CSR342.pdf

;<:--<;5):<;*773;5):<; ;]OI\W+PISZI^IZ\a .QN\P-LQ\QWV 8MZ[WVIT.QVIVKM\PZW]OP.IK\[ .QK\QWVIVL+WV^MZ[I\QWV − In print copy only − Online only Unmarked items are available both in print and online Street Smarts, Book Smarts: Personal Finance through Facts, Fiction and Conversation 5th Edition− Chakravarty, ISBN 10: 1−58152−787−X, ISBN−13: 978−1−58152−787−2 Table of Contents "Street Smarts, Book Smarts: Personal Finance through Facts, Fiction, and Conversation Title Page, Table of Contents, Foreward, and Pre−Course Questionnaire" by Chakravarty, Sugato i "Street Smarts, Book Smarts: Personal Finance through Facts, Fiction, and Conversation Chapter 1: Why Study Personal Finance?" by Chakravarty, Sugato 3 "Street Smarts, Book Smarts: Personal Finance through Facts, Fiction, and Conversation Chapter 2: Time Value of Money" by Chakravarty, Sugato 9 "Street Smarts, Book Smarts: Personal Finance through Facts, Fiction, and Conversation Chapter 3: What Are Stocks?" by Chakravarty, Sugato 23 "Street Smarts, Book Smarts: Personal Finance through Facts, Fiction, and Conversation Chapter 4: What?s in a (Fund) Name:Mutual, Exchange Traded, or Hedge?" by Chakravarty, Sugato 51 "Street Smarts, Book Smarts: Personal Finance through Facts, Fiction, and Conversation Chapter 5: Bonds" by Chakravarty, Sugato 75 "Street Smarts, Book Smarts: Personal Finance through Facts, Fiction, and Conversation Chapter 6: Pizza Coupons and Stock Options" by Chakravarty, Sugato 91 "Street Smarts, Book Smarts: Personal Finance through Facts, Fiction, and Conversation Chapter 7: Trading Assets" by Chakravarty, Sugato 111 "Street Smarts, Book Smarts: Personal Finance through Facts, Fiction, and Conversation Chapter 8: Advanced Topics" by Chakravarty, Sugato 135 "Street Smarts, Book Smarts: Personal Finance through Facts, Fiction, and Conversation Chapter 9: Consumer Credit" by Chakravarty, Sugato 155 "Street Smarts, Book Smarts: Personal Finance through Facts, Fiction, and Conversation Chapter 10: Life Insurance" by Chakravarty, Sugato 197 "Street Smarts, Book Smarts: Personal Finance through Facts, Fiction, and Conversation Chapter 11: Health and Property Insurance" by Chakravarty, Sugato 215 "Street Smarts, Book Smarts: Personal Finance through Facts, Fiction, and Conversation Chapter 12: Retirement" by Chakravarty, Sugato 239 "Street Smarts, Book Smarts: Personal Finance through Facts, Fiction, and Conversation Chapter 13: In Conclusion−The 50 Percent Rule" by Chakravarty, Sugato 263 "Street Smarts, Book Smarts: Personal Finance through Facts, Fiction, and Conversation Appendix" by Chakravarty, Sugato 269 "Street Smarts, Book Smarts: Personal Finance through Facts, Fiction, and Conversation Index, Post−Course Questionnaire" by Chakravarty, Sugato 323 Supplemental Reading: The Daily Economist "Supplemental Reading: The Daily Economist" "The Daily Economist: Risks We Take, Decisions We Make Front Cover" by Chakravarty, Sugato "The Daily Economist: Risks We Take, Decisions We Make Title Page, Table of Contents and Preface" by Chakravarty, Sugato i "The Daily Economist: Risks We Take, Decisions We Make Chapter One:The Economics of Grocery ClubMemberships: Supersize Me?" by Chakravarty, Sugato 1 "The Daily Economist: Risks We Take, Decisions We Make Chapter Two: Buy Online or Buy from a Regular Store? Hyperlink to Cyberspace" by Chakravarty, Sugato 7 "The Daily Economist: Risks We Take, Decisions We Make Chapter Three: The Economics of Bidding in eBay Auctions: Bid Goodbye to Good Ol? Buys" by Chakravarty, Sugato 11 "The Daily Economist: Risks We Take, Decisions We Make Chapter Four: Drive, Bike, or Bus to Work? The Fast or the Furious" by Chakravarty, Sugato 15 "The Daily Economist: Risks We Take, Decisions We Make Chapter Five: Buy a Newspaper or Read Online News? Leaf ?n Read or Click ?n Browse" by Chakravarty, Sugato 19 "The Daily Economist: Risks We Take, Decisions We Make Chapter Six: Regular Books or a Kindle?" by Chakravarty, Sugato 23 "The Daily Economist: Risks We Take, Decisions We Make Chapter Seven: Eat Out or Cook at Home?" by Chakravarty, Sugato 25 "The Daily Economist: Risks We Take, Decisions We Make Chapter Eight: Buy a Car or Lease It?" by Chakravarty, Sugato 29 "The Daily Economist: Risks We Take, Decisions We Make Chapter Nine: Rent an Apartment or Buy a House?" by Chakravarty, Sugato 33 "The Daily Economist: Risks We Take, Decisions We Make Chapter Ten: Should You Pay off Your Mortgage Ahead of Schedule?" by Chakravarty, Sugato 37 "The Daily Economist: Risks We Take, Decisions We Make Chapter Eleven: Cell Phones or Land Lines? I Just Called to Say−I Don?t Need You!" by Chakravarty, Sugato 41 "The Daily Economist: Risks We Take, Decisions We Make Chapter Twelve: What Kind of Credit Card Should You Sign Up For?" by Chakravarty, Sugato 43 "The Daily Economist: Risks We Take, Decisions We Make Chapter Thirteen: When Should You Buy That New Laptop?" by Chakravarty, Sugato 45 "The Daily Economist: Risks We Take, Decisions We Make Chapter Fourteen: Buy College Textbooks New or Buy Them Used?" by Chakravarty, Sugato 47 "The Daily Economist: Risks We Take, Decisions We Make Chapter Fifteen: Roth IRA or Traditional IRA?" by Chakravarty, Sugato 51 "The Daily Economist: Risks We Take, Decisions We Make Chapter Sixteen: When Is the Right Time to Buy Life Insurance, and What Kind Is Best?" by Chakravarty, Sugato 53 "The Daily Economist: Risks We Take, Decisions We Make Chapter Seventeen: Do Insurance Companies Want You to Live Longer or Die Sooner?" by Chakravarty, Sugato 57 "The Daily Economist: Risks We Take, Decisions We Make Chapter Eighteen: How Should We Use Technology in the Classroom?" by Chakravarty, Sugato 61 Street SmartS, Book SmartS Personal Finance through Facts, Fiction, and Conversation FIFtH edItIon Sugato Chakravarty Copley Custom Textbooks An imprint of XanEdu Publishing, Inc. Copyright © 2011 by FinTech Training, LLC. All rights reserved Printed in the United States of America digital ISBN 13: 978-1-58152-787-2 ISBN 10: 1-58152-787-X Print ISBN 13: 978-1-58152-788-9 ISBN 10: 1-58152-788-8 No part of this book may be reproduced in any manner without permission in writing from the publisher. Copley Custom Textbooks An imprint of XanEdu Publishing, Inc. 138 Great Road Acton, Massachusetts 01720 800.562.2147 Contents Foreword Dedication Pre-Course Questionnaire xi xiii xv Section A: Investments Chapter 1: Why Study Personal Finance? Evolution of the Financial Crisis Thought Questions 3 5 7 Chapter 2: Time Value of Money Bernard Madoff I Believe I Was a Ponzi Trader A Theory of Investment Decision Making The Reality of the Beta Trading versus Investing Discounting and Compounding Thought Questions Chapter 3: What Are Stocks? 9 10 12 13 14 16 16 22 23 Private and Public Companies Research on IPOs Importance of the Stock Price What Does Stock Ownership Provide? What to Look for When Buying Stocks Are All Stocks Equally Risky? Tracking Stocks Setting of Stock Prices Valuation of Stocks: The Dividend Growth Model Practical Ways to Tell If a Stock Price Is Too High or Too Low Finding Winning Companies The Top-Down Approach Beware of E-mail Scams The Saga of the Beardstown Ladies: Crooks or Just Naïve? Investor Sentiment and Overconfidence How Does Behavioral Finance Help (or Hurt) Individual Investors? 23 24 25 26 27 28 29 31 32 33 35 36 36 37 37 42 Contributed by Avandihar Subrahmanyam Stock Indexes: It’s All about the Pulse Thought Questions 44 47 iii . Gregoriou Linking the Pieces Together—and Then Some Thought Questions Chapter 5: Bonds 71 72 75 Who Issues Bonds? Important Information to Know about Bonds Bonds: What Are They Good For? Yet Another Benefit of U. or Hedge? Explosive Popularity Why Mutual Funds? Measuring Fund Performance It’s All in the Prospectus Index Mutual Funds Life-Cycle Funds Comparing Active and Passive Funds How to Pick Mutual Funds Research on Mutual Funds Exchange Traded Funds (ETF) Bond ETFs Risks of ETF Investment 51 52 52 55 56 58 60 61 61 61 63 65 66 Hedge Fund Protection in Bear Markets for the Retail Investor 68 Contributed by Greg N.S. Treasury Bonds How to Calculate Bond Yields Why Bond Yields Can Differ from Coupon Rates How to Make Money from Bonds Bond Ratings and Trading Strategies More on Bond Trading Strategies How Much of Your Portfolio Should Be in Bonds? Reverse Repos and the Orange County Fiasco Research on Bonds Thought Questions Chapter 6: Pizza Coupons and Stock Options What Are Options? Options and Pizza Coupons Long Call Options Put Options—For Investment Insurance Short Calls and Puts Pricing Options Properties of the Black-Scholes Option Pricing Formula Exercising Options iv 75 77 78 78 79 80 80 82 84 85 85 87 88 91 91 91 92 93 94 94 96 96 . Exchange Traded.Chapter 4: What’s in a (Fund) Name: Mutual. Gregoriou and Francois-Serge Lhabitant Thought Questions 108 Chapter 7: Trading Assets 111 Stock Tickers Where Your Stock Lists Is Important Too! Decimal Pricing Has Decimalization Cut into Wall Street’s Profit Margins? The Bid-Ask Spread The Saga of Wide Spreads Increased Market Volatility How to Reduce Excess Volatility in Our Stock Markets How to Narrow Down Your List of Stocks Basic Rules of Trading and Investing Shopping for Stocks Buying on Margin and Short Selling When to Sell Trading on Trends Are Moving Averages an Effective Investment Tool? The Research Evidence Thought Questions Chapter 8: Advanced Topics 111 112 114 114 115 116 117 118 119 123 125 128 130 131 132 133 135 Stock Analysts Leveling the Playing Field through Regulation Fair Disclosure Stock Splits Why Do Companies Split Their Shares? Reverse Stock Splits Insider Trading Martha Stewart and Insider Trading The Story of a High School Trader Stealth Trading Intermarket Sweep Orders (ISO) Games That Large Investors Play Shifting Gears Thought Questions v 135 137 137 137 138 139 141 142 143 145 146 147 149 .What If You Want Out of Your Contract? How Are Options Similar to Stocks? How Do Options Differ from Stocks? Research on Options Credit Default Swaps (CDS) The Credit Default Swap (CDS) Market 97 97 97 97 98 100 S. G. Badrinath Madoff: A Path Littered with Clues 102 Greg N. Responsibility. and Disclosure (CARD) Act of 2009 Street Smarts: A Real-Life Example Research on Consumer Lending Microcredit—A Revolutionary Loan Concept By Abu Zafar Shahriar Thought Questions Appendix A to Chapter 9 Appendix B to Chapter 9 Section B: Action Plan 155 156 157 158 159 159 160 162 164 165 165 168 169 169 170 172 173 175 176 181 185 189 193 Section C: Insurance Chapter 10: Life Insurance 197 Insurance Basics Ways to Deal with Risk What Is Underwriting? Do You Really Need Life Insurance? Specific Steps to Calculate Your Life Insurance Needs Types of Life Insurance Borrowing from Insurance vi 197 198 198 200 201 202 205 .Section A: Action Plan 151 Section B: Credit Chapter 9: Consumer Credit 155 Banking in a Different Culture Fast-Forward to the Present: Why Do We Need Credit? Credit Use in the United States How Credit Cards Work The Importance of Your Credit History How Lenders Use Your Credit Score Your Credit Report: Make Sure You Know Its Contents How Do You Score? The Invasion of the Credit Cards New Rules to Increase the Minimum Payments on Your Credit Card Balance Eleven Ways to Repair Credit and Pay Back Credit Card Debt The Bankruptcy Abuse Prevention and Consumer Protection Act The Look-Alikes: Debit Cards Credit Counseling What You Can Do to Protect Yourself against Identity Theft The Credit Care Accountability. An Insurance Mistake to Avoid Thought Questions Appendix to Chapter 10 Chapter 11: Health and Property Insurance Health Insurance Optimal Design of Health Insurance Contracts Major Providers of Health Insurance Types of Medical Expense Coverage Health Insurance Coverage You Don’t Need Sobering Statistics Long-Term Care Insurance Disability Income Insurance Property Insurance Homeowner’s Insurance Mortgage Insurance Avoid Paying Mortgage Insurance Renter’s Insurance Auto Insurance Other Types of Property and Liability Insurance Intuition from Insurance Research Bringing It Together: Shop Around for the Right Policy Thought Questions Section C: Action Plan 207 208 211 215 215 216 217 217 219 220 221 222 223 223 225 225 226 226 228 229 230 233 235 Section D: Retirement Chapter 12: Retirement We Are All Potential Millionaires The Three-Legged Stool The First Leg—Social Security How Do We Tackle the Problem of the Shrinking Social Security Fund? The Bush and Obama Plans for Social Security Who Qualifies for Retirement Benefits? Disability Insurance under Social Security The Second Leg—Pension Qualified versus Nonqualified Plans Defined Benefit versus Defined Contribution The Most Popular Defined Contribution Plan: The 401(k) Word of Warning about Borrowing from Your 401(k): Don’t! Other Types of Defined Contribution Plans Vesting The Third Leg: Do It on Your Own vii 239 239 241 241 243 243 245 246 246 246 247 248 249 249 250 250 . The Most Important Form of IRA: The Roth IRA Other Types of IRAs Retirement FAQs Thought Questions Appendix to Chapter 12 251 253 253 257 259 Section D: Action Plan 261 Chapter 13: In Conclusion—The 50 Percent Rule 263 A Prescription for Living while in College After Graduation—Invoke the 80–20 Rule In Your Thirties and Forties—Move to 70–30 In Your Fifties—Think 50–50 In Your Sixties and Seventies—Move to 35–65 In Your Eighties—Think 20–80 264 264 265 266 266 267 A Guide to Understanding Time Value of Money TVM Awareness Quiz 271 Answers 272 The Basics 273 Why Should I Learn Time Value of Money? The Time Value of Money The Intuition behind TVM Why Time? How Can We Compute Amounts in Different Time Periods? Simple Interest Defining Present and Future Values Exponential Growth under Compounding Single Sum Problems 273 373 274 274 274 275 275 275 277 Future Value of a Single Sum Examples Present Value of a Single Sum Some Examples Frequency of Compounding Frequency of Compounding Example Nominal Interest Rates Federal Funds Flow Rates Relationship between Mortgage Rates and Federal Funds Rate Effective Annual Interest Rate viii 277 278 278 279 280 280 281 281 282 282 . Cash Flows. Present Value: A Real World Story Specific Applications of Annuities in the Various Areas of Personal Finance Bond Pricing Examples A Stock Pricing Example Amortizing a Loan Application of Loan Amortization to Automobile Refinancing Credit Cards and TVM Application of TVM to Insurance Application of TVM to Retirement General TVM Examples The Ultimate TVM Challenge Problems TVM Is Everywhere Index Post-Course Questionnaire About the Author Testimonials 286 287 287 288 288 289 297 297 300 302 302 304 305 309 310 310 314 315 315 318 323 329 333 334 ix . Annuity.Annuities 286 Learn to Recognize Annuities Word of Warning How to Solve Annuity Problems Annuity Formulas Formulas or Tables? Solving Annuity Problems Quick Practice Problems Involving Annuities More Annuity Practice Problems Time Value. . and the world begins to look like a very dark place. then scampered around and some of us even withdrew our money from the bank and stored in under our pillows. Most of us had not faced this kind of a world ending proposition in our lifetimes. I was hungry to distill the concepts and intuition gleaned from cutting edge research (including some of my own work) and to convey the findings and their implications to my students. infuse them with some stories and anecdotes I had heard growing up. mix in my own life experiences as an individual from a very different country and culture. All this makes the area of personal finance a particularly important topic for a book. and write it all up in a conversational (and somewhat of a tongue-in-cheek) style without losing intellectual rigor. I decided to throw some of my lecture notes together.S. I was trained to read and understand research papers on the subject of finance. As the world almost collapsed under the weight of the U. My goal was to write a non-traditional textbook grounded in theory but with the entertainment value of a storybook. While there was a lot of information between the covers. Unfortunately. it was just around the time the Internet was coming into its own. Add to this the reality of Social Security not being able to meet its commitments to our senior citizens and Medicare as we know it being severely curtailed. there was nobody in the personal finance textbook market who was thinking like I was.Foreword May we always live in such interesting times! The last few years have been an economist’s dream. We. insurance. etc. I remember being extremely disappointed with the available set of text books I had to choose from. That was over ten years ago! xi . this implied that the world almost came to a standstill. which was like an insurance market for the powerful institutions. The big question: why this book in particular? When I started teaching personal finance many years ago. statistics. we have the recipe of impending doom with little respite in sight. subprime mortgage market. their presentation and lack of a theoretical framework made instruction seem almost recipe-driven with little regard to the “whys” of the issues. the world was a relatively simpler place.. the little guys. Substance and fun! Being an action-oriented person. added to the woes and further exacerbated the overall sense of disaster. The failure of the credit default swap market. And since the world functions on credit. whether it is through the fine print (written in legalese) or through stealing our identities. Add to this volatile mix the fact that people and organizations are lurking at every corner to try and separate us from our hard earned money. banks and other lending institutions went into a hole and refused to lend—not to borrowers and not even to one another. Possessing a doctorate in finance from a reputed business school. but none of this was covered in any significant sense in any of the books on personal finance. Those early experiments had mixed success and I quickly learned what worked and what didn’t. all the while making sure the narrative flowed smoothly and all of it made sense. I want to offer her a profound vote of thanks for a job well done. the bad. when the dust settles and the cows come home. more recently. and. Professor Amber Anand from Syracuse University. If some of you get pleasure out of reading the book and learn a thing or two. Generations of undergraduate students have provided me with their own feedback and. who went over and beyond his role as a publisher’s representative in personally working to ensure the minimization of typos and other omissions to give the book a professional finish. and the ugly. There is no professional glory in this for me other than the childlike delight in communicating material I love in a way that people of all ages and educational background can understand and appreciate with relative ease. I made quick course corrections and kept on tweaking and building on that foundation. generations of undergraduate and graduate students as well as colleagues and friends provided their own feedback—the good. it is all a labor of love. who worked tirelessly on the book and updated statistics. Just because something sounded profound or funny in my head did not necessarily translate as such on the written page. Lucy Miskin and her team at Copley Custom Textbooks provided the book with much of its current look and feel. This most recent edition owes a big debt of gratitude to Rebecca Myrick of Copley Custom Textbooks. Indiana xii . through it all. and deleted material. At the end of the day. While personally accepting the blame for any and all of the remaining errors in the book. corrected the writing. Professors Robert Wood and Christine Jiang from the University of Memphis. Mariya Pylypiv. Go forth and prosper! Sugato Chakravarty West Lafayette. the book kept evolving. the current form of the book slowly took shape. I look forward to seeing his art work in major galleries in the not-too-distant future. Through those early tentative steps. and Professor Richard Feinberg from Purdue University stand out in that regard. The jacket was designed by a very talented graduate student of mine and a gifted artist in his own right—Atul Todi. Graduate students with significant impact in those early years include Robert Scherer. Along the way. I would consider my decade-long experiment a success. I also owe a significant debt of gratitude to Kent Brewster. moved things around. Adam Hagen. Her suggestions were almost always right on the money. and Matthew. my inlaws.This edition is dedicated to: My wife (Ajita). Baby. who teach me the true meaning of unconditional love every day. Amma and Papa (Vrinda and Paleth Narayan). and Figaro. xiii . . Pre-Course Questionnaire . . I believe I am a risk taker. Working on your mind by solving puzzles and brain teasers d. Goal-oriented d. Could go either way d. Working on your body in the gym e. Working on your wardrobe c. Which of the following activities gives you most pleasure? a. Driven e. Strongly disagree b. Accommodating c. Agree e. Strongly disagree b. Disagree c. Working on your tan b.Pre-Course Questionnaire Name: ___________________________________________________________________ Age: ______________ Gender: M / F Major: __________________________________________________________________ School/College: __________________________________________________________ Class: __________________________________________________________________ Home State: _____________________________________________________________ General Questions 1. a. Disagree c. Which describes you best? a. I am very comfortable allowing others to run my life. Sleeping xvii . Could go either way d. Agree e. a. Strongly agree 3. Laid back b. Strongly agree 4. Get out of my way! 2. Agree e. a. Strongly disagree b. Could go either way d. Agree e. Strongly agree Course Specific Questions 9. “Get rich quick” books f. Disagree c. Suspense/thriller d. I hate uncertainties with any aspect of my life. I love for everything to be predictable. Strongly agree 7. Strictly nonfiction c. Disagree c. a. Agree e. What type of books do you read for pleasure? a. Could go either way d. Strongly agree xviii . Strongly disagree b. I believe investing is only for those with lots of money. Strongly agree 8.5. Strongly disagree b. Could go either way d. Disagree c. I get less pleasure from winning $100 relative to the pain I feel when I lose $100. Could go either way d. Strongly disagree b. Science fiction/comics e. Agree e. I love the uncertainty of jumping into any new experience. Romance novels b. a. a. Reading is for the birds. 6. Disagree c. I plan to hire professional financial planners to make those decisions on my behalf. Could go either way d. I know how to pick stocks/mutual funds. a. I know what an ETF is. Strongly disagree b. In the future. I am not in favor of making investment decisions myself. Strongly disagree b. Could go either way d. Disagree c. a. Strongly agree 14. Agree e. a. Agree e. Agree e. Strongly disagree b. a. Only qualified professionals should be making investing decisions—not individuals like me. Agree e. a. Could go either way d. Strongly agree 15. a. Disagree c. Could go either way d. Could go either way d. I know I will never use them in my life. Strongly agree 13. Disagree c. Could go either way d. Strongly disagree b. Strongly agree 12. Strongly agree xix . I believe that mutual funds are the only way to invest—individual stocks are for the professional investors only. Strongly disagree b. Agree e. Disagree c.10. Strongly disagree b. Strongly agree 11. Disagree c. Agree e. Time-value-of-money (TVM) concepts are a total waste of my time. Disagree c. Strongly disagree b. Agree e. a. Strongly agree 17. Strongly disagree b. Strongly disagree b. I know what a Roth IRA is. Agree e. a. Strongly agree 20. I will consider it when I am older and have money to spare. a. Could go either way d. a. Disagree c. Credit cards are wonderful things. could go either way d.16. I wish I had more of them. Disagree c. I believe that I am too young to think about planning for retirement. Could go either way d. Could go either way d. Disagree c. Strongly agree 19. Could go either way d. Strongly disagree b. Disagree c. Agree e. Disagree c. Agree e. Strongly agree 18. Agree e. Strongly agree xx . I know all there is to know about insurance. This class cannot teach me anything new. a. Strongly disagree b. Checking my credit report is a waste of my time. Section A: Investments . . and skills actually held by most American adults and those needed to understand the sophisticated markets cannot be bridged by financial literacy education. balance computation methods. a few senior bank executives are plotting away in the dead of night. comprehension.1 Why Study Personal Finance? Success is where preparation and opportunity meet. The purpose: to devise innovative strategies to ensure profits while simultaneously appearing to be sympathetic and helpful to the masses. while about half of the adults in the U. in itself. if we all became educated consumers. who are approaching retirement. You see the cynical logic at work here? Picture this: In a boardroom in New York City. For instance. Credit card companies wouldn’t be able gouge consumers with late fees and outrageous fines if those consumers were able to understand how to avoid those charges. cannot read beyond the eighth grade level. these companies would lose their advantage. “Here’s how we approach this: We start 3 . and compounding and amortization calculations involving annuity-type cash flows. As such. A 2006 survey found that over 80 percent of the baby boomers. Finally. Consumers need to understand these operations in order to understand which calculations to perform. the critics say that the fact that financial services companies finance a lot of the efforts to educate consumers is. Their arguments are based on a belief that the gap between the knowledge. could not correctly answer the following question: “You have $200 in a savings account that earns 10 percent interest per year. money. consumers are at a disadvantage. Furthermore. a reading assessment of credit card holder agreements found that information regarding grace periods. Most adults do not understand future value calculations involving either single sums or annuities. and therefore more likely to make financial decisions that cause them to lose money in the long run. After all. Bill pipes up: “I think I have it!” He seems excited even though he is tired and sleep-deprived. How much would you have in the account at the end of two years?” The critics of financial literacy education further argue that evaluating financial decisions often requires multiplication. division. —Bobby Unser There are scholars who argue that studying personal finance or gaining financial literacy is a waste of time. and payment allocation methods was written at an advanced college level. proof of the fact that they don’t work. The industry has a huge advantage because of Americans’ lack of knowledge about financial services. and thus.S. The night has been long and many ideas have been rejected. 4 Chapter One to fund various financial literacy initiatives across the country. Long after we are gone. We have to do the best we can to educate ourselves so that we can meet the industry halfway. compounding. but we know our ‘efforts’ will be ineffective. in a sense. policy makers.” The rest of the room agrees and the financial literacy program funded by the financial services industry is born. We have to understand the basics of discounting. Our customers will see us as the good guys . I will talk to the legal department tomorrow to find out if we can write some of the expenditure off. We have to understand the rudiments of stocks. We don’t have to become financial experts. We might as well get a head start. and economists. “What do you think about that?” The rest of the room is hushed. . let’s get back to the question: why study personal finance if it may not even help us? We should study personal finance not because we will become instant experts and be able to skillfully naviagate our way through the complex industry as it currently is. and we continue to clear our profit margins. In some sense. Bill! We pretend to want to help our customers. That is not realistic. . The supposed purpose of this initiative will be to educate consumers. So.” and here Bill’s voice drops. Finally. At no other time in our history over the last eighty years has it been more important for us to understand the basics of the financial products we deal with either directly or indirectly. . I disagree with the cynics who say we should not bother educating ourselves about finances because it is a waste of time. But before we start with financial literacy. However. so the industry is forced to provide answers we can all understand. which will create a lot of goodwill. and interest rate calculations. . valuations. Does this seem like a realistic scenario to you? Not to me. We have to ask the right questions. to be living through an event that will be important in our history. “Except we know that these initiatives don’t work. except . and mutual funds. the current financial crisis will be analyzed by future historians. . We are fortunate. bonds. Doing nothing is never an option. it is even more important now than in the 1930s because of the added complexity of the industry today. Our customers will not really improve their financial literacy and we will continue to make money while creating good buzz about our initiatives!” Bill stops and looks around. let’s take a moment and examine the evolution of the first global financial crisis of the twenty-first century. we have to know enough to get them to meet us halfway. Examining how each separate piece came together in such a devastating manner to create the perfect financial storm is a lesson in itself—one that will be debated for centuries to come. We are currently experiencing the worst financial crisis since the Great Depression of the 1930s and we certainly cannot “do nothing” now. a realistic goal is to know enough to be able to spot the traps and ask the hard questions. Megan breaks the silence. We have to understand the basics of risk and return and how to invest our hard-earned dollars in ways that will generate maximum wealth for us later in life. He is going to deliver the punch line. “It’s absolutely brilliant. We have to understand risk and insurance pricing so we can be aware of how our insurance premiums are calculated. Let’s educate ourselves in the ways of finance so we can ask the right questions. . We shouldn’t have to do all the work ourselves. Why Study Personal Finance? 5 Evolution of the Financial Crisis It is important to examine the root circumstances of the current financial crisis and how it evolved before analyzing the potential effects of various government actions. It is interesting to note that some of the same mechanisms that fuel an economy’s growth at one point in time can actually contribute to its decline at a different point in time, which is essentially where we are today. Some of the events of the last decade, when considered in isolation, could be considered innocuous or even beneficial to the economy. Similar to unintended negative interactions between medications that, individually, are useful in treating disease, the financial catastrophe that we are experiencing is the result of an interaction of circumstances in the financial sector. Over the last decade, strides were taken to ensure that small-scale investors had essentially the same tools as the largest Wall Street bankers. This empowerment and democratization of the investment landscape meant that millions of people were now able to participate in markets. In this new client pool, Wall Street saw a huge opportunity. They turned their attention to the nation’s top business schools, hiring hundreds of PhDs in mathematics and business who had the skills to combine finance with high-speed computing to create exceedingly complex financial derivative products. These products were so complicated that even the banks themselves had an incomplete understanding of the risks involved. Once the products were created, the marketing machinery went to work, and millions of new investors were convinced that these products represented wonderful new investment opportunities. It was a classic case of “the blind leading the blind.” While Wall Street’s marketing machinery was pulling thousands of new investors into their esoteric investment products, their lobbyists were hard at work in Washington convincing the nation’s lawmakers to ease up on financial regulations, arguing that this would allow U.S. investment companies to compete on the global stage and improve their international image. The lawmakers were convinced, and they started tinkering with policies that had been in place for many decades in order to give more power to the Wall Street giants. These events led to certain policy shifts at the federal level that occured at the end of the twentieth century and the beginning of the twenty-first that are important contributors to the current financial situation. The Gramm-Leach-Bliley Act and the Commodities and Modernization Act were passed in 1999 and 2001, respectively. This legislation essentially rescinded the banking regulations that were put in place by the Glass Steagall Act (and subsequently by the Bank Holding Company Act of 1956), which established the Federal Deposit Insurance Corporation and also placed barriers between commercial banks and investment banks. This legislation was instituted in 1933 in the wake of the 1929 stock market crash. Specifically, the Gramm-Leach-Bliley Act of 1999 essentially removed those barriers and allowed commercial banks to operate as investment banks. The justification for this was that it would better allow U.S. banks to compete internationally, as many foreign banks were not so constrained. 6 Chapter One The new administration in 2000 gave the Federal National Mortgage Association (also known as Fannie Mae) and the Federal Home Loan Mortgage Corporation (also known as Freddie Mac) the task of increasing home ownership in the U.S. At some point, it was decided that this goal should be reached without consideration for the buyers’ ability to sustain ownership. Such unwise lending required a mechanism to insure against default, and the so-called Credit Default Swap (CDS) fit the bill. Initially, CDS contracts were meant to apply to municipal bonds, corporate debt, and mortgage securities and were sold by banks, hedge funds, and other institutions. However, in the past decade, these CDS contracts expanded into structured finance contracts that contained pools of mortgages. Importantly, these pools contained subprime borrowers who were increasingly given loans through the Fannie Mae and Freddie Mac programs. In isolation, CDS is an insurance contract taken out by banks to protect their loans against default, much like an individual or family would secure a homeowner’s insurance policy to protect their investment in a home. However, by referring to them as swaps (and not insurance) they became classified as investment products rather than insurance products. This allowed the CDS industry to avoid the regulation and scrutiny that applies to the insurance industry and rendered CDS totally outside the purview of any regulatory mechanism. The ingredients for an implosion were all in place by early 2005. All that was needed was a spark to set it off. That spark came in the form of a downturn in the housing market, which resulted in a wave of defaults by subprime borrowers. This caused the holders (all major banks) of trillions of dollars in CDS contracts to exercise their option to trigger the insurance policies. Unfortunately, there was no one to honor them because, thanks to deregulation, the banks had sold and resold the credit default swaps to investors across the globe who had no interest in the original contracts. They had simply bet on them, much like a gambler might bet on the outcome of a sports competition. To these speculators, the credit default swaps were Credit Default Swaps These insurance-like contracts became infamous around the middle of 2008, when it was revealed to a largely unsuspecting world that these little-known products were behind much of the global financial meltdown. At its height in the middle of 2007, the CDS market was worth almost $50 trillion—many times the worth of the U.S. stock markets. CDS contracts are insurance contracts that promise to cover the losses of the underlying financial products in the event of a default. That is precisely what any insurance product— like homeowners’ insurance, for example—would do. CDS contracts were designed to insure municipal bonds, corporate bonds, and mortgage securities and were sold by banks and hedge funds. The buyer of a CDS contract would pay premiums with the knowledge that if something bad happened to his financial product the seller of the CDS would reimburse him his losses—which is still exactly like any standard insurance product. The problem, however, was that while standard banks and standard insurance companies are heavily regulated, the CDS market was not. Consequently, CDS contracts could be traded or swapped in secondary markets, just like stocks and bonds. Since the market was not regulated, there was no one ensuring that the buyers of these contracts had the financial capacity to honor them in the event of a default of the underlying security. Why Study Personal Finance? 7 purely a speculative position of high risk. Defaults in the CDS market very quickly led to great uncertainty concerning the financial positions of major banks that held these mortgage-backed securities. It was difficult for the banks themselves to determine the exact value of their CDS portfolio, so it was nearly impossible for potential creditors to evaluate the ability of the banks to repay loans. Thus, the great risk to the economy was that this uncertainty reduced and threatened to halt the willingness of banks to lend to one another, creating a liquidity crisis in financial markets. In such a situation, there is great potential that businesses will find it impossible to secure operating capital and will be forced to shut down. We have seen the first signs of borrowing limits, and if this kind of a crisis were to truly take hold, the result would be a halted economy and panic in the banking sector, which would eventually lead to a very severe recession or even depression. Recent Congressional action was designed to loosen lending between banks and provide liquidity to capital markets. What has not happened to date is a reassessment of regulations such as the Glass Steagall Act and the Gramm-Leach-Bliley Act to close loopholes in the regulation of banking and investment activities. The Japanese crisis of the early 1990s provides one final note of caution. During this crisis, the central bank of Japan employed an approach similar to that which the Federal Reserve and the Treasury are now taking. The Japanese were not successful in stemming an economy-wide recession that lasted over a decade. It is not known at this point how severe the U.S. recession will be and how long will it last. Granted, the American economy is more resilient than the Japanese economy ever was. The ability of our economy to withstand a macro shock and still be a dominant force is far better than that of any other country. This can give us hope that we will come out of this recession even stronger with the help of some fundamental structural changes. The question is, when? In sum, the world has become a significantly uncertain place—both because of the dizzying array of goods and services that consumers have access to and because the world itself has become more uncertain, even dangerous, as evidenced by the recent near meltdown of global finance and the ever present threat of global terrorism. In light of such developments, it behooves us to be educated so that we may help ourselves avoid the various financial pitfalls. We must learn to ask the right questions and force the other side to explain the answers in a way that makes sense—to us. That is also the goal of this book: to provide you with the tools to empower you to ask the right questions as you move along your path in life. Thought Questions 1. Do you believe studying personal finance is a waste of your time? 2. It is clear that every action has a benefit and a cost even if some of the costs are not immediately obvious, and instead reveal themselves over time? Can you think of other examples in your life or in the world around you where an action intended to have a positive result turned out to have a negative one? 8 Chapter One 3. Should Congress repeal the Gramm-Leach-Bliley Act and revert to the way banks operated under the Glass Steagall Act? 4. Does every American deserve to own a home? Why or why not? 2 Time Value of Money Take a chance! All life is a chance. The man who goes the furthest is generally the one who is willing to do and dare. The “sure thing” boat never gets far from shore. —Dale Carnegie As a teenager, stocks were not a part of my vocabulary, nor a part of the vocabulary of anyone I knew. Even my parents, who were very educated people, had no clue about stocks! My parents had a bank account, and they invested some of their money in a “chit fund,” where their money would earn periodic interest. In hindsight, it is shocking that they would invest their hard-earned money this way when they did not have an understanding of the safety or investment practices of such institutions. To them, these seemed like minor technicalities. Everybody trusted these funds, but they were ignorant of how they worked, why they were (or were not) smart investments, or whether there were better investments to be had elsewhere. I don’t know why no one worried about such things—perhaps we are just exceptionally trusting people. More careful analysis of these chit funds makes clear that they were nothing more than Ponzi schemes designed to lure new investors with promises of astronomical interest payments. The schemes needed a constant influx of new investors whose money was used to make the interest payments promised to the older investors. As long as the new investors were depositing more money than was owed in interest payments, the Ponzi scheme kept going. The trick in these rackets was to be first in the line. I say “racket” because it was an exploitative scheme designed to separate unsuspecting investors from their money. The funds never actually got invested anywhere—they were just used to pay off the earlier investors to keep them happy while new investors came in expecting huge returns. In such setups, the relative newcomers were the ones who were hurt the most, because the scheme would collapse before they could recover their money. There was no government regulation of these schemes. Bribery was rampant, and all the architect of a Ponzi scheme had to do to ensure success was engage in a few strategic payoffs to senior government and police officials. The chit fund my parents invested in had a colossal payout of 48 percent. One of my uncles had opened an account and was raking in money. He decided to tell my father about his incredible investment. My father was a physics professor, and about as worldly as the next professor. What did not occur to him, or to anybody else around us, was that the interest rates 9 10 Chapter Two Charles Ponzi Ponzi schemes are a type of illegal pyramid scheme named after Charles Ponzi, who duped thousands of New England residents into investing in a postage stamp speculation scheme in the 1920s. The idea behind the scheme was to take advantage of differences between U.S. and foreign currencies used to buy and sell international mail coupons. Ponzi promised his investors he could provide them with a 40 percent return in just ninety days, compared to the 5 percent offered by bank savings accounts in those days. Not surprisingly, Ponzi was deluged with funds from investors, taking in $1 million during one three-hour period—and this was 1921! Though a few early investors were paid off to make the scheme look legitimate, an investigation later discovered that Ponzi had, in fact, only purchased about $30 worth of the international mail coupons. Over time, the term Ponzi scheme has come to denote the concept of robbing one to pay another. In other words, the money from new investors is used to pay off the earlier investors. The scheme continues as long as enough new investors come in. As soon as the stream of new investors starts drying up, the scheme unravels. paid out were too high to be the result of legitimate investments. My father did not have “rational expectations.” Remember the old cliché, if it is too good to be true, it probably is? Obviously, he had not yet taken this maxim to heart. Nobody questioned how the interest rate could be so high, how the money was being invested, or what the average return on investment was. Everybody simply trusted the system. My parents thought they had invested in an excellent fund that would provide high returns for everyone. For a while, things went very well. My parents received those incredibly high interest rates. But, they eventually made the cardinal mistake that even those well educated in the ways of finance make when trying to make money in the markets: they got greedy. They invested more of their money in this scheme. My parents had no idea what Ponzi schemes were, so it is hardly surprising that they—along with many others lured by promises of riches—lost their entire investment capital when the scheme finally came crashing down. However, the organizers of the scheme and their friends and family (who were early entrants) made fabulous amounts of money and recovered their initial investments many times over. Luckily, the police eventually apprehended the brains behind this particular Ponzi scheme. My parents never spoke of it again. The embarrassment was too much to bear, so denial was their remedy. In fact, I never heard them consider any form of investing again. Their sole investment activity after that was the measly returns they received from their savings account at the bank. Bernard Madoff Bernie Madoff was a genial, well-known Wall Street legend that many people admired. He got started in the 1960s by trading penny stocks that were considered risky by most of his peers. He earned his profits by pocketing the bid-ask spread, which we will discuss later in the book. He promised his customers a penny a share discount for trading with him, which was a legal practice used to generate business. Time Value of Money 11 In the 1990s, as the stock market boomed, he began courting the regulators in Washington. This was a smart tactic; he was hoping that if he was considered one of the regulators, no one would think to investigate him. And he was right. The Securities and Exchange Commission (SEC) used to consult with Madoff about a variety of issues related to the stock markets. As Madoff’s reputation grew, investors around the world clamored to invest their money with him. They were You should ask questions about any investment dazzled by his ability to constantly deliver opportunity you come across before you invest. steady returns, regardless of market con- Such prudence will save you a lot of headaches, ditions. No one seemed too concerned and maybe even heartaches, later. about how he was able to do this. He was able to cultivate such an exclusive image of himself that he did not even have to sell his services—people were begging him to take them on as clients. And as long as these new investors continued to come, all he had to do was take their money and use it to pay off the older investors. No one knew he was simply running a Ponzi scheme. As the Internet bubble took hold in the mid-1990s, Madoff’s fortunes took off. Many people were suddenly making a lot of money, and a good deal of them turned to Madoff to invest it. This scheme continued unabated until the very end of 2008, when the slowing economy finally caught up to Madoff. He was no longer bringing in enough new investors to pay returns owed to the earlier investors. At this point, he decided to confess his scheme to his sons, who immediately notified the authorities. On March 12, 2009, Madoff pleaded guilty to eleven federal felonies, including securities fraud, wire fraud, mail fraud, money laundering, making false statements, perjury, and filing false reports with the SEC. His accountant, David Friehling, and his business partner, Frank DiPascali, also pleaded guilty to various crimes. The public eventually learned that Madoff had defrauded clients of nearly $65 billion—the largest Ponzi scheme in history. In his allocution, he admitted that he had never made a single legitimate investment with the money; instead, he simply deposited the “investments” into an account at Chase Manhattan Bank and withdrew funds from the same account when his clients requested returns. Later in 2009, Madoff was sentenced to 150 years in federal prison, the maximum allowable sentence. His projected release date is November 14, 2139. The case of Bernie Madoff goes to show that it is not always easy to identify a con artist. They can be our friends, relaUnfortunately, this same scenario, although not tives, or loved ones. Sometimes their proxon such a large scale, gets repeated over and imity makes us blind to the red flags that over again all over the world. People get into are usually there. In Madoff’s case, the red investments they have little understanding of, flag was the fact that he could deliver the lose their money, and subsequently develop a fear of all investments. Hopefully, after you have same returns year after year, good market read this book you will no longer be afraid of divor bad. It is human nature to avoid asking ing into the investment pool. the hard questions if things are working Ask the Right Questions BIG PICTURE 12 Chapter Two A Bubble Bubble is the term applied to an environment in which prices appreciate in ways that defy common sense due to investment euphoria, driving prices sky-high. It is actually quite similar to a Ponzi scheme, except that a bubble is a market-wide phenomenon and is not illegal, while a Ponzi scheme, with its premeditated actions by one or a few individuals, is explicitly illegal. As long as enough new investors come into the market, the bubble continues to grow. But sooner or later, the market runs out of new investors. The astronomically high prices induce some investors to start selling, making huge profits. But this usually starts an avalanche of selling; the prices come crashing back down to reasonable levels and the bubble bursts. The first financial bubble in the modern world was the tulip bulb bubble in Holland, which began in November 1636. The bubble burst in February 1637 when prices fell to insignificant levels, causing defaults on many outstanding contracts. out well for us, but that is exactly the wrong thing to do. If the lesson of Bernard Madoff does not teach us to question an investment that seems too good to be true, nothing else will. I Believe I Was a Ponzi Trader Reflecting on my childhood I now see that I once briefly ran my own small-scale Ponzi scheme. I was about ten years old and I did not know what a Ponzi scheme was, let alone that I was running one. Every day my father walked me to the corner of our street where the school bus would pick me up. The local candy store was on the way, and he would always buy me my favorite soft malted candies. I absolutely loved them and could never get enough. One day, however, my father was busy and could not take me to the bus stop, so the responsibility of taking me to the bus fell on one of our household employees. The employee did not have the money to buy me my malted candies. I was desperate; I needed my candy fix! I had to think on my feet. I told the employee that we had to make a slight detour to the store. I managed to talk the store owner into giving me the candies by convincing him that my father would pay him back extra tomorrow for this small favor he was doing for me today. He agreed. The next day my father happened to be busy again, so I repeated my performance for the candy store owner and once again told him that he would get his due plus something extra from my father for giving me my candy. This went on for a week or Famous Clients of Bernard Madoff Since the arrest of Bernard Madoff, the famous financier who could deliver incredible returns to his clients year after year, details of some of his famous clients have emerged. They include such diverse personalities as Steven Spielberg, Mort Zuckerman, John Malkovich, Henry Kissinger, Barbara Bach, Sandy Koufax, and John Denver Enterprises; banks such as HSBC; many charitable organizations; a foundation run by holocaust survivor Elie Wiesel; Austriaʼs Bank Medici; as well as Madoffʼs personal lawyer, Ira Sorkin (isnʼt that ironic?). We will discuss the This second measure captures the risk of the indexes later in the book. The higher the volatility. . It is call the Capital Asset Pricing Model (CAPM): Expected Return = risk-free return + sensitivity x expected market risk premium This formula captures the intuition that the expected risk premium (the extra return we would expect over that from a risk-free investment) is directly proportional to the risk sensitivity term above. That is. alternatively. A Theory of Investment Decision Making The theory of investment decision making is The risk-free rate is assumed to be the embodied in the well-known Modern rate paid on short-term Treasury bills of Portfolio Theory (MPT). CAPM is a useful formula for everybody. who use it to determine if a new investment is worth making. including corporate managers. I clearly did not understand the trade-off between short-term gains and long-term pains! But.” As individual investors. was piling up debt to the store owner. We will demand additional return on our investments for holding additional risk. Government. CAPM is simple. We will even give up some potential gains and instead choose a lower. I definitely understood that trade-off about a week later. who use it to decide if a stock is worth purchasing. The basis of MPT rests in analyzing all investments based on the U. we will demand greater compensation for taking on this added risk. we are presumed to be risk-averse. As the underlying risk of our investment increases. This relationship between risk and return is one that you should be cognizant of at all times. and individual investors. My father paid him and then came home to take up the matter with me. An important financial formula illustrates this relationship between risk and return. but the potential to get it must exist in order for us to take on more risk.Time Value of Money 13 so. mine unraveled quickly. The expected market risk premium is usually computed two important numbers: the mean return from the historical average on the market and the fluctuation of returns around the portfolio. we like certainties and dislike uncertainties. known as beta. the greater the risk of the investment. I was getting my regular candy fix and my dad. value. when the store owner happened to run into my father on the street and mentioned all the money (including the extras) that my father owed him. which we will revisit in future chapters. Investors should always seek combinations of investment assets that provide the highest mean return for a given level of risk or. but certain. the lowest level of risk for a given level of return. the S&P 500 Index.S. which is widely accepted to be mean (also known as variance or volatility). The academic term for this ideal investment situation is the “efficient frontier. and I was candyless for quite a while after that. which makes it easily accessible. investment. unknowingly. We may not always get that additional return. At my young age. Let it just be said that I will never again try my hand at running a Ponzi scheme! Like all schemes. This is important because if the discount rate is too high.. • Calculating market returns is problematic since emerging markets have limited market histories. investors should only expect to be compensated for the aggregate market risk they take on. If they are to keep spending after they no longer earn income. Richard Brumberg. the less risky your portfolio should be. Consequently. (2) the Godfrey Espinosa Approach. This part of the theory is behind the famous “Life-Cycle” hypothesis. and Albert Ando—in a series of articles in the 1950s and 1960s provides an economic explanation for why people save. a project’s Net Cost of Equity in Emerging Markets CAPM works well in developed markets. which is embraced by nearly all financial planners. • Emerging markets display thin trading and illiquidity. so beta is difficult to estimate. People save because they generally live longer than they earn income—that is. to scale down portfolio risk) because there is less time to recover from a downturn in their net worth. (3) the Goldman Sachs Approach. the closer they are to retirement. Journal of Applied Corporate Finance 19. Rather. individual investors should always invest in index mutual funds—a class of investments we will be discussing later in the book. According to MPT. a company’s or a project’s beta is essential to understanding the company’s or the project’s discount rate.14 Chapter Two Life-Cycle Hypothesis The Life-Cycle Hypothesis of consumption enunciated by three economists—Franco Modigliani. Another implication of MPT is that the closer you are to the day you hope to start spending your accumulated wealth. adjustments have to be made to the standard CAPM to make it applicable to emerging-market projects. These approaches are all somewhat ad hoc and are based on adjusting the basic CAPM framework to incorporate the risk of operating in a specific industry within a specific country. and (4) the Salomon Smith Barney Approach. Reference: Estrada. 2007. Various models (tweaks of the basic CAPM model) that have been used to deal with projects in developing countries are: (1) the Lessard Approach. Spring. or being able to estimate. Discount rates in emerging markets: Four models and an application.e. Therefore. they must have accumulated assets while they were earning so that they can spend from their accumulated wealth. The reasons are as follows: • Genuine risk-free rates do not exist in emerging markets. One important prediction flowing out of MPT is that investors should not expect to be appropriately compensated for the risks of investing in individual securities. knowing. people usually retire. Note that an interesting offshoot of this is that individual investors are taking a disproportionately higher risk (relative to the returns) to invest in individual stocks and bonds in the markets. emerging markets. like individual stocks. J. the more critical it is to not take unnecessary risks with their portfolio (i. but not so well in underdeveloped. . The Reality of the Beta As the discussion on the CAPM shows. According to a recent paper by Pablo Fernandez. Unfortunately. and different institutions can use . Another problem is that an estimate of beta will change depending on the time period over which it is estimated (five years versus ten years. there are other potential scales as well. etc..Time Value of Money 15 Present Value (NPV) could mistakenly be estimated to be negative when. for example) as well as the market index chosen (value-weighted versus equally-weighted. Weight Low 10% Management 25% Assets 3% Strategy 15% Country Risk 10% Operating Leverage 15% Financial Leverage 5% Liquidity of Investment 5% Access to Funds 2% Partners 5% Exposure to Other Risks (e.g. estimating beta is more of an art than science. we use the following scale to estimate the beta.07. The article provides an example of the estimated betas of three well-known companies.06 to 0. Another suggested approach is to calculate a qualitative beta associated with a company or a capital project.). calculated betas appear to change considerably from one day to the next—which should not be the case. Coca-Cola. The problem is that using this approach provides beta estimates that are significantly different from day to day. and Walmart. betas estimated from the historical data of a company do not appear to be a good estimation of the underlying risk of the company. in reality.57. and the beta of Walmart varies from –0. A company’s beta is estimated by taking five years of its monthly return data and regressing it against a value-weighted market index. The criticism with a qualitative approach is that it is somewhat ad hoc.05 to 0. you could lose out on a valuable investment opportunity. using the method outlined above during the month of April 2009. Thus.66 to 1. In this approach. the beta of The Walt Disney Company varies from 0. it was positive. To overcome these problems with estimating the betas of individual companies. Currency Risks) 5% Cash Flow Stability Risk Classification (on a scale of 1–5) Where 1 is Low and 5 is Very High Average Substantial High Very High Total =100% Keep in mind. In the empirical estimation.5. If you do this. the beta of Coca-Cola varies from 0. some recommend using the average beta of the industry that a given company belongs to. An industry-average beta is considered to be more reliable because the errors in estimating an individual company’s beta tend to be neturalized in aggregate. The Walt Disney Company. they get to make their commissions. Madrid. Most of us are probably characteristics including the commissions they pay. you only care about their trading characteristics. However. trading/investing activities.* Trading versus Investing Discount brokers would like you to trade as often as possible because they make money in commissions when you do. Betas used by professors: A survey with 2. there will be a full description of what those costs are. Spain. You care about the financial soundness of the companies you invest in. and force you to use them within thirty to forty-five days. what if you had a choice between paying someone $100 today versus $100 a year from now? When should you pay? Before you answer these *Fernandez. the discount rate. whether the economy is booming or has taken a downturn. somewhere in the middle—we Investors trade infrequently and care about the exhibit both characteristics in our underlying company fundamentals and not about the implicit and explicit trading costs.500 answers. . While different approaches lead to different beta estimates. if you rarely trade. should be the same for everybody. if you are a day-trader (someone who buys and sells several times a day) you probably don’t care very much about the underlying companies you are buying and selling. You don’t care at all about trading characteristics. The best recommendation is to use all of these beta estimates prudently and cross check them with other measures. The drawbacks associated with the estimation of beta are well-understood.16 Chapter Two different scales or weight them differently to arrive at their own beta estimates. including trading-related volatilities and commission fees. As an intermediary. IESE Business School. If you buy and sell ten times in a month. Working Paper. if you are an investor who does not trade as regularly and you hold your stocks for a while (you buy-and-hold). Traders trade frequently and care about trade-related and so on. If you prefer to trade frequently. commissions. Pablo. are of less concern to you. Later. they give you free trades when you sign up. The particular beta used in order to evaluate a company or project should best reflect its risk—however estimated. which is used to convert the value of cash flows to the present using the Time Value of Money approach. 2009. Investors versus Traders Discounting and Compounding Which would you rather have: $100 dollars given to you today or $100 given to you a year from now? Conversely. including commissions. you are probably concerned about costs related to trading. then the daily vagaries of the stock market. At the other end of the spectrum. You are more of an investor than a trader. In order to get you in the habit of trading frequently. you are a pure investor and you care solely about the underlying characteristics of the company. So. they make about $100 in commissions (after your free trades are used up) regardless of whether you make any money. buying power will remain the same over this period. On the other hand. Whenever my grandmother gave me money. I had a large goose feather–filled pillow with plenty of storage space underneath it. but this money comes at a cost. and I leave my new shoes in the closet. Your mantra should be “money in now. including plane tickets. The money you receive is a loan and you have to pay interest to the lender in addition to paying back the loan amount.Time Value of Money 17 questions. You can get the money you need from a bank. Because interest was not a factor. They keep some of it and pay the rest to the saver as interest on their saving account. which option should we choose? What if we figure in interest? Which options would be better for you? A little thinking should convince you that you would prefer to get the $100 today rather than wait for it. Suppose you want a better car than the clunker you drive currently. Let’s say you want to go to Maui for Spring Break in a year. Compounding is best illustrated with the following example. I did understand the concept of storing my money under my pillow. it would go straight under my pillow. The bank then takes your money and loans it to a spender. which would certainly beat getting $100 a year from now. so working and saving for it is not an option. money out later. It was comforting. When I was a young boy. but it was a small price to pay to have all my favorite possessions under the pillow with me.” If you can understand the above concept. Formally. I did not know very much about banks. Let’s call you a spender. Why? You could deposit the $100 in a bank immediately and have about $104 in a year. they stand as intermediaries between the savers and spenders of the world. Likewise. The bank earns interest from the spender on the loan. Unlike my pillow. and plenty of drinks on the beach. for that matter. hotel expenses. if you chose when to pay. Let’s start with discounting first. Now. did any other pillows in my acquaintance). sadly. I use the bank for all my financial transactions. You desperately want the car now. I even slept with new shoes under there whenever I got them! The pillow was a little lumpy and my neck always hurt in the morning. if you are a saver by nature. For those of us with access to banks with interest-bearing accounts. it pays me interest. you are well on your way to understanding discounting and compounding. But. you will understand this example. there is nothing under my pillow except an occasional book. you can deposit money in a bank and get paid interest on it. let me also add that there is no risk of nonpayment and that there will be no inflation in one year. This is how banks operate. I would be totally indifferent to the timing of my receipt or payment of money. If you are a student and cash is hard to come by. But you spend all your time taking classes and studying. You have about twelve months . However. Compounding is the technique used to calculate the future value of a given sum of money received today. you could deposit $95 right now and have about $100 in your account in one year. which you could use to pay off your debt. That is. my pillow did not pay any interest (nor. You have done your research and have calculated that it will cost you about two thousand dollars in total. Oh. discounting is the method used to calculate the present value of a given sum of money received in the future. Many accountants in the field use this rule of thumb: Amortize franchises no longer than 15 years and player contracts no longer than the period for which services are being rendered. Discounting and compounding. your premium is based on the present value of the expected cost to the insurance company depending on your risk category. Though these owners often have accumulated substantial holdings in real estate development and other areas. Credit card companies charge you interest on unpaid balances at the end of each month. and we are back to our starting point. Also. the longer you live. they typically only put up 10 to 20 percent of these assets as collateral when buying their teams. . all else being equal (also called ceteris paribus). lessening its drain as an expense and thus making the franchise look far more profitable than it actually is. bond. for example. the less you pay each month. retirement is also all about investments. one word signifying TVM concepts that will often come up is “amortization.” which is simply the process of paying off a loan—principal and interest. or anything else you can think of. Here is an excerpt from an article I came by a while ago in a magazine: . collectively referred to as Time Value of Money (TVM). assuming you can live up to a maximum of 100 years. This is true for any asset. Finally. if you had a choice between a fifteen-year mortgage and a thirty-year mortgage (both for the same dollar amount). Insurance companies calculate the premiums for their policies based on present value calculations. . TVM concepts are used to understand how to value financial assets. the monthly payments (interest + principal repayment) will be smaller with the latter than with the former (even adjusting for the fact that the thirty-year mortgage rate will usually be higher than the fifteen-year rate). The team’s purchase price may be amortized as long as 40 years. You would like to know how much you need to deposit in your savings account per month in order to have the required sum in a year. . whether it is a stock. For instance. Even outside of personal finance. Computing the present value of such obligations will help you understand what those credit obligations are worth to you today and help you budget accordingly. Remember.18 Chapter Two to save enough money. is the discounted present value of all its future cash flows. The new wave of professional-team ownership has taken cues from the leveraged buyouts of the 1980s. In the investment-related chapters. For instance. So. are everywhere—both within the sphere of personal finance as well as outside it. which makes you feel relatively cash rich. We will be using TVM concepts either directly or indirectly throughout the book. I challenge myself to find at least one TVM concept in everything I read. defined by your lifestyle choices. you can make it a habit to spot TVM concepts when you are reading a newspaper or a magazine. mutual fund. The longer the process. The price of any financial asset. This has a huge impact on reported profitability. for example. franchises sometimes amortize players’ signing bonuses and contracts far beyond their actual lengths. if you are a twenty-five years old and are buying a whole-life policy. We will see this in more detail later in the book. In fact. the less costly it is for the insurance company to insure you because you end up paying most of the policy payout in premiums. the bank has to come up with its own funds to meet the excess demand. it’s “hands off my benefits.e. and simply borrow the rest using the team’s growth potential as leverage for the remaining 80 percent or so (hence. everyone is happy. and it increases interest rates to discourage borrowing. Here is a brief excerpt from a recent CBS Sunday Morning news show.” says the local president of the Communication Workers of America union. the economy contains more savers than spenders (during a recession) or more spenders than savers (during a period of inflation). At various times. TVM concepts are not restricted to the print media either. “Every benefit cut that you have is a cut in your wages. and earn interest on the loans. North Carolina. “It’s a cut in your ability to provide for your family. over their declining health benefits from the company. there are depositors who keep their monies in banks and borrowers who loan monies from banks. The article says that new sports team owners are increasingly paying the exorbitant purchase prices through creative financing similar to that used in the leveraged buyout of companies in the 1980s. of course. Banks then the deposited monies. across many industries. Teams will also amortize the hefty contracts given to star players over far greater periods than those for which the contract is valid—with the blessing of their accountants. when spenders outnumber savers. including your mortgage payments. forty years or more). Moreover.” What Determines Bank Interest Rates? Banks operate using a very simple practice: taking money in and loaning money out. Instead. This is true for any loan.. as I discussed earlier. Doing so increases the present value of a project for any given cash flow stream. When savers outnumber spenders.” From health care to disability to pensions. the leveraged buyout analogy). This again has the effect of making the organization look healthier than it actually may be. Specifically. If you have real estate holdings worth 10–20 percent of the purchase price of the team. (Network Reporter) “The people are just fed up with their benefits being cut. thereby making the monthly loan payments more affordable. use these holdings as collateral.Time Value of Money 19 Let us examine this excerpt.” one employee remarks. workers today are realizing with dismay that company-provided benefits are costing them more and providing them less. It is almost like accounting magic—the kind that got Enron into trouble and nearly destroyed the big accounting firm Arthur Andersen. Another way to think about amortization over a longer time period is to think of it as using a relatively lower discount rate. the bank has a lot of money in its reserve. then you can go to a bank. which involved selling bonds to raise the required funds. doing so also makes the organization look like it has more money than it actually does. The segment was about Sprint employees who were on strike in Hickory. so it lowers the interest rate in order to encourage more spenders to borrow money. As long as the bank earns more from its lending activities than it pays to its depositors. and loan out a fraction of it. . The loans taken out to purchase the team can be amortized over a very long period (i. Likewise. “From going from paying nothing in 1996. has sold more than 2. Employees were trying to preserve the promised cash flow of benefits.20 Chapter Two The union president says his members walked. This would cause the employees’ health benefit costs to go up. a bitter pill for members who remember once paying nothing at all. much of their anger fueled by Sprint’s proposal to eliminate the caps on how much they pay for health insurance. in turn. by trying to curtail the present value of its expenditure stream may. who finished a controversial second to Ruben Studdard in season two. The employees’ collective anger was sparked by Sprint’s decision to eliminate the cap on how much employees would have to pay for their health benefits. Measure of a Man. The following is an excerpt of the CNNMoney article “‘American Idol’ Losers Win Big” by Joseph Lee. the argument does have some merit.” One side’s benefit is exactly equal to the other side’s loss. That is not to say that those who do not win never have as high a present value. Remember that the winner will get a record contract from a label owned by one of the Idol judges. and would keep the company’s cost of funding these benefits down. .. Let me show you another example of TVM concepts that is totally unrelated to sports or finance. a lot of near winners have managed to release successful CDs and have received significant publicity after their Idol days (i. Sprint saw this strategy as one way of increasing the present value of the company by cutting the present value of its expenditures. In a strictly dollars and cents world. Hence. the struggle between the two sides.400 a year in premiums. So far. Clay Aiken).” Where are the TVM concepts in the vignette above? When benefits are cut. at the end of the day. be curtailing the present value of its revenue stream—an unintended (and certainly economically foolish) consequence. The union president implies that benefits are like additional wages and every dollar cut from future benefits is like a slightly smaller cut in the present value of each employee’s wages. reduces the present value of the future cash flow stream of benefits.e. although one can argue that unhappy employees are less productive. and thereby maintain the present value of this annuity stream of benefits. Think of the winner of the Idol contest as one whose present value (of all future earnings) is considered to be the highest by the judges and the voting body. and that.5 million copies of his debut album. The economic term for this struggle is a “zero-sum game. The company. the future value of the cash stream is reduced. we now have some members who are paying as much as $2. and thereby contribute fewer dollars to company revenue. millions of fans wonder who will emerge as the next “American Idol” and receive a recording contract. But winning isn’t everything. Some of the show’s past contestants have signed record deals and released chart-topping albums without winning the competition. . . As the third season of Fox’s hugely popular talent search gears up for its finale. The company wants the exact opposite for its own longterm survival. They . it sums to zero. Clay Aiken. who had a lot of potential but has not become as popular as expected. there are Idol contestants whose fame has since diminished. and (b) because she believes that the present value of the income she would earn if she worked on other projects is greater than $12 million. but I have a lot of other things happening.” Lopez signed a one-year deal with the show in October for a reported $12 million.” she said.” debuted on the Billboard Top 200 charts at number thirty-four. Lopez received $12 million for one year’s work as an Idol judge. That performance won him a record contract with Koch Entertainment.000 copies during its first week. She is ambivalent because (a) she wants to drive up her value to something significantly greater than $12 million. Fernandez). and I’m glad about that because honestly I’m very on the fence about it. “I had an amazing time doing it and I loved it. I haven’t been forced to make a decision. “I don’t know.” Let’s consider the above for TVM content. I’m really enjoying the time of just waiting— and seeing. Here is an excerpt about a recent Idol judge—Jennifer Lopez—and the likelihood of her returning as an Idol judge in the next season (from “Jennifer Lopez ‘on the Fence’ about ‘Idol’ Return” by Sofia M. At the other extreme is the engineering student William Hung. The singer said in an interview with BBC Radio 1. Recall Justin Guarini. “We’re not really at the breaking point of ‘You have to make a decision right now!’ So I’m not. and it’s going to come down to making a choice of really what I want to do for the next year. Let’s assume that Lopez determines the present value of her potential earnings (from projects other than Idol) for next year to be $20 million. selling almost 38. “Inspiration. Talk about an undervalued commodity! Here is someone whose present value was initially considered to be nearly zero in the entertainment industry who instead has capitalized on his notoriety to propel his present value of future cash flows sky-high. His present value has declined considerably. TVM concepts can be found in very interesting places if you know where to look for them! .Time Value of Money 21 can be thought of as undervalued commodities who have since emerged as stars and taken their “stock” upward. She would most likely earn an even greater amount if she were to come back for a second season. On the other hand. His first album. who is famous for his off-key singing and comic performance of Ricky Martin’s “She Bangs” during the first round of auditions for Idol’s third season. She offered mostly positive critiques of the contestants and got emotional when some were eliminated. Then. she will only sign on for another year of Idol if the Fox Broadcasting Company is willing to pay her at least $20 million. was William Hung initially an undervalued or an overvalued commodity? Why? 16. what other ways can you invest your money? 4. What factors contributed to the creation of the dot-com bubble? 7. Can you think of other areas in your everyday life where you could have been using TVM concepts without realizing it? 15. Why did the Internet bubble burst? 8. When stock markets are not viable. What are the similarities and differences between a bubble and a Ponzi scheme? 6. What can you extrapolate from MPT about your “ideal” investing behavior? 9. In TVM terms. What was the rationale for deregulating commissions associated with trading in the 1970s? 11. What is a bubble? What are some examples of historical bubbles? 5. What are some differences between full-service brokers and discount brokers? 13. Why is it optimal from a TVM standpoint to wait until the last minute to pay a bill. What does the Life-Cycle Hypothesis imply about your investment portfolio over time? 10. Why are there so many brokerage houses in existence? Are they all doing the same thing? 14. What are some of the trade-related costs a trader could be worried about? 12.22 Chapter Two Thought Questions 1. but to take any payments at the earliest opportunity? . Can you think of other Ponzi schemes that are prevalent today? Are chain letters Ponzi schemes? 2. Who loses the most in Ponzi schemes? Why? 3. as we will see later). however. Being private means there are 23 . Unlike you and me. will carefully monitor the company’s actions while it owes them money. If he doesn't know how wide it is. One salient feamoney one time only: when it sells its shares for the first time (in what is called a ture of these money lenders is that they do not badger you for their money. a company has other options. wearthrough secondary market transactions). The company itself makes money from the Kabuliwallahs. like you. Only people who canonly the investors buying and selling the not get loans anywhere else resort to taking shares do. which can become a nuisance. flowing robes. ing long. Private companies (as the name implies) are privately held. It is company that has already gone public can apparently a very effective monitoring device sell more shares to investors in the form of since the default rates are reportedly very low. It can sell shares. They simply find out primary market) through what is known as whre you work and come and stand across the an Initial Public Offering (IPO). You and your spouse are thinking of adding a wing to the house.3 What Are Stocks? Risk—If one has to jump a stream and knows how wide it is. So what do you do? You probably go to the bank in order to get a loan for the renovations. This is exactly why companies sell shares: they need money to build more factories. The Kabuliwallahs Private and Public Companies You can broadly divide corporations into two types: private and public. The problem with loans is that the creditors. However. Also. a company does not make any In India. or develop new products. he'll jump and six times out of ten he'll make it. who lend money at exhorbitantly high interest rates. The company would also have to pay regular interest on the money borrowed. —Persian Proverb Suppose you have lived in your house for a long time and your family has grown steadily over the years. A company could get a loan from a bank. hire more people. a Seasoned Equity Offering (SEO). as companies have most of their cash tied up in the business. whether banks or outside investors. there is a wandering group of money money from the daily buying and selling of lenders from Afganistan known as Kabuliwallahs. he will not jump. or it could get a loan from the capital markets (by selling bonds. its shares in the stock exchanges (or They are big men with beards and turbans. a street quietly watching your every move. The house that seemed so big a few years ago no longer feels so spacious. Is this kind of price support of any economic consequence? Are supported IPOs merely small offerings from fringe underwriters who are buttressing stocks at artificially high prices? Until Underwriters are investment firms like Merrill recently.. While this practice is often regarded as a way of ensuring liquidity of new issues. and Citigroup. to the public and that trade on a stock it is separate from the people associated with it. public companies report information to the Securities Exchange Commission (SEC). Bose. There are many large private companies. There is now etc. It is easy to incorporate a company. and are likely to be through the IPO process. The stock is traded in the open market like any other commodity. ship) or a few people (a partnership) cannot issue but they don’t have to sell you anything. In the United States. companies have thousands of shareholders and are subject to strict rules and regulations. This is why the IPO process is and has special legal rights and responsibilities also referred to as “going public. that are actively responsible for doing a evidence showing that supported IPOs are risk assessment of a private company that typically larger. But don’t think only small companies are private. It isn’t usually possible to buy shares in a private company. Most small businesses are privately held. By law. all you have to do is pay a small fee. Goldman-Sachs. UBS. exchange. Frequently. you could A business owned by one person (a proprietorapproach the owners about investing. stock. the small offerings on the fringe Credit Suisse. the data has not been available to Lynch. Deutsche Bank. have lower underwriter wants to go public and for introducing its stock to the investing public for the first time commissions. which means it is sold for less than the cost of a similar share in the secondary markets. Barclays Capital. Anybody with enough money to buy a share can invest in a public company. Types of Businesses Research on IPOs Research has shown that when a company’s initial public offering hits the market. So.24 Chapter Three fewer shareholders and very little information about the company has to be disclosed by the owners.” Public as well as its own unique name. and Hallmark Cards. the underwriter will buy some of the shares to prop up the price and attract investors during the first few days of trading. little is known about what types of IPOs get bolstered and whether this really affects liquidity. its existence sold at least a portion of their ownership does not depend on the people who run it. fully answer these questions. Technically. All countries that oversee public companies have governing bodies similar to the SEC. A corPublic companies are those that have poration has a special legal status. Morgan Stanley. and follow the reporting rules of your local jurisdiction. are not supported—rather it is the big Underwriters . offer higher prices than unsupported stocks. The other top investment banking firms as of 2010 were underwritten by well-known investment banks. such as IKEA. They must have a board of directors and report financial information every quarter. file the right legal documents. Only a corporation can issue stock. it is typically underpriced. You could then sell your stocks and make a profit of $5 on each share. Of course. liquidity is very important. do not touch it right away. so does its prestige and reputation in the market. In fact. For instance. why does it care about its stock price after the IPO? As a company makes more and more money selling its products and services. research finds that investment banks sometimes support newly-issued stocks to help institutional customers avoid bad issues. if the company’s shareholders are happy. (That is. imagine you bought a few shares of stock for $10 each. word spreads. which further drives up the price. Yet. Experts start talking about the stock. But let us focus on the good news. In fact.1 If a stock price flounders. The company can also attract talented people from other companies to come and work for them. Google is a good example of a company that has done well in the markets over the last few years and to which all the above can be ascribed. until now. Finally. . if the company loses money. What does this finding mean for us. the unsupported stocks actually drift down in price more than the ones that had been supported. the data show that once price supports are withdrawn. Securities and Exchange Commission (think of the SEC as the stock market police) rules have exempted price supports from anti-manipulative measures on the grounds that they improve liquidity—the reason bankers often laud the practice. even after accounting for price supports. it stands to gain a lot indirectly when its stock price rises. there has been little proof that liquidity justifies price support. the research finds that IPOs are underpriced. and more investors line up to buy into the company. you incur a loss on your holdings. that is what we observe. If the company does well. In fact. the investors? It means that we can expect an IPO to shoot up in price as soon as it hits the secondary market.) In sum. Most importantly. the issuing investment bank simply buys back the issue. chances are you will lose money! Importance of the Stock Price If the company does not make any money directly from the daily trading of its shares. Price support seems to have an important role in determining aftermarket liquidity—as we have already seen. the shareholders’ meetings are happy events. So if you cannot get in on a new issue at the IPO price. demonstrating that bankers had not propped up bad stocks. even though a company does not make direct profits from the secondary market transactions. For about sixty years. by extension. the research findings refute accusations that banks participate in underwriter reimbursement. they require a larger gross spread—the difference between the price at which the underwriter buys stock from the corporate issuer and the price at which it sells the stock—which is effectively the underwriter’s commission in exchange for promising to buy back some of the stock after the offering. the shares might later be worth $15 each.What Are Stocks? 25 companies (and. the value of its stock goes up. the big issues) that are. As a company’s stock price rises. In sum. because once it starts trading in the secondary market. people usually earn more from owning stock than from leaving money in the bank or under their pillows. or equity holders. A good example of this is Warren Buffet’s company. companies have a way of selling shares of the company without distributing the voting rights proportionately. the small individual investor. where stockholders cast votes and ask questions of the company’s leaders.000. Class B. This is one way a company can maintain control. .00000017 percent of EMI. for example. Berkshire Hathaway. and only 1/200th of the voting rights of each Class A share.0000017 percent ownership in the company for that to happen.0000017 percent owners) hope the company will earn money as it grows. Most companies have annual meetings. A common way to accomplish this is to issue a different class of shares. Stockholders (even 0. Then we see the fine print on the bottom of the screen that says she owns something like 0. They vote on such issues as who will be elected to the board of directors (the group of people who oversee company decisions) and whether to buy other companies. which trades at around $80 a share. People who own stock are called stockholders. and you bought one. a stockholder with 1. who turns out to be an aspiring singer. If a company has issued one hundred shares of stock. you need more than a 0. Unfortunately. stockholders may use an absentee ballot to vote. every Class B share (BRK-B). you own 1 percent of that company. So. hears the conversation. takes the word “owns” literally. This is because Buffet does not believe in stock splits and is not particularly concerned if you. But. shareholders. Have you seen those commercials by Ameritrade in which a mother and daughter are having lunch and the daughter casually mentions that she now “owns” EMI (a multinational music company)? A waiter hovering nearby. Stockholders in a company usually have voting rights. the stockholders share in the profits. you do so with the understanding that while your shares are almost equivalent to the company’s Class A shares in every way. If they cannot attend. Each Class A share (BRK-A) trades in the neighborhood of about $110. has 1/30th of the general rights.26 Chapter Three What Does Stock Ownership Provide? Owning stock in a company means owning part of that company. that’s stock ownership for you. However. and breaks out into a song-and-dance routine to impress the “owner” of EMI. Stockholders typically have one vote for each share they own. If a company earns money. Shareholders also receive quarterly and annual reports that inform them how the company is performing. When you buy a Class B share of a company.000 BRK-A shares will have a much greater say in Berkshire than a shareholder with 1. Large shareholders are courted aggressively by companies. Cute! Well. ever hold any of his shares. Each part is known as a share. your Class B shares may have fewer votes than are enjoyed by Class A shareholders.000 BRK-B shares. They have a lot of influence on the companies in which they own stock. Over time. Good examples of value stocks are the oil sector stocks. Growth stocks are usually more popular when the economy is slowing. however. Starbucks’ average daily trading volume is about 6 million shares. like Exxon Mobil. Also. that growth stocks are quite risky and are not always good investments. IBM. Blue-chip stocks are the complete opposite of growth stocks. In the beginning stages of a growth stock. org/company/allbycountry. while others rely on no particular method or employ a mix of all of them. Therefore. These companies usually have several consecutive years of earnings growth well above that of the average Standard & Poor’s 500 corporations as well as prospects for continued rapid growth. growth stocks normally carry higher price to earnings ratios (P/E) than the general stock market. These are household names like AT&T. For a while. Value stocks tend to attract more investors when the economy is booming. value investors look for stocks that are temporarily out of favor with investors and that have been sold down to prices below their intrinsic value. It took about ten years after Microsoft’s founding for it to become a household name. They usually have heavy trading volume. .subsea. Some investors prefer using one method.What Are Stocks? 27 What to Look for When Buying Stocks There are different approaches to investing in stocks. There are also different types of investors who each prefer a particular type of stock. In contrast. asp?qcountry=USA. We discuss P/Es more thoroughly later in this chapter. Microsoft. For that reason. investors have been notoriously unsuccessful at predicting changes in market conditions. etc. especially when we are constantly being bombarded with information. keep in mind that it may take some time for growth stocks to become valuable. Blue chips have a long record of accomplishment and a great reputation.. Growth investors focus on companies whose earnings are expected to grow faster than both inflation and the economy over time. Shell. this category consists of the most venerable companies. The prices subsequently rose when it became clear that the damage to the oil companies was not as severe as initially estimated. and attract fewer investors when a recession looks imminent. the entire sector represented a great buying opportunity for the value investor. For example. In reality. [The following website lists all the oil and gas companies in the USA: http://www. and the combination of low P/Es and high dividend yields makes them attractive to investors looking for income and eventual appreciation. Remember. separating facts from the hype can be a daunting task. which tumbled in the wake of Hurricane Katrina’s destruction of off-shore oil rigs on the Gulf Coast.] Growth and value stocks take turns as the most popular way to invest. Value stocks ordinarily pay relatively high dividends. McDonald’s. they are better off owning both types of stocks— growth for long-term appreciation. Growth companies reinvest much of their earnings back into their businesses and do not pay out dividends. since their high earnings growth makes them more alluring. and value for both appreciation and dividends (a significant component of total return over time). and Starbucks. Sometimes there is a “fad” factor to consider. (Remember Ryan Leaf and the San Diego Chargers who drafted him?) If this happens.. not in football and certainly not in stocks. when the economy is coming out of a recession and moving towards inflation). information on penny stocks can be found at http://www. You can also add foreign stocks (including emerging market stocks). Penny stocks represent newer companies with little or no operating history or older companies that have fallen on hard times.com/aps_us/index. While there is no such thing as a sure bet. These stocks trade under $5.allpennystocks. By contrast. the team has essentially wasted millions of dollars in explicit and implicit costs. especially when markets are falling. the stock of some of the players rises while that of others falls. People buy new cars when interest rates are low (i. Cyclicals are stocks that rise and fall with the business cycle. whom they agree to pay millions of dollars in salaries and signing bonuses. who sometimes demand astronomical contracts). newer players are relatively cheaper to sign than the established stars. has performed quite poorly over the last few years and has lost a significant portion of its market value.e. for speculative investors. nothing is guaranteed. its consumption has nothing to do with the business cycle.aspx. The perfect mix of stocks in your personal portfolio is a function of your risk tolerance and your time horizon. pros who have been in the league for a few years are more of a proven commodity than newcomers. These players go through a series of drills and other workouts (like the forty-yard dash) under the watchful eyes of talent scouts. Stocks can be thought of in a similar way. Either way. such players fall flat on their faces. For example. [If you are interested. Ace Marketing & Promotions (ticker: AMKT).000 shares. However. An example of a cyclical stock is the General Motors Company (GM). on many occasions. investors should ideally prefer a variety of the above in their portfolios. in spite of all the scrutiny. the best college football players make themselves eligible to be drafted by one of the professional teams. Eastman Kodak. they are taking less of a risk. in another sense.] In general. For example. These players are essentially unproven at the highest level of the game and. there are the penny stocks. with some of the most undesirable ones trading under $1. and cyclical stocks to the mix. . When teams sign these proven talents. Before the NFL draft every year.50 a share. Accordingly. a penny stock trading around $0.28 Chapter Three They are usually considered “safe” investments. And finally. Additionally. Coca-Cola is a non-cyclical stock because people drink Coke all the time. the teams take a big risk when they draft players. Are All Stocks Equally Risky? Not all stocks carry the same degree of risk. However. They have very low trading volume. another venerable name. these are extremely speculative. the risk with proven players is that they are closer to the end of their careers— the teams must guess how many games/years they have left. has a daily trading volume of about 14. (Of course. Compare these rookies to players who have played in the NFL for a few years and have an established record of accomplishment. Value stocks are generally less risky than growth stocks. . less risk) than small start-up companies. which are considered quite risky. with market values below $500 million. the investors’ profits will decline. Foreign stocks carry the additional risk of currency fluctuation. Tracking stocks often result in greater analyst coverage because it is much easier to value a small part of a company than a complex corporate behemoth. Blue-chip corporations often occupy leading market positions that are expected to be maintained. Further down the ladder are micro-cap stocks. or even enhanced.. as previously state-run economies convert to free markets. who are the rookies entering the market. they should trade the players who are past their prime but have bloated contracts (i. with hopes of superior earnings growth over time. but most others will fail. since their higher dividend yields and lower P/Es offer some protection if the market declines. investors put money in European stocks and those currencies decline in relation to the dollar. with stocks. Keep your eyes open for other good prospects and sell quickly when you hit your pre-established selling rules (rules about selling are discussed later). and provide a greater margin of safety (i. Some of these companies will make it. If U. In the case of emerging markets. The NFL is actually quite efficient in this regard—to the frustration of some of the fans. Tracking stocks are issued when company management thinks that one part of their company is worth more than the whole. But the NFL is correct. have turned this value-based recruitment into an art form. undervalued stocks).. Tracking Stocks Tracking stocks are a class of shares of a parent company that are linked to the performance of a subsidiary—usually the fastest-growing one that the parent company owns. and other region-specific risks. it is probably not a good idea to become too attached.e. issuing tracking stocks on that part better allows it to reach its appropriate market value.. extreme volatility. overvalued stocks) in favor of younger players at cheaper prices (i. The prices of some of these stocks have dropped so low that they have actually become good buys.e. illiquidity. there are additional risks: political instability. since they are shares of companies that are still in their developing stages. Emerging growth stocks can be among the riskiest of all. In any event.S. like Bill Polian of the Indianapolis Colts. Large caps are considered the least risky because there is a large.e.What Are Stocks? 29 Blue-chip companies that have been around for awhile are proven commodities. which could exaggerate price swings. Large-cap companies with market capitalizations above five billion dollars are considered less risky than mid-cap (market capitalization between one and five billion dollars) or small-cap (market capitalization below one billion dollars) stocks. for example. Some team presidents. as with professional football players. liquid market for their shares and a longer history of earnings and dividend growth. After the collapse of the dot-com boom. Other issuers of tracking stocks include AT&T (T) and Ziff-Davis (ZD). Management must decide which option will best allow them to cash in on investor euphoria.30 Chapter Three Creating a tracking stock is like creating a corporate spinoff.S. The established companies needed to figure out how to take advantage of the high prices the newbies were getting. be sure to perform diligent research beforehand. Can you see that this could be a problem? Tracking stocks became wildly popular on Wall Street in the late 1990s. on average. the topic itself has more historical relevance than investment value. given the few remaining tracking stocks in the market. both of which are now defunct. If you do come across one you would like to invest in. and the remaining companies envied this. Further along. According to the above. there will be inherent conflicts of interest. The same article reports that. stock exchanges. The new entrants in the market (the emerging Internet-based companies) were trading at fantastic prices. A key determinant of a company’s decision to create a spinoff versus issue tracking stocks is market timing. tracking stocks trade as any other equity security on the U. . Critics of tracking stocks have pointed out that board members who serve both the parent company and its tracking subsidiary can create serious problems in terms of resource allocation (conflict of interest). coinciding with the dot-com boom (to be discussed later). In sum. there is a lot less corporate red tape involved in the issuing of a tracking stock than in the creation of a spinoff. “Remember Tracking Stocks? Most Are History. According to a 2004 article in USA Today. the directors of one entity were not ruling out the possibility of competing with the other. the performance of the twentyeight tracking stocks issued prior to 1999 lagged behind their expected benchmarks. Due to the extensive relationships between DLJ and DLJdirect. Additionally. only about five of the thirty-eight tracking stocks issued since 1984 are still around. Finally.” there has not been a tracking stock issued since 2002. The inherent conflict of interest emerges clearly in the following quote from a prospectus for DLJdirect (a now defunct tracking stock for Donaldson. the prospectus gets more explicit: There can be no assurance that DLJ will not expand its operations to compete with DLJdirect. Further. many of the biggest tracking stocks collapsed. however. with one important difference: management retains control. The answer? Tracking stocks. Lufkin & Jenrette): The board of directors may make decisions that favor DLJ at the expense of DLJdirect. research shows that tracking stocks are more likely to be issued when the pertinent division of the corporation generates tax benefits and when the management is not worried about being unseated by shareholders. Once issued. The General Motors Company (GM) issued the first such shares in 1984 and 1985 for its Electronic Data Systems (EDS) and Hughes Electronics (GMH) subsidiaries. when you factor higher-order beliefs into stock pricing. So. Lately. To gather this information. investors not only forecast its future payoff (consistent with rational expectations). While such esoteric research may be satisfying to academics. on a given day. For example. should be the present discounted value of all future cash flows associated with the asset. In simple terms. as opposed to the economists interested in the “absolute” pricing of a stock. To understand this. This concept is known as having “higher order beliefs. he wants to know if it is currently overpriced or underpriced. then their beliefs work against you. it provides little comfort to Joe Investor.What Are Stocks? 31 Setting of Stock Prices How are stock prices set? Surprisingly. Behavioral finance. From a rationaldiscounted value of all future cash expectations standpoint. That is. Joe’s problem is that he wants to make a profit from his purchase of stocks through price appreciation and occasional dividends. But. Although the rational expectations hypothesis is the basis of most contemporary financial asset pricing models. its empirical validation has been weak. for example. and the stock actually becomes a bad investment. economist Robert Shiller has shown that the price volatility evident in the stock markets is too large to be justified by rational expectations models.” The fact that this price may be inaccurate in an absolute sense is less of a concern for Joe as long as everyone is playing by the same rules. the price of a stock flows associated with the asset. the expected volatility of the stocks is significantly higher than that of stocks priced without including higher-order beliefs. if he wants to buy stock in a given company.” There has been some preliminary theoretical research showing that. many economists have argued that some other “irregularities” may be at work that explain the excess volatility. who needs to understand the “right” price for a stock he is interested in buying. Confronted by this apparent failure of the rational expectations framework to accurately price stocks (and other financial assets). and so on. this is not The price of a stock is the present a simple question to answer. he needs to examine the stock’s price on a daily basis and understand that. So. but your estimate of what others think it’s worth. To paraphrase Keynes: even if a stock seems like a good investment to you. experts have suggested another potential “non-fundamental” factor to better explain stock pricing. the price represents the consensus value created as if by an “invisible hand. he is interested only in “relative” pricing. But Joe should not worry. but (and here is the important point) also try to predict other investors’ forecasts of that stock and others’ forecasts of other forecasts. things happen on a day-to-day basis that make prices vary from their “true” unobservable value. if everyone else disagrees. the market value of the stock is a small range of prices . who argued that when considering whether to invest in a stock. we have to go back to 1936 and a British economist named John Maynard Keynes. deals with these supposed irregularities and attempts to explain why the empirical data do not perfectly fit the rational expectations framework (there will be more on behavioral finance later). the price of a stock is not what you think it is worth. investor disinterest pushes stock prices lower. corporate earnings. For one. and the level of dividends paid to shareholders. Valuation of Stocks: The Dividend Growth Model In the last section. Stocks are just like any other commodity: buyers and sellers come together in a competitive marketplace and perform transactions at mutually agreeable prices. K can be thought of as the sum of the risk free rate and a premium for holding a risky stock.32 Chapter Three around the true value. like fads and trends. let’s assume that our required rate of return for investing in this particular stock is given by another number. six months later. That is a problem for valuation. the problem of determining future cash flows is much more simple. For other kinds of financial assets. Finally. Also. the agreed upon prices should never deviate too far from their “true” value in a well-functioning market. We discussed. Institutional forces. . and then you get the face value back (there will be more on bonds later). as indicated above. and the attractiveness of competing investments. Let’s assume that the dividend at time 1 is denoted by D1. We have to figure out what the dividend for the stock is going to be at time 1. How does one obtain all future cash flows of an asset and what does one use for a discount rate? The answer to these questions depends on the kind of asset we are discussing. investor demand drives prices beyond reasonable valuations. As long as the company exists. its stock exists. The other problem is that stock dividends are unpredictable. K. bond coupon payments are fixed and occur at predetermined intervals as long as the company is financially healthy. the political climate is also a major influence on stock prices. Intuitively. bonds have a finite life. At times. pass up the opportunity to buy it for $15. For these and other reasons. the future cash flow is very hard to determine accurately. Dividends are paid on the discretion of the company’s board of directors. can also either boost or depress stock prices. such as demand from mutual funds and a host of psychological factors. but there are still questions to be answered. for example. It seems quite simple. stocks don’t have a finite maturity date. a direct consequence of the rational-expectations principle is that the value of any financial asset is the current discounted value of all future cash flows accruing from this asset. while at other times. The market value of any stock—the price people are willing to buy and sell it for—is a function of both the marketplace and other things. investors may be willing to pay $25 for a stock today that has a true value of $20. market frictions). Of course. Also. the level of interest rates. and. How can we use the dividend growth model to price stocks? Let’s start with a simple one period model in which there is the current period (time 0) and the future (time 1). Coupon payments occur with clockwork-like regularity until the bond matures. For stocks. such as bonds. given what we know it to be currently. Also. which accounts for market imperfections (or as the academics would say. Finally. as is the general state of the economy. how supply and demand for a particular stock will determine its value at any given point in time. The predictability of bond cash flows makes it much easier to price them. For starters. we discussed stock valuation in general terms. but before you get too excited. Current Value at time 0 = dividend at time 1 required return – dividend growth A fair amount of difficult math is involved in obtaining this formula. and so on. constant growth rate)? Exponentially? Another way entirely? Also notice that if the growth rate of the firm exceeds the firm’s required rate of return (i. let’s say that pharmaceutical stocks are currently trading at an average P/E of 14. you divide the current stock price by its earnings per share. The actual value of the stock will then have to be appropriately marked up over this base value. other data must be considered to be sure that it is a good buy. which we will not go into here. Of course. While the latter is a forwardlooking P/E ratio.e. In sum. The stock appears undervalued based on this measure. g > K).. Make sure you understand how the P/E ratio was calculated before you make your next investment decision. image. Also. If Help-to-Die (HTD) Pharmaceutical’s current stock price is $25 and the company earns $2. the former is a backward-looking measure. Be aware that there are different ways of calculating a P/E ratio.e. the current value of the stock (at time 0) in this two-period world can be expressed as: Current Value = D1 K–g In other terms. The major ratios are discussed below.50 per share. in real life. Price/Earnings A stock’s price/earnings multiple (P/E) can help you determine whether a stock is overvalued or undervalued. less than the industry average. For example. Yahoo! Finance reports P/E ratios based on a stock’s earnings for the prior fifty-two weeks. Practical Ways to Tell If a Stock Price Is Too High or Too Low We can calculate some important ratios based on publicly-available information in order to determine if a stock may be undervalued or overvalued. To find the P/E. provide a bottom line value of the stock. we have to consider a complicated multi-period model. Given the above assumptions. many market professionals use a stock’s projected following-year earnings in order to compute the P/E ratio of the stock. the P/E is 10.What Are Stocks? 