Savings and Investment July 23, 2014
Personal Financial Planning Process The personal financial planning process includes four main elements: Setting financial goals; Financial assessment; Developing and implementing plans / strategies; Monitoring progress.
Model for Financial Planning There are four sources of funds that can be applied towards realizing financial goals: existing savings; investment income on existing savings; annual savings (earnings less consumption) as per SCF; and investment income on annual savings.
Savings vs. Investment Savings = residual earnings, after consumption; Savings is reflected on the Statement of Cash Flows; Investment = commitment of money with the expectation of receiving payments in the future that will compensate for both the risk of the investment and for time (postponing consumption); Investing is undertaken (as a strategy) to achieve financial goals;
Types of Investments Investment strategies typically involve financial assets: debt or equity-based investments, and hybrids. Three categories of financial assets: Cash & Near Cash Fixed Income / Debt Obligations Equities Investments can also include assets such as real estate, precious metals, etc.
Characteristics of Investments Characteristics of investments: Investments are expected to provide a monetary return or benefit over time; Investments involve risk. Risk is associated with the expected return on the investment - as the risk of the investment increases so too should the expected return; Investments involve opportunity cost. Investors must consider what else could have been done with the invested funds;
Investment Returns Investment returns may be provided in the form of periodic income streams (interest or dividends) and/or capital gains; Various methods for determining investment returns: Holding Period Rate of Return: r = [(P1 - P0) + D] / P0 Average (Arithmetic) Rate of Return (Multiple Periods) Compound (geometric) rates of return Geometric Mean = ((1+k)*(1+k)*(1+k)*.) y 1/n where n = the number of periods and k = the periodic rate of return Effective Annual Rate (EAR) compounding within a given year: EAR = (1 + kj /m ) m 1 where m = the number of periods kj = the annual rate of return
Investment Returns Some investments are specifically held for the short term; To compare / evaluate investments where holding period is less than a year, investors should still consider the effective annual rate: EAR = [(1+r) 365/t - 1] where t = length of holding period in days EAR provides a common frame of reference for comparing investments with differing terms / holding periods;
Investment Risks Various elements of investment risk: Variability (uncertainty regarding rate of return) Default Interest rate risk Liquidity risk Reinvestment risk Inflation risk
Investment Risk - Variability Investments with greater variability are considered riskier - higher probability of receiving either a higher or lower than expected rate of return; Standard deviation of investment returns is used as a measure of variability / investment risk; Beta is another measure of investment risk measures the co-movement / correlation of an investment s return against the market s return; A beta value of 1.0 means that expected returns on an investment will move exactly with the overall market and has the same degree of risk.
Other Investment Risks Default risk = the risk of losing all / part of the future cash flows the investor expects; Interest rate risk = the risk that market interest rates will rise or fall, affecting asset valuation; Liquidity risk = the risk of being unable to liquidate the asset when required; Reinvestment risk = the risk of not knowing at what rates money can be reinvested in the future; Inflation risk = the risk that investment returns will be affected by inflation;
Investment Risk vs. Return Investors are risk averse in order to encourage investors to take select riskier investments, incentives (in the form of higher returns) must be offered; The expected rate of return on an investment is an increasing function of its risk;
Managing Investment Risk - Diversification Diversification reduces risk exposure by allocating funds across investment alternatives; Diversification can lower an investor s risk exposure without sacrificing expected return on investment; Portfolio approach to investing - select a portfolio of investments that are not highly correlated with each other; Research suggests much of the benefits of diversification achieved by investing in 15-20 securities. Portfolio risk will continue to decrease with additional investments, but at much slower pace;
