
4 17.5 If an investment earns a rate of return of 4% per year, then the value of the investment will double in approximately 17 years.
5 14 If an investment earns a rate of return of 5% per year, then the value of the investment will double in approximately 14 years.
6 11.67 If an investment earns a rate of return of 6% per year, then the value of the investment will double in approximately 12 years.
7 10 If an investment earns a rate of return of 7% per year, then the value of the investment will double in approximately 10 years.
8 8.75 If an investment earns a rate of return of 8% per year, then the value of the investment will double in approximately 9 years.
9 7.78 If an investment earns a rate of return of 9% per year, then the value of the investment will double in approximately 8 years.
10 7 If an investment earns a rate of return of 10% per year, then the value of the investment will double in approximately 7 years.
Table 2. Examples of using the rule of 70.
x 70/x Application of the rule of 70
to the rate of return on personal investments
1 70 If an investment earns a rate of return of 1% per year, then the value of the investment will double in approximately 70 years.
2 35 If an investment earns a rate of return of 2% per year, then the value of the investment will double in approximately 35 years.
3 23.33 If an investment earns a rate of return of 3% per year, then the value of the investment will double in approximately 23 years.
4 17.5 If an investment earns a rate of return of 4% per year, then the value of the investment will double in approximately 17 years.
5 14 If an investment earns a rate of return of 5% per year, then the value of the investment will double in approximately 14 years.
6 11.67 If an investment earns a rate of return of 6% per year, then the value of the investment will double in approximately 12 years.
7 10 If an investment earns a rate of return of 7% per year, then the value of the investment will double in approximately 10 years.
8 8.75 If an investment earns a rate of return of 8% per year, then the value of the investment will double in approximately 9 years.
9 7.78 If an investment earns a rate of return of 9% per year, then the value of the investment will double in approximately 8 years.
10 7 If an investment earns a rate of return of 10% per year, then the value of the investment will double in approximately 7 years.
Table 2. Examples of using the rule of 70.
Friday, June 6, 2008
Investing at 15% per year
Case C: Investing $1000 at 15% per year
Suppose you invest $1000 today at a 15% rate of return. Using the equation above, we can calculate the future value of this one time investment.
FV = ($1,000) (1.15)n where n = the number of years
After 10 years, this single $1,000 investment will be worth:
FV = ($1,000) (1.15)10 = $4,046
After 20 years, this single $1,000 investment will be worth:
FV = ($1,000) (1.15)20 = $16,367
After 30 years, this single $1,000 investment will be worth:
FV = ($1,000) (1.15)30 = $66,212
After 40 years, this single $1,000 investment will be worth:
FV = ($1,000) (1.15)40 = $267,864
After 50 years, this single $1,000 investment will be worth:
FV = ($1,000) (1.15)50 = $1,083,657
A single investment of $1,000 that earns a 15% rate of return for 40 years turns into over a quarter of a million dollars. If it is invested for 50 years, it becomes more than a million dollars!
Thursday, June 5, 2008
Investing at 10% per year
Case B: Investing $1000 at 10% per year
Suppose you invest $1000 today at a 10% rate of return. Using the equation above, we can calculate the future value of this one time investment.
FV = ($1,000) (1.10)n where n = the number of years
After 10 years, this single $1,000 investment will be worth:
FV = ($1,000) (1.10)10 = $2,594
After 20 years, this single $1,000 investment will be worth:
FV = ($1,000) (1.10)20 = $6,727
After 30 years, this single $1,000 investment will be worth:
FV = ($1,000) (1.10)30 = $17,449
After 40 years, this single $1,000 investment will be worth:
FV = ($1,000) (1.10)40 = $45,259
After 50 years, this single $1,000 investment will be worth:
FV = ($1,000) (1.10)50 = $117,391
Wednesday, June 4, 2008
Investing at 5% per year
Case A: Investing $1000 at 5% per year
Suppose you invest $1000 today at a 5% rate of return. Using the equation above, we can calculate the future value of this one time investment.