33 assume that the dividend growth rate for the stock is given by g. you will find it in any standard MBA-level investment textbook. we cannot calculate the value of the stock.. If you are interested. the above model does not take into account the series of intangibles that can realistically impact the value of a stock—things like good will. but the underlying intuition stays the same as outlined above. ascribing the true value of a financial asset is more an art and less a science. . trends. However. For example. at best. Then we have to worry about the process by which the dividend itself would grow: Linearly (i. A model like this can. Picking what stock to buy in a way reminds me of the way men have traditionally picked their brides in India and in a lot of ancient civilizations around the world. We’ll assume that the current average dividend yield in the utility sector is 5 percent. While dating is significantly more common with the younger crowd. the couple exchanged photographs to decide if they liked each other. A lower P/B ratio might imply that a stock is undervalued. arranged marriages are still the popular choice in ultra-conservative families and for the socially challenged. A girlʼs family begins the process of arranging a marriage for her. A far cry from even a decade ago! . especially in the villages. during my grandmotherʼs wedding. of course. in the case of upper-class educated families. many parents of girls of marriageable age can. evolved over time. in the case of lower-income families. land. An arranged marriage is a contract between two families completed either discreetly. Unfortunately. Engagements can last six months or longer. The stock may be overvalued according to this measure. depending on how progressive their parents are. Some are even allowed to go out on a "date" one-on-one. this is a wise assessment. The search for the perfect match is conducted primarily through advertising in the daily newspapers and through word of mouth.60 and its stock is selling for $40 per share. which is based on a company’s assets minus its liabilities. girls from wealthy families have a a big advantage. household furniture. and do. the socioeconomic background of their parents. but once again. Today. The institution of arranged marriage in India has. Indians will defend the practice by pointing out that one cannot pick out a wife or husband in the name of love while ignoring the equally important qualities of intellectual. If Lights Out (LO) Electric pays a dividend of $1. her most valuable asset. meet for coffee or a meal either at home or in a restaurant before deciding to commit. Potential grooms come with different “price tags” determined by where they went to college. go into significant debt in order to find suitable matches for their daughters. when my parentsʼ marriage was arranged.34 Chapter Three Dividend Yield This measure gives you the percentage of a company’s income that is returned on your investment. you come up with the price/ book value (P/B) ratio. and social compatibility. By dividing the stock price by the book value per share. however. Buying stocks responsibly is clearly not an easy task. potential couples. It Equating Picking Stocks with Picking Brides We have looked at a variety of issues related to stocks and stock trading. the 4 percent yield is below the industry average. or more openly. Prospective grooms at one point were not even allowed to see a photograph of their prospective brides so as to preserve an unmarried womanʼs purity. Typically. and. they were actually allowed to talk to one another prior to the wedding—with a roomful of gawking people. since the yield is low. You can calculate the dividend yield by dividing the stock’s dividend per share by the current stock price. The concept of a dowry is alive and well. and takes the form of cattle. investors should look at other factors to see if this is indeed the case. By the 1930s. cultural. Admittedly. Middle-class women are even allowed to reject suitors favored by their parents. and cash. By the 1960s. Price/Book Value This refers to the relationship between a stock’s current price and its intrinsic worth or book value. Such contractual arrangements can become quite oppressive. most importantly. jewelry. what degrees they have. As a result. but that is not usually the case. One day a squirrel (we will call him Chippy) happened to climb down from the huge oak standing over his deck chair. sometimes you can find a winning company by merely being in the right place at the right time. Journals like Nature and JAMA (Journal of the American Medical Association) Learning by Analogy: The Exploits of Chippy the Squirrel When my grandfather was young and living in his country home in India almost a hundred years ago. For example. However. Pretty soon. You should model your investment strategy after this.What Are Stocks? 35 could also imply that there is something fundamentally wrong with the firm. Chippy would wait patiently for him to finish his tea and go back into the house before climbing down and drinking the rest of the tea from the bottom of the cup. being the angel she was. Find a small company with a great product and do your research. my grandparents noticed another squirrel trailing Chippy during his evening visits to the house. As with other key measures. It got so bad that on those days when grandpa could not make it to the garden with his tea cup. Sometimes you have to do the hard work to create your own luck. is a fanatic about preparation. if you are interested in the biotech sector. this is rare. He even got his girlfriend in on it. read medical journals or attend pharmaceutical trade shows. little Chippy would wait in one of the low-lying branches of the tree for grandpa to show up with his teacup. which he then exploits on game day. Time passed. It was assumed she was Chippyʼs significant other. he would have his evening tea in his beautiful flower garden. Finding Winning Companies Let’s face it. He reviews hours of tapes of his opponents to find each tiny weakness. the quarterback of the Indianapolis Colts. you may even be able to create a little luck for yourself. both Chippy and his girlfriend became permanent fixtures of the house—both addicted to caffeine and needing their daily fix. and drank the tea left at the bottom of the cup. and not given to Chippyʼs boisterous behavior. and after awhile. . because Chippy was hooked. While you cannot control luck. the little guy became bolder and bolder. by the way) is that Chippy accidentally found a good thing and stayed with it. A higher P/B ratio might imply an overvalued stock. Peyton Manning. Chippy would come inside the house through one of the open windows and impatiently demand his tea. But you canʼt always be so lucky. The point of this little anecdote (it is a true story. my grandmother. This newcomer was shy. Soon after. started fixing tea separately for the regular evening house guest. So a second cup of tea was fixed for the new guest. The rest of us need to work hard and have a lot of luck. only to watch it grow and become more popular than they could have ever predicted. The caffeine in the tea must have worked. The key is to find potential trends before they become mainstream trends. you can certainly control your own preparation. you will need to compare the company’s numbers with those of its main competitors and with the industry group as a whole. Then. From then on. If you always do diligent research. and pretty soon. He would sit right next to grandpaʼs chair chirping impatiently for his evening fix. Some people are lucky enough to invest in a company when it is relatively unknown. utilities. and telecommunications. you have a plethora of e-mails from supposed stock-picking experts who claim to have identified a little-known penny stock that. Using this approach. that spent many years and millions of dollars on the development of a drug. If only you had invested in the company. investors identify industries that are likely to perform well in the coming years. in turn. reading about drug trials. retailers and wholesalers. Martha Stewart. These industry groups can be anything from basic materials to energy. Just because the tech boom is over does not mean that the prospects of all tech sub-sectors are grim. like AIDS and cancer. ultra-small chip! Beware of E-mail Scams If you are like me. you too could have received huge gains. such as semiconductors. and accordingly buying stock in the parent company might be a lucrative investment strategy. only to have it ultimately rejected by the FDA after a few rounds of trials that seemed positive.36 Chapter Three will make you more knowledgeable about ongoing drug trials by pharmaceutical companies for currently incurable diseases. had gained astronomically in value in a short amount of time. divided into a number of sectors. hardware. finance. spent time in prison after it became known that she was privately informed of the rejection before that information went public. since they discovered it. when a drug company completes a successful testing phase for any of its drugs under the auspices of the Food and Drug Administration (FDA) and gets approved for the next phase of tests (a successful drug has to go through many testing phases before being formally approved by the FDA for release in the market). software. you will read about how one drug company. An e-mail I received recently brought to my attention a small company called Global Exploration (ticker: GXXL). if it’s the technology industry that you identify. Failure at any stage will almost certainly lower stock prices. that operates websites aimed at Americans from South Asia. and subsequently tried to dump her shares of the company. technology. you have to chose a promising sector within it. For example. who was friends with the CEO and was a large shareholder herself. its stock price goes up. there are a variety of sectors within this group. with the magnitude of the decline determined by the importance of that particular drug to the company as a whole. cyclicals to noncyclicals. For instance. media and leisure. and many more. health care. In sum. The day after I received the e-mail. the stock was suddenly trading for . Each of these industry groups is. IMCLONE. Once you have identified an industry group that you think is promising. Semiconductors could easily regain popularity in the next few years with an ultra-powerful. The Top-Down Approach One way to find winning stocks is to follow what is known as the Top-Down Approach. and then attempt to identify specific companies in that industry that represent good investment opportunities. attempting to predict when they will be successful. In the chapter on insider trading. and television fame—boasted an average return of 23. the stock has since fallen to about 3 cents per share. the ladies went to Price Waterhouse for an audit and discovered that their actual return was an unimpressive 9. Before long. It sold 800. That was the end of their mystique.What Are Stocks? 37 twice its typical price and with twice the average volume of the prior two weeks. which showed some improvement. which combined down-home recipes with investment tips. That still lags behind the comparable S&P 500 return of 17. Sadly for those investors hoping to make a quick buck.000 copies.3 percent. had “23. usually in the basement of First Lutheran Church in Beardstown. This is known as a “pump and dump” scheme. but frauds nonetheless. Illinois. but it’s better than the average stock fund gain of 13.4 percent between 1983 and 1993. hundreds of speeches. But. investors had paid anywhere from 5 to 7 cents to snap up nearly 1.4 percent on their investments. Their first book. Do not to fall for these traps! They are designed to get you excited about a stock and entice you to buy shares. Subsequently.4 to 4 cents per share.” Have you ever wondered what it means? Investor sentiment implies that people trade for reasons that are not fully . Evidently. Five books.9 percent and even the average general stock fund return of 12. Unfortunately. which we will see again later in the book. the stock had typically traded for 3. a few years ago. and dozens of national television appearances later.1 percent—far less than the Standard & Poor’s 500 average annual return of 14.8 percent.2 percent. Investor Sentiment and Overconfidence We often hear the term “investor sentiment.6 percent during that same period. The women formed their club in 1983. as they earned an average annual return of 15. along with the potentially lucrative cottage industry they had developed. video. They meet the first Thursday of every month.2 million shares of the company. Specifically. The Saga of the Beardstown Ladies: Crooks or Just Naïve? The saga of the Beardstown Ladies is one of a group of stock-picking grandmas who made national news by popularizing their supposedly successful way of investing. the fifteen women who now comprise the Beardstown. The ladies first thought they might have been counting annual club dues as investment gains (they weren’t). Before the e-mail was sent out.4 percent” emblazoned across the cover. each investing $100. Ladies’ Investment Club—of book. they were making incorrect entries in their computer. the people who sent you the e-mail cash in on their holdings at the elevated prices you have helped create. mind you. The ladies had another audit in 1997. out-performing mutual funds and professionals. thereby pushing its price up. each member contributed $25 a month. the popular ladies were unmasked as frauds— unintentional. Chicago Magazine challenged their claim that they earned a compound annual average return of 23. No one double-checked the math. Feeling the heat but undaunted. Dan Kahneman and Amos Tversky. Some say that the questioning of modern finance began with the seminal paradigm known as Prospect Theory introduced in the 1970s by two economists. How does such overconfidence translate into trading strategies and trading profits? Research has found that investor overconfidence can have both good and bad effects. The theoretical explanation of why traders might become overconfident might go as follows: Let’s say that the trader in question does not initially know his own ability. Overconfidence reflects a very basic human instinct to overestimate our skills. women are no more risk averse than men. 2008. A. based on several experimental studies conducted by these gentlemen. . The tulip bulb fiasco in seventeenth century Holland is a classic example of this kind of behavior. Prospect theory. But in assessing his ability. The authors surveyed approximately 1. including the Efficient Market Hypothesis (we will talk about the EMH soon). Reference: Hibbert. were selling at exhorbitantly high prices because of market and investor overconfidence. Overconfidence can also manifest itself in a belief that we are somehow smarter than “them. he infers his ability from observing his own successes and failures. Tulip bulbs were trading at fantastically elevated prices and those who bought them truly believed that they could sell them at even higher prices. He becomes an overconfident investor. or large swings in stock prices—which is a bad thing. and the accuracy of our information.. Another term that is related to this is investor overconfidence. As he goes along in life. rational—or in ways that defy common sense. Lawrence. Silly companies. Their findings suggest that when individuals have the same level of education.38 Chapter Three Women Are No More Risk Averse than Men A recent paper measures the gender gap in risk aversion using a sample that controls for bias in the level of education and knowledge of finance. they managed to burst the very bubble they were trying to capitalize on. When entrepreneurs rushed to capitalize on the Internet bubble by taking companies with half-baked ideas public. It has been shown that almost 70 percent of negotiators believe that the arbitrator will rule in their favor. irrespective of their knowledge of finance. E. Over 80 percent of the drivers on the road believe that they rank among the best 30 percent. But it can also lead to increased price volatility. with even sillier ideas. Prakash. It can lead to higher trading volume and more informed stock prices—these are good things. and A. our prospects of success. is based. Florida International University. can be thought of as an alternative to the utility maximization idea on which modern finance.400 finance and English professors from universities across the United States and compared their actual portfolio allocations to those of respondents in the Federal Reserveʼs Survey of Consumer Finances (SCF). M. Overconfidence does not just afflict investors.” Such an attitude can lead entrepreneurs or investors to seriously overestimate their chances of success. he assigns too much weight to his successes and too little weight to his failures such that he overestimates the significance of his successes. Are women more risk averse than men? Working Paper. markets are weak-form efficient. To understand this more clearly. too. markets in emerging countries are probably closer to weak-form efficient. then an investor could not make systematic profits by trading only on publicly-available information because all public information would already be reflected in the stock prices. So what kind of markets do we have in the United States? Common sense suggests that they are probably close to semi-strong–form efficient markets. with the latter. in all their decisions in everyday life. by contrast. These critics argue that everything behavioral researchers claim disproves the standard finance paradigms can. The other foundation of modern finance was constructed by three economists in the late 1960s and early 1970s. a strong-form efficient market implies that stock prices contain all information—public and private. is a description of how individuals evaluate losses and gains. The EMH implies that if the U. If markets were weak form efficient. An important difference between the utility maximization theory and prospect theory is that. It is known as the Capital Asset Pricing Model . in which losing money is always a negative thing and the concept of framing has no place. in fact. From a regulatory standpoint. the price of an asset should reflect all of the available information on that asset. The fact that they are able to make a living looking for and trading on price patterns indicates that the markets are better than weak-form efficient. an investor could not make systematic profits by simply trading based on the past sequence of prices. changed how we viewed markets overall—not just the financial markets. a semi-strong–form efficient market. if our markets were strong-form efficient. are trying to maximize some unobservable utility function. and a strong-form efficient market. a Chicago economist. Prospect theory. he may gain positive utility from the loss—a notion that is unthinkable in the utility maximization theory. the EMH perhaps argued for governments to back off from interfering with their country’s day-to-day operations. however. behavioral finance has its critics too. Finally. The EMH argued that. be explained rationally. chartists. if an investor loses a lot of money in the stock market. the way in which an individual subjectively “frames” an outcome or transaction in his mind will affect the utility he expects to receive. there would be absolutely no legal way to make profits on a consistent basis. Thus. we need a bit of perspective. markets are semi-strong–form efficient. the term prospect was used to refer to a lottery. put forward the Efficient Market Hypothesis (EMH). How could an investor make profits in a semistrong–form efficient market? By using research to discover new information not already reflected in the price.S. Fama further conceived of three different types of markets: a weak-form efficient market. so the theory was a way to understand how the winnings and losses from a lottery will be evaluated (and internally processed) by individuals. The EMH. By contrast. and day traders who claim to make their living looking for price patterns would be out of work very quickly.What Are Stocks? 39 The utility maximization idea simply states that individuals. In its original formulation. The basic idea behind it was very simple. Eugene Fama. then all the technical traders. in an efficient market. but frames the loss as a learning experience. If. Put differently. Of course. In 1970. Professor Hershfield and his colleagues have an interesting method that tries to connect a personʼs present and future selves. financial planner is trying to tell them. San Francisco. Increasing saving behavior through age progressed renderings of the future self. F. but may be tuning it out or not taking it seriously until itʼs too late to do anything about it. Sharpe. the authors propose an experiment in which the subjects are allowed to interact with realistic.S. D. the researchers performed various robustness checks. If we take into account the recent financial meltdown. like smoking cessation or weight loss. I am always after my students to start thinking about their retirement portfolios when they are in their twenties. In recent research. References Hershfield. Specifically. Fox. The conclusion is that seeing age-processed renderings of themselves seems to trigger retirement planning behavior. the fifty-six participants who submitted acceptable photos were randomly assigned either the future-self or current-self groups. such warnings fall on deaf ears. financial planners and other investment professionals are always trying to get their clients to start planning for the future. L. Yeykelis. Talkinʼ ʼbout my generation: The economic impact of aging U. and then are observed to learn if such interaction causes them to allocate more resources for the future. by helping people become more connected with their future selves. The study builds on the work of those who have argued that the cause of irresponsible behavior is a failure to connect oneʼs present self with oneʼs future self because of a lack of imagination.S. Bailenson. 2011. that picture gets grimmer. L. In the first part of the study. This area seems promising. H. we are hearing the message. A survey done by the McKinsey Global Institute in 2007 observes that about two-thirds of the early baby boomers do not have the resources to maintain their pre-retirement standard of living in retirement. And who can blame the youngsters for ignoring what a grey-haired professor or an equally boring. but well meaning.. A few weeks later. Based on these and other related observations. age-processed renderings of themselves. In my personal finance class at Purdue. including testing if the saving behavior could be induced by showing participants any picture of an elderly person (not themselves). the researchers recruited Americans aged eighteen to thirty-five (twenty-two women) through Amazonʼs online marketplace to participate in a study on virtual reality in exchange for $11. Can we artificially tweak peopleʼs minds in a way that we can then get them to behave in “appropriate” ways? For example. While it is too early to tell how accurate and replicable such studies are. For the most part. Can we do something that will get them to think seriously about retirement savings? It turns out that there may be a ray of hope. Therefore. households would fall at least 10 percent short of reaching their target wealth accumulation rates in retirement. potential participants submitted photographs of themselves holding up a sign that displayed the current date and time. In the final analysis. When they did this. eighteen participants were assigned to the future-self condition (these participants would see both their current and future selves) and twenty participants were assigned to the current-self condition (these participants would see only their current selves). G.40 Chapter Three Can We Improve People’s Savings Behavior by Connecting Their Present and Future Selves? Here is an interesting thought. W. N. J. L. E. and J. To assure that their findings were accurate. Carstensen. observe that around 43 percent of U. Goldstein. the participantsʼ retirement savings did not show any noticeable increase. they do allow for the possibility that we could induce appropriate behavior in other areas. 2008. . McKinsey Global Institute. CA: McKinsey and Co. it appears clear that there is a systematic disconnect between the message and its execution. baby boomers. Put differently. Journal of Marketing Research (forthcoming). The researchers found that those who saw their future selves allocated a higher percentage of their pay towards retirement relative to the group that only saw their current selves. Hershfield et al. Hanukkah effects. In some sense. these reported effects were given the moniker “anomalies” to classify them as lying outside of the realm of the establishment. The crux of their argument was that we should stick with the EMH because there was no other viable alternative. while others are slowly gaining relevance. the weight of the evidence will eventually force a consensus decision. the conventional framework of the EMH will have to be adjusted to accommodate the new data. They also attacked the empirical evidence itself. Another economist found that smaller NASDAQ stocks were more “liquid” than comparable NYSE stocks.e. We will just have to wait and see. end-of-the-year effects. Investors should be expected to earn a premium for being willing to hold beta risk. The validity of the CAPM implies the existence of the EMH. The problem was that if the EMH was true. One popular theory is slowly fading from relevance. and they began to defend it vigorously. and so on. such abnormalities should not be observed. The slope of this relationship. we are at a crossroads in economic thought. Researchers analyzing actual market data started getting results that seemed to challenge the established doctrine. Simply put. whatever that may be. not systematic). researchers also started coming up with findings that suggested that stocks exhibited end-of-the-month effects. vying to replace it. Interestingly.What Are Stocks? 41 (CAPM) and it shows a linear relationship between market returns and an individual firm’s returns. January effects. We in academia publish the results we have and not the results we would like to obtain. To make matters worse. holding. The interesting thing is that the CAPM and the EMH are connected. Festivus effects (Seinfeld). it actually proved the validity of the EMH rather than disproved it. these researchers were reporting that the simple act of buying. arguing that because the evidence was random (i. For the next twenty-five years or so. As the weight of the evidence builds. whether the creators of the EMH like it or not. For example. Whether behavioral finance will become viable and eventually displace the EMH remains to be seen. Even if the creators of the EMH get indignant. and then selling stocks across the periods mentioned above provided systematically abnormal stock returns. also known as “ beta. The life’s work of the founders of the EMH was being challenged. weekend effects. EMH and CAPM continued to be the cornerstones of modern finance. Yom Kippur effects. researchers in the 1990s reported significantly higher returns for NYSE-listed firms than for firms listed in the NASDAQ. But then things started to change. It’s similar to former Defense Secretary Donald Rumsfeld’s now infamous comment about going to war with the army one has and not with the army one would like to have.. .” is the sole determinant of risk. rather than accepting the possibility that something may be challenging the status quo. but realizing losses causes one to implicitly admit an erroneous investment decision. Such studies have added to our understanding of why people trade. they may create momentum. Others have found that investors who choose to make investments online are better performers than those who did not go online before the switch to online investing. The researchers attribute their findings to the fact that men are generally more overconfident than women.8 An earlier related study reveals that . but a calibration of a specific model that would deliver the magnitudes of volume observed in reality would be desirable in order to build a complete understanding of trading activity. two economists confirm the disposition effect. Interestingly. Therefore. the NYSE website indicates that the annual share turnover rate in 2003 on the NYSE was almost 100 percent of all shares outstanding. which can be described as a tendency to sell winners too soon and hold on to losers too long.42 Chapter Three How Does Behavioral Finance Help (or Hurt) Individual Investors? Contributed by Avanidhar Subrahmanyam Goldyne and Irwin Hearsh Chair in Money and Banking University of California.6 Another study shows that individuals appear to particularly prefer stocks with lottery-like characteristics (i.7 Recently. but excessive trading after the switch dissipates their profits. A particular study finds that individuals who trade the most are the worst performers. again suggesting evidence of reference price effects. by under-reacting to negative information.5 The intuition is based on an evolutionary rationale where men.. it has been shown that small traders. In a comprehensive study of trading activity in the Finnish markets. high volatility and skewness). as hunter-gatherers. Los Angeles Traditional finance has focused on explaining asset prices. while trading activity itself has generally been ignored. on net. Apparently.4 A related study reports that women outperform men in individual stock investments. It has been shown that there is a disposition effect prevalent among individual investors. suggesting a perverse outcome to trades by individual investors. in that individuals are more likely to sell if the stock price attains a past month high. there is also a significant increase in volume if the stock achieves new maximum and minimum prices. Simple math reveals that the investing public is voluntarily paying several billion dollars in commissions to brokers every year. buy losers and subsequently become net sellers in these stocks suggesting that. past winners do better than losers following the date of sale of stock by an individual investor. are required to be overconfident to take risks for the purpose of hunting to acquire food.2 The disposition effect is consistent with the notion that realizing profits allows one to maintain self-esteem. overconfidence induces them to switch. it seems reasonable to want to analyze the extreme levels of trading volume and provide an intuitive explanation of where such volume comes from. an essential ingredient for survival. but became worse performers after the switch. and hence is avoided. Yet.e. They also show that there are reference price effects.3 Furthermore. has one tail that is longer than the other tail. letʼs first understand what skewness isnʼt. if I tell you that the prices of small-cap stocks are positively skewed.9 This implies loss-averse behavior.11 Further. investors in the options market do not react properly to volatility information about the stock market. which has the familiar bell shape and no skew. supporting the familiarity hypothesis. on the other hand. bond prices. The skewness of a probability distribution simply refers to the "tails" of the distribution and how they slope at each end.12 And while we prefer stocks with high brand recognition. individual investors appear to exercise their stock options when it would clearly be more profitable to sell them. and particularly investment-grade bond prices. The skewness of a probability distribution can determine the relative likelihood for extraordinary gains or extraordinary losses. First. have been shown to be negatively skewed. which should suggest that the chances of abnormal losses outweigh the chances of abnormal gains. consider the normal distribution. This means that each tail of this distribution has the same shape and length. A probability distribution is simply a range of outcomes that are plotted against the frequency that those outcomes occur. you may be wondering how all of this is related to personal finance. suggesting that we (the individual investors) may be exhibiting stronger behavioral biases. the trade imbalances of small investors are negatively related to future stock returns. These findings are consistent with the notion that small investors overreact to information. For example. a positively-skewed distribution has a longer tail on the left. The implication of a symmetric distribution with no skew is equal to the probability of the occurance of an outcome below the mean is equally likely as an outcome above the mean. Prices are affected by this behavior. in the sense of interacting more with peers at collective gatherings such as in churches or synagogues. skewness is related to probability distributions. more investors who are young and less wealthy hold under-diversified portfolios. The normal distribution is symmetric around its mean.13 we are also more prone to hold stock in firms that are located . A small but growing line of literature also provides evidence from derivative markets that investors do not seem to incorporate information properly. At this point. since the investors are willing to buy contracts at higher prices than those that prevailed earlier.10 Another study shows that reducing investor autonomy by forcing investors by default to participate in a savings plan until they choose to opt out (as opposed to requesting them to enroll in the plan) actually increases their savings rate. below the mean. Specifically. For comparison purposes. For example.What Are Stocks? 43 Skewness In order to understand what skewness is. it should immediately suggest to you that investing in such stocks has the potential to reward you with significant gains (and has less potential to cause significant losses). are more likely to invest in the stock market. An asymmetric probability distribution. Stock market participation may be also be influenced by social interactions in that people who are more social. Do behavioral biases of investors actually affect prices? Research provides evidence of this in that proprietary traders on the Chicago Board of Trade (which mainly trades derivative securities like options that we will discuss later) take more risk late in the day (as measured by number of trades and trade sizes) to cover their losses in the beginning of the day. Additionally. and the reversal of their sentiment may cause stock return predictability. Similarly. In fact. but intuitive. divide the total by twelve.. the number of . mutual fund managers are more likely to buy stocks that other managers in the same city are buying. This is like taking the pulse of the patient—the patient being the NYSE and the NASDAQ. while continuing to lose money on average. one study suggests that there is actually a wealth transfer from individuals to institutions via the stock market—the wrong direction!18 Why then do we trade? Perhaps because for us.e. the evidence on individual investors presented above suggests that we are not particularly sophisticated in designing trading strategies. To have a better understanding of indexes. if the NYSE ended the day down. individual investors. your personal holdings could have had a fantastic day. reflecting the agricultural base of the U. If you haven’t heard of it. Indeed.44 Chapter Three close to us—showing a geographic bias in addition to name recognition. it does not mean that every stock trading in the NYSE was down. proverb of the blind men and the elephant. as the economy grew in size and scope. would be extremely useful. the DJIA.16 Finally. we do not appear to achieve particularly impressive returns. But. Further investigation on why we may be willing to trade.14.S. affectionately referred to as the Dow. The chosen companies spanned agricultural products and utilities. economy. The Dow Jones Industrial Average (DJIA) The oldest and most popular index. Over time. and started publishing these numbers on a daily basis. suggesting that one factor impacting portfolio decisions is a word-of-mouth effect by way of social interaction between money managers. we trade for the sheer pleasure that trading provides us in a manner similar to watching a sport or a film. first consider the silly. Stock Indexes: It’s All about the Pulse Do you pay attention when the evening news anchor concludes the broadcast by saying something like “The Dow ended the day down twenty points and the NASDAQ ended flat?” We all hear it and nod our heads sagely. but do we really know what these guys are talking about? They are talking about stock market indexes. when an enterprising reporter named Charles Dow decided to add the closing prices of twelve important stocks. just read the following box and you will be up to speed. The value of the pulse and its direction—up or down—from the previous day’s closing value is simply a reflection of the overall mood of the market. And. worse. trading is akin to a consumption good—i. Here are some common indexes and what they stand for. or gambling in Las Vegas or Atlantic City.17 Overall. The pulse is supposed to capture how the markets performed overall that day in a single number. in the sense that such managers tend to show a proclivity for stocks headquartered in the region in which the managers themselves are based.15 The individual investor’s preference for local stocks extends to professional mutual fund managers. traces its history back to 1896. What Are Stocks? 45 Anecdote: Five Blind Men and an Elephant Five men who have been blind since birth approach an elephant.” while the man who touches the trunk says “An elephant is like a snake. There is another reason why it is preferred over the Dow by practitioners and researchers: the index is “market valueweighted. so this index is much broader and deeper than the Dow. Since each touches a different part of the beast. The Amex Market Value Index is a market value-weighted index of the American Stock Exchange. Given that the NASDAQ is the home of the technology stocks. In reality. but none of which capture the entire market.” says the one who touches its side. In addition. each of which tries to describe whatʼs going on in a part of the market. so each stock within the index has the potential to impact the index equally. they feel that it better conveys the uncertainty in the markets. One criticism with the Dow is that it is a simple “price-weighted average. . touch only one part of it. It is a market value-weighted measure of some stocks traded in the NASDAQ over-the-counter market.S. but each has its own truth.” which means that the DJIA simply averages the prices of the thirty stocks. Only one of the original companies has survived the years and continues to be included in the index today: General Electric (GE was dropped from the index in 1898 but included again nine years later).” says the man who touches the ear.S.” “Choppy” means swings in prices captured by the standard deviation. too. Finance experts in the media are fond of using this term. “An elephant is like a big leaf. stock market. intuition suggests that the larger stocks in the index should influence the index more than the relatively smaller stocks .” says the man who touches its tail. Here are some examples: The New York Stock Exchange Market Index is a market value-weighted index of all stocks traded on the NYSE. These stocks make up over 75 percent of the value of the U. Perhaps the most popular exchange average in recent years is the NASDAQ Composite Index. and then discuss what an elephant is. Each has its limitations. of course they disagree. “The Dow ended the day up twelve points” or “The Dow was choppy today and ended flat. stocks included in the index increased from twelve to thirty. “Youʼre all wrong.” That means the biggest companies make up the biggest part of the index. The man who touches the leg says “An elephant is like a tree. You will hear pronouncements like. each stock exchange also has its own index made up of some of its stocks.” What is the moral of this story? There is some truth in each of these impressions. the index is loaded with computer and technology companies. The Dow is the fodder of evening newscasts throughout the U. but none seems to describe the whole elephant. or the variance. as discussed earlier.” “An elephant is like a rope. so their price changes affect the index the most. “It is like a wall. It is the same with stock market indexes. The Standard & Poor’s Index of 500 Stocks (S&P 500) The S&P 500 index is a comprehensive index of 500 large-company stocks. independent of its relative size. enough about stock market indexes. The latter index is a popular measure of small company stock activity. do you think that during the next twelve months we’ll have good times financially. This question relates to the big things people buy for their homes—such as furniture. Would you say that you (and your family living there) are better off or worse off financially than you were a year ago? 2. the University of Michigan’s Index of Consumer Sentiment and the Conference Board’s Consumer Confidence Index. We are interested in how people are getting along financially these days. or just about the same as now? 3. Consumers are also asked to assess their personal financial situation. that we will have periods of widespread unemployment or depression? 5. do you think now is a good or bad time for people to buy major household items? After the surveys are conducted. consumer confidence is a term that represents for the opinions and attitudes of consumers about the current and future strength of the economy. What do these indexes measure? And why do they receive so much attention? Simply stated. This is a market value-weighted measure of all stocks. Since it is basically psychological in nature.000 stocks (the Russell 1000) and the bottom 2. Finally. Specifically. Changes in the indexes are often described as foreshadowing changes in economic conditions.S. television. traded on the New York. it is pretty difficult to measure.000 companies in the United States. What about other kinds of indexes. Amex. Looking ahead.200. . Generally speaking. of which there are approximately 8. Now looking ahead—do you think that a year from now you (and your family living there) will be better off financially. stove. the two primary measures of U. or bad times? 4. are released with much media fanfare. called an “index” of consumer confidence. the responses are aggregated into a single number. Russell has divided this index into the top 1. consumer confidence.000 stocks (the Russell 2000). The attention these indexes receive centers around the potential information they contain regarding current and future economic conditions. Each index gives you different information about the stock market. there is the Wilshire 5000. worse off. and NASDAQ stock exchanges. The University of Michigan and the Conference Board both measure consumer confidence by asking a random sample of consumers the same questions about current economic conditions and expected future conditions. Variation in this index is supposed to measure the variation in overall consumer confidence. Okay. which would you say is more likely? That in the country as a whole we’ll have continuous good times during the next five years? Or. a refrigerator.46 Chapter Three The Russell 3000 is a market value-weighted index of the largest 3. Now turning to business conditions in the country as a whole. like the Consumer Confidence Index? What does it measure? Consumer Confidence Index: Information or Noise? Every month. the questions asked are: 1. CFA Institute. 2008. In particular. In sum. economists have concluded that while the index has some power to predict changes in the economy. Can you think of some companies you have heard of that are not publicly traded? 7. A recent study attempts to tackle this question by investigating the change in the financial risk tolerance of many individuals over a five-year period and the factors that influence such change. the authors find a slight decrease in financial risk tolerance associated with a decrease in household size or the termination of a financial planner. What are some advantages and disadvantages of going public versus staying private? 6. Why might companies underprice their shares in the IPO market? 4. G. Thought Questions 1. we may be getting excited about something that is relatively insignificant. Working Paper. Why would an underwriter try to support a price level for the newly issued shares in the secondary market? 5. Is the infatuation with the index justified? After much investigation. Furthermore. Why does this index receive such attention? It is believed that such an index will provide an early glimpse of the strength of the economy or any impending downturn. V. What are some of the trade-offs between a company raising money by selling shares of its ownership versus simply borrowing the money from lenders? 3. What are the main differences between a growth stock and a value stock? . and D.What Are Stocks? 47 Does Your Ability to Tolerate Risk Remain Constant throughout Your Life? Academics appear to be divided on the question of whether risk tolerance is a genetic and constant personality trait or is something akin to an attitude or emotion that is likely to change over time. Reference: de Venter. Their results indicate that there is a relatively small change in individualsʼ financial risk tolerance over time. The authors conclude that financial risk tolerance is a stable personality trait that is unlikely to change substantially over the life of an individual. Can any company issue stock? 2. Michayluck. A longitudinal study of financial risk tolerance. its effect is really quite small. Another way of saying this is that consumer confidence is believed to predict the state of the economy.. the same studies also conclude that the Consumer Confidence Index does not appear to provide much additional information beyond that contained in other common forecasting data. Why would a company want to control voting rights through issuing multiple classes of shares? 8. you are getting proven talent. Why is a value-weighted index more reasonable than a price-weighted index? 22. What kind of a correlation would you expect between the Consumer Confidence Index and a major stock market index? Notes 1. Think carefully about the similarities and differences between Prospect Theory and the Efficient Market Hypothesis. M. Barber. 3. Why are the stocks of emerging markets considered risky? 13. B. and T. H. Keloharju. Shefrin and M. Does the presence of anomalies support or refute the EMH? Why? 21. Overconfidence and Common Stock Investment.” Journal of Finance 56 (2001): 589–616. The trade-offs of signing a veteran football player are on one hand. What conclusions can you draw about a company that has a very large P/E ratio? 16. Can you think of other ways (not discussed in this chapter) to identify a potentially hot trend. hot stock. Can you think of events in recent history when an entire sector of stocks was affected due to one company’s illegal activities? 12. what are the trade-offs of investing in penny stocks? 15. 5. Puri. “The Disposition to Sell Winners Too Early and Ride Losers Too Long. R. Do you think the Beardstown Ladies did anything unethical? Why or why not? 19. How does it apply to you as an investor? 20. When is a penny stock right for an investor? 11. Why are tracking stocks out of favor with investors now? What is an alternative to tracking stocks? 14.” Quarterly Journal of Economics 116 (2001): 261–292. you don’t know how many more games they can play. Stanford University. while on the other hand. How do you rationally explain the stock prices of companies like Google (GOOG) that trade at more than 100 times their earnings? 17. Grinblatt and M. T. “Boys Will Be Boys: Gender.48 Chapter Three 9. Prabhala and M. Language and Culture Influence Stockholdings and Trades. Statman. Odean. “Price Support for IPOs Justified” Working Paper. N. or a hot sector? 18. Similarly. . Where did the name “blue chip” stock originate? 10. 2. Odean. “Do Investors Trade Too Much?” American Economic Review 89 (1999): 1279–1298.” Journal of Finance 40 (1984): 777–790. 4. “How Distance. ” Journal of Financial and Quantitative Analysis 40 (2005): 57–85. Frieder and A. Subrahmanyam. Benartzi and R. Shumway. Hvidkjaer. “Do Behavioral Biases Affect Prices?” Journal of Finance 60 (2005): 1–34. Huberman. Odean. 2006. Hong. “Social Interactions and Stock Market Participation. Thaler. and J. “A Trade Based Analysis of Momentum. 18. S. B. L. Moskowitz. 7. T. Coval and T. 11. S. J. 8. Kumar. “Who Gains from Trade? Evidence from Taiwan. Hong. Y. Kumar. Stein.” Journal of Finance 59 (2004): 137–163. University of Texas. Grinblatt and M. and T. Stein. 12. W. 2003. Barber. “Thy Neighbor’s Portfolio: Word of Mouth Effects in the Holding and Trades of Money Managers. J. .” Journal of Political Economy 112 (2004): 164–187. Barber and T. N. “Online Investors: Do the Slow Die First?” Review of Financial Studies 15 (2002): 455–488. 17.” Journal of Finance 54 (1999): 145–166. Y. “Save More Tomorrow: Using Behavioral Economics to Increase Employee Saving. Yale University. Lee. Kubik. G. Keloharju. 2004. University of California at Berkeley. Liu. Odean. Kubik. Coval and T. M. H. “Who Gambles in the Stock Market?” Working Paper. “Brand Perceptions and the Market for Common Stock. J. H. 14. 10. B. Austin. A. J. and J. “What Makes Investors Trade?” Journal of Finance 56 (2001): 589–616. 15. 16.” Working Paper. Goetzman and A. “Familiarity Breeds Investment.” Journal of Finance 60 (2005): 2801–2824. 13. “Home Bias at Home: Local Equity Preference in Domestic Portfolios. 9.” Review of Financial Studies 14 (2001): 659–680.What Are Stocks? 49 6.” Review of Financial Studies 19 (2006): 457–491. “Why Do Individual Investors Hold Underdiversified Portfolios?” Working Paper. J. . The chassis.e. I didnʼt know what that entailed but. how to trade them.S. It was a sky-blue Ford Mustang. we don’t have to worry about each individual component. was completey dry. we have talked about individual stocks. 51 . you could still work on cars yourself and didnʼt have to have them hooked to diagnostic machines to determine what was wrong with them. However. One day. Someone told me that the axles of the car needed greasing at regular intervals. I crawled under the car.. We can buy and sell packages of many stocks. I was determined to be hands-on and involved in my carʼs future and well-being. Once we make that single decision. —John Maynard Keynes So far. I was very proud of it. • A steadfast holding of these in fairly large units through thick and thin. We look at the bundle’s overall performance and risk. We have discussed how to identify good stocks. we do not necessarily have to buy and sell stocks on an individual basis. opposed risks. unfortunately. until either they have fulfilled their promise or it is evident that they were purchased on a mistake. perhaps for several years. conveniently bundled for us. grease gun in hand. I emerged from underneath my car. and I had purchased it with my own saved money. and make our investment decisions based on that information. By purchasing stocks in this way. Whistling a happy tune myself. Back then. our investment is instantly diversified Anecdote: Grease Monkey This is a story dating back to when I had just purchased my first car as a graduate student in the U. like a new parent. and so on. The following Saturday was a beautiful summer morning and the birds were singing. as investors. or Hedge? Investors should follow the following prescription: • A careful selection of a few investments (or a few types of investment) having regard to their cheapness in relation to their probable actual and potential intrinsic value over a period of years ahead and in relation to alternative investments at the time.4 What’s in a (Fund) Name: Mutual. a variety of risks in spite of individual holdings being large. Half an hour later. • A balanced investment position. I borrowed a grease gun from a friend. how to understand their traits. i. Exchange Traded. I was going to grease those axles. Needless to say. while I was greased from head to foot! The moral of the story? There are some jobs that are best left to experts! What does this mean for investing in mutual funds? Simply that some (stock picking) jobs are perhaps best left to the mutual fund managers. This was my baby and I was going to take excellent care of it. These bundles are called mutual funds. and if possible. 000 in 2003. however. The number of available funds increased from about 3.52 Chapter Four across many stocks. One reason mutual funds have skyrocketed in popularity could simply be the marketing campaigns designed to lure in investors.000 to almost $400. the Massachusetts Investors’ Trust. Since their humble beginnings. While the idea of pooling money for investment purposes was first born in Europe in the mid-1800s. the first pooled fund in the U. The average household has about $25. if that is not diversification. there are many to choose from. you could not invest in the fund. • I want to make money. mutual funds seem like a convenient way to invest in the markets without spending a lot of personal time doing the research and making the buy/sell decisions. By all accounts it was a successful venture.000 in 1990 to more than 8. and there are even mutual funds that invest only in other mutual funds! Now. but maybe I should start! On a more serious note. And my personal favorite: • I want to have fun! I have to confess that the last one suprised me. The first official mutual fund for the masses. A less cynical explanation could be that as Americans get busier. if you were not affiliated with Harvard. I have no time to do research. Because of these campaigns.000 funds in existence. A mutual fund is simply a pool of investors’ monies that is used to buy many different stocks. and guardians hold the rest. mutual funds have come a long way. and many companies now exist to help investors make intelligent choices. which in those days was a lot of money.000 in assets within a year. • I want a diversified portfolio. why do people want to invest in mutual funds? . and more than one in three households made their first mutual fund purchase between 1990 and 1995. There are now close to 10. mutual funds are quite popular these days.000 invested in mutual fund shares. lessening its risk. trustees. I don’t know what is.S. Almost three quarters of mutual fund assets are held by individual investors like you and me. In all my years of researching and teaching about investments. owning mutual funds is now equated with a certain upper-class lifestyle in which an investor has people working to make investment decisions for them. Explosive Popularity The popularity of mutual funds is growing rapidly. was created in 1924. But. was created in 1893 for the faculty and staff of Harvard University. Why Mutual Funds? Some common reasons I hear for investing in mutual funds are: • They are convenient. I had never thought of mutual funds as fun. Institutions. it grew from about $50. As it happens. Today. But there is still a single fund manger (or. Investors like mutual funds because they can invest in a variety of stocks with a relatively small amount of money. Smart investors diversify because it greatly reduces risk without sacrificing returns. you will definitely lose money. Consider the well-known maxim. . More diversification means less risk. and trade in the market on a daily basis. or Hedge? 53 Diversification The biggest advantage of using mutual funds to invest is diversification. you have to trust the overall fund manager to do a good job of researching the component funds. With $2. If you are invested in a variety of stocks. These funds exist primarily to provide diversification across managers’ investment styles. Do you think wealthy investors purchase just a couple of stocks? Of course not! If they are not using mutual funds (many do). “Offense wins games. Even if some individuals are better at picking stocks than professionals. these days we are seeing funds of funds: mutual funds comprised of other mutual funds in their portfolio. is the second layer of fees that are absent in a regular mutual fund.400. Also. Why? If you’re invested in one stock and that stock’s price falls. which in turn gives you a shot at winning championships. As I mentioned in the beginning of this chapter. When we invest in a mutual fund. of course. you could buy into a mutual fund and invest in literally hundreds of stocks. What if you wanted to take advantage of many different investment philosophies simultaneously without buying many different mutual funds? The answer lies in buying funds of funds.400. research. experience. When you buy a single fund. defense wins championships. we are able to take advantage of the time the fund’s skilled manager puts into investment decisions. People choose these investment vehicles to obtain stable returns while further reducing risk. you are essentially hiring a professional manager at an inexpensive price. they are purchasing a large number of stocks. so you are diversified across stocks. and good academic credentials. The underlying funds have a fee just as the overall fund does. This is a good deal—these managers have skills. Here is another way to think of diversification: Good football teams also diversify across types of players. you are much less likely to be affected by the bad performance of one stock. you get a lot of stocks that are a part of the fund’s portfolio. The downside. Diversification is important for investing. Buying 100 shares of Microsoft at current prices will cost you about $2. The Indianapolis Colts exemplified this with their incredible run through the playoffs in 2007. a single investment philosophy) that is guiding the entire fund’s portfolio. most of us would not want to spend the amount of time it takes to watch. Professional Management When you purchase mutual funds. you need to have both offense and defense. Can you explain why? Let’s consider diversification with regard to investments.What’s in a (Fund) Name: Mutual. Exchange Traded.” To win games. That is not a good way for Jane to start! Wealthy stock investors get special treatment from brokers and wealthy account holders get special treatment from the banks. Cost Mutual funds are excellent for new investors because you can invest small amounts of money and can invest at regular intervals with no trading costs. You simply have to put in your sell order during the day and when the market closes. carries high transaction fees. Both the store and the end user take advantage of volume discounts. You’ll be properly diversified despite the small amount you’re investing. who in turn buy in large quantities from Costco. In fact. and the same investment. It works the same way in a mutual fund. Customers are able to buy things at low prices in their stores because Costco buys huge quantities of the items at a large discount from the manufacturer. If you are doing your own taxes. some investment advisors recommend that if you have less than $10. the same account access. you are getting the exact same manager. similar to your checking account at the bank. making it difficult for the small investor to make money. their trading volume entitles them to certain perks. or IRA. a check will be sent to you or or the funds will be wired to your bank account. If you don’t have time to do your own research to pick and manage stocks. however. this can be a big deal.000 to invest. but mutual funds are non-discriminatory. .000 invested in the fund. This can be much more difficult with individual stocks. which they can then pass on to the fund investors. mutual fund companies can take advantage of economies of scale. Consider Costco’s business model. It doesn’t matter whether you have $50 or $500. they often trade commissionfree and have personal contacts at brokerage firms. Investing in individual stocks. depending on what kinds of stocks you are invested in. With some funds. the minimum investment is as low as $250 for an Individual Retirement Account. They pass these savings on to their customers. In other words. then mutual funds are probably the best way to go. Another reason investors like funds is that they can invest small amounts of money. Ease of Use Can you imagine keeping track of a portfolio consisting of hundreds of stocks? The bookkeeping duties involved in owning individual stocks are much more complicated than in owning a mutual fund. With large sums of money to invest. her investment is automatically lowered 15 percent every time she invests. mutual funds are highly liquid (easily convertible to cash). or are short on time.54 Chapter Four Efficiency By pooling investors’ monies together. Liquidity If you find yourself in need of money in a short period of time. which means you can actually write checks from the account. Some mutual funds also carry check writing privileges. a fund is the only way to go. If Jane wants to put $100 a month into stocks and the broker charges her $15 per transaction. 000 companies. Certain mutual funds can be riskier than individual stocks. This is primarily due to diversification. . each mutual fund is set up as an individual corporation complete with a governing board of directors. Hence. but you There is a sense among novice investors that have to go out of your way to find them. one concern is that the company you are investing in will go bankrupt. Also. your money is still safe. But what happens if the mutual fund company itself were to go bankrupt? It turns out that if that were to happen (and chances are it wouldn’t). and many more. nor do you have to worry about converting to U. then you are in for a big unpleasant five-star funds. that are earning at least as much return as their risk would suggest—and possibly more. mutual funds allow you to invest without worrying about foreign restrictions on buying or selling securities. Yet another advantage is that for international stocks or bonds. Also. Some funds combine different kinds of assets. and the chance that all of those companies would go bankrupt is extremely low. For example. Exchange Traded. or Hedge? 55 Risk In general. if the fund were to file for bankruptcy. Focus Measuring Fund Performance How do we measure fund performance? Unfortunately. investing in a mutual fund is a completely safe bet.What’s in a (Fund) Name: Mutual. As long as you stay with four. Specifically. funds that invest in specific sectors.S. dollars when you buy and sell. Mutual funds typically hold anywhere from twenty-five to 5. it would be treated as a regular corporation filing for bankruptcy and the fund’s assets would be protected. fund performance mirrors the performance of the fund’s asset class. It is important to note that the past performance of a fund is never a guarantee of future performance. This makes international investing through mutual funds very convenient. With stocks. mutual funds care much less risky than individual stocks. you are investing in funds surprise. but I do hope you see the advantages of using mutual funds. bond funds. there are stock funds. there is no single measure for funds because they can invest in any type of asset. real estate funds. and that you will definitely make companies like Morningstar have made pickmoney if you do so. I won’t tell you to never invest in individual stocks. However. valuable information can still be gleaned from an accurate analysis of a fund’s past performance. you don’t have to deal with the innumerable regulations that come with investment purchases in foreign countries. an investor will want to compare a fund’s performance with that of other funds of a similar size and with the same type of asset in their portfolio. On average. Under the Investment Company Act passed in 1940. If you buy mutual funds ing mutual funds easy with their star rating system.and thinking that you are guaranteed to make money. The sections below are intended to help you locate and understand the important information in a prospectus. the Motley Fool. For example. Fund Investment Strategy Section You will want to know what investment strategy the fund uses. We may visit the comany’s website and cursorily scroll through the online prospectus. expenses. over time. and that it plans to have at least 80 percent of its assets invested in small-caps at any given time. which they would carefully examine. growth. It is easy to find the posessential questions: itive information about a fund in its prospectus. or aggressive growth) and then screened for funds in that category that have delivered good results in the past. which is a legal document containing information about the fund’s objectives. and other mutual fund–related websites. What returns have the fund delivmation. investment All prospectuses should answer two strategy. if you are the investor who likes small-cap companies. and what advertisement for the fund. you have to go beyond the cover. etc. and hardly anyone bothers to order printed copies. everything is available online. but this is not generally as thorough a reading as we would conduct with a printed copy in our hands. If you are a conscientious investor. In the past. but to really understand a fund. How much is the fund going to but a little more difficult to find the potentially make from managing your money? negative (and perhaps most important) infor2. Morningstar. growth and income. Say you like this objective because of the intrinsic profit potential in small-cap stocks. and you decide to invest in the fund.” it means any company with a market capitalization below $1 billion. The information provided below has been compiled from a variety of resources. but it also contains does it generally invest in to achieve useful information if you know what to look for these results? and where to look for it. 1. You should note that there is no guarantee in the prospectus that the fund will sell those stocks that. investors would receive a paper copy of the prospectus. this section might tell you that when the fund says “small-cap. but will describe the fund’s objective and how it intends to attain it. the prospectus serves as an ered for investors in the past.or large-cap.56 Chapter Four It’s All in the Prospectus Every mutual fund must release a prospectus. may grow from a small-cap to medium. For example. After all. you could learn from this section that the fund manager does not just . including private conversations. The sections of the prospectus dealing with the fund’s investment strategy and accompanying risks will provide specific details about the fund’s personnel and investment techniques. Questions Fund Objectives The prospectus will not detail actual fund holdings. then you will have determined the type of fund you want (for example. It is important to examine a fund’s objectives carefully and consider all possible outcomes. The basic information contained within the prospectus is usually outlined on the cover page. Now. keep in mind that it is not purely out of the goodness of their hearts.000 over the next few years. and “other” expenses. expenses run around 1. According to the experts. which is the SEC rule that permits funds to charge you up to 1 percent of assets per year for the cost of marketing the fund to you and other shareholders. Finally. and the exchange fee (what it will cost you to move money from one fund to another in the same family of funds). and using margin trading. Fund managers want to discourage investor redemptions because in order to provide the cash for a redemption. Many true no-load funds have no redemption fees. or a deferred sales charge. or the front-end load. We will discuss margin trading formally in Chapter 6. SEC rules require funds to disclose both shareholder fees and operating expenses in a fee table near the front of a fund’s prospectus. Before you start feeling warm and fuzzy about the funds giving you so much information. These time-sensitive redemption fees are designed to discourage investors from trying to time the market by jumping from one fund to another. Each is measured as a percentage of the fund’s average net assets and is payable every year. You should look for funds with expenses less than 1 percent. A healthy chunk of the expenses goes to 12b-1. The charge can run as high as 4 percent to 5 percent. All of these annual expenses are added up as a percentage of assets under management. Exchange Traded. filing documents with the SEC. A fund’s operating expenses can be broken down into the management fee. sending out financial reports. This is a charge for selling your shares in the fund.5 percent for the average equity fund. Revenues generated under 12b-1 may go to pay the broker who sold you on the fund. the sales charge to reinvest distributions (what it will cost to reinvest the annual profits the fund distributes to you). or Hedge? 57 invest in small-cap growth companies. That means funds will actually charge you for the cost of reeling you in. Another charge is a back-end load. also known as a redemption fee. other expenses include various administrative costs. so you can compare the operating expenses of different funds. and so forth. but it is usually reduced the longer you own the fund. for buying into the fund. managers must sell stock when they least want to. Fund Expenses Annual management fees are just one of the expenses an investor will find in the section on “Transaction and Fund Expenses. The expense ratio . or for that glossy brochure the investment company mailed you—all on your dime.” The transaction section tells you about the sales charge or “load” (what it will cost you to buy into the fund). for that commercial on cable that originally caught your eye. and some funds have no redemption fees except a 1 percent fee for investors who hold shares in the fund for fewer than six or twelve months. the marketing (or 12b-1) fee. The first item is the sales charge. but also gambles by trading futures and options. making the fund less attractive to you. taking short positions.What’s in a (Fund) Name: Mutual. the redemption fees (what it will cost you to sell your shares of the fund). which is made clear in a table showing what this will cost you in real money per $1. such as keeping shareholder records. The management fee is what you’re paying to fund managers for making the big investment decisions. S.5 percent. A broad-based index of large companies in the U. the fund should be able to save money just by virtue of its size (remember the Costco analogy?). Turnover Rate Another important metric often overlooked by investors is the portfolio turnover rate. would indicate that the fund manager doesn’t trade in and out of stocks. but is more comfortable making long-term investments (the fund has a passive investment strategy and lower costs). If you have to choose between two funds that generate similar total returns. The best known index is the Dow Jones Industrial Average (DJIA). This is because a fund investor typically pays taxes on the fund’s income and capital gains distributions. It’s not just simply advertising—it contains important information if you know where to look. stock market. which is defined as the percentage of total assets that were shifted from one investment to another over the past year. The pattern of turnover rates also gives you an idea of the kind of a tax bill you will be facing. The ratio of net investment income to average net assets is equivalent to the fund’s annual dividend yield. so an index fund tracking it will remain fairly constant. one of which has high turnover and one of which has low turnover. Collectively. is the S&P 500. A fund that doesn’t do a lot of trading should have higher unrealized gains and result in a smaller tax bill for you.S. while for an aggressive growth fund. stock .S. Index Mutual Funds An index fund is a collection of stocks (or bonds) which track the overall market or a specific segment of the overall market. this varies between 1. A mutual fund tracking the DJIA.58 Chapter Four should also be declining over the years because. for example. A turnover rate of 100 percent indicates that the entire portfolio was turned over (the fund has an active trading strategy and higher costs). In other words. don’t underestimate the prospectus. The stocks in the DJIA rarely get changed. these 500 stocks make up 75 percent of the value of the U. For an income-oriented fund. which consists of 500 stocks selected by Standard & Poor’s based on its internal research related to a company’s importance and its ability to represent a given sector of the economy. In sum. This is very important. the investment company should be able to leverage additional economies of scale. you should choose the lowturnover fund because you will save money on taxes. as we will soon see. whereas a series of years showing low turnover.5 and 3. This is an important measure because the fund manager’s trading pattern is one that you can reliably extrapolate from the past to the future. which is composed of the thirty major stocks across various industries that the editors at Dow Jones think best reflect the U. as a fund’s assets increase. this number is expected to be closer to 0. will hold those thirty stocks in its portfolio. Your tax bill will also be lowered because longer-term holdings will benefit from the lower capital gains tax rate.5 percent. say around 40 percent. because the goal of these funds is to maintain the same stocks in the same proportion as the particular index it is tracking. or Hedge? 59 market. Exchange Traded.42% 0. Computers do most of the work.18% Fidelity Spartan Total Market T. . so this average is much broader than the DJIA.23% Fund Name OTHER INDEX FUNDS Index Funds Don’t Have Fund Manager Continuity Issues Have you ever noticed that when the head coach of a sports team leaves and a new one is hired. However.10% T. with index funds. S&P 500 Index Dreyfus Basic S&P 500 Index SPFIX DSPIX 0. Manager continuity is one less thing to worry about with index funds. each manager has her own personal philosophy of investing. Mutual fund management is similar. this is not an issue.18 percent of the fund’s assets. while actively-managed funds can have expense ratios over 3.” meaning that the biggest companies make up the biggest part of the index and their price changes affect the index the most.50% 0.10% 0.09% 0. the organization goes through a period of flux? Almost predictably.36% 0.20% Dreyfus S&P 500 Index Fidelity Spartan 500 Index Schwab S&P 500 Select DWS S&P 500 Index S Fidelity Spartan Total Market Index PEOPX FSMKX SWPPX SCPIX FSTMX 0. Here are some examples of index funds (with ticker symbols for your convenience): Ticker Expense Ratio FUNDS TRACKING THE S&P 500 CA Inv. even within the specific philosophy of the fund. What’s so great about these index funds? Index Funds Have Lower Fees Index funds can be managed by a much smaller staff than an actively-managed fund. When a fund’s manager leaves and a new one takes her place. Index funds can have expense ratios as low as 0. Rowe Price Total Market Vanguard Total Stock Market POMIX VTSMX 0.40% Vantagepoint Broad Market Index II VPBMX 0. the team performs poorly for a couple of years until things settle down. It is also “market value–weighted. Rowe Price Total Market FSTMX POMIX 0. so there is no need to hire an expensive fund manager or research analysts.What’s in a (Fund) Name: Mutual. and then performance starts to improve.10% 0.40% 0.0 percent. the performance of the fund is in question until some time elapses and the performance of the new manager becomes easier to measure. This is because. While some life-cycle funds are funds of mutual funds. All life-cycle funds share the same goal of first increasing and then protecting your wealth. While some track indexes and maintain a relatively static mix of assets.m. For example. more conservative one. most life-cycle funds are more actively managed (read: higher management fees) by nature. the European market will be affected similarly when it opens the next day. This has resulted in the recent scandals concerning mutual funds. these funds and individuals make easy money. and degree of risk aversion all change in predictable ways. and conservative. invest about a quarter of each life-cycle portfolio in the actively-managed Vanguard Asset Allocation fund (ticker: VAAPX).m. if active fund management makes you nervous. and all trades made before that time are cleared at that established price. known as “late trading” is quite simple to understand when put in the right perspective. Vanguard funds. and Bank of America. One such practice. If a major event happens in the NYSE after European markets close. one’s needs. The hedge fund managers were allowed to make purchases after 4 p. and cash in accordance with their age and risk tolerance.60 Chapter Four The Real Deal: Fund-Related Scandals As in other areas. are valued at 4 p. Life-cycle funds simply adjust to the changing needs of the individual. the rest are just regular mutual funds.m.m. for example. by illegally buying at the previous dayʼs price. The problem with this is that sometimes news that seriously impacts the price of the component stocks. So. but hurt the rest of us. For example. and consequently the fund itself. Such news is sure to impact the fund price on the following day. You cycle through these funds (hence the name) as you journey through life—going from the young. Mutual funds. Life-Cycle Funds As one moves through life. you have the choice of staying with the more passively-run index funds. including Putnam Investments. ethical boundaries often get blurred by greed. major European markets close several hours before the NYSE. The scandals involve trade-related lapses that make money for mutual fund management at the expense of fund shareholders. scandals involving the mutual fund industry seem to be popping up everywhere and have implicated the bigest players in the industry. which advertise a passive indexing strategy. almost all available fund families offer life-cycle funds in three broad categories: aggressive. Another practice is known as “market timing. unlike the component stocks. They were first introduced in the early 1990s.” This is when hedge funds and connected individuals are allowed to trade at already-set prices in response to global events that occur after the close of the market in one region in order to take advantage of markets that are still open in another region. They make money for the wealthiest investors. As an investor. these investors can again make money (by selling at a higher price or by buying at a lower price) when Europe opens for trading the next day. bonds. Recently. moderate. . available wealth. which are private mutual funds run with the monies of a small group of wealthy investors. By trading the European stocks at the set prices today. at the already established price for that day. when they are legally mandated to stop taking buy and sell orders so that a correct fund value can be assigned. and offered investors groups of stocks. Any orders coming in after 4 p. But it turns out that many mutual funds have allowed exceptions to this rule—particularly those funds known as hedge funds. Merrill Lynch. EST. when funds grow very quickly with trillions of dollars invested industry-wide. are expected to be held over for clearance at the next dayʼs closing price. breaks after 4 p. aggressive investor to the older. These practices are illegal. So. And. Exchange Traded. Critics argue that any measure of fund performance is going to be colored by “survivorship bias. Statistics convincingly show that almost all mutual funds have suffered in the wake of the tech-bubble burst in March 2000. such as Morningstar. fund performance. for all this work. From here. Consequently. Research on Mutual Funds Economists have long tried to understand how mutual funds came into existence. the S&P 500 beats the returns of 80 percent of actively-managed funds (and that isn’t even taking into account tax efficiency). It’s not easy and requires patience if you want to do it right. invest in mutual funds if you want to expose your money to the stock market without spending too much time doing the research. They make the decisions about what to buy. ” That is. what to hold. Also. In sum. if you include all those funds that don’t make it. These can help you in the process of finding the right fund for you. By contrast. How to Pick Mutual Funds How do you pick the mutual funds that best suit your needs? I wish I could say that it’s a simple task. overall. Since the composition of the indexes rarely changes. Additionally. People have argued that because investors cannot constantly trade thoughout the day. Obviously. while index funds perform exactly like the indexes they track. they are cheap. the chances of any fund doing well are almost zero. many websites. you need to determine what your investment philosophy is and find a fund that best matches that philosophy. medium. categorize their funds by market capitalization (small. only the funds that survive get measured. which reflects the kind of stocks in which the fund is primarily invested. growth. the performance of actively-managed funds can vary.What’s in a (Fund) Name: Mutual. if you do. even though they would like us to believe they are. Fund managers are not miracle workers. If the whole market is down. then make sure you understand that mutual funds do lose money. And how do you do that? Fortunately. and diversified holdings. there are quite a few mutual fund screeners that are available now and are absolutely free to use. First. there would be a natural incentive to establish trading firms or financial market . and large) and by value. but it isn’t. passive (index) funds mirror well-known stock or bond indexes. in the long run. they charge you a lot of money. looks a lot worse. There are no guarantees in this business. and what to sell. or Hedge? 61 Comparing Active and Passive Funds Actively-managed funds have a portfolio manager or a team selecting the investments for the portfolio. In fact. Studies have shown that. no one has to decide what to buy/sell/hold. try to find the fund that has an investment philosophy that most closely matches yours. such as the Mutual Fund Power Screeners available on the MSN MoneyCentral website. For example. Why are there so many mutual funds around? What leads the industry to segment itself into an ever-increasing number of mutual fund categories? To address these questions. surveys find that over one-third of respondents have responded to a mutual fund advertisement.000 over approximately the same period. and it may not. no mutual fund manager displays any significant market timing ability. there are screeners for you too. 401(k) plans). Yahoo. Do you want a fund manager with a lengthy tenure? Do you want an aggressive new fund with an incredible record? Do you want a fund of a certain size? Interestingly.. are equally likely to be male or female. economists argue that such phenomena can be explained by marketing strategies used by the managing companies to exploit investors’ inherent differences (i. Letʼs say you are a timid person by nature and are not interested in the aggressive screening criteria above. Younger investors are more likely to invest in mutual funds through their pension plans (i. Over 80 percent of the mutual fund investors . etc. voting age population. When a group of economists examined whether mutual fund managers could successfully select stocks that outperform similar stocks. This may work out. relative to a median U. If you use these screens. These firms would therefore exist simply to take orders from their investors. answering questions like these helps you define your strategy and can be a useful exercise. an intuitive rationale for the existence of funds differing in trading style and size also emerges as a natural way to cater to investors with different styles and risk characteristics.e.62 Chapter Four Critical Information: What Are Fund Screeners? Fund screeners are database mining tools that sort through tons of financial data and produce a list of funds that meet the criteria you have requested.S. while those buying funds through banks. You should look for predefined screens. it appears that investors purchasing mutual funds directly from a fund company are more likely to be male.. intermediaries to control investors’ portfolios while they engage in other activities. For the mathematically-minded among you. You can fund mutual fund screeners on the Morningstar. and over three-fourths of those claim that they have responded to ads in national newspapers like the Wall Street Journal. which is older than the median age (thirty-eight years old) of the U. MSN MoneyCentralʼs predefined screens such as “Large Domestic Stock” and “Safe and Steady” will hopefully steer you in the right direction. Once we think of mutual funds this way. household income of a little over $30.e. Consistent with this notion. Sites like RiskGrades and Portfolio Science use mathematics to render judgments on funds. and we could interpret such firms or financial intermediaries as mutual funds. a majority have at least a college degree. Mutual fund investors are also well educated.. investor heterogeneity). and Wall Street Journal websites. they found that while the managers of aggressive growth funds show some “selective” ability. The median age of a typical mutual fund shareholder is about forty-three years old. Mutual fund investors have a median income of about $60. you are trusting someone elseʼs judgment of the funds.000.S.19 Survey research into the demographics of the typical mutual fund holder also yields fascinating insights. although higher income investors were more likely to be aware of their mutual funds’ expenses. bond.20 In sum.S. that are traded on an exchange and usually track an index. and bonds. Exchange Traded Funds (ETF) Exchange Traded Funds (ETFs) are similar to index mutual funds. while about 40 percent own money-market mutual funds and about a third own bond funds. ETFs tend to be priced efficiently because institutional investors will sell their ETFs and purchase the component securities individually if the ETF price changes lag behind the component price changes. Exchange Traded. Similarly. The level of mutual fund expenses seems to have little role to play in a fund purchasing decision for an overwhelming majority of the respondents. Over half the respondents claim to use mutual fund prospectuses to make their mutual fund purchases. ETFs were first introduced in 1993 and have grown into a $150 billion industry. population. As with all investment products. compared to about 66 percent of the U. Most mutual fund investors appear to know that it is possible to lose money buying stock. an overwhelming majority of those making direct purchases of mutual fund shares from fund companies cite the prospectus as their main source of information. but are traded more like stocks. ETFs trade just like stocks. such as stocks. The really scary finding is that fewer than 15 percent of the respondents were even aware that higher expenses could lead to lower than average returns. Over 70 percent of the mutual fund investors own stock mutual funds. based on supply and demand. commodities. The real challenge will lie in educated average American families such that they will feel comfortable investing in these vehicles. mutual funds remain the domain of investors who are more educated and more prosperous than the average American. Very few respondents appear to know what kind of expenses their invested mutual funds carry. Not surprisingly.What’s in a (Fund) Name: Mutual. or Hedge? 63 own their primary residence. in spite of their rocketing popularity. . ETFs represent a basket of securities. This practice is called arbitrage. exchange traded funds have their share of advantages and disadvantages. while mutual fund investors under thirty-five years of age are less likely to believe that one can lose money in a money-market mutual fund. those purchasing indirectly through brokers or bankers also cite it as their primary source of information. and money-market mutual funds. As their name implies. Wealthier investors are more likely to know about possible losses through their mutual funds.S. while older investors are more likely to know it is possible to lose money in bond funds. Further details on the pattern of mutual fund ownership in the U. College graduates are significantly more likely to believe it is possible to lose money in a stock fund. Almost all investors investing in mutual funds through their pension plans have little to no idea of the kind of expenses generated by the funds in their retirement portfolio. in the 1990s can be found in the article referenced in the footnote. due to SEC regulations. including Dow Jonesstyle indexes and Wilshire indexes VIPERs Vanguard Index Participation Receipts Several Vanguard Index funds Also. in which case they will be equally efficient). announced that its new Amex-traded iShares (IVV). and then return those shares to their broker. the world’s largest manager of index funds.09 percent. 5 and 10-year) HOLDRs Holding company depository receipts (marketed by Merrill Lynch) Narrow industry groups (Each initially owns 20 stocks) QUBEs Nasdaq-100 tracking stock (QQQQ) Nasdaq-100 Index Spiders Standard & Poorʼs Depository Receipts (SPDRs) Track a variety of Standard & Poorʼs indexes StreetTracks State Street Global Advisor ETFs Various indexes. The low annual expenses of owning ETFs rival the cheapest mutual funds.64 Chapter Four Examples of ETFs ETF TYPE DIAMONDs FULL NAME Diamonds Trust Series I TRACKS Dow Jones Industrial Average FITRs Fixed income exchange traded securities Various treasuries (including 1. SPDRs (funds that are shares of a family of ETFs) trading on the American Stock Exchange lowered annual expenses to 0. ETFs tend to be more tax-efficient than mutual funds (unless the account is nontaxable. Only institutions and extremely wealthy individual investors are able to deal directly with ETF companies—the rest of us are forced to go through a broker. For example. Finally. Vanguard announced that its S&P Vipers will also be traded on the Amex. Also.09 percent. would also have expenses of just 0. ETFs don’t always trade . 2. use the proceeds to buy the stock back after the price falls. they offer more flexibility (similar to individual stocks) than the typical mutual fund. allowing for intraday trading. like when trading individual stocks. making it less likely that investors will be hit with huge capital gains distributions if there are mass redemptions (if many shareholders want to sell at the same time). Advantages of Exchange Traded Funds There are several advantages of investing in ETFs. an investor will be “loaned” shares of a company whose stock they believe will soon decrease in price. ETFs generally have low costs. Buying on margin means buying shares using loaned money from an investors’ brokerage. Barclays Global Investors. Recently. investors must pay commissions. This allows investors to purchase more stock than they would be able to normally. which tracks the S&P 500. traders have the ability to short sell or buy ETFs on margin. turning a profit for themselves.02 percent. Also. Disadvantages of ETFs There are some negatives to exchange traded funds as well. with an annual expense ratio of just . To sell short. First. ETFs have certain tax advantages over traditional funds. Striking back. Investors can only buy and sell mutual funds at the end of each trading day. ETFs can be bought and sold throughout the trading day. They sell those loaned shares. In general. and asset-backed bonds. there is a bid-ask spread. Other ETF rating firms include Altavista Independent Research. the iShares $ InvesTop Corporate Bond Fund (ticker: LQD) might be an option. Some examples are Rydex. In fact. you may be better off finding a mutual fund doesn’t charge commissions and encourages active trading. or Hedge? 65 Rating the ETFs A Wall Street Journal article (“How to Rate the ETF Ratings. and Lipper. It appears that ETFs like SPDR (SPY). as with stocks. the iShares S&P 500 Index (IVV). Standard and Poorʼs. which tracks inflation-protected government notes. For investors wishing to play it safe. the iShares Barclays 7–10 Year Treasury Fund (ticker: IEF) might be another possibility. and vice . Profunds. bond ETFs increase in value when the underlying interest rates decline. the bond market does poorly. Bond ETFs Bond ETFs provide the investor with coupon income from the underlying component bonds that mirror a particular government or corporate bond index. meaning you might buy an ETF for 15.What’s in a (Fund) Name: Mutual. Notice the inverse relationship between the performance of the bond ETFs and the S&P Index. at the net asset values of their underlying holdings. When the stock market does well. Even if you are an active trader. Another offering is the iShares Barclays TIPS Bond Fund (ticker: TIP). the Nasdaq-100 Index tracking (QQQQ). mortgage. government. Morningstar has jumped into the fray by assigning its star ratings to ETFs. I have plotted the one-year returns on these bond ETFs and compared them to the S&P 500 Index. but this is especially so if you are working with a nontaxable account or if you are only investing a small amount (ETF commissions will destroy your investment if you plan to invest a set amount each month). As with regular bonds. 2006) states that more than 320 billion dollars of investor money are in ETFs. Since ETFs are indexes. investing in a mutual fund beats investing in ETFs. Several companies are trying to be the first to provide investment-related guidelines for ETFs much like Morningstar has done for mutual funds. more ETFs are sure to hit the market. is basically a hidden charge). Another disadvantage is slippage. do exist. check on how an ETF is doing related to the index it most closely resembles. For less risk-averse investors. Buyside Research. which. meaning an ETF could potentially trade above or below the value of the underlying portfolio. and the iShares Russell 2000 Index (IWM) top the charts among all five rating agencies. Do your own due diligence before investing in an ETF. while rare. The following are some examples of high-performing bond ETFs. and vice versa. However. the Midcap SPDR (MDY). With such increasing popularity comes increased attention. investors should not be blinded by the ratings alone.125 but only be able to sell it for 15 (the difference. The iShares Lehman Aggregate Bond Fund (ticker: AGG) offers investors comprehensive exposure to corporate. and Potomac Funds. Exchange Traded. In Figure 1. or the spread.” April 29. Over time. 66 Chapter Four Figure 1: A comparison of 5-year returns of several bond ETFs with the return on the S&P 500 Index. Source: Google Finance™ versa. Therefore, from a diversification standpoint, if you have a stock index and any one of the bond ETFs in your portfolio, you are in a good position. Risks of ETF Investment As ETFs become popular investment vehicles, it is important to keep the inherent risks of these investment vehicles in mind—especially during market meltdowns such as those on February 27 and March 13, 2007. Specifically, when stock prices nosedived in China on February 27, rippling effects were felt around the world, including in the U.S. markets. According to an article in the Wall Street Journal,21 a particular ETF managed by Barclays Global Investors tracking the Chinese stock market closed in the U.S. on February 27 down 9.9 percent even though the index it was tracking fell just 2.1 percent during Chinese trading hours. In another example, the iShares emerging market fund lost about 8.1 percent even though the index it tracked had fallen only about 3.1 percent over the same period. Although ETFs are advertised as an easy and convenient way for investors to get in and out of the markets, the above examples exemplify an inherent problem with such a strategy. During moments of severe market stress, prices of ETFs might become disparate from the index they track, resulting in significant losses for individual investors looking to unload their shares. This aspect of ETF investing has not been often discussed amid all the talk about their benefits, including their liquidity, flexibility, and their ability to track the market, or sections of it, like index mutual funds. Of course, the fact that ETF pricing can vary so significantly from the index it is tracking at times of high market volatility represents opportunities for arbitrage profits for sophisticated investors. Such profits are out of the purview of ordinary investors, who face the brunt of the high costs associated with volatility without the accompanying benefits of profit.22 What’s in a (Fund) Name: Mutual, Exchange Traded, or Hedge? 67 Downside of ETFs After comparing the advantages and disadvantages of using ETFs, it becomes apparent that mutual funds are a better deal. Commissions make ETFs unattractive. If your portfolio is a tax-deferred investment, like a 401(k) or an IRA, you can avoid paying commissions by investing directly with a mutual fund company. Even in a taxable account, commissions make exchange traded funds the wrong choice. As an example, consider the following. A lump-sum investment of $10,000 in the iShares S&P 500 Index, with a very low trading cost of $8, would need to be held for two years to beat out the Vanguard 500 Indexʼs costs. If you are investing less than $10,000 and are paying more than $8 in commissions, or you are investing more than once, this example would show that ETFs are a poor choice. Note that iShares.com is a valuable resource providing tools, strategy, and data on more than seventy-seven iShares ETFs. Another Wall Street Journal article discusses how the rapid growth of the ETF market is forming a large bubble that could easily burst.23 After the well-known Collateralized Debt Obligations (CDOs) were held responsible for the global economic meltdown, there is a natural fear that the growth of the ETF market could have similar consequences down the road, especially as increasingly complex ETF instruments are being designed to satisfy investor hunger for complex products with high profit potential. The parallels are troublesome to say the least. The other side of the argument, however, is that ETFs are nothing but a collection of underlying stocks and bonds. They cannot, by themselves, cause bubbles; the bubbles would have to be caused by the underlying assets. In that sense, ETFs can only be reflective of what happens to the assets in their portfolio, which provides a layer of investor protection that CDOs did not have. However, this early model of creating ETFs from component stocks and bonds that have risk properties that we understand fairly well is being eclipsed by swapbased ETFs. In plain terms, swap (or synthetic) ETFs use a swap mechanism with an investment bank in which the bank provides the performance of the index in exchange for the return on the ETF’s holdings. The problem is that no one is sure of what those holdings are in the ETF. Similar to a CDO, if the swap counterparty fails, then the ETF’s investors could have exposure to assets within the index that are completely different from the index in which they thought they were investing. In sum, as the ETF market grows in size and scope, we have to remain vigilant to ensure that the risks do not get out of hand and that we maintain an understanding of exactly what those risks are. The potential of getting carried away by greed is too dangerous to ignore. Due to the increasing popularity of ETFs, the new clientele of ETF investors are the professional investors. While traditional index mutual funds that can be traded once a day are good for individual investors, institutional investors with active trading strategies view the ability of ETFs to be traded continuously and to be shorted as big advantages allowing them to move in and out of markets, or particular sectors, with ease. Such strategies have the downside of exacerbating volatility—especially in times of market stress. 68 Chapter Four Individual investors need to be very careful about the changing demographic of ETF investors and the increase in risk this presents—especially when there is a market distrubance somwhere in the world. Hedge Fund Protection in Bear Markets for the Retail Investor Contributed by Greg N. Gregoriou Professor of Finance State University of New York (Plattsburgh) Hedging is frequently defined as using downside risk to achieve portfolio protection in bear markets. To protect their investments (crop), farmers in the United States began using futures contracts as a hedge against the price instability of various commodities, such as corn, cattle, etc., in the beginning of the twentieth century. One can apply this concept to the area of investments, whereby hedging insulates investors from down markets, more commonly known as bear markets. Many investors have a hard time understanding the term “hedge fund” because it encompasses numerous manager skill–based dynamic trading strategies. In fact, there is no exact definition of a hedge fund (a misnomer). In essence, hedge funds provide absolute returns rather than returns relative to standard passive benchmarks (i.e., S&P 500 Index, etc.). The goal of a hedge fund, or a fund of hedge funds (a basket of hedge funds), is to make money for its investors by taking leveraged positions and trying to capture price inefficiencies in global stock, bond, and currency markets. Contrary to the buy-and-hold or static strategies of mutual funds, hedge funds are known to use “dynamic” or “active” strategies, making hedge funds notorious as speculative vehicles. Dynamic strategies implies using options, futures, swaps, and other more complex derivatives instruments to amplify hedge fund returns. Hedge funds are not passive investors and can quickly liquidate their entire portfolio in times of market stress. Mutual funds, on the other hand, sit tight and hope the market turns around. Modern portfolio theory, as pioneered by Nobel Prize winner Harry Markowitz (1952),24 provides investors with an essential tool for diversifying traditional stock and bond investment portfolios by combining different assets to maximize return while minimizing risk. However, to attain proper diversification in traditional investment portfolios, hedge funds can further enhance the diversification process due to their low correlation features among hedge fund strategies. Furthermore, the correlations between hedge fund strategies and stock and bond markets tend to be low positive correlations, while some hedge fund strategies (short sellers) provide a negative correlation. Alfred Winslow Jones, an associate editor of Fortune magazine, was responsible for creating the first hedge fund in 1949 through a private investment partnership. Jones hedged the risk of his fund by purchasing stocks he believed were undervalued and short selling stocks he thought were overvalued. His idea of a What’s in a (Fund) Name: Mutual, Exchange Traded, or Hedge? 69 market-neutral fund was essentially to eliminate gains and losses from market fluctuations and provide protection to the investors against drops in the stock market. Using this newly created dynamic trading strategy during bull and bear markets, Jones outperformed the average U.S. equity mutual fund. Jones’s use of leverage was also a salient feature in his strategy that distinguished him from the pack by allowing him to magnify the returns of his fund. The number of hedge funds and assets under management increased at a feverish pace during the 1990s, with nearly $1.5 trillion in capital at the end of 2006, according to Business Week magazine. It is common knowledge that investing in alternative assets such as hedge funds offers investors low correlation to traditional stock and bond markets. The main advantage of hedge funds is to be less susceptible to the movements of the markets by seeking “absolute returns” and offering unique investment opportunities not available through mutual funds. Hedge funds offer superior risk/return trade-off and provide protection in negative S&P 500 quarters as well as in other developed and emerging markets. A key feature of hedge funds is that they can reduce the volatility of a global portfolio, increase risk-adjusted returns, and enhance the performance of traditional investment portfolios. Hedge funds have been the subject of in-depth reporting in many professional magazines as destabilizing world financial markets and are frequently seen as villains. A well-known example is George Soros’ speculative attack on the British sterling in the Fall of 1992, which netted $2 billion dollars for his group of funds in one week. However, there have been some spectacular losses in 1998 and 2006, with Long-Term Capital Management and Amaranth Advisors losing billions. Hedge funds are regarded as illiquid private investment pools that allow a maximum of 99 investors or, alternatively, 499 institutional and high net worth investors (e.g., only for U.S. onshore funds). Hedge funds are not allowed to solicit or advertise to the public and are not regulated like mutual funds or pension funds. Thus, hedge funds do not fall under the control of the Investment Company Act of 1940 and fall outside the regulation of the Securities Act of 1933. They are also exempt from the Securities Exchange Commission (SEC) Act of 1934 and do not have to reveal any of their holdings/positions. Who typically invests in hedge funds? Investors include high net worth individuals and institutional investors, foundations, pension funds, life insurance companies, endowment funds, and investment banks. Today, U.S. (onshore) hedge funds are limited to accredited investors with a net worth exceeding $1 million, but a fund of hedge funds allows investors with less money, or lower risk tolerance, to enter this world of privately managed money. Over the last five years, there has been a tremendous influx of capital migrating towards hedge funds for several reasons, such as recurring currency devaluations and high volatility in world financial markets. In these types of scenarios, hedge funds are regarded as risk management instruments that can provide portfolio protection against downside risk. 70 Chapter Four Hedge funds are typically seen as innovative financial instruments, and the strategies they employ can provide added liquidity and stability to stock, bond, and currency markets. Numerous studies have concluded that hedge funds and funds of hedge funds offer higher risk-adjusted returns than mutual funds and stock market indexes. With the recent turmoil in global financial markets, hedge funds and funds of hedge funds are becoming an important investment alternative for investors interested in further diversifying their traditional stock and bond portfolios. The number and popularity of hedge funds has grown at an explosive pace during the past decade, and will certainly rival the mutual fund industry in a few years. Numerous well-known mutual fund managers with excellent reputations are leaving the mutual fund industry and setting up hedge funds. Apparently, the brightest brains on Wall Street are migrating, including Fidelity’s Jeff Vinik, who left the Magellan Fund to head Vinik Asset Management, a Boston hedge fund. The financial market meltdown in February 2007 had its origins in China and caused tremors across global markets, giving investors a taste of panic and euphoria. The simple mention of a market correction is enough to cause vibrations across the entire financial world. How then can an individual investor protect himself from these wild market gyrations and simultaneously provide stability to his portfolio? What strategies can an investor adopt? Bonds, you say! Try again. The answer is hedge funds or a basket of hedge funds more commonly known as a fund of funds (FOFs). This popular strategy (classification) provides a collection of the best hedge fund managers with different strategies all included in one portfolio. The value added by FOFs allows for instant diversification and provides low volatility when compared to traditional mutual funds and stock market indices. In essence, FOFs provide equity-like returns with bond-like (low) volatility. However, this feature comes at a price; typical management and performance fees are about 2 percent and 20 percent, respectively. Furthermore, FOFs have the drawback of an extra layer of fees whereby the specialist is compensated for hedge fund manager selection and constant monitoring as well as monthly visits to the hedge funds that make up the FOF portfolio. It is very cumbersome and time consuming for the FOF manager to siphon through almost 8,000 hedge funds in various databases and select what he believes are the top performing funds, making sure that their individual strategies do not overlap. Although a great majority of unsophisticated and neophyte investors think that simply holding U.S. stocks, international stocks, and bonds will produce an efficient and well-diversified portfolio, their view is incorrect. A landmark study by Professor Bruno Solink concludes that investors have no place to hide anymore due to the high correlations existing among developed financial markets today.25 Even thirty years ago, many developed financial markets had low correlations among themselves, but the landscape today seems to be causing all markets to move in tandem whenever there is a market correction. With this in mind, now is an excellent time to add alternative investments (such as hedge funds and FOFs) to traditional portfolios. Typically, mutual funds use a relative benchmark to compare their returns. Hedge funds, however, produce absolute returns irrespective of market What’s in a (Fund) Name: Mutual, Exchange Traded, or Hedge? 71 conditions. When investing in hedge funds or FOFs, the investor typically will sacrifice upside gains for downside protection—a steep price to pay for protection, but well worth it! How do these absolute return vehicles, which are geared only for sophisticated and high net worth individuals, play a role in unsophisticated typical investor portfolios in the United States? There are a few FOFs in the U.S. in which investors can enter with a minimum investment of $1,000, and Geronimo Funds is one of the firms offering numerous absolute return vehicles for downside equity risk management. Linking the Pieces Together—and Then Some Mutual funds are the pioneers in the diversification business. They came first and have the most name recognition. They are only priced once a day, which can be a disadvantage in today’s fast moving world of instant access and 24-7 news coverage. If you are a dynamic investor, you will have to wait for your buy or sell order to clear at the end of the trading day once the closing prices of the component stocks are set. By then, many things could have happened that affect the markets, and you may have lost your competitive advantage. Therefore, traditional mutual funds are not favored as much by dynamic investors. If, on the other hand, you are buying for the long-term horizon and your purchase decision is based on fund fundamentals unrelated to day-to-day fluctuations, you probably don’t care when your order is formally executed. ETFs are mutual funds that behave like stocks. They have exposure to various sectors and can be bought and sold at all times during the day while markets are open. Therefore, we can buy and sell them just like we would individual stocks. For some investors, that is a big plus. You can think of ETFs as mutual funds with some extra features. However, their popularity also has a downside. Their relatively large trading volume implies that there is a lot of volatility associated with their prices over the course of the day, which you don’t see with mutual funds, as their price is set only at the end of the trading day. Hedge funds are smaller and more nimble, but hey are usually not open to the masses. They are typically used by very wealthy individuals who band together and use their size to glide in and out of markets quickly, which allows them to take advantage of market movements and inefficiencies in pricing in various sectors. They have grown tremendously over the last two decades, as the number of wealthy Americans has increased over this period. According to the website hedgefundresearch.com, over the last decade, hedge funds expanded beyond their traditional investor base among the ultra-rich and raised billions of dollars from pension funds, endowments, and foundations. From 1998 to 2008, the number of hedge funds grew from just over 3,000 to more than 10,000, and assets within the funds exploded from $374 billion to nearly $2 trillion. Since hedge funds are like country clubs and are accessible only through invitation, historically they have not been regulated as diligently by the SEC (the aforementioned stock market police). Although, in light of the recent discoveries of 72 Chapter Four fraudulent behavior by many hedge funds including direct attempts to influence stock prices and market direction overall, that is changing and hedge funds are coming under scrutiny similar to that endured by their more boring cousins— mutual funds. The main advantage of hedge funds is that they are small, which allows them to have more agility in the markets. But as hedge funds become successful and attract the attention of more wealthy people, they will grow in size, which can adversely affect their performance, since they will lose some of their agility. Therefore, a challenge facing hedge fund managers is to keep the funds small by opening new funds instead of adding more investors to current funds. A relatively new research study tries to examine this question. Authors Sugato Chakravarty and Saikat Deb argue that hedge fund families suffer from capacity constraints that drive the opening of a new hedge fund rather than the growth of an existing hedge fund.26 Using long-horizon hedge fund data, the authors show that the fund families’ propensities to open new hedge funds increase with the degree of capacity constraint faced by the existing funds within a given hedge fund family. Additionally, the strategy of starting new hedge funds to divert flows from an existing fund experiencing a capacity constraint works well, as flows to the existing funds decrease, and the performance of the existing funds improve, after the introduction of a new fund by a fund family. On a scale of riskiness, general ranking of these investment funds would be: mutual funds (least risky), ETFs and hedge funds (most risky). Thought Questions 1. Can mutual funds lose money on a regular basis? Why or why not? 2. What is one characteristic of mutual funds you can reliably take from the past and extrapolate to the future? 