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Explain the function of capital markets in a
market economy
Identify how diversification can reduce risk in
an investment portfolio
THE MARKET BASKET
History of United States Postage Rates
(Rate for first-class postage for a one-ounce letter)
Date
Rate
Date
Rate
July 6, 1932
3 cents
February 3, 1991
29 cents
August 1, 1958
4 cents
January 1, 1995
32 cents
January 7, 1963
5 cents
January 10, 1999
33 cents
January 7, 1968
6 cents
January 7, 2001
34 cents
May 16, 1971
8 cents
June 30, 2002
37 cents
March 2, 1974
10 cents
January 8, 2006
39 cents
December 31, 1975
13 cents
May 14, 2007
41 cents
May 29, 1978
15 cents
May 12, 2008
42 cents
March 22, 1981
18 cents
May 11, 2009
44 cents
November 1, 1981
20 cents
January 22, 2012
45 cents
February 17, 1985
22 cents
January 27, 2013
46 cents
April 3, 1988
25 cents
Source: http://en.wikipedia.org/wiki/History_of_United_States_postage_rates;
http://www.akdart.com/postrate.html.
THE MARKET BASKET
Inflation is a general, sustained
upward movement of prices for
goods and services in an economy.
As a result of inflation, it takes more money to buy the
same goods and services. Inflation means prices go
up!
THE MARKET BASKET
• The Bureau of Labor Statistics (BLS) is a federal
agency that collects and analyzes economic data.
• The BLS reports price changes using the consumer
price index (CPI) a market basket of consumer
goods and services
• Items are divided into more
than 200 categories,
arranged into eight major
groups:
THE MARKET BASKET
The Eight Major Groups of the CPI
Food and beverages
Housing
Apparel
Transportation
Medical care
Recreation
Education and communication
Other goods and services
ARKET BASKET
THE MARKET
BASKET
The CPI inflation rate can be determined comparing
the percentage increase in the price level of goods
and services from one time period to another.
Annual CPI Inflation Rate Formula:
Inflation
rate
CPI later year ─ CPI earlier year
CPI earlier year
X 100
1.
2.
3.
4.
Raise Capital
Storing, Protecting, and Making Profitable
Use of Excess Capital
Insuring Against Risk
Speculation

What does it mean to “raise capital”? Why is
this important within the economy? (150151)


Financial markets allow individuals, firms,
and governments to do things today that they
could not otherwise afford
Capital
◦ 1. Financial assets or the financial value of assets,
such as cash.
2. The factories, machinery and equipment owned
by a business and used in production.


What is “excess capital”? What is the role of
financial instruments in putting excess capital
to use?
How does this work?


Nominal return = how much money one
earns in Interest
Inflation calculated from the Consumer Price
Index (CPI)
◦ 1.6% 2013-2014


Real Return = Nominal return – Inflation
Investing allows “excess capital” to not lose
real value

What is risk? What role does insurance play
in negotiating risk?
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Insurance
Futures Contract- an agreement to sell a
product in the future for a currently
determined price
Credit Default Swaps (CDO’s)
Diversify investments (more later)

What does it mean to “speculate”? (157)

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The act of trading in an asset, or conducting
a financial transaction, that has a significant
risk of losing most or all of the initial outlay,
in expectation of a substantial gain
Basically Gambling

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Stocks
Dividend
Bonds
Mutual Fund
Index Fund
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A type of security that signifies ownership in
a corporation and represents a claim on part
of the corporation's assets and earnings.
Return comes from two factors:
◦ Change in price of the share
◦ Dividends

A distribution of a portion of a company's
earnings, decided by the board of directors,
to a class of its shareholders.
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A debt investment in which an investor loans
money to an entity (corporate or
governmental) that borrows the funds for a
defined period of time at a fixed interest rate
Stocks Versus Bonds

an investment vehicle that is made up of a
pool of funds collected from many investors
for the purpose of investing in securities such
as stocks or bonds

An index fund (also index tracker) is a fund
that aims to replicate the movements of an
index regardless of market conditions.
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Standard and Poor’s 500
Made up of 500 Large Cap companies meant
to mirror to US economy over all
Large Cap = market capitalization value of
more than $10 billion
◦ Wal-Mart
◦ Microsoft
◦ General Electric

Market Capitalization= number of stock
shares X stock price
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
How does the “efficient markets theory” play
a role in how the financial markets work?
How is investing (buying stocks, etc.) like a
line at the grocery store?
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An investment theory that it is impossible to
"beat the market" because stock market
efficiency causes existing share prices to
always incorporate and reflect all relevant
information.
the only way an investor can possibly obtain
higher returns is by purchasing riskier
investments.

What other factors in how people invest
challenge the efficient markets theory?
 Save,
Invest, Repeat
 Take Risk, Earn
 Diversify
 Invest for the Long Term
A
good rule of thumb for
young people is often:
◦ 50% of income used for needs
◦ 30% for lifestyle choices
◦ 20% saved
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More risk = higher return
More risk = higher probability of loss of
principle
Diversification and Risk
The Pyramid of Risks and Reward
Highest Risk - Highest Potential Return or Loss
10. commodities
9. collectibles
8. real estate
7. stocks
6. mutual funds
5. corporate bonds
4. government bonds
3. certificates of deposit
2. savings accounts
1. cash and checking accounts
Lowest Risk - Lowest Potential Return or Loss
Diversification and Risk
Portfolio
a collection of financial investments held by an individual
or financial organization
Diversification
investing in various financial instruments in order to reduce
risk
Diversification and Risk
Would you bet $100 on a coin flip if the deal were that you keep
your $100 and receive an additional $5.00 for heads, but lose
$100 for tails?
Would you bet $100 on a coin flip if the deal were that you keep
your $100 and receive an additional $100 for heads, but lose
$100 for tails?
Would you bet $100 on a coin flip if the deal were that you keep
your $100 and receive an additional $400 for heads, but lose
$100 for tails?
Diversification and Risk
Invest only what you can afford to lose.
Invest at your comfort level.
Invest according to your age.

Diversify across different financial
instruments
◦
◦
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Stocks
Bonds
Cash and CD’s
Diversify across sectors and geographic locations
Electronically Traded Funds (ETF’s) and
Mutual funds can provide easy diversification