Chapter 11:1: Saving and Investing:

Transcription

1 Chapter 11:1: Saving and Investing:

2 Objectives: We will examine how investing contributes to the free enterprise system. We will examine how the financial system brings together savers and borrowers. We will explain the role of financial intermediaries in the financial system. We will identify the trade-offs among liquidity, return, and risk.

3 (Deu 8:18) But thou shalt remember the LORD thy God: for it is he that giveth thee power to get wealth, that he may establish his covenant which he sware unto thy fathers, as it is this day.

4 o Investment is the act or redirecting resources from being consumed today so that they may create benefits in the future. o In more narrow economic terms, investment is the use of assets to earn income or profit.

5 o Investing is in fact, an essential part of the free enterprise system. o It promotes economic growth and contributes to a nation s wealth. o When people deposit money in a savings account in a bank, for example the bank may then lend the funds to businesses. o The businesses in turn may invest that money in new plants and equipment that give them the resources to increase production.

6

7 The Financial System: When people save they are in essence lending funds to others. Whether they put cash in a saving account, purchase a certificate of deposit or buy a government or corporate bond, savers obtain a document that confirms their purchase or deposit.

8 The Financial System: o These documents may be passbooks monthly statements, bond certificates. o Such documents represent claims on the property or income to the borrower. o These claims are called financial assets, or securities. o If the borrower fails to pay back the loan, these documents can serve as proof in court that money was borrowed and that commitments were made that were not fulfilled.

9 The Flow of Savings and Investments: o Financial Intermediaries: Borrowers and savers may also be linked through a variety of institutions pictured as in between the two. o These financial intermediaries are institutions that help channel funds from savers to borrowers. o These include:

10 Banking o Banking, saving and loan associations, and credit unions and finance companies. o Credit Union takes in deposits from savers and then lend out some of these funds to businesses and individuals. o Finance companies make loans to consumers and small businesses.

11 Mutual funds: o A mutual fund pools the savings of many individuals and invests this money in a variety of stocks, bonds, and other financial assets. o Mutual funds allow people to invest in a broad range of companies in the stock market. o Investing in this way is less risky than purchasing the stock of only one of two companies that might do poorly.

12

13 Hedge funds: o A hedge fund is a private investment organization that employs risky strategies that often make huge profits for investors. o These investors are generally wealthy and often are knowledgeable about investing. o Because hedge funds are private, they have not been regulated by the SEC and have not had to reveal information about themselves to the public.

14 Life insurance companies: o The main function of life insurance is to provide financial protection for the family or other people named as beneficiaries of the insured. o Working members of a family may buy life insurance so that if they die, money will be paid to survivors to make up for lost income.

15 Life insurance companies: o Insurance companies collect payments called premiums from the people who buy insurance. o They lend out to investors part of the premiums that they collect.

16 Pension Funds: o A pension is income that some retirees receive after working for a certain number of years or reaching a certain age. o In certain cases, injuries may qualify a working person for pension benefits. o Employers may set up pension funds in a number of ways.

17 Pension Funds: o They may contribute to the pension fund on behalf of their employees, they may place a percentage of worker salaries to deposit in a pension fund or they may do both. o Employers set up pension funds to collect deposits and distribute payments. o Pension fund managers invest those deposits in stocks, bonds, and other financial assets.

18 Financial Intermediaries: o Now that you know something about the types of financial intermediaries and why savers don t deal directly with investors. o The answer is that in general dealing with financial intermediaries offers three advantages.

19 Sharing risks o As a saver, you may not want to invest your entire life savings in a single company or enterprise. o For example, if you had $500 to invest, and your neighbor was opening a new restaurant, it would not be prudent to give them the entire $500 to invest. o Considering that half of new businesses fail.

20 Sharing risks o Instead you would want to spread the money around to various businesses. o This will reduce the chances of losing your entire investment.

21 Sharing risks o The strategy of spending our investment to reduce risk is called diversification. o If you deposited $500 in the bank or bought shares of a mutual fund, those institutions could pool your money with other people s savings and put your money to work by making a variety of investments. o In other words, financial intermediaries can diversify your investment and thus reduce the risk that you will lose all of your funds if a single investment fails.

22 Providing Information: o Financial intermediaries are also good sources of information. o Your local bank collects information about borrowers by monitoring their income and spending. o Finance companies collect information when borrowers fill our credit applications. o Mutual fund managers know how the stock in their portfolios or collections of financial assets are performing.

23 Providing Information: o As required by law, all intermediaries provide this and other information to potential investors in an investment report called a prospectus. o The typical prospectus also warns potential investors that past performance does not necessarily predict future results. o An investment that looks great today may fizzle tomorrow. o As economic conditions change, an investment, once considered safe may look very risky.

24 Providing Information: o By providing vital data about investment opportunities, financial intermediaries reduce the costs in time and money that lenders and borrowers would pay if they had to search out such information on their own. o The information however is sometimes provided in lengthy documents with small type. o So the careful investor must be knowledgeable and must study whatever information has been provided.

25 Providing Liquidity: o For example, if you decide to invest in a mutual fund and two years later, you need cash to pay your college tuition, you can get cash quickly by selling your shares of the mutual fund. o Other investments are not so liquid. o If you had purchased an investment quality painting instead, you would need to find another investor who would buy the art from you. o As you can see, financial intermediaries and the liquidity they provide are crucial to meeting borrowers and lenders needs in our increasingly complex financial system.

26 Liquidity, Return, and Risk. o Suppose you save money in a savings account. o Savings account are good ways, to save when you need to be able to get to your cash for immediate use. o On the other hand, savings accounts pay relatively low interest rates, about 2 to 3 percentage points below a certificate of deposit (CD). o In other words, saving accounts are liquid, but they have a low return. o Return is the money an investor receives above and beyond the sum of money that has been invested.

27 Return and Risk: o Certificates of deposit (up to $250,000) are considered very safe investments because they are insured by the federal government. o When you buy a CD valued at less than $250,000, you are giving up liquidity for a certain period of time, but you are not risking the loss of your money.

28

29 Return and Risk: o What if you decided to invest the money into a new company that your friends are starting? o You must consider the risk you are now incurring. o In general, the higher the potential return on an investment, the riskier the investment. o Whenever individuals evaluate an investment, the riskier the investment. o Whenever individuals evaluate an investment, they must balance the risks involved with the rewards they expect to gain from the investment.

30 ACTIVITY

31 Discussion Question What type of investment do you think is best for your needs? Stocks, saving accounts, CDs? Explain why you chose that investment. Then go to the designated subject corners.