3. What is the relationship between fund activity and fund philosophy? 4. Why is examining the current fund manager’s tenure when deciding whether to invest in that fund a useful activity? 5. What is the difference between very large funds (like Fidelity Magellan) and index funds? Which would you prefer and why? 6. When would you prefer a mutual fund over an ETF? 7. Why are mutual fund prospectuses important? 8. What does a high expense ratio say about a fund? 9. Should index funds have a high expense ratio? Why or why not? 10. Why is a 12b-1 fee important for a mutual fund? What’s in a (Fund) Name: Mutual, Exchange Traded, or Hedge? 73 11. Why is “market timing” considered a bad thing? Who gets hurt in market timing? 12. What is special about life-cycle funds? What are the differences between these funds and index funds? What are some other examples of life-cycle funds? 13. What does the evidence that the S&P 500 index funds beats over 80 percent of actively-managed funds suggest to you as an investor? 14. What is the economic rationale for the creation of mutual funds? Notes 19. K. Daniel, M. Grinblatt, S. Titman, and R. Wermers, “Measuring Mutual Fund Performance with Characteristic-based Benchmarks.” Journal of Finance 52 (1997): 1035–1058. 20. J. Poterba, “The Rise of the Equity Culture: U.S. Stockownership Patterns, 1989–1998,” Unpublished Manuscript, MIT. 21. “Fast Money Crowd Embraces ETFs, Adding Risk for Individual Investors,” Wall Street Journal (March 17, 2007), 1. 22. In fact, brokerages such as Goldman Sachs have internal teams of traders to take advantage of precisely such arbitrage opportunities. 23. Emma Dunkley, “Don’t Lose Your Grip,” Wall Street Jounral (June 22, 2011). 24. H. Markowitz, “Portfolio Selection,” Journal of Finance 7 (1952): 77–91. 25. B. Solnik, International Investments, Fourth Edition (Addison Wesley, 1999). 26. Sugato Chakravarty and S. S. Deb, “Capacity Constraint and the Opening of New Hedge Funds,” Working Paper, Deakin University, 2011. . The Junk Bond King People borrow money all the time. And they do so through a specific instrument that we. when the bond is sold.5 Bonds The right time for a company to finance its growth is not when it needs capital. at maturity. so the investor makes a profit when they mature. A lot of the short-term bonds issued by the government are of this type. If interest rates fall. how often interest (also known as coupon payments) will be paid. Why do companies do this? For the same reason we refinance our mortgage loans when interest rates go down: to borrow at newer. the face value (principal) of the bond is paid to the investor.” or set. When you purchase a bond. With these bonds. coupon payments occur at regular intervals (usually semi-annually) and then. do not have access to. the issuer pays no coupon interest and instead pays the face value plus accumulated interest at maturity. such as corporations. Forget your lunch money? Need to buy a house? A car? Need infrastructure to grow your small business? These days. but rather when the market is most receptive to providing capital. You (the lender) get a piece of paper that stipulates the principal (the original amountof the loan). and the term of the loan. With regular bonds. With callable bonds. callable bonds. These bonds are purchased at a discount from their face value. and cash-strapped companies sell debt to raise the money they need to expand. corporations will call their bonds and then re-issue new ones at the lower rate. and zero-coupon bonds. —Mike Milken. namely bonds. which are regular bonds. and state and local governments. it will generate exactly the same amount of money. cheaper rates. Who Issues Bonds? Bonds are known as “fixed-income” securities because the amount of income the bond generates each year is “fixed. need to borrow money regularly. The third example is a zero-coupon bond. people borrow money for many reasons. usually $1. Deficit-laden governments across the world use bonds as a way to finance their operations. Much like individuals. Bonds are a form of debt security that are sold to the public in set increments. you are effectively loaning the issuer (the debtor) money. 75 . the agreed-upon interest rate. large organizations. the corporation issuing the bond can decide to “call” the bond and pay the investors the face value at any time. No matter what happens or who holds the bond.000 for most bonds issued by corporations. as individuals. the federal government. Figure 2 illustrates the three basic bond types. Government for specific purposes. Treasury bonds are also called risk-free bonds. and those sold by state and local governments. A company has a lot of flexibility about how much debt it can issue and what interest rate it will pay. Treasury bills. sell bonds backed by the full faith and credit of the U. The Treasury Department also sells savings bonds as well as other types of debt through the Bureau of the Public Debt. and inflation-indexed notes. The second category of bonds are those sold by corporations. Short-term U. .S. Types of treasuries include Treasury notes. Bonds sold by the U. although it must make the bond attractive enough to interest investors or no one will buy them. and the Government National Mortgage Association (Ginnie Mae).76 Chapter Five REGULAR BOND Coupon payments Principal repaid at maturity CALLABLE BOND Normal maturity time Issuer may repay bond after a set time ZERO-COUPON BOND No interest payments Principal and interest paid at maturity Figure 2. Companies sell debt through the public securities markets just as they sell stock.S.” or length of time until maturity. Treasuries come in a variety of different “maturities. Types of Bonds Bonds can be split into three categories based on who issues them: those sold by the U. government are called “treasuries” because they are sold by the Treasury Department. such as funding home ownership. such as the Federal National Mortgage Association (Fannie Mae). as the chances that the U. Government and are free of state and local taxes on the interest they pay. those sold by corporations. Treasuries are guaranteed by the U. the Federal Home Loan Mortgage Corporation (Freddie Mac). ranging from one month to thirty years. Some government agencies and quasi-government agencies. These all vary based on maturity and the amount of interest paid. Treasury bonds.S.S.S. government will go bankrupt are very low.S. government. As a way around this problem. site directions. permits a portfolio of stocks and bonds to even The third category of bonds are those out the highs and lows and can result in an issued by state and local governments overall higher return at a relatively lower risk. though. Critical Info Important Information to Know about Bonds There are three important things to know about any bond before you buy it: The par value. semiannually. California. when bonds go up.up. however. par value for corporate bonds is normally $1. they have to offer competitive interest rates. the coupon rate. As mentioned earlier. although for certain government bonds it can be much higher. also market returns over the past seventy-five known as junk bonds. always an unpopular move. the federal government permits state and local governments to sell bonds that are free of federal income tax on the interest paid. . if a bond has a par value of $1. The bond will also specify when the interest is to be paid. quarterly. The coupon rate is the amount of interest that the bondholder will receive expressed as a percentage of the par value.Bonds 77 Corporate bonds normally carry higher interest rates than government bonds because there is a risk that the Bonds can diversify an investorʼs holdings. The par value is the amount of money the investor will receive once the bond matures. Unlike Treasury bills. bond prices go down.000 and a coupon rate of 10 percent. which are risk free. municipal bonds can be quite risky. Do your homework before investing in them. also called the principal. depending on what kind of bond you are buying) allows you to analyze the bond and compare it to other potential investments. a typical graph showing stock and bond on the bond. borrowers in high tax brackets can actually have a higher after-tax yield by holding these bonds than they would with other forms of fixed-income investments. So. just like corporate bonds. Even though they pay lower rates of interest. this negative correlation between stocks and bonds into stock if certain provisions are met. are corporate years shows one overwhelming trend: the bonds issued by companies that have stock and bond markets tend to move in oppocredit ratings below investment grade. the person holding the bond will receive $100 a year. and the maturity date. Because state and local governments can go bankrupt (ask the holders of Orange County. when the stock prices go Some corporate bonds are called convert. or annually. Unlike corporations. Over the long haul. Thus. when the entity that sold the bond returns the original amount that was loaned. High-yield bonds. ible bonds because they can be converted stocks go down.000. State and local governments can also waive state and local income taxes on the bonds. (municipal bonds or munis). whether monthly. muni bonds if you don’t believe that one). the only way that a state can get more income is to raise taxes on its citizens. In company could go bankrupt and default fact. Knowing these three facts (and a few other odds and ends. However. reduce the amount of governmental borrowing. This is because of the liquidity of the U. U. I discuss it here only as an illustration of how seemingly innocent actions can trigger a whole chain of events which may not even have been considered before such decisions were made. Treasury to eliminate certain bills was going on. a major objective of people in retirement is to live off their investments and not lose money in case they may need it for health care. bonds may not match your objective. Treasury markets. The call feature allows the issuing agency to pay the investor the face amount for the bond and buy back the bond before maturity.78 Chapter Five The maturity date is the date when the bond issuer has to return the principal to the lender. This apparently innocent action created shock waves around the world.S. bonds would fit the bill. For example. The U.S. Treasury Bonds Between 1996 and 2000. so the principal would be available without loss. Treasury reduced bill issuance by about 30 percent and decreased issuance of coupon securities by about 50 percent. there were at least three reasons cited for why this shrinking supply of treasuries might be a temporary phenomenon at best. All corporate bonds specify whether they can be called and how soon they can be called. Interestingly. They are also used as hedges to fixed income positions and are an important component of global bond indexes. meaning that it will return the principal to the lender before the maturity date of the bond. they are no longer obligated to make interest payments. i.S.S. This allows the issuer to then reissue the bond at lower interest rates. Yet Another Benefit of U. but state and local government bonds can be called before maturity. In this situation. But who could have known that such an action would trigger a domino effect in the rest of the world? Of course.e. such questions have become more academic than practical. . Sometimes a company will decide to “call” its bond..S. even while the debate about the decision by the U. Treasury made the decision to scale back because the government was running a surplus budget and it seemed to make fiscal sense to reduce new bill issuance. a portion of their retirement money might be invested for growth in stocks.S. Federal government bonds are never called. Bonds: What Are They Good For? If you are looking for long-term growth. if your objective is safety of principal and you want to earn current income from your investments. the U. Why? Among other things. After the debtor pays back the principal. and they are considered safe havens for investors’ monies in international bond markets. but a majority should probably be invested for income in bonds that mature at different times. now that the government carries a huge deficit. treasuries are used as benchmarks for pricing and quotations in the United States. S.Bonds 79 Connection between Treasuries and the Social Security (SS) Trust Fund The surplus money in the SS Trust Fund is invested in government bonds or T-bills.5 percent. The SS Trust Fund owns bonds or T-bills.” as one example. under current tax and expenditure policies. then its current yield is $75 divided by $1. Tax revenues would be significantly below the levels projected by the Congressional Budget Office—especially if the ongoing recession over the period 2000–2004 continued or worsened. as would the path of publicly held Treasury debt. for example. It is refreshing to see (on some levels) that two out of the three reasons have to come to fruition and the talk about shrinking U.” The yield to maturity includes not only the interest payments you will receive all the way to maturity. Knowing your bond’s yield also helps you compare it with other potential investments. made by a different arm of the government.S. We are unlikely to see a similar event in our lifetime. but also assumes that you will reinvest the interest payment at the same rate as the . bond investors often use another kind of yield called “yield to maturity. the extra money is actually already used to finance past government deficit spending. or 7.S. 2. presumably the Treasury Department. but these “assets” are really just promises to pay. You can calculate the yield on a bond by dividing the amount of interest it will pay over the course of a year by the current price of the bond. but they donʼt actually represent assets from the point of view of the government as a whole. 1. But for that brief period in history. Longer-term budget projections suggested that U. fiscal balance would. However. the SS Trust Fund owns no real assets. since we can buy a bond above or below its par value.000. eventually reverse course.000 pays $75 a year in interest. the decision to reduce issuance did provide economists with a natural laboratory to study what can happen when supplies of U. How to Calculate Bond Yields Investors can understand the returns thier bonds will generate by calculating their yield. They are assets from the point of view of SS as a program. Additionally. Treasury bonds are artificially reduced. if a bond that cost $1. due to the current (and future) “war on terrorism. expenditures could turn out to be significantly greater than expected. treasuries has receded to the background. The investment policy of the Social Security Trust Fund might be changed to include private assets. as opposed to being invested in stocks or corporate bonds or even simply placed in a bank account. Thus. 3. Ergo. Current thinking is that the SS Trust Fund should invest in some private assets and use T-bills to finance such purchases. So. 000 principal. where there . say you still ownes that bond in 1998. Why Bond Yields Can Differ from Coupon Rates You may ask: “Why not just look at the coupon rate to determine the bond’s yield?” But this does not always work. Yield to maturity is especially important when considering at zero-coupon bonds. If you bought a $1.000 back at the end. when you receive all of your principal back plus interest for the the face value of the bond. the yield to maturity will be very close to the current yield. there are two ways you can make money with bonds. This is because an investor in 1998 would only be expecting a 5 percent yield. so a bond can trade above or below the par value based on what the prevailing interest rates are. if you sell the bond before it matures. You then get $40 every year for ten years. How to Make Money from Bonds Most people assume that the only one way to make money with bonds is to collect interest. any yield you see associated with them is always a yield to maturity. Recall that this is a special type of bond that pays no interest until the maturity date. If you hold the bond to maturity. If issued in 1998. The second is the gain (or loss) when interest rates fall (or rise). you get interest or yield on your bond. you are guaranteed to get your principal back. you will have to sell it at the going price. and that’s the extent of your return. You buy the bond when it’s issued and hold it until maturity. and your $1. 1999. which is exactly the same as its coupon rate. Many investors buy bonds exclusively for their yield. Now. For high-quality bonds or treasuries. Bond prices fluctuate as interest rates change. If you buy a bond at par value. Because zero-coupon bonds have no current yield. you would actually be able to sell your bond for more than the $1. Actually. you won’t lose your principal if the borrower doesn’t default or restructure. If you buy and sell bonds before they mature. you can make or lose money on the bonds themselves completely separate from the interest rates. the change in interest rates. However.000 par value.000 bond in the late 1970s with a coupon rate of 10 percent and a maturity date of December 31. and the transaction costs involved. at which time you would get back the $1. How much more you are going to get depends on the exact maturity date of the bond. and takes into account any difference between the current par value of the bond and the actual trading price of the bond in the future. this bond would pay you $100 per year until December 31. so he would pay a premium for a bond that paid 10 percent.000 for a government bond with a 4 percent coupon and a tenyear maturity. If you hold a bond to maturity. that same bond would only pay $50 a year. not $100. when long-term interest rates touched 5 percent. As a reflection of the fact that interest rates have dropped since the coupon rate was set on the bond.80 Chapter Five current yield on the bond. Say you pay $1. 1999. The first is to collect the yield (interest). which may be above or below par value. Then it solves for the rate of return that best fits the cash flows. otherwise. It’s the most complete measure (in that it includes gain or loss and yield) of bond return. So if you sell a $1. That is. This is true for any bond you sell after interest rates fall. the price of your bond goes up.000. The issuer has to pay this according to the bond agreement. Interest rates may have been 5 percent one year. The yield to maturity (YTM) tells you what you will earn on the bond if you hold it until it matures. Remember. maturity. annual interest. you only paid $935 for a bond that is worth $1. when your bond is redeemed by the issuer. or for less than what you paid. A bond is priced based on the going market interest rate (which changes often). the price of your bond goes down. So if you bought a bond at a discount for $935.000 par value bond with a 5 percent coupon in a 3 percent market. or $50. the above example assumes that the underlying company selling the bond will not go bankrupt before the bond matures. at a premium. In sum. However. Therefore. investors can only get 3 percent. he will pass on your bond and go elsewhere. Very simply. which we will discuss later. The annual interest paid by the issuer is still going to be 5 percent of par. Yield to maturity takes into consideration any gain or loss you make on the bond along with the interest. and the probability of that happening is determined by the rating of the bond. the YTM calculation takes into account information about price. In order to provide a 3 percent yield that would be in accordance with the market. if interest rates go up. That’s a gain of $65. but the next. you’re going to make a capital gain. it’s important to include this gain. . There’s no reason why you should pay out more interest than the market dictates.000 par value bond with a 5 percent coupon? The investor who buys it will want his 6 percent yield. In calculating your total return on this bond. which is the interest rate at which the stream of cash flows associated with the bond equals zero. That is. things get a little more interesting. Of course. you can depend on the interest coming in as agreed. you can sell the bond for more than you paid—that is. you have to sell the bond at a discount. You make a capital gain on it. This is counterintuitive so it bears repeating: If interest rates go down. when looking at a bond. interest rates go up and down. Now you have a capital loss. it’s important to carefully evaluate the yield to maturity. The yield to maturity calculation is simply the internal rate of return (IRR) calculation. and what you get at redemption.Bonds 81 is little chance of the issuer collapsing. What if interest rates go up to 6 percent and you have the same $1. To give the buyer a 6 percent yield in a 5 percent market. it adds the redemption value to the mix. you want to sell it such that it yields 3 percent instead of 5 percent. if you buy or sell the bond on the secondary market. But the opposite can also happen. 82 Chapter Five Bond Ratings and Trading Strategies Almost all investors who buy bonds do so because they are generally safe investments. no matter how remote that risk might be. Baa1 Baa2 Baa3 BBB+ BBB BBB– Medium Future is not certain. Actual default rate less than 2 percent. C No interest Poor Investment Below Investment Grade Poor standing. Ca CC Default Extremely poor prospects. the rating agencies use entirely different rating systems. making it important to check what the ratings mean before you draw any conclusions. Aa1 Aa2 Aa3 AA+ AA AA– High Grade Over the long term. Acutal default rate less than 5 percent. Bond Ratings Investment Grade Moodyʼs Standard & Poorʼs Quality Investment grade best quality. Highly speculative. Acual default rate less than 5 percent. Developed by third parties like Standard and Poor’s and Moody’s. Ba1 Ba2 Ba3 BB+ BB BB– Speculative Little protection of interest and principal. However. B1 B2 B3 B+ B B– Speculative Caa1 Caa2 Caa3 CCC+ CCC CCC– Default Often in default. bond-rating services assign bonds a letter or a mixed letter and number rating based on the financial soundness of the bond issuer. To complicate things. some risk to investment. bonds carry the potential risk of default. Interest payments are protected by earnings and principal is secure. with Treasury bonds rated the highest and “junk” bonds rated the lowest. Aaa AAA High Grade Protection of interest is not as high as Aaa by still high quality. D In default . Actual defualt rate less than 2 percent. Whether it is a high-yield corporate bond or a bond sold by the sovereign state of Virginia. A1 A2 A3 A+ A A– Medium Adequate for now but may be unreliable over time. there is always a chance that the entity that borrowed the money will not be able to make the interest payments. Actual default rate about 26 percent. The higher the rating. May be in default. Moderate protection of interest and principal. Actual default rate about 17 percent. the higher the quality of the bond. Bond ratings were developed as a way to indicate the financial stability of the issuer of the bonds. Some speculation. with the exception of bonds issued by the federal government. Actual default rate over 40 percent. Government bonds. Highly liquid bonds include U. you can buy any type of Treasury security you want. anything rated under BBB– by Standard and Poor’s or Baa3 by Moody’s is not considered investment grade. you can buy anything from a thirty-year treasury to a three-month junk bond issued by a corporation on the edge of bankruptcy. Then the bank did a formal credit check on you through credit rating bureaus. Through a brokerage. so it does not hurt to shop around before making your decision. As long as you have enough money. bills. In fact. Investors can establish a single TreasuryDirect account that will hold all of their Treasury notes. The Bureau also allows you to direct deposit payments. and bonds. Investors are issued account statements periodically. in order to get information on whether you paid all your bills on time. depending on your brokerage.treasurydirect. Credit rating analysis is done by a few companies. and they are given a credit rating based on this financial examination. In some cases. Remember. you might be holding them for many years. treasuries. completely avoiding brokerage fees. only those speculating that there will be a corporate turnaround are willing to buy those bonds. you might even lose some or all of your principal. In an effort to make it easier for citizens to buy U. and sell bonds for a flat fee of $34. but the best known are Moody’s. visit www. To learn more.S. Now let’s discuss credit rating and credit rating agencies. These low-rated bonds are classified as high-yield. rarely trade on a fixed commission schedule. This program enables individuals to purchase bonds directly from the Treasury. Better credit ratings mean that the company is in better financial shape and there is less risk in holding its bonds. the Bureau of the Public Debt started the TreasuryDirect program. Illiquid bonds are generally the bonds of companies that are close to bankruptcy. meaning they trade less frequently. which we will discuss later. Liquidity has a direct effect on the commission you pay to trade a bond which. Interest and the repayment of principal are taken care of electronically via direct deposit to a bank or through a brokerage designated by the account holder. you can transfer bonds to and from your account whenever you desire. . and a C is not acceptable.gov.Bonds 83 Depending on the bond. reinvest money after a bond matures. it can either trade frequently at a low commission or it may be difficult to find a buyer or seller and therefore involve large transaction costs.S. Because they are no longer a safe investment. speculative. Remember the last time you went to the bank to get a loan? You filled out a long credit application that asked for information about your job and how much money you had. “Liquidity” is the term used to describe how easy it is to convert an asset to cash. etc. You can either participate in the direct offering of the bonds or pick them up in the secondary market. Critical Info: Picking a Bond Broker Bond commissions vary widely from brokerage to brokerage. The more As you get. or junk bonds. and Standard and Poor’s. unlike stocks. Lower credit ratings mean that buying the company’s bonds is more risky. Bond issuers go through the same process (except it’s a lot more complex and detailed). The company might not be able to pay interest. These credit ratings are kind of like grades in school. which have a daily trading volume worth billions of dollars. the better off you are. Additionally. An example is the Vanguard Total Bond Market Index (ticker: VBMFX) yielding around 3. As an example.e. one way to take advantage of trading in bonds is to invest in relatively short-term bonds. once a year. and this is a good thing for you. For example. the investor. since rising rates usually signal a stronger economy. or 0. Then. you may decide to buy five different Treasury notes or bonds (no default risk). Historically. Also. It’s the old risk and return paradigm again. You need to evaluate whether the return is worth the risk.84 Chapter Five In order to compensate you for the increased risk.. This entails holding bonds of varying maturities—from short-term to long-term—in order to guard against possible interest rate changes. Junk bonds provide yields of 5 percent to 9 percent above investment grade bonds. Think of laddering as a bond yield smoothing strategy.8 percent.2 percent. The benefit of this strategy is that the ladder that you have created should protect you from fluctuations in prices and yields that can occur in any one of the individual bonds. the ten-year T-bond yield in 2000 was about 6. bond prices are sensitive to the prevailing interest rates in the economy. however. So. If you are a long-term investor. instead. If you expect interest rates to go up in the future. your short-term bonds will have smaller fluctuations (i. but have a much higher default rate. as a long-term investor you may also decide to ride out the bond market and. Laddered bonds in your portfolio should be held to their maturity and should only be top-rated bonds. Just find yourself a lowfee bond mutual fund. bond prices change. turns out to be costly for you in terms of your returns.5 percent. put your money in the equity market and/or mutual and exchange traded funds. Another strategy used in bond investing is known as laddering. So this strategy. So when the Federal Reserve raises or lowers interest rates. After that. More on Bond Trading Strategies As we have seen so far. the yield dropped with each successive new ten-year T-bond issued for three straight years to less than 4 percent for those issued in 2003. Spreads—that is. even though safer from one angle. fear not. each maturing in the same month every year for five successive years. if you bought the ten-year T-bond in 2000. issuers give you a higher interest rate for bonds with lower credit ratings. Laddering protects you against such fluctuations because you would have the bond issued in 2000 in your portfolio to prop up your return even when the subsequent ten-year bonds in your portfolio were not doing so well. you would enjoy a nice return relative to the same bond issued a couple of years later. So. While no bond fund manager will . the difference in interest rates between the highest and the lowest quality investment grade bonds—can be 50 basis points. each expiring bond is replaced with a new bond maturing in five years. short-term bonds yield less than long-term bonds. If the above strategies still seem complicated. investing in short-term bonds will not be a good thing for you. if interest rates do happen to rise. lower volatility) than longer-term bonds. This way. on average. you should have more in bonds and cash than in stocks. Citron. and 6. in the early eighties. more than 75 percent of the money is in AAA bonds. About fifteen years before. Once the dust settled.83 percent cash.Bonds 85 ever explicitly claim they have a laddered investment approach. they set up their portfolios so certain bonds become due at certain times. including roads. you set up your portfolio with bonds such that the average maturity of the bonds stays within that time frame. income. A February 2003 Wall Street Journal survey of portfolio strategists at sixteen top brokerage firms showed that. But since the legislation stated that property taxes could not be raised. 68. it is good to spread your risk over bonds of similar quality that mature at different intervals. So. you are maintaining the average maturity of your preference in the portfolio. this presented a dilemma to the elected county officials. Investors should review their portfolios occasionally to make sure their portfolio mix continues to meet their investment objectives. he had access to the county’s tax receipts and the proceeds of public bond More on Bond Ladders Just like investing in stocks.16 percent bonds. When a bond matures. and the opposite if you are a risk taker by nature. and investment objectives. As county treasurer. Individual firm allocations ranged from as much as 40 percent bonds to 89 percent stocks. when investing in bonds. Another possibility is the Managers Bond Fund (ticker: MGFIX) with a yield of about 4. Reverse Repos and the Orange County Fiasco This is a story about Orange County in California—the nation’s fifth-largest county and one of its richest—and how it lost more than $2 billion in taxpayer money through risky bond trading. for example. if your comfort zone is between seven and ten years. so did its need for services.20 years (which makes it an intermediate term bond). How could they increase the county income without increasing taxes? It was at this propitious juncture that Robert Citron entered the picture. Additionally. How Much of Your Portfolio Should Be in Bonds? The answer to this question depends on your age. simply replace it with a new one of suitable maturity so your average maturity stays within the same interval. and other public works. they recommended a portfolio blend of assets that includes 23.6 percent and average maturity of about six years. schools. libraries. As the county grew. feel free to experiment with the percentages in each category depending on how risk averse (or risk taking) you believe yourself to be.66 percent stocks. In December 1994. the world was shocked when Orange County filed for bankruptcy protection. Orange County was attracting thousands of residents energized by legislation that limited property taxes. If you are risk averse. . In the case of VBMFX. The fund has an average effective maturity of 7. an unlikely villain emerged: Robert L. the county treasurer. In fact. If he could somehow borrow money at low. Through his actions.percent and increase in value by 5 percent if interest rates fall 1 percent. the investor purchases an asset accompanied by an agreement to sell that asset back to the original seller at a later date for a higher price. That provides us with leverage and brings with it risks. For example. In fact. he saved Orange County from a budget crunch by producing unexpected interest income. Bob Citron was never really trying to hide his trading strategy. for each percentage point the intering interest rates. Specifically. Articles written over this period reveal that in 1993. Each year. He set out to artificially boost the size of his investment portfolio. Citron managed to take the $7. When the seller buys their asset back on the agreed-upon date. predicting the future direction of interest rates is crucial and almost all strategies are geared towards that. he might be able to grow the county funds. The decade of the 1990s began and Citron’s performance continued.86 Chapter Five offerings. or with loaned money from our broker.4 billion county fund and create a $20 billion portfolio through reverse repos. lio on the belief that interest rates were not going to be going up anytime soon. the purchaser serves as a lender. Interestingly. which meant that he had artificially increased the interest rate sensitivity of his portfolio five times (the interest rate sensitivFormally. duration measures the sensitivity ity of a portfolio is also known as its “dura. While some people around him knew that Citron was using reverse repos to increase yields and some even knew of Duration . in effect. The cash helped save many popular county initiatives without having to raise taxes. Citron made another very risky move. This is important to note because in bond trading strategies. the portfolio would feel the duration means the bond will decrease in value by 5 percent if interest rates rise 1 effect magnified by five. And as an investor of these funds. the higher price represents. his investment strategy worked as he planned. He was a big proponent of using the reverse purchase agreements to increase portfolio yields and would often trumpet their virtues. a five-year est rate moved. for more than a decade. and the seller serves as a borrower. For awhile. Another belief he held that played a critical role was that interest rates would not increase in the near future. longer-term interest rates. We are now familiar with buying stocks on margin.of a bondʼs price to changes in the prevailtion”). In this process. an interest payment. Citron seemed convinced that there was only one way to go. for example. like the Federal National Mortgage Association (or Fannie Mae). Citron had a leverage ratio of his portfolio of 5:1. The way you leverage yourself in bond trading is through a practice known as reverse repurchase agreements (or “reverse repos”). As such. the Orange County investment pool returned about 8. So.7 percent). Citron pledged his securities as collateral and reinvested the cash thus obtained in new securities—mostly five-year notes issued by government-sponsored agencies. city officials started taking Citron’s magician-like ability to produce extra money for the county for granted. Citron was gambling his investment portfo. Next. In fact.5 percent (relative to the state of California’s 4. short-term interest rates and invest at higher. Early in 1994. The obvious implication of this is that the timing of the liquidation of the Orange County portfolio represented a gigantic opportunity cost—to the order of about $1.6 billion paper loss in December 1994. the Federal Reserve began a series of six consecutive interest rate increases. things went from bad to worse in a hurry. trading volume) of a bond determines about 7 percent of the cross sectional variation in bond yields for investment grade bonds and about 22 percent of a bond yield for speculative (or junk) bonds.6 billion. Citron. By Labor Day of that year. Orange County announced it was filing for protection from its creditors under Chapter 11 of the bankruptcy code. After this announcement. While publicly stating that he was not surprised by the Fed’s interest tightening. which is always 20/20.. soon after the liquidation. that rates would go back down again so soon. the county’s loss was pegged at a minimum of $2 billion. What no one knew was that Citron was actually borrowing more money in a last ditch effort to recoup his losses. investors in Citron’s pool were getting downright jittery. privately these were unsettling times for Bob Citron. 1994. But remember that awareness of this opportunity cost comes only with the benefit of hindsight. hung on to his belief that the increase in interest rates was at or near its peak and things would get better again soon. No one could have foreseen. Finally. Citron announced that the county investment fund faced a $1. no one wanted to question his strategy while the returns were pouring in. rather than trying to get out of some of his positions to stem his losses.Bonds 87 the inherent risks involved. 1994. the county locked in an actual loss (as opposed to paper losses) of about $1. Research on Bonds Research reveals that the extent of liquidity (i. on December 1. Do research on websites such as http://investinginbonds. Interest rates were rising and no one seemed to know what was happening with the portfolio.28 They show that similar trades on similar bonds executed in the same market can have very different volume and volatility patterns depending on which dealer .27 What are we as investors to make of these findings? Pay attention to the volume of the bond contract that you are interested in transacting—especially if you are interested in transacting speculative. Bob Citron resigned and on December 6. interest rates did go back down by about 2.4 billion. But surprisingly.5 percent. the first signs of trouble began to appear.com in order to learn more. But. In the immediate aftermath of the filing. sitting in the smoldering ruins of a $1.5 billion paper loss.e. beginning in February 1994. bonds. Unfortunately. and that any effects of this would be short lived. But here is the ultimate irony and a valuable lesson in investing: by (some say prematurely) liquidating the investment pool in December 1994. Another study examines the reputation of Wall Street dealers who buy and sell Treasury bonds and the effect of this reputation on the trading pattern of these treasuries. or junk. The Federal Reserve raised short-term interest rates for the first time since 1989. On December 4. its trading activity (volume). etc. 3. Why do companies sometimes choose to issue bonds to raise money rather than issue stocks? 2. bonds issued by firms in the utility and trade sectors have higher recovery rates. the paper estimates that the main determinants of bid-ask spreads in the bond market are the time to maturity of the bond. Treasury. a little less than half of the invested amount is recovered by bondholders in default. The bottom line is that bonds provide an important safety net in your portfolio. those are the three aspects of your bond that you need to pay close attention to in order to minimize your transaction costs. go to a large and reputed bond dealer. Also. like Merrill Lynch. including the United States government. Can you think of a way junk bonds may have been used to finance corporate takeovers? 6. So. As an investor. or someone you know. Treasury securities so important in the world economy? . to raise money? 4. insurance companies over a five-year period. Are bonds issued by corporations any safer than those issued by the government? Why or why not? 5.. lower-rated) bonds if you are feeling adventurous. Yet another paper looks at the corporate. Thought Questions 1.29 Arguing that the total value of bonds outstanding in these three markets is well over $14 trillion. Why are bonds a popular device used by cash-strapped governments. This means that bond dealers are very important. Such findings add to our insights regarding how safe or risky bond investments actually are. Salomon Smith Barney. Make sure you have some highly-rated corporate bonds and maybe even a few higher yield (and. They argue that their methodology uses data from firms’ investment grade bonds that do not present an imminent risk of default. may have “called” a loan they have? Think of the similarities between that and a company calling its bonds.S. bond ratings do not show any variation in recovery rates. Treasury bonds? Why or why not? 7. The authors find that the mean recovery rate is about 44 percent. Can you think of an example in your own life where you. In relatively recent research. the next time you are contemplating buying bonds. by extension.88 Chapter Five originated the trade. and municipal bond markets together.30 The authors then set out to estimate firms’ recovery rates by using data on individual corporate bond transactions made by U. Can you identify some years or periods where both bond and stock investments suffered? What drives this phenomenon? 8. In sum.S. Why are the U. and the bond’s credit rating. Are municipal bonds as safe as U. Morgan Stanley.S. Surprisingly. Sugato Chakravarty and Padma Kadiyala focus on fragmenting a firm’s distress risk into two components: its likelihood of default on its loans and the amount actually recovered by bondholders when the firm is in default (its recovery rate). Why is laddering such an important strategy for bond investors? Notes 27. A. D. Sugato Chakravarty and A. What happens to your bond’s yield if the company declares bankruptcy before the bond matures? 12. 28. Lesmond. (Fall 2009): 6–22. “Corporate Yield Spreads and Bond Liquidity. Massa and A. 30. How do you make money from your bond investments? 13. What is another term for the price sensitivity of bonds to prevailing interest rate changes? 14. Wei.” Journal of Finance 62(2007): 119–149. Sugato Chakravarty and Padma Kadiyala. M. .” Journal of Fixed Income. Sarkar. Would you buy a bond that is freshly issued or a bond of similar risk that has been around for a while? 10 Can a bond’s yield change after its issuance? Why or why not? 11.S.Bonds 89 9. Chen.” Journal of Financial Markets 6(2003): 99–141. “Ex Ante Estimation of a Firm’s Distress Risk Parameters From Bond Transaction Data. Simonov. “Trading Costs in Three U. and J. Bond Markets. Why do you think bonds are not as popular as stocks? 15. (June 2003): 39–48. What do bond ratings say about the underlying company? 16. L. 29. “Reputation and Interdealer Trading: A Microstructure Analysis of the Treasury Bond Market.” Journal of Fixed Income. Do you think investing in junk bonds is bad? When can such an investment strategy be lucrative? 17. . they are traded on an exchange.99 and is valid over the next month. Listen. what is it? And. Let’s talk later about some new policies we have that you shouldn’t be without. Can you sell me insurance of some kind so I can protect my investment? Stunned silence at the other end. But does this mean that you cannot have investment insurance? Sure you can! And here’s how. one-topping pizza for $9. The contracts are usually highly liquid. your agent coughs and says.6 Pizza Coupons and Stock Options If stock options aren’t a form of compensation. which means there are many buyers and sellers willing to conduct transactions. Pick up your phone and call your insurance agent—the person who writes your homeowner’s and auto policies. Options and Pizza Coupons Options don’t exist only in the world of investments. right? We don’t sell policies like that. “Uh. to exercise this coupon any time before it expires in order to get your pizza for the price on the 91 .” Click! You get the picture. We all receive pizza coupons in the mail stating things like one of their coupons entitles you to a large. Standard insurance companies do not sell investment insurance policies. as you know. These contracts are standardized—they control a fixed amount of shares and they expire at the same time. if expenses shouldn’t go into the calculation of earnings. I have been contemplating buying some stocks but. What Are Options? Options are simply legal contracts between two entities to buy and sell stock for a fixed price over a given time period. I have a client waiting here. conduct a simple experiment. just like shares of stock. where in the world do they go? —Warren Buffett. you’re kidding me. You might say something like this: “Say. Eventually. CEO. I have a question for you. I am very cautious by nature and hate losing money. Berkshire Hathaway Before you read this section. The basic idea here is the same as in investment options. but are not obliged. You can buy an option contract the same way you buy stock—by calling your broker or going to your online brokerage account. You have the right. what are they? If compensation isn’t an expense. Because of this standardization. for example. the demand for olive presses soared.000. you had “in essence” purchased an option to buy the house for $200. it might be the best decision. you will simply ignore the coupon and it will expire unused at the end of the month. just understand that. For now. much to the press ownersʼ collective dismay. unless otherwise stated. the value of the right to use the olive presses went through the roof—the result of demand far outstripping supply. Not surprisingly. or by simply selling his right to the presses to some other entrepreneur at a price higher than what he paid for them. . you make an “earnest money deposit” as a sign that you are serious about buying it. the house may drop in value. You can forfeit your right to purchase the house. more famous philosopher. say to $150. If the housing market suddenly tumbles. which was a slang term that came into use because that’s the price where the deal—the contract—was struck. You are allowed to purchase the stock for a fixed price. Thales had. his hunch paid off and. any asset that you buy is called a long position. Thales was able to exercise his option on the presses to make some real money in the olive business—either by pressing the olives and selling them for a profit. you are the owner. called the underlying stock. of course. which we will discuss later. If you buy a call option. Thales(640?–550 BC) (and friend of another. In trading lingo. but not required to do so. Long Call Options A call option gives its owner the right. Having faith in his prediction. but are not obliged.000 with an earnest payment of $2. to buy the house for the agreed-upon price. and as the bountiful olive crops arrived in town. In other words. but not the obligation. and have a long position in the contract. under the circumstances. each contract controls 100 shares of stock.000. to buy stock (or “call” it away from the owner) at a specified price over a specified time period.92 Chapter Six coupon regardless of how much it will actually cost in the establishment. Options in History One of the earliest examples of option use comes to us from Greece. Thales offered to pay the local olive refineries a fixed sum of money for the right. for $2. to buy stock. each contract controls 100 shares. Generally.000. You now have the right. The Greek philosopher. Another example of options occurs when you buy a house. retained the use of these presses through his “option” contract many months before. The owner with the long position has the right. This is an example of an option. You will lose your earnest money but. Apparently. you will use the coupon and exercise your option. but not the obligation. you have the option to buy—which is where these financial assets get their name. The price at which you can buy the stock is called the strike price. but not the obligation. to rent their facilities over the duration of the next harvesting season. Let’s say you offer to buy the house for $200. Hopefully. predicted that the upcoming olive harvest would be bountiful. when you make a bid on the house. Specifically. If you want pizza from that restaurant within the next month. Aristotle).000. If you don’t want pizza in that time frame. Thus. the put buyer (long position) has the right. here is an example of how you might buy a put option contract to give yourself some protection and peace of mind with your stock investments. you have the right. leading to losses in your investment portfolio. plus commissions. and a call option is that you must pay for the call option while pizza coupons arrive in your mailbox for free. if it does. to sell 100 shares of IBM for $100 per share through the third Friday in March.000 in total. So. you have bought some peace of mind with your 200 shares of MSFT. you could exercise your option and purchase the stocks for less than the market rate. Just as stock is traded in shares. But. or $600 plus commissions. but keep in mind that the price could just as easily move in the opposite direction. Now when would this call option contract become valuable? If IBM’s stock price were to rise over $100 before the option expired. but not the obligation. so you can’t pick the exact date you want it to expire. but not the obligation. Are you beginning to see how you can use options as an insurance policy for your stock investments? Put options can be used as investment insurance for your stock purchases—assuming. to buy one hundred shares of IBM (the underlying stock) for $100 per share (the strike price) through the expiration date in March—usually the third Friday of the month. This put option becomes valuable when IBM stock price falls below $100. This sounds wonderful. or $5. there is a catch. as discussed earlier. As with call options. which is not always the case. Having spent so much money. Put Options—For Investment Insurance A put option allows the owner to sell the stock (“put” it back somewhere else) for the strike price within a given time. for $600. Do you see it? . of course. If you buy one IBM March $100 call option (one contract). Why? You can still sell IBM shares for $100 when it’s trading in the open market for a price below $100. you are justifiably concerned that the MSFT share price may fall below $25 in the short term. that the stock you are interested in purchasing has options contracts trading on it. your share portfolio shows a loss but your option portfolio shows a gain to offset the loss in your stocks. Let’s say you have just bought 200 shares of MSFT for $25 each. Anytime MSFT share price goes below $25. but not the obligation to exercise the option. The big difference between an option represented by a pizza coupon. But. you have the right. options are traded in units called contracts. What should you do? Buy two put option contracts on MSFT with a strike price of $25 for $3 apiece. Think of a call option as a coupon giving you the right to buy stock at a fixed price until an expiration date. These are standardized time frames. Usually you can find contracts with expirations as little as a couple of weeks away and as long as three years away. If you buy an IBM March $100 put option.Pizza Coupons and Stock Options 93 Each contract is good only for a certain amount of time. to buy or sell. What does it mean to say you have a right to do something as opposed to saying you have an obligation to do the very same thing? Call Option Put Option Long Position (the buyer) Right. Think about the differences between the two. Short Calls and Puts With either calls or puts. it probably does have options trading on it. If you are interested in trading in options. For example. the short call trader must oblige and sell. The price of the stock changes every second. Depending on your situation then. to BUY stock at the strike price Right. maybe nine months at the most (unless you have those special option contracts known as LEAPS. keep in mind that not all traded stocks have underlying options written on them. It is important to note that buying options is far less risky than selling options. However. Following is a simple table that summarizes our discussion in terms of rights versus obligations. it is a safe bet that if it is a liquid stock. if your stock still hasn’t dipped below $25. Regardless of whether the short option seller is forced to buy or sell stock. The investor on the other side (the seller of the option.94 Chapter Six The option contract that you purchased has a finite life. So far we have talked about buying options (both calls and puts). but not the obligation. After nine months. you can enter the market slowly and carefully by buying rather than selling them. If a long call owner decides to buy the stock. Options may not be available for some of the stocks you are interested in. option prices display certain properties that are fairly easy to see. Likewise. which have expiration dates longer than one year). you may decide to get another option contract at a different strike price in order to be protected again. so the price of the options that are written on that stock do as well. if long put owners decide to sell their stock. the short put traders must purchase the stock. but not the obligation. the premium received from the initial short trade is theirs to keep. But you can also sell (or short) options. That said. options prices can never be negative (but can be zero). but not the obligation. However. That’s their compensation for accepting the risk. The reason for this is that options are “derivative” securities—they get their values from the underlying stock. to SELL stock at the strike price Short Position (the seller) Possible obligation to SELL stock at the strike price Possible obligation to BUY stock at the strike price Pricing Options Pricing options is not an easy task. also called the short position) has the obligation to fulfill the contract. He or she has no choice. the buyers (the long positions) have the right. your option will expire and you will once again be without protection. Another property is . This is similar to the process we used to value stocks as a discounted stream of future cash flows associated with the stock. These four possible paths could be drawn as a tree diagram and the price of the option today can be calculated based on the probabilities we assign to the likelihood of each of the four states occurring in the future and then discounting them to the present. bonds. ical portfolio using only stocks. Then.financial assets. It will only work during very small stretches of associated with the option. 1DOWN. named after the two economists. The advantage of this process is that it is amenable to being expanded to include many time periods and allows quick calculations to come up with new option prices as market conditions. becomes a “normal” distribution. of option pricing come in. For example. and two possible stock values at each of the two time steps (let’s call them UP and DOWN). 1 and 2. we simply construct a hypothet. and The Black-Scholes option pricing formula is the underlying stock conditions. as soon as an arbitrage opporties all follow from an argument often tunity arises. On a very basic level. consider that the stock price path has multiple time steps. except in an elementary and intuitive way to give you a general idea of how they work. everyone will take advantage of used in finance to set values of assets it until it goes away. and/or borrowed cash (all of which are easier to price) such that the portfolio payoff mimics that of the option we are attempting to price. It turns out that this arbitrage argument. Then. who developed the in the binomial tree mentioned above. if we considered two time steps. way condition is restored.Pizza Coupons and Stock Options 95 that a call option price can never be worth more than the underlying stock price. which No Arbitrage Principle Creators of Option Pricing . is a useful tool to price financial as the “replicating portfolio” idea. and finding the point of noto price options is to use what is known arbitrage. like the binomial model or the Black-Scholes model. we would have a total of four possible terminal values for the stock (namely: 1UP. In this assets or to set bounds on the prices of certain process. Since the underlying stock and bond prices are changing constantly. by extension. the now-famous formula in a paper published in statistical distribution of the stock return the Journal of Political Economy in 1973. These propertime because. you should consult these books. the idea of creating a replicating portfolio to value an option is a static concept and can only get us so far. If you want further education in the art of option pricing.” One intuitive. change. we have the value of the option. Unfortunately. This is where multi-period models. A third property is that a put option price Arbitrage represents a cost-free way to make can never be more than the strike price money—a perpetual money-making machine. There are entire books devoted to such dynamic option pricing approaches. the no-arbitrage known as the “no arbitrage principle. 2UP. 2DOWN). Fischer As we increase the number of time steps Black and Myron Scholes. and the simplest. we value the stockbond portfolio and. so we will not deal with them here. and at each of these times the stock can take only one of two possible values. replicating a portfolio becomes too cumbersome a process when used to value options in a dynamic context. Note that you cannot exercise portions of an option—you either buy or sell in lots of 100 shares. Properties of the Black-Scholes Option Pricing Formula The Black-Scholes option pricing formula makes some interesting properties evident. it is easy to figure out the price of the corresponding put option. Then. Call prices increase with time to expiration. your account will be debited for $5. The Black-Scholes option pricing formula was initially derived for a stylized situation involving a specific type of option and where the underlying stock paid no dividends. if you own more than one contract.000 ($50 per share times 100 shares per contract) plus commissions and credited 100 shares of stock on the third business day. The strike price. For instance.000 minus commissions and will be debited for 100 shares of stock on the third business day.96 Chapter Six has nice properties that are easy to work with. if you own a $50 strike call option and decide to exercise it. Call and put prices both increase as the volatility of the underlying stock increases. For example. Call prices increase as the stock price increases. we arrive at the Black-Scholes option pricing formula. You either buy 100 or none at all. three business days later. The time to expiration. Put prices decrease as the stock price increases. only exercise two of them and buy 200 underlying shares. The formula has the following as its inputs: • • • • • The underlying stock price. The volatility of the underlying stock price. for example. if you own a $50 strike put and exercise it. • • • • • • • Call prices decrease as the strike price increases. The interest rate (calculated on the basis of continuous compounding—a time value of money concept). you will receive $5. as outlined below. . if you own one contract.” This means that if you know the call option price for a given stock. Put prices increase as the strike price increases. Put prices may increase or decrease with time to expiration. Of course. the transaction will take place. with a little more statistical manipulation. Similarly. • Calls and puts of a given stock are bound by a relationship known as the “put call parity. you simply call your broker and tell him you want to exercise the option. If you have five contracts. you can certainly exercise only a portion. And. you cannot call your broker and use it to only buy 75 shares. you could. Exercising Options If you wish to buy stock with your call option or sell stock with your put option. Pizza Coupons and Stock Options 97 What If You Want Out of Your Contract? You can always get out of any option contract—long or short—by executing an offsetting position. So, for example, if you are long on a March $50 strike call, you can simply sell a March $50 call (called “selling to close”) and you no longer have the right to purchase the stock for $50. If you have sold a $75 put (called “selling to open”) and no longer want the obligation to buy the stock for $75, you can simply buy a $75 put (buy to close), which relieves you of your obligation. However, the catch is that the price you receive (or pay) is determined by the market and can be very different from when you entered into the contract. For example, if you sell a $75 strike put with the stock at $80, you may receive say $6 (per share). Later, if the stock is trading for $70, you may wish to get out of the contract. However, that $75 put may now be trading for $11, meaning you sold for $6 and had to pay $11 to exit: a loss of $5 per contract. In fact, most options are closed out in the open market this way. Contracts are actually exercised for stock less than 5 percent of the time. The moral of this story is that you can always get out of a contract at any time—it may just cost you money to do it. How Are Options Similar to Stocks? Options are similar to stocks in several ways. Both options and stocks are securities. They both trade on national, SEC-regulated exchanges. Option orders are transacted through market-makers and retail participants with bids to buy and offers (or asks) to sell, and can be traded like any other security. How Do Options Differ from Stocks? Options are different from stocks in several important ways. Options have an expiration date, while common stocks can be held forever (unless the company goes bankrupt).31 If an option is not exercised on or before its expiration, it expires worthless. Options only exist as a book entry, which means they are held electronically. There are no certificates for options as there are for stocks. There is no limit to the number of options that can be traded on an underlying stock, while common stocks have a fixed number of shares outstanding. Options do not confer voting rights or dividends. They are strictly contracts to buy or sell the underlying stock or index. If you want a dividend or wish to take advantage of voting rights, you need to exercise the call option. If you understood most of what was discussed in this chapter, you are already ahead of 90 percent of your peers. This is a big advantage. Research on Options The research on options has focused primarily on the impact of their trading on the price of the corresponding stock. Economists refer to this as price discovery. If 98 Chapter Six new information about a company is reflected in the company’s option trades, then economists would say that options Price discovery is one of the most important markets display significant price discovfunctions of an exchange—whether it is a ery. Why is this important? If you knew, stock exchange, an option exchange, or any for example, that new information about other exchange. If a particular venue is a given company always shows up in its associated with price discovery, you can option trades and then shows up in its safely take the asset prices from that stock prices and you noticed the compaexchange as indicative of all publicly-availny’s call options were doing well, it able information on the underlying company. might indicate the stock prices are about to go up, and you could use the information to buy the company’s stocks and create a profit. In a valuable research paper, three economists show that certain option trades can convey useful information about future stock price movements.32 Therefore, it would be advantageous to look at a company’s option trades in order to form opinions about its future stock prices. On the other hand, research has also shown that new information about a given company is reflected in the stock price first and then in the corresponding option trades.33 Another research study has applied sophisticated analysis using a large data set over a long time horizon and found evidence that significant price discovery occurs in the option markets.34 This study has actually quantified the amount of price discovery in the option markets as around 20 percent. The authors also state that the amount of price discovery occurring in the options tends to be greater when option trading volume is higher, when the corresponding stock trading volume is lower, and for stocks with high volatility. Pay attention to how a company’s options are trading before making transaction decisions. There is important information about a stock’s impending performance in the stock’s option trades. Price Discovery Credit Default Swaps (CDS) Definition of a CDS Credit Default Swaps (CDS) have been blamed for the collapse of the global A CDS is a contract between two counterparfinancial markets in the Fall of 2008. The ties. The buyer of a CDS contract makes definition of a CDS contract is innocuous; periodic payments to the seller of the CDS one would never expect they held the contract. In return, the buyer receives an power to cause a global financial catas- appropriate payoff if the underlying financial trophe. A CDS is a contract between two instrument defaults in the future. counterparties. The buyer of a CDS contract makes periodic payments to the seller of the CDS contract. In return, the buyer receives an appropriate payoff if the underlying financial instrument defaults in the future. If you are thinking that this sounds a lot like an insurance contract, you are correct—that is what they essentially are. Pizza Coupons and Stock Options 99 They say that innovations move in light years while regulations move merely in regularly years. Therefore, it is logical that innovations stay a few steps ahead of the law. CDS contracts, on their face, are regular insurance contracts, much like the home insurance policy that you have with your local insurance company. That policy states that if something bad should happen to your property, the company that has sold (or written) the policy will reimburse you for your losses consistent with the conditions of your policy. Critical in this arrangement is the ability of your insurance company to be available with cash when the need arises. But what if your insurance company resells your policy to another company across the world. Now, if you need to file a claim, it is the new purchaser of the policy that has the responsibility to provide the money in return for the insurance premium income it is now earning. But what if this company across the world never had any way to honor your claims? It bought the policy to simply earn your regular premium payments with no intention of ever paying your claims, and this was able to happen because there was no regulation in place to investigate whether the new buyer had the financial capability to meet its insurance obligation. Consider the same thing happening to thousands of insurance policies each worth many billions of dollars in assets, and you start to understand the magnitude of the problem. In reality, your local insurance companies cannot do this, because a company that declares itself to be an insurance company is regulated. The U.S. Congress has enacted legislation that severely curtails what insurance companies can, and cannot, do with your money. The problem is not them. It is companies that behave like insurance companies, but do not declare themselves to be so, that were behind the financial meltdown. Financial services companies like AIG and others of their ilk were acting like insurance companies, but since they did not fall under the rubric of a traditional insurance company, the rules that would normally apply to conventional insurance companies did not apply to them. So they could operate right under the noses of the regulators with impunity. And they did—until the sheer size of the market and the lack of regulation simply got out of hand. It may have gone on unnoticed had an event in the U.S. not created the ripple effects to bring the system down. The event was the failure of the subprime mortgage market. As millions of homeowners realized that they could no longer afford the terms of their mortgages and defaulted, the financial services companies that had purchased CDS contracts for protection for just such an eventuality turned to the companies that sold the contracts and requested their money. Suddenly, everyone realized that these so-called insurance contracts had been sold and resold many times over, and no one knew who the final buyer was or whether this buyer could pay. In most cases, the buyer resided across the world in a country with no jurisdiction to enforce payment. 100 Chapter Six The Credit Default Swap (CDS) Market S.G. Badrinath Professor of Finance San Diego State University Through the decade of the 2000s, the credit default swap (CDS) became the primary vehicle through which credit risk was transferred and traded. The CDS is best understood in the context a single-name bond for which a bondholder desires protection in the event of issuer bankruptcy, failure to pay, restructuring, or other potential interruption of the cash flow stream.35 To protect against this adverse credit event, the bondholder agrees to make a periodic payment to a counter party. By paying this periodic premium, the bondholder is buying insurance and selling the credit risk to the counterparty. By receiving the premium, the counterparty is buying the credit risk and selling protection to the bondholder. If and when a relevant credit event affects the value of the underlying asset, then the bondholder expects to be made whole by the counterparty either through a cash or physical settlement.36 This application is similar to that of any other form of insurance and can be compared to a protective put option.37 The appeal of the CDS becomes clear when compared with executing a similar transaction in the bond market. Exposure to credit risk can be achieved either by owning the bond or selling the CDS. Owning the bond requires the commitment of capital and creates interest rate risk exposure while selling the CDS only requires periodic mark-to-market adjustments and collateral deposit. Likewise, being short credit risk implies being either short on the bond or buying the CDS. Again, the former is difficult to do while the latter is easier to accomplish. In both cases, the CDS offers leverage and liquidity and is thus an easy expression of a view on credit in a manner that has not been possible in the secondary bond market. Illiquidity in the bond market is one of the reasons why the over-the-counter CDS market attracted the attention of market participants. Banks, hedge funds, and securities houses accounted for over 50 percent of both the sell-side and the buyside of this CDS market. As evident, the price of the CDS increases with market risk and protection sellers are required to post collateral to assure CDS buyers of their ability to honor their insurance obligations. Used in this fashion, the economic implications of the CDS are similar to that of the financial guarantee provided by the GSE’s and the monoline insurance companies in that they are also a form of insurance against losses.38 A more common application of the CDS has been to directly purchase it without owning the underlying bond. This is akin to a short sale and has attracted considerable notoriety in the media. As this market grew from initially insuring the default risk of individual bonds, CDS products on loans as well as mortgage-backed and asset-backed securities began to proliferate. Portfolio versions variously called basket CDS and index CDS products traded in the middle of the decade. The now infamous ABX index was constructed from one or two deals from twenty different ABS programs, with five different rating classes—AAA, AA, AA, BBB, BBB–. The bottom Pizza Coupons and Stock Options 101 two are further combined into the TABX which was the most sub-prime and experienced the most rapid declines in value at the beginning of the financial crisis.39 The synthetic CDO is a special purpose securitization vehicle that also makes extensive use of the CDS instrument. The Bistro structure conceived initially by JPMorgan in 1997 became a template by which the cash flows to tranches of securitizations were generated from the premiums received by selling credit default swaps on a portfolio of securitizable assets. In other words, instead of a pool of assets generating cash flows, the insurance premium representing their likelihood of default is itself distributed directly to the tranches. Since the rate of default in the pool of underlying assets governs the amount of the premium that will be received from credit default swaps sold on those assets, this amounts to essentially the same bet. In July 2010, Goldman Sachs settled a dispute with the SEC regarding the Abacus-2007 CDO in which investor John Paulson had a role in selecting the securities underlying the CDO against which he subsequently took short positions. In July 2010, the Dodd-Frank Act provided explicit rules for managing counterparty risk and made the clearing of derivatives trades mandatory. This Act has called for the passing of many rules and is presently bogged down in negotiations between regulators and market participants. Credit Default Swaps: A Numerical Example Warren Buffett once said: “Derivatives are financial weapons of mass destruction.” We have already looked at the basics of derivative contracts—options. One of the most popular derivative contracts is the interest-rate swap, which accounts for roughly three-quarters of the $550 trillion global derivatives market (credit default swaps accounts for roughly 10 percent). Usually, these swaps include a fixed-for-variable interest rate exchange between two parties. For instance, if you and I get into a fixed-for-variable swap agreement, I may agree to pay you a sum equal to a fixed interest rate times a contract amount while receiving from you a sum equal to a variable interest rate times that same amount. Why would I want to do that? If I have a business with an outstanding variable interest rate loan, I may look at this swap as a way to lower my annual borrowing cost and thereby avoid interest rate risk. In contrast, credit default swaps are side bets that allow for the transfer of default risk associated with a corporate bond between two parties. This is similar to betting on the result of a football game without owing any stake in the underlying teams. For instance, imagine that before the current market meltdown, CalPERS (the large California public pension fund) owned $100 million of IBM bonds, but wanted to insure against the risk of a bond default. CalPERS could accomplish this by negotiating a $100 million, five-year credit default swap with AIG—which, at one time not too long ago, was a AAA rated global financial institution. Under the terms of the swap, CalPERS would make an annual swap payment to AIG equal to, for example, 1 percent of the $100 million swap amount. In return, AIG would pay CalPERS the amount of any losses that CalPERS realized in the event of a default by IBM. For example, if IBM went bankrupt during the contract period, and bondholders were only repaid twenty cents on the dollar, AIG would pay CalPERS $80 million to make up the difference. Furthermore, the swap contract would also require that if AIGʼs credit rating were ever downgraded from AAA, AIG would post collateral equal to 20 percent of the swap contract amount, or $20 million, in order to compensate the other party for the added risk involved. Source: Paul, David. 2008. Credit default swaps, the collapse of AIG and addressing the crisis of confidence. The Huffington Post. October 11. 102 Chapter Six Madoff: A Path Littered with Clues Contributed by: Greg N. Gregoriou Professor of Finance State University of New York (Plattsburgh) Francois-Serge Lhabitant Professor of Finance HEC University of Lausanne EDHEC Business School This article is an abridged version and is reprinted with the permission of the authors. The complete article appears in The Journal of Wealth Management. On December 10, 2008, Bernard Madoff confessed to his two sons, his brother, and his wife that his investment advisory business was “a giant Ponzi scheme.” That evening, his sons turned Born on April 29, 1938, Bernard L. Madoff him in to U.S. authorities. Madoff was graduated from Far Rockaway High School in arrested the next day and charged with 1956. He attended Hofstra University Law securities fraud. The SEC filed a com- School but never graduated. In the early plaint in federal court in Manhattan seek1960s, he created BMIS with an initial capital ing an asset freeze and the appointment of US$5,000 earned from working as a lifeof a receiver for Madoff’s brokerage firm, guard during the summer and installing refrigBernard L. Madoff Investment Securities eration systems. LLC (hereafter BMIS). Let’s go back in time to the preceding decade. Bernie had an impeccable reputation on Wall Street. He was on the short list of guests for every family birthday, anniversary, bar mitzvah, wedding, and graduation. His firm was ranked as one of the top market makers in NASDAQ stocks. His solid and consistent track record generated a mixture of amazement, fascination, and curiosity. Investing with him was exclusive—a clear sign that one had “made it” socially. Bernie was truly a legend in the financial industry. Admired by most, venerated by some, his success was such that very few dared to criticize him without risking their careers. His house of cards nevertheless crumbled on December 11, 2008, when news broke that the F.B.I. had arrested Madoff and charged him and BMIS with securities fraud. According to the SEC complaint, Madoff himself informed two of his senior employees that his investment advisory business was “just one big lie” and “basically, a giant Ponzi scheme.” All Madoff investors should, in retrospect, kick themselves for not asking more questions prior to investing. As many of them have learned to their regret, there is no substitute for due diligence. Indeed, as discussed in this article, there were a number of red flags in Madoff's investment advisory business that should have been identified as serious concerns and warded off potential clients. Madoff’s Investment Strategy The strategy officially followed by Madoff was in theory remarkably simple—a combination of a protective put and a covered call. It can be summarized as follows: Pizza Coupons and Stock Options 103 1. Buy a basket of stocks highly correlated to the S&P 100 Index. 2. Sell out-of-the-money (OTM) call options on the S&P 100 with a notional value similar to that of the long equity portfolio. This creates a ceiling value beyond which further gains in the basket of stocks are offset by increasing liability of the short call options. 3. Buy out-of-the-money put options on the S&P 100 with a notional value similar to that of the long equity portfolio. This creates a floor value below which further declines in the value of the basket of stocks are offset by gains in the long put options. The terminal payoff of the resulting position is illustrated in Figure 3. Option traders normally refer to it as a “collar” or a “bull spread.” Some traders also call it a “vacation trade” because you can establish the position and not worry about it until the expiration date of the options approaches. Madoff referred to it as a “split strike conversion.” Collars typically aim at providing some downside protection at a cheaper cost than buying puts alone—the cost of purchasing the puts is mitigated by the proceeds from selling the calls. In addition, collars are commonly used to exploit the option skew, i.e., a situation where at-the-money call premiums are higher than the at-the-money put premiums. Overall, the cost of a collar varies as a function of the relative levels of the exercise prices, the implied volatility smiles of the underlying options, and the maturity of the strategy. Officially, Madoff claimed to implement this strategy over short-term horizons—typically less than a month. The rest of the time, the portfolio was allegedly in cash. Madoff’s promise was to reliably return 8–12 percent a year, regardless of what happens in the markets. Although results could vary from one feeder to another due Terminal payoff Ceiling from call options Participation to market Floor from put options Figure 3: Unbundling the split strike conversion portfolio S&P Index 104 Chapter Six Figure 4: Comparing Fairfield Sentry Ltd with the S&P 100 (OEX). to fees, leverage, and other factors, all of them did, in general, show persistently smooth positive returns. Over his seventeen year track record, Madoff would have delivered an impressive total return of 557 percent, with no down year and almost no negative months (less than 5 percent of the time). The stability of this track record combined with its positive skew were some of the most compelling arguments to invest with Madoff. Returns were good but not oversized, and their consistency made it seem that the outcome of the strategy was almost predictable—a perfect investment for a conservative portfolio and an even more perfect investment to leverage for an aggressive one. As an illustration, Figure 4 compares the cumulative performance of the strategy versus the S&P 100 Index. Returns are comparable (11.2 percent p.a. for the Fairfield Sentry Ltd. fund versus 8.5 percent p.a. for the S&P 100), but the difference in volatility is striking (2.5 percent p.a. for the fund versus 14.8 percent for the S&P 100). The maximum drawdown difference is also abysmal (–0.6 percent p.a. for the fund versus –49.1 percent for the S&P 100). Red Flags Operational Flags Lack of segregation among service providers Madoff worked alone with no third party independent oversight. He traded his managed accounts through his affiliated broker-dealer BMIS, which also executed and cleared these trades. More importantly, all assets were administered within his organization, which also produced all documents showing the underlying investments. In a traditional hedge fund, this should have been a clear no-go for all investors, as it allows for performance manipulation and substantially increases the 550-square foot office in the Georgetown Office Plaza in New City. How could one believe that ice providers. Obscure auditors BMIS was audited by a small accountancy firm called Friehling and Horowitz. Its staff consisted of one partner in his late seventies who lived in Miami (Jerome Horowitz). including research. to the American Institute of Certified Public Accountants. therefore. His youngest son. Officially. aged by such a small group of people? one or several brokers to execute trades.Pizza Coupons and Stock Options 105 risk for the misappropriation of assets. a According to investors. New York. Lack of staff and extreme secrecy In its regulatory filing. His brother Peter joined the firm in 1965. Mark. one should question the way the firm was rewarded for its investment services. which normally includes an such a large sum of money could be maninvestment manager to manage the assets. This allowed the distributor of the feeder funds to charge final investors a management and/or a performance fee—typically 2 percent and 20 percent. Shana. Andrew. it disclosed US$17 billion of assets under A typical hedge fund uses a network of servmanagement. access to fund administrator to calculate the NAV. there was no management or performance fee at BMIS—the sole form of compensation according to its Form ADV was a “market rate” commission charged on each trade. since there is no third party independently confirming the legal ownership of the Fund’s securities. . Bernard Madoff’s oldest son. and Madoff’s offices for on-site due diligence some custodians/prime brokers to custody was very limited or even denied. Unusual fee structure Since BMIS was not operating a fund. He was a Senior Managing Director. that is was not conducting an audit every year since 1993. Madoff’s nephew. the Head of Trading. Additional investigations would also have revealed that Friehling and Horowitz had claimed. joined the firm in 1995 and served as the in-house Legal Council and Rules Compliance Attorney for the market-making arm on the broker-dealer side. Simultaneously. One should clearly have questioned the choice of such a small audit firm given the large asset base of BMIS. Charles Wiener. Although this firm was accredited by the SEC. Madoff the positions. Heavy family influence Key positions of control at BMIS were held by family members of Madoff. Sandwiched between two medical offices. and one active accountant (David Friehling). had no independent check on its quality controls. it was virtually unknown within the investment management industry. The firm was not peer reviewed and. BMIS indicated that he had between one and five employees who performed investment advisory functions. and the Chief Compliance Officer for the investment advisor and the broker-dealer businesses. joined the family team in 1986 and was Director of Listed Trading. Peter’s daughter and Bernard’s niece. started in 1988 and was Director of NASDAQ. a secretary. joined in 1978 and served as the Director of Administration. it operated in a small. in writing. None of that did happen. but it will also generate some down months and exhibit significant levels of volatility. as his firm used no leverage and had very little inventory. Given the daily trading volume. However. In exchange.S. option prices would have experienced sharp moves in the wrong direction for Madoff. who only had ten down months out of 215 and a very low volatility. When applied systematically with a monthly rollover. No other split strike conversion manager was able to deliver such a consistent track record. He never provided any explanations or monthly performance attribution. there are not so many counterparties that could be consistently ready to sell cheap insurance every month—and lose money for seventeen years by doing so. this would have been illegal in the U. Investments Flags A black box strategy Madoff’s purported track record was so good and so consistent that it should have become suspect. the counterparty credit exposures . which are much less used than S&P 500 options. and then use this information to implement optimally his split strike option strategy. Front running: Madoff could have used the information from his market-making division to trade in securities ahead of placing orders he received from clients. But that explanation is unconvincing. First. Such an attitude is very unusual in the hedge fund world. Even the most secretive hedge funds are usually willing to demonstrate to investors that they have quality operations and provide operational transparency. Madoff himself dismissed this explanation. or to conduct more market making by purchasing additional order flow. Subsidized returns: Madoff could have used the capital provided by his feeders as pseudo equity. for instance. to leverage some position without having to explicitly borrow. Several possible explanations have been considered by investors to explain this puzzle. Madoff’s edge would then have been his ability to gather and process market order flow information from the massive amount of order flow BMIS handled each day. When questioned about the discrepancy between the daily trading volumes and his alleged needs. None of this was available with Madoff. This was not the case with Madoff. even informally. Madoff supposedly explained that he used primarily OTC markets. However. some of the profits made on the market making could have been used to subsidize and smooth the returns of the strategy. Let us mention some of them: Market intelligence: Madoff could have added value by stock picking and market timing. Second. a split strike conversion strategy can be profitable over long periods. and even threatened to expel some investors who asked too many questions. However. it is unlikely there would not be a single failure of this edge over seventeen years.106 Chapter Six refused to answer questions about his business in general and his investment strategies in particular. Market Size Executing a split strike conversion strategy with over US$17 billion of capital would have been prohibitively expensive using S&P 100 options. Markopolis tried again to capture the attention of the SEC’s Washington office. which are publicly available. the number of shares owned and the total market value of each security. These 13F Forms.” Interestingly. some of these counterparties would have hedged their books.Pizza Coupons and Stock Options 107 for firms that could have done such trades were likely to be too large for these firms to approve. but a few technical violations surfaced that were rapidly corrected. his 13F Form usually only contained scatterings of small positions in small (non-S&P 100) equities. and no option arbitrageur ever saw one of Madoff’s trades. investment managers who exercise investment discretion over US$100 million or more of assets must disclose quarterly their holdings on a 13F Form with the SEC. contain the names and “. and there was no indication of such movements. Markopolis listed twenty-nine red flags that suggested again that either Madoff was front-running his customer orders. while Madoff had over US$17 billion of positions. Impending Doom The most tenacious Madoff opponent turned out to be Harry Markopolis. the CUSIP number. this is hard to believe and it would have created massive movements on money markets. the names of these alleged counterparties could never be confirmed. . Not surprisingly. or he was conducting “the world’s largest Ponzi scheme. Last but not least. But his reports were laden with frothy opinions and provided no definitive evidence of a crime. In early 2008. And third. a former money manager and investment investigator. Since these violations “were not so serious as to warrant an enforcement action. This should have suggested that Madoff could not be doing what he said he was doing. Markopolis nevertheless continued his repeated requests. In May 1999. Again. . It found no evidence of front running or of a Ponzi scheme. the SEC’s New York Office followed up on Markopolis’s tips and investigated BMIS and one of its feeders. Madoff’s explanation was that his strategy was mostly in cash at the end of each quarter to avoid publicizing information concerning the securities he was trading on a discretionary basis. but Markopolis’s letters should have been a warning sign for investors.” the case was closed.. several banks refused to do business with Madoff.S. Markopolis started a campaign to persuade the SEC’s Boston office that Madoff’s returns could not be legitimate. Several professional advisers and due diligence firms attempted to analyze the strategy and/or some of its feeder funds and rejected them from their list of approved investments. so the SEC paid little attention. . One of them in particular black-listed Madoff in its asset management division and banned its brokering side from trading with BMIS. Incoherent 13F Filings In the U. which culminated in November 2005 with a seventeen-page letter titled “The World’s Largest Hedge Fund Is a Fraud. but obtained no response.” In this letter. These repeated failures by regulators to pursue investigations will certainly be examined and discussed extensively in the near future.” This time. class of the securities. London: John Wiley and Sons. E. Liang. N. Why is buying options safer as a trading strategy. Why is the phrase.S. 2001. Brown. December. U. B. When do you have the obligation to go through with an option transaction? 3. S.gov/about/forms/form13f. 2008. 2008a. Don’t ask. and C. 08-08. The Journal of Finance 63(6): 2785–2815. and how long is the policy valid for? 4. Thought Questions 1. Connecticut: Yale ICF Working Paper No. Markopolis. Goetzmann. and C. 1.” so important with call and put options? 2. MPI Quantitative Research Series. Markov. Madoff: A tale of two funds. Barrons May 7. Options actually expire on the Saturday following the third Friday of the expiration month.C. Brown. New Brunswick. 2008. 2005. SEC. N. this is for accounting purposes only. District Court for the Southern District of New York. Letter to the S. Madoff (2008). F.. When purchasing options as an insurance policy. Form 13F. S. what is the “premium” for the policy. Lhabitant. H. 2006. Goetzmann. What can the regulators do to minimize the destructive influence of credit default swaps? 8. Are there options traded on all publicly-traded stocks? Why or why not? 7. NJ.sec. U. relative to selling options? 5. don’t tell. Schwarz. W. The Handbook of Hedge Funds. W. Available at http://www. Were Bernard Madoff’s actions wrong? Should his investors share some of the blame? Why or why not? Notes 31. The world's largest hedge fund is a fraud. Mandatory disclosure and operational risk: Evidence from hedge fund registration. B. v. However.108 Chapter Six References Arvedlund. Do you always have to exercise your options or let them expire unexercised? What else can you do with your options? 6. as options cannot be traded on Saturdays. Liang.S. New Haven. “you have the right but not the obligation. Thus..E. 2008. Schwarz. 08-MAG-02735. M.pdf. Estimating operational risk for hedge funds: The ω-score. the third Friday of the expiration month is the last . “Informed Trading in Stock and Options Markets. which can limit its flexibility. and the day you want to consider as the expiration date. . Srinivas. Gulen. it is the notion of insurable interest that limited the size of guarantees that monoline insurers could provide. S.” Journal of Financial Markets 2(1999): 135–151. 36. 32. Contract terms and definitions of the credit event are standardized by the International Swap Dealer’s Association (ISDA). Traditional forms of insurance incorprate the notion of “insurable” inerest where the primary purchasers of insurance are those owners of assets who deam it necessary to seek protection against their loss of value. H. and P. D. Counterparty risk arises when the seller of insurance is unable to meet the demands from a series of credit events that are simultaneously triggered.” Journal of Finance 59(2004): 1235–1258. and S. More details on the CDS are available at www. As an illustration. Easley. M. O’Hara. Indeed. 34. Traditional forms of insurance incorprate the notion of “insurable” inerest where the primary purchasers of insurance are those owners of assets who deam it necessary to seek protection against their loss of value. 38.HE. 37. This was the case with AIG Financial Products in 2008. 39. 35. T. “Option Volume and Stock Prices: Evidence on Where Informed Traders Trade.isda. the ABX.” Journal of Finance 48(1998): 1957–1967.org. homeequity loans (HE) assembled from ABS programs originating in the first half of 2006. Some reform proposals have argued that CDS purchases should be restricted to this class of market participants.A-06-01 is an index of asset-backed (AB). S. 33. Chakravarty.Pizza Coupons and Stock Options 109 trading day and for practical purposes. Mayhew. J. Finucane. “A New Measure of the Direction and Timing of Information Flow Between Markets. . 500 OTC stocks. 1971. Some examples are: Citigroup (C). which is located at the corner of Wall and Broad Streets in New York City. has three major stock exchanges: the bricks-and-mortar NYSE and AMEX. The purpose of the NASDAQ was to popularize (and even legitimize) the OTC (over-the-counter) securities market. On its first day of trading on February 8. Understanding the meaning of a company’s ticker provides more information about the company itself. Kellogg (K). and so on. In essence. The National Association of Securities Dealers Automated Quotation (NASDAQ ) Stock Market. Below. Some single letters are still up for grabs. The NYSE was established in 1792 when twenty-four New York City stockbrokers and merchants signed an agreement and formed an exclusive organization for self-preservation purposes. a stock is known as an OTC stock if the company is small and does not yet meet the listing criteria of the established exchanges. the U. the NASDAQ system displayed quotes for over 2. comprised of computer terminals networked together. The first stock market in the United States was the New York Stock Exchange (NYSE).7 Trading Assets Don’t try to buy at the bottom and sell at the top. but the bulk of the day’s trading takes place during that time frame. This was the precursor to today’s stock exchanges. AT&T (T). “After-hours” trading does occur. —Bernard Baruch There are three stock markets in the United States. It is a physical (bricks-and-mortar) exchange that meets every day from 9:30 AM EST to 4:00 PM EST. First. which until then had been relatively unknown and unused by investors.S. one-letter symbols are rare. founded in 1971. 111 . we will explore why it is important to know where a stock is listed and why one market may be better than another. They are reserved for the very best companies and convey a certain status. like the NYSE and AMEX. and are being reserved for major companies. was the world’s first electronic stock market. Ford Motor (F). Stock Tickers Stock tickers are more than a combination of letters denoting a specific company. and the electronic NASDAQ. The traders in AMEX were enterprising and unconventional and handled the stocks of young and marginal companies. This cannot be done—except by liars. The American Stock Exchange (AMEX) began its existence in 1921 with no desire to compete with its older and bigger rival—the NYSE. Sprint Nextel (S). In sum. the Illinois-based company Caterpillar has as the ticker symbol CAT. mutual funds have five characters. The NYSE is like an exclusive country club full of tradition. AMEX. most new tech/dot-com companies in the late 1990s were listed in the NASDAQ. Companies’ exchange-listing decisions happen to be an important research topic in finance. Stocks listed in the NYSE have one to three characters. or NASDAQ) of the company you are interested in may suggest subtle. but important. That is because our two main listing exchanges—the NYSE and NASDAQ (AMEX is very small and mimics the NYSE for the most part)—have very different characteristics and listing requirements.e. and LaBranche. When the dot-com bubble burst. and Specialist Firms on Wall Street Specialist firms exist on Wall Street to connect buyers with sellers. On the other hand. Companies can take advantage of this in their choice of a stock ticker. the NASDAQ got hit much harder because the tech stocks were concentrated in that market. specialists end up acting as both agents and as principals. Finally. Van der Moolen. . That is. For example.. but those looking for information about the feline. Specialists post demand and supply of the stocks they make markets in and the price at which such demand or supply will be executed. such as lower trading costs. where the most liquid (and best) stocks trade. NASDAQ small-cap stocks (less liquid and smaller in size) have five characters. Incidentally. Parties who want to buy or sell post their particulars and are matched with someone who would like to transact with them. Some examples of specialist firms include Spear. everybody uses search engines to look up all kinds of information. It is full of younger. In the first approach. These days. comparable stocks trading in the NYSE and NASDAQ are examined to see which stocks display more favorable qualities. they arrange to bring buyers and sellers together and collect a purchasing stocks for their personal inventory if there are no other sellers or buyers at that particular point in time. the word “cat” is typed into search engines well over a million times a month—not necessarily by people looking for companies to invest in. lower volatility. the last of which is always X. hipper companies. have four characters. the NASDAQ has only been in existence for about thirty years. Choosing the right combination of letters for your company can get you a lot of free publicity. These firms are required to make continuous price quotes on both sides of the market (i. NYSE. Not surprisingly. In doing so. act both as buyers and sellers) in all the stocks they are responsible for in order to maintain a fair and orderly market. Leeds & Kellogg. The NASDAQ has much less stringent listing requirements and almost anybody can get in. since none were eligible to be listed in the NYSE.e. This research is done in one of two ways. Specialists provide “immediacy” and keep Wall Street humming like a well-oiled machine. which is a wonderful thing! Where Your Stock Lists Is Important Too! Knowing the listing exchange (i. information about the company itself.112 Chapter Seven There are general rules governing stock tickers.. Stocks trading in the National Market System of the NASDAQ. The NYSE is the old and established name and has been in existence for more than 200 years. Here is another twist. Some said that Sears was trying to distance itself from the aura of being established to embrace the freshness and innovation of youth. where. That’s one point for the NYSE and zero points for the NASDAQ. For example. consider the facts. Sears did not believe that it lost anything by moving from the NYSE to the NASDAQ. like Microsoft and Intel. incidentally. It is simply not believable that a company would leave money on the table by not switching exchanges if it has the option of doing so. yet. about 2. and overall lower trading costs. While this argument might hold for a fledgling tech company (that would not be eligible to be listed in the NYSE anyway). smaller bid-ask spreads. And. Again. naturally. one theory is that a lot of the stocks that can move to the NYSE but choose not to do so. and price variability find that NYSE stocks show smaller bid-ask spreads and lower trading costs overall. Furthermore. stocks that have switched from one exchange to another are followed in what is known as an “event study” to track how their trade-related characteristics changed. are already world leaders in their respective industries and have all the name recognition they want. Studies matching NYSE and NASDAQ stocks based on size. right? I would have thought so. In 2005. They are not the household name. always look at the bottom line and profits. Another plausible explanation related to tech stocks in particular is that the NASDAQ is considered to be the home of the tech stocks. Between 1986 and 1998. the NYSE is better for the investor than the NASDAQ. That’s two points for the NYSE and zero points for the NASDAQ. Hence. for the most part. . Large and well-known companies don’t have to be with their peer group to be legitimate. studies that examine stocks that move from the NASDAQ to the NYSE report that after the switch the same stocks display lower price volatility. So. this rationale is flawed. the retail giant Sears declared that they were moving from the NYSE to the NASDAQ! What makes the move interesting was the fact that Sears as a single-lettered stock (ticker: S) in the NYSE. trading volume. this reasoning does not hold true. While this explanation might fit the NASDAQ superstars. they are treated like royalty. none are able to provide a definitive answer that fits all companies. In the second approach.Trading Assets 113 lower bid-ask spreads. it seems clear that anybody with common sense would want to list in the NYSE as soon as they were eligible. It cannot be inertia or laziness. Why? While several plausible theories exist. That is just about 1 in 6 companies.700 non-financial companies listed in the NASDAQ satisfied the eligibility criteria for listing on the NYSE. too! But. it certainly does not hold for the tech giants that most of these NYSE-eligible companies are. only 460 firms chose to actually move to the NYSE. Yet. They do not see a gain in switching exchanges and simply choose to stay in the NASDAQ. companies like Microsoft and Intel would like to belong with their peer group. Companies. all else being equal. They threw away their glamorous position in the NYSE to move to the NASDAQ (where they now use the ticker SHLD). This implies that. shares outstanding. based on the research evidence. and they could certainly use the identified benefits of moving their primary listing to the NYSE. they don’t move. for the vast majority of companies listing in the NASDAQ that are eligible to move and choose not to do so. Why should stocks be any different? It turns out that for more than two hundred years stocks have been quoted in fractions. the U. Congress got in on the act and mandated that the exchanges had to switch to decimal pricing. department stores. under decimal pricing that same stock would be $50. The ization will reduce the slight disparities that can occur when foreign securities overall narrowing of spreads makes it likely that retail investors. companies.S. For example. It’s easier to understand. it is difficult for us to quickly convert these fractions into decimals in our heads. cent since decimalization went into effect. and other places we go to buy things. no one wants to change it because it will cost a lot of extra money to rebuild the infrastructure around decimal trading. exchange. and stock exchanges spend millions of dollars to support their trading activity. entering small orders. Similarly.114 Chapter Seven Decimal Pricing If your favorite stock is selling for $50 per share one second. munications is one example. The problem is.01 or decrease to $49. the entire infrastructure grows around it.S. securities market used fractions (sixteenths-of-a-dollar) instead. why would we want to trade in anything other than decimals? After all. as was the case with fractional trading. Eventually. as expected. because the way stock prices increase or decrease affects the best prices at which to buy or sell them. and this is all designed to support fractional trading. But. status quo was maintained for years and years. the securities industry and regulators have been simplifying the information that Preliminary reviews by the SEC and the NASinvestors need. why did the practice last so long? When something goes on forever. with a decimal point rather than in fractions. People. trade in decimals in their home markets have experienced reduced trading costs. Decimal pricing is a way of listing the price of something in dollars and cents. Hence. what can it change to in the next moment? Can it increase to $501⁄16 or decline to $4915⁄16? Or increase to $50. the SEC estimates that the average markets compete with foreign exchanges. Decimal pricNASDAQ reports that the average effective ing is another. and in fractions on a U. effective spread for New York Stock which already use decimals. until recently. that is how things are priced at supermarkets. You might be thinking.06. if you bought a stock at a price of $501⁄16. Using more “plain DAQ Stock Market show that decimal trading English” in prospectuses and client comhas substantially narrowed quoted spreads. You will find decimal pricing almost everywhere there are monetary transactions. So. Our decimalExchange securities shrunk 28 percent.99? Should we even care? It turns out we should care. Given all the money that has been spent. spread for its securities has shrunk 50 perDecimalization should also help the U.S. the transition to “decimalization” from quoting stocks in fractions is cutting into Wall Street’s profit . In general. Summary Has Decimalization Cut into Wall Street’s Profit Margins? The following is an excerpt from a Wall Street Journal story on decimalization:40 A just-completed academic study[41] has found that. Who? gains on trades with the uninformed traders. the investors. Bagehot’ s Intuition . we would want the spread therefore. the market-maker sets his bid-ask to be at its narrowest at all times. by about 55 percent on the AMEX and 4 percent on the NYSE. The professional market intermediaries Hence. decrease when more uninformed traders are in the market. the lower the cost to against informed traders since these traders trade on superior information. the investors. some. quoted bid-ask spreads shrank by about 48 percent for the six American Stock Exchange stocks taking part in a decimalization pilot program that began August 28. are incurring the cost. or the difference between the price offered to buy a stock and the price offered to sell it. prices to minimize losses on his trades with the investors. the higher the cost to us. and loses money trading narrower the spread. makes his money mostly by tradselling at a lower price. That is. and the you and me). and by 28 percent for the seven NYSE stocks in a concurrent pilot program. Naturally.Trading Assets 115 margins. Naturally.the informed traders and to maximize his one else must be earning this cost. once intuitively obin mind is that the ask price is generally served that the market-maker (the intermediary in the stock exchange). The wider the ing against uninformed traders (people like spread. On balance. Three economists investigated institutional trading costs both before and after decimalization using a proprietary database of institutional trades. But this is actually not the case. The study referred to above goes on to say that on average. here is the problem: a narrow spread means that investors like you and I are buying stocks at lower prices and selling stocks at higher prices. We. market-maker believes more informed traders The wider the spread. Another point to keep pseudonym Bagehot. who trades in any higher than the bid price. they want to keep spreads wide if possible. writing under the execute your order). are buying at a higher price and given stock. But. spreads should increase when the who are buying and selling stocks to us. it is tempting to conclude that the specialists and brokers on Wall Street (collectively known as the institutional traders) must be making less profit. All of this is certainly good news for us. Since we. 2001. which is an implicit cost incurred by investors for transacting that stock (note that the spread is a cost you incur in addition to the commission you are paying your broker to Economist Jack Treynor.42 Their study found that there has been no increase in institutional trading costs following decimalization. The study looked at transaction data before and after the decimalization pilot began and found that bid-ask spreads fell. The Bid-Ask Spread The difference between the best price to buy and the best price to sell a stock is known as the bid-ask spread. the change is narrowing bid-ask spreads. the more profitable are present in the market and should it is for them to transact stocks with us. on average. us. on average. or ex ante. as required by Preferencing and internalization of order flow NASDAQ rules. spawned a whole cottage industry of follow-up The Effective Bid-Ask Spread Preferencing and Internalization . the when actual trades take place in response to economists found that spreads on NAS. or by the stock dealtheir comparable NYSE stocks.” It is this statement that shook the trading world. both the Department of Justice and the Securities and Exchange Commission began broad investigations of the NASDAQ market. Soon after the study’s publication. and the dealer agrees to quotes wanes because posting better prices execute that order flow at prices no worse may not attract additional order flow. a dealer’s incentive to improve for a payment).” or ex post. stocks and fifty NASDAQ stocks. whether NASDAQ dealers implicitly collude to maintain wide spreads. than the best bid or ask. if agrees to route its retail customer order a large fraction of the order flow is preferenced flow to a particular dealer (often in return or internalized. Specifically. when a dealer trades with its own retail but not to the same degree. cost of trading represented by the quoted spreads. such as the NYSE. and regulators alike. Based on the of trading the stock compared to the theoretistudy’s results.cal. The original study customers at prices no worse than the best bid or ask of any dealer.the quoted bid-ask spreads posted by the marDAQ stocks were generally wider than ket-makers in the NYSE. In light of such scrutiny. practitioners. the authors concluded that no rational model of price quoting behav.actual trade price and the quoted bid-ask ing more to buy NASDAQ stocks and spread midpoint represents the effective spread and captures “actual. the difference between the that investors had been.116 Chapter Seven The Saga of Wide Spreads Did you know that wide spreads once almost brought the mighty NASDAQ market to its knees? The whole catastrophe was the result of a couple of academics An effective bid-ask spread (or simply an effecwriting a simple research paper. two practices prevalent in NASDAQ. known as preferencing and internalization of order flow.43 tive spread) differs a bit from the quoted bidUsing a matched sample of fifty NYSE ask spreads discussed above. The findings of this study and several related ones subsequently published by Christie and Schultz were hotly debated for years by academics. cost receiving less to sell them. the NASDAQ market underwent a tremendous structural overhaul. In addition. Order flow is internalized also exist in other markets. That is. This meant ers in the NASDAQ. would reduce the incentive for a Order flow is preferenced when a broker dealer to improve bid and ask prices. Economists published competing research papers aggressively refuting the suggestion of dealer collusion alluded to by the original authors. Academics prefer to use ior could explain the wider spreads and effective spreads rather than quoted spreads that this fact “raises the question of as an accurate estimator of trading costs. The point made by the refuting economists centered on the fact that competitive economic factors would explain the difference in spreads and would not necessarily imply collusion by NASDAQ dealers. pay. the instability was a result of to achieve proper diversification. In a recent study. each refuting parts of the original study’s findings and/or the conclusions. is that they being the most volatile since the 1970s. In fact. Basically. the volatility the New York Stock Exchange shows attributed to firm-specific sources has increased. That is. and the amount of is not uncommon to see the major mardebt carried by the big companies. Since 1962. oil price More on Volatility .44 These traders were called SOES bandits. the NASDAQ dealers may have kept the quoted spreads wider in order to compensate themselves for the added risk they perceived they were facing from the SOES bandits. While we will never really know what went on in the NASDAQ. A study by common part of the volatility that is shared across returns on different stocks. where such bandits were not active. Millions of traders are able to jump in and out of the markets. should hold more stocks in their portfolios in order Then. tend to volatile the market has become since the last for months. the authors argue that the high spreads observed in the NASDAQ might have been the work of day traders trading in the NASDAQ’s small order execution system (SOES). the SEC did tape conversations among traders employed by the NASDAQ market-makers that revealed some arm-twisting designed to keep the spreads wide. perimarket have noticed how much more ods of high volatility. and many do so based only on gossip and rumors. as well as low volatility. By contrast. shocks related to world events. industrial production. Research by economists has shown that stock Even casual followers of the stock market volatility tends to be persistent.Trading Assets 117 studies. Increased Market Volatility The advent of new technology and the influx of new. There is a reason other than collusion and preferencing/internalization of order flow that might explain why NASDAQ spreads were higher than those in the NYSE. younger investors has significantly altered the stock market landscape over the past decade or so. these SOES bandits took advantage of a loophole in the NASDAQ trading system that allowed them to quickly buy and sell low trading volume stocks whose prices may not have been updated in a timely manner in order to exploit changing market conditions. but not in the NYSE. it tively related to volatility in economic variables like inflation. One thing is certain: all that attention made NASDAQ a better and a more transparent market. Professors Benston and Wood analyzed market data over thirteen years between 1987 and 1999 and concluded that trading by the SOES bandits is an important reason for the relative increase in both the quoted and effective bid-ask spreads in the NASDAQ. And periods of high volatility tend to late 1990s as more and more traders occur when stock prices are falling—including durjump in and out of the stock markets at ing recessions. Faced with the prospect of not knowing which stocks were the target of these bandits. Stock market volatility is also posia moment’s notice. these days. that the last few years stand out as The implication for investors. then. ket indexes jump by as much as 3 perthere appears to have been a steady decline in the cent in a single day—something unheard of ten years ago. How to Reduce Excess Volatility in Our Stock Markets Our finance theories and models are fairly well calibrated to explain stock price behavior in the long run (daily. when there is a trading halt on a particular stock. Currently. The hallmark of a stable stock exchange is one where volatility is held at a minimum. He also asserts that markets are not efficient—certainly not in the short run. markets have gotten significantly more volatile than they were even ten years ago. If there is a huge amount of information buffeting stock prices each nanosecond then uncertainty builds up and eventually blows up the market. For example. The argument can be made that if we have call auctions on every stock once every hour (or at some other predetermined interval). a call auction is held when trading resumes.). Those huge swings in price that occur within a few seconds or minutes fall outside the rubric of finance theory as we understand it. One possible remedy to bring volatility under control would be to bring back call auction trading. When trading begins every morning in the NYSE at 9:30 AM. At almost every other time. etc. The catchword is “relatively. Investors don’t like uncertainty. Technology and the democratization of markets. High volatility means greater uncertainty because you cannot predict how prices will change minute-by-minute. the three most volatile minutes within a trading day are the first two minutes every morning when markets open (at 9:30 AM EST) and the final minute before markets close (4 PM EST). minutes. seconds. has contributed to the current state of our markets. One of the reasons the United States stock markets are so attractive to investors the world over is precisely because our markets are relatively less volatile than stock markets elsewhere. This problem will only get worse as technology further improves. etc. monthly. and the markets overall. an economist at Baruch College. Schwartz argues that inaccurate price discovery contributes to volatility. For example. etc. Risk-averse investors hate uncertainty.” U. it only exists under very special circumstances.). Volatility is a measure of the rate and magnitude of changes in the price of anything—in our case. The set of “laws” that governs stock price behavior within very short time intervals is completely different from the long-run equilibrium stock price behavior that we teach our undergraduates and graduates. according to Robert Schwartz. Obviously such volatility is not good. This gives investors the confidence to invest their money in stocks listed on that exchange. then a price discovery process occurs . because excess jumpiness in markets means that the average investor usually loses money.S. The downside of this power is the increase in volatility that we have seen in recent years. These days it appears to be a direct result of frequent trading based on rumors. it does so with a call auction. We have almost no handle on are how stock prices. behave in the short run(nanoseconds. whereby individuals and institutions all have access to the same set of tools to affect trades. stocks. trading occurs on a continuous basis. weekly. The ability of thousands of individuals to jump in and out of trades instantaneously counters the effect of a single institutional trade and affords individuals power as a group.118 Chapter Seven shortages. Such a mechanism would immediately lead to a reduction in volatility without sacrificing price discovery. as proposed by Robert Schwartz. I like to suggest at least opponent. It is the same with every other investment. which is lower than your in? More importantly. MacBooks. regulation is not the answer to our problems and neither is unrestricted free markets. These would be run by third party fiduciaries and would be responsible for buying shares in a falling market and selling shares in a rising market. Brady. Skeptics will point out that there are remaining minutes within each hour that will have no explicit price discovery. Coke would be ordered anyway and the beverage would be consumed by everyone at the table with obvious relish. It is clear Coke is there to stay in China.usual (or short-term) capital gains tax rate. Another way to reduce volatility. and I was enthusiastically offered it at every lunch and dinner I was invited to. While there are no rules on how long you Brees) have one thing in common: they all need to hold a stock for your strategy to be prepare extensively before playing an termed buy and hold. and consequently the risks you would be taking will be lessened. and talk to people in the know who you trust before deciding to buy or avoid Google stock. rent price worth getting into? For instance. is a stock at its cur. They are sleek. How about other stocks? Is Coca-Cola a good stock? I was in Beijing recently and Coke’s presence in that country was jaw dropping. In football. How to Narrow Down Your List of Stocks Entering the exciting world of investments requires some preparation. but it is unclear what a continual price discovery process accomplishes. iPods. The question is: is Google a great company to invest in at its current price of about $600/share? That is debatable. Caution . and with a population of 1. That’s one company you may want to seriously look into. It is no different in investments. How about Apple? We are all attached to our iPads. do your own thinking. A wellbalanced combination of the two can help the markets deal with the excessive volatility issue without sacrificing price discovery.Trading Assets 119 at that point in time.2 billion and counting it does seem like Coke’s future is bright. You will have to read the research. forward thinking. except the buying price per share may not always be as steep. while others will make an equally compelling case of the fact that Google’s best days may be numbered and may well be behind them. no one on the planet would argue that Google is not a great company. and assorted other Apple products. These are polar cases and both can lead to problems. To summarize. There are Coke advertisements everywhere. Even if I passed on it. extremely stylish. all the good quarterbacks (Manning. There are many who will claim that the stock has the potential to double its value in the next few years. is to establish well-defined stabilization funds that would buy and sell equity shares according to clearly stated procedures. This would be accomplished at regular intervals in pre-specified amounts through call auctions. one year so you are eligible for the long-term How do you find good stocks to invest capital gains tax rate. Almost any stock can be good or bad—depending on the current price.20 Inst.62B 10.51 0.23 (–1. This will enable you to determine if a .” denotes the actual volume of stocks transacted on that day (the first number) and the average daily trading volume (the second number). let’s consider one of the oil and natural gas giants. let’s assume you shop at Old Navy a lot and like their clothes.120 Chapter Seven and work well too.62–23. In most cases. “Range” is the range of prices at which the stock traded over the entire trading day. Exxon Mobil. I might be able to make a case that Google is not such a hot buy at $650 per share but a fantastic buy at $500 per share. 