Personal Finance - Term Paper Example

? Personal Finance Investments [Pick the Pick the Investments Introduction If one has money to invest, his first priority should be to ensure adequate liquidity. One can satisfy his liquidity needs by placing deposits in financial institutions or by investing in money market securities such as certificates of deposits. Since these types of investments are primarily focused on providing liquidity, they offer a relatively low return. If one has additional funds beyond his liquidity needs, he has a wide variety of investments to consider. Money market securities There are several different money market securities available, including certificates of deposit, money market deposit accounts and money market funds. Most money market securities provide interest income. Even if one’s liquidity needs are covered, one may invest in these securities to maintain a low level of risk. Yet, he can also consider some alternative securities that typically provide a higher rate of return but are more risky. Stocks Stocks are certificates representing partial ownership of a firm. Stock investors become shareholders of the firm. Firms issue stocks to obtain funds to expand their business operations. Investors invest in stock when they believe that they may earn a higher return than alternative investments offer. Primary and Secondary Stock Markets Stocks can be traded in a primary or a secondary market: The primary market is a market in which newly issued securities are traded. Firms can raise funds by issuing new stock in the primary market. The first offering of a firm’s stock to the public is referred to as an ‘initial public offering’ (IPO). A secondary market facilitates the trading of existing securities by enabling investors to sell their shares at any time. These shares are purchased by other investors who wish to invest in that stock. Thus, even if a firm is not issuing new shares of stock, investors can easily obtain shares of that firm’s stock by purchasing them in the secondary market. On a typical day, more than a million shares are traded in the secondary market. The price of the stock changes each day in response to changes in supply and demand. Types of Stock Investors Stock investors can be classified as institutional investors or individual investors: Institutional investors These are professionals employed by a financial institution who are responsible for managing money on behalf of the clients they serve. They attempt to select stocks or other securities that will provide a reasonable return on investment. The employees of financial institutions who make investment decisions are referred to as ‘portfolio managers’ because they manage a portfolio of securities (including stocks). More than half of all trading in financial markets is attributable to institutional investors. Individual investors commonly invest a portion of the money earned from their jobs. Like institutional investors, they invest in stocks to earn a reasonable return on their investment. In this way their money can grow by the time they wish to use it to make purchases. The number of individual investors has increased substantially in the last 20 years. Many individual investors hold their stocks for periods beyond one year. In contrast, some individual investors called ‘day traders’ buy stocks and then sell them on the same day. They hope to capitalize on very short-term movements in security prices. In many cases, their investments last for only a few minutes. Many day traders conduct their investing as a career, relying on their returns from investing as their main source of income. This type of investing is very risky because the stock prices of even the best-managed firms periodically decline. Day trading is not recommended for most investors. Return from Investing in Stock Stocks can offer a return on investment through dividends and stock price appreciation. Some firms distribute quarterly income to their shareholders in the form of dividends rather than reinvest the earnings in the firm’s operations. They tend to keep the dollar amount of the dividends per share fixed from one quarter to the next, but may periodically increase the amount. They rarely reduce the dividend amount unless they experience relatively weak performance and cannot afford to make their dividend payment. The amount of dividends paid out per year is usually between 1 and 3 percent of the stock’s price. A firm’s decision to distribute earnings as dividends, rather than reinvesting all of its earnings to support future growth, may depend on the opportunities that are available to the firm. In general, firms that pay high dividends tend to be older, established firms that have less chance for substantial growth. Conversely, firms that pay low dividends, tend to be younger firms that have more growth opportunities. The stocks of firms with substantial growth opportunities are often referred to as ‘growth stocks’. An investment in these younger firms offers the prospect of a very large return because they have not reached their full potential. At the same time, an investment in these firms is exposed to much higher uncertainty because young firms are more likely to fail or experience very weak performance than mature firms. The higher the dividend paid by a firm, the lower its potential stock price appreciation. When a firm distributes a large proportion of its earnings to its investors as dividends, it limits its potential growth and the potential degree to which its value (and stock price) may increase. Stocks that provide investors with periodic income in the form of large dividends are referred to as ‘income stocks’. Shareholders can also earn a return if the price of the stock increases by the time they sell it. The market value of a firm is based on the number of shares of stock outstanding multiplied by the price of the stock. The price of a share of stock is determined by dividing the market value of the firm by the number of shares of stock outstanding. Thus, a firm that has a market value of $600 million and 10 million shares of stock outstanding has a value per share of: Value of stock per share = market value of firm/number of shares outstanding = $600,000,000/10,000,000 = $60 The market price of a stock is dependent on the number of investors who are willing to purchase the stock (the demand for the stock) and the number of investors who wish to sell their holding