Finance: Time, Risk, and Money Value

• The financial system impacts life through savings, loans, and investments
• Employers may start retirement accounts, allowing investment in stocks, bonds, or index funds
• Media reports discuss stock market fluctuations and attempt to explain market behavior

Time & Risk

• Time and risk are key elements in financial decisions
• The financial system coordinates saving and investment, critical for economic growth
• Financial decisions and actions affect lives in an unknown future based on estimated outcomes

Finance

• Finance offers insights central to understanding how economies work
• Finance can also help people think through decisions to make in life
• This chapter covers:
• Comparing money sums across time
• Managing risk
• Determining asset value, like stock shares

Money Value

• Money is more valuable today because it can be deposited and earn interest
• Present value is used to compare money sums from different times
• The present value of a future sum is the amount needed today at current interest rates to produce that future sum

Future Value

• Calculating the future value of $100 in N years involves using the interest rate "r" in decimal form
• Interest paid annually and reinvested, it's called compounding
• Investing $100 at 5% for 10 years results in a future value of $163

Present Value Calc

• The present value of a $200 payment in N years indicates an investment amount today to yield $200 in N years
• The present value of $200 in 10 years at a 5% interest rate is $123
• An interest rate of "r", an amount "X" received in "N" years has a present value

Discount

• Discounting is the process of finding the present value of a future sum, reducing it by the interest earned
• The choice between $100 today and $200 in 10 years depends on the interest rate
• With a 5% interest rate, $200 in 10 years is preferable ($123 present value exceeds $100)
• With an 8% interest rate, $200 in 10 years has a $93 present value, making $100 today better

Interest Rate Matters

• The interest rate matters since a higher rate makes getting $100 today appealing
• The choice between real and nominal interest rates depends on whether the future sum is in nominal or real terms
• The real interest rate applies to inflation-adjusted dollars

Present Value in Investments

• Present value calculations aid decisions such as General Motors’ factory investment
• If a factory costs $100 million today and yields $200 million in 10 years, the decision depends on the interest rate
• At 5%, the present value of $200 million is $123 million, making the investment worthwhile
• At 8%, the present value drops to $93 million, making the project not worthwhile
• A lottery payout choice between $20,000 for 50 years ($1,000,000 total) and a $500,000 immediate payment involves present value calculation

Lottery Winnings

• The present value of a million-dollar lottery prize paid as $20,000 annually for 50 years calculated at a 5% interest rate, is only $383,000
• The $500,000 immediate payment is the superior choice

Risk Aversion

• Most people are risk averse which means that the dislike bad things more than comparable good things

Friend Felicity Deal

• A coin toss where heads wins $1,000 and tails loses $1,000 is often rejected by risk-averse individuals
• Risk aversion is modeled with the concept of utility, a subjective measure of well-being
• Diminishing marginal utility means the more wealth one has, the less each additional dollar provides

Utility

• A utility function shows that every level of wealth provides utility
• It flattens as wealth increases, showing diminishing marginal utility
• Losing $1,000 decreases utility more than an equivalent gain increases it

Risk Aversion Aspects

• Insurance, diversification, and the risk-return trade-off are aspects of risk aversion
• Insurance involves paying a fee to transfer risk to an insurance company

Insurance Examples

• Car insurance covers accidents
• Fire insurance covers house fires
• Health insurance covers medical costs
• Life insurance covers premature death
• Annuities provide a regular income stream in exchange for a current fee

Insurance

• Every insurance contract resembles a gamble
• The insurance company counts on most people not filing claims
• Insurance spreads risks across shareholders, rather than eliminating them
• Markets for insurance face adverse selection and moral hazard, impeding risk spread
• High-risk individuals are more likely to buy insurance due to its benefits
• After buying insurance, individuals may be less careful, affecting risk behavior

Enron History

• In 2001, Enron went bankrupt amid fraud and accounting irregularities
• Executives were prosecuted and lower-level employees lost jobs and savings
• Employees had two-thirds of retirement funds in Enron stock, rendering it worthless

Risk Averse Advice

• Finance advises risk-averse people to diversify
• Diversification involves spreading risk across multiple assets

Insurance is Diversification

• Insurance is an example of diversification
• In a town of 10,000 homeowners, each facing fire risk, an insurance company spreads the risk
• Each person faces 1/10,000 of the risk, reducing individual downside

Buying Financial Assets

• People reduce risks to savings through diversification by buying financial assets
• Stock is an individual betting on a company's future profitability
• Stock can be reduced through placing many small, imperfectly correlated bets

Standard Deviation

• A statistic called the standard deviation measures the volatility of a variable

Risk-Return Trade Off

• One of the Ten Principles of Economics is that people face trade-offs
• Trade-offs occur between risk and return in financial decisions
• High real rate of returns are achieved through riskier savings that has a 8% rate of return for stocks and 3% for bonds and bank savings

Asset Class Examples

• Risky stocks: they are in a diversified group, having 8% average annual return and 20% standard deviation
• Safe alternative: having 3% annual return and zero standard deviation

Stock Values

• Stock prices depend on supply and demand, thus understanding required
• To achieve diversification, you would want to 20 different stocks from available thousands
• When you own stock, its important to consider both value and price

Over/Under Valued

• Overvalued: Price exceeds value
• Fairly valued: Price equals value
• Undervalued: Price is less than value
• Undervalued stocks are seen as a bargain

Fundamental Analysis

• Fundamental analysis is a research process that refers to the detailed study of a company to estimate its value
• Companies profits have a variety of elements such as the demand, capital, the degree of competition it confronts, the extent of unionization etc
• There are three ways way to approach this:
• Research yourself by for instance, reading the companies' annual reports
• Rely on advice of Wall Street analysts
• Buy shares in a mutual fund, which has a manager who makes decisions for you

Stock Watcher Numbers

• A key number is a stocks price; usually reported as “last” price is the price at which the stock more recently traded
• Another key number is the dividend: the amounts that are paid out to their stockholders
• Accounting profit that measures revenue less the cost of production is another important number to consider
• Earnings per Share are also important because they give you the earnings in the company relative to the other stocks

Efficient Markets Hypothesis

• Choosing stocks randomly by, for example, throwing darts leads people to believe they are led astray by luck
• The main point of this idea is to realize each company is followed closely by managers and they seek potential
• The way that stock prices respond is referred to as informational efficient: reflecting all available information

Random Walk Definition

• A Stock's random walk tells us to unless you have inside information, changes in stock prices should be impossible to be predicted.
• The only thing that can move a company's stock price is news

Index Funds

• The performance of index funds may come from the efficient stock market hypothesis as it is a theory about how financial markets work
• Managers that are working on a the funds often will not outperform the index funds
• Often 86% of of stock funds and mutual funds will perform worse than the broadly based index fund

Superior Performance

• The managers may have beat the market due to luck rather than being smarter
• Studies tell us one of the reasons these funds have periods that can outperform the market
• Stockholder rationality is very important to consider when looking at deviations in stocks prices deviating
• When a Stock rises far beyond its original value is often referred to as the speculative bubble