19. You can ask people around you for tips and recommendations. The question is: are they good investments at their current prices? The first step in the process of deciding which stocks to invest in is to do some preparatory work and create a list of 15–20 stocks covering different sectors of the market. This is a bit like the Google scenario. my list will comprise the stocks I have already introduced above: Google (NASDAQ: GOOG). Gap (NYSE: GPS). Let’s first understand what the numbers above are telling us. 9. The company’s profits are a testament to their loyal and ever-growing customer base. For illustration purposes.33 1.59M/6. Apple’s innovators seem to be in tune with consumers’ needs and wants.11/2. the discussion is a little different from that concerning Google and Apple. The question is: is it a great buy at nearly $400/share? If you want to look into something more accessible. Below is the basic information for Gap. Before we look at the details. “Open” signifies the price at which the stock opened its trading on this day.68M Mkt cap P/E Div/yield EPS 10. How about the stock? Old Navy is owned by Gap. Notice that I list the primary listing exchange of the company followed by the actual stock ticker under which it trades. and Exxon Mobil (NYSE: XOM). “52 week” captures the stock price variation over the previous fifty-two weeks.84 Shares 550. especially NYSE and the NASDAQ NMS stocks.56 52 week 16. Let’s say you have done your due diligence and have come up with your list of stocks. In today’s market of $4+/gallon gas prices. Your friends also like their stores. let us keep one thing planted firmly in our minds.73 Open 19.43M Beta 1.24–19. The fact that the company is great is not in debate. own 67% Figure 5: Summary of information for GPS. which trades in the NYSE and is currently priced at a little over $19/share.29 –0. “Vol/Avg. Finally. and you know that they spend a lot of their surplus funds there. Apple (NASDAQ: AAPL). is this a company I might want to invest in? It is trading around $80/share.18%) Jul 29—Close Range 19. Apple’s shares are currently trading at almost $400/share. For instance. they are all good companies. We will need to determine how much upward price potential there is in the stock in order to determine if we want to purchase it. Is this something I should consider seriously? Here. when all of the oil companies are making impressive profits.32 Vol/Avg. while the “Beta” if 1. For instance. which conveys the multiple of earnings that the market values the stock. Here. or above its average on a particular day. if there is an upward trend in its revenue and earnings patterns. it will be reflected first and foremost in its trading volume (when compared to its average). This metric is important because if something important is happening to the stock on a given day. We might also want to take a quick peek at company profitability to see if it is making profits and. The higher the P/E.20 implies that the stock is riskier than average (or the market overall). Keep in mind that the company makes items which might . institutions own 67 percent of the shares of the company. income.Trading Assets 121 stock’s volume is below. Figure 6: Prior year revenue. “P/E” is the price-earnings ratio. “Shares” denotes the actual number of shares outstanding for the company (550. at. Always make sure you are aware how the earnings number is computed so that you are able to compare appropriately. which is the current price per share multiplied by the total number of shares outstanding.84/share).51. then the P/E ratio is a backward looking measure. the more optimistic the market is about a company’s future prospects. the earnings are the projected nextyear earnings. From this. “Div/Yield” captures the actual dividend paid by the company on each of its shares over the past year (11 cents) and the dividend yield. which makes it a large-cap company. then the resultant P/E ratio is a forward looking measure. which is the actual dividend divided by the stock price (2. GPS’s P/E is 10. on the other hand.5 times its earnings per share (EPS is given at $1.43 million). which means that its current stock price is about 10. “Mkt cap” denotes the market capitalization or the market value of the company. more importantly. the market cap is above $10 billion.33 percent). Also note that if the earnings are calculated based on actual prior fifty-week–earnings (as is the case here). which is good news in the sense that powerful institutions have influence over the company and an incentive for it to perform well. which is not a bad thing at all given the state of the economy. we can see that there is some increase in GPS’s pattern of revenue generation but its profit margin is just about flat. Finally. If. and profit margin for GPS. 15M (7. Net Share Purchase Activity Insider Purchases—Last Six Months Purchases Sales Net Shares Purchased (Sold) Total Insider Shares Held % Net Shares Purchased Shares N/A 16.071. Interestingly. which is another signal that the company’s management does not expect to do any major acquisitions or expansions in new markets requiring cash inflow.400) 191. such performance might be considered commendable by many analysts. while the current price price is $19. On Google Finance. There is a widely held belief among market practitioners and behavioral finance researchers that the maximum price reached in the prior year represents a ceiling for the stock that is hard to break through. I would pronounce a “hold” on this stock. I would not sell.071.400 (16. .96%) Figure 7: A snapshot of insider trading activity in GPS stock.700) % Change in Institutional Shares Held (15. One area to focus on is the stock’s current price in relation to its prior fiftytwo–week price range. the closer a stock’s current price is to this maximum. the analysts also collectively pronounce the stock a hold. It is always good to check the collective will of the professionals as a way to double check on your own research. This also lowers the likelihood of any major positive event in the near future that would lead to a large stock price bump.8%) Trans 0 15 15 N/A N/A Net Institutional Purchases—Prior Quarter to Latest Quarter Shares Net Shares Purchased (Sold) (48. you will find the analyst information under External Links at the bottom of the stock summary page. that maximum price is $23.471.29.122 Chapter Seven be labeled discretionary. That means that if I were already an investor in the stock. I would not buy. its further growth potential is limited. In light of that. We should wait and watch this stock to see what happens in the coming months.73. In this case. Another thing to keep in mind when picking stocks is to be aware of whether corporate insiders are buying or selling their own stocks. That is. Put differently. we can find the following information about GPS. Note that the stock also pays a healthy dividend. then it might be prudent to conclude that the stock’s upward potential is limited in the short to medium term unless the company can show a massive growth in sales or the economy picks up significantly. Overall. If we are to believe this theory. and if I were not a current investor. There. The website Yahoo! Finance makes finding that information simple with their “Insider Transactions” seciton. the more likely it is that this will represent a hard cap for the stock in the short run. 90 134. Let’s see how many of these you actually put on your “buy” list.93 150.46 12. you should be able to avoid many of the blunders made by novice investors.02 10.40 0.33 10. Inc. you might arrive at a different conclusion for a different set of reasons and that is absolutely okay.21 6.67M 496.80 0.31 Net profit Net margin income 8.00 0.52M 622. The data are all out there and you will need to study them in order to draw your own conclusions. this stock is still a “no” for me.27 0. 2.18 The Walking Co.17 bebe stores.53 Childrenʼs Place Retail Sto 3. That is actually good news. and a lot of research.91 The Wet Seal. Inc. While that in itself is no reason to panic.34 0.00 0. My suggestions encompass “investing” metrics and “trading” metrics.10B 1.25B 27.01 1.68 231.93 Aeropostale.18 28.92M 0.18 1. But I can promise you that if you follow the few basic rules that I outline below.11 1. That is another reason to hesitate to invest in this stock at this time.79B 2. Inc.20B 1.00 15. There is experience involved.24 15.70 0.41B 1.96 83.97 35.46 475.03 1. This is a stock that should probably be left alone for the time being. we see that all of the activity over the previous six months has been selling shares of GPS. 2.Trading Assets 123 From this information.08 1. Basic Rules of Trading and Investing Before we get into specifics. where GAP is almost at the bottom of the list. Choosing stocks is a combination of art and science. understand that you could do everything I suggest here and still lose money. Following is information about GPS’s competitors in the retail industry.23 Urban Outfitters.36B 5.43 0.62B 2. I will leave the remaining three stocks on my list as an exercise for you to complete following the same thought exercise I went through with GPS.00 0.00 1.88 Abercrombie & Fitch Co.48 2.04 14.96 0. 2. 0. Now that we have considered all of the information available to us.34 272.18 9.91 1. Company name GPS AEO ANF GYMB BKE ARO URBN PLCE WALK WTSLA BEBE Earnings P/E per share ratio The Gap.61 Mkt cap Dividend Beta 10.00 181. it is a telling statistic when considered in conjunction with the other information as previously discussed. From the above comparison it is clear that Gap is by far the largest company among its peers.00 4.79 The Buckle. However.67 1.204.07 1.57 –5.13 4.28 101. Smaller companies like the Urban Outfitters and Wet Seal are better thought of in the markets than Gap.51 14.55 21.84 American Eagle Outfitters 0.56B 6. 1.64 12.16 –1.88 0. 0.99 –1. The bad news is when we compare the P/E ratios. Inc.00 0.16 Figure 8: A snapshot of GPS in comparison to its competitors in the retail (apparel) industry. A final thing that should be considered is the company’s performance relative to its competitors. since larger companies are considered less risky relative to smaller companies. some intuition. Inc. Recall that pure investors are those who intend to trade stocks once in a while and buy primarily . inc. Holdings –0.07 The Gymboree Corporation 3.59 –3. 1.00 0.12 7. These are relatively risky (higher volatility) and you should only focus on these when you have more confidence in the market and have been trading for a while. They are the safest stocks to put your money in. under the rules of the NYSE short-term aspects of a stock. Most of the time. For investors—those intending to be in the market once in a long while—the above measures are less important than measures that reflect on the long-term prosperity of the underlying company.e. stocks with market values less than $5 billion. accounts. Pick stocks with overall analyst recommendations between 1 and 3. traders deemed “pattern day examine some of the important trading traders” must have at least $25. More importantly. Trading Rule 2 is to choose stocks that have at least one million shares in daily trading volume. Let’s first and NASDAQ. only those measures that capture the longthey have no information about the compaterm viability of a stock. the closer the consensus value is to 1 the better the stock’s future prospects. Stocks with relatively high trading volume are easier and cheaper to buy and sell and are less prone to uncertainty (price swings) than stocks that have very thin trading volume. preferably closer to 1. Trading Rule 4 relates to the opinion of the analysts..000 shares unless you are a seasoned investor. we will look for ingful profit in the aggregate. Instead.e. either negative or 0). Trading Rule 1 is not to touch anything that is trading around or above its fifty-two–week high. My rules for investors (those who wish to buy and hold) follow. you want to see either a negative change or no change in the consensus value from last week to the current week. measures and instead focus on only the Officially.” Most of us will probably fall position for a few seconds and making a couin between these two extremes and possess ple of cents in profits per stock. try to locate stocks that are trading around their fifty-two–week lows. focus on largecap stocks only. As pure investors. they characteristics of both an investor and a hope the small profits will add up to a meantrader. Remember. we will set aside all long-term tickers on the screen. They are just traders. and where the change from the previous week is nonpositive (i.000 in their measures of a stock (for investors who trading accounts and can only trade in margin intend to trade often). Closer to 5 spells trouble and closer to 3 is about neutral. while as pure nies they are buying and selling. Chances are these stocks are overpriced and will fall in value in the coming days. Avoid stocks with daily trading volume of less than 100.. In doing this often over the course of a single day. i. Some of these traders are known as throughout the day—sometimes holding a “day traders.and mid-cap stocks. on the other hand. To start with.124 Chapter Seven to hold. plan to buy and sell on a regular basis— sometimes many times within a single tradDay traders buy and sell stocks frequently ing day. Trading Rule 3 for the novice investor is to initially avoid small. Day Traders . Pure traders. These are the most established companies in their respective market sectors and have the most written about them. even if it’s under the guise of needing money for unrelated expenses (they have to declare a reason for wanting to sell shares). First. There is a lot of research suggesting that institutions are smart investors and usually know what is going on with the companies they invest in. Remember Shopping for Stocks How do we buy stocks? We already know that stocks sell in special markets known as the NYSE. An advisement to Remember.” it may not exactly be time to jump ship. where we walk in and pay for purchases ourselves at the counter. we cannot! Unlike the neighborhood supermarket or department store. then give them equal weights. Investing Rule 2 is to examine the firm’s trailing net income pattern to see (a) if there are profits. while a forward P/E ratio less than twenty implies an undervalued stock. selling is selling no matter how it is dressed up. is also good news. it’s not good news for the company. If they are net buyers. Also. you want it to be lower than both its competitors and the industry. check to see where the ttm P/E ratio ranks relative to its competitors and the industry as a whole. we are not really allowed inside a stock market. i. Yahoo! allows you to see the three previous years’ income (or loss) or just the three prior quarters.” If you see a “Hold. they absolutely have to. After all. check out what the institutions are doing. activities. are less than (or about the same as) the trailing earnings and that is not a good sign. Unchanged insider activity.Trading Assets 125 Investing Rule 1 is to check the stock’s P/E ratio based on the trailing twelve months (ttm) as well as its forward P/E ratio (based on next year’s expected earnings). Can we just go in one of these places and buy the stocks we want? Turns out. while the opposite Analysts do not like advising to “Sell” unless might be the case if they are net sellers. On the other hand. the AMEX. although itʼs have elements of each in your investment certainly not the right time to buy it. Investing Rule 3 concerns what company insiders are up to..000 over the third quarter of 2005—a mere pittance for a $115B market value company). and the NASDAQ. Google’s (ticker: GOOG) net income over 2002–2005 was almost non-existent ($381. if company insiders are buying. Research suggests that when company insiders are lining up to sell their own company shares. There should be signs that the company’s income has an increasing pattern or that the losses exhibit a declining pattern. no buys or sells. and (b) if the profits exhibit an increasing pattern over this period. the weight you give to each “Hold” is as good as a “Sell” pronounceof these rules depends on whether you aim ment.e. If you want to saying “Hold. that might imply good things on the horizon. Some analysts also swear by the “Rule of Twenty” which means that for stocks in the tech or tech-related sectors. Ideally. the projected earnings. Also. The latter is especially valid for new companies without established earnings patterns. you want the forward P/E ratio to be significantly less than the trailing P/E. If the projected P/E is greater than (or about the same as) the trailing P/E. . it is good news. They are just being polite about it by to be an investor or a trader. a forward P/E greater than twenty implies an overvalued stock. Accordingly. and so on. without breaking stride. What could she have done to make the water emerge? After she left. Dean Witter. Once again. the stock market does not have fixed prices. These personal shoppers.brokerage-review. or do we have some time to kill and don’t want the shopper to rush his purchases? Should we allow him to take his time to see if he can . I wasted the better part of an afternoon trying to figure out how to work the water fountain. who have paid lots of money for the privilege of entering the market. So I went back to my perch and continued the vigil. Charles Schwab. I was afraid people would think I was stupid and laugh at me. A second student came by after a few minutes and I edged closer. You will save a lot of time by doing things that are useful rather than standing around waiting for water to stream out of the fountain. One day I decided to solve the mystery. which is why I could not see anything obvious sticking out during my hurriedly casual inspections. Only special people. simply because of my stupid pride. The moral of this story is: do not be afraid to ask others for help getting started on something. are known as brokers. that afternoon. Prudential. What on earth were these people doing? Well. One of those things was drinking fountains. I parked myself in the vicinity of the fountain near my department and. A good list of online brokers can be found at http://www. Donʼt let pride get in your way. Can you guess what made the water discharge? It was a semi-disguised foot pedal. Once we have our personal shoppers ready to buy stocks for us on commission. Fidelity. A girl came by and stood in front of the fountain. How do we convey to our personal shopper what we are willing to pay for our purchases? We need to give clear instructions so they will know what to do once they are inside the market. I strolled casually by the fountain and. while humming a carefree tune. to whom we pay a commission to do our stock shopping for us. are we in such a hurry that we don’t want to waste a whole lot of time shopping for a better price. tried to see if there was a lever of some sort around the faucet that would make the water flow out. E-trade. let’s call them our personal shoppers. The moment was here! As she approached the fountain. to make a long story short. where the prices of individual items are clearly marked on the shelves. kept one eye peeled on the contraption. For example. She drank and walked away. are allowed inside. the stock prices change every second that the stock supermarket is open.com/stock-brokers/largestbrokerage-firms.aspx. I had never encountered them in my country and had no clue how to drink out of them. A few minutes passed and I was running out of humming material. I had missed the moment. the guy just stood there and water seemed to magically flow out. I was too proud to ask someone to show me how to operate them. We tell them what we want to buy and they go in and execute the transactions. Otherwise. the question is: what kind of instructions do we give our shopper? Unlike the grocery store. In fact. None was visible.126 Chapter Seven Anecdote: Foreigner in Water-Cooler Land When I came to the United States as a graduate student many years ago I was confused by many things. a lot of time and money will be spent in futility. water came spurting out. Just who are these brokers? They have names like Merrill Lynch. A market order is where you tell your shopper that it is okay to buy the stock at the best possible price that he can get for you. If your order is unexecuted at the end of the trading day. how long will your shopper try to execute it? That will depend on your limit order instructions. price uncertain.” A limit order is an instruction to your shopper to buy a specified quantity of a security at (or below) a price that you specify to him (or. Let us say that you bought Chuck E. . in which case your broker will keep trying to execute your order until you actually cancel the instruction. if you want him to buy 100 shares of MSFT. But there is no guarantee of execution. There is more! Another relatively common instruction involves what is called a “Stop Loss” order. As luck would have it. Two of the simplest instructions are “market” and “limit” orders. should we just allow him to buy for us immediately at our chosen price? What should he do if he is unable to execute the order? These are some of the points we need to instruct our shoppers on in order for them to do their job efficiently. For example. execution uncertain. you can never be certain of the “fill price” until you receive a confirmation from your broker notifying you of the exact price at which your order executed. Unlike the market order. You could. Not surprisingly. An economist’s way of expressing a market order is “execution certain. for example. Our instructions to the brokers do not end here.” If they execute. That is a lot of hard work for your shopper. in which case your broker will only try to execute your order as long as markets are open that day. if so. What you are telling your broker is that he has the freedom to sell on your behalf 100 shares of MSFT at $27 or higher. This is the most general instruction for buying (or selling) stocks that you can give your shopper. you simply put in a market buy for 100 shares of MSFT as your instruction to your broker. you place a limit order to sell 100 shares of MSFT at a limit price of $27. Limit orders are “price certain. The next day you have to start all over if you still want to buy or sell that stock. at or above your specified price if you were selling). placing a limit order with your shopper will cost you more than if you were to place a market order. Cheese (your favorite pizza place) stock for $25 a share. Or. what price do we consider a good deal)? Or. a limit order tells your shopper how much of a stock you would like to buy at what price. For example. make it a “Day” limit order. and you can guess the price your order will be executed at by studying market activity around the time of your order. While you know your order will execute.00 per share. The implicit understanding is that your broker will get your shares at the best price available at the time he runs your order through. this information has been standardized into order types that take away any possible ambiguities in our instructions to our shoppers. it is automatically deleted from the records. What happens if your shopper cannot find the price you want? Very simple! Your order does not go through.Trading Assets 127 find a good deal for us (and. you get the price you want (or better). Under no circumstances will you take less than $27 for your shares. If your limit order cannot be executed at the price you want. you could make it a “Good Till Canceled” (GTC) limit order. On the other hand. you do not lose any money below the stop loss price for the same reason. Cheese falls to $32. If. A related question is: when should you put in a stop loss order versus a limit sell order? Consider the fact that when you place a limit sell order. Cheese is trading at $35 a share and you are afraid one bad day in the market might wipe out all your paper gains. there is a possibility that the stock might dip momentarily to that price. your stop loss order will activate immediately and become a market order. Your broker understands your order as follows: if the price of shares of Chuck E.48 These are orders used by experienced professional investors that you do not need to concern yourself with as you get started on your journey. you are defensive-minded. you do not protect your potential gains very well. Now we will study other ways to buy or sell stocks. The broker agrees to loan you 50 percent of the purchase price as long as you pay the other 50 percent. You can characterize a limit sell order as an offensive strategy and a stop loss order as a defensive strategy. In a previous chapter. You will miss out on the subsequent rise in price that would have erased your paper losses because your shares will sell at the lower price. Buying on Margin and Short Selling So far. The same claim can be made for choosing the stop price. The idea behind buying on margin is quite simple. you are unable to participate in further gains of the stock above the limit price because your shares are automatically sold. fill-or-kill. but it is very important. where you put your stop price is a function of how risk tolerant you are and what you expect to happen to the stock in the short run.128 Chapter Seven After a few months. Chuck E. But after you have quelled your fear of the markets and are starting to feel confident.47 and a Contingent order. someday soon. The big question is: where do you set the stop loss price? If you set it too close to the current price. and then go back up again. If you are offensive-minded by nature. you may be more inclined to favor limit sell orders. then the broker advances . In a stop loss order. If you agree.46 At-theOpen. Say you want to buy shares of stock but don’t have the entire purchase price in your trading account. You ask your broker for a loan. But. on the other hand. Other less common trading instructions are. I said that ascribing the “right” price to a stock is more of an art than science. Your broker would then treat this as such and sell your shares in the vicinity of $32. thereby activating your order. on the other hand.45 Market-on-Close. we have looked at how to provide standardized instructions to our broker on how to buy or sell our stocks for us. these advanced orders might well become a part of your repertoire. Where you set the stop loss price is entirely up to you. These are aggressive strategies and should not be used by a novice. these advanced stock transaction tips can be quite useful. you will be more likely to protect your gains through placing of stop loss orders below the current price of the stock. What do you do? You can place a stop loss order at $32. thereby allowing you to protect most of your gains. Overall. if you set the stop loss price too low. But.e. consider the above example. When you buy on margin.50 soon after your purchase? This is the big risk of buying on margin. Instead. Leveraging can magnify your profits as well as your losses. You are lucky and MSFT according to the prevalent rules of the day. When MSFT goes up 50 percent in value. interest.250 (plus interest The margin requirements were dropped from and commissions) you owe. and you was highly over-leveraged. pay your broker the $1. rises 50 percent to $37. With the proceeds. you make about 100 percent on your investment (before interest and commissions). many of the market rules were changed. Keep in mind that the money from a short sale is not available to you for spending.Trading Assets 129 you the 50 percent and you are able to make your purchase. You are not earning any interest on this money and you have to pay History of Margin Trading . He will also come after you for anything he cannot recover from the stock sale. you first crash. and commissions. the market your total investment $3. making investors could borrow up to 90 percent of the purchase price of stocks. What if you don’t have the money to put in your account? Very simple! Your broker will immediately liquidate your stocks and pay himself back his principle. Given that your initial investment was $1. one of the factors you pay $1. How is this beneficial for you? Here’s a concrete example. the return on your investment is 100 percent. and whatever else he can charge you with.250. when you short sell. short selling involves selling shares of stock that you do not own personally but borrowed from someone who does own them (like your broker). However. Let us consider another risky investment tactic: short selling. People short sell in order to make money in falling markets.500 (minus interest and stands today. Buying on margin is also called leveraged buying. Very simply. 1929. which is where it the remaining $2. This is an example of how buying on margin can be quite beneficial to you. if the value of your investment falls below 50 percent of its original value. what you want to do is to be able to buy back these shares in the near future at a cheaper price (“cover your shorts”) and give the shares back to your lender (along with fees and commissions. The term leveraging implies that you can buy more than you could afford with the money you are actually investing. Let’s say you want to buy 100 shares of MSFT XYZ at $25 a share (total purchase When the stock market dropped about 12 perprice is $2. When MSFT falls 50 percent in value. of course). Ideally. the proceeds are held in escrow as collateral for the lender of the shares (i. your losses are 100 percent.” which means you have to put more money into your margin account.250 and your broker lends you blamed for the market plunge was the fact that.500). When you buy on margin. commissions) for yourself.50 a share. cent on October 29. the broker). fines. your broker will issue a “margin call.250. To see this. In the wake of the decide to sell.750. This is another example of leveraged investing—something that magnifies your profits and your losses. the other $1. your broker lends you shares of stock instead. and you keep 90 percent to 50 percent. what if you were wrong. Therefore. consider the downside too.. and MSFT falls 50 percent to $12. Typically. your broker lends you money. get a dog. For example. You can only short sell a stock while it is rising in value (on the “up tick”) or is stable (at “zero tick”). while the acquiring company faces the operational and business risk from having to integrate the acquired business into itself. and offer a premium over the current share price of the firm they are acquiring. There are also tax considerations to factor in. new rules were passed limiting the scope of short selling. greed clarifies and cuts to the essence. gets up in a shareholderʼs meeting of Teldar Papers to give a speech. Behavioral finance experts will tell you that we tend to hold on to losers too . the small investors. short selling is not permitted in falling markets. In addition. It captures corporate greed in a real way. based upon expected future revenues and profits. institutional short selling was among the culprits blamed for the stock market crash of 1987. The conclusion is that institutions who are short selling seem to know what they are doing. . In modern times.. . Gordon Gekko is a Wall Street mogul who has traded his way to wealth by indulging in risk arbitrage.” he states in his speech. that is not an easy task. greed works. We. as they typically receive a premium for the shares they hold. It appears that almost 13 percent of all NYSE trading volume involves a short seller. The authors also found that large short sell orders are informative (especially the institutional short sells) and that stocks with heavy shorting underperform stocks that are lightly shorted by over 1 percent. Even Wall Street is strangely quiet on this topic. Short selling has a polemic history in America. played by Michael Douglas. arguably the most unethical of the robber barons of the nineteenth century. However. Jay Gould. I suggest watching it.. shares that are freely available for buying and selling). For the uninitiated. If you havenʼt seen this scene. In its wake.” any dividends that may be paid on those shares while they are in your control. Another famous Gekko-ism: “If you need a friend. And believe me. . the notorious risk arbitrage (also known as “risk-arb”) trader of the 1980s.130 Chapter Seven Five-Minute Break Risk Arbitrage and Gekko-isms There is a great scene in the movie Wall Street where Gordon Gekko. A recent paper49 investigating the information content of short sell orders reports several interesting findings. His character is based on Ivan Boesky.e. thus diluting the value of the existing float (i. greed and capitalism. This is coined “arbitrage” due to the fact that companies will often finance takeovers through the issuance of more stock. “Greed is good. Gordon Gekko is an unapologetic champion of wealth. Risk arbitrage is a process by which an investor attempts to profit from short selling the stock of an acquiring company and buying the stock of the acquired company. nobody has the definitive answer. When to Sell Deciding when to sell is one of the most difficult questions in investing. would do well to keep track of institutional short selling. shareholders of the takeover target face little risk. Here is the research evidence. In the 1860s. became known for his questionable acquisition of Erie Railroad from Cornelius Vanderbilt via shady investment practices that involved copious amounts of short selling. Using moving averages takes the guesswork out of spotting trends. Do not try to make excuses to hang on to it when that day comes. you will sell. A very basic decision rule is to buy when the stock’s current price hits its moving average curve on the upside. you might sell a stock if its price is substantially more than twice its expected earnings growth over the next twelve months. Some investors use complex rules related to whether the stock price is too high relative to earnings growth. Of course. you will sell when the stock price passes twenty times its estimated earnings. is to keep those losses at a minimum. the immediate question is: what comprises a trend? You might say that an upward trend is simply formed when the most recent price is greater than the past price. you will have to sell it. You could. if the stock’s current price hits its moving average curve on the downside. It’s as certain as death and taxes. but it is more complicated than that. however. The rationale behind such a rule is really quite intuitive. a fifty-day moving average is simply the average of the past fifty days’ stock prices. so you would be in good company. or that a downward trend is formed when the most recent price is less than the past price. When that day comes. Remember that incurring losses is a part of investing. For example. you will have to have a predefined rule set up before you begin investing and you have to stick to it. sell the stock. you will dump it. you could have a rule that says that once a company misses its earnings estimates. So every day. There is a more accurate way of spotting trends (upward or downward) that statisticians have used for a long time—moving averages (MA). Eyeballing a chart to spot a trend might be fraught with inaccuracies. when the current price of the stock moves below its moving average. The investor then seeks to take advantage of the situation by buying early. Similarly. if a stock’s current price moves above the level it reached in the immediate past. decide that if the stock price falls $2 below your purchase price. if the stock is expected to increase its earnings by 10 percent next year. For this. What is important. The average is nothing but a simple centering of past prices. the fiftieth day is thrown out and replaced by the most recent day. And how do you do that? You sell stocks to cut losses. So. For example. Moving averages are simple averages of the prices over a trailing period. So. then we can assume that an uptrend in the stock has begun. Most market professionals use the trailing fifty-day moving average as a benchmark for establishing short-term trends and use a 200-day moving average as a . for example. Trading on Trends Consider the assumption that stock prices exhibit trends—either upward or downward. You need to have predefined rules for selling and follow through when it comes time to dump that errant stock. This one is actually followed by a few professional money managers.Trading Assets 131 long and sell winners too early. No wavering. then it is an indication that a downtrend has started and it is appropriate to sell the stock. Or. The starting investment sum in each stock was $100 (a pretty large sum forty years ago). Are Moving Averages an Effective Investment Tool? The Research Evidence What does the research have to say about the efficacy of using moving averages as a buy/sell tool? In an old research study done in the late 1960s using month-end stock prices. Notice that the 50-day MA line is choppier than the 200-day MA line Furthermore. http://www. any time the stock has dipped below its 200-day MA line might be a good time to sell. A reasonable conclusion is that it might be a good time to consider accumulating Microsoft stock. The fifty-day average is usually more volatile than the 200-day moving average. at which time the position was closed out. a simple experiment was designed. These are easily graphed on any website that has charting services (for example. Here then is a more advanced course of action. It’s probably a good time to buy when the stock price is above both the 200-day MA and the fifty-day MA.and 200day averages for any stock you are interested in buying or selling. As an example. If the current price had moved up above the moving average value. I have plotted the daily prices of Microsoft for a whole year and overlaid it with its fifty-day MA and 200-day MA plots.50 Each stock in the study was followed as though it were observed by an investor who could either take a position in the stock or hold cash. stockcharts. Microsoft’s latest stock price lies below both these averages and has for a while. was computed.com). In each following month.132 Chapter Seven benchmark for establishing long-term trends. The position was then held until the price movement reversed itself. The results show that an investor using the moving average decision rule on the stocks . Study the trailing fifty. based on its previous six-month month-end values. the initial number was updated by including the most recent month-end value and throwing out the oldest month value in the series. At the beginning. Figure 9: MSFT price path and moving averages. a moving average number for each stock. For a conservative sell signal. This strategy was compared against a simple buy-and-hold strategy of the same stocks. then as many shares of the stock as could be purchased with $100 were purchased. What are the inherent differences between established companies and the newer firms? Think about IBM and Google and see if your answer fits these two companies. 9. they would have realized that the comparisons were made with monthly stock prices (i. Can you articulate why the NYSE was impacted much less by the collapse of the dot-com bubble than the NASDAQ? 8.Trading Assets 133 would. Can you think of an emergent technology that might get popular in the next five years? What companies are behind this technology? Are they publicly traded yet? 11. Can the bid price ever be greater than the ask price? Can this condition be sustainable? 3. Yet. Why did it take over 200 years of trading for the minimum price ticks to change from sixteenths of a dollar to 1 cent? 4. In short. Why are institutions so against decimal pricing? 5. Do you think it is important for a stock to have a large float? Why or why not? 10. Why is high trading volume in a stock important for a small investor? 12. not the least of which is that none of these critics seem to have actually read the original paper. Why is the ask price generally greater than the bid price? 2. which would lead to a very different scenario than the one prevailing fifty years ago when the experiment described above was performed. using the last price of the stock on the last business day of the month). Why do you think the twenty-four merchants initially signed the agreement to create a cartel that eventually became known as the NYSE? 7. This is unthinkable in today’s world. this latter fact is conveniently ignored by the critics who claim that moving averages are not a good investment strategy. on average. be significantly worse off than if he simply bought the security and held it. should you invest in a stock with a large spread or one with a small spread? . it is entirely possible that an intra-daily moving average price series would lead to very different findings. What does it mean for a stock to have a large bid-ask spread? All else being equal. The author of the original article says so himself in his conclusions. I find that amazing due to a number of reasons. these results have been used by opponents of the moving average method of investing for years to argue against the technique. where we have second-by-second stock prices available and intra-day trends are established on a regular basis. What could be their reasoning? 6.e. Interestingly. If they had.. Thought Questions 1. Identify a few other companies trading in the NASDAQ that could move to the NYSE but are choosing to stay in the NASDAQ. Ceron. Texas A&M University. “Decimalization Cuts Wall Street Profit. Boehmer. 45. An order specifying execution at the opening of the market. Why are institutions (rather than individuals) considered to be smart. W.134 Chapter Seven 13. 44. “Decimals and Liquidity: A Study of the NYSE. . What do you think market volatility was like during the dot-com boom of the late 1990s? 19. 48. A. “Which Shorts are Informed?” Unpublished Manuscript. 47. James. Panchapagesan. “Has Decimalization Hurt Institutional Investors? An Investigation into Trading Costs and Order Routing Practices of Buy-Side Institutions.” Journal of Empirical Finance 15(2008): 17–40. M. A. Jones. 46. If you are trading in a high volume stock. are you more likely to use a market or a limit order? How about a stock with relatively little trading volume? 16. An order in which the execution depends on the execution or the price of another traded security. Benston and R. “Monthly Moving Averages—An Effective Investment Tool?” Journal of Financial and Quantitative Analysis 3(1968): 315–326. What are the main differences between a stop loss order and a limit sell order? 17. investors? 14. Zhang. R. C. and R. and X. or informed. Wood. Gaslon F. 41. 2005. Sugato Chakravarty. J. G. 2000). E. Wood. Says Study.” Wall Street Journal (September 8. V. A. A market order to be executed at the end of the trading day. Wood. Narrowing Bid-Ask Spreads.” Journal of Financial Research 27(2004): 75–94. Usually meant for a large limit order which must be filled in entirety or canceled (killed). 50. Christie and P. Schultz. and R. 49. Why are American stock markets less volatile than markets elsewhere? Notes 40. What are the main trade-offs between market and limit orders? 15. J. Sugato Chakravarty. “Why Effective Spreads on NASDAQ Were Higher Than on the New York Stock Exchange in the 1990s.” Journal of Financial Markets 8(2005): 400–420. 43. Van Ness. “Why Do NASDAQ Market Makers Avoid OddEighth Quotes?” Journal of Finance 42(1994): 1813–1840. F. Why is leveraging oneself a risky strategy? 18. 42. E. Say I pronounce a stock to be a great buy and then a few thousand of you run out and buy a hundred shares each. There is a problem. but because the sudden surge in demand made it so. the analysts know what they are doing. They were making millions of dollars in salaries and bonuses from their respective brokerage companies. however.G. rather.” A groundbreaking study published in the Journal of Finance in the mid-1990s used a large sample of analyst recommendations to conclude that changes in analyst recommendations were accompanied by a tremendous increase in trading volume and positive abnormal returns. are employed by big brokerage houses. almost 70 percent of a brokerage firm’s profits come from such activities). —Justyn Walsh Stock Analysts Stock analysts are professional stock researchers who are tasked with examining company profit and loss statements and other accounting data. Stock analysts.8 Advanced Topics To paraphrase Oscar Wilde. They made TV appearances and their proclamations about various stocks were eagerly consumed by millions of eager investors. analysts like Merrill Lynch’s Henry Blodgett and Morgan Stanley’s Mary Meeker became household names. etc.51 The findings implied that analyst recommendations are not cosmetic but. A. a speculator is a man who knows the price of everything and the value of nothing. “informed” events. for the most part. and producing pronouncements of “Buy. Doesn’t this seem like it might be a conflict of interest? The brokerages will all tell you emphatically and often that they have a “Chinese wall” between their analyst department and their investment banking group. Should we take their word for it? In the peak years of the dot-com boom. Naturally.” “Sell. In other words.” or “Hold. like Merrill Lynch. Edwards. People thought Blodgett and Meeker could do no wrong. These brokerage houses also make a lot of money from investment banking services. performing all kinds of research. Morgan Stanley. These analyst predictions tend to be self-fulfilling. There were a few wise people 135 . and one group does not talk to the other group. investors pay a lot of attention to what analysts say. talking to top company officials. which involve bringing a company public via IPOs (by some estimates. Goldman Sachs. not because it was a great stock to begin with. Soon it does become a great buy. ” Blodgett. she continued to recommend “buy” for Priceline. of course. made an impassioned pitch for Priceline. many of the stocks these analysts fessionals coined the phrase: “to blodwere enthusiastic about kept falling in price. she repeated her “buy” pronouncement! Brokerage firms continued to deny any connection between their analysts and their investment banking activity. Interestingly.136 Chapter Eight who pointed out that the analysts were behaving more like cheerleaders for the firms they were supposed to be analyzing than unbiased Henry Blodgett was so insistent with his researchers. Even when the stock fell almost 50 percent to about $77. When the stock plunged to less than $3 a share. While this was bullish predictions that Wall Street prohappening. Shocked? For example. another research study example. the analyst’s parent company claims he based his predictions on happened to be in an investment banking relasound analysis. during the course of their investigation. while he served as New York’s attorney general. To Blodgett a Stock Fun Facts . made it his mission to go after corporate crime. Mary Meeker. not because there was anything fundamentally wrong with it. As mentioned earlier. In 2002. Eliot Spitzer. to the point where objectivity was sacrificed. but because the company would not do business with them. Friedrich von Hayek and concluded that analyst recommendation Gunnar Myrdal shared the 1974 Noble changes are inherently uninformed liquidity Prize in Economics for saying completely enhancing events. Meeker was bullish on Priceline. Most of the star brokers (including Meeker. an article published in the Journal of Finance by Kent Womack of Dartmouth College in 1996 essentially concluded that recommendation changes Economics is the only discipline where embodied valuable information for which a two people can share a Nobel Prize for brokerage firm should be compensated. Mary Meeker now loudly professes her innocence and talks (for a hefty fee. Spitzer’s staff came across internal e-mail among Merrill Lynch analysts that said that they had downgraded a stock. Academic research has long examined the effect of buy/sell recommendations by financial analysts in equity markets. Among other things.52 This is not a question contradicting things. and Jack Grubmann) have been fired by their original companies and have found employment elsewhere—but not at the astronomical salaries they once commanded. he accused these firms and their star analysts of publicizing the stocks of companies with which they had an investment banking relationship. however. For recently. including analysts and the brokerage firms that employed them. a company that her own firm had helped bring to the market as a publicly traded company (through an IPO). of course) about the evils perpetrated by brokers everywhere. Morgan Stanley’s star analyst. Analysts as a group fell out of favor when the dot-com bubble collapsed in early 2000. More saying completely opposite things. gett a stock. but no one listened. then trading for $134 per share. with a simple answer. Blodgett. tionship with many of them. . the company will declare for every share a shareholder owns. was meant to level the playing field of information dissemination and make it easier for small investors (that would be you and me) to compete with the large ones. after a certain day (also known as the ex-date). it is a 2-for-1 split. and every other professional on Wall Street. investment bankers. But what about the quality of that information itself? Interestingly. both individually as well as in the aggregate. the stock price is proportionately adjusted. so the market value of the company remains exactly the same. In addition. each shareholder receives enough extra shares so that the fraction of the company he owns remains the same. From a theoretical standpoint. the exdate). The authors conclude that while splits realign prices to a lower trading range. This is not good news for small investors. which had allowed companies to give some analysts information in return for special access to their highest echelons.S. While the split reduces the portion of the company each share of stock represents. it will be replaced by two or three new shares.53 It also found that the earnings forecasts were relatively less reliable for small companies than for large firms. Security and Exchange Commission’s (SEC) Regulation Fair Disclosure.275 2-for-1 stock splits initiated by NYSE stocks between 1975 and 1990. on the day of the split (i. after the passage of Reg FD. In other words. In the former case. As the regulatory body has mandated a more democratic way of disseminating information. and reports a post-split excess return of about 8 percent in the first year and over 12 percent in the first three years following the split. One study in particular examines 1. a stock split is a non-event. some companies will split their stock.e.Advanced Topics 137 Leveling the Playing Field through Regulation Fair Disclosure Adopted in October 2000. academic research using a large sample of earnings forecasts made by analysts around the passage of Reg FD finds that analyst forecasts became less accurate. then–SEC Chairman Arthur Levitt said: “You are now privy to the same information. also known as Reg FD. the quality of the information publicly disseminated appears to have decreased. the U. . as analysts. Why Do Companies Split Their Shares? There have been suggestions that companies split their shares to signal future profitability. On the ex-date. Stock Splits As stocks increase in price.” Most observers concede that Reg FD largely accomplished its goal of abolishing the selective disclosure of inside information. At a meeting with small investors following the adoption of this regulation. and in the latter case. the stock trades at half the price (in case of a 2-for-1 split) and you own twice the number of shares you owned before the split. and at the same time. a 3-for-1 split. routinely split its stock. you would own one new share after the split. however. The most interesting reason for companies to split shares. over the course of its existence. would rather have institutions and wealthy individuals as his sole shareholders.55 Additional research suggests that firms with very low levels of institutional ownership prior to the split appear to gain liquidity following splits. It is clear that Buffett. things don’t look so bad. The classic example of the latter is the Warren Buffett’s Berkshire Hathaway. each share trades for about $110. these stocks declare stock splits to increase the relative tick size and thereby increase their liquidity. to stay listed in organized stock exchanges. Studies show that individual investors prefer to trade shares in the $20–60 range. however. Ergo. Reverse Stock Splits Reverse stock splits are used when a company tries to artificially increase its stock price. Contrarily.54 There have also been suggestions that minimum price variation rules (or minimum tick sizes) may have a role to play in companies’ decisions to split their shares. The stock price would also be adjusted up by a multiple of twenty. In the short run. more importantly. It is this relative tick size of a stock that declines as the stock’s price increases. It has. if a company declares a 1-for-20 reverse split. causing liquidity to decline. for every twenty shares you owned before the split. If a company wants new individual investors to own shares of the company. It means that the company is attempting a last ditch effort to stay afloat and. For example. so does the incentive for investors to provide liquidity in the stock. These are usually very thinly traded and are consigned to the basement of organized trading exchanges (known as pink sheet stocks). may be related to the psychological effect it has on investors. When a company announces a reverse split. And as the relative tick size declines. Most companies announcing reverse splits see their stock prices eventually fall below one dollar per share. if the exchange mandated minimum tick size (currently one penny) stays fixed while the stock price changes constantly. Microsoft is an example of a company that wants individual investors in its shareholder base. A study investigating the liquidity effects of reverse stock splits reports that bid-ask spreads .138 Chapter Eight the managers of the companies undertaking these splits self-select by conditioning the decision to split on expected future performance. and that a higher fraction of post-split trades are made by less sophisticated investors (investors like you and me).000. if a company does not want individual investors in its ownership demographic. The magnitude of Microsoft’s splits over the years of its existence as a publicly traded company can be understood with the following example: if you spent a couple of thousand dollars buying Microsoft shares in 1982 and held on to it. in spite of his folksy attitude. By contrast. Currently. the relative tick size of the stock—one penny divided by the stock price—also changes constantly. that investment would be worth in the neighborhood of $2 million today. it is usually not good news. they will regularly split their shares as they increase beyond this range in order to force the stock price back into the investors’ comfort zone. In particular. it may never split. What do you think? . reverse stock splits might enhance the liquidity of a stock. A more credible reason for prohibiting insider trading is the so-called “adverse selection” theory.000 to his son. A federal grand jury indicted the son on related criminal charges of insider trading and conspiracy to commit securities fraud. In other words.56 All things considered. the SEC was not happy with the father–son team and wanted them to return the profits and civil monetary penalties of up to three times that amount. in the short run. One group of scholars and practitioners claims that insider trading does not hurt any single individual in the market and argues that insider trading helps prices find their “correct” value. the father transferred $55. (Note that put options give the holder the right to sell stock at a given price. The defenseʼs argument was that the son was innocent because he was not aware of the insider information before it was made public. the investors have an incentive to become defensive and provide inferior Example of Insider Trading Recently. a manager in Sepracorʼs accounting department told his father that Eli Lilly & Co. then everyone else may be reluctant to trade in what they see as an unfair market. In recent years. Before 1968. In simple terms. he sold the put options for a profit of $55. While stock splits may be good news. insider trading helps to make prices efficient. This is the “market confidence” argument that the Securities and Exchange Commission (SEC) has used for years. 2000. insider trading was common and generally accepted by society. Insider Trading Insider trading occurs when someone with privileged information about a company trades shares of its stock based on that information for personal profit.Advanced Topics 139 decrease and trading volume increases immediately following reverse stock splits.000 after the value of Sepracor stock plunged. The second school of thought argues that allowing insider trading is psychologically harmful to the investor community at large. the long-term prognosis of reverse stock splits is not good. If it is common knowledge that insiders are trading on knowledge that we cannot possibly have. two schools of thought have developed. might terminate a licensing agreement with Sepracor involving a new version of Lillyʼs widely-sold antidepressant Prozac. Then market liquidity is compromised and society as a whole suffers. though. however. They also argue that allowing insiders to trade and profit is a form of incentive compensation for top management of a company—an argument that no longer holds much water due to the plethora of scandals involving stock options and company insiders.) After Lilly announced the agreementʼs termination on October 19. Several months later. this theory implies that when investors are faced with the prospect of trading against traders with superior information about a company. Experts say that the strongest argument against insider trading as compensation is the difficulty of measuring and benchmarking entitlement and rewards. Thus. it would be wise to stay away from them. The father quickly purchased put options on Sepracor stock. Naturally. In addition to the criminal sanctions against insider trading authorized by 10b-5. Boesky received a threeyear jail sentence in a minimum security prison.57. his gain was not seen as an outcome of luck or superior market analysis and insight. the Insider Trading Sanctions Act (ITSA) of 1984 provided for civil penalties (payable to the government) of up to three times the profit gained. just below 5 percent of all outstanding shares. Peabody & Company. In 1986. The SEC spends millions of our tax dollars annually in the name of oversight aimed at investigating. Chakravarty and McConnell also find that Boesky’s insider trading in Carnation stock had little effect on its bid-ask spread. Because of his trading based on inside information.140 Chapter Eight prices to the market at large in order to protect themselves from incurring certain losses. Boesky made a significant gain. Unfortunately (for Boesky). Unfortunately. Insider trading is a violation of SEC Rule 10b-5 known as the “disclose or abstain” rule. The SEC charged him with “insider trading. bid-ask spreads widen). the assumption itself has little empirical validation. or loss avoided. Moreover. pertaining to Boesky’s purchase of Carnation Company shares just before Carnation was bought by Swiss food company Nestlé SA.7 million shares of Carnation stock. Boesky made a profit of about $50 million. Ivan Boesky accumulated 1. which prohibits companies and individuals from engaging in fraudulent and unfair behavior. everyone is hurt. in insider trading. As a result of a subsequent offer from Nestlé to purchase all Carnation shares for a significant premium. and prosecuting insider trading based on the assumption that insider trading is bad. it is logical to impose a monetary penalty to eliminate that gain and punish the individual(s) who benefited from the insider information (it may or may not be appropriate to institute criminal penalties for this). Up Close: Ivan Boesky and Carnation During a three-month period in 1984. Thus. Unfortunately. In a collection of research studies.e. is not backed by the data. this argument. Ivan Boesky. He also pled guilty on one count of an unspecified criminal charge that resulted in the SEC barring him from the securities industry for life.. insider trading laws rest on the assumption that insider trading hurts the markets and other investors who do not have access to the same information. and insider trading is just one example. Ivan Boesky pled guilty and agreed to pay back the $50 million and another $50 million as civil penalty. curbing.” Boesky later acknowledged that he had received insider information about the takeover of Carnation from an investment banker at Kidder. However. .58 The authors analyze data from a well-known inside trader. economists Sugato Chakravarty and John McConnell have shown that insider trading does not appear to increase trading costs. All this begs the question: does insider trading really hurt the average investor? If insider information leads to gain. as a result of government action against him. since we pay relatively more to buy stock and get relatively less when selling stock (i. The two economists show that Boesky’s trades in Carnation shares based on illegal inside information did not move stock prices any more than other simultaneous buyers of the stock who did not have private information. This is an important discovery. since it establishes that insider trading does not have any more impact on stock prices than non-insider trades. These rules have their roots in the Securities Act of 1934. while certainly plausible. and no effect on market depth. the deeper the market. Market depth is the number of detailed examination of the spreads in shares available at each bid and ask price. ImClone Chief Operating Officer Harlan Waksal received a phone call informing him that the Food and Drug Administration (FDA) . The company will have to pay more for new capital. who may not even be in managerial positions. The evaluation of new information will be done efficiently through a pure market process. There is no need to regulate investment bankers. reflected in a higher risk premium. market liquidity The bid (ask) is the price at which the mareither increased or stayed the same during ket maker is willing to buy (sell) a stock. auditors. A transact. boards of directors and the managers themselves will have less reliable feedback on managerial performance. Thus. Nor does it mean that their gain detracts from the benefits others receive from the system. about the economic importance of reliable pricing. as spread and the cheaper it is for investors to presumed by insider trading laws. and the managers will be at greater risk of displacement. all other things being equal. and this one may explain why corporations did not regulate the practice themselves before the SEC got into the act. managers’ professional reputations will suffer. Boesky’s trades increased market depth by making more shares available. Management and shareholders of large. there are no delays or uncertainties about what has to be disclosed. insider trading is allowed. here are the highlights. The system would not work unless they profited.Advanced Topics 141 the effect of Boesky’s trading actually had positive effects on both the bid-ask spread and market depth. will have several negative effects. only did Boesky’s trades have no effect on bid-ask spreads. on the other hand. The fact that insiders. Boesky’s trading. the shares of a company with reliable pricing will sell for more than those without reliable pricing. If. price adjustments—at least in theory. There are no issues about when information must be published. Investors will receive full disclosures in the form of immediate. or in what form. That is. On Christmas day in 2001. Recall Martha Stewart and Insider Trading Remember Martha Stewart and the pharmaceutical company ImClone? For those who are not familiar with the story. but there is no need for them to understand the larger picture. publicly-held corporations have a strong common interest in the accurate pricing of the company’s shares. If pricing is not reliable. the narrower the the other consumers active in this stock. Carnation stock on Boesky-trading and on The greater the number of shares available non-Boesky-trading days revealed that not at each such price. but the minimal effect that Boesky’s trades did have on market depth were in a direction that would help the uninformed trader. Lack of confidence in the reliability of a share’s price. investors will demand a higher return in order to be compensated for assuming this added risk. Experts say there is yet another justification for insider trading. There were no ill effects on The deeper the market. or care. profit from the system does not mean that they necessarily understand. or stock analysts. and correct. 000 percent” and as “the most undervalued stock ever. Waksal and his brother were friends with Martha Stewart. Inc. He would then sell his shares quickly at the artificially inflated prices. The Story of a High School Trader This is a story about Jonathan Lebed. Lebed had been on the SEC’s radar for several years before formal charges were brought against him. secured by his stock. as any student of finance knows. He touted one company as the “next stock to gain 1. The stock itself. In the wake of the news.000 in profits. Lebed’s modus operandi included. and Havana Republic. ImClone trades at around $35 after dropping to about $9 right after the scandal broke.000 shares of ImClone herself. At a price of $75 a share reached just weeks before. He would plaster Internet message boards with extremely bullish predictions for the stocks.. and had . the FDA faxed a letter of rejection to ImClone offices.” and “dmaj431. was sure to tank when the FDA made its announcement publicly. Martha is accused of having received news about ImClone’s impending demise well before the public announcement by the FDA. His monthly interest payment on the margin was about $800. which would prompt other investors to buy them.142 Chapter Eight would be rejecting the company’s new cancer drug. identifying companies like Yes Entertainment. Inc. $65 million of which was on margin. he was regularly writing on Silicon Investor. Erbitux. according to the SEC. He got to keep more than $500.” Lebed bought 20.” “wmmkjj. Martha’s investment in ImClone was worth about $300. ImClone announced the news after the market’s close. Among the message-board names that Lebed used were “charmdw.. This news must have devastated Waksal because he happened to be leveraged to the hilt with $80 million in debt. If the price of ImClone stock collapsed. Beginning in early 1998. These days. “This stock will explode this week.. Interestingly. The very next day. Martha Stewart spent time in prison for her efforts. Merrill Lynch. Waksal would be ruined.” On the Yahoo! Finance message board for Firetector.000 Firetector shares the day of the posting and sold soon thereafter—at a profit. the SEC forced Lebed to repay some of his ill-gotten gains to the tune of $285.000—but he actually made over $800.000. ImClone’s stock price plunged 16 percent.” He used numerous aliases. Eventually. who owned about 4. who at sixteen years of age made a lot of money by purchasing stocks and then using Internet chat rooms to drive up the demand for those stocks. that were low in price and trading activity.000 in profits. a financial website. such as IBM. He would buy shares of the small company he had identified. creating the impression that many investors were interested in a single stock.000. and selling her entire holding in ImClone through her brokers. “charmdw” wrote. Inc. pushing their prices up. for example. then bombard Internet message boards with postings—sometimes hundreds of them—hyping the stock. when he was only thirteen. He targeted these stocks because it is easier to move the price of a small company than a big one. why has Lebed’s lawyer been calling attention to the fact that the SEC settlement didn’t force his client to give back all of his profits? What do you think? Stealth Trading If you were an investor with valuable information about a stock. for example. The huge volume of Lebed’s Internet postings indicated his intent to move the market. and included claims that he did a lot of research. defendants usually agree not to talk about the case. he may have violated the law. but contends that it isn’t illegal. but continued his trading activity. It’s difficult to characterize those statements as false. He would sometimes put out as many as 500 messages under different names. Hype crosses the line and becomes illegal. what would you do? Would you. nor did they have the resources for. trade openly on the information so that others could take advantage of it and make profits? Or. Lebed’s lawyer does not deny that his client made exaggerated statements in postings about the potential of stock prices for individual companies. the young man was called in to meet with enforcement attorneys at the SEC’s New York office. Message board participants shoot them down and discredit them immediately.Advanced Topics 143 formed a stock-picking website called StockDogs. Lebed shut down his website. When the website continued to tout stocks. the SEC alleges. The SEC had called the youth’s parents frequently to warn them that their son’s activities might not be appropriate.” his lawyer says. and then defrauds others by trading the shares. when someone knowingly provides false or misleading statements with the clear intent to affect a stock’s price. In SEC settlements. but I would certainly choose the latter option—to trade stealthily on my information to whatever extent possible. The SEC maintains there is a big difference between the normal stock-touting messages on the Internet and what Lebed was doing. the SEC says. spoke to company chief executives.” Lebed’s defense was that he hyped the stocks but did nothing wrong. or that it would increase 1. When Lebed predicted—without any basis. probing every message that hypes a stock. triple. would you trade secretively so that no one else could find out what you know until your trading is done? I don’t know about you. many of which have absolutely no impact. or quadruple without a reasonable basis. The SEC claims that they see outrageous pitches all the time. adding that Lebed’s online messages almost always offered a disclaimer that investors should do their own research. . The SEC alleges that if someone puts in a recommendation with a price prediction that a stock price will double. according to the SEC—that a stock would climb to $20 from $2. So.com. His lawyer echoed those sentiments. and even visited some of the companies he promoted.000 percent. “Some of his more enthusiastic statements or predictions about where the price might go could be seen as misleading. “It’s in the nature of puffing—it’s an opinion. It is clear that Lebed wanted to create an illusion that his false claims about stocks he promoted were beliefs held by many different investors. it is illegal. Regulators say they aren’t interested in. At his mother’s urging. the markets are not stupid. stock prices will jump up disproportionately after a medium buy and fall disproportionately after a medium sell.59 In fact. This is exactly what the research has shown. regardless of the investors saw that you were about to buy informed or uninformed nature of the trade. another economist showed that stealth trading is associated with the medium-size trades of institutional traders (rather than trades Sunshine Trading . and would do so as soon as they learned you planned to. In trading insurance in the mid-1980s and consists of jargon. When other information by itself. as the mation in advance. to the pre-announced schedule until the order Your intrinsic character as an informed trader might decide for you what course was completely executed. in itself. In later follow-up research. you are a large uninformed trader. and any untraded portion of the order would be withdrawn and re-entered according a “sunshine trader” would. Prices would rise before you could carry out your trade and you would have to pay a higher price. Of course. One way investors with private information might choose to trade is by breaking up their intended trades into smaller ones so they can fly under the radar. defined as trades of 500 shares to 9.and large-sized trades. announcing a particular basket. their analysis reveals that it is the medium-sized trades. the order would be entered between an informed trader? Maybe you would the bid and ask at the announced day and try to announce your trade beforehand as time. simple fact that someone wants to trade a Let’s assume that you were recognized large number of shares is a valuable piece of as an informed trader. what do you think would happen? Everyone would want to buy it also. where most of the informed trading action would be centered. a particular stock. Keep in mind that of an informed trader. Get the picture? You want to hide your trading plans. Put differently. tradWhat would your incentive be? Would ing plan before any orders are executed. If someone has this piece of inforThe technique is not without its flaws. thereby attenuating that the fact that you want to trade a large the market impact that is usually associated number of shares is valuable information with the execution of a large informed trade.144 Chapter Eight Consider an alternative scenario. What if you did not have valuable information about any stock but just wanted to trade a Sunshine trading has its origins in portfolio large quantity of some stock.999 shares. but big enough to avoid being prohibitively costly and time consuming. They know that this is what the informed intend to do. or index. they can profit from it. Important research by two economists established that informed traders would indeed have the incentive to break down their orders into a size small enough to go unnoticed. Therefore. The intuition for this technique is that the other market particiof action you want to follow—stealth pants are less likely to mistake the order for trading or sunshine trading. which results in an increased price response relative to small. we treat all medium-sized trades with an increased degree of scrutiny and suspicion. you try to trade stealthily as if you were Thus. We know that some of the medium-sized trades are disguised trades from informed investors—we just do not know exactly which ones they are. S. There were a whole lot of unhappy investors in the U. we discussed how a firm goes public. common investors like you and me are able to invest in the company when its shares start to trade in the secondary markets—usually at a price that is significantly higher than the IPO price. perhaps the most controversial new rule is Rule 611. you lose some! . Intermarket Sweep Orders (ISO) Attempting to understand the robustness of our financial markets has never been more important than in the wake of the recent Wall Street meltdown and the continued volatility of the markets overall. Facebook) and arrange to raise money for it through a private placement of its shares among the rich.Advanced Topics 145 from individual investors).61 In fact. the Order Protection Rule. completed in October of 2007. The evidence continues to be found in other Asian and European markets as well. they concluded that the risk of selling shares to its U. While the regulation consists for four main parts.S. two economists have shown that stealth trading is not just limited to the stock markets. In the end. shareholders.5 billion through a private sale of its equity (Goldman Sachs valued the company around $50 billion) and sell equivalent shares to Goldman Sachʼs top clients. It does so through at least one investment bank (usually a team of such banks with a lead bank calling most of the shots) using a process known as an IPO.S. Goldman Sachs made a private arrangement with Facebook to raise about $1. However. the SEC has in place very strict laws on what these investment bankers can and cannot do in order to sell these shares privately. While the laws associated with private companies headquartered in the U. the resulting media frenzy that ensued made Goldman Sachs take a second look at their plan. and the well-heeled. While the initial allocation of shares at the IPO price is restricted to the rich and the well-connected. prohibit them from having any more than 500 U. but is common in options markets too. Goldman Sachs believed it could pull an end around this rule by setting up what is known as a special purpose vehicle for the sale of these shares to its best U. represents one of the most significant changes in the structure of equity markets in recent memory. Earlier this year. The investment bankers can come to an agreement with a private company that is hugely in demand at that moment (for example. Some of the things that the investment bank cannot do is “general solicitation and advertising” or talk to the media about the shares.60 Even more recently. Stealth trading. There were ripples of excitement flowing through the halls of power in and around Wall Street. customers was not worth taking. but such is life in the world of high finance. famous. research has uncovered the presence of stealth trading in Australian and Japanese markets. therefore. The recent implementation of Regulation NMS. The essence of the Order Protection Rule is that market orders must The World of Private Placements In a previous chapter. When word of the impending deal leaked to the media.. appears to be a robust phenomenon executed by strategic traders to hide their intentions in all markets—here in the United States and in markets around the world.–based customers. are highly positively correlated).S. who are not bound by the SEC rules. when you think about it.S. They could only sell these shares to their foreign customers. You win some. But what happens if a company is not publicly traded? Is there a way to invest in it? It turns out that there is—if you have a lot of money and know the right people (which. 000 shares and chooses to “work” the order. As small investors ourselves. Such behavior also explains why such firms are able to pay millions of dollars in salaries and bonuses to their employees. we have to be careful about how we trade and make sure we don’t lose money by being caught in the crossfire of games played by more sophisticated investors. The trader divides the total demand into many small marketable limit buy orders. informed or strategic traders are finding increasingly creative ways to trade and hide behind uninformed traders. While. of the total demand.146 Chapter Eight be routed to the market center posting the best price. and how that money may be earned at the expense of naïve small investors. the fact that ISO orders from a single trader can be queued in many markets allows for a parallel processing. One such exception is the Intermarket Sweep Order (ISO). non-ISO orders. It appears. Almost ten years later. Research has uncovered that these large investors may have been using small investors in the company’s stock as pawns in their quest for high investment returns. it is immediately executed at the best price. ISO orders are marketable limit orders that allow traders to process demand in a parallel form rather than the sequential processing of regular. being routed to the market center that posts the best execution price. the trader can choose to designate the orders as ISO orders and route them to several market centers simultaneously. then the orders will execute sequentially. for a given market center. however. which can change during the execution of the order set. shares of Google were trading around $700 per share and the company was worth over $200 billion. two Stanford University graduate students left the university and formed a company they called Google. and a quicker execution. as the trading marketplace changes. Recent research finds that ISO orders are small in size (averaging around 179 shares). offered by the selected market center. these small-sized trades appear to be informed trades. Alternatively. As each order arrives at a market center.62 Note that such trades differ from the medium-sized stealth trades. up to the limit price of the ISO. In sum. indicating that informed traders may be using such orders—maybe even instead of stealth trading. All that is public information. the trades of large investors show that they are able to accurately predict the post–earnings release price of the company and use this information to make . Using data from both the stock and options trades in Google over an extended period. There are several exemptions to the Order Protection Rule identified in section 611(b) of the regulation. If the orders are all designated as non-ISO orders and submitted to the market. orders are processed sequentially. To highlight the differences between the ISO and non-ISO orders. consider a trader that wants to purchase 10. ISO orders are not redirected to other exchanges that may have a better posted price and can trade through the National Best Bid and Offer (NBBO) price. that Google stock may have been the victim of stock price manipulation by powerful Wall Street firms. Interestingly. Games That Large Investors Play In the fall of 1998. unit trusts. All financial instruments covered in this book are only superficially different—in the ways they are traded. suddenly (and almost inexplicably) the stock price did behave as predicted. and try out new ideas. Think of these simply as rules of the game. you will get better at it. The high success rate of such activities rules out pure chance. California State University–East Bay. in turn. they change. These are addressed in upcoming chapters. That’s all there is to it. For example. institutional investors appear to accurately buy call options in Google before a price rise and buy put options before a price decline. Option market and smart traders. Cramer bragged about how easy it is to move stock prices up or down with the cooperation of the financial press. ETFs. In anticipation of this. except in the potential risk and the corresponding returns. bonds. there is compelling evidence to suggest that large institutional traders appear to “know” the post-earnings stock prices. The research also finds evidence that in the few quarters where the institutional option trades did not appear to be profitable initially. Once you see the universality of investments. they sell options with strike prices that later become useless.com. Source: Liu. options. insurance. Cramer went on to say that he would do this in conjunction with placing large put orders on the companyʼs stock. Shifting Gears We have arrived at the end of our investment-related adventures and it’s time to move on to the other pillars of personal finance: credit. In sum. and how much are you willing to gamble for it? Your returns. W. Of course. 2008. there is a difference between working hard and working smart. and retirement. We have reviewed some of the common investment vehicles you could use to increase your net worth.Advanced Topics 147 profitable trades in the options markets. A second lesson is the following: practice makes perfect. Jim Cramer’s Play In March 2007. This is an important lesson that I want you to understand. there appear to be good reasons to believe that there are significant price manipulations going on in stock and options markets in ways that benefit large traders at the expense of smaller individual investors. are commensurate with the risk you take. It’s a continuum between risk and return: how much risk are you comfortable taking. there is little difference between stocks. In spite of superficial differences in pricing and how they are traded. invest. but the game stays the same.. He talked about specific stocks and how he could spend a few million dollars to knock a company out by driving their stock prices down. etc. My parents were academics by profession. not as distinct vehicles. mutual funds. We . the host of CNBCʼs Mad Money program boasted about manipulating stock prices in a video interview with TheSteet. but the game itself stays the same. you will just need to understand the different rules governing each investment vehicle. J. and so on. Working Paper. It is important to look at all investments within a common risk-return continuum as a whole. Overall. As you read. in unit sizes. Jim Cramer. There may be different rules. It is so important that it bears repeating. ” The student was beside himself. A story that closely exemplifies the concept of working hard and succeeding goes as follows: A long time ago in China. we have to learn to take our emotions out of it. if you persevere. and my father used to say. “Well. Despite the studentʼs embarrassed objections. without being permitted to go any further. overwhelmed and frustrated. who started with nothing and made and lost his fortune several times over during his lifetime. Accordingly. When he had finished. whether they are great investors. Is too much wealth good or bad? Is it obscene if it comes to you easily? Is working hard better than working smart? These were questions for which I had no clear answer. but it is the truth. but how long will it take for me to master it?” The teacher looked at the prospect with little interest and replied. it can be a wonderful thing. You may not realize it at the time. maybe twenty. The trick is to work smart and to do so harder. maybe fifteen. My parents believed that wealth itself was somehow obscene. a martial arts student approached his teacher and said. “There is no shortcut to success. were not wealthy.” I laughed at him then. used to say that in order to be a successful investor.” What do you think the teacher was trying to tell this impatient student? An important lesson to take away from the Investment section of this book is to try to master the art of self-control. What is the moral of this story? Hard work always pays off in the future. it is probably obscene and a waste. Philosophers have long argued that wealth in itself is meaningless. Think of Warren Buffett’s recent decision to give away the bulk of his more than 40 billion dollar fortune to charity. painters. day after day. I was raised with this inherent confusion. the most famous speculator this country has ever produced. but also seemed to enjoy the finer things of life. When I was young. “What if I study really hard. . I now believe that one can do both. the sponsor of the contest praised his performance.” This student later became known as the great performer Koshiji. Don’t get greedy! Jesse Livermore. “Maybe thirty years. I thought I knew it all. salesmen. One night. and take no time off for myself? How long will it take then?” The teacher looked at the student absent-mindedly and replied. or engineers. maybe ten years.” the sponsor asked. “I am very eager to study your martial arts. He entered the competition and sang the one passage that he knew so well. If we use it solely for our personal gratification. “Tell me. inventors. They have discipline and tenacity. while passing an inn. The hallmark of successful people. he stumbled upon a singing contest. But if we use some of it to make a difference for others. practice twice as hard as your best student every day of the week. the young student quit and found himself another profession. Both have important roles to play in building wealth. but we were financially comfortable.148 Chapter Eight Anecdote: The Chinese Singer A classical singer in ancient China was studying under a strict teacher who insisted that the student rehearse the same passage over and over again. is that they all have a tremendous work ethic and do not take no for an answer. Finally. but. the sponsor refused to believe that he had just heard a novice performance. But he persisted. good things will happen. “Who is your teacher? He must be a great master. it’s what we do with wealth that gives it value. ” The rich man became angry when he saw the masterʼs words. If we approach investments with the goal to become rich. What do you think are the long-term implications (if any) of Eliot Spitzer’s actions concerning the brokerage industry? 3. Our investment strategies should be geared toward making us comfortable.Advanced Topics 149 When it comes to investments. “First. Anecdote: The Circle of Life A rich man once asked a Zen master to write something down that would encourage the prosperity of his family for years to come. should your family. It would be something that the family could cherish for generations. If you somehow knew (or suspected) that a stock you are interested in was about to split. On a large piece of paper. or was he manipulating the market? 8. Do you believe analysts’ recommendations have value? Why or why not? 2. how would it alter your investing decision? 5. we are setting ourselves up for failure. disappear in the order I have described. Under what conditions are you likely to invest in a stock that has just had a reverse stock split? . Why do you give me such a depressing message?” The Zen master said. What are the main arguments for and against banning insider trading? Which do you agree with? 6.” Thought Questions 1. However. the master wrote. conquering our emotions and focusing on rational decision making is the key to success. those that will provide us with a temporary boost to our purchasing power. “I asked you to write something down that could bring happiness and prosperity to my family. Can you think of other areas where people behave stealthily in order to disguise their true motives? 9. it would bring you and your family unbearable grief. generation after generation. we will turn to the other important aspects of personal finance: those that are designed to protect that which we have built. Now that we have discussed ways to increase your wealth. and those that will help us in our golden years. then grandson dies. it too would bring your family great sorrow. Did Martha Stewart do anything wrong? What would you have done in her shoes? 7. Should your grandson die before your son. Do you think Reg FD has helped or hurt the common investor? 4. “Should your son die before you. it will complete the true circle of life. father dies. then son dies. not necessarily toward making us rich. And that is true happiness and prosperity. Was Jonathan Lebed innocent. G. 57. A. Chen.” Working Ppaper. 60. S. A. McConnell. University of Memphis. Stice. and Bid and Ask Depths Surrounding Ivan Boesky’s Illegal Trading in Carnation’s Stock. Wood. Han. 53. Badrinath. A. and M. “What Do Stock Splits Really Signal?” Journal of Financial and Quantitative Analysis 31(1996): 357–375.” Journal of Financial and Quantitative Analysis 42(2007): 167–188. Ikenberry. S. K. 62. L. . Chakravarty. “Stealth Trading: Which Traders’ Trades Move Stock Prices?” Journal of Financial Economics 61(2001): 289–307. S. J. and E. Kent Womack. G. 56. “Stealth Trading and Volatility: Which Trades Move Prices?” Journal of Financial Economics 34(1993). “Clean Sweep: Informed Trading through Intermarket Sweep Orders.” Working Paper. “Who Is Afraid of Reg FD? The Behavior and Performance of Sell Side Analysts Following the SEC’s Fair Disclosure Rules. A. D. Chadha. Chakravarty. Chakravarty and J. 54. 61. Agrawal. J. S. Chakravarty. Share Prices and Stock Splits. 281–305. Wood. P. What is the relationship between the available liquidity of a stock and its relative tick size? Notes 51. and R. Warner. K. J. 58. Barclay and J. Upson. J.150 Chapter Eight 10. University of Alabama. “An Analysis of Prices. 2009. M. S. “The Effects of Reverse Stock Splits on the Liquidity of the Stock. Anand and S. and R. A. Angel. 59. Bid-Ask Spreads. C. S. Jain. J.” Financial Management 26(1997): 18–34. “Stealth Trading in Options Markets. “Does Insider Trading Really Move Stock Prices?” Journal of Financial and Quantitative Analysis 34(1999): 191–210. K.” Journal of Financial and Quantitative Analysis 30(1995): 159–169. Rankine. Anand. “Is It Prudent to Trade around Analyst Recommendation Changes? An Analysis of Transaction Costs. Chakravarty. 52. McConnell. 55. “Do Brokerage Analysts’ Recommendations Have Investment Value?” Journal of Finance 54(1996): 137–157. 2005. “Tick Size.” Journal of Trading 1(2006): 22–37. S.” Journal of Finance 52(1997): 655–681. J. Chakravarty and J. Remember to have no more than 10 percent of your assets in precious metals. Go online to any one of the well-known brokerages. Get in the habit of reading newspapers like the Wall Street Journal or Barron’s and try to interpret what the various world and national events may mean for your investment portfolio. You should think about and analyze questions like: What does this particular event mean for my investment portfolio? What could I buy at this point to make my portfolio grow? Should I get in or out of bond funds? Should I have more gold-related investments in my portfolio? 151 .SECTION A: ACTION PLAN Here is an action plan to put you on the road to financial health and freedom. Make it a habit to put a few dollars every month into your investment account. Then. Once you are set up with an online account. TD Ameritrade. The discipline of regularly putting money in your investment account is the important thing. Start an investment account. as you accumulate more wealth. and open an account. 1. Your family and other loved ones can also benefit from it. The plan is not only for you. but $500 is enough to get started. or Scottrade. 2. think about a bond mutual fund and even a gold and precious metal ETF. 3. People often make the mistake of thinking they need lots of money to do this. 4. It is quick and easy and you can accomplish everything online. like Charles Schwab. It can be $50 or it can be more. begin investing with an index mutual fund or a sector ETF. . SECTION B: CREDIT . . We can “charge” things way beyond what we can afford. in order to obtain the item you need. It holds value to us simply because we all agree that it does. Banking in a Different Culture I grew up in a country where credit was shunned. game scores are analyzed in excruciating detail. the first metal coins were born. My father would go to the bank every Monday morning. these coins evolved into the paper money we use today. there is much heated discussion and debate about sports and current affairs. 155 . but can also be a very dangerous one. The earliest transactions were performed in a barter system— when one good was exchanged for another good perceived to have equal value. and also happens to want what you are able to offer in exchange. The bank itself was located in a high-ceilinged British colonial style building with large windows and ceiling fans that would creak and rotate ponderously. From this.” In other words. The problem with this system was it required a “coincidence of wants. Finally. How safe are these loans? --Mike Milken The evolution of commerce throughout humanity is a fascinating topic that spans thousands of years. Next. like gold and silver. In fact. with a very few made with checks. Eventually. he would set out for the bank. I would get to accompany him. all transactions were made in cash. These coins were made out of precious metals. Eventually. you must find someone who has that item. This is a powerful tool. people began to use small items. he would carefully make a list of how much he would need for the week. People soon realized that a better system was needed. He would make sure to dress nicely. During cricket season (cricket is similar to baseball and is played in the commonwealth countries).9 Consumer Credit What is a bank? It is nothing more than a bunch of loans. Before that. growing up. The interesting thing about paper currency is that it has no intrinsic value. It was an event. Traditionally. banking in India is a leisurely business and does not get going until about noon. The latest innovation in the evolution of currency is plastic—credit cards. we did not have credit cards. is willing to exchange it. If I was lucky and had no school. Carrying debt was considered shameful. such as shells and pieces of metal that were thought to have inherent value. as currency. In return for the better draft posiiont. For one. The NFL Draft and Credit Even NFL teams use a form of credit to trade draft picks with one another. our number would finally be called and my dad and I would head to the metal cage. However. from arrival to departure. Fast-Forward to the Present: Why Do We Need Credit? There are several primary reasons for using credit. after which all transactions were final. and my dad would greet and exchange pleasantries with the employees of the bank and neighbors and friends who were also there to do their banking. Once she had counted and double-checked the amount. my dad’s name would be called and he would receive a metal token with a number. There was only a small window of opportunity to spot any mistakes. there are nineteen other teams picking ahead of them. Through all this hustle and bustle. she handed it back to my father. green. my father would methodically fill out the paperwork with his fountain pen and then turn it into one of the metal cages behind which most of the banking business would be carried out. The team knows that if they simply wait until their turn to pick. She would meticulously count out the money. The banking operation itself. We would now move over to another section of the floor near a second set of metal cages where the actual financial transaction would occur. frequently moistening her fingers on a sponge so as to be able to rifle quickly through the stack of bills. This is a heavy price to pay for one athlete who may or may not work out! . Going to the bank was like going to a social club. we would commence another round of waiting. They want a particular player who they know will help them build their team in the near future.156 Chapter Nine weighed down with age and dust accumulated through the years. After the withdrawal forms had been submitted. The clerks would methodically enter the request for withdrawal in one of the large. there is no chance they will get the athlete they want. after what seemed like an eternity.” It allows us to purchase the things we need and want now and pay for them later. Letʼs assume that a particular sports franchise has the twentieth pick in the draft. A dozen or so chaprasis (waiters) would be bustling around carrying tea and snacks on trays to various rooms and cubicles around the large floor. I was not quite tall enough to see past the counters and metal bars of the cages but. who would then carefully count through the notes to make sure he had received the correct amount before leaving. standing on tiptoes. would take almost two hours. some of which also want this particular athlete. So what should they do? The team may make a deal with another team picking ahead of them. the team will surrender its second and third round picks to the other team and maybe even a first round pick in the next draft. Economists call that “shifting consumption from the future to the present. After more social chit-chatting. leather-bound ledgers. you don’t have to pay cash for large purchases. It was a time-consuming process and. I could just see the teller’s desk under the metal structure with a small opening for transactions. If used improperly.” Is there a rational economic explanation for this paradox? A study done by the Federal Reserve found Critical Info: Who Has Credit Cards? . credit can be instrumental in helping you achieve your personal financial goals. Researchers have shown that households tend to carry high-interest credit card debt while simultaneously holding liquid assets in low-interest accounts. is about $3. credit is a powerful tool but it should be used with caution. Whatever you borrow today will need to be paid back with interest in the near to intermediate future. serves as a signal Studies show that bank-issued credit cards of wealth. You can also use credit for investment purposes. Impulse purchases using your credit cards should also be kept to a minimum.000 a year to become eligilikely to be either under thirty-five or over ble for a Black card). The American Express Black card. Credit Use in the United States Americans have been using credit cards more and more in the last few decades. which is far greater than the returns usually earned on investment assets. In essence. there are certain things credit should not be routinely used for.400. you could borrow money from your broker to buy stocks—the practice known as “buying on margin. paying off their bills in full every month and are known as “credit revolvers. such as savings accounts.” conducted by the incomes are less likely to hold credit cards— Federal Reserve Bank of Boston. we are rewarded for are more likely to be held by married and spending money (one needs to charge highly-educated households with higher incomes. The median interest paid on credit cards is around 13 percent. The heads of these households are more than $250. While credit can help you buy that house you have always wanted or that car you need. By contrast. A majority have credit cards are likely to use them for of the households with credit cards are not revolving credit. however. credit can cause real problems. These things include routine household expenses or unnecessary expenditures.Consumer Credit 157 You can also use credit in financial emergencies if you run out of cash and absolutely need something. according to the survey. If you charge these things and do not pay your entire credit card balance in full at the end of each month.” The credit card companies love these people because they make money in interest when cardholders maintain balances. younger and According to the “Survey of Consumer less-educated households with lower Payment Choice. sixty-five years old. ” If used properly. Credit cards have even turned into a kind of status symbol. 