MONEY and BANKING LOW GRAPHICS

 HOW TO INVEST 1 MILLION

 Suppose you have just won 1 million dollars and want to invest it. You are considering saving account deposit, CD's, government bonds, mutual funds, stock market and investments into various business projects. How would you decide?

 Student 1 The first thing to consider when searching for options to invest your money is how you can achieve the maximum utility. To find the return on investments, one looks to calculate the NPV (net present value). This is the present value of all your investments and their future returns. NPV is calculated by taking the future value over the interest rate and time to maturity of your investment. In one period, NPV can be written as PV   =   FV/(1+r)t In more than one period, however, the NPV is the sum of all the payments, so PV  =   S[FV/(1+r)t]. If compounding interest rates are also a factor, then  PV   =   FV/(1+r/k)t, where k is the frequency of compounding. In the case of compounding interest, one can see that the higher the frequency, the less impact the compounding may have, and its rate of change eventually begins to level off. It is important to note that any increase in interest rates decrease the NPV of an investment. Risk is also a large factor when deciding where to invest your money. The higher the risk a project has, the higher the return is likely to be. Investments such as government bonds and CD’s have a much smaller return on average than, say, the stock market. A benefit, however is that the risk is very low. If a person is very risk averse, then they would choose to invest in low risk projects such as bonds and savings deposits. If the person is interested in a higher return, and risk isn’t an important factor when making an investment, then the stock market is a likely choice for their investment. One concept I believe is very important to consider when investing is diversification. By increasing the number of projects (stocks, options, bonds…) in your portfolio, one can minimize their risk (variance) and also maintain a sufficient level of return. It is also important to consider the correlation of each project in your portfolio. If the different project have the highly positive correlation, a portfolio would not make sense. On the other hand, if your projects are negatively correlated, you can still obtain a return through diversification. If a person values diversification, then they would choose to put their money in mutual funds and invest in various business projects. The ultimate decision of where to invest your money is a combination of return on investment, sensitivity to risk, and individual preferences.

 Student 2 In order to decide between these 6 options, one has to consider his/her risk/return preferences and time horizon. All of these options have different risks and benefits attributed to them. Described in order of safety: 1. Government Bonds – Since this is the less riskiest investment, it offers a below average return, but virtually no risk of default. This option is sometimes preferred by elderly people with a short time horizon. 2. Saving Account – Again, this is a comparatively safe investment, but it depends on the commercial institution you trust your money to. Your deposits are only protected up to \$100,000 by the FDIC; so, in case of a bankruptcy there is a chance of losing a significant portion of the investment. These usually offer a low return as well. 3. CD’s – this is relatively safe option with rate of return depending on the institution. Basically you loan the money to the bank and the longer the higher is the return. There are two major risks associated with this type of investment. First, you can tie your money for a long time without being able to manipulate it.  Second, if you decide to invest long term, inflation could eat a lot of interest you make on it.  4. Mutual Funds – Depending on the type of fund, this investment can be very risky and very profitable, or relatively safe with an average return. If you decide to invest in a sector fund, which specializes on one sector of the economy and that sector happens to be hot at the time, the return could be very high. Also there are different yield funds which buy stocks of different companies according to their risk/return objectives. 5. Stock Market – Again, if a person is able to create a well-diversified portfolio, then it would be possible to eliminate most of the unsystematic risk present in the market. By applying his/her risk/return preferences to the efficient frontier constructed using his/her mix of securities, it is possible to find the optimal mix for the investor. 6. Business Projects – To evaluate a business project, investor, first of all, has to calculate the Net Present Value of the cash flows generated by the project. Everything above zero is satisfactory. Then an ROI figure would have to be calculated to see whether it complies with investor’s preference. Source: www.about.com

