Investing Money towards Retirement - Essay Example

Saving and investing money towards your retirement is a very important decision working people should make. The earlier you start saving money towards your retirement the better off you will be in the future due to the power of compound interest. It is never too late to start saving money towards retirement. Sam Johnson is currently 40 years old and he wants to save money towards retirement and to put his two kids through college. His two kids are ages 3 and 8 years old. It is reasonable to assume they will start college at the age of 18 like most teenagers. In the United States traditionally parents assume the cost of putting their kids through college. Financing the college education of two kids can become a very expensive ordeal. Like most working adults Sam is struggling to get by, but he realizes he has to start saving towards these two goals or he won’t have enough time left to accomplish his goals. Sam’s master plan entails saving $150 a month for the foreseeable future in order to put his two kids through college and to be able to retire at the age of 60. His two kids are age 3 and 8 years old. Assuming his two kids will start college at the age of 18 like most teenagers Sam will have to start spending money on college tuition 10 years from now. Sam’s plan of saving 150 a month implies he will save $1,800 a year. Assuming he leaves the money in the bank and makes 1% rate on his saving Sam will have 10 years from now $18,919.25. This amount of money is not sufficient to put his elder kid through four years of college. Sam needs to make adjustments to his plan. The simplest way to adjust his plan is by making better investment options that will allow Sam to make a higher return on his investment. Depending on the banking industry for long range savings is not a wise move due to the extremely low interest rate that this industry offers. Typically interest earn on a banking account is not sufficient enough to offset inflation. Mr. Johnson has to start an investment plan that is aligned with his long term financial goals. Investing money is not a rocket science, but it requires a person to get educated on financial tools such as stocks, bonds, and mutual funds. Common stocks are one of the simplest types of investment options. A common stock is the transfer of a piece of ownership in a company in exchange for cash. Common stocks are equity securities having last claim on residual assets and earnings of corporation; common stockholders normally have the right to elect directors, authorize new stock issues, and approve or disapprove major corporate changes (Teweles, Bradley, Teweles, 1992). Common stockholders also benefit from capital gains and by receiving dividends. A capital gain occurs when the investor sells the common stocks purchased at a price higher than the buying price. Common stocks tend to go up in value through the passage of time. A common stockholder may receive cash or stock dividends typically once a year. Corporations are not mandated to pay dividends once a year, but they tend to do so to raise investor confidence and maximize shareholder value. Bonds are long term debt instruments that an investor can purchase to earn money. Bonds are sold in units of $1000. A $1000 bond can be purchased by an investor that will earn an interest rate known as the coupon rate and at the maturity date will receive back the principal investment. A bond can be purchased at the discount or premium. Federal government debt issuances have lower risk. The Treasury Bills are considered a risk free investment. The current 91 day T-bill auction discount rate is 3.5% (Bankrate, 2014). Commercial paper refers to the debt instruments sold by corporations. Corporate bonds typically pay a higher rate than governmental instruments, but they also have a higher risk of default. It is not uncommon in the market to obtain corporations that are willing to pay investors upwards of 10% on new bond issuances. A third type of investment that investors can use to earn a higher return that what bank pay is by purchasing mutual funds. A mutual fund can be defined as an open end investment company which continually sell and redeem their own shares. One of the inherent advantages of investing in mutual funds is the ability to diversify your investment. Investors should always seek to utilize a diversity strategy when building up an investment portfolio. Your portfolio should have the use of different equity and debt instruments as well as investing in companies from different industries. I am going to recommend three common stocks for Sam to invest in. The first company I am recommending is the industry leader in the fast food industry McDonalds. McDonalds has a history of paying dividends to its shareholders. The company has superb profitability with net margins, ROA, and ROE above the industry average. The market capitalization of McDonalds is $99.33 billion, while its earning per share is $5.50 (Yahoo, 2014). The second company I’m recommending is the industry leader in the software industry, Microsoft. Microsoft is considered a blue chip company. Blue chip companies have a long history of earnings success. These companies also tend to pay dividends to its shareholders. Microsoft common stocks are currently valued at $41.23 per share (Yahoo, 2014). The EPS and dividend yield of Microsoft are $2.67 and 2.70%. The third company I am recommending is a penny stock in the agricultural industry called Papyrus Australia (PPY). This company holds a patent that coverts banana trucks, a waste material, into banana ply paper. The long term outlook for this company is outstanding because in the future such a product will be needed to substitute wood pulp paper. The common stock price of PPY is only $0.02 a share. Due to the high risk nature of investing in penny stocks I would recommend that Sam only upwards of 5% of the value of his portfolio in PPY stocks. Sam will invest in these three stocks to start his investment portfolio. He is not going to limit his investment only to equity. Sam is going to also invest in debt instruments, mutual funds, and individual retirement accounts (IRA). The portfolio will divide the investment in 25% stocks, 25% bonds, 25% mutual funds, and 25% individual retirement account. Since not only does Sam want to put his kids through college he also wants to retire by 60, thus he received the recommendation of investing 25% of his budget on IRA instruments. An IRA provides both tax savings and return on investment. The amount an IRA makes over its lifetime fluctuates, but an IRA can earn 3% to 20% per year. Due to the fact that an investor does not take the money out of the IRA at no point in time the power of compound interest works in the favor of the investor. The potential earnings portfolio will outperform the bank’s interest rate of 1%. My estimate is that Sam can obtain a return on his portfolio of 7%. By saving $150 a week for 10 years at an interest rate of 7% Sam can earn $25,659.73 (Bankrate, 2014). Sam has increased the value of his portfolio in 10 years by nearly $7,000 without making any additional investment. It is important for people to start saving towards the kids college fund and towards retirement at a young age. The more time you have to save money the better your family will be in the future. Sam has increased his ability to earn money in long run by increasing his return on investment in the long run, but Sam’s plans are very optimistic. He wants to put both his kids through college, while at the same time retiring at 60. For Sam to accomplish his goals he must increase the amount of money he saves on a monthly basis. Instead of saving $150 a month, Sam must increase that amount to $300 a month. By saving $300 at an interest return of 7% Sam will accumulate in 10 years when his first kid goes off to college $51,317. References Bankrate.com (2014). Simple Earnings Calculator. Retrieved June 15, 2014 from http://www.bankrate.com/calculators/savings/simple-savings-calculator.aspx Bankrate.com (2014). Treasury Securities. Retrieved June 15, 2014 from http://www.bankrate.com/rates/interest-rates/treasury.aspx?ec_id=m1108415&s_kwcid=AL!1325!10!370394556!7016991897&ef_id=U31rTwAAABeqkZbz:20140615214159:s Teweles, R., Bradley, E., Teweles, T. (1992). The Stock Market (6th ed.). New York: John Wiley & Sons. Yahoo.com (2014). McDonalds Corporation (MCD). Yahoo Finance. Retrieved June 15, 2014 from http://finance.yahoo.com/q?s=mcd&ql=1 Yahoo.com (2014). Microsoft Corporation (MSFT). Retrieved June 15, 2014 from http://finance.yahoo.com/q?s=msft&ql=1 Read More