78 percent although a higher percentage of those who do of Americans own a credit card. The reported credit card debt appears to be sizable: the mean outstanding credit card balance. For example. This is known as the “household debt paradox. the interest charged will cause your balance to quickly grow and become unmanageable. To summarize. for example. mermarket his music directly to his fans and cut out chandise/retail. the music distributors in the middle. It receive it.their credit cards. suppose we buy an item novel concept. in fact. and Did you know that rock star David Bowie simplified record keeping (you get opened his own online bank in 2000 known as Bowiebanc. This is how credit cards work. payments and credits. normally made simultaneously. like rebates we may get for flying certain airlines. the superstarʼs image. (“micro payments”) will exceed $11 billion in Another explanation of the existence of the debt paradox lies with the notion that the U. Each borrower has a maximum amount she can borrow. in which credit is extended to the borrower in advance of any transaction. etc. and other services.S. may not actually be simultaneous if credit cards are a factor. credit card dispute line. Usually banks issue these credit cards. Customers of Bowiebanc. patronizing certain restaurants. aware of the interest rates on their credit cards.com neatly categorized into categories like were issued checks and bank cards bearing gas/automotive. or shopping in certain stores. then high-interest credit card debt and low-interest asset accounts could easily coexist. If the savings decisions and the consumption decisions are made by different members of the household (say the savings decisions are made by the wife while the husband uses the credit cards to decide how much to consume). restaurants. Now the trend is to put all your into bankruptcy-exempt assets (like hous. and services). like airplane tickets. A market research ing and automobiles) before declaring firm estimates that such small payments bankruptcy in order to protect those assets. also known as the credit limit. and the line of credit extended depends on the applicant’s financial status and his ability to pay. applicured debt while converting liquid assets ances. in the next few years.com? It was the Internetʼs first primonthly statements with your charges vate-abel bank. interest-free loan (it is only interest-free if we pay off our entire balance at the end of each billing cycle).purchases on your credit cards. They will take up Fun Facts: David Bowie and Credit .158 Chapter Nine that American credit card holders are. The advantages of credit cards include a short-term. It is argued that households Consumers used to charge big ticket items on contemplating bankruptcy may use unse. All we have to do is call the closed soon after. Credit Fact How Credit Cards Work One type of credit is Open Account Credit. Other features that come with credit cards include cash advances (which are not a good deal because of the high interest rates). Usually interest on the amount borrowed (or charged) can be avoided by paying back the full amount charged at the end of each billing cycle. the bank was soon saddled from a questionable source. Although a Additionally. It gave him a platform to home improvement. including those of just a few dollars. and we don’t with growing debt and fell out of favor with the think the item is adequate once we Federal Reserve (Americaʼs Central Bank). an individual’s saving and consumption decisions. . in itself. due to intense competition among the various credit card companies for essentially the same pool of potential card holders. he is able to evaluate your credit-worthiness compared to the entire pool of potential borrowers. This allows him to determine the likelihood that you will pay back the loan. you get reported to the credit bureaus (thereby badly damaging your ability to get loans from banks and other financial institutions). competition has gotten so intense. What do they look for specifically? They want to know how you have handled past loans. Recently.Consumer Credit 159 the dispute on our behalf and give us credit for the merchandise until the dispute is resolved. because everyone has a credit score measured on the same scale. When a lender looks at your credit score. which is calculated using the Fair Isaac and Company (FICO) credit scoring model. Now that we have covered the advantages of using credit cards. That signals to potential lenders that you are trustworthy and opens many doors for you. You want to have the highest possible credit score at all times. it will trigger the default interest rate. which usually is 30–35 percent). How Lenders Use Your Credit Score Credit bureaus use the information in your credit history to assign you a credit score. the greater are your chances of getting a loan. under favorable terms. If you overspend and are unable to make your payments. and MCI fought with each other in the late 1990s. But what if you have no credit history? It is very important to get one. This will build your credit profile and allow you get other loans that you really need. making sure you make every payment on time. Sprint. I would not be surprised if they started offering cash incentives to consumers to switch from one card to another— kind of like the long distance telephone battles that AT&T. this information comprises your credit history. Chances are that it will be resolved in our favor since most of these questionable merchants back down when faced with the credit card company’s legal team. and your credit card balance keeps growing exponentially due to the high interest rates (if you miss a payment. One relatively easy way is to take out a loan secured by money in your savings account and pay it back over the course of the next 12–18 months. let’s move on to the disadvantages. For one. credit cards have been reinvented as a multipurpose tool designed to help the cardholder in a number of different areas of his life. In fact. a disadvantage because it can lead to serious overspending. . The more confidence potential lenders have in your ability to pay their money back. The Importance of Your Credit History What do you think lenders are looking for when they are trying to decide whether to give you money? The simple answer: whether you will be able to pay back the principal plus interest. the convenience of using a credit card is. 160 Chapter Nine Your Credit Report: Make Sure You Know Its Contents The contents of your credit report. The Public Records section is one you want to be blank. the date you opened the account. each credit account you have had will be listed.com). social security number. In the report from Experian. In the Credit History section. employer. driver’s license numbers. which determines your credit score. It can affect your education. It may tell a college if you’re a good candidate for student financial assistance programs. Information in this section will include your name. and inquiries.” If the account is sent for internal collection or charged off as a bad loan. paid. In reality. potential employers. but some companies are more prominent in certain geographic areas and thus may receive reports on your credit status from different. This section lists everyone who has asked to see your report. For each account. how much of the loan you still owe. for example. the highest balance on the card. the status of the account (whether it is open.tuc. It typically lists financial data like bankruptcies.com).). Anything here is bad news.equifax. public records. will all appear on your report. Your credit report is used by not only lenders but also by insurers. those will each be listed. how well you have serviced the account. telephone numbers. the fourth section is Inquiries. and tax liens. Experian (www. your credit report may be checked as a character reference. such as “never pays late. You need to examine this section to ensure that it is accurate. the kind of credit it is (such as a mortgage or a car loan. affect more than your financial life. Typically.” or “typically pays thirty days late. and will sometimes reach very different conclusions. If you’re applying for a job.experian. date of birth. the fixed monthly payments. Finally. the three companies may end up having different subsets of your credit profile. including the creditor’s name and a scrambled version of the account number for security reasons. etc. The Identifying Information section provides information to identify you.com). Your report affects the rate you will pay on everything from life insurance to homeowner’s insurance. credit history. all three bureaus have the same information. Reports from other credit bureaus usually use payment codes ranging from 1 to 9. Your credit report is made up of four sections: identifying information. judgments. And couples planning to apply jointly for mortgages may face a rude relationship shock if one partner has kept his or her past credit problems a secret. Inquiries are divided into two categories: hard inquiries and soft . and spouse’s name. whether the account is in your name or jointly held. it will also be indicated. the total amount of the loan. inactive. how you have handled the account is expressed in simple terms. If you have multiple accounts with a creditor. current and previous addresses. local merchants. and TransUnion (www. career. and most importantly. and even your love life. and even some educational institutions. closed. Three major credit reporting bureaus keep track of the credit reports of millions of Americans: Equifax (www. or a revolving loan like department store credit). where 1 indicates good payment history and 9 indicates very bad payment history. a bankruptcy (and related information) stays on your report for ten years. But lenders often take an interest in your most recent payment patterns. You may have heard that too many inquiries into your account could have a negative impact on your credit score. even after a bankruptcy. The merchant then has thirty days to respond. you have the right to see your credit report to make sure it is complete and correct—your report is no longer the hazy record it has been in the past. A vast majority are innocuous and do not affect your score in any significant way. Also. Most negative information stays on your credit report for seven years. For the more serious errors. Hence. The model also counts two or more hard inquiries during a fourteen-day window as only one inquiry. Thanks to amendments to the Fair Credit Reporting Act which that into effect September 30. after investigation. as well as the credit bureau. is not generated until someone—either an authorized user. there is a thirty-day (or so) buffer where multiple auto loan and mortgage inquiries are not counted. and the model will only count one for the purposes of determining your credit score. say. The amended Fair Credit Reporting Act shifts responsibility to the retailers and lenders who provide credit information to ensure that the information they provide is accurate. So. By some estimates. a savings deposit at the issuing institution) and make regular and on-time payments. Hard inquiries are the ones you initiate by filling out a loan application form. you could have thirty such inquiries over this period. your credit report and. or you—requests a look at it. If. you can rebuild your credit without waiting seven or ten years. if you can get a secured credit card (credit that has collateral. 1997. . Rather. you still dispute an item on your credit report.Consumer Credit 161 inquiries. Only hard inquiries show up on your report. as many as 80 percent of all credit reports have errors. This is not totally accurate! The vast majority of inquiries are ignored by the FICO credit scoring model. by extension. or from current creditors monitoring your account to determine if your perceived risk has increased (or decreased). If you’ve been the victim of “identity theft”—someone has falsely used your name and Social Security number to open accounts—the credit bureau will “flag” your name and stop new accounts from being opened. realize that only the initiating merchant can make the correction. like a credit-granting merchant. If you see incorrect information on your credit report— such as an account that was closed in bad standing or one you never opened—you should contact the merchant immediately. Soft inquiries are from companies that want to send out promotional materials to a pre-qualified group of people. Understand that your score is not being generated every day of your life. there are steps consumers can take to avoid fraudulent reports and damaged credit ratings. but you can initiate a dispute with the merchant by contacting the credit bureau. you have the right to post a short explanatory statement that will be sent to anyone requesting the report. They will contact the merchant in order to resolve your problem. your credit score. For example. Fair Isaac and Company. two people with the same credit score might apply for a mortgage with the same lender. veil of secrecy is being lifted—in part due to Only about 13 percent of the surveyed popuconsiderable prodding by consumer groups lation rank above 800. Now. the scoring process has become so sophisticated that at least 75 percent of all mortgage lending approvals are based in part on a FICO score. while the other only needs a $150. One applicant has a 20 percent down payment. But.S. If your and by Congress. is 723. All of the information used to create your FICO score is drawn from your credit report.162 Chapter Nine How Do You Score? Your credit score is very important and you will be judged by it in all sorts of transactions. Or. score is below 620. a complicated analysis of the patterns of your financial life. is working with Equifax to make the data available. But while your credit report is a fairly straightforward compilation of your payment history on all credit accounts. your credit score is. Over the past twenty-five years. you are in the bottom 20 the California company that originally develpercent of the population. about 20 percent of the population rank between 740 and 780. so if you make a mistake and miss a payment. while the other is planning to put only 10 percent down. While your credit report is a direct reflection of your financial activities. Fair Isaac and Company created FICO scores to help lenders gauge the likelihood of a loan being repaid. One important thing to understand is that your credit score changes relatively infrequently and checking your credit score about once a year is more than sufficient for most people. Payment history carries the most weight in determining your credit score (about 35 percent). along with your rights and your ability to affect the information in them. even though you don’t have identical credit histories. If you cannot make payments. the calculation of this number was FICO credit scores range from 300 to 850. one is applying for a jumbo mortgage. There are new ways to check on your financial status—and to protect (or improve) it. Your credit score could be exactly the same as your neighbor’s. a highly guarded secret. Here is the most important message: Critical Info Pay Your Bills on Time! Any negative statements associated with missed bill payments will show up in your credit report for around seven years. FICO scores and online credit reports are now widely available to consumers. Your credit score is only one of the factors considered when you apply for a loan. Those additional factors will affect the loan decision. For years. For example. make . oped the credit scoring model. But first you must understand these reports. however. be sure to pay your bills on time from then on.000 loan. newer information carries more weight than older information. the FICO score is calculated with a complicated algorithm that evaluates many factors from your credit report in different weights. as we’ve said. the The median FICO score in the U. closing some of these accounts might prevent you from getting some of the loans that you want. ly opened accounts first. You want to keep your debt to credit ratio below 50 percent. and When you close your unused credit card should ideally aim for about 30 percent usage. However. not a loan. What determines how much credit is too much for you? Closing a lot of credit accounts in good standing with no balances will not raise your credit score. The conundrum is that sometimes you may have to lower your scores in order to be an attractive loan recipient.Consumer Credit 163 sure you talk to your creditors. representing 15 percent of your score. which could lower good idea to close unused credit accounts— your credit score in the short run. which improves your chances of getting these loans—but it lowers your scores too! The amount you owe counts for about 30 percent of your score. length of payThe length of credit history is important. How much of your available credit is being used is important too. New credit accounts have a 10 percent weight in the calculation of your credit score. be sure you close the more recentthe remaining 10 percent. closing them may actually help you qualify for a mortgage or a car loan from a bank. But there is the interesting conundrum regarding closing credit accounts that you are not using. If you amounts owed gets 30 percent. accounts. even if unused. This is because an open credit account. The most effective way to increase your credit score is to pay down your revolving debt and stop carrying balances on your cards. Carrying a large balance on your credit cards does not necessarily mean a low score as long as these accounts are in good standing. as I have said above. about a 35 percent weight. and which types of credit you have in use also accounts for 10 percent of the score. But it doing so will cause your debt-to-credit ratio to could also increase your chances of getting increase. Negotiating with creditors will improve FICO scores consider five main categories your scores in the long run if you are able to for scoring purposes: payment history has even partially remedy the situation. you are raising your credit used That is another reason why it may not be a to credit available ratio. Closing these accounts lowers your ratio. A good way to avoid this problem is to abstain from opening too many credit accounts in the first place. Closing unused credit accounts is really a double-edged sword. new credit have to close credit accounts you may not gets 10 percent. But it certainly implies an increased risk of loan default. but your credit score does take into account how much you owe on installment loans (secured) versus credit card loans (unsecured). opening a number of new credit cards just to increase your available credit is not a good idea either. and types of credit gets be using. While closing unused credit accounts will not increase your score. ment history has a 15 percent weight. Critical Info Credit Conundrum . represents potential debt and raises your debt-to-assets ratio. Don’t ignore it and hope it will go away—it won’t. While closing some of them will lead to a reduction in your credit score. and may cause loan officers to hesitate to extend further credit to you. You can compare the terms of different credit cards on websites such as http://cardweb. in connection with a credit or insurance transaction that is not initiated by the consumer by notifying the agency . We consumers are the net beneficiaries as long as we are careful of the traps.164 Chapter Nine All three credit rating agencies compute their own scores using FICO model.com or http://CreditCards. credit cards are a competitive business and companies are fighting over the same segment of the population. That zero percent interest rate can go away in an instant because of something as simple as an inquiry about a car loan. . and no more. Credit card companies have gotten smarter and more bold over the years. Each consumer reporting agency that compiles and maintains files on consumers on a nationwide basis shall establish and maintain a notification system . . Recall that different companies can have different information available about your credit accounts. . plug it in the formula and calculate exactly what it would do to our credit score. and each score can be different. the exact formula is unknown.” has helped consumers avoid the onslaught of unsolicited credit card offers. . on the other hand. . Can you guess why? If we all knew the exact formula. We would know exactly what to do to have a great credit score and would do only as much as it takes to accomplish this. the exact formula used to calculate the final score is still a closely guarded secret. that the consumer does not consent to any use of a consumer report relating to the consumer in connection with any credit or insurance transaction that is not initiated by the consumer. . You don’t even have to buy the car.com. In fact. or known only in general terms. Most lenders look at all three scores and take the middle score (median) as representative. there is research suggesting that relatively vague contracting terms will actually elicit extra effort on the part of one or both parties. “Election of Consumer to Be Excluded from Lists. Under this amendment: “A consumer may elect to have the consumerʼs name and address excluded from any list provided by a consumer reporting agency . we could take every good (or bad) debt. but buried in fine print somewhere in the back of your agreement form are the details about what will trigger the default interest rate (about 30–35 percent) if your “perceived” credit risk goes up. jointly with other such consumer reporting agencies. in contract theory. then we have an incentive to work over and beyond what we may have normally done. . mere inquiry is sufficient for them to conclude you are a higher risk and put the default rate into effect. as discussed above. § 1681e of the FCRA. If. They will lure you in with promises of 0 percent rates. The credit bureaus Critical Info Amendment Section 604. Even though we know the categories and the overall weights of each category. The Invasion of the Credit Cards These days. . What if you want to end the flood of prescreened credit card offers? The three main credit bureaus in the United States have established a system that allows consumers to remove themselves from all prescreened credit offer lists. .” . Removal from these lists is effective for two years after the request is made. But do not close all of your credit accounts. In the backwards world of credit card companies. it might be necessary to get rid of the cards altogether. well beyond the useful life of the item they were charging in the first Hereʼs a general rule of thumb for the use of place.” But then the government started getting concerned. it will hurt those that are already having trouble making payments. but it will take initiative on your part. Here are some relatively achievable ways to repair your damaged credit and get out of debt: 1. of course. . While this will generally help consumers (it requires that we pay down some of the principal every month). Lock your cards away. because they could make a huge the credit payments! amount of money in interest payments from them. must cover all interest and fees incurred within the month. The credit card companies were increasingly focusing their attention on the high-risk segment of society. Credit card companies loved these credit: the product purchased should outlive customers. Customers’ minimum payments were often less than the finance charges for that month. The new minimum payments more debt accumulating on your credit cards. and millions of Americans embraced this seemingly affordable source of credit. That is a case-by-case decision. if self-control is a problem for you. you may need a couple of those credit cards—to be used judiciously. these customers are known as “deadbeats. which meant they would be paying off their credit card bills far in the future. often the most vulnerable and least educated. You can fix it. credit card companies set the minimum required payments due at the end of each billing cycle very low (2 percent of their outstanding balance) in order to encourage Americans to use their credit cards more. However. New Rules to Increase the Minimum Payments on Your Credit Card Balance Early on. This ploy worked. and at least 1 percent of the principal balance (which generally amounts to 4 percent total). If your credit rating has taken a nosedive. The government decided to enforce an advisory forcing banks to increase the minimum payments from 2 percent to about 4 A lower mandatory monthly payment equals percent. because they do not earn interest payments from these cardholders. Caution Caution Eleven Ways to Repair Credit and Pay Back Credit Card Debt If you have gotten into debt trouble.Consumer Credit 165 each have extensive websites that explain marketing list opt-outs and how to request them. They don’t like people who pay off their balances each month. you cannot ignore it and hope it goes away. and you can take your time repaying the loan. Do you own your own home and have equity that’s accumulated through the years as you’ve paid off the mortgage? If so. Examine all your credit cards to find the one with the lowest interest rate. Examine your normal expenses. however. the outstanding balance plus interest will be deducted from the face value of the policy payable to the beneficiary. Budget in order to figure out where you stand. Break the habit of only paying the minimum required each month because paying the minimum only prolongs the agony.63 Try to double your minimum payment if you can. in interest payments and enable you to get out from under your debt. which will even further reduce your interest rate. You could use the cash in your savings and investment with excessive debt appear to have accounts for debt repayment. consider a home equity line (HEL) of credit for the maximum amount you can get to pay off your credit card balance. most homeowners itemize on their income tax returns. Don’t fall into the trap of the household debt paradox! 6. 4. Use the money in these accounts to pay down your debt. you use the loan proceeds to pay down your debt. . The interest rate will be close to secured interest rates (well below credit card interest rates). reducing the interest rate you are paying on your debt significantly. Move your balances to a lower-interest card. Give up happy hour. if not thousands. You may be able to squeeze out higher payments by cutting corners elsewhere. 3. you may want to consider borrowing against the policy. For example. stop going out to lunch everyday. If you happen to die before it’s repaid. Eliminate those trips to Starbucks. and then repeats the strategy after the introductory rate expires. Do you have life insurance that has a cash value? If so. Second. but you need to see the cold hard facts on paper before planning your battle. transfer your balance to that card if you have to. A lot of young people burdened 5. Borrow from friends or loved ones if you need to. You are losing become quite proficient at flipping. You will want to make sure that it is repaid. See if you can get a home-equity loan. Those increased payments will save you hundreds. You have to know your starting point in order to chart your destination. in most circumstances. 7. If you have a card that still has very low introductory rates. more money in interest charges on your credit cards than you are making in interest payments on your savings or returns on your investments. bring it from home instead. And it plays right into their hands since you pay huge amounts in fees. Cash in your savings account. Borrow against your life insurance. Doing this enables you to kill two birds with one stone. First. It may not be fun. HEL interest. and watch for other similar deals when that introductory rate expires. Pay more than the minimum.166 Chapter Nine 2. is a tax deductible item. Loan Flipping Loan flipping is one way of managing excessive debt where the borrower moves the loan balance from a higher interest-bearing account to a lower introductory rate. Tell them you’ve done all you can. there are organizations that can do it for you.000). You are entitled to add information presenting your side of the dispute if you feel this will help you with potential lenders who will be reading your file. the absolute last resort is bankruptcy. 10. Take advantage of them.64 See the “Word of Warning about Borrowing from Your 401(k)” section in Chapter 12 of this book.500 to $3. 9.000. Faced with the prospect that you may resort to such a drastic step (game theorists call this a “credible threat”) creditors will do what they can to protect themselves against a total loss. While this sounds like a great option. Your credit report could be damaging to you as much by the information that is omitted as by the negative information that is found there. Regulations permit you to write a letter of up to one hundred words regarding any credit dispute. thus ensuring that you will have a tough time obtaining affordable credit during that period. Interest rates usually are a point or two above prime. if necessary. Nonprofit organizations like the Consumer Credit Counseling Services (CCCS). And if you don’t wish to do this yourself. and the fact that filing for bankruptcy costs money that you don’t have (anywhere from $1.Consumer Credit 167 8. Every dime in interest paid on a 401(k) loan goes directly into the borrower’s 401(k) account. not into the lender’s. your credit record will contain this information for ten years. which usually makes them significantly cheaper than those found on credit cards. exist in all major cities in the United States. and the agency must provide this information to any creditors who ask for your report. there are some serious drawbacks. funded by the credit card issuers. whichever is smaller. . If you decide you can’t pay down your debt using any of the methods listed above. you are essentially borrowing money from yourself. Ask for a new and lower repayment schedule. and appeal to their desire to receive payment. It is certainly worth a shot. which further acts to your benefit. Thus. file for bankruptcy. Do you participate in a 401(k) qualified retirement plan at work? Most 401(k) plans have a loan feature that lets you borrow up to 50 percent of the account’s value or $50. Renegotiate the terms of your loan with your creditors. you may have no other recourse but to declare bankruptcy. However. request a lower interest rate. Add pertinent information to your credit file. Not only is the interest typically much lower than that on credit cards. Look into borrowing from your 401(k). Apart from the fact that bankruptcy filing (especially under Chapter 7) has become considerably more difficult (more on this in the next section). 11. If all else fails. 401(k) plan loans may be a smart solution to debt repayment. there are significant drawbacks to using this avenue of relief. Tell them that if you are unable to renegotiate terms. and you should carefully consider them before you borrow from your 401(k). Bush quickly lowed by Ohio at 2.9 be responsible for repaying a part of their families filing for every 100 households. The court approves a repayment plan based on your financial resources that provides for repayment of all or part of your debt over a threeto five-year period. However. Florida. Some states. child support. Other states—like Texas.S. your creditors may not harass you for repayment. where a portion of ones debts must be paid off within three to five years. Filers are also be required to pay for credit counseling for six months before actually filing for bankruptcy. legal judgments against the petitioner. if approved Source: Weston. Kansas. Can you keep your house or car? It depends on your state of residency. the Republican-controlled Senate. Most bankruptcy courts understand you need your car to get to work and to help you get back on your feet. sometimes called the “wage-earner plan. Liz Pulliam. If the car worth $12. student loans. households. President George W. like Arizona.000 over five years will now be forced to file under Chapter 13. it was the job of a Federal bankruptcy South Carolina has the lowest consumer court judge to determine if people had to pay bankruptcy filings at 0. taxes. and Iowa—have unlimited homestead exemptions. loans obtained using false financial statements. At the other end of the spectrum.000 on it.000 and you owe $10. you emerge debt free. can still file under Chapter 7 and. Under Chapter 13. and student loans. about 1 out of every 60 households Act (BAPCPA). During that time. passed the Bankruptcy Abuse Prevention and Consumer Protection In 2005.” is different. alimony. foldebts. Those that arenʼt discharged are alimony. Concerning cars. will not be wiped out Bankruptcy Filing Statistics Critical Info: Types of Consumer Bankruptcies There are two types of personal bankruptcy relief: Chapter 7 and Chapter 13. of their debts. Under the new law. . followed by Alaska.168 Chapter Nine The Bankruptcy Abuse Prevention and Consumer Protection Act In March of 2005. MSN Money. like child support.000. Vermont. and Hawaii. clean after certain assets are surrendered. While Chapter 7 relieves you of the responsibility of repaying most creditors. or part. the crucial difference is that bankruptcy filers with incomes higher than their particular state’s median income and who can pay at least $6. you keep your property but surrender control of your finances to the bankruptcy court. like $150. can still wipe their debt slates soaring again.81 families per 100 all. Indiana tops the list at 2. sidestepping a flurry of last minute Democratic challenges. and taxes.53 families. Before passage of this 2. bill. Bankruptcy filings by the judge. the low-income people and those with few assets District of Columbia. bankruptcy filers have to calculate their equity in the car from a reliable source (like Kelly Blue Book) and subtract the amount they owe. Chapter 7 is straight bankruptcy that allows the discharge of almost all debts. which requires more people filed for bankruptcy protection in the U. have a homestead exemption of a certain dollar value. When all conditions of the court-approved plan have been fulfilled. it is likely you will be able to keep it.69 families. Certain types of debts. loans not listed in the bankruptcy petition. ON who file for personal bankruptcy protection to a per-state basis. you may also have to surrender much of the property you own to help satisfy the debt. Chapter 13. and Utah at signed the bill into law. You also do not incur interest charges on your debt. You may be stuck with unlimited liability for losses should you fail to report the theft within a certain period of time (anywhere from two to sixty days). who are now more likely to get repaid. secured credit cards also look like standard credit cards. Debit cards withdraw money directly from your checking account.000 per day. If you are in big trouble with your credit. CCCS will help develop a debt repayment plan based on your overall debts and income for a reasonable monthly fee. (Customers usually have a $50 maximum liability with most credit cards. Some charge nonrefundable fees to apply for the card. Credit Counseling There are many organizations that can help you get out of debt.) Consumers recently raised a stink about this. . Stay away from such deals unless you are desperate. When you use a debit card. you may be charged a fee every time you use your debit card. he has complete access to your checking account. even if your checking account has more cash. For instance. It promotes itself as a nonprofit debt counseling service and has provided much-needed advice to those in serious debt. When a thief has your debit card. they can be responsible for up to $500 in fraudulent debit card charges. as long as the loss is reported promptly. you will be penalized with overdraft fees. supporters of this law include credit card companies. Many debit cards limit the amount you may purchase on the card to $1. services. Otherwise. read the fine print and make sure your lender offers you the same protections as those of a standard credit card. there is no grace period. Also. It is estimated that between 4 and 20 percent of those who would be eligible to file under Chapter 7 before the BAPCPA would be disqualified under the new law. The best known nationwide credit counseling service is the CCCS (Consumer Credit Counseling Service). debit cards may not offer the same rights consumers have with credit cards regarding disputing purchases. and other retailers. you pay for purchases immediately. But be aware that debit cards don’t always offer the same conveniences. and debit card issuers like Visa and MasterCard have made moves to improve security and liability. Using a debit card can keep you within your means. As I mentioned earlier. Say your debit card is stolen. but they work very differently. Still. and protections as conventional credit cards. The Look-Alikes: Debit Cards Debit cards may look just like conventional credit cards.Consumer Credit 169 under any circumstances. If you spend more with your debit card than you have in your account. Depending on your bank’s policies. you are paying with cash. They let consumers with shaky credit histories deposit money into an account and then extend credit of anywhere from 50 percent to 100 percent of the deposit amount. Not surprisingly. banks. and the agency won’t issue a new Social Security number unless it can be proven that an individual is being harmed because someone has improperly used . contact the credit bureau directly to have it changed. Summary What You Can Do to Protect Yourself against Identity Theft Abstain from giving out your Social Security number and any personal information to any organization that you don’t trust. continue to be in the same bad situation. Never sign up for such offers! you find information on your credit report that They will take your money and you will is outdated or inaccurate. The debt repayment plans they peddle encourage customers to turn over their paychecks each month for CCCS to dole out among creditors. Social Security officials cannot help straighten out damaged credit histories. If front fee. If you do sign up for a debt repayment plan from CCCS or any other organization.170 Chapter Nine CCCS then contacts your creditors on your behalf and gets them to lower monthly payment requirements and either lower interest rates or do away with them altogether.” which offers tips on how to protect the data. but never hand over control of your monthly income. you may find it exceedingly difficult to get all of them to lower interest rates or to work out an acceptable payment schedule. That’s where the services of CCCS can come in handy. In many instances you can negotiate lower rates on your own. it can show up as uncollected debt on your credit report for seven There are only two things that will improve a years—a flag almost as bad as bankruptcy. Should you renege on the plan. The agency’s website also features a page called “When Someone Misuses Your Number. Critics of the CCCS system allege that the organization is more concerned with getting the creditor paid off quickly than ensuring that the debtor has enough monthly income on which to live. One compromise is to listen to their advice.rate. credit repair clinics. It has relationships with nearly all unsecured creditors and can usually negotiate lower rates. bad credit record: time and re-established CCCS and other organizations like it credit. Debt doctors. the Social Security Administration’s Office of the Inspector General has issued an alert. The organization decides who to pay and how much. how to tell if it has been stolen. However. adapt it to your needs. and develop debt repayment programs. It is far cheaper for them to negotiate with you through CCCS than for them to hire expensive lawyers and take you to court. CCCS is funded by credit card issuers for one important reason: creditors don’t want you to declare bankruptcy and default on the debt altogether. Other such organizations cannot remove negative companies are out there that offer to repair information from your credit report if it is accuyour credit rating—usually for a large up. no matter how much you pay them. and what to do if it has. follow through. But if your creditors number in the double digits. warning people about the dangers of disclosing their Social Security numbers without verification. Concerned by the potential for fraud. or other identifying information) is a growing problem.Consumer Credit 171 Caution! Identity theft (when a thief opens a credit account with your name. contact them by telephone immediately to report the e-mail. consumers cannot be held responsible for more than $50 if they are the victims of fraud and report the theft promptly. insurance forms. we all ultimately pay with higher fees and interest rates. goods. tear them up when you don’t need them anymore. Consumers can also take steps to monitor whether their Social Security number has been obtained or their identity stolen. they linked millions of people to retirement and disability benefits. However. Because of their growing importance. or services. a great deal of identity theft still occurs by low-tech means. Make sure it’s accurate and includes only accounts you’ve authorized. • Order a copy of your credit report from the three major credit reporting agencies every year. expired charge cards. The Federal Trade Commission’s website urges the following steps: • Never respond to e-mails or other online solicitations that claim to need your Social Security number or other sensitive information to “verify” anything. The new credit card is delivered and maxed out. bank checks and statements. and How Social Security Numbers Play a Big Role in Web Identity Theft When Social Security numbers were first used in 1936. banking. copies of credit applications. In recent years. and you may never know about it until you get bills for things you never bought or a loan is denied due to unpaid credit card bills. health care. employment. Law enforcement agencies and credit bureaus are just beginning to grasp the extent of this type of fraud. such as stealing traditional mail or dumpster diving—thieves digging through your trash looking for discarded insurance or financial account statements that may contain Social Security numbers. Follow up with creditors if bills don’t arrive on time. In addition to hackers stealing Social Security numbers online. Make sure charge receipts. online hackers have increasingly focused their energies on obtaining Social Security numbers. their Social Security number. Social Security number. etc. Provide this information online only when absolutely necessary. • Keep items with personal information in a safe place. . If you do business with the organization in question. One way this happens is the thief puts his own address on the “special offer” you threw in the trash and sends it in. those nine-digit numbers have become universal identifiers for the purposes of taxes. which allow them to open fraudulent accounts in the victimʼs name in order to steal money. however. and government websites. • Pay attention to your billing cycles and use online accounts to track your spending. medical benefits. • Ask to use digits or alphanumeric characters other than your Social Security number to access account information on financial. financial accounts. By law. It is a good idea to purchase an inexpensive personal shredder for any documents that contain your personal informaiton. but the National Fraud Information Center says it costs financial institutions over a billion dollars a year. each bill will contain a date by which the next periodic payment in the account will need to be paid to avoid being considered a late payment. or thirty-six months. 2009. 2. . and the monthly payments required to pay off the entire balance in twelve. a credit card issuer is not allowed to increase the APR unless: 1. • A written payment warning will be included in every statement that states: “Making the minimum payment will increase the interest you pay and the time it takes to repay your balance. The credit card lobby fought hard to prevent it from passing. bringing some much needed relief to consumers. The Credit Card Accountability. 3. Under this act.172 Chapter Nine credit offers you get in the mail are disposed of properly. the billing statement will also include repayment information including the number of months it would take and the total cost to the customer to pay the entire balance if the customer makes minimum payments and no further charges are made. You may want to consider purchasing an inexpensive home-office paper shredder. Additionally. The increase is due solely to the fact that a consumer’s minimum payment has not been received within thirty days after the due date. but did not succeed. • At least twenty-one days of grace period will have to be provided by the issuer before payment is due for the current billing cycle. The increase results from a failure on the part of the consumer to comply with a negotiated payment plan. twenty-four. and became effective on February 22. and Disclosure (CARD) Act of 2009 The Credit CARD Act of 2009 was signed into law on May 22. Responsibility.” • At least once every three months. The following provisions are also included: • Any increases in the APR can only take place after the issuer has provided a written notice at least forty-five days before the change takes effect. 4. 2010. The increase is solely due to the expiration of a promotional rate. • Two-cycle billing is prohibited (some exceptions to this relate to return of payment for insufficient funds or following resolution of a billing error dispute). • Each monthly statement from the issuer has to contain a toll-free telephone number and an Internet address where the cardholder can access the payoff balance on the account. The increase is due to circumstances not controlled by the issuer and is also available to the general public. then you are indifferent to these options. is not simple and depends on your particular circumstances. the act has provisions to safeguard their interests as well. The default APR for cards B and quent-flier miles. You should ask for an explicit answer about that before opening a card. will not be issued a new credit card. These include the following: No credit card may be knowingly issued to a customer who is under 18 years of age. If you are a credit revolver. It should be a welcome relief for millions of Americans who have been at the mercy of the credit card companies for decades. or who already has one existing credit card. which may include a agreement. however. Street Smarts: A Real-Life Example Below is a table of relevant terms for three different credit cards each offering a 0 percent interest rate over an introductory period (which itself varies between the three cards). You are more interested in monthly payment.Consumer Credit 173 Given that the 16–25 year old population segment is an appealing demographic target for credit card companies. you are not interest rate– a late payment. you are entering a legally-binding default APR. You can pick the one that will give you the highest credit limit. In summary. while card A does If you are a credit revolver. If you had a choice between these three credit cards. A student who has no verifiable AGI. whichever is greater. So. First. • A college student will be permitted to have only one credit card account. pay less than the minimum or fee-sensitive. this is the first time in almost thirty years that major credit card reform has been enacted in Congress. like points limit. or make a payment with a check that towards a gift certificate at a bookstore or frebounces. if you pay off your entire balance each month. C are about the same. since the annual fee of all three cards is zero. which one would you choose? The answer. • No credit card will be granted to a student whose total debt ceiling including the current card would exceed 30 percent of the AGI of the student in the most recent year. exceed your credit the bonuses a card can offer you. • The amount of credit extended to a full time college student may not exceed 20 percent of the AGI of the student or $500. Remember that when you sign a credit card change your terms. since it will trigger if you have If you pay the entirety of your credit card balances each month. you need to not have any explicit default APR— read all the fine print and thoroughy underalthough the company reserves the right to stand your cardʼs interest rate and fees. The default APR is what you should be most concerned with. contract! Credit Card Commandment . unfortunately. there are several options to consider. let us review the salient features and you can decide which one may be right for you. Wait the right offer the long term. through the agreement in order to understand Wait for the Right Card .00 or more than $75 Rates. Default APR: None provided. Credit card companies are very powerful and exist to make money at your expense. We may change the rates. We reserve the right to change the account terms (including APRs) at any time for any reason.24% variable. APR for purchases Figure 9: Comparison across Credit Cards So. we may change the terms based on information in your credit report. a careful reading of the terms under “Rates. Balance transfer APR: same as purchases. fees. amounts owed to other creditors. 14.174 Chapter Nine Card A 0% for 9 months. and terms may change Variable rates could go up or down when Prime changes. The reasons may also include competitive and market related factors.24% variable Card C 0% for 12 months. Between card A and card B. Default APR: 31.24% variable Card B 0% for 12 months. If you know you are likely to be comes along—one with no annual fee and at a credit revolver it is imperative that you look least a twenty-five–day grace period. After that. fees. or the number of credit inquiries.00 or more than $75 3% of the amount of each transaction. such as your failure to make payments to another creditor when due. After that. Cash advance APR: 19. and terms may change.24% variable.49% variable. Balance transfer APR: Same as purchases. but not less than $5. In conclusion. such as the number of other credit card accounts you have and their balances. fees.” shows that card A may have slightly less stringent provisions to bump up your rates than card B. 17. These reasons may be based on the information in your credit report. card A gets 1 point and the others get 0 points. Grace period for repayment of purchase balances 25 days from the date of periodic statement At least 20 days At least 20 days Method of computing balance for purchases ADB (including new purchases) ADB (including new purchases) ADB (including new purchases) Annual Fee None None None Transaction fee for balance transfers None 3% of the amount of each transaction. All we can do is to be knowledgeable about their Watch out for iffers with outrageous annual business practices and able to walk away from fees and low introductory interest rates that a card with terms that are likely to hurt us in last less than six months.9% variable. for any time for any reason. including changes to competitive or general economic conditions. Cash advance APR: 23. 10. it appears that card A might have the edge between the three choices. Cash advance APR: 22.49% variable. including APRs and fees. We reserve the right to change the terms of your account. Default APR: 31. and terms of your account at any time for any reason. Other APRs Balance transfer APR: Same as purchases. After that. Card A also appears to have a twenty-five–day grace period relative to twenty days for cards B and C. but not less than $5.24% variable. For example. Learn to read the salient terms as above so you can make smart choices with your credit cards. the number of credit accounts outstanding. the number of different accounts that a borrower may have with a bank. deny some people the opportunity to borrow.67 The term “relationships” encompasses a variety of soft information.68. a borrower could conceivably take the money (at the high interest rate) and invest in a high-risk project (with a correspondingly high potential return) with a high probability of failure. Research on Consumer Lending In 1981. also known as hidden information. . It is people who are at the margin who might get a loan because of that relationship when they otherwise may have been rejected. This “soft” information that banks collect either formally or informally about a potential borrower over time can be used to make credit-related decisions down the road. keep the rate fixed and.” Under credit rationing. It is important to stress that relationships. you will probably get the loan even if you have no relationship with a bank. Stiglitz and Weiss termed this “credit rationing. instead. and so on.69 The authors show that relationships matter only in the loan approval/rejection decision. loan rates are not driven by relationships. including the length of time that a potential borrower has had an association with a lender. instead of in the project the borrower told the bank they wanted the loan for. and they could do this by developing “relationships” with potential borrowers. What I mean by that is that if you have a horrible track record with your existing and past loans. the default rate. research by two economists. Conditional on being approved for the loan. should work only at the margin. if you make lots of money or have lots of property. Joseph Stiglitz and Andrew Weiss. interest rates.66. Moral hazard is also known as hidden action. By the same token. or online. showed theoretically that banks may decide to deny credit to some borrowers who are big risks to the bank even if those borrowers are willing to pay a high interest rate. even if they exist.65 In the 1990s. whether the borrower does his or her banking personally. banks. Two economists have recently shown with fairly complex econometric analysis that interest rates are not lowered because of an ongoing relationship with your bank. many economists wrote papers showing that banks could reduce credit rationing if they could eliminate some of the adverse selection problem they face. Under this theory. you are probably not going to get another loan no matter how good your relationship is with your bank. and how that default rate will be triggered. basically means that the borrower knows more about her personal intentions than the bank does.Consumer Credit 175 its salient features: fees. Adverse selection. rather than raise interest rates. but the possibility of getting approved for a loan is increased. Why would a bank do that? The bank would rather ration credit than raise interest rates because of two problems: moral hazard and adverse selection. by telephone. Microcredit in its current incarnation has its origin in the Grameen Bank of Bangladesh. Unfortunately. to finance the entrepreneurial activities of the poor? One of the first lessons we learned in the introductory microeconomics class is the principle of diminishing returns to capital. etc. The success of Grameen Bank stimulated the establishment of several other microfinance institutions in Bangladesh as well as in other developing countries. such as Bangladesh Rural Advancement Committee (BRAC) in Banglasdesh. while others operate not for profit (NGOs). or goats to raise and sell.500 microfinance institutions (MFIs) across the world. some provide only banking services. Bank Rakayat in Indonesia. of whom three-fourth were women. there are at least 3. decided to form the Grameen Bank in 1983 that now serves more than 8 million borrowers. Association for Social Advancement (ASA) in Bangladesh. Some of these MFIs are very large. and 67 percent came from the poorest segment of the population. some raise funds from the market by issuing bonds and selling shares. firms with relatively . in spite of the success of this pilot program. the banks refused to continue with the loan granting project at the end of the pilot fearing it was too expensive and risky. for example. through the support of donors. Yunus designed an experimental credit program to serve the needs of the poor that spread rapidly to hundreds of villages. Yunus. with more than one million active borrowers. Around 1976. some are profit oriented (the banks and credit unions). while most of the others are small and locally based. to buy a sewing machine to make clothes. The typical clientele of microcredit are people of modest means lacking physical assets for collateral and with no verifiable credit histories. As of 2009. while others rely on subsidized funds from the governments and donor agencies. According to the estimation of The State of the Microcredit Summit Campaign Report 2011. more than 190 million people in more than 100 countries received microcredit in 2009. he disbursed and recovered thousands of loans. Specifically. Professor Muhammad Yunus along with his graduate students at the Chittagong University in Bangladesh took the initiative of addressing the banking problem faced by the poor through a program of action-based research. It says that as a firm adds more and more capital. such as microcredit. Bancosol in Bolivia.176 Chapter Nine Microcredit—A Revolutionary Loan Concept By Abu Zafar Shahriar Purdue University Microcredit is the use of small loans to finance income-generating activities—a loan of $75. each additional unit of capital will bring smaller and smaller incremental (marginal) gains. Undaunted. Why Do We Need Microcredit? Why do we need a unique financial product. while others provide education and health care services along with financial services. Through a special relationship with the rural banks. Thus. e. In the rural credit markets of developing countries. The failure of the government-sponsored specialized rural credit institutions to channel credit to the poor called for the innovation of financial products that are particularly suitable for the poor. and we should not need any specialized financial institutions. there is an ex-ante moral hazard problem). as poor borrowers lack pledgeable assets and any formal certification measures to prove their eligibility. for the poor. The use of credit scores and collateral. such as the MFIs. when the project matures. we describe the factors that have driven the success of microcredit programs. and heavy subsidies were deployed to these banks to undertake the risks that the private-sector commercial banks were reluctant to bear. the lender might remain ignorant about the actual return on the borrower’s project. information problems arise in three stages of a loan contract. What Makes the Microcredit Programs Successful? Over the past four decades. The large state-owned village banks were held responsible for extending credit to the poor. namely. Researchers have argued that two factors have primarily restrained traditional financial institutions from extending credit to the poor. In the next section. we see that poor entrepreneurs often lack access to financial services from the conventional banking system. But in reality. poor firms should be able to pay higher interest rates to the banks than the rich firms. Accordingly. with the support of donor agencies. First. is constrained in such markets. lenders in rural credit markets face difficulties in contract enforcement because an appropriate legal mechanism to induce repayment is often absent in these countries. when the loan is extended. the expectations that the state owned banks would provide poor farmers with easy access to credit have proved to be unfounded. Second. lenders cannot observe the effort delivered by the borrower in her project. lenders have no command over it (i. But unfortunately. as these banks largely failed to overcome the information and enforcement problems described above. a common solution to address information asymmetry and enforcement problems in credit markets.Consumer Credit 177 little capital should be able to earn higher returns to their investment than firms with a great deal of capital. While the effort level affects the probability of realizing positive project returns. and default rates remained very high. the governments of the developing countries considered the credit problems faced by the poor to be the highest priority. and inspired the microcredit movement across the world. In addition. The borrower might then falsely claim a loss and default intentionally (an ex-post moral hazard problem). capital should naturally flow from the rich to the poor borrowers. they took initiatives to provide cheap credit to the poor borrowers. After World War II. microcredit programs have shown that credit can successfully be extended to the poor without pledgeable assets while ensuring high repayment rates (the major microcredit programs report repayment rates over 90 . Funds were often skewed in favor of wealthier and influential farmers. asymmetric information and enforcement problems. lenders have difficulty in observing the characteristics and riskiness of a borrower’s project when signing a loan agreement (an adverse selection problem).. Accordingly. Third. in general. the use of “individual lending. we discuss the limitations of joint liability contracts. under joint liability contracts. This indicates that these programs have largely been successful in mitigating the information and enforcement problems in the rural credit markets. Thus. otherwise. Overall. Once the projects mature. the joint liability aspect of microcredit works as collateral. This is due to the fact that joint liability contracts have some practical limitations. In the loan utilization stage. Limitations of Joint Liability Lending: What Do MFIs Do as an Alternative? Researchers have shown that there exist several factors that adversely influence the effectiveness of the joint liability mechanism. which the MFI loan officers are aware of. Once a group is formed. while Bolivia’s Bancosol has moved a large share of its portfolio out of joint liability contracts into individual contracts. in this way. researchers have argued that a distinct feature of microcredit— the joint liability contract—has largely resolved the information and enforcement problems in the rural credit markets. Under joint liability contract. borrowers form groups and collectively apply for loans. when a borrower accepts the contract. relationship lending. such contracts transfer the task of screening on to the borrowers. The current literature on microcredit suggests that the microfinance institutions have successfully innovated loan contracts such that. namely. and discuss an alternative lending technology that the MFI loan officers adopt in their loan granting process.178 Chapter Nine percent). the dominant strategy for that member would . Thus. In the next section. worth underscoring that although the joint liability contract is apparently able to resolve the information and enforcement problems in the rural credit markets. the other members should contribute to bail the defaulting peer out. peer monitoring reduces the moral hazard problem. If. the entire group becomes eligible for the next loan cycle. The group size varies from program to program. she freely chooses actions in her own interest that serves to reduce the probability of default.” as opposed to joint liability–based group lending. It is. a loan is extended to each member of the group individually. group borrowers monitor each other’s actions so that no one in the group invests without prudence. For example. groups are formed with five borrowers in Grameen Bank. If the success of an individual member’s project is not verifiable by other group members. For example. the entire group loses access to future credit from the same program. an individual borrower’s reliance on fellow borrowers to repay the loan may open the door for free riding problem within the group. all members of a group repay their loans in a timely manner. who are in a better position to do so. but the group members are held jointly accountable for the repayment of the entire group. however. joint liability induces peer pressure within the group to enforce repayment. For example. If any member of the group defaults on her loan obligations. is increasingly gaining ground. Bangladesh’s ASA has weakened joint liability in its lending approach. while the group size in BRAC varies from five to eight. on the other hand. Specifically. borrowers have a clear incentive to pick creditworthy borrowing partners to form groups. in turn. approval. it is possible for them to collude against the bank and default intentionally as a group. the loan officers have emphasized that they develop and maintain close ties with their borrowers during the loan application.Consumer Credit 179 be to shirk and hold others liable for own default. it is worth noting that joint liability in group loan situations does not add to the bank’s storehouse of information on a borrower. Sugato Chakravarty and Abu Zafar Shahriar have shown that relationship lending is that technology. This belief. generated in the process of continuous interaction between lender and borrower. Finally. and such ties produce valuable soft information about the creditworthiness of a borrower and the level of effort that a borrower generally exerts in her project implementation. In other words. under joint liability contract. banks cannot successfully harness the collateral effect of joint liability. BRAC. those who have taken loans from the same MFI before. repayment by an individual borrower largely depends on her belief that the other members will do the same. the MFI loan officers rely on some other lending technology that adds to their storehouse of information so that they can make more informed lending decisions.71 The essence of relationship lending is that as a long term relationship is developed between the lender and the borrower. But the problem is that when group members share very close social ties.70. The results of this study suggest that the likelihood of being approved for microcredit increases as the length of membership with the potential MFI increases. the MFI loan officers have argued that in addition to joint liability contracts. Researchers have further shown that when microborrowers have alternative sources to borrow. and its role in the microcredit sector has largely been ignored. However. 372 applied for a joint liability–based microcredit. it is not surprising that in addition to joint liability contracts. In recent research. Put differently. This is because villagers choose creditworthy borrowers as borrowing partners based on locally available information that is not necessarily available to the bank. So far. they substantially rely on relationship-driven information in extending loans in order to overcome the information problems. depends on the existence of strong social ties within the group. as borrowers in such markets do not care for the access to future loans from the same MFI. Such information. ASA. Furthermore. or those who have maintained a non-mandatory savings . can help mitigate the adverse selection and moral hazard problems in the credit market. Chakravarty and Shahriar interviewed loan officers from Grameen Bank. In those conversations. in the summer of 2009.075 randomly selected poor individuals in thirty-four villages in Bangladesh. For a closer and deeper examination.075 individuals. Out of these 1. and 271 got accepted for a loan in the twelve months prior to the survey. the lender gathers relevant information about the prospects and the creditworthiness of the borrower over a considerable time period. Chakravarty and Shahriar interviewed 1. empirical research on relationship lending has been primarily performed with data compiled within the United States and other developed countries. Thus. and utilization stages. locally-based MFIs in Bangladesh. and some other small. especially in the absence of an appropriate legal mechanism to induce repayments. Thus. it is a behavior inducing mechanism and not an information gathering tool. as is the case in the more matured loan markets in Asia and Latin America. How Does Microcredit Help the Poor? In the last two sections. As a result. MFI loan officers cannot rely on the commonly used transactions-based lending technologies. it is important for the lender to make sure that the fund is invested in a relatively safe project so that the likelihood of being repaid is enhanced. we have discussed how microfinance institutions have been successful in providing financial services to the poor. asset-based lending. illness of a wage earner. these borrowers choose safe projects so that the likelihood of default is reduced. Maintaining association with multiple lenders reduces the likelihood of being approved for a loan.180 Chapter Nine account. Thus. Thus. Second. Since these borrowers do not have access to the conventional banking sector. we will discuss whether these services help improve the livelihood of the poor. or natural disasters create fluctuations in daily income and food consumption of the poor households. are more likely to be approved for microcredit compared to those who have not taken any loan before or those who have no non-mandatory savings accounts with the MFI. by extending loans to borrowers with extant relationships. As a result. In this section. extant evidence suggests that researchers do not have a unanimous stand on the role of microcredit in poverty alleviation. it is important for a lender to gather information about the creditworthiness of potential borrowers. those who acquire good reputations in the microcredit market have an obvious incentive to protect their valuable relationship with the lender so that they can borrow from the same lender in the future. Several studies have evaluated the impact of microcredit in improving the welfare of poor borrowers. or credit score–based lending. compiling soft information—that accrues from a continual connection between borrower and lender—could be one of the most effective ways to reduce the adverse selection problem. Income of the poor households in developing countries is often irregular and undependable. But the typical microcredit clients tend to be informationally opaque. Furthermore. microloans are not backed by collateral. the findings of this study confirms the anecdotal evidence that MFI loan officers make substantial use of relationshipdriven information in the loan granting process. Factors like seasonal unemployment due to agricultural cycle. nor can they offer credit scores or provide similar certification measures to the MFIs to prove their eligibility. many others have not found any significant impact of microcredit on income generation or poverty reduction. As bank-borrower relationship develops. First. such as financial statement–based lending. once a loan is extended. borrowers manage to acquire a good reputation through their repayment history. But there is clear evidence that microcredit contributes to reducing livelihood vulnerabilities of the poor borrowers. There are at least two reasons for which microfinance institutions may rely on relationship lending. In the absence of transactions-based lending technologies. as they cannot provide any financial statements to the MFI while applying for a loan. Access to microcredit helps . While some of these studies have shown positive impacts of microcredit on poverty alleviation and asset accumulation of the participating households. In sum. the MFI can eventually mitigate the moral hazard problem. in order to ensure high repayment rates. Finally. Researchers have also shown that participation in microcredit programs significantly empowers female borrowers. who are not involved in income generating activities of any sort. in evaluating the impact of microcredit. one must realize that financial services. Why was the minimum payment on your credit cards originally set at 2 percent of the outstanding balance? 14. credit is not appropriate for the destitute. What is the single most important thing affecting your credit score? 12. How do you build a credit profile if you have never borrowed money before? 11. Thought Questions 1. Is it necessarily bad to have the credit payments stretch beyond the life of the item it was used to purchase? 9. Why are credit card interest rates so high? 6. How has the same low minimum monthly payment become a headache for the government? . with access to working capital loans from the MFIs. Can you predict anything about a country’s economy overall by looking at its banking system? Why or why not? 3. What is good credit versus bad credit? 7. clothing. It has been found that. For example. particularly credit. MFIs can provide long-term. or education is lost. How would your behavior change if you knew exactly how your score was being computed? 13. In fact. How do you use credit currently? What are some of the ways you could use credit more efficiently based on the discussions in this chapter? 4. are not appropriate for all people at all times. which eventually enhances livelihood security. How does credit work in an NFL draft? 2. In the past. shelter. female borrowers enjoy enhanced decision making authority within their households.Consumer Credit 181 the poor to smooth cash flows and avoid periods where access to food. The poor can also use credit to build assets by buying land. how did the we cope? 8. Why is it important for you to know the contents of your credit report even if you have never had a credit card or taken out a loan? 10. when credit was neither widely available nor cheap. What are some things that should not be purchased with credit? Why? 5. stable credit access only when clients have the ability to meet the scheduled loan repayments. microcredit can best serve only those who have identified an economic opportunity and can capitalize on it if they have access to a small amount of ready cash. How can you build a relationship with your bank if you use electronic banking and not traditional banking? 27. First. What can you do to minimize identity theft? 19. if you have an outstanding credit card debt of $8. however. how would you start paying it down? 22. After reading this chapter how would you summarize the importance (or the lack thereof) of maintaining a good relationship with your local bank? 26.000 (not adjusted for time value). If you have amassed a lot of credit card debt. Has technology helped or hurt the average credit-revolving consumer? 16. the outstanding balance becomes due and payable immediately.182 Chapter Nine 15. it will take you thirty-one years to pay off your debt and you will end up paying a total of about $16. you must repay this loan in five years or less. Under what circumstances would a debit card be preferable to a credit card? 18. It is critical that you repay any 401(k) loans before you leave your job. 64. but the interest will be taxed again when you finally withdraw money from the 401(k) when you retire. According to the research findings presented. pay as much as you can each month. That is not all. If it’s not repaid. Instead. For example.500 and you made only the minimum payment every month. Why would a bank not give a willing high-risk borrower a loan at a very high rate of interest? 25. the loan and interest will be repaid with after-tax dollars. Try to avoid it if you can. If you leave your employer prior to full repayment. If you’re under the age of fifty-nine and one-half. you will also be assessed an additional 10 percent excise tax as a penalty for an early withdrawal of retirement funds. at 24 percent interest. you will be taxed on the amount at ordinary income tax rates. do good relationships help everybody in obtaining loans? Notes 63. Why would you use a debit card? 17. There are some serious drawbacks to doing this. What are some of the things you would do if your identity were stolen? 20. that amount will be treated as a distribution to you. How does budgeting help you stay out of credit card related troubles? 21. Should loan flipping be a part of your debt management strategy? 23. Should you purchase those credit card protection plans most banks want you to buy? 24. In other words. Additionally. . “Relationship Lending in Microcredit: Evidence from Bangladesh. Chakravarty and A. Chakravarty and A. M.” Financial Management Winter(2009): 781–816. 71. Purdue University. “A Multistage Model of Loans and the Rate of Relationships. J.” American Economic Review 71(1981): 393–410. S. 70. “Credit Rationing in Markets With Imperfect Information. . “Relationship and Rationing in Consumer Loans. Chakravarty and J. Stiglitz and A. Yilmazer.” Working Paper. 69. Udell. Purdue University.Consumer Credit 183 65. Berger and G. “Intra-group Resource Transfer and Choice of Borrowing Partners in Group Based Microcredit: Evidence from Framed Field Experiment in Bangladesh. S. “Relationship Lending and Lines of Credit in Small Firm Finance. Weiss. Scott. A. “The Benefits of Lending Relationships: Evidence from Small Business Data. G. S.” Journal of Business 72(1999): 523–544. 2011. 67.” Working Paper.” Journal of Business 68(1995): 351–382. S. N. Petersen and R. 66. Shahriar. 2011. S. Z. F. Chakravarty and T.” Journal of Finance 49(1994): 3–37. Shahriar. 68. Z. Rajan. A. . with interest calculated on the full amount borrowed over the life of the loan. Average Daily Balance: A method of computing the figure on which the finance charge for credit card financing will be based. so you can compare the true cost of this type of financing with simple interest financing. An 8 percent add-on interest loan for thirty-six months is equivalent to annual simple interest of 14.Appendix A to Chapter 9 Important Credit Definitions Acceleration Clause: Allows the lender to require entire repayment of the loan as soon as you are in default (see also Demand Feature). Balloon Note Financing: Allows a final loan payment substantially larger than regular periodic payments. or reduce your credit. Credit Disability and Credit Life Insurance: An optional insurance that makes loan payments if an illness or accident hinders your ability to earn income or pays 185 . Collateral (also called security): The property that backs up a loan. Adverse Action Notice: Reports a lender’s decision to refuse. end. It must disclose the reason. Your objection(s) must be filed in writing with the report. It becomes the lender’s property if you don’t repay the loan. Add-On Interest: One method of calculating installment-loan finance charges.54 percent. The account balances for each day in the billing period are totaled and divided by the number of days in the period. A young person who hasn’t established credit or a person with a poor credit rating may need a co-signer. Co-Signer (sometimes called co-maker): The second person who enters into a loan agreement. Credit Bureau: A reporting agency that assembles information on borrowers to help lenders evaluate credit worthiness. guaranteeing to make the payments if the borrower defaults. You are entitled to see your credit report and dispute or add to the information you feel is erroneous. Lenders are required to quote rates in terms of annual interest. which computes interest only on the outstanding balance. Annual Percentage Rate (APR): The cost of credit over a full year. Adjusted Balance: A method of calculating an open-end finance charge (such as on a charge account) by subtracting payments made during the billing period and applying the interest rate to the balance. The law requires lenders to express financing terms of the APR. High Balance Charge: A fee that may be assessed when you exceed your open-end credit limit.5 percent and a daily rate of 0. this insurance is included in the monthly payments. lenders will usually lend no more than the “blue book” value on a used car. Periodic Rate: The APR divided by the days.. Demand Feature: Allows the lender to call for repayment of the full balance owed under specified conditions. Net Payoff: The amount owed on a loan.186 Chapter Nine the remaining balance if you die. You may be required to pay a late fee. Grace Period: The time period an open-ended credit loan can be repaid without incurring a finance charge. Prepayment Penalty: A fee charged by some lenders for early payment of a loan balance as compensation for lost interest income. Loan Value: The amount financial institutions will lend on a particular item. excluding prepaid interest and insurance premiums. An APR of 18 percent has a monthly rate of 1. principal. held by the lender to meet property taxes and insurance premiums for property securing the loan. weeks or months in a year.0493 percent. usually included in mortgage payments. expressed as a flat fee or a percentage of the amount due. finance charge. periodic rate. and other fees associated with the loan. Delinquency: The failure to make a loan payment on time.g. e. It could apply to any part of the loan agreement. if your income decreases or your security (collateral) declines in value. Certain fees not included in the finance charge must appear separately in the disclosure statement. Escrow: A payment. For example. e. Signature Loan: A loan made without collateral. etc. including interest and other defined charges. Finance Charge: The total dollar cost of credit. Disclosure Statement: A document prepared by lenders that must explain certain applicable terms such as the APR. payment schedule. Security Interest: The lender’s right to claim collateral and sell it to recover a defaulted loan balance.g. Equity: The amount of loan principal paid—represents degree of ownership. . missing one or more loan payments. Lien: A creditor’s claim on a debtor’s collateral.. Default: The failure to carry out the terms of a loan contract. Generally. and how the number or amount of payments would be affected. what limits apply. The lender must disclose what indicators would cause the rate to increase. . Variable Rate Loan: A loan that has an APR that fluctuates according to certain economic indicators. Truth-in-Lending Act: The federal law requiring lenders to disclose full financing information to the borrower.Appendix A 187 Total of Payments: The sum of all installments on a loan. . org/ • Privacy Rights Clearinghouse: http://www. and the outstanding balance is generally determined using one of two variations of the Average Daily Balance (ADB) method: • ADB excluding new purchases (the most consumer-friendly) • ADB including new purchases (most frequently used—no grace period on new purchases if you carry a balance) Average Daily Balance Method • Every day.idtheftcenter. • Then the bank divides its annual interest rate by twelve (the number of months in the year) to get a “monthly interest rate. Others exclude those charges until the next statement (“average daily balance. the bank adds your charges and payments to learn what you owed it that day.org/identity.identitytheft.Appendix B to Chapter 9 Here are some useful links related to online fraud.privacyrights. Computing Finance Charges The interest rate is applied to the outstanding balance. We need to understand how finance charges are computed by our lenders in order to be well-informed consumers. which usually takes the form of finance charges.gov/pubs/10064. an 18 percent interest rate divided by twelve equals a monthly rate of 1. 189 .consumer. In calculating your daily balance.html • Federal Trade Commission’s identity theft website: http://www. • The bank multiplies your average daily balance by the monthly interest rate to obtain the finance charge for that month.ssa.htm • Identity Theft Resource Center: http://www. • Social Security Administration’s information on identity theft: http://www. It adds these totals and divides that figure by the number of days in the month to determine your average daily balance.” For example.gov/idtheft/ • Identity Theft Prevention and Survival: http://www.5 percent. most banks include charges made during the month (“average daily balance. including new purchases”). excluding new purchases”).org/ Understanding Finance Charges Credit generally comes at a cost. the more you will pay overall. • Mysterious fees. Calculate the finance charges using the average daily balance method including new purchases. of days (1) Balance (2) 5 7 15 4 Weighted balance (1 x 2) $ 582 932 986 961 Total: 31 ADB Monthly APR Finance charge $ 2.58 Credit Card Offenses to Watch For Here is a list of offenses that credit card companies are sometimes guilty of.790 3. Remember that finance charges add up quickly. cancel the card and find a better one.910 6. • Going after those with poor credit. those who declare bankruptcy may not be fiscally responsible. which can be around 2 . Creditors often prey on those who are least credit-worthy by scanning credit records for telltale signs. The maxed-out customer is then charged an additional fee for being above it. THE BOTTOM LINE: YOU SHOULD KNOW HOW YOUR BANK CALCULATES FINANCE CHARGES. But most banks charge hefty transaction fees. Use ADB including new purchases: No. You signed up for a card with no annual fee. Here is an actual example of how a bank might calculate finance charges. one appears on your statement.18 ÷ 12 = . One detestable practice is to entice a customer to use a cash advance check or a skip-a-month payment offer and then lower the credit limit on them. and the longer you take to pay off an account balance. A related tactic is to simply lower the customer’s credit limit once they reach it. Yet.844 $28. which means the companies don’t have to worry about your debts being erased for a long time. credit card companies want you badly.015 = $13.068 ÷ 31 = $905.5% $905.190 Chapter Nine which is to your benefit.068 = = = $28. Some lenders start charging an annual fee to their customers who pay their bill off every month. The recently bankrupt can’t declare bankruptcy for another seven years. Also.42 0.524 14.42 x . Interest rate is 18% per year. Watch out for them and if any of them happen to you. If you are a student with no income or have recently emerged from bankruptcy. • A sliding credit line. You may not have to pay a finance charge to get a cash advance.015 or 1. which is appealing to credit card companies. • The magically appearing annual fee. Here are some of the ways you are protected when you use your credit card for making purchases. Critical Info: Cardholder Protections Federal law protects your use of credit cards. a lot of credit card issuers will try and get you to buy a card protection plan for anywhere between $5 and $10 a month. you are not responsible for anything. or the seller misrepresented the item and now won’t talk to you. First. The issuer will take that item out of your bill while the matter is being investigated. Your liability is limited to $50 by law. not you. . But if the perpetrator uses your card before you report it missing. The card issuer will then initiate discussions with the merchant on your behalf and take the amount off your bill while the investigation is ongoing. You don’t need it. • The disappearing grace period. Watch out for lenders who pull the grace period out from under you—especially if you are someone who pays their balance in full every month. • Unauthorized charges. • Errors on your bill. you’ll accrue interest from the day you make a purchase. It protects the issuers. you can cancel payment with your credit card company. you must have made a good faith attempt to resolve the matter directly with the merchant.Appendix B 191 percent of the total amount and no less than $10. you owe at most $50. If you find a mistake in your credit card statement. Report your card missing as soon as you discover it is gone. Also watch out for transaction fees for calling the toll-free number to check your balance. you can dispute the charge. and penalty fees for account inactivity. The only way to avoid a finance charge would be to pay your bill before you received it. you are liable for up to $50. These days. • Merchandise or service disputes. If you are not happy with what you bought. the issuer will have you fill out (usually online) a form with details of the transaction and ask you to provide in writing any information you may have concerning the purchase in question. the item arrived in bad shape. If your card is used without your permission. If your grace period is eliminated. If you report the card missing before any charges are made on it. In such cases. . credit card rates will increase and fewer people will qualify (and those who do will have lower credit limits). You will need to become more conservative in how you approach unsecured debt and avoid using credit cards like an extended ATM. or pay off as much as you can right away. So make your monthly payments on time! • Continue to look for ways to lower or eliminate your credit card debt using one or more of the tools described in this chapter. Remember.SECTION B: ACTION PLAN • Examine all the credit cards in your purse or wallet. While cancelling the cards will lower your credit scores in the short term. 193 . most experts will tell you that it is the best option in the long term. the introductory rate is only for a few months and could also go away if you are late with any payments. try to be more like a deadbeat than a revolver. If you have more than two credit cards you have too many. • For the remainder of your debt. • While the new environment protects the consumer from the predatory practices pursued by most credit card companies. look for a new credit card with low introductory rates and switch your balance to the new card. In other words. Now that these practices are barred. This is standard operating procedure such as throwing all kinds of offers your way. in an effort to keep you as a customer. • Cancel the remaining cards by calling their toll-free numbers. You will have to be strong and make sure you get them to cancel the card. it it precisely these practices that kept credit card rates relatively low. Understand that the customer service representative will pull out all the stops. think about paying it off if you can. • If you are carrying credit card debt. . Section C: Insurance . . insurance contracts available to us and try to understand them intuitively. when insurance policies in existence for smaller legionnaires pledged to one another that they losses. then the product of the two is also a small number. There are many to the days of the Roman Empire. With from very large losses which have a very that goal in mind. After reading The Goal of Insurance Book Smarts: A Bit of History 197 . expensive and is unnecessary. The cost of insurance is related to what statisticians call “expected loss. but holding these policies is relatively would care for the families of fallen comrades. Insurance Basics Insurance is a crucial element of personal finance in the United States. in the next. has a very small likelihood of happening? While they are rare occurrences. Why would you need protection from something that. by definition. we will cover life insurance. we will cover health and property insurance. we will explore the standard small likelihood of occurrence. In this chapter. That may not make sense at first. The purpose of insurance is to be protected against the very small likelihood of very large losses. —Ambrose Bierce Remember the football adage “offense wins games. so it is imperative that you understand every dimension of it and The goal of insurance is to be protected how you can use it to protect your assets. if the dollar loss is large but the probability of it happening is very small. It is important to keep in mind that insurance only works well when the expected loss is very large and would cause you hardship The origin of modern life insurance goes back if you had to bear it yourself. insurance is affordable because large losses are so rare. At the same time.” Expected loss is computed as the dollar loss incurred multiplied by the probability of that loss occurring. So.10 Life Insurance Insurance: An ingenious modern game of chance in which the player is permitted to enjoy the comfortable conviction that he is beating the man who keeps the table. they are incredibly expensive when they do happen. Now we will focus on the defensive part—protecting what we’ve built. defense wins championships?” We have covered the offensive part of our financial strategy—building wealth. you are assuming the risk—if the item breaks. for a life insurance policy. You might decide to bear the risk of loss yourself. Through risk control. For example. risk is the possibility of occurrence of an adverse event. The insurance company needs to protect itself from the possibility that only very sick individuals will purchase life insurance. the applicant might be interested in buying a policy simply because she expects to fall critically ill in the near future. The larger the pool of people. This is how we are handling risk when we buy insurance. There are several ways to deal with risk. where you transfer the potential loss onto another party. an unexpected cash outflow. the insurance company takes on your risk for a fee. we have Risk Transfer. wearing a seat belt while driving might reduce the severity of an injury if you do have an accident. In this process. prefer to have only healthy people—people who would not need to file a claim for a long time. they will be out of business because they will be constantly paying claims. it is not always possible to avoid risk. To avoid this. you can avoid participating in activities that carry a risk of loss. First. for example.198 Chapter Ten this chapter. The insurance company then spreads the risk you have paid them to take on among the pool of other holders of insurance policies. they have to guard against adverse selection. If you choose to forgo purchasing an optional warranty on a purchase. you could choose not to drive or be a passenger in a car in order to completely avoid the possibility of being in a car crash. This is known as Risk Avoidance. then the company . Or.” People who are interested in buying insurance policies know more about their risk than the insurance company does. What Is Underwriting? Underwriting is the process by which an insurance company decides whom to insure and the rate to charge that person. If it charges too little for higher-risk individuals. For example. Finally. you will have a better understanding of which insurance contracts to focus on and which ones to avoid in order to maximize and protect your wealth. you will be solely responsible for the cost of repair or replacement. you could drive within the speed limit to reduce the likelihood of an accident. This is known as Risk Assumption. For example. the insurance company would. the insurers have to protect themselves from two things. So. Put differently. Ideally. you lessen the likelihood of a loss occurring. in this case. Of course. Ways to Deal with Risk Risk is defined as uncertainty with respect to loss. If the insurance company sells policies to sick people only. the company has to price these policies just right. of course. the more money the company receives and holds to use if a policyholder experiences an adverse event. First. which means “hidden information. the next best thing is Risk Control. hidden action). everything works like a charm. you should go to Best’s website at http://www. the number of people filing claims will be relatively small compared to the number of people with policies who are not filing claims.(Fair) A. B. then these individuals will not buy policies.. Best Company. and municipalities. This is when policyholders change their behavior after purchasing an insurance policy in a way that makes them more risky to insure. B+ (Very Good) C. C+ (Marginal) B++.ambest. You might wonder how it is feasible for insurance companies to assume your risk—even for money. The following table from Best’s website summarizes their rankings of insurance companies. As long as this is true. If it charges too much for low-risk individuals. they will go through a year when a lot of people file claims all at once due to a natural disaster or other common adverse event. but you need to be cautious about the quality of the company itself when you buy a policy. A. insurance companies have to protect themselves against moral hazard (i. After all. One of the more established rating agencies is A. states.e.M. like skydiving.Life Insurance 199 will lose money on those policies. the government will usually step in. when Hurricane Katrina devastated Louisiana.(Excellent) C++. An example of this is a customer who purchases life insurance and then takes up extreme sports. C. For example.(Weak) D (Poor) E (Under Regulatory Supervision) F (In Liquidation) S (Rating Suspended) Figure 10: Insurance Company Rankings If you are contemplating buying an insurance policy from a company that is not well known. Second. Insurance companies try to avoid this by carefully evaluating policyholders during the underwriting process.com and check out the company’s financial stability. In this case. What happens if everyone files a claim at once? The company is betting on the fact that. A+ (Superior) B. It’s a delicate balancing act. founded in 1899 with the goal of detecting insurer insolvency. There are organizations that rate bonds issued by corporations. Insurance companies do provide a level of protection. the insurance companies made some of the payments (about $11 billion). but then the government had to step in and help the families whose homeowner’s policies did not have explicit flood coverage (they paid out about $13 billion). . Secure Vulnerable A++. in a normal year. you want the insurance company to be around when you do have to make a claim and you also want them to have the financial strength to pay you. Occasionally. and your most recent bank statement showing how much you have in your checking and savings accounts. you can expect that certain expenditures—food.e. All those components are dynamic. Life insurance is designed to fill the gap between the financial resources your family would have if you died and what they would need. Other expenditures would not. in a cash equivalent of the stay-at-home • Select a large. financially secure spouse who raises children and does the company. your most recent statement from your brokerage account (if you have one). and transportation—would be likely to decline somewhat if one member of a household died. that even in the best of circumstances. consider: What tangible assets could you sell for cash. Remember. which are services that would • Select a reputable agent. enced couples might easily forget to factor • Compare costs. • Know the amount and type of coverage you When doing this planning. if necessary? What assets are you willing to liquidate? What current debts could be paid off with the proceeds? Are the debts bigger than the anticipated proceeds. or other people who rely on you for financial support. highly rated. meaning they change throughout your life. housework. Chances are your rent or mortgage expenses would stay the same and that your child care bills would go up. sold) quickly. but it’s possible to get a fairly accurate idea of your needs. What continuing expenses would the survivor be willing and able to cut? What added expenses might you face if one of you died? Normally. and how much you spend. need to be paid for if one spouse were to In Shopping for Life Insurance. and the answer depends on whether you have dependents—children. the tricky part is determining exactly how much coverage you might need. From your expenses. You Should: . This again depends on specific circumstances. one size definitely does not fit all. If you have any dependents and want to protect their financial health after you die. then you do need life insurance. From your list of assets. you must know how much you own. Allow anywhere from one month to nine months to sell a house. clothing. If you don’t have dependents. Get your most recent mortgage statement (showing its retirement) or a copy of your rental lease.200 Chapter Ten Do You Really Need Life Insurance? This is the big question. consider what expenses would disappear if you or your spouse died. or would the proceeds be sufficient to pay off the debts? If your calculations include the sale of a home. a spouse. be sure to estimate the home’s value conservatively (use the lowest of all possible values). If you decide you do need life insurance. how much you owe. To find the size of this gap. Start with a copy of your household budget and a net worth statement—a simple listing of your assets and liabilities. life insurance is unnecessary. inexperineed. though. It’s really that simple. a house is not a liquid asset—it cannot be converted to cash (i.. Estimate expenses that would be eliminated if one spouse died. 2. 5. but it will yield a good. Be sure to consider items such as child care. partly because the financial issues will depend on the children’s ages and guardians. For single parents. you can follow the specific steps that follow to come up with a rough estimate of how much life insurance coverage you should buy. Most will fall between these two extremes. 4. Record the income each spouse contributes to the family budget to determine how much income would be lost in the event of either spouse’s death. With the information you’ve collected now. Using the previous information. Some families will need income from insurance proceeds for a few years and others will need income for life. Remember. Specific Steps to Calculate Your Life Insurance Needs This is not the only way to calculate life insurance needs. How accurately you are able to estimate all this will determine how accurately you are able to predict your family’s life insurance needs and how much monthly income your survivors would need if something were to happen to you in the near future. the steps will be more complicated.Life Insurance 201 die. How old are your children? Are they so young that the surviving spouse would face either a daycare or a financial crisis if he or she had to work more hours to help close the economic gap your death would leave? Would your children’s college plans be affected by your death? How would your death affect your spouse’s retirement plans? If your spouse is not currently working. rough estimate. Feel free to approximate the figures to the nearest nice-looking number. so you can calculate the insurance need for each spouse. Calculate your current monthly expenses. If you have assets that could easily be liquidated to pay off some of your debts to reduce your monthly expenditures. 3. estimate what each spouse’s monthly expenses and income would be if the other spouse were to die. Now. factor that in. eliminate that car payment. record the number twice. 1. Estimate the increased monthly expenses you might have if one spouse died. if you would sell one of two cars. If you are married. this is not an exact science. For example. would he or she be employable today or in the near future without job training or further education? How long would it take to make your spouse employable? How long would it take before your spouse’s income could make up for the income he or she would lose if you were to die soon? The length of time your survivors will need income will have a big role in determining how much insurance you need. Subtract expenses from income to determine whether there is a gap between the income that survivors . consider how long the survivors would need that income. term insurance is the best policy to buy. Lately. dren grow up. and Variable Universal Life Insurance). but would diminish once they became independent. Dollar-for-dollar. As a general rule. and become When you are starting off with a young financially independent. it is the cheapest and most efficient policy for you. To calculate a long-term insurance need. you receive nothing. Types of Life Insurance Life insurance can be broken into two main categories—temporary and permanent. and if you die during that term. For simplicity’s sake.202 Chapter Ten would need and what they would have in the event of a death. If you would expect to need income from the insurance for more than five years. you should perform the calculation explained in the next step. Increase in such reserve costs for insurance companies implies that we. Term Life Insurance Term Life Insurance provides coverage for a specific number of years (the term). with pressing needs and little discretionary income. For instance. you should buy the maximum amount of life insurance you can afford to protect your family—this usually means term insurance. a family may figure that their income would be lower than expenses for a few years when the children need day-care and financial support. the government has been forcing insurance companies to be more prepared to readily pay anybody who files a claim so the government does not have to bail them out. You pay premiums. If sive as you age (because the probability of you do not die during that term and do not your death increases). 7. the customers. leave the home. you have an insurance need. Insurance companies Trade-Offs with Term Insurance . your need for life insurrenew your insurance. In this chapter. make sure you account for time value of money by discounting the dollar sum appropriately to get a realistic present value. Universal Life. If you come up with a negative number. ance declines as you age because your chilThe term can be one or more years. multiply the gap figure by the number of months you expect this gap to continue for a rough estimate of how much insurance you need. 6. family. up to age fifty. your beneficiary receives the face While term insurance does get more expenvalue of the policy (the death benefit). are paying more for policies. Finally. multiply your current monthly gap by twelve to come up with an annual amount. we will discuss one type of temporary life insurance (Term Life Insurance) and three types of permanent life insurance (Whole Life. we will discuss the different types of life insurance and how to decide which one is right for you. Now that you’ve identified the amount of coverage you will need to purchase. however. the more expensive it gets. a portion of your premium goes to fund the death benefit. and your blood pressure. Whole Life a hybrid product that’s part insurance. The other portion of your premium accumulates in a tax-deferred savings account. The first example of this type of policy is Whole Life Insurance. a significant amount of cash value has built up in your account. as you can see. insurance companies want you to live as long as possible so that you can fund as much of your death benefit as possible. Figure 18 illustrates this. By then. If you should live to be 100. your driving record. the insurance company takes this accumulated cash value and adds a small amount of its own funds to make up the face value. the bulk of your death benefit will come from the insurance company (because you will not have accumulated much savings. . Should you die then. will be paid to the beneficiary if the insured dies. like a term policy. It is in your best interest to be as healthy as possible! The problem with term insurance is that the older you are. the insurance company will take the small cash value accumulated and add a large amount of its own money to make up the face value to pay your beneficiary. Fast forward to when you are seventy. If you die then. By the time you are thirty. If you die young. What options do they have? Whole Life Insurance If you are older and are looking for a modest amount of insurance combined with a tax-favored investment vehicle. Let’s say you bought a Whole Life policy at twenty years of age. some type of permanent. If you die before the policy matures. your cholesterol.Life Insurance 203 have also increased the standards of qualification for their best rates for term life insurance. term insurance can get prohibitively expensive. which. Now. a much more thorough analysis is done. your beneficiary will receive a death benefit equal to face value of the policy that will consist of the savings accumulated in the account plus a payment from the insurance company equal to the difference between the face value and the value of the savings. Insurance companies look at family health history. the accumulated cash value is still very small. part savings account. then the cash value buildup exactly equals the face value of the policy and the insurance company incurs no expense to pay off your beneficiary. Whole life calculations are based on the assumption that life starts at zero and ends at 100. cash-value policy might be right for you. your height/weight ratio. For older Americans. if you die old. the bulk of the death benefit will come from your own savings. Each year. Thus. There used to be two rates: one for smokers and one for non-smokers. In essence. 