Tradeoffs
Dr. Katie Sauer
Metropolitan State College of Denver
([email protected])
Presented at
Junior Achievement’s Elementary School Personal Financial Literacy Workshop
in collaboration with
the Colorado Council for Economic Education
Session Overview:
I. Wants and Needs
II. Savings and Investment
III. The Time Value of Money
IV. Managing Risk
I. Wants and Needs
Maslow’s Hierarchy of Needs
Self-Actualization
Esteem
Belonging
Safety
Physiological
Source: wikipedia
Regardless of whether you are fulfilling a want or a need, every
action has a cost.
- time
- money
- other resources
Economists use the term opportunity cost to describe whatever
must be given up for a particular action.
What is your opportunity cost of being in this workshop today?
What is the opportunity cost of your career as an educator?
What is the opportunity cost of using tax dollars to pay for
national health care?
Because we live in a world with limited resources and unlimited
wants, we will always face tradeoffs.
Economists say that there is no such thing as a free lunch.
All of life is about trade offs and opportunity costs.
II. Savings and
Investment
The Big Picture:
Savings is
important for an
economy as a
whole and for
individuals.
savings
business investment
physical capital
capital per worker
productivity
standard of living
How does household savings become business investment?
The Financial System is the group of institutions in an economy
that help to match savings with investment.
The US economy has two basic types of financial institutions:
- financial markets
- financial intermediaries
A. Financial Intermediaries are institutions where funds are
transferred indirectly from savers to investors.
Examples:
1.
Banks accept savings deposits and make loans.
- pay interest to depositors, charge interest to borrowers
2. Mutual Funds are institutions that sell shares to the public and
use the proceeds to buy a portfolio of stocks and bonds.
- allows individuals with a small amount of money to
diversify
B. Financial Markets are institutions where funds are transferred
directly from savers to investors.
Examples:
1. Bond Market
A bond is a certificate of indebtedness.
“IOU”
When a firm or government issues a bond, they are borrowing
money from anyone who buys the bond.
They are promising to pay you back a certain value in the future.
A bond has a date of maturity and a rate of interest associated
with it.
Suppose you buy a $1,000 bond that matures in 5 years and pays
6% interest.
- Today, you give up $1,000 and receive the bond.
- You will receive periodic interest payments of 6% for
the next 5 years.
1,000 x 0.06 = $60
- At the end of the 5 years, you receive $1,000.
Bonds can be sold at par value (face value) or at a discount or at a
premium.
Characteristics that determine a bond’s value:
term: length of time until the bond matures
- longer maturity time … riskier
credit risk: the probability that the borrower will fail to pay the
interest or the principal
tax treatment: some bonds have interest that is tax free
Issue price: $18.75
Maturity date: May 2008
Interest over 30 years: $87.92
Final value: $106.67
Treasurydirect.gov
2. Stock Market
A stock is a claim of partial ownership of a firm.
- shareholder
If you buy a stock, you are not guaranteed to get your money back.
The price of a stock generally reflects the perception of a firm’s
future profitability.
What determines the price of a stock?
a. Fundamental analysis is the study of a company’s accounting
statements and future prospects.
It includes doing an economic analysis, industry analysis, and
company analysis.
- P/E ratio (stock price / net income per share)
- competitors
- the market for its product
- management
- credit risk
b. The Efficient Markets Hypothesis is the theory that asset prices
reflect all publicly available information about the value of the
asset.
- each company listed on a stock exchange is followed
closely by many many people
- equilibrium of supply and demand sets the price
According to this theory, at the market price, the number of people
wanting to sell exactly equals the number wanting to buy.
Remember, any stock that you think is “hot” and about to increase
in value, someone else thought it was not hot and was willing to
sell it.
c. Market Irrationality
Stock prices sometimes seem to be driven by psychological
reasons.
Herd Mentality is the tendency for individuals to copy the
actions of a larger group, even though without the group the
person may not choose to take the action on their own.