Managing Investment Risk - Diversification Diversification can take place: Within an investment type (i.e. between equities); Between investment types (equities vs. fixed income); and Across different markets / countries. Risk that cannot be diversified away is market risk ;
Investment Mgmt Deposit Insurance Canadian Deposit Insurance Corporation (CDIC) insures deposits in savings accounts and chequing accounts that are held in Canadian dollars at a CDIC member ( http://www.cdic.ca ) CDIC insures up to $100,000; CDIC deposit insurance is automatic for eligible deposits at its member institutions. Accounts and products insured by CDIC: Savings accounts and chequing accounts GICs and other term deposits with an original term to maturity of 5 years or less; Accounts that hold realty taxes on mortgaged properties
Investment Management In personal finance, Investment Strategies should consider: Financial goals / Investment objectives; Stage in Financial Life Cycle; Investment planning horizon (short vs. long term); Investor s risk tolerance; Appropriate diversification / risk management; Investor s management skills / commitment; Cost of investment management services; Taxation of investment income / Marginal Tax Rate
Investment Options Various investment products are commonly available to Canadian households through governments, banks, and/or investment dealers: Treasury Bills (T-bills) Canada Savings Bonds Savings Accounts Term Deposits / Guaranteed Investment Certificates (GICs) Government / Corporate Bonds Stocks Mutual Funds
Cash Equivalents - Treasury Bills Debt obligations issued by the Government of Canada; Short-term = 91 days, 182 days, 1 year; Purchased at a discount, redeemed at face value; Default risk = zero Requires minimum investment of $5,000 - $25,000; Ownership cannot be transferred - no trading market; Investment return is quoted as yield Current rates: At auction Jul 15/14 91 day = 0.94%; 182 day = 0.98%; 1 yr = 1.01%
Cash Equivalents - Savings Bonds Also represent debt obligations issued by the Government of Canada; Fixed rate of interest, compounded annually; Two types of Canada Savings Bonds: regular interest bond; premium interest bond Ownership cannot be assigned / transferred - no trading market;
Cash Equivalents Savings Bonds Government will redeem regular Canada Savings Bonds at any time for face value + accrued interest; Regular Canada Savings Bonds have a ten-year term to maturity. Interest rates are often announced for a shorter period and remain in effect for that announced period; Default risk = zero / Full liquidity Current rates: Series S131, November 1, 2013 Year 1 = 0.50% CSBs often used for household emergency funds;
Cash Equivalents Premium Bonds The Canada Premium Bond (CPB) - same general features as CSBs, but can only be redeemed each year on the anniversary of the issue date and 30 days after; The CPB has a higher rate of interest at the time of issue than a CSB, due to its liquidity restrictions; The Canada Premium Bond also has a ten-year term to maturity. Interest rates are announced for a shorter period (usually 1 year) and remain in effect for that period Default risk = zero; Bears some liquidity risk;
Cash Equivalents Premium Bonds Series P83 - December 1, 2013: Annual Interest Rate Average Annual Compound Rate 1-Dec-13 1.00% 1.00% 1-Dec-14 1.20% 1.09% 1-Dec-15 1.40% 1.19%
Cash Equivalents Savings Accts Bank savings accounts very low risk, highly liquid, convenient; Low interest rates / Not guaranteed, but usually deposit insured; Savings accounts can have various options / requirements for calculating interest minimum monthly balance requirement; daily vs. monthly interest calculation, semi-annual compounding
Cash Equivalents Term Deposits Term deposits issued by financial institutions; Provide a guaranteed rate of interest for a specified term less than one year (i.e. 30 364 days); Very low risk, liquid; Typically require a minimum deposit; Interest is typically paid at maturity; Current rates; e.g. BMO Term Investments: $5000-$24,999 30-59 days = 0.60% $5000-$24,999 270-359 days = 1.00%
Cash Equivalents - GICs Guaranteed Investment Certificates (GICs) also issued by financial institutions; Longer term deposits (1-10 years); Provide guaranteed rate of interest for specified term; Require a minimum deposit; Interest typically paid semi-annually or annually; Current rates: e.g. BMO Term Investments: $1000-$99,999 12-18 mo s, annual compound = 1.00% $1000-$99,999 10 years, annual compound = 2.30%
Cash Equivalents Real Rate of Return Annual Inflation Rate PEI, All Items As at December 2013 = 3.0% Real Rate of Return on Cash Equivalents can be negative: 1 Year BMO GIC = 1.0% Kr = [(1+Knom) / (1+i)] 1 Kr = [(1+0.01) / (1+0.03)] 1 = -1.94%