FV = ($1,000) (1.05)n where n = the number of years
After 10 years, this single $1,000 investment will be worth:
FV = ($1,000) (1.05)10 = $1,629
After 20 years, this single $1,000 investment will be worth:
FV = ($1,000) (1.05)20 = $2,653
After 30 years, this single $1,000 investment will be worth:
FV = ($1,000) (1.05)30 = $4,322
After 40 years, this single $1,000 investment will be worth:
FV = ($1,000) (1.05)40 = $7,040
After 50 years, this single $1,000 investment will be worth:
FV = ($1,000) (1.05)50 = $11,467
Tuesday, June 3, 2008
The Power of Compound Interest
Compound interest is a financial return that is earned on a previously earned financial return. It is interest that is earned on previously earned interest.
For example, suppose you put $1 in a savings account that pays 10% interest per year. In the real world, it would be difficult to obtain a 10% rate of return from a bank. It provides a fairly simple mathematical example, however.
Simple Example of Compound Interest with a 10% Rate of Return
Initial Deposit in the Savings Account $1.00
Interest Earned in the First Year ($1 times .10 ) $.10
Savings Account Balance After One Year $1.10
Interest Earned in the Second Year(1.10 times .10) $.11
Savings Account Balance After Two Years $1.21
Table 1. A simple example of compound interest.
Investing $1 at a 10 percent annual interest rate seems to suggest that the investment would earn 10 cents in interest each year. After two years, one might expect the value of the savings account to be $1.20. As this example illustrates, however, if the interest payments are left in the savings account, the interest earned in the second year will be 11 cents instead of 10 cents. The additional penny in interest is due to compounding. The extra penny is the interest earned in the second year on the 10 cents interest that was earned in the first year.
There is an equation that helps calculate the future value of investments based on the rate of return. This equation that relates the present value and future value of an investment is:
FV = PV (1 + i)n
where:
FV = future value of the investment
PV = present value of the investment
i = interest rate (i.e., rate of return)
n = number of years
In the example above, the present value of the investment is $1. The interest rate (i.e., rate of return) is .10. The dollar is invested for two years. Substitution into the equation above yields:
FV = ($1.00) (1.10)2
FV = ($1.00) (1.21)
FV = $1.21
This formula yields the same result that one dollar invested at 10 percent interest per year will be worth $1.21 after two years.
This equation can be used to develop a plan for one’s personal investments.
Consider the following three cases.
For example, suppose you put $1 in a savings account that pays 10% interest per year. In the real world, it would be difficult to obtain a 10% rate of return from a bank. It provides a fairly simple mathematical example, however.
Simple Example of Compound Interest with a 10% Rate of Return
Initial Deposit in the Savings Account $1.00
Interest Earned in the First Year ($1 times .10 ) $.10
Savings Account Balance After One Year $1.10
Interest Earned in the Second Year(1.10 times .10) $.11
Savings Account Balance After Two Years $1.21
Table 1. A simple example of compound interest.
Investing $1 at a 10 percent annual interest rate seems to suggest that the investment would earn 10 cents in interest each year. After two years, one might expect the value of the savings account to be $1.20. As this example illustrates, however, if the interest payments are left in the savings account, the interest earned in the second year will be 11 cents instead of 10 cents. The additional penny in interest is due to compounding. The extra penny is the interest earned in the second year on the 10 cents interest that was earned in the first year.
There is an equation that helps calculate the future value of investments based on the rate of return. This equation that relates the present value and future value of an investment is:
FV = PV (1 + i)n
where:
FV = future value of the investment
PV = present value of the investment
i = interest rate (i.e., rate of return)
n = number of years
In the example above, the present value of the investment is $1. The interest rate (i.e., rate of return) is .10. The dollar is invested for two years. Substitution into the equation above yields:
FV = ($1.00) (1.10)2
FV = ($1.00) (1.21)
FV = $1.21
This formula yields the same result that one dollar invested at 10 percent interest per year will be worth $1.21 after two years.
This equation can be used to develop a plan for one’s personal investments.
Consider the following three cases.
Monday, June 2, 2008
Personal Investments - Learning Objectives
After studying this module, you should be able to:
• define compound interest.
• state the equation that relates the present value and future value of an investment based on the interest rate (i.e., rate of return) and the number of years.
• calculate the future value of an investment from the present value, rate of return (interest rate), and number of years.
• calculate the present value of an investment from the future value, rate of return (interest rate), and number of years.
• state the rule of 70 and explain its function.
• use the rule of 70 to approximate the relationship between present and future values.
• explain how compound interest is most beneficial to people who start saving as soon as possible, when there is a long time horizon.