- when the stock market is booming and “everyone” is
investing, a person might decide it is a great time to buy
some stocks, too
Reading a stock page:
52W high / low: highest/lowest prices paid in past year
Stock: company name
Ticker (symb): stock symbol
Div: the dividend paid annually for each share owned
%: annual dividend divided by the current stock price
P/E: price of a share divided by last year’s earnings per share
Vol 00s: how many shares were traded yesterday… add two zeros
High/Low: highest and lowest price paid yesterday
Close (last): last price paid yesterday at market close
Net chg (chg): difference between price of most recent trade and
close yesterday
III. Time Value of Money
Intuitively we understand that an amount of money today is more
valuable than the same amount of money in the future.
- inflation
- earn interest
A. Future Value is the amount of money that can result from an
amount of money we have today.
Future Value = Present Value x (1 + r )
Ex: $18,000 wedding, 4% interest, 40 years
40
Future Value = 18,000 x (1.04)
Future Value = $86,418
Ex: $18,000 wedding, 6% interest, 40 years
40
Future Value = 18,000 x (1.06)
Future Value = $185,142
n
Suppose you spend $1000 to go to a relaxing all-inclusive resort
in Mexico for spring break.
If you had invested it at 5% interest, how much money would you
have had in 10 years?
10
Future Value = 1000 x (1.05)
Future Value = $1628.89
If you invested it for 20 years, how much would you have?
20
Future Value = 1000 x (1.05)
Future Value = $2653.30
The higher the interest rate, the higher the future value of your
money saved today.
The longer the time frame, the higher the future value of your
money saved today.
B. Present Value is the amount of money one would need today to
produce a given amount of money in the future.
n
Present Value = Future Value / (1 + r )
Ex. you want to have $1,000,000 in 25 years and the interest rate is
5%
25
Present Value = 1,000,000 / (1.05)
Present Value = $295,303
If you put $295,303 in an account earning 5% interest, you’d have
$1million in 25 years.
Suppose instead you want the $1,000,000 in 40 years.
40
Present Value = 1,000,000 / (1.05)
Present Value = $142,045.68
Suppose when your child begins his/her college education, you
promise to give you son/daughter $1000 cash if they graduate in 4
years. If your savings account earns 8% interest, how much
money would you need to put in today to have $1000 in 4 years?
4
Present Value = 1000 / (1.08)
Present Value = $735.03
Suppose instead your account earns 2% interest.
4
Present Value = 1000 / (1.02)
Present Value = $923.85
The higher the interest rate, the smaller the amount of money
needed in the present to obtain a particular future amount.
The longer the time frame, the smaller the amount of money
needed in the present to obtain a particular future amount.
C. The Cost of Borrowing
When you borrow money to pay for something, you end up paying
back more than the purchase price.
- pay interest
Most people know they have to pay interest on a loan. However,
they are often unaware just how much they are paying.
Example: Suppose you take out a $100,000 mortgage at 5%
interest for 30 years.
- compound the interest annually (simplified)
- $6000 in payments per year
Year
1
2
3
4
5
6
7
8
9
10
Principal
100,000
99,000
97,950
96,847.5
95,689.88
94,474.37
93,198.09
91,857.99
90,450.89
88,973.43
+
+
+
+
+
+
+
+
+
+
Interest
Payment
(0.05)(100,000) = 5,000
- 6,000
(0.05)(99,000) = 4,950
- 6,000
(0.05)(97,950) = 4,897.5
- 6,000
(0.05)(96,847.5) = 4,842.38 - 6,000
(0.05)(95,689.88) = 4,784.49 - 6,000
(0.05)(94,474.37) = 4,723.72 - 6,000
(0.05)(93,198.09) = 4,659.9 - 6,000
(0.05)(91,857.99) = 4,592.9 - 6,000
(0.05)(90,450.89) = 4,522.54 - 6,000
(0.05)(88,973.43) = 4,448.67 - 6,000
Total payments: 6,000 x 10 years = $60,000
How much of that $60,000 went to
principal?