204 Chapter Ten Figure 11: Relationship between age and insurance company payouts There are some negative aspects to Whole Life policies. the policy remains active. it is likely to remain a fraction of what you’ve paid in premiums. You are likely to lose all of your premium payments if you cancel in the early years of your policy. Premium payments for this type of insurance are a constant. this policy offers an option—as long as you pay enough to cover the insurance portion of your policy. In the first few years. your premium payments go mostly toward paying for the insurance. however. Companies spell out how much of each year’s premium will be used for mortality fees and how much will be invested. If you can’t pay the premium in a given year. and very little goes into the cash value compartment of your policy. Once a year. the policy will lapse and you’ll get the accumulated cash value back. when you pay your premium. A few things about Whole Life policies are clear. the premium payment can be taken out of the accumulated savings if you do not want to pay anything at all for a year. . the company will tell you what your policy’s cash value is. For example. Or. but with the advantage of being more transparent. minus any cancellation fees. They are relatively inflexible and offer policyholders little control and transparency. Universal Life Insurance Universal Life works much the same way as Whole Life. If you can’t afford the whole premium payment one year. you do not know how much of it will be invested. you do not know what rate of return you will earn on the invested portion of your account. And for a few years beyond that. That’s because the cost of writing these policies—the agent’s commission and the underwriting fees and expenses—are front-loaded. You may have to undergo physical examinations to prove that you are still healthy if you wish to increase the death benefit. Also. and they’ll tell you how much you need to pay in premiums. Thus. you can adjust the death benefit during the life of your policy. the cash value of your Whole Life policy after the first few years is likely to be zero. In addition. however. This is one of the most widely offered and least understood policy options. which gives you tax-favored status. Some policies do exist with relatively low fees. fear not—there is a dizzying array of life insurance products out there. the downside of Universal Life is that the invested portion of the policy is being handled by an insurance company. One downside of these products is the fees. However. You can invest the cash buildup in your policy in one option or in some combination of options. etc.) is just a bonus. but you are investing through an insurance vehicle. higherreward options. you are hit with fees not only to pay the insurance company and insurance agents. the cash buildup in the policy can’t be predicted. Borrowing from Insurance If you have some sort of permanent. fixed-income mutual funds to higher-risk. such as small stock funds and high-yield bond funds. However. Remember that the primary purpose of life insurance is to protect your dependents should you pass away. Although the vast majority of insurers offer this benefit. and one is bound to fit your needs. Thus. . and it varies based on the investment choices you make and how well those investments fare. Policyholders get investment options that range from safe. you can do that without triggering a gain from the sale that could be taxed as long as you chose another investment offered through the policy itself. cash-value life insurance. but modest. which buys fixed-income instruments such as low-risk bonds. so they created a new product: Variable Life Insurance. Insurance companies noticed that a lot of people were doing this. And if you wanted to switch investments. many consumers don’t fully understand how these loans work. or if an investor has less need for the insurance guarantees or the tax benefits. however. An experienced investor may find that the tax benefit of investing through an insurance policy outweighs the additional costs. These policies are sort of like buying term insurance and holding a separate investment account. Everything else (investment accounts. that may not be true with higher cost policies. When you buy an insurance product that is so closely associated with an investment product. so Variable Universal Life works better than other investment alternatives. This produces steady. However. Variable Universal Life Insurance The investment portion of the Variable Universal Life policy is much more flexible than that of a Universal Life policy. low-yielding.Life Insurance 205 The flexibility of these policies allow you to adjust your payments and benefits as your needs and circumstances change. People willing to take a little more risk will prefer to invest on their own in the stock market. you can borrow from the accumulated savings. but to pay the investment companies and investment managers. If none of these options is quite right for you. returns. the popularity of these policies is limited to highly risk-averse people who dislike taking risks with their insurance money. if interest rates rise in the future.000.5 percent opportunity cost. you can borrow an amount equivalent to the full cash value accumulated in your account. Some policy loans are a tremendous bargain and others come at a tremendous cost. Your effective interest rate on the loan is closer to 5 percent— the 3. This is required by government regulations. if you don’t feel like it. but in an emergency. there’s no set repayment schedule.000 in the invested portion of your account. and puts it into a “guaranteed” fund. where it might be earning. the amount of unpaid interest will accrue .” there should be no interest on the loan.5 percent rate of interest only our $10. and vice versa. you need to understand the facts. you can opt to pay as much or as little as you like. for example.000 policy with a $75.000. the insurance company is actually forwarding you the loan with the cash value buildup held as collateral. There is always a stated rate of interest. And it’s simple to get the loan—usually all you need to do is call your insurance agent.5 percent you are charged plus the 1. the loan is written against your cash value buildup that serves as the collateral to your loan. Here is an example of how borrowing against your insurance policy actually works. where the money earns just 2. In fact. You want to borrow $10. so the insurer would be taking a loss on the deal. If you take a loan out and do not repay it. a loan can sometimes be processed in as little as three days or less. since the return on the guaranteed account is 1. But. 4 percent annually. The insurer has to factor in these scenarios when deciding how much to charge you for the loan. How much interest you will pay on the loan is not always clear. How Much Can You Borrow from Your Insurance Policy? In most cases. Let’s say the insurer decides to charge you a 3. But if you don’t pay at least enough to cover the interest payments. It can take up to two weeks to process the check. Let’s say you have $75. The reason the loan carries any interest at all is because technically the money is not coming from your own cash value. Before you take out a loan. the insurer would be forced to pay you more on the accumulated cash value in your account than you were paying on the loan. the interest rate may be slightly higher than comparable market rates.000 accumulated cash value.5 percent lower than the return on the investment account. you needn’t pay back the loan at all.000 out of your policy’s investment account. once you take out the loan.5 percent to borrow that money? No. If. Also. Unlike credit card loans. In most cases. Since there is no set payoff date for your loan. but frequently there will be hidden costs that can after the effective interest rate. You won’t be required to make any kind of monthly payment on it. an insurer will let you keep the loan outstanding for as long as your policy is in force. the death benefit from the policy is scaled down accordingly.5 percent per year. the interest rate is locked. Some people think that because they are taking out “their own money. This aspect of borrowing from your insurance policy is very important and can have adverse consequences. The insurer advances you the money and simultaneously takes $10.206 Chapter Ten When you take out a loan against the cash value of your policy.000 loan. you have a $500. Does that mean you’re paying just 3. say. you could borrow as much as $75. you may the cash value in your policy has grown to have very real taxes that are due on it. And if you die while you have a loan outstanding.. whether the money is subject to estate taxes is a function of whether the insured person owned the policy . Why is this important? On tax rates.e. As that balance increases. What happens if you don’t comply? The insurance company will report to the IRS a taxable income based on the paper profit you have made since you took out the loan—about $40.000. This may be a smart way to go because it allows you to use pretax dollars—investment income earned in an insurance policy is not taxed until the money is withdrawn from the policy. If the loan balance goes high enough. you need to be sure you are paying at least enough to cover the interest or your loan amount will increase. Assume that the accumulated cash value in your policy at this point is $60. So you have to pay income taxes on a $40. it will eat up the cash value in your account. While it is true that you if you are the beneficiary of a life insurance policy. you receive the face value without having to pay any income tax. you are borrowing from your are responsible for paying taxes on the profit insurance company with your money as built up in the account at your ordinary income collateral. Also. you will get a bill from the insurance company asking you to immediately pay the difference. you money.000 phantom gain. that taxable profit could amount to ues to grow. $3. You could also pay the loan interest with the accumulated dividends building up in your account. assume that nothing more than a paper profit. the death benefit will be reduced by the amount of the loan and any unpaid interest. Something to think consider! Warning about Borrowing An Insurance Mistake to Avoid One mistake people often make is to assume that life insurance proceeds are free of tax. $100. recall from an IRS Form 1099 should you choose to cash in your policy at a later date. by asking the insurer to pay you the accumuyou are not actually borrowing your own lated cash value of the policy over time. A few years later.000 in this case. Since insurers will only allow you to borrow up to 100 percent of the cash value in your account. if you have borrowed from your paper. An Example of the Adverse Tax Consequences of Borrowing from Insurance Say you borrow $50.000 while the balance outstanding on your loan has grown to $103. yet. i.000.000 from the cash value of your life insurance policy. So. When you norour previous discussion that when you mally cash in your policy or even “annuitize" it borrow from your life insurance policy. causing the policy to lapse. But again. the interest you owe increases with it. the cash value in your policy continaccount.000—enough to The outstanding loan balance from your ensure that the policy premiums are paid so you do not have to make any payments insurance policy may trigger the issuance of on the loan for a while.Life Insurance 207 and be added to the loan balance. some have not. Thought Questions 1. The company that purchases the policy pays an amount between the total premiums paid and the face value—in other words. the insured can gift you money (up to $12. What would happen to your insurance premiums if you lived a very risky lifestyle? 2. In 1997. making you both the beneficiary and the policy owner. you have to pay estate taxes on it. The company would have the responsibility of making the premium payments to keep the policy active and upon the policyholderʼs death would receive the face value of the policy. there was little regulation of these practices. which led to fraudulent actions by some. Why do insurance companies accept your risk? . In most cases. but policyholders could collect only under very specific circumstances. were tax-exempt as long as the claimantʼs life expectancy was less than two years and the viatical settlement company was licensed. Over time. they had transferred ownership of the policy to you prior to death. While most states have made these settlements tax exempt.208 Chapter Ten Viatical Settlements A viatical settlement occurs when a life insurance policyholder sells that policy before it matures. Here is an example of how improper transfers of insurance ownership can hurt survivors. Initially. He also happened to die within three years of the transfer. If. If they did. however. you also have to make the premium payments. State taxes are another matter though. Insurance companies. or viatical settlements. Can you think of examples in your everyday life where you routinely use the concepts of adverse selection and moral hazard? 3. came up with innovations of their own. Congress weighed in by changing the tax code such that the proceeds from either accelerated benefits. If you own the policy. For that. These settlements involve policyholders with a shortened life expectancy—usually due to terminal illness. These settlements became popular during the AIDS crisis of the 1980s. An insured person transferred ownership of a $1 million policy to a life insurance trust but failed to make the trust the beneficiary. the insurance company would reduce the benefits provided the policyholder before death in order to compensate itself for the interest it would lose through early payout. on the other hand. which included an “Accelerated Benefits” provision in the life insurance policy which would offer anywhere from about 25 to 100 percent of the death benefit as early payment. not wanting to be left out of the action.000 in estate taxes that might have gone to them if things had been handled properly. Today. like cancer. The ailing policyholder can then use the proceeds that would normally be available to her designated beneficiary only after her demise while she was still alive for current medical expenses. at the time of their death. such buyouts became fairly standardized. they buy the policy at a discount. they are mainly used by patients with other types of terminal illnesses. however. then there are no estate taxes to worry about.000 per person in 2007) to make those payments. His mistake cost his heirs $450. What are the similarities and difference between investing in a funeral home and in a viatical scheme? 9. How does insurance fit in this model? 5. does life insurance play in your retirement planning? . What is the dominant characteristic of a Variable Life policy? Does it violate the basic tenets of insurance? 11. What are some possible risks involved in viatical settlements? 8. What role. When in your life cycle should you switch from no insurance to term insurance to a cash-value insurance? 6. Why do insurance needs decline as you age? 7.Life Insurance 209 4. if any. What would happen to the world if it were populated only by risk averse people? Hint: Think of a world comprised of only risk averse and risk seeking people. Can you think of any circumstances in which you might need life insurance even if you had no dependents? 12. Why is the inflexibility and opacity of Whole Life policies a bad thing? 10. . Guaranteed purchase options enable the insured to purchase additional coverage without providing evidence of insurability. Suicide clause specifies that benefits will not be paid if the insured commits suicide within a specified amount of time after policy inception. Nonforfeiture options provide a cash value life insurance policyholder with some benefits. Settlement options specify the way that benefits will be paid after the death of the insured. Summary of Life Insurance Contracts Term Insurance • Benefit paid if insured dies during the policy period. Multiple indemnity increases the face value of the policy by a multiplier (usually 2 or 3) if the insured dies in an accident. Exclusions stipulate circumstances in which benefits will not be paid. 211 . even when the policy is terminated prior to its maturity. Participating policies enable the policyholder to receive dividends that reflect the difference between premiums charged and the actual amount needed to fund the mortality experience of the company. Living benefits allow the insured to receive a portion of benefits prior to death. Grace period permits the policyholder to retain full coverage for a short period of time after missing a due date for a premium payment. Policy reinstatement revives the original contractual relationship between the insurance company and the insured. • No savings component. Policy loan provisions are loans secured by the cash value of the policy.Appendix to Chapter 10 Insurance Terms Beneficiary clause specifies the person(s) who will receive benefits after the death of the insured. Disability clause may include a waiver of premium benefit and/or a disability income portion. Change of policy provision permits the policyholder to switch policy forms. Payment of premiums specifies when premium payments are due. that amount is subtracted from the face value of your policy. insurance remains in force until death. Types of Term Insurance • Straight term—coverage remains the same while premiums increase. • Convertibility allows insured to convert to Whole Life policy without evidence of insurability. Types of Whole Life Insurance • Continuous premium—level premiums are paid until death or cancellation of policy. Whole Life Insurance • Provides death protection plus a savings feature called cash value. insured has the right to the cash value of the policy. . • Provides lower returns than other savings vehicles. This is also known as the nonforfeiture right. • Limited payment—level premiums are paid for a specified number of years.212 Chapter Ten • Economical way for young families to purchase large amounts of life insurance. • If you have a loan outstanding when you die. Features to Look for in Term Insurance • Renewability allows insured to renew policy without evidence of insurability. • Tax penalties may be assessed on cash values withdrawn early. • Decreasing term—premiums remain the same while coverage decreases. • Premiums remain constant. Universal Life Insurance • This insurance provides death protection plus a savings feature. • If policy canceled prior to death. • Loans must be repaid with interest. Advantages of Whole Life • It provides a savings vehicle. Disadvantages of Whole Life • This insurance provides much less death protection than term insurance. • Cash value can be borrowed against. • Single premium—lifetime coverage is purchased with a single premium. • Cash value accumulates tax free until redeemed. Appendix to Chapter 10 • Premiums are “unbundled” into two separate accounts. Other Types of Life Insurance • Variable and Variable Universal Life. 213 . • Group life insurance. • Insurance on multiple lives. • Provides flexibility in premiums paid and death benefit. • Savings grow at the current interest rate. . Health maintenance organizations (HMOs) offer comprehensive services that are usually contained within one facility. users make monthly premium payments directly to healhcare providers and receive services from a designated group of doctors and hospitals.11 Health and Property Insurance Are you in good hands? (Allstate commercial) Before you invite too many cooks in your kitchen to make broth. physicians operate out of their own offices and community hospitals. the insurance company would like to avoid the sick people and insure as many healthy people as they can. These are summarized below. In preferred provider organizations (PPOs). There are several types of managed care plans. It is based on the same risk-pooling concept we discussed regarding life insurance. The same problems of moral hazard and adverse selection apply. but the people who know they are likely to fall ill are the ones who are more enthusiastic about buying health insurance policies. health insurance has its own terminology. 215 . For example. pay for their services. it is important to be aware of the types of plans that are available. The wide variety in types of policies and quality of coverage can make choosing a health care plan very complicated. Managed Care Plans Under these policies. which will be covered here. However. make sure you have adequate homeowner’s insurance. as well as the features that characterize each type of plan. In individual practice associations (IPAs). Under these plans. —Sugato Chakravarty Health Insurance There is not much different about health insurance relative to other kinds of insurance. In selecting one. Traditional Indemnity Plans Traditional indemnity plans are also called fee-for-service plans. there is a broader network of “approved” physicians. policyholders typically choose their doctors and hospitals. and policyhodlers are allowed to use out-of-network providers if they are willing to pay increased fees. and then get reimbursed by the insurance company. Among the many questions asked are: “Are you a smoker?” If you are. . every time they feel a twinge they visit their doctor to have it checked out and demand supplementary tests.216 Chapter Eleven Critical Info: Smoking—The Great Elevator of Health Insurance Rates Smoking is the worst thing you could possibly do.com and observe how sensitive your insurance rates are to the various health-related questions you are prompted to answer. your rates at least double relative to those who do not smoke. who are the ones making the expenditure-related decisions (i. How does one operate in such an insurance market? Naturally. the challenge is to design appropriate coinsurance arrangements where patients pay for care up to the point where the marginal gains from less risk sharing are just offset by the marginal benefits of less wasteful care being provided. that can slow the system and make it difficult for truly ill patients to be adequately treated.insweb. What is interesting is that if you claim (in one of the other questions) that you are an intravenous drug user (but not a smoker) your rates hardly change. It also has an added problem in that it does not adequately incentivize the physicians. If you donʼt believe me. as far as your health insurance rates go. according to the insurance companies. by ordering more tests and prescribing expensive medication). go to www. The available data shows that both moral hazard and demand inducement are quantitatively important. However. Physicians have an incentive to encourage such hypochondriac behavior: they will be well reimbursed for it. the economists’ approach is to provide the patients with choices through a surge of managed care choices and allow each service-providing entity to compete freely in the market..e. the choice in health insurance is a mixed blessing because of adverse selection problems—the tendency for the sick to choose more generous insurance than the healthy. Simply stated. The resulting high premiums serve to discourage those who are currently healthier but would prefer generous care from enrolling in those plans (because the premiums are so high). plans that are heavier on the relatively sick (poor risk) would have to charge more to be profitable relative to plans that comprise an average (or better) mix of sick over healthy. Therefore. while simultaneously encouraging plans to device strategies that discourage the sick or sickly from enrolling so that the overall costs are reduced. That is. Optimal Design of Health Insurance Contracts A well-designed health insurance policy will have an appropriate trade-off between risk sharing and moral hazard—the perverse incentive of people to seek more care when they are insured. the goal is to adequately motivate physicians to buy into the supply side cost containment measures by financially rewarding such behavior. being a smoker is far worse than being an intravenous drug user. Therefore. Coinsurance-based control on expenditure is a crude incentive mechanism. When the sick and the healthy enroll in different plans. This allows patients to choose the plan that best fits their budgets at costs that are reasonable. Health and Property Insurance 217 The welfare losses from adverse selection are large in practice. NBER working paper #7176. genetic treatments and other forms of medical • Waiver of coinsurance. Critical Info Reference Cutler. and other government health programs at the federal. and local levels. this lack of futures health care insurance policies could become a significant issue.M. insurance: the right to buy health coverage at aver. Private Insurers • • • • Insurance companies Managed care organizations Blue Cross/Blue Shield (prepaid expense plans) Group plans (may incorporate any of the above) Government Agencies • Social Security’s Medicare program —Part A—basic hospital insurance for those sixty-five and over who are qualified —Part B—supplementary medical insurance. Major Providers of Health Insurance The major providers of health care insurance in the United States can be broadly divided in three components: private insurers. state. Boston. Zeckhauser. Because insurance contracts are annually costs down in policies through: renewable. and R. Added are further losses from having premiums that vary with observable health Insurance Companies try to keep status. the current research is not clear about which specific approach to health care insurance (universal coverage or some other formula) might promote health in the most cost effective manner. government agencies. we have to be clear in our minds about what exactly insurance does and how it relates to expenditures in the health care market. including Medicaid and programs for military personnel. J.• Continued-stay review. patients are denied a “futures contract” • Preadmission certification. Other sources of health care insurance include homeowner’s and automobile insurance policies containing limited amounts of medical coverage. Consistent with the confusion in public policy. optional coverage available for a monthly premium to those eligible for Part A . and workers’ compensation.. D. age rates in the future if they got sick today. As • Caseworkers. MA. Resolving this question will be the central focus of policy makers and politicians in the years to come. The Aanatomy of health insurance. At the end of the day. 1999. diagnosis get better and the ability to predict a patient’s future health status increases. If that crucial link between the two is better health for the covered citizenry then we will need to have a serious debate about whether the health care system today is promoting better health at affordable costs. • Second surgical opinions. and selected other services.218 Chapter Eleven Critical Info: Health Insurance Policy Provisions In comparing health care coverage offered by different providers. customary. so do the types of medical expense coverage they provide. At your expense. How restricted is the coverage? Workers’ Compensation Insurance • Premiums paid by employers for workers injured on the job • Coverage includes: —Medical and rehabilitation expenses —Disability income —Lump-sum payments for death or dismemberment —Second-injury funds Types of Medical Expense Coverage Just as health care plans differ. • Coordination of benefits. Plan may include a stop-loss provision to cap your out-of-pocket expenses. • Continuation of group coverage (COBRA). . This limits the amount paid on certain items to usual. What is the extent of the coverage provided? • Mental illness. you should examine the provisions of each type of plan. • Internal limits. How are they covered? • Pregnancy and abortion. Terms of Coverage Important provisions to consider in your health care policy: • Persons and places covered. you can continue your previous employerʼs coverage for up to eighteen months after you leave the job. • Rehabilitation coverage. Who is covered and where are you covered? • Cancellation. use of hospital facilities. even if the cost of the entire surgery or illness is within the norms. Company pays only a portion of the medical expenses after the deductible. Here are some examples of types of medical expense coverage: • Hospital insurance. and reasonable charges. Pays a portion of per-day room-and-board charges. How much is provided? • Pre-existing conditions. The initial amount which is not covered and is determined on a calendar-year or per-incident basis. This eliminates double payment when coverage is provided under more than one policy. Obtain a policy that cannot be canceled unless premiums are not paid. Provisions that are generally associated with health care coverage include: Terms of Payment How much your medical expense plan will pay is usually determined by the following four provisions: • Deductible. • Participation (Co-insurance). They are usually sold through employee benefit plans. Pays physician fees for nonsurgical care in the hospital. To receive $250 per day in hospital benefits (for a hospital stay of up to 365 days). extended care. Pays cost of surgery either in or out of the hospital. Provides insurance coverage for foreign trips. health care plans may also offer coverage that you don’t need. surgical. However. Covers necessary dental care and some dental injuries. not all procedures. . It is usually offered through group insurance plans. a forty-five year old male living in Indiana will have to pay an annual premium of about $325. is in the neighborhood of four days. Such policies can cost around $25 per month for individuals and about $30 a month for families and provide about $2. it combines major medical with basic hospital. loss of baggage.S. passport. statistics provided by the Department of Health and Human Services indicate that the average length of hospital stay in the U. However. are covered. usually travelrelated. For example. hospital stay. and physicians’ expense coverage. and outpatient surgeries. Here are some examples: • Accident policies. emergencies. Coverage includes emergency medical services on foreign soil and payout for dismemberment. • Surgical expense insurance. • Physicians’ expense insurance. They also provide limited additional benefits for intensive care. the cost of insurance for a one-week trip to Europe for a single individual is about $20 without winter sports–related coverage and about $40 with winter sports coverage included.500 in benefits with a $100 deductible. The most desirable coverage. It is estimated that over 10 million people in the U. • Hospital income policies. These policies provide a specified pre-determined amount for each day of a covered hospital confinement. including consultation with specialists and lab tests.S. such as cosmetic or experimental surgeries. A twenty year old female will have to pay around $290 annually for the same per diem payout. This type of coverage is usually offered through group plans with a low deductible. • Travel Insurance. Covers medical assistance or transport back home following illness or accident or if you have a serious illness of a close relative back home. • Cancer Insurance. but there are a lot of exceptions. • Major medical insurance. Health Insurance Coverage You Don’t Need Interestingly. have cancer insurance policies. Amount of coverage is large. • Comprehensive major medical.Health and Property Insurance 219 • Dental insurance. making this policy unnecessary. These only cover certain types of accidents. Provides broad coverage for illnesses and injuries of a catastrophic nature. etc. a cancer insurance policy may limit coverage for Stage A prostate cancer or exempt certain forms of skin cancer from coverage.7 percent had health insurance. many of today’s treatments.4 million people.3 million people. Census Bureau. or 46. such as chemotherapy and radiation. Commonly reported problems associated with this policy include: Pre-existing Conditions. cancerrelated illnesses or injuries such as infection. Most policies will deny coverage for pre-existing conditions. are done on an outpatient basis. narrow definitions of the conditions and treatment they will cover. They cost more than these policies bought individually but provide significantly more. insurance companies will no longer be able to deny coverage to children under the age of nineteen because of pre-existing conditions. radiation. However.000 in 2009. Narrow Definitions of Terms. When examined from a different angle.S. from 59. or 177.3 percent. about 15. health expenses. and preventative care. In addition. Cancer insurance will provide coverage only for cancer and it is subject to meeting all of the above hurdles to qualify. For example. (Starting in 2014.4 percent of the population. about 70. Many cancer insurance policies only cover procedures and treatment that occur during hospitalization. while for those with incomes of $75. Any way we look at . Sobering Statistics According to the U. including cancer. Among people in households with annual incomes of less than $25. Secondary Illness.7 million people in 2007. were without health insurance coverage in 2009. the percentage and number of people covered by employment-based health insurance fell between 2009 and 2007. or pneumonia. Furthermore.) Limited Outpatient Coverage.5 percent.2 percent had health insurance. up from 45.3 million people. which means they will not be covered. or 176.000 or more. Overall. Some cancer insurance policies will deny claims even if the person did not know they were sick when they applied. consider having one major medical policy that will pay you more in covered costs for any of the above issues and much more. surgery. diabetes.220 Chapter Eleven Cancer insurance policies promise to provide cash benefits for cancer-related medical expenses such as hospitalization. to 58. Also. Here are the cold hard facts. cancer treatment accounts for approximately 10 percent of U. the likelihood of being covered by health insurance rises with household income. They also have the benefit of providing significantly higher maximum dollar benefits—sometimes to the tune of $1 million. chemotherapy. according to the National Association of Insurance Commissioners. 92. Some insurers have strict. instead of buying the above policies piecemeal.S. Cancer insurance policies often do not cover secondary. major medical policies have the added benefit of covering you (and your family) for any accident and illness. anesthesia. What types and levels of care are covered? • Benefits.In determining whether or not you need longterm care insurance. How much are they? Will they increase? Is there an inflation clause built into the policy? Ideally. Long-Term Care Insurance An estimated 15 million Americans need assistance from others to carry out everyday activities. The act is intended to reduce the abuses of the insurance industry. ask yourself the followcent of the federal poverty level). the 11th Circuit Court of Appeals ruled on August 12th. other than hospital care to persons with chronic medical conditions due to illness or frailty. and not to pay for more coverage than you need. healthcare reform legislation called the Affordable Care Act was signed into law. but not all. Is the policy guaranteed renewable? • Pre-existing conditions. ing questions: Do I have a lot of assets to preMany major health care insurers still do serve for my dependents? Can I afford the not cover costs related to long-term medical premiums? Is there a family history of disand personal care. the market for abling disease? Will my family be able to care long-term care insurance is evolving.Health and Property Insurance 221 it. 2011. 40 percent of the older population with long-term care needs are poor or near poor (with incomes below 150 per. these are sobering numbers and underscore the need for major health care reform in this country. . It is important to calculate what your needs will be. when will the payments begin? • Renewability. It is very important to understand the policy provisions and when benefits will be paid if you become disabled. forty-four percent are working-age adults aged eighteen to sixty-four. Most. Thus. for me? Based on your answers. and 3 percent are children under age of eigheen. It can help to increase waiting periods if you can cover costs yourself for a certain time period. you want to buy a long-term care policy when you are still healthy. Approximately 53 percent are persons aged sixty-five and older. How will they be handled? • Premiums. In March 2010. What are the eligibility requirements? How much is the daily benefit and how long will it last? • Waiting period. Once eligible. Policy provisions that should be considered in selecting a long-term care plan include: Do You Need Long-Term Care Insurance? • Care. it should Long-term care coverage provides for become clear whether long-term care insurthe delivery of medical and personal care ance is right for you. persons in need of long-term care are elderly. However. that the health care reform law’s requirement that nearly all Americans buy insurance is unconstitutional. 8% 33. Estimate existing benefits such as: • Social Security • Other government benefits • Company benefits • Group disability policy benefits 3. on the other hand. guaranteed insurability option.1% 34.222 Chapter Eleven Disability Income Insurance There are two threats to your ability to earn an income—death and disability.6% 10. • Benefits. . isn’t a certainty. how long is it before benefit payments begin? • Renewability. but we know it is inevitable. Disability.1% 26.3% 40 45 21.3% 50 55 60 18.1% 31. is dependent on the provisions of the plan. “Own occupation” is most desirable (this implies that anytime you are unable to perform the duties of the occupation that you are trained and qualified for.3% 14.8% 30 35 23. Once disabled. you are considered disabled). as well as the amount of coverage provided.5% 22. 2. Age Death Disability 25 24. a disability between the age shown and age 65.8% 20. Disability income insurance provisions generally include: • Definition of disability. Critical Info The cost of disability insurance. We don’t know when death will occur. and a waiver of premium. How long will you have to wait before benefits are available? • Waiting period. Subtract (2) from (1). Disability insurance provides families with weekly or monthly income to replace income lost when the insured is unable to work due to an illness or injury. When estimating disability needs: 1. What are the chances that you will be disabled before the age of sixty-five? The table below puts it in perspective.4% 29.6% 17.3% 22.6% Figure 19: Probability of death vs. here. we deal with disability. Look for cost-of-living adjustment. How much will they be and how long will they last? • Probationary period. We dealt with death in the previous chapter on life insurance. Estimate monthly living expenses.9% 9. Is it guaranteed renewable or non-cancelable? • Other features. Recent statistics released by the Insurance Information Institute show that the nationwide average expenditure for homeowners’ insurance is about $600 annually. the insurance company will not fully repay you for your loss. or stolen. Almost all of the remainder goes toward commissions. Homeowner’s Insurance Usually. state premium taxes. • Liability—damage you cause others. Property insurance contracts generally have co-insurance provisions. the depreciated value of your property unless you have replacement cost coverage. There are two primary types of exposure that most people face: • Property loss—economic loss because your property is damaged. Therefore. it is important to make sure it is sufficiently protected. has its own distinct vocabulary and it is essential to understand it. licenses. This principle says that: • The insured is entitled to payment from the insurance company only if a loss has been suffered. • Actual cash value. a person’s home is among his or her most valuable possessions. You can only insure property in which you have an interest. at most. The following concepts are related to the principle of indemnity: • Insurable interest. which most of you will deal with in one form or another. . The latest data shows that homeowners’ claims accounted for about $78 out of every $100 in insurance premiums. • Subrogation. You will have become the “coinsured” and must bear part of the loss. the companies together will not pay you more than your economic loss. you must first understand the types of losses to which you may be exposed and how these potential losses can best be covered. You give your right to collect damages from the person who harmed you to the insurance company once the company has paid you. destroyed. and (2) otherwise. general overhead expenses. You can collect. If multiple companies insure the property. and fees. • Other insurance. either through your actions or through negligence.Health and Property Insurance 223 Property Insurance Now we turn to another application of the insurance principles we covered earlier: property insurance. To make decisions regarding the types of property insurance you need. • The amount of payment should not be greater than the economic value of the loss. which require that: (1) you must buy insurance in an amount equal to at least a certain percentage of the replacement value of your property. This area of insurance. Most property and liability insurance contracts are founded on the principle of indemnity. For example. bility. Some factors that limit homeowner’s insurance payments are: —Insurable interest —Subrogation —Other insurance The replacement cost is the amount necessary to restore your property at today’s prices. Your policy may also exclude other perils. Deductibles help hold down insurance costs because they eliminate frequent small loss claims. earthquakes. The following are examples of homeowner’s insurance policy provisions. jewelry. Coverage for guests may be limited. Persons Covered This section states who is covered under the policy. Section II deals with liaif you happen to have an older home. Check what conditions it will be covered. which are proportionately more expensive to administer. Section I ment at actual cash value. Critical Info There are several types of homeownerʼs insurance policies available. reimbursement for furnishings and personal property in your home will be limited to 75 percent of the policy amount.224 Chapter Eleven Homeowner’s insurance policies state the conditions (perils) under which the policy will pay a benefit and also stipulate the property that is covered and the extent to which it is covered. which may arise in connection with • HO-6—Condo ownerʼs insurance this property. For example. Policy limits state the maximum payouts for certain damages. For large dollar items that leave the home (watches. deals with loss to your property. the maximum payable on furnishings would be 75 percent of the policy amount. either through your actions or through negligence. such as the homeowner and residents of the household. consider adding a Personal Property Floater (PPF). All homeowner’s policies are now automatically sold at replacement cost unless you happen to live in a designated “older” home. Additional coverage can be obtained through the purchasing of “endorsements. This part of a homeowner’s insurance poliStandard HO policies are sold for replacecy is divided into two sections. Locations Covered Most policies cover your personal property worldwide even in a second home (although the second home’s dwelling structure is not covered). and the with your insurance agent before signing on extent of coverage. ”72 Limits are placed on the property covered. Having higher policy deductibles helps lower premium costs on the one hand and minimizes frivolous claims on the other. Perils that are rarely covered are floods. . For older homes. under policies are sold at replacement cost up to a pre-stated maximum dollar value. golf clubs). These include: • HO-4—Renterʼs insurance • HO-5—Homeownerʼs insurance Most homeownerʼs policies are now automatically adjusted so you have coverage for Perils and Property Covered at least 80 percent of the property value. and acts of war. PMI may be waived when the loan reaches 80 percent of the value of the property. The down payment may be a gift from a relative or it may be borrowed against the your own assets. monthly. Private mortgage insurance was developed to help borrowers purchase a home without putting 20 percent down as has been traditionally required by banks and lenders. When the loan-to-value for an owner-occupied residence is more than 80 percent (or the borrower is putting less than 20 percent down). You shuld shop around before you settle on an insurance company and the specific policy. Have your lender or mortgage broker set up two loans: The first mortgage of 80 percent and a “second” for 10 percent or 15 . that not all loans require mortgage insurance and the premium varies due to different criteria. the most severe homeowner’s losses resulted from: (1) fire. In 2009. and debris removal. The premiums are based on the amount and terms of the loan and may vary according to the loan-to-value. Avoid Paying Mortgage Insurance If you want to reduce (or avoid) paying mortgage insurance. and the amount of coverage required by the lender. (3) water damage and freezing. according to a survey conducted by an Insurance Research Group. private mortgage insurance (PMI) may be required. lightning. (2) wind and hail damage. the higher the premium. differ depending on location. such as for nonsmokers or for security systems. Note. • Put 20 percent down on a conventional loan. Keep these statistics in mind when you decide whether to purchase additional coverage through your homeowners’ policy. however. between the years of 2005 and 2009. you have several options. term of loan. Finally. Different types of loans have different requirements for the amount of coverage needed. Homeowner’s Insurance Claim Statistics According to the Insurance Information Institute.Health and Property Insurance 225 Homeowner’s insurance premiums differ from company to company. Mortgage Insurance Mortgage insurance covers the mortgage lender against loss caused by a borrower’s default. type of loan. and (4) theft. the average amound paid per claim was $8. It may cover all or part of the loss. and differ on discounts offered. but they essentially serve the same purpose: to protect the lender. and it may not relieve any liability on the borrower’s part if the mortgage is defaulted on. about 27 percent of homeowners had made at least one claim on their home or condo policy in the ten years between 1993 and 2003.116. The premium may be paid on an annual. such as a loan against your 401(k) or automobile. The less the borrower puts down. or single-premium plan. . and sudden or accidental damage from smoke. The most common misconception. Every twenty-five seconds. The first mortgage can then be sold by the bank to some national mortgage company while they keep the second loan in house. instead of receiving all cash from the buyer at the time of sale. The overall odds of having a vehicle stolen are about 1:190 and the odds are considerably higher in urban areas. lightning. a motor vehicle is stolen in the U. is that renters believe they are covered by their landlords’ homeowner’s policies. My experience has been that competition among lenders forces banks to be extremely proactive in working with you to avoid paying PMI (private mortgage insurance). The downside to this is that since there is no mortgage insurance. Since the mortgage insurance is built into the interest rate. the Cadillac Escalade is a popular choice among thieves. Renter’s insurance usually covers fire. • Apply for an 80 percent mortgage and have the seller carry back a second mortgage (also known as a line-of.credit that is junior to the first mortgage). should also be insured against loss. therefore. or even avoid. • Have the lender set up Lender Paid Mortgage insurance and build it in your mortgage. theft. Renter’s Insurance A 2003 poll conducted by the Independent Insurance Agents & Brokers of America found that 64 percent of respondents living in rental properties had no insurance. mortgage insurance. explosions. This is not true. hail.S. get renter’s insurance. including theft. Maybe there are just so many of them on the roads that they are the easiest and the most convenient to steal. vehicles. insurance companies paid out about $167 per year in theft claims for every insured Escalade. Among luxury cars. The average basic cost is about $100 per year for $10.226 Chapter Eleven percent. What does it mean to say that the seller carries back a mortgage? Simply that the seller helps finance the buyer’s purchase by loaning the buyer part of his equity. To protect yourself from losses occurring on rented property. depending on the facility’s construction type.000 of coverage. The latest available data shows that thieves prefer to steal Honda Accords and Toyota Camrys. the survey discovered. windstorms. A carry back does not mean the seller takes out an additional mortgage before selling. Note that the seller may wish to do this only if he or she is desperate to sell the house. Keep these facts in mind the next time you are thinking of buying a car. which is quite affordable. you can’t really drop it when the property value reaches 80 percent. discuss with your lender or mortgage broker what other options and loan programs may be available to reduce. Any time mortgage insurance is required on a home loan. On average. it may be tax deductible. Auto Insurance Automobiles also tend to be among people’s most valuable possessions and. For instance. Part C: Uninsured Motorists • Pays when other driver has no insurance or in the case of a hit-and-run.000.000.000 property damage per accident. $100. —Additional coverage available for protection against under-insured motorists. 227 Auto Insurance Reality Auto insurance rule of thumb: the car that is moving at the time of the accident is the guilty party! In the world of auto insurance.000. and passengers in covered vehicles. For example. $300. $40. increase the coverage appropriately. Must meet the following criteria: —Other driver was at fault. —Damages were incurred.000 bodily injury per person. are: Part A: Liability • Required in most states. family members. the higher the policy limits. and $15. Keep that in mind when you decide how much insurance to purchase. Then. as you become more established in life. However. the split is 20/40/15. and their respective provisions. • Covers the insured. and you hit him. • Usually required for financed cars (lender wants to protect the investment). • Some insurers split the limits of liability coverage available. in Illinois.000. the higher the premium. and $500. • Pays injury and property damages to others when you are responsible for the loss. • Covers costs of settling or defending claims for damages.000 bodily injury per accident. • Typical single dollar limits are $50. • Pays no matter who is at fault.73 These parts.Health and Property Insurance Auto insurance policies are comprised of four parts. —Other driver had no insurance and you know who they are. it pays to stand still. • Covers injuries sustained as a pedestrian or while riding a bicycle. . meaning that if you only have the minimum coverage. your insurer would pay at most $20. if the car ahead of you brakes suddenly because the driver wants to admire a flock of flying geese. Part B: Medical Payments • Reimburses for medical expenses resulting from an accident. The general rule of thumb here is to start off with the minimum coverage limits when you are starting off in life and have little money to spare. it is deemed to be your fault! Policy Limits • Insurance company will likely limit the total damages paid for any one accident. Part D: Damage to Your Car Collision • Pays the actual cash value of the damage (loss). of course. minus any deductibles. The question is: Who pays if the costs exceed these limits? You do. i. and a description of the vehicles of all parties involved. • Earthquake insurance is available as an endorsement on homeowner’s policies. Some of these factors are: where the car will be driven. people may have special needs for other related types of insurance. . the personal characteristics of the driver. fire. Some of these may include: • Flood insurance. which is not included in standard homeowner’s policies and is available as a separate policy. take driver’s education. the type of automobile. it is important that you comply with the claims procedures established by your insurance company. be a good student. take defensive driving. addresses. raise your deductibles. Settling Auto Insurance Claims In the event that a type of loss or accident that you are insured against occurs. the amount the vehicle will be driven. addresses. There are a number of factors that come into play in the determination of automobile insurance premiums. and phone numbers of any witnesses. In the event of an accident. and raise your liability limits. • Contact the police immediately. • Take pictures or sketch the accident.e. driver’s license numbers. phone numbers. your actions and your choice of vehicle can influence your automobile insurance premiums. • Investigate the claim. • Contact your insurance agent immediately. To hold premiums to a minimum. your company will: • Require timely notice of accident. • Require you to prove your loss. have airbags and a security system.. The claims adjustor will then: • Evaluate the claim. • Get names. Other Types of Property and Liability Insurance While homeowner’s and automobile insurance are the most commonly needed types of property and liability insurance. or recommend denial of the claim. The following are general recommendations that will help improve the likelihood your claim will be settled properly. To a great extent. After an accident: • Get names. • Recommend settlement of the amount requested. falling objects. or a lesser amount. theft. and the driving record of the insured. insurance policy numbers.228 Chapter Eleven Comprehensive • Protects against loss to insured auto caused by any peril other than by collision. etc. What happens to prices and traded quantities if agents on one side of the market are better informed than those on the other? What can better informed agents do to improve their individual market outcome? What can the less informed agents do to improve their individual market outcome? These are some of the most intuitive questions on which the science of insurance is based. You need to be protected from lawsuits against you. Akerlof’s brilliance lay in suggesting that many market institutions we observe all around us may have arisen precisely to cope with the problem of adverse selection. a seller of high-quality units is less willing to sell than the seller of low-quality units. golf carts. Another economist by the name of Michael Spence asked under what conditions can the better informed sellers in the market truthfully and credibly transmit. If the less able students need to spend more effort and time than the smart students in order to obtain any given level of education. who continue to leave the market until only low-quality items remain for sale. which further discourages sellers of high-quality units. the buyer of an insurance policy usually knows more about her individual risk than the insurance company. For example. Intuition from Insurance Research Here. That is. only indirectly through their educational record. I will essentially summarize the work of four economists whose research forms the cornerstone of any work in insurance markets. . George Akerlof was the first to explore the importance and implications of the fact that sellers in many markets are better informed about product quality than buyers. for example.” their information to the less informed (the buyers). • Insurance on other forms of transportation. This is another manifestation of adverse selection. Opposing counsel always looks at your financial means to decide whether it is worth her time to go after you in court.Health and Property Insurance 229 • Umbrella personal liability insurance—additional liability coverage. So. RVs. then the smart ones signal their ability by undertaking an education which is too costly for the less able students to mimic. or “signal. given the prevailing wage difference. At any given price. This rational skepticism depresses prices. This insight has led to a rich body of subsequent research. the “sellers” could be job applicants in a market where employers cannot observe the job candidates’ ability directly. boats. the seller of a product often knows more about its quality than the prospective buyer. sellers of high-quality items must take observable measures that are too costly for low-quality sellers to mimic. Recall that asymmetric information is a common feature of market interactions.74 Can you think of why? Rational buyers anticipate this. such as mobile homes. suspecting that the item they face is of low quality. • Professional liability insurance—lawsuit protection for professionals. This is especially important as you climb up the professional ladder. motorcycles. a job applicant will typically know more about his own ability than his potential employer. Similarly.75 For such signaling to work. Adverse selection may thus hinder mutually beneficial transactions. etc. albeit at a cost—the more able educate themselves more than the less able. Low-risk clients typically pay a lower premium. As a regular guy in your early twenties. Consumers now have more choices than ever before. They showed how. and a range of other observed phenomena. You go to several websites with instant quotes and compare several of them. you realize it may be wise to start thinking about buying some life insurance protection for your young family. which dismantled the Depression-era walls between insurers and banks. but have to accept a relatively high deductible. you only need to fill in some basic information and you receive a list of insurance quotes. the number of websites offering insurance information and instant price quotes is on the rise. banks and other financial-services firms are moving into the business of selling insurance. For any type of policy. and when. In the wake of the sweeping Gramm-LeachBliley legislation.230 Chapter Eleven In such circumstances. even in the absence of innate productivity differences between these groups. two economists. less-informed consumers might extract information from their better informed counterparts on the other side of the market by offering a menu of contracts. Why is it not practical for high-risk clients to mimic the contract meant for low-risk clients? Bringing It Together: Shop Around for the Right Policy Here is a typical scenario. provided a natural complement to Akerlof’s and Spence’s analyses. signaling overcomes the problem of adverse selection.com have made consumers’ searches a breeze. even if education has no direct effect on their productivity. Other examples of market signals are costly advertisements. So you scour the local billboards and watch TV commercials to find a local financial planner who will provide you with some direction. guarantees. You can even compare across multiple policies. At the same time. In this way. A prime example can be found in insurance. effectively divided into distinct risk classes. Finally. Spence pointed out the existence of a variety of situations and how these may entail different returns to education for men and women. you and your wife bought a new home and had your first child earlier this year. Not entirely trusting this guy. Based on the classes you took in college. . You find a promising policy that provides more coverage for about $20 a month—less than half the cost of the policy your adviser recommended. so you buy that policy online. or among the various races. enacted to law in 1999. Sites like insurance.76 They asked what lessinformed consumers could do to improve their lot. which is necessary so that high-risk clients to not mimic this option. by their own choice of contract. along with the insurance company ratings and other relevant information to help you come to a decision quickly and efficiently. Many consumers are embracing online insurance offerings from reputable companies to save both time and money. their clients are. highly taxed dividends paid to shareholders. where companies usually offer alternative contracts where higher deductibles may be traded off against lower premiums. Michael Rothschild and Joseph Stiglitz. you do some research on your own on the Internet. which includes links to ratings information. If the customer fails to pass the physical. For example. Further. some consumers are understandably leery about taking the do-it-yourself approach. research evidence indicates that agents often “oversell” insurance and customers end up buying more than they need. an affiliate of Fidelity Investments. But. or type of insurance to learn about a company’s stability. The accepted rule of thumb is to purchase enough insurance to replace the income of the deceased for as long as surviving family members might need it. Because so many factors are involved in deciding the right level of insurance coverage. only half that number allow users to purchase policies on the Internet. financial planners suggest that the first step should be to determine how much coverage you need.6 million consumers. In comparison. Some insurance portals can help consumers sift through the confusing details and help answer some basic questions. the Boston financial-services firm. But there are benefits to buying insurance on the Internet—most notably. when you go to the appropriate websites. investments. an online financial planning and advisory service based in Atlanta.com of West Hartford. or 12. Understanding the myriad types of insurance policies available is also important. When getting started. The site allows users to anonymously enter information about such factors as their annual income. a policyholder must undergo a physical to get “reapproved” for that policy.com. argue that because there’s so much information and so many options out there. And while price is important. Insurance. however. One available statistic measured in 2005 shows that 13.com. he or she could end up paying a higher rate. While the Internet has made shopping for insurance easier. and debts. Connecticut.S. you avoid the often intimidating initial consultation with an insurance agent who may be working for commission on behalf of certain insurance companies and may be a bit biased in his recommendations to you. you’re not paying exorbitant commissions for a straightforward product. assets. it’s very easy for consumers to be overwhelmed by their choices. demand for these services is growing. The goal of life insurance is to replace the income of a family member should he or she die unexpectedly. it’s also necessary to carefully consider the reliability of the companies issuing the policies and the terms of the policies you’re pricing in order to make a true apples-to-apples comparison. Users can search by state. has an extensive glossary with words and terms to become familiar with when buying insurance.6 percent of the U. experts suggest that you avoid buying “re-entrant” Term Life insurance. Sites like mostchoice. clearly. The site also offers an explanation of how ratings are determined. offers a needs analysis calculator that can help consumers determine how much they’ll need in a life insurance policy. Also. rating. and then estimates insurance needs.Health and Property Insurance 231 Experts. An even smaller number offer life insurance quotes and policy information. which means that at the end of a term. .-adult-active-online population. visit the site of insurance-news service insure. The online insurance industry is in its infancy and only about 22 percent of property and casualty insurance sites offer online quotes. consumers with complex financial situations. purchased Term Life insurance using the Internet as part of the process. To learn more about a company’s reliability and ability to pay out benefits. Your homeownerʼs and/or renterʼs policies do not extend to them. Do use an insurance agent. 6. 8. The bottom line is to be educated and make decisions based on all the possible options you have. 3. Doing some homework on the Internet before going into an insurance office can help put consumers at ease. in Indiana. you have about fourteen days (every company is a little different) to call your agent and add the new vehicle. Do buy high liability limits. Insurance is meant for catastrophic events in your life—not as warranty or maintenance tool for your property or appliances. Donʼt buy insurance for the little things. For trades where you want some professional input. like Scottrade. You need disability insurance coverage. Short-term health insurance is cheap and provides the coverage you need. consult a financial planner or use a full service broker like Merrill Lynch or Edward Jones. In fact. etc.. Do buy reasonable (i. renterʼs insurance converts to homeownerʼs/condo insurance easily if/when you become a property owner. Companies that have agents are not more expensive and you will get good advice at little or no extra cost. 9. or a discount stock broker. If they do. However. you should sign up. Ten Insurance Dos and Don’ts Neil Klemme.). and what they “give” you at work is usually not enough coverage. It is inexpensive. boats. 2. like Charles Schwab. Indiana. 4..e.e. many people change jobs. when you purchase an automobile that replaces one that is already covered by insurance. Do insure your recreational vehicles (i. In Indiana. Take the time to figure out how much you might need and the type of policy you need. Your chances of becoming disabled at work are high and you need to be adequately protected. an agent with State Farm Insurance in West Lafayette. a prudent approach might be to combine Internet research along with a conversation with a qualified agent. and your landlordʼs and/or parentʼs insurance does not cover you. in most other states. Donʼt ever go without health insurance (even if you are a young college graduate and will be picking up coverage soon from an employer). 10. would do well to consult a financial planner or insurance agent. Do remember that. 7. Do buy renters insurance. Donʼt count on your life insurance at work. It is possible that your homeownerʼs policy would give you minimal coverage for theft on premises but you will not receive liability coverage or any off-premise coverage.232 Chapter Eleven such as blended families or families with a special-needs child. use a website that is cheap. Many companies offer it as part of your employment package. For easy trades. It is the same in trading. four-wheelers. Many companies cut benefits. snowmobiles. It is not much more expensive and itʼs all that stands between your money/future earnings and the plaintiffʼs attorney. there is no grace period for any vehicles under any circumstances. 5. wishes his clients and others would be mindful of the following Dos and Donʼts: 1. Also. . motorcycles do not have a “grace period” for coverage. higher) deductible policies (low deductibles are not always a good thing). The lay person knows little to nothing about insurance. childcare liability. What are some actions you could take to lower your auto insurance premium? 12. What is a common insurance mistake that is particularly applicable to health insurance policies? 8. waterbed . Do you think health care insurance has reached crisis levels in the U. Why is disability insurance a useful policy? Why do consumers overlook it? 5.Health and Property Insurance 233 Thought Questions 1. Do you know why? 9. What are two major problems that insurance companies have to deal with when deciding who to insure and what rate to charge them? 14. many residents with full homeowner’s protection were told by the insurance companies they were not going to be reimbursed for the devastation of their homes. Can you think of other areas in your life where you could apply the intuition developed by the four economists discussed in the section “Intuition from Insurance Research”? Notes 72. nurses’professional liability. How do you get classified as a subprime borrower? 10.S. theft from new construction. do you see the traditional insurance agent becoming extinct anytime soon? Why or why not? 13. back-up of sewer or drain.? 2. Why are some insurance policies a waste of your money? 4. With the rise of websites selling insurance policies and the growing popularity of the Internet overall. Is there anything specific about health insurance vis-à-vis other insurance policies? 3. Why is smoking looked upon so negatively by insurance companies relative to drug usage? 7. Why do you think major health care insurers do not cover costs related to longterm medical and personal care? 6. mine subsistence insurance. damage through hydrostatic pressure. What happens if you are hit from behind by an uninsured motorist and it is clearly his fault? 11. In the Hurricane Katrina disaster. Examples of endorsements include earthquakes. How can you as a consumer “signal” your quality to the insurance company so you can get the best rates? 15. Stiglitz. building materials theft. Standard auto insurance policies have four broad classifications of autos: normal. Check with your insurance agent for a full list of endorsements that come with your homeowner’s policy. G. 73. and J. 75. and many more.” Quarterly Journal of Economics 90(1976): 629–650.234 Chapter Eleven liability. and commercial.d . “The Market for ‘Lemons’: Qualitative Uncertainty and the Market Mechanism. Rothschild. “Job Market Signaling. motorcycle. 76. “Equilibrium in Competitive Insurance Markets: An Essay on the Economics of Imperfect Information. M. Spence. Akerlof.” Quarterly Journal of Economics 84(1970): 488–500. antique/classic. M. 74.” Quarterly Journal of Economics 87(1974): 355–374. • Based on your needs analysis. • If you are in a line of work where disability is a concern. • Your property insurance coverages should have high deductibles in order to keep premiums reasonable. What discount rate would you use to compute an appropriate present value? Use the principles discussed in this book to justify your choice. make sure you have adequate insurance coverage. Do the same computations for your spouse. 235 . • Avoid taking out insurance on small losses and instead focus on potentially large dollar losses with a small likelihood of occurrence. • You should have some kind of health insurance protection as you graduate from college and before you start a job. buy an adequate disability policy with a generous definition of what being disabled means.SECTION C: ACTION PLAN • Do a needs analysis using some of the principles discussed here and compute an estimate of the amount your family might need if something happened to you. . Section D: Retirement . . I will use some graphs and numerical examples depicting growth rates that are reasonable. But. the day-to-day and short-term fluctuations of the markets get smoothed out over time and become increasingly investor friendly. Investing for retirement seems like a waste of our money. based on the historic performance of the stock markets in the United States over the past seventy years or so. The irony is that when we are young. Yet. it's at what income. and we don’t think we have to worry about it. retirement is very far away. if we did not win the lottery of life. Contrarily. I will show you exactly how. —George Foreman When a man retires. believe it or not. his wife gets twice the husband but only half the income.12 Retirement The question isn't at what age I want to retire. then left to grow. we started our journey of Personal Finance by discussing TVM and we will end that journey discussing TVM. we could live a life of leisure. as is the case with retirement. To make my point. In this chapter. we have all that is necessary to become a millionaire in our youth. 239 . We have little money (which is what we need to get started) and lots of time for time value of money (TVM) and compounding to work their magic. Remember that when we think long-term. Interestingly. —Chi Chi Rodriguez We Are All Potential Millionaires Growing up. this is not only possible but an eminently reachable goal. Never was it implied that we could be born a non-millionaire and then become one just by careful investing combined with the miracle of compounding and the time value of money (TVM). If we won that lottery. we would spend our lives figuring out ways to make a living and cutting corners to make ends meet. Time is the one commodity that is firmly on the side of the relatively younger readers of this book. It’s amazing how relatively small deposits made when young. I was led to believe that whether we were rich was simply a matter of winning the lottery of life by being born in the right family. can become a very large sum over time. growing our small investment into a million dollars by the time we retire. It’s only fitting! The bottom line is that just about anyone can retire as a millionaire with a little planning when they’re young. spending all our money. 000 600. stock market between 1926 and 2003 was about 10 percent.200.000. On the following page is a graph that illustrates the final value of your money.000 200. we see that if we deposited $300 per month in an account paying an 8 percent annual rate. then left the account alone without putting in any additional money. while between 1990 and 1999 it was 18 percent.S. However. After that. Say you decide in your twenties to start a retirement account and you religiously put in a small amount every month for ten years straight. in forty years we will have over a million dollars in our account. we see that if a twenty year old put $375 a month in an investment account paying an 8 percent annual rate (compounded monthly) for ten years.000 800. thirty-five years later. you just leave your money in the account and let it grow without any additional deposits. So don’t let anyone tell you that the only way to have lots of money is to be born rich! .240 Chapter Twelve 1. Now let’s look at the numbers another way. Based on these numbers.000 Future Value in $ 1. the average annual return from the U. since 2000. According to Ibbotson Associates.000 400. the average annual growth in the stock market has been about 2 percent (and has actually been negative if adjusted for inflation). he would have just over a million dollars in his account. The question is: is it reasonable to expect an 8 percent interest rate in an investment account? Some might question this in light of the fact that. From the graph above.000 Number of Months Figure 12: $300 monthly payments at 8 percent annual interest Let’s consider a specific example. keep in mind that we are talking about a long horizon here—about thirty to forty years. Thus. To put the 8 percent growth in perspective. consider the following. an 8 percent growth over a long horizon certainly appears reasonable. From this graph. we are all paper millionaires—we just don’t know it yet. 000.200. The First Leg—Social Security In the wake of the Great Depression.000 Dollar Amount of Monthly Annuity Payment for First 10 Years Figure 13: Monthly payments of the indicated amounts in the x-axis for 10 years and then do nothing for the next 35 years. In those days.Final Value of Retirement Account in $ Retirement 241 1.000 1. a person must be . President Franklin D. being old usually meant being poor.000 600. In the years following. with three legs representing Social Security. U. Let me provide you with an overview of each of those three legs. On the right is the often-used “three-legged stool” of retirement income.000 400. In order to qualify for SSI. the Social Security program was expanded to include Survivors Insurance in 1939 (this protects families when a wage earner dies).000 800. Assume growth at 8% annually the entire period. 1935. our personal lifetime savings. Roosevelt (FDR) signed the original Social Security Act on August 14. and a Disability Insurance Program that started in 1956. the Medicare Program started in 1965 and the Supplemental Security Income (SSI) Program started in 1972. for example. and company retirement plans. The Three-Legged Stool Retirement plans play a crucial role in providing a source of income in our later years. Additionally.000 200.S. FDR hoped that Social Security would provide a dependable foundation to people when they retired. It was never intended to be a traditional pension plan. And when the Act was passed.” and nothing more. This Trust Fund that has been the subject of intense debate in recent years as its levels dip lower causing concern that we may run through it in the next fifty years or so. Statistics show that by the year 2034. This was not something that was considered when the SSA was passed. about 74.7 percent is used for administration costs. population. All of this paints a grim picture of what is going to happen to the Social Security Trust Fund by the time the current twenty year olds hit retirement age. It is important to understand is that FDR did not intend for Social Security to be the sole source of retirement income for retirees. there were only three people paying into the system for every beneficiary. coupled with lack of major wars and relative prosperity over an extended period of time all worked together to ensure that Americans lived longer. or disabled (at any age). in 1960. It would work perfectly as long as people did not live very long in retirement. Advances in medicine. there was not long between the time one became eligible for full retirement benefits at sixty-two and one’s death so that each retiree did not tax the system too much. That is. and it is projected that two people will be paying for every beneficiary in the year 2034.7 years. and another 11 percent are survivors. when the Social Security Act was passed in 1935. life expectancy had reached 77. life expectancy was only 61. about 15 percent are disabled workers.6 percent is put in the Social Security Trust Fund. or about 20 percent of the U. Currently.242 Chapter Twelve sixty-five or older. and that future generations will have no Social Security benefits. In those early years. . By 2006. about 24. What does this do to the Social Security system? For one thing. It was what is called a “pay-as-you-go” plan: each generation of active workers would finance the benefits of the currently retired workers. will be at least sixty-five years old. Social Security is meant to provide the “foundation. Also note that of all the money coming to Social Security through payroll taxes. until medical science got in the way. or blind (at any age). For example. about seventy million people. a whopping 65 percent are retirees. That is precisely when the system started falling apart! According to the CDC. there were about five people paying into the system for every beneficiary withdrawing money from the system. Of these.S.7 percent is paid out in benefits. or have limited income or limited resources. and about 0. Not surprisingly.7 years (younger than the sixty-two years one had to live in order to become eligible for benefits). in which employees receive benefits without contributing. the Social Security Administration estimates that over sixty million people receive SS benefits. In 2000. more people are drawing from the system for longer periods of time in retirement than ever before. they didn’t. the ratio of the number of people contributing to the system for every person drawing from the system has declined dramatically over the years. the idea is to gradually increase the age at which we qualify for full benefits. Treasury Bonds (which. Of course. or demographic. So what can we do instead? Increase the retirement age.Retirement 243 How Do We Tackle the Problem of the Shrinking Social Security Fund? That is an extremely complicated question. we put a band-aid on the system and chug along blissfully. the main problem with Social Security is longevityrelated. depending on whose calculations you believe). The Social Security Trust Fund is in a very fragile state and has to be nurtured along if it has any chance of surviving in the long term. reducing the length of time that they do so. It is risky to take ownership of this gargantuan problem. So simple. In Figure 22. We pay more in and there is more in the pot for everyone. we push back the point at which retirees can start taking out of the system. but also very limiting in returns) to be cashed in when the current generation retires. as we know. The Bush and Obama Plans for Social Security As we have identified above. Nobody has to raise those ugly taxes. But there is a catch! Increasing any kind of taxes is not a popular course of action with a legislator who wishes to have a future in politics. . All of us born after 1960 will qualify for full retirement benefits only when we are sixty-seven years old. Basically what the Trust Fund does is to take any surplus and invest it in U.S. Everybody is happy and politicians can easily pass the buck along to the next administration. And that may still change! Year of Birth 1937 1938 Full Retirement Age 65 65 & 2 months 1939 1940 1941 1942 65 & 4 months 65 & 6 months 65 & 8 months 65 & 10 months 1943–1954 1955 1956 1957 1958 66 66 & 2 months 66 & 4 months 66 & 6 months 66 & 8 months 1959 1960 & later 66 & 10 months 67 Figure 14: Year of birth and age for full retirement benefits. the easiest way to fix it is to raise Social Security taxes. That way. we can see how the retirement age (the official age at which we qualify for Social Security benefits) has changed. Following such a forward-looking strategy will allow the fund to stay in business until about 2042 (or 2052. are very safe. of course! Simply stated. whichever comes first. tion. And given that we are already in deficit spending mode as a nation. none of these options are painless to all. but this one would be funded by your Social Security taxes. That beyond your full retirement age.gov. Time is of the essence with whatever course the government decides to adopt. everyone agrees that some. The problem is or reach age seventy.4 percent to about 13. implies that the president will have to sell Treasury bonds to cover the shortfall—some estimate to the tune of $1–2 trillion over the next ten years. For the moment. however. there are problems associated with setting them up. But what exactly did our forty-third president propose? His idea was to allow younger Americans to put a portion of their taxes (about 4 percent of their payroll taxes was floated as a trial balloon) in a private account that will be there for them when they retire.tored in automatically from the time you reach full retirement age until you start taking benefits. let us focus on the Retire Late. and our threshold for accepting pain as a nation is very low. Unfortunately. which would immediately stabilize the Social Security system for a good seventy-five years. the government will have to come up with other means to fund Social Security payments. benefits paid to upper income retirees could be reduced. young and the very old—by telling each that any reform of the Social Security system is not going to hurt them.when you were born. Finally. One quick solution that will never pass muster is to raise the payroll tax from today’s 12. For one. Another way to reduce benefits and still keep the system going for a while is to increase the age of eligibility for full benefits. benefits will have to be cut to ensure If you choose to delay receiving benefits outflows do not exceed the revenues. thing needs to be done.ssa. This is their demographic group—especially the very way of saying thanks to you. If a significant chunk of those monies is diverted to private accounts. Social Security depends on taxes paid by today’s workers to pay off today’s retirees. our The bottom line is that by delaying your benefits you are helping out Uncle Sam and the elected officials tend to appease every stretched Social Security system. Make More . since the president has simultaneously promised older Americans that their Social Security withdrawals are safe. The increase will be factions made. While the idea of a federal government–sponsored private retirement account for each citizen certainly sounds tempting at first blush. your benefit will is basic Economics 101.244 Chapter Twelve And then if changes are not made to the structure and the funding of the Trust Fund. This. While we can all be increased by a certain percentage tied to quibble about the math and the projec. It was sort of like another 401(k) plan (which we will discuss later). in turn. Any delay in implementing an increase in taxes means that. according to the Social Security Trustees.9 percent. which is probably not accurate. in order to make the system stable for seventy-five more years. and all are merely band-aids for the actual problem. that there is no universally painless soluFurther details are available on www. this promises to further burden our future citizens. As I said. an immediate and permanent reduction in benefits of about 13 percent will be required. in the short run. How he will do this remains teh big question. the group that will pay the price for such a tax increase will not be happy. President Obama has signaled that he wants to reduce government expenditures toward Social Security as a way to get the ballooning deficit under control. Divorced years. President Obama has not been specific about such taxes beyond hinting at them in generalities. qualifies for full benefits at age sixty-five (at age sixty-seven. age twenty-two. Who Qualifies for Retirement Benefits? You qualify for Social Security benefits by working and paying your Social Security (also known as FICA) taxes for a certain period of time. Candidate Obama had proposed a new Social Security tax on very high incomes—namely those with annual incomes of more than $250. and not be eligible for fies if under eighteen (under nineteen if an equal or higher benefit from another still in high school). you are fully covered for retirement under Social Security. if born after 1960). Obama’s advisors had signalled that the proposed rate would be somewhere between 2 and 4 percent and would apply to income earned as well as that made through dividends and investments. forty credits/ten years).000. the tax is levied only on the first $102.120 dollars from your job. Just about anybody can get retirement benefits. you qualify for full benefits. Finally.480 in employment earnings) per year. For example. given that it is a politically sensitive issue. be at least sixty-two years old. Not surprisingly.000.Retirement 245 existing Social Security system that is in place and see what we have to do to qualify for benefits. which earns you “credits. According to the plan he proposed before the presidential elections. Currently. However. your ex-spouse could or husband qualifies for benefits at her/his designated retirement age or at any age if qualify for benefits on your earnings under the following circumstances: he or she must caring for a child under sixteen. or if have been married to you for at least ten she/he were to be disabled. Any changes to the current system will have to come at the expense of some group of citizens. have been divorced from you at least spouses may qualify under certain circumtwo years. He could also qualify for increased benefits for retiring after the full retirement age.000 and $250.000 of each worker’s income. What do you have to do to qualify for Medicare coverage? You must be at least sixty-five years old and you must have been receiving Social Security disability Benefits when Divorced . A wife If you are divorced. and you can earn a maximum of four credits (or about $4. be stances. Obama would not levy any taxes on those making between $102. an unmarried child qualiunmarried currently. It’s that simple. A worker who qualifies for reduced benefits around age sixty-two (must be insured.” Once you have accumulated a certain number of credits. or if disabled before source (including his or her own workplace). After you have accumulated forty credits. to earn one credit you need to have earned about $1. I also provide a few definitions to help clarify some of the jargon commonly used by retirement professionals in discussing these plans. so they come with important tax benefits. If you qualify for Medicare. The Second Leg—Pension Pension plans serve many purposes for employers and employees alike. you need to provide your Social Security number. known as Supplementary Medical Insurance. and they come in many varieties. uses a significantly more stringent standard for deciding whether you are disabled or not. In order to apply for Social Security benefits. your bank information for direct deposit.gov). I begin by providing an overview of the most common retirement plans. any information you may have about your marriage and/or divorce. has a reasonable monthly premium and is designed to cover about 80 percent of doctor’s bills and other out-patient medical expenses.ssa. a defined contribution plan. or a hybrid plan. and you have an accident which forces you to quit your engineering position and take a job at McDonald’s flipping burgers at an hourly wage.” Say you are an engineer by training.246 Chapter Twelve benefits for at least twenty-four months (or have permanent kidney failure at any age). You are not disabled according to the federal government. applied after the first $100 in approved charges. it has two parts. But. Qualified retirement plans fall into one of three general categories: a defined benefit plan. and work experience. A better definition of disability from the consumer’s standpoint is “the inability to perform your job due to a sickness or an injury. and any military or railroad service. based on age. Qualified versus Nonqualified Plans A qualified retirement plan is one that meets the numerous requirements of the Internal Revenue Code (IRC) and the Employee Retirement Income Security Act of 1974 (ERISA). your earnings estimate. few of us really understand the plans we have. Further information is available on the Social Security Administration’s website (www. . proof of age (birth certificate). or expected to result in death. To help increase that understanding. latest W-2 or self-employment tax return. however. Disability Insurance under Social Security The federal government defines you as disabled if you have a medical condition preventing substantial work for at least twelve months. despite the critical function they fulfill in our lives.” The government. The key here is the phrase “substantial work. Part B of Medicare. which covers most in-patient hospital expenses and has a reasonable deductible which is adjusted almost every year. Part A is called Hospital Insurance. Qualified plans meet the minimum standards set down by the government. education. which was cheaper for the companies and the new plan was called a Defined Contribution Plan. The employee bore no risk! As you can imagine. The companies decided to change course and offer a new kind of retirement plan—one where the risk of the plan would be borne entirely by the employee. these are non-standard retiremore than twenty-four megabytes in size. and society was fresh from winning the Second World War. Employers receive no tax deduction until the employee receives proceeds from the plan.000 and 100 perthe employee.4 million words.500 pages long. But over time. from a number of investment options. and/or age. while allowing broader flexibility for the employers. These plans were funded entirely by the employer. ment approval stamp but are used and If printed sixty lines to a page. The companies decided that taking all the risk of funding their employees’ retirement wasn’t such a good idea. Formally. do not receive the same favorable tax treatment as permitted for the qualified plans. but the ultimate benefit paid to the employee is not. Companies instituted plans intended to take care of their retired workforce right to their deaths. is one that does not meet the requirements of the IRC or the ERISA. pre-retirement wages. a Defined Contribution Plan is a retirement plan in which the contribution is defined. The employer would contribute to the account and then let the employee decide how to invest the money. The benefits can also be transferred into individual retirement accounts in order to defer taxes.Retirement 247 A non-qualified retirement plan. The complete Internal Revenue Code is Essentially. it would be funded by corporations to provide some more than 7. and the responsibility for the payment of the benefit. the risk from these plans was shouldered entirely by the employers. it was a great system for employees. such retirement burdens started weighing heavily on employers. The employees usually receive proceeds in the form of annuities and are taxed at ordinary income tax rates. The Employer Contribution Limits . ment plans that do not have the governand contains more than 3. on the other hand. rested with the employer. The downside is that these plans. form of a tax-deferred compensation to key officials. The investment risk rests solely with 2011 is the lesser of $49. Each employee has a personal account and the amount accumulating in this account at retirement depends on how much was contributed over the years The total amount (over all defined contribution plans) that can be contributed by an and how the investment performed over the employer in one employeeʼs name for years. Did You Know? Defined Benefit versus Defined Contribution Defined Benefit Plans were popular in the good old days when America reigned supreme in the world. Put differently. and all the associated risk of coming up with the monies. its goods were in high demand. based on a preset formula that factored in the employee’s years of employment. who has the ability to choose cent of the employeeʼs annual earnings. Supreme Court has held that savings in a qualified retirement plan. But here is the beauty of the plan: often. each plan does have its own definition of what’s required to qualify for disability. such The employeeʼs elective deferral to all as a 401(k) or IRA. however. some courts can contribute an additional $5. you may also be able to take out any matching contributions your employer made even if you haven’t completed the years of service normally required for full ownership. However.000 and 100 percent of the employee’s annual earnings. Before you get too excited. A 401(k) plan generally offers participants an opportunity to direct their account contributions to a broad range of investment options ranging from low-risk bond mutual funds to high-risk growth mutual funds. the assets in your 401(k) are usually exempt from creditors in case you were to file for bankruptcy. The name. you’re saving money that you plan to use becomes disabled.500 in 2011. At retirement. Also. Under this plan.S. The Most Popular Defined Contribution Plan: The 401(k) Almost all of us will be dealing with a 401(k) plan in our working lives. they may also be paid as an annuity. If you withdraw finds Internal Revenue Service regulations. keep in mind that you will still owe ordinary income taxes on the money you withdraw. Those who are age fifty and over in 2011 claims in a bankruptcy. no matter how many different retirement plans we participate in. changes jobs. If you are completely disabled and cannot work. benefits are typically paid in installments or as a lump sum. Make sure you know what that definition is in order to qualify. you can live off your 401(k) plan without being charged a 10 percent penalty regardless of how old you are. withdrawals from recoup amounts owed by certain creditors. the employer allows employees to deposit a part of their compensation (on a pretax basis) in this plan. where it grows unfettered and untaxed until withdrawn at a certain age. The total amount that can be contributed in one employee’s name for 2011 is the lesser of $49.248 Chapter Twelve government sets a limit on how much can be contributed in our name each year. are exempt from creditor 401(k) plans is limited to $16. The U. it is usually better to save it fers a financial hardship as defined by outside your 401(k) plan. comes from the section of the Internal Revenue Code that defines this particular plan. from your 401(k) before the age of 591⁄2. 401(k). Generally. However. dies. you will Employee Contribution Limits . The rest of us will have either a 403(b) plan (if you work for a nonprofit) or a Keogh plan (if you have your own business). Employers sometimes even make their contributions even if the employee does not put in any contributions of her own. Sometimes such contributions can be tied to the underlying profits of the firm as part of some profit-sharing program.000 for have allowed the IRS to invade plan assets to the year. or sufbefore you retire. If you’re disabled. 401(k) plans are not permitted before age Here is something to be careful about: if 591⁄2 unless the employee retires. the employer matches his employees’ contribution according to a set formula (the best is a dollar-for-dollar match-up to a pre-set maximum). Most plans provide for full ownership whenever a participant becomes disabled. Overall.gov. This was once true of private. While this will suffice to familiarize you with the instruments. For example. is a good retirement resource. you will have to do some research on your own if you want further details. the interest you pay yourself on the loan comes from money on which you have already paid taxes. the employer will credit an employee’s account with a pre-set percentage of her annual compensation as well as interest charges. • Good chance that if you participate in one. They have names like: Profit Sharing plan. penalized 10 percent in addition for an early withdrawal of the money. the plan provides benefits to employees in terms of a hypothetical account balance. Target Benefit plan. Basically. and SIMPLE plan. assuming you’re younger than age 591⁄2. Other Types of Defined Contribution Plans Here are some typical defined contribution plans. 457 plan. Historically. few alternatives are better. Economists call this minimizing the agency cost. That means you will pay taxes on that money again in retirement when you make withdrawals from your 401(k). http://search. as of January 1.77 Word of Warning about Borrowing from Your 401(k): Don’t! You should borrow from a 401(k) plan only as a last resort. your employer will just give you money for doing so. If you change jobs before the loan is repaid. in a Cash Balance plan. .usa. that loan is payable immediately with interest. Employer Stock Ownership plan (ESOP). it will count as untaxed earnings.S. Government. It will be taxed and. 1997. Here’s a short summary of the 401(k) plan: • One of the best ways to save for your retirement. If you are unable to come up with the necessary funds to repay the loan. One common feature with all of these plans is that contributions and earnings accumulate tax free. Cash Balance plan. the unpaid debt will be labeled a “deemed distribution” from your 401(k). however. the latter may now establish a 401(k) plan for their qualified employees. Additionally. The 10 percent penalty is an expense you wouldn’t have if you had saved on an aftertax basis outside your 401(k) plan.Retirement 249 be assessed a 10 percent fee and will have to pay taxes on any earned interest. But for 401(k) purposes. Simplified Employee Pension (SEP) plan. • Start contributing at as early an age as you can and let time-value-of-money do its magic! • Invest the money in your account in an equity index fund. state and local governments were prohibited from offering 401(k) plans to their employees. A website maintained by the U. these plans are all based on companies’ desire to reward their employees with incentives designed to extract maximum effort out of them by aligning their personal interests with the interests of the firm. Money Purchase plan. tax-exempt employers as well. the hypothetical account is credited with interest based on an amount defined in the plan. When you are fully vested. what if you happen to work for a well-run and honest company with real products and real profits? By not investing more than a certain amount in your own company shares. The shorter the time required to be fully vested. and you leave the company after two years. In fact. and so on. Vesting Very simply. you could be 20 percent vested after one year. is a personal retirement savings plan available to most people receiving taxable compensation during the year. With a graded vesting schedule. In most companies you are fully vested within five years. The problem with this is. you have half ownership. The question is. your ownership of your employerʼs contribution increases proportionally with each year you stay in the company. The longest cliff vesting schedule currently allowed by law for contributions coming from employers is three years. the better it is for you. or in other words. their nest eggs also vanished into thin air. you are only entitled to a part of it as determined by the vesting schedule of the company you are leaving. One of the best things about a 401(k) retirement plan is that it is mobile. how vested are you in your own 401(k) plan? You are only entitled to all your money in your current 401(k) account if you are fully vested. if your company had a five-year graded vesting schedule. 40 percent vested after two years. A participant’s benefit at retirement will equal the accumulation of such credits at retirement. if your cliff vesting period is three years. the longest graded vesting schedule a 401k plan can have is six years. For example. Hence. you have full ownership. Otherwise. With cliff vesting. this is a question you should ask your potential employers while they are trying to get you to join their company. The Third Leg—Savings An IRA. . you get none of your employerʼs contributions. your ownership of your employerʼs contributions goes from 0 to 100 percent after the specified period of time. Types of Vesting There are two types of vesting schedules available: graded vesting and cliff vesting schedules. You can take it with you when you leave a company after so many years. vesting is the process of gaining ownership. Ask how long it will take for you to be fully vested.250 Chapter Twelve Additionally. When the company’s shares fell to pennies in the wake of the accounting-related scandal. ESOPs figured prominently in the news after the ENRON collapse when it came to light that hundreds of employees had invested their retirement monies in ENRON shares under ESOPs. or Individual Retirement Arrangement. By law. One easy way to address potential problems with ESOPs is to limit the amount of your own company’s stock in your retirement account. Make sure you factor that in before you decide to quit your job for another position elsewhere. you may be unfairly handicapping yourself from maximizing your retirement portfolios. If you are 50 percent vested. how much can you take with you. tips. • Earnings on the account are taxable only when a withdrawal is not a “qualified” distribution. • Are used to pay the costs of a first-time home purchase (subject to a lifetime limit of $10. • Occur because of the IRA owner’s death. • Are used to pay for the qualified expenses of higher education for the IRA owner and/or eligible family members. taxable alimony. the most important IRA for young people is this one. • Are used to pay medical insurance premiums after the IRA owner has received unemployment compensation for more than twelve weeks. Husbands and wives may each have an IRA even if one person in that marriage is not working. withdrawals) from the account are not taxable. • Are a series of “substantially equal periodic payments” made over the life expectancy of the IRA owner. you should aim to max out your annual contributions. commissions.000). but withdrawals may be taxed at ordinary income tax rates.Retirement 251 Compensation includes wages.000 if you are under age fifty ($6. The Roth IRA has the following features: • Contributions to the account are not tax deductible. Due to the tax benefits associated with an IRA. Roth Jr. the fact that you cannot carry over your contributions year-to-year dictates that you max out your contributions every year. and separate maintenance payments. Adjusted Gross Income (AGI). Except for an education IRA. Also. annual individual contributions are limited to the lesser of total taxable compensation or $5.000 if over fifty). The penalty does not apply to early withdrawals that: • Occur because of the IRA owner’s disability. bonuses. Contributions may or may not be deductible in the tax year they were made depending on the type of IRA used and the owner’s income tax filing status. • “Qualified” distributions (i. The Most Important Form of IRA: The Roth IRA Arguably. and eligibility to participate in a tax-qualified retirement plan through employment. Money may be withdrawn from an IRA at any time. There are seven exceptions to the 10 percent penalty for withdrawals prior to your full retirement.. who was the architect of the Retirement Savings Opportunity Act of 1999. There is no minimum or required IRA contribution. and all earnings within an IRA account are untaxed until withdrawn.e.. fees. Withdrawals from an IRA other than a Roth or Education IRA prior to age 591⁄2 will result in a 10 percent excise tax in addition to ordinary income tax. • Are used to pay for unreimbursed medical expenses that exceed 71⁄2 percent of AGI. It’s named after Senator William V. . salaries. IRA are limited to $5. For example. 1999 Senators William Roth Jr.irs. .000 for IRAs. What Is a Qualified Distribution? Introduction of Senator Roth’s Retirement Bill in March. may be made even after the owner reaches • It is made by a first-time homebuyer to acquire a principal residence. which is not the case with a traditional IRA. • Eliminating the 25 percent of compensation limitation on contributions.000 to $122. you are better off continuing with it. erʼs death. If you make too much money. This publication may be obtained at no cost by calling 1-800-TAX FORM.000 (single filer). a withbution limits are the same whether you drawl has to meet one or more of the following have a traditional IRA or a Roth IRA. you cannot enjoy the benefits of a Roth. however.000 (married filing jointly) or $107. However. The general rule of thumb is that if you have had your traditional IRA for twenty years or more. after those costs. or rolled into a Roth and then pulled out to pay the tax. the answer is not so simple since the act of switching involves cost. including the payment of taxes and penalties on the pre-tax money you had growing in your regular IRA. the contributions to a Roth IRA • It is made because the taxpayer is disabled. • Permitting individuals age fifty and older to make additional catch-up contributions to IRAs and 401(k) plans. For those of you who have had a traditional IRA for a while that are thinking of switching to a Roth IRA. and 401(k) programs by: • Significantly raising contribution limits to $15. the benefits of the Roth IRA stack up in your favor.000 limit is phased out as AGI increases from $166.000 minus the tax. the annual contributions to a Roth • It is made after the taxpayer attains age 591⁄2. • Removing the income limits that currently apply to IRA programs. (R-DE) and Max Baucus (D-MT) introduced the Retirement Savings Opportunity Act of 1999. The contriIn order to be a “qualified” distribution. age 701⁄2. Further details on IRA provisions may be found in IRS Publication 590. The relevant computation is whether. In conditions: 2011.252 Chapter Twelve No qualified withdrawals are allowed before a five-taxable-year period beginning with the year in which the taxpayer first contributed to a Roth IRA. if you happen to use IRA money to pay the tax on a Roth conversion (and you are under age 591⁄2). The bill proposed to significantly expand the IRA.• It is made by a beneficiary after the taxpaypayer’s deductible IRA contributions. you’ll probably have to pay a 10 percent (and maybe even a 20 percent) penalty on the amount that’s not rolled over into the Roth. The bottom line is that those of you starting a retirement fund should always select a Roth IRA over a traditional IRA. The $5. Individual Retirement Arrangements.000 to $176. Roth IRA.gov.000 for 401(k)s and $5. or it may be downloaded online at www. and for joint filers. you are out of luck as far as opening a Roth IRA goes. a maximum of $5. Retirement FAQs Following is a list of questions on retirement that I have been asked over the years by students in my personal finance class.000 and $176. The bottom line is that if you earn enough money. The question then becomes whether the taxes you will incur in the conversion make it worthwhile to switch. because you get the tax benefit at the end when you withdraw a large chunk of money with no taxes.000.000. But while some of these institutions will allow you to invest the money any way you want. this website has more information on all of these IRAs: http://www. the phase-out affects those with AGIs between $166.open-ira. The general rule of thumb is that the longer you have had a regular IRA. Sometimes making too much money has its drawbacks.000 and joint filers with combined income below $166. the less sense it makes to switch to a Roth. Once the Roth Conversion IRA has been established. you need to indicate on the Roth Conversion form whether taxes are to be withheld from the IRA funds or will be paid from another source. . assets in the ordinary IRA will be moved to the Roth Conversion IRA.htm. What’s the best type of financial institution to use for an IRA? You can establish an IRA just about anywhere you wish—through a bank. If you do not wish to convert the entire amount. a mutual fund company. How do I convert my existing traditional IRA into a new Roth IRA? The bottom line with these conversions is that when you opened your regular IRA. others may limit your selection or charge additional fees if you want to place money in something other than the types of investments offered through the financial institution itself. Now when you want to convert it to a Roth. To be specific. The maximum contribution phases out for single filers with adjusted gross income between $107. For example. or an insurance company. you must complete a Roth IRA Adoption Agreement and a Roth Conversion form. a brokerage firm.and middle-income people save. and the law restricts the ability of upper-income taxpayers to open such an account. you must indicate on the conversion form the exact security description and the amount of cash that is to be moved from the ordinary IRA. Can I establish a Roth IRA regardless of how much I make? The Roth IRA was created primarily to help low. Also. com/IRA_Center/Why_start_an_IRA.000 a year can currently be contributed to an account by single tax filers with an adjusted gross income (AGI) of less than $107. there are taxes that are due because Roth is about after-tax money. you did it with pre-tax money.000 and $122.000.Retirement 253 Other Types of IRAs The chapter appendix provides a brief list of other types of IRAs available to consumers. If you need further details. depending on how much you earn and whether you’re married or not. books. Its purpose was to ensure that people working for very small businesses did not fall through the retirement cracks. Is my IRA subject to the claims of my creditors in a bankruptcy proceeding? If you file for bankruptcy. State law determines if IRAs are subject to the claims of creditors in a bankruptcy. you’ll have to pay taxes on that sum at your current rate. How is a 401(k) different from a regular pension like a defined benefit plan? The biggest difference between a 401(k) and a regular pension is that a 401(k) gives you much more control over your retirement nest egg. it is not exactly a black or white issue. of which $7. fees. by a contribution from your employer as well. It depends primarily on where you live. But even if you can’t deduct the contribution on your income tax return. and room and board. For example. As with most things in life. But even in the same state. If you are participating in a simplified employee pension (SEP) plan. Some states protect IRAs from the claims of creditors and others do not.000 (after the money has been invested for five years) without paying any taxes or penalties. the investments inside the IRA will grow tax free until you begin making withdrawals.000. A 401(k) is funded with your own money and. Now. they allowed certain expenses for education to qualify as tax. What are the pros and cons of having a large amount of money in an IRA? The simple answer is that you can’t really do a whole heck of a lot with the money until you are almost sixty years old unless you are willing to pay a stiff penalty. It’s often called a defined benefit plan . your creditors may or may not be able to claim the assets of your IRA. supplies. A SEP is actually a special type of individual retirement account sometimes referred to as a SEP-IRA.000 are contributions and $3. If you withdraw the $3. interpretation of bankruptcy law can vary from one court to another. A traditional defined benefit pension is funded and controlled by your employer.000 are earnings. a type of retirement plan that is popular among sole proprietors and owners of small businesses. the Internal Revenue Service will allow you to save even more money for retirement by allowing you to set up a separate IRA.254 Chapter Twelve How do I use money saved in my Roth IRA to pay for college? When Congress put the finishing touches on the Roth IRA. What is a SEP? And can I invest both in a SEP and a traditional IRA? SEP stands for simplified employee pension. Qualified expenses exempt from the penalty include college tuition. I cannot see a downside to having a large retirement account. But. why is this important? Simply because the penalty for early distribution of a Roth IRA is 10 percent.000 in earnings. You decide how much to save and how to invest.and penalty-free distributions from a Roth IRA. if you had a Roth IRA with a value of $10. but a shade of grey. you could withdraw up to $7. in some cases. But there may be tax consequences from such an action. however. The money you contribute to the IRA may or may not be tax deductible. Technically. How long do I have to wait after being hired to join the company’s 401(k) plan? Some companies allow workers to join their 401(k) plans immediately. you should find yourself a good lawyer.. If younger workers are eligible to join the plan but don’t. What you get when you retire will be based on your salary and the number of years you worked for the company. But that is only what is required by law. a summary annual report. The plan administrator must respond to questions from participants and give an explanation for any denial of benefits. money market funds. a defined benefit. a guaranteed investment contract (GIC) that pays a fixed interest rate. you can easily do your own research and find a lot more information than the minimum required. The reason for that is that many employees quit before their first year is up and companies want to avoid the administrative costs involved in setting up a 401(k) for a worker who might not stay very long. . you can request a review and if you’re still not satisfied. all you’re entitled to is a summary of how the plan works. That’s the person or committee responsible for handling the day-to-day administration of the plan. it’s a promise that too many employers have been unable to keep. which guarantees benefits to workers of qualified firms even if the firm is liquidated in bankruptcy. A company is also allowed to exclude anyone under the age of twenty-one in part because younger employees often don’t take advantage of the plans even when they are eligible. The company is supposed to put aside enough money to fulfill this promise. What information about my 401(k) plan am I legally entitled to have? The federal government requires companies to provide only minimal information to workers who take part in a 401(k) plan. What happens to the money I put into a company’s 401(k) plan? The money is invested according to the choices you’ve made from a list of options offered by your employer. What recourse do I have if my employer and I disagree about my 401(k) account? Your employer is required by law to include a claims review process in which you can file a written claim with the plan administrator. If the plan allows you to invest in the company’s stock. their lower participation rate can reduce the amount that other employees are permitted to contribute due to federal rules. but as some loyal workers have recently discovered. These options typically include stock and bond mutual funds. and your company’s stock. you are also entitled to receive a prospectus or similar document. and an annual statement. Most pension plans are covered by the Pension Benefit Guarantee Corp. In today’s Internet age. but others utilize a federal law that allows a firm to wait until a worker has logged at least one year of service before joining the plan. If you don’t find the explanation acceptable.Retirement 255 because it promises to pay you a specific monthly income in retirement—in other words. informed investment decisions. Your beneficiary will have most of the same options with the money that you would have if you were leaving the company to take another job. Your beneficiary could roll the money over into an IRA.256 Chapter Twelve How do I know how well (or poorly) my 401(k) investments are doing? If you have invested in a 401(k) retirement plan. your estate will automatically become the beneficiary. Many plans report on a semiannual or quarterly basis and some even issue monthly updates. the money you invest. If you somehow fail to designate a beneficiary. which means they are legally responsible for supervising. you must also be given the opportunity to move your money among the available investments at least quarterly. Does the government guarantee my 401(k) account? There is no such guarantee for 401(k) accounts. What happens to my 401(k) account when I die? One of the first things you are supposed to do when you join a 401(k) is to designate a beneficiary who will receive the money in your account when you die. That’s not as good as a guarantee. most plans now have all the relevant information on their websites that you can access with a simple login ID and password. administrators. Furthermore. 