Economic Keys to Successful Investing

by astanhaus

Originally submitted for an Economic Literacy independent research project with Professor Christopher Ragan at McGill University.

Starring: the Kennedys, Carrie, Samantha, Miranda, Charlotte & Mr. Big, Joan Harris, Michael Ginsberg, James Bond, Bernie’s credit card, aliens, and a camel hair coat.

Interest Rate, Compound Interest, and the Rule of 72

Save? I was too busy spending my way to success. My fabulous outfits made me look like I should be running my company. Instead, I get the coffee.

I’ll be waiting approximately forever to earn the $$ that matches my outfits and pays off my closet’s credit card debt.

Forever is very expensive in debt-land.

Play with this compound interest calculator to see how $$ multiplied over and over again by an interest rate means more $$$$$$.

Compound interest goes both ways. Debt grows exponentially, but so does my cumulated savings.I’m hoping my saving account’s compound interest payments will pave the way to my own compound (à la the Kennedy Compound).

So how long would it take to double my $$?

The key # is 72.

If we divide 72 by an interest rate, the answer will tell us how many years until an amount of $$ is twice as much! Compound interest is truly a marriage of magic and math!

If I deposit $500 in a savings account with an interest rate of 5% (yes, not realistic for the times, but a girl can dream) it will be $1000 in … 72/5= 14.4… approximately 14 years!

In the meantime, any money I borrow I will have to repay plus interest to my lender (AKA my bank).

I noticed how the interest rate associated with my savings account is less than the interest rate I pay on my debt. Think I found the bank’s secret to making $$. Spread the word!

Balance Sheet

I’m rewatching the whole series of Sex and the City. I wish Carrie was real. We would for sure be besties, I tell myself. Her closet is covetable. Plus, I’m in a Mr. Big-esque love affair, so we would have lots to talk about!

Season 4’s “Ring a ding ding” was a fabulous review of what it takes for to bank to lend $$ for a mortgage. AKA a well-balanced balance sheet.

Aidan and Carrie have broken off their engagement (good riddance, he did not even match a fraction of her fabulosity) and Carrie is left with the option to vacate her apartment or buy it.

And in a key move (that I disagree with) she gave Aidan back her engagement ring.

Carrie gets all gussied up in a floral, primary colored dress for a trip to the bank, only to be refused a loan. She has no assets (stocks, bonds, property, fine jewelry) that could act as collateral (ways to pay off the loan if Carrie becomes strapped for cash).

From the Bank’s POV a mortgage is an asset. The interest payments associated with mortgages make the bank dream of dollar signs. Banks want to make sure dreams become reality (i.e. paid back plus interest). They have liabilities to pay off too. Banks need to make sure they have enough cash on hand to provide for customers’ withdrawal requests. Otherwise, uh-oh, bank run.

Miranda is the party pooper and mentions that if Carrie has a hundred shoes at $400 per pair, that’s $40k, “that’s your down payment.”

Carrie goes to Mr. Big (wearing a foreshadowing white suit) to learn about money. And leaves with a check for her down payment.

One of the most uncomfortable dinner sequences in the entire series ensues, as the subject of money is front and center. Samantha couldn’t say it any better, “Some people are funny about money.” Charlotte slurps her drink, while Samantha and Miranda offer to loan Carrie the money. Carrie rips up Mr. Big’s check.

In the end, after initial apprehension, Charlotte gives Carrie her 2.71 carat Tiffany wedding ring to sell and the proceeds become a loan Carrie can use for her down payment.

Banking Regulation & Moral Hazard

When spending my own money, I am frugal, bordering on stingy.

But when I was a young’un and had a credit card that Bernie paid, no expense was spared. Every want became an emergency must-have.

I know, it’s not great.

But I’m a needle in the haystack compared to the “too big to fail” banks who get crazy crafty with their balance sheet to make money, knowing the government has their back.

Yep, banks have the equivalent of Daddy’s credit card and invest & take on risk accordingly.

Banks feel that they are the government’s equivalent to Daddie’s princess–who cannot fail– no matter what happens to their balance sheet.

This is only magnified when, for example, you have a former Chairman/CEO become Secretary of the Treasury. (AKA Henry “Hank” Paulson of Goldman Sachs).

Sure, I’ll scratch your back, if you scratch mine.

Inflation & CPI

When I gained 15 lbs freshman year of college, it was a battle of the bulge to get dressed each morning. I refused to acknowledge my new figure by buying it appropriate clothes.

Anyway, when I finally caved and bought new clothes (à la Joan Harris), I felt and looked better.

And when I eventually lost the weight, it was not easy. I only ate fruits and veggies.

I’m sharing this fascinating life story to explain inflation.

Hmm yes, what is that? Why does it make everyone act like a scaredy cat?

Inflation means the dollar menu’s portions are smaller for the same price. [stomach growl] Inflation is when the price level is rising. AKA on average, all prices are on the up. What we need to know, less purchasing power.

Key #: 2. The Federal Reserve’s annual inflation target is 2%.

