Tradeoffs

Dr. Katie Sauer

Metropolitan State College of Denver (ksauer5@mscd.edu)

Presented at Junior Achievements 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 Maslows 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

savings

The Big Picture: Savings is important for an economy as a whole and for individuals.

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 bonds 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 firms future profitability.

What determines the price of a stock? a. Fundamental analysis is the study of a companys 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 years 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
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Future Value = 18,000 x (1.04) Future Value = $86,418

Ex: $18,000 wedding, 6% interest, 40 years Future Value = 18,000 x (1.06) Future Value = $185,142
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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? Future Value = 1000 x (1.05) Future Value = $1628.89 If you invested it for 20 years, how much would you have? Future Value = 1000 x (1.05) Future Value = $2653.30
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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. Present Value = Future Value / (1 + r )
n

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, youd have $1million in 25 years.

Suppose instead you want the $1,000,000 in 40 years. Present Value = 1,000,000 / (1.05) Present Value = $142,045.68
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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? Present Value = 1000 / (1.08) Present Value = $735.03 Suppose instead your account earns 2% interest. Present Value = 1000 / (1.02) Present Value = $923.85
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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, youve 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 M = 10,000 [ 0.0067(1.0067) ] 60 (1.0067) - 1 = $202.96
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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 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
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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 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
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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. - cant 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 cant avoid market risk.

To some degree, you can avoid some of the market risk associated with a particular nations 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