401(k)s do not involve a promise of future benefits. since the government wants to ensure that the payments a company promises its retirees will indeed be made.. and you could theoretically be wiped out if your investments perform badly. At a minimum. But your employer doesn’t offer you protection against any investment losses you may suffer. If it helps you sleep better. but it’s better than nothing. and investment managers and continuously monitor the performance of their duties. you may want to know that one of the duties of the federal Pension and Welfare Benefits Administration is to ensure that all employers and 401(k) trustees follow government requirements. Do employers guarantee 401(k) accounts? Employers never guarantee 401(k) accounts. And this supervisory relationship obligates the employer to protect your financial interests by choosing reputable and competent plan trustees. not guaranteeing. . or withdraw it all and pay income taxes on it. They are considered “fiduciaries” of 401(k) plans. the company that administers your plan should be able to provide you with an annual statement that shows the amounts you have contributed and how those investments have performed. While traditionally defined benefit pension plans are insured by the federal Pension Benefit Guaranty Corp. and sufficient information to help you make sensible. it is important to stay informed about your investment’s performance. Fortunately. The value of your account will rise and fall over the course of the years. Shiva chose that very time to return from his campaigns and found a strange man (not much father-son bonding here. Why does the government limit the amount of money you can put in your retirement account and write it off from taxes? . Thus. As luck would have it. What are some of the practical reasons why someone in their twenties may postpone starting with his or her retirement planning? 5. So. Upon realizing what he had done. a lovable god with an elephantʼs head and a human body. Hearing the commotion. lops its head off (PETA did not exist then). getting married. But Shiva. Because he lost his head guarding the entrance to his motherʼs chamber. Shiva was very contrite (a typical husband at this point). obviously) guarding his wifeʼs inner sanctum. and promised to make amends for his rash act by depriving the first living being he met of its head and replacing his sonʼs missing head with it. or the god who protects those who want to embark on a project or a new phase of their life—like starting a new business. Shiva rushes out only to find a baby elephant. known for his temper. she summoned her son to stand guard at the doorway. Ganesh was destined to spend the rest of his life (and live on in eternity) with an elephantʼs head. Shivaʼs wife came running out. Shiva. only to discover that her son had been decapitated by his father. minding its own business. or maybe even retiring. His wife was left behind (as was the custom in those days for wars were considered a manʼs domain) and wished to take a bath. Put yourself in the shoes of a twenty-one year old college graduate who has $200 per month to put in a retirement account that averages about 6 percent in annual returns over the next ten years. how much would he have in his account? 4. with almost no one to answer to. the ancient Hindu god of death and destruction. What is the one characteristic of compounding that helps those who start early? 3. If he were to contribute to his retirement account until he was thirty and then simply forget about the account until he was sixty-five. Lord Shiva.Retirement 257 Street Smarts: The Saga of Ganesh From ancient Indian folklore comes the story of Ganesh. What is the intuition behind starting early with your retirement planning? 2. and brings him back to life. flew into one of his rages (anger management was not for the gods) and lopped off his head. Not having anyone to guard her royal chambers (everyone was presumably off at war). Do you think Social Security should be saved? Is it possible it has outlived its useful life? 7. A long time ago. he is considered to be the god of gateways. Can you think of some other ways to prolong the life of the Social Security Trust Fund without raising Social Security taxes? Why is raising Social Security taxes not a viable option for making the Social Security Trust Fund healthy again? 6. was waging war with his enemies. places it on his sonʼs shoulders. rushes back home with it.) Ï Thought Questions 1. (Note: Other versions vary how Ganesh got his elephant head. you may wind up with more money by saving in the 401(k) plan. Do you think there is a chance the government will change the rules to delay full access to your 401(k) plans from the current 591⁄2 to (maybe) around 62 years? Why or why not? 12. Under what kind of income profile over your lifetime would having a traditional IRA make more sense than having a Roth IRA? Note 77. there are situations where it can make sense to use after-tax contributions for short term savings. Would you prefer a cliff vesting schedule or a graded vesting schedule? Why? 11.tax contributions and if you’re fully vested in the matching contributions by the time you withdraw the money.258 Chapter Twelve 8. Should there be a government mandated minimum contribution to your IRA account? Why or why not? 14. . However. When is it absolutely imperative for you to take advantage of a 401(k) plan at work? 9. Do you think IRA contribution limits should be indexed to inflation? Why or why not? 13. even after taking the 10 percent early withdrawal penalty into account. if your employer matches your after. For example. What is one way to avoid the kind of disaster that ex-employees of ENRON encountered through their ESOPs? 10. but cannot be made after the beneficiary reaches 18 years of age. you can’t start one of these! Contributions begin to phase out at $190. 1998. but are on top of the limits on any other IRA.Appendix to Chapter 12 Other Types of IRAs IRA Brief Description Simplified Employee Pension (SEP ) Set up by an employer for a firm’s employees.000 per year. This is designed for grandparents to set up an account for their grandchildren or a parent for their children. Additionally.000 in annual compensation. Employees may contribute up to $11. Specifically. and as much as $49. but all deposits and earnings may be withdrawn free of tax and penalties as long as the proceeds are used to pay for the costs of higher education. The couple must file a joint tax return in the year of contribution.500 per year to these IRAs and will receive some level of a matching percentage of pay from their employer.000 for single filers. A rollover to or from another IRA owned by the heir is not permitted. Inherited A traditional or a Roth IRA acquired by a non-spousal beneficiary of a deceased IRA owner. Distributions transferred to a rollover IRA are not subject to any contribution limits. the distribution may be eligible for subsequent transfer into a qualified retirement plan available through a new employer.000 in 2009. Rollover Set up by an individual to receive a distribution from a qualified retirement plan. They may be made regardless of the beneficiary’s income. they are deemed as earnings and must be included in the beneficiary’s gross income and subject to a 10 percent excise tax. Spousal Funded by a married taxpayer in the name of his or her spouse who has less than $2. Special rules apply to such inherited IRAs. and the proceeds must be distributed (and taxed) within a specific period as established by the Internal Revenue Code.000 for joint filers and $95. If the distributions exceed the education expenses of the beneficiary.000 per year to the Spousal IRA if spouse is under fifty years of age and up to $6. Problem is. Education Established after January 1. 259 . Contributions are limited to a maximum of $2. the employer can choose either a 2 percent non-elective compensation or a dollar-for-dollar match of up to 3 percent of pay. A Savings Incentive Match Plan for Employees (SIMPLE ) Set up by a small employer for a firm’s employees. An employer may contribute up to 25 percent of an employee’s compensation annually to each employee’s IRA. if you happen to make too much money. The working spouse may contribute up to $5.000 if fifty years or over. in order to provide funds that will allow a beneficiary to attend a program of higher education. A tax deduction is not allowed for contributions to this IRA. There are no tax deductions allowed for this contribution. . SECTION D: ACTION PLAN • Start a Roth IRA as soon as possible and get into the habit of contributing something to it every month. • Check your employer’s vesting schedule and plan your career moves accordingly. 261 . • Make sure you sign on to your work-related 401(k) and get your employer to contribute the maximum match. • Go into your 401(k) and Roth IRA accounts from time to time and adjust the allocations to appropriate funds using the principles discussed in this book. . or we can invest indirectly through our retirement funds—our 401(k)s and/or our IRAs. over time. As my primary care physician is fond of telling me at annual physical time: “We only control 50 percent of our health under the best of circumstances. We can eat well. and Retirement. credit cards. along with its accumulated interest. —Forrest Gump At long last. and take our vitamin supplements and control about 50 percent of what happens to us. The same principles are at work here. or maximize returns while minimizing risk. The downside of this current infusion of cash is that we have an obligation to pay off the loan. We need investments in order to grow our wealth. we are near the end of our journey. you have absolutely no chance of success.13 In Conclusion—The 50 Percent Rule Mama always said life was like a box of chocolates. and other important household items. exercise. a car. We can invest directly by buying (and selling) stocks. You never know what you’re gonna get. Therefore.” The other 50 percent is determined by what we are born with. It is possible to do all the right things in life and still end up with problems with our retirement. Where do credit and insurance fit into the big picture? Credit transfers wealth from the future to the present so we can buy an expensive house (costing many times our current income). We can only take care of the 50 percent we have control over. Now that is a guarantee! They say success is nothing but preparation meeting opportunity. mutual funds. How do we put it all together in a way that makes sense? Are you guaranteed to do well if you follow the prescriptions laid out in the previous chapters? Absolutely not! Why? Because we do not have complete control of our financial health. Credit. But if you don’t take care of the 50 percent that is within your control. futures. bonds. you will miss your opportunities. options. We are trying to take the least amount of risk and make the most money. credit used judiciously along with investments can give us a bump in our current wealth without creating too much of 263 . or some combination of these. If you are not prepared. But. It is as simple as that! So follow the rules and do the right things and chances are that the breaks will go your way. This 50 percent rule also applies to Personal Finance. Insurance. or investment accounts. in a certain sense. insurance. the journey has only begun! We have studied the four core concepts on which the whole discipline of Personal Finance is based: Investments. Do this before putting your money anywhere else. Offense in the form of prudent investments (both direct and indirect) wins games and enables us to have a good life. try to avoid credit card debt and try to maintain a good credit history and score.” The game of life is no different. Let TVM work for you in growing your retirement nest egg. Make sure you have adequate health and auto insurance protection. Buy an index fund or an index ETF for the long term. But ultimately it’s the defense we play (in the form of prudent insurance policies) that determines if we will win the championship of life. Buy a sector ETF that you think will outperform the market in the short run. You can afford to take chances with your investments at this stage of your life. Liability insurance is usually the cheapest auto insurance coverage. Life insurance policies are not necessary if you have no dependents to support. . think about starting a Roth IRA. but make sure that it is convertible to a cash value policy of your choice without any additional medical exams (guaranteed renewable). After Graduation—Invoke the 80–20 Rule You have a job and are beginning to have a bit of discretionary wealth. or a tree could fall on your house. “Offense wins games. Make sure to have health insurance coverage either through your parents or through work. your spouse becomes your dependent. you are investing for the long term (about a forty year time horizon). If you have some extra money. This is important because we live in a world where things can go wrong. at the end of the month. it probably does not make sense to have any coverage other than liability insurance coverage. You want to pay off your high interest loans before you start building your asset account. If you get married. and lives can change in an instant—you could be involved in a serious accident or diagnosed with a serious ailment. Most importantly. If you drive a car. This is where insurance comes in. remember to have more than the minimum amount mandated in your state of residence. Remember. Make sure to start paying off your student loans and any credit card debts you may have accumulated in college (if you didn’t listen to my warnings above). They are inexorably linked to help us succeed. Regarding auto insurance. if not completely.264 Chapter Thirteen a dent in our future worth. Consider getting a cheap Term Life insurance policy. defense wins championships. make sure you have adequate auto insurance. A Prescription for Living while in College You should only have one or two credit cards. Make sure you hold off on impulse purchases and always pay off your charges quickly. Insurance is a defensive strategy meant to protect our wealth from depletion due to a severe negative event. If it is an old car. around 80 percent of your investment dollars should be in equity or equity-related investments (stocks.) and about 20 percent in non-equity investments (like bond ETFs and precious metal ETFs). Remember that gold and precious metal funds do well in a defensive. ETFs. instruments. Investments should be in relatively low-risk. Whatever you invest in. if your company has a 401(k) plan and your employer matches your contribution to it. Make sure you take advantage by contributing as much of your own money as they will match. which states that in your twenties. high-return assets. In the play compartment. especially if your company is providing matching funds. In addition. If there is any surplus after this.In Conclusion—The 50 Percent Rule 265 Start budgeting your money and try to put some (even if it is $50 a month) into a Roth IRA. open a brokerage account and start investing outside your retirement account. Take some chances. If you think a particular company might take off in a few years. maybe even a Variable Universal Life policy. In Your Thirties and Forties—Move to 70–30 This is the period of your life when you are starting to bring in serious income. In terms of retirement. go ahead and buy some shares in it. If you are in mutual funds or ETFs. or depressed. but your expenses are also climbing as you have to cater to the needs of a growing family and your own upscale lifestyle. they should berated four or five stars according to Morningstar or a comparable rating agency. Make sure the charges on your credit cards don’t get out of hand and that you are paying off all. Buy into some sectors you think have long-term potential. Here. including gold. The latter is intended to provide your investment portfolio with a floor to stabilize it in case of a short-to-intermediate term market turmoil. In addition. or a rainy-day fund. You may want to compartmentalize your investment account into a “serious” compartment and a “play” compartment. make sure you feed the Roth IRA account and any 401(k) account that you may have through your employer. if you want to take some chances. try to have some fun with your investments. etc. do not put more than 25–30 percent of your investing dollars in non-equity investments. It is advisable to have a compartmental approach towards investing along with an overall 70–30 approach: 70 percent in equity and 30 percent in debt and precious metal. options. . find the parent company and buy some shares. Think about a precious metal ETF or even a gold index fund. Just make sure that this money is not needed elsewhere by you or your family. If you read about a promising drug trial. Buy some high-yield bonds. It might be time to trade in that Term Life policy for a fancier cash value policy like a Universal Life or. of your charges every month. equity mutual funds. or most. you should have some bond ETFs or high-grade bond mutual funds. The money in your serious compartment might be earmarked for your children’s college fund. You still need to grow your portfolio aggressively without sacrificing too much in downside risk. economy and to bring some balance to your portfolio. you will want to invoke my 80-20 principle. a bigger home purchase. this is free money. Check your retirement accounts and follow the same approach there: relatively less exposure to equities and more to high-grade bonds. In Your Fifties—Think 50–50 Your fifties should be similar to your thirties. although you may want to make sure you do not put all your eggs in that one basket. The play compartment of your investment portfolio should get a revamping. Your insurance needs should now be minimal. Also start getting more conservative with your investments. You should still have play money. but you also want to continue building. Start putting any surplus money into savings accounts with interest payments. Insurance needs decline as your children are growing up. Your house and cars should be all. Even though you are not getting the same kinds of tax breaks on your mortgage payment. . but keep an eye out for some strategic profit opportunities by selling some of your holdings at significant gains after a rise in prices.266 Chapter Thirteen Also. Your children are grown and have lives of their own. Remember from earlier discussions that the high price of safety is the significantly reduced returns that bonds provide. you could reduce the face value of the policy and use the accumulated cash value to service the policy in order to combat the natural increase in death benefit costs in your policy. You want to start being cautious. Your children are becoming teenagers and college expenses are looming. There is no need to hide behind the safety of bonds quite yet. paid off. You should start to concentrate on high-quality stocks and high-quality bonds and less on speculative/high-risk assets. Regarding insurance. but on a bigger scale. take advantage of ESOPs if you have the opportunity. but the crucial downside is also protected. you have the advantage of having significant equity in your house and other property. Think about lowering the face value of the policy. This way. or mostly. Those college funds you set up in your late twenties or early thirties should be looking mighty attractive now. In Your Sixties and Seventies—Move to 35–65 They say sixties are the new fifties. you should have relatively more exposure to corporate bonds and less to treasuries. Pull them out of risky ventures and consolidate them into blue chip stocks and high-quality government and corporate bonds. which will save you money in premiums. You want your investment portfolio to keep generating decent returns. and that means increased exposure to equities and maybe even some derivatives. At this stage of your life. there is still some risk being taken and returns earned. If you have significant cash value built up. People are living longer and healthier lives— well into their seventies and eighties. you can safely lower the coverage so that it will cover your funeral arrangements and other final medical expenses. Still in that respectful position. Ten years later. He immediately returns to the old Zen master (still raking leaves). Accordingly. our investment portfolio. scratches his head and ponders the situation. healthier lives. But there is no response from the elderly teacher. at sixty. There is no one size fits all here—only you can decide how much risk you are comfortable taking. Now. or even acknowledge.In Conclusion—The 50 Percent Rule 267 In Your Eighties—Think 20–80 Traditional thinking states that. The high-quality bonds and bond ETFs along with the stocks will still provide some much needed growth while the precious metal and gold funds will provide some defense. Very disconcerted. he suddenly achieves enlightenment (satori). seventies. Given our extended longevity. and eighties. think high quality in both areas. Master!" Go Forth and Prosper! . He decides to become the masterʼs student. the young manʼs presence (recall that this was before teaching evaluations). the old man continues with his raking and never even bothers to look up. while raking leaves. After much searching. While the exposure to equities needs to decrease to within 20 percent equity and 80 percent bonds by the end of our sixties. raking leaves. the way we live and think about our lives has changed dramatically over the last few decades and will change further as medical science continues to advance and we are able to lead longer. About 10 percent of your portfolio should be in precious metals and/or gold funds to provide you with an inflation buffer. the young man introduces himself and expresses his desire to become the masterʼs student. Your equities should be in high quality companies and certain sector ETFs. the young man stands. while the bonds should be in A-rated bonds. bond ETFs and treasuries. he manages to stumble upon the hut of the old master. we need to be thinking about our investments into our eighties. need to be in a relatively aggressive growth mode well into our sixties. "Thank you. You should be careful and avoid taking large risks. including our retirement accounts. we stop investing and begin spending our accumulated wealth. The young man rushes out and falls prone on the ground in front of the old man. bows. The awestruck student sees the elderly man in front of the hut. our thinking about how to invest our money will also have to change to keep pace with our lives. and says. In sum. But our increasing life spans are making this assumption obsolete. but you should still be mindful of your returns. He decides to go over to another part of the forest and build his own hut. In fact. Big Picture A young man hears that there is a Zen master living as a hermit in the forest. . A Guide to Understanding Time Value of Money . . It will take approximately twelve years for your money to double at an interest rate of 6 percent. True or false? 3. True or false? 10. If you missed a couple.TVM Awareness Quiz 1. The process of determining the future value of a present amount is called discounting. If a bank charges a 13 percent nominal interest rate on a loan. what is the effective interest rate assuming monthly compounding? 5. True or false? 2. Interest rates associated with credit cards are significantly lower than those associated with a mortgage loan. or less than 13 percent? 9. equal to 13 percent. is the effective interest rate assuming monthly compounding greater than 13 percent. True or false? Check your answers on the next page. Insurance premiums are computed on the basis of time value of money principles. Discounting refers to moving money from the future to the present. Compounding refers to moving money from the present to the future. If you got them all right. If a bank charges a 13 percent nominal interest rate on a loan. you should pay closer attention. 271 . True or false? 8. A stock or bond price is nothing but the discounted present value of all future cash flows attributed to the stock or bond. you still need to listen because there is a lot of subtlety in these concepts that you need to absolutely understand in order to take full advantage of them in life. Time Value of Money calculations are determined by two values: principal and interest rate. True or false? 6. True or false? 7. True or false? 4. 2.272 Time Value of Money Answers 1. True. 7. 13. False. TVM is determined by three variables: principal. 4. . True. and time period. interest rate. 5. 8. False. True. Greater than 13 percent.8 percent. True. True. 10. False. 9. 3. 6. it will most definitely help you make better business and/or investment decisions. and to do simple capital budgeting and related computations. The reason is that money received sooner rather than later allows one to use the funds for investment or consumption purposes. it will help you understand how to value basic financial securities. retirement plans. But unfortunately. In fact. car loans. job contracts.000 today is not the same as receiving $1. Among other things. TVM has applications in all areas of our lives. but to be able to take the same concepts and apply them to your own personal situations appropriately. if you are in business or into investing.The Basics Why Should I Learn Time Value of Money? That’s the most common question I hear at the beginning of each semester. it is also a concept that provides students with trouble. and a host of other issues. Such knowledge will help you become a better employee and thus help you get ahead in life. home equity loans. if you received the money sooner 273 . TVM uses the time-tested concepts of compounding (to convert the value of a sum of money from the present to some date in the future) and discounting (to convert the vaue of a given sum of money at a given date in the future to the present). I don’t just want you to mechanically solve TVM problems in class. The purpose of this guide is to make sure that you are comfortable enough with TVM concepts to use them freely and easily in your personal life and career. while TVM is a relatively simple concept with far-reaching applications. you need to thoroughly understand TVM. like stocks and bonds. It will help you understand how things like mortgages. This will be illustrated later.000 a year from now. and credit card bills work. credit. to fully appreciate any of the major financial decisions that you will soon have to make. estate planning. The Time Value of Money Receiving $1. These days. We all seem to have an intuitive understanding of that fact even if we are not always able to articulate exactly why. from investing to retirement. getting the money sooner allows you to invest it in an interest-bearing account in which the money grows in value. The reason is simple: understanding Time Value of Money (TVM) principles will help you make better decisions in your everyday life. almost everybody (regardless of where you work and what your major is) is required to know the basics of discounting and compounding. insurance. What makes the process of discounting or compounding interesting is that it is not a simple linear rule but an exponential rule. And. insurance contracts. Or. Put differently. . you have $500 that your grandmother gave you for Christmas and you decide to keep the money under your pillow for the next six months. who is a genius in the stock market. which would you rather have—$1. a six-month period. So. opportunity cost is same for everybody. and make a profit of $100 over venture that only earns 5 percent. Otherwise. Now. we give up the opportunity to use the money for some other purpose. So.000 today versus $5. So. or 2 percent.000 five years from now. you will need to know what would be the best possible alternative for your money. For example. Get the picture? Opportunity Cost How Can We Compare the Value of Money in Different Time Periods? The simple answer is: we can’t! We can only compare monies at the same point in time. If we use our money in one venture. which is better than delayed gratification. give up the opportunity to make 10 percould take the same amount of money. or • The value of $100 received in the future is less than $100 received today. say depositing it in a bank account. your friend important because we do not want to Sara. What our money could have earned in this alternative venture (that we can no longer take advantage of) is called the opportunity cost of our money. keep ular venture. Why Time? Times allows us the opportunity to postpone consumption and earn interest. the opportunity cost of your up by investing your money in a particoriginal action is $10. you can only do so after either compounding or discounting one of the cash amounts (using an appropriate compounding or discount rate) so they are both evaluated at the same point in time. Sara’s opportunity cost is 20 percent. which would you choose? The Intuition behind TVM • The value of $100 received today is more than $100 received in the future. invest cent on our money by putting it in a it in the market. This concept is referred to as the Time Value of Money. it is like comparing apples and oranges. It is different for different in mind that the opportunity cost is not the people. In finance.000 in five years? The corollary to this is: if you had the choice of paying someone $5. What is the opportunity cost of this action on your part? To answer this question.274 Time Value of Money and simply consumed it. You could open a bank account and earn (say) $10 interest over Opportunity cost is what you are giving that period.000 today or $1. For example. it will give you pleasure right now. If you are given money at two different points in time and asked to compare them. That is the value today. but also on any previous interest earned. First.000 + $140 = $1.000 you originally deposited. Present Value is the current value of a future amount of money (or a series of payments). assume that you deposit $1.000 in an account earning 7 percent simple interest for two years. Exponential Growth under Compounding In contrast to simple interest. The Present Value in the problem above is simply the $1. there is an exponential growth of money towards the end. or the amount borrowed (or lent). evaluated at a given interest rate. On the next page is a graphic illustration of the growth of a single deposit of $1.000 × . it is called compound interest. when interest is paid on not only the principal amount invested. SI = P0 × i × n = $1.140 Defining Present and Future Values Future Value is the value of a present amount of money (or a series of payments) at some future time. evaluated at a given interest rate. under the compound interest rate. . Notice the growth rate of money. What is the accumulated interest at the end of the second year? Simple Interest (SI) = P0 × i × n Future Value (FV) = P0 + SI SI: simple interest P0: deposit today (t = 0) i: interest rate per period n: number of time periods In the current case. Especially notice how.07 × 2 = $140 So what is the future value (FV) of the deposit? FV = P0 + SI = $1.000 at various interest rates—simple as well as compound.A Guide 275 Simple Interest Simple interest is the interest paid (or earned) on only the original amount. If you’re saving to retire in forty years.804. and your contributions grow at 8 percent annually. for example. After thirty years. After thirty years—threequarters into your retirement planning journey—you will only be at about 50 percent of your goal. when time and compounding begin to work their magic. For example. time is the crucial part of the growth here.072. but your retirement nest egg will increase to $298. the total will be $36. After twenty years— halfway to retirement—your total will be only about 17 percent of your final goal. let’s assume you contribute $200 a month to your retirement plan. . After twenty years. After ten years. The majority of your contributions’ growth occurs in later years. your $96. you'll have contributed $72.000 in contributions that will grow to $117.000 to the plan (unadjusted for time value of money) and with accumulated compound interest. you would be halfway to your destination after fifty miles.201 is the goal.000. over the last quarter of your time horizon.276 Time Value of Money So.201. assuming $698. Compound interest doesn’t work the same way. After ten years. If you were to take a 100-mile trip. After forty years. you'll have contributed $24. Critical Fact Examine the numbers above to understand how time helps grow your savings. you’ll accumulate much less than half your financial goal after saving for twenty years.589. So. youʼll have accumulated only 5 percent of your eventual goal.000 in total contributions will swell to an astounding $698. you'll have a total of $48. your savings grow an astounding 50 percent. Or.260 1. you might be promised $300 two years in the future and you would like to know its present value. you may decide to open a bank account with $500 today and you would like to know how much it would grow into at the bank’s stated interest rate.166 1.311 1.n (1a) By comparing equations (1) and (1a) we see that the term (1 + i)n in (1) is represented by the term FVFi. Now do you understand why the term FVFi. Typical situations in which you would perform these calculations include determining the future value of a single bank deposit made today.124 1. single sum.060 1.n in (1a)—otherwise known as the Future Value Factor.191 1.360 1. Notice that the defining characteristic of the above scenarios is the movement of a single sum of money either from the present to the future or from the future to the present. Following is a portion of a standard FVF table. i. FVn = P0 × FVFi.n is written with the i and n subscripts? Period 6% 7% 8% 1 2 3 4 5 1.145 1.403 1.e. right now) i = interest rate per period n = number of time periods Future Value of a Single Sum Let us now take equation (1) and rewrite it. FVF is especially useful for those among you who want to use the tables provided at the back of this guide.. i and n. or determing the value of a loan that you may have to repay in one lump sum in the future.Single Sum Problems Single sum problems involve a single dollar sum. Notice that the horizontal arm of the table contains the interest rates.080 1.262 1.469 277 . the FVF table will be supplied to you during exams and similar testing events.225 1. n. In order to solve such problems.070 1. at a certain growth rate.338 1. Computing the future value of a single sum involves determing the future value of a present. and the vertical arm of the table contains the time periods. The formula to solve problems involving a single dollar sum is given by: FVn = P0 (1 + i)n where FVn = future value at time n (1) P0 = present value at time 0 (i. For example. which is determined by two numbers. 110 2 . Hence.n 1 Once again. we see that the term (1 + i) in equation (2) is represented by the term PVFi. how much will be in the account at the end of two years if there are no withdrawals? Solution: FV2 = P0 (1 + i)n = $2.278 Time Value of Money Important Notice that the same formula (equation 1) can be used to solve both future and present value problems involving a single sum. Present Value of a Single Sum The present value of single sum involves computing the present value of a single dollar sum somewhere in the future.n —otherwise known as the Present Value Factor. In order to solve such problems.000 (1. i and n. A PVF table will be n . 1.000 × FVF10%. Solution: FV5 = $10. at a given discount rate. If you invested $2.20 Practice: Solve the same problem using the FVF table. with interest compounded annually. 5 = $10. Typical examples include estimating the present value of future promises or income. we simply take equation (1) and rearrange it to get PV0 = FVn (1 + i)n = FVn × 1 (1 + i)n (2) = FVn × PVFi. which is also determined by two numbers.000 today in an account that pays 6 percent interest. Examples Here are some examples of using the FVF tables to solve a problem.611 = $16. you can use PVF tables to solve the problem if you don’t want to use the actual formula given by equation (2).000 today will become at a compound annual interest rate of 10 percent for five years.000 × 1.247. Ali wants to know how large his deposit of $10.06)2 = $2. 06)10 = 3. Here is a portion of a standard PVF table.000 saved ten years from now.81 (1.A Guide 279 supplied to you during exams and similar events. 2 = $1. What is the present value of $1.763 .500 = $2. Assume today’s deposit will grow to 4 percent compounded annually.45.792 .890 .500 in five years. Assume that you need to have exactly $4.713 8% .943 .58 (1.935 .676. what rate of annual compound interest was earned? Hint: Use the appropriate single sum equation and solve for i.04)5 Variations on the Above We now know how to use the Single Sum formula to get either Present Values or Future Values.233.926 .000 × 0. Joann needs to know how large of a deposit to make today so that the money will grow to $2.840 .816 .857 .747 7% .735 .794 . so that you reach your goal of $4.000 exactly five years ago and has accumulated $2.000? Solution: PV0 = FV10 (1 + i) 10 $4. How much must you deposit today in an account that pays 6 percent interest.873 . and the vertical arm of the table contains of the periods.000 = $2. the horizontal arm of the table contains the interest rates.681 Some Examples Here are a few examples of using the PVF table. 1. As with the FVF table before. But what if I gave you both the PV and the FV and asked you to compute either n or i? 1. compounded annually.054. Solution: PV0 = FV5 (1 + i) 5 = $2. i.000 × PVF7%. If one invests $2. and you can also find them at the back of almost all basic investment texts. .873 = $873 2. n. Period 1 2 3 4 5 6% .000 received two years from now if the interest rate is 7 percent? Solution: PV0 = $1. written in its most general form as FVn. 2. such as every six months (twice a year).000 in an account that pays 12 percent interest. m: P0: 冢 = P0 1 + 冢 mi 冣 冣 m×n (3) number of years compounding periods per year annual interest rate FV at the end of year n (at compounding frequency m) PV of the cash flow today Notice that if we substitute m = 1 (or. . consider the Single Sum formula. Money is compounded more frequently. In fact. we have assumed that interest rate is compounded annually. cash advances on your credit cards are compounded daily. the frequency of your payments (or receipts) also determines the compounding frequency. How do we solve TVM problems under those situations? To see this. and so on. Frequency of Compounding Example Suppose you deposit $1. m where n: m: i: FVn. For example. credit card loans are compounded monthly. This is your n for the problem. This is your i for the problem. How much will be in the account after eight years if there are no withdrawals? Solution: The way to solve this problem is to first recognize two things: 1. equation (1). every quarter (four times a year). annual compounding) in (3). in most practical real world applications.000 today in a savings account paying 6 percent interest (compounded annually).000 in my account? Hint: Solve for n. If I invest $10. it is not. Armed with this information. When you are given an annual interest rate of 12 percent compounded every quarter. or sometimes even daily. For practical purposes. you are ready to do some serious problem solving. Frequency of Compounding Now we are going to learn another variation of single sum problems. we are back to equation (1). that makes it an interest rate of 12/4 = 3 percent every quarter.280 Time Value of Money 2. But it does not always have to be that way. So far. how long will it take for me to have $50. Eight years in quarters equals 8 × 4 = 32 quarters. monthly (twelve times a year). compounded quarterly. We can buy a basket of goods today and it will cost $100. By contrast.000 i = 12%/4% = 3% per quarter n = 8 × 4 = 32 quarters Solution based on formula: FV32 = PV0 × (1 + i)n = 1. is the nominal interest rate. which . The implication for banks is that they can borrow money for free from the Federal Reserve. Thus the loan has an interest rate of 6 percent. Most recently. is extremely vigilant about regulating inflation using the Federal Funds Flow Rate (which is the rate the Federal Reserve charges on overnight loans between banks). Whenever people speak of the interest rate they’re talking about the nominal interest rate.. or we can buy that same basket next year and it will cost $103. unless they state otherwise. the Board of Governors of the Federal Reserve have held the Federal funds rate between zero and 0.e. Suppose the inflation rate is 3 percent for that year.10 Nominal Interest Rates A real interest rate is one where the effects of inflation have been factored in. therefore. however. How do they do that? They raise the rate when inflation concerns are higher in order to deter borrowing by making it more expensive.25 percent in order to help banks recover from the recent recession. it is included in the interest you are paying on your loan and. given the current economic climate. a nominal interest rate is one where the effects of inflation have not been accounted for. Another way to see how this works is as follows.A Guide 281 PV0 = $1. Federal Funds Flow Rates The Federal funds flow rate is the overnight lending rate between banks. Suppose I take out a $100 loan with the condition that I pay back $106 at the end of the year. America’s central bank. Here is an example illustrating the difference. it is easy to see that under such circumstances you are paying less (in real terms) for borrowing money—i. because we have not accounted for inflation. The Federal Reserve. rates are lowered when the economy contracts in order to encourage consumer borrowing (and spending) by making borrowing costs cheaper. it raises the price of everything in the economy. What does inflation do? Generally. So if the prices of goods and services increase by about 2 percent over the year. Analysts feel that.0332 = $2575. about 4 percent.000 × 1. or reduces the value of a dollar. Conversely. this rate will stay close to zero for the next couple of years at the very least. This 6 percent. and m = 365 for daily compounding. the nominal rate nominal interest rate? As we have seen above. as the chart below shows. m = 4 for quarterly compounding. any correlation is small. 30 Year Fixed Mortgage Rate versus the Federal Funds Rate 8 30 year fixed rate Rate 6 Federal funds rate 2 Th 2000 2008T Effective Annual Interest Rate The effective interest rate is the actual (or.. While there is some correlation between the two rates. loans can equals the effective rate.282 Time Value of Money should help loosen credit and allow them to lend to consumers in order to get the economy moving. Caution . the time to lock in an interest rate is when the federal funds rate is low. m = 12 for monthly compounding. real) rate of interest earned (or paid) after adjusting the nominal rate for factors such as the number of compounding periods per year. i. Thus. but this is actually not true. So don’t let a low federal funds rate fool you into thinking that mortgage rates are favorable. ieff = 冢 1 + 冢 冣冣 i m m –1 (4) In this equation.e. be calculated with different compounding periods. Note that with annual comHow does the effective interest rate relate to the pounding. i is simply the given interest rate per period and m is the compounding frequency. This implies that the two directly reflect each other. Relationship between Mortgage Rate and Federal Funds Rate There is a belief that when you are looking for a favorable mortgage interest rate to either finance a home purchase or refinance an existing mortgage. quarterly. keep in mind that the actual value of the initial investment does not matter. for simplicity. annually. . What is the effective annual rate (EAR) of interest for a loan that has an 18 percent annual percentage rate. let us assume an initial investment of $1 (i. you should all convince yourself of this by redoing the problem with different initial investments. all loans should be stated in effective rate terms. therefore the FV = $4 if the value quadruples 2.58 percent. To protect the consumer.18 • m = 12 • EAR = 19. . Practice Problem: What is the effective annual rate of interest for a loan that has a 36 percent annual percentage rate. These days. Example: What is the effective rate of a 12 percent APR loan that is compounded daily? Solution: From the given formula.06 • n = 24 years • Hint: Use $1 as a PV. the effective rate of interest on your 12 percent loan is actually 12. etc. PV=$1). However. lenders are required by law to report the effective rate of interest on your loan in addition to the APR. semi-annually.75 percent.A Guide 283 monthly. We will get the same answer regardless of the amount of initial investment chosen. In fact.e. Can you articulate why? Talk it out! • i = 0. which factor in the compounding frequency on the nominal rate.12 365 –1 = 12. compounded monthly? Answer: 42. This makes it easier for the potential borrower to compare across loans and select the best rate when borrowing. • PV = $1 • FV = $4 • i = 0. the effective rate after monthly compounding will be considerably more than 18 percent. compounded monthly? Solution: Notice that if a loan has an annual 18 percent APR. you can easily infer the compounding frequency. How long does it take for an investment to quadruple in value if the investment yields 6 percent per year? Solution: Notice that we can take an investment of any value in this problem . we can write ieff = 冢1 + 365冣 .75% So.. More Examples of Single Sum Problems 1.56% • Hint: Simply apply the information provided to the formula for ieff. so. . So. 874.000) and solve for NPV. 4. 6.000 and one payment in four years for $10. If Abel invests $100 today in an account that earns 10 percent per year.81 at the end of each month for thirty months. CF4 = 10.. how much will he have in this account at the end of twenty years if he makes no withdrawals? Solution: • PV = $100 • i = 10%/2 = 5% • n = 20 x 2 = 40 • FV = $704 • Hint: Transform the given values to a semi-annual basis (i. Suppose you are trying to borrow money from the bank to finance your business. At what annual rate did ticket prices grow? Solution: • PV = $5.830 • Loan = sum of PVs = $10. compounded semi-annually. CF2 = 5.132 • PV of second payment = $6.4466% • Hint: There are two years over which the price has grown—from 1988 to 1989 (that’s one year).000 • CF = $3. And suppose you promise to repay the bank in two installments. CF1 = 0.00.e.000 today and must make monthly payments of $3.000. What does that mean for adjusting n and i? 5.000. CF3 = 0. you can solve this in one step using the cash flow registers (CF0 = 0. period = six months). Suppose Charlie borrows $100. i .81 • n = 30 • Solve for the monthly interest rate. one payment in two years for $5. how much is the bank willing to lend you? Solution: • PV of first payment = $4. The average price of a movie ticket at the end of 1988 was $5.874.50 and the average price of a movie ticket at the end of 1990 was $6.00 •t=2 • i = 4. and then from 1989 to 1990 (the second year).284 Time Value of Money 3.50 • FV = $6. If the bank’s opportunity cost of funds is 10 percent.962 (you can add cash flows at the same time) • Hint: if you have a financial calculator. What is the annual percentage rate (APR) on Charlie’s loan? What is the effective annual rate (EAR) on Charlie’s loan? Solution: • PV = $100. 9.71%. 7.05% Summary Single sum problems involve a single dollar sum that you have to move either to the relative present (present value problem) or to the relative future (future value problem).54%. FV. b. You borrow $1.25% Quarterly: i = . 3. i. 9. You borrow $250 and repay $500 at the end of eight years.025 EAR = 10. FVt. You borrow $500 and repay $600 at the end of five years.05 EAR = 10.000 and repay $1. c. d.5156% 8.79. Hint: identify PV.000 and repay $1.01)12 – 1 = 12. Calculate the average annual interest rate on each of the following transactions: a.68% 7. The four possible variables are P0. Semi-annual: i = . b.008333 EAR = 10. a. c. d.3813% Monthly: i = . c. . and n.200 at the end of two years. Calculate the effective annual rate (EAR) on a savings account with an annual percentage rate (APR) of 10 percent for the following compounding frequencies: a.350 at the end of four years.4713% Daily: i = . d. b. You will be provided with information on any three and asked to find the fourth. and n.000274 EAR = 10. You borrow $1.A Guide 285 • i = 1% per month • APR = 1% x 12 = 12% • EAR = (1 + 0. 2. • If one agrees to repay a loan by paying $1.000 every want to know its value at time 5. 2. you want to know the value example of a future value problem. Learn to Recognize Annuities In order to solve for annuities. That’s your first and most impor. this is a present value of an annuity. based on the future payments. and you ing of the problem.e. this is an tant clue. it is essential that you understand how annuities work so you will know what you are doing when you undertake these transactions in your daily life. compounded annually. For example. and 4. cash flows may occur at times 1. and 4. 2. of this annuity at the end of three years. you are making multiple and equal payments toward a loan you take out today. Therefore. For example. You want to save $1. since the final date of the cash flows is in the future. 3. while you may want to know its value at time 0 (i.000 a year at the end of every year for three years and the discount rate is 7 percent. Here is another example of an annuity. Multiple (and equal) payments imply an annuity. So.. 4. retirement savings—the list goes on and on. how much will one have at the end of the third year? Emphasis Future value problems involve cash flows that have to be moved to some date in the future relative to the date of Why is the above an annuity? Notice the word.000 a year at the end of every year for three years in an account earning 7 percent interest. So we can further say that this is a future value of an annuity. • If one saves $1. 3. Annuities will come disguised in words and other terminology and you will need to be able to spot them. 286 Emphasis Present value problems involve cash flows have to be moved to some date in the present relative to the date of cash flows. What kind of an annuity is it? Notice that you want to know how much you can borrow today. In this case. . Thus. this is an example of a present value problem. car loan payments. insurance premium payments. The problem is that it will not always be obvious in real life. mortgage payments. 4. Notice year for three years. Hence.to times 1. you have to first learn to recognize them. there are multiple cash that 5 is in the relative future compared flows involved.Annuities The real fun begins now! Most of the interesting real world applications of TVM are where a series of (usually equal) cash flows are involved. So. 3. cash flows may occur at times 1. 3. So. The final destination of the cash flows is the present. Annuities are everywhere: student loan payments. 2. Notice that 0 is in the relative present compared to times 1. how much could one borrow today? Why is this an annuity? Again.the cash flows. how do you recognize annuities? Here are some examples. at the present). the next step is to be able to value them in a way that is useful to you with regard to a financial decision you have to make. In that case.” The basic formula remains the same—including the CF. whichever is appropriate for the specific problem. you might like to know the value of your $850 monthly mortgage payments five years from today. . The Future Value Factor for Annuity is either computed from a given formula or found directly from the appropriate table. Why is the above an annuity? Think of the equal and regular payments you are making to your bank. for example. you may wish to know the present value of the $850 monthly mortgage payments. Present Value of annuity stream = CF × (Present Value Factor for Annuity) (5) In this equation. What about the Present Value Factor for Annuity? This is a number we need either from an appropriate table or computed directly from the appropriate formula. In the previous examples.000 is a CF. The fact is that any time value problem can be solved using either the Present Value or the Future Value approach as we will see with examples. It is a representative cash flow in the annuity stream. In TVM terminology. $850 is a cash flow (CF). How to Solve Annuity Problems Once you are able to spot annuities. • The second step is to move that equivalent single sum to wherever the problem asks for on the time line. this is what you do. what if you had to estimate the value of a given stream of equal and regular cash flows at some date in the future? For example. • The first step is to reduce the series of annuity payments to an equivalent single sum on the time line by using either equation (5) or (6). CF denotes a typical cash flow in the annuity stream. You may wish to understand the present value of an annuity stream. or $1. you would say Future Value of annuity stream = CF × (Future Value Factor for Annuity) (6) Notice that the only difference between these two formulas is the replacement of the term “present” with “future.A Guide 287 • You make an $850 a month payment to your bank for a mortgage loan you have taken out. Word of Warning Don’t get too caught up with the terms Present Value and Future Value. Now. annuities are normally solved in two steps. These are convenience terms only and not to be taken as the final word. In sum. Also. by contrast. n is determined by the number of annuity payments in the problem In a single sum case. the resultant single sum is located on the day of the final cash flow in the annuity stream. To determine this we will use the following rule. Formulas or Tables? The big question is. If you don’t particularly want to get deep in the subject and want to know just enough to be able to solve problems. n denotes the number of time periods. It provides a black box approach to solving TVM problems where you plug in the right combination .n = 1– 1 (1 + i)n i where i denotes the interest rate per period n denotes the number of annuity paments. • When using the Present Value Factor for Annuity (PVFA) to reduce an annuity stream to an equivalent single dollar sum on the time line. Future Value Factor for Annuity n FVFAi.288 Time Value of Money The big question is where the equivalent single sollar sum you have computed using the formula in the last section is on the time line. using equation (6). Advantage of Using Tables Using the tables provides a mechanical approach to solving TVM problems. understand that tables are nothing but the formulas computed for you over a range of interest rates and numbers of payments. • When using the Future Value Factor for Annuity (FVFA) to reduce an annuity stream to an equivalent single dollar sum on the time line. Annuity Formulas Present Value Factor for Annuity PVFAi.n = (1 + i) – 1 i where i denotes the interest rate per period n denotes the number of annuity payments. Caution • • With annuities. do you want to get used to solving TVM problems using tables or do you want to get in the habit of using the formulas? There are advantages and disadvantages to both. the resultant single sum is located one period before the start of the annuity stream. using equation (5). then this is the best approach for you. remember one thing. you are out of luck with a standard because you will have no idea how to work the clutch and manually shift gears. If you learn driving in a standard. 2. Disadvantage of Using Formulas Sometimes the computations can be tedious. Advantage of Using Formulas Using formulars provides the freedom to solve for any problem. Otherwise your problem will not work out correctly. Disadvantages of Using Tables 1. The operative word is appropriate. Sometimes the rates and the periods that you need to solve a problem may not be available in the table. However.A Guide 289 of i and n and look up the value from the appropriate table.5 or i = 12. 0 Present Value 100 100 100 100 100 1 2 3 4 5 . Regardless of how you choose to solve your TVM problems. Then you have no choice but to use the formulas. Looking up values from the tables is much easier. They give you more flexibility. It’s like learning to drive using a standard transmission versus with an automatic transmission. you have to know what you are doing—to a degree. then switching to formulas might be more challenging.6 percent may not have an entry in the tables. Solving Annuity Problems Problem 1: Using Present Value Factor for Annuity (PVFA) Find the present value of the following annuity. assume the discount rate to be 5 percent). It’s the same with formulas. If you understand the above formulas. (As always. But if you get dependent on tables. The tables are standardized and any non-standard problem like n = 3. Now it’s time to get our hands dirty and solve an actual annuity problem using the principles we have learned. You have to know from which table to look up the values. if you learn in an automatic. then using tables when the occasion calls for it will not be very difficult. So. you can always drive an automatic. 5256 = $552.95 at t = 0—the single sum replaces the $100 each payable at the end of each of original annuity stream. FVA = 100 × 5. (As always. Important Problem 2: Using Future Value Factor for Annuity (FVFA) Find the future value of the following annuity.290 Time Value of Money Solution: First notice the number of annuity payments in this stream. 0 100 100 100 100 100 1 2 3 4 5 Future Value Solution: Notice the following right away: CF = 100. we are now ready to solve the problem. n = 5. The big question is: where is this single sum located on the time line? To see that. Finally. from equation (5).95 where the PVFA number can either be found in the appropriate table or computed directly from the formula provided earlier. The Remember that once you compute the presinterpretation of $432. years 1 through 5. Accordingly. we can say PVA = 100 × 4. Aha! Then the $432.i=5% Substituting the values from the problem. and i = 5 percent. notice that this is a present value of annuity problem since the final destination is the relative present with respect to the cash flows. right? And so $432.56 . PVA = CF × PVFAn=5.95 is also the Present Value (at time 0) of the annuity stream.95 is the following: it ent value of annuity (PVA)—that would be is the present value of five payments of $432. Make sure you understand why this is so.3295 = $432. Now using equation (6). Armed with these observations. Also notice that the CF = 100. assume the discount rate to be 5 percent). refer back to the rules for solving for annuities: when using equation (5) to reduce an annuity stream to an equivalent single dollar sum.95 is located at time 0. That would be n = 5. we can write the future value of annuity (FVA) as: FVA = CF × FVFAn=5.i=5% Substituting the values from the problem. the resultant single dollar sum is located one period before the start of the annuity stream. corresponding to n = 3 and i = 5 percent. To do so. Why? We are. i = 5 percent. So n = 3. What is the value of this annuity today (i. and 7. we could compute the factor from the formula provided). So. Step 1 Step 2 2 t= 1 500 0 1 2 3 4 5 500 500 6 7 8 9 Present Value Here Solution: How many annuity payments are there? There are three annuity payments occurring at time 5. PVFA = 2. CF = 500.7232 = $1.e. $552. In the first step we reduced the annuity stream to an equivalent single sum.361. notice how we solved the annuity problem in two steps. P0 = 1361.60 x (PVFn=4. . Value (at time 5) of the annuity stream.56 at t = 5—you can forget about the This implies that $552. refer back to the rule of solving for annuities: when using equation (6) to reduce an annuity stream to an equivalent single dollar sum. we can use the tables as follows (or. however..60—located at t = 4. The question is: where is this single sum located on the time line? To see that. and the final destination of the cash flows is t = 0. Hence. the resultant single Remember that once you compute the future dollar sum is located on the day of the last value of annuity (FVA)—that would be payment in the annuity stream. and 7. Furthermore. not done solving the problem because the problem asks us to move the cash flows to t = 0.60 located at t = 4 and move it to t = 0 as a single sum. So. right? And $552.i=5% And from the present value of annuity factor table.56 is located at existence of the original annuity stream and work exclusively with the equivalent single time 5. 6.19 Summary To recap. we take the $1.56 is also the Future sum located at t = 5.361. at t = 0)? Assume i = 5 percent. PVA = CF × PVFAn=3.i=5%) = 1120.7232.A Guide 291 where the FVFA value can either be found in the future value of annuity table or computed directly from the FVFA formula provided earlier. PVA = 500 × 2. and in the second step we moved the resultant single sum to its desired destination (at time 0). this is a present value of annuity problem. 6. From equation (5). Important Problem 3 Assume you are going to receive payments of $500 in each of years 5. i = 5%= ____ (located at t = 6) (Why?) Now move the resultant single sum from t = 6 to t = 4 using PVF (present value factor for a single sum).75 (located at t = 4) and the present value of annuity 2 is PVA2 = 300 × PVFAn=2. i= 5% = $557. Finally. So. 3 and to the relative present of t = 5. 3.298. Recall. The future value of this cash flow stream obtained by FVA = 300 × FVFA n=5.503. So. we can add cash flows at the same point in time. 4 as a three-payment annuity (annuity 1) and consider the cash flows at t = 5.298. The CF associated with both annuities is 300 and n1 (the n associated with annuity 1) = 3.503. Make sense? Note that all three approaches should give you the same answer. we simply move the single sum. and n2 (the n associated with annuity 2) = 2.85 (located at t = 1) (Why?) But we need to know the value of the cash flow steam at t = 4. 6. Approach 1 Treat the cash flows at t = 2.298.292 Time Value of Money Problem 4 0 1 300 300 300 300 300 2 3 4 5 6 Present Value Here There are various ways of solving the above problem. i = 5% = $945. 6 as another two-payment annuity (annuity 2). $1. notice that t = 4 is to the relative future of t = 2.57.85. .85 x FVFn=3. Approach 2 Treat the given set of cash flows as one annuity stream rather than two as in the previous approach. i=5% = $1. the present value of the annuity stream is given by PVA = 300 × PVFAn=5.55 Approach 3 Once again. To do so. i = 5% = $1. from t = 1 to t = 4. treat the given set of cash flows as one annuity stream. So value of the cash flow stream at t = 4 is 1. the future value of annuity 1 is FVA1= 300 × FVFAn=3.82 (located at t = 4) And the value of the cash flow stream at t = 4 is: $1. We are asked to find the value of the cash flow stream at t = 1. So we need to move this three periods back to t = 1. is a three-payment annuity with CF2 = 500 (n2 = 3). is a three-payment annuity with CF1 = 300 (n1=3). the present value of the $500 annuity at t = 1 is given by (500 × PVFA n=3. annuity 1. one annuity is not.96 (located at t = 1) PVA = 500 × PVFA n=3. except now the final destination is t = 0 rather than t = 1. Problem 6 0 1 300 300 300 500 500 500 2 3 4 5 6 7 Present Value Here Once again.176.15 Note that the n = 3 for the PVF above corresponds to moving the cash flow three periods from t = 4 to t = 1. Make sure you understand this.11. i=5% = ______ (located at t = 4) (Why?) While one annuity stream has already been moved to the desired destination. . i=5% = $1. this is a two annuity problem identical to the one before. PVA = 300 × PVFA n=3. i=5%) × PVFn=3.993. while the second annuity. we can simply add the two cash flows at t = 1 and we have our answer. And that would be the equivalent single sum corresponding to the $500 annuity—which is located at t = 4.A Guide 293 Problem 5 0 300 300 300 500 500 500 2 3 4 5 6 7 1 Present Value Here To solve this problem. Answer: $1. annuity 2. first notice that we are dealing with two distinct annuity streams here. Now that we have both annuities reduced to equivalent single sums at t = 1. The first one. i=5% = $816. The most logical way to solve the above problem is to use present value of annuity factor. So. Now we need to move FVA1 located at t = 3 to t = 5. Next. Answer: $757. n1 = 3). Assignment Can you solve the Problem 7 using PVFA? Go ahead and try. How do we do that? And once we do that. Problem 8 0 100 100 100 100 200 200 1 2 3 4 5 6 Future Value Here .56. The final answer would be the same. Also notice that the final point at which we want to know the value of the cash flow is to the relative future. the simplest way to solve the problem is to follow the exact same steps as in the previous problem with one additional step at the end. FVA2 = 200 × FVFA n=2. i=5% =__________ which puts the resultant single sum at t = 3. FVA1 = 100 × FVFA n=3.294 Time Value of Money So. i=5% =__________ which puts this single sum at t = 5. we simply add it to the second single sum computed above. Make sense? But keep in mind that we can solve the same problem using the present value of an annuity too.898. More on that later. Why do we do this? After summing the two. Take the sum of cash flows at t = 1 and move that one period to t = 0. Answer: $1.20. Problem 7 0 100 100 100 200 200 1 2 3 4 5 Future Value To solve this problem first notice that it involves two annuity streams: annuity 1 is a three-payment annuity (CF = 100. and annuity 2 is a two-payment annuity (CF = 200. So we will use the future value of an annuity for this purpose. you have your final answer. n2 = 2). given the cash flows. FVA = 300 × FVFA n=2. Solve the same problem using the present value of annuity factor.44 Problem 9 0 250 300 300 1 2 3 4 5 6 Future Value Here Here.00 (located at t = 3) Now we need to move this single sum to t = 6. the final destination. How do we do that? You should know this by now. n = 2). To do so. Wait! We are not done yet. notice that PVA1 = 100 x PVFA n=3. if you wanted to use the tables.. we can do all the steps we performed for the previous problem and then move the final single sum (the answer to the last problem) from t = 5 to t = 6.e. Answer: $1031. Now let’s take the two-payment annuity and compute the future value of annuity as follows. we need to sum them for the final answer.05)5= $319. How do we do that? After we move them. notice that we have one single sum of $250 and one two-payment annuity of $300 (i.A Guide 295 Notice that this is the same problem as the last one with one difference. PVA2 = 200 x PVFA n=2. First. CF = 300. FV6 = 250 × (1. Thus. So. How do we do that? Answer: $795. The final cash flow is required at t = 6. i=5% =_________ (located at t = 0).00 . i=5% =_________ (located at t = 3). i=5% = $615.07 which. Answer: 795. i=5% = ___________. The two single sums need to be moved to their final destination: t = 6. lets take the single sum and move it five periods to t = 6. would look like FV6 = 250 × FVFn=5. Now take the second annuity stream and do the following.44. we can write PVA = 100 × PVFAn=6. using equation (5). To do so. Since we are headed to the future with this problem. The answer. So we take the single sum and move it seven periods (from t = –1 to t = 6). This single sum needs to be moved to its final destination of t = 6. Ultimately.361. The annuity is defined by CF = 300 and n = 3.76. notice that we have one single sum of $250 and one three-payment annuity of $300. Solve it as you would Problem 9. Which one you use is up to you. But we are not finished yet. Solve the same problem using present value of annuity factor. i=5% =__________ (located at t = 5) But we have to know the value of the annuity at t = 6. So that means that we have to move the equivalent single sum from t = 5 to t = 6. In this case. How would you do that? Any problem can be solved using either Present Value or Future Value factors. Answer: $1. however. FVA = 100 × FVFA n=6. . Answer: $714. i=5% = _____________(located at t = –1) Think about why PVA is located at t = –1. would be the same regardless of how you get there.296 Time Value of Money Problem 10 0 250 300 300 300 1 2 3 4 5 6 Future Value Here This is similar to Problem 9 with a minor change. notice that t = –1 is just a relative number and you shouldn’t worry about time being negative.20. Problem 11 100 100 100 100 100 100 0 1 2 3 4 5 6 Future Value Here Notice that this is a six-payment annuity with CF = 100 and n = 6. 71. Write down the cash flows and arrows on the time line.A Guide 297 SUMMARY Steps to Solve Time Value of Money Problems 1.60 one year from today is $354. Check with financial calculator (optional).000 Number of cash flows 12 30 10 12 12 More Annuity Practice Problems 1.5460) = $354.74 $12. Solve the problem.71 $40. or a mixed flow involving both annuities and single sums.000 $1. 4.32 $4.89 $12.50 Rate per period 1% 1% 4% 3% 4% Present Value at t = 0 $1. annuity stream(s). Create a time line.60 × 0. . • Value today of the $354.000 $100 $2.51 $25.888. compounded annually? • PV of annuity one year from today is $100 × (3. 5.125.807.416. 2.682.000 $5. How much should you deposit in an account today so that you can withdraw $100 per year for four years. 7.04 $93.594.48 $99.850. 6.74 Present Value of an Annuity Problem 1 2 3 4 5 Periodic cash flow $100 $1. beginning two years from now. Determine if it is a present value or a future value problem.540. if your deposits earn 5 percent interest.577.60. Determine if the solution involves a single cash flow.000 $10. Quick Practice Problems Involving Annuities Future Value of an Annuity Problem 1 2 3 4 5 Periodic cash flow $1. 3.9524 = $337.64 $48.000 Number of cash flows 5 40 20 10 12 Rate per period 4% 1% 2% 5% 1% Future value as of the date of the last cash flow $5.000 $10.000 $1. Read the problem thoroughly.554. 931. beginning in one month.629. compounded monthly.90 × 0.19 .517. If your opportunity cost of funds is 8 percent.000 × 8.000 each year for four years if my deposits earn 4 percent interest (compounded annually).000 each year for four years if my deposits earn 4 percent interest (compounded annually) and my first withdrawal is ten years from today? • PV of annuity nine years from today is $1. should you agree to this deal? Given: CF = $64.90 to be the future value (what you want in the account at the end of the ninth period) and solve for cash flows (deposits) that produce this future value.629. How much must she set aside each year for her retirement if she can earn 10 percent on her funds? Given: PV60 = $50. If you deposit $185. my first withdrawal is ten years from today. How much must I deposit in an account today so that I can withdraw $1.44 Note that the annuity is worth almost $34 million to you. 5.000 × (3.000 for four periods is $3.629. Now the Surely Company is offering you $30 million in exchange for the twenty installments on your winnings.200. i = 4% • Annual deposit = $302.000 for a new car. n = 10 (years 0 through 9). and my last deposit is nine years from today? • PV of annuity of $1.34 4. Congrats! You just won the $64 million Florida lottery. Roberta is twenty years old today. • FV = $3. with the first withdrawal on her sixty-first birthday.90 nine years from today is $3. She wants to put the same amount of funds aside each year for the next twenty years—starting next year— so that she will be able to withdraw $50. how long will you be saving for your car? Answer: 36 months. So what should your decision be? 6.000 per year for twenty years once she retires.000 × (PVFA n=20.298 Time Value of Money 2. but Surely Company is offering only $30 million.629.000 n = 20 i = 8% PV = $33.90 • To solve for the payment.629.629. i = 10%) PV60 = $50. Suppose you want to save $8.90. Roberta plans on retiring on her sixthieth birthday. in an account that pays 12 percent interest per year. consider the $3. How much must I deposit in an account each year starting today so that I can withdraw $1.71 every month.32 3.678.550.7026 = $2.000.90 • Value today of the $3.5136 PV60 = $425.6299) = $3.000/20 = $3. i=6% PV4 = $5.000 n = 25 i = 6% PV4 = $5.2750 CF = payment = $1.274.A Guide 299 Because she will stop making payments on her fortieth birthday (the first payment is on her twenty-first birthday.63 The best deal is to pay $28 at the beginning of each of the four years.63 (c) PV = $54 + $54 /(1+0. You can earn 6 percent on your investments.000 × (12.628.000. the last is on her fortieth birthday). . I am repaying you using terms such that the present value of my repayment is only $50.35 Then. i=10% $63. i=10% $63. pay $28 at the beginning of each year for four years.000 today.000.06)4 = $50.63 = $98. CF = $5. You can pay $100 now for a four-year subscription. the subscriber.000 × PVFAn=25. we must calculate the balance in the account on her fortieth birthday: PV40 = PV60/(1 + 0.78/(1 + 0. 8. my first payment to you is five years from today).7834) PV4 = $63.274. Will you lend me the money? Given: This is a deferred annuity problem.10)2 = $54 + 44.916. I promise to pay you back in twenty-five annual installments of $5.35 n = 20 i = 10% FV = CF × FVFA n=20.08. You have choices when subscribing to our magazine.35 = CF × FVFA n=20. Which is the best deal for you.08 You probably shouldn’t lend the money under these terms. we need to calculate the deposits necessary to reach the goal: FV40 = PV40 = $63.10)20 = $63.75 per year 7.916.104. If you lend me $100. starting five years from today (that is.78 PV0 = $63. if your opportunity cost of funds is 10 percent? Given: (a) PV = $100 (b) PV = $97. or pay $54 today and $54 again two years from today.35 = CF × 57.628.274. Have I got a deal for you! If you lend me $100.274. 000 = $8. we get i = 7. you can use the regular annuity approach. how much will you have in the thirteenth year? Answer: $249.000 today if you promise to repay the loan in six monthly payments of $2. This multibillion dollar shoe endorsement business has declined as the poor economy has precluded people from buying expensive sneakers carrying the endorsement of their favorite NBA stars.000 today.000 n=5 Solve for the i of the annuity: PV = CF × PVFAn=5. A recent news story reported that Reebok International has cut the number of its athlete endorsers in half and recently terminated a $5 million per year contract with Shaquille O’Neal. You are considering the purchase of two different insurance annuities. which would you prefer? Answer: Annuity B 11. Ouch! And those athletes . i=? or.000 CF = $2. Annuity. The Loans-R-Us loan company is willing to lend you $10.300 Time Value of Money 9. and each costs you $70.000 at the beginning of each year for eight years. What is the effective annual interest rate on Loans-R-Us’s loan terms? Given: If the company lends you $10. Assuming your money is worth 7 peercent.000 each. If you leave the money invested for another three years. Then you earn 8 percent after that. i=? $8.000 = $2.9308 percent (more precise). Present Value: A Real World Story It appears that professional athletes are not getting the same attention from sportswear companies as they used to. Gone are the days when Air Jordans commanded a huge premium in the sneaker market and made Michael Jordan a wildly rich man.000 × PVFAn=5.000 – 2.000 and you repay $2. beginning today. PVFA = 4 Using the PVFA table corresponding to the factor value nearest to 4 and n = 5 gives us i = 8 percent (corresponding to PVFA = 3. Cash Flows.000.045 Time Value.000 immediately. Therefore. Annuity B will pay you $14. 10. modifying the PV and n: PV = $8.9927) By directly using a financial calculator.000 at the end of each year for fifteen years. Annuity A will pay you $18. you are really only borrowing $10. You deposit $15.000 each year for ten years at 6 percent. What kind of analysis should Puma. How much money. Ouch again! The changing market for celebrity shoes might help explain why NBA player Vince Carter decided to walk away from his $800. ten-year endorsement contract with Puma. is Vince Carter walking away from? Assume a 5 percent discount rate. Reebok. Carter was the 1999 NBA Rookie of the Year and has been compared to a young Michael Jordan. What would constitute an appropriate discount rate for a calculation such as this? 3. Not anymore! The story from the frustrated Vince Carter camp maintains that Puma did not live up to its promotional obligations and the level of advertising was far lower than expected. Consider the other side of the proverbial coin: the shoe companies. Questions 1.A Guide 301 that are still on the shoe company roster have signature shoes on store shelves—but are no longer benefiting from major marketing campaigns. this kind of comparison and the accompanying publicity would have led to a marketing blitz from sportswear firms including shoe companies. Nike. or any other company do before signing a contract with the next celebrity endorser? .000 per year. 2. In the past. in present value terms. to examine specific issues within Personal Finance. Example 1 What price should we pay for a bond with an 8 percent semi-annual coupon. we need to perform further analysis.+ n=1 CFt (1 + i)T But all of the cash flows are not even. a $1. We apply this principle to price a bond. unlike a stock. the math looks like this: coupon rate × face value CF = payment frequency Present value of cash flows = $40 × PVFAn=20. i=5% = $498.000 principal at the end of the term.000 face value. the value of a bond is given as the sum of its cash flows (CF): T 兺 (1CF+ i) = (1CF+ i) + (1CF+ i) n 1 n 2 2 +. 2. which we will discuss next.49 302 . In order to put a value on these different payments... and the present value of a single sum formula to the return of principle at maturity. in order to value the bond. The bond will pay semi-annual coupon payments of $40 for ten years followed by the return of the $1.Specific Applications of Annuities in the Various Areas of Personal Finance This section provides some directed applications of annuities in particular. It begins with a bond pricing example and then examines areas within credit. insurance. a bond with a fixed coupon consists of two components: 1. all we need to do is value each piece separately and then add them all together. If we apply the present value of an annuity formula to the coupon payments. Price of a financial asset = Present Value of its future cash flows. Bond Pricing Examples From rational expectations we know that. and retirement. A bond is an example of a financial asset that is relatively easy to value. A series of interest payments (an annuity) and The return of principal at maturity (a single sum). This is because its cash flow pattern is relatively certain and straightforward. Distilled to its essence. and ten years to maturity if we want a yield of 10 percent? Mathematically. and TVM principles in general. Hence. i=5% = $376.37 2.6243 CF = $60 Time 1 price = P1 = 60 + 1. She has found an annuity that currently sells for $80.000 face value bond with a 5 percent coupon rate (interest is paid semi-annually) that has three years remaining to maturity? The bond is priced to yield 8 percent.A Guide 303 Present value of the principal repayment = $1000 × PVFn=20.48 1.08 Answer: $981. An elderly neighbor asks you for investment advice.39 Example 2 Today. After a bit of research.08)2 = $964. Practice Examples 1. . What is today’s value of a $1. Is it? Answer: No. a three-year annual payment bond is priced at $973.5 percent (Note: The monthly rate would be 8.000 (1.000 t=3 PVFAn=3.49 + 376.757 = CF × $60 + $1. When that bond makes its t = 1 interest payment.90 The price of the bond to yield 10 percent is simply the sum of the two present values: Bond Price = 498.48. so the bond will have a YTM = 8 percent. you determine that annuities of similar risk earn annual percentage rates around 8.34 Time 2 price = P2 = 1.060 = $981.000.757 to have a yield to maturity (YTM) = 7 percent. What will be the t = 1 price of that bond? What will be the price of the bond after its t = 2 coupon payment? Solution: t=0 $60 $60 t=1 t=2 973.5 percent divided by 12).i=7% + 1. Answer: $921.90 = $875.07)3 2. The annuity pays $800 per month (starting in one month) for the next ten years. market rates are higher than t = 0. at t = 0. She would like to know whether or not the annuity is a good deal.060 (1.08 1. . It may pay a certain amount of dividends for a while and then. As we have stated before. we have to express the above as a continuous series of terms that go on indefinitely in the future. we have written an infinite series. All of this uncertainty makes pricing a stock difficult. Assuming that the future cash flows are in the form of dividends that go on into the indefinite future. 2 n (1 + r) (1 + r) (1 + r) (1 + r)T where D1 is the dollar dividend paid the next period (at time 1). A stock may pay quarterly dividends.+ +. Notice that we have simply expressed the stock price as the discounted present value of its future dividend cash flow stream. D2 is the dollar dividend paid two periods from now. at the discretion of the corporate board.. It may increase or decrease its dividends. Since we do not know when the company will cease to exist in the future. its current price) as P0 = ⬅ D1 D2 Dn + +. Assume that n < T. a stock is relatively difficult to value because there are more uncertainties about the cash flows associated with a stock. the price of a financial asset is the discounted present value of all future cash flows attributable to the asset. or it may not.. we can express the present value of a stock (or. and so on. (1 + r) (1 + r)2 (1 + r)n D1 D2 Dn PT + +. The problem is that the cash flows associated with a stock are relatively harder to pin down than they are with a bond. r is the required rate of return. if at all. not pay any for a while. we can express the above infinite series very simply as D P0 = r – 1g .. What do we do when a stock does not pay any dividends? Does it mean that we cannot value stocks? We can make certain assumptions about future cash flows and provide a value for the stock which changes with time.. In mathematical jargon.304 Time Value of Money A Stock Pricing Example Unlike a bond. Can we find a nice and easy way to solve the above equation? It turns out we can—but only under very specific circumstances. and PT is the stock price at time T. The first assumption is that the dividend rates have to grow at a constant rate g such that Dt = D0 (1 + g)t The second assumption is that r>g If both of the above assumptions hold...+ +.. 56. in mortgage loans. That is a bit of a stretch.79. The monthly payments are the same every month. Fixed Monthly Payment Repayment of outstanding principal Servicing the interest generated on the loan Initially Later The diagram above elaborates on this idea. HellNo. what is the current price? Answer: $60. MakeMore. what would you expect MakeMore’s stock price to be five years from today? Answer: $62. Amortizing a Loan Amortizing a loan simply refers to the process of paying off the principal and interest of a loan. This is key to understanding the concept of amortizing a loan. Every loan payment you make (usually at the beginning of every month) consists of two parts: one part pays off a portion of the outstanding principal and the other part pays (or services) the interest on the loan. Inc.A Guide 305 Note that this simplified version of the current stock price is obtained as a limiting result assuming the stock can be treated as an asset that continues in the future with no finite ending date. is expanding rapidly in the media industry.. but a varying percentage of this constant sum goes into principal repayment and interest payment..40 dividend today. They paid a $2. but is a workable assumption because most established companies do exist for many years. 2. The dividend is then expected to grow at a constant 8 percent annual rate.75 dividend today that is expected to grow at a 20 percent annual rate over the next two years. If the dividend is expected to grow at a constant 5 percent rate and the required rate of return is 8 percent. Inc. For example. If the required rate of return on HellNo stock is 14 precent. paid a $1. Practice Examples 1. the payments in the first few years of the loan go primarily toward payment of interest . In general. the above expression can be written as: Pt = Dt+1 r–g where Pt is the stock price at any time t and Dt+1 is the dollar dividend paid at period t +1. 200 dollars of loan interest and $1.5 $10.200 1. But towards the end of the loan.689 2. P0 = CF × PVFAi. the situation reverses itself and relatively more of the payment goes toward paying off the principal and relatively less toward servicing the interest generated.774 So. The last payment of $2. Example Jorge has borrowed $10.n $10.605 = $2. (Payment – interest from Step 2).211 2.663 4.871 Interest Ending Principal $1. Calculate the payment per period. (Loan balance at t – 1) × (i/m). Jorge’s fixed annual payments for the duration of the loan are $2. 4.605 CF = $10. Also.306 Time Value of Money and little of the principal outstanding gets paid off.478 0 The first payment of $2.478 $10. Amortize the loan if annual payments are made for five years. the formal steps toward amortizing a loan are as follows: 1.871 $1.774 2 2.000 = CF × 3. the balance on the loan drops to zero and the loan is repaid in full. m = 12 for monthly payments.775 $13. With that in mind. 5.775 is split into $297 of loan interest and $2.000 8. Step 2: End of Year Payment 0 1 $2.478 of principal repayment. (Balance – principal payment from Step 3).011 800 563 297 $3. i = the annual loan interest rate. and so on.574 1.763 1.426 6.774 5 2.574 of principal repayment.774 4 2.774 is split into $1.000 = CF × PVFA 12%. Let’s apply the above steps to solve an actual loan amortizing example. 2.774. Step 1: Compute annual payments.000/3. Determine ending balance in Period t. . 3.974 2. After the final payment. So. Determine the interest in period t.000 at a compound annual interest rate of 12 percent. Note that m is the payment frequency.774 3 2.000 Balance $10. Start again at Step 2 and repeat. Compute principal payment in period t. A Guide 307 Another example of loan amortization is provided in the table below.000 loan at 6 percent annual interest.000.000 $200.000 $200. which is to be expected since the loan horizon is now half of what it was.10 $1.71 $1. with a $300 per month additional payment toward principal.58.10 $1.788.199.38 we were paying in interest with a thirty-year mortgage.75 12. The loan is paid off in twenty-one years (shaving off none years) with a cumulative interest payment of $151.46.10) we would have paid off our entire loan within 24.676.687. for a given loan at a given . We decide that every month we are going to add in $100 with our payment with explicit instructions to apply it toward repayment of principal only.75 Cumulative Interest Paid (dollars) $231.687.84 Now let’s introduce the following wrinkle.10 $1. Loan Amount $200.875.537. we see that over the course of the loan. an important lesson is that.58 11.71 $0 $100 $200 $300 $0 $100 $200 $300 Loan Scheduled Actual Paid off Number of Number of in Payments Payments (years) 360 360 360 360 180 180 180 180 360 295 252 221 180 165 151 141 30 24.99 $85.199. incurring a total interest expense of $130.71 $1.000 loan.788.10 go partially to pay the principal outstanding and the rest pays the interest on the loan. Consider a mortgage loan for $200.558.97 $151.97 (a 21 percent savings). What if you had a fifteen-year mortgage instead of a thirty-year one? Assume all other terms of the loan are the same: a $200. After the loan is paid off in fifteen years.570.715. Finally. we will have paid about $232.687. If we meticulously followed our schedule of including that extra $100 every month along with our normal house payment (of $1.38 $182.87 $130.000 $200.676.199.537.46 $93.199. Further.199.759.687. it is a thirty-year fixed rate mortgage at a 6 percent annual interest rate. The second part of the table shows that if we are not making any extra payments. The payments are higher than those of the thirtyyear mortgage. So.71 $1.000 $200.58 $103. the entire loan is paid off in a little over eighteen years.04 $78.6 years and would have made a cumulative interest payment of $182. This is significantly less than the $231. The monthly payments of $1. we would have paid a cumulative interest of $103.71.4 15 13.199.6 21 18.000 Loan Interest Period Rate (years) 6% 6% 6% 6% 6% 6% 6% 6% 30 30 30 30 15 15 15 15 Monthly Payments (dollars) Optional Extra Payment per Month toward Principal (dollars) $1. In the first example. What happens? Watch the second row of the table below.687.000 $200.000 $200.570.87 (a saving in interest payment of over 34 percent).000 in cumulative interest on a $200.10 $1.000 $200. our monthly payments are $1.875. What if we decided to add in an extra $200 per month toward the principal? Watch what happens to your loan in the third row of the table. 5 percent towards principal.56.88 $6. The annual interest rate is 7 percent. What is your annual payment? How much of the principal is still outstanding (the balance on the loan) after you make the first payment? Answer: $975.00 $1. How much is the mortgage loan for? Assuming you let the loan run its course.304.84 $5.58. the shorter the mortgage period. Keep this in mind if you have a mortgage loan.000 if interest is 7 percent and you will make annual payments. in my opinion.73 $6. The difference is more significant with longer maturity loans. .73 $7. The annual interest rate when the loan was initially made was 12 percent.89 Balance $25. Answer: $1.73 $7. 3.62 $6.39 $6. Conclusion: The amount that you pay in interest decreases over time and the amount that you pay towards principal increases over time.3 percent towards interest. The APR on the loan is 6 percent.85 $934.380. Calculate the monthly payment of a thirty-year (360 month).11 $482.446. You must pay back the loan in five annual installments.73 $7.897.000 at an annual interest rate of 7 percent. Last payment: 99. End of Year 0 1 2 3 4 Payment Interest Ending Principal $7. what percentage of the last payment would go towards principal repayment and what percentage towards interest on the loan? What percentage of the first payment would go towards principal repayment and what percentage towards interest? What can you conclude from the two scenarios? Answer: Mortgage loan = $177.380. 2.000.27. the lower the interest payments that are incurred.77 $0 5. . First payment: 40.369.755.380. Practice Examples 1.380.5 percent towards interest. $3.662. while the appropriate market rate is now 9 percent.40. The most important lesson from this table. A mortgage loan requires monthly payments of $1. 4. You made a payment yesterday and there are twenty remaining. How much of the principal is still outstanding (the balance on the loan) after you make the first payment? Answer: $462. Hint: First figure out the annual payments and then follow the usual steps.750.7 percent towards principal.897.308 Time Value of Money interest rate.355.27 $13.024.500.630.344. Construct an amortization schedule for a four-year loan of $25. Compare the value of the remaining payments versus the principal balance outstanding. 59.73 $1.44. is the fact that paying a little extra toward the principal each month can significantly reduce the loan repayment period as well as the toal interest you pay. A fifteen-year mortgage loan requires monthly payments of $1. $250. You take out a loan for $4.000 $19.000 mortgage. Assume you have already made your second monthly payment under the old loan arrangement. the principal repayment is: $541. you had no previous credit.75 percent under the original arrangement. This is computed by calculating the fraction of each monthly payment that goes into servicing the interest generated on the loan and then summing those over the entire period of the loan.000 for sixty months on your new Honda Accord.66 = $19. each monthly payment is $541. the total interest payment under the final loan arrangement can be shown to be equal to: $3. .07. or the dealer lied about your credit and charged you a greater APR than you should have paid.34 at the new APR of 7 percent. So. how much of this is principal repayment and how much is interest? To see that. What would your monthly payments have been under the original arrangement? What would they be under the new deal? How much total interest would you pay under each arrangement if you let them run the entire course? In order to solve this problem. consider the monthly interest charge on the loan. first figure out what your monthly loan payments would be under the original arrangement. invoking our annuity formula in terms of the present value of an annuity. when you make your second monthly payment of $541. So.A Guide 309 Application of Loan Amortization to Automobile Refinancing Suppose you borrowed $20. By contrast. your monthly interest rate is 1.34.700 (approximately). When you refinance your loan.716. Therefore.07. So.07 So. Let’s assume you had poor credit.66.716.07 – $348.41 = $192.000 = CF × PVFAi=1.75%. the principal outstanding is $19. you do so for $19. the interest on the loan is: _______________. we can write: $20. by getting the better deal.58%. The question is. So the principal outstanding after the first payment is _______________.34 = CF × PVFAi=0. So. Similarly.66 Total interest payments under the initial loan arrangement can be shown to be equal to: $12. the principal repayment after the first payment is ______________. First. So you start paying off your car loan for two months.716. Therefore. then refinance your car loan with another lender at 7 percent APR.464. Monthly interest charge = _____________. you end up saving a lot of money in interest charges.n=58 CF = $401. Suppose the dealer “got you approved when no one else would” at 21 percent APR for a sixtymonth car loan.n=60 CF = $541. after the second monthly payment.909 – $192. your new monthly payments for the remaining fifty-eight months of the loan are given by: $19. means you pay off your entire balance every month. Yes. The credit card company loves you because they get to charge you interest and make a profit on their loan to you. Try applying the effective interest rate formula to see this for yourself.820 male children (997. You see. How much higher it is depends on the compounding frequency. If you are not sure. So. Of 983. Application of TVM to Insurance In order to understand how insurance pricing is related to TVM.94 percent. Similarly. These effective rates would be even higher under daily compounding frequency.237 male nineteen year olds. and do not carry anything over. I’ll bet you are not exactly sure of how those finance charges are calculated in the bill you get from your credit card company every month. No mortality table goes beyond 100 and all life insurance contracts are designed to stop at 100. then the effective interest rate is 21.” you do not pay off your entire balance at the end of the month. if the stated APR on the card is 10 percent. One way credit card companies trick you is whether they compute your charges based on a monthly periodic rate or a daily periodic rate.” And they are expensive. Of course. While most credit cards apply a monthly compounding frequency (since you are paying them every month).416 are expected to make it to their twentieth birthdays.110 female children) will make it to their first birthdays. but this is not really the true rate you are paying on your loan. In the mortality table.000 women. you are out of luck as far as life insurance coverage is concerned. if you are a revolver. only 975.085 . Credit card companies are very smart.000 men and 1.310 Time Value of Money Credit Cards and TVM If you are a “credit revolver. Men and women have different death probabilities and are listed separately. in credit card jargon. You are not alone. and so on. That is determined by the effective interest rate. some might apply a daily compounding frequency for cash advances. An example of a mortality table is provided on the following page. For example. we need to introduce the mortality table. A mortality table documents how many men or women will die in a given year. if you are a “deadbeat” which. of 977. If the stated APR is 20 percent. Make sure you read the Important Disclosures form that comes with your credit card when you first sign up. the charges you make on the card are known as “unsecured loans. don’t hesitate to call the credit card company and verify the information before you use the card and get yourself into a world of trouble. which is higher than the stated APR. then the effective interest rate the card carries is 10. we see that if we started off with a sample of 1. Go back and review the effective interest rate formula provided earlier in the book.47 percent. assuming a monthly compounding frequency.000. the APR (annual percentage rate) that credit card companies are required to disclose by law is indeed the rate used to determine your finance charges. If you happen to live past 100 years of age. the credit card company gets minimal profits and does not like you.000. it is expected that 995. 876 4.098 20.A Guide 311 female nineteen year olds.481 16. 980.898 8.683 1.099 27.02785 0.218 2.898 21.237 975.770 992.00211 0.349 0.00176 0.825 13.01459 0.03044 0.926 3.65798 27.470 17.02687 0.03393 0.04765 0.850 0.4802 0.00222 0.37574 0.00356 0.754 993.590 673.00095 0.00329 0.094 921.614 978.412 710.815 928.03319 0.06419 813.882 728.00107 0.363 744.02542 0.723 934.956 2.693 1.436 994.00258 0.545 602.710 946.066 985 974 943 893 1.00077 0.826 22.763 691.924 1.712 962.883 984.124 714.00099 0.05264 0.095 627.171 947.651 549.174 520.614 Mortality Table MALE Age 1 2 3 4 5 17 18 19 20 FEMALE Number living 995.833 6.963 760.762 24.00186 0.02423 0.310 2.820 994.00189 0.402 801.0019 Number living 997.614 956.594 3.00387 0.636 19.623 2.00081 0.00287 0.00264 0.127 3.725 2.0433 0.00105 35 36 37 38 39 40 41 42 43 44 45 949.416 Number dying 1.00098 0.00419 0.00167 0.781 2.122 960.047 942.265 489.00165 0.02036 0.03824 96 97 98 9.839 648. the probability of a boy dying at 17 is 1.03951 0.819 1.38455 0.452 0.534 952.514 2.665 670.0024 0.168 945.0017.906 2.432 2.02211 0.00095 0.985 944.124 2.747 14.853 Probability of dying 0.00279 0.016 0.891 931.069 0.867 12.215 16.049 983.920 10.65585 .00455 963.145 3.782 0. only about 982.01884 0.600 15.832 3.909 30.192 0.346 937.077 11.00098 0.052 3.135 3.779 940.985 984.085 982.069 5.47497 0.031 Probability of dying 0.03617 0.268 2.649 993.853 980.795 26.00356 65 66 67 68 69 70 71 72 73 74 75 733. Hence.0009 0.274 31.00309 0.710 774.226 8.082 are expected to make it to their twentieth birthdays.00332 0.003 2.00079 0.535 788.082 Number dying 867 807 787 766 755 936 964 1.234 995.429 958.00178 0.01743 0.03011 0.144 22.658 954.815 1.488 694.003 1.00076 0.976 977.796 991.477 28.688 925.00102 0. The probability of dying at any age is the number living at any age divided by the number dying at that age.076 3.590 1.750 576.121 2.351 22.743 1.110 996.446 651.224 949.649 19.00087 0.05819 0.00244 0.00302 0.683 = 0.00242 0.00204 0.550 24.059 940.991 18. 80 383.004032 0.20 413. What is his premium? Step 1: Calculate expected claim costs for Mr.00302 number of 40 year olds alive 937.001147 403.003280 0. which means he pays this amount once and he is covered for life.002207 0. the present value of the expected claim costs for Mr.003098 0. Hence. of 40 year old dying at specified age Expected Claim Costs PV of Expected Claim Costs 0. D? To solve this problem. Doordie decides to purchase a whole life policy with a face amount of $100. Doordie is $22.054 413. D will be alive at each of the ages 41 through 99 to determine that he will be present to make the payments.30/1.723 Probability of a 41 year old dying before his 42nd birthday = number of 40 year olds dying before 41st birthday = 2.003020 0. the probability of a 40 year old dying before his 41st birthday = number of 40 year olds dying before 41st birthday = 2. however. first find the probability that Mr.053 383. Age 40 41 42 43 44 .373 So.312 Time Value of Money Example Suppose at the age of forty Mr.373. This is his (one-shot) premium. for example. that Mr.832 = 0.80/1. So.20/1.0557 309.05 328/1.80/1. Doordie does not have that kind of cash lying around. . : 96 97 98 99 Total Prob.80 220.000. .052 353.70 403.0560 $22.70/1.00328 # of 40 year olds alive 937.0559 114.004133 $302 328 353. Does it mean he cannot have life insurance? Of course not! He can pay his insurance premium as a level annual premium.055 0.30 302/1.832 = 0. Suppose.70 114. . what is this level annual premium for Mr.20/1.003538 0. Find the probability that a 40 year old will die at each age between 40 and 99. which will be much more affordable. Doordie (using a 5 percent interest rate).0558 220.20 309.003832 0.7/1.723 And so on . from the above table. 20/1.20 309.20/1.58—His annual premium. Practice Example: Consider the following mortality table.00 353.0559 114.002207 0. of Dying 35 36 37 38 39 949.80/1.05 328/1.00279 . Eventually. P = $1.346 2.986330 $302.003098 0.168 945.993700 × P (1.432 2.993700 0.30 × P Therefore. . of 40 year old dying at specified age 40 41 42 43 44 .80 383.004032 0.372.05) 58 prob.001147 403.268 2.373 = (1 × P) + prob.003354 × P (1..70/1.00240 .052 353.990162 0.121 2.00224 .00 328.0557 309.055 0. of living × P (1 + i) 1 0.0558 220.779 940.00211 .171 947.05)59 = $16.054 413.00258 .80 220.20 413.+ +.70 403..373. D will be alive at 41 to make his payment is the number of people alive at 41 divided by the number of people alive at 40 = 934891/937723 = 0.003 2.053 383.996980 × P (1.A Guide Age Prob.99698 • The probability that Mr. : 96 97 98 99 Total Expected Claim Costs 313 PV of Expected Claim Costs 1.7/1.993700 And so on .. of living × P (1 + i) 2 0.05) 1 + + prob. we can write the following in TVM terms: Lump Sum = (1 × P) + 22.047 942. .0560 $22..623 .00 • The probability that Mr.+ 0.0 0.30 302/1.05) 2 +.001147 × P (1. of living × P (1 + i)n + 0.70 114.80/1.30/1. Age # People Living # People Dying Prob. D will be alive at 42 to make his insurance payment is the number of people alive at 42 divided by the number of people alive at 40 = 931815/937723 = 0.996980 0. Assume that you are twenty-five today and decide to save for retirement. you save $1. and that your first withdrawal will be forty-one years from now.100 in your account when you turn sixty-five. If your first .000 per year for ten years for your retirement (i. ten withdrawals). Answer: $203. 5. $22. You have been given the choice between two retirement policies: Policy A: You will receive annual payments of $26. Which policy should you choose assuming an annual interest rate of 12 percent? Answer: Policy A. You want to have $518.000 in forty years. 1.000 a year for twen years in retirement. You want to know how much of your savings is left at t = 50. If you are thirty today how much must you save each year to meet your retirement goal if you plan to retire at sixty-five? Assume a 10 percent annual interest rate.000 benefit? Answers: $101. Answer: $349. and that your first withdrawal will be thirty-six years from now. 4. You believe that you will need $25.000 each year for retirement. You are twenty-five years old and decide to save $2. Here are some typical examples. These are nothing but simple variations on annuity problems that we have already seen. 2. If you save $800 a year and plan on withdrawing $40.000 a year for five years in retirement. forty payments). Assuming that you are twenty-five years old today. Answer: Yes. 3. You decide that you want to save 2 million dollars for retirement. Beginning today..e.78.000 benefit. Policy B: You will receive one lump sum of $200.67.43. Application of TVM to Retirement Applications of TVM to retirement involve problems of saving now and using the saved money later. that your first deposit will be one year from now.. assuming a 5 percent interest rate? What would an annual premium be for the same five-year term policy with a $10. how much is left in the account? (Your first deposit is today and your first withdrawal is at t = 40).52.29.500 per year for forty years (i.314 Time Value of Money If you are thirty-five years old. Assuming a 6 percent interest rate. how much would the one-time up-front payment be for a five-year term policy with a $10. 6.000 beginning thirty-five years from now for twenty years. and can earn an 8 percent annual rate on your deposits. At t = 40 you begin withdrawing $17.167. how much must you deposit each year to meet your goal? (Your first annual deposit will be one year from now). Answer: $7720. will you have saved enough to meet your goal? Assume a 9 percent annual interest rate. that your first deposit will be one year from now.e. will retire at the age of sixty-five. 56 The Ultimate TVM Challenge Problems By now you must be wondering when this nightmare will end. $452.000 per year for ten years for your retirement. Beginning today.01 C.000 in cash today B. if one is earning 5 percent interest. with the first cash flow one year from today. If you can solve them with minimum help. compounded annually? Find the value of these cash flows four years from today. Either option O. General TVM Examples Problem #1 You must decide between $25. Possible Answers: A. what interest rate must you receive to meet your goal? Answer: 8 percent. Good luck! 1.A Guide 315 deposit will be one year from now.550. suppose you save $1. If the interest rate is 7 percent. This is a future . Hint: Draw the timeline and put down all the payments on it. which is the better deal? Possible Answers: A.000 per year for forty years (i. forty deposits). you want to know the amount X of savings you will have left at date t = 50 if you follow the preceding plan. $25. Since you might live longer than you think. $431. $400 B. If you can earn 8 percent interest on your investments.000 in cash to be received two years from now.000 in cash today or $30.K. At t = 40 you begin withdrawing $20. $30. We will close with some real life problems you might encounter as you go through life. Try to solve these problems on your own before you look at the answers. The savings (inflow) is positive and withdrawals (outflow) are negative. Don’t worry! The end is near. you have mastered TVM and are well positioned to tackle life on your own financial terms.. what is X? Answer: $124. Problem #2 What is the value of $100 per year for four years.000 in cash to be received two years from now C.e. i=7%) × (1. Start from the first payment and then go to the second payment.000 50 X = 1000 × (FVFAn=40. and you must repay in six equal installments. Next figure out what the equal monthly payments have to be so that the present value of such monthly payments equals the true value.01 (this is the monthly rate) ieff (the effective annual rate) = (1.316 Time Value of Money value of annuity (FVFA) problem and you have to determine the net future value of inflows and outflows at t = 50.000 1 1. After your second payment at t = 2.662 X = FV(deposits) – FV (withdrawals) = 420.01)12 – 1 = 12. i=7%) × (1. or you may take a $248.000 – 248.662 = $124.000 ..212 FV50 (20000s) = 20000 x (FVFAn=10. Payments = 333. which is 4.000 FV50 (1000s) . 39 1. what is the remaining balance on the loan? Hint: First figure out what your equal monthly payments have to be such that you can pay off (principal and interest) the loan in six years.212 – 295. which is the rate that causes the PV0 (payments) to equal the true cost of $3.68. and it lists for $4. i= i m rm = 0. You may choose “zero percent” oneyear financing and make twelve equal monthly payments beginning in one month.68 = 333.751. 3751.000 40 20. What is the EAR that is implicit in the “zero percent financing” given the alternative cash method? Hint: First figure out what the true “value” of the car is. You borrow $10.33 = 4. . r = 10 percent.. break down each monthly payment into the amount that is used to pay off the principal outstanding and the amount that is the interest accrued on the loan.68% 3. The dealer will allow you to choose the payment method. You have found the used car you want.07) = $295.. 0 1.550 2. 49 20.000 12 With monthly payments you need to know the monthly rate rm.32 discount and pay cash.32..000 for six years.33 × PVFAn=12. Then.000.07)11 = $420. 3. given.68 percent. while all interest is paid when the loan matures. First pretend that there are no points and solve for the future value of a loan with PV = 100. and 7. the FV(deposits) = PV(withdrawals). If Mr. 6. so that you can withdraw $500 at t = 5. and 7. Solve for the interest rate. To obtain the loan.00  At t = 1. The second one is a three-payment annuity stream with the cash flows occurring at 5. Mr.296 ⬖ ending balance = 8.000 for five years.000)  Principal repaid = 2.03 × (100. Rogers must repay 100.. 3. 0 1 X 2 X 3 X 4 X 5 500 6 500 7 500 There are two annuity streams here. and 4. The FVA of the deposit annuity = X × FVFAn=4. Now imagine that you actually have in hand the promised value less the points but the future value of the loan is still the same as before.000) = $3.5061X (located at t = 4) The PVA of the withdrawal annuity = 500 × PVFA n=3.000 ⬖ 97. 2.6 = $7278. Rogers must pay 12 percent annually plus 3 points (3 percent).000 × (1 + i)5 = 176.68% 5.40 4.000 × (1.000 = 0. What is X if the discount rate is 8 percent? Hint: Draw a time line and express all cash flows as they occur in the time line.12)5 = $176.6 ⬖ ending balance = 8704 – 1425. what is the true interest rate? Answer: 12. Rogers accepts the loan. etc.10 (10. The points are paid up front.704 At t = 2. Remember that at any given point in time.000 = C × PVFAn=6. You want to deposit $X at t = 1.234 i = 12. you owe interest = 1. 6. Mr. i=8% = 1288. Rogers goes to the bank to borrow $100. C = 2296.40  Principal repaid = 2296 – 870. Hint: Remember that points are taken off the face value of the loan at inception.000 = 1. In five years.000 Rogers’s net borrowing = $97.55 (located at t = 4) . Mr. you owe interest = $870. i=8% = 4. i=10% payment.234 Points = 0. The first one (the deposit annuity) is a fourpayment annuity stream with cash flows occurring at 1.000 and the interest. and 4.A Guide 317 10. 2.40 = $1425.296 – 1. Here is an excerpt from a news item reporting that new home sales have tumbled over the past month. Chris. when new home construction increases.. or a market where homes can be purchased at a discount from their present values. Realtors keep track of these figures to gauge whether the value of existing homes will increase. or stay the same. How about new homes? New homes are watched by economists because they signify demand of home construction–related products and services—including new employment.5061X = 1288. Doing so will open up a whole new vista for you. When new home construction goes up. the value of homes also goes up (a direct impact of an increasing present value placed on home ownership). In summary. Learn to recognize them when you read articles or books (even those that seem unrelated to finance) and understand the implication of the information you are receiving. New home sales tumble. CNNMoney. bucking forecasts of a modest decline. like vinyl siding. The value of home ownership declines and that.55 Or. in turn. But the new home sales are closely watched by economists because they have a far greater economic impact. Thus. etc. brick. in turn. lumber. using the idea (at t = 4) FV(deposits) = PV(withdrawals) 4. and new home buyers are likely to spend more money on new appliances and furnishings than existing home purchasers.) A separate report Tuesday showed that existing home sales—by far the lion’s share of the nation’s housing market—rose to near record levels last month. prices of home-construction–related products.96 TVM Is Everywhere You have to be able to spot TVM concepts directly or indirectly in matters you come across in everyday life. They create jobs in construction. signals a buyers’ market. decrease.318 Time Value of Money Therefore. The opposite is true when new home construction goes down. (Isodore. How do we interpret this? When home sales drop. X = $285. 