 Student 3 In terms of making a sound investment, one must consider many factors and must pick a method of investing that corresponds most closely with one's preferences. As always, something that presents value comes with an inherent risk. One must decide what type of risk one is willing to assume. Financial innovations during the twentieth century have provided just about every instrument of investment that completely satisfies the market demand for investment. With a million dollars, I would have the opportunity to engage in just about any project of investment that I desire and would like to receive a substantial reward, while not risking my entire winnings. If I wanted a very safe investment that only paid minimal interest, I could consider savings accounts and government bonds. Since the Federal deposit commission (FDIC) would support up to \$100,000 in deposits, I could place this much in various banks and have nearly zero risk. I would have the added benefit of liquidity and therefore could take the money out when I need it. However, this savings account probably would not be a very profitable investment since most savings accounts pay less than 3% interest annually. Government bonds are another risk-averse type investment where I could chose a term to maturity that is in line with my preferences. A long-term bond will pay a higher interest rate, but only provides liquidity if I sell it on an exchange. Although bonds like this are usually very free of risk in the United States, interest-rate risk could pose unnecessary risks. During a time of recession, if the Fed were to increase interest rates enough in an attempt to spur investment, excess capital losses could turn into a poor investment. In addition I could choose between tax free municipal bonds, Treasury bills, or US government bonds. Each carries its own terms and provides some minimal amount of risk, but each also caters to various preferences. If I wanted to put my money in a CD (certificate of deposit), I would be assuming substantially more risk. This is because the CDs are contracts for a specific length of time and early withdrawal of funds has substantial penalties. Those CDs are bank deposits and therefore carry little default-risk. As almost all securities do, it does possess some interest rate risk. A recent financial innovation of negotiable CDs can eliminate the penalty of early withdrawal, but its returns are reduced. Another financial innovation allows people with even small quantities of money to make diversified investments. Mutual funds gather large sums of money from people and them invest on their behalf. If the expertise of the managers is high, the benefits can be enormous, but the risks assumed are inherent. Since I have \$1 million I could also invest in a hedge fund. This is a mutual fund, but requires a longer-term investment and an extremely large amount of capital. While historically it assumed little risk, Long Term Capital, a hedge fund demonstrated that the risks are not only present, but are quite large. Stock market investing implies a lot of risk. I would use lots of research in order to make sound investments, but must make sure to diversify. If I wanted the possibility of large returns with a corresponding risk of losing everything, this is the market for me. In terms of investing with business projects, I would need to consider the NPV of the project. First of all, it must exceed zero and must have a smaller amount of risk. Since investments in individual projects bring asymmetric information, I would be careful. In general when deciding what to invest in, one must consider risk, expected returns, liquidity, and various perks. Then I would make a decision, weighing the relative benefits versus the costs involved with the investment.

 Student 4 When making any investment decision, an investor must first consider an objective in mind, such as an expected rate of return the investor would like to earn over a given time horizon. The investor’s willingness to take on risk, or lack of risk tolerance, will also be an important decision in determining what investment vehicles to use. As a 21-year-old and the stock market being at a relatively low level now as compared to the past few years, I would invest a large portion, at least 70%, into stocks and mutual funds. These investment vehicles are more risky than government bonds and bank CD’s, but I have a higher risk tolerance because of my young age and lack of financial liabilities, such as mortgages, car insurance, etc. Of my investments into mutual funds, I would buy equity funds, bond funds, and growth & income funds (a mix of stocks and bonds) to diversify my risk. I would also invest in exchange traded funds, such as Spiders that mirror the S&P500 index, for greater risk diversification. Of the remaining 30%, 25% would be invested in CD’s and government bonds. Within the next several decades, I will be obligated to make fixed payments such as rent or mortgage payments. I want to make sure that I will have sufficient funds to accomplish this. By holding government bonds until maturity and CD’s, I can avoid paying transaction costs, such as brokerage commissions, allowing me to use the full value of my holdings to meet my fixed payment obligations. By holding government bonds until maturity, I also avoid interest rate risk.  I would put the remaining 5% into a savings account as a safety net until I start working full-time after graduation. None of my funds would be invested in various business products for two primary reasons. First of all, I feel that even a total of \$1 million is insufficient to be a venture capitalist. Secondly, for me to even consider investing in any business project, the project must have very high internal rate of return, which is the rate of return that sets the present value of the project's cash flows equal to the initial costs of the project. (Zvi Bodie: Essentials of Investments; 4. edition, McGraw-Hill/IRWIN; New York, 2001).  A high IRR would be needed because I would demand a high rate of return to compensate for my risk undertaking.  With asymmetric information issues, such as moral hazard and adverse selection, These risks would outweigh any expected return payoff possible and would therefore deter me from investing in various business projects.