of the stock (the supply of stock for sale). There is no limit to how high a stock’s price can rise. The demand for the stock and the supply of stock for sale are influenced by the respective firm’s business performance, as measured by its earnings and other characteristics. When the firm performs well, its stock becomes more desirable to investors, who demand more shares of that stock. In addition, investors holding shares of this stock are less willing to sell it. The increase in the demand for the stock and the reduction in the number of shares of stock for sale by investors results in a higher stock price. Conversely, when a firm performs poorly (has low or negative earnings), its market value declines. The demand for shares of its stock also declines. In addition, some investors who had been holding the stock will decide to sell their shares, thereby increasing the supply of stock for sale and resulting in a lower stock price. The performance of the firm depends on how well it is managed. Investors benefit when they invest in a well-managed firm because the firm’s earnings usually will increase, and so will its stock price. Under these conditions, investors may generate a capital gain, which represents the difference between their selling price and their purchase price. In contrast, s poorly managed firm may have lower earnings than expected, which could cause its stock price to decline. Bonds Bonds are long-term debt securities issued by government agencies or corporations. Treasury bonds are issued by the Treasury and backed by the government. Return from Investing in Bonds Bonds offer a return to investors in the form of coupon payments and bond price appreciation. They pay periodic interest (coupon) payments, and therefore can provide a fixed amount of interest income per year. Thus, they are desirable for investors who want to have their investments generate a specific amount of interest income each year. A bond’s price can increase over time and there fore may provide investors with a capital gain, representing the difference between the prices at which it was purchased, however, a bond’s price may decline, which could cause investors to experience a capital loss. Even the prices of Treasury bonds decline in some periods. Mutual Funds Mutual funds sell shares to individuals and invest the proceeds in a portfolio of investments such as bonds or stocks. They are managed by experienced portfolio managers. They are attractive to investors who have limited funds and want to invest in a diversified portfolio. Because a stock mutual fund typically invests in numerous stocks, it enables investors to achieve broad diversification with an investment as low as $4500. There are thousands of mutual funds to choose from. Return from investing in mutual funds The coupon or dividend payment generated by the mutual fund’s portfolio of securities is passed on to the individual investor. Since a mutual fund represents a portfolio of securities, its value changes over time in response to changes in the values of those securities. Therefore, the price at which an investor purchases shares of a mutual fund changes over time. A mutual fund can generate a capital gain for individual investors, since the price at which investors sell their shares of the fund may be higher than the price at which they purchased the shares. However, the price of the mutual fund’s shares may also decline over time, which would result in a capital loss. Real Estate One way on investing in real estate is buying a home. The value of a home changes over time, in response to supply and demand. When the demand for homes in an area increases, home values tend to rise. The return that one earn on his home is difficult to measure because he must take into account the financing, real estate agent commissions and tax effects. However, a few generalizations are worth mentioning. For a given amount invested in the home, one’s return is dependent on how the value of his home changes over the time that he owns it. His return is also dependent on his original down payment on the home. The return will be higher if he made a smaller down payment when purchasing the home. Since the value of a home can decline over time, there is the risk of a loss (a negative return) on his investment. If he is in a hurry to sell his home, he may have to lower his selling privce to to attract potential buyers, which will result in a lower return on his investment. One can also invest in real estate by purchasing rental property or land. The price of land is based on supply and demand. There is little open land and dense populations along the coasts of the United States, so open land along the coasts typically have a high price. Return from Investing in Real Estate Real estate that can be rented (such as office buildings and apartments) generates income in the form of rent payments. In addition, investors may earn a capital gain if they sell the property for a higher price than they paid for it. Alternatively, they may sustain a capital loss if they sell the property for a lower price than they paid for it. The price of land changes over time in response to real estate development. Many individuals may purchase land as an investment, hoping that they will be able to sell it in the future for a higher price than they paid for it. Works cited Fama, E. F. Efficient capital markets: A review of theory and empirical work. Journal of Finance vol. 25 (2000). pp. 383–417. Fama, E. F., Fisher, L., Jensen, M., and Roll, R. The adjustment of stock prices to new information.International Economic Review (1998) pp. 1–21. Gruber, M. J., Another Puzzle: The Growth in Actively Managed Mutual Funds. Journal of Finance  (2001): 783-810. Hendricks, D., Patel, J., and Zeckhauser, R., Hot Hands in Mutual Funds: Short Run Persistence of Relative Performance. Journal of Finance48 (2000): 93-130. Leffler, George Leland. The Stock Market. 2. Ronald Press Co., (2003), pp. 56-61. Malkiel, B. G., Returns from Investing in Equity Mutual Funds 1971 to 1991. Journal of Finance 50 (1998): 549-572. Markowitz, H., Portfolio selection. New Haven, CT: Yale University Press, (2003), pp. 165-179. Marlene G., "Active Investing vs. Indexing: The Bogles Disagree," Pensions and Investments (1996), pp. 36-50. Volkman, D. A., and Wohar, M. E., Abnormal Profits and Relative Strength in Mutual Fund Returns. Review of Financial Economics (1999): pp. 101-116. Read More