2004. also go up and. the present value of home ownership declines. TVM concepts are everywhere. . the present value of home ownership also increases. 1600 1.214 31.0122 2.743 16.2763 1.0938 2.420 29.0114 2.0757 7.3108 1.776 23.37 257.439 2.2697 1.02 1602.623 48.065 63.9672 2.3225 1.1829 2.2879 2.0600 1.1046 1.8 12.0800 2 1.7590 3.3345 1.81 1645.6658 3.4647 3.3839 7.6890 1.461 112.5376 1.6054 1.803 15.166 37.40 340.1068 2.901 60 1.6610 21 1.5804 2.948 59.2682 1.9316 3.1487 1.1406 5.6058 1.4002 1.71 3.247 140.6 7.646 2.7000 18 1.03 304.591 178.574 32.0 9.421 23.1436 2.9161 13.6488 8.8509 9 1.7975 4.761 12.1236 1.552 20.3159 1.667 18.4258 1.5769 1.2996 1.13 186.6231 10.959 50.6406 2.657 15.3401 1.67 7.8497 15.6844 3.1566 2.1593 1.186 38.142 55.4273 3.6295 5. i 1% 2% 3% 4% 5% 6% 7% 8% 1 1.39 866.5832 4.1255 1.0328 2.8223 6.8127 3.461 32.496 174.0609 1.0615 1.8871 6.7024 2.6600 2.1576 1.83 292.7405 5.1664 3 1.9736 2.48 897.3195 1.1268 1.50 197.1173 6.7435 7.5735 1.7069 2.4233 1.5557 4.974 21.519 18.9 4032.2202 1.89 195.000 87.864 139.488 31.3000 2.9987 3.3635 5.950 66.8485 26 1.72 750.5609 1.99 1364.1379 8.740 66.2100 1.2519 3.4760 2.14 783.6128 12.6996 2.2324 1.2071 3.0256 3.0510 1.756 74.9253 3.5513 1.1699 1.467 16.7623 1.7275 9.1881 1.4568 1.8983 2.8167 3.8715 24 1.9111 9.7490 1.9161 2.9254 2.8074 7.9 8.1588 3.375 14.1400 1.2765 10.874 62.6123 10.2522 2.3576 10.33 5.703 2.2170 11.1025 1.3964 27 1.386 24.90 1033.0824 1.1961 1.672 22.982 40.4301 10.758 36.23 1083.3382 1.26 6.4523 4.342 27.679 32.5580 1.37 634.4184 7.3310 1. 56347.9479 2.63 1800.805 16.0404 1.1371 9.2250 1.3842 1.5895 7.2338 6.186 38.6446 2.2400 1.4693 6 1.1500 1.2824 1.2625 1.6425 4.9310 9. i = interest rate per period.5126 1.6010 1.8660 9.3966 2.172 15.564 64.2080 3.1950 2.4685 1.242 51.1772 5.3600 1.567 108.0100 1.005 91.9388 2.0700 1.0900 1.1262 1.062 40 1.1067 11.6528 1.3864 4.9738 2.3674 2.44 637. 74.1449 1.6586 8.839 20.457 46.2597 4 1.5182 13 1.5599 7.625 35.5785 2.6526 1.3 2964.0 10143.6044 6.5938 1.86 378.000 26.2878 2.6105 1.1403 12.918 40.3699 2.8496 1.4114 5.1049 2.3082 1.0789 2.9 7370.6734 2.63 374.4924 6.19 1178.358 100.0360 3.366 19.1417 6.166 15 2.6430 1.0456 4.008 121.0338 22 1.2262 4.8106 1.2609 2.0972 2.7196 14 1.2544 1.1528 6.3 9100.673 26.9881 28 1.6533 3.3439 1.1589 11 1.7 5455.4098 2.1384 3.2800 1.2572 1.1917 8.7280 1.2919 5.5944 11.0736 2.9926 2.5036 1.4889 2.319 31.0829 1.6524 5.4364 2.4802 1.5077 5.3316 12 1.4259 17 1.055 14.0400 10.4641 1.3048 1.389 43.1200 1.644 26.3728 1.324 34.4785 4.5994 10. * * * 176.8834 3.6916 4.3275 1.4116 1.37 332.91 468.6900 10. 31.987 57.7317 1.693 57.2953 1.1041 1.00 700.946 101.2998 5.800 102.467 18.1329 2.2950 1.3579 2.2810 5.2434 1.7138 8 1.5 4142.84 412.5023 2.918 19.1495 1.47 268.2788 2. * * * * 9% FVF(n.0500 1.4049 1.54 478.285 14.8061 2.821 22.1187 4.2899 6.9860 3.0927 1.8010 7.3642 2.361 24.1843 1.211 85.4002 10.39 344.212 28.0200 1.7589 4.1951 1.337 73.948 114.0400 1.4883 2.5395 1.8960 4.3456 1.57 6.699 16.3980 5.3157 20 1.204 50.2876 8.9360 7.2155 1.7959 2.1941 1.883 39.6771 1.86 1004.7182 1.3412 25 1.9 10.5 3137.0258 2.Interest Rate per Period.30 593.9990 10 1.8531 3.267 17.1800 1.3200 1.396 216.6 1670.7410 2.053 3.1910 1.6084 2.1003 2.8114 2.245 13.1161 5.357 117.2653 1.4066 2.7908 1.4185 1.1726 1.2936 1.4355 5.0937 1.0816 1.4071 1.9522 3.4736 7.5404 2.4815 1.3459 1.9543 13.937 54.9 7458.5950 6.070 148.108 79.3502 5.3924 1.849 143.5869 7 1.95 1285.3219 5.449 29.2000 1.1381 1.0658 3.1717 1.4282 1.0489 5.8030 4.4400 1.2213 2.9201 5.8730 2.0075 4.129 18.0545 6.1088 7.5270 3.059 21.3417 3.2920 2.53 5.9 4383.4026 1.749 44.6651 1.7716 1.8543 3.5386 1.100 17.5494 5.5179 3.9703 4.0612 1.1855 3.8856 2.35 449.037 3.2 11.5937 3.2251 4.9875 10.2447 1.95 784.007 66.51 612.0721 1.0406 1.3605 5 1.861 21.0715 3.4304 5.6463 13.834 17.5209 1.748 14.259 137.7725 3.27 4.7731 3.1249 1.040 30.7758 2.0201 1. 66520.96 4. n 10% 12% 14% 15% 16% 18% 20% 24% 28% 32% 36% 1.1000 1.575 12.668 95.3799 3.8280 1.37 1469.038 85.5155 1.5007 1.2668 1.863 26.198 29.5157 1.2167 1.111 21.8858 8.724 *50 1.0300 1.2 5483.1159 8.1719 2.0590 3.1117 6.393 38.2139 7.8385 1.1157 1.891 30.1610 1.1722 16 1.923 84.8916 10.2613 7.7860 3.9066 2.214 19.376 45.1058 3.1759 7.691 48.167 14.2190 1.7103 1.9799 2.0 13.1143 9.5 2180.2620 4.59 2595.9487 2.3566 3.451 3.231 16.2234 12.6047 1.8262 3.953 136.6271 29 1.2784 3.2299 1.3213 1.7072 4.8197 4.8603 2.4360 4.6165 4.535 55.6289 1.2434 4.3276 5.1598 6.3996 4.9 19426.1 20555.96 164.4775 1.0724 6.7424 1.4 46890.7171 5.6352 4.1911 2.0303 1.81 511.3478 1.1304 8.414 73.6384 1.1372 9.39 289.25 Note: n = number of periods.8526 3.4274 6.5633 3.2058 9.5460 1.9826 8.2655 11. Number of Periods.8009 2.407 25. i) Table 1—Future Value of $1 at the End of n Periods (FVF) A Guide 319 .7 3927.460 27.57 228.4365 23 1.9372 15 1.236 53.110 21.3686 1.856 47.462 19.575 74.4859 1.88 267.050 188.4210 1.3173 30 1.178 23.6895 1.3131 2.323 46.973 15.2579 8.8179 5.8697 4.259 93.206 113.195 40.2081 1.3 2377.7535 2.147 12.6035 4.2107 2.37 237.02 253.6928 3.409 45.3992 11.9960 19 1.7335 4. 518 19.8923 9.113 59.539 33.0909 3.967 58.96 124.369 34.126 10.761 23.1216 3.577 13.895 41.2 87.33 356.237 50.3359 7.486 14.446 46.105 84.09 377.2 2404.74 244.581 40.002 81. n 8% 9% 10% 12% 14% 15% 16% 18% 20% 24% 28% 32% 36% 1.4684 6.035 100.971 12 12.59 767.33 245.16 213.510 84.30 164.716 28.487 13.3600 3.05 237.645 47.560 18.075 71.152 29.1 94.0300 2.79 154.140 103.543 104.0000 1.6 3271.129 27.41 154.925 72.029 32.350 102.8019 6.94 1181.270 29.639 30 34.156 27 30.505 43.168 12.49 241.1216 4.764 64.0624 4.025 15.76 50 64.08 405.676 31.37 146.0604 4.03 469. 28172.7 5627.8 22728.12 Note: n = number of periods.0484 8.7537 8.809 14.575 56.0000 1.521 25.135 13.48 723.7 1767.726 14.654 23.977 20.121 78.5355 8.836 84.7424 6.63 157.52 1253.163 25.351 15.783 16.719 39.015 15 16.712 29.3685 9.2464 3.0000 1.1000 2.74 128.786 42.9299 10.218 48.028 11.973 30.0000 1.5724 3.992 22 24.76 118.249 73.531 79.698 104.659 60.150 40.727 54.7 11197.88 327.60 494.6410 4.99 353.129 37.2 7343.2154 5.71 290.4399 4.697 25.9 68.522 28.379 41.86 1298.06 2128.697 95.50 479.917 16. * * * * 813.486 15.4 8223.21 342.68 303.749 68.8 3226.27 567.680 15.297 26.9 2400.001 30.840 28.497 118.5731 4.322 73.1010 5.785 17.49 283.2149 3.893 69.044 24.97 289.3528 6.9934 5.999 37.0000 1.792 45.030 36.8 44.0604 3.3746 5 5.23 202.894 65.598 21.459 41.84 174.109 84.553 44.422 56.09 169.44 115.159 10.141 12.785 21 23.840 25.9775 9.344 40.32 607.414 25.23 582.402 75.579 112.731 11.3 7425.291 19.755 32.430 20.0800 2.426 39.81 134.450 38.7507 5.299 30.089 10.405 14.582 11.116 27.544 48.019 27.347 133.15 158.580 51.882 14 14.35 377.085 20.6999 9.000 1.639 20.6 2443.192 15.692 47.580 50.2142 9.01 181.695 21.2 12940.74 530.499 19.460 113.276 16 17.22 1716.672 17 18.8975 9 9.8983 8.3 49.96 134.0156 6.678 29.323 109.87 212.0000 2 2.2400 2.2800 2.41 206.531 20.33 181.392 23 25.0 2360.1836 4 4.62 186.21 802.980 12.463 12.7776 3.439 78.2 1944. i) Table 2—Future Value of a n-Payment Annuity of $1 (FVFA) 320 Time Value of Money .20 190.1420 8.7546 10.061 57.9228 9.671 30.789 88.1500 2.676 79.421 34.669 114.528 29 33.096 17.8666 5.248 38.012 21.6101 6.72 121.051 42.815 25 28. 45497.384 24.60 471.949 42.240 15.450 41.0900 2.435 12.496 64.842 47.9 63.1542 7.8 4449.883 59.97 27.0400 2.62 1040.888 18.579 14. i = interest rate per period.778 33.37 238.47 22.645 28.243 32.888 30.969 88.146 7. 10435.599 55.947 15.30 148.864 26 29.0000 1.30 514.320 108.548 19.34 290.3200 2.6 18535.176 66.3938 8 8.939 87. Number of Periods.33 208.7793 4.1600 2.566 12.6 9802.27 183.463 84.218 52.5056 3.56 337.13 148.669 63.5061 4.504 43.762 51.401 95.79 347.140 21.1533 7.915 14.066 11.05 811.88 442.2465 4.43 20.27 40.9753 7 7.709 47.4725 3.346 103.023 21.798 24.024 102.402 92.02 377.003 35.025 120.257 18.34 271.673 87.05 337.0301 3.3983 10.0 1779.0 4994.995 24 26.645 17.713 18.61 149.48 326.452 36.0000 2.980 55.2096 4.25 233.16 456.46 1332.412 14.840 33.2781 3.3101 4.824 23.2 199.775 16.820 35.46 633.09 1706.338 112.617 41.954 93.643 38.6330 6.79 8.682 13.772 37.133 27.44 700.873 71.25 459.76 815.7 4260.311 51.0100 2.973 40.321 23.58 533.159 63.08 1163.550 24.85 1383.7251 5.4872 10.92 25.03 385.43 137.0700 2.732 28.Interest Rate per Period.1200 2.995 45.760 20 22.02 225.50 566.351 36.082 44.3680 5.1800 2.2040 5. 21813.998 17.63 214.9 4587.491 10 10.937 17.66 209.303 21.807 13.672 50.349 25.392 37.086 18.1152 8.084 54.021 13.6 15230.28 136.5491 9.6842 6.9 80.818 59.81 141.953 24.211 98.598 20.438 79.86 262.99 300.502 50.3 58.9 5873.865 50.66 33.132 30.7 4163.412 23.3100 3.695 72.259 10.301 45.058 40 48.931 39.47 954.3081 6.8 6052.6540 8.327 16.0000 1.2135 7.525 33.3624 6.845 32.0000 1.764 76.65 184.784 40.435 13.886 60.6371 6 6.360 31.442 126. * * * * * * 7% FVFA(n.30 669.3091 5.99 1401.413 12.006 12.140 21.79 249.614 21.3 1850.852 112.670 38.026 11.958 31.49 392.978 12.578 23.60 138.160 57.69 272.533 18.636 11.299 13.4396 3.398 63.966 62.79 152.31 790.58 312.700 98.30 197.502 120.5 72177.626 17.0000 1.615 16.969 35.068 105. 69377.10 392.52 573.430 46.5233 7.1525 3.78 434.394 75.37 1114.816 14.6625 7.005 55.2857 8.22 681.462 10.8771 7.212 18 19.4163 5.9211 4.0000 1.0000 1.495 22.9 20714.63 259.705 28 32.975 32.483 87. i 1% 2% 3% 4% 5% 6% 1 1.2000 2.337 20.6 2185.066 36.085 16.0000 1.5830 8.084 66.275 72.717 60. 46057.9847 6.69 30.180 11 11.6400 3.1400 2.44 984.4343 7.617 16.195 80.156 21.05 163.0000 1.7 3034.8 7471.0500 2.09 1342.753 50.973 17.239 25.4420 9.206 14.0000 1.0665 5.192 15.750 36.29 159.3744 3.1051 6.6 53.949 11.293 18. 29219.99 276.052 91.18 150.810 22.905 19 20.088 34.117 65.869 13 13.0600 3 3.0000 1.9184 4.0 3583.93 37.33 60 81.324 33.783 28.122 22.11 195.93 157.730 11.0000 1.232 13.0 74.214 26.60 244.436 60.603 123.7156 8.536 34.456 62.279 43.48 819.930 49.5256 5.0000 1.402 68.1836 4.657 25.568 47.870 29.98 898.8 2640.4416 8.2004 9.59 1060. * * 406.1 2798.496 109.1520 6.850 34.019 24.471 27.018 51.0200 2. 0611 .2992 .0309 .5775 .1078 .0150 .6139 .3220 .0662 .0935 .8396 .9053 .2292 .7441 .0649 .2317 .0013 .1954 .5919 .4243 .0155 .0002 .0016 .7130 6 .4150 14 .0182 .1722 27 .3769 .0923 .2812 .5158 .9259 .1938 .0024 .0808 .0115 .3207 .8772 .0291 .6750 .0021 .8528 .4776 .5019 .3411 .0126 .0508 .2495 .0404 .5245 .8444 .0284 .0005 .1085 .3589 .0010 .3704 .Interest Rate per Period. i 1% 2% 3% 4% 5% 6% 7% 1 .0976 .2618 .7084 .5874 .2176 .0003 .0460 .2415 22 .5066 .0200 .7921 .1597 .5051 .7224 .0007 .5744 .0779 .0003 .8227 .1160 .0016 .4632 .9057 .2765 20 .4348 .1352 .0376 .1159 .0623 .1987 .8626 .1015 .3996 .1827 .4057 .2519 .0492 .4120 .3075 .1432 .0588 .0118 .1117 .1064 .1486 .5645 .0039 .5083 11 .4289 .0854 .5002 .0334 .4761 .1697 .0451 .5553 .1637 .6730 .8700 .8360 .3936 .1784 .0938 .0008 .8963 .0271 .0340 .4637 .0628 .5219 .2502 .4556 .0057 .0211 .4371 .0431 .7002 .6446 .0181 .3878 15 .4502 .4919 .0264 .2109 24 .8131 .1122 .7050 .2149 .6504 .1163 .8475 .0057 .0026 .2633 .0006 .0174 .2281 .0151 .7118 .1162 .0531 .8890 .4972 .9426 .8573 .0822 .5739 .3387 17 .6355 .6756 .6342 .4371 .0072 .1314 40 .2046 .7885 .4440 13 .8114 .2074 .0525 .5537 .3305 .3855 .8696 .0462 .8195 .0105 .0668 50 .0022 .0374 .0168 .3262 .8734 3 .1703 .2394 .2584 21 .0073 .1619 .0262 .0255 .1073 .1945 .0071 .3901 .0205 .0085 .0951 .1890 .0107 .1776 .3139 .2745 .4936 .2791 .6050 .0037 .8043 .2267 .1406 30 .0320 .0008 .8375 .0034 .0001 * * * 36% A Guide 321 .1625 .2551 .0030 .4970 .0035 .6864 .0839 .2472 .3607 .6302 .3048 .1978 .8787 .1971 25 .0331 .7182 .5718 .2366 .4241 .6227 8 .4173 .0659 .0118 .2923 .8613 .7972 .3349 .2942 .5268 .0491 .0092 .2919 .8277 .1741 .1407 .0051 .7430 .6806 .0068 .8219 .0382 .0021 .0006 .0001 * * .0003 * 20% .9091 .3555 . i) .0224 .8264 .1631 .2314 .1229 .1911 .0703 .2470 .0994 .0247 .6274 .2897 .0600 .0070 .0378 .3405 .1452 .4388 .1229 .0135 .2959 19 .1401 .0318 .7284 .6651 .0250 .2775 .7307 .2843 .0134 .7938 .6810 .8535 .2678 .0972 . n 8% .1084 .2567 .5403 .0802 .9524 .7576 .9804 .0316 .5303 .8621 .6232 .2255 .0033 10% .2875 .7720 .2330 .9612 .2076 .1264 .3050 .0754 .2703 .6611 .1456 .3606 .5847 .3677 .1420 .2326 .3751 .0014 .4230 .0046 .0029 .0088 .0221 .1413 .0135 .0013 .1577 .7568 .0039 .1443 .0469 .7876 .3538 .1351 .3725 .7722 .5470 .0001 16% 18% .0543 .0872 .5703 .1378 .0053 .1252 .0160 .0763 .1504 29 .9346 2 .8548 .8885 .3294 .1846 .9706 .1842 26 .5584 .0004 14% Table 3—Present Value of $1 at the End of n Periods (PVF) 15% .5194 .9246 .0728 .5375 .9143 .0638 .7142 .2257 23 .4155 .1164 .8706 .0258 .1161 .4529 .0304 .5859 .0929 .0002 * * 28% .9803 .0691 .0930 .7462 .2311 .0158 .7493 .0173 Note: n = number of periods.8333 .0097 .6209 .0061 .4746 .3335 .0835 .0213 .1615 .6633 7 .7561 .0329 .2149 .0027 .8203 .4564 .3957 .3066 .8880 .6598 .0012 .0056 .0013 .0829 .5339 .7730 .2660 .0116 .4323 .1252 .6830 .0217 .7813 .0514 .5439 10 .1069 .1037 .1460 .0010 .6006 .0037 .8638 .0196 .0757 .6419 .2274 .1502 .0099 9% .0002 .0245 .0009 .0016 .6104 .6944 .6246 .4768 .0020 .0431 .0847 .2120 .8163 4 .3418 .0365 .4363 .2953 .9151 .5820 9 .6499 .4019 .0822 .3256 .0826 .7473 .7350 .0099 .0708 .0089 .8874 .0693 .9174 .0357 .9615 .0042 .1580 .3468 .9610 .0135 .7965 .5631 .7629 5 .0006 .0151 .6217 .1635 .6407 .3269 .0001 * 24% .5963 .7903 .0135 .2429 .4581 .0303 .5407 .2083 .4810 .0184 .9709 .7432 .2145 .2198 .3714 .6468 .7014 .2630 .0007 .2751 .5921 .2218 .6717 .2697 .7644 .1956 .6768 . i = interest rate per period.3118 .4220 . Number of Periods.1372 .3152 .9238 .0002 * * * 32% .5132 .4104 .7835 .4039 .0006 .1388 .0002 .8929 .0985 .0402 .7419 .6575 .0443 .5674 .3975 .0017 .0109 .5504 .5067 .0208 .7695 .4423 .0044 .0004 .8900 .1300 .3083 .4224 .0462 .1685 .5568 .7664 .3503 .0946 .7353 .3624 16 .0535 .4688 .0029 .2910 .8417 .9901 .3715 .8368 .0560 .3101 .7894 .7107 .1821 .0087 .5787 .9515 .0517 .8034 .3166 18 .0261 .0541 .9434 .1346 .9070 .0339 60 .3971 .4823 .0472 .4604 .1079 .6496 .0738 .1789 .4523 .0011 12% PVF(n.7579 .0082 .5835 .6095 .1228 .0419 .0926 .0397 .7026 .0630 .0610 .1799 .3505 .0001 .0054 .9235 .5523 .0313 .3875 .7798 .0073 .9327 .3759 .0222 .0573 .8065 .5976 .6086 .9420 .0596 .5134 .3186 .4751 12 .9423 .4665 .6080 .7513 .7599 .1869 .1839 .0349 .0230 .0895 .3506 .0051 .0188 .5521 .0193 .1609 28 . 8332 5.5482 5.6065 4.4331 3.1659 4.2161 5.3711 10.8424 6.2469 6.3522 3.9369 14.6221 14.5509 6.1210 17.0333 4.7455 15 13.1411 13.2459 2.1078 6.7232 2.7813 1.3527 5.3436 4.1604 4.7217 7.6605 6.3577 14 13.1656 6.8696 1.9135 1.5753 9.5660 6.2007 10.4236 25.7298 21.4353 7.8334 1.5638 4.6231 6.0463 13.3965 19.2470 13. n 0.4272 3.2064 5.9789 4.6517 7.0037 12.9847 9.0292 12.7487 5.4511 13.3045 8.9246 12.4212 3.9830 7.4873 4.2950 8.2578 11.8100 10.7845 4.1474 4.4206 5.1428 4.7591 2.9856 9.7982 3.5907 12.3162 5.1034 7.4268 9.5016 5.5831 5.0310 4.0658 21.2813 18.6755 4.0591 4.3601 7.8514 3.8897 4.0971 6.8178 5.6593 11.3725 13.2434 18.7864 5. i 1% 2% 1 0.1220 3.8435 4.5313 3.9427 13 12.3282 5.4466 17 15.8052 7.9355 15.6299 3.6901 3.6106 4.5903 12.0021 6.3841 8.6847 4.2559 15.1364 6.3356 20 18.8258 27 23.9410 2.6748 10.5026 3.4869 7.3452 2.5325 17.9927 4.3555 23.0392 Note: n = number of periods.2741 10.3121 3.3484 10.3696 9.1272 3.3514 14.4641 6.0612 23 20.9124 3.6036 9.5386 3.1982 6.7932 4.4518 4.6603 5.7952 20.7648 12.4321 5.7861 7.9837 15.5655 3.9352 6.5755 5.9095 5.7590 6.0957 2.6523 10.5619 3.1607 7.2651 6.4941 4.0330 5.9616 4.2397 3.0218 8.9906 3.1842 3.3658 7.0442 6.3066 9.3255 3.2105 11.1182 6.9999 28% 0.8957 7.7715 8.9259 1.5302 8.8684 2.0188 5.1667 32% 0.8772 1.3064 7.4834 3.4694 7.6651 18% 0.5660 8.1161 10.0081 5.5596 20.0799 4.5623 14.1180 3.4713 8.1327 7.3270 16.1210 3.3240 14% Table 4—Present Value of a n-Payment Annuity of $1 (PVFA) 15% 0.6046 3.6685 5.7245 5.7955 5.7135 4.9676 5.5541 5.0286 5.7171 3.1240 3.8929 1.5669 3.4651 3.4859 5.9920 13.5514 3.8212 11.5771 3.8869 7.3766 3% 8% Interest Rate per Period.3034 11.5278 2.4976 3.1250 322 Time Value of Money .8861 1.9636 4.5714 3.1601 4.0480 10% 0.1059 9.8333 1.3349 5.4773 9.4622 11.4693 25 22.5335 6.9304 2.2920 15.4527 5.6756 22.1158 3.1591 15.1944 6.5288 10.9617 11.9607 6.6580 15.5679 3.8065 1.9828 14.1661 12.5640 3.3936 8.5342 2.6446 7.7594 3.4720 6.0236 11 10.6502 5.3721 4.0456 16. i = interest rate per period.9995 4.1337 11.6048 4.8633 8.7556 8.1233 3.8570 17.2423 3.5595 8.5152 10 9.1300 4.9288 5.9379 11.8109 6.8431 7.5940 21 18.8077 3.6775 2.5714 0.2593 6.4669 5.5135 6.7860 2.9740 7.1039 3.6243 4 3.4699 10.9476 4.6282 6.1371 29 25.0112 15.6229 5.4392 4.2463 6.7908 4.2832 2.8115 4.5504 11.0967 4.5631 9.2014 8.9844 8.2421 5.7791 9.1197 3.7868 9.3752 13.8475 1.9137 3.0168 10.1103 4.1212 4.7282 6.8729 6. Number of Periods.4062 12.4131 15.3126 8.8017 6.3238 13.1622 7.2335 12.8913 4.7632 18 16.9434 0.2961 10.8077 22.4150 14.9563 4.9731 6.9804 0.6786 14.6730 2.5% 6% 7% 9% 4% 0.8775 13.9776 3.5436 8.9139 16.1250 3.0266 10.1079 16 14.3838 7.0404 3.5693 3.6430 13.5504 6.2337 5.3983 14.0027 7.8568 13.8444 19.2372 9.8493 11.7716 5.0764 3.9346 2 1.8351 6.6389 4.8355 22 19.6418 6.2438 8.7746 4.8122 4.0726 6.3837 5.0591 19 17.8534 4.0416 11.5098 5.5361 7.5177 3.5611 11.1196 7.8839 2.2442 8.1148 19.9020 3.8527 8.9094 4.9704 1.8550 3.4424 9.1614 14.4172 5.0511 11.2551 10.0472 6.8768 15.5824 5.3030 4.8594 1.8696 4.7757 3.6560 4.0113 6.0916 5.3719 9.8775 5.1422 6.9952 6.0882 3.5687 3.1339 12.3988 6.2497 7.9813 2.8681 2.0853 11.0939 12.6061 7.9615 0.1585 4.0757 4.5294 3.0758 3.6487 8.7179 13.9542 6.8514 9.1446 6.2919 13.1285 9.4177 6.8007 60 44.0216 8.1242 3.1280 6.2260 15.8684 5.7327 6.5168 5.5320 2.1216 9.2922 16.0021 5.9173 4.7122 9.7641 16.4436 14.3587 6.0373 3.3423 5.5777 12.4099 5.3868 2.2098 5.9966 4.2922 9.7454 3.6350 9.1390 7.5712 3.4674 6.0205 3.9370 3.1581 10.9038 8.1743 2.2124 4.7921 6.9245 4.5656 2.5887 2.1401 16% 0.2223 5.5458 3.6896 10.3317 50 39.7429 6.0013 4.1237 3.1584 11.1511 5.1090 3.3553 4.5136 8.2303 6.4804 5.4951 6.1961 31.7605 8.3296 14.3797 9.2492 20% 0.0776 4.4338 6.7535 12.3315 1.5802 9.3649 8.1520 6.4869 3.3676 9.9416 1.44919 5.9501 9.1971 5.6631 14.1129 3.2526 8.7928 17.2722 24 21.0971 3.1227 3.1566 4.9550 34.7574 10.7069 18.5348 5.9826 8.6052 2.1609 9.1002 6 5.9371 4.1983 10.9697 4.1250 3.6257 2.8137 7.1542 4.2737 10.4632 6.8887 4.1065 2.8986 9.2777 30 25.3125 6.9091 1.4090 40 32.3893 8 7.9709 0.5656 3.3255 7.7751 2.3164 21.9524 0.8474 5.1699 3.1050 7.6901 2.0232 19.5327 4.2732 5.7101 7.7355 2.6604 17.7619 13.4509 5.1184 10.1885 16.7641 10.8651 12.7833 2.4558 18.9901 0.9174 1.5460 3.1114 4.1624 5.8237 8.9426 7.7576 1.8226 9.0552 8.9540 9.9747 4.3729 6.8621 1.4235 6.9061 6.4568 2.2743 3.4675 5.3916 1.6014 5.9713 9 8.0179 6.4906 6.0386 4.7184 7.0032 11.7986 12.0607 8.4018 3.8276 10.4587 3.3872 5 4.4822 18.9672 12% PVFA(n.6870 6.9464 5.4987 12 11.7663 2.7466 6.8286 2.1666 4.4043 2.7834 11.5797 4.9290 10.1062 11.8347 27.6236 18.8981 13.9352 11.6819 3.7066 9.3295 4.8372 4.1772 6.1925 4.0770 9.1109 7.8080 3 2. i) 0.0133 3.2335 6.7843 7.9377 6.5533 24% 0.2410 3.3667 7.6004 17.1630 12.2883 4.9867 28 24.0609 3.3216 2.7296 4.5558 3.7665 7 6.6467 2.5620 7.1657 11.7609 27.8832 8.3351 3.2689 3.5592 3.6536 26 22.8378 10.8181 10.9148 9.9293 16.1371 4.4886 12.7862 8. 254. 282–283. 275–276. 175. 190 Chapter 7 bankruptcy 167. 100. 41. 63. 274. 98. 280–281. 267 acceleration clause 185 bond ratings 82–84 accident policies 219 bubble 11. 138. 39. 101 Beardstown ladies 37 collision 227 behavioral finance 31. 167. 41 auto insurance 226–229 change of policy provision 211 Average Daily Balance (ADB) 185. 254–256. 158. 14. 75–88. 96. 266. 167. 255. 198 Black-Scholes 95–96 C call option 92–93. 170. 87. 61. 285. 255 collateralized debt obligations (CDO) 67. 248–249. 113. 60. 42. 180. 305–309 cancer insurance 219–220 annual percentage rate (APR) 172–173. 239. 65–70. 309. 141 401(k) 62. 14–16 compounding 16–18. 140. 95. 273. 310 323 . 18. 43–44 Commodities and Modernization Act 5 beneficiary 202. 179. 115–117. 250. 177. 95. 310 capacity constraints 72 annuities 247. 12 add-on interest 185 buy and hold 119. 265 binomial model 95 403(b) 248 blue chip stocks 27. 286–300 Capital Asset Pricing Model (CAPM) 13. 85. 248. 161. 256 beneficiary clause 211 beta 13. 32. 168–169. 263. 207.Index Symbols 12b-1 57 bid-ask spred 65. 39. 208. 242. 58. 284. 29 52 week 120 A bond 14. 283. 55. 88. 203. 185. 83. 100. 248. 103 callable bond 75 amortization 18–19. 124 adjusted balance 185 adverse action notice 185 adverse selection 139. 265. 168–169 B Chapter 13 bankruptcy 168 cliff vesting 255 balloon note financing 185 coinsurance 216 Bank Holding Company Act 5 collateral 185 bankruptcy 55. 19. 164–166. 264. 163. 211 graded vesting 250 Gramm-Leach-Bliley Act 5. 71 dividend growth model 32–33 G Glass Steagall Act 5. 77. 173. 83. 68. 164 delinquency 186 finance charge 165. 180 escrow 186 cyclical stocks 28 exchange traded funds (ETF) 63–68. 172. 174. 274 diversification 53. 157–159. 66. 186. 160. 162–164. 170. 273. 185 efficient frontier 13 efficient market hypothesis (EMH) 38. 6. 162. 186 Federal Deposit Insurance Corporation 5 defined benefit 246. 177. 100–101. 160. 71–72. 70. 247–248 FICA 245 defined contribution 246. 39 credit bureau 159. 7 grace period 169. 172–173 Employee Retirement Income Security Act of 1974 (ERISA) 246–247 Credit CARD Act 172–173 Credit Default Swap (CDS) 6–7.comprehensive 228 dividend yield (Div/Yield) 34. 98–101 Employee Stock Ownership Plan (ESOP) 249–250. 267 D exclusions 235211 day trader 124 expected loss 197 decimal pricing 114–115 F deadbeats 165. 169–170. 265. 247–250 FICO 159. 186. 121 comprehensive major medical 219 Dodd-Frank Act 101 Consumer Confidence Index 46–47 Dow Jones Industrial Average (DJIA) 44–45. 161. 189–190 demand feature 186 flood insurance 228 dental insurance 219 fund screeners 62 disability clause 211 disability income insurance 222 disclosure statement 186 discounting 16–18. 7 324 . 185 credit card 155. 310 Fair Credit Reporting Act 161 debit cards 169 Fed Funds Flow Rate 281–282 default 163. 266 Credit Disability and Credit Life Insurance 185 equity 186 credit score 159–160. 169–170 duration 86 corporation 23 E co-signer 185 earthquake insurance 228 coupon rate 77. 58 Consumer Credit Counseling Services (CCCS) 167. 177–180. 155–181159. 175. 164. 80 effective interest rate 282–285 credit 3. 245–246 microborrower 179 microcredit 176–181 microfinance institution (MFI) 176–181 mid-cap 29 Modern Portfolio Theory(MPT) 13. 70. 139–143 insurable interest 223. 60 Martha Stewart 36. 15. 265 margin 457. 18. 87 homeowner’s insurance 223–225 living benefits 211 hospital income policies 219 load 57 hospital insurance 217. 256. 85 health insurance 217–221 lien 160. 44–47. 97. 80 Medicare 217. 163. 224 interest rate risk 101 intermarket sweep order (ISO) 145–146 Internal Revenue Code (IRC) 246–247 internalization 116–117 investing 16. 264. 78. 65 Initial Public Offering (IPO) 23–25 insider trading 36. 264 higher order beliefs 31 liquidity 54. 141–142 market capitilization (Mkt Cap) 29 maturity date 77–78.growth stocks 27. 128–130. 64. 220 Individual Retirement Account (IRA) 54. 311. 218 loan flipping 166 I loan value 186 identity theft 161. 66. 64. 161. 104 M index fund 58–59. 263–267 investment insurance 9591. 184 hedge fund 68–72 life-cycle funds 63 hedging 68 life-cycle hypothesis 1414 high balance charge 186 life insurance 197–208. 93 investor sentiment 37–38 large-cap 29 management fee 57. 250–254. 19. 160. 266 joint liability 178–179 mortgage insurance 225–226 325 . 162. 265 Madoff. 14 moral hazard 199 mortality table 310. 102–107 Individual Practice Associations (IPAs) 215 major medical insurance 219. 157 inflation 17. 166. 60. 83. 142. Bernard 10–12. 86. 170–172 long-term care insurance 221 index 14. 61. 241. 264. 29 K guaranteed purchase options 211 Keogh plan 248 H L Health Maintenance Organizations (HMOs) 215 laddering 84. 123–125. 313 J mortgage 6–7. 116–118. 173. 267 policy loan provisions 211 risk assumption 198 policy reinstatement 211 risk avoidance 198 Ponzi. 94. 266. 46. 121. 28–29. 215. 310 participating policies 211 personal property floater 224 risk 4–5. 264. 314–315 options 43. 45. 63. 163. 41. 125 preferencing 116–117 no-arbitrage principle 95 nominal interest rate 281. 66–72. 128. 116–117. 79–81 revolvers 157. Charles 10 risk control 198 Ponzi scheme 9–10 risk transfer 198 preferred provider organizations (PPOs) 241 Roth IRAs 251–254. 14. 52. 43. 102. 111–113. 167. 100–101. 32. 198–199. 129. 247. 265. 42. 216. 259. 47. 53. 175.multiple indemnity 211 price/earnings (P/E) ratio 33 municipal bonds 77. 266. 65. 18. 139. 44. 229. 111–113. 117. 176. 125 professional liability insurance 229 profit margin 114. 224 opportunity cost 312 retirement 54. 282–283 nonforfeiture options 211 R range 120 rational expectations hypothesis 31 real interest rate 281 O relationship lending 178–180 open 120 relationships 175 open account credit 158 replacement cost 223. 88 private placements 145 N NASDAQ 41. 13. 174. 91–107. 248. 177. 147 Orange County Fiasco 85–87 overconfidence 37–38 Retirement Savings Opportunity Act 252 reverse repurchase agreements 85–87 P reverse stock splits 138–139 par value 77. 265. 265 payment of premiums 211 peer monitoring 178 penny stocks 28 periodic rate 186 prepayment penalties 186 price discovery 97–98 Russell 3000 46 S Seasoned Equity Offering (SEO) 23 326 . 16. 123. 263. 82–88. 76–77. 230. 78. 121 property insurance 223–229 net payoff 186 prospect theory 38–39 net present value 14–15 prospectus 56–58. 276. 239–257. 55. 145. 7. 60. 45. 118. 38. 119. 264. 164. 17. 205. 63 NYSE 41. 124. 44. 161. 15. 264 time value of money (TVM) 18–21. 91–97. 53. 57. 111–113. 71–72. 239. 87 settlement options 211 Treasury bills 76 signaling 229 Treasury bonds 76 signature loan 186 Treasury notes 76 SIMPLE 249. 61. 255. 123–125 Securities Exchange Commission (SEC) 11. 117. 256 U small-cap 29 umbrella personal liability insurance 229 Social Security 241–246 underwriters 24–25 S&P 500 45. 71. 57. 69 underwriting (insurance) 198–199 stealth trading 143–145 uninsured motorists 227 stock analysts 135–136 universal life 202. 83. 254. 68–70. 97. 69. 250. 264. 145 sunshine trading 144 Vol/Avg. 263. 79–88 yield to maturity (YTM) 81 Z zero coupon bond 75–76. 135–147. 68. 79. 117–119. 86. 239–245. 267 value stocks 27. 80 total of payments 187 327 . 83. 61. 139–143 tracking stocks 29–30 travel insurance 219 security interest 186 Treasuries 76. 78. 137. 203–204 skewness 43 surgical expense insurance 219 T term life insurance 202–203. 64. 102. 211–212. 205 Wilshire 5000 46 Y yield 77. 213 stock tickers 111–112 utility maximization theory 39 stock splits 137–138 V stocks 9–21. 24. 101. 265. 120 supplementary medical insurance 241 W Supplemental Security Income (SSI) 241 whole life 202. 269–318 variable rate loan 187 variable universal life 202. 105. 266. 58. 85. 259 turnover rate 58 simple interest 275 truth in lending 187 Simplified Employee Pension (SEP) 249.trading 16. 76–78. 23–47. 65. 63. 58. 107. 66. 64. 55. 64. 80. 113. 29 strike price 92–96 vesting 250 subrogation 223 viatical settlements 208 suicide clause 211 volatility 112. 204–205. . Strongly agree 2. I believe that mutual funds are the only way to invest—individual stocks are for the professional investors only. Strongly disagree b. Time value of money (TVM) concepts are a total waste of my time. I know how to pick stocks/mutual funds. a.Post-Course Questionnaire Name: ________________________________________________________________ 1. Strongly agree 329 . Strongly agree 3. Agree e. Strongly disagree b. a. I believe investing is only for those with lots of money. I know I will never use them in my life. Agree e. Disagree c. Disagree c. I know what an ETF is. Could go either way d. Disagree c. Agree e. Agree e. a. Disagree c. Could go either way d. Strongly agree 5. a. Could go either way d. Could go either way d. Strongly disagree b. Agree e. Strongly agree 4. Strongly disagree b. Could go either way d. a. Disagree c. Strongly disagree b. Could go either way d. Disagree c. Only qualified professionals should be making investment decisions—not individuals like me. Strongly agree 9. Strongly agree 330 . Strongly disagree b. a. Strongly agree 10. Agree e. Checking my credit report is a waste of my time. The class cannot teach me anything new. I know what a Roth IRA is. Strongly agree 7. Agree e. Credit cards are wonderful things. Strongly disagree b. Disagree c. a. Strongly agree 11. Strongly disagree b. Strongly disagree b. I wish I had more of them. Agree e. I plan to hire professional financial planners to make those decisions on my behalf. Agree e. I know all there is to know about insurance. Disagree c. Disagree c. In the future. Could go either way d.6. Could go either way d. Strongly disagree b. Agree e. Could go either way d. I am not in favor of making investment decisions myself. a. Disagree c. Could go either way d. a. a. Strongly disagree b. Strongly agree 8. Agree e. a. Disagree c. Could go either way d. a. Disagree c. Strongly agree 331 . Could go either way d. Agree e.12. I believe that I am too young to think about planning for retirement. I will consider it when I am older and have money to spare. Strongly disagree b. . Investor’s Business Daily and others. in mechanical engineering from the University of Kentucky. He received his B. he is best known for popularizing a Personal Finance course that teaches undergraduates the basic skills of money management.D. and lots of colorful tropical fish. He plays his guitar. Van Ness) at the Eastern Finance Annual Conference. piano. The class is structured around the football cliche: “Offense wins games but defense wins championships. Sugato has worn many hats. Dr. Chakravarty’s research has been cited well over 1. and his Ph. Chakravarty’s research has appeared in leading academic journals. in chemical engineering from Jadavpur University (India). Chakravarty loves to spend time with his family including his wife.” Dr. The course also covers popular and current topics relating them to the basic principles. three cats. Credit plays the role of good special teams in that a judicious use of credit can move the line of scrimmage from one’s 20-yard line to the 45 or 50 yard line making it easier to score a personal finance touchdown. 333 . Chakravarty has won research awards including the Barclay’s Global Investors Research Award for the best paper on Australasian Markets (with P. At Purdue. Investments (including those for retirement) is an offensive strategy while insurance is a defensive strategy. Pham) and the Best Paper Award (with B. Dr. options and fixed income securities. Dr. Journal of Financial and Quantitative Analysis. He serves as Associate Editor of the Journal of Financial Markets. His research has also been used as evidence in hearings by the U. His work has been cited in leading newspapers like the Wall Street Journal. in finance from the Kelley School of Business at Indiana University. Dr. and spans both domestic and foreign markets. Journal of Business. including the Journal of Finance. He is probably best known for his work on the decimalization of stock prices. Van Ness and R.S. finance and mathematics. Kalev and L. Journal of Empirical Finance. marketing. banking and asset pricing involving stock. The class boasts enrollments of over 400 students every semester and is an elective in almost all majors across the West Lafayette campus. and the Journal of Financial Markets. and mouth harp whenever the mood hits him. insurance.S. and retirement. Chakravarty argues that in order to win the game of life one needs to have solid offensive and defensive strategies. He has also won a Q-group Research award and is listed in the Marquis Who’s Who in American Education. Congress. Over his career. His primary research areas include market microstructure.000 times. He has taught and researched in interdisciplinary fields of psychology. his M. two dogs. insider trading and stealth trading.About the Author Sugato Chakravarty is a professor and the head of the Department of Consumer Sciences and Retailing at Purdue University. Journal of Financial Economics.S. credit. Barron’s. According to Harzing’s Publish or Perish citation tracking software. . For laypersons. Even I. I strongly recommend this book for laypeople as well as professionals who deal with clients that require finance exposition in an accessible manner.Testimonials In contrast to the vast majority of personal finance books which are excellent antidotes for insomnia. All the important aspects of personal finance are discussed. UCLA 335 . Chakravarty has created a breezy and entertaining text which both informs and entertains. Avanidhar Subrahmanyam (Subra) Goldyne and Irwin Hearsh Professor of Finance Coeditor. have learned much from this manuscript about how to exposit material in introductory finance classes. the world of finance often seems inpenetrable with arcane technology and seemingly complex conceptual frameworks. Journal of Financial Markets The Anderson School of Business. Wood Distinguished Professor of Finance. This is an excellent text! Robert A. University of Memphis This is an extremely valuable volume which presents the basic principles of finance in a lucid and easily understood way. as a finance professor with several years of experience. The author brings these terms and concepts to life using simple analogies and examples that every individual can relate to. . Supplemental Reading: The Daily Economist . . Supplemental Reading: The Daily Economist . . . . Inc. Decisions We Make! Second Edition Sugato Chakravarty Copley Custom Textbooks An imprint of XanEdu Publishing. .THE DAILY ECONOMIST Risks We Take. Copley Custom Textbooks An imprint of XanEdu Publishing.Copyright © 2011 by FinTech Training. 138 Great Road Acton. LLC. All rights reserved Printed in the United States of America ISBN 13: 978-1-58152-817-5 ISBN 10: 1-58152-817-6 No part of this book may be reproduced in any manner without permission in writing from the publisher. Inc. MA 01720 800-562-2147 . Contents Preface v Chapter One: The Economics of Grocery Club Memberships: Supersize Me? 1 Chapter Two: Buy Online or Buy from a Regular Store? Hyperlink to Cyperspace 7 Chapter Three: The Economics of Bidding in eBay Auctions: Bid Goodbye to Good Ol’ Buys 11 Chapter Four: Drive. or Bus to Work? The Fast or the Furious 15 Chapter Five: Buy a Newspaper or Read Online News? Leaf ’n Read or Click ’n Browse 19 Chapter Six: Regular Books or Kindle? 23 Chapter Seven: Eat Out or Cook at Home? 25 Chapter Eight: Buy a Car or Lease It? 29 Chapter Nine: Rent an Apartment or Buy a House? 33 Chapter Ten: Should You Pay off Your Mortgage Ahead of Schedule? 37 Chapter Eleven: Cell Phones or Land Lines? I Just Called to Say—I Don’t Need You! 41 Chapter Twelve: What Kind of Credit Card Should You Sign Up For? 43 . Bike. and What Kind Is Best? 53 Chapter Seventeen: Do Insurance Companies Want You to Live Longer or Die Sooner? 57 Chapter Eighteen: How Should We Use Technology in the Classroom? 61 .Chapter Thirteen: When Should You Buy That New Laptop? 45 Chapter Fourteen: Buy College Textbooks New or Buy Them Used? 47 Chapter Fifteen: Roth IRA or Traditional IRA? 51 Chapter Sixteen: When Is the Right TIme to Buy Life Insurance. we do. This book is an effort to bring such unconscious thinking to the forefront of our thought process. and then still have time to meet Teresa for v .m. I remember not too long ago a colleague of mine.. go to Aldi’s right next door to pick up some milk and vegetables. when we indulge in thinking like. a well trained and highly educated economist. It is my belief that the best decisions are made when a conscious attempt is made to think through the costs and benefits (the tradeoffs) associated with each choice. Every little decision we make in our day-to-day lives involves economics whether we like it or not. a lot of us forget those steps and make decisions that are not carefully thought through. exclaiming to me: “Surely we do maximize utility functions in our heads all the time!” Actually. All of us make decisions. many times every day without being aware of the underlying thought processes. This involves trade-offs and an understanding of the costs of benefits of our actions. large and small.Preface The purpose of this little book is to create a sense of economic thinking among readers. Even the most mundane decisions have economic thinking buried beneath them. This little book is an effort on my part to get you to think logically. The only thing is that we may not be acutely aware of this process. Unfortunately. I can drop the kids off to school by 8 a. For instance. “If I leave now. becomes second nature. I am thankful to Jed Niederer and Bob Falk. as well as a number of my students. I thank Atul Todi for designing the jacket of the book and my wife. Sugato Chakravarty West Lafayette. The topics are both those we are likely to encounter on a daily basis and those that are relatively infrequent. both graduate and undergraduate.m. The decisions described here range from the trivial to the not so trivial. The brain is a muscle just like our biceps and triceps and.. The process is simple and. 2010 vi .coffee at 9 a. once we learn it. with whom I have discussed these issues in varying details over the years. we need to exercise those parts of our brain that help us make decisions. just as we exercise those muscles. It is my hope that reading this book and thinking about the underlying thought processes will exercise your brain and help you make better decisions overall. Indiana May. Ajita.” we are essentially maximizing a constrained utlity function in our heads. As you go through these scenarios hopefully a light will go off and you will apply similar thinking to other areas of your lives. for carefully reading the material and offering many useful suggestions. Do you happen to own a restaurant? If you don’t own a restaurant. Membership-only warehouse clubs such as Sam’s Club and Costco are doing brisk business. If not. Whoever thought of this first was a genius! Does this make economic sense? In order to answer this question. you need to consider other factors.CHAPTER ONE The Economics of Grocery Club Memberships: Supersize Me? According to recent reports.” then a membership probably makes sense for you. do you at least have a large family? Do you routinely spend over $200 a week on groceries? If your answer to any of these questions is a “yes. and grocery stores are adding bulk aisles in order to tempt customers to walk in through their doors and walk out with a huge cart full of stuff. buying in bulk has exploded in popularity. ask yourself the following questions. 1 . The rules of membership-only warehouse clubs are very simple: You pay approximately a $50 annual membership fee. and you have the privilege of walking in the store any number of times and spending lots of money on things you don’t really need in very large quantities. since they buy everything in large quantities. A good example is Walmart. they get volume discounts. you get a volume discount from the seller when you buy items in larger quantities. Hence. Consider purchasing a fleet of cars for your company’s motor pool. Second. each roll may be the size of a roll and a half at a regular grocery store. when you buy a package of twenty-four toilet paper rolls. which the wholesale company is able to negotiate since they are buying huge quantities of everything. there are actually two advantages you receive when you shop in wholesale clubs. It happens simply because the parent company has clout and is able to negotiate a better rate overall. the clubs repackage these items into larger units for purchase by their customers. Given the volume of their purchase­s—sometimes from foreign countries en masse—they are able to dictate the price they pay their suppliers. there is an overall discount. the end user and Walmart customer. you effectively end up buying thirty-six regular size rolls when all is said and done. These volume discounts are then passed down by Walmart to you. So the sixty-four thousand dollar question is: is a grocery club right for you? . They get two kinds of discounts from their suppliers. there is the repackaging of goods that results in larger quanities (and lower unit prices) than are available at general grocery stores. Second. which buys billions of dollars of manufactured goods from China. for example.2 Chapter One The way these wholesale clubs work is simple. So. The benefit to you is that the unit price of the item may be lower than the unit price of a similar item in a regular grocery store. First. You will be able to get yourself a whale of a deal from the car supplier (which could simply be your local car dealership) simply because you are buying so many of them. That is. Examples of clout are everywhere. So. This occurs at a global level and has nothing to do with you. First. The fact is that no one really knows how many votes she actually won. When I say benefits. you need to compare the price of a pound of butter in store A with the price of a pound of identical butter in store B. you may ask? It is because. in the Democratic Presidential Primaries of 2008. you would need to sum up the benefits and the costs of the membership. for example. For example. So. the butter in question in store A is pasteurized butter made with milk from organically-fed cows in the United States. and sometimes it is not even worth the effort. “You must always compare apples to apples. a lot of approximation is used in order to extrapolate what those numbers truly are. the direct price comparisons are never really that simple. Why. in wholesale clubs.The Economics of Grocery Club Memberships: Supersize Me? 3 To answer the question as an economist. the discounts. Except. if you are comparing the price of butter.” but as long as we are close.50 in your wholesale club. If. it is okay. where people don’t go in and cast votes for one candidate or another. . The problem was some of the states that she factored in to her “vote count” were caucus states. and that is a direct benefit. the same unit must be used for each. as we economists are fond of saying. while the butter in store B is made with milk from non-organically–fed cows in the Philippines.50 immediately. you have saved $0.” In simple English.” By that standard. you are not comparing “apples to apples. If you can buy an item for $5. I mean both direct and indirect benefits. of course. An example of a direct benefit is. She repeated it often enough that the press started printing it as if it were fact.00 in a regular grocery store and the same item costs $4. it is rare that we ever compare “apples to apples. Hillary Clinton was fond of claiming she won eighteen million votes. Thus. this means that in order to reliably compare one item with another. and second. because when you are buying a package of toilet paper. Did you come out ahead or not? Unfortunately. like milk and cheese. like toilet paper. For instance. Then. however. a comparison of the prices of the two butters provides an easy way to tell which store has cheaper butter. you may go to the grocery store and buy the same item you already had at home. If they are non-perishable items. Translation: extra expense you . you will have to find space in your already crowded garage or closet to store them. • Value of your time to go and fight the crowds in the club. for instance. it is not readily apparent. • Annual membership fee (approximately $50). you have more rolls in your package than a standard package in another store. • Buying larger quantities than you may end up using. In another grocery store. • You end up buying other things that you don’t really need but that looked good on the shelves. you may pay $10 for a package of twenty-four huge rolls in Costco. your costs are: • Gas to drive to and from the wholesale club. Let’s break it down. • If you put them away somewhere and forget about them. chances are some of it will spoil before you use it all. you might find twelve regular size rolls of the same brand for $6. let us say that you are able to find a basis of comparison such that you are comparing a pound of butter in store A with a pound of similar butter in store B. Keeping in mind that all of the following categories may not equally apply to you. each roll itself has more paper than a single roll in the other store. So you have a double whammy on your hands: first. it is a huge package with each roll supersized to have more toilet paper than those you would find in a regular grocery store. The problem is not simple with wholesale clubs. If they are perishable items.4 Chapter One But. The wholesale clubs want you to stay focused on the issue of your savings per unit. in turn. you control your caloric intake as well as your wallet. For their part. even if you feel the fresh glow from your purchases. . items on sale in regular stores can be cheaper per unit than those at the wholesale clubs. That way. You are better off going to a regular grocery store for your daily needs and looking for money saving coupons or price mark downs.” If you walk in with the purest intentions to buy one jumbo pack of toilet paper (cost $10). However. the wholesale clubs will argue that you get to buy all you want for one same annual fee and at a cheaper price per item. It makes little economic sense. The issue really is those extra costs you incurred in the process. and walk out forty-five minutes later with a grocery cart full of stuff (cost $125). you don’t really need to belong to a wholesale club. have lost. For opportunistic shoppers. Specifically. This is classic “reframing” of the issue. The bottom line is that if you are a regular individual.” This is really the major cost of club memberships. This is another manifestation of the “supersize” culture you don’t really need. the wholesale club has won. or a regular American family. A clear benefit for you is that you receive a discount per unit of the items you buy there. they are expecting you to indulge in “impulse purchases. You. Economists call it “unexpected expense. and one that these clubs count on. it is not true that items are always cheaper in wholesale clubs. Sometimes.The Economics of Grocery Club Memberships: Supersize Me? 5 were not planning on when you walked in the store. The issue is not whether you bought those items you really did not need for a cheaper price per unit than you would have elsewhere (probably true). it can work out to quite a few dollars in savings. 6 Chapter One Further Reading: www.com .grocerygame. A recent study found that 19 percent of Internet users shop online once per week—and this number is expected to continue to grow. If this tactile feeling is important to you. and retailers establish a stronger internet presence. One benefit of buying from a traditional store is the ability to touch and feel an item before purchasing it. online shoppers will double to 132 million in the next five years. If you live in a large city the store could be a few miles away. Another advantage is that if you are dissatisfied with the product. it is definitely the right approach for you. returning it to the store for a full refund is also usually pretty easy.S. the question facing us is: should we buy online or from a brick and mortar store? Let’s examine the economics of the arguments.CHAPTER TWO Buy Online or Buy from a Regular Store? Hyperlink to Cyberspace It has been predicted that U. which implies added mileage on your car. As the Internet becomes an increasingly dominant part of our lives. The costs of buying from a traditional store are the time it takes to drive to the mall and the resultant gas expense. higher gas expense. and greater opportunity cost in terms 7 . For items above the cutoff price. since cars are a standard product. I might be more inclined to look at the picture online and buy it if it looks okay. as it is very difficult to get a true sense of the item without actually touching or seeing it in person. and an online purchase is as good as any as long as the prices (with shipping) are similar to an in-store purchase. The main costs of online shopping are: you are unable to feel the product in your hands before buying it. and if you want to return it for any reason. you have to box it up. If the item is non standard—like a painting. or pet food—you know what you are getting. The package arrives at your doorstep a few days later. the . a kitchen utensil. This might also result in extra expenditure—not to mention the headache of an extra trip to the post office. For a non-standardized item. The prices with shipping are usually competitive relative to conventional store purchase. My rule of thumb in those situations is to use the price as a screening device. take it to the post office. and I can test drive the same make and model at the local dealership and choose to buy online if it is cheaper. the non-standardization cost is zero. I may be more inclined to go to the store and check it out in person before buying it. or even clothing and shoes—buying online might be a bit of a gamble. If the item in question is a standardized one—like a book. The economics of the decision then can be summarized as follows: consider the non-standardization cost—for a book or other item that is standardized (you know what you are getting when you buy it). where the quality and feel of the product is important. the item takes a few days to arrive (higher urgency cost). if not cheaper. Buying cars online is also possible. For items priced $150 or below.8 Chapter Two of the lost time that you could spend doing something else—maybe even earning money? The main benefit of online shopping is the convenience—you can shop quickly from your desk in between working on other projects. and mail it back. Buy Online or Buy from a Regular Store? Hyperlink to Cyberspace 9 non-standardization cost is a number greater than zero. How much is a value judgment, of course. Also, consider the urgency cost. If it is an item you can wait for, and assuming all other costs are manageable, you may want to buy online. If not, go to the store and buy it. There is also an age division here: younger people are more apt to shop online, while the relatively older (who are less comfortable with the computer overall) may prefer to shop in actual stores, regardless of the lower prices or the convenience of online shopping. For them, online browsing is intimidating enough that it imposes a high “cost” (which overwhelms all benefits of online shopping), while traditional shopping is a breeze. Further Reading: www.fatwallet.com www.ebates.com CHAPTER THREE The Economics of Bidding in eBay Auctions: Bid Goodbye to Good Ol’ Buys eBay has become very propular these days. I think all of us are either direct users of eBay or know someone who is. Any time we have something to buy or sell, we tend to check out eBay. And, chances are, the item we want is for sale, and usually for a lower price than what we would pay elsewhere. Whether we like it or not, eBay has become the great online marketplace for any commodity. For stocks and bonds there are the stock and bond markets. Who has not heard of the New York Stock Exchange or the NASDAQ? We are able to buy and sell stocks, bonds, and other kinds of financial assets in these markets. eBay is very similar—except it deals with items we use in our daily lives, and prices range from a few dollars to hundreds of thousands of dollars (and these days even millions). The usual strategy when bidding in an eBay auction is to enter your bid for the item and then wait for the auction to close. When it does, if you happen to be the highest bidder, you win the item at your price. 11 12 Chapter Three Then you make your payment and await its arrival with baited breath. Sounds simple and uncomplicated, right? Except it isn’t. Here is the first problem: chances are that the item you are really set on will go to someone else, because someone will outbid you at the last second. And if you are determined to get the item at any cost, you may well win it, but at a price significantly higher than its appropriate value. In that case, you may end up suffering from what is known as “buyer’s remorse.” This is when the winner of an auction regrets his (presumably high) bid for the item. So what is one to do? Let’s think like an economist. The first step in bidding for an item is to be clear about the maximum price you are comfortable paying for it. This has to be clear in your head before you submit your bid. A good way to decide an appropriate price is to do a quick search for a similar item online. Chances are, amazon.com will carry an identical or a similar item. See what you would pay for it if you were to buy it from amazon.com (include shipping and other charges), and then mark it down by a percentage to arrive at your best eBay bid price. This should be your reservation price for the item. Then it is time for step two. You want to maximize your chances of winning at or below your preferred bid price. Let’s examine the problem from the viewpoint of the other bidders. The problem you face is that the item you want may be equally desired by many other bidders, each of whom has her own reservation value for the good. Some of these reservation values may be above yours and some may be below. The Economics of Bidding in eBay Auctions 13 With all this fierce competition, how do you maximize your chances of winning and winning without going over your own reservation price? The main lesson here is to not reveal your hand beforehand. Being able to win auctions is a lot like being able to win at poker. You need to figure out your opponents’ hands without divulging your own. For eBay auctions, the best strategy is to wait. How long? As long as possible—until just seconds before the end of the auction. If you follow these auctions closely, you will see the flurry of activity that occurs seconds before the auction closes. That is when the real pros swoop in with their bids, which may be just a few pennies higher than the existing bid, and win the auction right under your very nose. So if you want to match wits with these auction pros, you need to behave like them. Sit tight with your bid until there are about two minutes left before the auction closes. These days there are auction sniper programs that will put in the bid automatically for you a few seconds before the auction closes up to your specified maximum price. Check the highest bid near the close of the auction. If it is already above your reservation price, it is time for you to walk away. You have lived to fight another day. Chances are, the same, or a similar, item will be on sale shortly, and you can try your luck then. The worst mistake you can make at this point is to lose your calm in the heat of the battle and, with your competitive juices stirred, start playing games with your mind. For example, you may convince yourself that you should increase your bid to try and win the item. Once this mindset takes over, you have lost even if you win the item. Chances are, you will have paid significantly more for the item than it is economically worth, and you may end up suffering from the winner’s curse. Let’s hope it never happens to you. CHAPTER FOUR Drive, Bike, or Bus to Work? The Fast or the Furious This is an intriguing topic and one that is particularly close to my heart. Since I live and work in a college town in the great American Midwest, nothing is really “too far” from anywhere else. There is also a bus service that is free to university employees. My neighbors, who are mostly university professors, either take the bus or bike to work. I am one of the few exceptions in that I drive to work (approximately 2.5 miles). And every spring, as the weather becomes nicer, I have this raging internal debate: should I drive to work or consider one of the alternatives? Let’s consider the economics of this question. If I drive to work, what are my costs? The cost of gas; the cost of the car’s wear and tear; higher insurance premiums on the car (relative to keeping the car in the garage during the week); the cost of the annual parking permit to park it in a university owned garage; and additional health related costs, since it can be argued that by driving to work I am giving in to a relatively sedentary 15 16 Chapter Four lifestyle that could lead to increased doctor visits, medication, blood tests, and other related medical expenses. If I take the bus instead, what are my costs? The bus ride is free (even if some of you are not so lucky, chances are that the cost is significantly less than the price of gas, so let us assume that the explicit cost is approximately zero). What are some of the implicit (or not so obvious) costs? The cost of having to wait for the bus to arrive. A related cost is the time is takes for me to get out of my home and walk to the nearest bus stop. Also, there is the cost of having to walk if the bus stop is not very close to my office building. Then there is the inconvenience cost vis-à-vis the extra time it takes to ride the bus to work versus driving my own car. If the value of my time is high, this could be a significant cost. How do I figure out the value of my time? An intuitive way of thinking about this is through what economists call “opportunity cost.” An opportunity cost measures the value of the other things I could be doing with my time. If, for example, I am twenty minutes late to work as a result of riding the bus and I miss an important meeting, then the value of my time (the opportunity cost) is probably high. If, on the other hand, it does not matter whether I am late as a result of my riding the bus to work, the value of my time is probably low. Another significant cost is that riding the bus limits my ability to run errands during the day—especially if those errands involve places far from the regular bus routes. If I have to call a taxi to run those errands, that adds another expense. What are some of the benefits of riding the bus? It is probably cheap or free, depending on where one lives. There is the benefit of the extra walk I have to undertake from the bus stop to my office building. In sum. and other related benefits. thereby accelerating its wear and tear. parking. I will take the bus to work. the costs of bike wear and tear and maintenance. or the direct costs of driving (gas. . what is my decision? I will choose taking the bus over driving if the net benefit of taking the bus exceeds the net benefit of driving. For me. or Bus to Work? The Fast or the Furious 17 This. has a cumulative health benefit resulting in fewer doctor visits. is too high. If buses are available. I may choose driving to work if the distance is relatively great. The costs of riding my bike are the inconvenience of having to carry extra clothing to work and changing once I get there. since there are no parking permits to buy. done on a regular basis. cold temperatures. There is a societal benefit of decreased pollution.) are not too prohibitive. I am getting a pretty intense workout at least twice a day. except that the health benefits are much more significant. etc. the inconvenience associated with carrying a change of clothing. cheap. • Saving money versus having to buy a parking permit. and fatigue once I get to work if the distance is great. etc. Also. as my car stays in the garage and does not contribute to global warming. • Health benefits of biking versus the inconvenience of arriving at work sweaty and needing a change of clothing. weight loss (with its beneficial implications). Bike. The pros and cons of biking versus driving are: • Gas savings versus incurring mileage on my car. that is an easy $150 per year. fewer medications. that is a potentially significant savings.. and do not take significantly longer to get me to work.Drive. The benefits of a bike ride to work include everything associated with taking the bus to work. Further Reading: www.gasbuddy.18 Chapter Four I may well decide to play a mixed strategy equilibrium whereby I drive to work during the school year and bike to work during the summer months—when the inconvenience factors are reduced significantly while the advantages. are increased.com . via health benefits. while reading the physical paper is not.CHAPTER FIVE Buy a Newspaper or Read Online News? Leaf ’n Read or Click ’n Browse These days lots of people are reading news online. Also. I might read a page or two and soon get tired of managing the large size pages and having to fold them into smaller subsections for convenience. we live in an age of the 24-hour news cycle. the physical paper is cumbersome to get through and requires effort and commitment on my part. and will be dated. and update news on their websites. This means that breaking news occurs at all times of the day and night. this still happens—except now we have a choice of reading online as well. If a significant news event occurs after that. Actually. Almost all newspapers nowadays have an online (usually free) presence. the print copy will not be able to carry it. Usually online reading is free. Gone are the days when newspapers came only in one form—the paper kind. A newspaper that has to go to print at a certain time is a fixed snapshot of events up to that point. It would be left on the driveway every morning and it would be quite a ritual to have your morning coffee and read the paper from cover to cover. 19 . while online news can be read conveniently while I am working on my computer and need a little break. Also. I suspect it is a generational thing. it is the convenience of sitting on your comfortable sofa or chair with your coffee at your elbow and reading. What are the benefits of online news? It is usually free—requiring only a free registration. there are always newer items to be perused. From a strictly economic standpoint it is a no brainer that online news trumps traditional copy. requiring one to go online anyway. is associated with happy times. as will the Internet access. In that sense. On balance. while access to the Internet can cost anywhere from $15 to $40 per month. the monetary cost of paying for the newspaper— ranging from a dollar upwards. it is . of course. The non-pecuniary costs could also be that news is dated. Economists have fancy terms for this difference: print news is static. A computer costs hundreds of dollars. What are the costs of the traditional newspaper? There is. Also.20 Chapter Five What are the benefits of the traditional newspaper? Mostly. or you might enjoy coverage of topics that may not be available online in as much detail. Of course. one has to keep in mind that the computer will be used for other purposes. while online news is dynamic. It could also capture the early morning quiet time before the madness of the day begins. As long as you have a computer and an Internet connection. A major cost associated with reading online news is that you need access to a computer with an Internet connection. at any given time. So the direct cost attributed to reading online news will only be a small fraction of these costs—especially those attributed to cost of the computer itself since that cost is spread out over many activities and over at least three to five years. It harks back to the past and. it is convenient to read briefly in between other activities on the computer. News is updated regularly and. the total time spent reading the news can be spread out over the day. for a lot of people. and for them it is a simple matter of going online for their news. online news will not be a free commodity anymore. the younger generation grew up with computers. and allows the convenience of reading the paper piecemeal. has updates throughout the day.Buy a Newspaper or Read Online News? 21 still mostly free. and they value the simplicity of the tactile feeling of a rustling newspaper in their hands. By comparison. By then. . But there are intangibles of habit and convenience that make traditional print copy a favorite amongst the older generation. I suspect as time goes on the popularity of online news will grow and print newspapers will be more of a novelty. Translation: this group is still not as familiar or comfortable with computers. One can already spot this trend: the New York Times recently started charging for unlimited online access. . if you enjoy reading new books “hot off the press. It’s cool to have one.CHAPTER SIX Regular Books or a Kindle? Digital book readers have become all the rage lately.” the cost of a hardcover copy is much higher (as much as $30). which would weigh down your backpack significantly if you were to take the paper copies. we can say that in the long run. the average cost of a book is $10. At this price. and have been eyeing one. Now let’s consider the non-pecuniary costs of one decision versus the other. Advantage Kindle. 23 . Considering that we can buy used books online for just a few dollars. If we don’t own one already. what are the underlying economics at play here? Buying a Kindle has a high fixed cost—$140 for the most basic model. Given that e-books cost in the neighborhood of $10 each. That is a steep price and can buy us many books. However.com’s Kindle. While there are a few digital book readers available in the market. leading the race clearly is amazon. although newer books are considerably more. that is fourteen books we cannot buy right off the bat. those that enjoy reading current releases can save a great deal of money by buying the electronic versions. There is the convenience of loading your Kindle with many electronic books. The Kindle. and capacity) is enough to offset the $140 purchase fee. a size and weight simulating an actual book—is not the real thing. if the savings on new releases or the convenience of the Kindle (in terms of its portability. Contrarily. an admitted Kindle junkie. Even I. it may make more economic sense to switch—even for the casual readers. prefer the look and feel of a conventional book. or take only one or two books with you on vacation. Buying a Kindle is a waste of your money. . compactness. Advantage paper book! On balance. As competition for book readers heats up and reader prices come down. will admit that. if you are not a big reader. Until then. the Kindle is yours.24 Chapter Six Some of us need to hold a paper book in order to experience the complete joy of reading. sit tight with your paperback. in spite of its hyped benefits—a non-reflective screen. you should stick with the traditional thing. the answer is obvious. and my wife likes to eat home-cooked meals. spices and other condiments. this is a subject close to my heart. eating out is the clear winner.CHAPTER SEVEN Eat Out or Cook at Home? I will not lie to you. think about the effect on your health when you eat a value meal from McDonald’s instead of cooking a healthy meal at 25 . here are the facts: I like to eat out. And if you add the value of your time spent cooking a meal when you come home from work exhausted. For example. It is safe to say that cooking at home is expensive—in the short run. Any number of the chains will sell you a value meal for under $5. Who is right and who is wrong? The answer depends on who you ask.­­ But is it really? Consider some other facts in the equation I did not bring up before. But what are the economics of the question? Assuming we stay away from the expensive restaurants and pick up a value meal from a local fast food establishment. Eating out is cheaper. My wife and I have a running discussion on this very point. In the interest of full disclosure. Cooking at home involves going grocery shopping and buying all the extra items you need to cook a meal—including the oil. what tips the scale in favor of eating in is the fact that the long-term costs of eating out include significantly higher medical costs associated with higher cholesterol. We have the same mindset when we confront a buffet. the economically optimal choice has to be eating in. all that money. One can indulge one’s taste buds for pizza and other calorie-loaded foods occasionally and maintain . As chains like McDonald’s and Wendy’s became a permanent fixture in the American landscape in the fifties and sixties. and instead gave you more and more food at the same price. competition forced them to change their business model to stay profitable. one has to pause and wonder. and suffer from significantly reduced life spans? So. One can reduce the inconvenience cost of eating in by planning ahead and doing most of the cooking for the week on weekends. But have we really won? If you look at the obesity epidemic and the skyrocketing incidence of childhood diabetes in our country. by extension.26 Chapter Seven home. Once you factor in both the short and long term costs and benefits of eating in versus out. So we started consuming more. We leave the restaurant rubbing our swollen bellies feeling like we won one over the restaurant. However. We have paid the money. as perfect competition would dictate. since we did not want to waste all that food and. We consumers. being the closet economic agents we are. they kept their prices more or less constant. so why not get the biggest bang for our buck? And we inevitably end up overeating. Are we sacrificing our long-term health and longevity as a nation in the interest of saving a few dollars in the short run? Are our escalating health costs at least partially driven by obesity related illnesses—for which we have to go to the doctor. what are the economics behind this question? Eating out is cheaper than the monetary cost of groceries and the non-monetary cost of time spent cooking a meal. and heart problems. be on medication. Instead of reducing prices. diabetes. More is always preferred to less. saw the immediate value in that. The bottom line: While eating out may look attractive in the short run. you buy items with a fixed cost (like utensils and spices) that can be used repeatedly. once you factor in the long term effects. if you buy groceries and cooking materials in bulk and use them over days or weeks. There is also the benefit of economies of scale. thereby reducing the health costs of eating out while maximizing the value of eating in. Think about that the next time you are about to dash through your neighborhood Taco Bell drive-through for their giant tortadas. . and do not cost you additional money every time you prepare a meal. Economies of scale in this context implies that if you start cooking regularly. eating in may be your better option.Eat Out or Cook at Home? 27 a reasonable exercise routine. . or simply because we thought the salesman was cute. The rental. is determined through a formula that takes into account the number of miles per year that you are expected to drive the car. the residual value is a predicted value (since we don’t know what will actually happen). You deliver the car to the manufacturer’s lot and you are done. Of course. think of leasing as renting the car. as well as residual value of the car at the end of the lease period. What are the advantages of leasing? An obvious one is that you do not have to worry about the car after the lease period. can help us make a sound decision. it may surprise us to learn that there are economic factors to this decision that. that is exactly how the car dealerships want us to make our decisions. First. when considered. So. You don’t really own the car. for example. you rent it from the manufacturer. The manufacturer lets you drive it for a fixed number of years and then return the car to them when your lease period is over. if it is determined that your car will be worth 60 percent of its current value at the end of three years. our gut. but is a reasonable estimate determined by a lot of statistical data compiled by the manufacturer over the years. then you pay for 40 percent of the car for using it 29 .CHAPTER EIGHT Buy a Car or Lease It? This is a situation many of us face multiple times in our lives. Of course. However. We often end up making decisions with our heart. or the monthly leasing fee. and Lexus hold their values well—other cars not as well. the lease structure is based on a down payment and a monthly lease payment. all else being equal. if you get bored with the car after awhile. So. the less you pay for leasing it. Usually luxury cars like the BMW. you cannot simply park it in the dealer’s lot and walk away. which can be very inconvenient. Now let’s consider an outright purchase of the car. while less effort is required to trade the car in. There is also an interest rate that the leasing company is charging you as they calculate your monthly payments. But luxury cars also cost more to begin with. the higher the residual value of the car. Private selling requires more effort. but you get to keep more of the value of the car. Mercedes. you are starting to see the economics of the decision at play here. and instead leave it parked . or trade it in for a new car. Most people get around this problem by taking a car loan out for a longer period (six years) than the normal leasing period (three years). have the required maintenance done. The difference is that you are responsible for the whole price of the car. and not exceed the stipulated mileage—or else you will end up paying more. This is not something you can haggle about. in the form of a charge per extra mile driven. as you can at the end of a lease period. You can still finance the car. At the end of the day. You have to either sell the car in the open market. However. which means borrowing the money from a bank or the manufacturer itself to buy the car. You are also expected to keep the car in good condition. Obviously. which takes less effort. One of the demands on your time and wallet include all the basic maintenance the car will need to make it marketable. you will usually be able to sell your car for more money in the open market than you will receive from a dealer for a trade it in. Your decision on whether to sell privately or trade in should depend on factors like how much you value the time and effort that you will need to put in to sell your car privately. Owning the car outright means that. You will need to make sure you don’t drive the car in the meantime. but you get to keep much less of its true value.30 Chapter Eight for three years. there is another cost. my wife and I were far too busy to try to attempt to sell our old car privately. which results in lower monthly lease payments. This is a significant advantage when one considers the fact that the resale market for higher priced luxury cars is small relative to cheaper cars. Every time someone wants to see it.000 luxury car results in more than double the monthly payments of a $30. If this leads to marital tension and strife at home. therefore it is not a one-size-fits-all solution. when leasing. you are responsible for only a part of the value of the car. Each of you will have to do the calculations for yourself. This brings an inconvenience cost. At the end of the day. Leasing an expensive car makes sense for the following reasons: a shorter lease period. you may simply decide to forego that extra value you may obtain in the open market for the safe option of trading it in. You may also advertise it in the local media. which costs money. Normally. Why? For one thing. Therefore. These costs are not the same for everybody. financing a $60. trading our car in was the best decision for us. Translation: We value our time pretty highly. you have made the right call. there is no guarantee the car will sell. people lease luxury cars and buy cheaper cars outright. Therefore. you will have to keep the car washed and in good shape (another cost). That can be a serious financial impediment for some. For instance. since you will have to make alternative arrangements for your transportation until your car sells. you may need to take time off from work to accommodate the visit (a cost). Additionally. There is also the advantage of walking away at the end of the lease period without having to try to sell it yourself. Also. As long as the foregone value is less than the combined cost of trying to sell the car privately. in spite of all the costs you incur. considering all this. . and for an affordable monthly payment you can drive a fancy car. Another thing to keep in mind in the buy versus lease decision is the sticker price of the car itself.000 car.Buy a Car or Lease It? 31 somewhere visible. you are only responsible for a portion of the value of the car. com . But ownership is important to a lot of people. and there is value to it as well. of course. is that it is yours and you are responsible for what you do with it when you are done driving it. buying a less expensive car outright makes sense. The cost. So.gasbuddy.32 Chapter Eight For the rest. The advantages are a cheaper price and affordable monthly financing payments. are you a leaser or a buyer? Further Reading: www. By contrast. You can live in an apartment for as long as you want. This is a major advantage of renting over buying. emotional reasons to prefer one over the other. Say 33 . This saves money as well.CHAPTER NINE Rent an Apartment or Buy a House? Everyone confronts this decision at some point in their lives: do I continue to rent an apartment or do I bite the bullet and buy a house? There are. as home repairs can be very expensive. For all the years you pay rent. Your only responsibility is to pay rent. when you buy a home. If something breaks in the apartment. But I am here to discuss the economics behind this decision. you can just walk away. It is not an easy question to answer and there is no one-size-fits-all answer. it can be a disadvantage for the following reason: there is no accumulated equity. of course. The correct answer is: it depends. One advantage of renting an apartment is that you have no responsibility in the upkeep of your place. and when you are done. there is equity buildup over time. While this may seem like an advantage. you have no assets to show for it. all you have to do is to call the landlord. As the house sits empty there are still utility bills and mortgage payments to be made (additional cost). your property increases in value. in part.34 Chapter Nine you buy a house for $250. And if you are a doit-yourself-er. you can bring down the cost of home ownership even . you have paid down your mortgage to an outstanding balance of $200. The difference of $100. On balance. Let’s say for argument that five years later the property is worth $300. If you sold the house at that point you walk away with approximately $100. but they are small compared to those associated with a mortgage. This is a major advantage of buying over renting. However. by then. And sometimes your monthly mortgage payments could be lower than your monthly rent payments on a comparable property. they take time to sell and convert to cash.” Simply put. by property value appreciation. a major disadvantage of home ownership is the fact that houses are what economists call “illiquid assets. But the big difference is that with a rental you have no equity build up.000 is your equity. associated with selling a house.000. you partially pay down your mortgage and. and take out a loan of $225. while with a purchase. That means that there is a significant cost. the amount of equity buildup varies from place to place.000. you do. Further. driven.000 in your pocket.000 from the bank. Over time.000 and. if you are planning to live in a neighborhood for five years or more. Do rent payments and mortgage payments differ by a great deal? Not really—they are comparable. It is true that renting also carries some tax deductions. it makes economic sense to buy a house. This can result in significant reductions in the tax bill for a lot of people and families. There is an additional benefit of home ownership over renting: paying less taxes. The government provides a tax deduction on the interest paid on a mortgage over the year. Of course. both monetarily and non-pecuniary. if you have bought wisely. you may not get your asking price and may have to settle for less. about. through savings in home repairs and other related modifications. Further Reading: http://homebuying.Rent an Apartment or Buy a House? 35 further. Given the tremendous tax advantages of homeownership in this country.com/od/buyingahome/Home_Buying_ Tips_Tricks_Techniques.htm . it makes sense to buy a home—but only if you plan to stay in it awhile. . with a monthly payment of about $1.000 in cumulative interest. Another clear benefit is that we pay less in interest charges over the life of the mortgage. Wouldn’t you like to experience that sense of freedom as well? And you may. What are the benefits of early payoff? The obvious answer is that we do not have a large mortgage payment every month.10. we would pay about $232. Ah. or even save it. There are advertisements on television and in the print media extolling the virtues of paying off your home mortgage as quickly as possible. consider a thirty-year fixed rate mortgage of $200. For example. That is certainly a major burden off our shoulders.199. This would free up that money and enable us to spend it on something else that might give us a lot of pleasure.000 at 6 percent interest. However. but the question is: does it make economic sense? Let us consider the facts. what a wonderful feeling that must be. Simple calculations reveal that if we hold the loan for the entire thirty-year period. if we were to add $100 to our monthly mortgage payment with instructions to apply this $100 toward principal 37 .CHAPTER TEN Should You Pay off Your Mortgage Ahead of Schedule? This is an interesting conundrum all homeowners face. 000.000 per year. consider the following: the federal government of the United States of America allows homeowners to deduct. Assuming a tax rate of roughly 28 percent.000 is principal repayment. This lowers the amount of taxes we pay every year. the sooner we lose an instrument for lowering our taxes—and I know for a fact that most (if not all) of you hate paying taxes. Let us say we have a $240. where most of your monthly payments are interest (very little goes toward principal repayment). What are the costs of such an action? In order to answer this. If our adjusted gross income is $150.000.000.38 Chapter Ten repayment only. To understand the tax benefits of having a home mortgage loan. and would have made a cumulative interest payment of about $182. and we apply the $12. Based on twelve monthly payments.000—of which $1. In other words. dollar-for-dollar.000 mortgage loan with a monthly payment of $2.538 (a 21 percent savings). our federal tax bill would be $42. Likewise. the amount of the interest payment on a mortgage loan (and even home equity loans) from our taxable income. if you are deep into your mortgage payment (this happens after you are about two-thirds into the life of your mortgage—say around twenty years into your thirty-year loan) where most of your monthly payment is going toward principal repayment (relatively little toward loan interest).000 interest payment to our gross income.640 in federal taxes. . The difference can get larger. we would pay off our entire mortgage in less than twenty-five years.360 more in taxes. your incentives to pay off the rest of the mortgage increase. If you have an interest-only or a balloon payment mortgage. our total interest payment is $12. we end up paying $38. we would be paying $3. consider the following example. our taxable income drops to $138.000 is interest and the other $1. The sooner we pay off our mortgage. since your tax advantage declines. Without a mortgage. your tax savings increase. depending on the kind of mortgage you have. keep in mind that the tax advantage starts to fade relatively late in the mortgage cycle. If yours does. is important to you. It also provides extra spending (or saving) money in your monthly budget. do not pay off your mortgage—even if you are able to. The downside is that you lose the annual tax advantage you were enjoying while you had the mortgage. Most loans from respectable lenders do not have this feature. then the prepayment penalty will have to be factored in (as an added cost) to your decision on whether to pay off your loan early. as the previous example reveals. This discussion assumes that your mortgage loan does not have prepayment penalties associated with it. . the tradeoff boils down to the following: by paying off the mortgage early you save significantly in interest payments. and less toward the loan interest.Should You Pay off Your Mortgage Ahead of Schedule? 39 So. then you should pay off your mortgage as quickly as possible. If the added financial freedom. However. as well as the fact that you are paying less in interest over the life of the loan. it becomes more attractive for you to pay off your mortgage at that stage. as you do not have to make a mortgage payment. Consequently. as more of your loan payments go toward the outstanding principal of the loan. If you do not want to pay additional taxes. . CHAPTER ELEVEN Cell Phones or Land Lines? I Just Called to Say— I Don’t Need You! The use of cell phones has exploded in most of the world. but they are not inexpensive. You can even store pictures of your children and your pets to share with friends. depending on the plan. The monthly cell phone bill can range from $25 to $100. Along with our cell phones we also have our old land lines. They co-exist. and it is hard to imagine life without it. and even send and receive e-mails. The benefits of a cell phone are that they are portable and they have quickly become an indispensable part of our lives. We can text. The phone number is well known among your friends (and a few telemarketers). 41 . or do we axe the land line? What are the benefits of a land line? It is convenient. Most of us have had a land line for a long time. They are cool looking and have interesting ringtones. call. So the economic conundrum is: do we maintain both the cell phone and the land line. Some of the costs are a one time purchase price ranging from zero to up to a few hundred dollars (iPhone. while basic land lines cost $60 or more. so there is a convenience factor. do you need them both? This one is actually easy. Think of the cell phone as “land line phone plus. So.42 Chapter Eleven anyone?). .” My family happens to live in a wooded area. We were already paying for high speed internet. For most of us. a monthly fee. since the cell phone can do everything the land line can do and then some. and cell phone reception is not the best. Assuming you don’t have horrible cell phone reception in your house. but also wanted the stability of a “land-like” line. For a small annual charge we can now make free domestic calls. so we compromised and bought a magicJack. the dominant strategy is to get rid of the land line. Another advantage of the magicJack is that you can take it with you when you travel internationally and use it to make free calls back to the United States. Get rid of one. and it serves as a backup to our cell phone when we are home. you are being economically inefficient by maintaining both. We felt that we were overpaying for our land line. This is a small USB device that plugs into your computer. and the implicit costs of bad reception and dropped calls. the credit card companies have a name for you. (drum roll): it depends! Before you decide what kind of a credit card is good for you. or free balance transfers? Or should we focus on the interest rates charged if we don’t pay off the entire balance at the end of the billing cycle. miles. Credit card companies are constantly trying to seduce us with promises of zero percent teaser rates for balance transfers.CHAPTER TWELVE What Kind of Credit Card Should You Sign Up For? Let’s face it: credit cards are a global way of life. The question most of us face is: what kind of cards should I sign up for? Those that promise us cash back. Are you a person who pays off her entire credit balance at the end of the month? That is. You 43 . free airline miles. These little pieces of plastic are how most of the world’s consumer commerce works these days. and other items from designer stores tied to how much money you charge on the card. or the default rate if we were to be even a day late in our payment? And the answer is . do you usually avoid rolling your balances over to the next billing cycle? If you are. Most of us carry multiple credit cards and are continuously barraged with offers for more. . . you have to ask yourself what kind of a consumer you are. extra gifts. But. Once you get caught in that cycle. If not. If you are the former. you could look at the rewards offered by those cards. or your loved ones. In economics we call someone like that “interest rate insensitive.” The rate can be sky high and it will be of limited consequence to you. Then. it is difficult to free yourself. you will need to pay attention to the card’s interest rate—maybe even those teaser rates for free balance transfers for six months or longer. ask yourself: how often do you travel? Are you a frequent shopper from online stores? Do you like getting those cash back checks? If you happen to be a frequent traveler. which is it for you? . are you habitually a partial payer (a revolver). especially the default interest rate. Contrarily. and like to carry over your balances into the future? If you are a revolver. you should gravitate toward cards that provide frequent flier miles. you do not care about interest rates banks charge for your unpaid balance. you might like the cash back provided by some cards. So. if you happen to be a habitual revolver. if you happen to be a revolver. You could then use that money to buy yourself. you want to pay attention to the interest rates charged.44 Chapter Twelve are a “deadbeat” in their eyes! Or. That is where the banks really get you. If you have determined that you are not a habitual credit revolver. the credit card companies love you and don’t call you derogatory names. you cannot turn on your TV without seeing newer machines selling at prices significantly lower than what you paid for your current clunker. To make matters worse. and the computer’s processor is simply not capable of handling them. You have a clunker in your study that you bought for a significant sum of money a few years ago that is now basically sitting and collecting dust. time has diminished its usefulness and its abilities. just like we do with cars. and therefore it may behoove us to think about the question from an economic perspective. You wish that there was an easy way to trade in that clunker for a brand new one. 45 .CHAPTER THIRTEEN When Should You Buy That New Laptop? This is a question we will all probably face many times in our lives. While it was the state of the art then and was a source of great excitement. We may even be asked to provide our input on this matter. If it feels like you can get more computer for less money—you are right! It is frustrating. Our files are larger and applications more complex. 46 Chapter Thirteen What is one to do? When is the right time to order the next laptop? The answer may surprise and disappoint you. If the combined value of the pleasure of a new computer and your increased productivity make up for the lost value. sit tight and use the existing computer. Otherwise. This implies that prices of computers have been decreasing over time. we may come to a different conclusion. newer ones will be selling for less with more features. You buy the computer today and. You have lost that very instant. The strict economic answer is: never! Computer prices have demonstrated one consistent trend over time: they are downward sloping.deals2buy. but you are getting more features for that price. The decrease is even more significant when you consider the fact that you are not only paying less overall. From a strict economic standpoint. therefore. what is your optimal wait time for the next computer? The answer is infinity. you should buy the new computer. In practical terms. there is no right time to buy your next computer! Does that mean that you should never buy a new computer? I did not say that—I just gave you the strict economic argument. and include factors like the value of the pleasure that a new computer affords you and your increased productivity from a new machine. Maybe a good dusting and a few dollars spent upgrading the existing computer is all you need. tomorrow. Here is the problem: you have an outdated product the moment you purchase a new computer. Further Reading: www.com . if we relax the above pricing argument. Now. . the decision seems like a no brainer. the answer seems obvious. Used books are cheaper than new ones. Really? Here is the economics behind their seeming generosity. They want you to believe that it is a selfless service they are providing to the student community.CHAPTER FOURTEEN Buy College Textbooks New or Buy Them Used? This is a debate that plays itself out at the beginning of every semester on every college campus around the nation. and proudly proclaim they are doing it purely for the students’ benefit. So. Their magnanimity is touching. . That is pure profit for the bookstores. and the savings add up. Hmmmm . You save about 25 percent (sometimes a little more). simply for stocking the book on their shelves. The bookstores promote the used books aggressively. BUY USED BOOKS! And why not? On the surface. a book priced $75 by the publisher is marked up to $99 (and sometimes more) by 47 . for example. Bookstores buy new books from the publishers and then mark them up about 25–35 percent. From a student and her parents’ standpoint. The students and their parents flock to the university bookstore and buy copies of the book and. So for the $99 book. The same university bookstore now starts to promote their desire to buy back used books aggressively around campus. Now. the publisher gets $75. They bought back the used copy for about $25 and sold it back for $70. since they don’t have to pay anything to the book’s publishers or its author. the bookstore stacks up the used books right next to the new ones—except that the new book is selling for $99 while the “same” used book is selling for $70. think about this from a bookstore’s standpoint. If I am a student or her parent.48 Chapter Fourteen the bookstore. Not a bad deal for the student—the $25 certainly comes in handy—especially for a book she may not have cared too much about in the first place. for each book sold. The difference—$45—is pure profit for them. I naturally make a beeline for the used copy and save myself $29 in one transaction. Let’s reexamine the scenario a bit more closely this time. Typically the buyback price varies between 25–40 percent of the new price. while the bookstore keeps $24. They set up trailers and other makeshift purchasing locations around campus—usually close to residence halls— and pay cash for the used books. It seems like a win-win. Who do you think is getting left out of the equation above? The publishers and the authors of the books. Here is where it gets interesting and complicated all at the same time. right? The bookstore is making more in profits and students are paying less for their books. of course! . At the beginning of the following semester. So far so good. One semester rolls by. the student might get $25 back. You will be paying more for new . What is the optimal economic strategy for the authors? That would be to write a new version of their book often. Doing so ensures that the existing inventory of used books cannot be resold to students and that the proceeds from the sale of new books come back to the publishers and the authors. at the very least. one semester after the publication of a new book or a new edition of an existing book. we are gaining in the short term. publishers have to make a profit from the books they publish. you are really paying for those small savings you receive when you buy used books through increased prices for new books. as well as make a profit from the books they publish. they will have some chance of recouping their costs. increased prices for used books—as the increase in the price of the new book means an increase in the price of the used version as well. those earnings do not come back to the publishers or the authors.Buy College Textbooks New or Buy Them Used? 49 Just like everyone else. Typically. Therefore. the sales of the new copies drop drastically as the used book market takes over. Every time a bookstore resells a used copy of the book. thereby choking off revenues and royalties back to the publisher and the authors. what is the most optimal economic strategy for the publishers? That would be to simply increase the price of the new book. That way they are assured that. and by extention. Therefore. Under these circumstances. when we buy used books. but losing in the long term. and authors need the royalties from the sale of their books for their own livelihood. Think about it the next time you are about to hand over your books to the bookstore’s purchasing agent. The cost of the bookstores buying and selling used books is eventually passed down to the students and their parents in the form of increased new book prices (which is precisely what we see). on the other hand. and publishers will not need to increase book prices. And that will help all students and their parents! .50 Chapter Fourteen (and used) books before the beginning of the next semester. over time. If. the shelf life of new books will increase. you do not sell your book back. The money you put into this IRA will also grow tax deferred. After that. and you contributed $5. The logic is that because you got all those tax breaks for these years.000 to this IRA. There is an immediate advantage of a traditional IRA. So. just like a Roth IRA. you have to pay the piper now.000 every year) is tax deductible. you might be hit with a $340.000. if your adjusted gross income is $50.000 tax bill. what is a Roth IRA and what is a traditional IRA? A Roth IRA is an individual retirement account into which you put after-tax money that then grows tax deferred until you are about sixty years old. So.000 in a given year. In contrast. if your account is worth $1. Since you are paying taxes on the money as you put it into the Roth IRA. you will have a tax bill of about 34 percent of the accumulated amount. you can access the account and take all the money out tax-free. a traditional IRA is an individual retirement account in which the money you contribute (up to about $5. your taxable income is $45.000.CHAPTER FIFTEEN Roth IRA or Traditional IRA? First. the government does not ask you to pay taxes again. Which one is better? You got it: It depends! 51 . except that when you access the account at age 60.000. However. when I use the example of Axl Rose I do not mean that literally since. That is precisely when we will receive the added income of the maturing IRA. They will allow you put in the $5. but you will not be able to deduct it for tax purposes. For you. By the time we reach the higher end of the tax bracket and the IRA matures. if your income is as high as Axl’s. it may not make sense to have a Roth IRA since you are at your highest tax bracket early in life. the government will not allow you to get a tax break from your IRA contributions.52 Chapter Fifteen For most of us with incomes that will increase over our lifetimes— economists call it an “upward sloping income curve”—we will be at our highest tax bracket at the end of our careers. The reason for that is that the government believes that you make too much money anyway and do not need the additional tax break. the Roth IRA makes sense for most of us. For such people.000 annually. the Roth IRA is a better alternative. Thus. resulting in that large tax bill I mentioned earlier.rothira. it is more sensible to have a traditional IRA. This is an example of the fairness principle whereby those less fortunate deserve the tax breaks that the more fortunate will not have access to. who hits his income peak in his twenties. because we are paying taxes on our contributions when we are on the lower part of the upward-sloping income curve. Of course.com . if you are someone like Axl Rose. where you are able to get a tax shelter earlier in your life when your tax burden is higher and then pay taxes on the accumulated amount when your tax rate is lower. Further Reading: www. that money is tax-free. Dependents are people or living beings (cats. however. homeowners insurance. you do not need life insurance. and What Kind Is Best? This is a question one encounters for the first time soon after graduation. birds. health insurance.CHAPTER SIXTEEN When Is the Right Time to Buy Life Insurance. dogs. we will analyze the question with economics in mind. Here we will restrict our discussion to life insurance. Here. If you come up with a total count of zero. and so on. there are other kinds of insurance for specific needs. 53 . Additionally. there are different kinds of insurance for different aspects of your life: life insurance.) who might depend on your income for their survival. accident insurance. and auto insurance. So. You need life insurance when you have dependents. As we all know. and you will usually get a different answer depending on who you ask. These are the foundational insurance policies. like travel insurance. look around you and count your dependents. dreaded disease insurance. etc. there is nothing to show for it. This is a convenient arrangement. and so does your insurance premium for a given level of coverage. That way you get the benefit of life insurance at an affordable rate when you are young. those earlier overpayments start to subsidize your current premium payments. These are like term life policies. your risk of dying increases. since it ensures that you are not priced out of insurance as you age and your need for it increases. As you age (and your insurance premiums increase). making it expensive as you age. Whole life insurance policies are expensive initially (when you can least afford it) but become useful and affordable as you age. one major problem with these policies is that as you age. cheapest. let us say you do have dependents. and part of those overpayments accumulate as savings. Here is the tradeoff: term life insurance is cheap initially but has no cash value component. After you cancel the policy. there is coverage up to the face value of the policy as long as you are current on the insurance premiums. These policies provide you and your dependents with insurance coverage without any frills. However. so that the amount you pay out of pocket remains the same. So what can you do? An economic compromise may be to buy term insurance that converts to a whole life policy as you age and can afford the increased premiums. You are now a candidate for buying life insurance. The problem lies in the early overpayment part—since a lot of young people cannot afford the relatively high premiums. except with a savings component built in. Basically. and can move up to the whole life . Then the question is: what kind of insurance should you purchase? The oldest. The way they work is as follows: in the early years when you are young (and your risk of dying is low) you overpay on your premiums. and most efficient form of life insurance is called term life insurance. There are also whole life insurance policies.54 Chapter Sixteen For this discussion. Another option may be to buy term life insurance. and invest the difference between that and a comparable whole life policy in the stock market.When Is the Right Time to Buy Life Insurance . 55 policy as you age. . A word of caution about the latter option: only opt for it if you are confident in your investing knowledge and understand the risks involved. . . . it would adversely affect your dependents. affords you the maximum coverage per dollar of premium. and protects you only as long as the policy is active. This is an economic discussion of the benefits and costs of our longevity and how it may affect insurance companies’ profits. When you stop paying rent. Term life insurance is the cheapest.CHAPTER SEVENTEEN Do Insurance Companies Want You to Live Longer or Die Sooner? I do not mean to suggest that somehow insurance companies are out to get us. or that they maintain a team of hit men on their staff. you have to leave. In this case. After you cancel it. Life insurance is essential when you have dependents that rely on your income. there is nothing to show for it. 57 . If something were to happen to you that would interrupt the income stream. In other words. term life insurance works much like renting an apartment. a life insurance policy becomes essential in order to financially provide for them. You get to live in it as long as you pay your rent. Life insurance policies come in two major kinds: term life insurance and whole life insurance. So. Let’s try to see these ideas on the graph below. Suppose at twentyfive years of age you purchase a $1 million policy. your beneficiaries would get $1 million (as per the contract) except that $10. If you were to pass away at this age. The insurance company will provide the remaining $990. If you cancel the policy at any time. the cash value of your policy equals its face value. Now. This cash value buildup is your money—not the insurance company’s. These policies charge you a higher premium per dollar of coverage than term life policies do. By now. the cash value of the account (minus fees) is due back to you.” and builds up cash value over time.000. After fifteen years. This is designed such that when you reach 100 years of age. when you pay your insurance premiums. the cash value is $10. Assume that every year you pay $750 in premium and a part of it goes to the cash value of your policy. Specifically.58 Chapter Seventeen Whole life insurance policies work differently.000. your cash value has built up to about $450. a part of each premium collects in a pool as cash value and slowly builds over time. fast forward to when you are seventy-five years old. your beneficiaries would still get the $1 Million Face Value Policy Dollars ($) Insurance company pays this Insurance company pays this Cash value buildup Cash value buildup Cash value buildup Age . The difference is that some of the excess premium you pay accumulates in a “savings account.000 of that money will be your own cash value. if you were to pass away at forty.000. I would not be surprised if insurance companies were funding studies to extend human longevity! . equals the face value. from an economic standpoint. . by design. they want you to live as long as possible—until at least 100 years of age. The remaining $550. the cash value of your policy.000 of it will be your own cash value. the cheaper it is for insurance companies to fund your death benefit to your chosen beneficiaries. The insurance company pays nothing from its own coffers! These are the economics of life insurance cash value policies. but $450. You get the picture? And if you are still alive when you reach 100 years of age. Therefore. Put another way. you have funded your face value yourself through the savings component of your policy. Your insurance company will close out your policy and send you a check for $1 million.Do Insurance Companies Want You to Live Longer . 59 $1 million. The longer you live. .000 comes from the insurance company. . opine on a topic. After all. Specifically. I experimented with advanced technology in the classroom. A lot of people have asked me what I hoped to gain from this. disagree with anything I said . which would show up on my computer screen. I believe that these social networking tools are valuable.CHAPTER EIGHTEEN How Should We Use Technology in the Classroom? Recently. . Just like tweets. you get the point. . I could choose whether or not to respond. they were allowed 140 characters to post their thoughts. since kids today are using them to communicate with each other. However. Students could ask me questions. the conventional wisdom is that young adults are distracted enough as it is—without giving them further ammunition for goofing off in class. the holy grail of higher education in 61 . Can we as educators use these tools to reach them in the same way that they are communicating among themselves? In fact. when an extensive article on my use of Hotseat in the classroom came out in The Chronicle. we used a variation of Twitter developed by the IT staff at Purdue called Hotseat in order to allow students to “tweet” their questions or comments in real time while I was lecturing. Another benefit is that students feel emboldened to ask questions or to share an opinion which they otherwise would not. The other cost is that the questions themselves can be a distraction which can take away from teaching. what are the benefits of allowing students to tweet in class? The obvious benefit to me is that I allow students to ask questions silently. However. A lot of faculty members do not believe in giving students that much control in the classroom. I have the ability to either respond to it myself. or to ignore it altogether. I could then use the question as a cue to explain the topic more clearly. many esteemed readers of the article opined that I was an “idiot” for allowing students to tweet in class. using different examples. Being an economist. Another cost is that a subset of the students might use this medium to tweet messages unrelated to the course content. Allowing them to tweet instead. I have to say that such comments did make me proud. I had to think about the economics of tweeting in class.62 Chapter Eighteen the United States. Even if I ignored it. reveal a level of understanding of the material I am covering in class that I did not see in years past when there was not the same kind of technology present in the classroom. have someone else in class who is logged into Hotseat respond to the question. the instructor. For me. the instructor. At eighteen or so the students are shy around their peers and don’t want to look silly. I have noticed that the questions that the students tweet to me. I could see if the question itself suggested that I may not have properly explained a particular topic. It was clear that my approach to teaching had touched a nerve in many people. . gives them a sense of control that encourages them to open up in ways they would not otherwise. anonymously to their peers if they so chose. What are the costs of using this technology? The obvious one is that there may be questions tweeted by the students which might be uncomfortable for the professors. and thereby create a distraction for others in the class. somewhat naïvely. every ten to fifteen minutes. Now let’s focus on the students. they are using a technology they are already familiar with in a social context in order to ask questions. that I could teach. Using Hotseat was beneficial to me—although it may not be so for other teachers. So. it was a disaster. Also. nothing worked. but the cost was manageable. And why not? I had seen television personalities do it. or even provide additional insights based on their personal experience.How Should We Use Technology in the Classroom? 63 A final cost. For instance. if I am forced to constantly monitor the postings and respond to questions and comments during class time. When I tried to do it all simultaneously. I thought. I would stroll over to the lectern where the computer was located and check the accumulated postings that the students had tweeted. and this is true . I was just not that smart! It was a humbling realization. My timing was off and I was a wreck. can I still effectively function as a teacher and cover the material? This was a problem when we first started with the Hotseat experiment. What’s the benefit to them of using this technology in class? First. I had time to do this about three to four times during a fifty minute lecture. I decided that the best strategy for me was to look at the Hotseat postings only infrequently while I taught. and one that I consider relevant. So. is what the posts themselves might do to my effectiveness as a teacher. and respond to them all at the same time. For instance. I could not teach and respond to the postings simultaneously. I would respond to the remaining questions after class. after a bit of experimenting. as in conventional classrooms. it was costly. in the end. How hard could it be? Well. That worked well for me and for the students. It keeps them engaged and actively involved in the education process—instead of being a passive recipient of the teacher’s lecture. I would pick a few interesting ones to respond to. and then resume my lecture. post comments. look at the postings. when a natural break in my material occurred. the teachers. in my opinion. students are normally too intimidated to raise their hands and ask questions. A few brave souls do. It is time we. It appears to be a win-win—from both a student’s and a teacher’s standpoint—although the net benefits are probably greater for the students than they are for the professors. Be that as it may. more often than not. Alas. . the use of social media in our education process is here to stay. adapt to the new teaching techniques and learn to take advantage of the benefits such technologies can offer. Some have asked why I was unable to make my lectures so riveting and attentiongrabbing that students would be compelled to listen. and are similar to the costs of distraction in any conventional classroom. The costs to the students are relatively insignificant. Whether we like it or not. it has been my experience that students are relatively more engaged through this medium than they are in conventional classroom settings. Overall. lost in their own world. but the rest are silent and.64 Chapter Eighteen especially in large classrooms. that ship has sailed and I am who I am. texting their friends or surfing the Internet on their laptops. there appears to be a net benefit to the students when this technology is used in the classroom.