 Student 8 The decision on how to invest \$1 million is difficult, which is why there are so many financial institutions that charge a lot of money to make to this decision for you. However, there are certain elements on which the favorability of the investment decision depends upon. First of all, one must take into account a person’s individual characteristics, such as the age, risk preference and investment purpose. Furthermore, the overall state of the economy must be taken into account. Expected interest rate and inflation rate can all affect an investments performance. Finally, it is also important to examine the risk/return relationship between the investment possibilities in question. Other things equal, the investor should prefer higher return for a given level of risk (or lower risk for a given level of return). With diversified portfolios it is often possible to achieve one of the two instances above. A person’s age is important, both to establish risk preference and the aim or the investment. For example, a young person in her twenties and thirties is probably much more likely to take investment risks than a person close to retirement. Not only does the young person still have many worker years ahead, through which she can make up for losses, but she also has a longer period of time over which she can make up for losses, but she also has a longer period of time over which fluctuations can be smoothed out. A typical stock goes through periods of high and low value. A person close to retirement who is dependent on their stocks for their wealth or pension can be strongly affected by such fluctuations. With such a close time horizon, it makes more sense to be invested in less risky assets such as T-bills or bonds than to invest in stock, because the invested capital is not so likely to be affected by short-term fluctuations. An investor who is investing with a longer time horizon, for example for their child’s college education, may choose some combination of stocks and bonds. Finally, as mentioned above, for people in their twenties an all-stock portfolio would be recommendable. Other things equal, the purpose of the investment will also contribute to narrowing down investment choices. If the purpose is to have a certain amount available to pay in the near future, then a CD may well be the choice of investment. These have the added advantage of being highly liquid – they can be sold immediately when cash is needed. The maturity of the investment may also be known beforehand (thus narrowing the scope of investment possibilities) because there may be a specified time when a liability will occur. For example, a liability to pay a bill in six months could be taken care of by investing the present value of the liability in a six month T-bill. The amount will grow to exactly the value of the liability in six months. Personal characteristics can also affect risk-preferences. An investor with a high risk tolerance would probably be likely to invest in more risky assets, such as stocks, regardless of age, investment purpose, and so on. The state of the economy is also important. Expected interest rates and inflation rates can strongly affect stock and bond prices and consequently can affect the expected return on these investments. In times of high inflation it would be unwise to invest in a bond that pays a fixed rate of interest, because the inflation will substantially lower the real rate of return on the investment. By contrast, if the investor believes that future interest rates are expected to fall it would be wise to invest in a bond that pays a fixed (relatively) higher interest rate now. The risk/return relationship can be analyzed with respect to mutual funds, stock markets and a potential investment in various business projects. Investing in a mutual fund, or stock market index as a whole, gives the investor the benefit of diversification and lowers transaction costs. Nevertheless, mutual funds must be evaluated on a risk-adjusted basis in order to determine which one’s do better. In my case, if I were to invest \$1 million I would most likely invest in a mutual fund. Given my lack of expertise in the financial markets it would be preferable for me to have someone set up a portfolio, thus reducing risk and transaction costs. Given my young age, the portfolio would probably contain a large number of stocks, which may have more potential profitability compared to more risk-free investments, such as government bonds. Source: Mishkin, Frederic S. The economics of Money, Banking and Financial Markets

 Student 9 In terms of making a sound investment, one must consider many factors and must pick a method of investing that corresponds most closely with one's preferences. As always, something that presents value comes with an inherent risk. One must decide what type of risk one is willing to assume. Financial innovations during the twentieth century have provided just about every instrument of investment that completely satisfies the market demand for investment. With a million dollars, I would have the opportunity to engage in just about any project of investment that I desire and would like to receive a substantial reward, while not risking my entire winnings. If I wanted a very safe investment that only paid minimal interest, I could consider savings accounts and government bonds. Since the Federal deposit commission (FDIC) would support up to \$100,000 in deposits, I could place this much in various banks and have nearly zero risk. I would have the added benefit of liquidity and therefore could take the money out when I need it. However, this savings account probably would not be a very profitable investment since most savings accounts pay less than 3% interest annually. Government bonds are another risk-averse type investment where I could chose a term to maturity that is in line with my preferences. A long-term bond will pay a higher interest rate, but only provides liquidity if I sell it on an exchange. Although bonds like this are usually very free of risk in the United States, interest-rate risk could pose unnecessary risks. During a time of recession, if the Fed were to increase interest rates enough in an attempt to spur investment, excess capital losses could turn into a poor investment. In addition I could choose between tax free municipal bonds, Treasury bills, or US government bonds. Each carries its own terms and provides some minimal amount of risk, but each also caters to various preferences. If I wanted to put my money in a CD (certificate of deposit), I would be assuming substantially more risk. This is because the CDs are contracts for a specific length of time and early withdrawal of funds has substantial penalties. Those CDs are bank deposits and therefore carry little default-risk. As almost all securities do, it does possess some interest rate risk. A recent financial innovation of negotiable CDs can eliminate the penalty of early withdrawal, but its returns are reduced. Another financial innovation allows people with even small quantities of money to make diversified investments. Mutual funds gather large sums of money from people and them invest on their behalf. If the expertise of the managers is high, the benefits can be enormous, but the risks assumed are inherent. Since I have \$1 million I could also invest in a hedge fund. This is a mutual fund, but requires a longer-term investment and an extremely large amount of capital. While historically it assumed little risk, Long Term Capital, a hedge fund demonstrated that the risks are not only present, but are quite large. Stock market investing implies a lot of risk. I would use lots of research in order to make sound investments, but must make sure to diversify. If I wanted the possibility of large returns with a corresponding risk of losing everything, this is the market for me. In terms of investing with business projects, I would need to consider the NPV of the project. First of all, it must exceed zero and must have a smaller amount of risk. Since investments in individual projects bring asymmetric information, I would be careful. In general when deciding what to invest in, one must consider risk, expected returns, liquidity, and various perks. Then I would make a decision, weighing the relative benefits versus the costs involved with the investment

