FHCE 3200 Week 2 Notes
FHCE 3200 Week 2 Notes FHCE 3200
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This 11 page Class Notes was uploaded by Morgan Notetaker on Monday August 22, 2016. The Class Notes belongs to FHCE 3200 at University of Georgia taught by Matthew Goren in Fall 2016. Since its upload, it has received 5 views.
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Date Created: 08/22/16
August 15, 2016 Module 1 A,B Cont. Why Financial Literacy Matters Many people—baby boomers now in retirement—don’t have enough money to live on o Money they have is often inadequate o Many people near retirement have a problem of outliving their money o Can be avoided if you start early enough o 50% of baby boomers don’t have enough o Average American is $4,000 in debt The more education you have, the more your net worth, wealth, and financial literacy increases o Most financially knowledgeable people are also the most likely to reach out to a financial advisor and ask for more help The more financial policies in place to protect people from going bankrupt, the better off the average person’s quality of life/ society is o Mandatory auto insurance, health insurance, etc. o Ex. People at individual levels may think auto insurance is a waste of money until they get into an accident and don’t have a car o If they don’t have insurance, then they’re out of a car and their quality of life plummets o By enforcing people to get these things, society as a whole is better Trend away from mandatory policies, guaranteed retirement income, pensions, etc. o Complex financial decisions being shifted from institutions to individuals o Ex. Nowadays, no pensions and people don’t contribute to 401k at all or nearly enough o Little confidence in getting social security Baby Boomers were financially illiterate and didn’t know how to deal with absence of pensions and retirement income Government had to step in with Social Security This bankrupted the system and depleted these resources for the next generation o Finances in general are more complex: ROTHs, IRA’s, ACA, etc. Characteristics of Financially Capable Individuals o Self-Regulation: Make yourself do things you don’t want to do Self-Efficacy: Belief that you can do it Self-Control: Actually pushing yourself to do it o Experience o Education/ Information o Interest o Being involved/ engaged in making financial decisions o Altruism Pathways to Wealth/ Financial Independency o Keep good financial records; tracking o Spending less than is earned o Maintaining appropriate risk management strategies Insurances Emergency funds o Saving money on a regular basis Module 1 C,D Risk Tolerance: Risk that you’re willing to accept Risk Capacity: How much risk you really should be accepting People who don’t have much money are risk-averse; not willing to take a lot of risk o If you don’t have the capacity, you shouldn’t be taking the risk Those who grew up wealthy are willing to take more risk than people who didn’t o This higher risk tolerance comes from a higher risk capacity o Higher risk tolerance grow wealthier o They invest in riskier things, which yield higher returns People who started poor tend to stay that way o Their risk capacity increases o Their risk tolerance doesn’t increase with the higher capacity Why is financial risk tolerance a big deal? o Investments in different asset classes require different levels of risk taking Ex. Savings accounts are very low risk; even if bank collapses the federal government insures it o Riskier assets lead to higher yields/ returns in order to remain competitive o Higher return from the market requires you to take higher risks o Amount of risk we take is constrained by our risk tolerance People are unwilling to take on additional amounts of risk o In order to take a little bit of risk people require a lot of return o No one will buy stocks or bonds unless given a higher return than a savings account o Assets from higher return (riskiest) to lowest: Stocks, corporate bonds, US government bonds, savings accounts How much should college students be investing in stocks fore retirement? o 95% of their portfolio What Increases Financial Risk Tolerance? o Experience of investing in financial markets o Educational attainment o Investment related education/ knowledge o Age o Gender o Other psycho-social factors Other Risk Tolerance Facts o Nobody is born with high financial risk tolerance; learned o What is riskier than investing in stocks? Investing in startup companies Investing in lottery tickets (don’t—there is such a thing as too much risk) o Risk taking behavior in other areas of your life does not mean that you are also financially risk taking o Risk tolerance can change- changes with the factors above o Everything else being equal, who accumulates greater wealth across time? Women more so than men; tend to take more appropriate amount of risk It is