But with my paycheck the same, the price of fun (and essentials) rises.  I didn’t think it was possible, but drinking Manhattans can take an even bigger bite out of my paycheck.

It may feel like forever, but eventually my wage will match the dollar’s inflation. And if I’m lucky, a bit more.

New clothes to match my new bod. New wage to match my new purchasing power.

There must be a way to track prices…

Consumer Price Index (CPI) is where I will find my answer.

CPI is an inflation warning sign. Rising average prices signal inflation. It’s produced by tracking a variety of good’s prices month to month.

Not only do businesses price their goods accordingly, but companies also alter their workers’ salaries accordingly.

Hm, was my recent raise real (I’m doing a superb job) or nominal (adjusting to inflation)? Hopefully it was both!

Investment Vehicles pt. 1

Now that I know I need assets for a mortgage and must find a way to fight inflation, where should my money go? Two basic forms of investment vehicles are stocks and bonds. I’ll first explain what I’ve learned about stocks, and bonds will follow.

“At last, something beautiful you can truly own.” —Michael Ginsberg

I’m a busy bee. Breakfast meeting, work, power lunch, work, afternoon coffee, work, dinner at the latest-greatest, then more work.

Yet, there is more that I would like to do—and own.

A stock gives the common woman a chance to own a piece of a company, without the daily grind of meetings and emails. Hallelujah!

Warning: Sleazeballs sometimes offer the ability to buy even more stocks by borrowing money. Leverage is lame. Don’t take the sleazeball up on his seemingly-irresistible offer.

Instead, I view stocks as a valuable investment. As a little black dress that I’ll wear for years to come, receiving a flow of compliments. And when I sell this piece of my closet’s capital stock for more than I bought it because it’s Yves Saint Laurent–not Saint Laurent Paris– I’ll have capital gains on my hands.I was disappointed to learn that bonds are not redeemable to meet James Bond.

Instead, Uncle Sam needs me to spot him some $$. A bond is a more official version of spotting $$.

I’ll get my $$ back when the bond matures. Hmm…but James never seems to!

A bond’s coming of age story includes semi-annual coupon interest payments until Uncle Sam returns my $$.

Companies also sell bonds. Corporate bonds are generally riskier than government bonds. A company cannot directly control its revenue and cash flow like a government can (by raising taxes, for example).

If the American Government is unable to pay me back, most likely we will have bigger problems on our hands (à la alien invasion). A space helmet could be a fun new accessory though!

Investment Vehicles pt. 2

I want to enter the stock market.  But, I don’t have the $$ it takes to do it sensibly.

There’s no way little me could buy all the stocks necessary to have a fully diversified investment portfolio.  My mutual friends at my mutual fund make it possible.Once I buy a share of a mutual fund, I get a piece of the pie. The pie filling has endless possibilities!

The mutual fund pools the membership’s $$ and invests according to its objectives, which can range from– but are not limited to–investing in bonds or a stock market’s index.  Regardless, I wait and reap the rewards—dividends and capital gains!

Watch out, mutual funds–as with all investment vehicles— are not created equal.  Before investing, it is a must to research the vehicle I’m investing in. Even more importantly, I continue to read up on how my investment is progressing, because it’s value can go up and down.

My rule is 5 minutes of gossip blog time, per 10 minutes of investment news time,  so I’m up-to-date whether my bestie tweets me “OMG! Did you see…” or I receive a call from my financial advisor, asking “How would you like to proceed…”

Present Value of a Bond

I’ll get bitten by a bond when the economy is bullish and interest rates rise accordingly. A bond’s worth is best explained in terms of present value. Warning: math ahead.

Even though the $$ loaned will not be mine for awhile, I want to know how much it’s worth NOW.

I need to divide the bond’s payoff by (1+ the interest rate).

Sorry, but it’s easier to rationalize with fractions. 2/4 is larger than 2/5.

Accordingly, when interest rates rise the current value of bonds lowers. AKA 1000/1.05 is larger than 1000/1.1.

That one looked painful, so I plugged it into a calc.

My savings account cannot wait for the interest rates to skyrocket. But bond-buyers beware!

Diversifiable vs. Non-diversifiable Risk

I love when winter turns to spring. Not because I want the weather to change, I’m a snow bunny. I want winter coats & jackets to go on sale!

I’ve gotten great deals (read: steals) on fabulously colorful wool coats that only I would wear. But every year, the camel hair coat I aspire to own is never marked down more than 10%.

When will my sale-ship come in? Approximately never, I’ve learned.

The likelihood of an item having a major markdown is equivalent to beta in stock market land.

A share’s beta is large if it is sensitive to market movements. Ex. Trendy investments will be at rock bottom prices when the trend comes to an end.

Beta is small for stocks that weather a stock market’s storm.

Now if it is unseasonably warm, all the coats, classic and trendy, will be marked down. This is equivalent to alpha in stock market land.

The Capital Asset Pricing Model takes into account the alpha and beta of each stock and price accordingly. When talking with the financier who just bought us drinks, pepper our prose with CAPM, alpha, beta & price and he’ll be sure to ask for our phone #s.