 Student 11 To decide between the various savings and investment opportunities, I would consider the current interest rates, historic returns, my investment time frame, my risk preference, the standard deviation of expected returns, liquidity, and give most weight to a calculation of expected future cash flows from the investments. When examining interest rates, I would determine the current rates for savings accounts, CD’s, and bonds. I would also try to project future interest rates. By examining a 30-year Treasury bill, I could compare investment returns to the “risk free” rate of return on the T-bill. To evaluate stock market and mutual funds, I would examine their historic returns versus the “risk free” rate to determine if the GENERALLY higher rate of return ON STOCKS AS COMPARED WITH SAVINGS ACCOUNTS, CD’S AND BONDS is enough to compensate for the increased risk. I would look at industry outlooks for various stocks and mutual funds and put together a securities portfolio BY MIXING VARIOUS INDUSTRIES AND SECTORS AND EXAMINING BETAS ON THE VARIOUS SECURITIES TO reduce risk by lowering the standard deviation of EXPECTED RETURNS. I would likely be more willing to invest in the stock market if I had a large time frame before I would need to liquidate the position, since the markets are cyclical. ALTHOUGH THE DOW HAD A NET INCREASE OF MORE THAN 150% IN THE LAST TEN YEARS, IT DECLINED CLOSE TO 25% IN THE LAST TWO YEARS. THEREFORE, DUE TO VOLATILITY, STOCKS AND MUTUAL FUNDS WOULD BE BETTER SUITED FOR AN INVESTOR WITH A LONGER TIME HORIZON. If I wanted high liquidity, I would be more apt to invest in savings accounts or stocks of companies with high trading volume and avoid long term investments like CD’s. IF I WERE TO INVEST IN VARIOUS PRIVATE BUSINESS PROJECTS, MY INVESTMENT WOULD BE VERY ILLIQUID AND DEPENDING ON THE TYPE OF CORPORATION OR BUSINESS, I COULD BE HELD FINANCIALLY ACCOUNTABLE FOR THE FIRM’S DEBTS BEYOND THE AMOUNT OF MY INVESTMENT. After determining my preferences, I would determine my personal discount rate for each investment, WHICH WOULD BE BASED ON THE RISK-FREE RATE OF RETURN, PLUS A MATURITY PREMIUM, INFLATION PREMIUM, AND default RISK PREMIUM, AND DISCOUNT THE FUTURE EXPECTED CASH FLOWS TO THE PRESENT AND CHOOSE THE INVESTMENT STRATEGIES WITH THE HIGHEST NET PRESENT VALUES. I WOULD DIVERSIFY AMONG VARIOUS OPPORTUNITIES TO REDUCE RISK.

 OK Economics was designed and it is maintained by Oldrich Kyn. To send me a message, please use one of the following addresses: okyn@bu.edu --- okyn@verizon.net This website contains the following sections: General  Economics: Economic Systems: Money and Banking: Past students: http://econc10.bu.edu/okyn/OKpers/okyn_pub_frame.htm Czech Republic Kyn’s Publications American education