Personal Finance Questions: Investing Basics

Question: What are the four financial questions that help focus on investing goals?
- If I do not accomplish this goal, what are the consequences?
- Am I willing to make the financial sacrifices necessary to meet this goal?
- How much money do I need to accomplish this goal?
- When do I need this money?


Question: A prerequisite to investing is to perform a financial reality check - Explain its 3 parts.
balance your budget
- If you do not live within your means, you will never be able to save, invest, or achieve any of your financial goals
- Put a safety net in place by carrying adequate insurance ? life, health, auto, homeowner's, liability ? to protect your assets and you against catastrophes
- Maintain adequate emergency funds in a safe investment of 6 to 9 months of take-home pay.


Question: Why is speculating in derivatives, futures contracts and options not appropriate for the typical, long-term investor?
These are highly speculative securities that are not appropriate for the typical investor using their important money to reach their long-term goals
- These securities require sophisticated knowledge and research not typically found in the average investor.
Because they derive their value from other assets, these securities do not generate a return unless the underlying assets behave in a certain manner.


Question: Compare and contrast lending and ownership investments
You actually lend someone your money in a lending investment, such as a saving account or a bond
- The original investment or principal does not grow in a lending investment
- It returns interest annually and the original investment when retiring it
- Note: Bonds appreciate or depreciate in value based on changes in interest rates
- Investing in bonds can lead to capital gain (loss) much the same as equities if timed properly.
An ownership investment, such as stocks or income-producing real estate, provides an annual return plus the potential for appreciation or growth in value of the original principal.


Question: What is the purpose of return on investment?
The return on investment communicates several pieces of important information
- First the potential return signals the risk associated with the investment
- Principle 8: Risk and
Return go hand in hand tells us that the higher the potential return, the more risk associated with the investment
- Secondly, the return signals the opportunity cost of the investment
- An investment with a potential return of 6% means that you would be giving up the opportunity to earn a higher or lower return on another investment option
- You would need to analyze the risk associated with each return to determine if one was more appropriate than the other
- Lastly, the potential return communicates how likely it will be for you to obtain your financial goals
- A low return may signal an investment that is to conservative for you to reach your long term goals
- A high return may signal that the investment is to risky and inappropriate for your needs.
- Principle #2: the time value of money tells us that time is our greatest ally - This being so, the most important and most difficult step is making the commitment to get started - Tell how to find the money and get started with Principle #15: just do it

-  Pay yourself first instead of last; that is, before spending for bills and life's necessities.
Making an automatic deposit directly from your paycheck or checking account makes it less painful because you do not see this money first
- Take advantage of your employer's matching funds retirement plans and the government's tax reductions, such as IRAs
- Use windfalls for investing instead of spending them
- If you are having trouble getting started, pick two months per year to cut back on spending and make those your investing months.


Question: Provide an explanation of the four points of making a comparison of investing returns on an after-tax basis
The tax rate we should be concerned with is the marginal tax rate, because it is the rate we pay on the next dollar of earnings
- Check out tax-free investments, which become more attractive as your marginal tax bracket increases
- Investigate investments made on a tax-deferred basis, which means the investment grows free of taxes until you liquidate the investment.


Question: How do interest rates affect returns on other investments?
The expected returns on all investments are related
- What you earn on one investment determines what you demand on another
- When interest rates go up, investors demand a higher return on all other investments, and when interest rates go down, the return investors demand on other investments goes down
- In effect, all the different investments compete for your investment dollars, and when interest rates go up, the other investments have to match that increase.


Question: The nominal return on an investment is an illusion - Explain.
An illusion is something that is different than what it appears to be
- The nominal return is an illusion because it inflates the nominal or face value of your money possibly without actually increasing your purchasing power of your money
- The real return adjusts for the impact of inflation on your ability to purchased goods and services
- The key to investing is to increase your standard of living to allow you to maintain or increase the quantity of goods and services that you desire
- Negative real returns that do not exceed the rate of inflation means that your purchasing power has diminished, lowering your standard of living
- Over the long term, this can seriously interfere with your retirement plans
- Young people need to be very aware of the impact of inflation and not to be too conservative with their longer term investments.


Question: Clarify the difference between systematic and unsystematic risk
Systematic risk is that portion of a security's risk or variability that cannot be eliminated through investor diversification, in other words, that is part of the entire market system.
(This explanation might help student remember what is 'systematic.')
- This type of variability or risk results from factors that affect all securities
- Unsystematic risk is the risk or variability that can be eliminated through investor diversification
- Unsystematic risk results from factors that are unique to a particular firm.


Question: How does the principle of diversification work?
diversification eliminates risk by investing in different assets instead of one
- It works by allowing the extreme good and bad returns to cancel each other out
- The result is that total variability or risk is reduced without affecting expected return.