a 1% difference ($1 million) Men tend to make more over-confident risks o Perceived risk tolerance Risk Preference: prefer to be wealthy or poor? Important priority to someone? o Person’s ability to take risk determines how much wealth they will accumulate Risk preference determines whether they are willing to invest in certain assets o People unfamiliar with the financial market will prefer to stay away from them (stocks, bonds, wills, trusts, etc.) o Research indicates that people are awful at perceiving the riskiness of an asset Human Capital o Net Worth= Total Assets – Total debt o Total Net Worth= Net worth + Value of your human capital o Human Capital: your skills, knowledge, and capacity Your ability to work, learn, earn, and make rational financial decisions Increased with income, education, health, training, experience, skill development People most likely to be taking reasonable risks: Those with high income and advanced degrees August 17, 2016 Module 1 E,F Financial Decision Making Influences: o Constraints: Other needs, income, time o Ability to Prioritize: Goals, deadlines, needs vs. wants Complex decisions result from too many choices, not sure which choice leads to best outcome, too little information o Use heuristics to simplify choices o Could use wrong heuristic e.g. focus on APR when choosing a credit card but you won’t go in debt Neuro-Economics o Two-Mind Framework Fast: emotional, intuitive thinking based on heuristics How we make almost every decision Slow: rational, calculating, patient thinking o Constant struggle between the two o Many people favor one over the other o Certain situations favor one over the other: stressful situations can overwhelm slow thinking and force people to rely on fast thinking Heuristics can create bias o Status Quo Bias: preference for how things are, resistance to change, fear of making wrong decision o Loss Aversion: Fearful of loss Investors with 20 year investment time horizon tend to focus on short term losses and not long term gains o Optimism Bias: Most believe they will never experience painful losses, most believe they are a little better than average in their tasks, Leads to overconfidence and risky decisions o Confirmatory Bias: Seeking to confirm that their decision is correct People often check reviews about a product after they bought it instead of before Ex. Right-wing people more likely to watch Fox; Left- wing more likely to watch msnbc Watch Out o Many business use behavioral economics to increase profits form customers o Insurance companies raise their premiums Status quo bias prevents consumers from shopping around o Cell phone providers add extra charges to monthly bills Status Quo o Credit card teaser rates Status Quo o Consumer staples companies often reduce the quantity within their packages while keeping price constant Status Quo o Poor saving is in our ancestry Hunter-gathers focused on getting food day by day Bad at accumulating How to Use Biases to Our Advantage o Pre-commit to decisions: use deadlines, friends, family, colleagues to hold you accountable and reduce procrastination o Automate good decisions: automatically save money through your employer or banks; have bills automatically paid o Set clear goals: Clearly define where you want to be financially and then begin working toward that goals; small steps are best Other things that increasing savings o How much should we save every month? Setting certain amount is an anchor; forces you to do it o Save before you spend o Pre-commit to saving future pay raises “Save more tomorrow” proven to be effective Save extra dollar each month People must save today to sustain their life style in retirement The outcome of investment decisions made today can only be known in the future Many financial decisions have to be made with incomplete information Inter-temporal decisions o Choices made depends on person’s time preference o Present Oriented: Prefer spending more today and save less for the future o Future Oriented: Spend less today to save more for the future o Marshmallow Test: Require kids to sit at table, marshmallow is put in front of them; If they cant eat marshmallow in next 5 minutes, they get two marshmallows and can then eat both of them 2/3 of the kids ate the first marshmallow before time was up These kids were present oriented and didn’t wait The 1/3 that were future oriented, in the future, had higher SAT scores and were more content/ healthier in life Changing the construal of the situation helped make children future oriented “Think of the marshmallow as a brick”; majority of kids then waited Told them to sit on their hands while waiting (new status quo, bigger effort to change it and grab marshmallow); also resulted in more kids waiting We are not bound by our personalities; changing our thinking can help us make better choices Hyperbolic Discounting o Would you rather hand $100 today or $102 tomorrow? Most would choose $100 today o Would you have $100 one year from today or $102 one year and one day from today? Most would choose $102 o Having time pushed away allows us to be more rational o 60-70% of people make impulsive decisions in general o Many people to defer gratification, but not today—in the future August 19, 2016 Module E,F Cont. Make financial decisions based on your time horizon o If goal is ultra short-term, be very cautious with your investments Keep money in safe assets (Savings accounts, CDs, money market, etc. o If horizon is more than 10 years, you can take more risks (equities, stock, etc.) A longer period of time means we have a larger sample size so our guesses are more likely to be right o More certainty= less risk o Very little of the time you will lose money in the stock market when time horizon is 20+ years o It’s much more likely to lose money in the stock market if time horizon is just one day/ one month/ a few years The percentage of risky assets in your investment portfolio can increase based on when you need the money (time horizon) How to become future oriented o Practice self-regulation o Greater human capital attainment o Setting goals o Prioritizing goals o Deciding between needs and wants Module 1G,H Time Value of Money (TVM): takes into account the rate of return (interest) when comparing investments o Also called opportunity cost o Also takes into account the effect of compounding interest rates o The Rule of 72: How to find out how long it’ll take to double your investment N= 72/i N= Number of years i= expected rate of return o Future Value (FV)= Present value (PV) * (1+r) t r= rate of return, t= time or number of periods for which money is invested Ex. You start with $100 (PV). You earn 10% yearly (r) for two years (t). What will your balance be at the end of the two years (FV)? t 2 FV= PV*(1+r) = 100*(1.10) =$121 How Does Compounding Work? o Money can be invested We earn rate of return on the investment Longer time periods means more wealth because of this power of compounding You gain interest on your investment, then that interest gains interest, and that interest gains interest, etc. o Money can be borrowed Auto loans, student loans, mortgages We pay the lenders interest computed on a compounding basis o Money can be lent Governments borrow money (bonds) and corporations borrow money (stock) We earn interest on this money that we lend out How Fast Does Your Money Grow? o Based on APR (Annual Percentage Rate) o Ex. Bank pays you 2.4% interest per year. APR= 2.4% Monthly interest= 2.4%/12= .2% o If you know the monthly rate, multiply by 12 to get APR APR vs. APY o APR ignores compounding; simple rate o Annual Percentage Yield (APY) tells the percent by which your investment actually increases; effective rate o APY= [1+ periodic interest rate) (number of period]-1n year) o Ex. Bank pays you .2% interest monthly. APY= [(1+.002) ]-1= 2.68% “Number of periods in a year” is 12 if monthly, 2 if semi-annually, etc. o APY > APR if there is more than one compounding period in a year APR=APY if it’s annually compounded o Financial institutions quote APR or APY, depending on what they’re selling EX. Amy wants to go on a cruise. The ticket costs $600 (pv), and the trip is in one month. She borrows money to buy the ticket with an APR of 18%. The APY is 19.56% (r). She plans to pay $50 a month toward the debt (pmt). o How long will it take Amy to pay off the debt (N)? PV= 600, N=?, r= 19.56/12, pmt=-50, FV=0 Presently, the cost of the loan is $600, so that is the present value. Use APY for the interest rate, and divide that by 12 to get the monthly rate. She makes monthly payments of $50. The future value is zero because at that point the loan will be paid off and at a balance of zero. Solve for N (number of periods) N= 13.46 months (1.12 years) **Substitute used excel to solve for this, which professor says we don’t need to know ** Substitute used APR and not APY; I believe this is a mistake, so I used APY, but this is up to you o If Amy saved up $50 each month and earned an APY of 2% interest, how much money would Amy have after a year? N=1x12, r= 2%/12, PV= 0, FV=? Amy starts off with zero dollars, so PV= 0. Use APY as r, and divide that by 12 because we are looking at it monthly. She saves $50 each month, so pmt=50. Solve for what the balance of the savings account will be in one year (12 months) (FV). FV= $605.53 o Ex. Johns buys a car for $20,000. He has a 5 year car loan at 2% APR. How much monthly payment does he have to make to pay off the loan in 5 years? PV= 20000, FV=0, N=5x12, r=2/12, Pmt=? Pmt=$350.56 Module 1 I,J,K Setting goals helps us develop focus towards achieving an objective Make goals objective rather than subjective o SMART goals o Specific, measurable, achievable, realistic, time-bound
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