• list and explain the four characteristics of investments that should be considered when making decisions about personal investments.
• define rate of return, interest rate, nominal rate of return, and real rate of return.
• use numerical examples to explain the difference between a nominal rate of return (nominal interest rate) and a real rate of return (real interest rate).
• define risk, market risk, bankruptcy risk
• explain the relationship between risk and rate of return.
• define liquidity and explain the relationship between liquidity and rate of return.
• define tax breaks and explain the relationship between tax breaks and rate of return.
• explain how deposits in bank accounts are typically used to facilitate transactions.
• define certificates of deposit and explain why they typically pay a higher rate of return than regular savings accounts.
• define bonds and explain the difference between corporate bonds, government bonds, municipal bonds, and junk bonds.
• define stocks, dividends, and capital gains.
• explain the difference between blue chip stocks and aggressive growth stocks.
• define diversification.
• define mutual funds and explain how their primary benefit is diversification.
• define a prospectus and explain its function.
• define money market funds.
• compare and contrast the following types of investments based on their potential rate of return, liquidity, risk and tax breaks: bank accounts, money market funds, certificates of deposit, bond mutual funds, blue chip stock mutual funds, aggressive growth stock mutual funds, and real estate.
• define transactions money and explain what types of investments are appropriate for transactions money.
• explain what types of investments are appropriate for money you are saving for a down payment on a house or a car.
• explain what types of investments might be considered for money you are investing for retirement.
• define compound interest.
• state the equation that relates the present value and future value of an investment based on the interest rate (i.e., rate of return) and the number of years.
• calculate the future value of an investment from the present value, rate of return (interest rate), and number of years.
• calculate the present value of an investment from the future value, rate of return (interest rate), and number of years.
• state the rule of 70 and explain its function.
• use the rule of 70 to approximate the relationship between present and future values.
• explain how compound interest is most beneficial to people who start saving as soon as possible, when there is a long time horizon.
• list and explain the four characteristics of investments that should be considered when making decisions about personal investments.
• define rate of return, interest rate, nominal rate of return, and real rate of return.
• use numerical examples to explain the difference between a nominal rate of return (nominal interest rate) and a real rate of return (real interest rate).
• define risk, market risk, bankruptcy risk
• explain the relationship between risk and rate of return.
• define liquidity and explain the relationship between liquidity and rate of return.
• define tax breaks and explain the relationship between tax breaks and rate of return.
• explain how deposits in bank accounts are typically used to facilitate transactions.
• define certificates of deposit and explain why they typically pay a higher rate of return than regular savings accounts.
• define bonds and explain the difference between corporate bonds, government bonds, municipal bonds, and junk bonds.
• define stocks, dividends, and capital gains.
• explain the difference between blue chip stocks and aggressive growth stocks.
• define diversification.
• define mutual funds and explain how their primary benefit is diversification.
• define a prospectus and explain its function.
• define money market funds.
• compare and contrast the following types of investments based on their potential rate of return, liquidity, risk and tax breaks: bank accounts, money market funds, certificates of deposit, bond mutual funds, blue chip stock mutual funds, aggressive growth stock mutual funds, and real estate.
• define transactions money and explain what types of investments are appropriate for transactions money.
• explain what types of investments are appropriate for money you are saving for a down payment on a house or a car.
• explain what types of investments might be considered for money you are investing for retirement.
Sunday, June 1, 2008
Personal Investments - Topics
Click on the hyperlinks below to go to a portion of the blog devoted to that topic:
Personal Investments - Learning Objectives
The Power of Compound Interest
Investing at 5% per year
Investing at 10% per year
Investing at 15% per year
The Rule of 70
Key Concepts of Investing
Characteristics of Investments
Types of Investments
Categories of Income
Summary Table of Personal Investments
Stock Market Indices
The Uncertain Future of Entitlement Programs
Social Security
Medicare & Medicaid
Questions for Further Study
Personal Investments - Learning Objectives
The Power of Compound Interest
Investing at 5% per year
Investing at 10% per year
Investing at 15% per year
The Rule of 70
Key Concepts of Investing
Characteristics of Investments
Types of Investments
Categories of Income
Summary Table of Personal Investments
Stock Market Indices
The Uncertain Future of Entitlement Programs
Social Security
Medicare & Medicaid
Questions for Further Study