Government / Corporate Bonds Debt obligations issued by federal / provincial / municipal governments and corporations = fixed income securities; Interest is payable on prescribed dates, normally semiannually; Annual interest rate on bond is referred to as coupon rate ; Ownership can be assigned / transferred there is an active bond market Bonds are typically quoted in Price/$100 of face value, to the previous interest date; Settlement of bond transactions include a payment of accrued interest since last coupon date;
Bond Returns / Yields Bonds are typically compared on the basis of yield ; Yield to maturity = average rate of return that will be earned on a bond if it is bought now and held to maturity; Yield to maturity is derived from: the present value of the stream of coupon payments + the present value of the face value at maturity Coupon Maturity Date Bid $ Yield Province of Nova Scotia 6.60% 06/01/2027 128.02 3.92 Canadian Tire Corp Ltd 4.95% 06/01/2015 104.70 1.99
Bond Returns / Yields Bond price equation: Current price P = CM [PVA] + M [PV] where CM = coupon payment M = face value at maturity Calculating Yield to Maturity: PV = Current Price FV = Face Value at maturity N = Periods to maturity PMT = Coupon payment Solve for I/Y Convert to Annual Rate = (x2)
In-Class Problems Problem # 15-2
Problem # 15-2 a) Yield to Maturity: i) PV -9,500 PMT 475.00 FV 10,000 N 40 I/Y 5.043% Yield to Maturity = 10.09%
Problem # 15-2 a) Yield to Maturity ii) PV -10,500 PMT 512.50 FV 10,000 N 60 I/Y 4.867% Yield to Maturity = 9.734%
Problem # 15-2 a) Yield to Maturity iii) PV -10,000 PMT 500.00 FV 10,000 N 20 I/Y 5.0% Yield to Maturity = 10.0%
Problem # 15-2 b) Are these yields to maturity guaranteed? No. The price of the bond will change as market interest rates change (i.e., as the available alternative opportunities change). If you sell any time before maturity, may receive a different price than expected; The issuer may default on the payments; Must reinvest the coupons in an investment yielding exactly the same rate of return. Bond pricing assumes funds are reinvested internally at the same rate.
In-Class Problems Problems # 15-3
Problem # 15-3 Bond Price / Holding Period Return i) PMT = $475 FV = $10,000 I/Y = 5.5% (11% YTM / 2) N = 38 PV (Bond Price) = $8,814.64 HPR = ($8,815 - $9,500 + $950)/$9,500 = 2.79%
Problem # 15-3 Bond Price / Holding Period Return ii) PMT = $512.50 FV = $10,000 I/Y = 5.5% (11% YTM / 2) N = 58 PV (Bond Price) = $9,348.73 HPR = ($9,349-10,500 + 1,025)/$10,500 = -1.2%
Problem # 15-3 Bond Price / Holding Period Return iii) PMT = $500 FV = $10,000 I/Y = 5.5% (11% YTM / 2) N = 18 PV (Bond Price) = $9,437.70 HPR = ($9,438-10,000 + 1,000)/$10,000 = 4.38%
Bond Risks Default risk will depend on the financial strength of the bond issuer; Bond ratings services evaluate borrowers and assess quality of their bonds (Ratings AAA C); The coupon rate on bonds is fixed, yet market interest rates fluctuate. As a result, bond prices will vary (inversely) with market rates = Interest rate risk. Coupon payments are paid to bondholders over time the future investment options for those payments is uncertain = Reinvestment risk.
Equities Equities (stocks) represent an ownership share of an incorporated entity; Ownership of share units can be assigned / transferred; Shares can be widely held and publicly traded - public companies; Shares of private companies are often closely held with infrequent transactions; Liquidity risk for private companies typically high;
Stock Markets Equities are publicly traded; There are various stock exchanges (TSE, NYSE) and several reported market indices (TSX Composite, TSX Venture, DJIA, Nasdaq, etc); Market index = selection of shares that are traded on a particular exchange the performance of the group intended to be indicative of overall market performance, or performance within a specific market sector; For a list of companies comprising TSX Composite: http://www.tsx.com/
Investing in Stocks Several considerations are involved when investing in individual publically-traded stocks: Annual / Quarterly Earnings History and Forecast Estimates; Dividend Rate (if any); Risk Measures (Variability); Corporate Management; Competitive Advantages; Industry trends / conditions; Merger & Acquisition prospects; Interest rates; National / global conditions & events; and Speculation / Bargain hunting
Stock Measures Some common stock measures include: Dividend Yield = dividend rate / share closing market price P/E Ratio = closing market price earnings /share (Reflects the amount an investor must pay for a $ of earnings) Substantial investment research information is readily available, as indicated by the following example: http://www.globeinvestor.com/servlet/page/document/v5/data/stock?id=cco-t