Investment Fundamentals
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Investing vs. Saving
Saving
- Accumulating excess funds by spending less than you earn
Investing
- Taking saved money and putting it to work so it can make more money
- Common investments: stocks, bonds, mutual funds, real estate
Portfolio
- Your portfolio is the collection of investments chosen to meet goals
Are You Ready to Invest?
Signs you’re ready:
- Live within income
- Save regularly
- Use credit wisely
- Carry adequate insurance
Common reasons people invest:
- Reach goals (vacation, car, etc.)
- Build wealth/financial security
- Increase current income
- Meet retirement needs
Sources of Money to Invest
Ways to free up investable cash:
- Pay yourself first
- Save windfalls/bonuses
- Contribute to employer retirement plan at least to get the match
- Automate saving/investing
- Break a habit and redirect spending to investing
Returns: Current Income + Capital Gains
Total return
Total return comes from:
- Current income: interest, rent, dividends
- Capital gain (or loss): change in value realized when you sell
Capital gain example structure
Use this text formula:
Capital Gain = Sale proceeds – Purchase cost – Transaction costs
Rate of return (yield)
Yield = Total return ÷ Price paid
Handling Investment Risk
Core idea
- Higher risk → higher potential return (investors demand compensation for risk)
Risk premium
Risk premium = extra return demanded over a “safe” return (often benchmarked to T-bills).
Lecture framework example:
- If T-bills return (1.5\%) and investors want a (3\%) risk premium:
- A top-quality corporate bond might target roughly (1.5\% + 2\% + 3\% = 6.5\%)
- Stocks might target roughly (1.5\% + 4\% + 3\% = 8.5\%)
Investment Philosophy (Risk Tolerance)
Risk tolerance
- Ability to handle swings in investment value
- If investments cost you sleep, risk is too high for you
Conservative philosophy (risk averse)
Focus: protect against loss; accept lower return.
Typical examples:
- Government obligations (T-bills/notes/bonds)
- Municipal bonds
- High-quality corporate bonds/stocks
- Balanced mutual funds
- CDs, annuities
Moderate philosophy
Focus: slow/steady growth + some income.
Typical examples:
- Dividend-paying stocks
- Growth & income mutual funds
- High-quality corporate/government bonds
- Real estate
Aggressive philosophy (risk seeker)
Focus: capital gains; accepts high volatility.
Typical examples:
- Fast-growing/new-company stocks
- High-yield (“junk”) bonds
- Cryptocurrencies
- Aggressive-growth mutual funds
Active vs. Passive Investing
Active investor
- Studies economy/markets, monitors often, buys/sells multiple times per year
- Tries to time news/events
Passive investor
- Makes regular investments; rarely trades for short-term profit
- Often uses broad mutual funds/index funds and ignores “hot tips”
- In the long run, passive approaches often outperform active after costs
Lending vs. Owning (Debt vs. Equity)
Lending investments (debt)
You receive an IOU plus interest:
- Bank deposits, CDs
- Government bonds
- Corporate bonds
- Annuities
Characteristics:
- Fixed maturity (principal repaid on a specific date)
- Fixed income (interest rate promised)
Ownership investments (equity)
You own an asset:
- Common/preferred stock
- Mutual funds
- Real estate
Characteristics:
- Potential for current income, but emphasis often on capital gains
Time Horizon: Match Goal to Investment
Short/intermediate horizon (≤ ~5 years)
Goal: preserve value; prefer stability and predictability.
- Usually more current-income focused
Long-term horizon (10+ years)
Goal: growth; can tolerate more risk.
- Seek capital gains + current income
Diversification (Reducing Random Risk)
Random/unsystematic risk
- Risk of owning too few investments (one company lawsuit/recall can crush you)
Diversification principle
- Reduce risk by spreading money across multiple opportunities
Key Terms & Definitions
| Term | Definition |
|---|---|
| Saving | Spending less than you earn; accumulating funds |
| Investing | Putting money to work to generate more money |
| Portfolio | Collection of investments |
| Current income | Interest, rent, dividends received while holding |
| Capital gain/loss | Profit/loss when selling an investment |
| Total return | Current income + capital gains |
| Yield | Total return ÷ price paid |
| Speculative risk | Potential for gain and loss |
| Risk premium | Extra return demanded for taking risk |
| Diversification | Spreading investments to reduce random risk |
| Debt investment | Lending money for interest (fixed claims) |
| Equity investment | Ownership claim (variable outcomes) |
Exam Tips
- ✅ Be able to break total return into current income vs. capital gain.
- ✅ Know yield as a percent: total return ÷ price paid.
- ✅ Risk premium logic: risky return must exceed “safe” return.
- ✅ Match investment choice to time horizon (short-term ≠ stock speculation).
- ✅ Diversification primarily reduces random/unsystematic risk.
Practice Problems
Problem 1: Yield
You buy an investment for $4,500. You receive $300 in dividends and sell later for a $500 capital gain.
Find: total return and yield.
Solution:
- Total return = 300 + 500 = 800
- Yield = 800 ÷ 4,500 = 0.1778 ≈ 17.78%
Problem 2: Debt vs. equity (concept)
Which investment type has fixed income and fixed maturity?
Answer: lending (debt) investments.
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