$100,000 - $88,973.43 = $11,026.57
interest?
$60,000 - $11,026.57 = $48,973.43
Still left to pay: $88,973.43 plus interest for 20 more years
In ten years, you’ve paid $60,000 on a $100,000 mortgage but still
have $88,973.43 left to pay (plus more interest).
The general loan payment formula is:
M = P [ i(1 + i)n ]
(1 + i)n - 1
M = monthly payment
P = principal amount
i = interest rate divided by 12
n = total number of payments
Ex: Suppose you take out a 5-year car loan for $10,000 at 8%
interest. Calculate your monthly payment.
first calculate i: 0.08 / 12 = 0.0066667 = 0.0067
then calculate n: 5 x 12 = 60
60
M = 10,000 [ 0.0067(1.0067) ]
60
(1.0067) - 1
= $202.96
Over the life of the loan, what is the total amount you end up paying
back?
monthly payment x number of payments
$202.96 x 60 = $12,177.60
How much did you pay in interest?
total amount paid – loan amount
$12,177.60 - $10,000 = $2,177.60
Suppose you charge $4500 on your credit card and your interest
rate is 21% annually.
Calculate how much you would have to pay per month to pay off
this debt in 2 years.
i = 0.21 / 12 = 0.0175
n = 2 x 12 = 24
24
M = 4500[ 0.0175(1.0175) ]
24
(1.0175) - 1
= $231.24
What is the total amount you end up paying back?
$231.24 x 24 = $5,549.76
How much do you pay in interest?
$5,549.76 - $4,500 = $1,049.76
Suppose instead you want to pay it off in 1 year. Calculate your
monthly payment.
i = 0.21 / 12 = 0.0175
n = 1 x 12 = 12
12
M = 4500[ 0.0175(1.0175) ]
12
(1.0175) - 1
= $419.08
What is the total amount you end up paying back?
$419.08 x 12 = $5,028.96
How much do you pay in interest?
$5,028.96 - $4,500 = $528.96
IV. Managing Risk
Risk Aversion is a dislike of uncertainty.
One way to deal with risk is to buy insurance.
- a person facing a risk pays a fee to an insurance firm
- the firm agrees to take on all or a part of the risk
From the standpoint of the economy as a whole, the role of
insurance is to spread around the risk.
- can’t eliminate it completely
Insurance markets suffer from adverse selection and moral hazard.
- people likely to use the insurance are the ones who
most want to buy it
- once a person has insurance, they may change their
behavior
Practical advice for risk-averse people:
Diversify!
Firm-specific risk only affects a single company.
ex: a software firm that goes bankrupt because they sold
a low quality product that no one bought
Market risk is the risk associated with the entire economy.
ex: in a recession, even good firms face hard times and
may have financial troubles
You can avoid firm-specific risk by diversifying but you can’t
avoid market risk.
To some degree, you can avoid some of the market risk associated
with a particular nation’s economy.
ex: buy assets in nations outside the US
However, as nations become more and more engaged in the global
economy, there is a global market risk that is unavoidable.
Keep in mind, there is always a tradeoff between risk and reward.
- savings account is safe, but pays lower interest
- stocks are much riskier, but pay a higher return
- US bonds are safer, 4% interest
- Greek bonds are much riskier, 11% interest
If you ever hear of an investment that pays a high rate of return, you
should assume that it is risky and not a sure thing.
Risk tolerance changes with age.
When a person is early in their working years, investing in
relatively riskier assets is okay.
- can ride out the ups and downs of the stock market…
can have big payoffs and can recover from any losses
When a person is getting closer to retirement, investing in safer
assets is wise.
- if the stock market has a downturn in the few years
before retirement… little time to make up that loss