Question: Describe the sources of risk in the risk-return trade off
The interest rate risk is the risk of fluctuations in security prices due to changes in the market interest rate
- Inflation risk reflects the likelihood that rising prices will eat away the purchasing power of your money, and that changes in the anticipated level of inflation will result in interest rate changes, which will in turn cause security price fluctuations
- The business risk deals with fluctuations in investment value that are caused by good or bad management decisions, or how well or poorly the firm's products are doing in the marketplace.
Financial risk is associated with the use of debt by the firm
- How a firm raises and uses its money affects its level of risk
- Liquidity risk deals with the inability to liquidate, or convert into cash, quickly a security at a fair market price
- Market risk is risk associated with the overall market movements
- upward and downward
- Political and regulatory risk comes from laws imposed by state and national governments that affect investment values
- The exchange rate risk refers to the variability in earnings resulting from changes in exchange rates among countries
- Call risk is the risk to bondholders that a bond may be called away from them before maturity, resulting in a loss of income or market value
- All of these types of risk make up the risk found in the risk-return trade off.


Question: Rank the historical rates of return of the common investments discussed in this chapter from highest to lowest
- Common stocks
- Long-term corporate bonds
- Long-term government bonds
- Treasury bills


Question: What makes up the interest rate risk?
The inflation risk premium is the rate in addition to the real rate of return that investors demand to compensate for anticipated inflation over the life of a security
- Interest rate risk also includes the default risk premium or an additional investment return to compensate investors for taking on the risk that the issuer may not pay the interest or principal on a security
- A third factor is the maturity risk premium, which is an additional return demanded by investors in longer-term securities to compensate for the fact that the value of securities with longer maturities tends to fluctuate more when interest rates change
- The liquidity risk premium reflects the risk that some bonds cannot be converted into cash quickly at a fair market price.


Question: Why do investors sometimes demand risk premiums when investing?
The typical investor is risk averse which means they don't like to take risks with their important money like retirement savings
- The problem is that conservative, low risk investments typically do not provide a high enough real return to allow these risk averse investors to reach their goals
- In order to motivate these investors to assume a higher level of risk, then there must be a higher potential return available
- The various risk premiums increase the potential nominal returns providing motivation for investors to assume higher risks
- Without these risk premiums no one would be willing to assume the risks inherent with entrepreneurial activities severely limiting access to financial capital needed for business investment.


Question: Explain the concept of liquidity relating to personal financial planning
Part of the risk-return tradeoff is the concept of liquidity
- With our emergency fund, we can't afford the risk of having our money tied up in an illiquid investment in case we experience an emergency
- Since we need to have quick access to our funds, we must accept the lower returns associated with liquid assets
- Unfortunately these liquid investments offer low returns because they don't include the liquidity risk premium
- With our longer term monies outside of our emergency fund, we can afford to give up liquidity for the extra returns
- It may take us months or more to be able to liquidate the investments but since we most likely don't need the money in a hurry, we generally have choices
- The main purpose of the emergency fund is to protect us from having to liquidate other investments, possibly at an unfavorable price or terms.


Question: Provide an explanation for the concept of asset allocation in investing and differentiate between the 3 stages.
Asset allocation attempts to ensure that the investor is well diversified, generally with holdings in several different classes of investments, with the objective being to increase your return on those investments while decreasing your risk
- The idea of the time dimension of risk is taken into account by recognizing that common stocks are much less risky over a longer time horizon.
Stage 1 is a time of wealth accumulation through age 54
- Because the time horizon is long, investments with higher returns and risks should be sought, especially common stocks, to grow into large sums by retirement
- Stage 2 consists of the golden years approaching retirement, ages 55 to 64
- Here the goal becomes preserving the level of wealth that has already been accumulated and to allow this wealth to continue to grow
- Move some of the portfolio, up to 40%, from common stocks into bonds
- Stage 3 is the retirement years over age 65 when you are no longer saving, you are spending
- Income is now of paramount importance
- Allow for some growth in savings simply to keep inflation from devouring your accumulation.


Question: How does the time dimension of investing relate to the concept of liquidity?
Liquidity concerns the ability to liquidate an asset for a fair market price in a reasonable amount of time
- The time dimension of investing means that having sufficient time available until you need your funds allows you invest in less liquid assets that generally have a higher return
- The stock market is very volatile and it is common for there to be severe market downturns from time to time
- To someone who needs their money now, they would not want to have to liquidate while the market value of their stocks has plummeted, causing them a serious financial loss
- Historically, the markets will recover and investors who were not forced to liquidate at the lower market values will recover most if not all of their capital
- For a younger investor, a severe market downturn represents a tremendous buying opportunity since many good stocks are 'on sale'
- To an older investor who is not properly diversified, a severe market downturn could seriously interrupt their retirement goals causing financial stress and anxiety.